Small Businesses: IRS Considers Taxpayer Burden in Tax Administration, but Needs a Plan to Evaluate the Use of Payment Card Information for Compliance Efforts
Published: 2015-06-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: A challenge IRS faces is balancing efforts to minimize taxpayer burden with efforts to ensure compliance with the tax code. Small businesses are a vital source of economic growth in the United States. Reducing their costs for complying with the tax code may free up resources to expand, hire new employees, and contribute to the growth of the U.S. economy. GAO was asked to examine small business tax compliance burden and IRS's payment card pilot that addresses taxpayer non-compliance. This report: (1) describes characteristics of the small business population (2) describes how characteristics of a small business affect compliance burden; (3) describes how IRS integrates small business compliance burden considerations in decision-making; and (4) assesses IRS's plan for evaluating its payment card pilot. To answer these objectives, GAO analyzed Treasury and IRS data, research, and other documentation and interviewed agency officials. GAO used its guidance on program design evaluation to assess IRS's payment card pilot evaluation plan.
section_title: What GAO Found
paragraphs: According to estimates produced by government tax researchers using 2010 taxpayer data, small businesses (defined in the research as individuals or entities with substantive business activity but with less than $10 million in total income and deductions) make up 99 percent of all businesses. Approximately 69 percent of small businesses (about 16 million) are individual taxpayers who report business income and the remaining 31 percent (or roughly 7.3 million) are partnerships or corporations. Small businesses with at least one employee make up about 20 percent of the small business population, but produce about 71 percent of total small business income.
Small businesses undertake a number of tax compliance-related activities that create burden. These activities can be grouped into general categories such as income tax activities, employer-related tax activities, and third-party information reporting activities. The tax compliance burden associated with these activities varies depending on the businesses' asset size, filing entity type (e.g., sole proprietor, partnership), number of employees, and industry type. According to IRS research, compliance burden increases with the size of businesses, whether measured in terms of assets, receipts, or employment. IRS also measured money and time burden as a portion of total business receipts, total assets, and burden per employee. Across all three measures, IRS results were consistent with the assumption that small businesses face significant fixed compliance costs combined with decreasing marginal costs as the business grows.
IRS's decision-making framework for administering the tax system includes consideration of small business compliance burden. For example, IRS's strategic plan identifies reducing taxpayer burden as a strategic goal. IRS provided examples of how it works with internal and external stakeholders to reduce taxpayer burden on small businesses. For example, IRS collaborated with Treasury and external stakeholders to develop a simplified method for some small businesses to calculate a home office deduction, which was introduced in January 2013. Previously, businesses had to complete a complex property depreciation calculation.
To improve tax compliance among small businesses, in 2012, IRS began piloting a program that compares payment data from payment settlement entities (such as credit card companies) with income reported by small businesses. IRS is testing ways to use payment data to detect underreporting of taxable income while minimizing small business taxpayer burden. While IRS's plans for evaluating the pilot include many key evaluation elements that GAO identified, other elements are missing. For example, IRS has defined high level pilot goals such as improving voluntary compliance and reducing the tax gap, but has not established measures for determining progress against these goals. Additionally, the plan did not adequately document evaluative questions, data collection needs, or the evaluative criteria necessary to assess whether pilot activities produced the intended results. Without these and other elements, IRS cannot ensure it is making evidence-based decisions about expanding and integrating pilot activities into broader small business compliance improvement efforts.
section_title: What GAO Recommends
paragraphs: To improve the evaluation of the payment card pilot, GAO recommends that IRS clearly define the stages of the pilot and establish measurable goals for determining when the pilot progresses from one stage to the next and develop an evaluation plan for the overall pilot that includes evaluation questions, complete descriptions of needed data, and evaluation criteria. IRS agreed to take the recommended actions.

section_title: Letter
paragraphs: Small businesses are a vital component of economic growth and job  development in the United States. Although no single definition of a small  business exists, one common characteristic used to identify a small  business is number of employees. Businesses employing fewer than 100  people accounted for a little more than 34 percent of U.S. employment in  2012. Businesses with fewer than 500 employees accounted for more  than 48 percent. Like all businesses, small businesses face compliance  burdens as a result of the tax code. Given the important role small  businesses play in U.S. employment and overall economic progress,  reducing the cost of compliance may free up resources to expand, hire  new employees, and further contribute to the growth of the U.S. economy.
GAO, Tax Gap: Sources of Noncompliance and Strategies to Reduce It, GAO-12-651T  (Washington, D.C.: Apr. 19, 2012). balancing efforts to encourage voluntary tax compliance through reducing  taxpayers’ costs of compliance with enforcement efforts to address  noncompliance.
Beginning in 2011, IRS began receiving new information that could help  improve voluntary compliance. Under a 2008 law, payment settlement  entities such as credit card companies and third-party network payers like  PayPal began reporting to IRS the gross payments they process for each  participating merchant on IRS Form 1099-K, Merchant Card and Third   In 2012, IRS began a payment card pilot to  Party Network Payments.research and test ways to use Form 1099-K data to most effectively and  efficiently improve voluntary compliance, detect noncompliance, and  minimize burden on taxpayers.
You asked us to examine small business tax compliance burden and  IRS’s payment card pilot. This report: (1) describes the characteristics of  the small business population; (2) describes how characteristics of a  small business affect compliance burden; (3) describes how IRS  integrates small business compliance burden considerations into decision  making; and (4) assesses IRS’s plan for evaluating its payment card pilot.
We used estimates from researchers at the U.S. Department of the  Treasury (Treasury), Office of Tax Analysis (OTA) to describe general  characteristics of the small business population, such as the number of   We examined IRS, academic, and  small businesses and total income.other research on small business tax compliance burden to identify how  small business characteristics affect compliance burden. We reviewed  IRS’s strategic plan and other relevant documents, and interviewed  agency officials about various burden reduction decisions and initiatives.  We obtained the perspectives of the small business community through  literature reviews, document reviews, and interviews. We used criteria  from our prior reports on program design and evaluation to assess IRS’s  plan for evaluating the payment card pilot.
We conducted this performance audit from July 2014 to June 2015 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.
subsections: section_title: Background
subsections: section_title: Identifying the Small Business Population
paragraphs: A consensus does not exist on a definition of small business, including  which specific attributes or thresholds distinguish small businesses from  other firms. Estimates of the small business population are driven by the  purpose, concepts, and data that are used to produce the estimates. As  we have previously reported, various thresholds such as number of  employees, gross receipts, and number of shareholders may be used  when determining which provisions of the tax code apply to a small  business.
In this report, we rely on studies that use taxpayer data for individuals and  entities that generate business income. Businesses (including small  businesses) file specific tax forms based on certain attributes of the  business, such as the ownership structure and how the business income  is taxed. Below are different types of businesses and the required forms  and schedules.
Nonfarm sole proprietorships (Form 1040, Schedule C) are  unincorporated and owned by a single individual. Net business  income or loss is included in the owner’s individual adjusted gross  income.
Landlords (Form 1040, Schedule E-Part I) are individuals who report  rental real estate activity on Part I of Schedule E.
Farmers (Form 1040, Schedule F or Form 4835) are individuals who  report farm income or landowners who report farm rental income.
C corporations (Form 1120) are owned by shareholders. Corporate  income is taxed at the corporate level on taxable income and at the  shareholder level on distributed profits.
S corporations (Form 1120-S) cannot have more than 100  shareholders, among other requirements. Gross income is distributed  to shareholders and taxed at the shareholder level.
Partnerships (Form 1065) are unincorporated businesses that have  two or more owners. Profits and losses are distributed to owners who  are taxed at the partner level.
IRS has separate operating divisions that focus on different types of  taxpayers—individuals, small businesses and self-employed, large  businesses, and tax exempt organizations. The Small Business and Self- Employed division oversees taxpayers filing tax returns as individuals with  business income and as businesses with less than $10 million in total  assets. However, not all of these tax returns are for business entities.  This is because the principal purpose of some entities that file tax returns  reporting business income may not be to generate revenue or to engage  in substantive business activity. For example, some C corporations can  serve as investment vehicles that engage in little or no business activity.  Further, partnerships may be created to redistribute profits generated by   Filers of  another partnership and may not generate income themselves.Form 1040, Schedule C, may be independent contractors who may more  closely resemble employees rather than small businesses. Additionally,  rental income for some individuals may be incidental and not represent  business activities.
section_title: Small Business Tax Compliance Burden
paragraphs: We define tax compliance burden as the time and money spent by the  taxpayer to meet tax obligations. This would include federal, state, and  local obligations. This does not include tax liability. For the purposes of  this report, we are only examining compliance burden as a result of  federal tax obligations. Time spent on tax activities can include working  with a paid professional, tax planning, keeping records, completing forms,  submitting forms, learning tax laws, and working with IRS on tax issues.  Monetary burden can include expenses for hiring a paid professional to  file taxes, investing in a tax software system, paying for payroll services,  and legal fees. When measuring tax compliance burden, researchers may  separate burden into both time and money, or they may place a value on  the time spent by taxpayers and add it to monetary burden to create a  single measure of tax compliance burden. A key concept in tax  administration is minimizing burden, including eliminating unnecessary  burden.
section_title: Most Small Businesses are Individuals, but Most Small Business Income is Earned by Partnerships and Corporations
paragraphs: As shown in figure 1, using data from researchers at Treasury’s Office of  Tax Analysis (OTA), most small businesses (approximately 69 percent or  16 million) are individual taxpayers who report business income on their  Form 1040, using Schedule C (sole proprietor), Schedule E-Part I  (landlords), or Schedule F (farmers). The remaining 31 percent of small  businesses (or roughly 7.3 million) are partnerships, S corporations, or C  corporations. OTA researchers also provide a total income measure,  generally defined as the sum of all business income reported on tax  returns, including gross receipts, rents, dividends, capital gains, royalties,  and interest. Individual small businesses generated only 23 percent (or  $1.4 trillion) of the total income of all small businesses, whereas small  business partnerships, S corporations, and C corporations accounted for  the majority—77 percent (or about $4.5 trillion)—of total small business  income.
