    Tax Gap: A Strategy for Reducing the Gap Should Include Options
    for Addressing Sole Proprietor Noncompliance (13-JUL-07,
    GAO-07-1014).

    The Internal Revenue Service (IRS) estimates that $68 billion of
    the annual $345 billion gross tax gap for 2001 was due to sole
    proprietors, who own unincorporated businesses by themselves,
    underreporting their net income by 57 percent. A key reason for
    this underreporting is well known. Unlike wage and some
    investment income, sole proprietors' income is not subject to
    withholding and only a portion is subject to information
    reporting to IRS by third parties. GAO was asked to (1) describe
    the nature and extent of sole proprietor noncompliance, (2) how
    IRS's enforcement programs address it, and (3) options for
    reducing it. GAO analyzed IRS's recent random sample study of
    reporting compliance by individual taxpayers, including sole
    proprietors.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-07-1014
        ACCNO:   A74367
      TITLE:     Tax Gap: A Strategy for Reducing the Gap Should Include
    Options for Addressing Sole Proprietor Noncompliance
         DATE:   07/13/2007
      SUBJECT:   Financial analysis
    	     Financial statement audits
    	     Financial statements
    	     Income taxes
    	     Noncompliance
    	     Personal income taxes
    	     Reporting requirements
    	     Self-employed
    	     Strategic planning
    	     Tax return audits
    	     Tax returns
    	     Tax violations
    	     Tax gap
    	     Underreporting
    	     IRS Automated Underreporter System

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    GAO-07-1014

         * [1]Results in Brief
         * [2]Background

              * [3]Information Reporting
              * [4]IRS Enforcement Programs
              * [5]Compliance Measurement and the Tax Gap

         * [6]Most Sole Proprietors Underreported Business Income, but a S

              * [7]Most Sole Proprietors Underreported Net Business Income, Mis
              * [8]Although a Small Proportion of Sole Proprietors, More Than 1

         * [9]Enforcement Programs Have Limited Reach over Sole Proprietor

              * [10]AUR Is Restricted by Limits on Information Reporting and Oth

                   * [11]AUR Is Limited by a Lack of Resources, Expense Matching,
                     and
                   * [12]Despite Limitations, AUR Annually Recommends Hundreds of
                     Mil

              * [13]Examination Program Is Not Geared toward Schedule C Issues b
              * [14]IRS Did Not Always Apply Negligence Penalties during NRP

         * [15]Current Treasury Tax Gap Strategy Discusses Neither Sole Pro

              * [16]Tax Gap Strategy Does Not Specifically Discuss Sole Propriet
              * [17]Many Options for Improving Sole Proprietor Compliance Exist

         * [18]Conclusions
         * [19]Recommendation for Executive Action
         * [20]Agency Comments and Our Evaluation
         * [21]Appendix I: Scope and Methodology
         * [22]Appendix II: Options to Address Problems with the Tax Compli

              * [23]A. Recordkeeping and Complexity

                   * [24]1. Work with small business representatives on their
                     ideas f
                   * [25]2. Provide assistance to first-time Schedule C filers.
                   * [26]3. Separate business and personal records and
                     transactions.
                   * [27]4. Repeal certain limitations in section 530 of the
                     Budget A

              * [28]B. Burdens and Problems for Third Parties in Filing Informat

                   * [29]5. Clarify Schedule C instructions to indicate that
                     informat
                   * [30]returns may be required
                   * [31]to be filed by sole proprietors who deduct expenses for
                     wage
                   * [32]6. Change the IRS Web-based system for filing
                     information re
                   * [33]filing information returns on payments made to
                   * [34]sole proprietors, particularly those filing a smaller
                     number
                   * [35]7. Create a new Form 1099-NEC to segregate NEC from the
                     vari

              * [36]C. Unreported Income for Sole Proprietors

                   * [37]8. Expand gross receipts reporting on the Schedule C.
                   * [38]9. Close gaps in existing information reporting on
                     payments
                   * [39]10. Require new information reporting by organizations
                     on pa
                   * [40]11. Require new information reporting on consumer
                     payments t

              * [41]D. Overstated Deductions for Sole Proprietor Expenses

                   * [42]12. Expand expense reporting on the Schedule C.
                   * [43]13. Match information returns filed by sole proprietors
                     with
                   * [44]14. Expand information reporting on the expenses of sole
                     pro
                   * [45]15. Verify additional expenses claimed to offset
                     unreported

              * [46]E. Nonpayment of Tax

                   * [47]16. Deny benefits/payments until tax obligations are
                     met.
                   * [48]17. Withhold tax to encourage tax compliance.

              * [49]F. IRS Management of Limited Resources

                   * [50]18. Improve audit selection of sole proprietor tax
                     returns.
                   * [51]19. Enhance data sharing with the states.
                   * [52]20. Use informational notices to encourage compliance.
                   * [53]21. Revise the rules for applying penalties to improve
                     consi

         * [54]Appendix III: IRS Form 1040 Schedule C, Tax Year 2001
         * [55]Appendix IV: Independent Contractors and Section 530 of the
         * [56]Appendix V: Backup Withholding Rules
         * [57]Appendix VI: Comments from the Department of the Treasury
         * [58]Appendix VII: GAO Contact and Staff Acknowledgments

              * [59]GAO Contact
              * [60]Acknowledgments

         * [61]Related GAO Products

              * [62]Order by Mail or Phone

    Report to the Committee on Finance, U.S. Senate

    United States Government Accountability Office

    GAO

    July 2007

    TAX GAP

    A Strategy for Reducing the Gap Should Include Options for Addressing Sole
    Proprietor Noncompliance

    GAO-07-1014

    Contents

    Letter 1

    Results in Brief 3
    Background 4
    Most Sole Proprietors Underreported Business Income, but a Small
    Proportion Accounted for the Bulk of Unpaid Taxes 9
    Enforcement Programs Have Limited Reach over Sole Proprietors but Still
    Make Billions of Dollars in Recommended Assessments 16
    Current Treasury Tax Gap Strategy Discusses Neither Sole Proprietor
    Noncompliance nor the Many Options That Could Address It 26
    Conclusions 33
    Recommendation for Executive Action 33
    Agency Comments and Our Evaluation 33
    Appendix I Scope and Methodology 35
    Appendix II Options to Address Problems with the Tax Compliance of Sole
    Proprietors 42
    Appendix III IRS Form 1040 Schedule C, Tax Year 2001 61
    Appendix IV Independent Contractors and Section 530 of the Revenue Act of
    1978 63
    Appendix V Backup Withholding Rules 65
    Appendix VI Comments from the Department of the Treasury 66
    Appendix VII GAO Contact and Staff Acknowledgments 67
    Related GAO Products 68

    Tables

    Table 1: Percentage of Recommended Assessments and Limitations of IRS
    Enforcement Programs for Detecting Sole Proprietor Reporting Noncompliance
    16
    Table 2: Options to Improve Sole Proprietor Tax Compliance 30
    Table 3: Confidence Intervals for Summary of Schedule C Misreporting for
    Tax Year 2001 36
    Table 4: Confidence Intervals for Estimated Understated Tax Amounts by
    Percentile for Individual Income Tax Returns with Schedule Cs Attached,
    Tax Year 2001. 36
    Table 5: Confidence Intervals for Estimated Cumulative Understated Taxes
    by Percentile for Individual Income Tax Returns with Schedule Cs Attached,
    Tax Year 2001 37

    Figures

    Figure 1: Distribution of Sole Proprietors and Their Gross Receipts by
    Size of Proprietorship, Tax Year 2003 5
    Figure 2: IRS's Nonemployee Compensation Information Returns Matching
    Process 8
    Figure 3: Summary of Unadjusted NRP Population Estimates for Schedule C
    Misreporting, Tax Year 2001 11
    Figure 4: Estimated Understated Tax Amounts by Percentile for Form 1040s
    with Schedule Cs Attached, Tax Year 2001 14
    Figure 5: Estimated Cumulative Understated Taxes by Percentile for Form
    1040s with Schedule Cs Attached, Tax Year 2001 15
    Figure 6: Number of AUR NEC Contacts Made and Total Recommended
    Assessments, Tax Years 1999-2003 21
    Figure 7: Examinations of Returns with Schedule C Attachments and
    Recommended Tax Assessments, Fiscal Years 2001-2006 24
    Figure 8: Recommended Penalties for Sole Proprietors and Non-Sole
    Proprietors in NRP Examinations with a 100 Percent or Greater Recommended
    Tax Change by Dollar Value of Tax Change in Tax Year 2001 25

    Abbreviations

    AGI adjusted gross income
    AUR Automated Underreporter Program
    EIN employer identification number
    FIRE Filing Information Returns Electronically
    IRS Internal Revenue Service
    NEC nonemployee compensation
    NMA net misreported amount
    NRP National Research Program
    SOI IRS Statistics of Income Division
    TIN taxpayer identification number

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
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    separately.

    United States Government Accountability Office
    Washington, DC 20548

    July 13, 2007

    The Honorable Max Baucus Chairman
    The Honorable Charles Grassley
    Ranking Member
    Committee on Finance
    United States Senate

    Voluntary compliance with federal tax laws is a critical component of the
    federal tax system. Each year, however, a gap arises between tax amounts
    that were voluntarily reported and paid on time and those that should have
    been paid. The Internal Revenue Service's (IRS) most recent estimate is
    that the gross federal tax gap for tax year 2001 was $345 billion.

    Sole proprietors, who own unincorporated businesses by themselves, have a
    relatively high rate of tax noncompliance and account for a significant
    portion of the tax gap. IRS estimates that sole proprietors misreported 57
    percent of their business income in 2001 and that $68 billion of the tax
    gap is attributable to sole proprietors underreporting such income.1 Key
    reasons for sole proprietors' relatively high tax noncompliance are well
    known. Sole proprietors are not subject to tax withholding, and only a
    portion of their net business income is reported to IRS by third parties.
    By comparison, misreporting rates for wage and interest income, which are
    subject to withholding or information reporting by financial institutions,
    are low (about 1 and 4 percent, respectively).

    Congress has been encouraging IRS to develop an overall tax gap reduction
    plan or strategy that could include a mix of approaches, like simplifying
    tax law, increasing enforcement tools, and reconsidering the level of
    resources devoted to enforcement. On September 26, 2006, the Department of
    the Treasury (Treasury), Office of Tax Policy, issued "A Comprehensive
    Strategy for Reducing the Tax Gap." At the time, Treasury officials said
    that a more detailed strategy would be forthcoming.

    1In addition, sole proprietors contributed to an unmeasured extent to the
    $54 billion in misreported employment taxes, the $34 billion underpayment
    tax gap, and the $27 billion tax gap created by individuals not filing
    required tax returns for tax year 2001.

    Because of your concern about the tax gap and the importance of sole
    proprietor compliance, you asked us to identify steps that might improve
    that compliance. Our objectives were to (1) describe the nature and extent
    of the noncompliance associated with sole proprietors, (2) describe the
    extent to which IRS's enforcement programs address the types of sole
    proprietor noncompliance found by IRS's most recent research, and (3)
    identify options to close the tax gap related to sole proprietors that
    could be included in the tax gap strategy being developed by Treasury. To
    describe the nature and extent of sole proprietor noncompliance, we
    analyzed IRS's National Research Program (NRP) results on the reporting
    compliance of individual taxpayers in tax year 2001, IRS's tax gap
    estimates, and IRS's Statistics of Income (SOI) data to develop a profile
    of sole proprietors and related tax compliance issues.2 To determine the
    extent to which IRS's compliance programs address sole proprietor
    noncompliance, we reviewed filing guidance and compliance program
    procedures and analyzed program results. We interviewed IRS staff on the
    operations and results of the Automated Underreporter Program (AUR), which
    tests for underreporting by computer matching information returns
    reporting selected payments made to sole proprietors with income tax
    returns. We also interviewed staff in IRS's correspondence, office, and
    field examination (or audit) programs. In addition, we reviewed NRP
    examination cases to identify examples of barriers when examining sole
    proprietors.

    We used several approaches to identify options for closing the sole
    proprietor tax gap that could fit into the tax gap strategy. We focused on
    options that could address the types of sole proprietor noncompliance
    profiled by IRS's research and the limitations of IRS's enforcement
    programs that address sole proprietors. We also reviewed existing
    recommendations from the President's Budget, President's Advisory Panel on
    Federal Tax Reform, our previous recommendations and reports of the
    Treasury Inspector General for Tax Administration, IRS's Taxpayer
    Advocate, and IRS advisory groups. We discussed the options with experts
    on sole proprietor compliance, including persons who have experience with
    IRS or other federal programs related to sole proprietors or who published
    related research. We met with officials from various small business
    organizations, professionals who provide tax advice to small businesses,
    and tax professional organizations. Further, we reviewed Treasury's tax
    gap strategy. A more detailed description of our methodology is in
    appendix I. This report contains estimates which have associated
    confidence intervals that are conveyed in the body or discussed in the
    appendix. We conducted our review from July 2006 through June 2007 in
    accordance with generally accepted government auditing standards.

    2NRP studied reporting compliance (versus filing or payment compliance)
    for a random sample of individual tax returns filed for tax year 2001. In
    most cases, the returns were audited to determine whether income,
    expenses, and other items were reported accurately by the taxpayers.

    Results in Brief

    Most sole proprietors underreported net business income for tax year 2001,
    but a small proportion of them accounted for the bulk of understated
    taxes. This underreported income was caused by misreporting of both gross
    income and expenses. Based on what was detected in NRP reviews, at least
    61 percent of sole proprietors underreported their net income by $93.6
    billion in 2001. IRS recognizes that these are underestimates because
    detecting underreported income is difficult, especially cash receipts.
    After upward adjustment, IRS estimated that underreported net income
    resulted in sole proprietors understating their taxes by $68 billion.
    Although most sole proprietors had understated taxes, the amounts were
    skewed. Of all sole proprietors who understated taxes, the lower half
    understated them by less than an estimated $903. Over 1 million sole
    proprietors had tax understatements above $6,200, which accounted for the
    upper 10 percent of understatements. These understatements averaged an
    estimated $18,000 and accounted for 61 percent of all understated taxes on
    returns filed by sole proprietors.

    IRS's main programs to check sole proprietor tax compliance--AUR and the
    Examination program--have a limited reach. AUR annually contacts about 3
    percent of the estimated population of noncompliant sole proprietors while
    Examination reaches less than 2 percent of them. Information returns that
    AUR uses to verify sole proprietor income only cover about 25 percent of
    sole proprietor gross receipts and generally few of their expenses.
    Barriers to submitting information returns, including complex requirements
    and lack of convenient electronic filing, also limit AUR's reach.
    Examinations of sole proprietors' tax returns are more costly and
    recommend lower additional tax assessments than some other examinations.
    However, examinations (like other enforcement programs) may have a
    deterrent effect and increase voluntary compliance by other sole
    proprietors. Because the rate of noncompliance of sole proprietors is so
    high, any change in their compliance rate from more enforcement activity
    could result in significant revenue increases. Even without taking into
    account any effect on voluntary compliance, IRS's enforcement programs
    annually make contact with hundreds of thousands of sole proprietors and
    recommend billions of dollars in additional tax assessments. Finally, IRS
    did not always apply negligence penalties during NRP for sole proprietors
    with large tax changes.

