Tax Administration: IRS Can Better Pursue Noncompliant Sole Proprietors
(Letter Report, 08/02/94, GAO/GGD-94-175).

Noncompliance in reporting sole proprietor income represents a major
challenge for the Internal Revenue Service (IRS). Such noncompliance
spreads over a majority of the estimated 13 million sole proprietors and
creates an estimated income tax gap--the difference between the amount
of income taxes owed and the amount voluntarily paid--of $34 billion a
year. During the past 15 years, sole proprietors rate of noncompliance
has fluctuated with little evidence that IRS' current compliance efforts
will lead to significant improvements. This report (1) analyzes the
extent of noncompliance by type of sole proprietor, (2) reviews steps
that IRS is taking to correct such noncompliance, and (3) identifies
additional steps that IRS could take to improve compliance.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-94-175
     TITLE:  Tax Administration: IRS Can Better Pursue Noncompliant Sole 
             Proprietors
      DATE:  08/02/94
   SUBJECT:  Tax returns
             Income taxes
             Reporting requirements
             Noncompliance
             Tax nonpayment
             Tax administration systems
             Law enforcement
             Taxpayers
             Management information systems
IDENTIFIER:  IRS Taxpayer Compliance Measurement Program
             IRS Compliance 2000 Initiative
             IRS Tax System Modernization Program
             TSM
             IRS Automated Issue Identification System
             IRS Service Industries Compliance Initiative
             
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Cover
================================================================ COVER


Report to the Joint Committee on Taxation, U.S.  Congress

August 1994

TAX ADMINISTRATION - IRS CAN
BETTER PURSUE NONCOMPLIANT SOLE
PROPRIETORS

GAO/GGD-94-175

Noncompliant Sole Proprietors


Abbreviations
=============================================================== ABBREV

  BMP - Business Master Plan
  CRIS - Compliance Research and Information System
  DORA - District Office Research and Analysis
  IGP - Information Gathering Project
  IRS - Internal Revenue Service
  MSSP - Market Segment Specialization Program
  SINC - Service Industries Compliance
  TCMP - Taxpayer Compliance Measurement Program
  TSM - Tax Systems Modernization

Letter
=============================================================== LETTER


B-256629

August 2, 1994

The Honorable Daniel Patrick Moynihan
Chairman, Joint Committee on Taxation

The Honorable Samuel Gibbons
Vice Chairman, Joint Committee on Taxation
Congress of the United States

The Internal Revenue Service (IRS) estimated that noncompliance with
income reporting by sole proprietors accounted for more than
one-third of the $94 billion individual gross income tax gap for
1992.\1 The income tax gap is the difference between the amount of
income taxes owed and the amount voluntarily paid.\2

This report responds to your request that we (1) analyze the extent
of noncompliance by type of sole proprietor; (2) review steps that
IRS is taking to correct such noncompliance; and (3) identify
additional steps, if any, that IRS could take to improve compliance. 


--------------------
\1 In this report, the term "sole proprietors" refers to
self-employed individuals other than farmers. 

\2 IRS issued its most recent tax gap estimate in 1988 using Taxpayer
Compliance Measurement Program (TCMP) data from 1979 and 1982 and
other IRS data.  Under TCMP, IRS' examiners do detailed audits of tax
returns for a random sample of taxpayers.  During 1994, IRS will make
new tax gap estimates based on the TCMP survey for tax year 1988
returns which was completed in 1992. 


   BACKGROUND
------------------------------------------------------------ Letter :1

Sole proprietors are required to file a Schedule C (Profit or Loss
From Business) with their Individual Income Tax Return Forms 1040 to
report business income and expenses.\3

Using TCMP data, we estimated that about 13 million individuals filed
a Schedule C for 1988.\4 In 1992, about 6.6 million individuals had
Schedule C income as their primary source of income.  IRS treats
these individuals as sole proprietors when selecting returns to
audit. 

IRS relies on two ways to detect sole proprietor noncompliance--(1)
auditing tax returns and (2) computer matching information returns to
tax returns.  IRS selects tax returns for audit by focusing on
returns with the greatest chance for error and as part of special
compliance programs.  One compliance program involves audits done as
part of district offices' Information Gathering Projects (IGP).  An
IGP focuses on a specific type of taxpayer or compliance issue to
identify the nature of the noncompliance and corrective actions
needed to reduce it. 

IRS also may audit sole proprietor returns in its Compliance 2000
projects.  These projects emphasize improving compliance in a
selected market segment (i.e., homogeneous groups of taxpayers with
similar behavior) by educating and assisting taxpayers before they
become noncompliant.  The underlying theme of the Compliance 2000
philosophy is that many taxpayers want to comply, but they may have
difficulty doing so because of inadequate information or complexity
of the tax laws.  At the end of fiscal year 1992, IRS had 1,162 IGPs
and 67 Compliance 2000 projects. 

The second detection method involves computer matching.  Third
parties such as banks and other businesses are required to file
annual information returns to report various payments made to
individuals.\5 IRS then matches amounts reported on information
returns against amounts reported on tax returns.  After matching, IRS
attempts to contact taxpayers about any discrepancies in the income
reported on the tax return. 


--------------------
\3 In addition to those filing a Schedule C, sole proprietors also
include nonfarm individuals who should have filed a Schedule C but
did not (according to TCMP results). 

