Tax Administration: Tax Requirements of Small Businesses
Published: 1999-08-24T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO provided information on small business tax requirements, focusing on: (1) the federal filing, reporting, and deposit requirements that apply to small businesses; and (2) the actual experience of small businesses in meeting these requirements, including their involvement in the Internal Revenue Service's (IRS) enforcement process.
section_title: What GAO Found
paragraphs: GAO noted that: (1) small businesses, like large businesses, are subject to multiple layers of filing, reporting, and deposit requirements; (2) GAO identified more than 200 different IRS requirements that potentially apply to small businesses; (3) through such requirements, IRS administers a variety of tax policies--notably those associated with income, employment, and excise taxes; (4) in considering the implications of the number of requirements, it is important to recognize that the requirements reflect the many decisions that have been made by Congress and the executive branch to accomplish their policy goals, including those that might benefit small businesses and other taxpayers; (5) it is equally important to recognize that most businesses do not need to comply with all or even most of these requirements; (6) the ones that apply to a particular small business would depend on how the business is organized, whether it has employees, and the nature of its business operations; (7) limitations on IRS' information systems prevented GAO from fully determining the extent to which small businesses filed the various forms and schedules or their involvement in key stages of IRS' enforcement processes; (8) IRS has acknowledged that these limitations hinder its ability to effectively manage small business activities and will continue to be a serious impediment until the systems are improved; (9) GAO was able to obtain and analyze limited data on small business filings of income tax forms and on some aspects of their involvement in IRS' enforcement processes; (10) GAO's analysis of IRS' 1995 data on the most commonly filed income tax forms and schedules showed that small businesses, on average, filed one secondary form in addition to their primary income tax return, with little variation among types of businesses; and (11) GAO's analysis of small business audits showed that the audit rate for small businesses is higher than the rate for all taxpayers and that about two-thirds of the audits of small businesses result in recommendations for assessment of additional taxes and penalties.

section_title: Letter
paragraphs: Small businesses—a category that includes all farmers and sole proprietorships and partnerships, S corporations, and corporations with assets of less than $5 million—are an important segment of taxpayers that are subject to substantial federal tax requirements. Not only do they account for nearly half of all taxes the Internal Revenue Service (IRS) collects annually, but they also have extensive interactions with IRS as they attempt to comply with their tax obligations.
Because of your interest in alleviating any unnecessary burden that the federal tax system places on small businesses, you asked us to assess the magnitude of the burden that complying with tax obligations imposes for these businesses. This report is the first of a series of reports to address your concerns. As agreed with your office, our objectives for this report were to determine (1) the federal filing, reporting, and deposit requirements that apply to small businesses and (2) the actual experience of small businesses in meeting these requirements, including their involvement in IRS’ enforcement processes.
subsections: section_title: Background
paragraphs: Businesses in the United States (including farmers) are generally structured in one of four forms: sole proprietorship, partnership, S corporation, and corporation. Each form of business has distinctive legal characteristics and different tax consequences. Corporations are taxed as corporations, with dividends included in the owner’s income; sole proprietors are taxed as individuals; and the income earned by S corporations and partnerships is passed through to their owners and taxed at the owners’ rates.
The Internal Revenue Code (IRC) distinguishes small businesses from larger businesses in a number of ways, and IRS has used different definitions of small business for different internal operating purposes. As part of its current reorganization effort, IRS has developed an agencywide definition of small business, which we used in our work. Based on that definition, small businesses include (1) all farmers and sole proprietorships and (2) partnerships, S corporations, and corporations that annually reported less than $5 million in assets.
A large majority of all businesses are small businesses. To illustrate, for tax year 1995, we used IRS data to identify approximately 23.4 million businesses that filed returns. Of this population, 94 percent of partnerships reported total assets of less than $5 million, and 98 percent of S corporations reported total assets of less than $5 million. About 97 percent of U.S. corporations reported assets of less than $5 million in 1995. Sole proprietorships accounted for approximately 16.3 million of the nearly 23.4 million business filers in 1995.
section_title: Scope and Methodology
paragraphs: To identify the federal filing, reporting, and deposit requirements that apply to small businesses, we examined information such as IRS forms, publications, manuals, and related IRC provisions. We also interviewed IRS officials who were cognizant of small business tax issues, including officials in IRS’ Office of Public Liaison and Small Business Affairs, Compliance Research Division, Appeals Division, and the Small Business/Self-Employed/Supplemental Income Team.
