Capital Gains Tax Gap
Requiring Brokers to Report Securities Cost Basis Would Improve Compliance if Related Challenges Are Addressed Gao ID: GAO-06-603 June 13, 2006For tax year 2001, the Internal Revenue Service (IRS) estimated a tax gap of at least $11 billion from individual taxpayers misreporting income from capital assets (generally those owned for investment or personal purposes). IRS did not estimate the portion of this gap from securities (e.g., stocks, bonds, and mutual fund capital gains distributions). GAO was asked for information on (1) the extent and types of noncompliance for individual taxpayers that misreport securities capital gains, (2) actions IRS takes to reduce the securities tax gap, and (3) options with the potential to improve taxpayer voluntary compliance and IRS's ability to address noncompliant taxpayers. For estimates of noncompliance, GAO analyzed a probability sample of examination cases for tax year 2001 from the most recent IRS study of individual tax compliance.
GAO estimates that 38 percent of individual taxpayers with securities transactions misreported their capital gains or losses in tax year 2001. A greater estimated percentage of taxpayers misreported gains or losses from securities sales (36 percent) than capital gain distributions from mutual funds (13 percent). This may be because taxpayers must determine the taxable portion of securities sales' income whereas they need only add up their capital gain distributions. Among individual taxpayers who misreported securities sales, roughly two-thirds underreported and roughly one-third overreported. Furthermore, about half of these taxpayers who misreported failed to accurately report the securities' cost, or basis, sometimes because they did not know the basis or failed to adjust the basis appropriately. IRS attempts to reduce the securities' tax gap through enforcement and taxpayer service programs, but challenges limit their impact. Through enforcement programs, IRS contacts taxpayers who may have misreported capital gains or losses and seeks to secure the correct tax amount. IRS also offers services to help taxpayers comply with capital gains tax obligations, such as guidance on how to determine securities' gains and losses. Challenges that limit these programs' impact include the lack of information on basis, which IRS needs to verify most gains and losses, and uncertainty as to whether taxpayers use or understand the guidance. Expanding the information brokers report on securities sales to include adjusted cost basis has the potential to improve taxpayers' compliance and help IRS find noncompliant taxpayers. IRS research shows that taxpayers report their income much more accurately when it is reported to them and IRS. Basis reporting also would reduce taxpayers' burden. For IRS, basis reporting would provide information to verify securities gains or losses and to better target enforcement resources on noncompliant taxpayers. However, basis reporting would raise challenges that would need to be addressed. For instance, brokers would incur costs and burdens--even as taxpayers' costs and burdens decrease somewhat--and many issues would arise about how to calculate adjusted basis, which securities would be covered, and how information would be transferred among brokers. However, industry representatives said that many brokers already provide some basis information to many of their clients and some use an existing system to track and transfer basis and other information about securities. Many of the challenges to implementing basis reporting also could be mitigated. For example, many of the challenges could be addressed by only requiring adjusted basis reporting for future purchases, and by developing consistent rules to be used by all brokers. To the extent that actions to mitigate the challenges to basis reporting delay its implementation or limit coverage to only certain types of securities, the resulting improvements to taxpayers' voluntary reporting compliance would be somewhat constrained.
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Report to the Committee on Finance, U.S. Senate:
June 2006:
Capital Gains Tax Gap:
Requiring Brokers to Report Securities Cost Basis Would Improve
Compliance if Related Challenges Are Addressed:
GAO-06-603:
GAO Highlights:
Highlights of GAO-06-603, a report to the Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
For tax year 2001, the Internal Revenue Service (IRS) estimated a tax
gap of at least $11 billion from individual taxpayers misreporting
income from capital assets (generally those owned for investment or
personal purposes). IRS did not estimate the portion of this gap from
securities (e.g., stocks, bonds, and mutual fund capital gains
distributions).
GAO was asked for information on (1) the extent and types of
noncompliance for individual taxpayers that misreport securities
capital gains, (2) actions IRS takes to reduce the securities tax gap,
and (3) options with the potential to improve taxpayer voluntary
compliance and IRS‘s ability to address noncompliant taxpayers. For
estimates of noncompliance, GAO analyzed a probability sample of
examination cases for tax year 2001 from the most recent IRS study of
individual tax compliance.
What GAO Found:
GAO estimates that 38 percent of individual taxpayers with securities
transactions misreported their capital gains or losses in tax year
2001. A greater estimated percentage of taxpayers misreported gains or
losses from securities sales (36 percent) than capital gain
distributions from mutual funds (13 percent). This may be because
taxpayers must determine the taxable portion of securities sales‘
income whereas they need only add up their capital gain distributions.
Among individual taxpayers who misreported securities sales, roughly
two-thirds underreported and roughly one-third overreported.
Furthermore, about half of these taxpayers who misreported failed to
accurately report the securities‘ cost, or basis, sometimes because
they did not know the basis or failed to adjust the basis
appropriately.
IRS attempts to reduce the securities‘ tax gap through enforcement and
taxpayer service programs, but challenges limit their impact. Through
enforcement programs, IRS contacts taxpayers who may have misreported
capital gains or losses and seeks to secure the correct tax amount. IRS
also offers services to help taxpayers comply with capital gains tax
obligations, such as guidance on how to determine securities‘ gains and
losses. Challenges that limit these programs‘ impact include the lack
of information on basis, which IRS needs to verify most gains and
losses, and uncertainty as to whether taxpayers use or understand the
guidance.
Expanding the information brokers report on securities sales to include
adjusted cost basis has the potential to improve taxpayers‘ compliance
and help IRS find noncompliant taxpayers. IRS research shows that
taxpayers report their income much more accurately when it is reported
to them and IRS. Basis reporting also would reduce taxpayers‘ burden.
For IRS, basis reporting would provide information to verify securities
gains or losses and to better target enforcement resources on
noncompliant taxpayers. However, basis reporting would raise challenges
that would need to be addressed. For instance, brokers would incur
costs and burdens”even as taxpayers‘ costs and burdens decrease
somewhat”and many issues would arise about how to calculate adjusted
basis, which securities would be covered, and how information would be
transferred among brokers. However, industry representatives said that
many brokers already provide some basis information to many of their
clients and some use an existing system to track and transfer basis and
other information about securities. Many of the challenges to
implementing basis reporting also could be mitigated. For example, many
of the challenges could be addressed by only requiring adjusted basis
reporting for future purchases, and by developing consistent rules to
be used by all brokers. To the extent that actions to mitigate the
challenges to basis reporting delay its implementation or limit
coverage to only certain types of securities, the resulting
improvements to taxpayers‘ voluntary reporting compliance would be
somewhat constrained.
What GAO Recommends:
To reduce securities capital gains noncompliance, GAO suggests that
Congress consider requiring brokers to report adjusted basis to
taxpayers and IRS and requiring IRS to work with the industry to
develop cost effective ways to mitigate reporting challenges. GAO also
recommends that IRS clarify its guidance on reporting capital gains and
losses.
In commenting on a draft of this report, IRS agreed with our
recommendations.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-603].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Michael Brostek at 202-
512-9110 or brostekm@gao.gov.
[End of Section]
Contents:
Letter:
Results in Brief:
Background:
Individual Taxpayers Frequently Misreported Their Capital Gains or
Losses from Securities Sales, Often Because They Misreported the
Securities' Basis:
IRS Attempts to Reduce the Individual Capital Gains Tax Gap for
Securities through Enforcement and Taxpayer Service Programs, but
Various Challenges Limit Their Impact:
Reporting of Cost Basis Could Reduce the Individual Capital Gains Tax
Gap for Securities, but Implementation Challenges Would Need to Be
Addressed:
Conclusion:
Matters for Congressional Consideration:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Scope and Methodology:
Appendix II: Comments from the Internal Revenue Service:
Appendix III: GAO Contact and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: Estimated Percentage of Individual Taxpayers with Securities
Transactions Who Misreported the Gain or Loss from One or More
Transaction, Tax Year 2001:
Table 2: Distribution of the Estimated Amount of Net Misreported
Capital Gains Income From Securities Sales by Misreporting Taxpayers,
Tax Year 2001:
Table 3: Estimated Distribution of Individual Taxpayers Who Misreported
Capital Gains or Losses from Securities Transactions and All Individual
Taxpayers by Adjusted Gross Income, Tax Year 2001:
Table 4: Estimated Frequency of Types of Noncompliance That Caused
Individual Taxpayers to Misreport Capital Gains or Losses from
Securities Sales, Tax Year 2001:
Table 5: IRS Enforcement Programs and Types of Securities Capital Gains
Tax Noncompliance They Can Detect:
Table 6: IRS Enforcement and Taxpayer Service Programs and Their
Principle Limitations on Reducing the Individual Capital Gains Tax Gap
for Securities:
Table 7: Challenges to Brokers Associated with Basis Reporting and How
the Challenges Could Be Mitigated:
Table 8: Challenges to IRS Associated with Basis Reporting and How the
Challenges Could Be Mitigated:
Figures:
Figure 1: Example of How Failure to Adjust Basis Can Lead to
Misreporting a Capital Gain or Loss from a Securities Transaction:
Figure 2: Individual Net Income Misreporting Categorized by the Extent
of Income Subject to Information Reporting, Tax Year 2001:
Letter:
June 13, 2006:
The Honorable Charles Grassley:
Chairman:
The Honorable Max Baucus:
Ranking Minority Member:
Committee on Finance:
United States Senate:
Every year, a gap arises between the tax amount that taxpayers pay
voluntarily and on time and the amount they should pay under the law.
For tax year 2001, the Internal Revenue Service (IRS) estimated a gross
tax gap of $345 billion.[Footnote 1] IRS estimated that it would
eventually recover $55 billion of the gross tax gap through late
payments and IRS enforcement efforts, leaving a net tax gap of $290
billion.[Footnote 2] The tax gap arises when taxpayers fail to comply
with the tax laws, whether intentionally or unintentionally. Because of
their noncompliance, the burden of funding the nation's commitments
falls more heavily on taxpayers who voluntarily and accurately pay
their taxes. In light of the size of the tax gap and the nation's
budget deficit, Congress has held several hearings seeking to identify
how the gap can be reduced. Given its size, even small or moderate
reductions in the net tax gap could yield substantial returns.
One type of noncompliance that contributes to the tax gap occurs when
individual taxpayers do not accurately report gains or losses from
transactions involving capital assets, which generally refers to
property owned for investment or personal purposes, on their tax
returns. Taxpayers generally determine their capital gains or losses by
subtracting the basis, which is generally the price they paid for an
asset, from the gross amount of proceeds they received from its sale.
IRS estimated that for 2001, individual taxpayers' failure to
accurately report their capital gains income accounted for at least $11
billion of the gross tax gap for that year.[Footnote 3] This amount is
due to taxpayers understating their capital gains or overstating their
capital losses, both of which reduced the amount of taxable income they
reported. Although IRS has not estimated the amount of the capital
gains tax gap attributed to specific types of capital assets, it has
estimated that in recent years, securities transactions have accounted
for the majority of individuals' capital gains and losses.[Footnote 4]
Securities transactions include the sale of securities--stocks, mutual
funds, bonds, and options--and capital gain distributions from mutual
funds.[Footnote 5] Securities transactions may be executed through
third parties, such as brokers.
