Tax Gap: IRS Could Do More to Promote Compliance by Third Parties with Miscellaneous Income Reporting Requirements
Released: 2009-02-27T00:00:00

Letter

Background

Payers are required to submit 1099-MISCs for a variety of payments made in the course of a trade or business. For 1099-MISC reporting, a trade or business generally includes businesses, non-profit organizations, and federal, state, and local government agencies.

The types of payments reportable on a 1099-MISC and their reporting thresholds vary widely. These include payments to nonemployees for services of at least $600 (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. Personal payments, such as a payment by a homeowner to a contractor to paint his/her personal residence, are not reportable on a 1099-MISC. Other payments that are not reportable on a 1099-MISC generally include payments to a corporation, payments for merchandise, and wages paid to employees. Wages paid to employees must be reported on a form W-2. There are many other types of payments that must be reported and numerous exceptions to these general rules. IRS provides eight pages of instructions detailing what payments to whom are reportable on the 1099-MISC. The form—shown in figure 1—consists of 14 boxes for reporting the various types of miscellaneous payments.

The Bush Administration’s fiscal years 2008 and 2009 budgets proposed legislative action further expanding 1099-MISC reporting to include service payments of $600 or more to corporations by all third-party payers. According to the Department of the Treasury’s estimate, the Bush Administration’s fiscal year 2009 budget proposal would generate about $8.2 billion over the 10-year budget period from 2009 through 2018, in part because of increased voluntary compliance and IRS’s ability to detect underreported payments received by businesses.

For tax year 2006, more than 5 million payers submitted more than 82 million 1099-MISCs to IRS, reporting over $6 trillion in payments. Nonemployee compensation payments totaled about $2.3 trillion and accounted for about 55 percent of all 1099-MISCs submitted. Medical and health payments totaled about $1.2 trillion and accounted for about 25 percent of all 1099-MISCs submitted. Each of the remaining payment types accounted for less than 10 percent of the number of 1099-MISCs submitted. Figure 2 shows the distribution of 1099-MISC payments types and amounts reported for tax year 2006.

In addition to the 8 pages of instructions for 1099-MISC reporting, IRS also has 19 pages of general instructions for third-party information reporting, detailing how and when payers are to submit 1099-MISCs to payees and IRS. 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, along with a Form 1096, Annual Summary and Transmittal of U.S. Information Returns. Payers submitting paper 1099-MISC 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 to submit the forms magnetically or electronically. Electronic submissions due at the end of March can be submitted through IRS’s Filing Information Returns Electronically (FIRE) system. As shown in figure 3, most 1099-MISCs for tax year 2006 were submitted electronically. However, most payers submit small numbers of 1099-MISCs, and most payers submitted paper 1099-MISCs.

IRS’s four business operating divisions are generally responsible for ensuring payers comply with their 1099-MISC reporting requirements. The Wage & Investment Division, Tax Exempt and Government Entities Division (TE/GE), Large and Mid-Size Business Division (LMSB), and Small Business and Self-Employed Division (SB/SE), as a part of their duties, conduct examinations of tax returns and documents to verify compliance with tax laws. Examinations can include checking payer compliance with 1099-MISC reporting requirements.

IRS can penalize payers for failing to submit or submitting an inaccurate 1099-MISC. The penalty is generally $50 per information return, increasing to $100 each for intentional payer noncompliance of 1099-MISC requirements. To encourage voluntary reporting compliance, the penalty is $15 (up to a maximum of $75,000 per calendar year or $25,000 for small businesses) if the 1099-MISC is submitted within 30 days of the due date; $30 (up to a $150,000 maximum per calendar year or $50,000 for small businesses) if submitted after 30 days but by August 1, and $50 (up to a maximum of $250,000 per calendar year or $100,000 for small businesses) if submitted after August 1 or not at all. IRS will waive the penalty if the payer can show “reasonable cause” or if the error or omission does not prevent or hinder the IRS from processing the 1099-MISC. In IRS’s fiscal year 2009 budget proposal, the Bush Administration proposed increasing the $50 and $100 penalties to $100 and $250 respectively for each information return. In 2007, we suggested that Congress consider requiring IRS to periodically adjust penalties for inflation, and round appropriately, the fixed dollar amounts of civil tax penalties to account for the decrease in real value over time and so that penalties for the same infraction are consistent over time.

Payees are responsible for reporting payments they received from payers on the appropriate lines of their tax returns. Payees are also responsible for paying self-employment taxes if they received nonemployee compensation. For example, a sole proprietor receiving a 1099-MISC for nonemployee compensation is to report the payments on Schedule C of the 1040 tax return and file Schedule SE to pay the associated self- employment taxes. Sole proprietor payees are supposed to report 1099- MISC payments as gross receipts and separately report their expenses rather than reporting only net amounts.

Figure 4 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.

According to IRS, third-party information reporting increases voluntary tax compliance in part because taxpayers know that IRS is aware of their income. For wages and salaries subject to tax withholding and substantial third-party information reporting, the percentage of income that taxpayers misreport has consistently been measured at around 1 percent. In contrast, for non-farm sole proprietor income subject to little or no third-party reporting, taxpayers misreported more than half of such income in 2001, according to IRS’s most recent tax gap estimates.

