Small Businesses: Tax Compliance Benefits and Opportunities to Mitigate Costs on Third Parties of Miscellaneous Income Reporting Requirements
Published: 2010-11-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Third parties, often businesses, reported more than $6 trillion in miscellaneous income payments to the Internal Revenue Service (IRS) in tax year 2006 on Form 1099-MISC. Payees are to report this income on their tax returns. It has been long known that if these payments are not reported on 1099-MISCs, it is less likely that they will be reported on payee tax returns. In 2010, the reporting requirements were expanded to cover payments for goods and payments to corporations, both previously exempt, beginning in 2012. This testimony summarizes recent GAO reports and provides information on (1) benefits of the current requirements in terms of improved compliance by taxpayers and reduced taxpayer recordkeeping, (2) costs to the third-party businesses of the current 1099-MISC reporting requirement, and (3) options for mitigating the reporting burden for third-party businesses. GAO has not assessed the expansion of 1099-MISC reporting to payments for goods.
section_title: What GAO Found
paragraphs: Information reporting is a powerful tool for encouraging voluntary compliance by payees and helping IRS detect underreported income. Also, information reporting may sometimes reduce taxpayers' costs of preparing their tax returns, although by how much is not known. IRS estimated that $68 billion of the annual $345 billion gross tax gap for 2001, the most current available estimate, was caused by sole proprietors underreporting their net business income. A key reason for this noncompliance was that sole proprietors were not subject to tax withholding and only a portion of their net business income was reported to IRS by third parties. The benefits from information reporting are affected by payers' compliance with reporting requirements and IRS's ability to use the information in its process that matches third-party data with tax returns. However, IRS does not have estimates of the number or characteristics of payers that fail to submit 1099-MISCs as required. To improve its use of 1099-MISC information, IRS has collected data to help identify ways to refine its matching process and select the most productive cases for review, as GAO recommended in 2009. Current 1099-MISC requirements impose costs on the third parties required to file them. The magnitude of these costs is not easily estimated because payers generally do not track these costs separate from other accounting costs. In nongeneralizable case studies conducted in 2007 with four payers and five vendors that file information returns on behalf of their clients, GAO was told that existing information return costs were relatively low. One small business employing under five people told GAO of possibly spending 3 to 5 hours per year filing Form 1099 information returns manually, using an accounting package to gather the information. Two vendors reported prices for preparing and filing Forms 1099 of about $10 per form for 5 forms to about $2 per form for 100 forms, with one charging about $0.80 per form for 100,000 forms. However, these prices did not include clients' recordkeeping costs. Payers face a variety of impediments preparing and submitting 1099-MISC forms, including complex rules and an inconvenient submission process. For example, payers must determine whether payees are incorporated, must get the payees' taxpayer identification number, and must use special forms if filing on paper. A variety of options exist for mitigating the costs of filing Form 1099-MISC. Most have pros and cons. IRS has already exempted payments, including those paid by credit card, which will be reported to IRS by other means. Other options include improving IRS guidance and education; adding a check-the-box question to business tax forms that would force return preparers to ask their clients whether they have complied with 1099-MISC reporting requirements; waiving late submission penalties for first-time payers; raising the payment reporting threshold; initially limiting the types of payments covered; having IRS develop an online filing capability; and allowing paper filers to submit computer-generated black and white 1099-MISCs rather than IRS's printed forms.
section_title: What GAO Recommends
paragraphs: GAO is not making new recommendations in this testimony. In 2009, GAO suggested that Congress consider requiring payers to report service payments to corporations. GAO did not study reporting of payments for goods. Other prior GAO recommendations included ways for IRS to improve its use of 1099-MISC information received. IRS agreed with six of eight recommendations and is taking action to address them.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the effects on small businesses of  filing third-party information returns with the Internal Revenue Service  (IRS) reporting various payments. Payees are responsible for reporting  payments they received from the third-party payers as income on their tax  returns. This income is labeled miscellaneous income and reported by the  third parties on Form 1099-MISC. IRS matches the third-party information  returns with payees’ tax returns to ensure that payees are accurately  reporting their income and paying any tax. Third parties reported more  than $6 trillion in payments for tax year 2006 on Forms 1099-MISC.