To address your long-standing concerns about the tax gap, and
particular concern about the tax gap from individual capital gains tax
noncompliance for securities, this report responds to your request for
information on (1) the extent of and primary types of noncompliance
that cause individual taxpayers to misreport capital gains from
securities, (2) actions IRS takes in attempting to reduce the
individual capital gains tax gap for securities and any challenges that
IRS faces with these actions, and (3) options with the potential to
improve taxpayers' voluntary compliance for reporting securities gains
and losses and IRS's ability to find noncompliance related to the
individual capital gains tax gap for securities.
To provide information on the extent of and primary types of
noncompliance that cause individual taxpayers to misreport capital
gains from securities, we reviewed a probability sample of case files
selected from the nearly 46,000 randomly selected individual tax
returns from tax year 2001 that IRS reviewed or examined through the
National Research Program (NRP), IRS's most recent study of individual
taxpayer compliance. We used the results of our case file review along
with data from IRS's examinations of the tax returns from NRP to make
estimates for the entire population of individual taxpayers. We present
information on the extent of noncompliance by estimating the percent of
noncompliant taxpayers. We did not estimate the portion of the capital
gains tax gap specific to securities. We could not provide a meaningful
estimate of the tax gap for securities because (1) of the 1,017 cases
in our sample, we only received 849 complete cases by the time we
completed our review, (2) the cases we received included too few
taxpayers who misreported securities transactions (when selecting our
sample, we could not determine which cases included misreported gains
and losses from securities as compared to other types of capital
assets), and (3) taxpayers misreported a wide range of dollar amounts
from the transactions. Since our estimates are based on a sample, we
express our confidence in our estimates as a 95 percent confidence
interval, plus or minus the margin of error indicated along with each
estimate in the report, which is the interval that would contain the
actual population value for 95 percent of the samples we could have
selected. To address the question of what actions IRS takes in
attempting to reduce the individual capital gains tax gap for
securities and related challenges, we reviewed documents from IRS's
enforcement programs and IRS publications that address capital gains.
We also interviewed IRS officials knowledgeable about the subject. To
identify options with the potential to improve taxpayers' voluntary
compliance for reporting securities gains and losses and IRS's ability
to find noncompliance related to the individual capital gains tax gap
for securities, we reviewed our prior reports, documents from IRS's
enforcement programs, IRS publications that address capital gains, and
industry reports on securities holdings and information
reporting.[Footnote 6] We also spoke with IRS officials and
representatives related to the securities industry. For further
discussion of our scope and methodology, see appendix I. We conducted
our review from June 2005 through May 2006 in accordance with generally
accepted government auditing standards.
Results in Brief:
For tax year 2001, an estimated 38 percent of individual taxpayers who
had securities transactions failed to accurately report their capital
gains or losses from the transactions (8.4 million out of 21.9 million
taxpayers), often because they misreported the securities' cost basis.
A greater percentage of taxpayers are estimated to have misreported
gains or losses from their securities sales (36 percent) than
misreported their capital gain distributions from mutual funds (13
percent). One reason for this difference could be because taxpayers
must determine what portion of income from securities sales is taxable
whereas taxpayers need only add up their capital gain distributions and
enter the amounts on their tax returns. We were not able to determine
the total amount of capital gains income from securities that taxpayers
misreported or the securities tax gap because the cases we reviewed
included too few misreported securities transactions and we did not
receive other cases in time to include them in our review. However, we
found that around half of taxpayers who did not accurately report their
securities sales were estimated to have misreported at least $1,000 of
capital gains or losses. Also, around half of the taxpayers who
misreported their gains or losses from securities sales did so because
they failed to accurately report the securities' basis, sometimes
because they did not know the securities' basis or failed to take
certain events into account that required them to adjust the basis of
their securities. Additionally, around 9 percent of taxpayers with
securities sales misreported whether their gains or losses were short-
term or long-term.
IRS attempts to reduce the individual capital gains tax gap for
securities through enforcement and taxpayer service programs; however,
various challenges limit the impact these programs have on reducing
this tax gap. IRS uses enforcement programs to contact selected
taxpayers it believes may have inaccurately reported capital gains or
losses. IRS's automated enforcement programs largely rely on matching
tax returns filed by taxpayers to information returns provided by
brokers that report taxpayers' gross proceeds from securities sales.
IRS also examines tax returns by reviewing taxpayers' records of their
securities transactions. Additionally, IRS offers various taxpayer
services intended to help taxpayers comply with capital gains tax
obligations, such as publications describing how to determine tax
liabilities from selling securities. The challenges that limit the
impact these programs have on reducing the tax gap for securities
include the relatively small portion of taxpayers with securities
transactions that IRS contacts through its enforcement programs and the
lack of information on the basis of securities sold, which IRS needs to
verify most gains or losses, and the difficulty in communicating
capital gains tax reporting requirements. Although IRS assesses
additional taxes through its enforcement programs, neither IRS nor we
know the extent to which these assessments reduced the 2001 capital
gains tax gap for securities, in part because the gap itself is not
known.
Expanding information reporting on securities sales to include cost
basis has potential to improve taxpayers' voluntary compliance and help
IRS find noncompliance related to the capital gains tax gap for
securities. On one hand, some of this potential exists if IRS were to
change its enforcement and taxpayer service programs, such as by
examining more tax returns or enhancing guidance related to securities
gains or losses. However, examinations can be costly, and taxpayers may
not know about or use the guidance. On the other hand, basis reporting
to taxpayers and IRS would help taxpayers to voluntarily comply and
would reduce their burden in computing capital gains or losses. IRS
research has repeatedly shown that taxpayers' compliance is strongly
related to the extent to which their income is subject to information
reporting. Basis reporting also would provide information to help IRS
verify securities gains or losses and target enforcement resources to
noncompliant taxpayers. However, such basis reporting would raise
challenges and trade-offs. Many of the challenges can be mitigated to
some extent. For example, tracking and reporting basis would increase
brokers' costs, but decisions about the scope and details of the
reporting could constrain the increase. Further, taxpayers' costs would
be reduced, and many brokers already provide some form of basis
information to taxpayers. The challenges arising when brokers do not
know the basis for securities purchased in the past could be mitigated
by only reporting basis for future purchases, which would somewhat
delay the full impact that basis reporting would have on reducing the
capital gains tax gap. Although IRS has broad authority to require
information reporting for securities sales, it may not have the
authority to require all of the actions that would be needed to
implement cost basis information reporting.
This report includes matters Congress may want to consider to reduce
the capital gains tax gap for securities. Specifically, Congress could
require brokers to report to both taxpayers and IRS the adjusted basis
of securities that taxpayers sell and whether the gains or losses were
short-or long-term, and direct IRS to work with brokers and related
parties to develop rules that seek to cost effectively mitigate some of
the challenges associated with requiring basis reporting. We are also
making recommendations to IRS on clarifying guidance related to
reporting capital gains and losses. In commenting on a draft of this
report, the Commissioner of Internal Revenue agreed with our
recommendations.
Background:
Individual taxpayers generally realize gains or losses when they sell
capital assets, which are generally defined as properties owned for
investment or personal purposes and outside the normal course of a
taxpayer's trade or business. In recent years, IRS studies show that
the majority of capital asset transactions and capital gains and losses
were for securities transactions, including sales of corporate stock,
mutual funds, bonds, options,[Footnote 7] and capital gain
distributions from mutual funds.[Footnote 8] For example, in 1999, the
latest year for which IRS published data on capital assets sales, an
estimated 91 percent of capital asset transactions, 62 percent of
capital gains, and 79 percent of capital losses were from securities
transactions.[Footnote 9] Also, over the past two decades, individual
ownership of securities assets held outside of retirement accounts has
increased.[Footnote 10] According to the Federal Reserve Board, the
percentage of families that own stock, mutual funds, and bonds outside
of retirement accounts increased from 25 percent in 1983 to a high of
42 percent in 2001, before falling to 38 percent in 2004.[Footnote 11]
When taxpayers sell or otherwise receive income from securities, they
must report the transactions on their federal income tax returns. For
securities sales, taxpayers are to report the dates they acquired and
sold the asset; sales price, or gross proceeds from the sale; cost or
other basis of the sold asset; and resulting gains or losses on
Schedule D to the individual tax return--Form 1040. Taxpayers are to
report this information separately for short-term transactions and long-
term transactions. Taxpayers also are to report the total amount of
their capital gain distributions from mutual funds, which are always
considered to be long-term transactions. Taxpayers are to report their
overall gains or losses from securities sales, capital gain
distributions, and other capital gains on the Form 1040 tax return
itself.
Generally, a taxpayer's gain or loss from a securities sale is simply
the difference between the gross proceeds from the sale and the
original purchase price, or original cost basis.[Footnote 12] However,
before taxpayers can determine any gains or losses from securities
sales, they must determine if and how the original cost basis of the
securities must be adjusted to reflect certain events, such as stock
splits, nontaxable dividends, or nondividend distributions. For
example, figure 1 shows how a taxpayer would need to adjust the basis
of a stock following a stock split to accurately determine the
resulting capital gain or loss when the stock is sold. In this example,
if the taxpayer fails to properly adjust the basis of the stock to
account for the split, he or she will incorrectly report a capital loss
from the sale.
Figure 1: Example of How Failure to Adjust Basis Can Lead to
Misreporting a Capital Gain or Loss from a Securities Transaction:
[See PDF for image]
[End of figure]
Taxpayers who buy and sell the same stock or mutual fund shares at
various times can determine basis in a number of ways. Taxpayers can
specifically identify the groups of shares they want to sell. For
example, if a taxpayer buys a group of 10 shares of stock in one year
for $1 per share and another group of 10 shares of the same stock in
the next year for $2 per share, and then sells 10 shares of the stock,
the taxpayer can choose to sell the stocks with either the $1 or $2
cost basis.[Footnote 13] If taxpayers cannot identify which shares they
sold among many they bought on varying occasions, they must report the
basis of the securities they purchased first as the basis of the sold
shares. Except for mutual fund shares, taxpayers cannot use the average
cost of securities they purchased at various times to determine basis.
When taxpayers sell securities through a broker, that broker is
required to file Form 1099-B with IRS and the taxpayers to report a
description of the security, sales date, number of shares sold, and
gross proceeds from the sale, along with other information.[Footnote
14] Brokers are not required to report the cost or other basis of the
sold security or, with the exception of regulated futures contracts,
the resulting gain or loss from a security sale. Capital gain
distributions from mutual funds are to be reported on Form 1099-
DIV.[Footnote 15]
The rate at which income from securities is taxed depends on how long
taxpayers held a security before sale and taxpayers' regular income tax
rates. Securities assets sold after being held for 1 year or less are
considered short-term and taxed at the taxpayers' regular income tax
rates. Assets sold after being held for more than 1 year are considered
to be long-term and are generally taxed at maximum rates of 5 percent
or 15 percent, depending on the taxpayer's regular income tax
rates.[Footnote 16] Capital gain distributions from mutual funds are
always taxed as long-term gains. Taxpayers can deduct capital losses
against their capital gains, and any excess losses can be deducted
against ordinary income up to a limit of $3,000 ($1,500 for married
taxpayers filing separately), beyond which the losses can be carried
over to offset capital gains or ordinary income in future tax years.
Individual Taxpayers Frequently Misreported Their Capital Gains or
Losses from Securities Sales, Often Because They Misreported the
Securities' Basis:
Thirty-eight percent of individual taxpayers who had securities
transactions misreported their securities gains or losses for tax year
2001. A greater percentage of taxpayers misreported their securities
sales (36 percent) than misreported their capital gain distributions
(13 percent), and most of the misreported securities transactions
exceeded $1,000 of capital gain or loss. Taxpayers often misreported
their capital gains or losses from securities sales because they failed
to accurately report the securities' basis.
