Tax Compliance: Opportunities Exist to Improve Tax Compliance of Applicants for State Business Licenses
Published: 2009-06-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The California Department of Industrial Relations, Division of Labor Standards Enforcement (DLSE), requires applicants for California business licenses in three industries--farm labor contracting, garment manufacturing, and car washing and polishing--to be in compliance with federal employment tax obligations to qualify. Based on questions about whether the Internal Revenue Service (IRS) is fully using data from state and local governments to reduce the tax gap, GAO was asked to analyze (1) the extent to which requiring a demonstration of federal tax compliance to qualify for a state business license has the potential to improve federal tax compliance and (2) what opportunities exist for increasing arrangements that require federal tax compliance to qualify for state business licensing. To address these objectives, GAO analyzed IRS administrative and tax data. GAO identified California as a case study. GAO interviewed IRS and state officials and contacted revenue officials in the 50 states and the District of Columbia.
section_title: What GAO Found
paragraphs: The California requirement that three types of businesses be in compliance with federal employment taxes to obtain a state business license shows promise as a valuable tool for improving federal tax compliance. According to data from IRS, of 7,194 businesses that applied for a California business license one or more times from calendar years 2006 through 2008 about 24 percent had to file employment tax returns or pay overdue taxes to come into compliance with federal employment taxes. California businesses filed 441 employment tax returns and IRS collected nearly $7.4 million in current dollars in employment taxes in calendar year 2006 and in 8 months of calendar year 2007. GAO estimated that IRS incurred about $331,348 to operate the data-sharing arrangement for this period. Using this cost estimate, the ROI for this arrangement is 22:1. IRS has not tracked the cost data needed to compare the ROI of the IRS-DLSE enforcement activity with other current enforcement activities. However, IRS's highest estimated ROI among five new direct revenue-producing enforcement initiatives proposed in its fiscal year 2009 budget was 11.4:1. Tax compliance among businesses after they applied for state business licenses showed continued improvement. GAO identified 2,017 businesses that applied for business licenses in calendar year 2006 only and found that 315 of these businesses had unpaid assessments as of September 18, 2006. By August 18, 2008, 165 of these businesses had resolved or lowered their unpaid assessment debt by $1,925,162. All but 1 of the 350 businesses that had unpaid assessments when they applied for business licenses in calendar year 2006 were small businesses. GAO's analysis, although showing a promising ROI, did not take into account certain factors, such as whether other tax collection activities were in process for the businesses that applied for licenses. Many opportunities exist to require federal tax compliance to qualify for state business licenses. GAO contacted revenue officials in every state and the District of Columbia to ask whether their states require tax compliance for business licenses. For the 48 respondents, 20 revenue officials said that their states require compliance with state taxes to obtain a state business license, and that these requirements exist for one or more industries. Twenty said that their states do not have such a requirement; 8 said that their states have no business license requirement at the state level. According to IRS, arrangements exist with 13 states that require compliance with one or more federal taxes to qualify for a state business license. Varying licensing requirements from state to state and lack of uniformity among states in categorizing a license as a "business license" make pinpointing the exact number of opportunities difficult. States that currently require compliance with state taxes for selected business license applicants may represent more of an immediate opportunity for establishing arrangements that require federal tax compliance to qualify for a state business license since they already see tax compliance as important for the businesses. Some challenges, such as a lack of current legal authority in some states to link businesses to tax compliance, would need to be addressed if requiring federal tax compliance for state business licenses is to be expanded.

section_title: Letter
paragraphs: Sharing data between federal and state agencies can be a cost-effective  way to improve tax compliance by uncovering information that helps  identify businesses and individuals that are noncompliant with their  taxes. According to Internal Revenue Service (IRS) studies, small  businesses with cash incomes contribute significantly to the 2001  estimated gross tax gap of $345 billion. IRS operates a wide variety of  data-sharing arrangements with state revenue and nonrevenue agencies  designed to improve tax compliance among individuals and businesses. In  one type of arrangement, IRS and state agencies share information about  businesses that apply for state business licenses.  Under this arrangement,  an individual applying for a business license from the state is required to  be in compliance with federal tax obligations, state tax obligations, or both  before the state issues a business license. Some state tax and IRS officials  believe this type of data sharing has the potential to benefit both IRS and  state governments since the businesses would need to initiate contact with  IRS or state revenue agencies to demonstrate compliance. If the  businesses cannot demonstrate compliance, they are then required to  come into compliance to qualify for a business license.
The Department of the Treasury’s 2006 Comprehensive Strategy for  Reducing the Tax Gap recognizes the potential benefits of increased  coordination with state governments to improve compliance and reduce  the tax gap. It envisions improved document-matching programs and  federal-state partnerships as a means to reduce the tax gap. In fact, we  found that federal and state partnerships that involve reciprocal  agreements covering collection of unpaid tax debts benefited both  governments, and the use of levies and offsets showed even greater  potential for collecting millions in unpaid debts. In fiscal year 2004, for  example, although most states submit only personal income tax debt and  not business income tax debt to the Financial Management Service (FMS)  for collection, FMS still collected over $217 million on behalf of various  states through offsets of federal income tax refunds to pay state income  tax debt. Conversely, IRS received over $77 million from states’ levy of  state income tax refunds to pay delinquent federal taxes.
