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

Letter

Background

As we reported in 2009, more than 5 million third parties submitted more than 82 million miscellaneous income information forms (Form 1099- MISC) to the IRS reporting more than $6 trillion in payments for tax year 2006. Third-party payers are businesses, governmental units, and other organizations that make payments to other businesses or individuals. Payers must submit payment information on 1099-MISCs to IRS when they make a variety of payments labeled miscellaneous income. Payees, or those being compensated, are required to report the payments on their income tax returns.

The types of payments reportable on a Form 1099-MISC—shown in figure 1—and their reporting thresholds vary widely. Under existing law, information reporting is required for payments by persons engaged in a trade or business to nonemployees for services of $600 or more (called nonemployee compensation), royalty payments of $10 or more, and medical and health care payments made to physicians or other suppliers (including payments by insurers) of $600 or more. However, personal payments, such as a payment by a homeowner to a contractor to paint his or her personal residence, are not required to be reported because these payments are not made in the course of a payer’s trade or business. Existing regulations also exempt certain payments to a corporation, payments for merchandise, wages paid to employees, and payments of rent to real estate agents. The expansion of information reporting to payments to corporations and for merchandise will apply to payments payments made after December 31, 2011. made after December 31, 2011.

Payers must provide 1099-MISC statements to payees by the end of January. Payers submitting fewer than 250 1099-MISCs may submit paper forms, which are due to IRS by the end of February. Payers submitting paper 1099-MISCs are required to use IRS’s official forms or substitute forms with special red ink readable by IRS’s scanning equipment. Photocopies and copies of the 1099-MISC form downloaded from the Internet or generated from software packages in black ink do not conform to IRS processing specifications. Payers submitting 250 or more 1099- MISCs are required by IRS to submit the forms electronically. Most 1099- MISCs for tax year 2006 were submitted electronically. However, most payers submitted small numbers of 1099-MISCs, and most payers submitted paper 1099-MISCs.

By matching 1099-MISCs received from payers with what payees report on their tax returns, IRS can detect underreporting of income including failure to file a tax return. Figure 2 shows the automated process IRS uses to detect mismatches between nonemployee compensation and other payments reported on 1099-MISCs and payees’ income tax returns. The Nonfiler program handles cases where no income tax return was filed by a 1099-MISC payee. The Automated Underreporter (AUR) program handles cases where a payee filed a tax return but underreported 1099-MISC payments. AUR’s case inventory includes payee mismatches over a certain threshold, and IRS has a methodology using historical data to select cases for review. AUR reviewers manually screen the selected cases to determine whether the discrepancy can be resolved without taxpayer contact. For the remaining cases selected, IRS sends notices asking the payee to explain discrepancies or pay any additional taxes assessed.

1099-MISC Information Reporting Increases Voluntary Taxpayer Compliance, Reduces the Cost and Intrusiveness of IRS Compliance Programs, and May Reduce Payees’ Costs of Preparing Their Tax Returns

Third-party information reporting is widely acknowledged to increase voluntary tax compliance in part because taxpayers know that IRS is aware of their income. As shown in figure 3, voluntary reporting compliance is substantially higher for income subject to withholding or information reporting than for other income. For example, for wages and salaries, which are subject to withholding and substantial information reporting, taxpayers have consistently misreported an estimated 1 percent of their income. For income with little or no information reporting, the tax year 2001 estimated percentage was about 54 percent. IRS has long recognized that if payments made to businesses are not reported on 1099- MISCs, it is less likely that they will be reported on payee tax returns.

In a 2007 report we highlighted the connection between a lack of information reporting and the contribution of sole proprietors, a significant portion of the small business community, to the tax gap. IRS estimated the gross tax gap—the difference between what taxpayers actually paid and what they should have paid on a timely basis—to be $345 billion for tax year 2001, the most recent estimate made. IRS also estimated that it will collect $55 billion, leaving a net tax gap of $290 billion. IRS estimated that a large portion of the gross tax gap, $197 billion, was caused by the underreporting of income on individual tax returns. Of this, IRS estimated that $68 billion was caused by sole proprietors underreporting their net business income. The $68 billion does not include other sole proprietor contributions to the tax gap, including not paying because of failing to file a tax return, underpaying the tax due on income that was correctly reported, and underpaying employment taxes. Nor does it include tax noncompliance by other types of businesses such as partnerships and S corporations. In the report, we noted that a key reason for this noncompliance was that sole proprietors were not subject to tax withholding, and only a portion of their net business income was reported to IRS by third parties. Tax noncompliance by some small businesses is unfair to businesses and other taxpayers that pay their taxes—tax rates must be higher to collect the same amount of revenue.

The 1099-MISCs are a powerful tool through which IRS can encourage voluntary compliance by payees and detect underreported income of payees that do not voluntarily comply. Increasing the numbers of 1099- MISCs IRS receives from payers in turn would increase information available for use in IRS’s automated matching programs to detect tax underreporting, including failure to file a tax return. For tax year 2004 (the last full year available for our 2009 report), the AUR program assessed $972 million in additional taxes for payee underreporting detected using 1099-MISC information. To help IRS improve its use of 1099-MISC information, we recommended in 2009 that IRS collect data to help refine its matching process and select the most productive cases for review. In response to our recommendation, IRS reviewed a sample of AUR cases and plans to modify its tax year 2010 matching criteria for 1099-MISC information.

