oversight

Tax Administration: Billions in Self-Employment Taxes Are Owed

Published by the Government Accountability Office on 1999-02-19.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to the Chairman, Subcommittee
                on Oversight, Committee on Ways and
                Means, House of Representatives


February 1999
                TAX
                ADMINISTRATION
                Billions in Self-
                Employment Taxes
                Are Owed




GAO/GGD-99-18
      United States

GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division



      B-276940

      February 19, 1999

      The Honorable Amo Houghton
      Chairman, Subcommittee on Oversight
      Committee on Ways and Means
      House of Representatives

      Dear Mr. Chairman:

      This report responds to the Subcommittee’s request that we (1) determine the number
      and characteristics of self-employed taxpayers who receive social security credit for self-
      employment earnings when they are delinquent in paying the self-employment taxes on
      those earnings; (2) determine why self-employed taxpayers who have not paid their self-
      employment taxes are allowed to receive social security credit; and (3) identify any
      potential actions that could enhance the collection of self-employment taxes. It makes
      recommendations to the Internal Revenue Service and the Social Security Administration
      to enhance the administration and collection of self-employment taxes.

      As agreed with your office, unless you publicly announce its contents earlier, we plan no
      further distribution of this report until 30 days from the date of this letter. At that time we
      will send copies of this report to the former Chair and the Ranking Minority Member of
      your Committee, the Chairman and Ranking Minority Member of the Senate Finance
      Committee, other interested Committees and Members, the Secretary of the Treasury,
      the Commissioner of Internal Revenue, and the Commissioner of Social Security. Copies
      will also be available to others on request.

      Major contributors to this report are listed in appendix V. If you have any questions,
      please call me on (202) 512-9110.




      Sincerely yours,
      James R. White
      Director, Tax Policy and
        Administration Issues
Executive Summary


             Internal Revenue Service (IRS) data show that the compliance rate for
Purpose      paying Social Security and Medicare taxes is over two times higher for
             wage-earners and their employers than for self-employed workers.
             Furthermore, regardless of whether they pay their self-employment taxes,
             most self-employed individuals can receive Social Security credit for their
             earnings.

             Because of the high self-employment tax noncompliance rate, the
             Subcommittee on Oversight, House Committee on Ways and Means, asked
             GAO to (1) determine the number and characteristics of self-employed
             taxpayers who receive Social Security credit for self-employment earnings
             when they are delinquent in paying the self-employment taxes on those
             earnings, (2) determine why self-employed taxpayers who have not paid
             their self-employment taxes are allowed to receive Social Security credit,
             and (3) identify any potential actions that could enhance the collection of
             self-employment taxes.

             The Social Security program is based on the concept that when individuals
Background   work, they pay taxes into the program based on their earnings, and when
             they retire, become disabled, or die, they or their spouse and qualified
             dependents may receive monthly benefits that are based on those earnings.
             The program was designed to be self-financing from taxes levied on
             employees’ wages and the net earnings of self-employed individuals, plus
             interest earned on the investment of trust fund balances in government
             securities.

             According to IRS, a key reason for the compliance rate difference between
             wage-earners and the self-employed is in how the Social Security and
             Medicare taxes are computed and paid. Employers are required to
             withhold these taxes from employees’ wages, remit withholdings to IRS at
             least quarterly, and report each employee’s earnings to the Social Security
             Administration (SSA) annually. In 1998, wage-earners and their employers
             each were required to pay 7.65 percent (a total of 15.3 percent) of an
             employee’s gross salary, up to $68,400. Self-employed taxpayers, however,
             were required to pay the entire 15.3 percent on net earnings from self-
             employment if their net earnings were more than $400 for the year, and
             they were generally required to remit self-employment taxes directly to
             IRS each quarter. From information reported on annual tax returns, IRS
             submits self-employed taxpayers’ earnings data to SSA, which posts them
             to its taxpayers’ accounts up to the earnings limit. This earnings
             information is used by SSA to determine if an individual is eligible for
             Social Security benefits and the amount of such benefits.




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                   Executive Summary




                   GAO’s analysis of self-employment tax delinquencies is based on IRS
                   records of taxpayers who, as of September 27, 1997, owed self-
                   employment taxes for one or more tax years. GAO identified self-employed
                   taxpayers with delinquent self-employment tax by assuming that partial
                   payments made by taxpayers were first applied against self-employment
                   taxes and any remaining payments were then applied to income and other
                   taxes shown on their returns. Thus, if the partial payments were sufficient
                   to cover the self-employment tax liability, these taxpayers were not
                   included in GAO’s estimates. While the self-employment tax delinquencies
                   included both Social Security and Medicare taxes, GAO did not examine
                   the number of self-employed delinquent taxpayers who were receiving
                   Medicare benefits. Also, GAO was not able to deduct the Medicare taxes
                   from the total self-employment taxes because the IRS accounts receivable
                   data GAO used did not separately list Social Security and Medicare taxes.

                   For all sample results, GAO calculated sampling errors and presents them
                   as 95-percent confidence intervals around each sample estimate.

                   Analysis of IRS’ accounts receivable data as of September 27, 1997,
Results in Brief   showed that more than 1.9 million self-employed taxpayers were
                   delinquent in paying $6.9 billion in self-employment taxes on 3.6 million
                   returns. These taxpayers can be generally characterized by their low
                   income and multiple delinquencies. Over 70 percent of their returns
                   reported net self-employment income of less than $20,000, and over half of
                   the taxpayers owed delinquent taxes for more than one tax year. Also,
                   more than 144,000 taxpayers with delinquent self-employment taxes of
                   $487 million were receiving about $105 million in monthly Social Security
                   benefits. The income on which the self-employment taxes had not been
                   paid resulted in at least an estimated $2.5 million (the 95-percent
                   confidence interval ranged from $2.5 million to $9.9 million) in monthly
                   benefits that would not have been paid if those earnings had not been
                   included in the benefit computation.

                   Self-employed taxpayers can get Social Security benefits based on earnings
                   for which they did not pay taxes because the Social Security Act requires
                   SSA to grant earnings credits, which are used to determine benefit
                   eligibility and amounts, and pay benefits without regard to whether the
                   Social Security taxes have been paid. However, not all self-employed
                   taxpayers can receive credit for their earnings. Under the Social Security
                   Act, when taxpayers do not file their tax returns within 3 years, 3 months,
                   and 15 days after the end of the year in which the income was earned, they
                   are not to receive Social Security credit. Of the 3.6 million returns with
                   delinquent self-employment tax, SSA did not post earnings to its records



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                             Executive Summary




                             for 473,755 returns. For an estimated 81.9 percent (plus or minus 6.5
                             percent) of the returns with unposted earnings, taxpayers filed the returns
                             after the statutory time limit. Many of the taxpayers may not have been
                             aware of the statutory time limit because neither SSA’s nor IRS’ widely
                             available publications discuss it.

                             There are several potential ways to enhance the collection of taxes from
                             self-employed individuals. IRS has recently been given the option to
                             continuously levy taxpayers’ Social Security benefits and other federal
                             payments to recover delinquent taxes and is in the process of developing a
                             program to do so. This levy program would affect taxpayers that are
                             already delinquent in paying their taxes and should reduce their tax debt.
                             With regard to collecting taxes before taxpayers become delinquent,
                             proposals have been made by the Department of the Treasury and others
                             to require withholding on business payments to certain self-employed
                             individuals, such as independent contractors, which could help reduce
                             self-employment tax delinquencies. However, Congress has not acted on
                             these proposals because of the administrative burden they would place on
                             those businesses that would have to withhold taxes.

                             Another way to collect taxes before taxpayers become delinquent would
                             be to encourage more self-employed individuals to make their required
                             estimated tax payments. GAO estimated that most self-employed
                             delinquent taxpayers did not make required estimated tax payments, and
                             many were assessed an estimated tax penalty. Taxpayers could be
                             encouraged to make estimated tax payments if IRS had a program to
                             remind previously noncompliant taxpayers to make such payments.


Principal Findings

Number and Characteristics   After applying all payments taxpayers made to their self-employment tax
                             liability, GAO found, as of September 27, 1997, more than 1.9 million
of Delinquent Self-          taxpayers involving 3.6 million returns still owed more than $20.5 billion in
Employed Taxpayers           total tax. Included in that amount were $6.9 billion in delinquent self-
                             employment taxes, or an average of $1,917 per return. The tax years
                             involved in these delinquencies ranged from 1963 to 1996. However, about
                             three-fourths of the 3.6 million returns were from tax years 1990 to 1996.
                             The average self-employment income per return was over $16,000, and
                             over 70 percent of the returns showed self-employment income of less
                             than $20,000. For 51 percent of the 3.6 million tax returns involving about
                             $3.3 billion in delinquent self-employment tax, the taxpayers filed the



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                            Executive Summary




                            required returns and self-assessed their taxes. For the remaining 49
                            percent, tax assessments were made as a result of one of IRS’ compliance
                            programs. Also, even though IRS was in the process of taking some sort of
                            collection action on the majority of the delinquencies, IRS said there was
                            no guarantee that it would collect those taxes.

                            GAO’s analysis of IRS and SSA records showed that as of April 21, 1998,
                            144,473 of the 1.9 million taxpayers delinquent in paying their self-
                            employment tax were receiving monthly Social Security retirement or
                            disability benefits. These taxpayers owed $487 million in self-employment
                            tax and were receiving $105 million a month in benefits, or an average of
                            $727 per taxpayer per month. At GAO’s request, SSA recalculated the
                            Social Security benefits for a representative sample of these taxpayers by
                            excluding from the benefit computation those earnings on which the self-
                            employment taxes had not been paid. On the basis of SSA’s recalculations,
                            GAO estimates that the benefit amount would be reduced by at least $2.5
                            million (the 95-percent confidence interval ranged from $2.5 million to $9.9
                            million) monthly, or $30 million annually (the 95-percent confidence
                            interval ranged from $30 million to $118.8 million). The average monthly
                            benefit payment would be reduced by about $43 per taxpayer.

The Social Security Act     The Social Security Act requires SSA to grant credits for coverage and pay
                            benefits without regard to whether the taxes have been paid. There were
Requires That Coverage Be   congressional proposals in the past to make credits for self-employment
Based on Self-Employment    earnings conditional upon the payment of the tax because of the
Earnings, Not Taxes Paid,   perception that the current policy undermines the compulsory
But There Is an Exception   contribution principle of the Social Security program and that it is unfair to
                            others who pay their taxes. However, Congress took no action on those
                            proposals.

                            Making self-employment earnings credits conditional on the payment of
                            the tax would reduce the total amount of Social Security benefit payments.
                            For the 144,473 self-employed delinquent taxpayers collecting Social
                            Security benefits as of April 21, 1998, the benefit payments would be
                            reduced by at least $30 million per year, or about 2 percent of the $1.3
                            billion in annual benefit payments paid to them.

                            Under current law IRS cannot administratively allocate taxpayers’ tax
                            payments among self-employment tax and other income taxes reported on
                            returns. Thus, if Congress made the posting of earnings conditional on the
                            payment of taxes, it would have to specify how IRS should allocate
                            taxpayer payments among self-employment taxes and other income taxes.
                            Whatever allocation formula was mandated would require IRS to develop a



                            Page 5                                GAO/GGD-99-18 Billions in SE Taxes Are Owed
                              Executive Summary




                              system to track payments by type of tax and send SSA information on the
                              self-employment tax payments made. SSA would also have to establish
                              procedures for tracking and posting the information received from IRS. It
                              was beyond the scope of GAO’s review to evaluate the effects of making
                              Social Security credit for earnings conditional on the payment of self-
                              employment taxes on the Social Security program or the tax system.

