GAO 

United States Government Accountability Office

Report to the Committee on Finance, 

U.S. Senate 

TAX GAP

Limiting Sole 

Proprietor Loss 

Deductions Could 

Improve Compliance 

but Would Also Limit 

Some Legitimate 

Losses 

September 2009 

GAO-09-815 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

September 2009

TAX GAP

Limiting Sole Proprietor Loss Deductions Could 

Improve Compliance but Would Also Limit Some 

Highlights of GAO-09-815, a report to the Legitimate Losses

Committee on Finance, U.S. Senate 

Sole proprietors, who own 

unincorporated businesses by 

themselves, underreported their 

net income by 57 percent or 

$68 billion for 2001, according to 

the Internal Revenue Service’s 

(IRS) most recent estimate. The 

underreporting includes both 

understated receipts and 

overstated expenses and may result 

in losses that can be deducted 

against income from other sources, 

such as wages. 

GAO was asked to (1) describe sole 

proprietor losses and the extent to 

which the losses are noncompliant, 

(2) assess how well IRS addresses 

the noncompliance, and (3) identify 

any options to better limit 

noncompliant losses. 

To meet its objectives, GAO 

analyzed IRS research databases, 

case files, and examination results 

data and met with IRS officials. 

What GAO Recommends

GAO recommends that IRS 

estimate the extent of sole 

proprietor not-for-profit (hobby) 

activity noncompliance using its 

research data. GAO is not 

recommending a loss limitation 

rule because the trade-off between 

reducing noncompliant losses and 

allowing legitimate losses requires 

a policy judgment. 

In commenting on a draft of this 

report, IRS agreed to implement 

both GAO recommendations. 

About 5.4 million or 25 percent of all sole proprietors reported losses in 2006. 

Ninety-five percent of these loss filers deducted some or all of their losses 

against other income, deducting a total of $40 billion. According to IRS 

estimates last made for 2001, 70 percent of the sole proprietor tax returns 

reporting losses had losses that were either fully or partially noncompliant. 

About 53 percent of aggregate dollar losses reported in 2001 were 

noncompliant. This noncompliance would correspond to billions of dollars of 

lost tax revenue. 

IRS’s compliance programs address only a small portion of sole proprietor 

expense noncompliance. Despite investing nearly a quarter of all revenue 

agent time in 2008, IRS was able to examine (audit) about 1 percent of 

estimated noncompliant sole proprietors. These exams are costly and yielded 

less revenue than exams of other categories of taxpayers, in part because sole 

proprietorships are small in terms of receipts. Another enforcement program 

that primarily uses third-party information to electronically verify compliance 

is not effective because little expense information is reported by third parties. 

One approach for limiting sole proprietor loss noncompliance would impose a 

rule that limits losses that could be deducted from other income. The tax code 

has a number of such limitations. A loss limitation could reduce noncompliant 

losses but would also limit the ability of sole proprietors to claim legitimate 

losses. Another approach would improve IRS’s estimates of the extent to 

which activities not engaged in for profit, such as hobbies, are contributing to 

noncompliant sole proprietor losses. Expenses associated with these 

activities are not deductible, but IRS’s research on the causes of sole 

proprietor noncompliance has not used available data to estimate the extent 

of this type of noncompliance. Without such an estimate, IRS could be missing 

an opportunity to reduce noncompliant sole proprietor losses. 

Percentage of Sole Proprietor Loss Returns Where Losses Were Used to Offset Other Income 

and Percentage of Net Losses Used to Offset Other Income, 2006 

0

20

40

60

80

100

None Some All

Percentage

Amount of loss reducing other income

Sole proprietors Total losses offset

92

78

5 5 0

Source: GAO analysis of 2006 cross-sectional SOI data.

3

View GAO-09-815 or key components.

For more information, contact James R. White 

at (202) 512-9110 or whitej@gao.gov. 
Page i GAO-09-815 Sole Proprietor Loss Deductions 

Contents 

Letter 1

Background 2 

Sole Proprietor Losses Are Substantial and Growing and Are a 

Compliance Problem 7 

IRS’s Examination Program and AUR Are Able to Address Only a 

Small Portion of Sole Proprietor Expense Noncompliance 15 

A Loss Limitation Rule and Collecting Data on Not-for-Profit 

Activities Could Help Address Expense Noncompliance, but a 

Limitation Rule Would Also Adversely Affect Compliant 

Taxpayers 17 

Conclusions 21 

Recommendations for Executive Action 22 

Agency Comments 22 

Appendix I Scope and Methodology 23 

Appendix II Examples of Current Income Tax Loss Limitation 

Rules for Individual Taxpayers 28 

Appendix III Comments from the Internal Revenue Service 31 

Appendix IV GAO Contact and Staff Acknowledgments 33 

Tables 

Table 1: Estimated Percentage of Sole Proprietor Loss and Profit 

Returns That Were Noncompliant, 2001 13 

Table 2: Selected Examples of Loss Limitation Rules for Individuals 30 

Figures 

Figure 1: Distribution of Sole Proprietor Returns and Their Net 

Profit or Loss in 2006 8 
Figure 2: The Cumulative Percentage Change in Sole Proprietor 

Returns, Net Profits, and Net Losses from 1998 through 

2006 9 

Figure 3: Percentage of Sole Proprietor Returns in 2006 with 

Reported Losses for Multiple Years from 1998 through 

2006 10 

Figure 4: Percentage of Sole Proprietor Loss Returns Where Losses 

Were Used to Offset Other Income and Percentage of Net 

Losses Used to Offset Other Income, 2006 12 

Abbreviations 

AGI adjusted gross income 

AUR Automated Underreporter Program 

CDW Compliance Data Warehouse 

EITC Earned Income Tax Credit 

IMF Individual Master File 

I.R.C. Internal Revenue Code 

IRS Internal Revenue Service 

NRP National Research Program 

RGS Report Generation Software 

SOI Statistics of Income 

TIN taxpayer identification number 

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Page ii GAO-09-815 Sole Proprietor Loss Deductions 
Page 1 GAO-09-815 Sole Proprietor Loss Deductions 

 

United States Government Accountability Office

Washington, DC 20548 

 

September 10, 2009 

The Honorable Max Baucus 

Chairman 

The Honorable Charles E. Grassley 

Ranking Member 

Committee on Finance 

United States Senate 

The Internal Revenue Service’s (IRS) most recent estimate of the federal 

tax gap, for tax year 2001, is $345 billion. The gap is the difference 

between what taxpayers should have paid and what they actually paid on 

time. IRS also estimated that it would eventually collect, through various 

enforcement efforts, about $55 billion of the gap, leaving a net tax gap of 

$290 billion. 

According to IRS, sole proprietors—persons who own unincorporated 

businesses by themselves—are responsible for a large portion of the tax 

gap. For 2001, IRS estimated that sole proprietors misreported 57 percent 

of their net business income and accounted for $68 billion of the tax gap. A 

key reason for this misreporting 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. 

We recently reported that sole proprietor tax returns included substantial 

misreporting of both gross income and expenses. In that report, we 

discussed the pros and cons of numerous options for reducing the sole 

proprietor tax gap, including changes to record keeping, third-party 

information reporting, relevant IRS compliance programs, and IRS’s use of 

resources.1

Expressing your concern about the tax gap and business expense 

misreporting, you asked us for additional information about sole 

proprietors’ expense noncompliance. Following up on our previous report, 

we agreed to focus in this report on those sole proprietors whose 

expenses were large enough to cause a net loss. Our objectives were to 

1

 GAO, Tax Gap: A Strategy for Reducing the Gap Should Include Options for Addressing 

Sole Proprietor Noncompliance, GAO-07-1014 (Washington, D.C.: July 13, 2007). 
(1) describe the population of sole proprietors who file losses, their 

patterns of losses over time, and their level of noncompliance; (2) assess 

whether IRS compliance programs are able to correct a significant portion 

of sole proprietor expense and loss noncompliance; and (3) identify what 

additional options are available for IRS to close the tax gap for sole 

proprietor expenses and losses. 

We used several approaches to analyze sole proprietor expense 

noncompliance and to identify options for reducing this noncompliance. 