When looking at the average total income for small businesses (total  income divided by number of filers), partnerships, S corporations, and C  corporations each generated more than $450,000 on average, while sole  proprietors, farmers, and landlords reported income of about $100,000 or  less on average. Figure 2 shows the estimated average total income by  small business type.
subsections: section_title: About 99 Percent of Businesses Report Total Income and Deductions of Less Than $10 Million
paragraphs: Small businesses (as defined as reporting total income and deductions of  less than $10 million) make up 99 percent of the taxpayers identified as   For  being engaged in substantial and substantive business activity.each type of filer, small businesses account for at least 95 percent of  businesses. Among individual filers reporting business income, small  businesses account for most of the reported income. However, among S  corporations, C corporations, and partnerships, larger businesses  account for most of the reported income, even though they are far  outnumbered by small businesses, as shown in figure 3. The estimated  average total income across all types of small businesses is $250,000,  while the average total income for larger businesses is estimated to be  $121 million.
section_title: Most Small Business Income Is Generated by Employers, but Most Small Businesses Are Not Employers
paragraphs: Small businesses with at least one employee (which we will refer to as  employers) generated most of the reported total income for small  businesses (or about 71 percent). Employers account for about 86  percent of total income for small business C corporations and S  corporations combined and about 55 percent for small business sole  proprietors, farmers, and partnerships.
Employers make up about 20 percent of all small businesses. Employers  make up 16 percent of the combined group of small business Schedule C  sole proprietors, Schedule F farmers, and partnerships and 51 percent of  the combined group of small business C corporations and S corporations.  Figure 4 shows the estimated number of small business filers and total  income separated by employers and non-employers.
As shown in figure 5, employer small businesses, on average, generate  more income than non-employer small businesses.
section_title: Tax Compliance Burdens Vary Depending on a Small Business’s Size, Number of Employees, Entity Type, Industry, and Other Characteristics
paragraphs: Small businesses undertake a number of tax compliance-related activities  that create burden. These activities can be grouped into general  categories: employer-related tax activities, and third-party information reporting and industry-specific tax activities.
The tax compliance burden associated with these activities varies by  characteristics of the small business. Some of these characteristics  include the business’s asset size, filing entity type, number of employees,  and industry type.
Tax compliance activities are not limited to the annual filing of a tax  return, but rather occur throughout the year. For example, sole proprietors  are generally required to file income tax returns every April. Some small  businesses need to pay estimated income taxes four times a year.  Moreover, small businesses with employees are required to deposit  employment taxes either monthly or semiweekly, and to report summary  information of these activities on a quarterly basis. Additionally,  depending on specific business operations, other tax compliance  activities such as reporting excise tax, tax planning, and recordkeeping  happen throughout the tax year. Figure 6 provides an overview of some  of these tax compliance activities for sole proprietors and when they  occur.
Appendix III, table 8 provides a more detailed description of tax activities.
subsections: section_title: Income Tax Activities, Such as Filing Income Tax Forms and Schedules, Vary by Small Business Type
paragraphs: Every year, small businesses need to file income tax returns and may pay  estimated income taxes quarterly. The type of small business dictates the  type of income tax returns and related schedules that need to be filed.  Some of the returns include a set of schedules embedded in the form— found within the income tax return—while some small businesses and  individuals with business income must attach a mandatory schedule to  their return. For example, the primary corporate income tax return, Form  1120, U.S. Corporation Income Tax Return, contains eight embedded  schedules, while sole proprietorships file Form 1040, U.S. Individual  Income Tax Return, and attach Form Schedule C, Profit or Loss from  Business.
section_title: Employer-Related Tax Activities, Such as Withholding Employment Taxes, Depend on a Business’s Number of Employees
paragraphs: Small businesses with employees are responsible for reporting,  withholding, and depositing employment and unemployment taxes. While  these requirements may impose a cost on employers, withholding is  widely believed to improve compliance and may reduce compliance  burdens for employees. The number of employment tax reports and  deposits depends on the number of employees and the resulting  employment tax liability owed at a particular time (see table 1). In general,  businesses with an employment tax liability greater than $50,000 need to  make deposits more frequently than businesses with a lower liability.  Additionally, each year, the employer must furnish a copy of Form W-2,  Wage and Tax Statement, to each employee. Since the characteristics of  employers vary, responsibilities for withholding, depositing, and reporting  employment taxes can differ. For example, consider a small business  restaurant owner who has 20 employees and has an employment tax  liability of less than $50,000. She files a Form 941 quarterly which details  the income tax withholdings for each of her 20 employees. Since her  liability is less than $50,000, she deposits these withholdings monthly. At  the end of the year, she must complete 20 Forms W-2 to report wages,  tips, and other compensation paid to each employee.
Small businesses also report health care and retirement information. The  information reported for these areas depends on a business’s number of  employees. The entity type also plays a role in the information reported  about health care. Under the Patient Protection and Affordable Care Act,  employers report the cost of coverage under an employer-sponsored  group health plan on Form W-2. Beginning in January 2016, employers  with 50 or more full-time employees will need to provide employees with a  Form 1095-C, Employer-Provided Health Insurance Offer and Coverage.  Some employers decide to offer pension plans and are responsible for  reporting this information. While businesses must maintain records about  these plans, most pension plans do not have any separate filing or  reporting requirements with IRS. However, certain retirement plans offer  small employers and self-employed individuals a deduction for  contributions, and allows them to defer tax on income paid into the plan.  To receive deductions, the small businesses must report this information  to IRS using certain forms.
section_title: Third-Party Reporting Varies Depending on Business Size and Entity Type; Excise Tax Burden Is Industry Specific
paragraphs: Many businesses, including small businesses, are required to report on  certain transactions they enter into with other entities. This is a form of  third-party reporting. IRS uses this information to verify compliance by  comparing the income or expenses reported by third parties to the income  or expenses reported by small businesses on tax returns. Using Form  1099-MISC, small businesses report items such as rent payments and  payments to nonemployees for services of at least $600, subject to  certain exceptions. The burden created by this requirement grows with  the size of the business because larger businesses would need to file  more 1099-MISC forms. However, while a larger business may have  more transactions, it may also have an accounting system designed to  identify transactions of more than $600 that a smaller business might not  have.
Another characteristic that affects third-party reporting requirements is  entity type. For example, partnership entities are required to report the  distributive shares of their partners on Schedule K-1. However, other  entity types such as sole proprietorships do not have similar  requirements.
Additionally, a small business may have many industry-specific  requirements related to excise taxes. IRS administers several broad  categories of excise taxes, including environmental taxes,  communications taxes, fuel taxes, retail sale of heavy trucks and trailers,  luxury taxes on passenger cars, and manufacturers’ taxes on a variety of  different products. For example, a small business in the trucking industry  that makes deliveries over public highways is required to file Form 2290,  Heavy Highway Vehicle Use Tax Return.
section_title: IRS’s Compliance Burden Models’ Estimates Provide Valuable Insights
paragraphs: IRS has developed several models to provide information for assessing  the impact of the tax code and IRS programs on taxpayers. These models  also help IRS assess the role of compliance burden and comply with  requirements by the Office of Management and Budget for information on  burden under the Paperwork Reduction Act. In the past 15 years, IRS  has developed a number of burden models for individual and business  taxpayers—both small and large.
section_title: Estimated Recordkeeping and Filing Burdens Vary with Characteristics of Businesses and Complexity of Returns
paragraphs: Estimates of business compliance burdens that IRS’s models have  produced over the years indicate that burdens increase with the size of  businesses, whether measured in terms of assets, receipts, or  employment; however burden per dollar of assets or receipts or per  employee decline with size due to economies of scale. For example, a  small business owner who does his own taxes may create a spreadsheet  to compute the business’s taxes and keep track of the employment taxes  he owes for each employee. The effort the small business owner makes  to build that spreadsheet is a fixed cost—a cost that does not change with  an increase or decrease in the amount of goods or services that are  produced. As the small business owner’s sales grow and as he hires  more employees, he doesn’t have to repeat that effort; he just has the  small additional cost of adding new data on income and employees to the  spreadsheet. As this business grows, its total compliance costs decline  both as a proportion of sales and on a per-employee basis. For these  reasons, the costs per dollar of receipts or per employee are larger for  small businesses than for larger ones.
