The“Tax Gap”
Vol. 8 No. 1 ◆ March 2006
Wesley D. Bigler, CFP®
Chief Executive Officer IRS to increase audits of high income filers in 2006.
L. Quinton Fisher
President
ou have heard debates over the budget gap though it may be news to them that they are “rich, big
and the trade gap. Lawmakers have talked guys”, the IRS apparently considers them potential tax
about the wage gap and education gap. abusers. In fact, your chances of being audited are one
Kris Dwyer, CDFA
Now the federal government has another in 20 if you make over $100,000.
Tom Bosley, CFP® gap to watch. It’s called the “tax gap” . The IRS seems a bit late on its announcement, as
Jim Bolton, CFP® As defined by the Internal Revenue Service (IRS), the agency already boosted its audit activity by 20% in
the tax gap is the difference between 2005—the highest level in 10 years. Moreover, audits
Bruce Ellis, CFP®
what the government expects to col- on filers making over $100,000
Gary Kirk, CFP® lect and what it actually collects. Who Bears the increased by 40%. The efforts have
Joel P. Smith, III The IRS wants to close the gap and Federal Tax Burden* paid off, as the IRS has enjoyed a
Jan Dahlin Geiger, CFP® is stepping up audits in 2006 to raise Income Average Share of
10% growth in collections from en-
collections. The agency recently an- Group Income(1) Fed. Tax(2) forcement activity.
Susan Ganser, CFP® Congress recently hiked the
nounced that it will commit more Lowest 20% $ 14,800 1.0%
Michael McKay resources to scrutinizing taxpayers Second 20% 34,100 4.5% IRS budget to $10.68 billion, with
Middle 20% 51,900 9.9% a higher portion earmarked for
Hector Diaz, CLU, ChFC with annual incomes over $100,000. Fourth 20% 77,300 18.6%
Highest 20% 184,500 65.7% enforcement. The agency also an-
Ralph Wagner
Targeting abusive nounced plans to hire collection
Top 10% $ 260,000 50.2%
shelters Top 5% 377,300 38.7% agencies to recover billions of dol-
Suzanne Barranco An IRS study in 2005 revealed Top 1% 1,022,400 22.6% lars owed from past audits.
that tax evasion and other noncom- *Based on 2003 filings
Kim Kelly
pliance cost the government more (1) Pre-tax income in 2003 dollars (2) Includes income,
social insurance, corporate and excise taxes. Audit risks
Cathy Bolton than a trillion dollars in lost revenue Source: Congressional Budget Office
The fact that the IRS audits only
Sharon Edwards each year. So, the increased auditing 2% of all tax returns offers little
will supposedly target abusive shelters, defined as trans- comfort if you happen to be in that 2%. As the IRS
Maureen Yoder
actions that lack economic purpose other than avoiding casts a wider net, it will likely devote more effort to
Scott Lewis income taxes. seeking out regular tax return items that have high audit
Kathleen French “Combating abusive shelters remains the centerpiece potential. So, the best audit defense strategy is to avoid
Jennifer Hanes of our enforcement efforts,” said IRS Commissioner the audit in the first place.
Mark Everson. “Average Americans don’t want to feel Certain types of filers, income sources, professions,
Deena Thomas transactions and deductions are more prone to scrutiny.
