Tax Gap: A Strategy for Reducing the Gap Should Include Options for Addressing Sole Proprietor Noncompliance
Published: 2007-07-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Internal Revenue Service (IRS) estimates that $68 billion of the annual $345 billion gross tax gap for 2001 was due to sole proprietors, who own unincorporated businesses by themselves, underreporting their net income by 57 percent. A key reason for this underreporting is well known. Unlike wage and some investment income, sole proprietors' income is not subject to withholding and only a portion is subject to information reporting to IRS by third parties. GAO was asked to (1) describe the nature and extent of sole proprietor noncompliance, (2) how IRS's enforcement programs address it, and (3) options for reducing it. GAO analyzed IRS's recent random sample study of reporting compliance by individual taxpayers, including sole proprietors.
section_title: What GAO Found
paragraphs: Based on what IRS examiners could find, most sole proprietors, at least an estimated 61 percent, underreported net business income, but a small proportion of them accounted for the bulk of understated taxes. Both gross income and expenses were misreported. Most of the resulting understated taxes were in relatively small amounts. Half the understatements that IRS examiners could find were less than $903. However, 10 percent of the tax understatements, made by over 1 million sole proprietors, were above $6,200. In this top group, the mean understatement of tax was $18,000. IRS's two main sole proprietor enforcement programs--the Automated Underreporter Program, which computer matches information on a tax return with information submitted to IRS by third parties, and examinations (audits)--have limited reach. The two programs each annually contact less than 3 percent of estimated noncompliant sole proprietors. The limited reach exists for a variety of reasons. In 2001, about 25 percent of sole proprietor gross income was reported on information returns by third parties; expenses generally are not subject to such reporting. Even when required, various barriers make information reporting inconvenient. Examinations of sole proprietors yield less in additional tax assessed and cost more to conduct than examinations for other taxpayers. However, because of the extent of sole proprietor noncompliance, any effect that examinations have on voluntary compliance by other sole proprietors could result in significant revenue. The Treasury Department's recently released tax gap strategy discusses neither sole proprietor noncompliance specifically nor the many options that could address it. GAO has reported on the need for such a detailed strategy for years. Specific options that address issues including sole proprietor recordkeeping, underreporting of gross income, overreporting of expenses, information reporting, and IRS's enforcement programs are listed in appendix II.

section_title: Letter
paragraphs: Voluntary compliance with federal tax laws is a critical component of the  federal tax system. Each year, however, a gap arises between tax amounts  that were voluntarily reported and paid on time and those that should have  been paid. The Internal Revenue Service’s (IRS) most recent estimate is  that the gross federal tax gap for tax year 2001 was $345 billion.
Sole proprietors, who own unincorporated businesses by themselves, have  a relatively high rate of tax noncompliance and account for a significant  portion of the tax gap. IRS estimates that sole proprietors misreported 57  percent of their business income in 2001 and that $68 billion of the tax gap  is attributable to sole proprietors underreporting such income. Key  reasons for sole proprietors’ relatively high tax noncompliance are well  known. Sole proprietors are not subject to tax withholding, and only a  portion of their net business income is reported to IRS by third parties. By  comparison, misreporting rates for wage and interest income, which are  subject to withholding or information reporting by financial institutions,  are low (about 1 and 4 percent, respectively).
Congress has been encouraging IRS to develop an overall tax gap  reduction plan or strategy that could include a mix of approaches, like  simplifying tax law, increasing enforcement tools, and reconsidering the  level of resources devoted to enforcement. On September 26, 2006, the  Department of the Treasury (Treasury), Office of Tax Policy, issued “A  Comprehensive Strategy for Reducing the Tax Gap.” At the time,  Treasury officials said that a more detailed strategy would be forthcoming.
Because of your concern about the tax gap and the importance of sole  proprietor compliance, you asked us to identify steps that might improve  that compliance. Our objectives were to (1) describe the nature and extent  of the noncompliance associated with sole proprietors, (2) describe the  extent to which IRS’s enforcement programs address the types of sole  proprietor noncompliance found by IRS’s most recent research, and   (3) identify options to close the tax gap related to sole proprietors that  could be included in the tax gap strategy being developed by Treasury. To  describe the nature and extent of sole proprietor noncompliance, we  analyzed IRS’s National Research Program (NRP) results on the reporting  compliance of individual taxpayers in tax year 2001, IRS’s tax gap  estimates, and IRS’s Statistics of Income (SOI) data to develop a profile of  sole proprietors and related tax compliance issues. To determine the  extent to which IRS’s compliance programs address sole proprietor  noncompliance, we reviewed filing guidance and compliance program  procedures and analyzed program results. We interviewed IRS staff on the  operations and results of the Automated Underreporter Program (AUR),  which tests for underreporting by computer matching information returns  reporting selected payments made to sole proprietors with income tax  returns. We also interviewed staff in IRS’s correspondence, office, and  field examination (or audit) programs. In addition, we reviewed NRP  examination cases to identify examples of barriers when examining sole  proprietors.
We used several approaches to identify options for closing the sole  proprietor tax gap that could fit into the tax gap strategy. We focused on  options that could address the types of sole proprietor noncompliance  profiled by IRS’s research and the limitations of IRS’s enforcement  programs that address sole proprietors. We also reviewed existing  recommendations from the President’s Budget, President’s Advisory Panel  on Federal Tax Reform, our previous recommendations and reports of the  Treasury Inspector General for Tax Administration, IRS’s Taxpayer  Advocate, and IRS advisory groups. We discussed the options with experts  on sole proprietor compliance, including persons who have experience  with IRS or other federal programs related to sole proprietors or who  published related research. We met with officials from various small  business organizations, professionals who provide tax advice to small  businesses, and tax professional organizations. Further, we reviewed  Treasury’s tax gap strategy. A more detailed description of our  methodology is in appendix I. This report contains estimates which have  associated confidence intervals that are conveyed in the body or discussed  in the appendix.  We conducted our review from July 2006 through June  2007 in accordance with generally accepted government auditing  standards.
subsections: section_title: Background
paragraphs: Sole proprietors own unincorporated businesses by themselves. As such,  they are distinct from corporations and partnerships. In this report, the  term sole proprietors refers to both the owners of the businesses and the  category of business. In tax year 2003, 20.6 million sole proprietors filed  tax returns (the latest year for which detailed IRS data were available).  Sole proprietors constitute about 72 percent of all businesses in the United  States but are small; they have only 4.8 percent of all business receipts.  Sole proprietors include a wide range of businesses, including those that  provide services, such as doctors and accountants; produce goods, such as  manufacturers; or sell goods at fixed locations, such as car dealers and  grocers. These activities may be full time or part time and may be all or  part of an individual’s income. Figure 1 shows the distribution of sole  proprietors and their gross receipts by the size of the proprietorship.
Sole proprietors report their business-related net profit or loss on IRS  Form 1040, U.S. Individual Income Tax Return, through their Schedule C  Profit or Loss from Business (see app. III). The Schedule C requires sole  proprietors to classify their type of business or profession, report gross  receipts and income, place expenses in 23 categories, and provide  additional data on vehicle expenses. Sole proprietors with expenses up to  $5,000 may qualify for simplified tax reporting on Schedule C-EZ, which  allows them to report all expenses on one line. Sole proprietors combine  their business profits or losses, reported on Schedule C, with income,  deductions, and credits from other sources that are reported elsewhere on  the Form 1040 to compute their overall individual tax liability.
In addition to income tax obligations, sole proprietors have other tax  requirements. If they have employees, sole proprietors are responsible for  withholding and paying Social Security, Medicare, and federal income tax,  and paying federal unemployment tax under an employer identification  number (EIN) that is the tax identification number (TIN) for the business.  Whether they have employees or not, sole proprietors are required to pay  self-employment tax, which is similar to the Social Security and Medicare  tax for wage earners.
subsections: section_title: Information Reporting
paragraphs: Sole proprietors may prepare and receive information returns for  payments made to them or made by them for services, known as  nonemployee compensation (NEC), on an IRS Form 1099-MISC. IRS uses  the NEC data in its matching programs, such as AUR, to help verify a sole  proprietor’s receipts. Generally, a Form 1099-MISC needs to be filed with  IRS and the recipient of the payment for    payments of $600 or more for services performed for a trade or business,  including a sole proprietor, by people who are not employees, such as  contractors;  rent payments of $600 or more, other than rents paid to real estate agents;  and    sales of $5,000 or more of consumer goods to persons for resale anywhere  other than in a permanent retail establishment.
Payments for purchases of goods and service to corporations generally are  not required to be reported.
Based on these rules, organizations (including sole proprietors) that make  NEC payments for services provided may be required to submit  information returns to IRS and the payee. For example, a store owner (a  sole proprietor) who hires a self-employed computer programmer  (another sole proprietor) to design the business Web site for $10,000 must  submit a Form 1099-MISC information return to report the $10,000  payment made to the computer programmer. However, if the programmer  is hired to design a personal, nonbusiness Web site for the store owner, no  information return is required.
Completing a Form 1099-MISC requires the payer to determine whether  the payee is an independent contractor or an employee. To determine  independent contractor status, payers are to use 20 common law rules.  Numerous controversies over interpretation of the common law rules led  to the enactment of Section 530 of the Revenue Act of 1978, which stops  IRS and Treasury from issuing new interpretations of these rules. In 1996,  we characterized these rules as confusing and resulting in many  misclassifications. If the determination results in an employee-employer  relationship, the organization is required to prepare a Form W-2 and  withhold tax from each payment to the employee.
Similarly, the payer must determine if the payee is a corporation, since  such payments generally are not subject to Form 1099-MISC reporting. To  determine if the service is provided by a corporation, service providers are  asked to declare their corporation status and, if not a corporation, provide  a TIN. To ensure that payees provide correct TINs on information returns  filed with IRS, NEC payments may be subject to backup withholding.  Independent contractors and Section 530 are discussed in appendix IV,  and backup withholding rules are discussed in appendix V.
section_title: IRS Enforcement Programs
paragraphs: IRS’s two main programs for ensuring compliance among sole proprietors  are AUR and Examination. AUR matches the NEC income reported on the  Schedule C of the sole proprietor’s tax return with the NEC income  reported on Form 1099-MISC. AUR may send a notice to the sole  proprietor if the AUR matching identifies a discrepancy between the NEC  reported. The notice proposes adjustments to the tax return filed and  requests payment of additional tax, interest, or penalties related to the  discrepancy. If the taxpayer disagrees with the notice, the taxpayer is  requested to explain the difference and provide any supporting  documents. Figure 2 describes the NEC information reporting process.
