President Joe Biden addresses the Ford Rouge Electric Vehicle Center in Dearborn, Michigan on May 18, 2021.

Nicholas Comb | AFP | Getty Images

President Joe Biden calls for crackdown on wealthy taxpayers who avoid taxes by hiding a large portion of their income from the IRS.

Tax compliance is one of the many ways Biden seeks tax revenue from households earning more than $ 400,000 a year to help fund the American Families Plan. The legislation would increase spending on initiatives such as advanced education, childcare and paid leave.

Underreported income, especially among the rich, is what contributes most to the so-called “tax gap”, according to a Treasury Department report released on Thursday.

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This gap is the difference between tax paid and tax owed. According to the Treasury Department, it was estimated at $ 584 billion in 2019 and $ 7 trillion over the next decade.

Around 80% of the tax gap results from underreported income – a large part of it is due to “opaque sources of income that are disproportionately incurred for higher incomes,” said the Ministry of Finance.

It identifies certain non-work incomes – for example, from businesses such as partnerships and owners, and rental income. In such categories, individuals report about 55% of their income, according to the ministry.

This means that on average more than half of their income is not taxed.

“We don’t know to what extent this is intentional or unintentional. But it’s high,” said Janet Holtzblatt, senior fellow at the Urban-Brookings Tax Policy Center.

This percentage is much higher than for other sources of income. For example, employees who earn a salary or wage incorrectly report about 1% of their income.

Tax reporting

The difference is due to third party reporting, according to tax experts.

Every year employers report a worker’s earned income on a W-2 that is distributed to the taxpayer and the IRS. In this case, the employer acts as a third party verification. (Employees also withheld taxes from their paychecks during the year.)

The same concept applies to investment income. For example, financial institutions would report a taxpayer’s dividend income on a 1099-DIV tax form.

However, according to tax experts, there is little or no third-party verification at certain companies.

Sole proprietorships, for example, report their income and expenses to the IRS themselves. In a partnership, every underreported income at the company level is traced back to the individual earnings of the business partner, said Holtzblatt. (However, the IRS has devoted more resources to examining partnerships in recent years, she added.)

“A self-reporting system has its own shortcomings,” said Leon LaBrecque, accountant and certified financial planner with Sequoia Financial Group. “And there is no easy way to get around that.”

This isn’t just true for high earners, however, LaBrecque said. The same concept applies, for example, to a restaurant employee or bartender who does not show cash tips as income.

But the IRS can get more tax revenue by cracking down on the rich who are underreporting income, he added.

Biden’s tax plan includes strengthening third-party reporting to the IRS, which the administration says is one of the most effective ways to improve tax compliance.

US $ 80 billion in IRS funding is expected to be allocated over the next decade, including hiring agents who can perform complex tax audits on the wealthy and complicated business structures. The plan would overhaul the IRS technology systems and increase penalties for tax evaders.

The Treasury Department estimates these changes would gross $ 700 billion over the next decade.