Individual Taxpayers Frequently Misreported Their Capital Gains or
Losses from Securities Sales:
For tax year 2001, individual taxpayers frequently misreported their
capital gains or losses from the securities they sold. Overall, an
estimated 8.4 million of the estimated 21.9 million taxpayers with
securities transactions misreported their gains or losses.[Footnote 17]
Table 1 shows the estimated percentages of taxpayers who misreported
their securities sales and capital gain distributions, overall and by
the securities' holding period.
Table 1: Estimated Percentage of Individual Taxpayers with Securities
Transactions Who Misreported the Gain or Loss from One or More
Transaction, Tax Year 2001:
Type of transaction: Securities sales;
Estimated percentage of taxpayers who misreported their transactions:
Short-term transactions: 28;
Estimated percentage of taxpayers who misreported their transactions:
Long-term transactions: 31;
Estimated percentage of taxpayers who misreported their transactions:
All transactions[A]: 36.
Type of transaction: Capital gain distributions;
Estimated percentage of taxpayers who misreported their transactions:
Short-term transactions: N/A[B];
Estimated percentage of taxpayers who misreported their transactions:
Long-term transactions: 13;
Estimated percentage of taxpayers who misreported their transactions:
All transactions[A]: 13.
Type of transaction: All securities[C];
Estimated percentage of taxpayers who misreported their transactions:
Short-term transactions: 28;
Estimated percentage of taxpayers who misreported their transactions:
Long-term transactions: 32;
Estimated percentage of taxpayers who misreported their transactions:
All transactions[A]: 38.
Source: GAO analysis of IRS data and examination case files.
Note: Percentage estimates have sampling errors of (+/-) 7 percent or
less.
[A] For securities sales, "all transactions" includes those for which
we could not determine whether the holding period was short-term or
long-term.
[B] Capital gain distributions are always considered long-term
transactions.
[C] "All securities" includes taxpayers who misreported both securities
sales and capital gain distributions.
[End of table]
Table 1 shows that a higher estimated percentage of taxpayers
misreported a securities sale than a capital gains distribution.
Overall, an estimated 7.3 million out of an estimated 20.3 million
taxpayers misreported their securities sales compared to the estimated
1.2 million out of an estimated 9.1 million taxpayers who misreported
their capital gain distributions.[Footnote 18] One reason taxpayers may
misreport securities sales more frequently is that taxpayers must
compute the portion of their sales proceeds that constitutes a gain or
loss, whereas taxpayers need only add up their capital gain
distributions from information returns they receive and enter the
amounts on their tax returns. Table 1 also shows that individual
taxpayers are estimated to have misreported their short-term securities
sales about as often as their long-term sales. In addition, our
analyses showed the following:
* Of those taxpayers who misreported securities sales, an estimated 97
percent misreported gains or losses from the sales of stocks and mutual
funds while an estimated 5 percent misreported bonds, options, or
futures.[Footnote 19]
* Individual taxpayers misreported securities sales more frequently
than other types of income, such as wages and salary, dividend income,
and interest income. Respectively, an estimated 10 percent, 17 percent,
and 22 percent of taxpayers with these types of income misreported the
income.[Footnote 20]
We were not able to estimate the capital gains tax gap for securities
because the cases we reviewed included too few misreported securities
transactions and taxpayers misreported a wide range of dollar amounts
from the transactions, among other reasons (see app. I). However, we
were able to determine the direction of the misreporting. For
securities sales, an estimated 64 percent of taxpayers underreported
their income from securities (i.e., they understated gains or
overstated losses) compared to an estimated 33 percent of taxpayers who
overreported income (i.e., they overstated gains or understated
losses).[Footnote 21] For both underreported and overreported income,
some taxpayers misreported over $400,000 in gains or losses. Also, as
shown in table 2, around half of taxpayers who did not accurately
report their securities sales were estimated to have misreported at
least $1,000 of capital gains or losses (that is, taxpayers not in the
less than $1,000 categories).[Footnote 22]
Table 2: Distribution of the Estimated Amount of Net Misreported
Capital Gains Income From Securities Sales by Misreporting Taxpayers,
Tax Year 2001:
Net misreported amount: Overreporting taxpayers;
Net misreported amount: Less than $1,000[A];
Percentage of misreporting taxpayers: 19%.
Net misreported amount: $1,000 to $9,999;
Percentage of misreporting taxpayers: 15%.
Net misreported amount: $10,000 and greater;
Percentage of misreporting taxpayers: 5%.
Net misreported amount: Underreporting taxpayers;
Net misreported amount: Less than $1,000;
Percentage of misreporting taxpayers: 27%.
Net misreported amount: $1,000 to $9,999;
Percentage of misreporting taxpayers: 19%.
Net misreported amount: $10,000 and greater;
Percentage of misreporting taxpayers: 14%.
Source: GAO analysis of IRS data and examination case files.
Notes: Percentage figures do not sum to 100 because of rounding.
Percentage estimates have sampling errors of (+/-) 8 percent or less.
[A] Category includes taxpayers that misreported securities sales in a
way that had no effect on the gain or loss from the sales.
[End of table]
In terms of income levels, the distribution of taxpayers who
misreported gains or losses from securities sales and capital gain
distributions did not vary greatly from the income level for all
individual taxpayers for tax year 2001, as shown in table 3.
Table 3: Estimated Distribution of Individual Taxpayers Who Misreported
Capital Gains or Losses from Securities Transactions and All Individual
Taxpayers by Adjusted Gross Income, Tax Year 2001:
Adjusted gross income: Less than $25,000;
Percentage of misreporting taxpayers: 51%;
Percentage of all individual taxpayers: 46%.
Adjusted gross income: $25,000 to $49,999;
Percentage of misreporting taxpayers: 20%;
Percentage of all individual taxpayers: 25%.
Adjusted gross income: $50,000 to $99,999;
Percentage of misreporting taxpayers: 20%;
Percentage of all individual taxpayers: 20%.
Adjusted gross income: $100,000 or greater;
Percentage of misreporting taxpayers: 9%;
Percentage of all individual taxpayers: 9%.
Source: GAO analysis of IRS data and examination case files.
Notes: For misreporting taxpayers, estimates have sampling errors of
(+/-) 8 percent or less. For all individual taxpayers, estimates have
sampling errors of (+/-) 0.3 percent or less.
[End of table]
Misreported Basis Was a Primary Type of Noncompliance That Caused
Taxpayers to Inaccurately Report Their Capital Gains or Losses from
Securities Sales:
Based on information in the files we reviewed, a primary type of
noncompliance that caused taxpayers to inaccurately report their
capital gains or losses from securities sales in tax year 2001 was
misreporting the basis of the securities they sold. Table 4 shows the
estimated frequency of the types of noncompliance that caused taxpayers
to misreport capital gains or losses from their securities
sales.[Footnote 23]
Table 4: Estimated Frequency of Types of Noncompliance That Caused
Individual Taxpayers to Misreport Capital Gains or Losses from
Securities Sales, Tax Year 2001:
Type of noncompliance: Misreported basis of security sold;
Estimated percentage of misreporting taxpayers: 49%.
Type of noncompliance: Failed to report sale;
Estimated percentage of misreporting taxpayers: 44%.
Type of noncompliance: Misreported sale proceeds;
Estimated percentage of misreporting taxpayers: 12%.
Type of noncompliance: Misclassified holding period;
Estimated percentage of misreporting taxpayers: 9%.
Type of noncompliance: Other;
Estimated percentage of misreporting taxpayers: 9%.
Source: GAO analysis of IRS data and examination case files.
Notes: Estimates in this table do not include the results of our review
for four cases where we could not determine the type of noncompliance
that caused taxpayers to misreport securities sales. The "Other"
category includes taxpayers who misclassified capital income as other
types of income or vice versa or made mathematical errors. Some
taxpayers misreported more than one security sale or misreported a sale
because of more than one type of noncompliance. Percentage estimates
have sampling errors of (+/-) 9 percent or less.
[End of table]
For taxpayers who misreported basis, a greater percentage failed to
accurately report basis for long-term securities holdings (35 percent
of taxpayers who misreported securities sales) than for short-term
holdings (21 percent).[Footnote 24] Taxpayers who failed to report
securities sales altogether did not report short-term and long-term
securities sales at a similar rate (20 percent and 22 percent,
respectively, of taxpayers who misreported securities sales).[Footnote
25]
Although we were able to determine the percentage of taxpayers who
failed to accurately report their securities sales because they
misreported basis (49 percent), we could not develop reliable estimates
on the reasons for this type of misreporting because most of the NRP
examination case files did not provide sufficiently descriptive
information. However, of the 133 taxpayers who misreported basis from
the 849 case files we reviewed, we were able to determine that 32
taxpayers misreported basis for the following reasons:
* Taxpayers did not have records of their securities purchases (16
taxpayers). Although during examinations, IRS was able to obtain basis
records for some of these taxpayers from their brokers, for 9
taxpayers, basis records could not be obtained. For these taxpayers,
IRS examiners considered basis to be zero and treated all gross
proceeds amounts as capital gains.
* Taxpayers used original cost basis instead of adjusted cost basis (6
taxpayers).
* Taxpayers did not understand how to determine basis (5 taxpayers).
* Taxpayers reported basis information that was incorrectly determined
by a tax return preparer (4 taxpayers).[Footnote 26]
* One taxpayer reported inaccurate basis information provided by a
broker.
Of taxpayers who failed to report their securities sales altogether, an
estimated 28 percent were estimated to have failed to report capital
losses.[Footnote 27] By not reporting losses, these taxpayers
potentially failed to offset other capital gains or deduct their losses
against other types of income they reported. Likewise, some of these
taxpayers who failed to report capital losses exceeding $3,000 did not
carry over these losses to offset capital gains or other income in
future tax years. Although in most cases we could not determine why
taxpayers did not report these losses, some taxpayers told IRS
examiners that they did not know they had to report losses. In
addition, IRS officials said some taxpayers might not report their
capital losses because they worry that their returns will be examined
if they overstate their losses. Also, the officials told us that
taxpayers might want to avoid the burden of filing a Schedule D or the
cost of paying someone to prepare their returns in cases where filing
Schedule D would make the difference between self preparing and using a
paid preparer.
As also shown in table 4, taxpayers failed to accurately report their
securities sales because they misreported the amount of their sale
proceeds (12 percent) or misclassified the securities' holding period
(9 percent). However, the case files did not contain enough information
to explain why taxpayers made these errors. Also, the responsible
officials we interviewed at IRS could not provide explanations for why
taxpayers might have made these errors.
IRS Attempts to Reduce the Individual Capital Gains Tax Gap for
Securities through Enforcement and Taxpayer Service Programs, but
Various Challenges Limit Their Impact:
IRS uses both enforcement and taxpayer service programs in attempting
to reduce the individual capital gains tax gap for securities. IRS
checks the accuracy of tax returns through its enforcement programs and
contacts taxpayers who may have inaccurately reported their securities
gains or losses. IRS also offers service programs to provide taxpayers
with assistance in fulfilling their capital gains tax obligations.
However, these programs face challenges that limit their impact on
reducing the capital gains tax gap for securities. Although IRS
assesses additional taxes for securities income through its enforcement
efforts, neither IRS nor we know the extent to which these assessments
reduced the 2001 capital gains tax gap for securities.