You have raised questions about whether IRS is fully using data from state  and local governments to reduce the tax gap. Related to this interest, and  at your request, we issued a report in November 2008 on the State Reverse  File Match Initiative (SRFMI) pilot program, which matches federal and  state taxpayer data to identify noncompliant federal taxpayers. You also  requested that we assess a data-sharing arrangement between IRS and the  California Department of Industrial Relations, Division of Labor Standards  Enforcement (DLSE). Under this arrangement, applicants for California  business licenses in three industries—farm labor contracting, garment  manufacturing, and car washing and polishing—must be in compliance  with federal employment tax obligations to qualify. You asked us to  analyze (1) the extent to which requiring a demonstration of federal tax  compliance to qualify for a state business license has the potential to  improve federal tax compliance and (2) what opportunities exist for  increasing arrangements that require federal tax compliance to qualify for  state business licensing.
To determine the extent to which requiring a demonstration of federal tax  compliance to qualify for a state business license has the potential to  improve federal tax compliance, we used the IRS and State of California  data-sharing arrangement as a case study. To determine the potential for  improving federal tax compliance, we estimated the return on investment  (ROI) for the IRS Ogden/California DLSE data-sharing arrangement by  determining the amount collected and estimating the cost of operating the  arrangement. To determine the amount collected, we used IRS Ogden  spreadsheets that record the number of federal tax returns filed by  business license applicants and the amount IRS collected from businesses  that IRS informed that they were not in compliance with federal  employment taxes covering calendar year 2006 and 8 months in calendar  year 2007. To determine the cost of operating this data-sharing  arrangement, we estimated the costs of collecting the amounts owed by  noncompliant businesses using actual cost categories provided by IRS  Ogden officials. We then compared the ROI ratio for this data-sharing  arrangement to IRS’s estimates for five revenue-producing enforcement  initiatives in the IRS fiscal year 2009 budget submission. To determine  whether California businesses remained in compliance over time, we  matched data on California business applicants from an Access database  maintained by IRS Ogden with taxpayers in IRS’s Unpaid Assessments  file. We used California business applicants for calendar year 2006 only  from the Access database and taxpayers in IRS’s Unpaid Assessments file  as of the week of September 18, 2006, and the week of August 18, 2008. We  reviewed agency agreements and memoranda, regulations, and reports  covering the data-sharing arrangement and interviewed IRS and California  officials about the compliance value of the arrangement. The Access  database did not contain data prior to calendar year 2006 because IRS  Ogden purged these historical data. While data from previous years would  be useful for evaluating the data-sharing arrangement, we believe that the  Ogden records that were available to us were sufficiently reliable for  developing an understanding of the arrangement. We did not verify the  accuracy of the data IRS provided or its estimate of the revenue costs of  its five new activities, including the estimated ROI of these activities.
To determine what opportunities exist for increasing data sharing that  requires federal business tax compliance to qualify for state business  licensing, we contacted state revenue officials in 50 states and the District  of Columbia via e-mail about the extent to which their states engage in  data-sharing arrangements that require applicants to be tax compliant to  qualify for business licenses, reviewed and identified IRS documentation  on data-sharing arrangements between IRS and state agencies that require  federal tax compliance to qualify for state business licensing, and  interviewed state revenue officials whose states engage in data-sharing  arrangements that require businesses to demonstrate federal tax  compliance to qualify for state business licenses.
We conducted this performance audit from June 2007 through June 2009 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
subsections: section_title: Background
paragraphs: IRS engages in hundreds of data-sharing arrangements with state revenue,  human services, and law enforcement agencies for tax compliance and  other purposes. In a small portion of IRS’s federal-state data-sharing  arrangements, states require federal tax compliance to qualify for a state  business license. In some instances, state licensing agencies require  compliance with both federal and state tax obligations, and requirements  can vary among states. These arrangements can vary by industry; by type  of taxes required for compliance, such as employment taxes or income  taxes; and even by the type of documentation required to prove  compliance. For example, in some states the businesses may self-certify  that they are in compliance with taxes, and in others businesses must  provide documentation from IRS or the state revenue agency that they are  in compliance with tax requirements.