that the big guy gets away with something just because
Judy Hammond he’s rich.” Consider a few high-risk audit areas:
Olga Golovan Business owners should take note. The IRS is
expected to focus more effort on examining self-em- • High income/self-employed
ployed people who deal largely in cash. In particular, • Cash-oriented business
the agency will look at questionable uses of foreign • High itemized deductions or tax shelter losses
FINANCIAL NETWORK
accounts, trusts, partnerships, insurance policies, an- • Rental expenses
1100 Johnson Ferry Road nuities and retirement plans. Moreover, anyone making • Home office or automobile deductions
Suite 420 over $100,000 a year may be at higher risk of audit. Al- Continued on back
Atlanta, GA 30342
Tel: 404.843.3100
Fax: 404.250.9850 Securities offered through Financial Network Investment Corporation • Securities Broker-Dealer • SIPC
Financial Network Corporation and Financial Network Investment Corporation are not affiliated
Tax Cuts and Deficits
Through July, real GDP averaged 4.3%, whereas
growth before the tax cuts was only 2.4%. From June
2001 to May 2003, total annual GDP was $10.9 tril-
Hear both sides of the story before casting your lot. lion; after the tax cuts were implemented, the econo-
my produced about $12.2 trillion per year.(3)
(1) On the spending side of hat’s better for the economy—lower Over 5 million new jobs were added as a result
the equation, military outlays
dropped substantially as policy taxes or a balanced budget? This will of new business formations, rising venture capital
makers erroneously assumed be a hotly debated question as Con- activity and increased initial public offerings. At
that the Cold War’s end would
eliminate the need for a large
gress and President Bush spar over this point, every job lost during the bursting of the
U.S. military presence. Further, the costs to rebuild the Gulf Coast. At stake is the ex- technology bubble and market decline of 2000-02
from 1996 to 2000, spending on tension of the 2003 tax cuts, future economic growth has been matched by a new job.(4) The stock market
Social Security, Medicare and
Medicaid actually fell from 8.2% and the government’s fiscal stability. rebounded in 2003-04, restoring about $2 trillion of
of GDP to 7.6%. On the income Balanced budget proponents say that the 2003 investor wealth lost in the 2000 crash.
side, the bull stock market and
Internet bubble doubled tax
tax cuts on personal income, dividends and capital As a result, the rising economy since 2003 has
collections on capital gains. gains rates reduced boosted federal rev-
But the red ink returned in 2001 federal revenues and enues. In fiscal year
as these uncontrollable factors
shifted. It is estimated that half worsened the deficit. 2005, tax receipts
of the big swing from surplus They warn that mak- climbed by more
to deficit was due to the stock
market crash and the economic ing the cuts perma- than $262 billion—
slowdown, while the other nent would produce the largest single
half resulted from tax cuts and even more federal year increase in his-
higher federal spending. (“The
Deficit: America’s Credibility red ink and establish tory. This raised the
Gap”, Fortune, 8 March 2004, pp a dangerous pattern government’s share
136-138)
of fiscal imprudence. of the economy to
(2) The first attempt gradually
reduced marginal tax rates and
Most deficit hawks 17.5% of GDP—
provided tax rebates designed to point to the surplus close to the 17.9%
boost consumer spending. This that arose in the postwar average.(5)
proved to be weak medicine,
however, since the policy tar- late 1990s as evi- According to U.S.
geted consumer activity rather dence that tax hikes Treasury numbers,
than supply side capital forma-
tion. The second attempt aimed
and spending cuts personal withheld
to offset a collapse in business advance economic tax revenues are up
investment by accelerating the activity. What they don’t mention is that other factors 7.3% compared to last year, and social insurance and
marginal rate cuts and dropping
the rate on both dividends and helped create the temporary surplus.(1) retirement receipts have grown 6.4%.
capital gains. Policies intended Supporters of tax reform claim that higher taxes The higher revenues have brought down the fed-
to increase business investment
and production have proven discourage risk taking, business spending, consumer eral budget deficit. The Congressional Budget Office
more beneficial to economic purchasing and other activities that fuel economic (CBO) estimates the 2005 deficit at $273 billion—or
growth than those designed to growth. So, a slowing economy would result in lower about 2.2% of GDP. This $58 billion is less than the
stoke consumer demand. This
offers strong evidence for the federal revenues, which is the last thing the govern- original 2005 forecast and far below the $412 billion,
supply side argument. (“The Tax ment needs as it struggles to control the deficit while or 3.6% of GDP, in 2004. In August, the CBO pro-
Cut Expansion”, The Wall Street
Journal, 12 July 2005, A16) fighting a war and helping the Gulf recovery effort. jected that the deficit would trend down to 2.4% in
(3) “Clinton, Katrina & Tax Cuts”,
They propose even lower taxes to supply individu- 2006 and fall to 2.0% by 2010.