                              Not all taxpayers can get Social Security credit for their earnings. Under
                              the Social Security Act, to get Social Security credit, self-employed
                              taxpayers must file their income tax returns within 3 years, 3 months, and
                              15 days after the end of the calendar year in which the income was earned.
                              About $9.6 billion of the $60 billion in self-employment income reported on
                              473,755 returns, did not get posted to SSA’s records for the delinquent
                              taxpayers in GAO’s population. In an estimated 81.9 percent (plus or minus
                              6.5 percent) of those returns, the earnings were not posted because the
                              taxpayer filed after the statutory time limit. In an estimated 11.3 percent
                              (plus or minus 4.9 percent) of these returns, the taxpayers were making
                              payments to clear their tax debt. Many of these taxpayers may not have
                              known that they would not receive credit for their self-employment
                              earnings because SSA’s and IRS’ widely available publications for the self-
                              employed made no mention of the time limit. GAO also found that when
                              IRS contacts taxpayers under its Non-Filer Program, it does not inform
                              taxpayers about the time limit for filing returns in order to get Social
                              Security credit.

Potential Actions to Reduce   The Taxpayer Relief Act of 1997 gave IRS the option of using a new type of
                              levy that would continuously levy up to 15 percent of federal payments
Self-Employment Tax           (including Social Security benefits) made to delinquent taxpayers until the
Delinquencies                 tax debt is paid in full. With this authority, IRS plans to give the
                              Department of the Treasury’s Financial Management Service, which is to
                              be responsible for levying payments, information on the delinquent
                              accounts to be levied. IRS and the Financial Management Service expect
                              the levy program to be operational by July 2000. IRS does not plan to levy
                              against all the delinquent taxpayers. For example, IRS does not plan to
                              levy Social Security benefits for those taxpayers whose accounts are
                              classified as currently-not-collectible because of hardship or those who
                              have installment agreements in effect. Applying IRS’ levy criteria, GAO
                              found that IRS would levy about 41,000 of the 144,473 taxpayers who, as of
                              April 21, 1998, were receiving Social Security benefits and who were
                              delinquent in paying about $108 million in self-employment tax.

                              In general, self-employed taxpayers are less likely to file their returns and
                              report their earnings than wage-earners, who are subject to withholding.



                              Page 6                                GAO/GGD-99-18 Billions in SE Taxes Are Owed
Executive Summary




Thus, it seems likely that withholding on business payments to certain self-
employed individuals, such as independent contractors, could reduce the
amount and number of self-employment tax delinquencies. As far back as
1979, Treasury proposed mandatory withholding on business payments to
independent contractors, but Congress did not act on the proposal because
of the costs and burdens on the businesses that would have to withhold. In
1992, GAO proposed withholding on payments made by businesses to
independent contractors, and in 1995, a panel of former senior Treasury
and IRS officials presented several options for increasing the compliance
of self-employed taxpayers, including withholding on business payments to
independent contractors. GAO categorized 1.1 million delinquent self-
employed taxpayers by business activity and found that 40 percent could
be subject to such withholding as independent contractors under the
various proposals. Any provision to withhold on payments made by
businesses to the self-employed would increase the burden on both the
self-employed and the businesses making the payments.

Taxpayers not subject to withholding are generally required to make
quarterly estimated tax payments. However, GAO found that most
delinquent self-employed taxpayers did not make these required payments.
GAO estimated that the taxpayers for 2.5 million (plus or minus 200,000
returns) of the 3.6 million returns with delinquent self-employment taxes
should have made estimated payments, but in an estimated 2.3 million
returns (plus or minus 200,000 returns), the taxpayers failed to make these
required payments.

In 1991, IRS initiated a reminder notice program to get more taxpayers to
make required estimated payments. IRS sent reminder notices to all
taxpayers who were compliant in making estimated payments during the
previous year but had not made any in the current year. However, IRS
stopped sending the notices because taxpayer response to them was
negative. The taxpayers considered the notices intrusive because they
believed IRS was making assumptions based on the previous year that
might not apply to the current year. IRS had no data to show whether the
reminder notices increased the estimated tax payment compliance of
individuals who received notices. Taxpayers would have less cause for
concern if the notices were sent only to taxpayers who were not compliant
in making estimated tax payments during the previous year—that is, to
those who (1) in the current year had not made an estimated tax payment
and (2) in the previous year owed self-employment taxes and were
assessed an estimated tax penalty. GAO estimated that about 1.2 million of
the 2.5 million returns (plus or minus 200,000 returns) where estimated
payments were required met these criteria.



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                    Executive Summary




                    To enhance the administration and collection of self-employment taxes,
Recommendations     GAO is making two recommendations to the Commissioner of Internal
                    Revenue and one recommendation to the Commissioner of Social Security.
                    GAO recommends that

                  • the Commissioner of Internal Revenue revise IRS’ self-employment
                    publications, including those given under its Non-Filer Program, to ensure
                    that self-employed taxpayers know about the need to file tax returns with
                    self-employment earnings within the statutory time frame;
                  • the Commissioner of Internal Revenue undertake a pilot project to test the
                    feasibility of sending notices to noncompliant self-employed taxpayers;
                    and
                  • the Commissioner of Social Security revise SSA’s publications dealing with
                    self-employed individuals to inform them about the need to file tax returns
                    with self-employment earnings within the statutory time frame.

                    In written comments on a draft of this report, both the Commissioner of
Agency Comments     Internal Revenue and the Commissioner of Social Security agreed to
                    implement the recommendations. Their written comments, discussed in
                    chapters 3 and 4, set forth the agencies’ specific strategies for
                    implementing the recommendations. In addition, both IRS and SSA
                    included technical comments that GAO incorporated throughout the
                    report as appropriate.




                    Page 8                               GAO/GGD-99-18 Billions in SE Taxes Are Owed
Page 9   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Contents



Executive Summary                                                                                      2


Chapter 1                                                                                             14
                         Background                                                                   14
Introduction             Objectives, Scope, and Methodology                                           17


Chapter 2                                                                                             21
                         Number and Characteristics of Self-Employed Delinquent                       21
Self-Employed              Taxpayers
Delinquent Taxpayers     Some Self-Employed Delinquent Taxpayers Are Receiving                        25
                           Social Security Benefits
Owe Billions in Self-    Conclusions                                                                  26
Employment Taxes
Chapter 3                                                                                             27
                         The Social Security Act Requires Credits for Social                          27
Taxpayers Receive          Security Coverage to Be Based on SE Earnings, Not SE
Social Security Credit     Taxes Paid
                         Self-Employment Earnings Do Not Get Posted When                              28
When Taxes Are Not         Returns Are Filed After a Certain Date
Paid, With One           Conclusions                                                                  30
                         Recommendation to the Commissioner of Internal                               31
Exception                  Revenue
                         Recommendation to the Commissioner of Social Security                        31
                         Agency Comments                                                              31


Chapter 4                                                                                             33
                         Levying Social Security Benefit Payments                                     33
Potential Ways to        Withholding on Payments Made by Businesses to Self-                          34
Reduce Self-               Employed Taxpayers
                         Reminding Delinquent Self-Employed Taxpayers to Make                         36
Employment Tax             Estimated Tax Payments
Delinquencies            Conclusions                                                                  36
                         Recommendation to the Commissioner of Internal                               37
                           Revenue
                         Agency Comments                                                              37


Appendixes               Appendix I: Sampling and Data Analysis Methodology                           40
                         Appendix II: Additional Characteristics of Delinquent                        42
                           Self-Employed Taxpayers




                         Page 10                              GAO/GGD-99-18 Billions in SE Taxes Are Owed
         Contents




         Appendix III: Comments From the Internal Revenue                            45
           Service
         Appendix IV: Comments From the Social Security                              47
           Administration
         Appendix V: Major Contributors to This Report                               50


Tables   Table 2.1: Returns With Delinquent SE Tax by Taxpayer                       22
           and Amount of SE Tax Owed
         Table 2.2: Returns With Delinquent SE Tax and the                           22
           Amount of SE Tax Owed by Tax Year
         Table 2.3: Returns and Amount of Delinquent SE Tax by                       23
           Self-Employment Income
         Table 2.4: Collection Status of Returns and the Amount of                   24
           Delinquent SE Tax
         Table 2.5: Returns and Delinquent SE Tax by Years in                        24
           Accounts Receivable Inventory
         Table 2.6: Monthly SSA Benefits Retained by Taxpayers                       25
           After Benefit Amount Recalculation
         Table II.1: Reasons IRS Categorized SE Returns With                         42
           Balance Due as Currently-not-Collectible
         Table II.2: Collection Status of Returns for Which                          43
           Delinquent Taxpayers Were Receiving Social Security
           Benefits
         Table II.3: Delinquent SE Taxes Assessed Through IRS                        43
           Compliance Programs
         Table II.4: Age of Delinquent Taxpayers Currently                           44
           Collecting Social Security Benefits and Delinquent SE
           Tax
         Table II.5: Age of Delinquent Taxpayers Not Yet                             44
           Receiving Social Security Benefits and Delinquent SE
           Tax




         Page 11                             GAO/GGD-99-18 Billions in SE Taxes Are Owed
Contents




Abbreviations

FMS         Financial Management Service
IRS         Internal Revenue Service
SE          Self-employment
SSA         Social Security Administration


Page 12                              GAO/GGD-99-18 Billions in SE Taxes Are Owed
Page 13   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Chapter 1

Introduction


               Self-employed workers have to pay Social Security and Medicare taxes,
               which are called self-employment (SE) taxes, when their net earnings from
               self-employment exceed $400 in a tax year. The collection of these SE
               taxes has long been a problem. The Internal Revenue Service (IRS)
               estimated that the noncompliance rate for the amount of these SE taxes
               that were owed but not paid voluntarily and timely has been over 50
               percent since 1984. Since 1951, self-employed taxpayers have been covered
               by Social Security, and they can receive Social Security credit for their
               earnings regardless of whether their SE taxes are paid.

               This report responds to a request from the Chairman, Subcommittee on
               Oversight, House Committee on Ways and Means, that we (1) determine
               the number and characteristics of self-employed taxpayers who receive
               Social Security credit for self-employment earnings when they are
               delinquent in paying the SE taxes on those earnings, (2) determine why
               self-employed taxpayers who have not paid their SE taxes are allowed to
               receive Social Security credit, and (3) identify any potential actions that
               could enhance the collection of SE taxes.

               Several types of employment taxes have been established to pay for Social
Background     Security and medical benefits to entitled workers. Social Security taxes are
               imposed on earnings to provide benefits and protect against the loss of
               earnings when individuals retire, die, or become disabled. Social Security
               is the largest income maintenance program in the United States and is
               financed by flat-rate taxes levied on wages and self-employment income. In
               1998, the Social Security tax rate for employees and their employers was
               6.2 percent each on gross wages up to $68,400 and 12.4 percent on
                                                                                     1
               earnings net of expenses for self-employed individuals up to $68,400. In
               addition, hospital insurance (Medicare) was established to help pay for
               hospital, home health, skilled nursing, and hospice care for the aged and
               disabled. In 1998, the Medicare tax rate for employees and employers was
               1.45 percent each and 2.9 percent for self-employed workers. There is no
               earnings limit for the Medicare tax.

               All Social Security and Medicare taxes are first deposited in the general
               fund of the Treasury. For Social Security, the revenues are allocated to the
               Social Security trust funds (one for old-age and survivors insurance and
               the other for disability insurance) and for Medicare, the revenues are
               allocated to the Medicare trust fund for hospital insurance. The exact
               amount of the Social Security and health insurance contributions are not

               1
               Self-employed individuals are not required to pay SE taxes unless earnings net of expenses are $400 or
               more for the year.




