Why Area Is Important

The Internal Revenue Service (IRS) estimates that $68 billion of the $345 billion gross tax gap for 2001 was due to underreporting of federal income tax liabilities by self-employed owners of unincorporated businesses—also known as sole proprietors. An additional part of the tax gap was due to the noncompliance of some sole proprietors with employment tax laws. The federal tax gap is the difference between the amount of income and other federal taxes owed and the amount that is voluntarily and timely paid. The gap arises from taxpayers underreporting taxable income, underpaying known tax liabilities, and not filing required tax returns.

Unlike wage and some investment income, sole proprietors' income is not subject to tax withholding and only a portion is subject to independent verification through third-party information reporting, such as those who pay sole proprietors for services rendered.

What GAO Found

Because the sole proprietor tax gap is so large, successful efforts to reduce it could result in significant revenue increases. Key reasons for the sole proprietor tax gap are well known. Their income is not subject to withholding, and only a portion of it is subject to third-party information reporting. When used, third-party reports on payments made give IRS a powerful tool for verifying the tax compliance of payment recipients.

A principal IRS compliance program—the Automated Underreporter Program (AUR)—has limited reach over sole proprietors. Under AUR, IRS computers match these third-party reports on payments made to taxpayers with the taxpayer's tax return in order to verify taxpayer compliance in reporting those payments as income. Currently, information reporting covers only about a quarter of sole proprietors' business gross receipts and very little of their expenses because of limited information reporting by third parties. Expanding information returns coverage would require IRS to identify other types of third parties who could file information reports about payments made to sole proprietors without imposing unacceptable burdens.

IRS's other compliance program for a sole proprietor—the examination (audit) program—also has limited reach. Because most of sole proprietors' understated tax was in small amounts—half of the understatements were for about $900 or less—IRS examinations of their tax returns generally have yielded less revenue per IRS staff hour than those covering other categories of taxpayers, such as larger businesses. IRS spent substantial time on sole proprietor examinations in 2008, but examined about only 1 percent of the estimated noncompliant population.

Without either examinations or AUR, IRS can not easily tell whether sole proprietors are reporting legitimate business losses that can be used to offset other taxable income. In a study for tax year 2001 only, IRS estimated that 25 percent of all sole proprietors reported losses with an estimated 70 percent of those losses being fully or partially noncompliant with tax laws. Since examinations of sole proprietor tax returns are costly for IRS, require experienced IRS examiners to conduct, and are burdensome for the businesses, additional options need to be considered to improve sole proprietor tax compliance.

Actions Needed

Because of the variety of challenges to addressing the sole proprietor tax gap, there is no single solution. However, a variety of actions are likely to help reduce that tax gap.

GAO recommended in July 2007 that the Department of the Treasury's tax gap strategy cover sole proprietor compliance in detail while coordinating it with broader tax gap reduction efforts. Such a strategy could include a mix of numerous options. These options recognize that some solutions, such as a large increase in audits, are not likely to be cost-effective given the large number of sole proprietors and the relatively small amounts of noncompliance on average. Also, many of the options involve tradeoffs, both for sole proprietors and for IRS. The list of options includes helping:

• sole proprietors keep better records of their income and expenses by, for example, requiring business bank accounts to be separated from personal accounts or targeting tax assistance on new businesses;
• third parties comply with current information return filing requirements by, for example, providing an online portal for submissions or exempting first-time filers from penalties for being late;
• IRS identify more unreported income and more overstated expense deductions through more detailed reporting of gross receipts on tax returns or matching of expense deductions claimed by a business with the information returns filed by the same business;
• IRS collect unpaid taxes from sole proprietors through expanded withholding or denial of federal benefits to delinquent sole proprietors; and
• IRS more efficiently manage its limited resources through more automated audit selection processes, assessing additional data sharing with states, more targeted use of notices to taxpayers about compliance issues, and clearer policies on when to apply penalties.

Furthermore, as GAO also recommended in September 2009, IRS should use its ongoing research efforts to develop a better understanding of the nature of sole proprietor noncompliance, including sole proprietors improperly claiming business losses. The high rate of noncompliance associated with claims of sole proprietor business losses suggests that limiting the ability of sole proprietors to use losses to offset tax on other income could present another option for reducing the sole proprietor tax gap. However, an indicator to target noncompliant losses without including compliant losses has not been identified. Absent such targeting, any policy change to limit all business losses would inevitably limit some legitimate businesses losses.

IRS has taken actions to implement some of these options. As of January 2011, IRS has initiated, but not completed, studies on: compliance with third-party information reporting requirements, additional data sharing with the states, and identifying the extent of noncompliant sole proprietor losses. These studies are scheduled for completion through 2015. Following completion, IRS will assess the study results and identify whether changes should be recommended and made. GAO expects to assess IRS's progress in completing these actions.

Because sole proprietors are responsible for almost one-fifth of the tax gap, the potential for raising substantial amounts of revenue by taking such incremental actions to improve sole proprietor tax compliance is significant. However, the revenue potential related to any of these actions has not been estimated.

Framework for Analysis

The information contained in this analysis is based on the related GAO products listed under the "Related GAO Products" tab.

Area Contact

For additional information about this area, contact James White at (202) 512-9110 or whitej@gao.gov.

Related GAO Products