What Could a Yield Curve Inversion Mean for IRS Tax Reporting Enforcement?

With unemployment low and productivity high, the US economy appears to be steaming along. But one key metric suggests otherwise: the yield curve is inverted, historically a sign that a recession is on the way. A downturn in the economy could have a major impact on how the IRS enforces tax reporting compliance. 

A yield curve inversion happens when interest rates on long-term government bonds are lower than those on short-term bonds. An unusual situation, an inversion frequently serves as a sign that the economy is getting ready to move toward “negative growth,” otherwise known as a recession. 

Why the IRS could increase tax reporting enforcement in a recession 

The last recession in the US, which hit in 2007-2008 following the subprime-mortgage crisis, was brutal. By October 2009, the unemployment rate was at a whopping 10 percent, its highest level since 1983. The current rate is an exceptionally healthy 3.7 percent, but fears of a recession are starting to shake financial markets worldwide. 

Companies obviously have to take a wide variety of precautions in preparation for a potential recession. One that might not seem like a priority at first blush is shoring up tax information reporting processes, but evidence suggests that the IRS could very well crack down on compliance should the economy recede, stepping up audits and delivering financial penalties to non-compliant businesses. 

There are several reasons why. First of all, the tax gap, essentially the difference between how much taxpayers owe and how much they actually pay, increased during the last recession. Any increase in the tax gap is likely to lead to an increase in enforcement of tax regulations in general simply because the IRS will need to use any method it can to make up for revenue shortfalls. 

Interestingly, the Joint Congressional Committee on Taxation determined that the increase in the tax gap in the last recession was not due to a drop in the voluntary compliance rate, or VCR, of taxpayers. The Committee report did note a drop in the VCR but concluded that it was the result of more specific measurement of the metric itself and not of a change in taxpayer behavior. Most taxpayers were still willing to pay what they owed. That means most companies were likely staying in compliance with tax information reporting, letting individuals know how much they had to pay and informing the IRS of those numbers as well. 

How tax information reporting can close a recessionary tax gap

So, what did cause the gap? The Committee report suggests that the vast majority of it came from income that is subject to little or no tax information reporting, mostly self-employment income, the type of income reported on Forms 1099. The report notes:

“[I]n 2008-10, the gross tax gap was $136 billion for income that is subject to little or no information reporting. In contrast, it was $15 billion and $5 billion for income that was subject to substantial information reporting, and information reporting together with withholding, respectively.”

In other words, tax information reporting will be critical to narrowing the tax gap in the next recession. Taxpayers pay taxes on reported income. They’re less likely to pay taxes in income the IRS doesn’t know exists. It’s no secret, but it’s a particularly important point to make in the context of a potential recession. 

The IRS knows that reporting can help mitigate what is by far the biggest threat of another recessionary tax gap. It will very likely focus more on enforcing reporting regulations during a recession than it does when the economy is strong, and the agency takes reporting compliance seriously even in the best of times.

Which forms could the IRS target for reporting crackdowns? 

One potential avenue the IRS could take for keeping the tax gap minimal, as mentioned specifically in the Committee’s report, would be to focus on 1099-K reporting. Third-party settlement organizations such as ride-share and home-share services use the 1099-K to report payments to service providers. 

The IRS is somewhat handcuffed by the high threshold for reporting a 1099-K, currently set at $20,000 and 200 transactions per year. But if Congress decides to lower the threshold, as some states already have, the result could be a revenue boon for the IRS at any time, and it could provide a major boost for closing the tax gap during a recession. 

Self-employment income of the type reported on the 1099-K has exploded since the last recession, and that type of income was already the primary driver of the tax gap during the downturn a decade ago. Strict enforcement of 1099-K reporting seems like an inevitability in the next recession.

Another target could be cryptocurrency revenues. Although the agency has still not clarified its own rules for crypto reporting, it is already informing individual investors that they must certify under penalties of perjury that they are in compliance with crypto tax regulations. Crypto trading exchanges could be in for increased scrutiny during the next recession, too.  

Significant crypto information reporting issues could be contributing upwards of $25 billion a year to the tax gap, and the IRS has already promised forthcoming guidance to help enforce compliance. Although a recession can sometimes set in as long as 22 months after the inverted yield curve, the IRS already has much enforcement to do in the crypto space to narrow the gap.  

Why companies should get their tax reporting processes in order 

Of course, in a pinch for revenues, the IRS is likely to step up enforcement of 1099 reporting in general, including the 1099-MISC and, as soon as it comes into use, the 1099-NEC. Making sure that tax reporting processes are centralized and automated, then, should be a priority for companies in preparing for a recession.

Increased backup withholding enforcement, launched by IRS this year, will continue to grow as the program expands to add more Forms 1099 to the penalty process. Further, it will likely lead to increased numbers of B and P notices for companies that aren’t prepared for closer scrutiny from the agency. 

Forms such as the 1099-K could see a spike in volume, which would catch unprepared companies off guard and leave them vulnerable to reporting errors and penalties. During a recession, when every penny is precious, expensive nuisance costs such as IRS penalties are the last expenses a company wants to incur. 

Moreover, recessions inevitably lead to a reduction in headcount. Another downturn could leave companies short-staffed for a forthcoming January reporting season. Those without centralized and automated reporting processes will very likely suffer from inefficiency, leading to reporting delays and errors and ultimately to penalties. And hiring and paying experienced professionals to react to and implement regulatory changes will be nearly impossible.  

Now is the time to centralize and automate reporting processes. A strong economy presents an opportunity to get tax information reporting under control and boost efficiency while minimizing risk. Companies that have access to tax information from a single source and can rely on a third party to update systems and processes as regulations change will be far ahead of the pack when the next recession hits–which, according to the yield curve, could be sooner than many companies expect.