IRS and California’s DLSE are engaged in an arrangement that requires  compliance with federal employment taxes to operate a business in any  one of three industries in California. An individual applying for a new  business license or a renewal of his/her business license to operate a farm  labor contracting, garment manufacturing, or car washing and polishing  business must first prove full compliance with federal employment taxes  by filing all required federal employment tax returns and resolving all  outstanding federal employment taxes through full payment or appeal.  Each business license applicant in the three industries requiring federal  tax compliance must submit a state business license application and a  signed IRS Form 8821, Tax Information Authorization, allowing IRS to  disclose the applicant’s tax information to DLSE. IRS tax examiners in  Ogden, Utah, review the tax information in IRS’s Integrated Data Retrieval  System (IDRS) to check the employment tax status of the applicant. If  the applicant is compliant, IRS provides DLSE and the applicant with a  statement that the applicant has met all filing and payment requirements.  If the applicant has an outstanding employment tax liability, has not filed a  federal employment tax return, or both, the tax examiner prompts the  system to generate a noncompliance letter, which is sent to the applicant.  Applicants with outstanding tax liability can pay the amounts due or  contact the IRS tax examiners for more information or to make  arrangements for payment. IRS officials told us that IRS Ogden does not  collect employment taxes from business applicants directly. Noncompliant  business applicants may pay federal employment taxes they owe at local  IRS offices or mail their payments to IRS. Ogden officials are notified by e- mail or phone when business applicants have paid the employment taxes  identified in the noncompliance letter. IRS informs DLSE that an applicant  has paid all employment taxes, is currently working with a revenue officer  to pay all balances due, or is otherwise compliant. After notification, DLSE  will issue the applicant’s business license.
DLSE officials told us that for purposes of business licensing, California  business applicants in the three industries have resolved their taxes if they  have (1) paid their tax liability, (2) entered into installment agreements, or  (3) completed offers in compromise with IRS. If an applicant’s tax case is  in bankruptcy, California’s DLSE makes the decision on whether to issue  the business license. If an applicant does not resolve his/her tax liability  within 90 days of applying, IRS staff in Ogden send the cases to the IRS  Agricultural Team in Fresno, where tax examiners open the case and do  investigative work on collecting the balance due. See figure 1 on how data  sharing between IRS and California operates.
Section 6103 of the Internal Revenue Code (I.R.C.) prohibits the disclosure  of tax returns and return information by IRS employees; other federal  employees, state employees, or both; and certain others having access to  the information except in specifically enumerated circumstances. Data  sharing between IRS and California DLSE is authorized by a subsection of  I.R.C. § 6103. Specifically, section 6103(c) authorizes IRS to disclose the  return information of a taxpayer to any other person at the taxpayer’s  request. State licensing entities that wish to review federal tax  information or have IRS attest to tax compliance before issuing the license  would need to require the applicant to provide a written request to IRS  authorizing release of the information to the licensing entity.
section_title: Data-Sharing Arrangement Requiring Tax Compliance of California Business License Applicants Can Be a Valuable Compliance Tool
paragraphs: The data-sharing arrangement between IRS Ogden and California DLSE  can be a valuable tool for improving compliance among certain  businesses. According to IRS officials, this type of data-sharing  arrangement has mutual benefits for IRS, by increasing filing and payment  compliance with federal employment taxes, and for states, by minimizing  concerns about the success of the business and its compliance with  unemployment requirements. IRS officials noted that growth in this data- sharing arrangement can generate many compliance benefits with a  relatively minimal resource allocation. According to a California DLSE  official, this data-sharing arrangement is beneficial because it helps to  ensure that businesses are competent and responsible and pay their taxes.
The amount of revenue in federal employment taxes collected through this  data-sharing arrangement appears to outweigh the cost of operating the  data-sharing arrangement. Thousands of California businesses apply for a  business license each year in order to operate a business in the three  industries previously mentioned, and must provide documentation to  DLSE to show that they are in compliance with federal employment taxes.  Many of these businesses were not in compliance with employment taxes  during the time of our analysis and, therefore, had to file tax returns or pay  employment taxes to rectify their compliance status. According to the IRS  Ogden database on business applicants, 7,194 businesses applied for a  business license in the three industries one or more times from calendar  years 2006 through 2008 and requested that IRS provide California with  information on their compliance with federal employment taxes. About 24  percent of businesses (i.e., 1,726 of the 7,194 that applied) had to file  employment tax returns or pay or otherwise resolve overdue taxes to  come into compliance with federal employment taxes.
IRS staff in Ogden use spreadsheets to track the number of federal tax  returns filed by noncompliant California business license applicants and  the amounts IRS collected from these businesses that are attributable to  the data-sharing arrangement. The spreadsheets show that businesses not  in compliance with federal employment taxes when they applied for  California business licenses filed hundreds of tax returns in calendar years  2006 and 2007 and IRS collected millions in federal employment taxes.  California businesses filed 441 employment tax returns to come into  compliance to qualify for California business licenses and IRS collected  nearly $7.4 million in employment taxes, according to IRS Ogden  spreadsheets. IRS Ogden officials told us that the nearly $7.4 million in  employment taxes collected represents the amount business applicants  paid after receiving noncompliance letters related to their DLSE business  license applications. Table 1 shows the number of tax returns filed and the  amount IRS collected from these applicants during calendar years 2006  and 2007.
Even though IRS did not track all of the costs it incurred for operating the  data-sharing arrangement, IRS officials noted that the arrangement  resulted in high revenues relative to costs. In order to get some  perspective on how this data-sharing arrangement compares with other  IRS enforcement efforts, we developed an estimate of the costs of the  arrangement using cost categories provided and confirmed by IRS  officials. The cost categories we considered included personnel costs and  nonpersonnel costs, such as computers, telephones, and fax machines.