IRS measured money and time burden as a portion of total business  receipts, total assets, and burden per employee. Across all three  measures, IRS results are consistent with the assumption that small  businesses face significant fixed compliance costs combined with  decreasing marginal costs as the business grows (see appendix III, tables  9 through 11).businesses, estimated total monetized business compliance costs by  business entity type varied depending on the type of entity and the  entity’s gross receipts. This variation is one reason why compliance  burden on small businesses is a concern (see appendix III, table 12).
When looking at total receipts and asset size across all  Figure 7 shows IRS’s estimates of compliance costs per employee for S  corporations, C corporations, and partnerships. According to the  estimates, costs for corporations and partnerships with 1 to 5 employees  range from $4,308 to $4,746, compared to $182 to $191 per employee for  businesses with 50 or more employees. IRS conducted this research  using 2002 taxpayer data. Estimates using more recent data have not  been produced. A number of factors would likely affect these estimates if  they were produced using current data, including inflation, accounting  software improvements, and tax law changes.
Estimates from IRS’s compliance burden models also show that burdens  vary by industry. According to IRS, the retail trade industry incurs the  largest pre-filing and filing time burden—businesses in this industry spent  an average of between 325 and 331 hours per year on such activities.  Manufacturing incurred the largest pre-filing and filing monetary burden,  with businesses spending an average of $2,740 to $2,813 per year on  these activities. Agriculture, forestry, and fisheries incurred the smallest  average time spent on tax compliance activities (180 to 184 hours) and  second smallest average compliance costs ($1,489 to $1,590). Some  industries have higher time and monetary compliance costs because the  nature of those businesses may affect the complexity of tax activities. For  additional information on industry burden, see table 13 in appendix III.
IRS and Treasury researchers have used both the business and  individual taxpayer burden models to estimate the influence of specific  business characteristics on compliance burdens. Their estimates suggest  that recordkeeping and filing burdens increase as the volume of complex  compliance activities undertaken by businesses increases, regardless of  the size or other characteristics of those businesses. The results for the  full population of individual taxpayers were similar. categorized into varying levels of complexity based on an overall  complexity of extracting information from the entity’s financial books,  items that may require a separate recordkeeping system or a process  with potentially separate rules for each item, and tracking records across  years.
These results are presented in Rosemary Marcuss, et.al., “Income Taxes and  Compliance Costs: How Are they Related?”, National Tax Journal, December 2013, 66  (4), pp. 833-854 and George Contos, et.al., “Taxpayer Compliance Costs for Small  Businesses: Evidence from Corporations, Partnerships, and Sole Proprietorships,” (2009)  Proceedings of the One Hundred Second Annual Conference on Taxation pp. 50-59,  National Tax Association, Washington, D.C. forms to about $2 per form for 100 forms, with one of them charging  about $.80 per form for 100,000 forms.
section_title: Audits and Other Compliance Contacts Can Be a Significant Source of Burden for Taxpayers, but Research Is Limited
paragraphs: IRS has not conducted research to estimate the compliance costs of  audits and other post-filing compliance contacts for small businesses.  However, IRS conducted preliminary research on compliance costs for  individual filers that can provide some insights into the sources of burden  that would affect some small businesses that report business income on  individual tax returns. From the taxpayer perspective, post-filing begins  when the taxpayer receives notice of an issue with an already filed tax  return and concludes when the issue has been resolved. Post-filing  compliance costs include any time spent on resolving an issue or money  spent on things ranging from postage to paying a tax professional. IRS’s  preliminary data on individual post-filing compliance costs provide  information on the time and money spent on post-filing activities such as  an audit—a review of accounts and financial information to ensure  information is being reported correctly—or collections—receiving a bill for  not paying taxes in full when a tax return was filed.
For individual filers, IRS research indicates that the level of compliance  costs are highly dependent on the approach IRS takes in how it contacts  the taxpayer to address potential underreporting or underpayment of tax  obligations. IRS’s preliminary estimates, based on survey data from 2011,  indicate that the average post-filing compliance costs were the highest for  a field exam—an audit conducted at an individual’s home or place of  business—at $4,800, followed by office exam—an audit conducted at an  IRS office—at $2,165. A notice informing the taxpayer that they did not  report all of their earnings had the lowest estimated average post-filing  compliance costs at $230. IRS’s research on the magnitude of audit costs  for individual filers likely includes individual filers who are small business  owners. Those businesses are likely to have more complicated returns  and, as a consequence, their burden is likely to be at least as great as the  averages show for individual filers. For more details concerning post-filing  compliance costs, see figure 13 in appendix III.
According to IRS, the audit rate for small business taxpayers is higher  than the rate across all individual taxpayers because small businesses  historically have higher noncompliance than other taxpayers. Table 2  provides detailed information on the audit rates across small business  types.
While we did not examine post-filing costs, in a past report on  correspondence audits, we found a number of issues which contribute to  taxpayer compliance burden. These issues included IRS backlogs in  responding to taxpayers who provide documentation in response to IRS’s  audit notices and unrealistic audit time frames set by IRS.
section_title: IRS’s Decision- Making Framework Includes Consideration of Small Business Compliance Burden
subsections: section_title: IRS’s Strategic Goals and Internal Revenue Manual Describe the Agency-wide Approach to Taxpayer Burden Reduction
paragraphs: One of IRS’s goals in its strategic plan is to deliver high quality and timely  service to reduce taxpayer burden and encourage voluntary  compliance. Under this goal, IRS has identified seven objectives that  further define how it intends to achieve the goal. One objective is to  reduce taxpayer burden and increase return accuracy at filing through  timely and efficient tax administration processing. IRS outlined  performance measures for each strategic goal and objective in a  supplement to its financial statement for fiscal years 2013 and 2014.this supplement, IRS describes some of the initiatives launched or  continued and progress made in achieving performance goals. IRS also  includes a discussion of goals missed. Several of these goals, if  achieved, could have a positive impact on reducing small business  compliance burden. For example, responding more quickly to telephone  calls, correspondence, and requests for in-person service, as well as  enhancing the online experience for customers, could benefit small  businesses by requiring them to expend less time and fewer resources for  IRS outreach.
In addition to the goals and objectives that focus on burden reduction in  the strategic plan, IRS listed general guiding principles for reducing  burden in the Internal Revenue Manual 22.24.1 - IRS Servicewide Burden  Reduction Activities. The guiding principles are intended to support the  consideration of compliance burden as part of tax administration.  According to the manual, IRS carries out its mission to achieve significant  reduction in unnecessary burden by considering taxpayer burden when  implementing and reviewing policies and procedures. See table 3 for a list  of the guiding principles.
According to the Internal Revenue Manual, the mission to reduce  taxpayer burden and improve service is embedded in the IRS culture and  a responsibility of all divisions. Though staffed to the Small Business and  Self-Employed division, a senior advisor serves as the single point of  contact for taxpayer burden reduction initiatives across all divisions. The  manual states that this arrangement is intended to provide a link across  the agency to ensure burden reduction is incorporated within decision- making frameworks. The advisor also acts as a liaison with external  stakeholders.
section_title: IRS Has Worked with Internal and External Stakeholders to Identify and Reduce Small Business Tax Compliance Burden
paragraphs: IRS officials provided examples of efforts made to engage with internal  and external stakeholders to reduce small business tax compliance  burden. To engage internal stakeholders, employees can suggest ways to  reduce burden by using Form 13285, Taxpayer Burden Reduction  Referral. This form allows employees to note an issue causing taxpayer  burden, describe the affected population, and propose a solution.  Employees can also explain who needs to be involved in making the  change, the resources needed, taxpayer benefits, compliance risks, and  suggestions for how to measure burden reduction savings (e.g., reduced  costs to the taxpayer or reduced costs to IRS). One notable example of a  burden reduction initiative at IRS was developing a simplified method for  determining the Office in the Home tax deduction.
Simplified Office in the Home Deduction Illustrates How IRS Considers Burden  When Implementing Initiatives  IRS officials offered an example of how the agency considered compliance burden  principles when implementing new or changed tax laws or administrative procedures  with the introduction of a simplified method for small businesses to calculate their Office  in the Home Deduction. This method was introduced in 2013 and generally allows filers  to receive a deduction of $5 per square foot of office space, up to a maximum area of  300 square feet. The alternative method involves a more complex calculation of  property depreciation.