Information reporting by third parties is a proven approach for improving  taxpayer compliance with the tax laws and for minimizing taxpayers’ costs  of complying. However, such reporting imposes a cost on the third parties.  Consequently, there is a trade-off. Our tax system shifts some of the costs  of tax administration to the third parties and gains improved compliance  and reduced compliance costs for taxpayers.
This trade-off is illustrated by the requirement for additional reporting of  miscellaneous income. Section 9006 of the Patient Protection and  Affordable Care Act requires expanded information reporting to include  payments to corporations and payments of amounts in consideration of  property and gross proceeds. For payments after December 31, 2011, every  person engaged in a trade or business would be required to file a Form  1099-MISC reporting aggregate annual payments of more than $600 to any  individual or corporate payee for the purchase of goods or services.  Currently, information reporting is only required for payments for services  and only to payees who are not incorporated. Concerns have been  expressed about the costs that the additional reporting will impose on  businesses. The Joint Committee on Taxation estimates that eliminating  the new requirement would result in revenue loss of approximately $19  billion from 2012 to 2020 from increased taxpayer noncompliance.
In 2009, we suggested that Congress consider requiring payers to report  service payments to corporations on the Form 1099-MISC, but we have not  assessed or recommended expanding 1099-MISC reporting to payments for  goods. As early as 1991, we determined that the benefits in terms of  increased tax revenue and voluntary taxpayer compliance would exceed  the costs of extending 1099-MISC reporting to corporate payments. IRS  agreed that the benefits of eliminating the corporate exemption for service  payments outweigh the costs, and the Bush Administration had proposed  legislation extending the reporting requirements to service payments to  corporations. The Obama Administration had similar proposals in its fiscal  year 2010 and 2011 budget requests.
Because of the debate about the cost imposed by the new requirement,  you asked us to summarize our prior reports on what is known about the  costs and compliance benefits of information reporting, particularly 1099- MISC reporting. More specifically, our objectives are to describe (1) what  is known about the benefits of the current requirements in terms of both  improved compliance by taxpayers and reduced taxpayer recordkeeping  and other costs, (2) what is known about the costs to the third-party  businesses of the current 1099-MISC reporting requirement, and (3) what  opportunities are available to mitigate the reporting burden for third-party  businesses. The reports we summarize in this statement did not assess the  expansion of 1099-MISC reporting to payments for goods.
My testimony today is based on three reports on information reporting by  third parties. We used multiple methodologies to develop our findings for  these reports. We conducted structured interviews with four organizations  volunteered through International Accounts Payable Professionals or the  National Federation of Independent Businesses, an organization of small  businesses that was on record as finding the information reporting  proposals we studied to be troublesome to small businesses. We also  selected five companies from lists of vendors, IRS-approved electronic  filers, and Information Reporting Program Advisory Committee members,  enough to include representatives of software vendors, service bureaus,  and return preparers and cover a sizable percentage of all information  returns. These nine case studies provide examples of costs related to  1099s, including 1099-MISCs, but are not representative of the general  population of payers and are not to be generalized. We interviewed IRS  officials and members of IRS advisory groups, tax professionals, and tax  software and information return filing vendors to identify impediments  facing payers in preparing and submitting 1099-MISCs. In addition, we  reviewed IRS documents and compliance data. We conducted our work  for these three reports in accordance with generally accepted government  auditing standards. A more detailed discussion of scope and methodology  is available in each of the three reports.
subsections: section_title: Background
paragraphs: As we reported in 2009, more than 5 million third parties submitted more  than 82 million miscellaneous income information forms (Form 1099- MISC) to the IRS reporting more than $6 trillion in payments for tax year  2006. Third-party payers are businesses, governmental units, and other  organizations that make payments to other businesses or individuals.  Payers must submit payment information on 1099-MISCs to IRS when they  make a variety of payments labeled miscellaneous income. Payees, or  those being compensated, are required to report the payments on their  income tax returns.