\4 Unless otherwise indicated, all statistical data in this report
are GAO estimates from IRS' 1988 TCMP data or IRS' tax gap estimates. 
Tax gap and TCMP estimates differ significantly.  To account for
noncompliance that TCMP is unlikely to identify, IRS' tax gap
estimates include a multiplier for underreported income and an
estimate for sole proprietors operating on an informal basis (i.e.,
informal suppliers).  In contrast, TCMP estimates rely on actual
changes made during the TCMP audit. 

\5 Businesses report payments to individuals on Forms W-2 for wages
and 1099s for other income such as interest and dividends. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

Sole proprietors have a disproportionate share of noncompliance. 
Although they accounted for an estimated 13 percent of individual
taxpayers, sole proprietors accounted for an estimated 40 percent of
underreported total income by individuals in the 1988 TCMP--IRS' most
recent.  They also accounted for an estimated 36 percent of the $94
billion individual tax gap for 1992.  Further, 1988 TCMP data showed
that sole proprietors reported only 75 percent of their net business
income while individuals reported almost 98 percent of nonbusiness
total income, which we view as comparable to Schedule C net income. 
IRS believes that this higher compliance results from withholding and
information reporting. 

Even with these compliance disparities, we did not find a
comprehensive linkage between IRS' compliance strategy and its
compliance efforts for sole proprietors.  While important as a
conceptual frame of reference, this strategy is not a detailed
operating plan for improving sole proprietor compliance and for
linking disparate compliance efforts--such as audits, computer
matching, and compliance projects--to each other and to the strategic
goal of reducing the tax gap. 

IRS' compliance efforts cover all types of taxpayers but have
limitations.  Because audits require many resources, they reach
relatively few sole proprietors.  In 1992, IRS audited only 2.3
percent of the 6.6 million individuals whose primary income was the
sole proprietorship.  This represented about 15 percent of all
individual audits.  Computer matching is limited because information
returns are not required for much sole proprietor income. 
Information returns largely cover income that sole proprietors earn
from providing services to other businesses but not from selling
goods. 

IRS also audits returns in its IGP and Compliance 2000 programs,
which also have limitations.  IRS often judgmentally selected
compliance projects on the basis of local officials' knowledge and
experience rather than more objective data, such as from TCMP or
local studies and databases.  As a result, IRS has little assurance
that projects addressed the most significant compliance problems for
the local area and beyond.  Even if projects succeeded locally, IRS'
system to consolidate and communicate the results was limited.  IRS
provided each district with a list of projects but not with
information on the projects' scope or results. 

IRS is developing new information systems to better identify the
causes of noncompliance and target enforcement resources, but the
systems are not expected to be fully implemented until after the turn
of the century.  IRS does not know whether they will produce the data
needed to systematically improve sole proprietor compliance.  IRS
also plans to improve its 1994 TCMP so that local problems and causes
can be identified.  However, such data will not be available until at
least 1998. 

Meanwhile, IRS could better use existing TCMP data to identify the
root causes of some sole proprietor noncompliance.  Our analysis of
TCMP data indicated that truckers were among the less compliant sole
proprietors.  The primary reason, as found in the TCMP workpapers,
was inadequate books and records.  IRS could work with the trucking
industry to fix this problem.  Similarly, TCMP workpapers indicated
that unincorporated automobile body shops did not report all income
from work done for businesses such as insurance companies.  Although
businesses are required to send information returns to the shops, the
shops seldom received them.  This suggests that IRS may need to work
with businesses on sending these information returns. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Our objectives were to (1) analyze the extent of noncompliance by
type of sole proprietor, (2) review the steps IRS is taking to
correct sole proprietor noncompliance, and (3) identify any
additional efforts that IRS could take to address this problem. 

To determine the extent of noncompliance, we analyzed IRS' TCMP data
on sole proprietors for 1988--the most recent available--and IRS' tax
gap estimates.  To measure the noncompliance of sole proprietors, we
determined that focusing on audit adjustments to their Schedule C net
income was the most reasonable approach.  We evaluated sole
proprietor noncompliance by their audit class (IRS' current method of
categorizing individual tax returns by income and type of return),
major industrial group, and primary business activity within each
industry group. 

To review the steps IRS is taking to improve sole proprietor
compliance, we interviewed IRS officials at the National Office, the
Western Regional Office, the Fresno Service Center, and the San
Francisco District Office.  In the National Office, we talked to
officials in the Examination, Taxpayer Services, and Research
Divisions and to representatives responsible for Compliance 2000.  We
reviewed IRS documents and progress reports for Compliance 2000
projects and discussed IRS' plans for upgrading its computer systems
through its Tax Systems Modernization (TSM) effort. 

To identify additional steps that IRS could take to improve sole
proprietor compliance, we first reviewed the workpapers from a
judgmental sample of 115 TCMP sample cases.  All 115 cases came from
the 10 business activities that TCMP data suggested were among the
least compliant and that had at least 100 or more cases and $10,000
in understated net income.  For these sample cases, we defined least
compliant in two ways--the estimated amount and percentage of net
business income that was underreported.  From this sample, we
identified several promising issues, two of which we
pursued--inadequate books and records among sole proprietors in the
trucking industry and failure of insurance companies to file
information returns on payments made directly to the sole proprietors
of automotive body repair shops.  Both truckers and automobile body
shop owners were among the top 10 least compliant sole proprietors by
industry in either their compliance rate or dollar value of
noncompliance. 