IRS Attempts to Reduce the Individual Capital Gains Tax Gap for
Securities through Enforcement and Taxpayer Service Programs:
Consistent with its overarching philosophy that a combination of
enforcement and service efforts are essential to tax compliance, IRS
attempts to reduce the individual capital gains tax gap for securities
through its programs that enforce the tax laws and that seek to help
taxpayers voluntarily comply with the laws. IRS uses its enforcement
programs to check the accuracy of filed tax returns and contacts
taxpayers who have potentially made errors or inaccurately reported
capital gains:
information on their returns.[Footnote 28] Aspects of IRS's enforcement
programs related to capital gains income for securities appear in table
5.[Footnote 29]
Table 5: IRS Enforcement Programs and Types of Securities Capital Gains
Tax Noncompliance They Can Detect:
IRS program: Math Error;
Capable of detecting: Data reported inconsistently between Schedule D
and Form 1040.
IRS program: Automated Underreporter (AUR);
Capable of detecting: Inaccurately reported gross proceeds from
securities sales and capital gain distributions.
IRS program: Automated Substitute for Return (ASFR);
Capable of detecting: Taxpayers who received proceeds from securities
sales but did not file tax returns.
IRS program: Examination;
Capable of detecting: All forms of capital gains noncompliance for
securities.
Source: IRS.
[End of table]
Math Error, AUR, and ASFR are automated enforcement programs. IRS uses
the Math Error program to check filed tax returns for internal
inconsistencies or mathematical errors, and contacts taxpayers,
including when the errors result in a tax change. Through AUR, IRS
computers match the amounts of capital gains proceeds that taxpayers
report on their tax returns and that brokers report on information
returns. If this matching indicates that taxpayers may have
underreported their sale proceeds for securities and IRS cannot resolve
the discrepancies based on available information, IRS may send notices
asking taxpayers to explain the discrepancies or pay any taxes
assessed. When IRS determines through ASFR that taxpayers for whom IRS
received information returns on the sale proceeds for securities failed
to file tax returns, it may create tax returns for the taxpayers and
assess tax liabilities.
During examinations, IRS uses information from third parties as well as
from taxpayers to determine if taxpayers have accurately reported their
capital gains or losses.[Footnote 30] Examiners also may use other
resources, such as online services, to help them determine the basis of
taxpayers' securities. IRS assesses additional taxes if it determines
that taxpayers have underreported their capital gains income from
securities.
IRS's taxpayer service programs provide taxpayers with information,
support, and assistance to help them understand and fulfill their
capital gains tax obligations for securities. For example, IRS produces
publications that explain how to report capital gains or losses and
provide examples of how to determine adjusted basis.[Footnote 31] IRS
also provides Web-based information and telephone, written, or face-to-
face assistance at Taxpayer Assistance Centers on how to accurately
report capital gains and losses.
Various Challenges Limit the Impact IRS Programs Have on Reducing the
Individual Capital Gains Tax Gap for Securities:
IRS's enforcement and taxpayer service programs face limitations in
reducing the individual capital gains tax gap for securities. In
addition to resource constraints that limit how many cases of potential
noncompliance are pursued, table 6 summarizes the main limitations each
program faces.
Table 6: IRS Enforcement and Taxpayer Service Programs and Their
Principle Limitations on Reducing the Individual Capital Gains Tax Gap
for Securities:
IRS program: Math Error;
Principle limitations: Not intended to verify if taxpayers have
accurately reported their capital gains tax liabilities for securities.
IRS program: AUR;
Principle limitations: Lack of basis information from brokers prevents
AUR from verifying the accuracy of reported capital gains or losses
from securities sales.
IRS program: ASFR;
Principle limitations: Lack of basis information from brokers prevents
AFSR from accurately determining how much of taxpayers' gross proceeds
from securities sales is taxable.
IRS program: Examination;
Principle limitations: Capital gains are too complex and time consuming
to examine through correspondence;
Face-to- face examinations are resource intensive and cover a small
percentage of taxpayers with capital gains.
IRS program: Taxpayer services;
Principle limitations: Taxpayers may not use the services;
Taxpayers may not understand information IRS provides.
Source: IRS.
[End of table]
As table 6 shows, IRS cannot use its automated programs to fully verify
the reported capital gains or losses from securities sales because it
does not receive basis information from brokers. Also, according to IRS
officials, a lack of basis information reduces productivity because IRS
spends resources contacting taxpayers for whom it ultimately does not
assess additional taxes. For example, for tax year 2002, the latest
year for which IRS has complete data, IRS did not assess additional
taxes for around 46 percent of the taxpayers it contacted through AUR
to address potentially misreported securities sales.[Footnote 32] By
comparison, this "no tax change" percentage was around 20 percent for
AUR contacts for all other types of income for 2002.[Footnote 33] For
ASFR, IRS officials said that the lack of basis information hampers
IRS's ability to determine which taxpayers with gross proceeds from
securities sales should have filed tax returns and to productively
pursue those taxpayers who did not file.
Given that IRS does not receive basis information from brokers, it can
only verify the accuracy of the basis and gains and losses that
taxpayers report for their securities sales by examining these
individuals' tax returns. IRS does not examine these taxpayers' returns
through correspondence because it believes the returns are too
difficult and would take too much time to examine. IRS can only verify
the accuracy of the reported basis and gains and losses from securities
sales through face-to-face examinations. However, these examinations
are resource intensive and only cover a small percentage of individual
taxpayers. For example, in fiscal year 2004, IRS conducted
approximately 200,000 face-to-face examinations[Footnote 34] for the
130 million individual taxpayers that filed tax returns in 2003,
including the estimated 22.7 million taxpayers that filed a Schedule D
with their tax returns.[Footnote 35] Even when IRS selects individual
taxpayers to examine face-to-face, IRS often places a greater focus on
issues it believes are more productive than securities sales, such as
business income or the sale of personal or business real property,
according to an IRS official responsible for examination planning.
In providing taxpayer services, IRS faces challenges in communicating
information to taxpayers on complying with capital gains reporting
requirements. Taxpayers may not use the services IRS offers or may not
understand the information that IRS provides. For example, IRS recently
changed the instructions for filing Schedule D to include language that
specifies taxpayers must include the details of all their capital gains
transactions when filing their tax returns. Although IRS included this
language to clarify an existing reporting requirement, some taxpayers
and tax practitioners perceived that the instructions required
taxpayers to report each capital asset transaction on Schedule D itself
and not on attached brokerage statements, as otherwise allowed. This
misconception required IRS to clarify on its Web site that taxpayers
could continue to report the details of their transactions on attached
statements as long as all transactions were included and they reported
aggregate information on Schedule D.
The Extent to Which IRS Enforcement Programs Have Reduced the 2001
Capital Gains Tax Gap for Securities Is Not Known:
Through its enforcement programs, IRS assessed additional taxes for
taxpayers who misreported their securities gains and losses for tax
year 2001; however, neither IRS nor we know the extent to which these
assessments reduced the securities tax gap for that year. IRS has not
estimated the portion of the capital gains tax gap attributed to
securities for tax year 2001, and we were not able to estimate this
portion of the tax gap from our review of NRP case files. Likewise, IRS
does not have complete information on the amount of additional taxes it
assessed for taxpayers who underreported their income from securities
sales for 2001.
Through AUR for tax year 2001, IRS assessed around $190 million in
additional taxes for securities sales and around another $5 million for
capital gain distributions, and refunded over $8 million to taxpayers
who overreported securities income.[Footnote 36] For tax year 2001
examinations, IRS does not have complete data for the amount of taxes
it assessed for misreported capital gains or losses. IRS maintains a
database that tracks examination results by the type of issue examined,
such as capital gains or losses. However, prior to October 2004, the
database only captured examination results for around 60 percent of
individual examinations, according to IRS officials.[Footnote 37]As
such, the database does not include all capital gains noncompliance
that IRS identified in tax year 2001 examinations. Even when it
includes such noncompliance, the database does not distinguish between
misreported capital gains income from securities versus other capital
assets. Likewise, the database does not specify the portion of
additional tax assessments that is attributable to misreported capital
gains income versus other types of noncompliance.[Footnote 38] Finally,
IRS does not maintain data on additional taxes assessed and collected
because of capital gains noncompliance through the Math Error or ASFR
programs.
Reporting of Cost Basis Could Reduce the Individual Capital Gains Tax
Gap for Securities, but Implementation Challenges Would Need to Be
Addressed:
Expanded reporting of cost basis information has the potential to
reduce the individual capital gains tax gap for securities. Making
administrative changes to IRS's compliance programs that address
capital gains also has some potential to reduce the tax gap, but
enforcement programs can be resource intensive and taxpayers do not
always use IRS's taxpayer service programs. With such limitations,
these changes likely would not significantly boost taxpayers' voluntary
compliance involving securities sales. Information reporting of
adjusted cost basis to taxpayers and IRS would likely help reduce the
tax gap from securities sales by improving taxpayers' voluntary
compliance and IRS's ability to cost effectively address noncompliant
taxpayers. Consistent reporting of basis information would involve
challenges that would need to be, and to some extent can be, mitigated.
Increasing Examinations of Taxpayers with Securities Sales Could Reduce
That Portion of the Tax Gap but at the Expense of Not Covering Other
Areas of Noncompliance:
IRS could seek to reduce the capital gains tax gap for securities by
increasing examination coverage of taxpayers with gains or losses from
securities, either by considering them when selecting taxpayers to
examine through correspondence or by increasing face-to-face
examinations of these taxpayers. Conducting more of each type of
examination could increase the amount of taxes assessed for
misreporting securities income. However, absent an increase in
resources or access to basis information, which would help IRS better
target its resources toward truly noncompliant taxpayers, focusing on
taxpayers with securities gains or losses would divert IRS's
examination resources away from other productive areas of
noncompliance, according to IRS officials. An increased focus on
securities sales could reduce the capital gains tax gap, but a
diversion of resources could result in greater noncompliance for other
types of income. Moreover, although increasing examination coverage
could induce taxpayers who are misreporting willfully to voluntarily
comply, expanded coverage would not significantly affect voluntary
compliance for taxpayers who make mistakes while trying to comply, such
as taxpayers who made errors calculating basis, according to an IRS
research official who has studied the impact of enforcement on taxpayer
compliance.
Enhanced Taxpayer Services Might Improve Taxpayers' Voluntary
Compliance, but the Impact of Any Changes Would Be Hard to Gauge:
Addressing capital gains tax noncompliance for securities sales by
enhancing IRS's taxpayer service efforts might improve taxpayers'
voluntary compliance by helping them to better understand and fulfill
their capital gains tax obligations for securities. However, the
effects of any additional guidance that IRS might develop, for example
on reporting losses or on resources for determining basis, would be
tempered by challenges similar to those previously discussed, such as
taxpayers not using or understanding information IRS provides. Although
IRS attempts to generally ensure tax compliance through its service
efforts, IRS researchers have found it difficult to determine the
extent to which taxpayer services improve compliance among taxpayers
who want to comply. As such, it is hard to know if these improvements
to IRS's service efforts would have a substantial impact on taxpayer's
reporting compliance for securities sales.
Regardless, IRS's instructions for reporting capital gains and losses
and related guidance do not contain some information related to the
causes for taxpayers misreporting the basis of securities they sold or
failing to report sales at all--the leading types of noncompliance when
taxpayers erred in reporting capital gains and losses. In many cases,
we could not determine and IRS did not know exactly why taxpayers made
these errors. However, some taxpayers did not know they had to report
gains or losses and others did not understand how to determine basis.
