Government Accountability Office Report: Tax Gap --A Strategy for Reducing the Gap Should Include Options for Addressing Sole Proprietor Noncompliance (GAO-07-1014)
August 15, 2007
Government Accountability Office report : Tax gap : Sole proprietor noncompliance .
United States Government Accountability Office
GAO
Report to the Committee on Finance, U.S. Senate
July 2007
TAX GAP
A Strategy for Reducing the Gap Should Include Options for Addressing Sole Proprietor Noncompliance
GAO
Accountability * Integrity * Reliability
GAO-07-1014
Highlights
Highlights of GAO-07-1014 , a report to the Committee on Finance, U.S. Senate
Why GAO Did This Study
The Internal Revenue Service (IRS) estimates that $68 billion of the annual $345 billion gross tax gap for 2001 was due to sole proprietors, who own unincorporated businesses by themselves, underreporting their net income by 57 percent. A key reason for this underreporting is well known. Unlike wage and some investment income, sole proprietors' income is not subject to withholding and only a portion is subject to information reporting to IRS by third parties.
GAO was asked to (1) describe the nature and extent of sole proprietor noncompliance, (2) how IRS's enforcement programs address it, and (3) options for reducing it. GAO analyzed IRS's recent random sample study of reporting compliance by individual taxpayers, including sole proprietors.
What GAO Recommends
GAO recommends that the Secretary of the Treasury ensure that the tax gap strategy (1) covers sole proprietor compliance and is coordinated with broader tax gap reduction efforts and (2) includes specific proposals, such as the options in this report. GAO is not making recommendations regarding specific options. IRS and the Department of the Treasury provided technical comments on a draft of this report, which we incorporated as appropriate.
www.gao.gov/cgi-bin/getrpt?GAO-07-1014 .
To view the full product, including the scope and methodology, click on the link above. For more information, contact James R. White at (202) 512-9110 or whitej@gao.gov.
July 2007
TAX GAP
A Strategy for Reducing the Gap Should Include Options for Addressing Sole Proprietor Noncompliance
What GAO Found
Based on what IRS examiners could find, most sole proprietors, at least an estimated 61 percent, underreported net business income, but a small proportion of them accounted for the bulk of understated taxes. Both gross income and expenses were misreported. Most of the resulting understated taxes were in relatively small amounts. Half the understatements that IRS examiners could find were less than $903. However, 10 percent of the tax understatements, made by over 1 million sole proprietors, were above $6,200. In this top group, the mean understatement of tax was $18,000.
IRS's two main sole proprietor enforcement programs --the Automated Underreporter Program, which computer matches information on a tax return with information submitted to IRS by third parties, and examinations (audits) --have limited reach. The two programs each annually contact less than 3 percent of estimated noncompliant sole proprietors. The limited reach exists for a variety of reasons. In 2001, about 25 percent of sole proprietor gross income was reported on information returns by third parties; expenses generally are not subject to such reporting. Even when required, various barriers make information reporting inconvenient. Examinations of sole proprietors yield less in additional tax assessed and cost more to conduct than examinations for other taxpayers. However, because of the extent of sole proprietor noncompliance, any effect that examinations have on voluntary compliance by other sole proprietors could result in significant revenue.
The Treasury Department's recently-released tax gap strategy discusses neither sole proprietor noncompliance specifically nor the many options that could address it. GAO has reported on the need for such a detailed strategy for years. Specific options that address issues including sole proprietor recordkeeping, underreporting of gross income, overreporting of expenses, information reporting, and IRS's enforcement programs are listed in appendix II.
Sole Proprietors' Estimated Understated Tax by Percentile for Tax Year 2001 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
Contents
Letter
Results in Brief
Background
Most Sole Proprietors Underreported Business Income, but a Small Proportion Accounted for the Bulk of Unpaid Taxes
Enforcement Programs Have Limited Reach over Sole Proprietors but Still Make Billions of Dollars in Recommended Assessments
Current Treasury Tax Gap Strategy Discusses Neither Sole Proprietor Noncompliance nor the Many Options That Could Address It
Conclusions
Recommendation for Executive Action
Agency Comments and Our Evaluation
Appendix I Scope and Methodology
Appendix II Options to Address Problems with the Tax Compliance of Sole Proprietors
Appendix III IRS Form 1040 Schedule C, Tax Year 2001
Appendix IV Independent Contractors and Section 530 of the Revenue Act of 1978
Appendix V Backup Withholding Rules
Appendix VI Comments from the Department of the Treasury
Appendix VII GAO Contact and Staff Acknowledgments
Related GAO Products
Tables
Table 1: Percentage of Recommended Assessments and Limitations of IRS Enforcement Programs for Detecting Sole Proprietor Reporting Noncompliance
Table 2: Options to Improve Sole Proprietor Tax Compliance
Table 3: Confidence Intervals for Summary of Schedule C Misreporting for Tax Year 2001
Table 4: Confidence Intervals for Estimated Understated Tax Amounts by Percentile for Individual Income Tax Returns with Schedule Cs Attached, Tax Year 2001.
Table 5: Confidence Intervals for Estimated Cumulative Understated Taxes by Percentile for Individual Income Tax Returns with Schedule Cs Attached, Tax Year 2001
Figures
Figure 1: Distribution of Sole Proprietors and Their Gross Receipts by Size of Proprietorship, Tax Year 2003
Figure 2: IRS's Nonemployee Compensation Information Returns Matching Process
Figure 3: Summary of Unadjusted NRP Population Estimates for Schedule C Misreporting, Tax Year 2001
Figure 4: Estimated Understated Tax Amounts by Percentile for Form 1040s with Schedule Cs Attached, Tax Year 2001
Figure 5: Estimated Cumulative Understated Taxes by Percentile for Form 1040s with Schedule Cs Attached, Tax Year 2001
Figure 6: Number of AUR NEC Contacts Made and Total Recommended Assessments, Tax Years 1999-2003
Figure 7: Examinations of Returns with Schedule C Attachments and Recommended Tax Assessments, Fiscal Years 2001-2006
Figure 8: Recommended Penalties for Sole Proprietors and Non-Sole Proprietors in NRP Examinations with a 100 Percent or Greater Recommended Tax Change by Dollar Value of Tax Change in Tax Year 2001
Abbreviations
AGI adjusted gross income
AUR Automated Underreporter Program
EIN employer identification number
FIRE Filing Information Returns Electronically
IRS Internal Revenue Service
NEC nonemployee compensation
NMA net misreported amount
NRP National Research Program
SOI IRS Statistics of Income Division
TIN taxpayer identification number
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United States Government Accountability Office
Washington, DC 20548
July 13, 2007
The Honorable Max Baucus
Chairman
The Honorable Charles Grassley
Ranking Member
Committee on Finance
United States Senate
Voluntary compliance with federal tax laws is a critical component of the federal tax system. Each year, however, a gap arises between tax amounts that were voluntarily reported and paid on time and those that should have been paid. The Internal Revenue Service's (IRS) most recent estimate is that the gross federal tax gap for tax year 2001 was $345 billion.
Sole proprietors, who own unincorporated businesses by themselves, have a relatively high rate of tax noncompliance and account for a significant portion of the tax gap. IRS estimates that sole proprietors misreported 57 percent of their business income in 2001 and that $68 billion of the tax gap is attributable to sole proprietors underreporting such income.1 Key reasons for sole proprietors' relatively high tax noncompliance are well known. Sole proprietors are not subject to tax withholding, and only a portion of their net business income is reported to IRS by third parties. By comparison, misreporting rates for wage and interest income, which are subject to withholding or information reporting by financial institutions, are low (about 1 and 4 percent, respectively).
Congress has been encouraging IRS to develop an overall tax gap reduction plan or strategy that could include a mix of approaches, like simplifying tax law, increasing enforcement tools, and reconsidering the level of resources devoted to enforcement. On September 26, 2006, the Department of the Treasury (Treasury), Office of Tax Policy, issued "A Comprehensive Strategy for Reducing the Tax Gap ." At the time, Treasury officials said that a more detailed strategy would be forthcoming.
Because of your concern about the tax gap and the importance of sole proprietor compliance, you asked us to identify steps that might improve that compliance. Our objectives were to (1) describe the nature and extent of the noncompliance associated with sole proprietors, (2) describe the extent to which IRS's enforcement programs address the types of sole proprietor noncompliance found by IRS's most recent research, and (3) identify options to close the tax gap related to sole proprietors that could be included in the tax gap strategy being developed by Treasury. To describe the nature and extent of sole proprietor noncompliance, we analyzed IRS's National Research Program (NRP) results on the reporting compliance of individual taxpayers in tax year 2001, IRS's tax gap estimates, and IRS's Statistics of Income (SOI) data to develop a profile of sole proprietors and related tax compliance issues.2 To determine the extent to which IRS's compliance programs address sole proprietor noncompliance, we reviewed filing guidance and compliance program procedures and analyzed program results. We interviewed IRS staff on the operations and results of the Automated Underreporter Program (AUR), which tests for underreporting by computer matching information returns reporting selected payments made to sole proprietors with income tax returns. We also interviewed staff in IRS's correspondence, office, and field examination (or audit) programs. In addition, we reviewed NRP examination cases to identify examples of barriers when examining sole proprietors.
