In recent years, IRS studies show that the majority of capital  asset transactions and capital gains and losses were for securities  transactions, including sales of corporate stock, mutual funds, bonds,  options, and capital gain distributions from mutual funds. Misreported Basis Was a Primary Type of Noncompliance That Caused Taxpayers to Inaccurately Report Their Capital Gains or Losses from Securities Sales

Based on information in the files we reviewed, a primary type of  noncompliance that caused taxpayers to inaccurately report their capital  gains or losses from securities sales in tax year 2001 was misreporting the  basis of the securities they sold. For taxpayers who misreported basis, a greater percentage failed to  accurately report basis for long-term securities holdings (35 percent of  taxpayers who misreported securities sales) than for short-term holdings  (21 percent). IRS Attempts to Reduce the Individual Capital Gains Tax Gap for Securities through Enforcement and Taxpayer Service Programs, but Various Challenges Limit Their Impact

IRS uses both enforcement and taxpayer service programs in attempting to  reduce the individual capital gains tax gap for securities. IRS also offers service programs to provide taxpayers with  assistance in fulfilling their capital gains tax obligations. Examiners also may use other resources, such as  online services, to help them determine the basis of taxpayers’ securities. This misconception  required IRS to clarify on its Web site that taxpayers could continue to  report the details of their transactions on attached statements as long as all  transactions were included and they reported aggregate information on  Schedule D.

		The Extent to Which IRS Enforcement Programs Have Reduced the 2001 Capital Gains Tax Gap for Securities Is Not Known

Through its enforcement programs, IRS assessed additional taxes for  taxpayers who misreported their securities gains and losses for tax year  2001; however, neither IRS nor we know the extent to which these  assessments reduced the securities tax gap for that year. Reporting of Cost Basis Could Reduce the Individual Capital Gains Tax Gap for Securities, but Implementation Challenges Would Need to Be Addressed

Expanded reporting of cost basis information has the potential to reduce  the individual capital gains tax gap for securities. Information reporting of adjusted cost basis to taxpayers and IRS  would likely help reduce the tax gap from securities sales by improving  taxpayers’ voluntary compliance and IRS’s ability to cost effectively  address noncompliant taxpayers. Consistent reporting of basis information  would involve challenges that would need to be, and to some extent can be,  mitigated. However,  some taxpayers did not know they had to report gains or losses and others  did not understand how to determine basis. Expanding Basis Reporting Involves Implementation Challenges That Would Need to Be Addressed

Expanding information reporting on securities sales to include basis  information would involve challenges for brokers and IRS. Some brokers use a system to transfer basis among one another,  but the system is not used by all brokers. Representatives from the securities industry told us that in order to  implement basis reporting, a set of rules would need to be developed to  clearly establish, for example, what types of securities transactions would  be covered by any requirement and how a system to transfer basis would  be standardized. Of those erring, an estimated 64 percent  underreported their income and 33 percent overreported income. However, we could not produce meaningful  estimates of the total amount of net misreported capital gain income from  securities or determine the securities tax gap, in part because (1) in  selecting our sample, we could not distinguish which cases included  misreported securities transactions as opposed to misreported  transactions for other types of capital assets, (2) some cases with large  amounts of misreported capital gains or losses were due to noncompliance  for assets other than securities, (3) 53 of the cases we requested from IRS  from our first substratum, which represented a large percentage of the total  amounts of misreported capital gains or losses, were not provided in time  to include in our review, and (4) taxpayers misreported a wide range of  dollar amounts from the transactions. To identify options with the potential to improve taxpayers’ voluntary  compliance for reporting securities gains and losses and IRS’s ability to find  noncompliance related to the individual capital gains tax gap for securities,  we reviewed prior GAO reports and other documents on capital gains  reporting and compliance such as those from IRS compliance programs  and industry reports on securities holdings and information reporting.
Why GAO Did This Study

For tax year 2001, the Internal Revenue Service (IRS) estimated a tax gap of at least $11 billion from individual taxpayers misreporting income from capital assets (generally those owned for investment or personal purposes). IRS did not estimate the portion of this gap from securities (e.g., stocks, bonds, and mutual fund capital gains distributions). GAO was asked for information on (1) the extent and types of noncompliance for individual taxpayers that misreport securities capital gains, (2) actions IRS takes to reduce the securities tax gap, and (3) options with the potential to improve taxpayer voluntary compliance and IRS's ability to address noncompliant taxpayers. For estimates of noncompliance, GAO analyzed a probability sample of examination cases for tax year 2001 from the most recent IRS study of individual tax compliance.

What GAO Found

GAO estimates that 38 percent of individual taxpayers with securities transactions misreported their capital gains or losses in tax year 2001. A greater estimated percentage of taxpayers misreported gains or losses from securities sales (36 percent) than capital gain distributions from mutual funds (13 percent). This may be because taxpayers must determine the taxable portion of securities sales' income whereas they need only add up their capital gain distributions. Among individual taxpayers who misreported securities sales, roughly two-thirds underreported and roughly one-third overreported. Furthermore, about half of these taxpayers who misreported failed to accurately report the securities' cost, or basis, sometimes because they did not know the basis or failed to adjust the basis appropriately. IRS attempts to reduce the securities' tax gap through enforcement and taxpayer service programs, but challenges limit their impact. Through enforcement programs, IRS contacts taxpayers who may have misreported capital gains or losses and seeks to secure the correct tax amount. IRS also offers services to help taxpayers comply with capital gains tax obligations, such as guidance on how to determine securities' gains and losses. Challenges that limit these programs' impact include the lack of information on basis, which IRS needs to verify most gains and losses, and uncertainty as to whether taxpayers use or understand the guidance. Expanding the information brokers report on securities sales to include adjusted cost basis has the potential to improve taxpayers' compliance and help IRS find noncompliant taxpayers. IRS research shows that taxpayers report their income much more accurately when it is reported to them and IRS. Basis reporting also would reduce taxpayers' burden. For IRS, basis reporting would provide information to verify securities gains or losses and to better target enforcement resources on noncompliant taxpayers. However, basis reporting would raise challenges that would need to be addressed. For instance, brokers would incur costs and burdens--even as taxpayers' costs and burdens decrease somewhat--and many issues would arise about how to calculate adjusted basis, which securities would be covered, and how information would be transferred among brokers. However, industry representatives said that many brokers already provide some basis information to many of their clients and some use an existing system to track and transfer basis and other information about securities. Many of the challenges to implementing basis reporting also could be mitigated. For example, many of the challenges could be addressed by only requiring adjusted basis reporting for future purchases, and by developing consistent rules to be used by all brokers. To the extent that actions to mitigate the challenges to basis reporting delay its implementation or limit coverage to only certain types of securities, the resulting improvements to taxpayers' voluntary reporting compliance would be somewhat constrained.