IRS Has Little Information about 1099-MISC Reporting Compliance, but Available Evidence Points to the Possibility of a Significant Problem

IRS does not have an estimate of 1099-MISC reporting compliance or know the characteristics of those payers that fail to comply with the reporting requirements. Without an estimate of payers’ 1099-MISC noncompliance, IRS does not know to what extent such noncompliance allows payees to underreport their income without being detected. If a large number of payers fail to submit required 1099-MISCs, then the resulting decrease in payee tax compliance and lost revenue could be large. According to IRS, it is a common misconception among payees that they are not required to report payments if they have not received a 1099-MISC from payers.

IRS has invested significant resources in measuring compliance with other aspects of the tax laws. For example, the National Research Program (NRP) estimated the compliance rate for individual taxpayers for tax year 2001 based on an intensive review of a sample of 46,000 tax returns. IRS is in the process of completing a new study of the rate of tax compliance by individual taxpayers for tax years 2006 and 2007, and is conducting a similar study of S-corporations. IRS uses such research to understand where compliance problems are greatest and to understand the sources of noncompliance. Armed with such understanding, IRS can make better decisions about where and how to deploy its resources to address noncompliance.

Although IRS Does Not Know the Extent of 1099- MISC Payer Noncompliance, Available Evidence Points to the Possibility of a Significant Problem

Our analysis of 1099-MISC submission patterns by small businesses as well as past studies of federal, state and local government agencies suggests that payer noncompliance with 1099-MISC reporting requirements may be potentially significant. Our analysis of IRS’s PMF data for tax year 2005 (the last complete year available) showed that, in aggregate, 8 percent of small businesses (sole proprietorships, and corporations and partnerships with assets under $10 million) submitted a 1099-MISC. As shown in figure 5, over 4 million small businesses submitted 1099-MISCs in tax year 2005, and in comparison, 50 million small businesses filed income tax returns with IRS that same year. Results were similar for the three previous years.

The fact that a relatively low percentage of small businesses submitted a 1099-MISC does not indicate on its own that there is a significant payer noncompliance problem. The many exceptions to the general rules for submitting 1099-MISCs along with the payment thresholds mean that many small businesses may not be required to submit a 1099-MISC. However, if even a small proportion of the almost 46 million small businesses that did not submit 1099-MISCs in 2005 improperly failed to report as required, there could be millions of missing 1099-MISC information reports. As a consequence, payees could have less incentive to voluntarily report that 1099-MISC income on their own tax returns if they did not receive a 1099- MISC from the payer, and IRS would be unable to detect payee underreporting through document matching. Yet, IRS has no idea of the magnitude of payer noncompliance and thus the amount of missing 1099- MISCs, as discussed above.

As a proxy for a possible 1099-MISC reporting requirement, we examined the 1099-MISC submission rate for Schedule C small businesses that reported amounts of $600 or more in contract labor expenses. Based on IRS’s Statistics of Income (SOI) data for tax year 2006, about 29 percent of Schedule C filers reporting contract labor expenses of $600 or more submitted 1099-MISCs. Again, we could not determine whether the other 71 percent of Schedule C filers reporting contact labor expenses over the 1099-MISC reporting threshold were noncompliant. Some payers may have amounts under the reporting threshold to multiple payees, and other payers may have paid corporate payees currently exempt from 1099-MISC reporting. However, some payers may have failed to submit 1099-MISCs as required, and IRS does not have data to estimate how often this occurs.

Our 2003 assessment of federal agency compliance with 1099-MISC reporting requirements did find significant payer noncompliance. While most federal agencies in the 14 departments we studied submitted information returns as required for calendar years 2000 and 2001, there were some significant exceptions. Three federal departments— Agriculture, Commerce and Justice—collectively made $5 billion in payments to 152,000 payees in 2000 and 2001 but did not report the payments to IRS on Form 1099-MISCs. In turn, about 8,800 of the payees who collectively received payments totaling about $421 million dollars— an average of about $48,000 each—did not file income tax returns for those 2 years.

In June 2007, TIGTA reported that trends in 1099-MISC reporting by state and local governments demonstrated potential payer noncompliance for tax years 2003 through 2005. For example, while TIGTA found that over half of the 81,000 state and local government entities submitted 1099-MISC forms for each of the 3 years, 30 percent did not submit any 1099-MISC forms over the period. As of December 2008, IRS had research planned for fiscal year 2009 to determine whether state and local governments that did not submit any 1099-MISCs for tax years 2003 through 2005 were noncompliant and reasons why they did not report.

Research about Payers’ Noncompliance with 1099- MISC Reporting Requirements Could Help IRS Target Efforts to Increase Payer Voluntary Reporting Compliance

Research about the extent and causes of payer noncompliance could help IRS develop more effective strategies to increase 1099-MISC submissions. Such research would involve costs, but there are options for mitigating the costs. IRS might be able to build on current research efforts, such as the NRP, or use existing data from the Payer Master File.