The types of payments reportable on a Form 1099-MISC—shown in figure  1—and their reporting thresholds vary widely. Under existing law,  information reporting is required for payments by persons engaged in a  trade or business to nonemployees for services of $600 or more (called  nonemployee compensation), royalty payments of $10 or more, and  medical and health care payments made to physicians or other suppliers  (including payments by insurers) of $600 or more. However, personal  payments, such as a payment by a homeowner to a contractor to paint his  or her personal residence, are not required to be reported because these  payments are not made in the course of a payer’s trade or business.  Existing regulations also exempt certain payments to a corporation,  payments for merchandise, wages paid to employees, and payments of  rent to real estate agents. The expansion of information reporting to  payments to corporations and for merchandise will apply to payments  payments  made after December 31, 2011.  made after December 31, 2011.
Payers must provide 1099-MISC statements to payees by the end of  January. Payers submitting fewer than 250 1099-MISCs may submit paper  forms, which are due to IRS by the end of February. Payers submitting  paper 1099-MISCs are required to use IRS’s official forms or substitute  forms with special red ink readable by IRS’s scanning equipment.  Photocopies and copies of the 1099-MISC form downloaded from the  Internet or generated from software packages in black ink do not conform  to IRS processing specifications. Payers submitting 250 or more 1099- MISCs are required by IRS to submit the forms electronically. Most 1099- MISCs for tax year 2006 were submitted electronically. However, most  payers submitted small numbers of 1099-MISCs, and most payers  submitted paper 1099-MISCs.
By matching 1099-MISCs received from payers with what payees report on  their tax returns, IRS can detect underreporting of income including  failure to file a tax return. Figure 2 shows the automated process IRS uses  to detect mismatches between nonemployee compensation and other  payments reported on 1099-MISCs and payees’ income tax returns. The  Nonfiler program handles cases where no income tax return was filed by a  1099-MISC payee. The Automated Underreporter (AUR) program handles  cases where a payee filed a tax return but underreported 1099-MISC  payments. AUR’s case inventory includes payee mismatches over a certain  threshold, and IRS has a methodology using historical data to select cases  for review. AUR reviewers manually screen the selected cases to  determine whether the discrepancy can be resolved without taxpayer  contact. For the remaining cases selected, IRS sends notices asking the  payee to explain discrepancies or pay any additional taxes assessed.
section_title: 1099-MISC Information Reporting Increases Voluntary Taxpayer Compliance, Reduces the Cost and Intrusiveness of IRS Compliance Programs, and May Reduce Payees’ Costs of Preparing Their Tax Returns
paragraphs: Third-party information reporting is widely acknowledged to increase  voluntary tax compliance in part because taxpayers know that IRS is  aware of their income. As shown in figure 3, voluntary reporting  compliance is substantially higher for income subject to withholding or  information reporting than for other income. For example, for wages and  salaries, which are subject to withholding and substantial information  reporting, taxpayers have consistently misreported an estimated 1 percent  of their income. For income with little or no information reporting, the tax  year 2001 estimated percentage was about 54 percent. IRS has long  recognized that if payments made to businesses are not reported on 1099- MISCs, it is less likely that they will be reported on payee tax returns.