To help ensure completeness, we had knowledgeable IRS officials review our listing of IRS requirements. To develop a more comprehensive list of federal tax requirements that apply to small businesses, we contacted the Bureau of Alcohol, Tobacco, and Firearms (ATF) in the Department of the Treasury for information on requirements pertaining to the excise taxes that it administers. The ATF requirements apply generally to any business.
To determine the actual experience of small businesses in meeting their filing, reporting, and deposit requirements, including their involvement in IRS’ enforcement processes, we (1) interviewed IRS compliance officials specializing in examination, appeals, and collection issues to ascertain how small businesses are affected by the enforcement processes and (2) obtained some computerized information from IRS databases on the filing and enforcement experience of small businesses. This included data from IRS’ Statistics of Income Division, Audit Information Management System (AIMS), and Accounts Receivable databases. Throughout this review, we drew on our previous work at IRS and on tax administration issues in general.
Our work did not address IRS activities related to small businesses that had not filed returns. Also, we experienced several limitations during the course of our work because much of the data we sought were not collected in IRS’ information systems and databases or were not sufficiently reliable. To obtain and analyze the available data, we often had to rely upon sampling, matching, and ad hoc techniques. In addition, data were not available for a single year across all variables, so we had to use data from different years as needed. We did not verify the reliability of the IRS data we used except for some limited checking. Appendix I describes the data limitations we experienced in more detail.
We requested comments on a draft of this report from IRS. Their comments are reprinted in appendix IV. Our work was performed in accordance with generally accepted government auditing standards between September 1998 and May 1999 at IRS headquarters in Washington, D.C.
section_title: Small Businesses Face Multiple Layers of Tax Requirements
paragraphs: Small businesses, like large businesses, are subject to multiple layers of filing, reporting, and deposit requirements that reflect how the business is organized, whether it has employees, and the nature of its business operations. By our count, there are more than 200 requirements—which we grouped into four layers—that may apply to small businesses as well as larger businesses and other taxpayers. The requirements are designed to implement a variety of tax policies. They provide a way not only to collect taxes from businesses, but also to use businesses to collect taxes owed by third parties (e.g., withholding employees’ personal income tax and Social Security and Medicare (FICA) taxes).
It is highly unlikely that any business would need to complete all 200 requirements. This is because the forms, schedules, and other requirements that apply to a particular small business reflect how the business is organized, whether it has employees, and the nature of its business operations. Although a few of the requirements must be submitted more frequently than once a year, the vast majority are submitted annually. Appendix II provides a listing of all the requirements that we identified. They reflect the decisions of Congress and the executive branch in keeping with their policy goals and objectives.
subsections: section_title: Primary Income Tax Returns Represent One Layer of Requirements
paragraphs: The requirements with which a small business must comply depend upon how it is organized—sole proprietorship, partnership, S corporation, and corporation. Each business type has its own primary income tax return, some of which include a set of schedules embedded in the form. For example, the primary corporate income tax return, Form 1120, U.S. Corporation Income Tax Return, contains eight embedded schedules. To support their primary income tax return, certain types of businesses and individuals with business income must also attach a mandatory schedule to their return. (See table 1.) For example, sole proprietorships must file Form 1040, U.S. Individual Income Tax Return, and Schedule C, Profit or Loss From Business. As pass-through entities, partnerships and S corporations each have two separate sets of returns–one for the entity and one for its owners. In addition to the primary income tax return filed by the entity, each owner must file a Form 1040 and a Schedule E, Supplemental Income and Loss.
section_title: Employment Tax Adds Another Layer of Tax Requirements
paragraphs: A small business’ decision to hire employees adds a second layer of tax requirements. We identified 10 different federal employment tax deposit requirements that potentially apply to small businesses. The number of employment tax filings and deposits depends on the number of employees and the resulting employment tax liability owed at a particular time. (See table 2 and table II.2 in app. II.) For each employee, a small business is generally responsible for collecting and remitting several federal taxes with varying frequency stipulations–withholding for employees’ personal income tax and the employee’s share of FICA, the employer’s share of FICA, and federal unemployment tax (FUTA).