Because NRP is already collecting detailed information about small business compliance with the rules for reporting receipts and expenses, the design of the NRP could be tailored at a relatively low cost to assess the extent to which these small businesses submitted 1099-MISCs as required.

In the 2006 and 2007 NRP, IRS is studying whether payers that submitted 1099-MISCs correctly classified the payees as nonemployees. By misclassifying employees as nonemployees, employers could avoid withholding taxes as well as paying employment taxes. The 2006 NRP used a supplemental questionnaire to collect information on 1099-MISC payer reporting for use in assessing misclassification issues. The 2007 NRP procedures will direct NRP examiners to more systematically capture data about whether small business payers in the NRP sample were required to submit information returns—including 1099-MISCs—but did not. At this time, IRS has not studied the extent to which payers failed to submit 1099- MISCs, but the future NRP results could be useful for this purpose.

Another option IRS could explore at a relatively low cost is using PMF data to identify businesses that stop reporting or never report 1099-MISCs. The PMF data set was used by TIGTA and us in detecting whether federal, state, and local governments reported 1099-MISCs. In turn, IRS used PMF data to select a sample of state and local governments that did not submit any 1099-MISCs for a compliance research project planned for fiscal year 2009. To explore small business payer noncompliance, IRS could use the PMF data to identify those businesses that submitted 1099-MISCs in past years but stopped reporting. IRS also could compare the PMF population to its master file to identify small businesses that never submitted 1099- MISCs, and subsequently conduct research to audit a sample of the population to determine whether those not submitting 1099-MISCs should have. From this type of research, IRS could decide how to target particular segments of the payer population (e.g., Schedule C filers that report contract labor expenses over $600 or more but do not submit 1099-MISCs) for more education and outreach in order to reduce payer noncompliance.

Benefits of 1099-MISC payer compliance research could be significant. For perspective, payers reported $6 trillion in 1099-MISC payments for tax year 2006, so a one percent increase in reported payments could result in an additional $60 billion reported to payees and IRS.

IRS Efforts to Detect Payers That Fail to Submit 1099-MISC Forms Are Uneven

Within IRS, TE/GE is active in detecting and pursuing 1099-MISC payer noncompliance among federal, state, and local agencies in part so that government contractors and vendors cannot evade their tax liabilities. A TE/GE official said that the division’s focus is on employer quarterly returns that governmental entities file, as opposed to annual income tax returns that the other business divisions examine. According to IRS officials, as a part of this resource-intensive focus on quarterly returns, TE/GE examiners also scrutinize information returns, including 1099- MISCs, that governmental entities file. To illustrate the impact that TE/GE’s efforts had on detecting noncompliance among government payers, IRS audit specialists identified and secured over 30,000 additional 1099-MISCs totaling over $522 million in payments that governmental entities made to payees for tax years 2005 through 2007.

According to IRS officials, TE/GE implemented a “stop filer” program in response to our 2003 recommendation that IRS develop a mechanism for identifying and tracking federal agencies that fail to submit Form 1099- MISCs. This automated stop filer notice program, which is a minimal cost approach compared to other enforcement options for detecting possible payer noncompliance, was developed for federal agencies that submitted 1099-MISCs one year but not the next. Using PMF data, TE/GE issues IRS form 3939 to a federal agency that stops submitting 1099-MISCs, asking the agency to provide an explanation. TE/GE officials said they sent over 1,100 stop filer notices for tax year 2006 to federal entities in August 2008. The officials also said the federal agencies’ responses to these notices are useful to TE/GE in selecting federal agencies for voluntary compliance checks or examinations. Servicewide, IRS also uses PMF data to identify payers that submit 1099-MISCs late or with missing tax identification numbers (TINs). However, IRS does not systematically use the database to identify payers with gaps in 1099-MISC reporting history or those that never submit the 1099-MISC forms.

At the time of our review, TE/GE officials stated that numerous discrepancies exist in the PMF with the coding for state and local governments, and the division is working to correct them. For fiscal year 2009, TE/GE plans a 1099-MISC compliance check for a random sample of 200 state and local governments that did not submit 1099-MISCs for tax years 2003 through 2005. Once they have completed this activity, they will determine whether sending notices to state and local governmental agencies to check for payer noncompliance with 1099-MISC reporting requirements is an option they should pursue.

Another low cost approach that TE/GE officials used is to compile a listing of common 1099-MISC payer compliance problems drawn from information obtained through examinations and compliance checks. For example, government payers sometimes fail to report all payments, or submit 1099-MISCs late or with missing payee information. According to TE/GE officials we interviewed, their list of common 1099-MISC reporting errors is used both to educate examiners on what to look for during examinations and reach out to government agencies to help them better comply.

For business taxpayers, IRS policy instructs SB/SE and LMSB examiners to determine whether all information returns, including 1099-MISCs, are submitted as required and consider internal controls for information return reporting. LMSB examiners are to conduct risk analyses of tax returns to identify potential noncompliance issues as part of the audit planning process. As a result of the risk analysis and in contrast with SB/SE practices, LMSB examiners can waive the compliance checks for LMSB taxpayers to ensure efficient and effective use of resources.