We used several approaches to identify options for closing the sole proprietor tax gap that could fit into the tax gap strategy. We focused on options that could address the types of sole proprietor noncompliance profiled by IRS's research and the limitations of IRS's enforcement programs that address sole proprietors. We also reviewed existing recommendations from the President's Budget, President's Advisory Panel on Federal Tax Reform, our previous recommendations and reports of the Treasury Inspector General for Tax Administration, IRS's Taxpayer Advocate, and IRS advisory groups. We discussed the options with experts on sole proprietor compliance, including persons who have experience with IRS or other federal programs related to sole proprietors or who published related research. We met with officials from various small business organizations, professionals who provide tax advice to small businesses, and tax professional organizations. Further, we reviewed Treasury's tax gap strategy. A more detailed description of our methodology is in appendix I. This report contains estimates which have associated confidence intervals that are conveyed in the body or discussed in the appendix. We conducted our review from July 2006 through June 2007 in accordance with generally accepted government auditing standards.
Results in Brief
Most sole proprietors underreported net business income for tax year 2001, but a small proportion of them accounted for the bulk of understated taxes. This underreported income was caused by misreporting of both gross income and expenses. Based on what was detected in NRP reviews, at least 61 percent of sole proprietors underreported their net income by $93.6 billion in 2001. IRS recognizes that these are underestimates because detecting underreported income is difficult, especially cash receipts. After upward adjustment, IRS estimated that underreported net income resulted in sole proprietors understating their taxes by $68 billion. Although most sole proprietors had understated taxes, the amounts were skewed. Of all sole proprietors who understated taxes, the lower half understated them by less than an estimated $903. Over 1 million sole proprietors had tax understatements above $6,200, which accounted for the upper 10 percent of understatements. These understatements averaged an estimated $18,000 and accounted for 61 percent of all understated taxes on returns filed by sole proprietors.
IRS's main programs to check sole proprietor tax compliance --AUR and the Examination program --have a limited reach. AUR annually contacts about 3 percent of the estimated population of noncompliant sole proprietors while Examination reaches less than 2 percent of them. Information returns that AUR uses to verify sole proprietor income only cover about 25 percent of sole proprietor gross receipts and generally few of their expenses. Barriers to submitting information returns, including complex requirements and lack of convenient electronic filing, also limit AUR's reach. Examinations of sole proprietors' tax returns are more costly and recommend lower additional tax assessments than some other examinations. However, examinations (like other enforcement programs) may have a deterrent effect and increase voluntary compliance by other sole proprietors. Because the rate of noncompliance of sole proprietors is so high, any change in their compliance rate from more enforcement activity could result in significant revenue increases. Even without taking into account any effect on voluntary compliance, IRS's enforcement programs annually make contact with hundreds of thousands of sole proprietors and recommend billions of dollars in additional tax assessments. Finally, IRS did not always apply negligence penalties during NRP for sole proprietors with large tax changes.
Since the mid-1990s, we have reported on the need for a strategy to address the overall tax gap as well as the part caused by sole proprietors. That need still exists. Treasury's recently released tax gap strategy discusses neither sole proprietor noncompliance nor the many options that could address it. Although the fiscal year 2008 budget request had legislative proposals on the tax gap, including some related to sole proprietors, these proposals do not make up a long-term, comprehensive strategy. Because no single approach is likely to cost effectively reduce the tax gap by sole proprietors, various options could be considered as part of the overall tax gap strategy and would require IRS, Treasury, or legislative action. These options include enhancing assistance to taxpayers, making information return submission more convenient, requiring more information reporting, and increasing IRS enforcement. Each option has pros and cons. In general, the pros include increasing voluntary compliance, enhancing IRS's ability to detect noncompliance, and reducing the burden of complying. The cons include additional burdens imposed on sole proprietors and third parties as well as costs imposed on IRS. We do not rank the options or recommend particular ones because IRS has other compliance objectives in addition to sole proprietor compliance, some options may be substitutes for each other, and quantitative information about the pros and cons is often lacking. Details on all of our options, including some of the pros and cons, are included in appendix II.
We recommend that the Secretary of the Treasury ensure that the tax gap strategy includes (1) a segment on improving sole proprietor compliance that is coordinated with broader tax gap reduction efforts and (2) specific proposals, such as the options we identified, that constitute an integrated package. In commenting on a draft of this report, Treasury said that although not addressed specifically, the seven elements of the department's strategy are intended to apply broadly to all types of businesses and individual taxpayers, including sole proprietorships. Treasury also stated that this report provides valuable insight for applying the strategy to the tax gap. IRS and Treasury also provided technical comments on a draft of this report, which we incorporated as appropriate. IRS did not provide written comments.
Background
Sole proprietors own unincorporated businesses by themselves. As such, they are distinct from corporations and partnerships. In this report, the term sole proprietors refers to both the owners of the businesses and the category of business. In tax year 2003, 20.6 million sole proprietors filed tax returns (the latest year for which detailed IRS data were available). Sole proprietors constitute about 72 percent of all businesses in the United States but are small; they have only 4.8 percent of all business receipts. Sole proprietors include a wide range of businesses, including those that provide services, such as doctors and accountants; produce goods, such as manufacturers; or sell goods at fixed locations, such as car dealers and grocers. These activities may be full time or part time and may be all or part of an individual's income. Figure 1 shows the distribution of sole proprietors and their gross receipts by the size of the proprietorship.
Figure 1: Distribution of Sole Proprietors and Their Gross Receipts by Size of Proprietorship, Tax Year 2003 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
Sole proprietors report their business-related net profit or loss on IRS Form 1040, U.S. Individual Income Tax Return, through their Schedule C Profit or Loss from Business (see app. III). The Schedule C requires sole proprietors to classify their type of business or profession, report gross receipts and income, place expenses in 23 categories, and provide additional data on vehicle expenses. Sole proprietors with expenses up to $5,000 may qualify for simplified tax reporting on Schedule C-EZ, which allows them to report all expenses on one line. Sole proprietors combine their business profits or losses, reported on Schedule C, with income, deductions, and credits from other sources that are reported elsewhere on the Form 1040 to compute their overall individual tax liability.
In addition to income tax obligations, sole proprietors have other tax requirements. If they have employees, sole proprietors are responsible for withholding and paying Social Security, Medicare, and federal income tax, and paying federal unemployment tax under an employer identification number (EIN) that is the tax identification number (TIN) for the business. Whether they have employees or not, sole proprietors are required to pay self-employment tax, which is similar to the Social Security and Medicare tax for wage earners.
Information Reporting
Sole proprietors may prepare and receive information returns for payments made to them or made by them for services, known as nonemployee compensation (NEC), on an IRS Form 1099-MISC.3 IRS uses the NEC data in its matching programs, such as AUR, to help verify a sole proprietor's receipts. Generally, a Form 1099-MISC needs to be filed with IRS and the recipient of the payment for
Ÿ payments of $600 or more for services performed for a trade or business, including a sole proprietor, by people who are not employees, such as contractors;4
Ÿ rent payments of $600 or more, other than rents paid to real estate agents;5 and
Ÿ sales of $5,000 or more of consumer goods to persons for resale anywhere other than in a permanent retail establishment.
Payments for purchases of goods and service to corporations generally are not required to be reported.6
Based on these rules, organizations (including sole proprietors) that make NEC payments for services provided may be required to submit information returns to IRS and the payee. For example, a store owner (a sole proprietor) who hires a self-employed computer programmer (another sole proprietor) to design the business Web site for $10,000 must submit a Form 1099-MISC information return to report the $10,000 payment made to the computer programmer. However, if the programmer is hired to design a personal, nonbusiness Web site for the store owner, no information return is required.
Completing a Form 1099-MISC requires the payer to determine whether the payee is an independent contractor or an employee. To determine independent contractor status, payers are to use 20 common law rules.7 Numerous controversies over interpretation of the common law rules led to the enactment of Section 530 of the Revenue Act of 1978, which stops IRS and Treasury from issuing new interpretations of these rules.8 In 1996, we characterized these rules as confusing and resulting in many misclassifications. If the determination results in an employee-employer relationship, the organization is required to prepare a Form W-2 and withhold tax from each payment to the employee.
Similarly, the payer must determine if the payee is a corporation, since such payments generally are not subject to Form 1099-MISC reporting. To determine if the service is provided by a corporation, service providers are asked to declare their corporation status and, if not a corporation, provide a TIN. To ensure that payees provide correct TINs on information returns filed with IRS, NEC payments may be subject to backup withholding. Independent contractors and Section 530 are discussed in appendix IV, and backup withholding rules are discussed in appendix V.
IRS Enforcement Programs
IRS's two main programs for ensuring compliance among sole proprietors are AUR and Examination. AUR matches the NEC income reported on the Schedule C of the sole proprietor's tax return with the NEC income reported on Form 1099-MISC. AUR may send a notice to the sole proprietor if the AUR matching identifies a discrepancy between the NEC reported. The notice proposes adjustments to the tax return filed and requests payment of additional tax, interest, or penalties related to the discrepancy. If the taxpayer disagrees with the notice, the taxpayer is requested to explain the difference and provide any supporting documents. Figure 2 describes the NEC information reporting process.