Focusing on these two issues, we selected a stratified random sample
of 207 trucker cases from TCMP and reviewed the audit workpapers to
determine whether inadequate books and records were a significant
problem in the industry.  In addition, we discussed the books and
records issue with industry representatives from the American
Trucking Association and the Independent Truckers Association.  We
also reviewed audit workpapers for 61 automobile body repair shops
shown in the TCMP database to determine the extent to which insurance
companies made payments directly to body shops and also reported
those payments to IRS.  Appendix I discusses our sampling methodology
and statistical analysis. 

IRS provided written comments on a draft of this report.  These
comments are presented and evaluated on page 16 and are reprinted in
appendix IV.  We did our fieldwork between November 1992 and February
1994 in accordance with generally accepted government auditing
standards. 


   MANY SOLE PROPRIETORS ARE
   NONCOMPLIANT
------------------------------------------------------------ Letter :4

Sole proprietors have been one of the least compliant segments of the
individual taxpayer population.  They often fail to comply with
requirements of the tax system--to file a timely, accurate, and fully
paid return.  IRS' data showed the following: 

  IRS' filer and nonfiler TCMPs showed that an estimated 2.6 million
     sole proprietors failed to file a Schedule C for 1988.\6 Of
     these, (1) 1.8 million did not file at all and (2) 751,000 filed
     a tax return but not a Schedule C. 

  Unreported sole proprietor income accounted for an estimated $33.7
     billion (36 percent) of the 1992 individual tax gap. 

  For 1988, TCMP data indicated that individuals claiming sole
     proprietor income accounted for about $39 billion of the
     estimated $99 billion in underreported total income among all
     individual taxpayers.\7 Although they accounted for 40 percent
     of this noncompliance, these sole proprietors represented just
     13 percent of all individual taxpayers. 

  For 1988, 8.7 million sole proprietors understated their business
     income by an estimated average of $4,768.  Another 1.4 million
     sole proprietors overstated their business income by an average
     of $1,656. 

  Sole proprietors owed delinquent taxes totaling almost $11 billion
     as of January 1993.  This was 15 percent of the assessed taxes
     owed by individuals. 

Sole proprietors materially differ from nonbusiness taxpayers.  IRS'
TCMP data show that they are less compliant, file more complex
returns, appear to be intentionally noncompliant more often, and tend
to be better off financially than nonbusiness taxpayers.\8 Also, sole
proprietors are less likely to prepare their own returns.  Figure 1
compares these and other characteristics of sole proprietors and
nonbusiness individuals. 

   Figure 1:  Comparison of
   Business and Nonbusiness
   Characteristics

   (See figure in printed
   edition.)

Note 1:  Intentional noncompliance is defined as noncompliance where
a negligence penalty was assessed. 

Note 2:  Complex returns are defined as those having 2 or more
schedules other than schedule B. 

Source:  1988 TCMP database. 

A possible reason for compliance differences between sole proprietors
and other individuals is that sole proprietors have a lower
percentage of income reported on information returns.  IRS has found
taxpayers are more likely to report income on tax returns when that
income is reported on information returns by third parties. 

Sole proprietors' compliance may be more similar to compliance for
small corporations (i.e., those with gross assets under $10 million)
than for individual taxpayers.  A comparison of TCMP data shows that
neither small business group approaches the compliance level of
nonbusiness individuals.  Improvements in sole proprietor compliance
have been inconsistent, fluctuating between an estimated 68 percent
and 80 percent over the past 15 years.  Small corporate compliance
went from 81 percent in 1980 to 61 percent in 1987.  Table 1 compares
the voluntary compliance of small corporations in tax year 1987 to
sole proprietors in tax year 1988. 



                           Table 1
           
              IRS Estimates of Small Corporation
           Compliance for 1987 and Sole Proprietor
               Compliance for 1988 by Industry


                                        Sole           Small
Industry                       proprietors\b    corporations
----------------------------  --------------  --------------
Services                                85.1            48.0
Real estate, insurance,                 84.4            62.9
 finance
Wholesale trade                         82.8            65.4
Production                              75.0          68.6\c
Transportation and                      68.9            60.3
 communication
Retail trade                            67.8            55.5
Agricultural                            65.6            74.4
U.S. average                            79.8            61.1
------------------------------------------------------------
\a Voluntary compliance level, as a percentage, equals the amount of
tax reported divided by this amount and additional tax recommended
after audit.  Sampling error for sole proprietors is less than plus
or minus 10 points at the 95 percent confidence level.  No sampling
errors were provided for corporations. 

\b These percentages reflect recommended tax increases resulting from
adjustments to all return items, not just those from the Schedule C. 

\c The production category includes the corporate categories of
mining, manufacturing, and construction. 

Source:  The IRS Research Bulletin, 1992. 

Reasons for the higher compliance rate among sole proprietors in the
service industry are not known, although IRS officials believe
information reporting could explain it.  Much of the income from
providing services is subject to information reporting.  In other
industries, such as retail and manufacturing, very little sole
proprietor income is subject to information reporting. 