We estimated that IRS incurred about $331,348 to operate the data-sharing  arrangement in calendar years 2006 and 2007. Our cost estimate included  personnel costs of about $202,125 in pay and about $61,042 in benefits for  one General Schedule (GS) 5 clerk and two GS 7 tax examiners. We also  included about $10,197 for three computers, $1,237 for one dedicated  printer, $313 for one fax machine with a dedicated line and two dedicated  phone lines with voice mail boxes, and approximately $56,435 for supplies,  facilities, utilities, and supervision. These costs may be somewhat  overstated because, for instance, we used approximate purchase costs for  equipment and did not spread those costs over the useful life of the  equipment or other uses of the equipment.
Using our estimate, the ROI for this data-sharing arrangement is 22:1. IRS  has not tracked the cost data needed to do a study comparing the ROI of  the IRS Ogden/DLSE enforcement activity with those of other current  enforcement activities to determine how the IRS Ogden/DLSE data-sharing  arrangement ROI compares with those of IRS’s other enforcement  activities. However, IRS has developed ROI estimates for five new direct  revenue-producing enforcement initiatives it proposed in its fiscal year  2009 budget submission. IRS estimates that the average ROI for these  activities at full performance (at the end of their second year of  implementation) will be 7.1:1. IRS projects the highest ROI for one of the  five new initiatives (expanded document matching) at 11.4:1. IRS officials  told us that IRS calculates the ROI each year for the revenue-producing  initiatives included in the President’s budget request. They also said that  these ROI calculations are based on historical information in the  Enforcement Revenue Information System and the annually updated unit  cost rates used in budget formulation. We did not verify the accuracy of  the data IRS provided or its estimate of the revenues and costs of its five  new enforcement activities, including the estimated ROI of these activities.
subsections: section_title: Tax Compliance among Businesses Showed Improvement after They Applied for State Business Licenses
paragraphs: We identified the 2,017 businesses that applied for business licenses in  calendar year 2006 only, and found that 315 of these businesses had  unpaid assessments at the time of applying and that tax compliance  improved for these 315 businesses. We identified the businesses that  applied for a California business license in 2006 only so that we could  follow the tax compliance of this set of specific businesses over time. We  matched data of California business license applicants for calendar year  2006 from the IRS Ogden Access database with IRS’s Unpaid Assessments  file at two points in time—for the week of September 18, 2006, and the  week of August 18, 2008.
Our analysis of California business license applicants matched against the  IRS Unpaid Assessments file database showed that 315 businesses owed  employment taxes as of September 18, 2006, and by August 18, 2008, 165 of  those businesses had resolved or lowered their unpaid assessment debt.  The 165 businesses resolved or lowered their 2006 unpaid assessments in  either calendar year 2007 or 2008. Our analysis also revealed that 150  businesses had not resolved or reduced unpaid assessment debt by August  18, 2008. Table 2 shows business license applicants with unpaid  assessments as of September 18, 2006, and businesses that resolved/did  not resolve their debt by August 18, 2008.
The 165 businesses resolved or lowered their unpaid assessments by  nearly $2 million—$1,925,162—from the weeks of September 18, 2006,  through August 18, 2008. The 115 business license applicants that  completely resolved their debt before August 18, 2008, resolved nearly  $800,000 in unpaid tax assessments in calendar years 2007 and 2008.  These applicants, in total, had a nearly $800,000 tax liability as of  September 18, 2006, but the unpaid assessments file showed no tax  liability for them as of the week of September 18, 2008. Fifty additional  businesses lowered their tax assessments from the weeks of August 18,  2006, through September 18, 2008, by $1,135,216. However, the 165  businesses may have resolved more than $1,925,162 because these  taxpayers may have had additional taxes assessed after the week of  September 18, 2006, and may have resolved them before the week of  August 18, 2008. Our analysis compares unpaid assessments at two points  in time since the data file we used did not allow us to track weekly  changes in the businesses’ unpaid assessments. Table 3 shows the amount  of unpaid tax assessments as of the week of September 18, 2006, and as of  the week of August 18, 2008, and the amount of unpaid employment tax  assessments resolved by the 165 businesses.
All but 1 of the 350 businesses that had unpaid assessments when they  applied for business licenses in calendar year 2006 were small businesses.  The remaining business was a medium or large business. According to IRS,  “small businesses” includes businesses with assets of less than $10 million.
The IRS Ogden/California DLSE data-sharing arrangement can be a  valuable compliance tool because the requirement to renew business  licenses annually provides a motivation to resolve tax debts timely. The  arrangement may help flag unpaid tax assessments when they are recent  and have a greater likelihood of collection. Our previous work found that  the age of the unpaid assessment is an indicator of the extent to which the  outstanding amounts owed are likely to be collected. This work showed  that the older an unpaid assessment the lower the probability it will be  paid. In another report, we found that the IRS records we examined  showed that 70 percent of all unpaid payroll taxes—estimated at $58  billion as of September 30, 2007—were owed by businesses with more  than a year (4 tax quarters) of unpaid federal payroll taxes. Over a quarter  of unpaid federal payroll taxes were owed by businesses that accumulated  tax debt for more than 3 years (12 tax quarters). One reason why older  debts may not be collected is that they lead to large and increasing  amounts of accrued interest and penalties. The requirement that annual  business license renewals depend on resolving unpaid employment tax  assessments may help businesses avoid the pyramiding of interest and  penalties.