Although the Department of the Treasury (Treasury) and IRS officials reported  considering this proposal as early as 2006, in July 2012, Treasury and IRS redoubled  their efforts in response to an Office of Management and Budget request to identify  initiatives that would eliminate at least 2 million hours in annual burden. To meet this  request, IRS reached out to employees and Senior Executive staff, and also reviewed  prior submissions, form burden statistics, and other suggestions that had been  considered in the past. The group reviewed the proposals and made a final  determination that this initiative should be implemented. IRS officials told us that they  considered burden and compliance risk within this decision-making process and  discussed tradeoffs of their decisions. IRS received external stakeholder input from  representatives of the small business community, such as the U.S. Chamber of  Commerce and the National Federation of Independent Business, who have  recognized this as a positive development. IRS said  the process of working  collaboratively across the organization, with external parties, and with Treasury allowed  them to consider the interests and concerns of all parties. This helped IRS weigh  tradeoffs of decisions that could affect both compliance and compliance burden.
Other internal activities include providing employees with an online  burden risk estimator tool designed to aid employees in determining  whether certain decisions about the design of tax forms for individuals  (Form 1040 and associated schedules and forms) could impose  significant burdens on taxpayers. This tool is an Excel spreadsheet that  uses some of the data used in the more elaborate burden estimation  models discussed previously in this report. The tool provides staff with an  estimate of the number of taxpayers who would be affected by a specific  potential tax form change, as well as a rough indication of whether the  effect on compliance burden would be significant. Divisions can use this  tool to identify decisions that merit more in-depth evaluations, potentially  involving the full burden estimation model.
IRS undertakes a number of activities to engage external stakeholders  such as providing information on its website and holding forums with  small business representatives. IRS has a website page that defines  taxpayer burden, provides links to submit ideas for burden reduction, and  outlines how IRS selects burden reduction initiatives. Another example of  IRS outreach to the small business community is the quarterly Small  Business Forum. IRS officials told us that they use the information from  these forums to inform their decision-making process for practices and  policies that affect small businesses. For example, IRS used feedback  from forum participants to refine the language used in burden surveys it  administers to the business community, and used what was learned to  inform its current burden models. Similar to internal stakeholders, external  stakeholders can make burden reduction suggestions using Form 13285- A, Reducing Tax Burden on America’s Taxpayers (Referral Form for Use  by the Public), which allows them to describe the issue causing taxpayer  burden, the affected population, and the proposed solution.
section_title: Small Business Representatives We Spoke with Identified Areas That Contribute to Compliance Burden
paragraphs: We also interviewed small business representatives (external  stakeholders) who acknowledged IRS’s external stakeholder outreach  efforts and how they have been effective in identifying opportunities to  reduce compliance burden. However, they also described a number of  areas where small business compliance burden could be further  reduced. These areas include issues related to IRS customer service,  filing requirements, lack of or delayed official guidance, and compliance  contacts. According to these representatives, when they call IRS, they  can have long wait times, be disconnected, or be directed to IRS staff  who are unable to provide the needed assistance. We have recently  reported on these issues as well.
Further, several representatives shared the perspective that complex  filing requirements contribute to compliance burden. While small  businesses sometimes anticipate significant tax relief through tax credits  and deductions such as the small employer health care credit and  mileage and vehicle deductions, some small businesses may not be  claiming these credits due to the time, cost, and complexity associated  with claiming them. One concern we heard from small business  representatives was that after a tax practitioner expends resources to  compile the necessary documentation and calculate the credit, their client  (the small business) is ineligible to claim the credit. This could result in  additional taxpayer burden if tax preparers bill their clients for calculating  the credit when it is not claimed.
In addition to facing burdens due to new and complex tax provisions,  representatives we spoke with also expressed concern over the  compliance burden associated with delayed or missing official guidance,  particularly for the Patient Protection and Affordable Care Act employer   Representatives also noted that deadlines for responding to  mandate.certain IRS notices can be difficult for small businesses when the  requested information is not readily available. We recognize that IRS is  aware of many of these concerns and, through various initiatives, has  made efforts to address these issues. However, continued attention to  these areas will be key to effectively reducing burden.
We routinely issue reports on aspects of IRS’s enforcement and  administrative operations, some of which may impact small business tax  compliance burden. In many cases we have made recommendations that,  if implemented, could help to reduce these burdens. Selected  recommendations that have yet to be implemented are listed in appendix  IV.
section_title: IRS’s Overall Evaluation of Its Payment Card Pilot Has Several Strengths, but Does Not Fully Address All Elements Necessary to Effectively Assess Results
subsections: section_title: New Payment Card Data Provide Opportunities to Improve Voluntary Compliance and Have Potential to Help IRS Better Identify Noncompliant Small Business Taxpayers
paragraphs: Beginning in tax year 2011, payment settlement entities were required to  send IRS Forms 1099-K to report gross merchant payments in which a  payment card or a third-party payment network was used as the form of  payment. Payment settlement entities report the gross amount of all  reportable transactions a merchant made through them, for the calendar  year, without regard to adjustments for credits, cash equivalents,  discounts, fees, refunds, or other deductions.
A copy of the 1099-K is also sent to the taxpayer. The reporting of this  information to both IRS and the taxpayer can encourage voluntary  compliance by small businesses in at least two ways. First, since  taxpayers know IRS is also receiving this income information, they are  more likely to include it on their tax return. Second, taxpayers have  another source of information they can use to help calculate or verify  business income.
Payment card reporting also provides IRS with an information source it  can use to compare against the income reported by small business  taxpayers on their tax returns. As such, it can serve as a tool for  identifying noncompliant taxpayers, including those who failed to file a tax  return at all and those who underreported their income. This type of  comparison is a common IRS enforcement technique. For example, IRS  can directly compare information it receives on a taxpayer’s Form W-2,  Wage and Tax Statement, against a tax return to determine if the  taxpayer reported earnings and withheld taxes correctly.
However, matching is more complicated for Forms 1099-K than Forms W- 2 because IRS cannot directly match the line items on 1099-Ks to line  items on tax returns. The Form 1099-K reports the gross amount of  payment card and third party network transactions made through a  payment settlement entity. This does not match the gross receipts line on  tax returns because Form 1099-K transactions may include items like  sales tax, gratuities, and cash back, all of which are not income.  Furthermore, tax return gross receipts can include cash and check  revenue, which is not captured on Form 1099-K. To leverage Form 1099- K data, IRS researched and tested ways in which the new data can be  used to most effectively and efficiently improve voluntary compliance,  detect noncompliance, and identify those who did not file returns.
The Payment Card Pilot includes six activities to test three methodologies  for selecting cases, as described in table 4.
In all of the pilot activities, IRS uses taxpayer identification numbers to  first match Forms 1099-K with the correct tax returns. IRS then compares  Form 1099-K information with business income reported on individual and  business tax returns. This process is detailed in figure 8. In the two  underreporter pilot activities, IRS compares line by line the gross dollar  amount of payments listed on Form 1099-K to gross receipts reported on  the tax return to identify potential underreporting of payment card and  third-party network revenue.
The payment mix methodology aims to identify potential underreporting of  gross receipts from both card and cash sources. For this methodology,  IRS first calculates a payment mix—the relative ratio of cash and card  revenues of similar businesses. IRS determines this ratio by dividing the  gross payment amount on Form 1099-K by gross receipts on the tax  return. IRS then computes the amount of potential underreporting by  comparing this payment mix to that of similar businesses based on  variables including industry type and size, population density, per capita  income, and average transaction sizes. As part of the test and learn  process, IRS has expanded the number of variables to refine  identification of possible underreporting taxpayers. One example of this is  illustrated in figure 9.
If implemented successfully and properly evaluated, the payment card  pilot could allow IRS to determine which, if any, pilot activities are  effective enough to justify broader expansion, including integration with or  replacement of other compliance enforcement efforts.
section_title: IRS’s Evaluation Plan Enabled It to Rapidly Test, Learn from, and Adapt Pilot Activities, but Does Not Include Key Elements for Assessing Overall Pilot Performance
paragraphs: To assess IRS’s plan for evaluating the payment card pilot we used our  previously developed guidance to identify key elements for designing  quality evaluations. Addressing each element at the overall pilot and  pilot activity levels can provide program managers with objective  information to iteratively assess program performance. The five key  elements we identified for quality evaluation design are described in   table 5.
IRS’s evaluation plan for pilot activities integrated many characteristics of  a well-designed evaluation. As a result, IRS was able to make rapid,  ongoing assessments of pilot activities and continually incorporate  changes based on what was learned. This approach allowed IRS to test  many hypotheses simultaneously while limiting the number of small  business taxpayers affected by the pilot.
However, the overall evaluation plan for the pilot lacked characteristics of  each element that are necessary to ensure a quality evaluation. If IRS  does not address these gaps, it risks not having the evidence needed to  effectively decide whether, how, and when to integrate pilot activities into  broader small business compliance improvement efforts.
subsections: section_title: Clarify Understanding of the Pilot’s Goals and Strategy
paragraphs: IRS clearly defined the overall pilot goal, which is to use Form 1099-K  data to identify and reduce underreported and unreported income. IRS  outlined and detailed the specific program activities it tested and  documented pilot planning and results in a strategic planning document  and several other executive-level updates. These documents detailed  various actions, including internal meetings, assessments, outreach,  training, and information technology activities, during the early stages of  the pilot. IRS’s strategic planning document also provided a conceptual  representation of the different stages of the pilot and the growth of  compliance case volume at each stage, as seen in figure 10.
