[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



                                                   S. Hrg. 102-000 deg.
 
         CLOSING THE TAX GAP AND THE IMPACT ON SMALL BUSINESS

=======================================================================




                                HEARING

                               before the

                      COMMITTEE ON SMALL BUSINESS

                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                     WASHINGTON, DC, APRIL 27, 2005

                               __________

                           Serial No. 109-13

                               __________

         Printed for the use of the Committee on Small Business


 Available via the World Wide Web: http://www.access.gpo.gov/congress/
                                 house

















                 U.S. GOVERNMENT PRINTING OFFICE

21-288                 WASHINGTON : 2005
_________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government 
Printing  Office Internet: bookstore.gpo.gov  Phone: toll free 
(866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2250 Mail:
Stop SSOP, Washington, DC 20402-0001















                      COMMITTEE ON SMALL BUSINESS

                 DONALD A. MANZULLO, Illinois, Chairman

ROSCOE BARTLETT, Maryland, Vice      NYDIA VELAZQUEZ, New York
Chairman                             JUANITA MILLENDER-McDONALD,
SUE KELLY, New York                    California
STEVE CHABOT, Ohio                   TOM UDALL, New Mexico
SAM GRAVES, Missouri                 DANIEL LIPINSKI, Illinois
TODD AKIN, Missouri                  ENI FALEOMAVAEGA, American Samoa
BILL SHUSTER, Pennsylvania           DONNA CHRISTENSEN, Virgin Islands
MARILYN MUSGRAVE, Colorado           DANNY DAVIS, Illinois
JEB BRADLEY, New Hampshire           ED CASE, Hawaii
STEVE KING, Iowa                     MADELEINE BORDALLO, Guam
THADDEUS McCOTTER, Michigan          RAUL GRIJALVA, Arizona
RIC KELLER, Florida                  MICHAEL MICHAUD, Maine
TED POE, Texas                       LINDA SANCHEZ, California
MICHAEL SODREL, Indiana              JOHN BARROW, Georgia
JEFF FORTENBERRY, Nebraska           MELISSA BEAN, Illinois
MICHAEL FITZPATRICK, Pennsylvania    GWEN MOORE, Wisconsin
LYNN WESTMORELAND, Georgia
LOUIE GOHMERT, Texas

                  J. Matthew Szymanski, Chief of Staff

          Phil Eskeland, Deputy Chief of Staff/Policy Director

                  Michael Day, Minority Staff Director

                                  (ii)



















                            C O N T E N T S

                              ----------                              

                               Witnesses

                                                                   Page
Everson, The Honorable Mark W., Commissioner, Internal Revenue 
  Service........................................................     2
Sullivan, The Honorable Thomas M., Chief Counsel for Advocacy, 
  U.S. Small Business Administration.............................     5
Satagaj, Mr. John, President and General Counsel, Small Business 
  Legislative Council............................................    18
Hall, Mr. Keith, CPA, Partner, Hall and Hughes...................    20
Schneier, Mr. Abraham, Abraham Schneier & Associates.............    22
Steinberg, Mr. Leonard, EA, CMC, The Steinberg Group.............    23
Hegt, Mr. Ronald, Member, American Institute of Certified Public 
  Accountants....................................................    25

                                Appendix

Opening statements:
    Manzullo, Hon. Donald A......................................    28
    Velazquez, Hon. Nydia........................................    30
Prepared statements:
    Everson, The Honorable Mark W., Commissioner, Internal 
      Revenue Service............................................    34
    Sullivan, The Honorable Thomas M., Chief Counsel for 
      Advocacy, U.S. Small Business Administration...............    46
    Satagaj, Mr. John, President and General Counsel, Small 
      Business Legislative Council...............................    54
    Hall, Mr. Keith, CPA, Partner, Hall and Hughes...............    58
    Schneier, Mr. Abraham, Abraham Schneier & Associates.........    65
    Steinberg, Mr. Leonard, EA, CMC, The Steinberg Group.........    72
    Hegt, Mr. Ronald, Member, American Institute of Certified 
      Public Accountants.........................................    80

                                 (iii)























          CLOSING THE TAX GAP AND THE IMPACT ON SMALL BUSINESS

                              ----------                              


                       WEDNESDAY, APRIL 27, 2005

                   House of Representatives
                                Committee on Small Business
                                                     Washington, DC
    The Committee met, pursuant to call, at 2:15 p.m. in Room 
311, Cannon House Office Building, Hon. Donald Manzullo 
[Chairman of the Committee] presiding.
    Present: Representatives Manzullo, Kelly, Sodrel, 
Fitzpatrick. 

    Chairman Manzullo. Good afternoon and welcome to this 
hearing on a very important topic for small businesses around 
the country, closing the tax gap.
    There would be no tax gap without the Income Tax Code. 
Interestingly, almost 92 years ago to the day and in this very 
hearing room, then Ways and Means Chairman Oscar Underwood, 
with the assistance of Representative Cordell Hull, reported 
the first income tax out of Committee shortly after the 
ratification of the 16th Amendment.
    This income tax consisted of only eight pages in an 814-
page tariff bill. Today the Internal Revenue Code spans more 
than 60,000 pages.
    I guess maybe we can go back 92 years and back to eight 
pages again. That might work.
    As we sit here today, President Bush is delivering a speech 
during the Small Business Administration 2005 Small Business 
Expo. His speech will likely not include anything about the 
topic of the hearing today.
    The tax gap is something not many want to talk about, but 
is nonetheless real. There is a difference between what is owed 
by many taxpayers and what is actually paid to the Treasury.
    The National Research Project was an effort to study the 
tax gap. Using data from 2001, the study validated that there 
was a big tax gap in the magnitude of $300 billion. A large 
portion of this gap has been attributed to small businesses and 
the self-employed.
    The purpose of the hearing is to review with the 
Commissioner and other witnesses where to go with this data. 
Before we begin that process, it is important to point out that 
the preliminary data is woefully incomplete, because it 
provides no estimate of the tax gap for C corporations or flow-
through entities, such as partnerships.
    The data for these entities is still from the 1980's, a 
time that is far removed from the aggressive tax strategies 
that many blue chip accounting and law firms developed during 
the late 1990's.
    While the data has some deficiencies, no one can argue that 
there is not a big problem. The question becomes, ``What is the 
appropriate response?''
    How do we make small business taxpayers more compliant, 
while at the same time minimizing the burden? Increasing 
enforcement means nothing if those being policed don't 
understand the laws or the nature of the violation.
    While I understand the push to lower the budget deficit and 
the readily available statistics that support increased 
enforcement, imposing increased burdens on small businesses 
through more audits cannot be the only answer.
    Many times small business owners are attempting, to the 
best of their ability, to comply with the complex Tax Code. It 
is not that they don't want to comply. Rather, the system and 
paperwork are so complex that it is difficult to comply.
    No matter how many additional auditors and collection 
agencies are added to the IRS, there will still be a more 
pressing need to educate taxpayers about their obligations.
    The IRS will never have enough resources to police everyone 
and thereby enforce compliance. Small business people are not 
tax experts and they face real difficulties with complying with 
the tax system.
    The method used by the IRS to interact with these 
individuals can be the difference between success and failure. 
It is much easier for a small business owner to learn how to 
comply with the tax laws through taxpayer education and 
outreach than the adversarial audit and collection processes.
    Congress certainly needs to simplify the Code and strongly 
support the President's effort to analyze and reform the 
current system.
    While the IRS Commissioner will not be able to stay for the 
entire hearing, Kevin Brown, the Commissioner of the Small 
Business Self-Employed Division and other staff will stay for 
the entire hearing so that they can listen to the testimony of 
the other witnesses. We appreciate that very much.
    Commissioner Everson, it is a pleasure to have you here 
today as well as Mr. Sullivan. Mr. Everson, you are up first. 
Go ahead. I am not going to set the clock here.
    [Chairman Manzullo's opening statement may be found in the 
appendix.]