The ROI for these enforcement activities can vary depending on factors  such as the efficiency of operating the data-sharing arrangements and  whether the data-sharing arrangements experience higher collections in  the early years of operation. For example, an IRS official suggested that  there may be a way to more efficiently operate this type of data-sharing  arrangement and thereby obtain a higher ROI. Applying an automated  filter to isolate business applicants with no taxes due, IRS staff would only  need to manually review data on businesses with balances due or that  have not filed required returns, and fewer IRS staff may be needed to  operate the data-sharing arrangement. An IRS official in Ogden told us that  the taxes collected by the IRS Ogden/California DLSE data-sharing  arrangement about 10 years ago were substantially higher because there  was very little compliance when the data-sharing arrangement first started.  This official recalled that when the program was transferred to Ogden the  numbers of noncompliant applicants were at least three or four times  higher than they are now. In this official’s view, consistency in enforcing  the business tax compliance requirement of the three industries has  steadily improved compliance and has resulted in fewer business  applicants that are noncompliant with their employment tax obligations  when they apply for business licenses.
section_title: A More Complete Evaluation Could Further Isolate and Quantify the Benefits and Costs of the Business Licensing Requirement
paragraphs: Given that our analysis indicates that the California business licensing  requirement likely has a higher ROI than the direct revenue-producing  enforcement initiatives IRS proposed in its 2009 Congressional budget  submission, a fuller examination is warranted. A more complete  evaluation could address some potential factors that could reduce or  increase the ROI we calculated. For example, it could evaluate whether  IRS had taken other enforcement actions against the California businesses  at the same time as they were applying for licenses. If IRS had sent  collection notices to the businesses or taken other enforcement action at  or close to the time the businesses went through the licensing reviews, the  resolution of their debts might be attributable to those enforcement  actions. A more complete evaluation could also compare the results of this  enforcement approach to the results for similar businesses that were not  subject to the business licensing requirement. Such an analysis could help  demonstrate how well the business licensing requirement fares compared  to the “normal” enforcement actions that would be taken by IRS with  similarly situated businesses. A more complete evaluation could take into  account the resolution of debts that may have been incurred before a  business applied for a license. Since the affected businesses know they  must resolve their employment tax debts in order to receive business  licenses, some may pay or otherwise resolve their debts in anticipation of  the licensing review by IRS. Any such advance payments or resolutions  could be included.
Similarly, although our tracing of businesses’ compliance from calendar  years 2006 to 2008 shows improvement in the resolution of many firms’  debt, a more complete evaluation could compare their improvement to  similarly situated businesses that were not subject to the licensing  requirement. Such a comparison would help show whether this continued  improvement in the delinquent debts was better than what could have  occurred absent the licensing requirement.
During the period we reviewed, Ogden staff responsible for the business  licensing reviews discarded older operational data when they were no  longer needed for their purposes. Further, a few months of data were lost  even before they would have normally been discarded. Although these  data may not be needed to administer the program, they are needed to  support a more complete review of the program’s ROI.
section_title: Many Opportunities Exist to Require Federal Tax Compliance to Qualify for State Business Licenses, but Challenges Exist
paragraphs: We contacted revenue officials in every state and the District of Columbia  to ask whether their states have business licensing requirements and, if so,  whether they require demonstration of state tax compliance before  business licenses are granted. Of the 47 states and the District of  Columbia that responded, 20 revenue officials told us that the states  require demonstration of compliance with one or more state taxes for  businesses to qualify for state business licenses, and these requirements  exist for one or more industries. Based on these responses, the tax  compliance requirement is typically limited to a few industries, requires  compliance with selected taxes, and varies on the amount of  documentation required to show compliance with tax requirements. Table  4 summarizes responses on the number of states that require businesses to  be tax compliant to qualify for state business licenses in one or more  industries as of April 6, 2009.
Of the 19 states and the District of Columbia that require business  applicants to be compliant with state taxes, only the District of Columbia  requires applicants in all industries to be state tax compliant to qualify for  business licenses. Nineteen states require business license applicants in  one or more industries to be state tax compliant to qualify for business  licenses.