Examinations may address any type of noncompliance issue and come in  three forms. Correspondence examinations are conducted through the  mail and usually cover a narrow issue or two. Office examinations are also  limited in scope but involve taxpayers going to an IRS office. For field  examinations, IRS will send a revenue agent to a taxpayer’s home or  business to examine the compliance problem that IRS suspects.
section_title: Compliance Measurement and the Tax Gap
paragraphs: IRS estimates the gross tax gap—the difference between what taxpayers  actually paid and what they should have paid on a timely basis—to be $345  billion for tax year 2001, the most recent estimate made. IRS also  estimates that it will collect $55 billion, leaving a net tax gap of $290  billion. IRS estimates that a large portion of the gross tax gap, $197 billion,  is caused by the underreporting of income on individual tax returns. Of  this, IRS estimates that $68 billion is caused by sole proprietors  underreporting their net business income. This estimate does not include  other sole proprietor contributions to the tax gap, including not paying  because of failing to file a tax return, underpaying the tax due on income  that was correctly reported, and underpaying employment taxes.  According to IRS, estimates for some parts of the tax gap are more reliable  than those for others. For both these reasons, the precise proportion of  the overall tax gap caused by sole proprietors is uncertain. What is certain  is that the dollar amount of the tax gap associated with sole proprietors is  significant.
IRS bases its estimates of the tax gap caused by underreporting of  individual income on its compliance research program—NRP.  The  individual reporting compliance study was a detailed review and  examination of a representative sample of 46,000 individual tax returns  from tax year 2001. IRS generalized from the NRP sample results to  compute estimates of underreporting of income and taxes for all  individual tax returns. Because even the detailed NRP reviews could not  detect all noncompliance, IRS adjusted the NRP estimates to develop final  estimates of income misreporting and the resulting tax gap. IRS did not  adjust all the NRP population estimates, only those necessary for  developing its final tax gap estimates. However, NRP population estimates  are a rich source of data about the nature and extent of sole proprietor  noncompliance. Consequently, our report sometimes presents NRP  population estimates and sometimes final tax gap estimates.
section_title: Most Sole Proprietors Underreported Business Income, but a Small Proportion Accounted for the Bulk of Unpaid Taxes
paragraphs: The significant amount of sole proprietor noncompliance reported in IRS’s  tax gap estimates is caused by underreporting of net business income,  including the misreporting of both gross business income and expenses.  The distribution of the resulting unpaid taxes is uneven. A small  proportion of sole proprietors, but still a significant number, has relatively  large amounts of unpaid taxes.
subsections: section_title: Most Sole Proprietors Underreported Net Business Income, Misreporting Both Gross Income and Expenses
paragraphs: Based on the unadjusted NRP results, an estimated 70 percent of Schedule  C filers in 2001 (about 12.9 million) made an error when reporting net  business income (that is, net profit or loss on line 31 of Schedule C). Most  of the misreporting was underreporting. These NRP results showed that an  estimated 61 percent of Schedule C filers underreported their net income  and 9 percent overreported.
These reporting errors resulted in $93.6 billion, before adjusting, of  misreported net business income as shown in figure 3. This misreporting  included an estimated $99 billion of underreported and $5.4 billion of  overreported net income.
The underreporting of net business income was caused by misreporting of  both gross income and expenses, as shown in figure 3. An estimated 39  percent of sole proprietors (6.9 million) made an error on the gross  income line of Schedule C and underreported about $53 billion net after  subtracting overstatements from understatements. An estimated 73  percent of sole proprietors (10.9 million) made an error on the total  expense line of the Schedule C and overreported about $40 billion net  after subtracting understatements from overstatements. Overstating  expenses reduces net business income and thus taxes. However,  understating expenses may also contribute to understated tax if it is done  to disguise understating higher amounts of gross income.
The misreporting of expenses was spread over all the 23 expense  categories on the Schedule C. However, 55 percent of expense  misreporting was concentrated in four categories: car and truck,  depreciation, supplies, and other.
The unadjusted NRP results underestimate the amount of misreporting.  The estimates in figure 3 are based on errors detected in the NRP reviews.  IRS knows that not all misreporting is detected during its examinations,  including NRP reviews. Unreported cash receipts, for example, are  difficult to detect. IRS uses various methodologies and other sources of  data (on cash transactions, for example) to adjust the aggregate NRP  results (but not individual line items) to estimate misreporting. The NRP  data limitations are more fully described in appendix I.
After these adjustments, IRS estimates that sole proprietors misreported  57 percent of their net business income in 2001 and that the tax gap caused  by this misreporting of sole proprietor net business income in 2001 was  $68 billion. This is a substantial upward adjustment from the estimated  $36.9 billion in understated taxes from all sources on returns with a  Schedule C attached based on what NRP detected.
Taxpayers misreport income and expenses for a variety of reasons. Some  misreporting is intentional; some is unintentional. How much misreporting  is in each category is not known. IRS refers some misreporting for  criminal prosecution, but often it is impossible to tell from a tax return  whether errors are intentional. Beyond intentional misreporting, reasons  for errors include transcription mistakes, misunderstanding of the relevant  tax laws or regulations, and poor recordkeeping. Examples from our  review of NRP examination case files illustrate some of these types of  reporting errors:    The sole proprietor operated a cash-card business and reported about  $900,000 in gross receipts on the Schedule C. The business is largely done  with cash transactions. The examiner found evidence of more than $1  million in additional sales income, as well as additional expenses from  purchases, leading to an adjustment of about $30,000 for Schedule C net  income. The adjustment contributed to a total proposed additional tax  assessment of about $8,000.
The sole proprietor owned a construction business and reported Schedule  C losses of over $30,000. The examiner found that that the sole proprietor  had poor business skills and shoddy records. Organizing the  documentation to support the Schedule C required over 25 hours of  examiner time and resulted in net adjustments to receipts and expenses on  the Schedule C of over $45,000.
The sole proprietor owned a retail business and reported Schedule C gross  income of almost $250,000. The examiner proposed adjustments of about  $9,000 to Schedule C expenses because the expenses were undocumented  or were personal living expenses not associated with the business. In  protesting the related assessment to IRS Appeals, the taxpayer’s  representative said that the taxpayer’s records were spread across several  store accounts, several accounts for rental properties, and two personal  accounts. Eventually, Appeals identified additional records and sent the  case back to Examination.
The taxpayer was selling craft-related items and admitted to the IRS  auditor that the sales were not engaged in for profit. Accordingly, the  taxpayer should not have filed a Schedule C, and several thousand dollars  of expenses reported by the taxpayer on Schedule C were disallowed.
The taxpayer was a minister and filed a schedule C. The examiner  explained that although the taxpayer was self-employed in performing  ministerial services for Social Security purposes, the taxpayer was  considered an employee for income tax purposes. The taxpayer should not  have filed a Schedule C.
section_title: Although a Small Proportion of Sole Proprietors, More Than 1 Million Accounted for the Majority of Understated Taxes
paragraphs: Understated taxes are spread unevenly among the population of sole  proprietors, and slightly more than 1 million sole proprietors accounted  for most of the understatements. On one hand, the amount of tax  understatement caused by underreported net Schedule C income cannot  be calculated precisely. Understated taxes on a return could result from  the misreporting of multiple items, and the tax calculations depend on all  such misreporting rather than just one item. On the other hand, using the  best available data on underreporting detected by NRP, we estimate that  72 percent of the underreported adjusted gross income (AGI) on income  tax returns filed by sole proprietors was caused by changes in Schedule C  income. As a result, it is likely that most of the NRP-estimated $36.9  billion (unadjusted) in understated taxes on these returns can be  attributed to underreported net business income on Schedule C.
Although most sole proprietors had understated taxes, the amounts were  skewed. Based on NRP estimates, half of sole proprietors who understated  taxes on their individual income tax returns, understated less than an  estimated $903 (the 50th percentile amount), as shown in figure 4. Above  the 50th percentile, the amount of tax understatement significantly  increased to an estimated $2,527 at the 75th percentile, $6,210 at the 90th  percentile, and $20,387 at the 98th percentile. About 1.25 million sole  proprietors accounted for the largest 10 percent of understatements for  which the mean was about $18,000; for the largest 5 percent, the mean  understatement was about $27,000. By comparison, as will be discussed  further in the next sections, IRS’s field examiners assessed on average  $27,800 of additional tax for examinations of individual returns without  Schedule Cs.
Most of the aggregate $36.9 billion of understated taxes (unadjusted NRP  estimate) on returns filed by sole proprietors was concentrated in a small  proportion of sole proprietors. As shown in figure 5, the 11.2 million sole  proprietors at and below the 90th percentile understated their taxes by a  cumulative $14.3 billion. The remaining 10 percent (1.25 million) above the  90th percentile understated a cumulative $22.6 billion in taxes, accounting  for 61 percent of the total.
When arrayed by the size of the sole proprietor and based on reported  gross receipts, understated taxes are less skewed. Based on Schedule C  gross receipts, those sole proprietors at or below the 90th percentile  ($127,462) accounted for 65 percent of cumulative understated taxes  ($23.9 billion of $36.9 billion). Those with the largest 10 percent of gross  receipts accounted for the other 35 percent or $12.9 billion of the  understated taxes.
section_title: Enforcement Programs Have Limited Reach over Sole Proprietors but Still Make Billions of Dollars in Recommended Assessments
paragraphs: IRS’s two main programs for addressing sole proprietor reporting  compliance— AUR and Examination—have limited reach over  noncompliant sole proprietors, although they annually contact hundreds  of thousands of taxpayers and recommend billions of dollars in  assessments. Table 1 shows the types of sole proprietor noncompliance  that AUR and Examination investigate, the percentage of the  noncompliant sole proprietor population with recommended assessments,  and the limitations of the programs.
Assuming that Schedule C filers would misreport net income at the same  rate in subsequent years as they did in 2001, AUR recommended that  additional tax be assessed on about 2.7 percent of noncompliant sole  proprietors for tax year 2003. Similarly, Examination recommended that  additional tax be assessed on about 1.4 percent of noncompliant sole  proprietors for returns from tax year 2004.
subsections: section_title: AUR Is Restricted by Limits on Information Reporting and Other Program Constraints but Still Identifies Significant NEC Noncompliance
paragraphs: AUR cannot detect all sole proprietor misreporting because the third-party  information returns used for matching do not report all sole proprietor  receipts or expenses. One quarter of sole proprietor receipts reported on a  Schedule C in 2001 also appeared on a Form 1099-MISC that year. Since  not all receipts are reported on a Schedule C, the true percentage would  be lower. Exemptions to information reporting requirements prevent  greater coverage of sole proprietor receipts. Most merchandise sales,  nonbusiness services (such as construction or repairs for homeowners),  and payments of less than $600 are exempt from Form 1099-MISC  reporting. Additionally, because payments to corporations are generally  exempt, sole proprietors that want to avoid information reporting of their  receipts could incorporate.
Several barriers may inhibit information return filing on NEC payments.  First, preparing a Form 1099-MISC to report NEC payments can be a  complex process. The general instructions for filling out any information  return are 21 pages long, and the instructions for Form 1099-MISC are 8  pages long. Payers must figure out whether the businesses they have hired  are independent contractors or exempt corporations and whether the  payments meet other exemption criteria as well as acquire the payees  TINs or EINs.
