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

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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][email protected] . 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 [email protected]
			  
			  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 .

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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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