National Review Online, 23 Sept. als and businesses with the capital needed to invest The storm rebuilding effort will force an upward
2005. and spend on new endeavors. Moreover, they believe revision in the deficit. But the fact remains that the
(4) The strong employment num- the private sector can allocate this capital more pro- revenue component of the budget has improved with
bers are coinciding with a larger
population of active workers.
ductively than the government. The expected result tax cuts.
Labor force participation is now would be a rising economy and expanding tax base
around 66% today, compared that generate more wealth, higher living standards The truth about deficits
to a 63% postwar average. The
4.9% jobless rate is almost a and more federal revenues. Despite contrary evidence, tax reform opponents
percentage point below its level still claim that the 2003 tax cuts were a costly mis-
during the same stage of the
late-90s economic expansion.
The tax cut boom take. The intense disagreement produces enough
(“The Great American Jobs Ma- The 2003 tax law was a second attempt to restore misinformation to confuse the issues and lead many
chine”, The Wall Street Journal, growth after the dot-com bubble crash, the 2001 to inaccurate views of tax policy. In recent years, the
8 Aug. 2005, A10)
recession and aftermath of 9/11.(2) Since the tax cuts mass of evidence has supported the following:
(5) “Tax Cut Dividends”, The
Wall Street Journal, 17 Aug. were implemented, the economy has experienced a • Tax cuts don’t create deficits. The notion that tax
2005, A10. robust expansion driven by investment and productiv- cuts compromise federal revenues is a half-truth. Tax
ity gains. cuts reduce federal collections over the short
term, but produce higher growth rates, increased spending. But spending rose again in 2000 and has (6) This economic view is
known as the crowding out
wealth and rising federal revenues over the long term. been climbing ever since, reaching over 20% of GDP theory. It proposes that rising
Conversely, a tax hike immediately boosts federal in fiscal year 2005.(11) deficits add to the national
debt, which ultimately forces
receipts, but drags down the economy as people and interest rates up as the gov-
businesses spend less, send capital overseas and seek Growth priorities ernment competes with other
to minimize taxes at the expense of more productive The argument about tax cuts and balanced budgets borrowers for capital. The re-
sult is less capital flowing into
activities. points to a broader ideological struggle over the role the private sector and slower
• Rising deficits don’t guarantee higher interest of government and markets in our economy. economic growth. Their phi-
losophy is based on the notion
rates. Linking economic growth to a budget surplus Preoccupation with a moderate-sized deficit might that a balanced budget leads
is a relatively new theory popularized by Treasury crowd out the more prudent emphasis on growth. In to strong growth, even though
Secretary Robert Rubin and the Clinton adminis- fact, the true economic cost of Katrina and Rita may higher taxes are needed to
raise the revenues to pay off
tration.(6) But history shows no clear relationship be realized in how lawmakers respond to the fiscal the national debt.
between interest rates and deficits. Despite swelling strain. The economy has enough momentum, excess (7) In 1990, the deficit was
deficits in the 1980s, interest rates were lower and capacity and efficiency to bear the financial burden of 3.9% of GDP while interest
economic growth higher than during the rates were around 3.5%. In
2000, the budget had a 2.4%
1990s.(7) Further, there’s scant evidence surplus and real interest rates
that rising deficits harm a country’s were 3.6%. From 1983 to 1990,
the economy grew 4% annu-
relative currency value or produce poor ally, despite high deficits. From
returns in the stock market.(8) 1993 to 2000, the economy
expanded at 3.9% annually. In
Moreover, drastic changes in the 2004, the deficit reached 3.5%
U.S. economy and world capital mar- while rates were at a 30-year
kets have altered many of the forces low.
that drove the crowding out theory.(9) (8) Federal deficits are as-
sociated over the short term
• The current deficit level is moder- with bull stock markets, while
ate by historical standards. Original budget surpluses have been
CBO projections showed the 2006 followed by lower equity
returns. In the last six periods
budget deficit at 2.4% of GDP. After when the deficit spiked rela-
Katrina, economists revised this to 3% tive to GDP, the stock market
averaged 12% annualized in
to 3.5% of GDP.(10) But even this level the following two years. (“Pray
is neither unprecedented nor danger- For Deficits”, Forbes, 27 Dec.
ous from an historical perspective. In 2004, p 188)
previous recessions, the deficit peaked at 5% of GDP. restoring the Gulf. But the downstream effects of tax (9) The U.S. bond market alone
has almost tripled in size since
Deficits are only too large if they usurp the private policy and spending decisions will impact inflation, 1990—from $8 trillion to over
economy’s need for capital and labor, which pro- output, employment, distribution, innovation and $20 trillion. Also, the inter-
duces an inflationary surge. other factors of growth for many years. national sector is now more
prevalent that in the past.