 STATEMENT OF THE HONORABLE MARK W. EVERSON, INTERNAL REVENUE 
                            SERVICE


    Mr. Everson. I don't think I will use too much time, sir. 
Mr. Chairman, thank you for the opportunity to discuss the 
important subject of the tax gap and in particular, the portion 
of the gap relating to small businesses and self-employed 
individuals.
    I very much appreciate your interest in and efforts to 
increase compliance with the tax laws.
    Simply put, the tax gap is the difference between the tax 
that taxpayers should pay according to law and what they 
actually pay on a timely basis.
    Our research confirms that the vast majority of Americans 
pay their taxes honestly and accurately, but the findings also 
show that even after IRS enforcement efforts and late payments, 
the government is being shortchanged by over a quarter trillion 
dollars each year, because some pay less than their fair share.
    People who aren't paying their taxes shift their burden to 
the rest of us. In this time of budget deficits, a dollar not 
received by the government becomes debt, the burden of which 
will be felt by future generations.
    Our research shows the gross tax gap to be between $312 
billion and $353 billion. The old tax gap estimate for 2001 was 
$311 billion, a figure based on studies conducted in 1988 and 
earlier.
    So there has been what I would term a modest deterioration 
in tax compliance among individual taxpayers since the last 
study was conducted in 1988.
    IRS enforcement efforts, coupled with late payments, 
recover about 55 billion of the total gross tax gap, leaving a 
net annual tax gap of between $257 billion and $298 billion. 
Current data are preliminary, so our tax gap estimates are 
shown as ranges.
    As refinements are made to the analyses, some estimates may 
change. It is unlikely, but possible, that the final estimates 
of the total tax gap will fall outside the established range.
    There are two views of the tax gap: By type of 
noncompliance, that is non-filing, underreporting and 
underpayment and by type of tax. The new research for 2001 
addresses the underreporting of income and self-employment 
taxes by individual taxpayers. It is based on audits of 46,000 
individual returns.
    As you indicated, Mr. Chairman, the study did not address 
compliance for either small or large businesses organized as 
corporations.
    Preliminary findings include: Underreporting noncompliance 
is the largest component of the tax gap. Preliminary estimates 
show underreporting accounts for more than 80 percent of the 
total tax gap, with non-filing and underpayment at about ten 
percent each.
    Individual income tax is the single largest source of the 
annual tax gap, accounting for about two-thirds of the total.
    For individual underreporting, more than 80 percent comes 
from understated income, not overstated deductions. Most of the 
understated income comes from business activities, not wages or 
investment income.
    Compliance rates are highest where there is third party 
reporting or withholding. For example, preliminary findings 
show less than 1.5 percent of wages and salaries are 
misreported.
    The next stage of our research will be to finish the data 
analysis and refine the tax gap data by late 2005. The IRS will 
use the data to update its statistical tools for selecting 
individual returns for audit.
    Our tax gap research confirms two key points involving tax 
enforcement and simplification. The IRS needs to enforce the 
law so that, when Americans pay their taxes, they are confident 
that their neighbors and business competitors are doing the 
same.
    At the same time, this research underscores the President's 
call for tax reform. Complexity obscures understanding. 
Complexity in the Tax Code compromises both the Service and 
enforcement missions of the IRS.
    Those who try to follow the law, but cannot understand 
their tax obligations, may make inadvertent errors or 
ultimately throw up their hands and say, why bother?
    Meanwhile, individuals who seek to pay less than what they 
owe often hide behind the Code's complexity in order to escape 
detection by the IRS and pay less.
    Mr. Chairman, as I have said before, enforcement activity 
to close the tax gap is only part of the equation. We must also 
provide good service to taxpayers to help them understand their 
tax obligations.
    Small businesses in particular struggle to deal with an 
increasingly more complex Tax Code. We view our goals of 
reducing taxpayer burden and helping small businesses 
understand our very complicated and I would note ever changing 
Tax Code as a cornerstone of the services we provide.
    We are very cognizant of the fact that small business 
owners have unique needs. In recognition of the fact that 
different groups of taxpayers have different characteristics, 
the IRS is currently organized around four taxpayer segments.
    Our small business and self-employed operating division's 
mission is to address the tax compliance needs of small 
businesses and self-employed individuals through education, 
outreach, assistance and where necessary, enforcement.
    I was pleased to note that the NFIB, in its written 
statement, observed that ``One of the lesser known successes 
over the past five years has been that with the assistance of 
the staff of the small business, self-employed division at IRS, 
the concept of common sense rules for smaller business owners 
has taken root.''
    Through the small business, self-employed division, we are 
able to focus on initiatives to reduce the burden of tax 
compliance on small business.
    For example, we recently increased the Federal Unemployment 
Tax deposit threshold from $100 to $500, reducing burden for 
over 2.6 million employers.
    We also simplified the Schedules K-1 for partnerships and S 
corporations, reducing burden by an estimated 95 million hours 
for the 20 million taxpayers who file these forms.
    In addition, we are actively considering allowing very 
small employers to file their employment tax returns annually 
instead of quarterly.
    We estimate this action alone could reduce burden on 
approximately one million businesses by some 50 million hours.
    Finally, I would like to point out that our system of tax 
administration is fundamentally one of self-assessment and 
enjoys a high compliance rate.
    The IRS is moving aggressively to reduce the tax gap. With 
proper funding over a number of years, we will be able to close 
a significant portion of the gap, but no one should think we 
can totally eliminate the gap. That would take Draconian 
measures and make the government too intrusive.
    We have to strike the right balance. Thank you.
    [The Honorable Everson's statement may be found in the 
appendix.]

    Chairman Manzullo. Thank you, Commissioner.
    Our next witness is Tom Sullivan, Chief Counsel for 
Advocacy at the U.S. Small Business Administration.
    Mr. Sullivan, we look forward to your testimony.

    STATEMENT OF THE HONORABLE THOMAS M. SULLIVAN, US SMALL 
                    BUSINESS ADMINISTRATION


    Mr. Sullivan. Thank you, Mr. Chairman. Thank you for giving 
me the opportunity to appear before the Committee this 
afternoon. My name is Tom Sullivan, the Chief Counsel for 
Advocacy at the Small Business Administration.
    My office is an independent office within the SBA and 
therefore, the comments expressed in this statement do not 
necessarily reflect the position of the Administration or the 
SBA.
    With the Chair's permission, I would like to submit my 
written statement for the record.

    Chairman Manzullo. The entire written statements of all the 
witnesses will be made part of the record without objection.