Where an examination identifies that a business failed to comply with its requirement to submit information returns, including Form 1099-MISC, the examiner is to secure the missing information returns. IRS could not provide data on how many business examinations detected payers that failed to submit 1099-MISCs or how many missing 1099-MISCs have been secured by LMSB and SB/SE examiners. While examinations primarily focus on income and employment tax liabilities for business payers, the examiner also is to consider whether to pursue information return penalties depending on the facts and circumstances of the case. Improved voluntary compliance by the payer and its payees may justify the expenditure of time required to track down the missing 1099-MISCs and assess the penalties. However, the maximum penalty is $50 for unintentional payer noncompliance and $100 for intentional noncompliance for each additional 1099-MISC collected. IRS has proposed increasing information return penalties to $100 and $250, respectively.

Further, examinations have limitations in that they are costly and cover relatively few businesses each year, and thus would not necessarily be cost-effective as the sole means to address 1099-MISC payer reporting compliance. For example, IRS data show that IRS examinations covered less than 1 percent of the 2.2 million tax returns that small corporations filed for fiscal year 2007. As we previously reported, IRS examined about 3 percent of Schedule C returns in fiscal year 2006.

Beyond conducting examinations, which we have described as having limitations, IRS does not have an agencywide approach in place to identify payers that do not submit 1099-MISC forms. More specifically, IRS does not have a stop filer notice program for businesses, as it does for federal agencies, to detect 1099-MISC reporting gaps. In contrast with the relatively small and stable populations of federal, state, and local government payers, the large and shifting population of small businesses might challenge IRS in designing a cost-effective method for isolating and contacting business payers that do not submit 1099-MISCs. Given that new businesses start each year while others stop operating or merge with other businesses, one approach would be to first check to see whether a business filed a tax return before sending any notice inquiring about 1099- MISC reporting. While notices are likely to provide a more cost-effective approach for pursuing possible payer noncompliance compared to examinations, it would be important for IRS to test a stop filer program to determine how to target notices to businesses. For Schedule C filers for example, a notice program could target payers that reported large contract labor expenses but did not submit 1099-MISCs. Without testing the viability of a broader stop filer notice program, IRS could be overlooking a useful tool that would help increase 1099-MISC payer compliance.

Payers Face Impediments in Preparing and Submitting 1099- MISCs, and Some Options Could Help Promote Voluntary Reporting Compliance by Payers

According to IRS officials, IRS advisory groups, and members of the 1099- MISC community we interviewed, a variety of impediments inhibit 1099- MISC reporting compliance. As a result, some payers report erroneous information or fail to submit all 1099-MISCs as required. 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 by various aspects of the 1099-MISC requirements. Finally, the inconvenience of submitting 1099-MISCs—whether on paper forms or electronically—may deter compliance. While the extent to which these impediments contribute to payer noncompliance is unknown, interviewees and others identified options for addressing them to promote voluntary compliance.

Table 1 highlights options based on our analysis and includes options we previously reported. We note 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 legislative 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.

According to our interviewees, multiple approaches could help IRS to increase payer compliance with 1099-MISC reporting requirements. For some options, such as eliminating the exemption on reporting corporate payments, the evidence shows that the benefits outweigh the costs. For other options, it is not clear whether the benefits outweigh the associated costs. In those cases, 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.

IRS Aims to Improve AUR Efficiency but Lacks a Systematic Process for Learning about the Causes of Mismatches

Adopting strategies, discussed above, to promote voluntary compliance with 1099-MISC reporting requirements and to better monitor payer noncompliance would likely increase the number of 1099-MISCs IRS receives from payers. This in turn would increase the number of automated mismatches identifying potential underreporting by payees. However, the AUR program does not pursue all the mismatches from the 1099-MISCs currently received. Given limited resources for the AUR program, it is important for IRS to find ways to more efficiently expand AUR coverage and select the best 1099-MISC related cases to work.

While 1099-MISCs constituted 5 percent of all information returns AUR used to detect underreporting, a significant portion of the AUR cases and assessments were based on 1099-MISC information, as shown in table 2. For tax year 2004 (the last full year available), 19 percent of 1099-MISC related cases were selected for review, yielding 21 percent of the additional tax dollars assessed by the AUR program. From the 1.9 million 1099-MISC related cases with identified income discrepancies, AUR selected a larger proportion (47 percent) for review than from the AUR inventory as a whole (31 percent). Over three-quarters of all 1099-MISC related cases selected involved nonemployee compensation. The remaining 1099-MISC related cases involve other types of 1099-MISC payments, such as those for rent and medical services. For tax year 2004, 1099-MISC related cases in total yielded $972 million additional assessments, accounting for 21 percent of AUR assessments.