• Not all deficits are the same. Much depends on With this in mind, the best avenue for long-term Both of these sources provide
the reason for the deficit and whether the capital mar- financial health is to advance policies that will en- much more capital to fund the
national debt. Furthermore, the
kets think the federal government is acting prudently. courage economic growth while taming the deficit U.S. government’s practices
The deficits of the last few years have resulted from a through major cuts in discretionary spending and en- are not considered imprudent
since nearly every major na-
recession made worse by the terrorist attacks, as well titlement reforms. This will require fiscal discipline, tion is running deficits. Finally,
as the military buildup to fight the war. The deficit’s proven supply side policies and political courage. inflation has a more important
effect on long-term debt also matters. In the 1980s, A good first step would be to make the 2003 tax role to play in the general
direction of interest rates, and
economists concluded that the cumulative size of the cuts permanent. Most of these cuts expire by 2010— the Fed has maintained a strict
national debt is more critical than the deficit’s size. and the higher dividend and capital gain rates return policy on controlling inflation
growth with rate hikes and
The U.S. currently owes an aggregate debt equal to in 2008. Congress was preparing to debate these is- tight money. (“Duking It Out
37% of GDP, and the CBO expects it to peak at about sues in the 2006 budget reconciliation bill before the Over the Deficit”, Fortune, 26
40%. Above 50% is considered the danger zone. storm crisis delayed the action. May 2003, p40)
• Uncontrolled spending has driven the deficit The governing coalitions in Washington agree that (10) “Katrina Will Force Hard
Choices”, Business Week, 26
higher. Federal outlays are rising about 7% per year, rebuilding the Gulf will strain government finances. Sept. 2005, p 29.
and the long-term trend is disturbing. The CBO proj- The most relevant question is whether we want to (11) Federal revenues boomed
ects that by 2030, the three major entitlement pro- embark on the project with a sluggish economy or a during the late 1990s due to the
grams will consume half of all federal receipts. vigorous one that can provide the revenue growth to Clinton tax increases and the
rising stock market. Revenues
The last time Congress showed any budget disci- keep the deficit contained. hit a postwar record of 20.9%
pline was in the high deficit years of the mid-1990s. Maintaining low taxes—and indeed, making them of GDP in 2000, then declined
during the recession. (“Hooray
Federal spending (as a share of GDP) fell throughout permanently lower—is the best fuel for the national for the Deficit”, The Wall Street
most of the 1990s, mainly due to reduced defense economic engine. n Journal, 8 Feb. 2005, A18)
Tax Gap
(Continued) FNC NEWS
• Casualty or hobby losses He Ain’t Heavy; He’s My Brother
• Alimony payments Wes Bigler, CFP®
• High investment expenses or gifts
• Prior IRS audit resulting in higher tax paid He Ain’t Heavy, He’s My Brother. The Hollies, a 60s
• Shareholder or partner in an audited part- singing sensation, first made this song famous. The title
nership or corporation was a motto for Boys Town, a community formed in
• High business expenses relative to income 1917 by Catholic priest Father Flanagan. Boys Town
• Uncommon transactions was a rare place where boys on the street could find
nourishment of body and soul. Father Flanagan’s in-
Of course, take the deductions in which spiration for the motto was a drawing of a boy carrying
you are entitled. But also know that certain a younger boy on his back with the caption “He ain’t
deductions could raise suspicion. Determine heavy Father, he’s my brother.” These words captured
whether these offer enough tax savings to the spirit of Boys Town and became the motto for this
justify a higher audit risk. Most importantly, place that gave boys hope in a troubled world.