Most of the states that responded do not require compliance with three  types of taxes, employment, income, or sales and use, except for the  District of Columbia, which requires compliance with all three types of  taxes. Of the 19 states that identified compliance with state taxes to  qualify for a state business license, 15 identified the specific type of tax or  taxes being reviewed. Seven states require compliance with their  employment taxes, 8 states require compliance with state sales and use  taxes, and 10 states require compliance with state income taxes. State  requirements also vary in the amount and kind of documentation required  to prove compliance with tax requirements. For example, Rhode Island  allows businesses to self-certify that they are in compliance with state tax  requirements. Pennsylvania requires licensing agencies to request  verification of state tax compliance from the state tax agency when a  business owner applies for or renews a license.
subsections: section_title: Federal Tax Compliance Requirements to Qualify for State Business Licenses Differ by State
paragraphs: IRS maintains information on data-sharing arrangements that include  requirements for federal tax compliance to qualify businesses for state  business licenses. According to an IRS document, 13 data-sharing  arrangements exist that require compliance with federal taxes to qualify  for state business licenses. For example, the State of Oregon requires  farm/forest labor contractors comply with federal and state taxes to  qualify for state business licenses. Each farm/forest labor contractor  applicant must submit IRS Form 8821 with the application. In addition,  applicants can be denied licenses if state and federal taxes are owed.  Similarly, the State of Connecticut requires applicants for gaming licenses  to be compliant with federal and state income taxes to qualify for business  licenses. Applicants for gaming licenses must submit complete copies of  their most recent federal and state income tax returns and certify that  there are no outstanding tax delinquencies or unresolved disputes.
section_title: Officials See Benefit in Requiring Tax Compliance to Qualify for Business License but Acknowledge That Challenges Exist
paragraphs: While most states told us that they do not track tax collections and  program costs associated with these data-sharing arrangements, those  revenue officials that provided comments and participate in data-sharing  arrangements requiring state tax compliance told us that the state  arrangements improve state tax collections and promote voluntary  compliance. For example, a revenue official said that data sharing is used  as another tool to collect outstanding taxes due the state. This official also  said that the data-sharing arrangement has been very effective in  furthering the state’s tax collection efforts. He added that without a  license, a business cannot operate. Another state revenue official told us  that the individual or business must keep all state tax obligations current  in order to prevent the denial or revocation of the applicable license. In  this official’s view, this causes the affected individuals or businesses to be  less likely to have delinquent returns and outstanding tax bills that are not  on payment agreements. Our analysis shows that 19 states and the District  of Columbia allow the taxpayer to obtain a business license if the taxpayer  sets up a payment agreement with the state’s revenue agency.
IRS staff in Ogden told us that requiring tax compliance makes the  businesses think about the consequences of not being tax compliant. They  added that the data-sharing arrangement itself becomes a deterrent after a  while, since businesses, for which IRS is checking compliance, learn that  they cannot get licenses without being compliant.
While some state revenue officials see benefit in requiring tax compliance  to qualify for a business license, they recognize certain challenges their  agencies face from linking state business licensing with tax compliance.  One of the challenges is coordination between state agencies. For  example, a revenue official said that obtaining key information from state  agencies, such as tax identification numbers and licensee names, and  acting on her agency’s request to suspend the licenses are ongoing  challenges. A 2008 state study noted that agency coordination is crucial to  the success of any tax clearance program. In order for the program to be  effective, each agency must be prepared to share information with other  agencies and to act on information received from other agencies. Finally,  states also face technical issues with linking tax compliance with business  licensing. For example, a revenue official said that her state does not have  electronic linking between its Division of Alcoholic Beverages and  Tobacco and the Department of Revenue for verification of applicant sales  and use tax information. This official also said that the challenge would be  to link their present licensing computer system with the Department of  Revenue system. Another official said that her agency’s computer  programs vary, are outdated, and are not integrated.
Some challenges identified by states likely would be especially important  for any expansion of requirements for federal tax compliance to obtain  state business licenses. For example, some of the revenue officials we  contacted identified legal issues relating to data sharing. A state revenue  official said that various licensing statutes do not permit the revocation or  threat of action against a licensee due to tax noncompliance. An additional  revenue official said that with limited resources, implementing the legal  requirement to review licenses is difficult.
section_title: Opportunities Exist to Expand Federal Tax Compliance Requirements to Qualify for State Business Licenses
paragraphs: The potential to increase data-sharing opportunities between IRS and state  business licensing entities exists, but pinpointing the exact number of  opportunities is difficult. According to the Small Business Administration,  business licensing requirements vary from state to state. For example, a  state “business license” is the main document required for tax purposes  and conducting other basic business functions. However, some states have  separate licensing requirements based on the product sold, such as  licenses to sell liquor, lottery tickets, gasoline, or firearms. Ultimately, it is  up to each state to determine what industries, occupations, and  professions must be licensed and the licensure requirements that  applicants must meet.