The value of information reporting also applies to compliance among
small corporations.  Corporations generally are not subject to
information reporting.  As table 1 shows for the service industry,
small corporations had only a 48 percent compliance rate compared to
85 percent for sole proprietors. 

Across all industry groups, IRS separated sole proprietors into 173
types based on principal business or professional activity code. 
Compliance in reporting income varied widely by activity code in the
1988 TCMP.\9 For example, doctors voluntarily reported an estimated
95 percent of their net business income.  On the other hand, eating
places--one of the less compliant groups--reported an estimated 39
percent of this income.\10

Relying on one compliance measure, however, to devise programs to
enhance compliance can be misleading.  A fuller analysis of the TCMP
database and workpapers could offer insights on the nature and causes
of noncompliance among sole proprietors. 


--------------------
\6 IRS also does a nonfiler TCMP, most recently for 1988.  To do this
TCMP, IRS randomly selected Social Security numbers for which no tax
return was filed in 1988.  IRS then tried to contact the individuals
and determine whether a return was required. 

\7 The $39 billion in noncompliance resulted from sole proprietors
understating their gross business income by an estimated $20 billion
and overstating their business expense deductions by an estimated $19
billion. 

\8 IRS has no definition or criteria for intentional or unintentional
noncompliance.  On the basis of the Internal Revenue Manual's
definitions, we believe that the existence of negligence penalties
could be considered as reasonable indicators of taxpayer's intent. 

\9 Table II.1 in appendix II provides details on reporting rates for
the 46 types of businesses in which IRS audited at least 100 TCMP
returns.  We limited most analyses to these 46 because the estimates
were more likely to be statistically reliable.  Even so, comparisons
across businesses may not be meaningful because confidence intervals
for the point estimates might overlap. 

\10 The sampling errors for the percentage of underreported net
business income are plus or minus 15 points for doctors and plus or
minus 22 points for eating places at the 95 percent confidence level. 


   SOLE PROPRIETOR COMPLIANCE
   EFFORTS DID NOT LINK TOGETHER
   SYSTEMATICALLY
------------------------------------------------------------ Letter :5

Inconsistent improvement in the compliance of sole proprietors in
reporting income and deductions since at least 1979 suggests that
IRS' compliance efforts have not been sufficient.  IRS has recently
developed a broad strategy for improving compliance, which includes
identifying critical compliance issues and directing regions to
develop projects to implement the strategy.  At the working level,
IRS has used audits, computer matching, and projects to identify sole
proprietor noncompliance.  However, these specific efforts have not
been integrated into a cohesive program that links with this broad
strategy. 

Even without this linkage, IRS' new strategy and compliance efforts
have constraints.  This compliance strategy identified eight critical
issues of which just one--cash businesses and self-employed
taxpayers--related to sole proprietor compliance in Schedule C
reporting.  But national direction and monitoring of regional efforts
to implement the strategy have been limited.  Moreover, each specific
compliance effort, such as audits, has limits to how it can address
compliance problems. 


      AUDITS AND COMPUTER MATCHING
      HAVE LIMITATIONS
---------------------------------------------------------- Letter :5.1

The audit has been a key enforcement tool to identify and correct
noncompliance among sole proprietors.  However, audits require many
resources, and with IRS' limited enforcement resources, its audit
rate is low.  According to IRS' fiscal year 1992 annual report, IRS
audited 151,000 of the 6.6 million returns (2.3 percent) in which the
sole proprietorship provided the individual's primary source of
income.\11 Staff available for sole proprietor audits may have been
reduced in fiscal year 1993 because IRS shifted over 2,200 audit
staff years to pursue nonfilers, a group that accounted for less than
11 percent of the 1992 tax gap. 

Though helpful, audits alone cannot resolve sole proprietor
noncompliance.  IRS has not had enough resources to pursue all
noncompliant sole proprietors.  According to TCMP data, to audit just
sole proprietors who understated net income by $10,000 or more would
require that IRS audit at least seven times as many returns from sole
proprietors as it audited in 1992.  This assumes that IRS could
accurately target the least compliant returns in order to have a no
change rate of 0 percent.\12 The current no change rate for sole
proprietor returns averages over 11 percent. 

IRS has successfully used computer matching to identify noncompliance
among nonbusiness individuals.  For sole proprietors, IRS' match is
limited because not all types of sole proprietor income are required
to be reported on information returns.  Information reporting is
generally required for transactions between businesses for services,
such as legal and accounting advice.  On the other hand, reporting is
not required on the sale of goods such as groceries. 

Because of such limitations, IRS' computer matching program cannot
identify all noncompliant sole proprietors.  For example, in the
matching program for tax year 1989, the most recent data available,
IRS identified 327,064 sole proprietors who underreported Schedule C
income.  TCMP results indicate the number of sole proprietors that
underreport this income exceeded 8 million for 1988.  Also, matching
for 1991 identified over 730,000 sole proprietors who did not file a
tax return, but 1988 TCMP data suggested that the number exceeded
1,000,000. 


--------------------
\11 IRS has no summary information on audits of sole proprietors
whose primary income is from a source other than the Schedule C. 

\12 The no change rate is the percent of returns in which audits
result in no change to the taxes owed. 