Second, submitting Form 1099-MISC returns is not convenient. In its  instructions, IRS requires payers to use forms printed with red, magnetic  ink so that IRS scanners can more easily process the forms; payers are  instructed not to print Form 1099-MISC off of IRS’s Web site. However, we  observed plain paper Form 1099-MISC returns being scanned in IRS’s  Ogden, Utah, processing center. Furthermore, payers must submit Form  1099-MISC returns separately from their tax returns. There is $50 penalty,  as the instructions prominently remind payers, for failing to use the  correct form. In practice, IRS may not assert the penalty for every  violation because of the administrative and collection costs.
IRS has an Internet-based system for submitting information returns called  Filing Information Returns Electronically (FIRE), but barriers exist to the  use of that system. FIRE requires payers to put return information in a  particular format that IRS can use, which requires appropriate software  that payers must purchase. Payers cannot simply call up a Web site and fill  out an online form, and they need to register with IRS before using the  system. The likelihood that a payer would submit a Form 1099-MISC  return electronically decreases as the number of forms that the payer files  decreases. For example, IRS data from tax year 2005 show that 93 percent  of paper Form 1099-MISC returns were filed by payers with 24 or fewer  submissions. One common tax preparation software package allows users  to print Form 1099-MISC and submit them to IRS on paper, but the users  cannot transmit Form 1099-MISC returns electronically as they can income  tax returns. This software vendor said that it had a special arrangement  with IRS for its users to print Form 1099-MISC on plain paper.
Paper forms are more costly for IRS to process than electronically filed  forms. With paper, IRS workers scan forms into a database and visually  verify that the information was scanned correctly, a labor-intensive  process. A substantial number of Form 1099-MISC returns are filed on  paper. For filing year 2005, the Form 1099-MISC constituted 87 percent of  all the paper information returns submitted that IRS could scan. Nearly 40  percent of Form 1099-MISC returns (31.5 million) were submitted via  paper that year.
subsections: section_title: AUR Is Limited by a Lack of Resources, Expense Matching, and Examination Authority
paragraphs: Because of resource constraints, IRS officials said they do not contact  taxpayers in all cases where AUR finds a mismatch between what was  reported on an information return and what was reported on a tax return.  The annual average of NEC-related contacts for tax years 1999 through  2003 is much less than half of the roughly 2 million cases that AUR  officials say they annually identify for taxpayer contacts caused by  potential NEC underreporting.
Also, AUR matching generally does not address misreported Schedule C  expenses. First, according to IRS, AUR does not match sole proprietors’  Schedule C expenses with the information returns they file for their own  payments. Second, third-party information generally is not required on  sole proprietor expenses.
AUR reviewers are directed to consider the reasonableness of the  taxpayers’ responses to notices but generally do not examine the accuracy  of the information in the responses because they do not have examination  authority. IRS officials said that addressing larger issues raised in the  returns would take more time and possibly reduce the productivity of AUR  overall. Consequently, taxpayers could, after being contacted by AUR  about underreported NEC, create fictitious expenses to offset the  underreported NEC.
AUR does not systematically check for related parties trying to shift  income from a tax return in a high-rate bracket to another return with a  lower bracket. Related parties may include taxpayers who own multiple  businesses, husbands and wives who file separate tax returns, unmarried  couples, siblings, or parents and their children. IRS data showed that 3  percent of all Form 1099-MISC returns had the same address for the payer  and the payee—one indicator that a related-party transaction might exist.  A nonrandom file review of 55 Form 1099-MISC filings at IRS’s Ogden,  Utah, campus found 8 examples in which the payer and payee had similar  addresses or names. We did not determine the appropriateness of the  apparent related-party transactions in the IRS Form 1099-MISC data based  on the incidence of name and address matches.
Two NRP cases are illustrative of apparent related-party transactions  involving Form 1099-MISCs. In one case, a couple shared a financial  account, and one of them was a sole proprietor. The sole proprietor, who  earned more than $450,000 as an executive at a separate company, paid  the other individual to run the sole proprietorship and deducted the  payment on a Schedule C. The sole proprietorship had over $100,000 in  losses and less than $1,000 in revenue. In the case file, an examiner noted  that a Form 1099-MISC was filed on the NEC income paid from the  executive to the person at the same address. This case file did not note  whether the payment inappropriately shifted income to lower the couple’s  overall tax liability or whether the payment was an allowable business  deduction for services actually rendered as an ordinary and necessary  expense of carrying out a business, as required by the Internal Revenue  Code. In another case, however, IRS disallowed deductions for wages  that a psychiatrist paid to his children because the taxpayer did not show  that the children had rendered services or even that the wages were  paid—only that the deductions were taken.
section_title: Despite Limitations, AUR Annually Recommends Hundreds of Millions of Dollars in Assessments on NEC Misreporting
paragraphs: Annually, AUR receives more than 80 million 1099-MISC forms. From  those submissions, AUR contacts hundreds of thousands of taxpayers  about potential sole proprietor misreporting on those forms and makes  billions of dollars in recommended assessments. From tax years 1999  through 2003, AUR annually, on average, sent 371,989 notices on NEC  cases and recommended $666 million in tax assessments. Figure 6 shows  the trends in NEC contacts and total recommended assessments that AUR  made from 1999 through 2003.
Contacts and assessments related to underreported NEC make up a  significant portion of the AUR caseload. Of more than 60 categories that  AUR uses to sort income data, the two NEC categories combined rank first  in the number of contacts with taxpayers and in the dollars of  recommended assessments made from tax year 1999 through tax year  2003. NEC cases constituted 17 percent of all AUR contacts and 21 percent  of all AUR assessments for tax years 1999 through 2003.
section_title: Examination Program Is Not Geared toward Schedule C Issues but Still Finds Significant Noncompliance
paragraphs: Most of IRS’s examinations do not focus on noncompliance by sole  proprietors. Correspondence examinations account for the majority of  IRS’s examinations that IRS did in fiscal year 2006 and generally take the  least amount of time to conduct, typically an hour or less, because they  deal with simple, limited issues. Schedule C tax issues are generally too  complex to make an examination through correspondence practical. For  example, in our review of NRP files, we found a case in which an examiner  manually sorted through a taxpayer’s records and organized them to  accurately calculate the taxes owed—a task that could not occur through  correspondence. In any case, IRS’s correspondence tax examiners, the  lowest-graded examiners, do not have the training to examine many  Schedule C issues, such as business depreciation or accounting methods.
Schedule C tax issues typically must be addressed in field examinations.  Field examinations took 20 hours on average to complete in fiscal year  2006. Furthermore, field examinations of returns with Schedule C forms  took about 50 percent longer per return (7.2 hours more) to complete than  those not categorized as Schedule C returns in that year.
Among field examinations, the recommended additional tax assessed for  examinations of returns with attached Schedule C forms tended to be  smaller than for other types of examinations. For example, the average  recommended assessment for revenue agents examining returns with  attached Schedule C forms (the employees most likely to do these  examinations) was $24,000 in fiscal year 2006. This was $3,800 less than  examinations of returns without Schedule C attachments and was less  than the average dollars per return for 18 other types of returns without  Schedule C attachments, such as tax-shelter program cases.
The relatively higher costs and lower yields for Schedule C examinations  do not necessarily mean than Schedule C examinations are not cost- effective. The statistics reported above include only the additional taxes  expected from the taxpayer who was examined. Examinations may have a  deterrent effect on other taxpayers and increase the rate of voluntary  compliance. Because the rate of noncompliance is so high for sole  proprietors, any change in their voluntary compliance from doing more  examinations could result in significant revenue increases.
IRS has been examining more tax returns with attached Schedule C forms,  resulting in billions of dollars in recommended tax assessments. From  fiscal years 2001 through 2006, the number of examinations of returns that  IRS categorized as Schedule C returns increased by 132 percent, from  128,062 to 297,626, as shown in figure 7. In fiscal year 2006, IRS examined  about 3 percent of the Schedule C categorized returns. Recommendations  of additional tax assessments also increased each year. The large increase  in these assessments in 2005 was primarily for returns reporting income  greater than $100,000. IRS officials also cited Son of Boss fraud cases from  fiscal years 2005 and 2006 and increased examination efficiency as causes  for the upward trends. Assessments do not reflect amounts actually  collected. Amounts ultimately collected are not yet known from the  examinations closed in 2005 and 2006.
section_title: IRS Did Not Always Apply Negligence Penalties during NRP
paragraphs: IRS did not apply negligence penalties in a substantial portion of NRP  cases with a tax change. IRS uses negligence penalties to encourage  compliance and to assure compliant taxpayers that the tax system is fair.
Although sole proprietors were more frequently penalized than non-sole  proprietors, just 62 percent of the sole proprietors who had a 100 percent  or more tax change in their tax liability after the NRP examination and had  a tax change of $10,000 or more were penalized. For smaller tax changes,  the percentage penalized was lower. Figure 8 summarizes the penalty  results from the NRP examinations for tax returns with a 100 percent or  more change for sole proprietors and non-sole proprietors.
Our NRP case file review provided some examples in which penalties were  not assessed at all or seemed to be assessed inconsistently.
A sole proprietor reported AGI of about $10,000 and zero tax liability on  the return. An examiner proposed total adjustments of about $3,000, which  included unreported Schedule C receipts and overstated expenses  resulting in additional tax of about $450. The examiner proposed a  negligence penalty of about $90, explaining that the taxpayer did not take  reasonable care in preparing the tax return, which was done by a tax  preparer.
A sole proprietor reported AGI of about $90,000 and a tax liability of about  $16,000. An examiner proposed total adjustments of about $35,000, based  on unreported Schedule C receipts and overstated expenses, and a tax  increase of $15,000. The examination workpapers explained that no  negligence penalty was proposed since the tax preparer was responsible  for most of the adjustments.
The differences in individual cases might be caused in part by IRS  procedures that give revenue agents discretion on whether to pursue a  penalty, even when the tax change is substantial. Recommended  penalties must be reviewed by the examiner’s manager. Explanations  ranging from a lack of knowledge to reliance on a paid preparer can lead  some examiners to mitigate a penalty but not others.
IRS officials said the application of penalties in NRP cases should be  similar to that for operational examinations because NRP examiners were  required to follow IRS’s standard guidance for penalties. We have started  work on a study that will more fully analyze the use of penalties in IRS’s  operational examinations.
section_title: Current Treasury Tax Gap Strategy Discusses Neither Sole Proprietor Noncompliance nor the Many Options That Could Address It
paragraphs: The tax gap strategy issued by Treasury in September 2006 does not  discuss sole proprietor noncompliance or specific options to address it. A  number of options to improve sole proprietor compliance exist and could  be considered as part of the overall tax gap strategy. Each option has both  pros (such as improved compliance) and cons (such as burdens on  taxpayers or third parties).
subsections: section_title: Tax Gap Strategy Does Not Specifically Discuss Sole Proprietor Noncompliance
paragraphs: Treasury’s tax gap strategy does not discuss specific options to address  the tax gap overall or sole proprietor noncompliance in particular. As we  discussed in February 2007 testimony, the strategy generally does not  identify specific steps that Treasury and IRS will undertake to reduce the  tax gap, the related time frames for such steps, or explanations of how  much the tax gap would be reduced. Rather, the strategy broadly discusses  opportunities for tax evasion and the preventive role of tax research,  information technology, compliance activities, taxpayer service, tax law  simplification, and working with stakeholders. For example, the portion  on improving compliance activities generally discusses initiatives on  expanded information reporting, improved document matching, refined  detection programs, and increased examinations in selected areas.  However, no specifics are provided. Without specifics, the strategy does  not include actions that potentially would reduce the tax gap.
