Tax Compliance: What it is, Its Types and Components

With the IRS projecting a $696 billion tax gap, tax enforcement has tightened, particularly for high-income earners and corporations. The Inflation Reduction Act of 2022 also significantly boosted IRS funding and has enabled the agency to expand audits and modernize tax collection efforts. As tax laws grow more complex and enforcement intensifies, staying compliant has become more critical than ever.

What is Tax Compliance?

Tax compliance refers to the process of following tax laws and regulations established by relevant authorities. It involves accurate reporting of income, calculating taxes owed, and making timely payments. Tax compliance applies to multiple levels—federal, state, local, and international—each with its own distinct regulations and requirements. Failure to comply with tax laws at any level can result in audits, fines, and penalties, while proper compliance helps reduce the tax gap. 

At the federal level, the Internal Revenue Service (IRS) enforces tax laws for income, payroll, and other taxes. In 2023, the IRS collected $4.7 trillion and processed over 271 million tax returns, reflecting the scale of federal tax compliance. Taxpayers, including individuals and businesses, must file returns accurately, pay taxes owed, and adhere to IRS guidelines to avoid compliance issues.

State tax compliance varies across jurisdictions, with different states imposing taxes like sales tax, property tax, and state income tax. Each state has its own tax authority and regulations that residents and businesses must follow.

Local tax compliance refers to taxes imposed by local government entities, such as counties, cities, or municipalities. Local taxes can include property taxes, local sales taxes, and special assessments. Compliance requires businesses and individuals to follow the specific tax rules of their locality, often in addition to state and federal taxes.

International tax compliance applies to taxpayers engaged in cross-border activities, requiring adherence to tax treaties and agreements to avoid double taxation and ensure compliance with foreign tax laws. In fact, in 2023, the IRS increased its focus on international tax compliance, auditing 60 large corporations through the Large Corporate Compliance (LCC) program, each with assets over $24 billion. Compliance letters were also sent to 150 subsidiaries of foreign corporations to address U.S. tax obligations.

Types of Tax Regulations

Tax regulations are the rules and guidelines set forth to enforce tax laws. They provide the framework for tax compliance and ensure that taxpayers and tax professionals understand how to apply tax laws in various situations. 

There are three primary types of tax regulations: procedural, legislative, and interpretive regulations.

1. Procedural Regulations

Procedural regulations outline the processes and procedures taxpayers must follow when complying with tax laws. These regulations explain how to file tax returns, pay taxes, request extensions, and handle audits or appeals. They ensure that taxpayers follow the correct administrative steps to meet their obligations. For instance, procedural regulations guide how to report income, claim deductions, or file amended returns, ensuring smooth interaction with tax authorities like the IRS.

2. Legislative Regulations

Legislative regulations are directly authorized by tax laws passed by Congress or other legislative bodies. These regulations carry the weight of law and are mandatory for taxpayers to follow. They detail specific provisions of the Internal Revenue Code and other tax laws, ensuring that the legislative intent is fully implemented. Legislative regulations leave little room for interpretation and serve as a critical tool for the IRS and other authorities in enforcing compliance with tax statutes.

3. Interpretive Regulations

Interpretive regulations provide detailed guidance on how to apply tax laws when the statutory language is unclear or ambiguous. These regulations help clarify specific provisions, allowing tax professionals to apply them accurately in complex situations. For example, in cases where a law doesn’t clearly define how certain business expenses should be deducted, interpretive regulations can clarify whether those expenses qualify as deductible under existing tax laws.

While not as binding as legislative regulations, interpretive regulations address gray areas in tax law and help professionals make informed decisions and apply the tax code in a way that aligns with its intent.

Key Components of Tax Compliance

Effective tax compliance is built on several key components that ensure individuals and businesses meet their tax obligations in a proper and lawful manner. These components include accurate reporting, timely filing, and payment of tax liabilities. Together, they form the foundation of a strong compliant tax system.