In a 2007 report we highlighted the connection between a lack of  information reporting and the contribution of sole proprietors, a  significant portion of the small business community, to the tax gap. IRS  estimated the gross tax gap—the difference between what taxpayers  actually paid and what they should have paid on a timely basis—to be $345  billion for tax year 2001, the most recent estimate made. IRS also  estimated that it will collect $55 billion, leaving a net tax gap of $290  billion. IRS estimated that a large portion of the gross tax gap, $197 billion,  was caused by the underreporting of income on individual tax returns. Of  this, IRS estimated that $68 billion was caused by sole proprietors  underreporting their net business income. The $68 billion does not include  other sole proprietor contributions to the tax gap, including not paying  because of failing to file a tax return, underpaying the tax due on income  that was correctly reported, and underpaying employment taxes. Nor does  it include tax noncompliance by other types of businesses such as  partnerships and S corporations. In the report, we noted that a key reason  for this noncompliance was that sole proprietors were not subject to tax  withholding, and only a portion of their net business income was reported  to IRS by third parties. Tax noncompliance by some small businesses is  unfair to businesses and other taxpayers that pay their taxes—tax rates  must be higher to collect the same amount of revenue.
The 1099-MISCs are a powerful tool through which IRS can encourage  voluntary compliance by payees and detect underreported income of  payees that do not voluntarily comply. Increasing the numbers of 1099- MISCs IRS receives from payers in turn would increase information  available for use in IRS’s automated matching programs to detect tax  underreporting, including failure to file a tax return. For tax year 2004 (the  last full year available for our 2009 report), the AUR program assessed  $972 million in additional taxes for payee underreporting detected using  1099-MISC information. To help IRS improve its use of 1099-MISC  information, we recommended in 2009 that IRS collect data to help refine  its matching process and select the most productive cases for review. In  response to our recommendation, IRS reviewed a sample of AUR cases  and plans to modify its tax year 2010 matching criteria for 1099-MISC  information.
Information reporting has allowed IRS to use its computerized matching  programs as an alternative to audits to address some issues. The matching  programs generally require less contact with taxpayers and thus are less  intrusive and involve less taxpayer time.
In addition, information reporting may reduce taxpayers’ costs of  preparing their tax returns. In a 2006 report we described how additional  information reporting on the basis of securities transactions could reduce  taxpayers’ need to track the basis of securities they sold. The extent to  which 1099-MISC reporting reduces taxpayer recordkeeping costs is not  known, but to the extent it reduces the need to track receipts by year from  each payer it could have some effect on those costs.
IRS does not know the magnitude of 1099-MISC payer noncompliance or  the characteristics of payers that fail to comply with the reporting  requirements. Without an estimate of payer noncompliance, IRS has no  way of determining to what extent 1099-MISC payer noncompliance  creates a window of opportunity for payees to underreport their business  income and go undetected by IRS. Research would be key for IRS in  developing a cost-effective strategy to identify payers that never submit  1099-MISCs. In 2009, we recommended that IRS study the extent of 1099- MISC payer noncompliance and its contribution to the tax gap, as well as  the nature and characteristics of those payers who do not comply. In  response to our recommendations, IRS plans to study payer  noncompliance through its National Research Program studies with  results estimated to be available in December 2015.
section_title: Third Parties Incur Costs to File 1099- MISCs, but Case Study Entities Reported That the Costs of Complying with Current Requirements Were Relatively Low
paragraphs: Existing information reporting requirements impose costs on the third- party businesses required to file Form 1099-MISC. The expanded reporting  requirements will impose new costs. To comply with information  reporting requirements, third parties incur costs internally or pay external  parties. In-house costs may involve additional recordkeeping costs beyond  normal recordkeeping costs related to running a business, as well as the  costs of preparing and filing the information returns themselves. If the  third parties go outside their organizations for help, they would incur out- of-pocket costs to buy software or pay for others to prepare and file their  returns.
Data on the magnitude of these information reporting costs are not readily  available because taxpayers generally do not keep records of the time and  money spent complying with the tax system. A major difficulty in  measuring tax compliance costs, including the costs of filing information  returns, is disentangling accounting and recordkeeping costs due to taxes  from the costs that would have been incurred in the absence of the federal  tax system. Data on compliance costs are typically collected by contacting  a sample of taxpayers, through surveys or interviews, and asking them for  their best recollection of the total time and money they spent on particular  compliance activities. The quality of the resulting data depends on the  ability of taxpayers to accurately recall the amount of time and money  they spent.