Since the mid-1990s, we have reported on the need for a strategy to  address the federal tax gap as well as sole proprietor noncompliance. In  May 1994, we summarized many ideas on reducing the tax gap, including  ideas on information reporting, tax withholding, and tax simplification. In  August 1994, we reported on the lack of a comprehensive linkage between  IRS’s compliance strategy and compliance efforts for sole proprietors and  on the need for better systems to identify the causes of noncompliance  and target enforcement resources. More recently, in July 2005, we  reported that IRS needed a results-oriented approach to reduce the tax gap  based on long-term, quantitative voluntary compliance goals and  performance measures to determine the success of its strategies and  adjust as necessary. In April 2006, we testified that IRS had established  such compliance goals but lacked a data-based plan for achieving the  goals. In February 2007, we testified on the need for multiple approaches  to reduce the tax gap, including improved taxpayer services, tax code  simplification, more information reporting, and an appropriate level of  resources for tax enforcement. Our products related to the tax gap are  listed in the Related GAO Products section at the end of this report.
IRS is not without some of the elements of a tax gap strategy. IRS’s  management continually makes decisions about reallocating resources  and has taken steps that demonstrate an understanding of the value of a  more strategic approach. One important step is NRP, which gives IRS  management more information about the nature of noncompliance and is  being used to better target examinations on noncompliant taxpayers. IRS’s  annual budget requests include specific compliance program proposals.  For example, the fiscal year 2008 budget submission had 16 legislative  proposals on tax gap reduction. Some of these proposals related to sole  proprietors, such as those requiring information reporting on certain  government payments made for the procurement of property and services  and on merchant card payment reimbursements. Several IRS and Treasury  experts, and other knowledgeable individuals also commented that many  of these options would be applicable to any small business regardless of  its organizational form (such as partnerships, limited liability companies,  and corporations).  However, these elements do not make up the type of  long-term, comprehensive strategy, described above, that provides an  overall rationale and specific steps, time frames, and predicted impact on  the tax gap.
section_title: Many Options for Improving Sole Proprietor Compliance Exist and Could Be Considered for the Tax Gap Strategy, But All Have Trade-offs
paragraphs: Many options exist that could help reduce sole proprietor noncompliance.  These options range from enhancing IRS’s assistance to taxpayers to  instituting tax withholding on payments made to all or certain types of  sole proprietors. Each option has pros and cons.
We identified options and their pros and cons by reviewing our reports  and the reports of others on sole proprietor compliance as well as through  extensive conversations with experts and knowledgeable individuals  inside and outside of IRS. Consistent with our previous reports, we tried to  identify options that represented a range of approaches, such as improving  taxpayer service, more information reporting, and various enforcement  actions. Many of the options are directed at the specific sole proprietor  compliance problems and IRS program limitations described earlier in this  report. We placed the options into broad categories of problems, such as  poor recordkeeping, unreported business income, and overstated business  expenses. Our list, in table 2, is not exhaustive and not ranked in any  order. Appendix II contains a longer description of each option, including  pros and cons.
All the options have pros and cons. Because the options are presented as  concepts, rather than as detailed plans ready for implementation, the pros  and cons could vary with such detail. In most cases, pros and cons are  described qualitatively and are not intended to be exhaustive; additional  analysis might find others. In general, the pros include helping sole  proprietors to comply voluntarily, helping IRS detect and prevent  underreporting of income and understatement of taxes, and reducing the  burden on taxpayers or third parties for filing tax returns and information  returns. The cons include the costs and burdens imposed on sole  proprietors, third parties, and IRS.
We are not recommending particular options for a number of reasons:    Trade-offs. IRS has other compliance objectives in addition to sole  proprietor compliance. Devoting more IRS staff and other resources to  close the sole proprietor tax gap means that fewer resources are available  for combating other types of noncompliance, such as corporate,  individual, or tax-exempt entity noncompliance. Forgoing enforcement  revenue elsewhere is an opportunity cost of devoting more resources to  sole proprietor noncompliance. Also, the resources and management  capacity devoted to sole proprietor noncompliance may not be sufficient  to implement all the options. Priorities would need to be established.  Interaction between options. Some of the options may be substitutes for  each other. Others may be complements. Improving assistance to  taxpayers might reduce the need for some enforcement actions. Some of  the options may reinforce each other—such as expanded information  reporting and more convenient filing options—making it desirable to  package them together.
Policy judgments. Some of the options involve policy judgments about  how the options would affect different groups of people. For example,  information reporting invariably imposes some costs on the third parties  required to report, but no objective criteria exist for assessing when third- party costs are excessive. In many cases, quantitative information about  the effects is not available. Judgments would have to be made based on  qualitative information.
For all of these reasons, we are not ranking or otherwise making  recommendations on the value of each option, nor are we opining on  which options should be packaged together and in what manner. The  options could be considered as part of an overall Treasury and IRS tax gap  strategy. For most options, Treasury and IRS would need to develop the  details on how the options would work both singly and as part of a  coordinated strategy. Issues that could be considered in an overall strategy  include how much emphasis should be placed on    sole proprietor noncompliance versus other types of noncompliance,    efforts to help sole proprietors voluntarily comply versus efforts to help  IRS detect noncompliance after it occurs,  the reporting requirements and added burden placed on sole proprietors  versus the reporting requirements and burden placed on third parties, and  legislative changes versus administrative changes at IRS.
section_title: Conclusions
paragraphs: The tens of billions of dollars in tax revenue lost annually because sole  proprietors underreport over half of their aggregate net income contribute  to the nation’s long-term fiscal challenge. This underreporting is also  unfair to compliant taxpayers. Because underreporting is spread among  more than 12 million sole proprietors, much of it in small amounts,  because the underreporting is for both gross income and expenses, and  because IRS’s enforcement programs are limited and costly, the sole  proprietor tax gap cannot be closed by IRS enforcement alone. As we have  said before, improving compliance will require a variety of new  approaches.
Many options exist for improving sole proprietor compliance; however,  they all have individual pros and cons, some may be substitutes for each  other and some may reinforce each other. Trade-offs also exist at a  broader level. Devoting more IRS resources to sole proprietor compliance  must be judged relative to what those resources could accomplish in IRS’s  other programs. Furthermore, IRS’s resources are not the only ones  devoted to tax administration. Taxpayers and third parties spend their  time and money to make our tax system work. For these reasons, the  options are best considered as part of an overall strategy. Such a strategy  would provide more assurance that taxpayer, third party, and IRS  resources are being used efficiently to promote compliance.
section_title: Recommendation for Executive Action
paragraphs: We recommend that the Secretary of the Treasury ensure that the tax gap  strategy includes (1) a segment on improving sole proprietor compliance  that is coordinated with broader tax gap reduction efforts and (2) specific  proposals, such as the options we identified, that constitute an integrated  package.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested written comments from the Secretary of the Treasury and  received comments on behalf of the Treasury from its Tax Legislative  Counsel (see app. VI).  In commenting on a draft of this report, the  Treasury said that although not addressed specifically, the seven elements  of the department’s strategy are intended to apply broadly to all types of  businesses and individual taxpayers, including sole proprietorships.   Treasury also stated that this report provides valuable insight for applying  the strategy to the tax gap. IRS and Treasury also provided technical  comments on a draft of this report, which we incorporated as appropriate.   IRS did not provide written comments.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after its  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 whitej@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix VII.
section_title: Appendix I: Scope and Methodology
paragraphs: To describe the nature and extent of the noncompliance associated with  sole proprietors, we analyzed the Internal Revenue Service’s (IRS)  National Research Program (NRP) results, tax gap estimates, and  Statistics of Income (SOI) data, and interviewed IRS officials. The NRP  data are IRS estimates of individual tax reporting compliance based on  reviews and examinations of filed tax returns. IRS randomly selected the  returns for tax year 2001, which were filed with IRS during calendar year  2002. To compute the percentage of returns with an understatement or  overstatement on a Schedule C line and the net misreported amounts, IRS  used the following definitions, including related limitations:  Percentage of returns with an error: This ratio is the weighted number  of taxpayers that have a non-zero net misreported amount divided by the  weighted number of returns that should have reported the amount. For  some items, taxpayers may have errors that exactly offset each other  resulting in no net tax change. For example, a taxpayer may have reported  a transaction as an “office expense,” but an examiner reclassified the same  amount as “repairs and maintenance.” NRP did not consider these  offsetting changes as errors for those line items.
Net misreported amounts (NMA): The NMA is the sum of all amounts  underreported minus the sum of all amounts overreported for an item. The  NMA does not include adjustments between schedules of the return. For  example, the NRP examiner may disallow reported amounts for expense  deductions on Schedule C that should have been reported on Schedule A  and increase the deductions on Schedule A by the same amounts. Neither  adjustment would be in IRS’s NMA. However, the adjustments would be  included in IRS’s definition of the amounts that should have been  reported, which are reflected in the denominator of the net misreporting  percentage. The NMA does not include adjustments that were made  because the taxpayer used the wrong form or line item.
Because the percentage of returns with an error and the NMA are derived  from samples, table 3 lists the confidence intervals for each amount. IRS  did not compute confidence intervals for its estimates. When we  calculated confidence intervals, we got slightly different point estimates  than IRS. The difference appears to arise from varying definitions of sole  proprietors. We are 95 percent confident that the percentages and  amounts reported are between the low estimate and the high estimate. In  the body of this report, we present IRS’s point estimates.
Estimated understated tax amounts, as shown in figure 4, were derived  from NRP sample data. Table 4 lists the estimated percentile amount and  confidence intervals for each percentile. We are 95 percent confident that  the percentages and amounts reported are between the low and high  estimates.
Estimated cumulative understated tax amounts, as shown in figure 5, were  derived from NRP sample data. Table 5 lists the estimated percentile  amount and confidence intervals for each percentile. We are 95 percent  confident that the percentages and amounts reported are between the low  and high estimates.
According to IRS Research officials, NRP results are not tax gap-related  estimates since they do not account for misreporting that the auditors did  not detect. Typically, the undetected misreporting of Schedule C net  income likely takes the form of understated gross receipts and overstated  expenses, for which IRS did not prepare separate tax gap estimates.  Overstated expenses tend to be detected since the burden of proof is on  the taxpayer to justify them. However, when taxpayers intentionally  understate gross receipts, they may also understate expenses to hide the  gross-receipt underreporting from IRS. Also, NRP includes estimates of  some net business income that is not reported on Schedule C. These  amounts are not added to the line-item detail and are not included in the  analyses for this report. We could not estimate the amount of tax change  that would result from NRP’s examinations of Schedule C income because  it must be combined with the taxpayer’s filing status, exemptions, other  types of income, deductions, credits, and other taxes.
