Under present law, most Americans’ taxable income is reported by both the payor and the payee. Wage income is reported by the employer on a form W-2 and by the employee on an annual tax return. Independent contractor income is reported by the paying business on a form 1099 and by the contractor on an annual tax return. While banks report interest paid to an accountholder on a form 1099-INT, banks do not currently report an accountholder’s deposits and withdrawals to the IRS. Such records are of course available if the accountholder is audited, but they are not reported to the IRS by default.
For some taxpayers, especially small business owners who sell products or services to the public, taxable income is reported only by the taxpayer on an annual tax return. A small business’s customers do not report to the IRS how much money they spend at the business. Requiring such reports is simply impractical. With nothing against which to match the small business owner’s tax return, the IRS has no way of knowing whether the return is correct without conducting an audit.
The Biden administration has proposed a solution to this problem: a comprehensive regime of reporting by financial institutions. The administration has described the proposal in the American Families Plan Tax Compliance Agenda, a report released by the Treasury Department this month. Under the proposal, financial institutions would be required to file a new annual return with the IRS, which reports “gross inflows and outflows on all business and personal accounts.” All bank, loan, and investment accounts above a low de minimis threshold would be covered.
This new reporting regime would allow the IRS to automatically calculate the difference between inflows and outflows for every American. By using statistical information on personal spending, the IRS could roughly estimate the taxable income of every American. If a particular small business owner’s tax return reports taxable income significantly below the rough estimate, that small business owner could be automatically identified for audit.
Privacy advocates may have concerns about the increased financial surveillance and possibilities of abuse. Nevertheless, the proposed regime if implemented may be of assistance to the IRS in identifying small business owners who underreport their federal taxes.