      EFFECTIVENESS OF COMPLIANCE
      PROJECTS IS LIMITED
---------------------------------------------------------- Letter :5.2

At the end of fiscal year 1992, IRS had over 1,200 compliance
projects, including IGPs and Compliance 2000 initiatives, to identify
and correct noncompliance among particular groups of taxpayers. 
These projects have had limited value in correcting sole proprietor
noncompliance for various reasons. 

We found that few of these special projects addressed Schedule C
reporting compliance by sole proprietors.  IRS had 67 Compliance 2000
projects at the end of fiscal year 1992, of which only 11 (16
percent) involved reporting compliance by sole proprietors.  Of the
1,162 IGPs open at the end of fiscal year 1992, IRS could not tell us
exactly how many dealt with sole proprietor reporting compliance. 
IRS was able to collect data from four regions.\13

Using such data, we identified 672 IGPs, of which only 56 (8 percent)
involved Schedule C reporting compliance. 

We found that IRS had not always selected these compliance projects
by using objective data.  Instead, projects were selected by field
staff relying on their experience or perceptions or on leads from
outside sources.  This may result in these projects being
misdirected.  For example, less than half of the 56 IGPs targeted
sole proprietors that TCMP data showed to have the lowest compliance. 

While it is still too early to have results from the Compliance 2000
prototypes, many of the IGPs involving Schedule C compliance have
been unproductive.  In almost two-thirds of the 56 IGPs terminated
during fiscal year 1992 in the 4 regions for which we had data, the
suspected noncompliance did not materialize, or the results did not
justify the time spent.  Such data suggest that these projects are
not targeting the least compliant industries. 

Even when IGPs were productive, IRS did not effectively communicate
IGP results throughout the agency.  We also discussed this problem in
an April 1990 report to Congress.\14 While some communication does
occur, this process is not systematic. 

For example, IRS officials stated that regional officials have the
option of sending the information to either the National Office or to
other regional offices.  They also said a list of open IGP titles is
disseminated annually, and field staff use this list to keep abreast
of IGP activities in other offices.  However, we found this listing
to have little value.  Titles were vague, usually making it difficult
to identify the strategic issue being addressed.  These informal
systems did not ensure that important IGP results were available
throughout IRS. 

IRS' National Office has taken a more active role in monitoring
Compliance 2000 projects.  The National Office receives progress
reports on Compliance 2000 prototypes and has begun to hold seminars
with IRS staff throughout the country to share information on key
compliance issues.  However, IRS officials told us they had not yet
developed an ongoing system to consistently communicate the progress
and results of Compliance 2000 projects. 

IRS' ongoing reorganization, which consolidated all compliance
functions into one core office, presents IRS with an opportunity to
address sole proprietor compliance problems in a systematic and
coordinated manner.  This compliance office could gather information
on the many compliance projects, identify those that are worthwhile,
and incorporate them into a strategy directed at improving sole
proprietor compliance.  However, it is too soon to determine how this
reorganization will affect sole proprietor compliance. 

At the same time, IRS hopes to develop new information systems to
support its compliance strategy.  As part of its computer upgrades
under TSM, IRS is developing an Automated Issue Identification System
(AIIS), which it hopes will improve the selection of returns for
audit.  Other systems are being designed to obtain and analyze data
by market segments.  Under the market segment approach, IRS puts
taxpayers with common filing characteristics or behavior into groups
so that similar corrective actions can be undertaken for the entire
group.  Because these systems are still being developed, it is too
early to know whether they will improve sole proprietor compliance. 
Appendix III discusses some of these new systems. 


--------------------
\13 IRS' National Office does not maintain detailed information on
IGPs.  We asked National officials to survey IRS regional offices for
such information.  When we finished our work, five of seven regions
had responded.  Information from one region was not useable because
it provided data from a different fiscal year. 

\14 Tax Administration:  Profiles of Major Components of the Tax Gap
(GAO/GGD-90-53BR, Apr.  4, 1990). 


   IRS CAN BETTER USE EXISTING
   DATA TO IMPROVE SOLE PROPRIETOR
   COMPLIANCE
------------------------------------------------------------ Letter :6

IRS will be implementing its planned computer system upgrades and new
compliance strategies throughout the next decade.  Given existing
levels of noncompliance, IRS cannot afford to wait until all its new
systems are on line to better focus its compliance efforts.  Instead,
IRS needs to better use existing objective data to identify pockets
of sole proprietor noncompliance and determine the causes. 

The TCMP database and workpapers offer large amounts of objective
data on national sole proprietor noncompliance.  Although it is not
shown in the database, information on causes can be found in TCMP
workpapers.  By reviewing the workpapers for two market segments with
significant noncompliance, we obtained deeper insights into the
nature and causes of the compliance problem. 

Knowing the causes of noncompliance would allow IRS to better focus
its compliance efforts and corrective actions for national market
segments that TCMP found to be noncompliant.  In its next TCMP, IRS
plans to obtain data on compliance that will allow projections to the
local level as well as identify causes using the database rather than
just workpapers.  These TCMP results will not be ready until 1998 at
the earliest. 

To test the usefulness of existing TCMP data to identify causes for
noncompliance, we analyzed returns from what appeared to be the 10
least compliant sole proprietor industries in the 1988 TCMP.  Our
analysis suggested several causes for noncompliance in these
industries, including inadequate books and records and the absence of
required information reports on payments made to automotive body
repair shops. 