               Page 14                                           GAO/GGD-99-18 Billions in SE Taxes Are Owed
                          Chapter 1
                          Introduction




                          known at the time taxes are deposited because they are not specifically
                          identified in collection reports. Thus, the allocation to each of the trust
                          funds is estimated. Periodic adjustments to the trust funds are
                          subsequently made based on earnings reports filed with the Social Security
                          Administration (SSA) by employers for each of their employees and tax
                          returns filed with IRS by the self-employed. IRS subsequently provides
                          reports of each self-employed taxpayer’s earnings net of expenses to SSA.
                          SSA records these reported earnings in each worker’s account. It then
                          certifies the amount of Social Security earnings in its records to the
                          Treasury, which uses the certified amounts in conjunction with the
                          appropriate tax rates to adjust the trust fund records. All program benefits
                          are paid from the trust funds. To the extent that tax revenues are greater
                          than program operating expenses and benefit payments, the excess
                          revenues are invested in interest-bearing federal securities. This process
                          gives no consideration to whether Treasury has collected all Social
                                          2
                          Security taxes.

Tax Compliance Is Lower   The Social Security program is based on the concept that when individuals
                          work, they pay Social Security taxes into the system, and when they retire,
for Self-Employed         become disabled, or die, they or their spouse and qualified dependents
Individuals Than Wage-    receive monthly benefits based on the insured worker’s average lifetime
Earners                   earnings. According to IRS data, the compliance rate for paying Social
                          Security and Medicare taxes is considerably higher for wage-earners and
                          their employers than for self-employed workers. IRS estimated that in
                                                                                3
                          1994, the gross Social Security and Medicare tax gap, which is the annual
                          amount of Social Security and Medicare taxes that were owed but not paid
                          voluntarily and timely, was between $17.1 billion and $18.1 billion for
                          wage-earners and their employers, which represents a compliance rate
                          between 95.8 percent and 96 percent. The SE taxes that were owed but not
                          paid voluntarily and timely by self-employed individuals was between
                          $27.9 billion and $31.6 billion, which represents a compliance rate of
                          between 41.3 percent and 44.4 percent.

                          IRS data also indicate that its enforcement programs (i.e., Examination
                          and Collection) were able to reduce the gross tax gap associated with
                          Social Security and Medicare taxes for wage-earners and their employers
                          by about 40 percent. IRS did not have data on how much the gross tax gap
                          2
                           In a report, Social Security: Reconciliation Improved SSA Earnings Records But Efforts Were
                          Incomplete (GAO/HRD-92-81, Sept. 1, 1992), we said Congress should consider revising section 201(a)
                          of the Social Security Act to provide that the trust funds receive revenue based on the amount of Social
                          Security taxes collected each year.
                          3
                          The gross tax gap consists of taxes that were not reported on returns and taxes that were reported but
                          not paid.




                          Page 15                                           GAO/GGD-99-18 Billions in SE Taxes Are Owed
                          Chapter 1
                          Introduction




                          for self-employed taxpayers was reduced through its enforcement
                          programs.

How Social Security and   A key difference between wage-earners and self-employed individuals is in
                          how the Social Security and Medicare taxes are computed and paid. Wage-
Medicare Taxes Are        earners and their employers each are required to pay half of the Social
Computed, Paid, and                                     4
                          Security and Medicare taxes. The Internal Revenue Code requires
Reported                  employers to withhold the employees’ share of these taxes from their
                          wages. Wage withholding is mandatory for employees, and taxes are
                          imposed starting with the first dollar of earnings. Employers are
                          responsible for remitting withholdings and their share of the taxes to IRS
                          at least quarterly and for reporting each employee’s earnings to SSA
                          annually.

                          Self-employed taxpayers are required to pay all of their SE taxes. Self-
                          employed individuals get two deductions that reduce their tax liability to
                          treat them in much the same way as employers and employees for Social
                          Security and income tax purposes. First, in determining SE tax liability,
                          self-employment earnings net of expenses are reduced by the product of
                          the taxpayer’s net earnings from self-employment and one-half of the SE
                          tax rates. This is similar to the way employees are treated under the tax
                          laws in that the employer’s share of Social Security and Medicare taxes is
                          not considered income to the employee. Second, self-employed individuals
                          can deduct half of their SE tax as a trade or business deduction from their
                          gross income in determining adjusted gross income for income tax
                          purposes. This is similar to the way employers are treated under the tax
                          laws in that the employer’s share of Social Security and Medicare taxes
                          can be deducted from gross income.

                          Unlike wage-earners, self-employed taxpayers do not have a third party
                          (employer) to withhold and pay taxes to the Treasury. Instead, these
                          taxpayers are to make their own quarterly estimated payments each year
                          to cover their expected tax liability. Taxpayers who make insufficient tax
                          payments to cover the expected tax liability are subject to estimated tax
                          penalties. Generally, no estimated penalty is to be assessed if the amount
                          of tax due at filing is less than $1,000 or the amount of withholding and
                          credits is 90 percent of the total current year tax liability or 100 percent of
                          the taxpayer’s prior year tax liability.


                          4
                           Most economists agree that the burden of Social Security and Medicare taxes is borne by wage-earners
                          in the form of lower wages. For example, both the Congressional Budget Office and the Joint
                          Committee on Taxation attribute these taxes to wage-earners when making estimates of the
                          distributional effects of taxes.




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                           Introduction




                           In addition to the differences in the computation and payment of taxes,
                           there is also a difference in how the earnings are reported between wage-
                           earners and self-employed individuals. For wage-earners, employers are to
                           report employee earnings annually to SSA on Form W-2 (Wage and Tax
                           Statement). However, self-employed individuals are to report their
                           earnings to IRS on Schedule SE (Self-Employment Tax), which is required
                           to be filed with their annual Form 1040 (U.S. Individual Income Tax
                           Return). IRS is to subsequently submit Schedule SE earnings data to SSA.

How SSA Credits Earnings   When SSA receives earnings data, it is to post them to the taxpayers’
                           accounts on its Master Earnings File up to the earnings limit. This earnings
and Determines Benefit     information is used by SSA to determine the number of Social Security
Amounts                    coverage credits and amount of benefits for individuals seeking Social
                           Security benefits. For example, to be eligible for retirement benefits, a
                           person needs 40 credits, which is equivalent to 10 years of work. In 1998,
                           both wage-earners and self-employed taxpayers earned one coverage
                           credit for each $700 in earnings. A maximum of four credits can be earned
                           per year. The amount of earnings required to earn a coverage credit is
                           statutorily set to increase each year as average wage levels rise.

                           Generally, the amount of a Social Security benefit is based on each
                           person’s average lifetime earnings. When an eligible taxpayer requests
                           Social Security retirement or disability benefits, SSA computes the benefit
                           amount by (1) determining the number of years of earnings to use as a
                           base, (2) adjusting those earnings for inflation, (3) determining the average
                           adjusted monthly earnings, and (4) multiplying the average adjusted
                           earnings by percentages in a formula specified by law.

                           Because of the high SE tax noncompliance rate, the Chairman of the
Objectives, Scope, and     Subcommittee on Oversight, House Committee on Ways and Means, asked
Methodology                us to review various issues relating to SE tax delinquencies. Our specific
                           objectives were to (1) determine the number and characteristics of self-
                           employed taxpayers who receive Social Security credit for self-
                           employment earnings when they are delinquent in paying the SE taxes on
                           those earnings, (2) determine why self-employed taxpayers who have not
                           paid their SE taxes are allowed to receive Social Security credit, and (3)
                           identify any potential actions that could enhance the collection of SE
                           taxes. (See app. I, which describes how we selected, analyzed, and
                           projected our sample.)




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                          Introduction




What Are the Number and   To determine the number and characteristics of taxpayers who receive
                          Social Security credit for their self-employment earnings when delinquent
Characteristics of SE     in paying the SE taxes on those earnings, we first contacted IRS National
Taxpayers?                Office staff in the Information Systems Development, Research, Collection,
                          and Examination Divisions. Next, we obtained an extract from IRS’
                          Individual Master File, as of September 27, 1997, for all returns with
                                                                                5
                          delinquent SE tax included in the total tax liability. At the same time, we
                          obtained access to IRS’ Accounts Receivable File, which contained
                          detailed information on returns with delinquent taxes. We matched the two
                          files to create a new database containing both master file and accounts
                          receivable data. This match produced a population of 6,020,291 tax returns
                          with SE tax included in total tax liability.

                          IRS does not allocate taxpayer payments to any particular type of tax;
                          therefore, we met with various IRS officials to discuss how we could
                          determine the amount of SE taxes that were still owed. We agreed to the
                          most conservative methodological approach, which was to assume that
                          partial payments were applied to the SE tax portion of the delinquency
                          until paid in full and then to income and other taxes owed. Working with
                          IRS officials, we developed a two-step formula that we used to determine if
                          taxpayers were delinquent in paying their SE tax. For the first step in the
                          formula, we subtracted the total tax owed for each delinquent return, as of
                          September 27, 1997, from the original total tax liability. The difference
                          represented the total amount of tax paid by the taxpayer as of September
                          27, 1997. In the second step, we subtracted the total amount of taxes paid
                          by the taxpayer from the SE tax amount included on the return. If the
                          amount of SE tax exceeded the total amount of taxes paid by $1 or more,
                          we considered the taxpayer delinquent in paying SE taxes on that return.

                          To confirm whether these taxpayers were receiving credit at SSA for their
                          earnings, we matched delinquent taxpayers against SSA’s earnings records.
                          In addition, we matched the universe of delinquent taxpayers against SSA’s
                          Master Benefit Record to determine how many of these delinquent
                          taxpayers were currently receiving Social Security retirement or disability
                                                               6
                          benefits under their own entitlement. While the SE tax delinquencies
                          included both Social Security and Medicare taxes, we did not examine the
                          number of self-employed delinquent taxpayers who were receiving

                          5
                           The data extracted included the (1) taxpayer identification number, (2) master file tax code, (3)
                          delinquent tax year, (4) adjusted gross income, (5) taxable income, (6) total tax liability per taxpayer,
                          (7) SE tax amount, and (8) SE income.
                          6
                          Individuals may be eligible for Social Security benefits under their own entitlement or that of a parent
                          or spouse.




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                             Introduction




                             Medicare benefits. Also, we were not able to deduct the Medicare taxes
                             from the total SE taxes because the IRS accounts receivable data we used
                             did not separately list Medicare and Social Security taxes.

                             To determine what effect, if any, the earnings on which the SE taxes had
                             not been paid had on the SSA’s monthly benefit amount, we asked staff at
                             SSA’s Kansas City Program Service Center to recompute benefits for a
                             random sample of 125 current benefit recipients, excluding such earnings.
                             This sample was weighted to project to the population of self-employed
                             delinquent taxpayers collecting Social Security benefits.

                             To determine if taxpayers were making estimated payments when required
                             to cover their tax liability, we selected a stratified random sample of 352
                             returns with delinquent SE tax as of September 27, 1997. This sample was
                             weighted to project to the total population of returns with delinquent SE
                             tax. For each of the returns, we reviewed IRS transcripts of the taxpayers’
                             accounts to determine if (1) the taxpayer should have made estimated tax
                             payments, (2) such payments were made, and (3) IRS assessed an
                             estimated tax penalty against the taxpayer when such payments were not
                             made.

Why Do Self-Employed         To determine why taxpayers receive credit for their earnings when the SE
                             taxes on such earnings have not been paid, we interviewed officials in IRS’
Individuals Receive Credit   National Office as well as various staff at SSA headquarters. We also
for Earnings on Which SE     researched the Social Security Act to determine if it required SSA to post
Taxes Are Unpaid?            self-employment earnings regardless of whether IRS had collected the
                             related SE tax. In addition, we obtained and analyzed IRS’ and SSA’s
                             policies and procedures relative to the posting of self-employment
                             earnings to determine (1) the type of self-employment data IRS sends to
                             SSA and how frequently IRS sends the data to SSA and (2) how SSA posts
                             self-employment earnings to its Master Earnings File.