One counterintuitive situation existed among the cases we reviewed,
that is some taxpayers did not report losses, which generally help them
by lowering their tax liabilities. IRS's instructions for filing
Schedule D direct taxpayers to report their capital gains or losses but
the instructions do not clarify the appropriate use of capital losses
to offset capital gains or other income. Further, although IRS provides
guidance on how to calculate basis for a variety of securities
transactions, the instructions to Schedule D do not contain guidance on
resources available to taxpayers and tax practitioners to determine
basis for securities. Some examples of resources taxpayers might use to
determine the basis of their securities holdings include brokers, tax
preparers, or Web sites for companies that issue stocks or other
information. Providing taxpayers more information on the benefits of
reporting losses and resources available to them on calculating basis
would be consistent with IRS's responsibility to ensure that taxpayers
pay the right amount of tax. Further, compared to other steps such as
enforcement actions, providing additional guidance to taxpayers would
be a low cost option to potentially increase their capital gains
reporting compliance. Finally, any improvement in taxpayers' compliance
due to better guidance would reduce IRS's enforcement expenses related
to capital gains.
Information Reporting of Adjusted Basis Could Reduce the Capital Gains
Tax Gap for Securities:
According to IRS officials and some representatives related to the
securities industry, taxpayers would likely report their gains or
losses from securities sales more accurately and at a reduced burden if
brokers consistently provided them with the adjusted basis of the
securities they sold. Likewise, basis reporting would allow IRS to
verify taxpayers' securities gains and losses through its automated
enforcement programs and take more efficient enforcement actions to
address noncompliant taxpayers, according to IRS compliance officials.
The likely increase in taxpayers' voluntary compliance and in the
productiveness of IRS enforcement actions resulting from basis
reporting would likely substantially reduce the capital gains tax gap
for securities.
Taxpayers would benefit from basis reporting because, in many cases,
they would not have to track and compute the adjusted basis of the
securities they sold. Therefore, basis reporting would likely reduce
the chance that taxpayers who had not been tracking their adjusted
basis would misreport it for securities they sold. Also, if taxpayers
received basis information from their brokers for the securities they
sold, they would enjoy a reduced burden in filing Schedule D with their
tax returns because, in many cases, they would not need to make basis
calculations on their own.
For taxpayers, the greater accuracy and reduced burden of reporting
basis that would result from basis reporting would likely improve their
voluntary compliance. As shown in figure 2, taxpayers tend to
accurately report income that third parties report on information
returns because the income is transparent to taxpayers as well as to
IRS. For example, individual taxpayers misreport nearly twice the
percentage of their income from sources subject only to some
information reporting, which is the case with income from securities
sales now, compared to income subject to substantial information
reporting, such as income from dividends and interest, and which would
be close to the case for securities sales if basis were consistently
reported, according to an IRS research official. Also, as discussed
previously, based on our file review, taxpayers were much less likely
to misreport capital gain distributions (13 percent), which are similar
to dividends and are subject to substantial information reporting,
compared to income from securities sales (36 percent), for which
information reporting only covers gross proceeds but not cost basis.
The smallest percentage of misreporting is for wage and salary income,
for which substantial information reporting exists and taxes are
withheld by taxpayers' employers.
Figure 2: Individual Net Income Misreporting Categorized by the Extent
of Income Subject to Information Reporting, Tax Year 2001:
[See PDF for image]
[End of figure]
Cost basis reporting would also benefit IRS, to the extent the
reporting was complete and accurate. IRS could use basis information to
verify securities gains and losses through its automated enforcement
programs and could more effectively allocate its enforcement resources
to focus on the most noncompliant taxpayers. For AUR and ASFR, IRS
officials told us that basis information would allow it to more
precisely determine taxpayers' income for securities sales and would
allow it to identify which taxpayers who misreported securities income
have the greatest potential for additional tax assessments. IRS's
examination program could similarly benefit. Specifically, IRS
officials told us that receiving cost basis information might enable
IRS to examine noncompliant taxpayers through correspondence because it
could productively select tax returns to examine. Also, having cost
basis information could help IRS identify the best cases to examine
face-to-face, making the examinations more productive while
simultaneously reducing the burden imposed on compliant taxpayers who
otherwise would be selected for examination. As a result of all these
benefits, basis reporting would allow IRS to better allocate its
resources that focus on securities misreporting across its enforcement
programs.
IRS has endorsed the concept of matching information returns to tax
returns for the purpose of identifying unreported income since the
1960s and Congress has created a number of statutes requiring
information reporting for various types of income or taxpayer
information.[Footnote 39] The related GAO products section at the end
of this report provides references to selected GAO reports related to
information reporting.
We previously discussed the notion of basis reporting to help reduce
capital gains tax noncompliance in our May 1994 report on the tax
gap.[Footnote 40] Also, based on discussions we had with officials from
IRS's Taxpayer Advocate Service when we initiated our review, the
National Taxpayer Advocate recommended that brokers be required to
track and report cost basis for stocks and mutual funds in her 2005
Annual Report to Congress.[Footnote 41] In March 2006 a bill was
introduced in the U.S. Senate and in April and May 2006 bills were
introduced in the House of Representatives that would require brokers
to report taxpayers' basis for their securities transactions.[Footnote
42]
Expanding Basis Reporting Involves Implementation Challenges That Would
Need to Be Addressed:
Expanding information reporting on securities sales to include basis
information would involve challenges for brokers and IRS. There are
various ways to mitigate each challenge. Tables 7 and 8 list some major
challenges for brokers and IRS, respectively, as well as some ways to
start mitigating the challenges. Discussion after the tables covers
some issues to consider when evaluating these mitigation strategies.
Table 7: Challenges to Brokers Associated with Basis Reporting and How
the Challenges Could Be Mitigated:
Challenges to brokers: Implementing systems to track and report basis
involves monetary costs;
Ways to mitigate challenges: * Although the following do not directly
mitigate costs for all brokers,; * Many brokers and mutual funds
already track and report basis to many taxpayers, which could help form
a foundation for expanded basis reporting; * Brokers could leverage
existing systems that track and report gross proceeds to taxpayers and
IRS; * Congress or IRS could provide an appropriate effective date that
would allow brokers that lack such systems to develop them.
Challenges to brokers: Brokers may not be able to determine basis for
some securities transactions because of complex tax laws;
Ways to mitigate challenges: * Brokers could report on those securities
transactions not affected by complex tax laws; * Tax laws on selling
securities could be simplified[A]; * Absent tax law changes, IRS could
develop consistent reporting rules in concert with those who report.
Challenges to brokers: Brokers may not know basis for securities
purchased through another broker;
Ways to mitigate challenges: * Brokers could use an existing system
that allows them to transfer basis information when taxpayers move
their securities holdings from one broker to another.
Challenges to brokers: Brokers may not know basis for securities
purchased through companies that directly issue stock (e.g., employee
stock purchase plans);
Ways to mitigate challenges: * Companies that directly issue stock
could track and report basis and use the basis transfer system.
Challenges to brokers: Brokers may not know basis for older securities;
Ways to mitigate challenges: * Brokers could track and report basis
prospectively (i.e., only for securities purchased after a particular
date).
Challenges to brokers: Brokers that do not know the basis may rely on
taxpayers to provide basis without any verification (e.g., for stocks
received as gifts);
Ways to mitigate challenges: * Prospective reporting would likely
produce fewer cases in which the broker does not know the basis; *
Brokers could indicate on the information return if the basis
information came from taxpayers.
Challenges to brokers: Brokers cannot always obtain timely adjusted
basis information from companies that issue stock and engage in
corporate events (e.g., mergers, acquisitions);
Ways to mitigate challenges: * These companies and the securities
industry in concert with IRS could develop a system to timely make such
information available on corporate events that affect basis.
Source: GAO.
[A] Tax code simplification is a method through which some believe tax
compliance could be enhanced. See GAO, Understanding the Tax Reform
Debate: Background, Criteria, & Questions, GAO-05-1009SP (Washington,
D.C.: September 2005).
[End of table]
Table 8: Challenges to IRS Associated with Basis Reporting and How the
Challenges Could Be Mitigated:
Challenges to IRS: Expanding IRS's computer system capacity to store
and use additional data on basis involves monetary costs;
Ways to mitigate challenges: * Cost to implement system would be
outweighed by increased tax revenue resulting from higher voluntary
reporting compliance (although such funds would not be IRS's to
directly use); * Funds could be budgeted to cover these costs.
Challenges to IRS: IRS systems may not be able to process and match
basis for each securities sale reported on information returns and on
Schedule D of the Form 1040 (including any attachments on the
securities sold);
Ways to mitigate challenges: * Brokers could report aggregate adjusted
basis for all securities sold for a taxpayer on the information return
while reporting adjusted basis for all sales on annual statements
provided to taxpayers.
Challenges to IRS: IRS may still encounter taxpayers that misclassify
the holding period for their securities sales;
Ways to mitigate challenges: * Brokers could report aggregate basis and
gross proceeds for short-term and long-term transactions separately on
the information return.
Challenges to IRS: Taxpayers may improperly report basis when they sell
portions of their holdings in a security that they purchased on
multiple occasions;
Ways to mitigate challenges: * Allow taxpayers to use the average costs
of their securities holdings to determine basis for securities beyond
mutual funds; * Taxpayers could indicate the method they will use to
determine basis when their security is sold and brokers then would
report the method selected and the related basis amount on the
information return.
Source: GAO.
[End of table]
Although not all inclusive, the strategies discussed above could help
mitigate many of the challenges facing brokers and IRS if information
reporting were expanded to include cost basis. However, the strategies
also involve a number of trade-offs that would need to be considered in
terms of the costs and burdens associated with basis reporting for
taxpayers, IRS, and brokers, and the impact on reducing the capital
gains tax gap for securities.
Representatives from the securities industry we interviewed said that
brokers would incur additional costs to develop and maintain systems to
track and report basis, although they did not provide precise costs.
However, we were also told that almost all of the largest brokers
directly provide basis information to a significant portion of their
clients, and many smaller brokers provide basis to a significant
portion of their clients through outsourcing. Also, representatives of
the mutual fund industry estimated that 80 to 90 percent of mutual
funds provide average cost basis information to their shareholders.
Likewise, from a societal perspective, the cost that brokers would
incur in reporting basis information would be offset to some extent by
the reduced costs to taxpayers in researching, calculating, and
reporting basis, or paying a return preparer to perform such services.
However, some brokers may pass on the costs of reporting basis
information to their customers. Further, decisions about the scope and
details of basis reporting, as further discussed below, could constrain
how much brokers' costs would increase.[Footnote 43]
Also, representatives from the securities industry told us that their
ability to provide taxpayers and IRS with accurate basis information
would be challenged when taxpayers move their securities holdings from
one broker to another. Some brokers use a system to transfer basis
among one another, but the system is not used by all brokers. In
addition, brokers do not always track and transfer basis in a
consistent manner; that is, some track original cost basis while others
track adjusted cost basis. Without a system through which all brokers
transfer standardized basis information, the effectiveness of basis
reporting would be limited.