    Mr. Sullivan. Thank you, Mr. Chairman.
    The Office of Advocacy shares with the Commissioner the 
view that the tax gap is a serious problem. The funding 
shortfall is not the only problem created by the tax gap.
    As National Taxpayer Advocate Nina Olson stated in her 2004 
testimony before the Senate Committee on Finance, ``It comes 
down to a simple issue of fairness.''
    The fact that 85 percent of taxes are paid in full 
reinforces the view that the remaining 15 percent needs to be 
paid by those who owe it.
    The Office of Advocacy, however, does not agree with the 
view that prioritizing enforcement will necessarily close the 
tax gap. We believe, like the Commissioner stated in his oral 
statement, that a balanced approach, relying on a combination 
of compliance, assistance, taxpayer education and enforcement, 
is likely to close the gap in an efficient manner.
    Most small businesses pay their taxes in full and on time. 
However, doing so is never easy for them, as the cost of 
complying and the difficulty in following the Tax Code can be 
overwhelming.
    In 2001, my office released a report on the regulatory 
costs faced by small firms. That study contained an estimate of 
tax paperwork compliance costs and in 2000, the typical small 
business, with fewer than 20 employees, spent over $1,200 per 
employee to comply with tax paperwork, recordkeeping and 
reporting requirements.
    This is over two times the compliance costs faced by larger 
firms, but the estimated burden hours for filling out forms do 
not tell the whole story of how difficult compliance can be for 
small business.
    Most small firms do not have full-time personnel to handle 
tax compliance issues. Many hire outside assistance and many 
more small business owners devote valuable time to taxes that 
is not then available for them to run their business.
    This Committee certainly knows the contribution of small 
business to the United States' economy. Small businesses make 
up over 99 percent of all businesses in the United States and 
employ just over half of the American workforce.
    Perhaps even more importantly, small firms create over two-
thirds of the net new jobs annually and recently led the 
American economy out of a recession.
    Yet, small business accomplishes this even while facing a 
regulatory compliance burden that is roughly 60 percent greater 
per employee overall than that faced by larger firms and a tax 
compliance burden more than twice as large.
    At issue then is how compliance can be improved and the tax 
gap narrowed without adding to the burden of small business?
    My office favors a balanced approach, one that includes 
commensurate doses of education, compliance assistance and 
enforcement.
    In order to focus its efforts, the IRS did develop the 
National Research Program to measure reporting, filing and 
payment compliance for different types of taxes and different 
groups of taxpayers.
    The final report isn't available, but IRS has published 17 
pages of preliminary results. The release generated a flurry of 
comments coinciding with the weeks preceding April 15, when 
Federal tax filings were due.
    I think that this Committee and really all the folks and 
policy leaders in Washington, D.C. should be clear that these 
results are preliminary.
    Let me also caution that the connection between enforcement 
and compliance is not necessarily clear either. Research by 
economist Bruno Frey and Lars Feld suggests that excessive 
enforcement can lead to less compliance.
    Compliance cannot be increased only through enforcement, 
but rather the more balanced approach that was mentioned by the 
Commissioner and myself.
    Although tax rates have declined over recent years, the 
costs of complying with taxes has increased. Noncompliance is a 
more subtle, hidden cost of tax complexity, but the direct 
costs in time and effort to maintain the necessary records and 
complete the proper forms is the more obvious direct cost.
    According to OMB paperwork burden estimates, the number of 
hours Americans spend on taxes has grown by 24 percent over the 
last ten years.
    I believe in the honesty of the majority of small 
businesses and their willingness to comply with the Tax Code 
and contribute their fair share.
    Additional taxpayer education, compliance assistance and a 
more simple Tax Code are key ingredients to increased 
compliance. If small businesses are able to understand and 
easily follow the rules, they probably will.
    Thank you for allowing me to present these views and I am 
looking forward to questions.
    [The Honorable Sullivan's statement may be found in the 
appendix.]

    Chairman Manzullo. Thank you. I guess what concerns me is 
that the last IRS report done addressing the tax gap was done 
in 1988. The latest update by the National Research Program 
excludes C corporations and the extent to which they may be 
underreporting or cheating.
    Our concern here at the Small Business Committee is that if 
you are talking about more enforcement and the only study that 
has been done as to noncompliance or updated study as to 
noncompliance are small businesses and individuals, then why 
are we having enforced compliance if we don't know the extent 
to which the C corporations may be ripping off the taxpayer? 
That is sort of a loaded question.

    Mr. Everson. No. But I am happy to explain why I think the 
sequencing is what it was. This program was all laid out about 
three or more years ago and the decisions taken at the time was 
that this was the place to start. It wasn't a view that you 
would never get to C corporations.
    For the last several years, Mr. Chairman, we have 
articulated four enforcement priorities that have been in the 
heart of the President's budget request for more enforcement 
monies. The very first element of that is to detect and deter 
abusive activities by corporations, high income individuals and 
other contributors to the tax gap.
    The more monies that have been requested for the IRS, up to 
this point for enforcement, have been largely targeted towards 
abusive tax shelters, towards corporations and high income 
individuals.
    We can show you the rate of increase in the high income 
audits that have taken place over the last several years. It 
has been doubled basically in terms of the total number of 
returns.
    You can see what happened here was a very precipitous 
decline that was coincident with the Roth hearings, the bashing 
that the Service took in the 1990's. Real efforts were made to 
increase services and those efforts were successful by any 
measure.
    But what happened was we backed away from enforcement 
generally. What is happening now is a recovery of enforcement. 
This is the high income piece.

    Chairman Manzullo. If I could interrupt you.

    Mr. Everson. Yes.

    Chairman Manzullo. I accept that, but my question deals 
with new energy at the IRS for increased audit, et cetera. But 
the study excludes C Corporations. These could be small 
businesses.

    Mr. Everson. You are exactly right. Let us go to the tax 
gap map if we could, Bill. The map will show you that of that 
estimated gross gap of $312 to $353 billion, the corporations, 
using that old methodology from the 1988 study that you talked 
about and updating it for changes in economics and 
demographics, the corporate piece would be about 30 billion.
    Now, you are right. If you--

    Chairman Manzullo. I have to interrupt you on it, because I 
am concerned that there is not a new study updating the 1988 
study for C corporations.

    Mr. Everson. Yes.

    Chairman Manzullo. As to everybody, except the C 
corporations, but you are making conclusions here and you are 
also going to step up your enforcement, as to those people to 
whom you find are involved in the tax gap.

    Mr. Everson. We knew there were problems with corporations 
and we have been devoting the additional resources to that. 
That has been the very top line item of the President's budget 
request to get more auditors for corporations.
    We have been working aggressively on that. Congress has not 
provided all the money. You may know that we asked for an 
additional 500 million last year. We got 50 million.
    But we have been devoting more to corporations. The rough 
point I would say is even if you believe that there is more 
noncompliance there and I do, I am on the record repeatedly, as 
you may know, to go after these areas. We are devoting more 
resources to that.
    Even if you look at 2001 as you indicate, there is a change 
in receipts mix, by the way, too. Since 2001, receipts have 
recovered for corporations. The individual rates have resulted 
in income taxes going down for individuals as a portion of the 
two trillion we get.
    Even if you double this though, sir, in terms of the 
corporate number, you get 60 or 70 billion. You are still left, 
even if the total gross gap approaches 400 billion, with over 
half of it coming from small business and by small businesses. 
That would be the combination of the individuals with the 
Schedule C, it would be the Subchapter S corps, those C corps 
and as you know the C corps for small businesses and by small 
businesses for C corps we say those are less than $10 million 
in assets.
    Those numbers have been coming down over the years. They 
have been replaced by more partnerships and more S corps.
    If you take all that, you are right. That number is 
understated. It is no doubt understated. But still half that 
gap, even if you inflated these numbers, would still be in the 
small business area. So it needs to be addressed.

    Chairman Manzullo. It needs to be studied before we can 
enforce it.
    Mr. Fitzpatrick?

    Mr. Fitzpatrick. Mr. Everson, thanks for your testimony 
today.

    Mr. Everson. Thank you, sir.

    Mr. Fitzpatrick. My district is in Pennsylvania. I don't 
have a lot of big businesses. We have a ton of small 
businesses. We like to say in Bucks County, Pennsylvania, small 
business is big business. So a lot of people are watching this.

    Mr. Everson. Yes.

    Mr. Fitzpatrick. I would be happy to report back to them. I 
have a question on the tax gap. I think it was reported that 
back in the 1970's the tax gap was about ten percent, but by 
1984 it had risen 40 percent to about 14 percent, but by the 
time President Reagan's tax cuts and his Tax Reform Acts were 
fully implemented and realized, the tax gap had come back down 
to below ten percent. That it was easier I guess for small 
business, you could conclude, to comply--

    Mr. Everson. Yes.

    Mr. Fitzpatrick. --with the simpler Tax Code.
    Is it your belief that there is a relationship between the 
tax gap and the simplification of the Tax Code and lower taxes 
specifically?

    Mr. Everson. Yes, absolutely, sir. I think you may have 
come in after I started to give my oral statement.
    I believe that what has happened here is the enforcement 
has fallen off. You have to recover there and have a balanced 
approach, but that the second piece of this and the President 
has got it right, is a call for tax reform.
    I have testified before the Tax Panel and made this very 
clear. Complexity obscures understanding. There is a real 
element of this where if people don't understand the law, they 
make inadvertent errors. Some throw up their hands and say, why 
bother?
    At the same time, those who seek to avoid detection or not 
comply and here you get to the Chairman's point, largely the 
more sophisticated corporations who have been led into these 
structures by attorneys and accountants, they profit from the 
complexity.
    At the IRS, we are absolute advocates of simplification of 
the Code. Yes, sir.