    Since the mid-1990s, we have reported on the need for a strategy to
    address the overall tax gap as well as the part caused by sole
    proprietors. That need still exists. Treasury's recently released tax gap
    strategy discusses neither sole proprietor noncompliance nor the many
    options that could address it. Although the fiscal year 2008 budget
    request had legislative proposals on the tax gap, including some related
    to sole proprietors, these proposals do not make up a long-term,
    comprehensive strategy. Because no single approach is likely to cost
    effectively reduce the tax gap by sole proprietors, various options could
    be considered as part of the overall tax gap strategy and would require
    IRS, Treasury, or legislative action. These options include enhancing
    assistance to taxpayers, making information return submission more
    convenient, requiring more information reporting, and increasing IRS
    enforcement. Each option has pros and cons. In general, the pros include
    increasing voluntary compliance, enhancing IRS's ability to detect
    noncompliance, and reducing the burden of complying. The cons include
    additional burdens imposed on sole proprietors and third parties as well
    as costs imposed on IRS. We do not rank the options or recommend
    particular ones because IRS has other compliance objectives in addition to
    sole proprietor compliance, some options may be substitutes for each
    other, and quantitative information about the pros and cons is often
    lacking. Details on all of our options, including some of the pros and
    cons, are included in appendix II.

    We recommend that the Secretary of the Treasury ensure that the tax gap
    strategy includes (1) a segment on improving sole proprietor compliance
    that is coordinated with broader tax gap reduction efforts and (2)
    specific proposals, such as the options we identified, that constitute an
    integrated package. In commenting on a draft of this report, Treasury said
    that although not addressed specifically, the seven elements of the
    department's strategy are intended to apply broadly to all types of
    businesses and individual taxpayers, including sole proprietorships.
    Treasury also stated that this report provides valuable insight for
    applying the strategy to the tax gap. IRS and Treasury also provided
    technical comments on a draft of this report, which we incorporated as
    appropriate. IRS did not provide written comments.

    Background

    Sole proprietors own unincorporated businesses by themselves. As such,
    they are distinct from corporations and partnerships. In this report, the
    term sole proprietors refers to both the owners of the businesses and the
    category of business. In tax year 2003, 20.6 million sole proprietors
    filed tax returns (the latest year for which detailed IRS data were
    available). Sole proprietors constitute about 72 percent of all businesses
    in the United States but are small; they have only 4.8 percent of all
    business receipts. Sole proprietors include a wide range of businesses,
    including those that provide services, such as doctors and accountants;
    produce goods, such as manufacturers; or sell goods at fixed locations,
    such as car dealers and grocers. These activities may be full time or part
    time and may be all or part of an individual's income. Figure 1 shows the
    distribution of sole proprietors and their gross receipts by the size of
    the proprietorship.

    Figure 1: Distribution of Sole Proprietors and Their Gross Receipts by
    Size of Proprietorship, Tax Year 2003

    Sole proprietors report their business-related net profit or loss on IRS
    Form 1040, U.S. Individual Income Tax Return, through their Schedule C
    Profit or Loss from Business (see app. III). The Schedule C requires sole
    proprietors to classify their type of business or profession, report gross
    receipts and income, place expenses in 23 categories, and provide
    additional data on vehicle expenses. Sole proprietors with expenses up to
    $5,000 may qualify for simplified tax reporting on Schedule C-EZ, which
    allows them to report all expenses on one line. Sole proprietors combine
    their business profits or losses, reported on Schedule C, with income,
    deductions, and credits from other sources that are reported elsewhere on
    the Form 1040 to compute their overall individual tax liability.

    In addition to income tax obligations, sole proprietors have other tax
    requirements. If they have employees, sole proprietors are responsible for
    withholding and paying Social Security, Medicare, and federal income tax,
    and paying federal unemployment tax under an employer identification
    number (EIN) that is the tax identification number (TIN) for the business.
    Whether they have employees or not, sole proprietors are required to pay
    self-employment tax, which is similar to the Social Security and Medicare
    tax for wage earners.

    Information Reporting

    Sole proprietors may prepare and receive information returns for payments
    made to them or made by them for services, known as nonemployee
    compensation (NEC), on an IRS Form 1099-MISC.3 IRS uses the NEC data in
    its matching programs, such as AUR, to help verify a sole proprietor's
    receipts. Generally, a Form 1099-MISC needs to be filed with IRS and the
    recipient of the payment for

               o payments of $600 or more for services performed for a trade or
               business, including a sole proprietor, by people who are not
               employees, such as contractors;4
               o rent payments of $600 or more, other than rents paid to real
               estate agents;5 and
               o sales of $5,000 or more of consumer goods to persons for resale
               anywhere other than in a permanent retail establishment.

               Payments for purchases of goods and service to corporations
               generally are not required to be reported.6

    3See IRS's Publication 334, Tax Guide for Small Business, and Form
    1099-MISC instructions.

    4Other reportable items include other income payments, medical and health
    care payments, crop insurance proceeds, and gross proceeds to an attorney.

    5The real estate agent is responsible for reporting payments of rent to
    the landlord. See Treasury Regulation 1.6041-3(d).

               Based on these rules, organizations (including sole proprietors)
               that make NEC payments for services provided may be required to
               submit information returns to IRS and the payee. For example, a
               store owner (a sole proprietor) who hires a self-employed computer
               programmer (another sole proprietor) to design the business Web
               site for $10,000 must submit a Form 1099-MISC information return
               to report the $10,000 payment made to the computer programmer.
               However, if the programmer is hired to design a personal,
               nonbusiness Web site for the store owner, no information return is
               required.

               Completing a Form 1099-MISC requires the payer to determine
               whether the payee is an independent contractor or an employee. To
               determine independent contractor status, payers are to use 20
               common law rules.7 Numerous controversies over interpretation of
               the common law rules led to the enactment of Section 530 of the
               Revenue Act of 1978, which stops IRS and Treasury from issuing new
               interpretations of these rules.8 In 1996, we characterized these
               rules as confusing and resulting in many misclassifications. If
               the determination results in an employee-employer relationship,
               the organization is required to prepare a Form W-2 and withhold
               tax from each payment to the employee.

               Similarly, the payer must determine if the payee is a corporation,
               since such payments generally are not subject to Form 1099-MISC
               reporting. To determine if the service is provided by a
               corporation, service providers are asked to declare their
               corporation status and, if not a corporation, provide a TIN. To
               ensure that payees provide correct TINs on information returns
               filed with IRS, NEC payments may be subject to backup withholding.
               Independent contractors and Section 530 are discussed in appendix
               IV, and backup withholding rules are discussed in appendix V.

    			  IRS Enforcement Programs

               IRS's two main programs for ensuring compliance among sole
               proprietors are AUR and Examination. AUR matches the NEC income
               reported on the Schedule C of the sole proprietor's tax return
               with the NEC income reported on Form 1099-MISC. AUR may send a
               notice to the sole proprietor if the AUR matching identifies a
               discrepancy between the NEC reported. The notice proposes
               adjustments to the tax return filed and requests payment of
               additional tax, interest, or penalties related to the discrepancy.
               If the taxpayer disagrees with the notice, the taxpayer is
               requested to explain the difference and provide any supporting
               documents. Figure 2 describes the NEC information reporting
               process.

    6Payments for merchandise, telegrams, telephone, freight, storage, and
    similar items are also not reported nor are payments to informers from
    government agencies about criminal activity.

    7See GAO, Tax Administration: Issues in Classifying Workers as Employees
    or Independent Contractors, [63]GAO/T-GGD-96-130 (Washington, D.C.: June
    20, 1996).

    8Pub. L. No. 95-600, November 16, 1978.

               Figure 2: IRS's Nonemployee Compensation Information Returns
               Matching Process

               Examinations may address any type of noncompliance issue and come
               in three forms. Correspondence examinations are conducted through
               the mail and usually cover a narrow issue or two. Office
               examinations are also limited in scope but involve taxpayers going
               to an IRS office. For field examinations, IRS will send a revenue
               agent to a taxpayer's home or business to examine the compliance
               problem that IRS suspects.

    			  Compliance Measurement and the Tax Gap

               IRS estimates the gross tax gap--the difference between what
               taxpayers actually paid and what they should have paid on a timely
               basis--to be $345 billion for tax year 2001, the most recent
               estimate made. IRS also estimates that it will collect $55
               billion, leaving a net tax gap of $290 billion. IRS estimates that
               a large portion of the gross tax gap, $197 billion, is caused by
               the underreporting of income on individual tax returns. Of this,
               IRS estimates that $68 billion is caused by sole proprietors
               underreporting their net business income. This estimate does not
               include other sole proprietor contributions to the tax gap,
               including not paying because of failing to file a tax return,
               underpaying the tax due on income that was correctly reported, and
               underpaying employment taxes. According to IRS, estimates for some
               parts of the tax gap are more reliable than those for others. For
               both these reasons, the precise proportion of the overall tax gap
               caused by sole proprietors is uncertain. What is certain is that
               the dollar amount of the tax gap associated with sole proprietors
               is significant.

               IRS bases its estimates of the tax gap caused by underreporting of
               individual income on its compliance research program--NRP. The
               individual reporting compliance study was a detailed review and
               examination of a representative sample of 46,000 individual tax
               returns from tax year 2001. IRS generalized from the NRP sample
               results to compute estimates of underreporting of income and taxes
               for all individual tax returns. Because even the detailed NRP
               reviews could not detect all noncompliance, IRS adjusted the NRP
               estimates to develop final estimates of income misreporting and
               the resulting tax gap. IRS did not adjust all the NRP population
               estimates, only those necessary for developing its final tax gap
               estimates. However, NRP population estimates are a rich source of
               data about the nature and extent of sole proprietor noncompliance.
               Consequently, our report sometimes presents NRP population
               estimates and sometimes final tax gap estimates.

    			  Most Sole Proprietors Underreported Business Income, but a Small
    			  Proportion Accounted for the Bulk of Unpaid Taxes

               The significant amount of sole proprietor noncompliance reported
               in IRS's tax gap estimates is caused by underreporting of net
               business income, including the misreporting of both gross business
               income and expenses. The distribution of the resulting unpaid
               taxes is uneven. A small proportion of sole proprietors, but still
               a significant number, has relatively large amounts of unpaid
               taxes.

    			  Most Sole Proprietors Underreported Net Business Income, Misreporting
    			  Both Gross Income and Expenses

               Based on the unadjusted NRP results, an estimated 70 percent of
               Schedule C filers in 2001 (about 12.9 million) made an error when
               reporting net business income (that is, net profit or loss on line
               31 of Schedule C). Most of the misreporting was underreporting.
               These NRP results showed that an estimated 61 percent of Schedule
               C filers underreported their net income and 9 percent
               overreported.

               These reporting errors resulted in $93.6 billion, before
               adjusting, of misreported net business income as shown in figure
               3. This misreporting included an estimated $99 billion of
               underreported and $5.4 billion of overreported net income.

               The underreporting of net business income was caused by
               misreporting of both gross income and expenses, as shown in figure
               3. An estimated 39 percent of sole proprietors (6.9 million) made
               an error on the gross income line of Schedule C and underreported
               about $53 billion net after subtracting overstatements from
               understatements. An estimated 73 percent of sole proprietors (10.9
               million) made an error on the total expense line of the Schedule C
               and overreported about $40 billion net after subtracting
               understatements from overstatements.9 Overstating expenses reduces
               net business income and thus taxes. However, understating expenses
               may also contribute to understated tax if it is done to disguise
               understating higher amounts of gross income.

               The misreporting of expenses was spread over all the 23 expense
               categories on the Schedule C. However, 55 percent of expense
               misreporting was concentrated in four categories: car and truck,
               depreciation, supplies, and other.

    9IRS NRP and Research officials cited various reasons why a higher
    percentage and number of sole proprietors misreported expenses compared to
    overall net income. For example, some taxpayers who misreported expenses
    were not counted as misreporting net income because of other income or
    expense adjustments made during the examinations that produced the correct
    net income amounts.

    Figure 3: Summary of Unadjusted NRP Population Estimates for Schedule C
    Misreporting, Tax Year 2001

    Notes: Each line estimate is computed separately. For example, the
    estimate of total expenses is based on a different number of tax returns
    than for net profits. For this reason, in part, the percentage of returns
    with errors for total expenses is greater than those for net profits. The
    computations and confidence intervals are discussed in app. I.

    aA positive NMA refers to misreporting that could understate tax.
    Therefore, the NMA for income items is understatements minus
    overstatements, and the NMA for expense items is overstatements minus
    understatements.

    The unadjusted NRP results underestimate the amount of misreporting. The
    estimates in figure 3 are based on errors detected in the NRP reviews. IRS
    knows that not all misreporting is detected during its examinations,
    including NRP reviews. Unreported cash receipts, for example, are
    difficult to detect. IRS uses various methodologies and other sources of
    data (on cash transactions, for example) to adjust the aggregate NRP
    results (but not individual line items) to estimate misreporting. The NRP
    data limitations are more fully described in appendix I.

    After these adjustments, IRS estimates that sole proprietors misreported
    57 percent of their net business income in 2001 and that the tax gap
    caused by this misreporting of sole proprietor net business income in 2001
    was $68 billion. This is a substantial upward adjustment from the
    estimated $36.9 billion in understated taxes from all sources on returns
    with a Schedule C attached based on what NRP detected.10

    Taxpayers misreport income and expenses for a variety of reasons. Some
    misreporting is intentional; some is unintentional. How much misreporting
    is in each category is not known. IRS refers some misreporting for
    criminal prosecution, but often it is impossible to tell from a tax return
    whether errors are intentional. Beyond intentional misreporting, reasons
    for errors include transcription mistakes, misunderstanding of the
    relevant tax laws or regulations, and poor recordkeeping. Examples from
    our review of NRP examination case files illustrate some of these types of
    reporting errors:

               o The sole proprietor operated a cash-card business and reported
               about $900,000 in gross receipts on the Schedule C. The business
               is largely done with cash transactions. The examiner found
               evidence of more than $1 million in additional sales income, as
               well as additional expenses from purchases, leading to an
               adjustment of about $30,000 for Schedule C net income. The
               adjustment contributed to a total proposed additional tax
               assessment of about $8,000.

    10The $36.9 billion estimate excludes returns with no understatement and
    is based on unadjusted NRP results. We are 95 percent confident that the
    actual estimate is between $34.7 billion and $39.0 billion.

               o The sole proprietor owned a construction business and reported
               Schedule C losses of over $30,000. The examiner found that that
               the sole proprietor had poor business skills and shoddy records.
               Organizing the documentation to support the Schedule C required
               over 25 hours of examiner time and resulted in net adjustments to
               receipts and expenses on the Schedule C of over $45,000.
               o The sole proprietor owned a retail business and reported
               Schedule C gross income of almost $250,000. The examiner proposed
               adjustments of about $9,000 to Schedule C expenses because the
               expenses were undocumented or were personal living expenses not
               associated with the business. In protesting the related assessment
               to IRS Appeals, the taxpayer's representative said that the
               taxpayer's records were spread across several store accounts,
               several accounts for rental properties, and two personal accounts.
               Eventually, Appeals identified additional records and sent the
               case back to Examination.
               o The taxpayer was selling craft-related items and admitted to the
               IRS auditor that the sales were not engaged in for profit.
               Accordingly, the taxpayer should not have filed a Schedule C, and
               several thousand dollars of expenses reported by the taxpayer on
               Schedule C were disallowed.
               o The taxpayer was a minister and filed a schedule C. The examiner
               explained that although the taxpayer was self-employed in
               performing ministerial services for Social Security purposes, the
               taxpayer was considered an employee for income tax purposes. The
               taxpayer should not have filed a Schedule C.