                             While analyzing SSA posted earnings on which the SE taxes had not been
                             paid, we identified a universe of taxpayers who had earnings per IRS
                             records that were not posted by SSA. To determine why these earnings
                             were not posted, we analyzed a sample of 143 returns randomly selected
                             from the total population of returns with unposted earnings. This sample
                             was weighted to project to the total population of 473,755 returns.

                             All sample results are subject to sampling error because we reviewed only
                             a sample of the population. For all sample results, we calculated sampling
                             errors and present them as 95-percent confidence intervals around each
                             sample estimate.



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                         Chapter 1
                         Introduction




What Potential Actions   To identify any potential actions that could enhance the collection of SE
                         taxes, we interviewed SSA headquarters officials in various offices,
Could Enhance SE Tax     including the Offices of Legislation and Congressional Affairs, Program
Collection?              Benefits Policy, and Financial Policy and Operations. In addition, we
                         interviewed IRS National Office officials in the Submissions Processing,
                         Collection, and Examination Divisions. We also visited IRS’ St. Louis and
                         Chicago District Offices and discussed options for change with Collection
                         and Examination officials. We also reviewed prior reports by IRS and us
                         relative to self-employed individuals.

                         We reviewed legislative changes in the Taxpayer Relief Act of 1997 that
                         gave IRS the option of using a new type of levy to continuously levy up to
                         15 percent of federal benefit payments, including Social Security benefits,
                         made to delinquent taxpayers. In addition, we met with IRS and Financial
                         Management Service officials to document the status of efforts to
                         implement the continuous levy program and the milestones for such
                         implementation.

                         We obtained written comments on a draft of this report from the
                         Commissioner of Internal Revenue and the Commissioner of Social
                         Security. We have summarized the relevant portions of their comments at
                         the end of chapters 3 and 4 and reprinted the written comments in
                         appendixes III and IV. In addition, we incorporated technical comments
                         provided by both IRS and SSA throughout the report, as appropriate.

                         We did our work from April 1997 to September 1998 in accordance with
                         generally accepted government auditing standards.




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Chapter 2

Self-Employed Delinquent Taxpayers Owe
Billions in Self-Employment Taxes

                           Our analysis of IRS’ accounts receivable data, as of September 27, 1997,
                           showed that more than 1.9 million taxpayers owed $6.9 billion in SE taxes
                           on about 3.6 million returns. The taxpayers were delinquent in paying their
                           SE taxes for tax years 1963 to 1996, and over half owed taxes on two or
                           more returns. For almost half of the 3.6 million returns, tax assessments
                           were made as a result of one of IRS’ compliance programs. Although the
                           other taxpayers filed their returns and self-assessed their tax liability, they
                           did not pay the liability in full. IRS was in the process of taking some sort
                           of collection action on the majority of the delinquencies; however,
                           according to IRS, there is no guarantee that IRS will be able to collect
                           those taxes.

                           SSA posts reported self-employment earnings without considering whether
                           the SE taxes on those earnings have been paid. When an individual applies
                           for benefits, those earnings are used in determining eligibility for benefits
                           and in computing monthly Social Security benefits. Thus, even though they
                           had not paid about $487 million in SE taxes for the years 1963 through
                           1996, more than 144,000 taxpayers were receiving at least an estimated
                           $2.5 million in monthly Social Security benefits that were based on
                           earnings for which the SE taxes were delinquent.1

                           Below, we describe some of the characteristics of the 1.9 million self-
                           employed delinquent taxpayers. Appendix II describes additional
                           characteristics.

                           IRS’ accounts receivable data as of September 27, 1997, showed that over 6
Number and                 million tax returns filed by 3.4 million taxpayers included SE tax in the
Characteristics of Self-   total tax liability. These returns reported total tax liabilities of $28 billion,
Employed Delinquent        including about $14 billion in SE taxes. We applied the payments taxpayers
                           had made to the SE tax portion of their total tax liability first and found
Taxpayers                  that more than 1.9 million taxpayers, involving nearly 3.6 million returns,
                           still owed more than $20.5 billion in total tax, including over $6.9 billion in
                           SE taxes, or an average SE tax delinquency of $1,917.

Profile of SE Tax          Many of the 1.9 million taxpayers delinquent in paying their SE tax were
                           delinquent for more than one tax year. Our analysis of IRS’ accounts
Delinquencies              receivable data as of September 27, 1997, showed that about 59 percent of
                           the taxpayers were delinquent on two or more returns, accounting for over
                           86 percent of the $6.9 billion delinquent SE taxes. Forty-five percent of the
                           delinquent SE tax was owed by 15 percent of taxpayers who had five or
                           more returns with delinquent taxes. (See table 2.1.)
                           1
                               The 95-percent confidence interval ranged from $2.5 million to $9.9 million.




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Table 2.1: Returns With Delinquent SE
Tax by Taxpayer and Amount of SE Tax    Returns per                        Delinquent          Percent           Delinquent            Percent
Owed                                    taxpayer                            taxpayers          of total              SE tax            of total
                                        1                                      786,181            40.8        $943,563,492                13.7
                                        2                                      422,798            22.0          970,706,066               14.0
                                        3                                      256,964            13.4          975,864,003               14.1
                                        4                                      163,777              8.5         910,840,190               13.2
                                        5                                      109,684              5.7         821,945,830               11.9
                                        6-10                                   175,191              9.1       2,067,039,263               29.9
                                        More than 10                            10,703              0.6         222,975,171                 3.2
                                        Total                                1,925,298           100.0       $6,912,934,015              100.0
                                        Note: Percentages may not add to 100 because of rounding.
                                        Source: GAO analysis of IRS’ accounts receivable data.

                                        IRS data showed that the tax years involved in these delinquencies ranged
                                                             2
                                        from 1963 to 1996. About three-fourths of both the 3.6 million returns and
                                        $6.9 billion in delinquent SE taxes were for tax years 1990-96. Tax year
                                        1996 accounted for the highest percentage of returns, with about 480,000
                                        or 13.5 percent, and 11.8 percent of the $6.9 billion in delinquent SE taxes.
                                        (See table 2.2.)

Table 2.2: Returns With Delinquent SE
Tax and the Amount of SE Tax Owed by                                          Number of        Percent           Delinquent            Percent
                                                     a
Tax Year                                Tax year                                 returns       of total              SE tax            of total
                                        1996                                     480,357          13.5        $818,715,284                 11.8
                                        1995                                     403,973          11.3          762,721,779                11.0
                                        1994                                     381,160          10.7          771,164,165                11.2
                                        1993                                     379,496          10.6          778,524,728                11.3
                                        1992                                     357,834          10.0          762,761,167                11.0
                                        1991                                     333,548            9.4         717,788,098                10.4
                                        1990                                     322,218            9.0         678,678,014                 9.8
                                        1980-89                                  906,051          25.4        1,618,274,425               23.4
                                                                                                                                                b
                                        1963-79                                    3,958            0.1           4,756,546
                                        Total                                  3,568,595         100.0       $6,913,454,590               100.0
                                        Note: Percentages may not add to 100 because of rounding.
                                        a
                                        We obtained our data as of September 27, 1997, and it included 32 returns for tax year 1997 and
                                        $70,384 in delinquent SE tax, which we included in our analysis, but not in this table.
                                        b
                                            Less than one-tenth of one percent.
                                        Source: GAO analysis of IRS’ accounts receivable data.

                                        IRS’ accounts receivable data as of September 27, 1997, showed that the
                                        delinquent taxpayers reported about $60 billion in self-employment income
                                        on the 3.6 million returns, for an average of over $16,600 per return. About

                                        2
                                         Typically, by statute, IRS has 3 years from the date of the return to assess taxes and 10 years from the
                                        date of assessment to collect the taxes. However, IRS and the taxpayer could agree to extend the
                                        statutory limit at any time before its expiration. The IRS Restructuring and Reform Act of 1998 restricts
                                        the situations where the statute may be extended by agreement and requires IRS to notify the taxpayer
                                        of his or her right to refuse to extend the statute.




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                                       70 percent of the returns showed self-employment income of less than
                                       $20,000, and they accounted for about 40 percent of the delinquent SE tax.
                                       Fifteen percent of the returns with over $30,000 in self-employment
                                       income accounted for over 40 percent of the delinquent SE tax. (See table
                                       2.3.)

Table 2.3: Returns and Amount of
Delinquent SE Tax by Self-Employment   Self-employment                      Number of       Percent        Delinquent     Percent
Income                                 income range                            returns      of total           SE tax     of total
                                       Less than$10,000                      1,501,424         42.1    $1,100,835,389         15.9
                                       Between $10,000 and $19,999           1,041,328          29.2    1,642,986,945         23.8
                                       Between $20,000 and $29,999             490,598          13.8    1,368,492,069         19.8
                                       Between $30,000 and $39,999             237,115           6.6      948,033,032         13.7
                                       Between $40,000 and $49,999             149,444           4.2      768,871,356         11.1
                                       $50,000 or more                         148,718           4.2    1,084,235,799        15.7
                                       Total                                 3,568,627        100.0    $6,913,454,590       100.0
                                       Note: Percentages may not add to 100 because of rounding.
                                       Source: GAO analysis of IRS’ accounts receivable data.

How Delinquent Taxes                   Our analysis of IRS’ accounts receivable data showed that taxpayers
                                       responsible for over 51 percent of the 3.6 million returns involving about
Were Assessed                          $3.3 billion in delinquent SE taxes filed the required return and self-
                                       assessed their SE tax. However, these taxpayers did not pay their tax
                                       liability in full. For the remaining 49 percent of returns, involving over $3.6
                                       billion in delinquent SE tax, assessments were made as a result of one of
                                       IRS’ compliance programs, such as its Examination, Non-Filer, Substitute-
                                       for-Return, or Underreporter Programs.

                                       Our analysis showed that about $0.9 billion in SE tax was assessed under
                                       IRS’ Examination Program. Also, about $2.7 billion in SE tax was assessed
                                       through IRS’ document matching program, which covers the Non-Filer,
                                       Substitute-for-Return, and Underreporter Programs. The document
                                       matching program matches tax return information against data on
                                       information returns, such as Form 1099-MISC (Miscellaneous Income), to
                                       identify people who either fail to file returns or underreport their income.
                                       The Substitute-for-Return Program is similar to the Non-Filer Program
                                       except that IRS prepares the return for the taxpayer, using available
                                       information.

Collection Status of Self-             As of September 27, 1997, IRS’ records showed that returns with
                                       delinquent SE taxes were in various collection stages. IRS was pursuing
Employed Delinquent                    collection in 60 percent of the returns involving about 63 percent of the
Taxpayers                              delinquent SE taxes through installment agreements with the taxpayer,
                                       telephone calls to taxpayers through its Automated Collection System,
                                       delinquency notices to taxpayers, and revenue officer contacts with
                                       taxpayers. The remaining 40 percent were in an inactive status because



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                                          they had been classified as currently-not-collectible, the delinquency
                                          amounts were below the dollar tolerance for pursuing collection, or they
                                          were in the queue awaiting assignment to revenue officers in the field for
                                          enforced collection action. Table 2.4 shows the collection status of the 3.6
                                          million returns and the amount of delinquent SE tax associated with such
                                          returns.