Additionally, brokers do not always know or may be challenged in
determining the basis of taxpayers' holdings. For example, some
taxpayers may hold securities that they purchased long ago or received
as a gift, for which neither they nor their brokers know the original
purchase dates. In these cases, brokers cannot know the basis of the
securities. However, this challenge could be mitigated to a large
extent if brokers were to track and report basis prospectively, that
is, only for securities purchased after a specified future date. The
trade-off to prospective basis reporting, however, is that it would not
help some taxpayers report basis for securities they owned before
brokers began to report basis, which for a period of time would limit
the impact basis reporting would have on reducing the tax gap. Also,
prospective reporting would be complicated in cases where a taxpayer
held a security prior to the specified date and then purchased
additional shares of the same security after the specified date.
Brokers would likely incur some additional costs to separately account
for shares of stock purchased before and after the specified date for
prospective reporting on information returns.
Likewise, it is difficult for brokers to determine basis for some
complicated securities transactions, according to representatives of
the securities industry. For example, when taxpayers sell stock for a
loss and then buy shares of the same stock within 30 days, they are
prohibited from claiming a loss on the original sale. For these sales,
known as wash sales, basis is difficult for the broker to determine
because the taxpayer is required to add the disallowed loss from the
wash sale to the basis of the subsequently purchased stock. The
difficulty in determining basis for wash sales is compounded when
taxpayers sell a stock at a loss through one broker and then buy the
same stock within 30 days from another broker. In this case, the second
broker would not know of the wash sale the taxpayer executed through
the first broker and would not know to adjust the taxpayer's basis
accordingly. We only found two cases through our file review where
taxpayers had misreported basis because of wash sales. Regardless,
transactions such as wash sales may be too complex for brokers to
feasibly report basis. Excluding these transactions from basis
reporting, however, would further reduce the impact of basis reporting
on closing the securities tax gap.
For IRS, having basis information, along with gross proceeds
information, for each of a taxpayer's securities sales would best
enable the agency to check whether taxpayers properly reported their
capital gains and losses. However, storing and making use of such
information would be challenging because of the costs and difficulty
involved in storing and computer matching the large volume of
information that transactional reporting would entail. However, if
brokers were to report only aggregate basis amounts to IRS for all of a
taxpayer's transactions, the costs and difficulties of storing and
using the information for matching would be reduced. Aggregate
reporting would also reduce the costs to brokers of reporting basis to
IRS, although they could still report basis for all transactions to
taxpayers.
Another complication for IRS and brokers is that taxpayers can choose
among various methods for reporting basis in cases where they sell some
of their shares of a security they purchased on multiple occasions.
Taxpayers may choose to report basis in a different way than brokers
would otherwise choose because taxpayers can (1) specifically identify
which shares they sell among many they hold and report basis for those
shares; (2) use the basis of the first shares they bought; or (3) in
the case of mutual funds, use the average cost of the shares they
own.[Footnote 44] Taxpayers could indicate the method they chose to
determine basis when they sell their securities, and brokers then could
report the method selected and the related basis amount on information
returns. However, this additional layer of tracking would likely add to
costs to taxpayers, brokers, and IRS. Although this challenge could be
alleviated if taxpayers were required to report basis in a consistent
manner, this requirement would end taxpayers' ability to determine
basis in the most advantageous manner for their particular tax
situations.
Given the number of decisions that would need to be made in conjunction
with basis reporting, IRS may not be able to require such reporting
given its current authority. Although IRS has long had the authority to
require information reporting related to securities, an official from
IRS's Office of Chief Counsel told us that IRS may not have the
authority to require all of the actions that would be needed to
implement cost basis information reporting, such as regulating a system
through which brokers transfer standardized basis information.
Therefore, it may be difficult for IRS to implement cost basis
information reporting without further statutory authority.
Representatives from the securities industry told us that in order to
implement basis reporting, a set of rules would need to be developed to
clearly establish, for example, what types of securities transactions
would be covered by any requirement and how a system to transfer basis
would be standardized. These representatives thought their input could
be helpful in designing any set of rules.
Conclusion:
Although neither IRS nor we know the size of the tax gap related to
securities sales, tens of millions of taxpayers hold securities outside
of their retirement accounts and, according to our analysis of IRS
data, an estimated 36 percent of taxpayers who sold securities in 2001
erred in reporting their gains and losses (an estimated 7.3 million out
of an estimated 20.3 million taxpayers). Of those erring, an estimated
64 percent underreported their income and 33 percent overreported
income. Also, an estimated 9 percent of individual taxpayers who sold
securities misclassified their holding periods, either reporting short-
term holdings as long-term, or vice versa. Enhancing IRS's current
enforcement and service efforts is an option for addressing these
compliance problems, but the most effective tool for improving
taxpayers' compliance levels has long been information reporting and
tax withholding. Individual taxpayers misreport nearly twice the
percentage of their income from sources subject only to some
information reporting--which is the case for securities income now--
compared to income subject to substantial information reporting. Also,
given that the tax consequences associated with the holding period of
securities are significant, broker reporting on this specific issue,
whether as part of basis reporting or separately, would help taxpayers
apply the proper tax rules to their gains or losses and help IRS in
identifying compliance problems.
Extending information reporting for securities sales to include basis
information is not a simple and straightforward proposition. The manner
in which basis reporting is designed would affect how the costs of
basis reporting are distributed among taxpayers, brokers, and IRS, and
the extent to which basis reporting would close the securities-related
tax gap. In addition, although IRS has the general authority to require
basis reporting, IRS officials were not certain the agency had
sufficient authority to regulate how such reporting is implemented,
such as regulating a system through which brokers transfer standardized
basis information.
In the event that brokers were required to report basis for securities
purchased as of a specific future date, some taxpayers may continue to
misreport their gains and losses from the securities holdings they
currently hold. For these taxpayers, additional guidance on reporting
basis and gains or losses for securities sales could be a low cost way
to help them voluntarily comply with their tax obligations. For
example, an estimated 28 percent of taxpayers who failed to report
their securities sales had losses. Clarification of IRS's instructions
for Schedule D on the appropriate use of capital losses to offset
capital gains or other income could be a means to help ensure that
taxpayers do not disadvantage themselves when they experience losses
from their investments. Also, given the complexity involved in
determining some securities' basis because of events such as stock
splits, guidance on the resources available to taxpayers on determining
basis, such as utilizing brokers, or services offered by companies that
issue stocks or other information available on Web sites, could help
improve taxpayers' ability to determine their securities' basis.
Matters for Congressional Consideration:
In order to reduce the capital gains tax gap for securities, Congress
may want to consider requiring brokers to report to both taxpayers and
IRS the adjusted basis of securities that taxpayers sell and ensuring
that IRS has sufficient regulatory authority to implement the
requirement. Either in connection with requiring basis reporting or
separately, Congress could also require brokers to report to taxpayers
and IRS whether the securities sold were short-term or long-term
holdings. Additionally, Congress could direct IRS to work with brokers
and related parties to develop rules that seek to mitigate some of the
challenges associated with requiring basis reporting.
Recommendations for Executive Action:
To assist taxpayers in accurately reporting their capital gains and
losses from securities, in the instructions to Schedule D the
Commissioner of Internal Revenue should (1) clarify the appropriate use
of capital losses to offset capital gains or other income and (2)
provide guidance on resources available to taxpayers to determine their
basis.
Agency Comments and Our Evaluation:
In written comments on a draft of this report, which are reprinted in
appendix II, the Commissioner of Internal Revenue agreed with our
recommendations. He also concurred that for some securities, basis
reporting involves unique challenges and noted that IRS is committed to
working with industry stakeholders to develop cost effective methods to
mitigate such reporting challenges. IRS also provided comments on
several technical issues, which we incorporated in this report where
appropriate.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from its issue date. At that time, we will send copies to the Chairman
and Ranking Minority Member, House Committee on Ways and Means; the
Secretary of the Treasury; the Commissioner of Internal Revenue; and
other interested parties. Copies will be made available to others upon
request. This report will also be available at no charge on GAO's Web
site at [Hyperlink, http://www.gao.gov].
If you or your staff have any questions, please contact me at (202) 512-
9110 or brostekm@gao.gov. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last
page of this report. Key contributors to this report are listed in
appendix III.
Signed by:
Michael Brostek:
Director, Tax Issues:
Strategic Issues Team:
[End of section]
Appendix I: Scope and Methodology:
To provide information on the extent of and primary types of
noncompliance that cause individual taxpayers to misreport capital
gains from securities, we performed a number of activities that relied
on data from IRS's National Research Program (NRP). Through NRP, IRS
selected and reviewed a stratified random sample of 45,925 individual
income tax returns from tax year 2001. The NRP sample is divided across
30 strata by the type of individual tax return filed and income levels.
IRS accepted as filed some of the NRP returns, accepted others with
minor adjustments, and examined the remainder of returns either through
correspondence or face-to-face meetings with taxpayers. If IRS
examiners determined that taxpayers misreported income for any aspect
of the selected tax returns, they adjusted the taxpayers' income
accordingly and assessed additional taxes.
IRS captured data from taxpayer returns and examination results in the
NRP database, including capital gains income. However, the data on
capital gains do not indicate the type of capital asset for which
taxpayers reported gains or losses or for which examiners made income
adjustments. Therefore, to obtain information on the extent and primary
types of capital gains tax noncompliance specific to securities, we
selected a statistical sample of NRP examination files to review.
The sample we selected contained 1,017 cases spread across 90
substrata, defined by replicating each of the 30 NRP strata across 3
GAO substrata. The first GAO substratum consisted of examination cases
for which the adjustments to capital gain income the examiners made had
the largest impact on the total amount of these adjustments for all
taxpayers when weighted for the entire population of individual
taxpayers. We focused on cases with the largest adjustments, in
weighted terms, because including these cases would improve the level
of confidence of any estimates of the total amount of capital gains
income adjustments for securities. Because our sample is a subsample of
the NRP sample and is subject to sampling error, we added cases, when
applicable, to ensure that each of the 30 NRP strata in this GAO
substratum contained a minimum of 5 cases. In total, we selected 290
cases for the first GAO substratum, and these cases accounted for
around 75 percent of the total capital gains adjustments in NRP when
weighted for the population of individual taxpayers.
The second substratum consisted of 187 cases for which IRS did not
identify misreported capital gains income when it reviewed or examined
the tax returns. We included these returns as part of our sample to
verify that the NRP examinations had correctly recorded when taxpayers
were compliant with respect to reporting capital gains and losses. We
selected these cases at random and in proportion to the NRP sample
through an iterative process, ensuring that a minimum of 5 cases and a
maximum of 15 cases was included in each of the 30 NRP strata.
The remaining 540 cases that constitute the third GAO substratum were
selected from cases for which IRS examined taxpayers' capital gain
income. We selected these cases at random and in proportion to the
number of NRP returns for which IRS examined capital gains income,
ensuring that we selected a minimum of 5 cases for each NRP stratum.
For one stratum, we only included 2 cases because they were the only
cases in the corresponding NRP stratum.
Of the 1,017 cases we selected for our sample, we reviewed 849 cases.
We did not review the remaining 168 cases because either IRS did not
provide the files in time to include in our review (164 cases) or the
files did not contain examination workpapers essential to determining
if examiners made adjustments to taxpayers income from securities (4
cases).[Footnote 45] Based on an analysis of the response rates by the
90 GAO substrata, we concluded that the missing cases did not bias our
analyses. We requested the cases at two points, in late-December 2005
and late-January 2006, and periodically checked on the status of our
requests with IRS. We were only able to review cases that arrived by
April 21, 2006 in order to meet our agreed upon issue date for the
report.