    			  Although a Small Proportion of Sole Proprietors, More Than 1 Million
    			  Accounted for the Majority of Understated Taxes

               Understated taxes are spread unevenly among the population of sole
               proprietors, and slightly more than 1 million sole proprietors
               accounted for most of the understatements. On one hand, the amount
               of tax understatement caused by underreported net Schedule C
               income cannot be calculated precisely. Understated taxes on a
               return could result from the misreporting of multiple items, and
               the tax calculations depend on all such misreporting rather than
               just one item.11 On the other hand, using the best available data
               on underreporting detected by NRP, we estimate that 72 percent of
               the underreported adjusted gross income (AGI) on income tax
               returns filed by sole proprietors was caused by changes in
               Schedule C income.12 As a result, it is likely that most of the
               NRP-estimated $36.9 billion (unadjusted) in understated taxes on
               these returns can be attributed to underreported net business
               income on Schedule C.

    11This tax calculation is difficult to do and requires assumptions to
    account for how tax changes on one part of the income tax return affect
    the rest of the tax return (including changes to other types of wage,
    business, or investment income as well as to itemized deductions,
    exemptions, and credits), and ultimately flow through to the final tax
    liability and tax rate to be used.

               Although most sole proprietors had understated taxes, the amounts
               were skewed. Based on NRP estimates, half of sole proprietors who
               understated taxes on their individual income tax returns,
               understated less than an estimated $903 (the 50th percentile
               amount), as shown in figure 4. Above the 50th percentile, the
               amount of tax understatement significantly increased to an
               estimated $2,527 at the 75th percentile, $6,210 at the 90th
               percentile, and $20,387 at the 98th percentile. About 1.25 million
               sole proprietors accounted for the largest 10 percent of
               understatements for which the mean was about $18,000; for the
               largest 5 percent, the mean understatement was about $27,000. By
               comparison, as will be discussed further in the next sections,
               IRS's field examiners assessed on average $27,800 of additional
               tax for examinations of individual returns without Schedule Cs.

               Figure 4: Estimated Understated Tax Amounts by Percentile for Form
               1040s with Schedule Cs Attached, Tax Year 2001

               Notes: Figure 4 excludes returns with no understatement and is
               based on unadjusted NRP results. Confidence intervals are
               discussed in app. I.

    			  12 We are 95 percent confident that the actual estimate is between
    			  68 percent and 76 percent.

               Most of the aggregate $36.9 billion of understated taxes
               (unadjusted NRP estimate) on returns filed by sole proprietors was
               concentrated in a small proportion of sole proprietors. As shown
               in figure 5, the 11.2 million sole proprietors at and below the
               90th percentile understated their taxes by a cumulative $14.3
               billion. The remaining 10 percent (1.25 million) above the 90th
               percentile understated a cumulative $22.6 billion in taxes,
               accounting for 61 percent of the total.

               Figure 5: Estimated Cumulative Understated Taxes by Percentile for
               Form 1040s with Schedule Cs Attached, Tax Year 2001

               Notes: Figure 5 excludes returns with no understatement and is
               based on unadjusted NRP results. Confidence intervals are
               discussed in app. I.

               When arrayed by the size of the sole proprietor and based on
               reported gross receipts, understated taxes are less skewed. Based
               on Schedule C gross receipts, those sole proprietors at or below
               the 90th percentile ($127,462) accounted for 65 percent of
               cumulative understated taxes ($23.9 billion of $36.9 billion).13
               Those with the largest 10 percent of gross receipts accounted for
               the other 35 percent or $12.9 billion of the understated taxes.

    13We are 95 percent confident that the actual 90th percentile amount is
    between $124,720 and $134,263 and the cumulative amount is between $22.1
    billion and $25.8 billion.

               Enforcement Programs Have Limited Reach over Sole Proprietors but
    			  Still Make Billions of Dollars in Recommended Assessments

               IRS's two main programs for addressing sole proprietor reporting
               compliance14-- AUR and Examination--have limited reach over
               noncompliant sole proprietors, although they annually contact
               hundreds of thousands of taxpayers and recommend billions of
               dollars in assessments. Table 1 shows the types of sole proprietor
               noncompliance that AUR and Examination investigate, the percentage
               of the noncompliant sole proprietor population with recommended
               assessments, and the limitations of the programs.

    Table 1: Percentage of Recommended Assessments and Limitations of IRS
    Enforcement Programs for Detecting Sole Proprietor Reporting Noncompliance

                                     Percentage of
                                      noncompliant
                   Sole proprietor population with
                   noncompliance       recommended
    IRS program addressed           assessments Program limitations
    AUR         Inaccurately               2.7a    o Form 1099-MISC is not
                   reported gross                     required to be filed on
                   receipts                           all gross receipts (e.g.,
                                                      sales of goods).
                                                      o Form 1099-MISC is not
                                                      always filed as required
                                                      because of various
                                                      barriers.
                                                      o Does not address sole
                                                      proprietor expenses.
                                                      o Does not follow up on
                                                      all the mismatches
                                                      identified.
                                                      o Some information
                                                      submitted by taxpayers is
                                                      not verified.
    Examination Receipts and               1.4b    o Most examinations are
                   expense                            not designed to address
                   noncompliance                      sole proprietor tax
                                                      issues.
                                                      o Examinations can take a
                                                      lot of time.
                                                      o Recommended assessments
                                                      are lower from examining
                                                      sole proprietor issues
                                                      compared to examining
                                                      other types of tax return
                                                      issues.

    Source: GAO analysis of IRS data.

    aTax year 2003, the most recent year for which the appropriate AUR data
    were available.

    bExaminations conducted in fiscal year 2005 on calendar year 2004 returns,
    the most recent year for which the appropriate Schedule C filing data were
    available.

    14IRS also has programs for addressing nonpayment and nonfiling types of
    noncompliance, as well as taxpayer service programs for encouraging all
    types of tax compliance. Because this report focuses on sole proprietor
    reporting noncompliance, references to "noncompliance" refer to
    misreporting unless otherwise noted.

    Assuming that Schedule C filers would misreport net income at the same
    rate in subsequent years as they did in 2001, AUR recommended that
    additional tax be assessed on about 2.7 percent of noncompliant sole
    proprietors for tax year 2003.15 Similarly, Examination recommended that
    additional tax be assessed on about 1.4 percent of noncompliant sole
    proprietors for returns from tax year 2004.16

    AUR Is Restricted by Limits on Information Reporting and Other Program
    Constraints but Still Identifies Significant NEC Noncompliance

    AUR cannot detect all sole proprietor misreporting because the third-party
    information returns used for matching do not report all sole proprietor
    receipts or expenses. One quarter of sole proprietor receipts reported on
    a Schedule C in 2001 also appeared on a Form 1099-MISC that year. Since
    not all receipts are reported on a Schedule C, the true percentage would
    be lower. Exemptions to information reporting requirements prevent greater
    coverage of sole proprietor receipts. Most merchandise sales, nonbusiness
    services (such as construction or repairs for homeowners), and payments of
    less than $600 are exempt from Form 1099-MISC reporting. Additionally,
    because payments to corporations are generally exempt, sole proprietors
    that want to avoid information reporting of their receipts could
    incorporate.

    Several barriers may inhibit information return filing on NEC payments.
    First, preparing a Form 1099-MISC to report NEC payments can be a complex
    process.17 The general instructions for filling out any information return
    are 21 pages long, and the instructions for Form 1099-MISC are 8 pages
    long. Payers must figure out whether the businesses they have hired are
    independent contractors or exempt corporations and whether the payments
    meet other exemption criteria as well as acquire the payees TINs or EINs.

    15This percentage should not be confused with IRS's "examination coverage
    rate," which is merely the number of returns examined divided by the
    number of returns filed.

    16For both AUR and Examination, amounts of recommended assessments should
    not be construed as amounts ultimately collected. For example, recommended
    assessments could be abated in appeals or the amounts may not be
    collectible.

    17We have started work on a study that will more fully discuss taxpayer
    burdens in filing 1099-MISC forms.

    Second, submitting Form 1099-MISC returns is not convenient. In its
    instructions, IRS requires payers to use forms printed with red, magnetic
    ink so that IRS scanners can more easily process the forms; payers are
    instructed not to print Form 1099-MISC off of IRS's Web site. However, we
    observed plain paper Form 1099-MISC returns being scanned in IRS's Ogden,
    Utah, processing center. Furthermore, payers must submit Form 1099-MISC
    returns separately from their tax returns. There is $50 penalty, as the
    instructions prominently remind payers, for failing to use the correct
    form. In practice, IRS may not assert the penalty for every violation
    because of the administrative and collection costs.

    IRS has an Internet-based system for submitting information returns called
    Filing Information Returns Electronically (FIRE), but barriers exist to
    the use of that system. FIRE requires payers to put return information in
    a particular format that IRS can use, which requires appropriate software
    that payers must purchase. Payers cannot simply call up a Web site and
    fill out an online form, and they need to register with IRS before using
    the system.18 The likelihood that a payer would submit a Form 1099-MISC
    return electronically decreases as the number of forms that the payer
    files decreases. For example, IRS data from tax year 2005 show that 93
    percent of paper Form 1099-MISC returns were filed by payers with 24 or
    fewer submissions. One common tax preparation software package allows
    users to print Form 1099-MISC and submit them to IRS on paper, but the
    users cannot transmit Form 1099-MISC returns electronically as they can
    income tax returns. This software vendor said that it had a special
    arrangement with IRS for its users to print Form 1099-MISC on plain paper.

    Paper forms are more costly for IRS to process than electronically filed
    forms. With paper, IRS workers scan forms into a database and visually
    verify that the information was scanned correctly, a labor-intensive
    process. A substantial number of Form 1099-MISC returns are filed on
    paper. For filing year 2005, the Form 1099-MISC constituted 87 percent of
    all the paper information returns submitted that IRS could scan. Nearly 40
    percent of Form 1099-MISC returns (31.5 million) were submitted via paper
    that year.

    18Payers filing 250 or more information returns must use FIRE or send IRS
    special cartridges with the data.

      AUR Is Limited by a Lack of Resources, Expense Matching, and Examination
      Authority

    Because of resource constraints, IRS officials said they do not contact
    taxpayers in all cases where AUR finds a mismatch between what was
    reported on an information return and what was reported on a tax return.
    The annual average of NEC-related contacts for tax years 1999 through 2003
    is much less than half of the roughly 2 million cases that AUR officials
    say they annually identify for taxpayer contacts caused by potential NEC
    underreporting.19

    Also, AUR matching generally does not address misreported Schedule C
    expenses. First, according to IRS, AUR does not match sole proprietors'
    Schedule C expenses with the information returns they file for their own
    payments. Second, third-party information generally is not required on
    sole proprietor expenses.20

    AUR reviewers are directed to consider the reasonableness of the
    taxpayers' responses to notices but generally do not examine the accuracy
    of the information in the responses because they do not have examination
    authority.21 IRS officials said that addressing larger issues raised in
    the returns would take more time and possibly reduce the productivity of
    AUR overall. Consequently, taxpayers could, after being contacted by AUR
    about underreported NEC, create fictitious expenses to offset the
    underreported NEC.

    AUR does not systematically check for related parties trying to shift
    income from a tax return in a high-rate bracket to another return with a
    lower bracket. Related parties may include taxpayers who own multiple
    businesses, husbands and wives who file separate tax returns, unmarried
    couples, siblings, or parents and their children. IRS data showed that 3
    percent of all Form 1099-MISC returns had the same address for the payer
    and the payee--one indicator that a related-party transaction might exist.
    A nonrandom file review of 55 Form 1099-MISC filings at IRS's Ogden, Utah,
    campus found 8 examples in which the payer and payee had similar addresses
    or names. We did not determine the appropriateness of the apparent
    related-party transactions in the IRS Form 1099-MISC data based on the
    incidence of name and address matches.

    19AUR contacts do not always lead to a tax change. For example, from tax
    years 1999 through 2003, 26 percent of the NEC contacts did not lead to a
    tax change.

    20We have started work on a study that will more fully discuss Schedule C
    expense reporting.

    21AUR may refer suspicious cases to Examination, but IRS officials have
    told us that historically, that happens infrequently. IRS started a test
    in March 2007 on referring such suspicious cases to Examination for
    questionable NEC income and expenses.

    Two NRP cases are illustrative of apparent related-party transactions
    involving Form 1099-MISCs. In one case, a couple shared a financial
    account, and one of them was a sole proprietor. The sole proprietor, who
    earned more than $450,000 as an executive at a separate company, paid the
    other individual to run the sole proprietorship and deducted the payment
    on a Schedule C. The sole proprietorship had over $100,000 in losses and
    less than $1,000 in revenue. In the case file, an examiner noted that a
    Form 1099-MISC was filed on the NEC income paid from the executive to the
    person at the same address. This case file did not note whether the
    payment inappropriately shifted income to lower the couple's overall tax
    liability or whether the payment was an allowable business deduction for
    services actually rendered as an ordinary and necessary expense of
    carrying out a business, as required by the Internal Revenue Code.22 In
    another case, however, IRS disallowed deductions for wages that a
    psychiatrist paid to his children because the taxpayer did not show that
    the children had rendered services or even that the wages were paid--only
    that the deductions were taken.

      Despite Limitations, AUR Annually Recommends Hundreds of Millions of Dollars
      in Assessments on NEC Misreporting

    Annually, AUR receives more than 80 million 1099-MISC forms. From those
    submissions, AUR contacts hundreds of thousands of taxpayers about
    potential sole proprietor misreporting on those forms and makes billions
    of dollars in recommended assessments. From tax years 1999 through 2003,23
    AUR annually, on average, sent 371,989 notices on NEC cases and
    recommended $666 million in tax assessments. Figure 6 shows the trends in
    NEC contacts and total recommended assessments that AUR made from 1999
    through 2003.

    22I.R.C. S 162(a).

    23Because IRS officials said data for 2004 were not complete when we
    requested them, we used only data through 2003. It is possible that
    contacts and assessments related to NEC are somewhat higher, but IRS does
    not have the data to separate all contacts that included NEC as well as
    other types of misreporting. NEC figures used here only refer to those
    cases where 50 percent or more of the taxpayer's income was NEC or where
    the tax change was 80 percent or greater than the original tax reported.

    Figure 6: Number of AUR NEC Contacts Made and Total Recommended
    Assessments, Tax Years 1999-2003

    Contacts and assessments related to underreported NEC make up a
    significant portion of the AUR caseload. Of more than 60 categories that
    AUR uses to sort income data, the two NEC categories combined rank first
    in the number of contacts with taxpayers and in the dollars of recommended
    assessments made from tax year 1999 through tax year 2003. NEC cases
    constituted 17 percent of all AUR contacts and 21 percent of all AUR
    assessments for tax years 1999 through 2003.