    Mr. Fitzpatrick. How much time and effort is spent on 
advocacy and education I guess is the better word? An awful lot 
of small businesses get to the end of the quarter and they are 
struggling. They have got to make their quarterly payment. The 
resources aren't there and so some just sort of drop out of 
compliance.
    This is Small Business Week. I think this is financial 
literacy month. What does the IRS and perhaps Mr. Sullivan, 
from the SBA, can comment as well, what is the plan for a 
greater education of small business on the importance of and 
obvious benefits of compliance?

    Mr. Everson. At this stage, what happened was, as I 
indicated, the IRS, it was reorganized after these hearings in 
the mid 1990's to have four business units, as well as our 
criminal investigation unit. That is the bulk of the employees.
    One of the units that was established was the small 
business, self-employed unit, to focus on this basket of 
taxpayers, if you will.
    I think that that has been a successful reorganization, 
because it has allowed a targeting, if you will, just along 
these lines.
    We have got about 400 people who work full-time. They do do 
the work of education, working with practitioner groups, 
working with the various organizations, if you will.
    I meet from time-to-time with some of these groups as well 
and we try to get the word out through publications, a whole 
series of things.
    I think that has been successful, frankly and made a 
difference, in terms of the relationship. I quoted the NFIB's 
statement in my oral remarks and I think that there is a rather 
positive story here.
    Now I will be clear. At this stage, because of the absolute 
problem on the enforcement side, the incremental resources we 
are putting into this are on the enforcement side.
    The President has asked for a bump up of eight percent in 
the budget. I would like to say that is supported by GAO. If 
the Chairman will indulge me for just a minute, I will tell you 
what GAO has said on this subject.
    It says on service that the IRS has made significant 
progress in improving the quality of its taxpayer services. For 
example, IRS now provides many Internet services that did not 
exist a few years ago and has noticeably improved the quality 
of telephone services.
    This opens up the possibility of maintaining the overall 
level of taxpayer service but with a different menu of service 
choices.
    Cuts in selective services could be offset by the new and 
improved services. On the other hand, they have listed 
enforcement of the tax laws as one of their high risk areas.
    I don't know if you are familiar with this, but every two 
years they issue a list of about two dozen high risk areas for 
government and what they have said on enforcement is, this is a 
quote from the GAO's report, ``Given the broad declines in IRS' 
enforcement workforce, IRS' decreased ability to follow up on 
suspected noncompliance, the emergency of sophisticated evasion 
concerns and the unknown affect of these trends on voluntary 
compliance, IRS is challenged on virtually all fronts in 
attempting to ensure that taxpayers fulfill their 
obligations.''
    ``IRS'' success in overcoming these challenges becomes ever 
more important, in light of the nation's large and growing 
fiscal pressures. Accordingly, we believe the focus of concern 
on the enforcement of tax laws is not confined to any one 
segment of the taxpaying population or any single tax 
provision.
    Our designation of the enforcement of tax laws as a high 
risk area embodies this broad concern.
    So we are not suggesting we wouldn't want to do more in 
services, but this is a tight fiscal situation for the country, 
but the greater need frankly is in enforcement.

    Chairman Manzullo. Mrs. Kelly.

    Ms. Kelly. Thank you, Mr. Chairman.
    Thank you both for speaking today. Mr. Everson, you are 
talking about going out and essentially the way it is going to 
read to the public, lowering the boom on small businesses.
    I want you to tell me some things now that you are going to 
do to make sure that if an IRS agent walks into a small 
business, it isn't going to be a ``gotcha'' attitude, but it is 
going to be a helpful attitude.
    Our tax laws are so complex. Our small businesses are 
taxed. Some people who own small businesses are taxed twice. 
This is hardly fair to small businesses carrying a huge tax 
load of huge tax burden in this nation. We need our small 
businesses. We are creating the new jobs.

    Mr. Everson. Yes.

    Ms. Kelly. Tell me, sir, what you are doing to bring across 
an attitude and ensure that the people who enter a small 
business will be there saying, ``I am from the IRS and I am 
going to help you figure out how you can do this right.''
    Most people want to live by the law. Most people don't want 
to evade, but they eventually throw up their hands, because it 
costs small businesses much more to file than it does large 
businesses. You know that, sir.
    What can you tell me? How can you help me go back and tell 
my small businesses that you aren't going to come in and really 
just wrap the rules around their neck?

    Mr. Everson. I think those are all valid points and the 
first thing I would say is obviously the experience of the 
1990's where there were the difficult hearings and the great 
focus on the service issues. They have had a very clear effect.
    First of all, the Congress wrote in a whole series of new 
procedures that protect taxpayer rights. If our people get out 
of line, rest assured they get into pretty significant trouble 
quite quickly. So that is very important. The procedures are 
different.
    The second thing I would say, and this is where the 
research will be very helpful, right now the audit rate is 
around one percent. This is not a very high rate and when an 
audit takes place, the no change rate within the audits, that 
is to say what happens you go in and then do you assess tax or 
not, the no change rate, where we are not assessing more tax, 
it is about 12 percent.
    As we update this research, it better helps us to find out, 
based on what is on the return or third party information we 
have received, where we should go so that we are not going into 
a business that is or looking at a Schedule C return where it 
doesn't look pretty likely, frankly, that there is a problem. 
So that is a very important part of this as well.

    Ms. Kelly. Excuse me, sir, but you really didn't answer my 
question. I want to know what you in particular are doing to 
tell the people when they arrive, because you have suspicion 
that there may be a problem there. I was here. I voted on that 
law.

    Mr. Everson. Yes.

    Ms. Kelly. Mr. Manzullo was here. He voted on that law.

    Mr. Everson. Yes.

    Ms. Kelly. What I want to know is what you are doing right 
now? If you are going to push this enforcement, to make sure 
that when people come in, the person from the IRS doesn't walk 
in and say, ``Look I am sorry, but I have got to find 
something, because they think you have hidden something?''

    Mr. Everson. Sure. All I can tell you, ma'am, is that we 
constantly emphasize this in our meetings with executives and 
other employees that, as we rebuild enforcement, we have to pay 
absolute attention to taxpayer rights and to not letting 
anybody go overboard thinking that this is a license to act 
inappropriately. We talk about--

    Ms. Kelly. Have you ever--

    Mr. Everson. I am sorry?

    Ms. Kelly. Have you ever fired anybody for abusing taxpayer 
rights?

    Mr. Everson. We fire people all the time. I can get you 
data on what happens, and I don't want to give you a precise 
answer on what the history is on this. Since RRA98, what has 
happened is there is a series of ten deadly sins that you wrote 
into the law and there is a Committee that is below me that 
looks at this.
    There are things where they are automatic firings and they 
bring up to me cases where they are asking for some mitigation 
and typically they are not in this area. That is not an area 
where we would count as a problem.
    You wrote in standards where somebody might presumably be 
fired for late filing their own tax return, even if it was a 
refund to a return. Those are the kinds of things that are 
brought to my attention, to mitigate the automatic presumption 
of firing.

    Ms. Kelly. Thank you.

    Mr. Everson. Certainly.

    Chairman Manzullo. I am still intrigued by the study that 
is incomplete and yet the results of this incomplete study are 
being used to increase enforcement upon what is apparent to be 
small business people.
    Let me tell you how bad this study is and why there may be 
a limitations amendment to the appropriations bill to not give 
you any more money for enforcement until this is taken care of.
    This was a study of 45,000 taxpayers. In the general 
population, six percent of the returns have a Schedule C, but 
in the sample through this study, 46 percent of the returns had 
Schedule C.
    I can only come to the conclusion that this thing was 
targeted right at the small business people. Can you or perhaps 
your aide with you who did the study, explain to us why this 
sampling is so grossly out of proportion to the normal people 
that have, normal number of taxpayers that file a Schedule C?