IRS’s New Soft Notice Initiative Could Increase AUR Program Efficiency

AUR currently has a limited reach, pursuing less than half of 1099-MISC related cases in its inventory and less than a third of the overall inventory for tax year 2004. Attempting to increase AUR program efficiency, IRS has pilot tested an automated “soft notice” program since 2005. The goal of this program pilot is to increase accurate reporting compliance with minimal additional expenditures for IRS. For this program pilot, AUR first selected cases from the inventory that involved relatively small amounts of money and thus would not have been selected for review, and then expanded the pilot to include cases with higher-dollar potential tax assessments. The 2,505 cases in the pilot test during fiscal years 2005 and 2006 included 550 nonemployee compensation cases based on 1099-MISC information. AUR sent letters to these taxpayers asking them to either fix the identified discrepancy by filing an amended return. However, if the taxpayer’s reported income is correct, IRS encouraged the taxpayer to contact the third party providing the information to IRS. The soft notice is intended to educate and promote future compliance, requiring minimal response to the notice from taxpayers.

Based on the pilot, IRS concluded that the soft notice approach increased taxpayer compliance, without placing a heavier burden on AUR resources to respond to taxpayers’ queries. In total for the 2 pilot years, 25 percent of taxpayers receiving AUR soft notices filed amended tax returns, and 78 percent corrected their reporting behavior in the next year’s AUR inventory. Less than 13 percent called IRS to inquire about the soft notices. With phased rollout slated to begin in fiscal year 2009, AUR would be able to achieve a greater coverage over the balance of cases in the inventory beyond those selected for AUR review. Accordingly, the soft notice approach may be an innovative, cost-effective way for IRS to have a greater enforcement presence using 1099-MISC information. However, it is too early to assess whether the effectiveness of the soft notice pilot can be generalized to the AUR program overall. For tax year 2007, IRS plans to send about 30,000 AUR soft notices across the range of AUR income categories—including about 4,400 1099-MISC related cases. As of October 2008, IRS plans to collect data on taxpayer responses and develop an analysis plan to determine which AUR case types are suited for future soft notices.

IRS Could Use Data on Unproductive 1099-MISC Cases to Better Target Case Selection and Provide Service to Reduce Misreporting

Some cases AUR selected from its inventory are not productive; that is, some cases do not yield any additional tax revenue. About 36 percent of the 1099-MISC related cases selected for tax year 2004 were manually screened out by AUR reviewers without taxpayer contact. Such cases may be screened out because the payee erroneously reports a 1099-MISC payment on the wrong tax return line but paid the correct taxes or because the discrepancy was because of an IRS error in transcribing a paper 1099-MISC. Of the 64 percent of the tax year 2004 1099-MISC cases selected that involve taxpayer contact, about 22 percent yielded no change in tax assessments. These unproductive cases cost IRS time and money that could be spent pursuing other taxpayers who owe additional taxes and burden honest taxpayers who must respond to IRS inquiries. A case may result in no tax change if a taxpayer responds to the AUR notice with information explaining the discrepancy. For example, an unproductive 1099-MISC discrepancy may be because the payer reported payments made to a partnership under an individual partner’s SSN rather than under the partnership TIN.

The screen-out process and handling taxpayer contacts are labor-intensive for AUR compared with computer processing, so reducing the number of unproductive cases would free up resources to work more productive cases. IRS officials told us that in fiscal year 2007, IRS implemented a new case selection tool using historical data to target cases with high assessment potential and that this new methodology has yielded progress in terms of increased AUR assessments during fiscal year 2008. An additional approach would be to gain insight into the source of discrepancies between information reported by payers submitting 1099- MISCs and by payees filing tax returns. An understanding of the specific causes could help IRS in evaluating its matching operations and refining the AUR case selection tool for 1099-MISC related cases. Additionally, the information would be useful to help IRS target activities to clarify guidance or target outreach to educate payers or payees to avoid common reporting errors.

Currently, IRS does not systematically collect and analyze information on the causes of unproductive mismatches that would allow it to determine how best to reduce or eliminate such mismatches. The AUR management information system has codes showing whether the case was closed with or without a tax change, but does not specify how AUR accounted for the discrepancy. For example, no change closing codes do not specify whether the discrepancy was because of payer misreporting, payee misreporting, or IRS error in transcribing paper 1099-MISCs. Additionally, IRS does not routinely collect data on the screen-out process, so IRS does not have information on the nature and cause of recurring 1099-MISC discrepancies. According to AUR officials, the AUR program periodically does special analyses to identify how to reduce screen-out rates but has not specifically studied 1099-MISC related cases. Capturing information on specific reasons why cases were unproductive is one approach to improve AUR’s efficiency. The information would be useful to the AUR program in making informed decisions on how to improve the match process and refine its case selection methodology for 1099-MISC related cases.

Moreover, IRS could draw on AUR data to identify common 1099-MISC reporting errors and determine how to target service activities to improve payer and payee reporting. For example, IRS could avoid some unproductive AUR cases by reminding taxpayers doing business as a corporation or partnership to provide their business TIN rather than their SSNs to payers. Insight about productive AUR cases also could help IRS identify opportunities to educate taxpayers on how to avoid common mistakes and correctly report 1099-MISC payments.

Conclusions

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. However, IRS has limited knowledge about the extent of payer noncompliance with 1099-MISC reporting requirements. If 1099-MISC reporting compliance increased by even one percent, it could result in an additional $60 billion of payments reported. Without better information about the extent and causes of payer noncompliance, IRS has no way of determining if placing a heavier emphasis or shifting more resources toward addressing 1099-MISC payer noncompliance could lead to an increase in payee voluntary compliance and ultimately help reduce the tax gap.