Principally, we analyzed data from IRS’s 2001 National Research Program 

(NRP) to identify the extent of sole proprietor loss and expense 

noncompliance. We also used IRS Statistics of Income (SOI) program data 

to profile profits and losses for sole proprietors in 2006 and combined 

these data with other IRS data to form panels of sole proprietor tax 

returns from 1998 to 2006 in order to describe patterns of losses over time. 

For estimates based on samples of taxpayers in this report, we are 95 

percent confident that the estimates are within 10 percent of the 

population values for dollar amounts and counts and 3 percent of 

population values for percentages, unless otherwise noted. We also 

interviewed IRS officials on the operations and results of its Examination 

and Automated Underreporter programs and reviewed case files for a 

sample of examinations of sole proprietors filing losses from the 2001 

NRP, selected to reflect a range of income and compliance. 

We conducted this performance audit from July 2008 through September 

2009 in accordance with generally accepted government auditing 

standards. Those standards require that we plan and perform the audit to 

obtain sufficient, appropriate evidence to provide a reasonable basis for 

our findings and conclusions based on our audit objectives. We believe 

that the evidence obtained provides a reasonable basis for our findings 

and conclusions based on our audit objectives. A more detailed 

description of our methodology is in appendix I. 

Sole proprietors are relatively numerous in terms of tax filers but small as 

measured by receipts. In 2003, the most recent year for which IRS data 

were available, sole proprietors constituted about 72 percent of all 

businesses in the United States, while earning about 5 percent of all 

business receipts. Sole proprietors engaged in a wide range of businesses, 

including legal and consulting services, manufacturing, and retail sales. A 

sole proprietor may engage in these activities full- or part-time and the sole 

proprietorship may account for all or part of an individual’s income. 

Background 

Page 2 GAO-09-815 Sole Proprietor Loss Deductions 
Sole proprietors report their business-related profit or loss on their 

individual income tax returns—IRS Form 1040—through Schedule C, 

Profit or Loss from Business. Schedule C requires sole proprietors to 

report receipts and expenses to determine profits or losses. These 

business profits or losses are combined with income, deductions, and 

credits from other sources that are reported elsewhere on Form 1040 to 

compute a taxpayer’s overall individual tax liability. Thus, sole proprietors 

who report losses on Schedule C can use their losses to offset other 

categories of income on their returns, such as wages and interest, in the 

year that they incur the loss. 

Identifying which of a sole proprietor’s payments qualify as business 

expenses and the amount to be deducted can be complex. Deductible 

business expenses must be “ordinary and necessary” and paid or incurred 

during the tax year in carrying on a trade or business.2

 Two types of 

payments—costs of goods sold and capital improvements—must be 

distinguished from other types of payments because they are treated 

differently under tax rules. To identify the cost of goods sold, businesses 

that manufacture or resell merchandise must follow tax rules that require 

valuing their inventory at the beginning and end of the tax year. Payments 

for capital improvements, such as start-up costs, business assets, and 

improvements, usually are not fully deducted in the current tax year but 

instead must be depreciated over a multiyear period. Expenses that are 

used partly for business and personal purposes can be deducted only to 

the extent they are used for business. For example, business use of the 

taxpayer’s home or car requires allocating the costs between business and 

personal use. 

The general standard for measuring taxable income is to match receipts 

and expenses as they occur, that is, their recognition should not be limited 

or postponed. However, under certain conditions, the tax code limits the 

extent to which losses can be deducted from other categories of income. 

One of these limits is that an individual may not deduct losses from 

activities that are not engaged in for profit against other income. There are 

also limits when an individual did not materially participate in the activity 

or for funds that the individual did not put at risk. 

 

2

 Ordinary means that the expense is common and accepted in the sole proprietor’s 

industry. Necessary means that the expense is helpful and appropriate for the sole 

proprietor’s industry. Generally, to be a trade or business the sole proprietor has to 

demonstrate that he or she has a profit motive and the scope of the business’s activities is 

considerable, regular, and continuous. 

Page 3 GAO-09-815 Sole Proprietor Loss Deductions 
Regulations specify a nine-factor test to help identify activities that are not 

engaged in for profit.3

 The losses an individual incurs from activities not 

engaged in for profit are sometimes called hobby losses. No single factor is 

determinative, and the regulations state that factors other than the nine 

cited can be taken into account when identifying a profit objective. 

However, taxpayers may still deduct these expenses up to the limit of the 

income earned from an activity not engaged in for profit. Additionally, 

activity not engaged in for profit rules presume that the activity is engaged 

in for profit if the activity produced a profit in at least 3 of the last 5 years 

or for some activities 2 of the last 7 years. 

IRS Compliance Programs IRS has three principal compliance programs covering various types of 

taxpayers and various types of income and expenses. Two are used to 

ensure that sole proprietors are properly reporting expenses. 

• The Examination Program—examinations are often called audits—is the 

principal compliance program for sole proprietor expenses and is 

operated in three forms. Correspondence examinations are conducted 

through the mail and usually cover one or two narrow issues. Office 

examinations require taxpayers to go to an IRS office and are broader than 

correspondence exams but still limited in scope. Field examinations send 

revenue agents to taxpayers’ homes or businesses and cover all 

compliance issues regardless of complexity or scope. The field 

examinations staff have the highest skill levels among staff in IRS’s 

compliance programs. In 2008, simple correspondence examinations for 

sole proprietor returns required an average of 2 hours, while field 

examinations, which may require more sophisticated analysis and 

judgment, averaged 21 hours. 

• The Automated Underreporter Program (AUR) matches an information 

return with a related item on the tax return as reported by the taxpayer. 

Information returns are prepared for certain types of transactions, such as 

payment of interest on a bank account. If AUR identifies a discrepancy 

between the information return and the taxpayer’s reporting for that item, 

 

3

 Treasury Regulation 1.183-1 and 2. The regulations’ nine factors consider (1) the manner 

in which the taxpayer carries on the activity; (2) the expertise of the taxpayers or his or her 

advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; 

(4) the expectation that assets used in the activity may appreciate in value; (5) the success 

of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s 

history of income or losses with respect to the activity; (7) the amount of occasional 

profits, if any, that are earned; (8) the financial status of the taxpayer; and (9) the elements 

of personal pleasure or recreation associated with the activity. 

Page 4 GAO-09-815 Sole Proprietor Loss Deductions 
AUR may send a notice to the taxpayer, after the discrepancy is verified by 

an IRS examiner, requesting payment of additional tax, interest, and 

penalties. If the taxpayer disagrees with the notice, the taxpayer is asked 

to explain the difference and may provide any other information, such as 

supporting documents. The taxpayer’s response is reviewed by an 

examiner who determines whether the tax should be assessed. AUR staff 

use some judgment and skill in their reviews, which require about half an 

hour to complete. 

• The Math Error Program verifies the accuracy of tax returns during 

processing. It uses IRS computers to identify and generate notices to 

contact taxpayers about obvious errors, such as mathematical errors, 

omitted or inconsistent data, or other inconsistencies on the basis of other 

data reported on their returns or to IRS. This compliance program is not 

currently used to ensure that sole proprietors are properly reporting 

expenses. IRS may use this program in specific instances as authorized by 

Congress through the Internal Revenue Code. The errors must be 

corrected to process the returns and ensure that all taxpayers comply with 

tax rules. For example, during return processing, the Math Error Program 

identifies whether all taxpayers have complied with mathematical limits in 

the tax law, such as the $3,000 net capital loss limitation. Since math 

errors are obvious, there is little review of the error by IRS staff before 

adjustment notices are sent to the taxpayers. The Math Error Program and 

its possible use in ensuring sole proprietor expense noncompliance is 

discussed in more detail in later sections of this report.4

Compliance Measurement 

and the Tax Gap 

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 

amount, IRS estimates that $68 billion is caused by sole proprietors 

underreporting their net business income, which can stem from either 

understated receipts or overstated expenses. The precise proportion of the 

overall tax gap caused by sole proprietors is uncertain because of 

sampling error and the exclusion from the estimate of factors affecting the 

tax gap, such as sole proprietors’ not paying because of failing to file tax 

returns, underpaying the tax due on income that was correctly reported, 

and underpaying employment taxes. 