A small business employer must report quarterly the amount of personal income tax withheld and FICA taxes paid for employees on Form 941, Employer’s Quarterly Federal Tax Return. The employer must deposit employee income tax and FICA taxes withheld and the employer’s share of FICA taxes by mail or electronically either quarterly, monthly, semiweekly, or the next business day, depending on the employers’ tax liability. If total deposits of withheld income and FICA taxes were more than $50,000 in the second year preceding the current year, the employer must make electronic deposits using the Electronic Federal Tax Payment System (EFTPS). In addition, a small business employer must annually report and quarterly deposit FUTA taxes separately from FICA and withheld income tax. Lastly, an employer must send a federal Form W-2, Wage and Earnings Statement, to each of its employees and file federal Forms W-3, Transmittal of Wage and Tax Statements, and W-2 with the Social Security Administration. In sum, hiring employees—even just one employee—is a critical decision for small businesses in terms of their tax liability and the complexities of the tax administration processes that they face.
section_title: Offering Employee Benefits Adds a Third Layer of Requirements
paragraphs: The decision to offer employee pension, fringe, and welfare benefit plans adds another layer of requirements for a small business. Some benefit plans may substantially increase the number of filing requirements that small businesses face, while others are simplified and entail few, if any, filing requirements. We counted over 10 filing and reporting requirements pertaining to benefit plans, including requirements like the Form 5500 series and related schedules.
Certain pension plans are tailored to small businesses and self-employed individuals, offering them a tax-favored way to save for retirement. Simplified Employee Pensions (SEP), Savings Incentive Match Plans for Employees (SIMPLE), and Keogh plans offer small employers and self- employed individuals a deduction for contributions to the plan and deferral of tax on income of the plan. Generally, SEP and SIMPLE plans are less complex than Keogh plans, and while businesses must maintain records about the plans, they do not have any separate filing or reporting requirements with IRS. Keogh plans offer certain benefits not offered by SEP and SIMPLE, but they tend to be more complex and entail substantial filing and reporting requirements with IRS using Form 5500 and related schedules. In addition, most fringe and welfare benefit plans entail filing and reporting requirements with IRS using the Form 5500 series. (For a complete list, see table II.3 in app. II.)
section_title: Other Business Operations Add a Fourth Layer of Requirements
paragraphs: The remaining tax requirements that potentially apply to small businesses depend upon the nature of the business activities. A few of these requirements are specific to a type of business, but most are generally applicable to all businesses. For example, there are requirements that pertain to the depreciation of assets, the sale of business property, and claims for a credit to increase research activities. These requirements, of which there are nearly 140, range across income taxes, excise taxes, and information reporting. (For a complete list, see tables II.4, II.5, and II.6 in app. II.)
Some of these requirements are used to implement provisions in the Internal Revenue Code that can benefit small (and other) businesses. For example, businesses must complete Form 8861, Welfare-to-Work Credit, to receive a tax credit for hiring long-term family assistance recipients. Also, businesses must complete Form 4562 to claim deductions for depreciation and amortization of business assets or to make the election to immediately expense the cost of certain property. The election to expense property allows the taxpayer to take an immediate deduction instead of using the depreciation schedules to recover a portion of the costs annually over the property’s useful life. (The total cost that may be expensed is $18,500 for 1998.)
Among excise taxes alone, we identified about 70 requirements that potentially apply to small businesses. (For a complete list, see tables II.5 and II.6 in app. II.) Generally, though, most small businesses are not responsible for filing excise taxes. According to IRS, fewer than 800,000 small businesses filed excise tax returns in 1997. IRS and ATF administer many of the federal excise taxes. The excise taxes administered by IRS consist of several broad categories, 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. ATF administers excise taxes on the production, sale, or import of guns, tobacco, or alcohol products or the manufacture of equipment for their production.
section_title: Small Businesses’ Experience in Filing and Enforcement Processes Could Not Be Fully Determined
paragraphs: Limitations in IRS’ information systems prevented us from fully determining the extent to which small businesses actually filed various required forms and schedules and which businesses made deposits or the extent of small businesses’ involvement in IRS’ enforcement processes. We were, however, able to obtain and analyze limited data on small businesses’ filing of income tax forms and on some aspects of small businesses’ involvement in IRS’ enforcement processes.
The data limitations currently hinder IRS’ ability to effectively manage its activities and serve small businesses and, as IRS has acknowledged, will continue to be a serious impediment until the systems are improved. (For a more detailed discussion of IRS’ data limitations, see app. I.)
subsections: section_title: Filing Experience of Small Businesses
subsections: section_title: Income Tax
paragraphs: Although we weren’t able to obtain data on most types of requirements, we were able to obtain information pertaining to small business income tax requirements. Our analysis of 1995 IRS data for approximately 44 forms and 46 related schedules that IRS believes are those most commonly filed showed that small businesses, on average, filed one secondary form in addition to their primary income tax return, with little variation among the different types of business. The most commonly filed secondary income tax form among the 44 was Form 4562, Depreciation and Amortization. Approximately 74 percent of farmers, 62 percent of partnerships, 69 percent of S corporations, and 73 percent of corporations filed the depreciation and amortization form in 1995. The returns for sole proprietorships were lower, with slightly less than 40 percent filing the depreciation and amortization form in 1995.