      INADEQUATE BOOKS AND RECORDS
---------------------------------------------------------- Letter :6.1

Our initial analysis of the TCMP workpapers showed that sole
proprietors in the trucking industry often failed to keep adequate
books and records.  To determine the extent of this problem, we
selected a stratified random sample of 207 trucking industry sole
proprietors.  We analyzed the TCMP workpapers to determine, where
possible, the reasons for noncompliance.  Using this sample, we
estimate that over 66 percent of noncompliant truckers have
inadequate books and records, which hampers their ability to track
income and expenses.\15 As a result, these truckers did not fully
support some of the claims made on their tax returns, distinguish
between personal and business expenses, or claim all the expenses
they were entitled to deduct.  For example: 

  One sole proprietor deducted close to $20,000 in Schedule C
     expenses for items ranging from wages to repairs and supplies. 
     Due to inadequate books and records, the taxpayer could
     substantiate only $2,000 of these expenses.  As a result, the
     taxpayer was assessed over $2,500 in additional income taxes. 

  Due to inadequate books and records, a sole proprietor had not
     separated insurance payments for the business from those for
     personal use and deducted all insurance payments as business
     expenses.  By interviewing the taxpayer, the auditor determined
     that this taxpayer used his vehicle for both business and
     non-business purposes.  The auditor disallowed almost 25 percent
     of the $4,500 deduction as being personal.  This particular
     change resulted in additional income taxes of about $150. 

Inadequate books and records also can cause a sole proprietor to pay
more taxes than required.  In one case, a sole proprietor failed to
deduct any expenses for meals while traveling for the business.  The
auditor determined that the taxpayer had been on the road for 158
days during 1988 and allowed a $1,770 deduction for meals expenses,
based on the $14 per diem rate that is allowed.  This adjustment
reduced the tax liability by over $250. 

Our analysis of TCMP workpapers suggested that IRS could use a
nonenforcement approach to improve the compliance of the trucking
industry.  One approach would be to help develop a set of prototype
books and records along with clear instructions aimed specifically at
the trucking industry.  This approach would provide truckers with a
format for keeping track of income and expenses for key Schedule C
line items, and the instructions would clearly identify the
requirements for deductible expenses and documentation, giving
particular emphasis to line items where TCMP data indicate truckers
had the greatest problems. 

IRS provides some guidance on keeping books and records for small
businesses.  However, this guidance is not directed at specific
industries and their particular problems.  IRS has developed an audit
technique guide for trucking companies.  Although we found that this
guide provides information on accounting requirements and record
keeping, it focused on large trucking companies.  Sole proprietors
who could benefit from this guide must request it, assuming that they
know the guide exists.  IRS officials said taxpayers could obtain
copies of this guide only by filing a Freedom of Information Act
request.  However, we believe that to effectively reach target
populations, IRS may need a proactive approach, such as working with
industry groups or providing guidance to all taxpayers within the
industry. 

We discussed this proactive approach with representatives of the
trucking industry, who believed that having this guidance would help
truckers become more compliant.  Officials from the American Trucking
Associations and the Owner, Operator, and Independent Drivers
Association indicated a willingness to help develop a prototype and
help disseminate the guidance to their members.  This approach would
be consistent with IRS' Compliance 2000 philosophy. 


--------------------
\15 All taxpayers are required by law to maintain adequate books and
records to allow for the preparation of a proper return.  The
taxpayer is to maintain permanent books of accounts and records
sufficient to establish the amounts of gross income, deductions,
credits, or other matters to be shown on the taxpayer's return. 


      INFORMATION RETURNS FOR
      AUTOMOBILE BODY SHOPS
---------------------------------------------------------- Letter :6.2

During our review of TCMP workpapers, we noted that automobile body
shops received few information returns, even though many were paid
directly by insurance companies.  Insurance companies and other
businesses are required to submit information returns for service
payments of $600 or more made directly to sole proprietors operating
automobile body repair shops. 

We reviewed TCMP workpapers for 61 automobile body shops in the TCMP
database.  In 48 cases, the workpapers contained some information on
payments made to the automobile body shop by insurance companies or
other businesses.  On the basis of information in the TCMP workpapers
and IRS' information returns data, we estimated that $5.4 million of
the $8.2 million in gross receipts for these 48 automobile body shops
should have been reported to IRS on information returns.\16 The data
also showed that only $1.1 million of this estimated $5.4 million was
reported on information returns by insurance companies and other
businesses. 

To determine the extent to which insurance companies report payments
for repair of physical damage to automobiles, we reviewed a sample of
information returns data for 10 insurance companies.\17 Overall,
these 10 insurance companies reported about 19 percent of their total
payments to automobile body shops.  However, for various reasons, we
could not determine what portion of these payments were required to
be reported on information returns.  For example, insurance companies
are not required to report automobile body repair payments made to
body shops organized as corporations.\18

Although we could not tell whether insurance companies and other
businesses filed all required information returns, the TCMP
workpapers suggested that they did not file all required returns. 
IRS may need to clarify the information reporting requirements and
work with payors to ensure that they understand their information
return reporting responsibilities.  IRS may also need to develop a
compliance program to ensure that information returns are being filed
properly. 