To analyze the extent to which IRS’s enforcement programs address the  types of sole proprietor noncompliance found by IRS’s most recent  research, we used several data sources. We reviewed instructions for tax  and information returns and filing guidance as well as program  procedures. We analyzed program results data collected from the  Automated Underreporter Program (AUR) and Examination officials, and  interviewed IRS staff on the operations and results of AUR and the  correspondence, office and field examination programs. We reviewed  examination plans and Internal Revenue Manual procedures and other  instructions to IRS staff describing program procedures. We analyzed data  on examination results and numbers of Schedule C forms filed from the  IRS Data Book, and data on paper Form 1099-MISC returns published by  IRS’s Office of Research for 2006. We did not analyze IRS’s math error  program since all NRP-examined returns were reviewed by this program,  which is an integral part of IRS’s returns processing function.
To calculate the percentage of noncompliant sole proprietors on which  AUR and Examination made recommended assessments, we first  multiplied the percentage of noncompliant sole proprietors found in NRP  data by the number of Schedule C returns for the most recent years that  we had available from the IRS Data Book that matched the most recent  years for which we had complete AUR and Examination data (tax year  2003 for AUR and tax year 2004 returns for work Examination did in fiscal  year 2005). Then we divided the number of recommended assessments  made in each program by the number of noncompliant sole proprietors to  arrive at the percentage of noncompliant sole proprietors on which the  programs made recommended assessments.
We reviewed a sample of completed NRP examination case files to  understand the types of sole proprietor noncompliance being detected. We  selected the sample using the NRP case results database to identify all  NRP cases with adjustments to Schedule C items for sole proprietor tax  returns. We then selected a nonestimation sample of NRP examination  cases with adjustments to gross receipts or sales, total expenses, net profit  or loss on the Schedule C, and the business income line on the Form 1040  return, because these lines summarize the sole proprietor’s operations. We  also randomly selected some Schedule C adjustment cases.
We also used NRP data and the NRP case file sample to analyze IRS’s use  of penalties in NRP examinations. The analysis describes the proportion of  NRP cases closed with adjustments and the proportion closed with a  penalty recommended by the NRP examination. Because the cases with  adjustments and penalties were not drawn from the population of all  individual returns, they cannot be used to estimate a penalty assessment  rate and other characteristics for all individual taxpayers. Even with these  limitations, this analysis provides useful information on the outcome of  the NRP sample.
To estimate the percentage of reported Schedule C receipts that were on a  Form 1099-MISC, we compared amounts reported on the Form 1099-MISC  and on Schedule C (line 1 total gross receipts or sales). This analysis used  SOI data on individual tax returns for tax year 2001, which included a  sample of information returns. We found that three Form 1099-MISC items  could be reported on a Schedule C, including nonemployee compensation  (NEC), medical payments, and fish sales. According to IRS, these Form  1099-MISC items could also be reported on two other IRS forms— Schedule F, Profit and Loss From Farming, and Form 4835, Farm Rental  Income and Expenses—other than the Schedule C. We found that about 4  percent of the amounts reported on the Form 1099-MISC were reported on  Schedule F or Form 4835. This difference was not material to our  computation. Further, our analysis did not consider several sources of  noncompliance that could affect the computation, such as the nonfiling of  the required Schedule C or Form 1099-MISC or the underreporting of  Schedule C or Form 1099-MISC amounts.
To estimate the percentage of Form 1099-MISC returns where the payer  and the payee have the same address, we used an SOI data file with tax  year 2001 individual income tax return information. We compared the  postal codes and the numeric portion of street addresses reported by the  payer and payee to identify whether they had the same address. For those  who did, we reviewed a sample to verify that the addresses were the same.  We also reviewed 55 Form 1099-MISC filings at the Ogden, Utah, campus,  which provided 8 examples in which a payer and payee had similar  addresses or names. We did not review other IRS records to determine  whether these Form 1099-MISC filers were related parties.
To assess the likelihood of being assessed a penalty, controlling for other  factors, we used logistic regression analysis, an econometric method  appropriate for analyzing variables with dichotomous outcomes. We used  the deciles of the continuous variables as the independent variables in the  model. We did not weight the NRP returns or incorporate the NRP  stratification because penalties are a function of the audit and the NRP  returns are not representative of audited returns.
Controlling for use of a paid preparer, adjusted gross income, Schedule C  amount, and total tax as reported by the taxpayer, a logistic regression  was used to predict a penalty based on the absolute value of the difference  between the total tax reported on the Form 1040 and the total tax after the  NRP audit and the percentage of tax change (the difference in total tax  divided by the total tax reported on the Form 1040). We found a significant  effect of the percentage change in tax owed and the absolute value of the  tax change on the likelihood of receiving a penalty. That is, individuals in  higher deciles (5th through 10th deciles) of the percentage increase in tax  were generally more likely than those in the lowest decile to be  recommended for a penalty. Additionally, taxpayers in higher deciles of  the absolute value of the tax change (4th through 10th deciles) were more  likely than those in the lowest decile to be recommended for a penalty  controlling for other factors. We also found that the odds of a penalty  decreased with each decile increase in the taxpayer’s reported total tax  liability.
Although we did not test for interactions that could mitigate this effect, we  found our results to be robust across a variety of model specifications. We  did not control for other potentially relevant variables, such as differences  among examiners, and did not test for whether the case was abated.
We used several approaches to identify options to close the tax gap related  to sole proprietors that could be included in the tax gap strategy being  developed by the Department of the Treasury (Treasury). First, we sought  ways to address the gaps between the nature of sole proprietor tax  noncompliance and existing IRS programs. Second, we reviewed various  research publications on sole proprietors and our recommendations, as  well as those from the President’s Budget, President’s Advisory Panel on  Federal Tax Reform, Treasury Inspector General for Tax Administration,  IRS’s Taxpayer Advocate, and IRS advisory group reports. Third, we  identified and discussed options and their the pros and cons with experts  and knowledgeable individuals on sole proprietor compliance issues,  including former Commissioners of Internal Revenue; persons who have  experience with IRS or other federal programs related to sole proprietors;  representatives for various national organizations representing sole  proprietors, tax return preparers, or tax lawyers; tax staff working for  Congress; and relevant staff at IRS and Treasury. All of the national  organizations representing sole proprietors had large memberships and we  contacted each organization’s committee which focuses on small business  issues. From this work, we consolidated the list of options and pros and  cons. We excluded a few options that were raised near the end of our  work, lacked details, or generated comments or questions from experts  and knowledgeable individuals on how the options would work.
The list of options is not exhaustive and has limitations. Since data did not  exist for analyzing the effect on the tax gap, taxpayers, or IRS for each  option, we could not independently validate or weigh the pros or cons  suggested by our experts and knowledgeable individuals. Because the  experts and knowledgeable individuals had competing interests on  questions of tax policy and administration, we did not seek consensus on  the “best” options or on the pros and cons. Experts had limited time to  discuss all the options and pros and cons. Thus, we did not discuss each  option in detail in each interview, but overall, the interviews provided  enough details for the options in our report. As a result of such limitations,  we did not try to rank the options. Instead we described the options based  on input from the literature and experts. More detailed proposals could  raise other pros or cons not listed in our report.
We used several approaches to assess data reliability. We assessed  whether the examination results and data contained in the NRP database  were sufficiently reliable for the purposes of our review. For this  assessment, we interviewed IRS officials about the data, collected and  reviewed documentation about the data and the system used to capture  the data, and completed testing of relevant data fields for obvious errors in  accuracy and completeness. We completed analytic testing to ensure that  tax return items that should logically be equal were equal. For example,  the net profit and loss line on Schedule C should be accurately transferred  and equal to the similar line on the individual income tax return. We also  compared the information we collected through our case file review to  corresponding information in the NRP database to identify  inconsistencies. This testing found that the NRP results for Form 1040  returns with Schedule C forms were sufficiently reliable for our review.
The tax gap, SOI, AUR, and Examination data are all from sources that we  used in previous reports. Based on assessments done for those reports, the  fact that the sources are public and widely used, and additional testing we  did to ensure that we were properly interpreting individual data elements,  the data were sufficiently reliable for our review.
We conducted our review at IRS Headquarters in Washington, D.C., and at  IRS’s Ogden, Utah, campus from July 2006 through June 2007 in  accordance with generally accepted government auditing standards.
section_title: Appendix II: Options to Address Problems with the Tax Compliance of Sole Proprietors
paragraphs: We have developed a list of options for reducing the tax gap for sole  proprietors by reviewing our past reports as well as other related literature  and by talking to experts and knowledgeable persons about sole  proprietors’ tax compliance. As we built the list of options, we discussed  the options and the related pros and cons with these experts, including  past and current IRS and Treasury staff; former IRS Commissioners;  congressional staff; representatives of organizations representing sole  proprietors, tax preparers, and tax lawyers; and others who have working  knowledge of tax compliance and IRS programs.
This list is not exhaustive nor is the list of the pros and cons associated  with each option. Many of the options are concepts rather than fully  developed proposals with details of how they would be implemented.  Additional detail could bring more pros and cons to light. The pros and  cons are not weighted, and options should not be judged by the number of  pros and cons. We are not making recommendations about the options or  ranking their desirability. Rather, we have aligned these options with a  series of known problems with sole proprietor tax compliance. Some of  the options overlap, covering more than one problem while other options  only deal with specific aspects of a problem.
subsections: section_title: A. Recordkeeping and Complexity
paragraphs: For our system of voluntary compliance to work, taxpayers must keep  appropriate records. Our work on sole proprietors has raised issues about  incomplete or inaccurate recordkeeping by sole proprietors as well as  about the difficulties they face in dealing with complex tax rules. The  options in this section look for ways to improve recordkeeping, simplify  some of the rules, or provide more guidance and education to sole  proprietors to reduce their burden.
subsections: section_title: 1. Work with small business representatives on their ideas for improving the instructions for keeping records and meeting their Schedule C filing obligations.
paragraphs: More education and better guidance could help sole proprietors comply  with the complex tax rules for reporting on the Schedule C. IRS could  work with small business and trade representatives to determine whether  and how specific changes to IRS’s existing education and guidance would  help those filing the Schedule C.
Helping educate sole proprietors on their recordkeeping requirements and  filing obligations (Schedule C and information returns) could reduce  noncompliance.
The costs to update the instructions is probably minimal, while the cost  for the education would not be.
Getting specific ideas that would help sole proprietors might take some  time and effort, depending on the extent to which IRS tests these ideas.  It may be difficult to target the education and guidance and improve  instructions for the sole proprietors who need them the most, that is, those  who keep poor records or make errors on the Schedule C. These sole  proprietors may not have the time or incentive to pay attention.
Changes may not help those who rely on a paid tax return preparer or  bookkeeper because of IRS’s tendency to forward tax information to the  taxpayer but not to the tax return preparer.