The number of schedules small businesses submitted varied, depending on the type of business. This includes the mandatory schedules filed with the primary return by certain business types and individuals with business income as well as secondary schedules and other schedules embedded in the primary tax return. On average, sole proprietorships and corporations filed approximately three schedules, while farmers filed slightly less than three. Partnerships and S corporations filed more schedules than other types of businesses. Partnerships filed approximately 11 schedules, and S corporations filed approximately 6 schedules, on average, in 1995. The filing results are higher for partnerships and S corporations because of their unique structure as pass-through entities. Partnerships and S corporations must file a Schedule K-1, Partner’s or Shareholder’s Share of Income, with IRS for each partner or shareholder. As a result, Schedule K-1 filings accounted for a significant proportion of the multiple schedules filed by partnerships and S corporations in that year.
section_title: Employment Tax and Pensions
paragraphs: IRS did have information on federal employment taxes, but it could not be broken out by small businesses. Further, IRS did not have sufficient, reliable data on the number of small businesses that filed pension forms in 1995. We were able to obtain very limited disaggregated data on the number of pension forms filed in 1995. However, the results could not be projected to the larger population of small businesses.
We worked with IRS’ Employee Plans/Exempt Organizations Division to obtain a sample of the number of small businesses that filed Form 5500, using an employer identification number match. From a sample of 65,701 small business employer identification numbers, we matched 11,585 that filed Form 5500. The data indicated that 1,090 sole proprietorships, 824 partnerships, and 9,671 corporations filed forms from the Form 5500 series in 1995.
section_title: Enforcement Experience of Small Businesses
paragraphs: IRS had limited data on the extent to which small businesses are involved in both examination and collection activities. We obtained limited data on audit rates; duration; recommendations, such as refunds, no change, or changes recommended by IRS examiners; and appeals and petitions.
When IRS has indications that a small business may have failed to meet one or more of the aforementioned requirements, the business can become involved in IRS’ enforcement processes. These processes are basically the same for small businesses as for other taxpayers. They involve examining returns for potential errors or compliance problems, notifying taxpayers of suspected discrepancies, settling disputes over additional taxes recommended, and collecting taxes assessed. (App. III provides a simplified picture of IRS’ audit and dispute resolution process.)
subsections: section_title: Audits
paragraphs: IRS’ primary technique for assessing compliance with tax laws is to examine the accuracy of the tax reported on filed tax returns. In selecting returns to be audited, IRS attempts to focus on those it believes are most likely to have compliance problems. IRS data showed that about 2.3 percent of the income tax returns filed by small businesses in 1997 were audited, generally through audits conducted by IRS’ district offices. By contrast, IRS audited 1.3 percent of all returns filed in 1997. The audit rate for sole proprietors (individuals filing Schedule C) was 3.2 percent, compared to 1.2 percent for individuals not filing Schedule C.
According to IRS officials, the audit rate for small business taxpayers is higher than the overall rate because small businesses tend to have more compliance problems than other taxpayers. A common kind of problem that small businesses can face is in the area of employment tax compliance. A small business can fall short of operating capital, and as a consequence, it may divert some or all of its estimated tax deposits or employment tax withholdings to make up the shortfall, hoping to pay IRS at a later date. According to IRS officials, the amount of these unpaid taxes, penalties, and interest can pyramid quickly. The danger is that a business that must rely on these funds for working capital is likely to have other liabilities and delinquencies that reflect financial problems so severe that it cannot recover.
Table 3 provides detailed information on the audit rates in 1997 for the four types of small businesses and farmers.
IRS has little data on the burden imposed by its audits of small businesses and other taxpayers. IRS’ AIMS database does include information on the length of audits from an administrative perspective—that is, the number of days from when IRS’ auditors first begin working on a case until the case is closed. This information, although not a complete indicator of the burden that IRS audits imposed on small businesses, does provide some insight on the time it takes to go through the audit process.
During an audit, a taxpayer is likely to spend some time searching for documentation, responding to IRS’ inquiries, and meeting with IRS examiners. However, over the course of the audit, there are also periods of time when the taxpayer is not actively involved, such as while IRS is evaluating records and researching issues, or when IRS examiners are temporarily reassigned to other cases or activities. Table 4 provides data on the average length of small business IRS audits that were closed in 1995.