Figure 2: IRS's Nonemployee Compensation Information Returns Matching Process Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
Examinations may address any type of noncompliance issue and come in three forms. Correspondence examinations are conducted through the mail and usually cover a narrow issue or two. Office examinations are also limited in scope but involve taxpayers going to an IRS office. For field examinations, IRS will send a revenue agent to a taxpayer's home or business to examine the compliance problem that IRS suspects.
Compliance Measurement and the Tax Gap
IRS estimates the gross tax gap --the difference between what taxpayers actually paid and what they should have paid on a timely basis --to be $345 billion for tax year 2001, the most recent estimate made. IRS also estimates that it will collect $55 billion, leaving a net tax gap of $290 billion. IRS estimates that a large portion of the gross tax gap, $197 billion, is caused by the underreporting of income on individual tax returns. Of this, IRS estimates that $68 billion is caused by sole proprietors underreporting their net business income. This estimate does not include other sole proprietor contributions to the tax gap, including not paying because of failing to file a tax return, underpaying the tax due on income that was correctly reported, and underpaying employment taxes. According to IRS, estimates for some parts of the tax gap are more reliable than those for others. For both these reasons, the precise proportion of the overall tax gap caused by sole proprietors is uncertain. What is certain is that the dollar amount of the tax gap associated with sole proprietors is significant.
IRS bases its estimates of the tax gap caused by underreporting of individual income on its compliance research program --NRP. The individual reporting compliance study was a detailed review and examination of a representative sample of 46,000 individual tax returns from tax year 2001. IRS generalized from the NRP sample results to compute estimates of underreporting of income and taxes for all individual tax returns. Because even the detailed NRP reviews could not detect all noncompliance, IRS adjusted the NRP estimates to develop final estimates of income misreporting and the resulting tax gap. IRS did not adjust all the NRP population estimates, only those necessary for developing its final tax gap estimates. However, NRP population estimates are a rich source of data about the nature and extent of sole proprietor noncompliance. Consequently, our report sometimes presents NRP population estimates and sometimes final tax gap estimates.
Most Sole Proprietors Underreported Business Income, but a Small Proportion Accounted for the Bulk of Unpaid Taxes
The significant amount of sole proprietor noncompliance reported in IRS's tax gap estimates is caused by underreporting of net business income, including the misreporting of both gross business income and expenses. The distribution of the resulting unpaid taxes is uneven. A small proportion of sole proprietors, but still a significant number, has relatively large amounts of unpaid taxes.
Most Sole Proprietors Underreported Net Business Income, Misreporting Both Gross Income and Expenses
Based on the unadjusted NRP results, an estimated 70 percent of Schedule C filers in 2001 (about 12.9 million) made an error when reporting net business income (that is, net profit or loss on line 31 of Schedule C). Most of the misreporting was underreporting. These NRP results showed that an estimated 61 percent of Schedule C filers underreported their net income and 9 percent overreported.
These reporting errors resulted in $93.6 billion, before adjusting, of misreported net business income as shown in figure 3. This misreporting included an estimated $99 billion of underreported and $5.4 billion of overreported net income.
The underreporting of net business income was caused by misreporting of both gross income and expenses, as shown in figure 3. An estimated 39 percent of sole proprietors (6.9 million) made an error on the gross income line of Schedule C and underreported about $53 billion net after subtracting overstatements from understatements. An estimated 73 percent of sole proprietors (10.9 million) made an error on the total expense line of the Schedule C and overreported about $40 billion net after subtracting understatements from overstatements.9 Overstating expenses reduces net business income and thus taxes. However, understating expenses may also contribute to understated tax if it is done to disguise understating higher amounts of gross income.
The misreporting of expenses was spread over all the 23 expense categories on the Schedule C. However, 55 percent of expense misreporting was concentrated in four categories: car and truck, depreciation, supplies, and other.
Figure 3: Summary of Unadjusted NRP Population Estimates for Schedule C Misreporting, Tax Year 2001 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
The unadjusted NRP results underestimate the amount of misreporting. The estimates in figure 3 are based on errors detected in the NRP reviews. IRS knows that not all misreporting is detected during its examinations, including NRP reviews. Unreported cash receipts, for example, are difficult to detect. IRS uses various methodologies and other sources of data (on cash transactions, for example) to adjust the aggregate NRP results (but not individual line items) to estimate misreporting. The NRP data limitations are more fully described in appendix I.
After these adjustments, IRS estimates that sole proprietors misreported 57 percent of their net business income in 2001 and that the tax gap caused by this misreporting of sole proprietor net business income in 2001 was $68 billion. This is a substantial upward adjustment from the estimated $36.9 billion in understated taxes from all sources on returns with a Schedule C attached based on what NRP detected.10
Taxpayers misreport income and expenses for a variety of reasons. Some misreporting is intentional; some is unintentional. How much misreporting is in each category is not known. IRS refers some misreporting for criminal prosecution, but often it is impossible to tell from a tax return whether errors are intentional. Beyond intentional misreporting, reasons for errors include transcription mistakes, misunderstanding of the relevant tax laws or regulations, and poor recordkeeping. Examples from our review of NRP examination case files illustrate some of these types of reporting errors:
Ÿ The sole proprietor operated a cash-card business and reported about $900,000 in gross receipts on the Schedule C. The business is largely done with cash transactions. The examiner found evidence of more than $1 million in additional sales income, as well as additional expenses from purchases, leading to an adjustment of about $30,000 for Schedule C net income. The adjustment contributed to a total proposed additional tax assessment of about $8,000.
Ÿ The sole proprietor owned a construction business and reported Schedule C losses of over $30,000. The examiner found that that the sole proprietor had poor business skills and shoddy records. Organizing the documentation to support the Schedule C required over 25 hours of examiner time and resulted in net adjustments to receipts and expenses on the Schedule C of over $45,000.
Ÿ The sole proprietor owned a retail business and reported Schedule C gross income of almost $250,000. The examiner proposed adjustments of about $9,000 to Schedule C expenses because the expenses were undocumented or were personal living expenses not associated with the business. In protesting the related assessment to IRS Appeals, the taxpayer's representative said that the taxpayer's records were spread across several store accounts, several accounts for rental properties, and two personal accounts. Eventually, Appeals identified additional records and sent the case back to Examination.
Ÿ The taxpayer was selling craft-related items and admitted to the IRS auditor that the sales were not engaged in for profit. Accordingly, the taxpayer should not have filed a Schedule C, and several thousand dollars of expenses reported by the taxpayer on Schedule C were disallowed.
Ÿ The taxpayer was a minister and filed a schedule C. The examiner explained that although the taxpayer was self-employed in performing ministerial services for Social Security purposes, the taxpayer was considered an employee for income tax purposes. The taxpayer should not have filed a Schedule C.
Although a Small Proportion of Sole Proprietors, More Than 1 Million Accounted for the Majority of Understated Taxes
Understated taxes are spread unevenly among the population of sole proprietors, and slightly more than 1 million sole proprietors accounted for most of the understatements. On one hand, the amount of tax understatement caused by underreported net Schedule C income cannot be calculated precisely. Understated taxes on a return could result from the misreporting of multiple items, and the tax calculations depend on all such misreporting rather than just one item.11 On the other hand, using the best available data on underreporting detected by NRP, we estimate that 72 percent of the underreported adjusted gross income (AGI) on income tax returns filed by sole proprietors was caused by changes in Schedule C income.12 As a result, it is likely that most of the NRP-estimated $36.9 billion (unadjusted) in understated taxes on these returns can be attributed to underreported net business income on Schedule C.
Although most sole proprietors had understated taxes, the amounts were skewed. Based on NRP estimates, half of sole proprietors who understated taxes on their individual income tax returns, understated less than an estimated $903 (the 50th percentile amount), as shown in figure 4. Above the 50th percentile, the amount of tax understatement significantly increased to an estimated $2,527 at the 75th percentile, $6,210 at the 90th percentile, and $20,387 at the 98th percentile. About 1.25 million sole proprietors accounted for the largest 10 percent of understatements for which the mean was about $18,000; for the largest 5 percent, the mean understatement was about $27,000. By comparison, as will be discussed further in the next sections, IRS's field examiners assessed on average $27,800 of additional tax for examinations of individual returns without Schedule Cs.
Figure 4: Estimated Understated Tax Amounts by Percentile for Form 1040s with Schedule Cs Attached, Tax Year 2001 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
Most of the aggregate $36.9 billion of understated taxes (unadjusted NRP estimate) on returns filed by sole proprietors was concentrated in a small proportion of sole proprietors. As shown in figure 5, the 11.2 million sole proprietors at and below the 90th percentile understated their taxes by a cumulative $14.3 billion. The remaining 10 percent (1.25 million) above the 90th percentile understated a cumulative $22.6 billion in taxes, accounting for 61 percent of the total.