 

4

 For more information on the Math Error Program, see GAO, Tax Administration: IRS’s 

2008 Filing Season Generally Successful Despite Challenges, although IRS Could Expand 

Enforcement during Returns Processing, GAO-09-146 (Washington, D.C.: Dec. 12, 2008), 

and Tax Administration: IRS Should Continue to Expand Reporting on Its Enforcement 

Efforts, GAO-03-378 (Washington, D.C.: Jan. 31, 2003). 

Page 5 GAO-09-815 Sole Proprietor Loss Deductions 
IRS estimates the tax gap caused by underreporting of individual income 

from the NRP, IRS’s compliance research program. For tax year 2001, the 

NRP study used a detailed review and examination of a representative 

sample of about 45,000 individual tax returns to compute estimates of 

underreporting of income and taxes for all individual tax returns. The NRP 

individual sample was designed to include a disproportionately large 

number of sole proprietors because of their known compliance issues.5

This allowed more detailed data to be collected about the nature of sole 

proprietor compliance issues. However, the NRP reviews could not detect 

all noncompliance. As a consequence, IRS adjusted the NRP estimates to 

develop final estimates of income misreporting and the resulting tax gap. 

IRS has started work on an updated NRP study. The study will examine 

about 13,500 randomly selected returns annually, starting with tax year 

2006. According to IRS, after 3 years the combined sample will be 

comparable to tax year 2001 and will allow for annual updates of 

noncompliance estimates. IRS plans to issue a preliminary estimate of the 

2006 individual reporting tax gap by 2012. 

 

5

 NRP’s oversampling is corrected for statistically in order to make valid population 

estimates. 

Page 6 GAO-09-815 Sole Proprietor Loss Deductions 
A noticeable proportion of sole proprietors reported a loss in tax year 

2006. Of the 21.7 million sole proprietor returns in 2006, an estimated 5.4 

million, or 25 percent, reported losses while 16.2 million, or 75 percent, 

reported profits.6

 Total reported losses were $49 billion and total reported 

profits were $330 billion. 

Most sole proprietors reported small amounts of profit or loss, but a few 

reported substantial amounts. As figure 1 shows, 85 percent of sole 

proprietor returns reported net profit or loss of less than $25,000. On the 

other hand, the 13 percent of sole proprietor returns with at least $25,000 

in profits accounted for 72 percent of all reported profits. Similarly, the 1 

percent of sole proprietor returns with at least $25,000 in losses accounted 

for 47 percent of all reported losses. 

Sole Proprietor 

Losses Are 

Substantial and 

Growing and Are a 

Compliance Problem 

 

6

 This estimate of the number of sole proprietors in 2006 includes only those returns 

reporting a profit or loss. The total above excludes about 400,000 returns reporting no 

profit or loss. If these were included, the total number of sole proprietors in 2006 would be 

22.1 million. 

Page 7 GAO-09-815 Sole Proprietor Loss Deductions 
Figure 1: Distribution of Sole Proprietor Returns and Their Net Profit or Loss in 2006 

Number of sole proprietors (in millions)

Aggregate net profit or loss (in billions)

Number of sole proprietors

Aggregate net profit or loss

Net loss per sole proprietor Net profit per sole proprietor

Source: GAO analysis of 2006 cross-sectional SOI data.

0

1

2

3

4

5

6

>-$25K -$10K>-$25K -$2500>-$10K <0 to>-$2500 >0 to<$2500 $2500<$10K $10K<$25K $25K<$100K $100K+

-40

-20

0

20

40

60

80

100

120

140

>-$25K -$10K>-$25K -$2500>-$10K <0 to>-$2500 >0 to<$2500 $2500<$10K $10K<$25K $25K<$100K $100K+

Net loss per sole proprietor Net profit per sole proprietor

Page 8 GAO-09-815 Sole Proprietor Loss Deductions 
Total sole proprietors’ losses, after adjusting for inflation, grew by 69 

percent from 1998 to 2006.7

 As figure 2 shows, losses grew faster than both 

profits and the number of sole proprietor returns in each year except 2005. 

Over the same period, expense deductions reported for loss returns grew 

about four times as fast as expense deductions reported for returns 

showing a profit.8

Sole Proprietor Losses Are 

Growing 

Figure 2: The Cumulative Percentage Change in Sole Proprietor Returns, Net 

Profits, and Net Losses from 1998 through 2006 

Number of returns

Net losses

Net profits

0

10

20

30

40

50

60

70

80

1998 1999 2000 2001 2002 2003 2004 2005 2006

Cumulative percentage change (dollars inflation adjusted to 2009)

Fiscal year

Sources: GAO analysis of SOI studies, tax year 1996 to 2006. 

 

7

 Inflation adjustments were made using the gross domestic product price index because 

sole proprietors cover a broad group of goods and services. 

8

 From 1998 to 2006, after accounting for inflation, business deductions for loss returns 

increased by about 43 percent as compared to a roughly 9 percent increase for profit filers. 

Page 9 GAO-09-815 Sole Proprietor Loss Deductions 
As figure 3 shows, based on data from a panel we constructed, 26 percent 

of all sole proprietor returns in 2006 reported losses in 2 or more years 

from 1998 through 2006.9

 However, when only sole proprietors who 

reported losses in 2006 are considered, the frequency of multiple loss 

years increases. Seventy percent of these sole proprietor returns reported 

losses in 2 or more years during this period.10

Many Sole Proprietors 

Reported Losses in 

Multiple Years 

Figure 3: Percentage of Sole Proprietor Returns in 2006 with Reported Losses for 

Multiple Years from 1998 through 2006 

0

10

20

30

40

50

60

9 years

8 years

7 years

6 years

5 years

4 years

3 years

2 years

Losses reported

No lo

for 1 year

sses

reported

Percentage of sole proprietors

Losses reported for multiple years

Number of years filing losses from 1998 through 2006

57

16

9

5 4 3 2 1 1 1

Source: GAO analysis of 2006 SOI cross-sectional data and 1998-2006 Compliance Data Warehouse data. 

 

9

 We dropped from our 2006 sole proprietor panel returns where taxpayers changed marital 

status and a small number of returns where data were not available. As a result, our panel 

represents about 17.2 million of the estimated 21.7 million returns with sole proprietorship 

income in 2006. See app. I for an explanation of the panel data and methodology. 

10 Sole proprietors may not file Schedule C each year and may file multiple years of losses 

or zero profit out of the 9 years that we reviewed in the panel data. We examined the 

frequency of filing for 2006 sole proprietor returns. About 83 percent filed Schedule C in at 

least 1 prior year. Nearly half of 2006 sole proprietors have a filing history of less than 5 

years. Another 29 percent filed all 9 years, and 62 percent of 2006 sole proprietors filed for 

2 or more consecutive years ending in 2006 with no gaps between filing. 

Page 10 GAO-09-815 Sole Proprietor Loss Deductions 
In terms of dollars, a large portion of 2006 losses were reported by sole 

proprietors with losses in multiple years. Seventy-seven percent of the 

losses reported in 2006 by the sole proprietors in our panel were reported 

on sole proprietor returns that also reported 2 or more years of losses 

from 1998 through 2006. Thirty-five percent of total 2006 losses were 

reported on sole proprietors’ returns that reported 5 or more years of 

losses.11

Losses in multiple years can occur for many reasons. Situations that may 

result in multiple years of reported losses include starting a business, 

developing a new product, or facing unfavorable economic conditions. 

Reported losses may also be due to noncompliance, caused by either 

understated receipts or overstated expenses. IRS regulations cite 

examples of compliant businesses that have profit objectives and several 

years of losses before realizing profits. In one example, a chemist works 

developing a new product that could have extensive uses and could 

generate substantial profits if it is successful. In this example, IRS finds 

that the chemist is engaged in activities for profit, and the losses can be 

deducted against other categories of income.12

Sole proprietors with a history of losses are less likely to recover their 

losses through sole proprietorship profits in other years. Of sole proprietor 

returns reporting a loss in 2001 but not in previous years, 45 percent 

earned an overall profit from 1998 through 2006.13 However, of the sole 

proprietor returns reporting a loss in 2001 and 2 previous years of reported 

losses, 16 percent earned an overall profit. In contrast, 95 percent of sole 

proprietor returns with profits in 2001 earned an overall profit from 1998 

through 2006. 