As shown in the table, on average, the audits lasted less than 1 year, and nearly half closed in less than 6 months. Still, some audits—especially those of partnerships—lasted much longer. For example, more than half of the audits of partnerships lasted more than 1 year, as did nearly 30 percent of those for S corporations and corporations. Also, although not shown in the table, 16 percent of partnership audits and from 1 to 3 percent of the audits for other types of small businesses continued beyond 4 years.
According to IRS’ Examination Division officials, a variety of factors can lengthen the time it takes to complete a business audit. Examples cited included (1) difficulties in scheduling appointments with taxpayers, (2) the time required for a taxpayer to assemble needed information, and (3) the fact that some audits involve highly complex business tax issues requiring extensive research and investigation. With respect to audits of partnerships in particular, the officials said that the audits tend to take longer because IRS must secure and examine each partner’s return in addition to the partnership return. An audit of a partnership’s return remains open as long as any partner is in disagreement with any audit issue. Also, audits of partnerships often require special procedures and analyses, such as reviewing the linkages between the returns filed by the partnership and each of the partners and checking the application of complex tax laws affecting partnerships in some circumstances.
section_title: Recommended Additional Taxes and Penalties
paragraphs: Small business audits often result in recommendations for the assessment of additional taxes and penalties. For the small business audits closed in 1995, 67 percent resulted in a recommended change to the reported tax liability or refundable credits, while about 33 percent resulted in no such changes. Some audits resulting in no change to the reported tax liability did result in changes to other return items deemed significant by IRS examiners. For example, net loss, which can be carried forward and claimed in future years, may have been overstated on the return and adjusted by IRS. Table 5 provides more detailed information on IRS examiners’ recommendations on audits closed in 1995. In considering the information presented, it is important to note that the audit recommendations do not equate to final audit outcomes. For example, recommendations may be partially or fully overturned in IRS appeals or in court decisions.
IRS’ 1995 data show that small businesses appealed to IRS or filed court petitions in 8 percent of the audits where it recommended additional tax and penalties. Table 6 provides more detailed information on audits that were appealed and petitioned by each small business category.
According to IRS Appeals officials, the lower appeals rates for sole proprietorships and farms may reflect the fact that their returns generally involve less complex tax issues, which leads to fewer potential tax disagreements. Similarly, the officials attribute the much higher appeals rate for partnerships to the complexity of the tax laws affecting partnerships and their returns.
IRS’ collection process starts at the point IRS identifies a taxpayer as not having paid the amount of tax due as determined by the tax assessment.First, IRS is to send a notice (or series of notices) to the taxpayers informing them of the amount owed. If the amount is not paid, IRS is authorized to employ enforcement powers to collect what is owed.
IRS can refer the delinquency to an automated collection system call site, where an employee calls the taxpayer by telephone and asks for payment. The payment arrangements may include installment agreements or an offer-in-compromise from the taxpayers if the full amount owed cannot be paid.
Information about large and chronic tax delinquencies can be referred directly to one of IRS’ 33 district offices, where IRS revenue officers may contact the taxpayer in person. According to IRS officials, small business audits that involve employment taxes are often referred directly to district offices. In addition to liens and levies, IRS collection officials have authority to seize and sell taxpayers’ property, such as cars or real estate. Seizure is generally a last resort to get payment of the amount owed, and the IRS Restructuring and Reform Act now requires a district director’s approval.
IRS could not provide information on the number of small businesses undergoing enforced collection actions (i.e., liens, levies, or seizures). However, recent IRS information shows that enforced collections, in general, have declined dramatically since 1997. For example, in fiscal year 1997, IRS made about 10,000 seizures compared to about 2,300 in fiscal year 1998, and fewer than 200 in fiscal year 1999.
section_title: Agency Comments
paragraphs: We requested comments on a draft of this report from the Commissioner of Internal Revenue. On July 23, 1999, we received IRS’ written comments, which discuss IRS’ plans and actions to assist small businesses with their filing and reporting burdens. The comments are reprinted in appendix IV. We also met with IRS officials, including the Deputy National Director of the Public Liaison and Small Business Affairs Office and the Assistant Commissioner for Forms and Submission Processing, to discuss their technical comments, which we incorporated where appropriate.