Information reporting has allowed IRS to use its computerized matching programs as an alternative to audits to address some issues. The matching programs generally require less contact with taxpayers and thus are less intrusive and involve less taxpayer time.

In addition, information reporting may reduce taxpayers’ costs of preparing their tax returns. In a 2006 report we described how additional information reporting on the basis of securities transactions could reduce taxpayers’ need to track the basis of securities they sold. The extent to which 1099-MISC reporting reduces taxpayer recordkeeping costs is not known, but to the extent it reduces the need to track receipts by year from each payer it could have some effect on those costs.

IRS does not know the magnitude of 1099-MISC payer noncompliance or the characteristics of payers that fail to comply with the reporting requirements. Without an estimate of payer noncompliance, IRS has no way of determining to what extent 1099-MISC payer noncompliance creates a window of opportunity for payees to underreport their business income and go undetected by IRS. Research would be key for IRS in developing a cost-effective strategy to identify payers that never submit 1099-MISCs. In 2009, we recommended that IRS study the extent of 1099- MISC payer noncompliance and its contribution to the tax gap, as well as the nature and characteristics of those payers who do not comply. In response to our recommendations, IRS plans to study payer noncompliance through its National Research Program studies with results estimated to be available in December 2015.

Third Parties Incur Costs to File 1099- MISCs, but Case Study Entities Reported That the Costs of Complying with Current Requirements Were Relatively Low

Existing information reporting requirements impose costs on the third- party businesses required to file Form 1099-MISC. The expanded reporting requirements will impose new costs. To comply with information reporting requirements, third parties incur costs internally or pay external parties. In-house costs may involve additional recordkeeping costs beyond normal recordkeeping costs related to running a business, as well as the costs of preparing and filing the information returns themselves. If the third parties go outside their organizations for help, they would incur out- of-pocket costs to buy software or pay for others to prepare and file their returns.

Data on the magnitude of these information reporting costs are not readily available because taxpayers generally do not keep records of the time and money spent complying with the tax system. A major difficulty in measuring tax compliance costs, including the costs of filing information returns, is disentangling accounting and recordkeeping costs due to taxes from the costs that would have been incurred in the absence of the federal tax system. Data on compliance costs are typically collected by contacting a sample of taxpayers, through surveys or interviews, and asking them for their best recollection of the total time and money they spent on particular compliance activities. The quality of the resulting data depends on the ability of taxpayers to accurately recall the amount of time and money they spent.

In the nine case studies we conducted in 2007, filers of information returns told us that existing information return costs, both in-house and for external payments, were relatively low. While these nine case studies are not to be generalized to the entire population, they do provide examples of costs and insights from the perspective of organizations of different sizes and from different industries and of organizations filing their own information returns and those filing on behalf of others. In-house compliance costs include the costs of getting taxpayer identification numbers (TIN), buying software, tracking reportable payments, filing returns with IRS, and mailing copies to taxpayers.

One organization with employees numbering in the low thousands estimated that its costs of preparing and filing a couple hundred Forms 1099, which include recordkeeping and distinguishing goods from services, were a minimal addition to its normal business costs.

One small business employing under five people told us of possibly spending 3 to 5 hours per year filing Form 1099 information returns manually, using an accounting package to gather the information.

An organization with more than 10,000 employees estimated spending less than .005 percent of its yearly staff time on preparing and filing Forms 1099, including recordkeeping.

Unit prices for services provided to payers by selected software vendors, service bureaus, and return preparers decreased as the number of forms handled increased. Two external parties selling services reported prices for preparing and filing Forms 1099 with IRS of about $10 per form for 5 forms to about $2 per form for 100 forms, with one of them charging about $0.80 per form for 100,000 forms. These prices do not include the payers’ recordkeeping costs.

This relationship of price to size for entities we studied is consistent with what studies that we have seen show about the role of fixed costs and economies of scale in complying with the tax code; we are familiar with no similar studies of information returns.

Although our case study organizations indicated that 1099 recordkeeping and reporting costs are relatively low, costs may not be as low as they could be. According to IRS, advisory group members, and others we interviewed for our 2009 report, payers are confronted with a variety of impediments to preparing and submitting 1099-MISC forms. Some payers that do not submit their 1099-MISCs as required may be unaware of their 1099-MISC reporting responsibilities. Other payers may be confused about whether payments are reportable because of different dollar reporting thresholds and the general exemption for payments to corporations under current law. Some payers misreport or neglect to report payee taxpayer identification numbers (TIN) and could be subject to penalty and required to do backup withholding on 1099-MISC payments to payees with bad TINs. For the large number of payers each submitting a few 1099-MISCs, IRS does not offer a fillable form on its Web site and requires payers to submit scannable red ink forms, but some payers submit black and white 1099-MISCs anyway.