 

11 This estimate is based on the 1.2 million 2006 sole proprietor returns with net losses and 

a total of 5 or more years of reported losses from 1998 through 2006. These sole proprietors 

may not have filed Schedule C each year and may have filed only 5 years of losses and no 

profits out of the 9 years reviewed. 

12 Treasury Regulation 1.183-2. 

13 As in the case of the 2006 panel, we dropped from our 2001 sole proprietor panel returns 

where taxpayers changed marital status and a small number of returns where data were 

not available. As a result, our panel represents about 14.9 million of the estimated 18.3 

million returns with sole proprietorship income in 2001. We adjusted dollar amounts for 

inflation using the gross domestic product price index when calculating the percentage of 

sole proprietor returns that earned an overall profit from 1998 through 2006. The 

confidence interval for the estimate of the percentage of returns that reported a loss in 

2001 but not in previous years that earned an overall profit from 1998 through 2006 is +/- 3.1 

percent. 

Page 11 GAO-09-815 Sole Proprietor Loss Deductions 
As shown in figure 4, of the 5.4 million sole proprietors with losses in 2006, 

92 percent deducted all of their reported losses from other categories of 

income, while 5 percent were unable to deduct any of the losses.14 In terms 

of dollars, of the $49 billion of total losses reported in 2006, 78 percent was 

fully deducted against other income and another 5 percent was partially 

deducted. In total, $40 billion was deducted against other categories of 

income. 

Most Sole Proprietors with 

Losses Deducted Them 

against Other Categories of 

Income 

Figure 4: Percentage of Sole Proprietor Loss Returns Where Losses Were Used to 

Offset Other Income and Percentage of Net Losses Used to Offset Other Income, 

2006 

0

20

40

60

80

100

None Some All

Percentage

Amount of loss reducing other income

Sole proprietors

Total losses offset

92

78

5 3 5

0

Source: GAO analysis of 2006 cross-sectional SOI data.

 

14 Some sole proprietors could not deduct allowable losses because they did not have 

enough other income to deduct the losses against. However, these taxpayers may claim a 

net operating loss if their adjusted gross income net of itemized deductions or the standard 

deduction is negative. Generally, taxpayers can use their net operating loss from one year 

to offset income in other years. We could not examine the extent to which this is occurring 

with the data available from IRS. 

Page 12 GAO-09-815 Sole Proprietor Loss Deductions 
Most reported losses were a small proportion of the sole proprietors’ other 

income. Among those sole proprietor returns where losses offset other 

income, 61 percent had deductions from sole proprietorship losses that 

were less than 10 percent of their other income, and 92 percent had 

deductions from sole proprietorship losses that were less than 50 percent 

of their other income. 

Sole Proprietors Reporting 

Losses Were Likely to Be 

Noncompliant 

A large proportion of sole proprietors reporting losses in 2001, the most 

recent year data were available, underpaid their taxes and a larger 

percentage of sole proprietors reporting losses were noncompliant than 

those reporting profits. As shown in table 1, IRS estimated in its 2001 NRP 

study that 70 percent of sole proprietor returns with net losses (3 million 

returns) underreported net income by at least $100 compared to 52 

percent of those with profits. Further, of these loss returns that were 

noncompliant by at least $100, 57 percent were fully noncompliant (i.e., 

the entire loss was disallowed) and the remaining 43 percent were 

partially noncompliant (i.e., some of the loss was disallowed). 

Table 1: Estimated Percentage of Sole Proprietor Loss and Profit Returns That 

Were Noncompliant, 2001 

Sole proprietor 

returns with 

Percentage underreporting 

net income by at least $100 

Percentage underreporting 

net income by at least $1,000

Net losses 70 55

Net profits 52 40

Source: GAO’s analysis of IRS’s 2001 NRP. 

In terms of aggregate dollars, based on NRP results, about $15 billion of 

the $28 billion in losses reported in 2001, or about 53 percent, were 

noncompliant.15 Assuming 2001 was not unusual, this translates into 

billions of dollars of unpaid taxes each year because of noncompliant loss 

claims by sole proprietors. In addition to noncompliant losses, sole 

proprietors reporting losses also failed to report about $12 billion in net 

profits.16

 

15 The confidence interval for the estimate of the percentage of losses that were 

noncompliant in 2001 is +/- 3.3 percent. 

16 The confidence interval for the estimate of the amount of profits sole proprietors with 

losses failed to report is +/- 10.8 percent. 

Page 13 GAO-09-815 Sole Proprietor Loss Deductions 
Three examples from our NRP case file review illustrate how sole 

proprietors with a range of incomes used noncompliant losses and 

expenses to reduce the taxable income they reported on their tax returns. 

• On a joint return, one taxpayer was employed and the other reported 

operating a sole proprietorship described as providing investment 

advisory services. The taxpayers had over $1 million of adjusted gross 

income (AGI) for 2001 with reported sole proprietorship losses over 

$25,000. In 2001, based on a statement from the taxpayer, the examination 

file noted that the sole proprietorship did not have a business purpose, and 

IRS disallowed the sole proprietorship loss. 

• Another taxpayer’s 2001 joint return reported over $50,000 of AGI and 

included a sole proprietorship loss from competitive athletics. This loss 

totaled over $5,000. The IRS examiner stated that the taxpayer provided no 

documentary support for the sole proprietorship receipts and expenses 

and found that the taxpayer’s reported sole proprietorship activity was 

recreational and not engaged in for profit. IRS reclassified the sole 

proprietorship receipts as miscellaneous income and did not allow 

deduction of the undocumented expenses. 

• Tax year 2001 was the taxpayer’s first year in a construction-related 

business. The taxpayer had an AGI of over $4,000, which included wages 

from employment. The return reported no income tax liability after 

including a sole proprietorship loss of over $4,000. To examine the 2001 

return, the IRS staff had to reconstruct the sole proprietorship records 

from bank account data because books and records were not available 

from the taxpayer. Based on the examination, the taxpayer owed over 

$10,000 of income tax. The tax liability following the examination included 

the recapture of over $1,000 of Earned Income Tax Credit (EITC) paid to 

the taxpayer because the postexamination AGI was above the $32,121 

EITC earning limit in 2001. 

Page 14 GAO-09-815 Sole Proprietor Loss Deductions 
During fiscal year 2008, IRS used about 2.8 million staff hours to examine 

sole proprietor returns, about 23 percent of all revenue agent direct 

examination time.17 However, even with this relatively large investment, 

IRS examined about only 1 percent of the estimated noncompliant 

population of sole proprietors.18

Most sole proprietor examinations are field examinations because, as our 

recent report found, sole proprietor issues are generally too complex to 

examine through IRS’s lower-cost correspondence program.19 IRS officials 

cited several reasons why field examinations are more appropriate than 

correspondence examinations for sole proprietors. Examination at the 

taxpayer’s place of business, which is often also the taxpayer’s residence, 

expedites the determination of whether unallowable personal expenses 

have been deducted on the sole proprietorship return. Examining sole 

proprietor expenses often involves complex auditing and legal issues, such 

as identifying which payments qualify as “ordinary and necessary,” which 

requires the high skill levels of revenue agents (rather than those of the 

less skilled and less trained correspondence examiners) and interaction 

with the taxpayers to understand their books and records. As a practical 

matter, taxpayer records can be voluminous and are therefore best 

reviewed at the sole proprietor’s place of business. 

IRS’s Examination 

Program and AUR Are 

Able to Address Only 

a Small Portion of 

Sole Proprietor 

Expense 

Noncompliance 

Sole proprietor examinations take longer to complete and have a lower 

average assessed tax per examination hour than examinations of other 

categories of taxpayers. For fiscal year 2008, examinations of sole 

proprietor returns took 40 percent more time to complete and yielded 43 

percent fewer dollars per hour of examination time as compared to other 

small business income tax examinations.20 Despite the relatively low 

 

17 For fiscal year 2008, IRS used 2.77 million revenue agent examination hours to examine 

sole proprietors. Based on revenue agents using 58 percent of their time for examinations 

(called direct time) with 10,080 revenue agents assigned to examinations rather than 

support functions, sole proprietors’ examinations used 23 percent of direct revenue time. 