We reviewed each selected case file to determine if the taxpayers
reported securities transactions on their returns or if examiners
discovered any misreported securities transactions. For returns where
examiners discovered misreported income from securities transactions,
we determined, when possible, the related security type, holding
period, adjustment amount, and reason for the adjustment, along with
other information. We recorded all determinations on a data collection
instrument (DCI) that we developed.
To ensure that our data collection efforts conformed to GAO's data
quality standards, each DCI that a GAO analyst completed was reviewed
by another GAO analyst. The reviewers compared the data recorded on the
DCI to the data in the corresponding case file to determine whether
they concurred with how the data were recorded. When the analysts
differed on how the data were recorded, they met to reconcile any
differences.
We input the data we recorded on the DCIs into a computer data
collection program. To ensure the accuracy of the transcribed data,
each electronic DCI entry was compared to its corresponding paper DCI
by analysts other that those that electronically entered the data. If
the reviewers found any errors, changes were made to the electronic
entries, and the entries were reviewed again to ensure that all data
were transcribed accurately.
The estimates we included in this report were based on the NRP database
and the data we collected through our file review and were generated
using statistical software. All computer programming for the resulting
statistical analyses were checked by a second, independent analyst. Our
final sample size was large enough to generalize the results of our
review or had margins of error small enough to produce meaningful
estimates in terms of percentages of taxpayers who were noncompliant in
reporting capital gains from securities transactions. However, we could
not produce meaningful estimates of the total amount of net misreported
capital gain income from securities or determine the securities tax
gap, in part because (1) in selecting our sample, we could not
distinguish which cases included misreported securities transactions as
opposed to misreported transactions for other types of capital assets,
(2) some cases with large amounts of misreported capital gains or
losses were due to noncompliance for assets other than securities, (3)
53 of the cases we requested from IRS from our first substratum, which
represented a large percentage of the total amounts of misreported
capital gains or losses, were not provided in time to include in our
review, and (4) taxpayers misreported a wide range of dollar amounts
from the transactions.[Footnote 46] We discussed our estimates with IRS
officials to obtain their perspectives on the results of our analysis.
Because we followed a probability procedure based on random selection,
our sample is only one of a large number of samples that we might have
selected. Since each sample could have resulted in different estimates,
we express our confidence in the precision of our particular sample's
results as a 95 percent confidence interval, plus or minus the margin
of error indicated along with each estimate in the report. This
interval would contain the actual population value for 95 percent of
the samples we could have selected.
We assessed whether the examination results and data contained in the
NRP database were sufficiently reliable for the purposes of our review.
For this assessment, we interviewed IRS officials about the data,
collected and reviewed documentation about the data and the system used
to capture the data, and performed electronic testing of relevant data
fields for obvious errors in accuracy and completeness. We compared the
information we collected through our case file review to corresponding
information in the NRP database to identify inconsistencies. Based on
our assessment, we determined that the NRP database was sufficiently
reliable for the purposes of our review.
We also used IRS's Statistics of Income (SOI) file for individual
taxpayers, which relies on a stratified probability sample of
individual income tax returns, to develop estimates for categories of
individual taxpayers on adjusted gross income, the percentage of
individual taxpayers that used paid tax preparers, and the number of
taxpayers that filed a Schedule D with their tax returns for tax year
2003. We compared our analyses against published IRS data to determine
that the SOI database was sufficiently reliable for the purposes of our
review.
To provide information on actions IRS takes in attempting to reduce the
individual capital gains tax gap for securities and on challenges that
IRS faces with these actions, we reviewed documents from IRS compliance
programs as they related to capital gains and interviewed IRS officials
knowledgeable about the subject. We reviewed documentation for IRS's
enforcement programs that address capital gains and reviewed IRS
publications and other documents that provided information on how to
accurately report capital gains and losses. To provide additional
information on IRS's compliance programs and identify challenges IRS
faces in using these programs to reduce the individual capital gains
tax gap for securities, we interviewed IRS officials from various areas
of the agency, including the enforcement, taxpayer service, and
research functions.
To identify options with the potential to improve taxpayers' voluntary
compliance for reporting securities gains and losses and IRS's ability
to find noncompliance related to the individual capital gains tax gap
for securities, we reviewed prior GAO reports and other documents on
capital gains reporting and compliance such as those from IRS
compliance programs and industry reports on securities holdings and
information reporting. We also spoke with IRS officials and numerous
representatives from, and related to, the securities industry. At IRS,
we spoke with officials from various areas of the agency, including the
enforcement, taxpayer service, and research functions. Additionally, we
spoke with officials from the Taxpayer Advocate Service and members of
IRS's Information Return Program Advisory Committee (IRPAC).[Footnote
47] We also spoke with representatives of the Securities Industry
Association; Investment Company Institute, which represents the mutual
fund industry; Bond Market Association; American Banking Association
Securities Association; American Institute of Certified Public
Accountants; and the American Bar Association to get their perspectives
on capital gains tax noncompliance, ways to reduce noncompliance, and
any challenges related to reducing noncompliance and how those
challenges could be mitigated.
[End of section]
Appendix II: Comments from the Internal Revenue Service:
Commissioner:
Department Of The Treasury:
Internal Revenue Service:
Washington, D.C. 20224:
June 5, 2006:
Mr. Michael Brostek:
Director, Tax Issues:
U.S. Government Accountability Office:
441 G Street, N.W.
Washington, D.C. 20548:
Dear Mr. Brostek:
I have reviewed the draft Government Accountability Office (GAO) report
titled "Capital Gains Tax Gap: Requiring Brokers to Report Securities
Cost Basis Would Improve Compliance if Related Challenges Are
Addressed" (GAO-06-603). We agree with the recommendation contained in
the report and would like to offer several comments.
Accurate reporting of capital gains and losses related to securities is
an important component of the tax gap. Determining cost calculations
for stocks or mutual funds is complex especially when purchased over a
long time span, and where dividends and other distributions are
automatically reinvested. Calculations may also be complicated by the
taxpayer's choice of accounting methods, stock splits, mergers and
corporate reorganizations.
This report suggests that Congress consider requiring brokers to report
the adjusted basis of securities sold and identify whether gains and
losses are short or long-term. IRS research shows that taxpayer's
reporting compliance is strongly related to the extent of third party
reporting, however, basis reporting would raise unique challenges in
the area of burden on brokers and taxpayers when reporting unique
situations such as wash sales and options. The report discusses that a
solution would be to exclude wash sale transactions from basis
reporting. To exclude these transactions from basis reporting, a broker
must be able to distinguish them from non-wash sale transactions.
Because of the way wash sale transactions are defined under current
law, however, in many cases brokers would not be able to identify the
transactions by the time reporting would be required, so excluding them
may not be possible in all situations.
In the short term, the IRS will continue to clarify guidance related to
the accurate reporting of capital gains and losses. We will revise the
instructions for Schedule D, "Capital Gains and Losses," to clarify the
appropriate use of capital losses and provide guidance on resources
available to taxpayers to determine their basis. A previous example of
our efforts is the 2005 revision of instructions for Schedule D. The
revision provides taxpayers with references to IRS publications and
applicable Internal Revenue Code sections, and reminds taxpayers to
report information critical to evaluating the accuracy of the capital
gain or loss claimed.
I am pleased to inform you that the IRS Office of Taxpayer Burden
Reduction is leading an effort to address the capital gains tax gap and
related tax burden. We are committed to working with industry
stakeholders to develop cost effective methods to mitigate reporting
challenges that impact taxpayers, tax practitioners, financial
institutions and tax software vendors.
I appreciate your continued support and the valuable assistance and
guidance from your staff. Our response to your recommendation is
enclosed. If you have any questions please contact Floyd Williams,
Director, Legislative Affairs, at (202) 622-4725.
Sincerely,
Signed by:
Mark W. Everson:
Enclosure:
GAO Draft Report - Capital Gains Tax Gap: Requiring Brokers to Report
Securities Cost Basis Would Improve Compliance if Related Challenges
Are Addressed (GAO-06-603):
GAO Recommendation: To assist taxpayers in accurately reporting their
capital gains and losses from securities, in the instructions to
Schedule D the Commissioner of Internal Revenue should (1) clarify the
appropriate use of capital losses to offset capital gains and (2)
provide guidance on resources available to taxpayers to determine their
basis.
IRS Response: We agree with the recommendation and will revise the
instructions for Schedule D to clarify the appropriate use of capital
losses and provide guidance on resources available to taxpayers to
determine their basis.
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
Michael Brostek, (202) 512-9110 or brostekm@gao.gov:
Acknowledgments:
In addition to the contact named above, Wes Phillips and Tom Short,
Assistant Directors; Jeff Arkin; Susan Baker; Candace Carpenter; Keira
Dembowski; Fred Jimenez; Matthew Keeler; Donna Miller; John Mingus;
Franklin Ng; Karen O'Conor; Cheryl Peterson; Sam Scrutchins; Jay Smale;
and Jennifer Li Wong made key contributions to this report.
[End of section]
Related GAO Products:
Tax Gap: Making Significant Progress in Improving Tax Compliance Rests
on Enhancing Current IRS Techniques and Adopting New Legislative
Actions. GAO-06-453T. Washington, D.C.: February 15, 2006.
Tax Gap: Multiple Strategies, Better Compliance Data, and Long-term
Goals Are Needed to Improve Taxpayer Compliance. GAO-06-208T.
Washington, D.C.: October 26, 2005.
Tax Compliance: Better Compliance Data and Long-term Goals Would
Support a More Strategic IRS Approach to Reducing the Tax Gap. GAO-05-
753. Washington, D.C.: July 18, 2005.
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal
Sustainability but Will Require a Variety of Strategies. GAO-05-527T.
Washington, D.C.: April 14, 2005.
Tax Administration: More Can Be Done to Ensure Federal Agencies File
Accurate Information Returns. GAO-04-74. Washington, D.C.: December 5,
2003.
Tax Administration: IRS Should Continue to Expand Reporting on Its
Enforcement Efforts. GAO-03-378. Washington, D.C.: January 31, 2003.
Tax Administration: IRS Can Improve Information Reporting for Original
Issue Discount Bonds. GAO/GGD-96-70. Washington, D.C.: March 15, 1996.
Reducing the Tax Gap: Results of a GAO-Sponsored Symposium. GAO/GGD- 95-
157. Washington, D.C.: June 2, 1995.
Options Reporting to IRS. GAO/GGD-95-145R. Washington, D.C.: May 5,
1995.
Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy Needed.
GAO/ GGD-94-123. Washington, D.C.: May 11, 1994.
Tax Administration: Computer Matching Could Identify Overstated
Business Deductions. GAO/GGD-93-133. Washington, D.C.: August 13, 1993.
Information Reporting. GAO/GGD-93-55R. Washington, D.C.: July 22, 1993.
Tax Administration: Information Returns Can Improve Reporting of
Forgiven Debts. GAO/GGD-93-42. Washington, D.C.: February 17, 1993.
Tax Administration: Overstated Real Estate Tax Deductions Need to Be
Reduced. GAO/GGD-93-43. Washington, D.C.: January 19, 1993.
Tax Administration: Federal Agencies Should Report Service Payments
Made to Corporations. GAO/GGD-92-130. Washington, D.C.: September 22,
1992.
Tax Administration: Approaches for Improving Independent Contractor
Compliance. GAO/GGD-92-108. Washington, D.C.: July 23, 1992.