    Examination Program Is Not Geared toward Schedule C Issues but Still Finds
    Significant Noncompliance

    Most of IRS's examinations do not focus on noncompliance by sole
    proprietors.24 Correspondence examinations account for the majority of
    IRS's examinations that IRS did in fiscal year 2006 and generally take the
    least amount of time to conduct, typically an hour or less, because they
    deal with simple, limited issues. Schedule C tax issues are generally too
    complex to make an examination through correspondence practical. For
    example, in our review of NRP files, we found a case in which an examiner
    manually sorted through a taxpayer's records and organized them to
    accurately calculate the taxes owed--a task that could not occur through
    correspondence. In any case, IRS's correspondence tax examiners, the
    lowest-graded examiners, do not have the training to examine many Schedule
    C issues, such as business depreciation or accounting methods.

    Schedule C tax issues typically must be addressed in field examinations.
    Field examinations took 20 hours on average to complete in fiscal year
    2006. Furthermore, field examinations of returns with Schedule C forms
    took about 50 percent longer per return (7.2 hours more) to complete than
    those not categorized as Schedule C returns in that year.

    Among field examinations, the recommended additional tax assessed for
    examinations of returns with attached Schedule C forms tended to be
    smaller than for other types of examinations. For example, the average
    recommended assessment for revenue agents examining returns with attached
    Schedule C forms (the employees most likely to do these examinations) was
    $24,000 in fiscal year 2006. This was $3,800 less than examinations of
    returns without Schedule C attachments and was less than the average
    dollars per return for 18 other types of returns without Schedule C
    attachments, such as tax-shelter program cases.

    The relatively higher costs and lower yields for Schedule C examinations
    do not necessarily mean than Schedule C examinations are not
    cost-effective. The statistics reported above include only the additional
    taxes expected from the taxpayer who was examined. Examinations may have a
    deterrent effect on other taxpayers and increase the rate of voluntary
    compliance.25 Because the rate of noncompliance is so high for sole
    proprietors, any change in their voluntary compliance from doing more
    examinations could result in significant revenue increases.

    24IRS Examination data treat a minority of Schedule C returns it receives
    as business returns. This section deals only with returns IRS has
    categorized as Schedule C business returns for Examination purposes and
    will be referred to as returns with an attached Schedule C.

    25GAO, Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a
    Variety of Approaches, [64]GAO-06-1000T (Washington, D.C.: July 26, 2006).

    IRS has been examining more tax returns with attached Schedule C forms,
    resulting in billions of dollars in recommended tax assessments. From
    fiscal years 2001 through 2006, the number of examinations of returns that
    IRS categorized as Schedule C returns increased by 132 percent, from
    128,062 to 297,626, as shown in figure 7.26 In fiscal year 2006, IRS
    examined about 3 percent of the Schedule C categorized returns.
    Recommendations of additional tax assessments also increased each year.
    The large increase in these assessments in 2005 was primarily for returns
    reporting income greater than $100,000. IRS officials also cited Son of
    Boss fraud cases from fiscal years 2005 and 2006 and increased examination
    efficiency as causes for the upward trends.27 Assessments do not reflect
    amounts actually collected. Amounts ultimately collected are not yet known
    from the examinations closed in 2005 and 2006.

    26IRS provided us examination data that did not differentiate between
    examinations of returns that have Schedule C forms attached and those that
    actually audited Schedule C issues. For example, a real estate agent
    filing a Schedule C may also own rental real estate and file a Schedule E.
    IRS may audit the real estate losses reported on the Schedule E, but
    nothing on the Schedule C. Therefore, IRS's data may overstate the number
    and amount of time that IRS spends auditing Schedule C returns.

    27Son of Boss was an abusive transaction aggressively marketed in the late
    1990s and 2000 primarily to wealthy individuals. IRS's settlement
    initiative regarding Son of Boss required taxpayers to concede 100 percent
    of the claimed tax losses and pay a penalty of either 10 percent or 20
    percent unless they previously disclosed the transactions to IRS. We did
    not verify whether examinations were more efficient in 2005 and 2006.

    Figure 7: Examinations of Returns with Schedule C Attachments and
    Recommended Tax Assessments, Fiscal Years 2001-2006

    IRS Did Not Always Apply Negligence Penalties during NRP

    IRS did not apply negligence penalties in a substantial portion of NRP
    cases with a tax change. IRS uses negligence penalties28 to encourage
    compliance and to assure compliant taxpayers that the tax system is fair.

    Although sole proprietors were more frequently penalized than non-sole
    proprietors, just 62 percent of the sole proprietors who had a 100 percent
    or more tax change in their tax liability after the NRP examination and
    had a tax change of $10,000 or more were penalized. For smaller tax
    changes, the percentage penalized was lower. Figure 8 summarizes the
    penalty results from the NRP examinations for tax returns with a 100
    percent or more change for sole proprietors and non-sole proprietors.

    28The negligence penalties discussed in this section refer to those in
    I.R.C. S 6662(b)(1).

    Figure 8: Recommended Penalties for Sole Proprietors and Non-Sole
    Proprietors in NRP Examinations with a 100 Percent or Greater Recommended
    Tax Change by Dollar Value of Tax Change in Tax Year 2001

    Our NRP case file review provided some examples in which penalties were
    not assessed at all or seemed to be assessed inconsistently.

               o A sole proprietor reported AGI of about $10,000 and zero tax
               liability on the return. An examiner proposed total adjustments of
               about $3,000, which included unreported Schedule C receipts and
               overstated expenses resulting in additional tax of about $450. The
               examiner proposed a negligence penalty of about $90, explaining
               that the taxpayer did not take reasonable care in preparing the
               tax return, which was done by a tax preparer.
               o A sole proprietor reported AGI of about $90,000 and a tax
               liability of about $16,000. An examiner proposed total adjustments
               of about $35,000, based on unreported Schedule C receipts and
               overstated expenses, and a tax increase of $15,000. The
               examination workpapers explained that no negligence penalty was
               proposed since the tax preparer was responsible for most of the
               adjustments.

               The differences in individual cases might be caused in part by IRS
               procedures that give revenue agents discretion on whether to
               pursue a penalty, even when the tax change is substantial.29
               Recommended penalties must be reviewed by the examiner's manager.
               Explanations ranging from a lack of knowledge to reliance on a
               paid preparer can lead some examiners to mitigate a penalty but
               not others.

               IRS officials said the application of penalties in NRP cases
               should be similar to that for operational examinations because NRP
               examiners were required to follow IRS's standard guidance for
               penalties. We have started work on a study that will more fully
               analyze the use of penalties in IRS's operational examinations.

    			  Current Treasury Tax Gap Strategy Discusses Neither Sole Proprietor
    			  Noncompliance nor the Many Options That Could Address It

               The tax gap strategy issued by Treasury in September 2006 does not
               discuss sole proprietor noncompliance or specific options to
               address it. A number of options to improve sole proprietor
               compliance exist and could be considered as part of the overall
               tax gap strategy. Each option has both pros (such as improved
               compliance) and cons (such as burdens on taxpayers or third
               parties).

    			  Tax Gap Strategy Does Not Specifically Discuss Sole Proprietor
    			  Noncompliance

               Treasury's tax gap strategy does not discuss specific options to
               address the tax gap overall or sole proprietor noncompliance in
               particular. As we discussed in February 2007 testimony,30 the
               strategy generally does not identify specific steps that Treasury
               and IRS31 will undertake to reduce the tax gap, the related time
               frames for such steps, or explanations of how much the tax gap
               would be reduced. Rather, the strategy broadly discusses
               opportunities for tax evasion and the preventive role of tax
               research, information technology, compliance activities, taxpayer
               service, tax law simplification, and working with stakeholders.
               For example, the portion on improving compliance activities
               generally discusses initiatives on expanded information reporting,
               improved document matching, refined detection programs, and
               increased examinations in selected areas. However, no specifics
               are provided. Without specifics, the strategy does not include
               actions that potentially would reduce the tax gap.

    29We used a statistical model to assess whether various factors are
    related to the recommended assessment of penalties. Controlling for other
    factors, we found that the dollar value of the tax change and the
    percentage tax change are related to the recommendation to assess a
    penalty. The relationship raises questions because the guidance about
    assessing penalties does not provide a basis for considering the
    percentage error or the dollar amount of the error, above a threshold,
    when deciding to assess a penalty. App. I describes the model we used, our
    analysis of the penalty-related data, and results.

    30GAO, Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax
    Gap, [67]GAO-07-488T (Washington, D.C.: Feb. 16, 2007).

    31IRS is part Treasury, which is responsible for tax policy analysis and
    formulation.

               Since the mid-1990s, we have reported on the need for a strategy
               to address the federal tax gap as well as sole proprietor
               noncompliance. In May 1994, we summarized many ideas on reducing
               the tax gap, including ideas on information reporting, tax
               withholding, and tax simplification.32 In August 1994, we reported
               on the lack of a comprehensive linkage between IRS's compliance
               strategy and compliance efforts for sole proprietors and on the
               need for better systems to identify the causes of noncompliance
               and target enforcement resources.33 More recently, in July 2005,
               we reported that IRS needed a results-oriented approach to reduce
               the tax gap based on long-term, quantitative voluntary compliance
               goals and performance measures to determine the success of its
               strategies and adjust as necessary.34 In April 2006, we testified
               that IRS had established such compliance goals but lacked a
               data-based plan for achieving the goals.35 In February 2007, we
               testified on the need for multiple approaches to reduce the tax
               gap, including improved taxpayer services, tax code
               simplification, more information reporting, and an appropriate
               level of resources for tax enforcement.36 Our products related to
               the tax gap are listed in the Related GAO Products section at the
               end of this report.

    2GAO, Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy
    Needed, [68]GAO/GGD-94-123 (Washington, D.C.: May 11, 1994).

    33GAO, Tax Administration: IRS Can Better Pursue Noncompliant Sole
    Proprietors, [69]GAO/GGD-94-175 (Washington, D.C.: Aug. 2, 1994).

    34GAO, Tax Compliance: Better Compliance Data and Long-term Goals Would
    Support a More Strategic IRS Approach to Reducing the Tax Gap,
    [70]GAO-05-753 (Washington, D.C.: July 18, 2005).

    35GAO, Internal Revenue Service: Assessment of the Interim Results of the
    2006 Filing Season and Fiscal Year 2007 Budget Request, [71]GAO-06-615T
    (Washington, D.C.: Apr. 6, 2006).

               IRS is not without some of the elements of a tax gap strategy.
               IRS's management continually makes decisions about reallocating
               resources and has taken steps that demonstrate an understanding of
               the value of a more strategic approach. One important step is NRP,
               which gives IRS management more information about the nature of
               noncompliance and is being used to better target examinations on
               noncompliant taxpayers. IRS's annual budget requests include
               specific compliance program proposals. For example, the fiscal
               year 2008 budget submission had 16 legislative proposals on tax
               gap reduction. Some of these proposals related to sole
               proprietors, such as those requiring information reporting on
               certain government payments made for the procurement of property
               and services and on merchant card payment reimbursements. Several
               IRS and Treasury experts, and other knowledgeable individuals also
               commented that many of these options would be applicable to any
               small business regardless of its organizational form (such as
               partnerships, limited liability companies, and corporations).
               However, these elements do not make up the type of long-term,
               comprehensive strategy, described above, that provides an overall
               rationale and specific steps, time frames, and predicted impact on
               the tax gap.

    			  Many Options for Improving Sole Proprietor Compliance Exist and Could
    			  Be Considered for the Tax Gap Strategy, But All Have Trade-offs

               Many options exist that could help reduce sole proprietor
               noncompliance. These options range from enhancing IRS's assistance
               to taxpayers to instituting tax withholding on payments made to
               all or certain types of sole proprietors. Each option has pros and
               cons.

               We identified options and their pros and cons by reviewing our
               reports and the reports of others on sole proprietor compliance as
               well as through extensive conversations with experts and
               knowledgeable individuals inside and outside of IRS. Consistent
               with our previous reports, we tried to identify options that
               represented a range of approaches, such as improving taxpayer
               service, more information reporting, and various enforcement
               actions. Many of the options are directed at the specific sole
               proprietor compliance problems and IRS program limitations
               described earlier in this report. We placed the options into broad
               categories of problems, such as poor recordkeeping, unreported
               business income, and overstated business expenses. Our list, in
               table 2, is not exhaustive and not ranked in any order. Appendix
               II contains a longer description of each option, including pros
               and cons.

    36GAO, Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax
    Gap, [72]GAO-07-391T (Washington, D.C.: Jan. 23, 2007).

               Table 2: Options to Improve Sole Proprietor Tax Compliance

    A. Recordkeeping and complexity
    1. Work with small business representatives to improve instructions for
    keeping records and completing the Schedule C.
    2. Provide assistance to first-time Schedule C filers.

    a. Target outreach to sole proprietors filing their first Schedule C--IRS
    could provide guidance to help them keep records and report accurately on
    their Schedule C forms.

    b. Notify first time Schedule C filers who did not use a paid tax preparer
    and who reported on certain Schedule C lines known to generate more
    noncompliance about guidance on IRS's Web site.
    3. Separate business and personal records and transactions.

    a. Require sole proprietors to include all business transactions in a
    financial account or accounts used only for business purposes.

    b. Require sole proprietors to obtain TINs for business transactions in
    lieu of using their Social Security numbers.
    4. Repeal certain limitations in section 530 of the Budget Act of 1978
    involving guidance on rules on classifying workers.
    B. Burdens and problems for third parties in filing information returns
    5. Clarify Schedule C instructions to indicate that an information return
    may be required from sole proprietors who are deducting expenses for
    wages, fees, and commissions.
    6. Ensure that IRS's Web-based system for filing information returns can
    accommodate those filing information returns on payments made to sole
    proprietors.
    7. Create a new Form 1099-NEC to segregate the NEC from the various boxes
    on the existing Form 1099-MISC.
    C. Unreported sole proprietor income
    8. Expand gross receipts reporting on the Schedule C.
    9. Close gaps in existing information reporting on payments made to sole
    proprietors, for example, by requiring information reporting on annual
    service payments that are

    a. made to all corporations or to some subset, such as small corporations,
    non-publicly held corporations, or noncompliant corporations, or

    b. less than $600, which is the current trigger for information reporting.
    10. Require new information reporting by organizations on payments to sole
    proprietors.

    a. Require businesses that process credit (and debit) card payments to
    report on the amount of payments made to sole proprietors for a tax year.

    b. Require federal, state, and local governments to file information
    returns on all nonwage payments made to procure property and services from
    businesses.

    c. Require financial institutions to file information returns on business
    deposits and withdrawals by sole proprietors.
    11. Require new information reporting on consumer payments to sole
    proprietors for property owners who pay contractors for improvements, if
    the payments will be used to adjust the basis of the property.
    D. Overstated deductions for sole proprietor expenses
    12. Expand expense reporting on the Schedule C.
    13. Match information returns filed by sole proprietors with related
    expenses on their Schedule C forms.
    14. Expand information reporting on the expenses of sole proprietors under
    two options.

    a. Require businesses that receive certain types of payments from sole
    proprietors in large amounts (i.e., thousands of dollars) to file
    information returns to report those amounts.

    b. Require businesses that process credit (and debit) card payments to
    report information on the amount of payments by sole proprietors for each
    tax year.
    15. Verify additional expenses claimed to offset unreported income.
    E. Nonpayment of tax
    16. Deny benefits/payments until tax obligations are met, for example, by
    requiring that

    a. sole proprietors pay their self-employment tax obligations in order to
    receive credit for Social Security benefits and

    b. federal agencies do a tax compliance check with IRS before providing a
    government benefit to a sole proprietor.
    17. Withhold tax to encourage compliance through situational or universal
    means by requiring those who are to file information returns on payments
    made to sole proprietors to

    a. withhold a small amount from payments until the sole proprietor's TIN
    is certified through an IRS system that is quick and accurate and

    b. withhold a very small percentage of the payments made to sole
    proprietors in all cases or in limited situations, such as when the sole
    proprietor voluntarily consents.
    F. IRS management of limited resources
    18. Improve IRS's audit selection of sole proprietor tax returns in at
    least two ways.

    a. Use more advanced automated systems to update the current manual
    system.

    b. Improve the ability of AUR to refer cases for audit.
    19. Enhance data sharing with the states.
    20. Use informational notices to encourage compliance.
    21. Revise the rules for penalties to improve consistency and compliance
    under two options.

    a. Simplify the process for assessing penalties and develop standards on
    using penalties.

    b. Increase the penalty for subsequent failures to file required
    information returns.