    Mr. Everson. Certainly, sir. If my answer is too general, 
my director for research will answer that. This was intentional 
and it was intentional both for high income individuals and 
Schedule C filers, because of the more complexity.
    Just because you over sample, it helps you make sure you 
have the right results. This was looked at by GAO. GAO has 
reviewed the National Research Program three times as to how it 
was set up and their initial review of this in 2002, they 
concluded, ``NRP's design is likely to yield the sort of 
detailed information that IRS needs to measure overall 
compliance, develop formulas to select likely noncompliant 
returns for audit and identify compliance problems for the 
agency to address. The sample is adequately sized for these 
tasks'' and they go on from there.
    Just because you take a larger sample doesn't mean you 
don't adjust that for when you extrapolate or do the research. 
That is what they are doing.

    Chairman Manzullo. It still doesn't make sense. Six percent 
of the general population files a Schedule C, but 46 percent of 
the returns in your sample has Schedule C's. Therefore, the IRS 
purposely aimed its guns at small businesses.

    Mr. Everson. I don't share that assessment of that.

    Chairman Manzullo. Let me ask you a question. If 46 percent 
of the returns had Schedule C's attached to them, what does 
that indicate to you? I mean who files Schedule C's?

    Mr. Everson. I am sure you are aware there about 18 or 19 
million Schedule C filers at present. So it is a big number. It 
has increased to almost 15 percent of the 1040 returns.

    Chairman Manzullo. Wouldn't you agree that small business 
people are more likely to file a Schedule C?

    Mr. Everson. Absolutely. Yes, sir. Yes, sir, but--

    Chairman Manzullo. That is the whole point.

    Mr. Everson. But it is not blown out of proportion. The 
statistics they are using this to get a better handle. I would 
have thought you would be happy about it, because 
statistically, as I understand it, you are going to get a more 
reliable projection from this.

    Chairman Manzullo. I can't accept that. The sample has 
seven times more people with Schedule C than the general 
population.
    If you are going to do a sample, you go all the way across 
the breadth on it. This survey was intended and aimed at small 
business people.

    Mr. Everson. It was aimed at the more complex. The 
overstatement was in the more--

    Chairman Manzullo. Those are small business people.

    Mr. Everson. Not only small business people. Not only small 
business people.

    Chairman Manzullo. One thing that the work has not been 
done is on the C corporations. I would suggest before the IRS 
lowers the hammer on going after small business people, who 
have enough problems in this world, that you do your research 
on C corporations so instead of extrapolated and whatever the 
words that were used on there, we know exactly what is going on 
with the gross tax gap. Because the resources that you are 
going to take, the additional resources are going to be aimed 
at those small business people and not at the C corporations.

    Mr. Everson. That is not true, sir.

    Chairman Manzullo. That is--

    Mr. Everson. That is not what the budget request has 
provided. We asked for--

    Chairman Manzullo. That may be the budget request, but I 
can assure you that this is the gravamen of your whole study. 
It is the small business people.

    Mr. Everson. We are seeking to do more in this area, but as 
I say, the allocation of resources has been--

    Chairman Manzullo. You know, Commissioner, allocation of 
resources--I mean this is not a class in English. If you don't 
have enough money, you don't have enough money. But you know 
what? There isn't one agency in this city, there isn't one 
Committee, there isn't one member of Congress that says I have 
more than sufficient money to run my operation.
    To say we don't have enough money for audits, I mean there 
are what, 97,000 IRS employees?

    Mr. Everson. That is about right.

    Chairman Manzullo. And it is down. It is down.

    Mr. Everson. It has come down because of the electronic 
filing, you don't need as many--

    Chairman Manzullo. Right.

    Mr. Everson. --people to process returns.

    Chairman Manzullo. Of that, 400 are involved in education, 
is that correct?

    Mr. Everson. No, sir. That is a number that is within this 
business unit for the small business, self-employed piece. That 
unit is maybe something like 28,000 people.

    Chairman Manzullo. Okay. Mr. Fitzpatrick, do you have some 
more questions?

    Mr. Fitzpatrick. Yes. I just want to get back to the issue 
of how to get small businesses into compliance, those who have 
fallen out of compliance and I heard the Commissioner talk 
about some of the programs.
    I thought maybe, Mr. Sullivan, from the Administration, you 
may have--

    Mr. Sullivan. I would love to respond and give the 
Commissioner just a little breathing room, if I may. I think 
what you have heard, Congressman, not only from me and the 
Commissioner, but also GAO, the Taxpayer Advocate and the 
Inspector General on April 14 on the Senate side, talked about 
balance.
    I think the balance has got to be based on data. That is 
what the Chairman was just referring to making sure that that 
data is as best possible, before directing the IRS where to 
direct its resources, whether it be education or enforcement.
    A problem, Congressman Fitzpatrick, is there does not seem 
to be that type of data on whether or not the education, the 
taxpayer education is producing compliance benefit.
    Now there is positive news on this side. The Treasury IG in 
his statement on April 14 does say that taxpayer education has 
led to many improvements and I quote, ``Individual taxpayer 
satisfaction rates with IRS have increased since the law's 
passage, rising from 51 to 64 percent, between 1999 and 2004.''
    If you put that type of statistical analysis on top of 
economic work, like those that are contained in my written 
statement by Dr. Bruno Frey, it shows that that type of 
satisfaction has a direct correlation into greater compliance.
    So what I think is missing in part of this balance is more 
data that shows that taxpayer education is in fact working and 
if better prioritized will also help fill the gap, commensurate 
with increased or greater attention to enforcement.
    Now that is lacking and so I am hopeful that now that 
Congress has their attention on the President's budget, the 
Commissioner, my office and others have already done our work 
in presenting the President's budget to Congress. Now it is 
your chance to look at that and how you prioritize.
    I am hoping that the IRS will focus on creating data that 
documents whether or not taxpayer education will fill in that 
tax gap. Because as of now, aside from the IG, there really 
isn't information that documents all the hard work from the 
taxpayer education, whether or not it is making a positive or 
negative difference.

    Mr. Fitzpatrick. Do you, Mr. Sullivan, have any 
recommendations as to how we could get non-filers back into the 
system?

    Mr. Sullivan. I believe that again--

    Mr. Fitzpatrick. Through education.

    Mr. Sullivan. Congressman, I believe that the way to 
approach the tax gap is through the balance. It is the balanced 
approach. It is one, reducing the complexity and the President 
has absolutely made that a priority and many of us are looking 
forward to the bipartisan Tax Panel's recommendations to reduce 
complexity.
    I should also point out that behind the scenes there is a 
division at IRS. Mr. Chessman, who heads the Office of Burden 
Reduction, is behind me. They actually look at administrative 
ways to reduce complexity. The Commissioner mentioned some 
great success stories there.
    So one is reduce complexity. Two is obviously prioritize 
enforcement as an important ingredient. Three is to bring in an 
equal and balanced way of taxpayer education and I think 
through a balanced approach, through all of those three, you 
will see the tax gap reduced.

    Mr. Fitzpatrick. Is there the possibility though over 
reliance on the enforcement piece of the three-pronged 
approached you just talked about, could have the maybe 
unintended consequence of driving more small businesses 
underground?

    Mr. Sullivan. Yes, Congressman. Not only does this seem to 
be the case, you know where is that fine balance between just 
enough enforcement and too much?
    That was detailed out by Dr. Bruno Frey in a paper that I 
cite in my written statement. It does show that too much 
enforcement actually does drive more folks underground.
    So you would have, despite good intentions, you would have 
the exact opposite consequence. So again, I will just restate 
that the real key to reducing the tax gap is a balanced 
approach.

    Mr. Fitzpatrick. Thank you. I yield back.

    Chairman Manzullo. For every one dollar in revenues that is 
collected by the IRS, how much of that is represented by 
employees? How much by small businesses? Then how much by large 
businesses? Do you have--

    Mr. Everson. Yes. The small--

    Chairman Manzullo. I guess on that pie--

    Mr. Everson. The IRS collects about two trillion dollars a 
year. Probably, Mr. Chairman, about a quarter of that comes 
from small businesses. By small businesses, I am taking that 
whole family of the Schedule C filers, the 1120 filers, the S 
filers, the partnership filers, that whole group.
    Now what is different about this population, sir, is that 
it is the mix of taxes within that total. The preponderance of 
those monies that I am talking about are employment taxes. They 
are not the income taxes.
    If you look at the whole two trillion, employment taxes are 
a little less than 40 percent or so of what is the budgeted 
receipts this year, but if you look at this population that you 
are concerned about, the small business population, the biggest 
driver in there is in the employment tax area, where I think 
that is about two-thirds of the total, sir.

