Tax Gap: Limiting Sole Proprietor Loss Deductions Could Improve Compliance but Would Also Limit Some Legitimate Losses
Published: 2009-09-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: 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.
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) 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.
subsections: section_title: Background
paragraphs: 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.
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. 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.
Regulations specify a nine-factor test to help identify activities that are not  engaged in for profit. 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.
subsections: section_title: IRS Compliance Programs
paragraphs: 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,  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.
section_title: Compliance Measurement and the Tax Gap
paragraphs: 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.
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.  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.
section_title: Sole Proprietor Losses Are Substantial and Growing and Are a Compliance Problem
paragraphs: 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. 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.
subsections: section_title: Sole Proprietor Losses Are Growing
paragraphs: Total sole proprietors’ losses, after adjusting for inflation, grew by 69  percent from 1998 to 2006. 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.
section_title: Many Sole Proprietors Reported Losses in Multiple Years
paragraphs: 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. 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.
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.
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.
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. 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.
section_title: Most Sole Proprietors with Losses Deducted Them against Other Categories of Income
paragraphs: 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. 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 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.
section_title: Sole Proprietors Reporting Losses Were Likely to Be Noncompliant
paragraphs: 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).
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. 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.
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.
section_title: IRS’s Examination Program and AUR Are Able to Address Only a Small Portion of Sole Proprietor Expense Noncompliance
paragraphs: 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. However, even with this relatively large investment,  IRS examined about only 1 percent of the estimated noncompliant  population of sole proprietors.
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. 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.
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. Despite the relatively low  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.
subsections: section_title: AUR Does Not Focus on Expense Compliance, and Expanding Coverage Faces Significant Obstacles
paragraphs: 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. The program is intended to  provide automated, and therefore low-cost, compliance checks to avoid  high-cost examinations of taxpayers’ records.
section_title: 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
paragraphs: 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. 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.
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 proprietorship  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.
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  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. 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. 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. 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.
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.
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 pre-  or 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.
Elective reviews would create administrative costs for IRS and some  compliance burden for taxpayers, but targeting might reduce the number  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. 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.
subsections: section_title: IRS Has Not Estimated the Extent of Noncompliance with Rules for Activities Not Engaged in for Profit
paragraphs: 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. 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. Without adding this code to RGS, IRS  cannot use the NRP sample to estimate the extent of noncompliance with  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.
section_title: Conclusions
paragraphs: 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.
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  improving its enforcement approach and reducing the portion of the tax  gap caused by sole proprietor noncompliant losses.
section_title: Recommendations for Executive Action
paragraphs: 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.
section_title: Agency Comments
paragraphs: 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.
section_title: Appendix I: Scope and Methodology
paragraphs: 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.
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.
subsections: section_title: SOI Data
paragraphs: 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.
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.
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.
section_title: NRP Data
paragraphs: 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.
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.
section_title: IMF Data
paragraphs: 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.
section_title: IRS’s Enforcement Programs
paragraphs: 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.
section_title: Appendix II: Examples of Current Income Tax Loss Limitation Rules for Individual Taxpayers
paragraphs: 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.
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. 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. 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,  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.” 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.
section_title: Appendix III: Comments from the Internal Revenue Service
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: 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.