18 Of the 22.1 million sole proprietor returns filed for tax year 2006, as reported by SOI, 

165,000 sole proprietor returns were examined in fiscal year 2008. Assuming that these 

returns were noncompliant at about the same rate as tax year 2001 sole proprietor returns 

(70 percent) examined in the 2001 NRP study and that 90.5 percent of the noncompliant 

sole proprietor returns were accurately selected (corresponding to the 9.5 percent no 

change rate in 2008), then about 1 percent of the noncompliant returns were examined. 

19 GAO-07-1014, 22. 

20 These rates are for all examinations within IRS’s Small Business and Self-Employed 

Division, which examines, for example, sole proprietors, individuals with business or farm 

income, partnerships, and small corporations. 

Page 15 GAO-09-815 Sole Proprietor Loss Deductions 
productivity, some sole proprietor examinations may be worth conducting 

because, as IRS officials told us, they strive for balanced coverage of the 

taxpayer population along with additional focus on taxpayer groups with 

high levels of noncompliance, regardless of the yields per hour. However, 

because most sole proprietors report small amounts of income, greatly 

increasing the number of examinations may not be cost-effective. 

AUR Does Not Focus on 

Expense Compliance, and 

Expanding Coverage Faces 

Significant Obstacles 

Little sole proprietor expense noncompliance is detectable from existing 

information returns. We estimated that at least 91 percent of such 

noncompliance is in expense categories not reported on information 

returns. Only one expense item, mortgage interest, is included in AUR. 

One major reason that little information reporting on sole proprietor 

expenses exists is because of the difficulty of identifying third-party 

payees upon whom a reporting requirement could be enforced without 

undue burden on both the third parties and IRS. For example, there is no 

third party who could verify the business use of cars or trucks by sole 

proprietors. 

Furthermore, IRS officials have concerns about expanding use of 

information returns for expenses. AUR is designed to check, through 

computer matching, that amounts reported on information returns are 

transferred to the appropriate line of a tax return by taxpayers. Unless all 

of the business expenses on a given line were subject to information 

reporting, taxpayers could properly report more expenses than shown on 

information returns. In such cases, IRS’s computers would show a 

mismatch. According to the IRS staff, resolving these mismatches could be 

considered a correspondence examination because IRS staff probably 

would need to examine a taxpayer’s records to accept the expenses. 

However, this defeats the purpose of AUR (relying on computer matching 

to avoid costly examinations) and may prohibit IRS from completing 

additional reviews of the taxpayer’s return.21 The program is intended to 

provide automated, and therefore low-cost, compliance checks to avoid 

high-cost examinations of taxpayers’ records. 

 

21 IRS is prohibited by law from completing more than one examination of any taxpayer 

during any tax year. Therefore, IRS may need to determine whether any additional issues 

on the return need to be examined before concluding the contact with reviewing sole 

proprietor expenses through the AUR program. 

Page 16 GAO-09-815 Sole Proprietor Loss Deductions 
A rule limiting taxpayers from deducting sole proprietor losses against 

other income would involve trade-offs. The primary benefit would be 

limiting the ability of taxpayers to use noncompliant sole proprietor losses 

to reduce the amount of tax they owe on their other income. Assuming the 

2006 compliance rate is the same as the estimated 2001 compliance rate 

based on NRP data, an estimated $26 billion of reported sole proprietor 

losses in 2006 would have been noncompliant.22 As a result, a rule limiting 

deductions for sole proprietor losses could have a significant impact on 

noncompliance, raise significant revenue from noncompliant losses, and 

correspondingly reduce the tax gap. 

A rule limiting deductions for sole proprietor losses would also reduce 

IRS’s costs. Because losses are clearly identified on the return, the rule 

could be administered as part of the returns filing process through the 

Math Error Program. This could enable IRS to immediately disallow 

deductions not allowed by the rule without having to resort to costly 

examinations. 

A Loss Limitation 

Rule and Collecting 

Data on Not-for-Profit 

Activities Could Help 

Address Expense 

Noncompliance, but a 

Limitation Rule Would 

Also Adversely Affect 

Compliant Taxpayers 

However, disadvantages of a rule limiting sole proprietor loss deductions 

could be significant. Such a rule would reduce the fairness of the tax 

system by limiting loss deductions for compliant taxpayers. The extent 

would depend upon the specifics of how the rule is structured, as 

discussed below. The rule could also introduce economic distortions by 

(1) creating disincentives for starting or running a sole proprietorship23

and (2) creating incentives to form other types of businesses, such as S 

corporations, where the tax treatment of some losses may be more 

beneficial.24

The Internal Revenue Code (I.R.C.) already contains limitation rules for 

many types of deductions. These rules are structured in several ways, 

including absolute ceilings, ceilings linked to AGI or other information 

from the return, and carrybacks and carryforwards that allow deductions 

 

22 As reported earlier, the NRP estimated that $15 billion of reported sole proprietor losses 

were noncompliant in 2001. We estimated the amount of noncompliant losses in 2006 

assuming that the same percentage (53 percent) of dollars of sole proprietor losses 

reported in 2006 was noncompliant as in 2001. 

23 However, significant sole proprietor noncompliance has also created a distortion that 

encourages sole proprietor formation. 

24 Taxpayers are allowed to fully deduct allowable losses from S corporations against other 

income. See Internal Revenue Code § 1366. 

Page 17 GAO-09-815 Sole Proprietor Loss Deductions 
over the limit to be carried back or forward to previous or future returns 

to be used as deductions. For example, only $3,000 of capital losses over 

the amount of capital gains may be deducted from income. In addition, 

losses from passive activity are normally deductible only against passive 

income.25 The legislated limits have been enacted for a variety of 

compliance reasons, including preventing taxpayers from manipulating the 

timing of realizing gains and losses to reduce tax owed, in the case of the 

capital loss limitation, and addressing the prevalence of tax shelters, in the 

case of the passive income limitation.26 Appendix II provides additional 

examples of loss limitations rules. 

A rule limiting the deduction of sole proprietor losses could contain 

various mechanisms to mitigate some of the disadvantages. The 

possibilities include the following: 

• Targeting. A rule could limit the ability to deduct sole proprietor losses 

deductions from other, non-sole proprietor income. This limit could either 

be an absolute amount (e.g., up to $3,000 from other income) or an amount 

determined by formula (e.g., filers may only deduct sole proprietor losses 

up to a certain percentage of their other income). Our analysis showed 

that targeting could improve the fairness of a loss limitation rule by better 

focusing the rule on noncompliance. For example, while 70 percent of sole 

proprietor returns with losses were estimated to be noncompliant, 82 

percent of returns in 2001 that would have been affected by a $3,000 limit 

on sole proprietor loss deductions were noncompliant.27 Further, while 53 

percent of the dollars of sole proprietor losses in 2001 were noncompliant, 

55 percent of the dollars that would have been affected by a $3,000 limit 

were noncompliant losses.28

 

25 An exception to the passive activity rule is the case of passive rental activity wherein 

$25,000 in losses over the amount of passive rental income may be deducted. This $25,000 

deduction limit is gradually reduced to zero dollars from AGI of $100,000 to $150,000. See 

I.R.C. § 469. 

26 Sole proprietorships that are noncompliantly offsetting other income are effectively tax 

shelters. 

27 The $3,000 ceiling is approximately the median Schedule C loss in 2001, according to 

NRP data. 

28 The confidence interval for the estimate of the percentage of losses that were 

noncompliant in 2001 is +/- 3.3 percent and the confidence interval for the estimate of the 

percentage of losses that would have been affected by a $3,000 limit in 2001 is +/- 4.3 

percent. 

Page 18 GAO-09-815 Sole Proprietor Loss Deductions 
• Carry forward or back rule. A carry forward or back rule would allow 

taxpayers reporting sole proprietor losses to offset sole proprietor income 

earned in other years. This would prevent taxpayers from deducting 

noncompliant losses against other income, but would allow sole 

proprietors with profits in other years to deduct their losses. 