    Chairman Manzullo. The National Taxpayer Advocate, Nina 
Olson, suggested in her 2003 annual report to Congress that 
implementing non-wage withholdings, in particular, withholding 
for income reported on Form 1099, by the small business people, 
would greatly enhance compliance among independent contractors 
and help to close the tax gap.
    Same question to both of you. Do you agree this reform 
would help close the gap?

    Mr. Everson. I have stated, Mr. Chairman, I am not an 
advocate of going down the withholding path. I just think that 
it would be very burdensome and I stick by the perhaps 
unpopular desire to do more in the enforcement area with those 
who are noncompliant, rather than have that withholding regime, 
which I think would be quite burdensome.

    Chairman Manzullo. Mr. Sullivan?

    Mr. Sullivan. I think the idea first stated by Nina Olson 
in her annual report, then picked up by GAO and then the IG, is 
absolutely the wrong way to go.
    It would be a disaster for small business and 
coincidentally a disaster for the economy primarily for two 
reasons. First of all, the recommendation of proprietors 
withholding for folks who use their premises as independent 
contractors punishes the very population of small businesses 
that recovered America from a recession.
    So here we are after pulling ourselves out of recession, 
where small businesses are literally the only entities hiring 
new employees and their reward is, according to this 
recommendation, you will now be responsible for withholding 
from another set of taxpayers.
    I think that would be a disaster and you would unbelievably 
stifle the economic engine that is created by small business.
    The second reason why it is a terrible idea is that it 
further blends, it further blurs the distinction between 
employer and independent contractor.
    Now this could be a whole other Congressional hearing, and 
in fact, there have been plenty of Congressional hearings on 
this issue. In the construction field in particular, there 
still are, in the small business community, the folks who talk 
with me every day. They still are very, very troubled by the 
confusion that exists over whether you are an employer or an 
independent contractor and if something bad happens, who is 
responsible?
    The idea that withholding then become the responsibility of 
the proprietor further blurs and confuses the distinction 
between employer and independent contractor. It would be a 
terrible way to go, Mr. Chairman.

    Chairman Manzullo. The Commissioner agrees with you. It 
took him 20 seconds to say so. It took you three minutes, but 
that is okay.
    The Office of Burden Reduction, how many employees are in 
that?

    Mr. Everson. It is not a large office. It is a highly 
skilled office. I am not sure. Half a dozen, dozen people. Ten 
people.

    Chairman Manzullo. Ask him if he needs more people to help 
reduce the burden of reduction.

    Mr. Everson. I think you have done fine in asking the 
question, sir. Let me tell you something though, Mr. Chairman. 
What we did do here was in order to increase the prominence of 
this effort. When Kevin took over from this business division, 
we asked Mike to report directly to him so that it gets enough 
prominence within that business unit. Those issues are 
addressed on an ongoing basis. I think that has helped this 
area.

    Chairman Manzullo. Thank you very much for coming this 
afternoon. Sorry we were running late. I appreciate the 
testimony. I appreciate your candor. If we could get the second 
panel ready.
    Mr. Sullivan, is there somebody from your office that might 
be able to stick around?

    Mr. Sullivan. Yes, I will.

    Chairman Manzullo. Thank you. We will recess for about five 
minutes until we can set up the table.
    [Whereupon, a short recess was taken.]

    Chairman Manzullo. We are starting our second panel. First 
witness is John Satagaj, testifying on behalf of the Small 
Business Legislative Council. We look forward to your 
testimony.
    The complete written statements will be made part of the 
record, without objection and I will set the five-minute clock 
here.
    You need to push the button and then pull the--

    Mr. Satagaj. I am used to talking without the microphone. I 
don't need it normally.

 STATEMENT OF JOHN SATAGAJ, SMALL BUSINESS LEGISLATIVE COUNCIL


    Mr. Satagaj. Mr. Chairman, it is great to be here. I am 
John Satagaj. I am the President and General Counsel for the 
Small Business Legislative Council, which is a coalition of 
about 60 trade associations, all of which have common interests 
that they represent the interest of small business.
    For us, this comes down to a pretty simple equation in 
regards to what needs to be done and what we can accomplish to 
help small businesses.
    Number one, we have got to simplify. We heard it here in 
the first panel of testimony today about the need for 
simplification. We think a lot of the problems that small 
business has with Tax Codes and with complying has to do with 
the complexity of the Code. So if we can simplify, we can solve 
a lot of these problems.
    Secondly, we need to educate. We are particularly concerned 
about where things are going at the IRS in general and in the 
small business sector in particular, as it relates to 
education.
    There is taxpayer education and communication. They call it 
TEC, which has done a marvelous job. You talked today about 
it--I think you used the hammer.
    Representative Kelly used the boom. For me the metaphor is 
the pendulum and the pendulum is coming right at small business 
again. What is remarkable for me is how quickly the pendulum 
has swung back.
    In Washington terms, it has been like a nanosecond since we 
recognized that there was a lot of burdens being imposed on 
small business. That we were really aggravating the small 
business taxpayer with the audits. That it was unfair and in 
that nanosecond it switched back already to where we are coming 
back to that.
    We had eased off on it and now we are right back to the 
point where we are very aggressively going to pursue small 
businesses.
    We needed to give taxpayer education more time. We haven't 
given it enough time. We hear some rumors that over at the IRS 
they are even cutting back further on taxpayer education.
    Mr. Chairman, if you could see one of the cool sessions 
that we are all involved in, in the small business community, 
once every two months we get together in a session hosted on a 
rotating basis by NFIB, the Chamber and SBLC.
    Our partner is TEC at the IRS. We have a meeting every two 
months. They bring in different folks. We talk about problems.
    You should see all the material we are getting from them 
that we then use for our members, but you can't change that 
overnight. It takes time.
    We are working hard. We are making a lot of progress. If 
they are, in fact, diverting resources elsewhere instead of 
that education, I fear we are going to lose everything we built 
up when the pendulum was going our way. We are going to lose it 
in a nanosecond and that is where we are right now.
    For us, simplification is number one. Number two, taxpayer 
education. We do those two things, we are going to do great.
    The last thing I want to mention--I don't know if he has 
come back in the room or not, you noted at the beginning that 
Kevin Brown was going to stay for the entire--

    Chairman Manzullo. Kevin's here.

    Mr. Satagaj. Kevin's here. He has come back in the room. He 
is behind me. I want to mention, because you know you don't get 
too many chances to say, you got a friend at the IRS. I can 
tell you I have had my share of non-friends at the IRS. This is 
a good person for small business running that section.

    Chairman Manzullo. The record will note your friendship.

    Mr. Satagaj. Good friendship. Maybe I won't get audited 
next year if I am lucky. But it is important to have somebody 
there who understands small business and Kevin does do that. I 
think he is a great asset for us to have over there.
    With that, Mr. Chairman, that concludes my testimony. Thank 
you.
    [Mr. Satagaj's statement may be found in the appendix.]

    Chairman Manzullo. Thank you.
    Our next witness is Keith Hall. He runs the Tax Talk 
service for the National Association of Self-Employed. He is a 
resident of Texas, where he is also partner in Hall and Hughes, 
a local accounting firm.
    We look forward to your testimony, Mr. Hall.