IRS could make better use of existing data to detect some kinds of payer noncompliance. Extending the stop filer notice program used for federal payers may be one tool for IRS to reach out to other government and business payers that drop off the radar. Developing an estimate of payer noncompliance and the characteristics of those payers would be key for IRS in developing a cost-effective strategy to identify payers that never submit 1099-MISCs.

Another approach for increasing 1099-MISC reporting compliance is for IRS to address the variety of impediments facing payers preparing and submitting 1099-MISCs. Eliminating the reporting exemption for payments to corporations would ease payer burden associated with first determining the status of their payees to identify whether payments are reportable. As early as 1991, we determined that the benefits in terms of increased tax revenue and voluntary taxpayer compliance would exceed the costs of extending 1099-MISC reporting, although we did not formally recommend the matter for congressional consideration at that time. IRS agrees that the benefits of eliminating the corporate exemption outweigh the costs, and the Bush Administration has proposed legislative action in its last two budgets. Although it is unclear the extent to which taxpayers read guidance on reporting requirements, especially taxpayers who use paid preparers, options for additional guidance and general reminders are a low cost way to help payers understand whether they have a 1099-MISC reporting requirement. For other options where it is unclear whether the benefits outweigh the associated costs, additional research by IRS could help to evaluate whether specific options would be feasible or effective in increasing payer compliance.

In turn, IRS research and other activities aimed at increasing payer reporting compliance would likely increase the number of 1099-MISC related AUR cases. Reducing the number of unproductive cases would free up resources for IRS to handle this increased workload and make better use of the 1099-MISC information it receives.

Matter for Congressional Consideration

To simplify the burden that the corporate exemption places on payers to distinguish payees’ business status and also provide greater information reporting, Congress should consider requiring payers to report payments to corporations on the form 1099 MISC, as we previously suggested and as proposed in the Bush Administration’s budget.

Recommendations for Executive Action

We are making eight recommendations to the Commissioner of Internal Revenue.

To gauge the extent of 1099-MISC payer noncompliance and its contribution to the tax gap, we recommend that the Commissioner of Internal Revenue as part of future research studies develop an estimate of 1099-MISC payer noncompliance and determine the nature and characteristics of those payers that do not comply with 1099-MISC reporting requirements so that this information can be factored into an IRS-wide strategy for increasing 1099-MISC payer compliance.

To increase IRS’s ability to detect 1099-MISC payer noncompliance, we recommend that the Commissioner of Internal Revenue test the option of developing a stop filer notice program to target business, state, and local entities that submitted 1099-MISC one year but did not do so the next.

To help payers better understand their 1099-MISC reporting responsibilities, we recommend that the Commissioner of Internal Revenue add a general reminder to Publication 535 Business Expenses to highlight 1099-MISC reporting responsibilities; assess whether adding a checkbox to business tax returns, inquiring whether all 1099-MISCs have been submitted, to serve as a reminder to payers would help increase 1099-MISC payer compliance; and include a chart on the Form 1099-MISC as well as business income tax instructions for distinguishing reportable from non-reportable payments and for calculating whether reportable payments reached the 1099-MISC reporting threshold.

To reduce the submission burden facing many payers each submitting small numbers of 1099-MISCs, we recommend that the Commissioner collect data on the numbers of computer-generated black and white 1099-MISCs submitted by payers and the labor spent reentering forms that cannot be scanned, and evaluate the cost-effectiveness of eliminating or relaxing the red ink requirement.

To help IRS improve its use of 1099-MISC information, we recommend that the Commissioner collect and analyze data on the types of unproductive AUR cases to help identify reoccurring errors for use in the AUR case selection process and for identifying ways to improve guidance and outreach to help payers and payees more accurately report 1099-MISC payments.

Agency Comments and Our Evaluation

In written comments on a draft of this report (which are reprinted in appendix II), IRS’s Deputy Commissioner for Services and Enforcement acknowledged that the evidence in our report indicates that the number of 1099-MISCs that payers are required to submit could be much higher than what IRS currently receives. IRS agreed with six of our eight recommendations. IRS staff provided technical comments that we incorporated as appropriate.

IRS agreed to gather additional data from its ongoing and planned NRP studies to determine the extent of 1099-MISC noncompliance. IRS also agreed to determine the nature and characteristics of noncompliant 1099- MISC payers once several years of reporting compliance data are available. In addition, IRS agreed to (1) analyze PMF data and develop a 1099-MISC stop filer notice test; (2) evaluate the cost effectiveness of eliminating or relaxing the red ink requirement; and (3) analyze data for a sample of AUR cases to identify opportunities to improve case selection and outreach and education for payers and payees.