IRS has generally documented the expected short-, medium- and long- term impacts of the pilot. One important short-term impact included  learning about the small business population to improve identification of  noncompliant taxpayers. For example, IRS realized an issue was arising  because some small businesses—such as high-end restaurants—have  lower cash revenue than other similar businesses. To address this issue,  IRS added a line to Form 1099-K to collect data about the number of  payment transactions (see figure 11). IRS uses this information to  determine the average payment card transaction amount. In the medium  term, IRS sees the potential for improved taxpayer voluntary compliance.  After the first year of the pilot, IRS tested compliance levels of taxpayers  before and after the introduction of the pilot and found that almost half of  taxpayers increased their reported gross receipts, and about 60 percent  of those contacted reported their income more accurately the following  year. In the long term, IRS sees these activities helping to reduce the tax  gap.
While IRS has defined high-level pilot goals, such as improving voluntary  compliance and reducing the tax gap, it did not establish performance  measures for these goals and has not decided on a time frame for  developing them. IRS has defined broad stages for pilot implementation,  but has not clearly identified measures or indicators to determine when  the pilot has moved or will move from one stage to the next.
IRS identified pilot staffing needs. In June 2012, IRS estimated the  number of full-time equivalents (FTE) it would need to conduct field  exams. IRS officials also said they track resources for some of the pilot  activities, including the implementation of the payment mix methodology  pilots. However, IRS’s evaluation plan has not fully identified and tracked  resource needs or use, including the actual numbers of FTEs hired or  management resources to design and monitor test and learn pilots.
IRS identified external factors that could affect the progress or  effectiveness of the overall pilot. It identified potential hurdles, including  possible litigation and access to necessary technology solutions.  However, IRS has not articulated how these factors affect the future of  the pilot and what decisions it will make to address them under different  scenarios.
section_title: Develop Relevant and Useful Evaluation Questions and an Analysis Plan
paragraphs: IRS evaluated pilot activity results, but there is no clear documentation of  its evaluation questions or analysis plan. However, these can be inferred  based on the evaluation results. According to IRS officials, one of the  evaluation goals was to learn why some compliant taxpayers were  identified as potential underreporters of income. IRS examined the results  of closed cases to learn how to better identify compliant and  noncompliant taxpayers. An example of this analysis and resulting  change is described in more detail in the text box.
IRS Test and Learn Approach to Improve Identification of Noncompliant  Taxpayers One IRS pilot learning goal is to test a new case selection methodology called the  payment mix methodology. IRS is learning how to improve this methodology to better  identify noncompliant taxpayers.
When analyzing results of the first year of the pilot program, IRS found that a significant  percentage of online-only businesses—which do not accept cash—were falsely  identified by the payment mix methodology as potential underreporters of cash income.  To decrease the likelihood that compliant online-only businesses were selected in  future years, IRS added a line to Form 1099-K that allows the payment settlement entity  to specify the aggregate gross amount of all reportable payment transactions during the  calendar year where the card was not present at the time of the transaction or the card  number was keyed into the terminal. Typically, this relates to online sales, phone sales,  or catalogue sales. Because IRS reduces the probability that compliant small business  taxpayers are identified as potential underreporters of income, the overall burden for  compliant taxpayers is reduced.
IRS evaluated the results of all pilot activities. IRS compared the average  time to complete an audit and the average dollars assessed in additional  tax for each case against existing compliance and enforcement efforts.  IRS could use this information to decide which pilot activities to implement  in a full compliance program.
IRS did not have evaluative questions and criteria to assess whether the  overall pilot or the pilot activities achieved the intended goals or produced  the intended results. Understandably, as IRS tests and adapts different  approaches, it has learned and will continue to learn which approaches  demonstrate the most promise in efficiently and effectively identifying  noncompliant taxpayers. Clearly articulated evaluative questions and  related analysis plans would allow IRS to determine whether the overall  pilot and pilot activities are achieving results that would signal what next  steps should be taken. These may include deciding the pilot can move  beyond the learning stage, be expanded, or, ultimately, moved from pilot  to full implementation as a compliance program. Conversely, the  determination could be that the pilot and pilot activities are not achieving  the intended results and should be discontinued or modified.
section_title: Assess the Relevance and Quality of Available Data Sources
paragraphs: During the early stages of the pilot, part of IRS’s evaluation of pilot  activities involved assessing Form 1099-K data quality. IRS monitored  potential errors that payment settlement entities could make when filling  out the form, including invalid or missing taxpayer identification numbers.  Such data entry errors could negatively affect IRS’s efforts to compare  the data with information reported on small business taxpayer returns.  When errors were identified IRS contacted the payment settlement  entities to make corrections. IRS officials told us that because of this  effort, accuracy rates for matching rose from 90.3 percent for tax year  2011 to 95.4 percent for tax year 2013. IRS officials have told us that  analysis of Form 1099-K data is ongoing.
Since IRS lacks evaluative questions and an analysis plan for assessing  the overall pilot, it does not have complete descriptions of the information  or data and sources needed to assess the overall pilot against evaluation  criteria, how that information will be gathered, and an assessment of data  reliability. Because IRS addressed the relevance and quality of data  sources in some of the early evaluations of some pilot activities, this  information could feed into the development of the broader evaluation  plan.
section_title: Address Data, Scope, and Methodology Limitations
paragraphs: IRS documented certain assumptions of its analysis. For example, in the  alternative notice pilot, IRS sent assessments to taxpayers who did not  respond to the notice and those who admitted to underreporting. IRS  referred cases to IRS field work when taxpayers sent insufficient  responses or communicated that a review of books and records was  necessary.
Furthermore, in the early stages of the pilot, IRS showed evidence that it  checked that data were free of errors. In the first year of the pilot, officials  took steps to ensure that compliance examiners understood and  consistently applied decision rules to determine compliance results.
IRS provided evidence that it estimated timelines and relative resource  needs to move from the test and learn phase to a full compliance  program. IRS outlined three scenarios to achieve a given level of  compliance at program implementation. However, these scenarios were  developed without a program level evaluation. Until IRS conducts an  evaluation, it will not have the information it needs to determine which  approach to take.
Although IRS showed evidence that data, scope, and methodology  limitations were considered and addressed for certain pilot activities,  these limitations were not fully addressed for the overall pilot. IRS would  first need to develop evaluative questions, assessment criteria, and an  analysis plan for the overall pilot before it could clearly assess data,  scope, and methodology considerations. An assessment of design  limitations would include stating any limitations of pilot scope, determining  comparisons against which to assess pilot results, and assessing whether  the evaluation fits available time and resources. Asking these questions  would help clarify the potential impact of any project design limitations  when determining whether to move pilot activities toward full program  implementation.
section_title: Facilitate Use of the Evaluation Results in Program Management Decision Making
paragraphs: IRS provided evidence that leadership from multiple offices across the  agency—the Small Business and Self-Employed Division, Office of  Compliance Analytics, and the Information Technology Organization— demonstrated commitment to using evaluation data to inform pilot  decision making for the beginning of the pilot. Senior officials from each of  these offices met weekly during the early stages of the pilot. The  leadership actively engaged internal stakeholders and developed  strategies to internally communicate information about pilot program  activities. These strategies included organizing employee focus groups,  training, and leadership updates on pilot progress. For example, in  October and November of 2012, IRS provided an update on project  communication status to communication directors across all operating  divisions.
In addition, IRS leadership engaged with external stakeholders before  launching the pilot. In October 2011, IRS addressed small business  representatives’ concerns about paperwork burdens by announcing that it  would not require taxpayers to reconcile gross receipts and merchant  card transactions. IRS also worked to address tax practitioner questions  about the use of the payment mix methodology for case selection. As a  result of the outreach, for example, IRS developed and tested a tool to  help tax practitioners determine if their clients would be at risk for  underreporting cash transactions.
section_title: Conclusions
paragraphs: IRS’s payment card matching program has the potential to enhance the  agency’s ability to identify noncompliant small business taxpayers. Better  identification of noncompliance would reduce the burden placed on  honest taxpayers because the likelihood they would be selected for costly  and time-consuming audits or other compliance contacts could be  reduced. Further, more effective identification of noncompliant taxpayers  means IRS can more efficiently use limited resources.