We are sending copies of this report to Senator John Kerry, Ranking Minority Member of your Committee; Senator William V. Roth, Jr., Chairman, and Senator Daniel P. Moynihan, Ranking Minority Member, Senate Committee on Finance, and Representative Bill Archer, Chairman, and Representative Charles B. Rangel, Ranking Minority Member, House Committee on Ways and Means. Copies will also be sent to the Honorable Lawrence H. Summers, Secretary of the Treasury; the Honorable Charles O. Rossotti, Commissioner of Internal Revenue; and the Honorable Jacob Lew, Director, Office of Management and Budget. Copies will be made available to others upon request.
If you or your staff have any questions concerning this report, please contact me or Charlie W. Daniel on (202) 512-9110. Key contributors to this report were Robert Floren and Daniel Lynch.
section_title: IRS’ Information Systems Limit Availability of Data on Small Businesses
paragraphs: In general, the Internal Revenue Service’s (IRS) numerous information systems do not collect or store information by taxpayer groups, such as small businesses. Rather, IRS’ current data systems reflect the agency’s stovepipe structure and transaction-based business approach. Even if IRS’ information systems maintained data by taxpayer groups, obtaining complete account information for a taxpayer would not be easy because IRS’ systems are not linked together.
Historically, IRS has operated through functions, such as Examination or Collection, and information about taxpayers tended to be developed to serve each function’s specific needs and its specific interactions with taxpayers rather than IRS’ overall needs or taxpayers’ needs. As a result, IRS’ various and discrete databases provide information pertaining to certain transactions, such as seizures or the filing of income tax returns. The structure of IRS’ information systems does not easily allow for a complete assessment of a small business taxpayer’s interactions—from filing to postfiling—with IRS.
IRS maintains information about taxpayers’ filing and compliance histories in masterfile accounts, currently housed in Martinsburg, WV. The majority of the information about taxpayers’ filing and compliance histories is stored in two masterfiles—the individual masterfile and the business masterfile. Neither of these files is coded to distinguish small businesses from other taxpayers. To further complicate matters, data on filings and payments by small businesses may be divided between the individual and business masterfile. Data from Schedule C (sole proprietorship), Schedule E (partnership and S corporation shareholder), and Schedule F (farmer) are posted to the individual masterfile. Data from Schedule 1120 for corporations, including S corporations, are posted to the business masterfile. In addition, all employment and excise tax data are posted to the business masterfile. As a result, certain small businesses may have data on both masterfiles. A similar situation exists with postfiling data, such as that pertaining to examination and collection activities. The data are scattered across numerous information systems and are not coded to distinguish small businesses from other taxpayers.
The business masterfile accounts are especially complicated, having multiple reporting requirements and being more difficult for IRS to maintain without error or to use to access data. Also, the information on the masterfiles is not complete because other databases may have other related information. For example, income received about the business from a bank or other payer that has been reported to IRS on an information return is not included in the masterfiles.
Further, IRS updates the masterfiles weekly, after the transactions have taken place. Most of IRS’ compliance systems (e.g., Collection) operate off uploads and downloads of selected taxpayer account information on the masterfiles. These systems are used on-line by IRS employees to assist taxpayers or assess their compliance. But the account information on the systems is limited to the intended purpose, and updates are not reflected until the masterfiles are updated on weekends.
The limitations in IRS’ information systems prevented us from fully determining the extent to which small businesses actually filed various required forms and schedules and made deposits. The limitations also prevented us from fully determining the extent of small businesses’ involvement in IRS’ enforcement processes.
Many of the IRS databases do not allow for a detailed analysis of the information they contain. We were unable to separate out the four types of small businesses in some of the databases. For example, the Form 941 that employers are to use to file their employment taxes does not have information on business assets or gross receipts that would have allowed us to categorize employers by size. Without this information, our alternative was to use information from the business masterfile. Accessing the appropriate tax module in that file might have made it possible to capture information on assets.
However, extracting masterfile data is a time- and resource-intensive undertaking that is prone to errors and data reliability problems. It involves requesting IRS’ Information Services to provide an extract from various masterfiles, working with the files to validate them, and then merging the data into one that would be suitable for analysis. IRS receives many internal and external requests for data, and each request must await its turn in the queue. IRS’ resources are limited, and the request could have taken many months for the agency to complete. Thus, we decided not to ask IRS to make the extractions for us.
Some of the information we sought was not readily available from IRS’ compliance databases. For example, IRS’ Audit Information Management System (AIMS) database does not identify some small business taxpayers or adequately distinguish small businesses from other businesses. Because AIMS does not include the asset size of partnerships or S corporations, it cannot distinguish between small and other partnerships or S corporations. AIMS does, however, include asset data for sole proprietorships and corporations.