In the nine case studies we conducted in 2007, filers of information returns  told us that existing information return costs, both in-house and for  external payments, were relatively low. While these nine case studies are  not to be generalized to the entire population, they do provide examples of  costs and insights from the perspective of organizations of different sizes  and from different industries and of organizations filing their own  information returns and those filing on behalf of others. In-house  compliance costs include the costs of getting taxpayer identification  numbers (TIN), buying software, tracking reportable payments, filing  returns with IRS, and mailing copies to taxpayers.
One organization with employees numbering in the low thousands  estimated that its costs of preparing and filing a couple hundred Forms  1099, which include recordkeeping and distinguishing goods from  services, were a minimal addition to its normal business costs.
One small business employing under five people told us of possibly  spending 3 to 5 hours per year filing Form 1099 information returns  manually, using an accounting package to gather the information.
An organization with more than 10,000 employees estimated spending less  than .005 percent of its yearly staff time on preparing and filing Forms  1099, including recordkeeping.
Unit prices for services provided to payers by selected software vendors,  service bureaus, and return preparers decreased as the number of forms  handled increased. Two external parties selling services reported prices  for preparing and filing Forms 1099 with IRS of about $10 per form for 5  forms to about $2 per form for 100 forms, with one of them charging about  $0.80 per form for 100,000 forms. These prices do not include the payers’  recordkeeping costs.
This relationship of price to size for entities we studied is consistent with  what studies that we have seen show about the role of fixed costs and  economies of scale in complying with the tax code; we are familiar with no  similar studies of information returns.
Although our case study organizations indicated that 1099 recordkeeping  and reporting costs are relatively low, costs may not be as low as they  could be. According to IRS, advisory group members, and others we  interviewed for our 2009 report, payers are confronted with a variety of  impediments to preparing and submitting 1099-MISC forms. Some payers  that do not submit their 1099-MISCs as required may be unaware of their  1099-MISC reporting responsibilities. Other payers may be confused about  whether payments are reportable because of different dollar reporting  thresholds and the general exemption for payments to corporations under  current law. Some payers misreport or neglect to report payee taxpayer  identification numbers (TIN) and could be subject to penalty and required  to do backup withholding on 1099-MISC payments to payees with bad  TINs. For the large number of payers each submitting a few 1099-MISCs,  IRS does not offer a fillable form on its Web site and requires payers to  submit scannable red ink forms, but some payers submit black and white  1099-MISCs anyway.
section_title: Opportunities Exist to Mitigate the Burden and Promote Reporting Compliance for Third Parties Submitting 1099-MISC Information Returns
paragraphs: Although businesses will face additional costs for each additional Form  1099, some options for modifying the 1099-MISC reporting requirements  could help mitigate the burden and promote payer reporting compliance.  Table 1 highlights options we previously reported. We noted those options  that were proposed by IRS, IRS advisory groups, and the National  Taxpayer Advocate. Our list of 1099-MISC impediments and options is  not exhaustive, nor is the list of pros and cons associated with the options.  Improved IRS guidance and education are relatively low-cost options, but  most taxpayers use either tax preparers or tax software to prepare their  tax returns and may not read IRS instructions and guidance. While  taxpayer service options may improve compliance for those that are  inadvertently noncompliant, they are not likely to affect those that are  intentionally noncompliant. Some options to change 1099-MISC reporting  requirements require congressional action, and other options would be  costly for IRS to implement. Where the option involves particular issues,  such as cost or taxpayer burden, we note them in our table.
As we reported in 2009, multiple approaches could help IRS to mitigate the  reporting costs and promote payer compliance with 1099-MISC reporting  requirements. For example, the evidence shows that the benefits  outweigh the costs for information reporting for payments to  corporations. For other options, it is not clear whether the benefits  outweigh the associated costs, and additional research by IRS could help  to evaluate the feasibility of more costly options, such as allowing black  and white paper 1099-MISCs. Action to move forward on options to target  outreach to specific payer groups or clarify guidance to reduce common  reporting mistakes would hinge on IRS first conducting research to  understand the magnitude of and reasons for payer noncompliance.