Tax Administration: Benefits of a Corporate Document Matching Program
Exceed the Costs. GAO/GGD-91-118. Washington, D.C.: September 27, 1991.
IRS Needs to Implement a Corporate Document Matching Program. GAO/T-
GGD-91-40. Washington, D.C.: June 10, 1991.
Tax Administration IRS Can Improve Its Program to Find Taxpayers Who
Underreport Their Income. GAO/GGD-91-49. Washington, D.C.: March 13,
1991.
Tax Administration: Expanded Reporting on Seller-financed Mortgages Can
Spur Tax Compliance. GAO/GGD-91-38. Washington, D.C.: March 29, 1991.
IRS' Compliance Programs to Reduce the Tax Gap. GAO/T-GGD-91-11.
Washington, D.C.: March 13, 1991.
IRS Can Use Tax Gap Data to Improve Its Programs for Reducing
Noncompliance. GAO/T-GGD-90-32. Washington, D.C.: April 19, 1990.
Tax Administration: Information Returns Can Be Used to Identify
Employers Who Misclassify Workers. GAO/GGD-89-107. Washington, D.C.:
September 25, 1989.
Tax Administration: Missing Independent Contractors' Information
Returns Not Always Detected. GAO/GGD-89-110. Washington, D.C.:
September 8, 1989.
Tax Administration: IRS' Efforts to Establish a Business Information
Returns Program. GAO/GGD-88-102. Washington, D.C.: July 22, 1988.
The Merits of Establishing a Business Information Returns Program.
GAO/T- GGD-87-4. Washington, D.C.: March 17, 1987.
(450428):
FOOTNOTES
[1] According to an IRS research official, in mid-2006, IRS plans to
publish its final report on the 2001 tax gap that will include an
updated tax gap estimate based on a refined methodology. It is possible
that the updated tax gap figures could differ from the current
estimates.
[2] Unless otherwise noted, references to the tax gap refer to the
gross tax gap.
[3] The overall capital gains tax gap could be larger than $11 billion
because IRS did not estimate the portion of the combined $48 billion
tax gap attributable to capital gains for individual taxpayers who did
not file tax returns or did not pay the taxes they reported on filed
returns.
[4] IRS's most recent published studies of capital asset transactions
were for tax years 1997 through 1999. See IRS Statistics of Income
Bulletin, Sales of Capital Assets Reported on Individual Tax Returns,
1999, Summer 2003, Publication 1136 (Rev. 09-2003), and Sales of
Capital Assets Reported on Individual Tax Returns, 1998 and 1997,
Summer 2002, Publication 1136 (Rev. 08-2002).
[5] Options are contracts giving the purchaser the right to buy or sell
a security at a fixed price within a specific period of time. Mutual
funds pay capital gain distributions from their net realized long-term
capital gains.
[6] Information reporting involves the filing of returns with IRS and
taxpayers that contain information on certain transactions, such as
information on gross proceeds that brokers report from securities
sales.
[7] Although by statute, futures contracts are not considered
securities, we include them as securities for the purposes of this
report because futures transactions are generally reported by brokers
to IRS and we found 2 taxpayers through our file review who misreported
such transactions. A futures contract is an agreement to buy or sell a
specific quantity of a commodity or financial instrument at a specified
price on a particular date in the future.
[8] Other types of capital assets include personal residences and other
personal-use property; real property held for investment; collectibles,
such as art, coins or precious metals; and interest in a partnership, S
corporation, estate, or trust. Capital gains and losses for assets sold
by partnerships, S corporations, estates, or trusts are generally taxed
at the partner, shareholder, or beneficiary level. Non-business bad
debts are treated as capital losses. All or part of the net gains from
certain other transactions may be treated as capital gains, including
involuntary conversions from destruction, theft, condemnation, or
eminent domain; other depreciable real property or personal property
used in a business; land used in a business, including farmland;
timber; livestock; patents; and copyrights.
[9] Includes futures transactions.
[10] References to capital assets in this report refer to assets held
outside of retirement accounts.
[11] The Federal Reserve Board surveys U.S. families' holdings of
financial assets in its triennial Surveys of Consumer Finances. See
Robert B. Avery, Glenn B. Canner, Gregory E. Elliehausen, and Thomas A.
Gustafson, Survey of Consumer Finances, 1983, Federal Reserve Bulletin,
vol. 70 (September 1984), and Brian K. Bucks, Arthur B. Kennickell, and
Kevin B. Moore, Recent Changes in U.S. Family Finances: Evidence from
the 2001 and 2004 Survey of Consumer Finances, Federal Reserve
Bulletin, vol. 92 (February 2006).
[12] The original cost basis of a security can also include costs of
purchase, such as sales commissions.
[13] Taxpayers who specifically identify groups of shares sold among
multiple groups held must inform their brokers which shares to sell,
and brokers are to provide written confirmation of taxpayers'
decisions.
[14] Congress established the requirement that brokers report proceeds
in the Tax Equity and Fiscal Responsibility Act of 1982--Pub. L. No. 97-
248 (1982). Other information that can be reported on Form 1099-B
includes the security's Committee on Uniform Security Identification
Procedures number; gross amounts received through bartering; federal
income tax withheld; classes of stock exchanged, such as preferred or
common stock; and profit or loss for regulated futures contracts.
Brokers may send a substitute for Form 1099-B if it meets IRS
requirements for substitutes.
[15] A number of other dividends and distributions are also reported on
Form 1099-DIV.
[16] The Jobs and Growth Tax Relief Reconciliation Act of 2003--Pub. L.
No. 108-27 (2003)--established maximum tax rates for long-term gains at
5 percent for income otherwise taxed in the 10 percent and 15 percent
marginal income tax brackets and 15 percent for income otherwise taxed
at higher rates, effective for assets sold or exchanged on or after May
6, 2003, and before January 1, 2009. These rates were extended for
assets sold or exchanged before January 1, 2011 in the Tax Increase
Prevention and Reconciliation Act of 2005--Pub. L. No. 109-222 (2006).
[17] We are 95 percent confident that from 7.3 million to 9.5 million
taxpayers misreported securities transactions and from 20.3 million to
23.5 million taxpayers had securities transactions.
[18] We are 95 percent confident that from 6.2 million to 8.3 million
taxpayers misreported securities sales, from 18.7 million to 21.9
million taxpayers sold securities, from 0.66 million to 1.7 million
taxpayers misreported capital gain distributions, and from 7.8 million
to 10.4 million taxpayers had capital gain distributions.
[19] Some taxpayers misreported both stocks and mutual funds and bonds,
options or futures. Estimates have sampling errors of (+/-) 5 percent
or less.
[20] Estimates have sampling errors of (+/-) 2 percent or less.
[21] Figures do not sum to 100 percent because some taxpayers
misreported securities sales in a way that had no effect on the amount
of income from the sales, for example, in cases where taxpayers only
misreported the securities' holding periods. Estimates have sampling
errors of (+/-) 9 percent or less.
[22] By comparison, from 49 percent to 96 percent of taxpayers that
misreported their capital gain distributions were estimated to have
misreported between $0 and $1,000 of income.
[23] For taxpayers who misreported capital gains distributions, from 48
percent to 89 percent were estimated to have failed to report the
distributions altogether.
[24] Estimates have sampling errors of (+/-) 8 percent or less.
[25] Estimates have sampling errors of (+/-) 8 percent or less.
[26] Of all taxpayers who misreported a securities transaction, an
estimated 52 percent used a tax return preparer with a sampling error
of (+/-) 9 percent or less. Of all individual taxpayers, an estimated
56 percent used a tax return preparer for tax year 2001 with a sampling
error of (+/-) 0.4 percent or less. We recently reported that some tax
return preparers make serious errors when completing returns. See GAO,
Paid Tax Return Preparers: In a Limited Study, Chain Preparers Made
Serious Errors, GAO-06-563T (Washington, D.C.: Apr. 4, 2006).
[27] Estimate has a sampling error of (+/-) 13 percent or less.
[28] Taxpayers can appeal additional taxes that IRS assesses.
[29] For a more complete discussion of these programs, see GAO, Tax
Administration: IRS Should Continue to Expand Reporting on Its
Enforcement Efforts, GAO-03-378 (Washington, D.C.: Jan. 31, 2003).
[30] IRS performs some examinations through correspondence and others
through face-to-face meetings with taxpayers.
[31] IRS publications related to capital gains or losses from
securities include Publication 544, Sales and Other Dispositions of
Assets, Publication 550, Investment Income and Expenses; Publication
551, Basis of Assets, and Publication 564, Mutual Fund Distributions.
[32] For some taxpayers, IRS did not assess additional taxes when it
identified underreported income from securities sales because the
changes to reported income only reduced taxpayers' capital loss
carryovers.
[33] Through AUR, IRS contacted around 190,000 taxpayers who
potentially misreported securities sales out of a total of over 2.3
million taxpayers it contacted for all types of misreported income for
tax year 2002. IRS does not collect information on the number of
taxpayers it contacts through Math Error and ASFR programs who
potentially misreported capital gains.
[34] By comparison, IRS examined through correspondence approximately
800,000 individual tax returns in fiscal year 2004. Approximate
examination figures are given because, according to IRS, in general,
examination activity may be associated with returns filed in the
previous calendar year.
[35] We are 95 percent confident that the number of taxpayers who
reported capital gains or losses was from 22.4 million to 22.9 million.
[36] For tax year 2002, IRS increased the number of taxpayers contacted
for potentially misreported securities sales to around 190,000,
assessing over $550 million in additional taxes.
[37] As previously reported, IRS had not been entering all examination
cases into this database, and started implementing improvements in
October 2004 to case processing and data capture. See GAO, Tax
Compliance: Better Compliance Data and Long-term Goals Would Support a
More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753
(Washington, D.C.: July 18, 2005).
[38] If the data were complete, according to IRS it would be possible
to estimate the portion of additional taxes IRS assessed that could be
attributed to capital gains.
[39] For a list of major legislation affecting IRS's information
returns program, see GAO-03-378.
[40] GAO, Tax Gap: Many Actions Taken, But a Cohesive Compliance
Strategy Needed, GAO/GGD-94-123 (Washington, D.C.: May 11, 1994).
[41] Internal Revenue Service, Taxpayer Advocate Service, National
Taxpayer Advocate 2005 Annual Report to Congress (Washington, D.C.:
Dec. 31, 2005).
[42] S. 2414, 109TH Cong. §2 (2006), H.R. 5176, 109TH Cong. §206
(2006), and H.R. 5367, 109TH Cong. §2 (2006).
[43] Although IRS has not estimated the costs to taxpayers of filing
Schedule D, taxpayers spend billions of dollars every year in complying
with their tax obligations. See GAO, Tax Policy: Summary of Estimates
of the Costs of the Federal Tax System, GAO-05-878 (Washington, D.C.:
Aug. 26, 2005).
[44] Taxpayers who own mutual funds face similar choices through
reinvested dividends. However, tracking and computing cost basis for
dividend reinvestments may not be as challenging to track because
mutual funds shareholders can use the average costs of their holdings
to determine basis, a method that cannot be used for stocks or other
securities.
[45] IRS could not provide one of these cases that was not yet closed
because it was with IRS's Appeals function.
[46] IRS could not provide one of these cases that was not yet closed
because it was with IRS's Appeals function.
[47] IRPAC advises IRS on information reporting issues of mutual
concern to the private sector and federal government. It is composed of
17 members who represent various private and public sector
organizations with an interest in, or responsibility for, information
reporting.
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