IRS’s Payment Card Pilot shows promise in producing these results.  However, IRS has a long road ahead to figure out whether and how the  pilot, and its many activities, can be fully implemented. IRS has not  clearly defined the stages of the pilot or measurable goals that it can use  to determine when the pilot has moved from one stage to the next, or if it  should. Without defining the stages and establishing related metrics, IRS  will not be able to articulate the pilot’s status at critical points in time.  Further, it will not be able to justify the investment of additional resources  if it cannot demonstrate progress toward those goals. In addition, IRS has  not developed a full evaluation plan that will allow for a systematic  assessment of the overall pilot against evidence-based criteria. Such a  plan is necessary so IRS can ensure that it is making informed decisions  about moving forward. Following key elements of evaluation design will  help ensure that the results of the evaluation are valid and reliable.  Finally, documenting the plan’s limitations will reduce the risk that IRS will  draw conclusions that are beyond what can be supported.
section_title: Recommendations
paragraphs: To improve the evaluation of the payment card pilot, the Commissioner of  Internal Revenue should take the following actions:
Clearly define the stages of the payment card pilot and establish  measurable goals for determining when the pilot advances from one  stage to the next.
Develop an evaluation plan for the overall pilot and building on pilot  activities to inform decisions about whether, how, and when to  integrate pilot activities into overall enforcement efforts. This plan  should include evaluation questions, evidence-based evaluative criteria, an analysis plan, a complete description of data to be collected, a data reliability assessment, and documentation of evaluation limitations.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Commissioner of Internal  Revenue and the Secretary of the Treasury for their review and comment.  IRS’s Deputy Commissioner for Services and Enforcement provided  written comments, which expressed appreciation to GAO for recognizing  IRS’s efforts to consider taxpayer burden when implementing processes  and procedures. In its response to the draft, IRS agreed to incorporate an  evidence-based assessment of the payment card pilot that includes  identifying clearly defined pilot stages and implementing an evaluation  plan with measurable goals. IRS stated it will provide a more detailed  response to our recommendations after this report has been released.  These comments are reprinted in appendix V. IRS also provided us with  technical comments, which we incorporated into the report as  appropriate. Treasury did not provide comments.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Secretary of the  Treasury, the Commissioner of Internal Revenue, and other interested  parties. In addition, this report will be available at no charge on GAO’s  website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or by email at mctiguej@gao.gov. Contact points  for our Offices of Congressional Relations and Public Affairs may be  found on the last page of this report. GAO staff who made key  contributions to this report are listed in appendix VI.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report are to: (1) describe the characteristics of the  small business population; (2) describe how characteristics of a small  business affect compliance burden; (3) describe how the Internal  Revenue Service (IRS) integrates small business compliance burden  considerations in decision making; and (4) assess IRS’s plan for  evaluating its payment card pilot.
To describe general characteristics of the small business population such  as the number of small businesses and total income, we reviewed  taxpayer data from IRS Statistics of Income (SOI) and studies with  access to taxpayer data. We reviewed SOI documents about data  reliability and sampling methodology, and interviewed officials in SOI. We  reviewed reports from researchers at the U.S. Department of Treasury,  Office of Tax Analysis (OTA). We interviewed two of the OTA authors  about their methodology for identifying the small business population. We  performed data reliability tests by comparing OTA estimates for all filers  against SOI estimates and by comparing OTA estimates for tax year 2007  and 2010. We found the estimates from researchers at OTA were  sufficiently reliable for our purposes of describing general characteristics  of the small business population. See appendix II for a more detailed  discussion of OTA researchers’ methodology and assumptions.
To describe how characteristics of a small business affect compliance  burden, we conducted a literature review where we reviewed IRS  research papers and conference presentations, academic studies, and  our prior work on taxpayer compliance burden. We searched relevant  databases such as ProQuest, Accounting & Tax, EconLit, ABI/Inform,  Nexis.com, and Tax Notes. We identified and reviewed selected IRS  studies on tax compliance burden conducted over the last 11 years. We  also asked IRS officials from the Research, Analysis, and Statistics (RAS)  division to identify any additional IRS research assessing small business  tax compliance burden and post-filing burden. To obtain information  related to federal small business tax requirements, we reviewed IRS  taxpayer guidance found on the IRS website including the 2015 tax  calendar. We interviewed relevant IRS officials to clarify our  understanding of the research and models, and to verify our analysis.
To describe how IRS integrates small business compliance burden  considerations in decision making, we examined IRS’s strategic plan and  relevant goals and objectives related to taxpayer burden. We also  reviewed IRS’s Internal Revenue Manual, which outlines, among other  things, guiding principles for considering burden reduction. We  interviewed IRS officials in the Small Business and Self-Employed  division (SB/SE), RAS, and the Office of Taxpayer Burden Reduction  about other activities IRS conducts related to taxpayer burden reduction,  tools it uses to manage burden reduction efforts, and initiatives it  implemented. In addition, we interviewed tax practitioners, associations,  and other liaisons to the small business community to identify areas of  burden associated with interactions between IRS and the small business  community, and discuss what might alleviate burden. We conducted  unstructured interviews with a non-generalizable sample of 12  organizations based on their knowledge of small business tax policy  resulting from historical involvement and relationships with the small  business community and IRS. We reviewed supporting documentation,  where available. We selected these organizations to represent a variety  of perspectives and groups within the small business community.
To assess IRS’s plan for evaluating the payment card pilot, we reviewed  and summarized documentation that included IRS’s Information  Reporting and Document Matching Strategic Roadmap; Communication,  Outreach, and Education Strategic Plan; and IRS internal presentations to  the IRS Commissioner. We interviewed IRS officials from SB/SE and  Office of Compliance Analytics divisions on the pilot to link IRS’s test and  learn approach to defining strategic goals, evaluation questions, an  analysis plan, and the ability to track benefits of the pilot efforts. We  compared these efforts to our guidance on program evaluation design  and applied criteria adapted from the guidance to both the overall pilot  and pilot activities.
We conducted this performance audit from July 2014 to June 2015 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.
section_title: Appendix II: Description of Methodology and Reliability of Data Used to Produce Small Business Population Estimates
paragraphs: For our analysis, we use estimates from researchers at the U.S.  Department of the Treasury, Office of Tax Analysis (OTA), to describe the  characteristics of the small business population, such as the number of  small businesses and total income. There are no universally accepted  criteria for defining the small business population. OTA estimates address  some of the limitations of describing the small business population using  estimates based solely on the type of tax return that is filed by excluding  certain tax returns that may not be actual businesses. Not all tax returns  that report business income represent business entities with the principal  purpose to generate revenue or to engage in substantive business  activity. For example, some C corporations can serve as investment  vehicles that engage in little or no business activity. Further, partnerships  may be created to redistribute profits generated by another partnership  and may not generate income themselves. Filers of Form 1040,  Schedule C, may be independent contractors who may more closely  resemble employees than small businesses. Additionally, rental income  for some individuals may be incidental and not represent business  activities. Uncertainty within OTA estimates can come from: (1)  assumptions that were made to distinguish small businesses engaged in  substantial and substantive business activities from other entities that file  the same tax return; and (2) that the estimates are based on sampled  taxpayer data and subject to sampling error. Consequently, results that  are slightly higher or lower than those reported in this particular analysis  may be equally valid for describing the numbers of businesses in each  subgroup and the size of their incomes. We found the estimates from the  researchers at OTA were sufficiently reliable for our purposes of  describing general characteristics of the small business population.
Throughout this report, we refer to the estimated number of small  business filers as the number of small businesses. Using these estimates  may understate the number of small businesses where individual  taxpayers can own multiple small businesses. For example, individual  taxpayers can file multiple schedules to report business activity (profit,  loss, and supplemental income and loss from rental real estate activity)  from different lines of business. The number of schedules filed is greater  than the number of Form 1040 tax returns to which these schedules are  attached due to some returns having multiple schedules. The total  income estimates are the sum of all business income reported on tax  returns, including gross receipts, rents, dividends, capital gains, royalties,  and interest. Total income for Schedule E filers is limited to rental real  estate activity from Part I of that schedule to avoid attributing income from  pass-through entities or from royalties to these businesses.
The OTA analysis had access to taxpayer data made available by IRS  Statistics of Income (SOI). Available data from SOI samples indicate that  the sampling errors for the total number of filers and total business  receipts for each type of taxpayer is less than +/- 6 percent at the 95  percent confidence level. Sampling errors of subpopulations may be  higher where tax returns have been sampled at lower rates. Data were  not available to determine sampling errors for the OTA total income  measure; however, business receipts make up such a substantial portion  of the OTA total income that we would not expect the sampling error to be  significantly greater for the OTA total income estimates than it is for the  SOI estimates for business receipts. For C corporations, S corporations,  partnerships, and sole proprietorships in 2010, the OTA number of filers  is within +/- 2 percent of SOI estimates of the number of filers. OTA total  income estimates are higher (within + 20 percent) of SOI total receipts  estimates for these filers because OTA’s total income measure includes  types of income other than business receipts.