Accurate Reporting

Accurate reporting requires taxpayers to correctly report all taxable income, deductions, credits, and other relevant financial information on their tax returns. Interestingly,  the IRS recovered over $539 billion from underreported income in the 2022 fiscal year. Errors in reporting, whether intentional or unintentional, can lead to audits or penalties imposed by the IRS and other tax authorities. Taxpayers must ensure that all financial data is thoroughly reviewed before filing to avoid discrepancies that could raise red flags during the compliance process. 

Timely Filing

Timely filing refers to submitting tax returns by the designated deadlines set by federal, state, and international tax authorities. Missing deadlines, such as the April 15 federal filing date in the U.S., can result in late-filing penalties and interest on unpaid taxes. Different deadlines may apply depending on whether the taxpayer is an individual, a corporation, or an entity subject to international tax compliance rules. Filing extensions may be requested, but they must be done properly. 

Payment of Tax Liabilities

Once tax returns are accurately reported and filed on time, the final component of compliance is paying the tax liabilities. Taxpayers must settle the amount owed by the due date. Failure to do so can lead to interest charges, penalties, and possible collection actions. The standard penalty for late payments is typically 5% of the unpaid amount per month, capped at 25% of the total owed. Taxpayers can avoid these issues by paying in full or arranging a payment plan with the IRS. For businesses, this includes ensuring compliance with payroll, sales, and other federal and state tax obligations.

Types of Tax Compliance

Tax compliance includes various categories based on the type of tax involved, and each category comes with specific rules and responsibilities for both individuals and businesses. 

Here are the primary types of tax compliance that taxpayers and tax professionals must manage.

Payroll Tax Compliance

Payroll tax compliance requires employers to accurately withhold and remit employee income taxes, Social Security, Medicare, and other employment-related taxes to federal, state and even local authorities. Non-compliance can result in severe penalties, making it a vital responsibility for businesses to manage. In one IRS initiative focused on high-dollar tax delinquents, the agency collected $38 million from over 175 high-income earners with significant payroll tax debt. This highlights the need for employers to stay vigilant and adhere to payroll tax compliance. 

Excise Taxes

These are taxes on specific goods, such as gasoline, tobacco, alcohol, and airline tickets. Excise taxes are often included in the price of the product and vary by state and federal laws.

Gross Receipts Tax

Some states impose a tax on a company's gross receipts, which is often passed on to consumers through higher prices for goods and services.

Corporate Tax Compliance

In 2023, Americans filed 271.5 million tax returns, with nearly 71% (or 192.3 million) being individual and corporate income tax returns, alongside 36.3 million employment tax returns. 

Corporate tax compliance requires companies to meet their tax obligations on profits, which includes accurately reporting income, deductions, and credits. With individual and corporate returns making up a significant portion of the 271.5 million tax filings, any errors in corporate tax reporting can trigger audits and increased scrutiny from the IRS.

Global Tax Compliance

Global tax compliance is applied to businesses that operate across borders. It involves adhering to international tax laws, treaties, and reporting requirements to avoid double taxation and comply with the regulations in each country where the business operates. International tax compliance can be complex and requires careful planning to manage global operations effectively.

Business Tax Compliance

Business tax compliance covers a broad range of obligations, including income taxes, payroll taxes, sales taxes, and more. Businesses need to ensure compliance with both federal and state tax regulations to avoid penalties and ensure smooth operations. 

Property Tax Compliance

Property tax compliance requires individuals and businesses to accurately report the value of their property to the relevant local or state authorities. This compliance involves paying property taxes based on property valuations, which can vary by region. Failing to pay property taxes on time can lead to liens or even property seizure.

Income Tax Compliance

Income tax compliance requires individuals and businesses to accurately report their income, calculate taxes owed, and meet payment deadlines. Regulated at both federal and state levels, compliance varies, with some states like Alaska and Florida imposing no income tax, while others may exceed 10%. It remains one of the most fundamental forms of tax compliance.

State Tax Compliance

State tax compliance involves adhering to the specific tax regulations of each state, including income tax, sales tax, and other state-level obligations. Since state tax laws vary widely, taxpayers must understand the rules that apply in their specific jurisdiction to ensure compliance.