Some states and some business types may represent more of an immediate  opportunity for establishing arrangements that require federal tax  compliance to qualify for state business licenses. States that currently  require compliance with state taxes for selected business license  applicants may be more amenable to requiring federal tax compliance than  states that do not even require state tax compliance since they already  recognize tax compliance as important for the businesses. For example,  North Carolina, Texas, and Missouri have a requirement for tax  compliance with state taxes for retail sales businesses. These states do not  require compliance with federal taxes. In addition, states that currently  require compliance with federal employment taxes may be amenable to  extending the requirement to include federal income taxes. For example,  California’s DLSE requires applicants for the three industries requiring  licensing to be compliant with federal employment taxes only. California’s  garment manufacturing, farm labor contracting, and car washing and  polishing license applicants have no requirement to be in compliance with  federal income taxes to qualify for business licenses.
section_title: Conclusions
paragraphs: Increasing data sharing between IRS and state governments to help reduce  the tax gap can be beneficial to IRS when such data-sharing arrangements  demonstrate firm compliance value. Data-sharing arrangements requiring  tax compliance among business license applicants show real potential to  be a valuable tool to improve tax compliance among certain businesses.  Our estimated ROI of the data-sharing arrangement between IRS Ogden  and California DLSE suggests that requiring tax compliance to qualify for  state business licenses can be a cost-effective way of collecting tax debt.  In fact, the data-sharing arrangement’s estimated ROI is higher than the  estimated ROI for the new direct revenue–producing tax enforcement  initiatives in IRS’s fiscal year 2009 budget submission. However, a more  complete evaluation could take into account all the factors that could  affect ROI. To be in a better position to evaluate these data-sharing  arrangements, IRS needs to ensure that program data are retained.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Commissioner of Internal Revenue take the  following three actions:    Collect and retain the cost and revenue data needed to develop ROI  estimates for programs requiring businesses to demonstrate federal  tax compliance to obtain state business licenses.
Evaluate the ROI of existing arrangements where states require federal  tax compliance to qualify for state business licenses to determine  whether the ROI of these programs is sufficient to merit their  expansion.
To the extent that existing data-sharing arrangements have a  sufficiently high ROI, coordinate with states to expand requirements to  comply with federal taxes to qualify for state business licenses and  monitor the ROI of these expansions to gauge their success.
section_title: Agency Comments
paragraphs: On behalf of the Commissioner of Internal Revenue, the Deputy  Commissioner for Services and Enforcement provided written comments  on a draft of this report in a June 8, 2009, letter. The Deputy Commissioner  agreed with our recommendations. IRS plans to gather appropriate data to  develop ROI estimates for this program, evaluate the results to determine  whether these programs merit expansion, and if so, work with states to  expand the programs.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 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. This  report will also be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-9110 or brostekm@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix II.
section_title: Appendix I: Scope and Methodology
paragraphs: Our objectives were to analyze (1) the extent to which requiring a  demonstration of federal tax compliance to qualify for a state business  license has the potential to improve federal tax compliance and (2) what  opportunities exist for increasing arrangements that require federal tax  compliance to qualify for state business licensing. This report focuses on  data-sharing arrangements that require compliance with federal or state  tax obligations to qualify for state business licensing. We did not include  licensing requirements at the local level or licensing for professions or  occupations.
To provide background on data-sharing arrangements that require  compliance with tax obligations to qualify for state business licensing, we  reviewed relevant Internal Revenue Service (IRS) and California  Department of Industrial Relations, Division of Labor Standards  Enforcement (DLSE) documents and interviewed IRS and California  officials. We also reviewed laws and regulations related to taxpayer  disclosure.
To determine the extent to which requiring a demonstration of federal tax  compliance to qualify for a state business license has the potential to  improve federal tax compliance, we used the IRS and State of California  data-sharing arrangement as a case study. To determine the potential for  improving federal tax compliance, we estimated the return on investment  (ROI) for the IRS Ogden/California DLSE data-sharing arrangement. To  determine the amount collected, we used IRS Ogden/California DLSE  spreadsheets that record the number of federal tax returns filed by  applicants for business licenses in the three industries and the amount IRS  collected from businesses that were notified by IRS that they were not in  compliance with federal employment taxes covering calendar year 2006  and 8 months in calendar year 2007. Spreadsheet data for calendar year  2007 excluded 4 months. Ogden misplaced data for July and August, and  data for November and December were not available when we obtained  the data in November 2007. We also reviewed agency agreements and  memoranda, regulations, and reports covering the data-sharing  arrangement between IRS and California DLSE and interviewed IRS and  California officials about the value of the data-sharing arrangement to IRS  and the state.
To determine the cost of operating this data-sharing arrangement, we  estimated the costs of collecting the amounts owed by noncompliant  businesses using actual cost categories provided by IRS Ogden officials.  We used the guidance for preparing agency budgets in Executive Office of  the President, Office of Management and Budget, Circular A-11,  Preparation, Submission, and Execution of the Budget, and our Cost  Estimating and Assessment Guide: Best Practices for Developing and  Managing Capital Program Costs, GAO-09-3SP (Washington, D.C.: March  2009). We estimated personnel costs using the Office of Personnel  Management Salary Table 2009-RUS, for the locality pay area “of rest of  U.S.,” effective January 2009, for General Schedule (GS) 5 and 7 personnel  at step 5. We used step 5 to capture the midpoint of the GS 5 and 7 grade  levels so as not to bias pay in the direction of a low or high estimate. We  estimated the cost of benefits for these employees using the Department  of Labor’s Bureau of Labor Statistics 30.2 percent average compensation  cost for calendar year 2008. We estimated the cost of fax machines and  printers by averaging the costs for these items as shown on the Web sites  for federal government customers of two leading manufacturers of these  products. We shared our estimates with IRS officials to obtain  concurrence with our estimates of nonpersonnel costs. We did not analyze  the taxes IRS may collect or the costs it may incur after the noncompliant  cases leave Ogden. We then compared the ROI ratio for this data-sharing  arrangement to IRS’s estimates for five revenue-producing enforcement  initiatives in the IRS fiscal year 2009 budget submission. The Ogden  Service Center sends information on the taxpayers that have unpaid  assessments 90 days after Ogden first receives their application materials  to the Fresno Service Center for collection.