A carry forward or back rule could mitigate both the risk to business 

formation and the inequities that can arise from the loss limitation. A 

significant proportion of sole proprietors who reported losses could avail 

themselves of a carry forward or back rule, but analysis of IRS data 

showed that these sole proprietors were not less likely to be 

noncompliant. An estimated 36 percent of sole proprietorships reporting 

losses on returns in 2001 would have been able to use their entire loss to 

offset either previous or future sole proprietor income, and another 10 

percent would have been able to use part of their loss.29

• Elective document review or examination. A rule limiting sole 

proprietor loss deductions could include an option for sole proprietors to 

request an IRS review of documents provided by the taxpayer, either preor postfiling. For example, new sole proprietors could include their 

business plans and other evidence of their intent to make a profit. The IRS 

staff could review these documents in the relatively lower-cost compliance 

center environment. IRS does something similar in its Innocent Spouse 

program, which makes a complex determination regarding liability for a 

tax debt based on a document review, in most cases, in the compliance 

center environment. If IRS judges it to be helpful (for example, to ensure 

that documents are valid and supportable), this option could require the 

sole proprietor extend the statute of limitations for the returns filed with a 

sole proprietorship loss so that IRS would have more time to examine the 

taxpayer.30

Elective reviews would create administrative costs for IRS and some 

compliance burden for taxpayers, but targeting might reduce the number 

 

29 This analysis assumes that these taxpayers had not filed before 1998 because we did not 

have data for years before 1998. Also, we assumed that the rule had been in effect since at 

least 1998, and the taxpayers had already offset as much income as possible from previous 

years’ losses. Finally, we assumed that taxpayers would carry losses back to previous years 

if possible before carrying them forward. 

30 I.R.C. § 183(e) authorizes a taxpayer to elect a deferral of a determination of the profit 

motive. However, with the election the taxpayer agrees to extend the statute of limitations 

for the period of the deferral for up to 2 years after the due date of the return for the last 

year of the deferral period. 

Page 19 GAO-09-815 Sole Proprietor Loss Deductions 
of reviews significantly. Assuming that only sole proprietors with 

compliant losses of $100 or more would apply for review and assuming 

that the compliance rate in 2006 is the same as in 2001, we estimated that 

there were 3 million sole proprietor returns with compliant losses of at 

least $100 in 2006.31 Targeting the rule to those with losses above about 

$7,000 (the top 25 percent of loss filers by the size of filed loss in 2001) 

could reduce the number of affected returns for which taxpayers might 

apply for review to about 870,000. Targeting the rule further to only affect 

those who filed previous losses or exempting those who have gone 

through a recent review could further reduce the number of reviews. If 

taxpayers behave differently than our assumptions, the effectiveness and 

cost of the option would be different. 

IRS Has Not Estimated the 

Extent of Noncompliance 

with Rules for Activities 

Not Engaged in for Profit 

Neither the 2001 NRP study nor the ongoing NRP study, which started 

with tax year 2006 returns, collected data on examinations that resulted in 

additional assessed tax based on noncompliant losses from activities not 

engaged in for profit (hobby losses). As we noted in the Background 

section of this report, to be compliant losses must result from business 

activities with legitimate profit objectives. Without the data from NRP, IRS 

could not estimate the extent of noncompliance with activities not 

engaged in for profit in tax year 2001 and will not be able to do so for 2006. 

The ongoing tax year 2006-2008 NRP added a code for activities not 

engaged in for profit when the tax return was assigned to the examiner, 

indicating whether NRP managers thought the issue must be reviewed 

during the examination.32 However, neither the 2001 study nor the ongoing 

study included a specific code in IRS’s Report Generation Software (RGS) 

to identify whether the examinations found activities not engaged in for 

profit or whether an adjustment was made to the return because of 

noncompliance with the rules.33 Without adding this code to RGS, IRS 

cannot use the NRP sample to estimate the extent of noncompliance with 

 

31 Forty-eight percent of taxpayers filing losses in 2001 were found to have at least $100 in 

compliant loss by the NRP examination, giving a population of about 2 million taxpayers in 

2001 with compliant Schedule C losses of at least $100 in 2001. For the 2006 estimate, we 

assumed that the percentage of those filing Schedule C losses that have at least $100 in 

compliant losses remains stable over time. 

32 The process of identifying issues or return line items for examination is called 

classification. If an item is classified, the examiner must audit this issue and document the 

results of this work in the examination workpapers. 

33 RGS is used to prepare examination reports, propose adjustments, and complete 

examination closing documents. It also provides a taxpayer with a report on tax law and 

interest computation resulting from an examination. 

Page 20 GAO-09-815 Sole Proprietor Loss Deductions 
the activities not engaged in for profit and the extent to which such 

improper losses contribute to noncompliant sole proprietor losses. 

The same problem exists for IRS’s regular examination program. The 

examination program, which also uses the RGS system, does not collect 

data on the how often issues related to activities not engaged in for profit 

were classified during examinations or how often those issues resulted in 

an adjustment to a return. A minimal RGS system update could include a 

specific code for activities not engaged in for profit classification and 

adjustment issues. More detailed revisions could include specific reasons 

why activities not engaged in for profit issues were examined or not 

examined, such as likely strength of the case or likely tax change when 

compared to additional examination costs. Without these data, IRS cannot 

monitor how often the current compliance program addresses activities 

not engaged in for profit and the connection to noncompliant sole 

proprietor losses, and will not have the data to improve its examination 

program. 

The large number of relatively small sole proprietorships limits IRS’s 

opportunity to ensure their compliance through its regular compliance 

programs. On the other hand, based on the NRP analysis from 2001, over 

half of losses reported by sole proprietorships are not valid losses, and 

those losses are often used to reduce the taxes owed on other income. 

Conclusions 

One alternative approach to avoid the obstacles faced by IRS’s 

enforcement programs would be a rule limiting deduction of sole 

proprietor losses against other income. However, such a rule would treat 

all sole proprietors with losses, compliant and noncompliant, the same. In 

considering such a rule, policymakers would have to trade off reducing 

noncompliance against disallowing some legitimate losses. Because this is 

a policy judgment, we are not making a recommendation to implement 

such a rule. 

Short of such a policy change, however, there are steps IRS could take that 

have the potential to help mitigate noncompliant sole proprietor losses. 

Our review of IRS case files suggests that a portion of noncompliant filers 

reporting sole proprietor losses that have been examined may have had 

their losses disallowed because of activities not engaged in for profit. 

However, because IRS does not estimate a compliance rate for activities 

not engaged in for profit or how often these provisions are applied in 

regular examinations, IRS lacks information that could be useful for 

Page 21 GAO-09-815 Sole Proprietor Loss Deductions 
improving its enforcement approach and reducing the portion of the tax 

gap caused by sole proprietor noncompliant losses. 

In order to better assess whether changes are needed in the way IRS 

administers activities not engaged in for profit provisions, we recommend 

that the Commissioner of Internal Revenue take steps to 

• estimate the extent of activities not engaged in for profit noncompliance 

from its ongoing research programs and 

• collect information on examinations of activities not engaged in for profit 

issues from the compliance program. 

Recommendations for 

Executive Action 

Agency Comments In commenting on a draft of this report IRS agreed to implement both 

recommendations and stated that our report covers a timely and important 

topic because of the potential for increasing sole proprietor losses. 

IRS’s comment letter is reprinted in appendix III. 

As agreed with your offices, unless you publicly announce the contents of 

this report earlier, we plan no further distribution until 30 days after the 

report date. At that time, we will send copies to the Commissioner of 

Internal Revenue and other interested parties. This report also will 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 IV. 