               Source: GAO analysis and interviews with tax experts and
               knowledgeable individuals.

               All the options have pros and cons. Because the options are
               presented as concepts, rather than as detailed plans ready for
               implementation, the pros and cons could vary with such detail. In
               most cases, pros and cons are described qualitatively and are not
               intended to be exhaustive; additional analysis might find others.
               In general, the pros include helping sole proprietors to comply
               voluntarily, helping IRS detect and prevent underreporting of
               income and understatement of taxes, and reducing the burden on
               taxpayers or third parties for filing tax returns and information
               returns. The cons include the costs and burdens imposed on sole
               proprietors, third parties, and IRS.

               We are not recommending particular options for a number of
               reasons:

               o Trade-offs. IRS has other compliance objectives in addition to
               sole proprietor compliance. Devoting more IRS staff and other
               resources to close the sole proprietor tax gap means that fewer
               resources are available for combating other types of
               noncompliance, such as corporate, individual, or tax-exempt entity
               noncompliance. Forgoing enforcement revenue elsewhere is an
               opportunity cost of devoting more resources to sole proprietor
               noncompliance. Also, the resources and management capacity devoted
               to sole proprietor noncompliance may not be sufficient to
               implement all the options. Priorities would need to be
               established.
               o Interaction between options. Some of the options may be
               substitutes for each other. Others may be complements. Improving
               assistance to taxpayers might reduce the need for some enforcement
               actions. Some of the options may reinforce each other--such as
               expanded information reporting and more convenient filing
               options--making it desirable to package them together.
               o Policy judgments. Some of the options involve policy judgments
               about how the options would affect different groups of people. For
               example, information reporting invariably imposes some costs on
               the third parties required to report, but no objective criteria
               exist for assessing when third-party costs are excessive. In many
               cases, quantitative information about the effects is not
               available. Judgments would have to be made based on qualitative
               information.

               For all of these reasons, we are not ranking or otherwise making
               recommendations on the value of each option, nor are we opining on
               which options should be packaged together and in what manner. The
               options could be considered as part of an overall Treasury and IRS
               tax gap strategy. For most options, Treasury and IRS would need to
               develop the details on how the options would work both singly and
               as part of a coordinated strategy. Issues that could be considered
               in an overall strategy include how much emphasis should be placed
               on

               o sole proprietor noncompliance versus other types of
               noncompliance,
               o efforts to help sole proprietors voluntarily comply versus
               efforts to help IRS detect noncompliance after it occurs,
               o the reporting requirements and added burden placed on sole
               proprietors versus the reporting requirements and burden placed on
               third parties, and
               o legislative changes versus administrative changes at IRS.

    			  Conclusions

               The tens of billions of dollars in tax revenue lost annually
               because sole proprietors underreport over half of their aggregate
               net income contribute to the nation's long-term fiscal challenge.
               This underreporting is also unfair to compliant taxpayers. Because
               underreporting is spread among more than 12 million sole
               proprietors, much of it in small amounts, because the
               underreporting is for both gross income and expenses, and because
               IRS's enforcement programs are limited and costly, the sole
               proprietor tax gap cannot be closed by IRS enforcement alone. As
               we have said before, improving compliance will require a variety
               of new approaches.

               Many options exist for improving sole proprietor compliance;
               however, they all have individual pros and cons, some may be
               substitutes for each other and some may reinforce each other.
               Trade-offs also exist at a broader level. Devoting more IRS
               resources to sole proprietor compliance must be judged relative to
               what those resources could accomplish in IRS's other programs.
               Furthermore, IRS's resources are not the only ones devoted to tax
               administration. Taxpayers and third parties spend their time and
               money to make our tax system work. For these reasons, the options
               are best considered as part of an overall strategy. Such a
               strategy would provide more assurance that taxpayer, third party,
               and IRS resources are being used efficiently to promote
               compliance.

    			  Recommendation for Executive Action

               We recommend that the Secretary of the Treasury ensure that the
               tax gap strategy includes (1) a segment on improving sole
               proprietor compliance that is coordinated with broader tax gap
               reduction efforts and (2) specific proposals, such as the options
               we identified, that constitute an integrated package.

    			  Agency Comments and Our Evaluation

               We requested written comments from the Secretary of the Treasury
               and received comments on behalf of the Treasury from its Tax
               Legislative Counsel (see app. VI). In commenting on a draft of
               this report, the Treasury said that although not addressed
               specifically, the seven elements of the department's strategy are
               intended to apply broadly to all types of businesses and
               individual taxpayers, including sole proprietorships. Treasury
               also stated that this report provides valuable insight for
               applying the strategy to the tax gap. IRS and Treasury also
               provided technical comments on a draft of this report, which we
               incorporated as appropriate. IRS did not provide written comments.

               As agreed with your offices, unless you publicly announce its
               contents earlier, we plan no further distribution of this report
               until 30 days after its date. At that time, we will send copies to
               the Secretary of the Treasury, the Commissioner of Internal
               Revenue, and other interested parties. This report will also be
               available at no charge on GAO's Web site at [65]http://www.gao.gov
               .

               If you or your staff have any questions about this report, please
               contact me at (202) 512-9110 or [66]whitej@gao.gov . Contact
               points for our Offices of Congressional Relations and Public
               Affairs may be found on the last page of this report. Key
               contributors to this report are listed in appendix VII.

               James R. White
    			  Director, Tax Issues Strategic Issues

    			  Appendix I: Scope and Methodology

               To describe the nature and extent of the noncompliance associated
               with sole proprietors, we analyzed the Internal Revenue Service's
               (IRS) National Research Program (NRP) results, tax gap estimates,
               and Statistics of Income (SOI) data, and interviewed IRS
               officials. The NRP data are IRS estimates of individual tax
               reporting compliance based on reviews and examinations of filed
               tax returns. IRS randomly selected the returns for tax year 2001,
               which were filed with IRS during calendar year 2002. To compute
               the percentage of returns with an understatement or overstatement
               on a Schedule C line and the net misreported amounts, IRS used the
               following definitions, including related limitations:

               Percentage of returns with an error: This ratio is the weighted
               number of taxpayers that have a non-zero net misreported amount
               divided by the weighted number of returns that should have
               reported the amount. For some items, taxpayers may have errors
               that exactly offset each other resulting in no net tax change. For
               example, a taxpayer may have reported a transaction as an "office
               expense," but an examiner reclassified the same amount as "repairs
               and maintenance." NRP did not consider these offsetting changes as
               errors for those line items.

               Net misreported amounts (NMA): The NMA is the sum of all amounts
               underreported minus the sum of all amounts overreported for an
               item. The NMA does not include adjustments between schedules of
               the return. For example, the NRP examiner may disallow reported
               amounts for expense deductions on Schedule C that should have been
               reported on Schedule A and increase the deductions on Schedule A
               by the same amounts. Neither adjustment would be in IRS's NMA.
               However, the adjustments would be included in IRS's definition of
               the amounts that should have been reported, which are reflected in
               the denominator of the net misreporting percentage. The NMA does
               not include adjustments that were made because the taxpayer used
               the wrong form or line item.

               Because the percentage of returns with an error and the NMA are
               derived from samples, table 3 lists the confidence intervals for
               each amount. IRS did not compute confidence intervals for its
               estimates. When we calculated confidence intervals, we got
               slightly different point estimates than IRS. The difference
               appears to arise from varying definitions of sole proprietors. We
               are 95 percent confident that the percentages and amounts reported
               are between the low estimate and the high estimate. In the body of
               this report, we present IRS's point estimates.

    Table 3: Confidence Intervals for Summary of Schedule C Misreporting for
    Tax Year 2001

    Dollars in billions
                   Percentage of returns with an error           Net misreported amount
                                 GAO                 IRS                  GAO               IRS
    Schedule C        Low calculated     High percentage       Low calculated     High reported
    line         estimate percentage estimate   reported  estimate     amount estimate   amount
    Gross              38         40       42         39     $52.8      $56.8    $60.8    $52.6
    income, line
    7
    Car and            44         46       48         50       6.9        7.5      8.1      7.8
    truck
    expenses,
    line 10
    Depreciation       36         38       41         42       2.0        2.4      2.8      2.7
    and section
    179 expense
    deduction,
    line 13
    Supplies,          34         36       38         41       2.4        2.8      3.2      2.9
    line 22
    Other              50         52       54         55       7.2        8.5      9.8      9.0
    expenses,
    line 27
    Total              67         69       71         73      36.4       38.6     40.8     40.4
    expenses,
    line 28
    Net profit         68         70       72         70      91.7       95.8     99.9     93.6
    or loss,
    line 31

    Source: GAO analysis of IRS data.

    Estimated understated tax amounts, as shown in figure 4, were derived from
    NRP sample data. Table 4 lists the estimated percentile amount and
    confidence intervals for each percentile. We are 95 percent confident that
    the percentages and amounts reported are between the low and high
    estimates.

    Table 4: Confidence Intervals for Estimated Understated Tax Amounts by
    Percentile for Individual Income Tax Returns with Schedule Cs Attached,
    Tax Year 2001.

                           Percentile lower                      Percentile upper
                        confidence interval         Estimated confidence interval
    Percentile                    amount percentile amount              amount
    25th                            $255              $273                $294
    50th                             859               903                 956
    75th                           2,422             2,527               2,674
    90th                           5,976             6,210               6,766
    95th                          10,635            11,081              12,353
    98th                          19,631            20,387              64,075

    Source: GAO analysis of IRS data.

    Estimated cumulative understated tax amounts, as shown in figure 5, were
    derived from NRP sample data. Table 5 lists the estimated percentile
    amount and confidence intervals for each percentile. We are 95 percent
    confident that the percentages and amounts reported are between the low
    and high estimates.

    Table 5: Confidence Intervals for Estimated Cumulative Understated Taxes
    by Percentile for Individual Income Tax Returns with Schedule Cs Attached,
    Tax Year 2001

    Dollars in billions
                           Percentile lower                      Percentile upper
                        confidence interval         Estimated confidence interval
    Percentile                    amount percentile amount              amount
    25th                            0.30              0.36                0.44
    50th                            1.84              2.05                2.35
    75th                            6.31              6.93                7.65
    90th                           13.47             14.26               15.64
    95th                           18.24             19.37               21.08
    98th                           23.68             24.91               33.06
    100th                          34.77             36.86               38.95

    Source: GAO analysis of IRS data.

    According to IRS Research officials, NRP results are not tax gap-related
    estimates since they do not account for misreporting that the auditors did
    not detect. Typically, the undetected misreporting of Schedule C net
    income likely takes the form of understated gross receipts and overstated
    expenses, for which IRS did not prepare separate tax gap estimates.
    Overstated expenses tend to be detected since the burden of proof is on
    the taxpayer to justify them. However, when taxpayers intentionally
    understate gross receipts, they may also understate expenses to hide the
    gross-receipt underreporting from IRS. Also, NRP includes estimates of
    some net business income that is not reported on Schedule C. These amounts
    are not added to the line-item detail and are not included in the analyses
    for this report. We could not estimate the amount of tax change that would
    result from NRP's examinations of Schedule C income because it must be
    combined with the taxpayer's filing status, exemptions, other types of
    income, deductions, credits, and other taxes.

    To analyze the extent to which IRS's enforcement programs address the
    types of sole proprietor noncompliance found by IRS's most recent
    research, we used several data sources. We reviewed instructions for tax
    and information returns and filing guidance as well as program procedures.
    We analyzed program results data collected from the Automated
    Underreporter Program (AUR) and Examination officials, and interviewed IRS
    staff on the operations and results of AUR and the correspondence, office
    and field examination programs. We reviewed examination plans and Internal
    Revenue Manual procedures and other instructions to IRS staff describing
    program procedures. We analyzed data on examination results and numbers of
    Schedule C forms filed from the IRS Data Book, and data on paper Form
    1099-MISC returns published by IRS's Office of Research for 2006. We did
    not analyze IRS's math error program since all NRP-examined returns were
    reviewed by this program, which is an integral part of IRS's returns
    processing function.

    To calculate the percentage of noncompliant sole proprietors on which AUR
    and Examination made recommended assessments, we first multiplied the
    percentage of noncompliant sole proprietors found in NRP data by the
    number of Schedule C returns for the most recent years that we had
    available from the IRS Data Book that matched the most recent years for
    which we had complete AUR and Examination data (tax year 2003 for AUR and
    tax year 2004 returns for work Examination did in fiscal year 2005). Then
    we divided the number of recommended assessments made in each program by
    the number of noncompliant sole proprietors to arrive at the percentage of
    noncompliant sole proprietors on which the programs made recommended
    assessments.

    We reviewed a sample of completed NRP examination case files to understand
    the types of sole proprietor noncompliance being detected. We selected the
    sample using the NRP case results database to identify all NRP cases with
    adjustments to Schedule C items for sole proprietor tax returns. We then
    selected a nonestimation sample of NRP examination cases with adjustments
    to gross receipts or sales, total expenses, net profit or loss on the
    Schedule C, and the business income line on the Form 1040 return, because
    these lines summarize the sole proprietor's operations. We also randomly
    selected some Schedule C adjustment cases.

    We also used NRP data and the NRP case file sample to analyze IRS's use of
    penalties in NRP examinations. The analysis describes the proportion of
    NRP cases closed with adjustments and the proportion closed with a penalty
    recommended by the NRP examination. Because the cases with adjustments and
    penalties were not drawn from the population of all individual returns,
    they cannot be used to estimate a penalty assessment rate and other
    characteristics for all individual taxpayers. Even with these limitations,
    this analysis provides useful information on the outcome of the NRP
    sample.

    To estimate the percentage of reported Schedule C receipts that were on a
    Form 1099-MISC, we compared amounts reported on the Form 1099-MISC and on
    Schedule C (line 1 total gross receipts or sales). This analysis used SOI
    data on individual tax returns for tax year 2001, which included a sample
    of information returns. We found that three Form 1099-MISC items could be
    reported on a Schedule C, including nonemployee compensation (NEC),
    medical payments, and fish sales. According to IRS, these Form 1099-MISC
    items could also be reported on two other IRS forms--Schedule F, Profit
    and Loss From Farming, and Form 4835, Farm Rental Income and
    Expenses--other than the Schedule C. We found that about 4 percent of the
    amounts reported on the Form 1099-MISC were reported on Schedule F or Form
    4835. This difference was not material to our computation. Further, our
    analysis did not consider several sources of noncompliance that could
    affect the computation, such as the nonfiling of the required Schedule C
    or Form 1099-MISC or the underreporting of Schedule C or Form 1099-MISC
    amounts.