IRS disagreed with our recommendation to assess whether adding a checkbox to business tax returns would increase 1099-MISC reporting compliance. IRS agreed to enhance instructions about 1099-MISC reporting requirements to improve voluntary compliance by payers. We do not believe this is fully responsive to our recommendation. IRS stated that a similar question was removed from the corporate tax return after the Paperwork Reduction Act of 1980 was enacted. IRS said that the act requires reducing unnecessary burden on taxpayers and prohibits collecting information already available. We recognize that the Paperwork Reduction Act requires agencies to certify that any collection of information avoids unnecessary duplication and is necessary for the proper performance of the functions of the agency, including whether the information has practical utility. In recommending that IRS explore the potential for this option to increase 1099-MISC reporting, we believe information about the experience of California and other states using a similar checkbox query could yield insight on how this option could improve payers’ reporting compliance by reminding payers of their reporting obligations. As discussed in this report, many taxpayers rely on tax preparers and tax software and may not look at IRS guidance. For this reason, the checkbox option—which we clarified would require taxpayers to respond under penalty of perjury—might be more effective because it would force tax preparers and software to query taxpayers about their expenses. Further, results from the evaluation we recommend could be useful to IRS in revisiting its 1981 assessment and weighing the benefits and burdens associated with the checkbox option. We clarified in the report that the National Taxpayer Advocate has reported that the taxpayer burden associated with the checkbox option would be small.

IRS also disagreed with our recommendation to include a chart in the 1099-MISC instructions and business income tax instructions. IRS stated that the Form 1099-MISC instructions already contain two bulleted lists describing which payments are reportable as well as explanations of the rules for specific payment types. However, these two lists as well as a third bulleted list describing reportable payments to corporations include 19 bullet points spanning two pages of the eight pages of single-spaced 1099-MISC instructions. We added an example to the report citing a chart in IRS’s 19-page general instructions that highlights what payments and amounts to report on the Form 1099-MISC. We believe that the chart approach is an effective way to provide taxpayers with a quick guide for navigating the detailed instructions for the Form 1099-MISC. For this reason, we continue to recommend adding a chart to the 1099-MISC instructions and business tax instructions.

As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days from its issue date. At that time, we will send copies to the Chairman and Ranking Member, House Committee on Ways and Means; the Secretary of the Treasury; the Commissioner of Internal Revenue; and other interested parties. This report will be available at no charge on the GAO Web site at http://www.gao.gov.

If you or your staff have any questions, please contact me on (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 III.

Appendix I: Scope and Methodology

The objectives of this report were to determine: (1) what IRS knows about 1099-MISC reporting noncompliance by payers; (2) how IRS detects and pursues 1099-MISC reporting noncompliance by payers; (3) what impediments payers encounter in preparing and submitting accurate 1099- MISC forms and what options could help IRS address these impediments; and (4) what opportunities exist to enhance IRS’s use of 1099-MISC information to both detect payee noncompliance and promote voluntary compliance.

For background about 1099-MISC reporting requirements, we reviewed laws and regulations as well as IRS guidance related to the Form 1099- MISC and also spoke with IRS officials. For background about the numbers and amounts of payments reported on the 1099-MISC, we obtained information reporting program data from Martinsburg Computing Center for tax year 2006. We also obtained data from IRS’s Payer Master File (PMF) on the aggregate numbers of payers submitting 1099-MISCs on paper and electronically for tax year 2006. We determined that these data were sufficiently reliable for our descriptive purposes.

To determine what IRS knows about the extent of 1099-MISC payer noncompliance, we reviewed IRS documents including plans for reducing the federal tax gap and National Research Program (NRP) as well as budget proposals to expand 1099-MISC reporting. Other reports we reviewed include past GAO and Treasury Inspector General for Tax Administration (TIGTA) reports on 1099-MISC reporting compliance by federal, state and local government entities. We also interviewed NRP officials and staff about research on 1099-MISC reporting compliance.

To obtain perspective on the potential magnitude of payer noncompliance, we compared the number of small businesses filing tax returns with number of small businesses submitting 1099-MISCs for tax years 2002 to 2005. We used IRS’s definition of small businesses—businesses entities including sole proprietorships, S-corporations, and partnerships with assets under $10 million—under supervision of IRS’s Small Business and Self-Employed (SB/SE) business operating division. We obtained total numbers of small business tax returns submitted in these four years from IRS’s Business Master File and the Individual Master File. For these IRS databases, we relied on the work we perform during our annual audits of IRS's financial statements. While our financial statement audits have identified some data reliability problems associated with coding some fields in IRS's tax records, we determined that the tax form count data were sufficiently reliable to address the report's objectives. We then compared the aggregate number of payers identified as small businesses from IRS’s PMF database to calculate the percentage of small business tax filers that submitted 1099-MISCs. The last complete year of payer type information available at the time of our analysis was 2005. While we could not isolate which businesses were required to submit a 1099-MISC but did not, we determined the data were sufficiently reliable to show how many small businesses submitted 1099-MISCs to IRS.

We could not produce a comparable 1099-MISC reporting percentage for large corporations and partnerships under supervision of IRS’s Large and Mid-Size Business (LMSB) business operating division. Large businesses may file a consolidated corporate income tax return under the parent company’s taxpayer identification number (TIN) for all its subsidiaries but submit 1099-MISCs under the individual subsidiaries’ TINs.