Some education efforts could be costly to IRS, such as efforts to contact  taxpayers individually.
section_title: 2. Provide assistance to first-time Schedule C filers.
paragraphs: IRS could consider at least two broad approaches that would   a) specifically target outreach to sole proprietors filing their first Schedule  C to inform them about the option to receive regular e-mails on topics of  interest, the small business hotline, the resource guide, and other services  specifically targeted to help small businesses and   b) automatically send computer-generated notices (i.e., soft notices) to  first-time Schedule C filers who did not use a paid tax preparers (to reduce  the number of notices) and who reported on certain Schedule C lines that  involve more complexity or higher noncompliance (e.g., accounting  method, depreciation, travel, or home office) about guidance on IRS’s Web  site on reporting such issues.
This would provide new sole proprietors with the specific information that  they need to comply.  It would also help new sole proprietors avoid “bad habits” before they  become rooted.
Using e-mail would reduce IRS’s costs.    Using automated screening and soft notices would increase IRS’s  “presence” without the costs of an enforcement contact (e.g., audit).
There is no assurance that sole proprietors will read the information and  comply.
Some sole proprietors may not use e-mail or want to provide an e-mail  address to IRS.  IRS would incur some costs for the outreach and notices.
Soft notices may not boost compliance if they are too vague or if sole  proprietors perceive that IRS will not follow up in future tax years on the  soft notices.
Waiting to act until after the first Schedule C filing may be too late to  change the behavior of some sole proprietors.
section_title: 3. Separate business and personal records and transactions.
paragraphs: Two requirements could help sole proprietors distinguish their business  transactions and records from personal ones. Details would need to be  worked out on any exceptions or tolerances; on offering incentives rather  than requirements; and on enforcing and penalizing any noncompliance  with the requirements, which follow.  a) Require sole proprietors to include all business transactions in a  business bank account or accounts used only for business purposes. Such  transactions would include deposits of business receipts and payments of  business expenses. Receipts or expenses generated outside of the business  would not be part of these business accounts. Further, financial  institutions could provide sole proprietors with an annual summary of  inflows and outflows for the business account(s).  b) Require each sole proprietor to obtain a taxpayer identification number  (TIN) for a business. Currently, sole proprietors generally are required to  obtain business TINs, known as employer identification numbers (EIN),   when they have wage-earning employees for filing certain types of returns.  In this option, sole proprietors could use EINs for their business  transactions in lieu of using their Social Security numbers.
Recordkeeping could improve, which would reduce the time and burden  of preparing returns and responding to IRS’s inquiries.  IRS could save money if its computer matching and audits could be done  more quickly and with more certainty.
Retroactively creating fictitious business expenses after the tax year  would be easier to detect.
Tax compliance would improve to the extent that sole proprietors would  weed out personal expenses from their business expenses.
Financial institutions may charge fees for separate business accounts and  statements.
Taxpayers who want to evade may not deposit all their income in the  business accounts or still could run personal expenses through their  business accounts.  It might be unnecessary or burdensome for Schedule C filers who are not  regularly operating a business but have intermittent Schedule C receipts  and expenses.  IRS may have difficulty enforcing such a requirement.
section_title: 4. Repeal certain limitations in section 530 of the Budget Act of 1978 involving guidance on rules for classifying workers.
paragraphs: Lift the limitations on IRS issuing rules and guidance on the criteria to  determine whether a worker is to be treated as an employee or an  independent contractor for tax purposes as well as on the related safe  harbors for employers that classified workers as independent contractors.
Guidance and rules might help clarify confusion in the myriad of  employment relationships that have evolved since 1978.
Clarification might help ensure that the correct amounts of taxes are being  paid.
Some types of sole proprietors might prefer  legislative clarification rather than trusting IRS to lead the efforts to  clarify and   living with the current confusion rather than opening the door to  changes, particularly if they do not trust IRS to make equitable  decisions about the proper classification or the existing safe harbors.
section_title: B. Burdens and Problems for Third Parties in Filing Information Returns
paragraphs: Information reporting offers a way to cover more of the income of sole  proprietors who do not report all of their gross receipts. However,  information reporting suffers when the information returns are not filed or  are filed erroneously and late. Those filing the information returns may  face difficulties or burdens in filing information returns on paper or when  a sole proprietor does not provide a valid TIN. A number of options exist  to better ensure that IRS receives the required information returns on  payments made to sole proprietors while minimizing the burden of those  filing these information returns.
subsections: section_title: 5. Clarify Schedule C instructions to indicate that information returns may be required to be filed by sole proprietors who deduct expenses for wages, fees, and commissions.
paragraphs: To the extent more Forms 1099-MISC are filed, sole proprietors are likely  to be more compliant in reporting business income.
The instructions would provide another outlet for notifying taxpayers of  their Form 1099-MISC reporting obligations at a minimal cost.
If those who are to file the required information returns do not read or  follow the instructions, the clearer instructions would not boost required  filings.  If IRS receives more information returns, its costs to process and use them  would rise.
section_title: 6. Change the IRS Web- based system for filing information returns to accommodate those filing information returns on payments made to sole proprietors, particularly those filing a smaller number of information returns.
paragraphs: To the extent more Forms 1099-MISC are filed, sole proprietors are likely  to be more compliant in reporting business income.
Web-based filing could reduce the costs, burdens, and errors for everyone  compared to filing/processing paper information returns. IRS may be able  to reduce its start-up costs by modifying its Filing Information Returns  Electronically system.
If those who are to file the required information returns are not  comfortable filing information through the Web, do not have access to  computers, or do not want to file them at all, more filings of the required  returns may not occur.
If IRS requires extensive registration steps in order to file on the Web,  some filers might find those steps too burdensome.  IRS would incur start-up costs to create a new form and a Web-based filing  system.  IRS would incur additional costs to process and use the information from  a significant increase in the number of filed information returns.
section_title: 7. Create a new Form 1099- NEC to segregate NEC from the various boxes on the existing Form 1099- MISC.
paragraphs: Although payment of NEC would trigger the requirement to file a Form  1099-NEC, IRS could request other summary information in the expanded  space on this separate form about payments to sole proprietors, such as  expenses reimbursed, noncash payments, type of services received, or  payments for goods.
To the extent more information returns are filed with the new form and  1.  sole proprietors are likely to be more compliant in reporting business  2.  filing would be less confusing,  3.  IRS could refine its computer matching to minimize “false” leads that  burden compliant taxpayers, and  4.  IRS would have better data to improve its research and case selection  for enforcement contacts to the extent that IRS requested other  information.
IRS has no assurance that a new form would reduce taxpayers’ burden  enough to lead to more filings of the required information returns.  IRS would incur additional costs if it has to process a significant increase  in the number of filed information returns and if it has to expand its  existing enforcement activities to check compliance in filing these types of  required information returns.
section_title: C. Unreported Income for Sole Proprietors
paragraphs: For tax year 2001, about 70 percent of the sole proprietors misreported  about 57 percent of their net business income. IRS’s examinations are  limited in number and scope and do not find much of the unreported  income. Information reporting offers a way to cover more noncompliant  sole proprietors and focus on unreported gross receipts. However,  information reporting covered just a quarter of the gross receipts reported  on Schedule Cs. One reason for the gap is that current information  reporting focuses on payments for services and excludes certain  payments, such as those totaling below a certain threshold and those to  corporations. These options attempt to address these gaps in information  reporting for sole proprietors.
subsections: section_title: 8. Expand gross receipts reporting on the Schedule C.
paragraphs: Sole proprietors would break out their total gross receipts on the Schedule  C to show the amount reported to them on information returns. Other  information could be required, such as the number of information returns  received and details on large payments.
Sole proprietors could be more sensitized to use the information returns  received and thus more accurately report gross receipts.  IRS could be more productive in detecting unreported gross receipts by  matching the Schedule C and information returns filed or analyzing the  ratio of total gross receipts reported on the Schedule C and information  returns in audit selection.
No additional burden would be placed on third parties.
The reporting is unlikely to stop all businesses that wish to hide payments.
If their records do not account for whether the income was reported on a  Form 1099-MISC, sole proprietors may have an additional burden to report  the information.  IRS would incur some costs to process and use the additional data.
section_title: 9. Close gaps in existing information reporting on payments made to sole proprietors.
paragraphs: Information returns are not required on all payments for services, creating  gaps when matching information returns that are filed to determine if all  the service payments received have been properly reported. Two options  to address these gaps include requiring information reporting on annual  service payments that (1) are made to all corporations or to some subset ,  such as small corporations, non-publicly held corporations, or  noncompliant corporations (clear definitions of exclusions would be  needed), and (2) total less than $600, which now triggers information  reporting.
Sole proprietors who incorporate or receive payments below $600 should  be more likely to comply in reporting business income.
Sole proprietors would be less likely to structure payment amounts to  avoid information reporting.
Businesses would not have to distinguish between incorporated and  unincorporated businesses in determining whether to file information  returns.  IRS could improve the productivity of its computer matching for  unreported income.
Businesses that file more information returns could incur significant costs  and burdens, particularly if they have to expand their recordkeeping or  make distinctions between small and large corporations.  IRS would incur costs to process and match more information returns, and  might not be able to use all of the new data if the number filed increases  significantly.
The information returns would be unlikely to encourage larger  corporations that provide services to comply or help IRS find unreported  income among larger corporations.
Those receiving payments that are less than $600 might not account for  much of the unreported income or might not be more noncompliant than  other sole proprietors.
section_title: 10. Require new information reporting by organizations on payments to sole proprietors.
paragraphs: These options would offer a way to get new information from  organizations about payments made to sole proprietors.  a) Require businesses that process credit card payments for merchants to  report information on the amount of payments made to sole proprietors  for a tax year. This reporting could be a summary or include details for  payments above some specified amount.  b) Require federal, state, and local governments to file information returns  on all nonwage payments made (or those above a threshold) for property  and services from corporate and noncorporate businesses. Certain  payments, such as those related to interest, real property, and tax-exempt  entities, would be excluded.  c) Require financial institutions to file information returns on business  deposits and withdrawals by sole proprietors, which would be facilitated  to the extent that business transactions are segregated in business  accounts under business TINs.
Sole proprietors covered by any of these options might be more compliant  in voluntarily reporting more business income on their Schedule Cs.
Each of the options would provide information that IRS could use to select  better enforcement cases or to be more productive in its enforcement  activities. For example, credit card reporting could allow IRS to develop a  ratio of credit card receipts to all receipts reported by sole proprietors by  type of industry, and knowing deposit and withdrawal activity could allow  IRS to better identify sole proprietors’ gross receipts through its bank  deposit analysis method. Similarly, the information can be used to avoid  selecting a company for audit if the information reports suggest that the  taxpayer is compliant.
Credit card companies and financial institutions would have some  reporting costs.
Governments would incur some reporting costs, but they already would  have to incur similar costs to meet the tax withholding requirement that  Congress approved for these payments starting in 2011, and federal  agencies are already required to file some of these data with IRS for  federal contracts.  IRS would incur some costs to analyze the information from all the  options and to figure out its best uses to identify underreporters.  IRS might find it hard to use the increased amount of information returns  at all or productively.  If some businesses that use credit cards want to underreport income, they  might move more transactions to the cash economy.