IRS’ audits do not include all taxpayer contacts that can result in recommended assessments of additional tax. In particular, notices resulting from IRS’ information matching math-error programs are generally not counted as audits, according to IRS officials. In 1997, IRS’ information matching program generated about 2.8 million notices, resulting in assessments totaling about $1.5 billion. We could not identify any readily available data on the proportion of these assessments directed at small businesses.
IRS is taking interim steps to address some of its data problems. IRS expects to develop a way of linking a customer identifier to the case information in 35 of its most important information systems. When this “workaround” is complete, IRS managers and frontline workers should know whether the return or information report data they might be using are for a small sole proprietor, partnership, S corporation, or corporation. However, the interim solution will not provide real-time information about the full range of transactions currently ongoing for a particular taxpayer. Neither will the interim solution link IRS’ systems to provide comprehensive information about taxpayers’ interactions with the agency. IRS has acknowledged that its systems limitations hinder its ability to effectively manage its activities and serve small businesses and plans to continue making information systems improvements as part of its ongoing modernization and restructuring efforts.
section_title: Tax Requirements That Potentially Apply to Small Businesses
paragraphs: Form 1040, U.S. Individual Income Tax Return Form 1065, U.S. Partnership Return of Income Schedule F, Profit or Loss from Farming Schedule J, Farm Income Averaging Form 990C, Farmers' Cooperative Association Income Tax Return Form 1040 ES, Estimated Tax for Individuals Form 2210F, Underpayment of Estimated Tax by Farmers and Fisherman Form 1065, U.S. Partnership Return (information return)
If a partner in a partnership (even if no income received) to report share of partnership income or loss See explanation above If elected to be an S corporation to report income, gains, losses, etc. (continued)
Tax formSchedule K-1 (form 1120S), Shareholder's Share of Income, Credits, Deductions Estimated Tax, Form 8109, Tax Deposit Coupon or EFTPS Form 1040, U.S. Individual Income Tax Return Schedule E, Supplemental Income and Loss (part II)
If business has employees (must file on magnetic media if 250 or more Form W-2s)
If business sold or exchanged capital assets If filing as an individual, estate, or trust and paid certain foreign taxes to a foreign country or U.S. possession If claiming investment in building rehabilitation, alternative energy, or reforestation If more than one type business credit claimed If required to refigure investment credit (e.g., when investment credit property sold) If depreciating, amortizing, or expensing certain business property If deducting losses due to fire, storm, theft, or other casualty If sold or exchanged business property If filing as an individual, estate, or trust and claiming deduction for investment interest expense If claiming the work opportunity credit for wages paid to targeted groups of employees If incurred loss from specified "at risk activities" (e.g., farming, exploring for oil, others) If tax on alternative minimum tax income is greater than tax reported on form 1040 If reporting income from casual sales (other than inventory) where payments received in a tax year after the year of sale If claiming the credit for alcohol used as fuel If claiming the credit for increasing research activities If claiming gains or losses from (1) section 1256 contracts under the marked-to-market rules (such as regulated futures contracts) or (2) straddles (offsetting positions that decrease the risk of loss) If disclosing items that are otherwise not adequately disclosed for the purpose of avoiding penalties If disclosing positions taken on a tax return that are contrary to Treasury regulations If a shareholder in a Interest Charge Domestic International Sales Corporation and receiving deferred DISC income that increases taxable income If reporting a net loss from "passive activities" (e.g., most real estate investments) If an owner of certain low-income housing projects and claiming credit If bought or sold a trade or business and goodwill or going-concern value attaches or could attach to assets (continued)
If business operates as a broker or barter exchange, it must report proceeds from transactions (continued)
If made a loan that is a certified indebtedness amount on any mortgage credit certificate If a casino in the U.S. with annual gross gaming revenues in excess of $1 million, to report currency transactions of $10,000 or more (continued)
