Tax Gap:

Limiting Sole Proprietor Loss Deductions Could Improve Compliance but Would Also Limit Some Legitimate Losses

GAO-09-815: Published: Sep 10, 2009. Publicly Released: Oct 13, 2009.

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Sole proprietors, who own unincorporated businesses by themselves, underreported their net income by 57 percent or $68 billion for 2001, according to the Internal Revenue Service's (IRS) most recent estimate. The underreporting includes both understated receipts and overstated expenses and may result in losses that can be deducted against income from other sources, such as wages. GAO was asked to (1) describe sole proprietor losses and the extent to which the losses are noncompliant, (2) assess how well IRS addresses the noncompliance, and (3) identify any options to better limit noncompliant losses. To meet its objectives, GAO analyzed IRS research databases, case files, and examination results data and met with IRS officials.

About 5.4 million or 25 percent of all sole proprietors reported losses in 2006. Ninety-five percent of these loss filers deducted some or all of their losses against other income, deducting a total of $40 billion. According to IRS estimates last made for 2001, 70 percent of the sole proprietor tax returns reporting losses had losses that were either fully or partially noncompliant. About 53 percent of aggregate dollar losses reported in 2001 were noncompliant. This noncompliance would correspond to billions of dollars of lost tax revenue. IRS's compliance programs address only a small portion of sole proprietor expense noncompliance. Despite investing nearly a quarter of all revenue agent time in 2008, IRS was able to examine (audit) about 1 percent of estimated noncompliant sole proprietors. These exams are costly and yielded less revenue than exams of other categories of taxpayers, in part because sole proprietorships are small in terms of receipts. Another enforcement program that primarily uses third-party information to electronically verify compliance is not effective because little expense information is reported by third parties. One approach for limiting sole proprietor loss noncompliance would impose a rule that limits losses that could be deducted from other income. The tax code has a number of such limitations. A loss limitation could reduce noncompliant losses but would also limit the ability of sole proprietors to claim legitimate losses. Another approach would improve IRS's estimates of the extent to which activities not engaged in for profit, such as hobbies, are contributing to noncompliant sole proprietor losses. Expenses associated with these activities are not deductible, but IRS's research on the causes of sole proprietor noncompliance has not used available data to estimate the extent of this type of noncompliance. Without such an estimate, IRS could be missing an opportunity to reduce noncompliant sole proprietor losses.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendations for Executive Action

    Recommendation: In order to better assess whether changes are needed in the way IRS administers activities not engaged in for profit provisions, the Commissioner of Internal Revenue should take steps to estimate the extent of activities not engaged in for profit noncompliance from its ongoing research programs.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Open

    Comments: IRS will use the National Research Program (NRP) reporting compliance study of form 1040 filers to gather information to estimate the extent of activities not engaged in for profit. This research will start with NRP's Tax Year (TY) 2009 sample. According to IRS, the time required to complete this research will depend on the number of observations identified during each tax year's NRP examinations. Update: Since the TY 2009 examinations do not start until FY 2011 and 3 years of examinations are needed to measure the noncompliance and a year is needed to analyze examination results, noncompliance data will not be available until FY 2015. Update: IRS added guidance in the IRM (Sec 4.22.3.2.2.9) in 2011 for NRP auditors of Schedule C filers that they suspect of being not engaged in for profit to classify the issue under " Section 183 - Not Engaged in for Profit Activity."

    Recommendation: In order to better assess whether changes are needed in the way IRS administers activities not engaged in for profit provisions, the Commissioner of Internal Revenue should take steps to collect information on examinations of activities not engaged in for profit issues from the compliance program.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Implemented

    Comments: IRS has provided a preliminary update on revisions to its information systems which capture and analyze the results of all individual income tax examinations. According to IRS, additional codes were added to identify whether examiners considered not for profit issues during individual income tax examinations. GAO has requested additional supporting documentation related to these changes. In February 2010, IRS modified the software used to record and analyze income tax examination results. Codes were added that identified whether not-for-profit activities were considered during the examination. From February 2010 to the end of fiscal year 2010, these not-for-profit activities codes were cited 621 times during examinations.

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