In 2009, we recommended two actions that IRS could take to help payers  understand their 1099-MISC reporting responsibilities:    Provide payers with a chart to identify reportable payments. IRS disagreed  with our recommendation and stated that the Form 1099-MISC  instructions already list which payments are reportable and explain the  rules for specific payment types. We believe that a chart would provide  taxpayers with a quick guide for navigating the Form 1099-MISC  instructions, already eight pages long under the current reporting  requirements.
Evaluate adding a new checkbox on business tax returns for payers to  attest whether they submitted their 1099-MISCs as required. IRS also  disagreed with this recommendation and stated that a similar question was  removed from the corporate tax return after the Paperwork Reduction Act  of 1980 was enacted. We believe results from the evaluation we  recommend would be useful in weighing the benefits and burdens  associated with a checkbox option.
To reduce the submission burden facing many payers submitting small  numbers of 1099-MISCs, we also recommended that IRS evaluate the cost- effectiveness of eliminating or relaxing the red ink requirement to allow  payers to submit computer-generated black and white 1099-MISCs. In  April 2009, IRS conducted a test to determine the labor to process a  sample of 4,027 red-ink 1099-MISCs versus the same documents  photocopied. IRS told us that, using the same scanning equipment and  employees, the red-ink sample took 2 hours and 9 minutes to process  versus 28 hours and 44 minutes to process and manually key the  photocopy sample. Based on the test results, IRS decided to maintain the  red ink requirement to minimize labor costs. We have not reviewed the  results of the IRS test.
Our prior work did not assess requiring 1099-MISC reporting on payments  for goods. Some of our findings and recommendations may be relevant,  but we do not know the extent of relevance.
Madam Chair, this concludes my statement. I would be pleased to respond  to any questions you or other Members of the Committee may have.
section_title: GAO Contacts and Acknowledgments
paragraphs: For questions about this statement, please contact me at (202) 512-9110 or  whitej@gao.gov. Contact points for our Offices of Congressional Relations  and Public Affairs may be found on the last page of this statement.  Individuals who made key contributions to this testimony include Amy  Bowser, Bertha Dong, Lawrence Korb, MaryLynn Sergent, and Cheri  Truett.
section_title: Related GAO Products
paragraphs: Tax Gap: IRS Could Do More to Promote Compliance by Third Parties  with Miscellaneous Income Reporting Requirements. GAO-09-238.  Washington, D.C.: January 28, 2009.
Tax Gap: Actions That Could Improve Rental Real Estate Reporting  Compliance. GAO-08-956. Washington, D.C.: August 28, 2008.
Highlights of the Joint Forum on Tax Compliance: Options for  Improvement and Their Budgetary Potential. GAO-08-703SP. Washington,  D.C.: June 2008.
Tax Administration: Costs and Uses of Third-Party Information Returns.  GAO-08-266. Washington, D.C.: November 20, 2007.
Business Tax Reform: Simplification and Increased Uniformity of Taxation  Would Yield Benefits. GAO-06-1113T. Washington, D.C.: September 20,  2006.
Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis  Would Improve Compliance if Related Challenges Are Addressed.  GAO-06-603. Washington, D.C.: June 13, 2006.
Tax Policy: Summary of Estimates of the Costs of the Federal Tax System.  GAO-05-878. Washington, D.C.: August 26, 2005.
Tax Administration: IRS Should Continue to Expand Reporting on Its  Enforcement Efforts. GAO-03-378. Washington, D.C.: January 31, 2003.
Tax Administration: Benefits of a Corporate Document Matching Program  Exceed the Costs. GAO/GGD-91-118. Washington, D.C.: September 27,  1991.
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