Figure 5: Estimated Cumulative Understated Taxes by Percentile for Form 1040s with Schedule Cs Attached, Tax Year 2001 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
When arrayed by the size of the sole proprietor and based on reported gross receipts, understated taxes are less skewed. Based on Schedule C gross receipts, those sole proprietors at or below the 90th percentile ($127,462) accounted for 65 percent of cumulative understated taxes ($23.9 billion of $36.9 billion).13 Those with the largest 10 percent of gross receipts accounted for the other 35 percent or $12.9 billion of the understated taxes.
Enforcement Programs Have Limited Reach over Sole Proprietors but Still Make Billions of Dollars in Recommended Assessments
IRS's two main programs for addressing sole proprietor reporting compliance14 --AUR and Examination --have limited reach over noncompliant sole proprietors, although they annually contact hundreds of thousands of taxpayers and recommend billions of dollars in assessments. Table 1 shows the types of sole proprietor noncompliance that AUR and Examination investigate, the percentage of the noncompliant sole proprietor population with recommended assessments, and the limitations of the programs.
Table 1: Percentage of Recommended Assessments and Limitations of IRS Enforcement Programs for Detecting Sole Proprietor Reporting Noncompliance
___________________________________________________________________________________
Percentage of
noncompliant
Sole proprietor population with
IRS noncompliance recommended
program addressed assessments Program limitations
___________________________________________________________________________________
AUR Inaccurately 2.7a l Form 1099-MISC is not
reported gross required to be filed on
receipts all gross receipts
(e.g., sales of goods).
l Form 1099-MISC is not
always filed as required
because of various
barriers.
l Does not address sole
proprietor expenses.
l Does not follow up on
all the mismatches
identified.
l Some information
submitted by taxpayers
is not verified.
___________________________________________________________________________________
Examination Receipts and 1.4b l Most examinations are
expense not designed to address
noncompliance sole proprietor tax
issues.
l Examinations can take a
lot of time.
l Recommended assessments
are lower from examining
sole proprietor issues
compared to examining
other types of tax
return issues.
___________________________________________________________________________________
Source: GAO analysis of IRS data.
a Tax year 2003, the most recent year for which the appropriate AUR data were
available.
b Examinations conducted in fiscal year 2005 on calendar year 2004 returns, the
most recent year for which the appropriate Schedule C filing data were available.
Assuming that Schedule C filers would misreport net income at the same rate in subsequent years as they did in 2001, AUR recommended that additional tax be assessed on about 2.7 percent of noncompliant sole proprietors for tax year 2003.15 Similarly, Examination recommended that additional tax be assessed on about 1.4 percent of noncompliant sole proprietors for returns from tax year 2004.16
AUR Is Restricted by Limits on Information Reporting and Other Program Constraints but Still Identifies Significant NEC Noncompliance
AUR cannot detect all sole proprietor misreporting because the third-party information returns used for matching do not report all sole proprietor receipts or expenses. One quarter of sole proprietor receipts reported on a Schedule C in 2001 also appeared on a Form 1099-MISC that year. Since not all receipts are reported on a Schedule C, the true percentage would be lower. Exemptions to information reporting requirements prevent greater coverage of sole proprietor receipts. Most merchandise sales, nonbusiness services (such as construction or repairs for homeowners), and payments of less than $600 are exempt from Form 1099-MISC reporting. Additionally, because payments to corporations are generally exempt, sole proprietors that want to avoid information reporting of their receipts could incorporate.
Several barriers may inhibit information return filing on NEC payments. First, preparing a Form 1099-MISC to report NEC payments can be a complex process.17 The general instructions for filling out any information return are 21 pages long, and the instructions for Form 1099-MISC are 8 pages long. Payers must figure out whether the businesses they have hired are independent contractors or exempt corporations and whether the payments meet other exemption criteria as well as acquire the payees TINs or EINs.
Second, submitting Form 1099-MISC returns is not convenient. In its instructions, IRS requires payers to use forms printed with red, magnetic ink so that IRS scanners can more easily process the forms; payers are instructed not to print Form 1099-MISC off of IRS's Web site. However, we observed plain paper Form 1099-MISC returns being scanned in IRS's Ogden, Utah, processing center. Furthermore, payers must submit Form 1099-MISC returns separately from their tax returns. There is $50 penalty, as the instructions prominently remind payers, for failing to use the correct form. In practice, IRS may not assert the penalty for every violation because of the administrative and collection costs.
IRS has an Internet-based system for submitting information returns called Filing Information Returns Electronically (FIRE), but barriers exist to the use of that system. FIRE requires payers to put return information in a particular format that IRS can use, which requires appropriate software that payers must purchase. Payers cannot simply call up a Web site and fill out an online form, and they need to register with IRS before using the system.18 The likelihood that a payer would submit a Form 1099-MISC return electronically decreases as the number of forms that the payer files decreases. For example, IRS data from tax year 2005 show that 93 percent of paper Form 1099-MISC returns were filed by payers with 24 or fewer submissions. One common tax preparation software package allows users to print Form 1099-MISC and submit them to IRS on paper, but the users cannot transmit Form 1099-MISC returns electronically as they can income tax returns. This software vendor said that it had a special arrangement with IRS for its users to print Form 1099-MISC on plain paper.
Paper forms are more costly for IRS to process than electronically filed forms. With paper, IRS workers scan forms into a database and visually verify that the information was scanned correctly, a labor-intensive process. A substantial number of Form 1099-MISC returns are filed on paper. For filing year 2005, the Form 1099-MISC constituted 87 percent of all the paper information returns submitted that IRS could scan. Nearly 40 percent of Form 1099-MISC returns (31.5 million) were submitted via paper that year.
AUR Is Limited by a Lack of Resources, Expense Matching, and Examination Authority
Because of resource constraints, IRS officials said they do not contact taxpayers in all cases where AUR finds a mismatch between what was reported on an information return and what was reported on a tax return. The annual average of NEC-related contacts for tax years 1999 through 2003 is much less than half of the roughly 2 million cases that AUR officials say they annually identify for taxpayer contacts caused by potential NEC underreporting.19
Also, AUR matching generally does not address misreported Schedule C expenses. First, according to IRS, AUR does not match sole proprietors' Schedule C expenses with the information returns they file for their own payments. Second, third-party information generally is not required on sole proprietor expenses.20
AUR reviewers are directed to consider the reasonableness of the taxpayers' responses to notices but generally do not examine the accuracy of the information in the responses because they do not have examination authority.21 IRS officials said that addressing larger issues raised in the returns would take more time and possibly reduce the productivity of AUR overall. Consequently, taxpayers could, after being contacted by AUR about underreported NEC, create fictitious expenses to offset the underreported NEC.
AUR does not systematically check for related parties trying to shift income from a tax return in a high-rate bracket to another return with a lower bracket. Related parties may include taxpayers who own multiple businesses, husbands and wives who file separate tax returns, unmarried couples, siblings, or parents and their children. IRS data showed that 3 percent of all Form 1099-MISC returns had the same address for the payer and the payee --one indicator that a related-party transaction might exist. A nonrandom file review of 55 Form 1099-MISC filings at IRS's Ogden, Utah, campus found 8 examples in which the payer and payee had similar addresses or names. We did not determine the appropriateness of the apparent related-party transactions in the IRS Form 1099-MISC data based on the incidence of name and address matches.
Two NRP cases are illustrative of apparent related-party transactions involving Form 1099-MISCs. In one case, a couple shared a financial account, and one of them was a sole proprietor. The sole proprietor, who earned more than $450,000 as an executive at a separate company, paid the other individual to run the sole proprietorship and deducted the payment on a Schedule C. The sole proprietorship had over $100,000 in losses and less than $1,000 in revenue. In the case file, an examiner noted that a Form 1099-MISC was filed on the NEC income paid from the executive to the person at the same address. This case file did not note whether the payment inappropriately shifted income to lower the couple's overall tax liability or whether the payment was an allowable business deduction for services actually rendered as an ordinary and necessary expense of carrying out a business, as required by the Internal Revenue Code.22 In another case, however, IRS disallowed deductions for wages that a psychiatrist paid to his children because the taxpayer did not show that the children had rendered services or even that the wages were paid --only that the deductions were taken.
Despite Limitations, AUR Annually Recommends Hundreds of Millions of Dollars in Assessments on NEC Misreporting
Annually, AUR receives more than 80 million 1099-MISC forms. From those submissions, AUR contacts hundreds of thousands of taxpayers about potential sole proprietor misreporting on those forms and makes billions of dollars in recommended assessments. From tax years 1999 through 2003,23 AUR annually, on average, sent 371,989 notices on NEC cases and recommended $666 million in tax assessments. Figure 6 shows the trends in NEC contacts and total recommended assessments that AUR made from 1999 through 2003.
Figure 6: Number of AUR NEC Contacts Made and Total Recommended Assessments, Tax Years 1999-2003 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
Contacts and assessments related to underreported NEC make up a significant portion of the AUR caseload. Of more than 60 categories that AUR uses to sort income data, the two NEC categories combined rank first in the number of contacts with taxpayers and in the dollars of recommended assessments made from tax year 1999 through tax year 2003. NEC cases constituted 17 percent of all AUR contacts and 21 percent of all AUR assessments for tax years 1999 through 2003.