    To estimate the percentage of Form 1099-MISC returns where the payer and
    the payee have the same address, we used an SOI data file with tax year
    2001 individual income tax return information. We compared the postal
    codes and the numeric portion of street addresses reported by the payer
    and payee to identify whether they had the same address. For those who
    did, we reviewed a sample to verify that the addresses were the same. We
    also reviewed 55 Form 1099-MISC filings at the Ogden, Utah, campus, which
    provided 8 examples in which a payer and payee had similar addresses or
    names. We did not review other IRS records to determine whether these Form
    1099-MISC filers were related parties.

    To assess the likelihood of being assessed a penalty, controlling for
    other factors, we used logistic regression analysis, an econometric method
    appropriate for analyzing variables with dichotomous outcomes. We used the
    deciles of the continuous variables as the independent variables in the
    model. We did not weight the NRP returns or incorporate the NRP
    stratification because penalties are a function of the audit and the NRP
    returns are not representative of audited returns.

    Controlling for use of a paid preparer, adjusted gross income, Schedule C
    amount, and total tax as reported by the taxpayer, a logistic regression
    was used to predict a penalty based on the absolute value of the
    difference between the total tax reported on the Form 1040 and the total
    tax after the NRP audit and the percentage of tax change (the difference
    in total tax divided by the total tax reported on the Form 1040). We found
    a significant effect of the percentage change in tax owed and the absolute
    value of the tax change on the likelihood of receiving a penalty. That is,
    individuals in higher deciles (5th through 10th deciles) of the percentage
    increase in tax were generally more likely than those in the lowest decile
    to be recommended for a penalty. Additionally, taxpayers in higher deciles
    of the absolute value of the tax change (4th through 10th deciles) were
    more likely than those in the lowest decile to be recommended for a
    penalty controlling for other factors. We also found that the odds of a
    penalty decreased with each decile increase in the taxpayer's reported
    total tax liability.

    Although we did not test for interactions that could mitigate this effect,
    we found our results to be robust across a variety of model
    specifications. We did not control for other potentially relevant
    variables, such as differences among examiners, and did not test for
    whether the case was abated.

    We used several approaches to identify options to close the tax gap
    related to sole proprietors that could be included in the tax gap strategy
    being developed by the Department of the Treasury (Treasury). First, we
    sought ways to address the gaps between the nature of sole proprietor tax
    noncompliance and existing IRS programs. Second, we reviewed various
    research publications on sole proprietors and our recommendations, as well
    as those from the President's Budget, President's Advisory Panel on
    Federal Tax Reform, Treasury Inspector General for Tax Administration,
    IRS's Taxpayer Advocate, and IRS advisory group reports. Third, we
    identified and discussed options and their the pros and cons with experts
    and knowledgeable individuals on sole proprietor compliance issues,
    including former Commissioners of Internal Revenue; persons who have
    experience with IRS or other federal programs related to sole proprietors;
    representatives for various national organizations representing sole
    proprietors, tax return preparers, or tax lawyers; tax staff working for
    Congress; and relevant staff at IRS and Treasury. All of the national
    organizations representing sole proprietors had large memberships and we
    contacted each organization's committee which focuses on small business
    issues. From this work, we consolidated the list of options and pros and
    cons. We excluded a few options that were raised near the end of our work,
    lacked details, or generated comments or questions from experts and
    knowledgeable individuals on how the options would work.

    The list of options is not exhaustive and has limitations. Since data did
    not exist for analyzing the effect on the tax gap, taxpayers, or IRS for
    each option, we could not independently validate or weigh the pros or cons
    suggested by our experts and knowledgeable individuals. Because the
    experts and knowledgeable individuals had competing interests on questions
    of tax policy and administration, we did not seek consensus on the "best"
    options or on the pros and cons. Experts had limited time to discuss all
    the options and pros and cons. Thus, we did not discuss each option in
    detail in each interview, but overall, the interviews provided enough
    details for the options in our report. As a result of such limitations, we
    did not try to rank the options. Instead we described the options based on
    input from the literature and experts. More detailed proposals could raise
    other pros or cons not listed in our report.

    We used several approaches to assess data reliability. We assessed whether
    the examination results and data contained in the NRP database were
    sufficiently reliable for the purposes of our review. For this assessment,
    we interviewed IRS officials about the data, collected and reviewed
    documentation about the data and the system used to capture the data, and
    completed testing of relevant data fields for obvious errors in accuracy
    and completeness. We completed analytic testing to ensure that tax return
    items that should logically be equal were equal. For example, the net
    profit and loss line on Schedule C should be accurately transferred and
    equal to the similar line on the individual income tax return. We also
    compared the information we collected through our case file review to
    corresponding information in the NRP database to identify inconsistencies.
    This testing found that the NRP results for Form 1040 returns with
    Schedule C forms were sufficiently reliable for our review.

    The tax gap, SOI, AUR, and Examination data are all from sources that we
    used in previous reports. Based on assessments done for those reports, the
    fact that the sources are public and widely used, and additional testing
    we did to ensure that we were properly interpreting individual data
    elements, the data were sufficiently reliable for our review.

    We conducted our review at IRS Headquarters in Washington, D.C., and at
    IRS's Ogden, Utah, campus from July 2006 through June 2007 in accordance
    with generally accepted government auditing standards.

    Appendix II: Options to Address Problems with the Tax Compliance of Sole
    Proprietors

    We have developed a list of options for reducing the tax gap for sole
    proprietors by reviewing our past reports as well as other related
    literature and by talking to experts and knowledgeable persons about sole
    proprietors' tax compliance. As we built the list of options, we discussed
    the options and the related pros and cons with these experts, including
    past and current IRS and Treasury staff; former IRS Commissioners;
    congressional staff; representatives of organizations representing sole
    proprietors, tax preparers, and tax lawyers; and others who have working
    knowledge of tax compliance and IRS programs.

    This list is not exhaustive nor is the list of the pros and cons
    associated with each option. Many of the options are concepts rather than
    fully developed proposals with details of how they would be implemented.
    Additional detail could bring more pros and cons to light. The pros and
    cons are not weighted, and options should not be judged by the number of
    pros and cons. We are not making recommendations about the options or
    ranking their desirability. Rather, we have aligned these options with a
    series of known problems with sole proprietor tax compliance. Some of the
    options overlap, covering more than one problem while other options only
    deal with specific aspects of a problem.

    A. Recordkeeping and Complexity

    For our system of voluntary compliance to work, taxpayers must keep
    appropriate records. Our work on sole proprietors has raised issues about
    incomplete or inaccurate recordkeeping by sole proprietors as well as
    about the difficulties they face in dealing with complex tax rules. The
    options in this section look for ways to improve recordkeeping, simplify
    some of the rules, or provide more guidance and education to sole
    proprietors to reduce their burden.

    1. Work with small business representatives on their ideas for improving the
    instructions for keeping records and meeting their Schedule C filing
    obligations.

    More education and better guidance could help sole proprietors comply with
    the complex tax rules for reporting on the Schedule C. IRS could work with
    small business and trade representatives to determine whether and how
    specific changes to IRS's existing education and guidance would help those
    filing the Schedule C.

    Pro:

               o Helping educate sole proprietors on their recordkeeping
               requirements and filing obligations (Schedule C and information
               returns) could reduce noncompliance.
               o The costs to update the instructions is probably minimal, while
               the cost for the education would not be.

               Con:

               o Getting specific ideas that would help sole proprietors might
               take some time and effort, depending on the extent to which IRS
               tests these ideas.
               o It may be difficult to target the education and guidance and
               improve instructions for the sole proprietors who need them the
               most, that is, those who keep poor records or make errors on the
               Schedule C. These sole proprietors may not have the time or
               incentive to pay attention.
               o Changes may not help those who rely on a paid tax return
               preparer or bookkeeper because of IRS's tendency to forward tax
               information to the taxpayer but not to the tax return preparer.
               o Some education efforts could be costly to IRS, such as efforts
               to contact taxpayers individually.

    			  2. Provide assistance to first-time Schedule C filers.

               IRS could consider at least two broad approaches that would

               a) specifically target outreach to sole proprietors filing their
               first Schedule C to inform them about the option to receive
               regular e-mails on topics of interest, the small business hotline,
               the resource guide, and other services specifically targeted to
               help small businesses and

               b) automatically send computer-generated notices (i.e., soft
               notices) to first-time Schedule C filers who did not use a paid
               tax preparers (to reduce the number of notices) and who reported
               on certain Schedule C lines that involve more complexity or higher
               noncompliance (e.g., accounting method, depreciation, travel, or
               home office) about guidance on IRS's Web site on reporting such
               issues.

               Pro:

               o This would provide new sole proprietors with the specific
               information that they need to comply.
               o It would also help new sole proprietors avoid "bad habits"
               before they become rooted.
               o Using e-mail would reduce IRS's costs.
               o Using automated screening and soft notices would increase IRS's
               "presence" without the costs of an enforcement contact (e.g.,
               audit).

               Con:

               o There is no assurance that sole proprietors will read the
               information and comply.
               o Some sole proprietors may not use e-mail or want to provide an
               e-mail address to IRS.
               o IRS would incur some costs for the outreach and notices.
               o Soft notices may not boost compliance if they are too vague or
               if sole proprietors perceive that IRS will not follow up in future
               tax years on the soft notices.
               o Waiting to act until after the first Schedule C filing may be
               too late to change the behavior of some sole proprietors.

    			  3. Separate business and personal records and transactions.

               Two requirements could help sole proprietors distinguish their
               business transactions and records from personal ones. Details
               would need to be worked out on any exceptions or tolerances; on
               offering incentives rather than requirements; and on enforcing and
               penalizing any noncompliance with the requirements, which follow.

               a) Require sole proprietors to include all business transactions
               in a business bank account or accounts used only for business
               purposes. Such transactions would include deposits of business
               receipts and payments of business expenses. Receipts or expenses
               generated outside of the business would not be part of these
               business accounts. Further, financial institutions could provide
               sole proprietors with an annual summary of inflows and outflows
               for the business account(s).

               b) Require each sole proprietor to obtain a taxpayer
               identification number (TIN) for a business. Currently, sole
               proprietors generally are required to obtain business TINs, known
               as employer identification numbers (EIN), when they have
               wage-earning employees for filing certain types of returns. In
               this option, sole proprietors could use EINs for their business
               transactions in lieu of using their Social Security numbers.

               Pro:

               o Recordkeeping could improve, which would reduce the time and
               burden of preparing returns and responding to IRS's inquiries.
               o IRS could save money if its computer matching and audits could
               be done more quickly and with more certainty.
               o Retroactively creating fictitious business expenses after the
               tax year would be easier to detect.
               o Tax compliance would improve to the extent that sole proprietors
               would weed out personal expenses from their business expenses.

               Con:

               o Financial institutions may charge fees for separate business
               accounts and statements.
               o Taxpayers who want to evade may not deposit all their income in
               the business accounts or still could run personal expenses through
               their business accounts.
               o It might be unnecessary or burdensome for Schedule C filers who
               are not regularly operating a business but have intermittent
               Schedule C receipts and expenses.
               o IRS may have difficulty enforcing such a requirement.

    			  4. Repeal certain limitations in section 530 of the Budget Act of
    			  1978 involving guidance on rules for classifying workers.

               Lift the limitations on IRS issuing rules and guidance on the
               criteria to determine whether a worker is to be treated as an
               employee or an independent contractor for tax purposes as well as
               on the related safe harbors for employers that classified workers
               as independent contractors.

               Pro:

               o Guidance and rules might help clarify confusion in the myriad of
               employment relationships that have evolved since 1978.
               o Clarification might help ensure that the correct amounts of
               taxes are being paid.

               Con:

               Some types of sole proprietors might prefer

    			               o legislative clarification rather than trusting IRS
                            to lead the efforts to clarify and
                            o living with the current confusion rather than
                            opening the door to changes, particularly if they do
                            not trust IRS to make equitable decisions about the
                            proper classification or the existing safe harbors.

               B. Burdens and Problems for Third Parties in Filing Information Returns

               Information reporting offers a way to cover more of the income of
               sole proprietors who do not report all of their gross receipts.
               However, information reporting suffers when the information
               returns are not filed or are filed erroneously and late. Those
               filing the information returns may face difficulties or burdens in
               filing information returns on paper or when a sole proprietor does
               not provide a valid TIN. A number of options exist to better
               ensure that IRS receives the required information returns on
               payments made to sole proprietors while minimizing the burden of
               those filing these information returns.

               Pro:

                            o legislative clarification rather than trusting IRS
                            to lead the efforts to clarify and
                            o living with the current confusion rather than
                            opening the door to changes, particularly if they do
                            not trust IRS to make equitable decisions about the
                            proper classification or the existing safe harbors.

    			  5. Clarify Schedule C instructions to indicate that information
    			  returns may be required to be filed by sole proprietors who deduct
    			  expenses for wages, fees, and commissions.

    			  Pro:

               o To the extent more Forms 1099-MISC are filed, sole proprietors
               are likely to be more compliant in reporting business income.
               o The instructions would provide another outlet for notifying
               taxpayers of their Form 1099-MISC reporting obligations at a
               minimal cost.

               Con:

               o If those who are to file the required information returns do not
               read or follow the instructions, the clearer instructions would
               not boost required filings.
               o If IRS receives more information returns, its costs to process
               and use them would rise.

    			  6. Change the IRS Web-based system for filing information returns to
    			  accommodate those filing information returns on payments made to
    			  sole proprietors, particularly those filing a smaller number of
    			  information returns.

               Pro:

               o To the extent more Forms 1099-MISC are filed, sole proprietors
               are likely to be more compliant in reporting business income.
               o Web-based filing could reduce the costs, burdens, and errors for
               everyone compared to filing/processing paper information returns.
               IRS may be able to reduce its start-up costs by modifying its
               Filing Information Returns Electronically system.

               Con:

               o If those who are to file the required information returns are
               not comfortable filing information through the Web, do not have
               access to computers, or do not want to file them at all, more
               filings of the required returns may not occur.
               o If IRS requires extensive registration steps in order to file on
               the Web, some filers might find those steps too burdensome.
               o IRS would incur start-up costs to create a new form and a
               Web-based filing system.
               o IRS would incur additional costs to process and use the
               information from a significant increase in the number of filed
               information returns.

    			  7. Create a new Form 1099-NEC to segregate NEC from the various boxes
    			  on the existing Form 1099-MISC.

               Although payment of NEC would trigger the requirement to file a
               Form 1099-NEC, IRS could request other summary information in the
               expanded space on this separate form about payments to sole
               proprietors, such as expenses reimbursed, noncash payments, type
               of services received, or payments for goods.

               Pro:

               o To the extent more information returns are filed with the new
               form and filed more clearly,

                            1. sole proprietors are likely to be more compliant
                            in reporting business income,
                            2. filing would be less confusing,
                            3. IRS could refine its computer matching to minimize
                            "false" leads that burden compliant taxpayers, and
                            4. IRS would have better data to improve its research
                            and case selection for enforcement contacts to the
                            extent that IRS requested other information.