Table 2.4: Collection Status of Returns
and the Amount of Delinquent SE Tax                                                  Number of Percent                Delinquent        Percent
                                          Collection status                            returns of total                   SE tax        of total
                                          Active
                                           Installment agreement                         738,951         20.7    $1,280,707,155             18.5
                                           Automated Collection System                   683,366         19.1     1,186,892,127             17.2
                                           Delinquency notice                            406,216         11.4       844,411,019             12.2
                                           Field collection - revenue officers           309,090          8.7     1,061,750,197             15.4
                                          Inactive
                                                                    a
                                           Currently-not-collectible                   1,003,105         28.1     2,071,673,761             30.0
                                           Below tolerance                               208,775          5.9        65,188,458              0.9
                                           In queue awaiting assignment                  219,021          6.1       402,539,810              5.8
                                                 b
                                           Other                                             103                        292,063
                                          Total                                        3,568,627        100.0    $6,913,454,590            100.0
                                          a
                                          Appendix II, table II.1 provides information on the reasons why IRS classified the returns as currently-
                                          not-collectible.
                                          b
                                           Other includes returns on which IRS was taking no collection action because (1) returns had not
                                          been posted, (2) taxpayers had been granted extensions for filing, or (3) IRS’ Examination or Criminal
                                          Investigation units were reviewing the case.
                                          Source: GAO analysis of IRS’ accounts receivable data.


                                          IRS’ records as of September 27, 1997, showed that the agency was
                                          pursuing collection in the majority of returns with delinquent SE tax;
                                          however, according to IRS officials, there is no guarantee IRS will actually
                                          collect the taxes. For example, IRS’ financial statement data for fiscal year
                                          1997 indicated that about 65 percent of all types of delinquent taxes may
                                          be uncollectible. According to IRS officials, the longer a delinquency is in
                                          the accounts receivable inventory, the less likely it is that IRS will collect
                                          those taxes. Table 2.5 shows the number of years returns with delinquent
                                          SE taxes have been in the accounts receivable inventory.

Table 2.5: Returns and Delinquent SE
Tax by Years in Accounts Receivable                                               Number of       Percent            Delinquent         Percent
Inventory                                 Years in inventory                         returns      of total               SE tax         of total
                                          Less than 1                                935,242         26.2        $1,851,512,531             26.8
                                          Between 1 and up to 2                      565,853         15.9         1,174,591,505            17.0
                                          Between 2 and up to 5                    1,243,026         34.8         2,520,074,103            36.5
                                          Between 5 and up to 10                     781,455         21.9         1,299,981,157            18.8
                                          More than 10                                43,051           1.2           67,295,294              1.0
                                          Total                                    3,568,627        100.0        $6,913,454,590           100.0
                                          Note: Percentages may not add to 100 because of rounding.
                                          Source: GAO analysis of IRS’ accounts receivable data.




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                                      As of April 21, 1998, a match of taxpayers with delinquent SE tax with
Some Self-Employed                    Social Security benefit records showed that 144,473 of the 1.9 million self-
Delinquent Taxpayers                  employed delinquent taxpayers who owed $487 million in SE taxes were
Are Receiving Social                  receiving $105 million in monthly Social Security benefits, or an average
                                      monthly benefit of $727 per taxpayer.
Security Benefits
                                      Of the 144,473 delinquent taxpayers receiving Social Security benefits,
                                      nearly two-thirds were receiving retirement benefits while the remaining
                                      one-third were receiving disability benefits. The taxpayers were delinquent
                                      in paying their SE tax on 291,114 returns. Also, almost 60 percent of the
                                      returns were in an inactive collection status (e.g., currently-not-collectible
                                      or below tolerance). Appendix II, tables II.2, II.3, and II.4 describe
                                      additional characteristics of the 144,473 taxpayers currently collecting
                                      Social Security benefits.

                                      At our request, SSA recomputed the monthly benefit amounts for a sample
                                      of delinquent taxpayers currently receiving benefits. The recomputed
                                      benefit amounts show the effect of excluding earnings on which the SE
                                      taxes had not been paid from the benefit computation. On the basis of
                                      SSA’s recalculation, we estimate that the monthly benefit payments to the
                                      delinquent self-employed taxpayers would be reduced by at least $2.5
                                                                       3
                                      million, or $30 million annually. As shown in table 2.6, the benefits for an
                                      estimated 34 percent of the taxpayers would not be affected by the
                                      recalculation because either SSA had posted no self-employment earnings
                                      for the delinquent years or the earnings excluded were low and not used in
                                                                         4
                                      the original benefit computation. The table also shows that about 3
                                                                                                     5
                                      percent of the taxpayers would have lost all of their benefits.

Table 2.6: Monthly SSA Benefits
Retained by Taxpayers After Benefit   Percent of benefits remaining
Amount Recalculation                  after recalculation                                      Number of taxpayers       Percent of total
                                      0                                                                      4,096                    2.8
                                      50-89                                                                 11,699                    8.1
                                      90-99                                                                 80,043                   55.4
                                      100                                                                   48,635                   33.7
                                      Total                                                                144,473                 100.0
                                      Source: GAO analysis of IRS and SSA data.




                                      3
                                      The 95-percent confidence interval ranged from $2.5 million to $9.9 million monthly, or from $30
                                      million to $118.8 million annually.
                                      4
                                          The 95-percent confidence interval ranged from 22.9 percent to 44.5 percent
                                      5
                                          The 95-percent confidence interval ranged from 0.1 percent to 5.5 percent.




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                The effect on Social Security benefits of excluding earnings for which SE
                taxes were not paid would be dependent upon the significance of the
                earnings excluded relative to a beneficiary’s total lifetime earnings, as
                shown in the following examples.

              • An individual who owed SE taxes on more than $160,000 in self-
                employment earnings for 5 years, was receiving $1,121 per month in
                disability benefits. According to SSA, when these earnings were excluded
                from the benefit calculation, the recomputed benefit amount was zero
                because without the excluded earnings, the individual lacked sufficient
                earnings credits to be eligible for the disability benefits.
              • An individual who owed SE taxes on earnings of more than $290,000 over a
                12-year period was receiving $990 per month in retirement benefits. If
                those earnings had been excluded, the benefit amount would have been
                reduced to $688 per month—a reduction of about $302.

                In most instances, however, the effect of excluding such earnings was
                much less significant, as shown in the following examples.

              • For an individual receiving $824 in retirement benefits, the recomputation
                had no effect on the benefit amount after excluding over $1,300 in earnings
                for one tax year. Because the earnings during the delinquent tax year were
                low, SSA had not used them in computing the original benefit amount.
              • An individual’s $349 monthly benefit would have been reduced by $19, to
                $330, after SSA excluded over $26,000 in earnings for 2 tax years.

                The number of taxpayers delinquent in paying their SE tax and collecting
                Social Security benefits could increase in the future. We found that as of
                September 27, 1997, 72,000 taxpayers who still owed SE taxes were over
                age 62, the minimum age to be eligible for SSA retirement benefits, and
                could begin drawing benefits at any time. However, we cannot say with
                any certainty how many taxpayers delinquent in paying their SE tax will
                receive Social Security benefits in the future.

                Substantial numbers of self-employed individuals do not pay all of their SE
Conclusions     taxes. These taxpayers can be generally characterized by their low income
                and multiple delinquencies. Owing SE taxes does not prevent individuals
                from receiving Social Security benefits, and some do receive them.




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Chapter 3

Taxpayers Receive Social Security Credit
When Taxes Are Not Paid, With One
Exception
                          The Social Security Act requires SSA to credit individuals’ earnings for
                          Social Security coverage without regard to whether their SE taxes have
                          been paid. As a consequence, individuals can receive Social Security
                          benefits based on earnings for which they have not paid SE taxes. An
                          exception prevents certain individuals (including the self-employed) from
                          receiving credit for their earnings when tax filing was not timely, even if
                          the taxes eventually are paid. Congress could make Social Security credit
                          conditional on payment of SE taxes and has considered proposals to do so
                          in the past. Making credit conditional would raise a number of issues, such
                          as how to allocate payments between SE and other income taxes.

                          As noted in chapter 2, a significant number of self-employed individuals
The Social Security Act   are collecting Social Security benefits, a portion of which are based on
Requires Credits for      earnings for which the SE taxes have not been paid. The Social Security
Social Security           Act requires SSA to grant credits for coverage and pay benefits without
                          regard to whether the taxes have been paid. This issue has been addressed
Coverage to Be Based      by the Supreme Court. In a 1960 decision, the Court stated that the amount
on SE Earnings, Not       of Social Security benefits do not in any true sense depend on
SE Taxes Paid             contributions to the program through the payment of taxes, but rather on
                                                                  1
                          the earnings record of the beneficiary.

                          Past congressional proposals have sought to make credits for self-
                          employment earnings conditional upon the payment of the tax because of
                          the perception that to give credit for earnings where taxes have not been
                          paid undermines the compulsory contribution principle of the Social
                                                                                                2
                          Security program and that it is unfair to others who pay their taxes.
                          However, no action was taken on those proposals. While wage-earners can
                          also receive credit for Social Security coverage when their Social Security
                          and Medicare taxes are not paid, these proposals were not directed at
                          them because they do not have the same responsibilities for assessing and
                          paying the taxes as the self-employed. For wage-earners, employers are
                          responsible for assessing and withholding taxes and remitting those
                          withheld taxes to IRS. Thus, while wage-earners can be considered
                          innocent third parties when their employers fail to pay withheld taxes, the
                          self-employed cannot because they are responsible for assessing their
                          taxes and paying those taxes to IRS.



                          1
                              Flemming v. Nestor, 363 U.S. 603 (1960).
                          2
                           During the 95th Congress, the Chairman of the Ways and Means Oversight Subcommittee introduced
                          H.R. 12565, the “Self-Employment Tax Payment Act of 1978,” which contained such a change. In 1979,
                          the Subcommittee Chairman reintroduced the bill, which was renumbered as H.R. 5465.




                          Page 27                                         GAO/GGD-99-18 Billions in SE Taxes Are Owed
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                      Taxpayers Receive Social Security Credit When Taxes Are Not Paid, With One Exception




                      Excluding the earnings on which the SE taxes had not been paid from
                      benefit calculations would reduce the total amount of Social Security
                      benefit payments made. For example, we found that for the 144,473
                      delinquent self-employed taxpayers receiving benefits as of April 21, 1998,
                      the benefit amount would be reduced by an estimated $74.4 million (plus
                      or minus $44.4 million) annually, which is about 6 percent of their $1.3
                      billion in annual benefit payments.

                      If Congress made the posting of earnings conditional on payment of SE
                      taxes, it would have to resolve some issues related to tax payments. For
                      example, Congress would have to specify how to allocate taxpayer
                      payments between SE taxes and other income taxes because IRS cannot,
                      under current law, administratively make these allocations. Furthermore,
                      since only a minimum amount of earnings are required to get Social
                      Security credit, the Social Security Act would have to include a provision
                      as to when SSA could give taxpayers credit for their earnings. To illustrate,
                      taxpayers could get credit when they paid taxes on the minimum earnings
                      amount or when they paid their full SE tax liability.

                      In addition, making Social Security credit conditional on the payment of
                      SE taxes could require IRS to develop a system to track payments and
                      send SSA the information when SE taxes were paid. SSA may also have to
                      develop procedures to post the earnings data more frequently than it does
                      now, depending upon whether IRS would send the earnings data to SSA
                      after each SE tax payment or when the liability was completely paid.
                      Currently, IRS forwards self-employment earnings data to SSA after it
                      processes the Schedule SE, and SSA then posts the earnings to the
                      person’s earnings record. Generally, the posting occurs once a year for
                      each taxpayer when SSA receives the Schedule SE data. It was beyond the
                      scope of our review to evaluate the effects of making Social Security credit
                      for earnings conditional on the payment of SE taxes on the Social Security
                      program or the tax system.

