The Tax Gap: The Feds Target Small Businesses

A raft of proposals could cause a sea of paperwork.

The federal government says there’s a $290 billion gap between what it’s owed in taxes and what Americans actually pay every year. To close that gap, the U.S. Treasury Department proposes to toughen tax enforcement starting in 2008 and much of the focus will be on small businesses. Critics and small-business groups charge that the proposals will be costly—for business and the Internal Revenue Service—and will produce meager returns. Some questions whether the “tax gap” is indeed a growing problem.

The Treasury Department has put forward 16 legislative proposals as part of its 2008 budget, seven of which would increase reporting requirements for businesses. To get more compliance (meaning convincing taxpayers to declare their true income and refrain from inventing deductions) the IRS is using a tried-and-true formula: Requiring third-party reporting.

The proposal that has drawn the most fire from small-business groups would require every business to file a 1099 form for every business to which it remits payments of $600 or more annually. Businesses have long been required to issue 1099s to contractors, sole proprietors and freelance employees who bill them more than $600, but have been exempted from furnishing 1099s for payments to other corporations. Ending the Form 1099 exemption for corporations would bring in more than $7.7 billion over the next 10 years, according to the Treasury Department.

In order to catch a small number of non-compliant businesses, the measure places “a huge burden on the compliant business,” says Macey Davis, tax counsel for the National Federation of Independent Business. Davis is also co-director of The Coalition for Fairness in Tax Compliance, a joint effort of the NFIB, the Small Business Legislative Counsel, and the U.S. Chamber of Commerce. The requirement “doubles or triples” the paperwork burden on small businesses, Davis asserts, and it’s unknown whether the IRS has the capacity to handle all of the extra data it will receive.

“If you’re looking for exactitude in what a service corporation is bringing in revenues, indiscriminate filing of 1099s is not the way to do it,” says Giovanni Coratolo, executive director for the U.S. Chamber of Commerce’s Council on Small Business.

Also of concern to small business advocates is a proposal to require businesses to verify the Taxpayer Identification Numbers of the contractors with whom they deal – and to withhold money from those whose TINs don’t match up with those on file with the IRS. OK?

“How are they going to match [withheld money] to the actual taxpayer record if they don’t have an accurate number?” asks Todd McCracken, president of the National Small Business Association.

Small-business advocates also object to a proposal to promulgate rules to require credit card companies to report merchants’ credit card sales. The idea is to compare credit-card receipts with reported incomes. In a letter to members of Congress, the Coalition for Fairness in Tax Compliance cautioned, “[T]he time disparity in which income is reported in one tax year and the credit card payment associated with that income is received in a different tax year can give rise to inconsistencies that would defeat attempts for the IRS to accurately use the information.”

Revenue Projections for Two Tax-Gap Proposals That Affect Small Business
Merchant Reporting (including credit-card reimbursement), millions of dollars
2008	2009	2010	2011	2012	2008-2012	2008-2017
$113	$404	$694	$949	$1,174	$3,334	$10,745
Reporting of contractor Tax Information Numbers, millions of dollars
2008	2009	2010	2011	2012	2008-2012	2008-2017
$5	$42	$72	$76	$80	$275	$749

Source: U.S. Treasury Dept.

The group also worries that the cost of such reporting will be passed along to small businesses.

How much of a burden Treasury’s proposals represent to businesses remains a matter for conjecture. The IRS won’t comment on legislation that has yet to be enacted, and the Treasury Department has made no effort to estimate the burden the new requirements are likely to represent for small business owners.

Small businesses already spend a great deal of time and money to prepare their own taxes. According to a study conducted for the IRS by IBM Business Consulting Services, firms with fewer than 20 employees spend 214 hours and $1,839 per year complying with the income tax. Employment-tax compliance costs another 127 hours and $436. Compliance costs related to Treasury’s new proposals would be in addition to those numbers.

The IRS Spends More to Collect Taxes from Small Businesses Than from Corporations
Source: Internal Revenue Service

The Coalition’s position is that under-reporting is mostly a function of error, not malfeasance, and it blames the complexity of the tax code for the problem. “We’re in the process right now of looking at different simplification proposals because there are many taxpayers who want to comply but are unable to do so,” says Davis.

Indeed, in testimony before the House Budget Committee, IRS Commissioner Mark Everson acknowledged that, “the tax gap does not arise solely from tax evasion or cheating. It includes a significant amount of noncompliance due to the complexity of the tax laws that results in errors of ignorance, confusion, and carelessness.”

In some quarters, the very idea that tax compliance is a problem is open to question. Chris Edwards, Director of Tax Policy Studies for the Cato Institute told the House Budget Committee that the 86% compliance rate implicit in the IRS data on under-reporting is not necessarily bad. “I think to most people, that compliance rate would sound quite high. After all, we rarely get 100 percent compliance with any law,” he said. He also cited estimates of the size of the U.S. underground economy, another indication of tax evasion. According to the Organization for Economic Cooperation and Development, the U.S. ranked last among 21 member nations on this measure.

Perhaps the biggest hurdle faced by the Treasury’s legislative proposals is the relatively modest $2.9 billion each year they’re expected to produce in return for the pain they cause—a penny on each dollar of the tax gap. And that’s the best-case scenario.

“They don’t have the data to actually calculate how much return they’re going to get,” objects the Chamber’s Coratolo.

The tax-gap proposals’ prospects in Congress are uncertain at this time. But the Democratic leadership has said it is committed to deficit reduction, which makes improved tax collection a high priority. Senator Max Baucus (D-Mont.), Chairman of the Senate Finance Committee told Treasury Secretary Henry Paulson: “We need a lot more from you.” He wants the IRS to trim the gap by $30 billion each year–10 times the amount expected to be produced by the Treasury plan.