            STATEMENT OF KEITH HALL, HALL AND HUGHES


    Mr. Hall. Mr. Chairman, members of the Committee, I 
appreciate the opportunity to be here today, both as a small 
business owner and as a member of the National Association for 
the Self-Employed.
    I hope to provide a small business owner's perspective on 
the existing tax gap and various proposals for reducing that 
tax gap.
    Through the NASE Tax Talk service, I help answer over 8,000 
questions every year from small business owners across the 
country. I think that gives me a unique opportunity to share 
the small business perspective.
    A vast majority of the questions that we answer are based 
on some specific complexity in the Tax Code. For example, many 
small business owners operate out of their home, but they are 
intimidated by a very complicated home office deduction form.
    Most use their personal vehicle in operating their 
business, but are confused regarding that deduction as well.
    Some hear that they can fully deduct the cost of their 
vehicle, but only if it weighs over a certain number of pounds. 
Then they find out that there is a different set of rules for 
SUVs and then still a different set if it is purchased before 
October 22 or after October 22.
    Now these issues directly contribute to the tax gap, since 
the small business owner doesn't know what they owe. That leads 
to incorrect estimated tax payments, late filing of returns and 
late payment of tax that is due.
    It is my opinion that the number one reason for 
noncompliance among small business owners is the complexity of 
the Tax Code.
    Further, I believe that reducing that complexity will lead 
directly to increased compliance and therefore a reduced tax 
gap.
    There are a number of other proposals, besides reducing 
complexity, that have been proposed. As mentioned earlier, the 
National Taxpayer Advocate has proposed withholding 
requirements on payments made to independent contractors.
    This is the most troubling of any proposals so far for the 
small business owner. First, by adding another level of 
reporting and complexity, another level of potential 
noncompliance is also added.
    But more importantly, withholding based solely on gross 
payments disregards the expenses that are incurred to generate 
those gross payments.
    Consider an independent painter of office space who has a 
$5,000 contract. They have no employees but do all the work 
themselves.
    After the cost of paint and supplies, they may have about 
$4,000 in gross profit. Withholding five percent right off the 
top, about $250, may make some sense, but what about a second 
painter who uses other contractors or employees to do the work?
    They may have only a ten percent gross profit or about $500 
in taxable income. Withholding the same $250 straight off the 
top represents a 50 percent withholding on their taxable 
income. Treating those two small business owners the same just 
doesn't make sense.
    Further, the current proposal would only apply to sole 
proprietors. A painter who happens to operate as a corporation 
would not be subject to the requirement. The same painter, the 
same issues, the same headaches would have a different set of 
rules solely based on business structure.
    Another proposal is based on increased IRS enforcement. 
This proposal does have merit. Those taxpayers who willfully 
disregard their tax liability should be held accountable.
    I certainly support efforts to make sure they are held 
accountable. My concern is at what cost? The Commissioner 
mentioned, and has mentioned before, that he believes that 
service plus enforcement equals compliance. My concern is that 
budget dollars added to enforcement might be taken away from 
service.
    The complexity of the Tax Code clearly contributes heavily 
to noncompliance, especially for the small business owner. Over 
the last several years, the IRS has done a tremendous job in 
providing service to the small business taxpayer.
    Their website is unparalleled in depth of information and 
ease of navigation. Their commitment to developing 
comprehensive publications to address complex tax issues has 
been unbelievable and I truly believe that their commitment has 
made a real difference.
    Diverting the attention of the IRS to enforcement, at the 
cost of service, would be devastating.
    Another option is to increase the level of compliance data 
and the efforts to review that data. As a professional 
accountant, I always think it is a good idea to look at the 
numbers.
    Knowing which taxpayers are noncompliant, whether 
intentional or unintentional, can only improve efforts to 
increase compliance, therefore reducing the tax gap.
    However, the data can only be effectively analyzed in 
connection with the why related to that noncompliance. It is my 
concerted opinion that the why is in fact the complexity of the 
Tax Code itself.
    Tax compliance and its effect on the tax gap is clearly a 
significant issue. However, efforts to close that gap and 
reclaim missing revenue must be based on balanced and equitable 
measures.
    I believe that these efforts should avoid adding new levels 
of complexity, but instead focus on overall simplification of 
the Tax Code.
    Most taxpayers want to comply with tax laws and pay their 
fair share. Simplifying the Code will give them the ability to 
do that.
    Thanks again for the opportunity to be here.
    [Mr. Hall's statement may be found in the appendix.]

    Chairman Manzullo. Thank you.
    Our next witness is Abraham Schneier. Mr. Schneier is a tax 
consultant for the National Federation of Independent 
Businesses and a certified financial planner.
    I look forward to your testimony.

  STATEMENT OF ABRAHAM SCHNEIER, ABRAHAM SCHNEIER & ASSOCIATES


    Mr. Schneier. Thank you, Mr. Chairman, members of the 
Committee. My name is Abraham Schneier and I am a tax 
consultant to the National Federation of Independent Business 
and a self-employed business owner.
    On behalf of the 600,000 members of NFIB, I appreciate the 
opportunity to offer views on the tax gap and to express the 
concerns of small business owners over IRS attempts to address 
this gap.
    Let me first state that NFIB does not defend or attempt to 
rationalize that portion of the tax gap that is created by 
willful violation of our tax laws.
    Clearly, the tax gap is caused by different factors and 
NFIB agrees with others that tax complexity continues to be 
responsible for a significant portion of the tax gap.
    As Nina Olson, Taxpayer Advocate for the IRS, stated in her 
testimony before the Senate Finance Committee on April 14, 
``Tax law complexity provides gray areas and loopholes for 
taxpayers who are not trying to comply. Complexity also trips 
up taxpayers who are trying to comply. It is just too hard to 
figure out what the law requires and honest efforts to comply 
can result in a gotcha situation.''
    Since the Commissioner was kind enough to mention some of 
my testimony, I figure it is only right that I mention some of 
his previous testimony.
    At the same hearing, the Commissioner said, ``The tax gap 
does not arise solely from tax evasion or cheating. It includes 
a significant amount of noncompliance, due to complexity of the 
tax laws that results in ignorance, confusion and carelessness. 
We do not have sufficient good data to help us know how much of 
the tax gap arises from willfulness, as opposed to innocent 
mistakes.''
    We have heard both Commissioner Everson and Tom Sullivan 
from SBA's Office of Advocacy talk about the cost of compliance 
to the government. But there is also a heavy cost to the small 
business owner, in terms of the cost of advice that he is 
required to obtain on a regular basis, in terms of the cost of 
not knowing whether he or she is doing the right thing.
    Too often they get tripped up on footfalls and too often 
they get tripped on just not knowing that there is a certain 
requirement coming.
    Granted some of them do get into difficulties because of 
financial issues and at that time, you certainly don't want to 
be in debt to the IRS, which unfortunately too often can 
happen.
    But we seriously believe that the tax gap is being driven 
in a major portion by the complexity. In that regard, I would 
like to echo some of John Satagaj's thoughts about the efforts 
of the small business, self-employed and the TEC division, in 
terms of the outreach and the communications that has been 
going on with the small business community over the last 
several years.
    It has been a long time since small business has had the 
opportunity to have input on the front end of items that were 
going to come out before the small business community. That has 
been a major benefit of having this regular communications.
    Too often we hear this is what you have to do and maybe we 
can't change that, but on a more regular basis we were having 
an opportunity to have input on the front end on new forms that 
were going to be put forward and on new rules.
    I guess probably the best example is maybe the cash method 
of accounting changes that we all worked on so hard several 
years ago.
    There is an increased reliance as well on technology, which 
I think we have to be a little concerned about. NFIB does 
regular surveys of its members on a variety of issues and 
despite everything we read in the news, not all taxpayers, 
which includes small business owners, use or are comfortable 
with computer technology.
    17 percent of small employers are not even on the Internet. 
The issue is not just relevant to those who are not on the 
Internet. Many questions simply require talking to a real 
person who can sometimes ask the appropriate follow up question 
that will lead to a correct answer.
    Sometimes the taxpayer will call up Taxpayer Service and 
ask a particular question or look up something on the Internet. 
Unless he has a live person on the other end who can maybe ask 
a follow up question to really help him get to the kernel of 
the issue, he is going to come up with the wrong answer more 
often than not or come up with no answer, which can also lead 
to unfortunate events.
    Recently NFIB asked a sample of small employers if they had 
contacted government to learn about or clarify an existing rule 
or obligation, such as a tax rule.
    60 percent indicated that they had. Of that number, only 
five percent said that their primary means of contact was the 
Internet. The most frequent was by telephone.
    It is highly likely that the proportion using the Internet 
and using it effectively will increase, but to the extent that 
reliable, readily accessible and easily understandable 
information reduces the tax gap, mismatches between the way 
IRS--

    Chairman Manzullo. Mr. Schneier, I am going to cut you off 
here. I want to get this testimony and we have got a bunch of 
votes and a big fight going on, on the floor. I am going to cut 
you off right there and go to our next witness, Mr. Steinberg.