To obtain additional perspective on potential 1099-MISC payer reporting noncompliance among small businesses, we examined the 1099-MISC submission rates for a sample of small business Schedule C filers. Contract labor payments to a non-incorporated payee totaling $600 or more are reportable on a 1099-MISC, so we used contract labor line on Schedule C as proxy for a possible 1099-MISC reporting requirement. We included all Schedule C filers that reported $600 or more contract labor expenses from IRS’s Statistics of Income (SOI) for tax year 2006 (the last year available). We identified the Schedule C filers and provided their TINs to IRS. IRS provided data on whether these filers submitted a 1099-MISC as indicated on the IRS’s Information Return Master File. This resulted in 44 percent of the SOI sample (unweighted) matching 1099-MISC forms. We then used these matches to produce generalizable estimates of Schedule C filers reporting $600 or more in contract labor expenses. Using SOI sampling weights, we provide the margin of error based on 95 percent confidence for our SOI estimate. We determined the SOI results were reliable for estimating how many Schedule C filers who reported contract labor submitted a 1099-MISC. However, we could not discern whether those that did not submit 1099-MISCs had a filing requirement due to the exceptions for any payment under $600 and payments to corporations.

To determine how IRS detects and pursues payer noncompliance with 1099-MISC reporting requirements, we reviewed IRS’s procedures for checking compliance used by IRS’s business operating divisions—Tax Exempt and Government Entities Division (TE/GE), LMSB, and SB/SE. We also interviewed IRS examination and compliance staff from each of these divisions. Within TE/GE, we spoke with IRS officials responsible for working with federal, state and local government entities as well as Indian tribal governments. We interviewed IRS officials and staff about information returns processing and related penalties. Data on IRS’s small business examination coverage came from IRS’s publicly available Data Book. We believe the data were sufficiently reliable for the purposes of our review.

To identify impediments that payers encounter with 1099-MISC reporting, options and challenges IRS confronts in addressing these concerns, we reviewed IRS and IRS advisory committee reports, previous GAO reports as well as those of the National Taxpayer Advocate. Further, we reviewed IRS’s 1099-MISC form, instructions, and related guidance in addition to outreach material used to educate payers about 1099-MISC reporting requirements. We interviewed members of IRS advisory groups— Electronic Tax Administration Advisory Committee (ETAAC), Information Reporting Program Advisory Committee (IRPAC), and Internal Revenue Service Advisory Council (IRSAC). To obtain perspectives from tax preparers and others professionals knowledgeable about 1099-MISC payers, we interviewed attendees at IRS’s fall 2007 National Public Liaison meeting that included members of national stakeholder organizations, business and professional associations, tax professionals who prepare and submit forms to the IRS, and tax software vendors. We also observed IRS’s November 2007 National Phone Forum on Form 1099-Information Reporting and reviewed IRS’s question and answer summary provided to participants. We also reviewed California Franchise Tax Board’s corporation and S corporation tax return forms and interviewed the California officials about their experience with the check-the-box question on the California business returns.

To determine IRS’s use of 1099-MISC information, we reviewed IRS guidance for 1099-MISC submission processing and the Automated Underreporter (AUR) program. We also interviewed IRS’s Martinsburg Enterprise Computing Center, AUR, and nonfiler program officials and staff. We obtained program data on the AUR inventory, case selection, and additional dollars assessed for tax year 2004, the last full year available in time for this report. The number of information returns submitted to IRS came from SOI’s Data Book. We determined that the data we used were sufficiently reliable for the purpose of our review.

IRS nonfiler officials stated they are not able to distinguish nonfiler income tax return cases that were identified through 1099-MISC information from those identified through its stop filer program that identifies a gap in a taxpayer’s filing of tax returns. Consequently we were unable to quantify the extent to which 1099-MISC information is used to detect payee nonfiling in the program.

We conducted this performance audit from June 2007 through January 2009 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Comments from the Internal Revenue Service

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Acknowledgments

In addition to the contact named above, MaryLynn Sergent, Assistant Director; Jeff Arkin; Bertha Dong; Ellen Grady; Leon Green; Shirley Jones; Donna Miller; Karen O’Conor; Jessica Thomsen; Cheri Truett; James Ungvarsky; Shana Wallace; and John Zombro made key contributions to this report.

Related GAO Products

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.

Tax Compliance: Inflation Has Significantly Decreased the Real Value of Some Penalties. GAO-07-1062. Washington, D.C.: August 23, 2007.

Tax Gap: A Strategy for Reducing the Gap Should Include Options for Addressing Sole Proprietor Noncompliance. GAO-07-1014. Washington, D.C.: July 13, 2007.

Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax Gap. GAO-07-488T. Washington, D.C.: February 16, 2007.

Opportunities for Congressional Oversight And Improved Use of Taxpayer Funds: Budgetary Implications of Selected GAO Work. GAO-04-649. Washington, D.C.: May 4, 2004.

Tax Administration: More Can Be Done to Ensure Federal Agencies File Accurate Information Returns. GAO-04-74. Washington, D.C.: December 5, 2003.

Tax Administration: Federal Agencies Should Report Service Payments to Corporations. GAO/GGD-92-130. Washington, D.C.: September 22, 1992.

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