February 14, 2019
A review of Internal Revenue Service tax-administration procedures showed that the U.S. income tax withholding system could benefit from an expansion modeled on systems from other countries, a report said Feb. 12.
The Taxpayer Advocate Service’s annual report to Congress, issued by National Taxpayer Advocate Nina E. Olson, presented 58 legislative recommendations for improving tax administration. The release of the report, which is required to be issued by Dec. 31, was delayed because of the partial federal government shutdown, which started Dec. 22 and ended Jan. 25. The service is an independent agency within the IRS.
The IRS should consider expanding the number of income sources that are included in withholding, transitioning to using a code-based withholding system to determine amounts, and implementing real-time reporting of withholding information, the report said. A real-time system would decrease opportunities for fraud, the report said. The IRS’s fraud-detection systems rely on outdated technology not fully integrated with other IRS systems and suffered from high false-positive rates in 2018, the report said.
Additionally, legislation that prevents the IRS from including voluntary withholding arrangements in worker classification disputes could increase tax compliance from independent contractors, the report said.
The U.S. income tax withholding system could see improvements through the adoption of systems similar to those in countries with real-time pay-as-you-earn (PAYE) withholding, the report said.
While the U.S. withholding system is primarily based on income from wages, countries such as the U.K. and New Zealand tax other types of payments beyond wages, such as pensions and dividends, the report said.
The goal of a PAYE system is exact withholding, meaning that individuals have exactly the correct amount of tax withheld and do not have a tax liability or refund at the end of the year. However, this requires real-time reporting by employers of income paid and tax withheld, such as by using a payroll system that automatically reports such information to the government, the report said.
Under the British PAYE system, about 67 percent of taxpayers pay their tax liabilities in full by the end of the year. In using such a system, year-end reporting may be simplified or some taxpayers may not have to file a return, the report said. About 36 countries allow qualifying taxpayers to satisfy tax liabilities through exact withholding without filing a return, and nearly all do so with a form of PAYE.
In the U.S., withholding is carried out at the same rates throughout the year, regardless of changes in an employee’s tax liability. Additionally, individuals must make changes to their withholding themselves, the report said.
For example, if an employee is entitled to a deduction, a PAYE system would automatically decrease withholding to allow the individual to immediately receive the benefit. In the U.S., the deduction would have to be claimed on next year’s tax return and would be included in the individual’s refund, delaying their benefit from the deduction, the report said.
The American approach hinders compliance through its retrospective nature and requires the IRS to spend much of its resources processing and issuing refunds, dealing with fraudulent refunds, and collecting tax underpayments, the report said.
In the U.K., 5.2 percent of the taxes due for the 2014-15 tax year were not collected, compared with 14.6 percent when the American figure was last measured in 2006, the report said.
Implementing a broader PAYE system in the U.S. would mean that individuals would not have to seek a refund and fewer year-end tax returns would be necessary, the report said. The IRS would receive payments and other tax information from third parties instead of taxpayers themselves, increasing compliance and decreasing opportunities for fraud, the report said.
However, implementing a PAYE system would also increase costs and workloads for employers and other withholding agents and employees may be reluctant to share additional personal information, such as part-time work, with employers, the report said.
Using withholding codes to determine amounts of tax to withhold would protect employee privacy and increase the accuracy of withholding, the report said.
In New Zealand, employees fill out an anonymous questionnaire on the tax authority’s website that asks about the employee’s income, number of dependents, and other circumstances that affect tax liability. The website then generates a withholding code based on the employee’s responses, and the employee submits the code to an employer to determine how much to withhold and remit each pay period.
An employee may obtain a revised withholding code by filling out the questionnaire again when circumstances change, making it easier for employees to make adjustments to withholding and for employers to change withholding amounts, the report said.
Congress should pass legislation directing the Treasury Department to analyze the feasibility of switching from a system based on Form W-4, Employee’s Withholding Allowance Certificate, to one that uses withholding codes, the report said.
The IRS is developing a revised Form W-4 that accounts for withholding changes under the tax code overhaul (Pub. L. 115-97). A draft Form W-4 reflecting the elimination of personal exemptions initially was to be finalized for use in 2019, but a new draft is expected to be released in early 2019 for use in 2020 to give employers time to make changes to payroll systems.
Implementation of a withholding code-based system may not be simple, but would be “less cumbersome than redesign and subsequent use of the Form W-4,” the report said.
A system that uses withholding codes would eliminate the need for employees to disclose personal information to employers for income tax calculations. Switching to such a system would minimize the risk of data breaches and decrease the likelihood that employers would be accused of misusing personal information, the report said.
If the IRS implements a withholding code system, the agency should ensure that the questionnaire is accessible by telephone and that the website can be viewed on mobile phones, the report said.
The IRS should create guidance that protects employers that withhold taxes from independent contractors, the report said.Independent contractors often fail to make required quarterly tax payments and may have difficulties saving enough money during the year to pay tax liabilities, the report said. Less revenue is collected from workers who do not have tax withheld, and the problem grows as the gig economy expands, it said. “To reduce the risk that they will not save enough money to pay taxes, some independent contractors would prefer that taxes be withheld throughout the year,” the report said.
Many employers already have withholding systems that have the ability to include payments to independent contractors, the report said. However, some employers do not offer voluntary withholding arrangements because of concerns that the IRS may use the agreement as evidence of an employment relationship. There is little guidance on withholding from payments under a voluntary withholding agreement, and the guidance that exists should be clarified, the report said. Internal Revenue Code provisions allowing withholding agreements should be amended to prevent the IRS from considering voluntary withholding agreements as a factor when determining employment status, the report said.
The IRS should also consider providing “a safe-harbor worker classification in which it affirmatively agrees not to challenge the classification of workers who are a party to such agreements at all,” the report said.
IRS fraud-detection systems suffer from high false-positive rates and outdated technology, the report said.
From Jan. 1 to Oct. 3, 2018, the false positive rate for tax returns selected for fraud detection was 63 percent for identity theft cases and 81 percent for nonidentity theft cases, the report said.
The systems stopped about $7.6 billion in fraudulent payments, but delayed the processing of about $20 billion in legitimate refunds, the report said.
If a tax return is selected for fraud detection, it generally takes about 40 days from the time it was filed for a refund to be issued, even if the return is legitimate, the report said.
One reason why legitimate refunds are delayed is the absence of third-party wage information, the report said. Even if wage information is subsequently provided, IRS fraud systems only checked for new wage information once a week during the 2018 filing season, instead of every day. The IRS plans to have the systems check every day in the 2019 filing season, the report said.
The IRS’s Electronic Fraud Detection System contributes to delays because it does not interact with the IRS system for maintaining third-party wage information. Because of the interaction, employees must manually enter information received into the fraud-detection system and release the refunds themselves, the report said. The IRS has been planning to retire the system, which was introduced in 1994, and replace it with a new system for more than a decade, the report said.
Additionally, individuals whose refunds are delayed by the fraud-detection system cannot receive updates on the status of their refunds from IRS customer service representatives because the representatives do not have access to the correct information, the report said.
The Taxpayer Advocate Service handled some cases where refunds were delayed even if the third-party information provided would not affect or would increase the refund, the report said, recommending that the IRS add the capability for its fraud systems to release refunds in such cases.
The report also recommended that the IRS determine ways to improve its false positive rate, as well as develop a method to determine how many legitimate returns took longer than four weeks to be processed after being selected for fraud detection.
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