TAX GAP’S EFFECT ON SMALL BUSINESS

April 30, 2011 – 2:39 pm

In 2006, the IRS released its findings of a National Research Program (NRP) reporting compliance study it conducted to determine the estimates of the tax gap for tax year 2001. The tax gap is defined as the difference between the amount of tax owed by taxpayers and the amount of tax actually paid in a timely fashion. The study evaluated the returns of 46,000 randomly selected individual taxpayers to see if there were occurrences of noncompliance – unreported and underreported income, as well as non-filing and underpayment of tax.

As a result of this study, the IRS estimated the gross tax gap to be about $345 billion and the net tax gap to be $290 billion annually, corresponding to a 16% rate of noncompliance by taxpayers. As a result, these estimates have led to an increase in information reporting requirements, such as the new 1099 reporting requirement (which Congress recently passed a bill to repeal), and auditing of as many as 2,000 small businesses, often causing undue hardship on these small businesses.

In a report to the Finance Committee dated September 2009, the U.S. Government Accountability Office stated that the “IRS has started work on an updated NRP study. The study will examine about 13,500 randomly selected returns annually, starting with tax year 2006. According to the IRS, after three years the combined sample will be comparable to tax year 2001 and will allow for annual updates of noncompliance estimates. The IRS plans to issue a preliminary estimate of the 2006 individual reporting tax gap by 2012.” (GAO, 2009)

According to a recent study by Quantria Strategies at the request of the Small Business Administration’s (SBA) Office of Advocacy in March 2011, the estimates reported in the initial NRP study are skewed, as they attribute a large portion of the tax gap to individual taxpayers and small businesses. The smaller portion of the tax gap that the IRS ascribes to corporations is based on information that dates back to the 1970s and 80s; the IRS neglected to update the corporate data when publishing the NRP study. As a result, policymakers are focusing more attention on particular taxpayer segments in an attempt to close the tax gap, which in this case are small businesses.

The reason these tax gap estimates are important is that they have a hand in determining future tax legislation and policy. Those who voluntarily pay their taxes in essence subsidize those who do not; the brunt of the responsibility falls on honest taxpayers.

The SBA/Quantria Strategies study aimed to “explore the implications of the tax gap estimates for IRS enforcement and legislative activities, particularly with respect to small businesses; the weaknesses of the tax gap estimates relating to large corporations and taxpayers involved in international transactions; and the possible alternative approaches to tax compliance to reduce the burdens on small businesses.” (p. 1)

The initial NRP study indicates that small businesses’ underreporting accounts for approximately $83-99 billion, nearly one-third of the tax gap. Due to the use of incorrect data to determine the corporate and international portions, small businesses may be inaccurately seen as the primary cause of the tax gap.

To successfully reduce the tax gap for small businesses, the SBA/Quantria Strategies study suggests that education and outreach are in order to assist small businesses with understanding their tax obligations.

Tax preparers are encouraged to complete their due diligence in assisting their small business clients to report all their income accurately in the event that if their returns come under examination by the IRS, they are less likely to have a negative result. Not only should preparers accurately prepare their clients’ tax returns, but asking the appropriate questions is key.

For more information, read the full SBA/Quantria Strategies study at http://www.sba.gov/sites/default/files/2001%20IRS%20Tax%20Gap_0.pdf and the GAO report to the finance committee at http://www.gao.gov/new.items/d09815.pdf.

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