The information would not help identify unreported income among sole  proprietors who do not use credit cards, do not have accounts with  financial institutions, or do not contract with governments.
To the extent that financial institutions are reporting deposits and  withdrawals related to nonbusiness activities, or that sole proprietors  move funds between multiple business accounts, the information could  create false leads for IRS that burden compliant taxpayers.
section_title: 11. Require new information reporting on consumer payments to sole proprietors.
paragraphs: This option envisions new information reporting by organizations but also  by consumers. It would require property owners to report on payments  made to contractors for improvements if the payments will be used to  adjust the basis of the property for depreciation or sales purposes.  Property owners would be required to report the contractors’ TINs. Absent  the information return in their records, the property owners could not  adjust the basis for tax purposes.
Information reporting on such contracts could cover a substantial dollar  value.
Sole proprietors may be more likely to report the payments on their tax  returns.
The payment information could cover a larger portion of the gross receipts  than just service payments.
Consumers would not have to be burdened with distinguishing the type of  business or type of payment in doing the reporting, and overall burden  would be limited by how often they contract for improvements.
Property owners would have some incentive to report the contractor  payments and a defensible foundation for basis adjustments claimed in the  future.
The incentive for property owners may dissipate if their basis adjustments  offer few tax benefits because they do not depreciate or are not expected  to have a taxable gain when they are sold, or because property owners do  not keep the information returns in their records in order to compute and  justify adjustments to basis many years later.
Property owners would have some burden to track and report the  information and to deal with contractors that do not want to provide their  TINs, for which some recourse would be needed.
If contractors want to avoid having these payments reported to IRS, they  could negotiate with property owners for a lower price in return for  property owners not filing the information returns.  IRS would have to spend some time and money sorting the information,  particularly if the information is reported on paper rather than  electronically, and then using the information for research or enforcement.  IRS might find it hard to use all of the new information or to use it  productively.
Some may view disallowing a basis adjustment as a harsh penalty for  failing to file an information return.
section_title: D. Overstated Deductions for Sole Proprietor Expenses
paragraphs: A portion of the $68 billion sole proprietor tax gap arises from overstating  deductions for business expenses. Based on what NRP detected, IRS has  estimated for 2001 that about 73 percent of the sole proprietors  misreported about $40 billion in expense deductions. Although IRS  auditors find it easier to check claims for expense deductions than to hunt  for unreported income, IRS audits cover few of the noncompliant sole  proprietors who overstate business deductions. And the information  reporting system does not cover payments made by sole proprietors that  could be deductible business expenses. The options in this section look to  provide more information about expenses to allow IRS to match or  otherwise use to find overstated deductions.
subsections: section_title: 12. Expand expense reporting on the Schedule C.
paragraphs: Sole proprietors would break out the amount of payments made for  services on the relevant expense lines of the Schedule C. Additional  information could be required, such as for payments above a specified  amount.
Sole proprietors might be more sensitized to the need to accurately claim  expense deductions on the Schedule C and the need to also report them on  required information returns.
Tax preparers would have more incentive to check expense reporting  compliance.  If adequate, IRS could use the data to detect overstated expenses by  matching amounts reported as expenses on the Schedule C lines with the  amounts reported on information returns filed by the sole proprietor or by  analyzing the ratio of total expenses to amounts reported on an  information return’s audit selection.
No additional burden would be placed on third parties.
IRS might have difficulties processing and matching all of the new expense  data.  IRS would incur difficulties, such as extra costs, to process and use the  additional data.  If their records are incomplete on their expenses and information returns  or their accounting systems do not break out expenses by the services  provided, sole proprietors may have an additional burden to report the  information.
This would not stop all reporting noncompliance.
section_title: 13. Match information returns filed by sole proprietors with related expenses on their Schedule Cs.
paragraphs: IRS would match the existing information returns filed by sole proprietors  to report their payments made for wages, services, and so forth to the  related lines of the Schedule C in order to see whether the expenses  claimed are consistent with the amounts reported on the information  returns. As with any computer match, IRS would need to develop rules for  doing the match and tolerances for contacting the sole proprietors about  discrepancies.
Such reverse matching could help identify excess deductions, especially  for wages, without incurring the costs of audits.  If sole proprietors learn about the reverse matching, they may become  more compliant in reporting expenses    This matching would not impose any new burdens on third parties and  little burden on compliant sole proprietors if the matching criteria are  effective.
Beyond wages and possibly some types of nonemployee compensation,  IRS may find it difficult to effectively match expenses in order to avoid  contacting compliant sole proprietors.  If sole proprietors want to overstate deductions and know that IRS can  use the information returns they file to look for overstated deductions,  some of them may file fictitious information returns.
section_title: 14. Expand information reporting on the expenses of sole proprietors.
paragraphs: The expanded information reporting to cover expenses claimed on the  Schedule C could include two options:  a) Businesses receiving certain types of payments from sole proprietors in  large amounts (i.e., thousands of dollars) would file information returns to  report those amounts by type of expense. Beyond limiting such reporting  to large dollar amounts (which would need to be set), the reporting also  could be limited to certain types of payments that are easier to report or  that tend to be overstated as expenses on the Schedule C (e.g., rents, fees,  insurance, and travel).  b) Businesses that process credit (and debit) card payments would be  required to report information on the amount of payments by sole  proprietors for each tax year. This reporting could be a summary total or  include more details for payments above some specified amount. IRS  would need to decide how it would use this information to check for  overstated expenses on the Schedule C.
Having the data might help IRS detect certain overstated expenses without  incurring the costs of an audit. Otherwise, IRS would have more  information on the expenses of sole proprietors for use in selecting cases  for auditing.
Sole proprietors might report their expenses more accurately with third- party data.
Third-party businesses doing the reporting would have additional costs to  file the information returns or burdens to know whether the payments are  personal or business related.
Some businesses might not want to report to IRS about payments they  receive from sole proprietors, particularly if those payments account for  most of their gross receipts and they underreport those payments on their  tax returns.
Sole proprietors wishing to avoid the credit reporting may use more cash  purchases.  If IRS were to use the information in a matching program, it would incur  costs to process and match it in order to avoid contacting compliant sole  proprietors and to identify personal expenses mixed in with business  expenses.
section_title: 15. Verify additional expenses claimed to offset unreported income.
paragraphs: Through some form of review or audit of documentation, IRS could verify  additional business expenses in those cases where sole proprietors claim  additional expenses after IRS informs them that it has discovered  unreported business income.
IRS could improve the effectiveness of its AUR matching to the extent that  it stops sole proprietors from claiming unverified expense offsets.
If AUR staff do the verification, IRS would incur costs to train them to do  the verification and find additional staff to keep up the volume of AUR  contacts.  If audit staff do the verification, IRS would have to make sure that the  return on investment justifies allocating more expensive, better-trained  staff to do the verification.  If IRS develops some other verification program, it would incur start-up   and operational costs.
section_title: E. Nonpayment of Tax
paragraphs: In addition to misreporting business income and expenses, the  noncompliant sole proprietors do not pay their tax liabilities. Even so, they  can receive government benefits, such as contract payments and Social  Security credits. And they are not subject to a proven tax compliance  technique for many individual taxpayers—tax withholding. This section  lists options that could help induce sole proprietors to meet their tax  obligations to receive benefits or avoid tax withholding.
subsections: section_title: 16. Deny benefits/payments until tax obligations are met.
paragraphs: One way to induce sole proprietors to pay their taxes owed is to deny  them government benefits unless they have paid the taxes. Federal  agencies that provide the benefits would need to check for tax compliance  with IRS, and the prohibitions against disclosing tax data would need to be  revised to ensure that the authority exists. Two options for checking tax  compliance before providing government benefits are to  a) require that sole proprietors pay their self-employment tax obligations  in order to receive credit for Social Security benefits or  b) require federal agencies to do a tax compliance check with IRS before  making a contract payment or otherwise providing a government benefit  (certain loans or grants) to a sole proprietor (either all or just  contractors). At a minimum, a check would be made to see whether the  sole proprietor has unfiled tax returns or unpaid tax liabilities.
Sole proprietors would have an incentive to meet their tax obligations.    This would help ensure that compliant sole proprietors’ competitors pay  their taxes.
To the extent that sole proprietors are not motivated by the loss of Social  Security credits or government benefits, some of them may continue to not  pay their taxes.
Sole proprietors could be unjustly denied credits or benefits because of a  systemic/human error and thus would need some venue for seeking an  administrative remedy.
Federal agencies would incur costs to check compliance and might incur  some contracting delays if the compliance checks take a lot of time.
Denying some types of loans/grants (e.g., for disaster or poverty) may be  seen as harsh.
section_title: 17. Withhold tax to encourage tax compliance.
paragraphs: Another way to induce sole proprietors to pay their taxes owed is to  require situational or universal tax withholding from the payments made  to them. Two basic options would require those who are to file  information returns (e.g., government and business entities) on payments  made to sole proprietors to do tax withholding:  a) Withhold a small amount from payments until the sole proprietor’s TIN  is certified. This up-front withholding would replace “backup withholding”  in those cases where, over a year or more later, IRS informs the sole  proprietor that the TIN provided is invalid. IRS would need a system for  quickly and accurately certifying TINs, which can be either EINs or Social  Security numbers. Also, decisions would be needed on how much to  withhold and on what to do with the withheld amounts (e.g., paid to the  sole proprietor once the TIN is certified or remitted to IRS and reconciled  when the tax return is filed).  b) Withhold a small percentage of the payments made to sole proprietors  for services either in all cases or in limited situations, such as when sole  proprietors (1) voluntarily consent or (2) have a recent history of tax  noncompliance and IRS has not annually certified that they are now tax  compliant.
Sole proprietors would be more motivated to provide TINs that can be  certified, file their returns, report their income, and pay their taxes.
Those paying sole proprietors would probably have fewer burdens from  withholding the taxes up front compared to doing backup withholding  over a year later.
Using a low rate could get the sole proprietors into the system without  necessarily creating an undue burden on their business operations.  IRS would have fewer information returns with erroneous TINs that it  spends resources trying to correct or that cannot be used in its computer  matching programs.
Withholding would create an added burden for those doing business with  the sole proprietor, especially if they do not have systems for doing  withholding or periodically remitting tax amounts to IRS, or if they would  not have had to do backup withholding.
Business relationships or operations might be disrupted if IRS’s system for  validating TINs is slow or burdensome, or generates errors, while some  businesses may refuse to validate the TINs or to withhold payments if  requested to do so by the sole proprietor that they want to use.