Examination Program Is Not Geared toward Schedule C Issues but Still Finds Significant Noncompliance
Most of IRS's examinations do not focus on noncompliance by sole proprietors.24 Correspondence examinations account for the majority of IRS's examinations that IRS did in fiscal year 2006 and generally take the least amount of time to conduct, typically an hour or less, because they deal with simple, limited issues. Schedule C tax issues are generally too complex to make an examination through correspondence practical. For example, in our review of NRP files, we found a case in which an examiner manually sorted through a taxpayer's records and organized them to accurately calculate the taxes owed --a task that could not occur through correspondence. In any case, IRS's correspondence tax examiners, the lowest-graded examiners, do not have the training to examine many Schedule C issues, such as business depreciation or accounting methods.
Schedule C tax issues typically must be addressed in field examinations. Field examinations took 20 hours on average to complete in fiscal year 2006. Furthermore, field examinations of returns with Schedule C forms took about 50 percent longer per return (7.2 hours more) to complete than those not categorized as Schedule C returns in that year.
Among field examinations, the recommended additional tax assessed for examinations of returns with attached Schedule C forms tended to be smaller than for other types of examinations. For example, the average recommended assessment for revenue agents examining returns with attached Schedule C forms (the employees most likely to do these examinations) was $24,000 in fiscal year 2006. This was $3,800 less than examinations of returns without Schedule C attachments and was less than the average dollars per return for 18 other types of returns without Schedule C attachments, such as tax-shelter program cases.
The relatively higher costs and lower yields for Schedule C examinations do not necessarily mean than Schedule C examinations are not cost-effective. The statistics reported above include only the additional taxes expected from the taxpayer who was examined. Examinations may have a deterrent effect on other taxpayers and increase the rate of voluntary compliance.25 Because the rate of noncompliance is so high for sole proprietors, any change in their voluntary compliance from doing more examinations could result in significant revenue increases.
IRS has been examining more tax returns with attached Schedule C forms, resulting in billions of dollars in recommended tax assessments. From fiscal years 2001 through 2006, the number of examinations of returns that IRS categorized as Schedule C returns increased by 132 percent, from 128,062 to 297,626, as shown in figure 7.26 In fiscal year 2006, IRS examined about 3 percent of the Schedule C categorized returns. Recommendations of additional tax assessments also increased each year. The large increase in these assessments in 2005 was primarily for returns reporting income greater than $100,000. IRS officials also cited Son of Boss fraud cases from fiscal years 2005 and 2006 and increased examination efficiency as causes for the upward trends.27 Assessments do not reflect amounts actually collected. Amounts ultimately collected are not yet known from the examinations closed in 2005 and 2006.
Figure 7: Examinations of Returns with Schedule C Attachments and Recommended Tax Assessments, Fiscal Years 2001-2006 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
IRS Did Not Always Apply Negligence Penalties during NRP
IRS did not apply negligence penalties in a substantial portion of NRP cases with a tax change. IRS uses negligence penalties28 to encourage compliance and to assure compliant taxpayers that the tax system is fair.
Although sole proprietors were more frequently penalized than non-sole proprietors, just 62 percent of the sole proprietors who had a 100 percent or more tax change in their tax liability after the NRP examination and had a tax change of $10,000 or more were penalized. For smaller tax changes, the percentage penalized was lower. Figure 8 summarizes the penalty results from the NRP examinations for tax returns with a 100 percent or more change for sole proprietors and non-sole proprietors.
Figure 8: Recommended Penalties for Sole Proprietors and Non-Sole Proprietors in NRP Examinations with a 100 Percent or Greater Recommended Tax Change by Dollar Value of Tax Change in Tax Year 2001 Inline TIFF Image Download TIFF Image Full-sized PNG Image Screen-Width PNG Image
Our NRP case file review provided some examples in which penalties were not assessed at all or seemed to be assessed inconsistently.
Ÿ A sole proprietor reported AGI of about $10,000 and zero tax liability on the return. An examiner proposed total adjustments of about $3,000, which included unreported Schedule C receipts and overstated expenses resulting in additional tax of about $450. The examiner proposed a negligence penalty of about $90, explaining that the taxpayer did not take reasonable care in preparing the tax return, which was done by a tax preparer.
Ÿ A sole proprietor reported AGI of about $90,000 and a tax liability of about $16,000. An examiner proposed total adjustments of about $35,000, based on unreported Schedule C receipts and overstated expenses, and a tax increase of $15,000. The examination workpapers explained that no negligence penalty was proposed since the tax preparer was responsible for most of the adjustments.
The differences in individual cases might be caused in part by IRS procedures that give revenue agents discretion on whether to pursue a penalty, even when the tax change is substantial.29 Recommended penalties must be reviewed by the examiner's manager. Explanations ranging from a lack of knowledge to reliance on a paid preparer can lead some examiners to mitigate a penalty but not others.
IRS officials said the application of penalties in NRP cases should be similar to that for operational examinations because NRP examiners were required to follow IRS's standard guidance for penalties. We have started work on a study that will more fully analyze the use of penalties in IRS's operational examinations.
Current Treasury Tax Gap Strategy Discusses Neither Sole Proprietor Noncompliance nor the Many Options That Could Address It
The tax gap strategy issued by Treasury in September 2006 does not discuss sole proprietor noncompliance or specific options to address it. A number of options to improve sole proprietor compliance exist and could be considered as part of the overall tax gap strategy. Each option has both pros (such as improved compliance) and cons (such as burdens on taxpayers or third parties).
Tax Gap Strategy Does Not Specifically Discuss Sole Proprietor Noncompliance
Treasury's tax gap strategy does not discuss specific options to address the tax gap overall or sole proprietor noncompliance in particular. As we discussed in February 2007 testimony,30 the strategy generally does not identify specific steps that Treasury and IRS31 will undertake to reduce the tax gap, the related time frames for such steps, or explanations of how much the tax gap would be reduced. Rather, the strategy broadly discusses opportunities for tax evasion and the preventive role of tax research, information technology, compliance activities, taxpayer service, tax law simplification, and working with stakeholders. For example, the portion on improving compliance activities generally discusses initiatives on expanded information reporting, improved document matching, refined detection programs, and increased examinations in selected areas. However, no specifics are provided. Without specifics, the strategy does not include actions that potentially would reduce the tax gap.
Since the mid-1990s, we have reported on the need for a strategy to address the federal tax gap as well as sole proprietor noncompliance. In May 1994, we summarized many ideas on reducing the tax gap, including ideas on information reporting, tax withholding, and tax simplification.32 In August 1994, we reported on the lack of a comprehensive linkage between IRS's compliance strategy and compliance efforts for sole proprietors and on the need for better systems to identify the causes of noncompliance and target enforcement resources.33 More recently, in July 2005, we reported that IRS needed a results-oriented approach to reduce the tax gap based on long-term, quantitative voluntary compliance goals and performance measures to determine the success of its strategies and adjust as necessary.34 In April 2006, we testified that IRS had established such compliance goals but lacked a data-based plan for achieving the goals.35 In February 2007, we testified on the need for multiple approaches to reduce the tax gap, including improved taxpayer services, tax code simplification, more information reporting, and an appropriate level of resources for tax enforcement.36 Our products related to the tax gap are listed in the Related GAO Products section at the end of this report.
IRS is not without some of the elements of a tax gap strategy. IRS's management continually makes decisions about reallocating resources and has taken steps that demonstrate an understanding of the value of a more strategic approach. One important step is NRP, which gives IRS management more information about the nature of noncompliance and is being used to better target examinations on noncompliant taxpayers. IRS's annual budget requests include specific compliance program proposals. For example, the fiscal year 2008 budget submission had 16 legislative proposals on tax gap reduction. Some of these proposals related to sole proprietors, such as those requiring information reporting on certain government payments made for the procurement of property and services and on merchant card payment reimbursements. Several IRS and Treasury experts, and other knowledgeable individuals also commented that many of these options would be applicable to any small business regardless of its organizational form (such as partnerships, limited liability companies, and corporations). However, these elements do not make up the type of long-term, comprehensive strategy, described above, that provides an overall rationale and specific steps, time frames, and predicted impact on the tax gap.
Many Options for Improving Sole Proprietor Compliance Exist and Could Be Considered for the Tax Gap Strategy, But All Have Trade-offs
Many options exist that could help reduce sole proprietor noncompliance. These options range from enhancing IRS's assistance to taxpayers to instituting tax withholding on payments made to all or certain types of sole proprietors. Each option has pros and cons.
We identified options and their pros and cons by reviewing our reports and the reports of others on sole proprietor compliance as well as through extensive conversations with experts and knowledgeable individuals inside and outside of IRS. Consistent with our previous reports, we tried to identify options that represented a range of approaches, such as improving taxpayer service, more information reporting, and various enforcement actions. Many of the options are directed at the specific sole proprietor compliance problems and IRS program limitations described earlier in this report. We placed the options into broad categories of problems, such as poor recordkeeping, unreported business income, and overstated business expenses. Our list, in table 2, is not exhaustive and not ranked in any order. Appendix II contains a longer description of each option, including pros and cons.