    Mr. Schneier. Thank you, Mr. Chairman.
    [Mr. Schneier's statement may be found in the appendix.]

    Chairman Manzullo. I look forward to your testimony.

      STATEMENT OF LEONARD STEINBERG, THE STEINBERG GROUP


    Mr. Steinberg. Thank you, Mr. Chairman.

    Chairman Manzullo. I am going to reduce your time to four 
minutes. I just want to get everybody in and get this 
completed, because we may be gone for an hour, an hour and a 
half on a floor fight.

    Mr. Steinberg. All right. Thank you, Mr. Chairman. I 
appreciate it very much and I will be as brief as possible.

    Chairman Manzullo. If you could move the mike closer to 
you, Mr. Steinberg. Thank you.

    Mr. Steinberg. Thank you, sir. I am here to talk about the 
how and why of the tax gap and although everyone has talked 
about the complexity of the tax gap, I will give you a classic 
example.
    There are some people that will form a business as a 
limited liability corporation. According to the IRS rules, if 
you are a single person limited liability corporation, you are 
considered a sole proprietor.
    If you are a two-person limited liability corporation, you 
are considered a partnership. These kinds of complexity drives 
small business people nuts, because they really don't 
understand the difference in the type of organizations that 
they are really forming.
    Another reason for the tax gap is the effect of the 
alternative minimum tax. Although this is not a hearing on the 
alternative minimum tax, many small business owners and self-
employed individuals will intentionally underreport their 
income in order to specifically avoid the AMT. This is 
accomplished by not reporting all cash transactions and by not 
reporting all income derived from other sources.
    The AMT is specifically devastating to those small business 
owners and taxpayers who live in high tax states, such as New 
York, my home state of New Jersey, California and 
Massachusetts.
    Another reason for the tax gap is operating a cash 
business. As an example, a small business owner may operate a 
pizzeria. The store is open six days per week from Tuesday 
through Sunday.
    The business has been in the same location for many years 
and though the ownership has changed twice, the business has a 
wonderful reputation.
    On very busy days, the owner and helpers prepare pizzas and 
other foods as quickly as they can. Orders are phoned in. 
Customers come to pick up their orders.
    The people behind the counter do not have either the time 
or the proximity to get to the cash register in order to record 
the sale. The cash is held and then placed in the register at 
the end of the busy period and each cash sale is not accurately 
reported.
    So the mathematics of this non-reported cash will work as 
follows: If there are five unreported transactions with a value 
of $10 each day, the total amount of unreported sales 
transactions will equal $15,600 for a year, based on a six-day 
week for 52 weeks.
    If the money goes into the owner's pockets, that is $15,600 
of unreported income and there is also an effect on state and 
local sales tax.
    Another reason for the tax gap is that many people do not 
understand the tax laws. As an example, I had a case of a 
client who did not understand why he could not expense his 
entire franchise fee.
    His franchise fee was $40,000. Why can't I expense it? I 
had to explain to him that it has to be amortized over 15 
years, over the life of the business.
    Here again, the franchisor received the $40,000, which is 
claimed as income, but the franchisee can only take a portion 
of it.
    Lastly, I would like to talk about unenrolled preparers. I 
know Nina Olson has talked about this. This is a pernicious 
affect on unreported income. There are unscrupulous, unenrolled 
preparers who will prepare tax returns and take undue 
deductions and not claim all the income for the people. I know 
my time is almost up.
    So I would like to thank the Committee for the opportunity.
    [Mr. Steinberg's statement may be found in the appendix.]

    Chairman Manzullo. Thank you very much.
    Mr. Hegt, we look forward to your testimony. I am sorry 
about the rushed up time. Please.

   STATEMENT OF RONALD HEGT, AMERICAN INSTITUTE OF CERTIFIED 
                       PUBLIC ACCOUNTANTS


    Mr. Hegt. Thank you, Mr. Chairman. The AICPA thanks you for 
the opportunity to appear before you today. I am Ron Hegt, a 
member of the AICPA Tax Executive Committee.
    The AICPA is the national professional organization of 
CPA's comprised of more than 350,000 members, many of whom 
provide services to America's small businesses.
    It is from this broad base of experience that we offer our 
comments today. The AICPA has long been an advocate for tax 
simplification. Small business in particular needs advocates to 
collect and voice their concerns about the burdens imposed on 
them.
    We are committed to helping make our tax system as simple 
and as fair as possible. Unfortunately, we believe that the 
law's complexity in certain key areas may be strangling 
voluntary compliance.
    The lack of deliberation in the legislative process, the 
frequent law changes in recent years and the increasing 
magnitude and complexity of the Internal Revenue Code creates 
serious compliance issues for small businesses.
    The end result is the erosion of voluntary compliance. By 
and large, small businesses obey the law, but it is only human 
to inadvertently disobey a law if you do not or cannot 
understand the rules.
    The dynamic American economy is changing and moving rapidly 
against an unnecessarily cumbersome income tax system. The 
AICPA has long understood the consequences of tax law 
complexity and has supported efforts to move toward a simple 
system.
    More recently, the AICPA has developed three tax policy 
concept statements guiding principles for good tax policy, 
guiding principles for tax simplification and guiding 
principles for tax law transparency, which are intended to aid 
in the development of tax legislation in a direction that we 
believe is in the public interest.
    Simplification must be given a prominent position in the 
tax process on an ongoing basis. Although it should not take 
precedence over revenue and tax policy objectives, 
simplification must be an integral part of the tax legislative 
regulatory and administrative process.
    We recognize that a tax system that is simple for all 
taxpayers may never be designed, but we do believe a simpler 
system is attainable.
    For a number of years we have joined our professional 
colleagues from the ABA tax section and the Tax Executive 
Institute in this simplification effort.
    We have, on many of occasions, submitted simplification 
recommendations to Congress, which specifically address a 
number of issues that add to the difficulties small businesses 
have in complying with the tax laws.
    Some of these suggestions have particular interest to small 
businesses include eliminating the alternative minimum tax, 
clarification in worker classification area, developing 
objective, administrable tests relating to capitalization, 
expensing and recovery of capitalized costs, simplifying 
capital gains provisions and rationalizing estimated tax safe 
harbors.
    In addition, we suggest allowing small business start ups 
an additional tool to successfully navigate their start up life 
cycle by providing the flexibility to adopt any fiscal year 
from April through November.
    The AICPA supported the Small Business Tax Flexibility Act 
of 2003, HR 3225, which would have increased small business 
prospects for survival.
    Moving to another area, I would like to address two 
critical topics. One, how the IRS can help taxpayers in its own 
enforcement efforts through administrative simplification and 
two, how the IRS can leverage its external stakeholders to 
achieve a more highly compliant tax population.
    We are well aware of the substantial decline in the number 
of income tax return examinations conducted by the Service in 
recent years.
    We support the Service's efforts to reverse this trend by 
hiring new revenue agents and implementing a number of 
administrative simplification measures within its four 
operating divisions.
    Over the years, the AICPA has urged full funding of the IRS 
budget and continues such support. Commissioner Everson 
recognized that any increase in enforcement funding must be 
balanced with positive responses to the taxpaying public, his 
customers. We encourage--

    Chairman Manzullo. I have to enforce the clock, which I 
can't stop.
    [Mr. Hegt's statement may be found in the appendix.]

    Chairman Manzullo. What I would ask is this: I am going to 
formally end the hearing. I will come back personally and we 
will have about a 20-minute or so town meeting so the people 
here can ask questions and we can get more input from you, 
especially those of you that have traveled far distances.
    The stenographer would be excused, because at this point 
the hearing is formally adjourned.
    [Whereupon, at 3:30 p.m., the Committee meeting was 
adjourned.]


[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]


                                 
