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. 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. 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. 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. 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. 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.