                      The Social Security Act provides that the posting of self-employment
Self-Employment       earnings is conditional upon taxpayers filing their income tax returns
Earnings Do Not Get   within 3 years, 3 months, and 15 days after the end of the tax year in which
Posted When Returns   the income was earned. However, the law applies the time limitation
                      differently to self-employed individuals than to wage-earners. It requires
Are Filed After a     SSA to strictly enforce the time limitation when posting the reported
Certain Date          earnings of self-employed individuals, but allows the posting of the
                      earnings of wage-earners after expiration of the time limitation if the wage-
                      earners submit proof of earnings, such as pay records and tax returns.




                      Page 28                                    GAO/GGD-99-18 Billions in SE Taxes Are Owed
  Chapter 3
  Taxpayers Receive Social Security Credit When Taxes Are Not Paid, With One Exception




  In comparing the self-employment earnings reported to IRS with the
  earnings posted by SSA for the 3.6 million returns with delinquent SE tax,
  we found 473,755 returns where the self-employment earnings did not get
  posted to Social Security records. The earnings not posted by SSA
  amounted to $9.6 billion, or 16 percent of the over $60 billion in SE income
  reported to IRS by 273,476 taxpayers. In the majority of these returns, the
  earnings were not posted because taxpayers had not filed their income tax
  returns within the statutory time limit. On the basis of our analysis of a
  representative sample of self-employed delinquent taxpayers whose
  earnings were not posted to SSA records, we estimate that 81.9 percent of
                                                                    3
  the returns were filed after the statutory time limit had expired. IRS had
  pursued these returns under its Non-Filer Program but had not secured the
  returns in time for the taxpayers to get Social Security credit for their
  earnings. Although the remaining returns were filed within the statutory
  time limit, SSA officials told us there could be a number of reasons why
  the earnings were not posted, including the taxpayers’ use of invalid Social
  Security numbers and names on their tax returns.

  The following two examples illustrate how late-filed returns affect the
  posting of earnings for self-employed individuals.

• One taxpayer reported over $14,000 in self-employment earnings on his
  1992 individual tax return. To receive Social Security credit, the return had
  to be filed by April 15, 1996. However, IRS did not receive the return until
  December 19, 1996, which was 8 months after the 3-year, 3-month, and 15-
  day time limit. Therefore, SSA did not post the earnings.
• Another taxpayer did not file a tax year 1991 return, so IRS, using data
  from information returns, filed a substitute return for the taxpayer. On
  April 21, 1996, IRS assessed over $8,000 in SE tax on earnings of more than
  $53,000. SSA did not post the earnings because the assessment was made
  after the April 15, 1995, time limit for filing a timely return.

  Even if the taxpayers in these instances were to eventually pay the SE tax
  owed, they would not receive credit for their self-employment earnings.
  We estimate that in about 11.3 percent of the returns where taxpayers filed
  returns after the statutory time limitation expired, they were making
  payments to clear their tax debt even though their self-employment
                                          4
  earnings would not be posted by SSA.


  3
      The 95-percent confidence interval ranged from 75.4 percent to 88.4 percent.
  4
      The 95-percent confidence interval ranged from 6.4 percent to 16.2 percent.




  Page 29                                              GAO/GGD-99-18 Billions in SE Taxes Are Owed
              Chapter 3
              Taxpayers Receive Social Security Credit When Taxes Are Not Paid, With One Exception




              SSA officials told us that self-employed taxpayers who file their returns too
              late for their earnings to be posted may not realize they will not receive
              credit toward Social Security benefits. They said they receive many
              inquiries from taxpayers applying for benefits who question why they did
              not receive credit for their self-employment earnings. In 1995, SSA began
              sending Personal Earnings and Benefit Estimate Statements automatically
              to workers who had reached age 60. Starting in fiscal year 2000, SSA plans
              to send the statements annually to almost every worker in the country age
              25 and older—an estimated 123 million people each year. These six-page
              statements provide workers with a list of their yearly earnings on record at
              SSA, information about their eligibility for benefits, and estimates of those
              benefits. The statement also provides workers with a toll-free number for
              any questions they may have concerning the statement.

              Our review of widely available SSA and IRS publications that address
                                                                             5
              self-employment issues showed no mention of the time limit. We also
              found that when IRS contacts taxpayers under its Non-Filer Program, it
              does not inform them about the time limit for filing returns in order to get
              Social Security credit. Letting taxpayers know about the statutory time
              limit could increase the number of taxpayers who would file within that
              time limit.

              The Social Security Act requires SSA to post all of the reported earnings of
Conclusions   a self-employed person, regardless of whether the SE taxes on those
              earnings have been paid, as long as the return is filed within the statutory
              time limit. While this may be unfair to taxpayers who pay their taxes,
              changing it to make getting Social Security credit conditional on paying
              taxes would require congressional action. This change would require a
              detailed analysis of all costs and benefits as well as an evaluation of the
              effect such a change would have on other aspects of the Social Security
              program and the tax system. Such analysis was beyond the scope of our
              review.

              When individuals apply for benefits, their earnings are used to determine
              eligibility and compute their monthly benefit amount. However, as of
              September 27, 1997, SSA had not posted about $9.6 billion in self-
              employment earnings from 473,755 returns. We estimate that SSA did not
              post the self-employment earnings in 81.9 percent (plus or minus 6.5
              percent) of those returns because they were not filed within the statutory
              time limitation. Many of these taxpayers may be unaware that they will not

              5
              These publications include SSA Publication 05-10022: If You’re Self-Employed and IRS Publication 533:
              Self-Employment Taxes.




              Page 30                                          GAO/GGD-99-18 Billions in SE Taxes Are Owed
                      Chapter 3
                      Taxpayers Receive Social Security Credit When Taxes Are Not Paid, With One Exception




                      receive Social Security credit for these earnings. Neither IRS nor SSA
                      publications relating to self-employment make note of this time limitation.

                      To better inform taxpayers of the importance of filing tax returns within
Recommendation to     the statutory time limit, we recommend that the Commissioner of Internal
the Commissioner of   Revenue revise IRS’ self-employment publications, including those given
Internal Revenue      under its Non-Filer Program, to ensure that self-employed taxpayers know
                      about the need to file tax returns with self-employment earnings within 3
                      years, 3 months, and 15 days after the end of the calendar year in which
                      the self-employment income was earned in order to get Social Security
                      credit for those earnings.

                      To better inform potential Social Security recipients of the importance of
Recommendation to     filing tax returns within the statutory time limit, we recommend that the
the Commissioner of   Commissioner of Social Security revise SSA’s publications for self-
Social Security       employed individuals to inform them about the need to file tax returns
                      with self-employment earnings within 3 years, 3 months, and 15 days after
                      the end of the calendar year in which their self-employment income was
                      earned in order to get Social Security credit for those earnings.

                      In written comments on our draft report, the Commissioner of Internal
Agency Comments       Revenue and the Commissioner of Social Security agreed with the
                      recommendations to better inform self-employed taxpayers of the
                      statutory time limit for filing returns with SE income in order to receive
                      Social Security credit.

                      The Commissioner of Internal Revenue said that IRS has included
                      information on the statutory time limit for filing returns in the 1998
                      revision of Publication 533, Self-Employment Tax. Also, IRS plans to revise
                      the 1999 versions of Publication 583, Starting a Business and Keeping
                      Records, and Publication 334, Tax Guide for Small Business, to provide
                      such information. In addition, the Commissioner agreed to modify IRS’
                      non-filer notices to make it clear to taxpayers that they will not receive
                      Social Security credit for their earnings if they do not file their returns
                      within the time limit.

                      The Commissioner of Social Security agreed to include information on the
                      statutory time limit in all publications for the self-employed as those
                      publications are revised. The Commissioner stated that SSA Publication
                      05-10022: If You’re Self-Employed, was recently revised, but will be
                      updated in the Fall of 1999 to include information on the statutory time
                      limit. The Commissioner also stated that SSA plans to use a public
                      information package that is distributed monthly to all field offices to better



                      Page 31                                    GAO/GGD-99-18 Billions in SE Taxes Are Owed
Chapter 3
Taxpayers Receive Social Security Credit When Taxes Are Not Paid, With One Exception




inform taxpayers of the statutory time limit for filing. This package
includes, among other information, a newspaper column that the field
offices provide to local newspapers as part of an ongoing column on Social
Security matters. According to the Commissioner, the February 1999
column will focus on self-employment issues and will include information
on the statutory time limit.




Page 32                                    GAO/GGD-99-18 Billions in SE Taxes Are Owed
Chapter 4

Potential Ways to Reduce Self-Employment
Tax Delinquencies

                          There are several potential ways to enhance the collection of delinquent
                                                                1
                          taxes from self-employed individuals. IRS has recently been given the
                          option to continuously levy taxpayers’ Social Security benefits and other
                          federal payments to recover delinquent taxes and is in the process of
                          developing a program to do so. This levy program affects taxpayers that
                          are already delinquent in paying their taxes and should reduce their tax
                          debt. With regard to collecting taxes before taxpayers become delinquent,
                          proposals have been made by Treasury and others to require withholding
                          on certain types of payments made to the self-employed, which could help
                          reduce SE tax delinquencies. However, Congress has not acted on these
                          proposals because of the administrative burden they would place on those
                          businesses that would have to withhold taxes. Also, since most self-
                          employed delinquent taxpayers did not make required estimated tax
                          payments, a program, such as one that reminds taxpayers to make the
                          payments could enhance self-employment tax collections.

                          The Taxpayer Relief Act of 1997 gave IRS the option of using a new type of
Levying Social Security   levy to continuously levy up to 15 percent of federal payments (including
Benefit Payments          Social Security benefits) made to delinquent taxpayers until their entire
                          tax debt is paid in full. Although IRS had the authority to levy Social
                          Security benefits prior to the 1997 act, it did not have authority to levy
                          such benefits continuously. Federal payments are made by the Department
                          of the Treasury’s Financial Management Service (FMS), and it is to be
                          responsible for developing and administering the program, including
                          levying the payments and forwarding levy payments to IRS. Under the
                          program, IRS plans to give FMS information on the delinquent accounts to
                          be levied. For Social Security payments, FMS is to match these accounts
                          against its file of Social Security benefit recipients and levy benefit
                          payments. Because of the sensitivity of levying delinquent taxpayers’
                          Social Security benefit payments, IRS wants to ensure that the program
                          will function as authorized and will not result in inappropriate levies.
                          Therefore, IRS plans to issue two notices before levying Social Security
                          payments to give taxpayers time to resolve their delinquencies. The first
                          notice is to be sent when the match is made, and a second 30 days later.

                          Initially, IRS officials believed the levy program could be implemented by
                          January 1999. However, both IRS and FMS officials told us that they had
                          jointly agreed to delay implementation of the program until July 2000. The
                          delay is to afford both IRS and FMS time to negotiate a mutually

                          1
                           It was beyond the scope of this review to examine all potential options that could enhance the
                          collection of SE taxes. For example, we did not examine what impact increased IRS enforcement
                          action might have on compliance.




                          Page 33                                          GAO/GGD-99-18 Billions in SE Taxes Are Owed
                      Chapter 4
                      Potential Ways to Reduce Self-Employment Tax Delinquencies




                      acceptable set of implementation requirements as well as time for FMS to
                      make necessary modifications to its offset program. Also, the delay will
                      allow both IRS and FMS more time to develop regulations for the levy
                      program.