To determine whether California businesses remained in compliance over  time, we matched data on California business applicants from an Access  database maintained by IRS Ogden with taxpayers in IRS’s Business  Master File Unpaid Assessments file. We selected the businesses that  according to the Access database, applied for California DLSE business  licenses in calendar year 2006 only—that is, applied in calendar year 2006  and did not reapply in calendar year 2007 or in the 10 months in 2008 for  which we have IRS Ogden DLSE Access database data. The Access  database contained January 2006 through October 2007 data on business  license applicants in the three covered industries. For our analysis, we  matched records of the California businesses that we selected from the  Access database because they applied in calendar year 2006 only with  IRS’s Unpaid Assessments file as of the weeks of September 18, 2006, and  August 18, 2008; identified the number of businesses with unpaid  assessments and the amounts of their tax debt as of the week of  September 18, 2006; and identified the applicants for business licenses in  2006 only that had resolved their unpaid assessments as of August 18,  2008, and the amounts of their tax debt they resolved. Our analysis  compares unpaid assessments at two points in time since the data file we  used did not allow us to track weekly changes in the businesses’ unpaid  assessments. We could not follow the tax compliance of earlier applicants  into the present because IRS Ogden purged data from the Access database  for calendar years earlier than 2006. Unpaid assessments in this report  include the total tax assessment plus interest and penalties where these  exist.
To determine what opportunities exist for increasing data sharing for  arrangements that require federal tax compliance to qualify for state  business licensing, we (1) analyzed and summarized which states and the  District of Columbia have data-sharing arrangements that require state tax  compliance to qualify for state business licensing, which states do not  have such arrangements, and which states do not require businesses to  obtain business licenses on the state level; (2) contacted revenue officials  in 50 states and the District of Columbia via e-mail with structured  questions about the extent to which their states engage in data-sharing  arrangements that require demonstration of tax compliance before  business licenses are granted; and (3) sent a follow-up e-mail to 21 state  revenue officials who confirmed that their states require applicants to be  compliant with state taxes to qualify for business licenses, by requesting  information on the amount of taxes collected, the costs associated with  operating the data-sharing arrangements, and benefits of these data- sharing relationships to the states. Three states did not respond to our  structured questions about the extent to which their states engage in data- sharing arrangements that require demonstration of tax compliance before  businesses qualify for business licenses. We also (1) summarized IRS  information on existing data-sharing arrangements between IRS and state  agencies that require compliance with federal taxes to qualify for state  business licensing, (2) interviewed IRS officials to determine which states  have state licensing requiring federal tax compliance, and (3) reviewed IRS  documentation on data-sharing arrangements between IRS and state  agencies that require businesses to demonstrate federal tax compliance to  qualify for state business licensing.
Our review was subject to some limitations. We did not verify the accuracy  of the data IRS provided or its estimate of the revenues and costs of its  five new enforcement activities, including the estimated ROI of these  activities. IRS Ogden’s Access database on California business applicants  did not contain data prior to calendar year 2006 because IRS Ogden  purged these historical data. While data from previous years would be  useful for evaluating the data-sharing arrangement, we believe that the  Ogden records that were available were sufficient to attain an  understanding of the potential value of this arrangement as a compliance  tool. The IRS Ogden spreadsheet used to track the number of federal tax  returns filed by noncompliant California business license applicants and  the amount IRS collected from these businesses attributable to the data- sharing arrangement did not contain data for the months of July, August,  November, and December 2007. We acknowledge that data for the entire  calendar year of 2007 would affect the number of tax returns filed and the  amount IRS collected from applicants during those months. Our estimate  of the cost of IRS and California’s data-sharing arrangement may be  somewhat overstated because, for instance, we used approximate  purchase costs for equipment and did not spread those costs over the  useful life of the equipment or other uses of the equipment and used  calendar year 2009 costs. Additionally, our analysis did not address some  other potential factors that could reduce, or increase, the ROI we  calculated. We did not verify the responses from the states about tax  compliance to qualify for state business licenses. We recognize that the  state revenue officials may not be knowledgeable about all of their states’  requirements for tax compliance to qualify for business licenses, but they  are a credible source of information about state tax compliance to qualify  for state business licenses.
We conducted this performance audit from June 2007 through June 2009 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contact named above, Signora J. May, Assistant Director;  Amy R. Bowser; Jennifer K. Echard; Amy C. Friedlander; Arthur L. James,  Jr.; Stuart M. Kaufman; Edward J. Nannenhorn; Lou V. B. Smith; Jessica  Thomsen; and James J. Ungvarsky made key contributions to this report.