               Con:

               o IRS has no assurance that a new form would reduce taxpayers'
               burden enough to lead to more filings of the required information
               returns.
               o IRS would incur additional costs if it has to process a
               significant increase in the number of filed information returns
               and if it has to expand its existing enforcement activities to
               check compliance in filing these types of required information
               returns.

    			  C. Unreported Income for Sole Proprietors

               For tax year 2001, about 70 percent of the sole proprietors
               misreported about 57 percent of their net business income. IRS's
               examinations are limited in number and scope and do not find much
               of the unreported income. Information reporting offers a way to
               cover more noncompliant sole proprietors and focus on unreported
               gross receipts. However, information reporting covered just a
               quarter of the gross receipts reported on Schedule Cs. One reason
               for the gap is that current information reporting focuses on
               payments for services and excludes certain payments, such as those
               totaling below a certain threshold and those to corporations.
               These options attempt to address these gaps in information
               reporting for sole proprietors.

    			  8. Expand gross receipts reporting on the Schedule C.

               Sole proprietors would break out their total gross receipts on the
               Schedule C to show the amount reported to them on information
               returns. Other information could be required, such as the number
               of information returns received and details on large payments.

               Pro:

               o Sole proprietors could be more sensitized to use the information
               returns received and thus more accurately report gross receipts.
               o IRS could be more productive in detecting unreported gross
               receipts by matching the Schedule C and information returns filed
               or analyzing the ratio of total gross receipts reported on the
               Schedule C and information returns in audit selection.
               o No additional burden would be placed on third parties.

               Con:

               o The reporting is unlikely to stop all businesses that wish to
               hide payments.
               o If their records do not account for whether the income was
               reported on a Form 1099-MISC, sole proprietors may have an
               additional burden to report the information.
               o IRS would incur some costs to process and use the additional
               data.

               9. Close gaps in existing information reporting on payments made to
    			  sole proprietors.

               Information returns are not required on all payments for services,
               creating gaps when matching information returns that are filed to
               determine if all the service payments received have been properly
               reported. Two options to address these gaps include requiring
               information reporting on annual service payments that (1) are made
               to all corporations or to some subset , such as small
               corporations, non-publicly held corporations, or noncompliant
               corporations (clear definitions of exclusions would be needed),
               and (2) total less than $600, which now triggers information
               reporting.

               Pro:

               o Sole proprietors who incorporate or receive payments below $600
               should be more likely to comply in reporting business income.
               o Sole proprietors would be less likely to structure payment
               amounts to avoid information reporting.
               o Businesses would not have to distinguish between incorporated
               and unincorporated businesses in determining whether to file
               information returns.
               o IRS could improve the productivity of its computer matching for
               unreported income.

               Con:

               o Businesses that file more information returns could incur
               significant costs and burdens, particularly if they have to expand
               their recordkeeping or make distinctions between small and large
               corporations.
               o IRS would incur costs to process and match more information
               returns, and might not be able to use all of the new data if the
               number filed increases significantly.
               o The information returns would be unlikely to encourage larger
               corporations that provide services to comply or help IRS find
               unreported income among larger corporations.
               o Those receiving payments that are less than $600 might not
               account for much of the unreported income or might not be more
               noncompliant than other sole proprietors.

    			  10. Require new information reporting by organizations on payments
    			  to sole proprietors.

               These options would offer a way to get new information from
               organizations about payments made to sole proprietors.

               a) Require businesses that process credit card payments for
               merchants to report information on the amount of payments made to
               sole proprietors for a tax year. This reporting could be a summary
               or include details for payments above some specified amount.

               b) Require federal, state, and local governments to file
               information returns on all nonwage payments made (or those above a
               threshold) for property and services from corporate and
               noncorporate businesses. Certain payments, such as those related
               to interest, real property, and tax-exempt entities, would be
               excluded.

               c) Require financial institutions to file information returns on
               business deposits and withdrawals by sole proprietors, which would
               be facilitated to the extent that business transactions are
               segregated in business accounts under business TINs.

               Pro:

               o Sole proprietors covered by any of these options might be more
               compliant in voluntarily reporting more business income on their
               Schedule Cs.
               o Each of the options would provide information that IRS could use
               to select better enforcement cases or to be more productive in its
               enforcement activities. For example, credit card reporting could
               allow IRS to develop a ratio of credit card receipts to all
               receipts reported by sole proprietors by type of industry, and
               knowing deposit and withdrawal activity could allow IRS to better
               identify sole proprietors' gross receipts through its bank deposit
               analysis method. Similarly, the information can be used to avoid
               selecting a company for audit if the information reports suggest
               that the taxpayer is compliant.

               Con:

               o Credit card companies and financial institutions would have some
               reporting costs.
               o Governments would incur some reporting costs, but they already
               would have to incur similar costs to meet the tax withholding
               requirement that Congress approved for these payments starting in
               2011, and federal agencies are already required to file some of
               these data with IRS for federal contracts.1
               o IRS would incur some costs to analyze the information from all
               the options and to figure out its best uses to identify
               underreporters.
               o IRS might find it hard to use the increased amount of
               information returns at all or productively.
               o If some businesses that use credit cards want to underreport
               income, they might move more transactions to the cash economy.

    1See section 511 of the Tax Increase Prevention and Reconciliation Act of
    2005, Pub. L. No. 109-222, May 17, 2006.

               o The information would not help identify unreported income among
               sole proprietors who do not use credit cards, do not have accounts
               with financial institutions, or do not contract with governments.
               o To the extent that financial institutions are reporting deposits
               and withdrawals related to nonbusiness activities, or that sole
               proprietors move funds between multiple business accounts, the
               information could create false leads for IRS that burden compliant
               taxpayers.

    			  11. Require new information reporting on consumer payments to sole
    			  proprietors.

               This option envisions new information reporting by organizations
               but also by consumers. It would require property owners to report
               on payments made to contractors for improvements if the payments
               will be used to adjust the basis of the property for depreciation
               or sales purposes. Property owners would be required to report the
               contractors' TINs. Absent the information return in their records,
               the property owners could not adjust the basis for tax purposes.

               Pro:

               o Information reporting on such contracts could cover a
               substantial dollar value.
               o Sole proprietors may be more likely to report the payments on
               their tax returns.
               o The payment information could cover a larger portion of the
               gross receipts than just service payments.
               o Consumers would not have to be burdened with distinguishing the
               type of business or type of payment in doing the reporting, and
               overall burden would be limited by how often they contract for
               improvements.
               o Property owners would have some incentive to report the
               contractor payments and a defensible foundation for basis
               adjustments claimed in the future.

               Con:

               o The incentive for property owners may dissipate if their basis
               adjustments offer few tax benefits because they do not depreciate
               or are not expected to have a taxable gain when they are sold, or
               because property owners do not keep the information returns in
               their records in order to compute and justify adjustments to basis
               many years later.
               o Property owners would have some burden to track and report the
               information and to deal with contractors that do not want to
               provide their TINs, for which some recourse would be needed.
               o If contractors want to avoid having these payments reported to
               IRS, they could negotiate with property owners for a lower price
               in return for property owners not filing the information returns.
               o IRS would have to spend some time and money sorting the
               information, particularly if the information is reported on paper
               rather than electronically, and then using the information for
               research or enforcement.
               o IRS might find it hard to use all of the new information or to
               use it productively.
               o Some may view disallowing a basis adjustment as a harsh penalty
               for failing to file an information return.

    			  D. Overstated Deductions for Sole Proprietor Expenses

               A portion of the $68 billion sole proprietor tax gap arises from
               overstating deductions for business expenses. Based on what NRP
               detected, IRS has estimated for 2001 that about 73 percent of the
               sole proprietors misreported about $40 billion in expense
               deductions. Although IRS auditors find it easier to check claims
               for expense deductions than to hunt for unreported income, IRS
               audits cover few of the noncompliant sole proprietors who
               overstate business deductions. And the information reporting
               system does not cover payments made by sole proprietors that could
               be deductible business expenses. The options in this section look
               to provide more information about expenses to allow IRS to match
               or otherwise use to find overstated deductions.

    			  12. Expand expense reporting on the Schedule C.

               Sole proprietors would break out the amount of payments made for
               services on the relevant expense lines of the Schedule C.
               Additional information could be required, such as for payments
               above a specified amount.

               Pro:

               o Sole proprietors might be more sensitized to the need to
               accurately claim expense deductions on the Schedule C and the need
               to also report them on required information returns.
               o Tax preparers would have more incentive to check expense
               reporting compliance.
               o If adequate, IRS could use the data to detect overstated
               expenses by matching amounts reported as expenses on the Schedule
               C lines with the amounts reported on information returns filed by
               the sole proprietor or by analyzing the ratio of total expenses to
               amounts reported on an information return's audit selection.
               o No additional burden would be placed on third parties.

               Con:

               o IRS might have difficulties processing and matching all of the
               new expense data.
               o IRS would incur difficulties, such as extra costs, to process
               and use the additional data.
               o If their records are incomplete on their expenses and
               information returns or their accounting systems do not break out
               expenses by the services provided, sole proprietors may have an
               additional burden to report the information.
               o This would not stop all reporting noncompliance.

    			  13. Match information returns filed by sole proprietors with related
    			  expenses on their Schedule Cs.

               IRS would match the existing information returns filed by sole
               proprietors to report their payments made for wages, services, and
               so forth to the related lines of the Schedule C in order to see
               whether the expenses claimed are consistent with the amounts
               reported on the information returns. As with any computer match,
               IRS would need to develop rules for doing the match and tolerances
               for contacting the sole proprietors about discrepancies.

               Pro:

               o Such reverse matching could help identify excess deductions,
               especially for wages, without incurring the costs of audits.
               o If sole proprietors learn about the reverse matching, they may
               become more compliant in reporting expenses
               o This matching would not impose any new burdens on third parties
               and little burden on compliant sole proprietors if the matching
               criteria are effective.

               Con:

               o Beyond wages and possibly some types of nonemployee
               compensation, IRS may find it difficult to effectively match
               expenses in order to avoid contacting compliant sole proprietors.
               o If sole proprietors want to overstate deductions and know that
               IRS can use the information returns they file to look for
               overstated deductions, some of them may file fictitious
               information returns.

    			  14. Expand information reporting on the expenses of sole proprietors.

               The expanded information reporting to cover expenses claimed on
               the Schedule C could include two options:

               a) Businesses receiving certain types of payments from sole
               proprietors in large amounts (i.e., thousands of dollars) would
               file information returns to report those amounts by type of
               expense. Beyond limiting such reporting to large dollar amounts
               (which would need to be set), the reporting also could be limited
               to certain types of payments that are easier to report or that
               tend to be overstated as expenses on the Schedule C (e.g., rents,
               fees, insurance, and travel).

               b) Businesses that process credit (and debit) card payments would
               be required to report information on the amount of payments by
               sole proprietors for each tax year. This reporting could be a
               summary total or include more details for payments above some
               specified amount. IRS would need to decide how it would use this
               information to check for overstated expenses on the Schedule C.

               Pro:

               o Having the data might help IRS detect certain overstated
               expenses without incurring the costs of an audit. Otherwise, IRS
               would have more information on the expenses of sole proprietors
               for use in selecting cases for auditing.
               o Sole proprietors might report their expenses more accurately
               with third-party data.

               Con:

               o Third-party businesses doing the reporting would have additional
               costs to file the information returns or burdens to know whether
               the payments are personal or business related.
               o Some businesses might not want to report to IRS about payments
               they receive from sole proprietors, particularly if those payments
               account for most of their gross receipts and they underreport
               those payments on their tax returns.
               o Sole proprietors wishing to avoid the credit reporting may use
               more cash purchases.
               o If IRS were to use the information in a matching program, it
               would incur costs to process and match it in order to avoid
               contacting compliant sole proprietors and to identify personal
               expenses mixed in with business expenses.

    			  15. Verify additional expenses claimed to offset unreported income.

               Through some form of review or audit of documentation, IRS could
               verify additional business expenses in those cases where sole
               proprietors claim additional expenses after IRS informs them that
               it has discovered unreported business income.

               Pro:

               o IRS could improve the effectiveness of its AUR matching to the
               extent that it stops sole proprietors from claiming unverified
               expense offsets.

               Con:

               o If AUR staff do the verification, IRS would incur costs to train
               them to do the verification and find additional staff to keep up
               the volume of AUR contacts.
               o If audit staff do the verification, IRS would have to make sure
               that the return on investment justifies allocating more expensive,
               better-trained staff to do the verification.
               o If IRS develops some other verification program, it would incur
               start-up and operational costs.

    			  E. Nonpayment of Tax

               In addition to misreporting business income and expenses, the
               noncompliant sole proprietors do not pay their tax liabilities.
               Even so, they can receive government benefits, such as contract
               payments and Social Security credits. And they are not subject to
               a proven tax compliance technique for many individual
               taxpayers--tax withholding. This section lists options that could
               help induce sole proprietors to meet their tax obligations to
               receive benefits or avoid tax withholding.

    			  16. Deny benefits/payments until tax obligations are met.

               One way to induce sole proprietors to pay their taxes owed is to
               deny them government benefits unless they have paid the taxes.
               Federal agencies that provide the benefits would need to check for
               tax compliance with IRS, and the prohibitions against disclosing
               tax data would need to be revised to ensure that the authority
               exists. Two options for checking tax compliance before providing
               government benefits are to

               a) require that sole proprietors pay their self-employment tax
               obligations in order to receive credit for Social Security
               benefits or

               b) require federal agencies to do a tax compliance check with IRS
               before making a contract payment or otherwise providing a
               government benefit (certain loans or grants) to a sole proprietor
               (either all or just contractors). At a minimum, a check would be
               made to see whether the sole proprietor has unfiled tax returns or
               unpaid tax liabilities.

               Pro:

               o Sole proprietors would have an incentive to meet their tax
               obligations.
               o This would help ensure that compliant sole proprietors'
               competitors pay their taxes.

               Con:

               o To the extent that sole proprietors are not motivated by the
               loss of Social Security credits or government benefits, some of
               them may continue to not pay their taxes.
               o Sole proprietors could be unjustly denied credits or benefits
               because of a systemic/human error and thus would need some venue
               for seeking an administrative remedy.
               o Federal agencies would incur costs to check compliance and might
               incur some contracting delays if the compliance checks take a lot
               of time.
               o Denying some types of loans/grants (e.g., for disaster or
               poverty) may be seen as harsh.

    			  17. Withhold tax to encourage tax compliance.

               Another way to induce sole proprietors to pay their taxes owed is
               to require situational or universal tax withholding from the
               payments made to them. Two basic options would require those who
               are to file information returns (e.g., government and business
               entities) on payments made to sole proprietors to do tax
               withholding:

               a) Withhold a small amount from payments until the sole
               proprietor's TIN is certified. This up-front withholding would
               replace "backup withholding" in those cases where, over a year or
               more later, IRS informs the sole proprietor that the TIN provided
               is invalid. IRS would need a system for quickly and accurately
               certifying TINs, which can be either EINs or Social Security
               numbers. Also, decisions would be needed on how much to withhold
               and on what to do with the withheld amounts (e.g., paid to the
               sole proprietor once the TIN is certified or remitted to IRS and
               reconciled when the tax return is filed).

               b) Withhold a small percentage of the payments made to sole
               proprietors for services either in all cases or in limited
               situations, such as when sole proprietors (1) voluntarily consent
               or (2) have a recent history of tax noncompliance and IRS has not
               annually certified that they are now tax compliant.

