If you're self-employed, sell used items occasionally on eBay or own a home, now would be a good time to start keeping really good records. Your tax returns could receive more scrutiny, thanks to a growing push to narrow the "tax gap" — the billions of dollars in federal taxes that go uncollected every year.
Ebay Tax-Democrats and Republicans don't agree on much, but they do share a desire to narrow the tax gap. That's not surprising. The IRS estimates that the tax gap exceeds more than $300 billion a year. Collecting even half that amount would let Congress repeal the alternative minimum tax — a parallel tax system that increasingly threatens middle-income taxpayers — without raising taxes or cutting government programs.
Ebay Taxpayers like the idea of closing the tax gap, too. More than 86% of taxpayers believe that cheating on income taxes is unacceptable, according to a survey released last month by the IRS Oversight Board.
But closing the tax gap is a lot more complicated than chasing down the proverbial deadbeats who hide money under the mattress. Government proposals to narrow the gap would affect people who probably don't think of themselves as scofflaws. And tax experts say the IRS can't make a serious dent in the tax gap unless it conducts more audits.
"If you're going to do away with the entire tax gap, it's going to be real painful for everybody," says Mel Schwarz, a partner at Grant Thornton's national tax office in Washington.
The IRS estimates that unpaid taxes from individuals, as opposed to big corporations, account for more than 70% of the tax gap. And within that group, the self-employed are considered the biggest offenders. Sole proprietors who underreport their income and self-employment taxes account for roughly one-third of the tax gap, the IRS says.
The Treasury Department has proposed requiring credit card companies to report to the IRS payments made to small businesses and other self-employed workers. That would allow the IRS to compare the self-employed workers' tax returns with the payments and determine whether they're underreporting their income.
But groups representing small-business owners worry that the proposal could increase the costs that credit card companies charge small businesses. More fundamentally, they say, the IRS figures fail to distinguish between sole proprietors who deliberately hide income and those who make honest mistakes.
"They don't make it easy for you," says Dennis Waters, 55, of Exeter, N.H., who buys and sells antique photographs via his website, www.finedags.com. "Every year, they're changing the rules, changing the types of deductions. You can't plan ahead to try and do something."
Complicated Ebay tax returns
Because of the complexity of their returns, many self-employed workers must pay someone to do their taxes, which reduces their profits, says Todd McCracken, president of the National Small Business Association. Those who can't afford to hire a professional must take time away from their businesses to meet complex reporting requirements, such as filing estimated taxes every quarter, he says.
They need to keep comprehensive records, too, because sole proprietors are up to three times more likely to be audited than are individual taxpayers who don't file a Schedule C, the form used by self-employed workers to report their business income.
"Chances are, you'll be audited if you're in business long enough," says Frederick Daily, a tax attorney and author of Stand Up to the IRS.
Chuck Smith Jr., co-owner of JR Services, a mortgage servicing company in Norton, Ohio, knows that all too well. Since he went into business for himself in the 1970s, he's been audited three times.
None of the audits resulted in a higher tax bill, but in one case, he had to track down a receipt for a used truck cap. In an e-mail message, Smith said he now saves receipts for everything, some for as little as 50 cents.
A stepped-up effort to capture unreported income would lead to more audits of the self-employed. And it could also prove costly for families who employ nannies or other full-time household help.
If you paid a nanny $1,500 or more in 2006, you're supposed to file Schedule H with your tax return and withhold a portion of your employee's pay for Social Security, Medicare and unemployment tax.
Few pay nanny Ebay tax
But despite some high-profile cases of nanny-tax evasion, the tax is widely ignored. In 2003, the most recent year available, only about 241,000 taxpayers filed Schedule H, according to the IRS. The International Nanny Association estimates that about 1 million households employ nannies in the USA. Families bypass the nanny tax for many reasons. Some are already struggling to pay for child care and can't afford it.
Others employ undocumented workers. And some don't understand the rules, or think the tax is too complicated or burdensome, says Robert King, co-owner of Legally Nanny, an Irvine, Calif.-based company that helps people pay nanny taxes.
But this much is clear, King says: If the IRS audits your return and finds you have an off-the-books nanny, you'll owe back taxes and interest — along with penalties for tax evasion and fraud.
Other taxpayers who could be affected by efforts to narrow the tax gap include:
•Online sellers. More than 200 million people buy and sell items on eBay. If you use eBay or another Internet auction site to sell old stuff that's been piling up in your garage, you probably don't have to worry about paying taxes on the proceeds. But if you earn extra income by selling items online, you're supposed to pay taxes on your profits.
An IRS advisory committee recommended last year that online auction sites be required to file reports of sales transactions with the IRS. The committee also suggested requiring sellers to obtain a taxpayer identification number, which would let the government track the transactions.
A crackdown probably wouldn't affect professional sellers. Nor would it affect people who sell used personal items on eBay for less than they originally paid for them. Proceeds from those sales, like money earned from a garage sale, aren't taxable.
But it could cause headaches for people who occasionally buy items at yard sales and sell them online months later, Grant Thornton's Schwarz says. To calculate their profits, those people would have to keep records of the amount they originally paid — known as the basis — for every item they sell. That kind of inventory accounting "is sophisticated even for people who do taxes for a living, much less a guy who is trying to make a little extra money," Schwarz says.
EBay spokeswoman Catherine England says the proposals reflect "a misunderstanding of how eBay's business model works."
EBay doesn't have records on transactions, because once a winning bid is posted, the sale takes place offline, she says. "We have no way to confirm whether or not that transaction actually happened," she says.
•Homeowners who deduct property Ebay taxes.
One big benefit of homeownership is the ability to deduct all sorts of expenses. In fiscal 2006, homeowners deducted nearly $20 billion in real estate taxes and nearly $70 billion in mortgage interest. But the non-partisan Joint Committee on Taxation says it believes homeowners are deducting more property taxes and mortgage interest than the law allows — and that tightening those deductions could reduce the tax gap.
In a report to Congress last year, the committee said many homeowners' real estate tax deductions include user fees and special assessments for improvements. Those aren't legal deductions. But it's an easy mistake to make, the committee said, because property tax bills often don't distinguish between deductible taxes and non-deductible fees.
Many homeowners also incorrectly deduct "points" — prepaid interest — when they refinance their mortgages, the committee report said. Under the tax code, points are fully deductible on a mortgage to buy a home, but points on a refinanced mortgage must be prorated over the life of the loan.
To address both issues, the committee recommended increasing reporting requirements for local governments and mortgage lenders. That would lead to more IRS scrutiny of the deductions, and more audits of homeowners who claim them incorrectly.
More audits?
Ebay Tax- The IRS has increased the rate of audits in recent years, particularly among high-income earners and the self-employed. Still, most taxpayers are more likely to be hit by a meteor than be audited by the IRS.
Some analysts say the IRS can't close the tax gap without significantly increasing audits. But doing so would risk the kind of backlash that led to congressional hearings of allegedly abusive collection tactics in the mid-1990s.
IRS Taxpayer Advocate Nina Olson says she believes audits can be more effective if they're targeted at specific problem groups, such as self-employed workers who are paid in cash.
If the IRS audited a food vendor in a New York City neighborhood, she says, he would probably talk about it with other vendors. They'd get nervous and start reporting more of their income, she says. That's more effective, Olson adds, than "scattershot audits."
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