Tax Compliance for Different Entities

Tax compliance requirements vary depending on the type of entity involved. Individuals, businesses, and entities with international operations each face unique compliance challenges and regulations.

Individual Tax Compliance

Individual tax compliance involves meeting personal income tax obligations at both the federal and state levels. Individuals must report their income, claim applicable deductions and credits, and ensure timely filing of returns. Compliance also includes paying estimated taxes, if necessary, for those with income that isn’t subject to withholding, such as self-employment income or investment gains. 

Business Tax Compliance

Business tax compliance includes a broad set of obligations, from corporate income taxes to payroll taxes and sales taxes. Businesses must accurately report their income, account for deductible expenses, and meet all filing deadlines. Proper compliance ensures that businesses avoid penalties and maintain good standing with tax authorities. Business tax compliance also involves staying up to date with constantly evolving tax regulations at both federal and state levels. Larger businesses may also need to comply with industry-specific tax requirements, such as excise taxes or indirect taxes.

International Tax Compliance

International tax compliance applies to individuals and businesses involved in cross-border transactions or operations. This includes understanding and adhering to tax treaties, managing foreign income reporting, and complying with regulations to avoid double taxation. For multinational companies, it involves keeping track of tax laws in multiple jurisdictions, transfer pricing rules, and global tax reporting standards. International tax compliance can be complex and often requires strategic planning to manage effectively, particularly with increased scrutiny from global tax authorities.

Tax Compliance Planning

Tax compliance planning helps individuals and businesses meet tax obligations and reduce non-compliance risks. Effective planning involves proactive strategies and a thorough understanding of tax laws and regulations to avoid compliance challenges.

Strategies for Effective Compliance

To develop effective tax compliance strategies, follow these key steps:

Keep Accurate Records

Stay on top of financial statements, receipts, and documentation for deductions or credits.

Use Tax Compliance Software

Automate tax filings, calculate liabilities, and ensure you meet deadlines with reliable software.

Consult Tax Professionals

Regular check-ins with tax professionals keep you updated on changes in tax laws and ensure compliance at all levels—federal, state, local and international.

Conduct Internal Reviews

Regularly audit your processes to spot potential compliance gaps.

Stay Informed

Keep up with changes in tax regulations to adjust your strategies and avoid unnecessary risks.

Risk Assessment and Management

Risk assessment and management in tax compliance involves identifying areas where non-compliance could occur and taking steps to mitigate those risks. For businesses, this can include regularly assessing payroll systems, sales tax collection processes, and corporate tax filings to ensure compliance with IRS and state tax regulations.

A comprehensive risk management plan involves monitoring potential triggers for tax audits, such as inconsistencies in income reporting or discrepancies in tax filings. It’s also essential to have a plan in place for responding to audits or inquiries from tax authorities, which could involve working closely with tax professionals to provide the necessary documentation and resolve issues.

Common Challenges in Tax Compliance

Tax compliance is often challenging due to shifting regulations, complex tax situations, and the risk of human error. Both individuals and businesses must stay adaptable to navigate these challenges effectively.

Keeping Up with Changing Regulations

One of the most significant challenges in tax compliance is staying up to date with constantly changing tax laws and regulations. Tax codes at the federal, state, and international levels frequently evolve, introducing new compliance requirements. Changes in tax policy, such as updates to deductions, credits, or tax rates, can make it difficult for taxpayers and tax professionals to remain compliant. To overcome this challenge, regularly monitor tax legislation and utilize tax compliance software to incorporate the latest regulations into tax planning strategies.

Complex Tax Situations

Many taxpayers, particularly businesses, face complex tax situations that make compliance more difficult. For example, multinational corporations must navigate global tax compliance obligations, including transfer pricing, international treaties, and foreign income reporting. Similarly, small businesses may encounter challenges with multi-state tax compliance, especially in sales tax collection and reporting. These complexities require careful planning and often involve seeking expert guidance to ensure all regulations are met accurately.

Human Error and Miscalculations

Another common challenge in tax compliance is human error. Mistakes in tax reporting, such as miscalculations or incorrectly inputting financial data, can lead to penalties, interest, or even tax audits. Simple errors, such as incorrect income reporting or missed deductions, can have significant financial consequences. To reduce the risk of human error, implement automated tax filing systems and work with qualified tax professionals who can review filings for accuracy and completeness.