--------------------
\16 We did not project the results to the total population of
automobile body shops because the TCMP database had too few cases to
yield adequate precision for estimation purposes. 

\17 The insurance companies were selected judgmentally from companies
listed on the Statistics of Income database.  The 10 companies were
selected based on their size, location, and payments for auto damage
claims, according to an industry report (A.M.  Best Insurance Report,
Property and Casualty). 

\18 In the spring of 1993, the administration proposed the Service
Industries Compliance (SINC) initiative.  SINC would have required
that payors report all payments made to independent contractors, even
those incorporated.  Treasury estimated that SINC would bring in $5
billion in additional taxes over 5 years, whereas the Joint Committee
on Taxation estimated that it would bring in less than $0.5 billion. 


   CONCLUSIONS
------------------------------------------------------------ Letter :7

Noncompliance in reporting sole proprietor income represents a
significant challenge for IRS.  Such noncompliance spreads over a
majority of the estimated 13 million sole proprietors and creates an
estimated tax gap of $34 billion a year.  Over the past 15 years,
sole proprietors' rate of noncompliance has fluctuated with little
evidence that IRS' current compliance efforts, such as its many
compliance projects, will prompt significant improvements. 

IRS' broad strategy for improving compliance has not linked these
diverse compliance efforts.  Further, IRS' compliance projects are
not as effectively managed as they could be.  Currently, IRS depends
on its field offices to select and implement the projects.  Even if
projects are successful, the mechanisms to disseminate their results
throughout the agency are weak.  If IRS improved its project
selection process by making it more data- driven and developed the
infrastructure to communicate the results, it could address sole
proprietor compliance problems more effectively. 

The TCMP database and workpapers contain valuable information that
IRS is not fully using to identify the source and causes of sole
proprietor noncompliance.  The TCMP workpapers can be used to
indicate the root causes of sole proprietor noncompliance and assist
IRS in designing programs to improve compliance.  We used this
approach to identify sole proprietor compliance issues during our
review.  We believe that IRS could use the same approach to develop a
more comprehensive sole proprietor compliance program. 

Our analysis illustrates how TCMP workpapers can help to identify
possible causes for specific noncompliance.  In analyzing TCMP
workpapers, we identified two sole proprietor noncompliance
issues--books and records for truckers and insurance company
compliance with information reporting requirements.  IRS could
improve compliance in the two industries by pursuing these issues. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :8

We recommend that the Commissioner of Internal Revenue take the
following actions: 

  Develop a system for managing and monitoring all sole proprietor
     compliance projects, linking them to IRS-wide plans, and
     disseminating their results throughout IRS. 

  Use existing TCMP information, including workpapers, to help
     identify projects that would address the most noncompliant sole
     proprietor market segments on a nationwide basis and analyze the
     underlying causes of noncompliance. 

  Work with trucking industry groups to improve record keeping and
     with other sectors where TCMP indicates that record keeping may
     be a problem. 

  Clarify information return filing instructions for insurance
     companies and work with these companies to improve compliance
     with information reporting requirements. 


   IRS COMMENTS AND OUR EVALUATION
------------------------------------------------------------ Letter :9

In a June 13, 1994, letter, the Commissioner of Internal Revenue
commented on our recommendations.  This section summarizes these
comments and our evaluation of them.  IRS' comments are reproduced in
appendix IV. 

First, IRS pointed to efforts that address our recommendation on
developing a system for managing and monitoring sole proprietor
compliance projects.  IRS said it has produced the Business Master
Plan (BMP), which links IRS' strategic objectives and business vision
with tactical actions needed to accomplish them, including actions to
improve sole proprietor compliance.  IRS said its compliance research
and analysis system, under development through fiscal year 1997, will
be the driving force behind compliance and enforcement activities. 

We strongly support IRS' expanded use of planning and research to
identify and correct noncompliance.  Our concern still centers on
linking specific compliance actions such as IGPs to broad plans such
as BMP.  In reviewing the BMP, we did find broad linkages between
general actions and performance goals.  For example, BMP cites the
action of developing a strategy to improve compliance among cash and
privately owned businesses.  However, the BMP has no specific
references to IGPs and other actions for improving compliance among
sole proprietors.  Without such specific linkages, IRS cannot tell
how efforts such as IGPs or projects coming from the new research
efforts advance the objectives in the plans.  Because the BMP deals
with general actions and goals, making these specific linkages at
some level below the BMP could meet the intent of our recommendation. 

Also, we believe that IRS should develop a system to monitor
compliance actions such as IGPs.  Although such a system would cost
some money, it could save resources by identifying unneeded
duplication among the 1,162 IGPs.  It also could identify audit
techniques to apply across districts, allowing IGP resources to be
used more efficiently. 

For our second recommendation on using TCMP data and workpapers to
identify projects that address the most noncompliant sole
proprietors, IRS pointed to plans to use TCMP data.  IRS said its
National and District Office Research and Analysis staffs will use
TCMP and other data to identify and profile market segments that
represent 25 percent of all cash and privately owned businesses.  IRS
also noted that it will use TCMP data to develop strategies to
address noncompliance and improve compliance among these market
segments and businesses. 