Opportunities Exist to Mitigate the Burden and Promote Reporting Compliance for Third Parties Submitting 1099-MISC Information Returns

Although businesses will face additional costs for each additional Form 1099, some options for modifying the 1099-MISC reporting requirements could help mitigate the burden and promote payer reporting compliance. Table 1 highlights options we previously reported. We noted those options that were proposed by IRS, IRS advisory groups, and the National Taxpayer Advocate. Our list of 1099-MISC impediments and options is not exhaustive, nor is the list of pros and cons associated with the options. Improved IRS guidance and education are relatively low-cost options, but most taxpayers use either tax preparers or tax software to prepare their tax returns and may not read IRS instructions and guidance. While taxpayer service options may improve compliance for those that are inadvertently noncompliant, they are not likely to affect those that are intentionally noncompliant. Some options to change 1099-MISC reporting requirements require congressional action, and other options would be costly for IRS to implement. Where the option involves particular issues, such as cost or taxpayer burden, we note them in our table.

As we reported in 2009, multiple approaches could help IRS to mitigate the reporting costs and promote payer compliance with 1099-MISC reporting requirements. For example, the evidence shows that the benefits outweigh the costs for information reporting for payments to corporations. For other options, it is not clear whether the benefits outweigh the associated costs, and additional research by IRS could help to evaluate the feasibility of more costly options, such as allowing black and white paper 1099-MISCs. Action to move forward on options to target outreach to specific payer groups or clarify guidance to reduce common reporting mistakes would hinge on IRS first conducting research to understand the magnitude of and reasons for payer noncompliance.

In 2009, we recommended two actions that IRS could take to help payers understand their 1099-MISC reporting responsibilities: Provide payers with a chart to identify reportable payments. IRS disagreed with our recommendation and stated that the Form 1099-MISC instructions already list which payments are reportable and explain the rules for specific payment types. We believe that a chart would provide taxpayers with a quick guide for navigating the Form 1099-MISC instructions, already eight pages long under the current reporting requirements.

Evaluate adding a new checkbox on business tax returns for payers to attest whether they submitted their 1099-MISCs as required. IRS also disagreed with this recommendation and stated that a similar question was removed from the corporate tax return after the Paperwork Reduction Act of 1980 was enacted. We believe results from the evaluation we recommend would be useful in weighing the benefits and burdens associated with a checkbox option.

To reduce the submission burden facing many payers submitting small numbers of 1099-MISCs, we also recommended that IRS evaluate the cost- effectiveness of eliminating or relaxing the red ink requirement to allow payers to submit computer-generated black and white 1099-MISCs. In April 2009, IRS conducted a test to determine the labor to process a sample of 4,027 red-ink 1099-MISCs versus the same documents photocopied. IRS told us that, using the same scanning equipment and employees, the red-ink sample took 2 hours and 9 minutes to process versus 28 hours and 44 minutes to process and manually key the photocopy sample. Based on the test results, IRS decided to maintain the red ink requirement to minimize labor costs. We have not reviewed the results of the IRS test.

Our prior work did not assess requiring 1099-MISC reporting on payments for goods. Some of our findings and recommendations may be relevant, but we do not know the extent of relevance.

Madam Chair, this concludes my statement. I would be pleased to respond to any questions you or other Members of the Committee may have.

GAO Contacts and Acknowledgments

For questions about this statement, please contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this statement. Individuals who made key contributions to this testimony include Amy Bowser, Bertha Dong, Lawrence Korb, MaryLynn Sergent, and Cheri Truett.

Related GAO Products

Tax Gap: IRS Could Do More to Promote Compliance by Third Parties with Miscellaneous Income Reporting Requirements. GAO-09-238. Washington, D.C.: January 28, 2009.

Tax Gap: Actions That Could Improve Rental Real Estate Reporting Compliance. GAO-08-956. Washington, D.C.: August 28, 2008.

Highlights of the Joint Forum on Tax Compliance: Options for Improvement and Their Budgetary Potential. GAO-08-703SP. Washington, D.C.: June 2008.

Tax Administration: Costs and Uses of Third-Party Information Returns. GAO-08-266. Washington, D.C.: November 20, 2007.

Business Tax Reform: Simplification and Increased Uniformity of Taxation Would Yield Benefits. GAO-06-1113T. Washington, D.C.: September 20, 2006.

Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis Would Improve Compliance if Related Challenges Are Addressed. GAO-06-603. Washington, D.C.: June 13, 2006.

Tax Policy: Summary of Estimates of the Costs of the Federal Tax System. GAO-05-878. Washington, D.C.: August 26, 2005.

Tax Administration: IRS Should Continue to Expand Reporting on Its Enforcement Efforts. GAO-03-378. Washington, D.C.: January 31, 2003.

Tax Administration: Benefits of a Corporate Document Matching Program Exceed the Costs. GAO/GGD-91-118. Washington, D.C.: September 27, 1991.

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