James R. White 

Director, Tax Issues 

Strategic Issues 

Page 22 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix I: Scope and Methodology 

Page 23 GAO-09-815 Sole Proprietor Loss Deductions 

Appendix I: Scope and Methodology 

In conducting our work, we employed multiple methodologies, including 

analyzing data from the Internal Revenue Service’s (IRS) National 

Research Program (NRP), Statistics of Income (SOI) samples, and 

Individual Master File (IMF); examining a sample of NRP case files; 

interviewing IRS officials, and reviewing related legislation, regulations, 

and guidance.1

For all of the analysis of NRP, SOI, and IMF data for this report, we 

analyzed the net profit or loss reported on line 12 of Form 1040. This line 

contains the sum of all sole proprietor income reported on line 31 of any 

Schedule C attached to the return. Because line 12 of Form 1040 is a sum 

of sole proprietorship income from potentially several sole 

proprietorships, individual sole proprietorships could have had losses 

while the net sole proprietorship income that we analyzed was positive, if 

the other sole proprietorships on the return had profits. We did not 

analyze data from Schedule F, Profit and Loss from Farming, or from 

corporate taxpayers electing treatment as small business corporations 

under Subchapter S. 

For estimates based on samples of taxpayers in this report, we are 95 

percent confident that the estimates are within 10 percent of the 

population values for dollar amount and counts and 3 percent of 

population values for percentages, unless otherwise noted. 

SOI Data We used IRS SOI data to describe the population of sole proprietors and 

construct a panel of sole proprietors to analyze their reporting of profits 

and losses over a 9-year period from 1998 through 2006. To describe the 

population of sole proprietors, including those who file losses, we 

analyzed tax return data from SOI’s stratified random sample of 320,987 

individuals, including 81,588 sole proprietors, for tax year 2006—the most 

recent data available. In the data analysis in this report, the term sole 

proprietor refers to a taxpayer who files a 1040 return with one or more 

Schedule C forms attached regardless of the filing status of the taxpayer. 

Therefore, for example, a joint return with two Schedules C forms 

attached is considered a single sole proprietor. 

 

1

 IMF is IRS’s authoritative data source for individual tax account data, including assessed 

tax liabilities, refunds sent, and tax payments due. 
Appendix I: Scope and Methodology 

To examine sole proprietors’ profits and losses over time, we created two 

panel data sets based on tax return data from SOI’s tax years 2006 and 

2001 stratified random samples of taxpayers. The panels followed tax 

returns with one or more Schedule C forms attached as the unit of 

analysis. Because the SOI data are a random sample, returns that appear in 

the 2006 or 2001 sample may not appear in the samples taken in other 

years. Therefore, to construct the panel, we matched the returns in the 

2006 and 2001 samples with the same taxpayers’ returns in other years as 

stored in another IRS database. Specifically, we obtained tax return data 

from 1998 through 2006 from IMF, a copy of which is stored in IRS’s 

Compliance Data Warehouse (CDW) for access and analysis for research 

purposes. We matched data from IMF to the data from SOI by taxpayer 

identification number (TIN) and were able to obtain matching data in the 

base year from IMF for 99.9 percent of the individuals in the SOI 2006 

sample and 99.9 percent of the individuals in the SOI 2001 sample. 

Because the filing unit can change over time because of marriage or 

divorce, an accurate population estimate cannot be calculated for those 

tax returns. Therefore, we excluded from analysis those tax returns that 

had a change in marital status from 1998 through 2006. This is a common 

method for analyzing taxpayer data over time, which conforms to SOI’s 

practice. For the 2006 panel, 20.4 percent of the returns included in the 

2006 SOI stratified random sample and 20.9 percent of the estimated net 

sole proprietorship income was excluded because of a change in marital 

status from 1998 through 2006. For the 2001 panel, 17.9 percent of returns 

in the 2001 SOI sample and 16.3 percent of the estimated net sole 

proprietorship income was excluded. 

Based on several analyses of the data, we concluded that the panels 

sufficiently represent the population of sole proprietors. To assess how 

representative the panel is, we compared filing status and average 

Schedule C income as computed from the panel and from the SOI sample 

for both 2001 and 2006. Regarding filing status, we found similar 

percentages in the panel and sample data of taxpayers reporting the same 

status. Approximately 54 percent of returns in the 2006 panel had joint 

filers, while approximately 60 percent of returns in the 2006 SOI sample 

had both a primary and secondary taxpayer. Similarly, approximately 63 

percent of returns in the 2001 panel had joint filers, while approximately 

64 percent of returns in the 2001 SOI sample had joint filers. We also found 

very similar average income amounts. For 2006, the average estimated 

Schedule C income in the panel is $13,000 compared to $12,800 in the 

sample, and for 2001, the average estimated Schedule C income in the 

panel is $12,200 compared to $11,800 in the sample. 

Page 24 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix I: Scope and Methodology 

As a final test, we compared adjusted gross income amounts (AGI), return 

by return, for the years for which we had data for sole proprietorship 

returns from both SOI and IMF (2001 and 2006). Again, the results 

supported the accuracy of our panel data. Ninety-eight percent of the 

returns had AGI that matched within $100 between the two data sets, and 

99 percent of the returns data sets had total Schedule C income that 

matched within $100 between the two data sets. For analyses that required 

data from multiple years, we used the IMF data from each year for 

consistency. 

NRP Data To assess sole proprietor compliance, we used data from IRS’s compliance 

research program (NRP). We used these data to profile the compliance of 

Schedule C taxpayers, assess the relationship between sole proprietor 

compliance and filing history, assess qualitative information on sole 

proprietor compliance, and analyze options for a loss limitation targeting 

rules. The 2001 NRP study was a detailed review and examination of a 

representative sample of 44,768 individual tax returns from tax year 2001, 

20,868 of which reported sole proprietorship income. Unless otherwise 

noted, we define a taxpayer as noncompliant if the NRP examination 

revealed that the taxpayer underreported income by $100 or more. 

To assess the relationship between sole proprietor compliance and filing 

history, we created a panel data set based on NRP data. The panel 

followed tax returns with one or more Schedule C forms attached as the 

unit of analysis. For the sole proprietor returns in the NRP sample, we 

obtained tax return data from 1998 through 2006 from IMF in CDW. We 

matched data from IMF to the data from NRP by TIN, and were able to 

obtain matching data from IMF for 99.9 percent of the individuals in the 

NRP 2001 sample. Using the same methodology that we used for the SOI 

panels, we excluded from analysis those tax returns that indicated a 

change in marital status from 1998 through 2006. For the NRP panel, 11.8 

percent of the returns included in the 2001 NRP sample and 10.2 percent 

of the estimated net sole proprietorship income was excluded because of a 

change in marital status from 1998 through 2006. Comparing the 

differences in estimates between the returns included in the panel and 

those in the NRP sample, approximately 60 percent of returns in the panel 

had both a primary and secondary taxpayer, while approximately 65 

percent of returns in the NRP sample had joint filers. The average 

estimated Schedule C income in the panel is about $12,800 compared to 

the NRP sample estimate of about $12,600. 

Page 25 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix I: Scope and Methodology 

For 2001, the year for which we had data for individuals from both NRP 

and IMF, 97 percent of the returns had AGI that matched within $100 

between the two data sets, and 99 percent of the returns had total 

Schedule C income that matched within $100 between the two data sets. 

For analyses that used data from multiple years, we used the IMF data 

from each year for consistency. 

To provide qualitative information on sole proprietors filing losses and 

assess how not-for-profit activity issues are considered during exams, we 

reviewed a sample of NRP examination case files with Schedule C losses. 

We selected a sample of NRP cases for review that while not intended to 

allow us to make generalizations to the entire population of sole 

proprietors, did include sole proprietors of various AGI and Schedule C 

income levels and both compliant and noncompliant returns. Some cases 

were selected based on the dollar amount of the Schedule C 

noncompliance, and some were randomly selected. We requested a total of 

234 cases and reviewed 49 cases, ensuring that the cases reviewed 

represented a range of cases from all income levels. 

To determine whether targeting a rule limiting Schedule C loss deductions 

to a subset of the population could increase the percentage of affected 

filers and dollars that would be noncompliant, we analyzed items on the 

return that would be available to the Math Error Program and that could 

reasonably be used to identify noncompliant returns. 

IMF Data To assess the reliability of IMF data, we reviewed the steps IRS took to 

create a data set at our request, assessed IRS’s use of IMF data, and 

compared the data to NRP and SOI data to ensure consistency. Based on 

these steps, we determined that the data were sufficiently reliable for our 

review. 