make sure your tax return is complete and “He ain’t heavy, he’s my brother” is on my mind. On April 4, 2005, my younger
accurate. If you have unusual transactions, at- and only brother Terry died in a tragic mining accident in my hometown, Green River,
tach documentation. Wyoming. This sad event affected everyone in this small mining town and love, support
And if you do receive an IRS inquiry let- and sharing were showered upon my family and me. Everyone there took a share of the
ter, don’t panic. This doesn’t guarantee an burden. We saw how people come together with a common bond and move mountains,
audit. Avoid talking to an examiner about whether they are mountains of dirt and rock or grief and sadness.
your filing until you have reviewed the de- Listen to the verses of this song: “The road is long with many a winding turn that leads
tails. Direct the IRS rep to your tax profes- us to who knows where. It’s a long, long road from which there is no return. While we’re
sional—then get in touch with your advisor on the way to there, why not share? And the load doesn’t weigh me down at all. He ain’t
to prepare a case. n heavy, he’s my brother.”
These words speak to me personally in a powerful way. I really miss Terry and I wish
we had more “long road with winding turns” together. His life is lived, from which there
Asset Protection or Tax Avoidance? is no return. And, I’m grateful for what we shared, like sports and humor. Having Terry
as my brother and being his brother doesn’t weigh me down. Terry ain’t heavy, he’s my
Many individuals and companies have expatriated income brother.
and assets to offshore accounts over the years. While You have people in your life who “ain’t heavy”. You tell me all about your parents,
some entities have legitimate financial planning and busi- children, brother, sisters, family and friends who share the winding road of your life. To-
ness purposes, many are intended solely to shield money
from creditors, court settlements and IRS. day, make that phone call, write that letter, take the trip to visit them. Bring these words
Numerous schemes are devised to hide or disguise in- with you and tell those people they “ain’t heavy”. Say “I love you”, hold hands, and tell
come and assets in foreign jurisdictions. These tax havens stories. Like with Terry and me, there will come a day when the long road ends and there
offer financial secrecy and protection from U.S. laws. The is no return on this earth. I would love to have one more hunting trip, golf game or shared
techniques include the use (or improper use) of:
joke with my brother.
• Foreign trusts, corporations, partnerships, and LLCs These words speak to me professionally in a powerful way as well. As we go down the
• Offshore bank accounts and credit cards long, winding road with you, we want to help you prepare for the turns of life. We ask the
• International business companies big questions about what you want to accomplish with your financial resources. We help
• Offshore private annuities you protect the people in your life who “ain’t heavy”. We’re honored to share our knowl-
• Private banks, personal investment companies or captive edge with you as, together, we design your own individual wealth plan, a personalized
insurance companies
solution for your financial future. Know that you “ain’t heavy” to us. You don’t weigh us
• Related party loans
down. We count it a privilege to go down the long, winding road with you.
In recent years, Congress has passed legislation to track
money laundering, tax evasion and terrorist activities.
Terry was the best brother. One way he “ain’t heavy” is that he loved humor. Our
Americans who open offshore trusts are now required to family’s favorite TV show was Everybody Loves Raymond. Terry was Robert because he
report income each year and the penalties for noncompli- was a big guy and single and I was Raymond because I was married with kids. We even
ance have increased dramatically.
signed our holiday cards as Raymond and Robert. He joked, saying “Mom likes you best.
The U.S. and many foreign governments now have trea- She sent you cookies, and I didn’t get any.” For today and all the yesterdays and all the
ties with most tax haven governments to freeze accounts
and relinquish information on the assets and owners. With tomorrows, Everybody Loves Terry and he ain’t heavy, he’s my brother.
proper legal action, the federal government can access
virtually any account around the globe. Terry Bigler
Americans can still legally own many offshore investment June 20, 1957 – April 4, 2005
structures sanctioned by the IRS. But anonymity is now
limited and the price for noncompliance is severe.
The publisher is not engaged in rendering product, investment, legal, accounting or tax advice through the newsletter. No statement should be construed as a recommendation to make any financial or investment decision.
Editorial content is judged on its relevance to investment decision-making and the publisher makes every attempt to objectively present a forum of news and ideas, but does not warrant the accuracy of any information contained
herein. This is not an offer to sell or a solicitation of an offer to buy any security.