Table 2: Options to Improve Sole Proprietor Tax Compliance
____________________________________________________________________________________
A. Recordkeeping and complexity
____________________________________________________________________________________
1. Work with small business representatives to improve instructions for keeping
records and completing the Schedule C.
____________________________________________________________________________________
2. Provide assistance to first-time Schedule C filers.
a. Target outreach to sole proprietors filing their first Schedule C --IRS
could provide guidance to help them keep records and report accurately on
their Schedule C forms.
b. Notify first time Schedule C filers who did not use a paid tax preparer
and who reported on certain Schedule C lines known to generate more
noncompliance about guidance on IRS's Web site.
____________________________________________________________________________________
3. Separate business and personal records and transactions.
a. Require sole proprietors to include all business transactions in a
financial account or accounts used only for business purposes.
b. Require sole proprietors to obtain TINs for business transactions in
lieu of using their Social Security numbers.
____________________________________________________________________________________
4. Repeal certain limitations in section 530 of the Budget Act of 1978 involving
guidance on rules on classifying workers.
____________________________________________________________________________________
B. Burdens and problems for third parties in filing information returns
____________________________________________________________________________________
5. Clarify Schedule C instructions to indicate that an information return may be
required from sole proprietors who are deducting expenses for wages, fees, and
commissions.
____________________________________________________________________________________
6. Ensure that IRS's Web-based system for filing information returns can
accommodate those filing information returns on payments made to sole proprietors.
____________________________________________________________________________________
7. Create a new Form 1099-NEC to segregate the NEC from the various boxes on the
existing Form 1099-MISC.
____________________________________________________________________________________
C. Unreported sole proprietor income
____________________________________________________________________________________
8. Expand gross receipts reporting on the Schedule C.
____________________________________________________________________________________
9. Close gaps in existing information reporting on payments made to sole
proprietors, for example, by requiring information reporting on annual service
payments that are
a. made to all corporations or to some subset, such as small corporations,
non-publicly held corporations, or noncompliant corporations, or
b. less than $600, which is the current trigger for information reporting.
____________________________________________________________________________________
10. Require new information reporting by organizations on payments to sole
proprietors.
a. Require businesses that process credit (and debit) card payments to
report on the amount of payments made to sole proprietors for a tax year.
b. Require federal, state, and local governments to file information
returns on all nonwage payments made to procure property and services from
businesses.
c. Require financial institutions to file information returns on business
deposits and withdrawals by sole proprietors.
____________________________________________________________________________________
11. Require new information reporting on consumer payments to sole proprietors for
property owners who pay contractors for improvements, if the payments will be used
to adjust the basis of the property.
____________________________________________________________________________________
D. Overstated deductions for sole proprietor expenses
____________________________________________________________________________________
12. Expand expense reporting on the Schedule C.
____________________________________________________________________________________
13. Match information returns filed by sole proprietors with related expenses on
their Schedule C forms.
____________________________________________________________________________________
14. Expand information reporting on the expenses of sole proprietors under two
options.
a. Require businesses that receive certain types of payments from sole
proprietors in large amounts (i.e., thousands of dollars) to file
information returns to report those amounts.
b. Require businesses that process credit (and debit) card payments to
report information on the amount of payments by sole proprietors for each
tax year.
____________________________________________________________________________________
15. Verify additional expenses claimed to offset unreported income.
____________________________________________________________________________________
E. Nonpayment of tax
____________________________________________________________________________________
16. Deny benefits/payments until tax obligations are met, for example, by requiring
that
a. sole proprietors pay their self-employment tax obligations in order to
receive credit for Social Security benefits and
b. federal agencies do a tax compliance check with IRS before providing a
government benefit to a sole proprietor.
____________________________________________________________________________________
17. Withhold tax to encourage compliance through situational or universal means by
requiring those who are to file information returns on payments made to sole
proprietors to
a. withhold a small amount from payments until the sole proprietor's TIN is
certified through an IRS system that is quick and accurate and
b. withhold a very small percentage of the payments made to sole
proprietors in all cases or in limited situations, such as when the sole
proprietor voluntarily consents.
____________________________________________________________________________________
F. IRS management of limited resources
____________________________________________________________________________________
18. Improve IRS's audit selection of sole proprietor tax returns in at least two
ways.
a. Use more advanced automated systems to update the current manual system.
b. Improve the ability of AUR to refer cases for audit.
____________________________________________________________________________________
19. Enhance data sharing with the states.
____________________________________________________________________________________
20. Use informational notices to encourage compliance.
____________________________________________________________________________________
21. Revise the rules for penalties to improve consistency and compliance under two
options.
a. Simplify the process for assessing penalties and develop standards on
using penalties.
b. Increase the penalty for subsequent failures to file required
information returns.
____________________________________________________________________________________
Source: GAO analysis and interviews with tax experts and knowledgeable individuals.
All the options have pros and cons. Because the options are presented as concepts, rather than as detailed plans ready for implementation, the pros and cons could vary with such detail. In most cases, pros and cons are described qualitatively and are not intended to be exhaustive; additional analysis might find others. In general, the pros include helping sole proprietors to comply voluntarily, helping IRS detect and prevent underreporting of income and understatement of taxes, and reducing the burden on taxpayers or third parties for filing tax returns and information returns. The cons include the costs and burdens imposed on sole proprietors, third parties, and IRS.
We are not recommending particular options for a number of reasons:
Ÿ Trade-offs. IRS has other compliance objectives in addition to sole proprietor compliance. Devoting more IRS staff and other resources to close the sole proprietor tax gap means that fewer resources are available for combating other types of noncompliance, such as corporate, individual, or tax-exempt entity noncompliance. Forgoing enforcement revenue elsewhere is an opportunity cost of devoting more resources to sole proprietor noncompliance. Also, the resources and management capacity devoted to sole proprietor noncompliance may not be sufficient to implement all the options. Priorities would need to be established.
Ÿ Interaction between options. Some of the options may be substitutes for each other. Others may be complements. Improving assistance to taxpayers might reduce the need for some enforcement actions. Some of the options may reinforce each other --such as expanded inf ormation reporting and more convenient filing options --making it desirable to package them together.
Ÿ Policy judgments. Some of the options involve policy judgments about how the options would affect different groups of people. For example, information reporting invariably imposes some costs on the third parties required to report, but no objective criteria exist for assessing when third-party costs are excessive. In many cases, quantitative information about the effects is not available. Judgments would have to be made based on qualitative information.
For all of these reasons, we are not ranking or otherwise making recommendations on the value of each option, nor are we opining on which options should be packaged together and in what manner. The options could be considered as part of an overall Treasury and IRS tax gap strategy. For most options, Treasury and IRS would need to develop the details on how the options would work both singly and as part of a coordinated strategy. Issues that could be considered in an overall strategy include how much emphasis should be placed on
Ÿ sole proprietor noncompliance versus other types of noncompliance,
Ÿ efforts to help sole proprietors voluntarily comply versus efforts to help IRS detect noncompliance after it occurs,
Ÿ the reporting requirements and added burden placed on sole proprietors versus the reporting requirements and burden placed on third parties, and
Ÿ legislative changes versus administrative changes at IRS.
Conclusions
The tens of billions of dollars in tax revenue lost annually because sole proprietors underreport over half of their aggregate net income contribute to the nation's long-term fiscal challenge. This underreporting is also unfair to compliant taxpayers. Because underreporting is spread among more than 12 million sole proprietors, much of it in small amounts, because the underreporting is for both gross income and expenses, and because IRS's enforcement programs are limited and costly, the sole proprietor tax gap cannot be closed by IRS enforcement alone. As we have said before, improving compliance will require a variety of new approaches.
Many options exist for improving sole proprietor compliance; however, they all have individual pros and cons, some may be substitutes for each other and some may reinforce each other. Trade-offs also exist at a broader level. Devoting more IRS resources to sole proprietor compliance must be judged relative to what those resources could accomplish in IRS's other programs. Furthermore, IRS's resources are not the only ones devoted to tax administration. Taxpayers and third parties spend their time and money to make our tax system work. For these reasons, the options are best considered as part of an overall strategy. Such a strategy would provide more assurance that taxpayer, third party, and IRS resources are being used efficiently to promote compliance.
Recommendation for Executive Action
We recommend that the Secretary of the Treasury ensure that the tax gap strategy includes (1) a segment on improving sole proprietor compliance that is coordinated with broader tax gap reduction efforts and (2) specific proposals, such as the options we identified, that constitute an integrated package.
Agency Comments and Our Evaluation
We requested written comments from the Secretary of the Treasury and received comments on behalf of the Treasury from its Tax Legislative Counsel (see app. VI). In commenting on a draft of this report, the Treasury said that although not addressed specifically, the seven elements of the department's strategyare intended to apply broadly to all types of businesses and individual taxpayers, including sole proprietorships. Treasury also stated that this report provides valuable insight for applying the strategy to the tax gap. IRS and Treasury also provided technical comments on a draft of this report, which we incorporated as appropriate. IRS did not provide written comments.
As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days after its date. At that time, we will send copies to the Secretary of the Treasury, the Commissioner of Internal Revenue, and other interested parties. This report will also be available at no charge on GAO's Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix VII.