Even with one low withholding rate, some sole proprietors may be  burdened if, for example, they operate on thin profit margins or have  limited working capital.  If multiple, withholding rates or exceptions for withholding were created  by industry, location, years in business, compliance history, and so forth to  minimize the negative business impacts on sole proprietors, questions  might arise about complexity, equity, and opportunities for “gaming” the  system to have a lower or no withholding rate.  If withholding were limited to sole proprietors, some could incorporate or  claim to be a corporation to avoid withholding.
section_title: F. IRS Management of Limited Resources
paragraphs: Following up on AUR mismatches and conducting examinations are  costly. Furthermore, some of IRS’s compliance and enforcement actions  mistakenly select compliant, rather than noncompliant, taxpayers. This  section discusses options for more effectively using IRS’s limited  resources by better using data and other tools.
subsections: section_title: 18. Improve audit selection of sole proprietor tax returns.
paragraphs: IRS could explore opportunities for improving its selection of sole  proprietor tax returns and tax issues to be audited in at least two ways.  a) IRS would use advanced automated selection systems to update the  current manual classification system to better select returns and tax issues  for audit.  b) IRS would improve the ability of AUR to refer cases for audit, such as  when unverified (e.g., oral) claims about income and expenses are made.  AUR is limited in pursuing such cases, and IRS Examination already has  selected many cases for audit by the time the referrals are made.
IRS could select returns with a higher likelihood of tax changes at a lower  cost and with lower burden on compliant sole proprietors.
More automation could free a number of experienced audit staff who help  select these returns and these tax issues for audit to do more audits.  IRS might be able to increase the dollar yield from finding unreported  income and denying unjustified claims for offsetting deductions.
IRS would incur costs to collect and test enough data to create an effective  automated system.  IRS is likely to still need some manual intervention to account for location- specific issues that cannot be programmed into the automated system  IRS might find that these AUR cases are still less productive than other  audit cases.
section_title: 19. Enhance data sharing with the states.
paragraphs: IRS would seek to improve data-sharing arrangements with the states.  State data could include using business licensing, ownership of real estate  or other large assets, sales receipts, and tax compliance data to identify  unfiled returns and underreported income.
IRS could cost effectively identify noncompliance, especially nonfilers,  that it otherwise would miss.
State data may be difficult to match with federal data because states  impose different taxes than the federal government, may use a different  taxable base, and may report the data in a format that IRS cannot easily  use.
section_title: 20. Use informational notices to encourage compliance.
paragraphs: IRS would send notices (soft notices) to Schedule C filers when it sees  potential compliance issues that it does not have the resources to audit.  These notices notify and educate the filers about a potential problem with  a tax reporting obligation, and suggest that they either recheck their filed  tax returns or change their reporting on future returns.
IRS can expand its presence/education and sensitize sole proprietors  about tax obligations without the costs of enforcement contacts.
Some sole proprietors may become more compliant voluntarily.
Some sole proprietors will ignore the soft notices, particularly if they are  received years after a return was filed or if IRS will not take follow-up  action regardless of what they do.
section_title: 21. Revise the rules for applying penalties to improve consistency and compliance
paragraphs: One tool to increase compliance is to punish improper behavior with  penalties. Two options to remedy the inconsistent application of penalties  are to    simplify the process for assessing penalties and develop standards to  ensure the consistency of their application to sole proprietor errors and  misconduct and    make information return penalties scalable by increasing the dollar  amount of penalties for subsequent failures to file required information  returns (e.g., the penalty for the tenth failure to file an information return  may be significantly higher than the first).
Sole proprietors who are significantly noncompliant would be penalized,  and the equity and consistency of penalty application might improve.
Some sole proprietors might become more compliant if they are certain  that penalties will be applied.  If IRS applies the penalties more consistently, fewer sole proprietors may  need to incur the burden of seeking abatements for unnecessary penalties.  IRS could receive more required information returns that are accurate and  timely.
If the process becomes too rigid, some sole proprietors might resent the  perceived inequities. Some sole proprietors might have equity concerns if  IRS cannot reduce higher penalties caused by a systemic glitch for many  information returns (e.g., a computer error that occurred over and over).  If revised penalty rules go too far in accounting for inadvertent actions,  hardships, and other reasonable causes, the penalty consistency may be  hard to achieve.  If many sole proprietors are required to file only a few information returns,  scaling penalties would have little impact, and if only a small dollar  amount of penalties is at stake, IRS procedures are likely to continue  authorizing abatement of the penalties.
section_title: Appendix III: IRS Form 1040 Schedule C, Tax Year 2001
section_title: Appendix IV: Independent Contractors and Section 530 of the Revenue Act of 1978
paragraphs: With increased IRS enforcement of the employment tax laws beginning in  the late 1960s, controversies developed over whether employers had  correctly classified certain workers as independent contractors rather  than as employees. In some instances when IRS prevailed in reclassifying  workers as employees, the employers became liable for portions of  employees’ Social Security and income tax liabilities (that the employers  had failed to withhold and remit), although the employees might have fully  paid their liabilities for self-employment and income taxes.
In response to this problem, Congress enacted section 530 of the Revenue  Act of 1978 (Pub. L. No. 95-600). That provision generally allows an  employer who meets certain requirements (such as filing required  information returns) to treat a worker as not being an employee for  employment tax purposes (but not income tax purposes), regardless of the  individual’s actual status under the common-law test, unless the taxpayer  has no reasonable basis for such treatment. Under section 530, a  reasonable basis is considered to exist if the taxpayer reasonably relied on  (1) past IRS audit practice with respect to the taxpayer, (2) published  rulings or judicial precedent, (3) long-standing recognized practices in the  industry of which the taxpayer is a member, or (4) any other reasonable  basis for treating a worker as an independent contractor. Section 530 also  prohibits the issuance of Treasury regulations and revenue rulings on  common-law employment status. Congress intended that this moratorium  to be temporary until more workable rules were established but the  moratorium continues to this day. The provision was extended indefinitely  by the Tax Equity and Fiscal Responsibility Act of 1982.
The rules to classify a worker as an employee or an independent  contractor are still complex and often difficult to apply. The determination  of whether a worker is an employee or an independent contractor is  generally made under a facts and circumstances test that seeks to  determine whether the worker is subject to the control of the employer,  not only as to the nature of the work performed but the circumstances  under which it is performed. In general, the determination of whether an  employer-employee relationship exists for federal tax purposes is made  under a common-law test.
IRS has developed a list of 20 factors that may be examined in determining  whether an employer-employee relationship exists. The 20 factors were  developed by IRS based on an examination of cases and rulings  considering whether a worker is an employee. The degree of importance  of each factor varies depending on the occupation and the factual context  in which the services are performed.
Misclassification of workers can be either inadvertent or deliberate.  Because the determination of classification is factual, reasonable people  may differ as to the correct result given a certain set of facts. Thus, even  though a taxpayer in good faith determines that a worker is an  independent contractor, an IRS agent may reach a different conclusion by,  for example, weighing some of the 20 factors differently. The prohibition  on issuance of general guidance by IRS may make the likelihood of  classification errors greater; IRS is not permitted to publish guidance  stating which factors are more relevant than others. In the absence of such  guidance, not only may taxpayers and IRS differ, but different IRS agents  may also reach different conclusions, resulting in inconsistent  enforcement.
A significant issue is the potential revenue loss to the federal government  when employees are misclassified as independent contractors. An IRS  survey of 1984 employment tax returns found that nearly 15 percent of  employers misclassified employees as independent contractors. When  employers classified workers as employees, more than 99 percent of wage  and salary income was reported. When workers were misclassified as  independent contractors, 77 percent of income was reported when a Form  1099-MISC was filed and only 29 percent was reported when no Form  1099-MISC was filed.
section_title: Appendix V: Backup Withholding Rules
paragraphs: Persons (payers) making certain types of payments must withhold and pay  to IRS a specified percentage of those payments under certain conditions.  Related to sole proprietors, for example, both (1) the commissions, fees,  or other payments for work as an independent contractor and (2)  payments by fishing boat operators, but only the part that is in money and  that represents a share of the proceeds of the catch, are reported on Form  1099-MISC. Other payments are not subject to backup withholding,  including wages, real estate transactions, foreclosures and abandonments,  and canceled debts. Also corporations, governmental entities, and foreign  governments generally are exempt from backup withholding.
For backup withholding to be initiated on payments to sole proprietors, a  payment must be reportable and the payee must fail to furnish a correct  TIN. If an incorrect TIN is provided, IRS is to notify the payer regarding  the missing, incorrect, or not currently issued payee TIN. At that time the  payer is required to compare the listing with his or her records and send a  notice to the payee, asking for the correct TIN. Under tax rules, if the  payee refuses to provide a TIN, the payer is required to immediately begin  withholding 28 percent of the amount of the payment and remit that  amount to IRS. IRS procedures describe how the payer is to verify the TIN  and request that the payee provide a correct TIN. The payer must make up  to three solicitations for the TIN (initial, first annual, and second annual)  to avoid a penalty for failing to include a TIN on the information return. If  the payer files an information return with a missing TIN or with an  incorrect name and TIN combination, or does not follow the procedure to  correct the TIN, the payer may be subject to a $50 penalty for each  incorrect return filed.
section_title: Appendix VI: Comments from the Department of the Treasury
section_title: Appendix VII: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contact named above, Tom Short, Assistant Director;  Evan Gilman; Eric Gorman; Leon Green; George Guttman; Shirley Jones;  Donna Miller; Karen O’Conor; Anna Maria Ortiz; and Sam Scrutchins made  key contributions to this report.
section_title: Related GAO Products
paragraphs: Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax  Gap. GAO-07-488T. Washington, D.C.: February 16, 2007.
Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax  Gap. GAO-07-391T. Washington, D.C.: January 23, 2007.
Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a  Variety of Approaches. GAO-06-1000T. Washington, D.C.: July 26, 2006.
Tax Gap: Making Significant Progress in Improving Tax Compliance  Rests on Enhancing Current IRS Techniques and Adopting New  Legislative Actions. GAO-06-453T. Washington, D.C.: February 15, 2006.
Tax Gap: Multiple Strategies, Better Compliance Data, and Long-Term  Goals Are Needed to Improve Taxpayer Compliance. GAO-06-208T.  Washington, D.C.: October 26, 2005.
Tax Compliance: Better Compliance Data and Long-term Goals Would  Support a More Strategic IRS Approach to Reducing the Tax Gap.   GAO-05-753. Washington, D.C.: July 18, 2005.
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal  Sustainability but Will Require a Variety of Strategies. GAO-05-527T.  Washington, D.C.: April 14, 2005.
IRS Audits: Weaknesses in Selecting and Conducting Correspondence  Audits. GAO/GGD-99-48. Washington, D.C.: March 31, 1999.
Tax Administration: Billions in Self-Employment Tax Are Owed.  GAO/GGD-99-18. Washington, D.C.: February 18, 1999.
Tax Administration: Issues Involving Worker Classification.   GAO/T-GGD-95-224. Washington, D.C.: August 2, 1995.
Tax Administration: Estimates of the Tax Gap for Service Providers.  GAO/GGD-95-59. Washington, D.C.: December 28, 1994.
Tax Administration: IRS Can Better Pursue Noncompliant Sole  Proprietors. GAO/GGD-94-175. Washington, D.C.: August 2 1994.
Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy  Needed. GAO/GGD-94-123. Washington, D.C.: May 11, 1994.
Tax Administration: Approaches for Improving Independent Contractor  Compliance. GAO/GGD-92-108. Washington, D.C.: July 23, 1992.