                      IRS plans to levy the federal payments (including Social Security benefits)
                      for the total tax liability including interest and penalties. The 144,473
                      delinquent self-employed taxpayers who were receiving Social Security
                      benefits as of April 21, 1998, owed about $2.1 billion in total taxes, of
                      which $487 million was SE tax and $1.6 billion was income tax. In addition,
                      the taxpayers owed $4.6 billion in assessed and accrued interest and
                      penalties. However, IRS does not plan to levy against all delinquent
                      taxpayers. For example, IRS does not plan to levy Social Security benefits
                      for those taxpayers whose accounts are classified as currently-not-
                                                                                                  2
                      collectible because of hardship or those who have installment agreements.
                      Applying IRS’ levy criteria, we found that IRS would levy about 41,000 of
                      the 144,473 taxpayers delinquent in paying about $108 million in SE tax.

                      While the continuous levy program should result in recovering some
Withholding on        delinquent SE taxes, it would be preferable to get taxpayers to pay their SE
Payments Made by      taxes at the time they earn their income instead of when they begin
Businesses to Self-   collecting Social Security benefits. IRS officials in Collection and
                      Examination told us that withholding taxes from payments by businesses
Employed Taxpayers    to certain self-employed individuals could reduce the number of SE tax
                      delinquencies. In general, self-employed taxpayers are less likely to report
                      their earnings or pay their tax liability than are wage-earners, who are
                      subject to withholding. IRS data show that the compliance rate for
                      reporting income for taxpayers subject to withholding is 99 percent versus
                      80 percent for self-employed taxpayers.

                      Withholding on payments by businesses to self-employed individuals is not
                      a new idea. As far back as 1979, the Department of the Treasury proposed
                      withholding by businesses on payments made in the course of a trade or
                      business for services provided by independent contractors, who include
                      subcontractors, accountants, lawyers, and engineers. It proposed
                      withholding at a flat rate of 10 percent, but would have exempted workers
                      who normally worked for five or more businesses in a calendar year or
                      expected to owe less tax than the withheld amount. However, this
                      proposal was not enacted by Congress because of the administrative


                      2
                       Section 3462(b) of the IRS Restructuring and Reform Act of 1998 prohibits IRS from levying while an
                      installment agreement is pending or in effect or while an offer-in-compromise is pending.




                      Page 34                                          GAO/GGD-99-18 Billions in SE Taxes Are Owed
Chapter 4
Potential Ways to Reduce Self-Employment Tax Delinquencies




burden that would have been placed on those businesses that would have
to do the withholding.

In July 1992, we reported that the noncompliance among independent
contractors was serious enough to warrant some form of withholding and
proposed that Congress consider legislation to improve compliance
                                                    3
through withholding, but Congress took no action. In addition, in 1995, a
panel of tax experts, including former senior officials in IRS and Treasury,
presented several options for increasing the compliance of self-employed
taxpayers. One such option supported by most panelists was withholding
on business payments to independent contractors. Furthermore, various
IRS studies have recognized that withholding could be an up-front tool to
reduce the number of SE tax delinquencies. Of the 1.9 million delinquent
SE taxpayers, we were able to categorize 1.1 million by type of business
using IRS data. Of the 1.1 million, 40 percent were engaged in personal,
professional, or business services and would have been subject to the
mandatory withholding under the various proposals.

Mandatory withholding by employers of taxes from employees has been
the cornerstone of the U.S. tax compliance system for years, and it has
worked very well with over 99 percent of wages voluntarily reported.
Implementing mandatory withholding on business payments to
independent contractors could have a similar effect on the tax compliance
of these individuals. However, there are administrative concerns that
would need to be resolved, such as determining the rate of withholding so
that the tax withheld approximates the tax due for the year.

In addition to administrative considerations, withholding on business
payments to independent contractors would increase the burden on both
the independent contractors and the businesses that use them. It could
adversely affect the cash flow of some independent contractors who could
have business expenses that reduce their annual net income and taxes
owed below the withheld amount. In addition to the burden on taxpayers,
businesses would have costs and burdens associated with withholding and
depositing the taxes into the Treasury as well as reporting the income and
taxes to IRS. Businesses would also have the burden of identifying those
independent contractors who would be exempted from withholding.




3
 Tax Administration: Approaches for Improving Independent Contractor Compliance (GAO-GGD-92-
108, July 23, 1992).




Page 35                                       GAO/GGD-99-18 Billions in SE Taxes Are Owed
                       Chapter 4
                       Potential Ways to Reduce Self-Employment Tax Delinquencies




                       Taxpayers not subject to withholding are generally required to make
Reminding Delinquent   quarterly estimated tax payments. IRS’ Statistics of Income data for tax
Self-Employed          year 1994 showed that about 4.4 million of the 12.2 million taxpayers who
Taxpayers to Make      reported SE taxes on their returns made estimated tax payments. About 5
                       million taxpayers were assessed an estimated tax penalty because they
Estimated Tax          failed to make required quarterly payments.
Payments
                       As of September 27, 1997, we estimate that of the 3.6 million returns with
                       delinquent SE tax, the taxpayers responsible for 2.5 million returns (69
                                                                                 4
                       percent) were required to make estimated tax payments. However, in an
                       estimated 2.3 million (92 percent) of those returns, taxpayers failed to
                                                               5
                       make the required estimated payments.

                       In 1991, IRS sent reminder notices to all taxpayers who were compliant in
                       making estimated tax payments in the prior year but had not made any in
                       the current year. According to an IRS official, the taxpayer response to
                       these notices was negative, and taxpayers considered them to be intrusive
                       because they believed that IRS was making assumptions based on the
                       previous year that might not apply to the current year. As a result of the
                       negative taxpayer reaction, IRS stopped sending the notices. IRS had no
                       data to show whether the reminder notices increased the estimated tax
                       payment compliance of individuals who received notices.

                       However, taxpayers would have less cause for concern if the notices were
                       sent only to taxpayers who were not compliant in making estimated tax
                       payments during the previous year--that is, to those who (1) in the current
                       year had not made an estimated tax payment and (2) in the previous year
                       had filed a Schedule SE and were assessed an estimated tax penalty. We
                       estimate that about 1.2 million of the 2.5 million returns (48 percent)
                       where the taxpayer was required to make estimated payments met these
                                6
                       criteria. Sending such a reminder notice would not be costly and could
                       encourage noncompliant taxpayers to make required estimated payments.

                       IRS now has the option to continuously levy taxpayers’ Social Security
Conclusions            payments to collect delinquent taxes. How much delinquent SE taxes IRS
                       would be able to secure through the continuous levy program is unknown;
                       however, less than 30 percent of delinquent self-employed taxpayers that


                       4
                           The 95-percent confidence interval ranged from 2.3 million to 2.7 million returns.
                       5
                           The 95-percent confidence interval ranged from 2.1 million to 2.5 million returns.
                       6
                           The 95-percent confidence interval ranged from 1.0 million to 1.4 million returns.




                       Page 36                                               GAO/GGD-99-18 Billions in SE Taxes Are Owed
                      Chapter 4
                      Potential Ways to Reduce Self-Employment Tax Delinquencies




                      we identified as receiving Social Security benefits would meet IRS’ criteria
                      for levying.

                      Intervening with taxpayers before they become delinquent may reduce the
                      amount and limit the number of SE tax delinquencies. One potential way to
                      do this would be to implement withholding on payments made by
                      businesses to independent contractors. This would help ensure that some
                      portion of the tax liability is collected at the time the income is earned.
                      However, withholding would impose costs and burdens on those
                      businesses that would have to withhold the taxes and could affect the cash
                      flow of independent contractors. Congress has not enacted prior proposals
                      to implement withholding on independent contractors.

                      Since self-employed taxpayers are not subject to withholding, many are
                      required to make estimated payments to cover their tax liability. However,
                      we found that 2.3 million taxpayers did not make required estimated tax
                      payments. In the past, IRS tried sending notices to all self-employed
                      taxpayers who had made estimated payments in the prior year but not the
                      current year, reminding them that they may be liable for estimated
                      payments in the current year. According to an IRS official, taxpayers
                      considered these notices intrusive because they believed that IRS was
                      making assumptions based on the previous year that might not apply to the
                      current year. IRS could send a reminder notice only to those taxpayers
                      who were noncompliant in making estimated tax payments in the previous
                      year. We estimate about 1.2 million of the 2.5 million returns where the
                      taxpayer was required to make estimated payments met these criteria.

                      To reduce SE tax delinquencies, we recommend that the Commissioner of
Recommendation to     Internal Revenue undertake a pilot project to test the feasibility of sending
the Commissioner of   notices to noncompliant self-employed taxpayers who in the current year
Internal Revenue      had not made estimated payments and in the previous year had filed a
                      Schedule SE and were assessed an estimated tax penalty.

                      Although this report discusses the issue of extending mandatory
                      withholding to cover payments by businesses to certain self-employed
                      individuals, such as independent contractors, such action would require
                      legislation, which would require Congress to make a value judgment as to
                      the need for such a change. A full-scale evaluation of the costs and
                      burdens of withholding was beyond the scope of our review. Therefore, we
                      do not make a recommendation on this issue.

                      In written comments on our draft report, the Commissioner of Internal
Agency Comments       Revenue agreed with the recommendation to pursue a pilot project to test



                      Page 37                                   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Chapter 4
Potential Ways to Reduce Self-Employment Tax Delinquencies




the feasibility of sending reminder notices to noncompliant self-employed
taxpayers. The Commissioner stated that IRS plans to incorporate the
recommendation into its national non-filer strategy. Under this strategy,
IRS plans to improve compliance and service to taxpayers by emphasizing
delinquency prevention. The Commissioner also stated that IRS had
selected an executive to head up the non-filer strategy, and expected the
strategy to be in place by the end of fiscal year 1999.




Page 38                                   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Page 39   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix I

Sampling and Data Analysis Methodology


                       This appendix describes how we selected, analyzed, and projected the
                       sample data for three random samples to the universe of returns of
                       taxpayers delinquent in paying their SE taxes. The samples pertain to (1)
                       computing Social Security benefit amounts, (2) determining whether the
                       taxpayers were required to make estimated payments, and (3) determining
                       why SSA did not post self-employment earnings in some cases.

                       Our computer analysis of IRS and SSA records showed that of the 1.9
Recomputation of SSA   million taxpayers delinquent in paying their SE tax as of September 27,
Benefits               1997, 144,473 were collecting $105 million in monthly Social Security
                       retirement or disability benefits as of April 21, 1998. To determine what
                       effect, if any, the earnings on which the SE taxes had not been paid had on
                       SSA’s monthly benefit amount, we selected a stratified random sample of
                       125 taxpayers from the population of delinquent taxpayers receiving Social
                       Security benefits. The population was divided into 14 strata based on the
                       amount of delinquent SE tax and the Social Security monthly benefit
                       amount. Once the sample was selected, we asked staff at SSA’s Kansas
                       City Program Service Center to recompute benefits for those taxpayers,
                       excluding from the computation earnings on which the SE taxes had not
                       been paid. In the analysis, the sample selections were weighted to
                       represent the total population of 144,473 taxpayers receiving monthly
                       Social Security retirement or disability benefits.

                       In the process of confirming that self-employment earnings were being
Nonposting of Self-    posted at SSA, we identified about $9.6 billion from 473,755 returns that
Employment Earnings    SSA did not post to the taxpayers’ accounts. The Social Security Act
by SSA                 provides that for self-employed individuals, SSA will post earnings to their
                       account so long as the return is filed timely. The act defines “timely” as
                       being within 3 years, 3 months, and 15 days after the end of the calendar
                       year in which the income was earned. For returns filed after that date, no
                       self-employment earnings are to be posted.

