GAO Finds Widespread Misreporting Of Capital Gains

by Mike Godfrey, Tax-News.com, Washington

15 June 2006

The Government Accountability Office has estimated that as many as 38% of US-based individual taxpayers who undertook securities transactions misreported their capital gains or losses to the Internal Revenue Service in 2001.

According to the GAO report, based on a sample of examination cases for tax year 2001 and the latest IRS data on tax compliance, there was a greater estimated percentage of taxpayers misreporting gains or losses from securities sales (36 percent) than capital gain distributions from mutual funds (13 percent).

The GAO concluded that this situation may have arisen 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, the GAO found that 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.

While the IRS is attempting to reduce the securities tax gap through enforcement and taxpayer service programs, the report noted that challenges limit their impact. Under current enforcement programs, the IRS contacts taxpayers who may have misreported capital gains or losses and seeks to secure the correct tax amount. The IRS also offers services to help taxpayers comply with capital gains tax obligations, such as guidance on how to determine securities' gains and losses.

However, the GAO noted that 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, is one of the biggest challenges that limits the program's impact.

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, the GAO stated.

Basis reporting would provide the IRS with information to verify securities gains or losses and to better target enforcement resources on noncompliant taxpayers, the report observed. However, it also went on to note that 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 decreased 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.

According to the report, industry representatives said that many brokers already provide some basis information to their clients, and some use an existing system to track and transfer basis and other information about securities.

However, many of the challenges to implementing basis reporting could also be mitigated by only requiring adjusted basis reporting for future purchases, and by developing consistent rules to be used by all brokers, the GAO concluded.

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