Consequences of Non-Compliance

Failing to adhere to tax compliance obligations can lead to severe consequences for individuals and businesses. These repercussions include financial penalties, audits, and potential legal actions, all of which can negatively impact both personal and business finances.

Penalties and Fees

The most immediate consequence of non-compliance is the imposition of penalties and fees. The IRS and state tax authorities charge penalties for late filing, underpayment, and inaccurate reporting. For example, according to new IRS rules, if a return is over 60 days late, the penalty is the lesser of $485 or 100% of the tax owed. These penalties can quickly accumulate, and unresolved issues lead to higher financial burdens due to interest accruals and additional fines.

Audits

Non-compliance increases the likelihood of tax audits, which can be both time-consuming and costly. The IRS and state tax authorities may audit individuals or businesses that show signs of discrepancies in their tax filings, such as inconsistent income reporting or questionable deductions. During an audit, taxpayers are required to provide supporting documentation for their reported income and expenses. Inaccuracies or failure to provide proper documentation can result in additional taxes owed, further penalties, or even escalated legal scrutiny.

Legal Implications

Serious cases of non-compliance can lead to legal implications, including criminal charges for tax evasion or fraud. Intentional underreporting of income, failure to file tax returns, or falsifying financial documents can lead to severe legal consequences, including prosecution. Convictions for tax evasion or fraud can result in heavy fines, asset seizures, and even imprisonment, particularly for businesses or individuals found guilty of willful non-compliance.

Tools and Resources for Ensuring Tax Compliance

• Professional Tax Services: Engaging professional tax services—such as CPAs, enrolled agents, and tax attorneys—is one of the most reliable ways to ensure tax compliance. These tax professionals are well-versed in current tax laws and can provide personalized advice and support, especially in complex situations. They can help with everything from tax planning and filing to audit representation and compliance with both federal and state tax regulations. Professional services are particularly valuable for businesses and individuals with complicated tax scenarios, such as international operations or multiple income streams.
• Tax Software: Tax software has become a valuable tool for ensuring accurate and timely compliance. These systems automate many aspects of the tax filing process, reducing the likelihood of human error and simplifying the management of various tax obligations. High-quality tax software provides features like real-time tax law updates, automated calculations, and reminders for filing deadlines. 
• Continuing Education and Updates: Both individuals and tax professionals must commit to continuing education and updates to keep up with evolving tax codes. This can include attending seminars, subscribing to tax law publications, or enrolling in courses designed to provide insights into new compliance requirements. 

FAQs

What is a tax compliance measurement audit?

A tax compliance measurement audit is a detailed audit conducted by the IRS to evaluate whether taxpayers are accurately reporting their income, deductions, and credits. This audit helps the IRS assess the overall level of tax compliance and identify areas where taxpayers may be underreporting or incorrectly filing. It is typically used to refine IRS enforcement strategies and ensure that taxpayers are adhering to current tax laws.

What is the current tax gap according to IRS projections?

The tax gap is the difference between the total taxes owed and the taxes that are actually paid on time. According to the most recent projections from the IRS, the annual tax gap is estimated to be over $696 billion. This gap highlights the importance of improving tax compliance to reduce revenue losses for the federal government.

What are common pitfalls in tax compliance?

Common pitfalls in tax compliance include inaccuracies in income reporting, failure to claim eligible deductions or credits, missing filing deadlines, and not keeping thorough financial records. These errors can result in penalties, audits, and even legal issues. Businesses may also face issues with incorrect payroll tax submissions or sales tax collections, which can complicate compliance further.

What are the specific challenges in state tax compliance?

State tax compliance can be particularly challenging due to the varied tax laws and regulations across different states. Each state has its own set of tax obligations, including income tax, sales tax, and property tax, which often differ from federal tax requirements. Additionally, businesses that operate in multiple states face the added complexity of adhering to each state’s distinct tax regulations, requiring careful planning and often professional assistance to ensure compliance.