James R. White
Director, Tax Issues
Strategic Issues
Appendix I: Scope and Methodology
To describe the nature and extent of the noncompliance associated with sole proprietors, we analyzed the Internal Revenue Service's(IRS) National Research Program (NRP) results, tax gap estimates, and Statistics of Income (SOI) data, and interviewed IRS officials. The NRP data are IRS estimates of individual tax reporting compliance based on reviews and examinations of filed tax returns. IRS randomly selected the returns for tax year 2001, which were filed with IRS during calendar year 2002. To compute the percentage of returns with an understatement or overstatement on a Schedule C line and the net misreported amounts, IRS used the following definitions, including related limitations:
Percentage of returns with an error : This ratio is the weighted number of taxpayers that have a non-zero net misreported amount divided by the weighted number of returns that should have reported the amount. For some items, taxpayers may have errors that exactly offset each other resulting in no net tax change. For example, a taxpayer may have reported a transaction as an "office expense," but an examiner reclassified the same amount as "repairs and maintenance." NRP did not consider these offsetting changes as errors for those line items.
Net misreported amounts (NMA) : The NMA is the sum of all amounts underreported minus the sum of all amounts overreported for an item. The NMA does not include adjustments between schedules of the return. For example, the NRP examiner may disallow reported amounts for expense deductions on Schedule C that should have been reported on Schedule A and increase the deductions on Schedule A by the same amounts. Neither adjustment would be in IRS's NMA. However, the adjustments would be included in IRS's definition of the amounts that should have been reported, which are reflected in the denominator of the net misreporting percentage. The NMA does not include adjustments that were made because the taxpayer used the wrong form or line item.
Because the percentage of returns with an error and the NMA are derived from samples, table 3 lists the confidence intervals for each amount. IRS did not compute confidence intervals for its estimates. When we calculated confidence intervals, we got slightly different point estimates than IRS. The difference appears to arise from varying definitions of sole proprietors. We are 95 percent confident that the percentages and amounts reported are between the low estimate and the high estimate. In the body of this report, we present IRS's point estimates.
Table 3: Confidence Intervals for Summary of Schedule C Misreporting for Tax Year 2001
____________________________________________________________________________________________________
Dollars in billions
____________________________________________________________________________________________________
Percentage of returns with an error Net misreported amount
________________________________________________________________________________
GAO IRS GAO
calculated percentage calculated IRS
Low High Low High reported
Schedule C line estimatepercentage estimate reported estimate amount estimate amount
____________________________________________________________________________________________________
Gross income, line 38 40 42 39 $52.8 $56.8 $60.8 $52.6
7
____________________________________________________________________________________________________
Car and truck 44 46 48 50 6.9 7.5 8.1 7.8
expenses, line 10
____________________________________________________________________________________________________
Depreciation and 36 38 41 42 2.0 2.4 2.8 2.7
section 179 expense
deduction, line 13
____________________________________________________________________________________________________
Supplies, line 22 34 36 38 41 2.4 2.8 3.2 2.9
____________________________________________________________________________________________________
Other expenses, 50 52 54 55 7.2 8.5 9.8 9.0
line 27
____________________________________________________________________________________________________
Total expenses, 67 69 71 73 36.4 38.6 40.8 40.4
line 28
____________________________________________________________________________________________________
Net profit or loss, 68 70 72 70 91.7 95.8 99.9 93.6
line 31
____________________________________________________________________________________________________
Source: GAO analysis of IRS data.
Estimated understated tax amounts, as shown in figure 4, were derived from NRP sample data. Table 4 lists the estimated percentile amount and confidence intervals for each percentile. We are 95 percent confident that the percentages and amounts reported are between the low and high estimates.
Table 4: Confidence Intervals for Estimated Understated Tax Amounts by Percentile
for Individual Income Tax Returns with Schedule Cs Attached, Tax Year 2001.
____________________________________________________________________________________
Percentile lower Estimated percentile Percentile upper
confidence interval confidence interval
Percentile amount amount amount
____________________________________________________________________________________
25th $255 $273 $294
____________________________________________________________________________________
50th 859 903 956
____________________________________________________________________________________
75th 2,422 2,527 2,674
____________________________________________________________________________________
90th 5,976 6,210 6,766
____________________________________________________________________________________
95th 10,635 11,081 12,353
____________________________________________________________________________________
98th 19,631 20,387 64,075
____________________________________________________________________________________
Source: GAO analysis of IRS data.
Estimated cumulative understated tax amounts, as shown in figure 5, were derived from NRP sample data. Table 5 lists the estimated percentile amount and confidence intervals for each percentile. We are 95 percent confident that the percentages and amounts reported are between the low and high estimates.
Table 5: Confidence Intervals for Estimated Cumulative Understated Taxes by
Percentile for Individual Income Tax Returns with Schedule Cs Attached, Tax Year
2001
____________________________________________________________________________________
Dollars in billions
____________________________________________________________________________________
Percentile lower Estimated percentile Percentile upper
confidence interval confidence interval
Percentile amount amount amount
____________________________________________________________________________________
25th 0.30 0.36 0.44
____________________________________________________________________________________
50th 1.84 2.05 2.35
____________________________________________________________________________________
75th 6.31 6.93 7.65
____________________________________________________________________________________
90th 13.47 14.26 15.64
____________________________________________________________________________________
95th 18.24 19.37 21.08
____________________________________________________________________________________
98th 23.68 24.91 33.06
____________________________________________________________________________________
100th 34.77 36.86 38.95
____________________________________________________________________________________
Source: GAO analysis of IRS data.
According to IRS Research officials, NRP results are not tax gap-related estimates since they do not account for misreporting that the auditors did not detect. Typically, the undetected misreporting of Schedule C net income likely takes the form of understated gross receipts and overstated expenses, for which IRS did not prepare separate tax gap estimates. Overstated expenses tend to be detected since the burden of proof is on the taxpayer to justify them. However, when taxpayers intentionally understate gross receipts, they may also understate expenses to hide the gross-receipt underreporting from IRS. Also, NRP includes estimates of some net business income that is not reported on Schedule C. These amounts are not added to the line-item detail and are not included in the analyses for this report. We could not estimate the amount of tax change that would result from NRP's examinations of Schedule C income because it must be combined with the taxpayer's filing status, exemptions, other types of income, deductions, credits, and other taxes.
To analyze the extent to which IRS's enforcement programs address the types of sole proprietor noncompliance found by IRS's most recent research, we used several data sources. We reviewed instructions for tax and information returns and filing guidance as well as program procedures. We analyzed program results data collected from the Automated Underreporter Program (AUR) and Examination officials, and interviewed IRS staff on the operations and results of AUR and the correspondence, office and field examination programs. We reviewed examination plans and Internal Revenue Manual procedures and other instructions to IRS staff describing program procedures. We analyzed data on examination results and numbers of Schedule C forms filed from the IRS Data Book, and data on paper Form 1099-MISC returns published by IRS's Office of Research for 2006. We did not analyze IRS's math error program since all NRP-examined returns were reviewed by this program, which is an integral part of IRS's returns processing function.
To calculate the percentage of noncompliant sole proprietors on which AUR and Examination made recommended assessments, we first multiplied the percentage of noncompliant sole proprietors found in NRP data by the number of Schedule C returns for the most recent years that we had available from the IRS Data Book that matched the most recent years for which we had complete AUR and Examination data (tax year 2003 for AUR and tax year 2004 returns for work Examination did in fiscal year 2005). Then we divided the number of recommended assessments made in each program by the number of noncompliant sole proprietors to arrive at the percentage of noncompliant sole proprietors on which the programs made recommended assessments.
We reviewed a sample of completed NRP examination case files to understand the types of sole proprietor noncompliance being detected. We selected the sample using the NRP case results database to identify all NRP cases with adjustments to Schedule C items for sole proprietor tax returns. We then selected a nonestimation sample of NRP examination cases with adjustments to gross receipts or sales, total expenses, net profit or loss on the Schedule C, and the business income line on the Form 1040 return, because these lines summarize the sole proprietor's operations. We also randomly selected some Schedule C adjustment cases.
We also used NRP data and the NRP case file sample to analyze IRS's use of penalties in NRP examinations. The analysis describes the proportion of NRP cases closed with adjustments and the proportion closed with a penalty recommended by the NRP examination. Because the cases with adjustments and penalties were not drawn from the population of all individual returns, they cannot be used to estimate a penalty assessment rate and other characteristics for all individual taxpayers. Even with these limitations, this analysis provides useful information on the outcome of the NRP sample.
To estimate the percentage of reported Schedule C receipts that were on a Form 1099-MISC, we compared amounts reported on the Form 1099-MISC and on Schedule C (line 1 total gross receipts or sales). This analysis used SOI data on individual tax returns for tax year 2001, which included a sample of information returns. We found that three Form 1099-MISC items could be reported on a Schedule C, including nonemployee compensation (NEC), medical payments, and fish sales. According to IRS, these Form 1099-MISC items could also be reported on two other IRS forms --Schedule F, Profit and Loss From Farming, and Form 4835, Farm Rental Income and Expenses --other than the Schedule C. We found that about 4 percent of the amounts reported on the Form 1099-MISC were reported on Schedule F or Form 4835. This difference was not material to our computation. Further, our analysis did not consider several sources of noncompliance that could affect the computation, such as the nonfiling of the required Schedule C or Form 1099-MISC or the underreporting of Schedule C or Form 1099-MISC amounts.