While we were compiling the three panels of IMF data (the panel based on 

2006 SOI data, the panel based on 2001 SOI data, and the panel based on 

NRP data), an IRS official notified us that about 2,000 returns, all from 

either 1998 or 1999, which were less than 1 percent of the returns 

requested, could not be provided from the copy of IMF in CDW because 

the source data for those returns had been lost. We determined that the 

unavailable data would not materially affect our findings. 

Page 26 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix I: Scope and Methodology 

IRS’s Enforcement 

Programs 

We used several data sources 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 reviewed 

instructions for filing sole proprietor returns, regulations for activities not 

engaged in for profit, as well as examination program procedures. We 

analyzed program results data collected from the Automated 

Underreporter Program (AUR) and data on examination results. The exam 

data were extracted from IRS’s Examination Operational Automation 

Database. We also 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. 

For our previous report on sole proprietors, we used tax gap, NRP, SOI, 

AUR, and examination data. We determined that the data were sufficiently 

reliable for our review based on assessments done for those and previous 

reports, the fact that many of these sources are public and widely used, 

and additional testing we did to ensure that we were properly interpreting 

individual data elements. 

Our work was completed in accordance with generally accepted 

government auditing standards from July 2008 through September 2009 at 

IRS Headquarters in Washington, D.C. 

Page 27 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix II: Examples of Current Income Tax 

Loss Limitation Rules for Individual Appendix II: Examples of Current Income Taxpayers 

Tax Loss Limitation Rules for Individual 

Taxpayers 

The general standard for measuring income is to recognize all sources of 

gross income less expenses and losses as they occur. Taxable income is 

computed following this basic principle with some exceptions. In general, 

gross income from all sources is included when computing taxable 

income, with some exclusions, such as gifts, inheritances, and some death 

benefits. Deductions are typically allowed only for expenses related to 

activities intended to produce income, such as those related to a trade or 

business, or nonbusiness investment expenses, though some personal 

expenses can also be deducted to a limited extent.1

When expenses exceed income, the resulting loss can be disallowed, 

limited to a certain amount, or deferred to other tax years. Losses have 

been limited for several reasons, including preventing tax avoidance, 

reducing noncompliance, restricting deductibility of losses against other 

sources of income to reduce tax shelters, and disallowing personal 

expenses or losses that are not related to the production of income (such 

as activities not engaged in for profit or the loss of value on the disposition 

of personal property, including residences). 

Several current tax rules limit losses to increase equity and reduce tax 

shelters and noncompliance. In 1969, the activities not engaged in for 

profit provisions were enacted, in part, because of the perception that 

individuals invested in certain aspects of farm operations solely to obtain 

losses to reduce their tax on other income.2

 Before 1986, taxpayers could 

realize losses in excess of their actual amounts at risk, typically through 

limited partnerships, and deduct those losses from other sources of 

income.3

 The Tax Reform Act of 1986 included several provisions to limit 

transactions that reduced income. Examples include the following: 

• Tax shelters. Passive activity losses were limited to prevent taxpayers 

from using losses from real estate and other investments in which they had 

minimal participation to offset other sources of income, such as wages, 

 

1

 Some personal expenses can be deducted if the taxpayer itemizes deductions, such as 

charitable contributions, mortgage interest, or medical expenses. These deductions may 

have a minimum allowed amount (such as amounts greater than 7.5 percent of a taxpayer’s 

AGI for medical expenses), or a maximum amount (such as charitable contributions in 

excess of 20 percent, 30 percent, or 50 percent of AGI, depending on the type of 

contribution), or they may be reduced or disallowed for taxpayers with higher incomes. 

2

 S. Rep. No. 552, 91st Cong. 1st Sess., 103 (1969), U.S. Code Cong. & Admin. News 1969, 

1969-3C.B. 635. 

3

 Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085. 

Page 28 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix II: Examples of Current Income Tax 

Loss Limitation Rules for Individual 

Taxpayers 

salaries, and capital gains. Similarly, at-risk rules were enacted to limit 

losses to the actual amount of money invested because of the prevalence 

of tax sheltering. 

• Limitations on interest. Another example is limiting the deduction of 

investment interest to the amount of investment income to prevent 

“taxpayers from sheltering or reducing tax on other, non-investment 

income by means of the unrelated interest deduction.”4

 Personal interest 

was disallowed as a deduction because it enabled taxpayers to avoid taxes 

by purchasing consumables rather than purchasing assets that produce 

taxable income. 

• Capital losses. Limitations on capital losses were implemented to reduce 

the reward for timing loss and gain transactions to avoid paying taxes. 

Taxpayers can control when they realize a gain or a loss, thereby 

minimizing tax liabilities. The limitations on deducting capital losses are 

different for corporate and noncorporate taxpayers. For noncorporate 

taxpayers, capital losses can be carried forward indefinitely, but corporate 

taxpayers are limited to a 3-year carryback and 5-year carryforward, with 

some exceptions. For corporations, capital losses can only be allowed up 

to the amount of capital gains, and individuals are allowed an additional 

$3,000 loss above the amount of capital gains. 

In some cases, taxpayers have losses that exceed their gross income, 

resulting in a negative income flow or a net operating loss. When this 

occurs, taxpayers do not owe income tax for that year and can deduct the 

net operating loss against taxable income by carrying the losses back or 

forward to profitable years in which they paid taxes or would owe taxes. 

These deductions allow taxpayers to smooth out business income and 

taxes over business cycles. Some taxpayers would attempt to avoid paying 

taxes by purchasing stock or assets of a business that had incurred a net 

operating loss and using the carryover loss to offset expected future 

profits. To reduce such tax avoidance, Congress enacted legislation that 

limited corporations from deducting net operating losses when there is a 

change in ownership. 

Table 2 summarizes examples of common loss limitation rules. 

 

4

 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986

(Washington, D.C., May 4, 1987), 263. 

Page 29 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix II: Examples of Current Income Tax 

Loss Limitation Rules for Individual 

Taxpayers 

Table 2: Selected Examples of Loss Limitation Rules for Individuals 

Loss Loss limitation rule 

Net operating loss Limited to extent of taxable income. Can be carried back 2 years or forward 20 years with other 

carryback periods allowed for eligible losses, such as from casualty, theft, disaster, or farming. 

There also are rules for limiting what can be deducted for figuring a net operating loss. Items 

such as personal exemptions, capital gains, and nonbusiness deductions may be adjusted 

when figuring a net operating loss. 

Capital loss Limited to extent of capital gains plus $3,000, which can be carried forward indefinitely. 

Personal expenses Some are disallowed (e.g., personal interest, primary residence sales, living expenses) while 

some are limited (e.g., personal property taxes, medical expenses, charitable donations). 

Passive activity losses and credits Generally limited to extent of passive activity income. Exceptions include a phaseout of the 

limitation if the taxpayer actively participates in the passive rental income and has AGI from 

$100,000 to $150,000. Also, there is an exemption for real estate professionals who materially 

participate in the activity. 

Gambling Limited to extent of gambling gains. Cannot be carried forward or back to other tax years. 

Not-for-profit activity Losses cannot be offset against other income if the activity is not engaged in for profit. 

Additionally, the not-for-profit activity rules presume that the activity is engaged in for profit if it 

has produced a profit in at least 3 of the last 5 years or for some activities 2 of the last 7 years. 

Source: GAO analysis. 

Page 30 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix III: Comments from the Internal Appendix III: Comments from the Internal Revenue Service 

Revenue Service 

Page 31 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix III: Comments from the Internal 

Revenue Service 

Page 32 GAO-09-815 Sole Proprietor Loss Deductions 
Appendix IV: 

A

GAO Contact and Staff 

cknowledgments 

Page 33 GAO-09-815 Sole Proprietor Loss Deductions 

Appendix IV: GAO Contact and Staff 

Acknowledgments 

James R. White, (202) 512-9110 or whitej@gao.gov 

In addition to the contact named above, Kevin Daly, Assistant Director; 

Michele Fejfar, Leon Green, Shirley Jones, Edward Nannenhorn, Karen 

O’Conor, Erin Saunders-Rath, Sabrina Streagle, and Ethan Wozniak made 

key contributions to this report. 

GAO Contact 

Acknowledgments 

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