                       Discussions with SSA officials led us to believe that late-filed returns was
                       the primary reason earnings were not posted by SSA. To determine if our
                       belief was valid, we selected a stratified random sample of 143 returns
                       from the population of 473,755 returns for which no earnings were posted.
                       The population was divided into 10 strata based on the amount of SE tax
                       owed as of September 27, 1997. Our review of IRS transcripts of account
                       for the 352 returns selected for the estimated payment sample identified 40
                       returns for which SSA had posted no earnings. However, that sample was
                       too small to produce reliable estimates. As a result, we selected a
                       supplemental sample of 103 returns with unposted earnings. The 40
                       returns previously identified were excluded from the supplemental sample.



                       Page 40                              GAO/GGD-99-18 Billions in SE Taxes Are Owed
                        Appendix I
                        Sampling and Data Analysis Methodology




                        For the 143 returns, we reviewed IRS transcripts of account to determine if
                        the returns were filed timely and if the taxpayers were making payments to
                                                1
                        satisfy their liability. In our analysis, the sample selections have been
                        weighted to represent the total population of 473,755 returns with self-
                        employment earnings per IRS records that were not posted to the
                        taxpayer’s account by SSA.

                        Self-employed taxpayers are not covered by mandatory withholding. As a
Estimated Payments      result, they are to make estimated tax payments when, after subtracting
                        withholding and credits from the tax liability, they expect to owe more
                                   2
                        than $500. There are some exceptions to this requirement. For example, if
                        the taxpayer’s withholding and credits are equal to 100 percent of their
                        prior year’s tax or 90 percent of the current year’s tax, no estimated
                        payment is required. Because not all self-employed taxpayers are required
                        to make estimated payments, we selected a stratified random sample of
                        352 returns from the total population of 3.6 million returns for which
                        taxpayers were delinquent in paying their SE tax. The population was
                        divided into 10 strata based on the amount of SE tax owed as of September
                        27, 1997, and the source of the taxpayers’ income. For each of the returns,
                        we reviewed IRS transcripts to determine if (1) the taxpayer should have
                        made estimated tax payments, (2) such payments were made, and (3) IRS
                        assessed an estimated tax penalty against the taxpayer when such
                        payments were not made. In the analysis, the sample selections have been
                        weighted to represent the total population of 144,473 receiving monthly
                        Social Security retirement or disability benefits.

                        Because our results come from samples, the estimates used in the report
Sampling Errors for     are subject to sampling errors. Sampling errors measure the extent to
Key Estimates Used in   which estimates from samples of these sizes and structure can be expected
the Report              to differ from the total population values. From the sample estimates,
                        together with estimates of their sampling errors, interval estimates can be
                        constructed with prescribed confidence that they each include actual
                        population values. Each of our sample estimates is surrounded by a 95-
                        percent confidence interval indicating that we are 95-percent confident
                        that the results for the total population will be within each confidence
                        interval.




                        1
                        Because of difficulties in obtaining a transcript for one of the 143 returns, we reviewed transcripts for
                        only 142 returns.
                        2
                            For tax year 1998, the $500 requirement has been raised to $1,000.




                        Page 41                                               GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix II

Additional Characteristics of Delinquent Self-
Employed Taxpayers

                                         This appendix provides additional characteristics of the taxpayers
                                         delinquent in paying their SE tax. These characteristics include IRS’
                                         reasons for classifying returns as currently-not-collectible, collection
                                         status of delinquent taxpayers collecting Social Security benefits, IRS
                                         enforcement actions required to obtain a return and assess the taxes owed
                                         for those taxpayers currently collecting Social Security benefits, and the
                                         ages of both those currently collecting Social Security benefits and those
                                         not yet collecting benefits.

                                         As noted in chapter 2, table 2.4, IRS had classified 28 percent of the 3.6
                                         million returns with delinquent SE tax and 30 percent of the delinquent SE
                                         tax as currently-not-collectible. Table II.1 shows, as of September 27, 1997,
                                         the most common reasons IRS used in categorizing a balance due as
                                         uncollectible.

Table II.1: Reasons IRS Categorized SE
Returns With Balance Due as Currently-                                         Number of          Percent          Delinquent   Percent
not-Collectible                          Reason                                   returns         of total             SE tax   of total
                                         Undue hardship on taxpayer               746,845            74.5      $1,597,301,095       77.1
                                         Unable to contact taxpayer               127,376            12.7         199,878,431        9.7
                                         Unable to locate taxpayer                 86,924              8.7        197,054,660        9.5
                                         Deceased taxpayer                         40,718              4.1         75,511,492        3.6
                                               a
                                         Other                                      1,242              0.1          1,928,083        0.1
                                         Total                                  1,003,105           100.0      $2,071,673,761     100.0
                                         Note: Percentages may not add to 100 because of rounding.
                                         a
                                         Other includes returns with a balance due below the tolerance for collection action.
                                         Source: GAO analysis of IRS’ accounts receivable data.


                                         Analysis of IRS and SSA data showed that, as of September 27, 1997, about
                                         58 percent of the returns for the 144,473 taxpayers collecting Social
                                         Security benefits were in an inactive collection status because they had
                                         been classified as currently-not-collectible, were below the tolerance for
                                         collection action, or were in the queue awaiting assignment to revenue
                                         officers in the field. These returns accounted for 56 percent of the $487
                                         million in delinquent SE tax. (See table II.2.)




                                         Page 42                                           GAO/GGD-99-18 Billions in SE Taxes Are Owed
                                           Appendix II
                                           Additional Characteristics of Delinquent Self-Employed Taxpayers




Table II.2: Collection Status of Returns
for Which Delinquent Taxpayers Were                                                    Number of         Percent       Delinquent Percent
Receiving Social Security Benefits         Collection status                             returns         of total          SE tax of total
                                           Active
                                            Installment agreement                           45,442         15.6        $62,172,414      12.8
                                            Automated Collection System                     36,719         12.6         56,063,820      11.5
                                            Delinquency notice                              21,597          7.4          37,732427       7.7
                                            Field collection by revenue officers            19,559          6.7         60,408,421      12.4
                                           Inactive
                                            Currently-not-collectible                      132,046         45.4       239,899,340       49.2
                                            Below tolerance                                 20,426          7.0         5,517,467        1.1
                                            In queue awaiting assignment                    15,319          5.3        25,424,191        5.2
                                            Other                                                6                          8,731
                                           Total                                           291,114        100.0      $487,226,811      100.0
                                           Note: Percentages may not add to 100 because of rounding.
                                           Source: GAO analysis of IRS’ accounts receivable data.

                                           Taxpayers voluntarily filed returns self-assessing the taxes owed in about
                                           51 percent of the returns for taxpayers who were receiving Social Security
                                           benefits. These returns accounted for 45 percent of the delinquent SE tax.

                                           For the remaining 49 percent of the returns, IRS enforcement action was
                                           required to obtain the return or assess the taxes owed. As of September 27,
                                           1997, these returns accounted for 55 percent of the $487 million in
                                           delinquent SE tax. As shown in table II.3, IRS used various compliance
                                           programs to assess the taxes due.

Table II.3: Delinquent SE Taxes
Assessed Through IRS Compliance                                                      Number of         Percent        Delinquent     Percent
Programs                                   IRS compliance program                      returns         of total           SE tax     of total
                                           Non-Filer                                   57,373              40.5     $102,303,549         38.0
                                           Substitute-for-Return                       26,094             18.4        65,961,971        24.5
                                           Audit by Examination                        35,617             25.1        80,412,961         29.9
                                           Underreporter                               15,496             10.9        12,716,049          4.7
                                                 a
                                           Other                                        7,136               5.0        7,946,358          2.9
                                           Total                                      141,716            100.0      $269,340,888       100.0
                                           Note: Percentages may not add to 100 because of rounding.
                                           a
                                           Other includes adjustments, math errors, and penalties.
                                           Source: GAO analysis of IRS’ accounts receivable data.

                                           About 69 percent of the 144,473 delinquent taxpayers receiving Social
                                           Security benefits were age 63 and over and accounted for about 76 percent
                                           of the delinquent SE tax.




                                           Page 43                                         GAO/GGD-99-18 Billions in SE Taxes Are Owed
                                          Appendix II
                                          Additional Characteristics of Delinquent Self-Employed Taxpayers




Table II.4: Age of Delinquent Taxpayers
Currently Collecting Social Security                                         Number of         Percent          Delinquent     Percent
Benefits and Delinquent SE Tax            Age                                taxpayers         of total              SE tax    of total
                                          30 and under                             575              0.4            $614,212         0.1
                                          31-40                                  5,829              4.0          10,650,448         2.2
                                          41-50                                 12,559              8.7          30,631,544         6.3
                                          51-55                                  8,967              6.2          25,549,207         5.2
                                          56-62                                 15,533            10.8          47,264,519          9.7
                                          63-65                                 24,746            17.1          88,609,353        18.2
                                          66-70                                 41,481            28.7         163,081,601        33.5
                                          Over 70                               33,145            23.0         117,809,196        24.2
                                          No date of birth available             1,698              1.1           2,982,291         0.6
                                          Total                                144,473           100.0        $487,192, 371      100.0
                                          Source: GAO analysis of IRS and SSA data.

                                          Finally, our analysis of IRS and SSA data showed that, as of September 27,
                                          1997, over 72,000 taxpayers delinquent in paying their SE tax were over
                                          age 62, the minimum age to be eligible for Social Security retirement
                                          benefits, but were not yet receiving those benefits. In addition, there were
                                          about 190,000 taxpayers between the age of 56 and 62 that could become
                                          eligible for Social Security benefits within the next several years.

Table II.5: Age of Delinquent Taxpayers
Not Yet Receiving Social Security                                              Number of           Percent        Delinquent   Percent
Benefits and Delinquent SE Tax            Age                                  taxpayers           of total           SE tax   of total
                                          30 and under                            148,313               8.3     $211,816,368        3.3
                                          31-40                                   494,819             27.8     1,462,396,521      22.8
                                          41-50                                   550,376             30.9     2,313,429,461      36.0
                                          51-55                                   211,827             11.9     1,025,227,749      16.0
                                          56-62                                   189,928             10.7       915,022,838      14.2
                                          63-65                                    31,304               1.8      164,336,108        2.6
                                          66-70                                    21,173               1.2      100,336,474        1.6
                                          Over 70                                  19,642               1.1       56,038,381        0.9
                                          No date of birth available              113,443               6.4      177,137,744        2.8
                                          Total                                 1,780,825            100.0    $6,425,741,644     100.0
                                          Note: Percentages may not add to 100 because of rounding.
                                          Source: GAO analysis of IRS’ accounts receivable data.




                                          Page 44                                         GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix III

Comments From the Internal Revenue Service




               Page 45     GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix III
Comments From the Internal Revenue Service




Page 46                                  GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix IV

Comments From the Social Security
Administration




              Page 47       GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix IV
Comments From the Social Security Administration




Page 48                                   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix IV
Comments From the Social Security Administration




Page 49                                   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Appendix V

Major Contributors to This Report


                        James M. Fields, Senior Social Science Analyst
General Government      James J. Ungvarsky, Computer Specialist
Division, Washington,   Elizabeth W. Scullin, Communications Analyst
D.C.

                        William J. Staab, Senior Evaluator
Health and Human        Vanessa R. Taylor, Evaluator
Services Division,
Washington, D.C.
                        Shirley A. Jones, Senior Attorney
Office of General
Counsel, Washington,
D.C.

                        Ralph Block, Assistant Director
San Francisco Office

                        Terry Tillotson, Evaluator-in-Charge
Kansas City Office      Yong Meador, Evaluator
                        Thomas N. Bloom, Computer Specialist




                        Page 50                              GAO/GGD-99-18 Billions in SE Taxes Are Owed
Page 51   GAO/GGD-99-18 Billions in SE Taxes Are Owed
Page 52   GAO/GGD-99-18 Billions in SE Taxes Are Owed
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