To estimate the percentage of Form 1099-MISC returns where the payer and the payee have the same address, we used an SOI data file with tax year 2001 individual income tax return information. We compared the postal codes and the numeric portion of street addresses reported by the payer and payee to identify whether they had the same address. For those who did, we reviewed a sample to verify that the addresses were the same. We also reviewed 55 Form 1099-MISC filings at the Ogden, Utah, campus, which provided 8 examples in which a payer and payee had similar addresses or names. We did not review other IRS records to determine whether these Form 1099-MISC filers were related parties.
To assess the likelihood of being assessed a penalty, controlling for other factors, we used logistic regression analysis, an econometric method appropriate for analyzing variables with dichotomous outcomes. We used the deciles of the continuous variables as the independent variables in the model. We did not weight the NRP returns or incorporate the NRP stratification because penalties are a function of the audit and the NRP returns are not representative of audited returns.
Controlling for use of a paid preparer, adjusted gross income, Schedule C amount, and total tax as reported by the taxpayer, a logistic regression was used to predict a penalty based on the absolute value of the difference between the total tax reported on the Form 1040 and the total tax after the NRP audit and the percentage of tax change (the difference in total tax divided by the total tax reported on the Form 1040). We found a significant effect of the percentage change in tax owed and the absolute value of the tax change on the likelihood of receiving a penalty. That is, individuals in higher deciles (5th through 10th deciles) of the percentage increase in tax were generally more likely than those in the lowest decile to be recommended for a penalty. Additionally, taxpayers in higher deciles of the absolute value of the tax change (4th through 10th deciles) were more likely than those in the lowest decile to be recommended for a penalty controlling for other factors. We also found that the odds of a penalty decreased with each decile increase in the taxpayer's reported total tax liability.
Although we did not test for interactions that could mitigate this effect, we found our results to be robust across a variety of model specifications. We did not control for other potentially relevant variables, such as differences among examiners, and did not test for whether the case was abated.
We used several approaches to identify options to close the tax gap related to sole proprietors that could be included in the tax gap strategy being developed by the Department of the Treasury (Treasury). First, we sought ways to address the gaps between the nature of sole proprietor tax noncompliance and existing IRS programs. Second, we reviewed various research publications on sole proprietors and our recommendations, as well as those from the President's Budget, President's Advisory Panel on Federal Tax Reform, Treasury Inspector General for Tax Administration, IRS's Taxpayer Advocate, and IRS advisory group reports. Third, we identified and discussed options and their the pros and cons with experts and knowledgeable individuals on sole proprietor compliance issues, including former Commissioners of Internal Revenue; persons who have experience with IRS or other federal programs related to sole proprietors; representatives for various national organizations representing sole proprietors, tax return preparers, or tax lawyers; tax staff working for Congress; and relevant staff at IRS and Treasury. All of the national organizations representing sole proprietors had large memberships and we contacted each organization's committee which focuses on small business issues. From this work, we consolidated the list of options and pros and cons. We excluded a few options that were raised near the end of our work, lacked details, or generated comments or questions from experts and knowledgeable individuals on how the options would work.
The list of options is not exhaustive and has limitations. Since data did not exist for analyzing the effect on the tax gap, taxpayers, or IRS for each option, we could not independently validate or weigh the pros or cons suggested by our experts and knowledgeable individuals. Because the experts and knowledgeable individuals had competing interests on questions of tax policy and administration, we did not seek consensus on the "best" options or on the pros and cons. Experts had limited time to discuss all the options and pros and cons. Thus, we did not discuss each option in detail in each interview, but overall, the interviews provided enough details for the options in our report. As a result of such limitations, we did not try to rank the options. Instead we described the options based on input from the literature and experts. More detailed proposals could raise other pros or cons not listed in our report.
We used several approaches to assess data reliability. We assessed whether the examination results and data contained in the NRP database were sufficiently reliable for the purposes of our review. For this assessment, we interviewed IRS officials about the data, collected and reviewed documentation about the data and the system used to capture the data, and completed testing of relevant data fields for obvious errors in accuracy and completeness. We completed analytic testing to ensure that tax return items that should logically be equal were equal. For example, the net profit and loss line on Schedule C should be accurately transferred and equal to the similar line on the individual income tax return. We also compared the information we collected through our case file review to corresponding information in the NRP database to identify inconsistencies. This testing found that the NRP results for Form 1040 returns with Schedule C forms were sufficiently reliable for our review.
The tax gap, SOI, AUR, and Examination data are all from sources that we used in previous reports. Based on assessments done for those reports, the fact that the sources are public and widely used, and additional testing we did to ensure that we were properly interpreting individual data elements, the data were sufficiently reliable for our review.
We conducted our review at IRS Headquarters in Washington, D.C., and at IRS's Ogden, Utah, campus from July 2006 through June 2007 in accordance with generally accepted government auditing standards.
Appendix II: Options to Address Problems with the Tax Compliance of Sole Proprietors
We have developed a list of options for reducing the tax gap for sole proprietors by reviewing our past reports as well as other related literature and by talking to experts and knowledgeable persons about sole proprietors' tax compliance. As we built the list of options, we discussed the options and the related pros and cons with these experts, including past and current IRS and Treasury staff; former IRS Commissioners; congressional staff; representatives of organizations representing sole proprietors, tax preparers, and tax lawyers; and others who have working knowledge of tax compliance and IRS programs.
This list is not exhaustive nor is the list of the pros and cons associated with each option. Many of the options are concepts rather than fully developed proposals with details of how they would be implemented. Additional detail could bring more pros and cons to light. The pros and cons are not weighted, and options should not be judged by the number of pros and cons. We are not making recommendations about the options or ranking their desirability. Rather, we have aligned these options with a series of known problems with sole proprietor tax compliance. Some of the options overlap, covering more than one problem while other options only deal with specific aspects of a problem.
A. Recordkeeping and Complexity
For our system of voluntary compliance to work, taxpayers must keep appropriate records. Our work on sole proprietors has raised issues about incomplete or inaccurate recordkeeping by sole proprietors as well as about the difficulties they face in dealing with complex tax rules. The options in this section look for ways to improve recordkeeping, simplify some of the rules, or provide more guidance and education to sole proprietors to reduce their burden.
1. Work with small business representatives on their ideas for improving the instructions for keeping records and meeting their Schedule C filing obligations.
More education and better guidance could help sole proprietors comply with the complex tax rules for reporting on the Schedule C. IRS could work with small business and trade representatives to determine whether and how specific changes to IRS's existing education and guidance would help those filing the Schedule C.
Pro:
Ÿ Helping educate sole proprietors on their recordkeeping requirements and filing obligations (Schedule C and information returns) could reduce noncompliance.
Ÿ The costs to update the instructions is probably minimal, while the cost for the education would not be.
Con:
Ÿ Getting specific ideas that would help sole proprietors might take some time and effort, depending on the extent to which IRS tests these ideas.
Ÿ It may be difficult to target the education and guidance and improve instructions for the sole proprietors who need them the most, that is, those who keep poor records or make errors on the Schedule C. These sole proprietors may not have the time or incentive to pay attention.
Ÿ Changes may not help those who rely on a paid tax return preparer or bookkeeper because of IRS's tendency to forward tax information to the taxpayer but not to the tax return preparer.
Ÿ Some education efforts could be costly to IRS, such as efforts to contact taxpayers individually.
2. Provide assistance to first-time Schedule C filers.
IRS could consider at least two broad approaches that would
a) specifically target outreach to sole proprietors filing their first Schedule C to inform them about the option to receive regular e-mails on topics of interest, the small business hotline, the resource guide, and other services specifically targeted to help small businesses and
b) automatically send computer-generated notices (i.e., soft notices) to first-time Schedule C filers who did not use a paid tax preparers (to reduce the number of notices) and who reported on certain Schedule C lines that involve more complexity or higher noncompliance (e.g., accounting method, depreciation, travel, or home office) about guidance on IRS's Web site on reporting such issues.
Pro:
Ÿ This would provide new sole proprietors with the specific information that they need to comply.
Ÿ It would also help new sole proprietors avoid "bad habits" before they become rooted.
Ÿ Using e-mail would reduce IRS's costs.
Ÿ Using automated screening and soft notices would increase IRS's "presence" without the costs of an enforcement contact (e.g., audit).
Con:
Ÿ There is no assurance that sole proprietors will read the information and comply.
Ÿ Some sole proprietors may not use e-mail or want to provide an e-mail address to IRS.
Ÿ IRS would incur some costs for the outreach and notices.
Ÿ Soft notices may not boost compliance if they are too vague or if sole proprietors perceive that IRS will not follow up in future tax years on the soft notices.
Ÿ Waiting to act until after the first Schedule C filing may be too late to