The estimates used in this report are based on thousands of returns from  the 2010 SOI Individual, Corporate, and Partnership Studies. Although we  do not know the exact number of records used for each estimate, the  Individual sample has 50,464 Form 1040 returns with a Schedule C with a  sample selection amount of less than $10 million and 5,804 Form 1040  returns with Schedule F but without a Schedule C. The sample selection  amount is the greater of indexed negative income and indexed positive  income. The Corporate sample has 20,085 Form 1120 returns with total  assets less than $10 million and size of proceeds less than $2.5 million  where proceeds is defined as the larger of the absolute value of net  income (deficit) or absolute value of cash flow (which includes net  income, depreciation, and depletion). The Corporate sample also has  15,741 Form 1120S returns that have total assets less than $10 million  and size of proceeds less than $2.5 million. The Partnership sample has  35,744 returns with total assets or current activity measure less than $10  million. Current activity measure is the maximum of the absolute value of  receipts and income/loss. In this situation, receipts is the sum of the net  receipts, rental income, gross income, portfolio interest income, dividend  interest income, royalty income, and net long-term capital gain/loss.  Income/loss is the sum of ordinary income, net income, net income from  the balance sheet, portfolio interest income, royalty income, and net long- term capital gain/loss.
Table 6 shows SOI estimates for the total number of filers and total  income by type of tax return for tax year 2010 (as reported by Prisinzano  et al.). The OTA analysis and Prisinzano et al. apply two tests to exclude  tax returns filed that do not represent filers that generate substantial  income or engage in substantive business activity. The first test is a de  minimis activity test that requires taxpayers to report total income or total  deductions greater than $10,000, or that their sum be greater than  $15,000. The second test requires total deductions be greater than  $5,000, which indicates substantive business activity based on expenses  related to employees, inventories, and investment, among other things.  The application of these two tests results in the exclusion of 46.7 percent  of the 44.6 million total tax returns, but only 0.6 percent of the total $33.3  trillion in total income represented by these tax returns.
Using this threshold of $10 million or less in both total income and total  deductions, small businesses represent 99 percent of tax returns  generating substantial income and engaged in substantive business  activities (and more than 95 percent of tax returns for each type of tax  return). Small businesses account for 17.8 percent of the total income for  these tax returns (and more than 91 percent of total income for each type  of individual filer and between 5 and 40 percent of total income for each  type of corporation and partnership).
Table 7 shows the OTA small business estimates are consistent across  the years 2007 and 2010, and are similar to corresponding estimates for  all filers. In addition to the measurement errors discussed above, OTA  estimates for these tax years are affected by other factors, including  changing economic conditions. In spite of these factors, small business  estimates for 2010 are within +/- 11 percent of 2007 values for number of  filers and within +/- 18 percent of 2007 values for total income. For each  type of filer, the percent change from 2007 to 2010 for small businesses  is similar to the percent change for all filers (the difference in percent  change is within +/- 10 percentage points). We found similar relationships  for other subpopulations reported within this report. While we do not  have sampling errors for these estimates, we consider estimates of  percentages that differ by more than 30 percentage points or totals that  differ by more that 100 percent to be different.
section_title: Appendix III: Additional Information on Small Business Compliance Burden
paragraphs: The figures and tables in this appendix supplement those in the second  objective providing additional information on small business tax-related  activities, IRS burden model methodology, and results from IRS burden  models.
Table 8 provides a detailed description of tax-related activities that may  create burden for small businesses. These activities are grouped by  income taxes, employer-related taxes, and third-party information  reporting and industry-specific tax activities.
Figure 12 illustrates a simplified depiction of IRS pre-filing and filing  burden models. Essentially, IRS uses the data from its compliance  burden surveys, combined with data that IRS obtains from the tax returns  of survey respondents in econometric models. These models estimate the  relationship between taxpayer characteristics and reported burden; the  models can then be used to estimate total compliance burden.
IRS then uses estimates of these relationships in simulation models to  predict how potential IRS administrative decisions, such as those relating  to tax form design and recordkeeping requirements, may affect taxpayer  burden. Although such simulation results may provide useful insights, it is  difficult to assess the reliability of those results; consequently they should  be used with caution. We found IRS research estimates were reliable for  our purposes of obtaining an overview of small business tax compliance  costs. One difficulty is that to be able to simulate the effect of burden, IRS  needed to develop a complicated methodology for apportioning aggregate  burden across all of the different types of pre-filing and filing activities.  There are no formal statistical tests to estimate the margins of error  around the ultimate simulation results.
The following tables and figure are results from IRS burden models. The  data were taken from IRS studies concerning how small business  characteristics such as size and industry affect small business  compliance costs.
Tables 9 through 11 examine the estimated pre-filing and filing  monetized burden per employee, as a percentage of total receipts,  and as a percentage of total assets.
Table 12 provides information on total monetized business  compliance costs by business entity type and total gross receipts  across all businesses.
Table 13 shows the estimated average pre-filing and filing time and  money burden by industry.
Figure 13 provides the estimated post-filing compliance costs for  individual filers.
section_title: Appendix IV: Selected Open GAO Recommendations to IRS That May Affect Small Business Taxpayer Burden
paragraphs: Appendix IV: Selected Open GAO  Recommendations to IRS That May Affect  Small Business Taxpayer Burden Open recommendations  The Commissioner of the Internal Revenue should direct  the appropriate officials to take the following three  actions:  (1) Systematically and periodically compare its telephone  service to the best in business to identify gaps between  actual and desired performance.  (2) Include specific countermeasures or options in risk  management plans that could guide a response when an  adverse event occurs.  (3) Develop outcomes that are measurable and plans to  analyze service changes that allow valid conclusions to  be drawn so that information can be conveyed to  Congress, IRS management, and others about the  effectiveness of IRS’s service changes and impact on  taxpayers.
Status    (1) IRS disagreed with this recommendation,  noting in February 2015 that it is difficult to  identify comparable organizations with a size  or scope similar to that of the IRS to identify  performance gaps, and that such efforts  would not yield improved results over the  benchmarking process currently used by IRS.  We disagree that IRS’s telephone operations  cannot be compared to others. We believe  this recommendation remains valid and  should be implemented.
Report: Tax Filing Season: 2014 Performance Highlights  the Need to Better Manage Taxpayer Service and Future  Risks, GAO-15-163 (Washington, D.C.: Dec.16, 2014). (2) IRS agreed with this recommendation  and, in February 2015, reported it has already  included specific countermeasures or options  in risk management plans for those risks  ranked highest in likelihood and impact. IRS  also reported it considers such efforts to be  ongoing as it develops new risk management  plans over time. (3) IRS agreed with this recommendation  and, in February 2015, reported it is  developing outcome measures and plans for  analysis to identify and report on the effect of  service changes during the 2015 filing  season. IRS also reported it anticipates  completing this analysis by the end of fiscal  year 2015.
To reduce the need for taxpayer calls, ensure that IRS is  providing taxpayers with more realistic time frames on  when IRS will respond, and more efficiently use IRS  resources, the Commissioner of the Internal Revenue  Service should:  (1) Collect data to analyze whether IRS is responding  within the time frames cited in the revised audit notices.  (2) If IRS delays are continuing, further revise the notices  to provide more realistic response times based on the  data and take other appropriate actions to ensure  efficient use of IRS tax examiner resources.
According to IRS officials:  (1) Correspondence audit program officials  analyzed fiscal years 2012-2015 data to  provide a monthly breakdown of the volumes  of taxpayer correspondence worked in less or  more than 75 days. Supporting  documentation from IRS is pending.
Open recommendations  goals on ensuring compliance in a cost-effective way  while minimizing taxpayer burden.
To better inform decisions being made about the  correspondence audit program, the Commissioner of the  Internal Revenue Service should:  (6) Document how the decisions are to be made about  the correspondence audit program using performance  information.  (7) Track and use other program data that have not been  used to provide more complete performance information,  such as taxpayer burden and experience.
Status   their respective inventory levels at the time  notices are sent. The notices are expected to  be available and implemented in January  2016 after necessary program updates.  Supporting documentation from IRS is  pending.
To better ensure an effective investment of resources in  the Correspondence Assessment Program (CEAP)  efforts, the Commissioner of the Internal Revenue  Service should:  (8) Clearly document the intended benefits of ongoing  efforts to address identified problems, and the process  for measuring and tracking actual benefits.  (9) Develop a plan and timeline for implementing the  CEAP contractor’s recommendations on possible ways  to improve the (a) selection of correspondence audit  workload and (b) allocation of resources between  providing telephone assistance and reviewing taxpayer  correspondence. (3) through (5) IRS will review current  documentation and ensure there is a clear  link establishing the correspondence audit  program objectives and measures with the  overall IRS goals and objectives. Officials  also said they will update official guidance as  warranted. Actions on these three  recommendations are due by March 2016.  Supporting documentation on timeframes for  specific actions related to these  recommendations is pending. (6) IRS will thoroughly document the original  plan development process. Action on this  recommendation is due by March 2016.  Supporting documentation on timeframes for  specific actions related to these  recommendations is pending.
Report: IRS Correspondence Audits: Better  Management Could Improve Tax Compliance and  Reduce Taxpayer Burden, GAO-14-479 (Washington,  D.C.: June 5, 2014).
Open recommendations  agreement data into accounts.