               Pro:

               o Sole proprietors would be more motivated to provide TINs that
               can be certified, file their returns, report their income, and pay
               their taxes.
               o Those paying sole proprietors would probably have fewer burdens
               from withholding the taxes up front compared to doing backup
               withholding over a year later.
               o Using a low rate could get the sole proprietors into the system
               without necessarily creating an undue burden on their business
               operations.
               o IRS would have fewer information returns with erroneous TINs
               that it spends resources trying to correct or that cannot be used
               in its computer matching programs.

               Con:

               o Withholding would create an added burden for those doing
               business with the sole proprietor, especially if they do not have
               systems for doing withholding or periodically remitting tax
               amounts to IRS, or if they would not have had to do backup
               withholding.
               o Business relationships or operations might be disrupted if IRS's
               system for validating TINs is slow or burdensome, or generates
               errors, while some businesses may refuse to validate the TINs or
               to withhold payments if requested to do so by the sole proprietor
               that they want to use.
               o Even with one low withholding rate, some sole proprietors may be
               burdened if, for example, they operate on thin profit margins or
               have limited working capital.
               o If multiple, withholding rates or exceptions for withholding
               were created by industry, location, years in business, compliance
               history, and so forth to minimize the negative business impacts on
               sole proprietors, questions might arise about complexity, equity,
               and opportunities for "gaming" the system to have a lower or no
               withholding rate.
               o If withholding were limited to sole proprietors, some could
               incorporate or claim to be a corporation to avoid withholding.

    			  F. IRS Management of Limited Resources

               Following up on AUR mismatches and conducting examinations are
               costly. Furthermore, some of IRS's compliance and enforcement
               actions mistakenly select compliant, rather than noncompliant,
               taxpayers. This section discusses options for more effectively
               using IRS's limited resources by better using data and other
               tools.

    			  18. Improve audit selection of sole proprietor tax returns.

               IRS could explore opportunities for improving its selection of
               sole proprietor tax returns and tax issues to be audited in at
               least two ways.

               a) IRS would use advanced automated selection systems to update
               the current manual classification system to better select returns
               and tax issues for audit.

               b) IRS would improve the ability of AUR to refer cases for audit,
               such as when unverified (e.g., oral) claims about income and
               expenses are made. AUR is limited in pursuing such cases, and IRS
               Examination already has selected many cases for audit by the time
               the referrals are made.

               Pro:

               o IRS could select returns with a higher likelihood of tax changes
               at a lower cost and with lower burden on compliant sole
               proprietors.
               o More automation could free a number of experienced audit staff
               who help select these returns and these tax issues for audit to do
               more audits.
               o IRS might be able to increase the dollar yield from finding
               unreported income and denying unjustified claims for offsetting
               deductions.

               Con:

               o IRS would incur costs to collect and test enough data to create
               an effective automated system.
               o IRS is likely to still need some manual intervention to account
               for location-specific issues that cannot be programmed into the
               automated system
               o IRS might find that these AUR cases are still less productive
               than other audit cases.

    			  19. Enhance data sharing with the states.

               IRS would seek to improve data-sharing arrangements with the
               states. State data could include using business licensing,
               ownership of real estate or other large assets, sales receipts,
               and tax compliance data to identify unfiled returns and
               underreported income.

               Pro:

               o IRS could cost effectively identify noncompliance, especially
               nonfilers, that it otherwise would miss.

               Con:

               o State data may be difficult to match with federal data because
               states impose different taxes than the federal government, may use
               a different taxable base, and may report the data in a format that
               IRS cannot easily use.

    			  20. Use informational notices to encourage compliance.

               IRS would send notices (soft notices) to Schedule C filers when it
               sees potential compliance issues that it does not have the
               resources to audit. These notices notify and educate the filers
               about a potential problem with a tax reporting obligation, and
               suggest that they either recheck their filed tax returns or change
               their reporting on future returns.

               Pro:

               o IRS can expand its presence/education and sensitize sole
               proprietors about tax obligations without the costs of enforcement
               contacts.
               o Some sole proprietors may become more compliant voluntarily.

               Con:

               o Some sole proprietors will ignore the soft notices, particularly
               if they are received years after a return was filed or if IRS will
               not take follow-up action regardless of what they do.

    			  21. Revise the rules for applying penalties to improve consistency
    			  and compliance

               One tool to increase compliance is to punish improper behavior
               with penalties. Two options to remedy the inconsistent application
               of penalties are to

               o simplify the process for assessing penalties and develop
               standards to ensure the consistency of their application to sole
               proprietor errors and misconduct and
               o make information return penalties scalable by increasing the
               dollar amount of penalties for subsequent failures to file
               required information returns (e.g., the penalty for the tenth
               failure to file an information return may be significantly higher
               than the first).

               Pro:

               o Sole proprietors who are significantly noncompliant would be
               penalized, and the equity and consistency of penalty application
               might improve.
               o Some sole proprietors might become more compliant if they are
               certain that penalties will be applied.
               o If IRS applies the penalties more consistently, fewer sole
               proprietors may need to incur the burden of seeking abatements for
               unnecessary penalties.
               o IRS could receive more required information returns that are
               accurate and timely.

               Con:

               o If the process becomes too rigid, some sole proprietors might
               resent the perceived inequities. Some sole proprietors might have
               equity concerns if IRS cannot reduce higher penalties caused by a
               systemic glitch for many information returns (e.g., a computer
               error that occurred over and over).
               o If revised penalty rules go too far in accounting for
               inadvertent actions, hardships, and other reasonable causes, the
               penalty consistency may be hard to achieve.
               o If many sole proprietors are required to file only a few
               information returns, scaling penalties would have little impact,
               and if only a small dollar amount of penalties is at stake, IRS
               procedures are likely to continue authorizing abatement of the
               penalties.

    			  Appendix III: IRS Form 1040 Schedule C, Tax Year 2001

    			  Appendix IV: Independent Contractors and Section 530 of the Revenue
    			  Act of 1978

               With increased IRS enforcement of the employment tax laws
               beginning in the late 1960s, controversies developed over whether
               employers had correctly classified certain workers as independent
               contractors rather than as employees. In some instances when IRS
               prevailed in reclassifying workers as employees, the employers
               became liable for portions of employees' Social Security and
               income tax liabilities (that the employers had failed to withhold
               and remit), although the employees might have fully paid their
               liabilities for self-employment and income taxes.

               In response to this problem, Congress enacted section 530 of the
               Revenue Act of 1978 (Pub. L. No. 95-600). That provision generally
               allows an employer who meets certain requirements (such as filing
               required information returns) to treat a worker as not being an
               employee for employment tax purposes (but not income tax
               purposes), regardless of the individual's actual status under the
               common-law test, unless the taxpayer has no reasonable basis for
               such treatment. Under section 530, a reasonable basis is
               considered to exist if the taxpayer reasonably relied on (1) past
               IRS audit practice with respect to the taxpayer, (2) published
               rulings or judicial precedent, (3) long-standing recognized
               practices in the industry of which the taxpayer is a member, or
               (4) any other reasonable basis for treating a worker as an
               independent contractor. Section 530 also prohibits the issuance of
               Treasury regulations and revenue rulings on common-law employment
               status.1 Congress intended that this moratorium to be temporary
               until more workable rules were established but the moratorium
               continues to this day. The provision was extended indefinitely by
               the Tax Equity and Fiscal Responsibility Act of 1982.2

               The rules to classify a worker as an employee or an independent
               contractor are still complex and often difficult to apply. The
               determination of whether a worker is an employee or an independent
               contractor is generally made under a facts and circumstances test
               that seeks to determine whether the worker is subject to the
               control of the employer, not only as to the nature of the work
               performed but the circumstances under which it is performed. In
               general, the determination of whether an employer-employee
               relationship exists for federal tax purposes is made under a
               common-law test.

    1A taxpayer may, however, request and obtain a written determination from
    IRS regarding the status of a particular worker as an employee or
    independent contractor.

    2Pub. L. No. 97-248, September 3, 1982.

               IRS has developed a list of 20 factors that may be examined in
               determining whether an employer-employee relationship exists. The
               20 factors were developed by IRS based on an examination of cases
               and rulings considering whether a worker is an employee.3 The
               degree of importance of each factor varies depending on the
               occupation and the factual context in which the services are
               performed.4

               Misclassification of workers can be either inadvertent or
               deliberate. Because the determination of classification is
               factual, reasonable people may differ as to the correct result
               given a certain set of facts. Thus, even though a taxpayer in good
               faith determines that a worker is an independent contractor, an
               IRS agent may reach a different conclusion by, for example,
               weighing some of the 20 factors differently. The prohibition on
               issuance of general guidance by IRS may make the likelihood of
               classification errors greater; IRS is not permitted to publish
               guidance stating which factors are more relevant than others. In
               the absence of such guidance, not only may taxpayers and IRS
               differ, but different IRS agents may also reach different
               conclusions, resulting in inconsistent enforcement.

               A significant issue is the potential revenue loss to the federal
               government when employees are misclassified as independent
               contractors. An IRS survey of 1984 employment tax returns found
               that nearly 15 percent of employers misclassified employees as
               independent contractors. When employers classified workers as
               employees, more than 99 percent of wage and salary income was
               reported. When workers were misclassified as independent
               contractors, 77 percent of income was reported when a Form
               1099-MISC was filed and only 29 percent was reported when no Form
               1099-MISC was filed.

    3IRS has also developed three categories of evidence that may be relevant
    in determining whether a worker is a contractor or employee under the
    common-law test. The three categories are behavioral control, financial
    control, and type of relationship.

    4For a list of the 20 factors and a discussion of their application, see
    GAO, Tax Administration: Approaches for Improving Independent Contractor
    Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23, 1992).

               Appendix V: Backup Withholding Rules

               Persons (payers) making certain types of payments must withhold
               and pay to IRS a specified percentage of those payments under
               certain conditions. Related to sole proprietors, for example, both
               (1) the commissions, fees, or other payments for work as an
               independent contractor and (2) payments by fishing boat operators,
               but only the part that is in money and that represents a share of
               the proceeds of the catch, are reported on Form 1099-MISC. Other
               payments are not subject to backup withholding, including wages,
               real estate transactions, foreclosures and abandonments, and
               canceled debts. Also corporations, governmental entities, and
               foreign governments generally are exempt from backup withholding.

               For backup withholding to be initiated on payments to sole
               proprietors, a payment must be reportable and the payee must fail
               to furnish a correct TIN.1 If an incorrect TIN is provided, IRS is
               to notify the payer regarding the missing, incorrect, or not
               currently issued payee TIN. At that time the payer is required to
               compare the listing with his or her records and send a notice to
               the payee, asking for the correct TIN. Under tax rules, if the
               payee refuses to provide a TIN, the payer is required to
               immediately begin withholding 28 percent of the amount of the
               payment and remit that amount to IRS. IRS procedures describe how
               the payer is to verify the TIN and request that the payee provide
               a correct TIN. The payer must make up to three solicitations for
               the TIN (initial, first annual, and second annual) to avoid a
               penalty for failing to include a TIN on the information return. If
               the payer files an information return with a missing TIN or with
               an incorrect name and TIN combination, or does not follow the
               procedure to correct the TIN, the payer may be subject to a $50
               penalty for each incorrect return filed.

    1Backup withholding also applies when the payee fails to certify, under
    penalties of perjury, that the TIN provided is correct for interest,
    dividend, and broker and barter exchange accounts opened or instruments
    acquired after 1983.

               Appendix VI: Comments from the Department of the Treasury

    			  Appendix VII: GAO Contact and Staff Acknowledgments

    			  GAO Contact

               James R. White, (202) 512-9110 or [73]w hitej@gao.gov

    			  Acknowledgments

               In addition to the contact named above, Tom Short, Assistant
               Director; Evan Gilman; Eric Gorman; Leon Green; George Guttman;
               Shirley Jones; Donna Miller; Karen O'Conor; Anna Maria Ortiz; and
               Sam Scrutchins made key contributions to this report.

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    [93]www.gao.gov/cgi-bin/getrpt?GAO-07-1014 .

    To view the full product, including the scope
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    Highlights of [94]GAO-07-1014 , a report to the Committee on Finance, U.S.
    Senate

    July 2007

    TAX GAP

    A Strategy for Reducing the Gap Should Include Options for Addressing Sole
    Proprietor Noncompliance

    The Internal Revenue Service (IRS) estimates that $68 billion of the
    annual $345 billion gross tax gap for 2001 was due to sole proprietors,
    who own unincorporated businesses by themselves, underreporting their net
    income by 57 percent. A key reason for this underreporting is well known.
    Unlike wage and some investment income, sole proprietors' income is not
    subject to withholding and only a portion is subject to information
    reporting to IRS by third parties.

    GAO was asked to (1) describe the nature and extent of sole proprietor
    noncompliance, (2) how IRS's enforcement programs address it, and (3)
    options for reducing it. GAO analyzed IRS's recent random sample study of
    reporting compliance by individual taxpayers, including sole proprietors.

    [95]What GAO Recommends

    GAO recommends that the Secretary of the Treasury ensure that the tax gap
    strategy (1) covers sole proprietor compliance and is coordinated with
    broader tax gap reduction efforts and (2) includes specific proposals,
    such as the options in this report. GAO is not making recommendations
    regarding specific options. IRS and the Department of the Treasury
    provided technical comments on a draft of this report, which we
    incorporated as appropriate.

    Based on what IRS examiners could find, most sole proprietors, at least an
    estimated 61 percent, underreported net business income, but a small
    proportion of them accounted for the bulk of understated taxes. Both gross
    income and expenses were misreported. Most of the resulting understated
    taxes were in relatively small amounts. Half the understatements that IRS
    examiners could find were less than $903. However, 10 percent of the tax
    understatements, made by over 1 million sole proprietors, were above
    $6,200. In this top group, the mean understatement of tax was $18,000.

    IRS's two main sole proprietor enforcement programs--the Automated
    Underreporter Program, which computer matches information on a tax return
    with information submitted to IRS by third parties, and examinations
    (audits)--have limited reach. The two programs each annually contact less
    than 3 percent of estimated noncompliant sole proprietors. The limited
    reach exists for a variety of reasons. In 2001, about 25 percent of sole
    proprietor gross income was reported on information returns by third
    parties; expenses generally are not subject to such reporting. Even when
    required, various barriers make information reporting inconvenient.
    Examinations of sole proprietors yield less in additional tax assessed and
    cost more to conduct than examinations for other taxpayers. However,
    because of the extent of sole proprietor noncompliance, any effect that
    examinations have on voluntary compliance by other sole proprietors could
    result in significant revenue.

    The Treasury Department's recently released tax gap strategy discusses
    neither sole proprietor noncompliance specifically nor the many options
    that could address it. GAO has reported on the need for such a detailed
    strategy for years. Specific options that address issues including sole
    proprietor recordkeeping, underreporting of gross income, overreporting of
    expenses, information reporting, and IRS's enforcement programs are listed
    in appendix II.

    Sole Proprietors' Estimated Understated Tax by Percentile for Tax Year
    2001

    References

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