Schedule H (form 1120), Section 280H Limitations for a Personal Service Corporation Schedule PH (form 1120), U.S. Personal Holding Company Tax Form 1118, Foreign Tax Credit (form 1120); (attached to form 1118 are Schedule I, Reduction of Oil and Gas Extraction Taxes and Schedule J, Separate Limitation Loss Allocations) Form 2438, Undistributed Capital Gains (attach to form 1120-RIC or 1120-REIT)
If a personal holding company If electing to claim the foreign tax credit; separate forms 1118 must be filed for each of nine limitation categories that apply If a Regulated Investment Company or Real Estate Investment Trust and had undistributed capital gains (continued)
TitleTax Information Authorization Excise Tax Return Excise Tax Return–Alcohol and Tobacco (Puerto Rico) Excise Tax Return–Alcohol and Tobacco (Puerto Rico) Specific Transportation Bond-Distilled Spirits or Wines Withdrawn for Transportation to Manufacturing Bonded Warehouse–Class Six Specific Export Bond–Distilled Spirits or Wine Application and Permit to Ship Puerto Rico Spirits to the United States Without Payment of Tax Certification of Tax Determination–Wine Drawback on Wine Exported Drawback on Beer Exported Beer for Exportation Application and Permit to Ship Liquors and Articles of Puerto Rico Manufacture Tax Paid to the United States Bond, Drawback of Tax on Tobacco Products, Cigarette Papers,or Tubes Monthly Report – Manufacturer of Tobacco Products Computation of Tax Agreement to Pay Tax on Puerto Rican Cigars or Cigarettes Inventory–Manufacturer of Tobacco Products Federal Firearms and Ammunition Excise Tax Deposit Claim for Drawback of Tax on Tobacco Products, Cigarette Papers, or Cigarette Tubes Claim–Alcohol, Tobacco, and Firearms Taxes Special Tax Registration and Return (Alcohol and Tobacco) Application for Tax Paid transfer and Registration of a Firearm Application for Tax-Exempt Transfer and Registration of a Firearm Special Occupational Tax Printing Request Continuing Export Bond–Distilled Spirits and Wine Continuing Transportation Bond Distilled Spirits Or Wines Withdrawn for Transportation to Manufacturing Bonded Warehouse –Class Six Drawback Bond–Distilled Spirits and Wine Tax Deferral Bond–Beer (Puerto Rico) Certification of Prepayment of Tax on Puerto Rico Cigars, Cigarettes, Cigarette Papers, or Cigarette Tubes Report of Multiple Sales or Other Disposition of Pistols and Revolvers Firearms Transaction Record Part I–Over-the-Counter Firearms Transaction Record Part I–Low Volume–Over-the-Counter Firearms Transaction Record Part I–Intra-State Over-the-Counter (English-Spanish) Firearms Transaction Record Part II–Non-Over-the-Counter Firearms Transaction Record Part II–Low Volumne–Intra-State Non-Over-the-Counter Floor Stocks Tax Return 1993 Floor Stocks Tax Return (Cigarettes) Certificate of Taxpaid Alcohol Drawback on Distilled Spirits Exported Tax Deferred Bond–Distilled Spirits Floor Stocks Tax Return–Pipe Tobacco Federal Firearms and Ammunition Excise Tax Return Application for Registration for Tax Free Transactions Under 26 USC 4221 (Firearms and Ammunition) Statement of Adjustment to the Puerto Rico or Virgin Islands Tax Account (continued)
TitleTax Collection Waiver Certification of Ultimate Vendor for Use in Tax Refund Claim Under Section 6416 (b) (2) of the Internal Revenue Code (27 CFR 53.179 (b) (iii)) Purchaser’s Certificate of Tax-Free Purchase for Use as Supplies for Vessels and Aircraft (27 CFR 53.134 (d) (2)) Purchaser’s Certificate of Tax-Free Purchase for State or Local Government Use (27 CFR 53.135 (c) (1)) Vendor’s Certificate of Tax-Free Purchase for Resale for Export (27 CFR 53.133 (d) (2)) Vendor’s Certificate of Tax-Free Purchase for Resale for Further Manufacture (27 CFR 53.132 (c) (2)) Application for Extension of Time for Payment of Excise Tax Consent to Extend the Time to Assess ATF Excise Tax Special Tax “Renewal” Registration and Return Special Tax Location Registration Listing Special Tax Stamp Special Tax Registration and Return National Firearms Act (NFA) Special Occupational Tax Inquiry Letter IRC Guideline/Worksheet for Late Excise Payment/Deposit or Tax Return Bond for Spirits or Distilled Spirits or Rum Brought Into the US Free of Tax (used by Virgin Islands) Bond for Articles Brought Into the U.S. Free of Tax (used by Virgin Islands)
section_title: Simplified Audit and Dispute Resolution Processes
paragraphs: This appendix illustrates a simplified process for auditing tax returns, resolving disputed taxes, and collecting taxes owed. For the small percentage of returns that are audited, most tax issues are resolved during the audit process. However, some audited taxpayers dispute their additional taxes to Appeals, and a few seek to resolve their disputes with IRS in the courts.
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