Report: 2013 Tax Filing Season: IRS Needs to Do More  to Address the Growing Imbalance between the Demand  for Services and Resources, GAO-14-133 (Washington,  D.C.: Dec. 18, 2013).
Status   since the agency changed its installment  agreement program, it has decided to  evaluate those changes before exploring  whether adopting our recommendation will  yield increased efficiencies and lower costs  without adversely impacting tax  administration. IRS officials stated they will  provide a status update in October 2015.
To increase the effectiveness of IRS’s examinations of  individual tax returns, the Commissioner of the Internal  Revenue Service should:  (1) Transcribe data from paper-filed Form 1040  Schedules C and E that are not currently transcribed and  make those data available to Small Business and Self- Employed division (SB/SE) examiners for classification. If  IRS has evidence that the costs related to transcribing all  such data on Schedules C and E are prohibitive, IRS  could do one or both of the following actions: (a)  transcribe less data by transcribing only the missing data  for selected line items, such as certain, large expense  line items; or (b) develop a budget proposal to fund an  initiative for transcribing Schedule C and E.
As of March 2015, IRS agreed to study:  (1) whether to increase data transcription of  additional tax return information as GAO  recommended in May 2013. The agency also  agreed to study whether to use more data  from electronically-filed returns. IRS's study is  scheduled to be completed by November  2015, and is expected to weigh the benefits to  the agency and the impacts on taxpayers who  file returns electronically. (2) expanding the use of electronic data to  enhance return classification while weighing  the benefits of increased information against  the risks of potential impacts to electronic  filing. (2) Make all data collected from electronically submitted  Form 1040s available to examiners conducting  classification.
Report: Tax Administration: IRS Could Improve  Examinations by Adopting Certain Research Program  Practices, GAO-13-480 (Washington, D.C.: May 24,  2013).
The Commissioner of Internal Revenue should:  (1) Outline a strategy that defines appropriate levels of  telephone and correspondence service and wait time,  and lists specific steps to manage service based on an  assessment of time frames, demand, capabilities, and  resources. (1) IRS has taken steps to modify services  provided to taxpayers, but has not yet  developed a strategy outlining IRS’s customer  service goals. (2) Tailor appropriate and timely interventions with  taxpayers who file balance due returns by pilot testing  risk-based approaches that could include (a)  implementing the Advanced Consolidated Data Analytics  plan, and (b) using more data-driven methods to identify  the most appropriate method for contacting a taxpayer.
Report: 2012 Tax Filing: IRS Faces Challenges  Providing Service to Taxpayers and Could Collect  Balances Due More Effectively, GAO-13-156  (Washington, D.C.: Dec. 18, 2012). (2) IRS agreed with our December 2012  recommendation to pilot more risk-based  approaches for contacting taxpayers who  have a balance due. However, IRS has  reported that because that project was not  funded, it used an alternative model to  conduct analysis. IRS implemented its  updated model in late April 2014. In October  2014, IRS reported that better (more  productive) cases will be assigned to select  work streams. Further, in January 2015, IRS  officials said they will be placing revised  models into production in fiscal year 2015.
Open recommendations  To help ensure that IRS uses its examination resources  efficiently, the Commissioner of the Internal Revenue  Service should:  (1) Document and analyze the results of examinations  involving the Small Employer Health Insurance Tax  Credit to identify how much of those results are related to  the credit versus other tax issues being examined, what  errors are being made in claiming the credit, and when  the examinations of the credit are worth the resource  investment.
Status   (1) As of October 2014, SB/SE analyzed a  statistical sample of 2010 examination results  for the Small Employer Health Insurance Tax  Credit. As a result of the research, SB/SE  concluded that the findings do not justify  selecting a specific number of returns for  examination with the Credit as the primary  issue. Instead, they will identify issues as part  of the normal classification process, and  prepare guidelines for classifiers to reference  when selecting returns for examination. (2) Related to the above analysis of examination results  on the credit, identify the types of errors with the credit  that could be addressed with alternative approaches,  such as soft notices.
Report: Small Employer Health Tax Credit: Factors  Contributing to Low Use and Complexity, GAO-12-549  (Washington, D.C.: May 14, 2012). (2) As of October 2014, IRS told us that Math  Error Authority, fully implemented in January  2014, addresses many of the common errors  claiming the Credit. Therefore, there is not an  immediate need for alternative approaches,  such as soft notices. However, IRS will still  consider alternatives.
The Commissioner of the Internal Revenue Service  should:  (1) Develop a new refund timeliness measure and goal to  more appropriately reflect current capabilities. (1) As of October 2014, IRS has yet to  develop a new refund timeliness measure.  However, IRS has taken steps to identify the  number of days it takes to issue a refund in  addition to the percentage of refunds received  in daily increments from 5 to 60 days. (2) Complete an Internet strategy that (a) provides a  justification for the implementation of online self-service  tools, and includes an assessment of providing online  self-service tools that allow taxpayers to access and  update elements of their account online; (b)  acknowledges the cost and benefits to taxpayers of new  online services; (c) sets the time frame for when the  online service would be created and available for  taxpayer use; and (d) includes a plan to update the  strategy periodically. (2) IRS has made progress in improving its  Internet online services strategy. In  September 2012, IRS provided us with an  updated version of that strategy. However,  IRS still needs to take a number of steps to  more fully develop its long-term online  strategy. As of February 2015, IRS officials  reported that it does not have a separate  online services strategy.
Report: 2011 Tax Filing: Processing Gains, but  Taxpayer Assistance Could Be Enhanced by More Self- Service Tools, GAO-12-176 (Washington, D.C.: Dec. 15,  2011).
Open recommendations  questions, upcoming outreach, and description of the  letter ruling process.
Status   coordination. However, IRS officials said they  share with external stakeholders the general  timeframes for upcoming guidance.
Report: Information Reporting: IRS Could Improve Cost  Basis and Transaction Settlement Reporting  Implementation, GAO-11-557 (Washington, D.C.: May  19, 2011).
To gain efficiencies and improve taxpayer service, the  Commissioner of Internal Revenue should direct the  appropriate officials to:  (1) Determine a customer service telephone standard,  and the resources required to achieve this standard  based on input from Congress and other stakeholders. (2) Assess business units’ needs for holding Contact  Analytics calls beyond 45 days and store calls for this  period or document that the costs of doing so exceed the  benefits. (1) As of August 2014, IRS’s position  remained that its measure of telephone  service does not need to be revised and the  current process for establishing IRS  telephone plans is sufficient. However, we  continue to believe that a telephone standard  would serve as a means of communicating to  Congress and others what IRS believes  would constitute good service. (3) Establish a performance measure for taxpayer  correspondence that includes providing timely service to  taxpayers.
Report: 2010 Tax Filing Season: IRS’s Performance  Improved in Some Key Areas, but Efficiency Gains Are  Possible in Others, GAO-11-111 (Washington, D.C.:  Dec. 16, 2010). (2) IRS disagreed with this recommendation.  As of August 2014, IRS officials continue to  maintain that increasing the recorded call  storage beyond 45 days would not be a low  cost effort. However, we continue to believe  that storing calls for extended periods would  allow IRS to better identify trends and  taxpayer concerns, thus offsetting the costs. (3) IRS agreed with this recommendation and  started using more detailed performance  measures that includes an  overaged/timeliness measure for its  correspondence beginning in fiscal year  2011. However, in April 2014, we reported  that overaged correspondence increased  from 25 to 47 percent; thus, we continue to  believe that elevating this measure to IRS’s  suite of balanced measures would help  provide more visibility and ultimately better  service.
Open recommendations  To gauge the extent of 1099-MISC payer noncompliance  and its contribution to the tax gap, we recommend that  the Commissioner of the Internal Revenue Service, as  part of future research studies:  (1) Develop an estimate of 1099-MISC payer  noncompliance.
Status   (1) According to IRS, developing such an  estimate requires a multi-pronged approach  and a large amount of coordinated effort. As  of September 2014, IRS estimates results will  be available in December 2015. (2) Determine the nature and characteristics of those  payers that do not comply with 1099-MISC reporting  requirements so that this information can be factored into  an IRS-wide strategy for increasing 1099-MISC payer  compliance. (2) IRS researchers are collecting data on  1099-MISC reporting as part of its National  Research Program study on employment  taxes, a program that involves examinations  of a sample of tax returns expected to  culminate in 2015. As of September 2014,  IRS estimates results will be available in  December 2015.
Report: Tax Gap: IRS Could Do More to Promote  Compliance by Third Parties with Miscellaneous Income  Reporting Requirements, GAO-09-238 (Washington,  D.C.: Jan. 28, 2009).
section_title: Appendix V: Comments from the Internal Revenue Service
section_title: Appendix VI: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact named above, Brian James, Assistant Director;  Sonya Phillips, Analyst-in-Charge; Courtney Liesener, Robert MacKay,  James R. White, and Nell Williams made major contributions to the  report. Robert Gebhart, Kirsten Lauber, Donna Miller, Edward  Nannenhorn, Karen O’Conor, Andrew Stephens, and James Wozny also  provided assistance.