We are encouraged that IRS' research staffs will use TCMP data.  On
the basis of discussions with IRS Examination officials, we now focus
our recommendation on using TCMP data at the national level.  IRS
districts could use such results to help craft compliance projects
for noncompliant market segments. 

However, IRS' letter did not indicate whether it would use either the
existing TCMP data or the TCMP workpapers.  We believe IRS should use
both.  Because the new TCMP for 1994 will not be completed until late
1998 according to BMP, existing TCMP data offer the best objective
compliance data.  Also, we found that analyzing samples of TCMP
workpapers can help uncover possible causes of sole proprietor
noncompliance.  In developing ways to automate the new TCMP data, IRS
may wish to consider including information from the TCMP workpapers. 
Such automation could increase IRS' ability to access available
information for identifying and understanding the causes of
noncompliance. 

IRS disagreed with our recommendation to work with the trucking
industry on problems with books and records.  IRS said various stores
and libraries already offer information on keeping books and records. 
Although these sources also offered such information prior to the
1988 TCMP, this TCMP showed that truckers did not have adequate books
and records.  IRS also stated that such information and assistance
was often available from paid preparers.  Even so, the TCMP data
showed that sole proprietors using paid preparers other than
certified public accountants were less compliant than those preparing
their own returns. 

IRS also said it would be difficult to create prototype books and
records for every industry.  We agree.  As a result, we recommended
working with the trucking industry and other industries if available
data pointed to a problem with keeping books and records.  Our work
identified this problem among truckers and a willingness among
trucking industry officials to work with IRS on solutions.  We
refined our recommendation to emphasize working with industry
officials.  IRS' letter referred to a similar approach.  IRS said if
an industry had unique recordkeeping issues, it would use a
Compliance 2000 approach in working with that industry.  We believe
that our recommendation mirrors this approach. 

IRS agreed with our recommendation to clarify information reporting
requirements for insurance companies making payments to automobile
body shops.  IRS noted that the instructions need to be clarified and
insurance companies need to be made aware of the information
reporting requirements. 


---------------------------------------------------------- Letter :9.1

As agreed with the Committee, unless you publicly release its
contents earlier, we plan no further distribution of this report
until 30 days from the date of this letter.  At that time, we will
send copies of this report to the Secretary of the Treasury, the
Commissioner of Internal Revenue, and other interested parties.  We
also will make copies available to others upon request. 

This report was prepared under the supervision of Natwar M.  Gandhi,
Associate Director.  Major contributors to the report are listed in
appendix V.  If you have any questions, please contact me at (202)
512-5407.


Jennie S.  Stathis
Director, Tax Policy
 and Administration Issues


STATISTICAL SAMPLING METHODOLOGY
AND PRECISION OF ESTIMATES
=========================================================== Appendix I

This appendix describes the statistical sampling methodology we used
to identify reasons for noncompliance among truckers and how we
estimated the amount of casualty payments by insurance companies that
were reported to IRS on information returns.  We analyzed our sample
data to determine the cause of noncompliance among truckers and
projected these results to the total population of truckers
represented by TCMP.  We also analyzed a sample of information
returns prepared by insurance companies to determine the extent to
which the selected insurance companies had reported auto-related
casualty payments to IRS. 

The statistical estimates in the report are point estimates that are
weighted to account for strata size.  Point estimates alone are not
adequate representations of statistical results because statistical
estimates correspond to range estimates, referred to as the precision
of the estimates, stated at a 95 percent confidence level.  The
narrower a confidence interval, the more reliable a point estimate
becomes as being representative of the population.  The precision of
estimates varies with sample size, variability of sample
observations, and the characteristics of the sampling process. 


   STATISTICAL ESTIMATES ON
   REASONS FOR NONCOMPLIANCE AMONG
   TRUCKERS
--------------------------------------------------------- Appendix I:1

The data we used came from IRS' 1988 Individual TCMP database and the
Examination workpapers associated with these files.  The TCMP file is
a stratified, nationwide IRS sample that included 54,095 tax returns
in 32 strata.  The IRS strata are defined by taxpayer income and type
of return filed.  IRS staff audited each tax return selected for the
TCMP sample to determine whether the correct taxes had been computed. 

We focused on the 17,048 TCMP sample returns that involved a Schedule
C for reporting income from a sole proprietorship.  As part of our
survey, we looked at TCMP audit results for a sample of tax returns
from the 10 least compliant types of sole proprietors as indicated by
the 1988 TCMP sample.  We defined least compliant as those sole
proprietors on whose returns the TCMP audits identified the (1)
greatest amounts of underreported net Schedule C income and (2)
largest percentage of underreported Schedule C net income.  On the
basis of our review of TCMP workpapers for this sample, we identified
several issues, including indications that certain types of sole
proprietors, such as truckers, appeared to have problems maintaining
adequate books and records. 

On the basis of our survey results, we focused on the 517 returns
from truckers that involved 25 of the 32 TCMP strata.  By eliminating
strata that had fewer than 3 returns, we were left with 510 trucker
returns in 19 strata.  The remaining sample cases represent about 91
percent of the nationwide population of truckers.  From these 510
returns, we randomly selected a subsample of 207 tax returns,
including (1) all returns in strata with 5 or fewer returns; and (2)
5 returns, or 30 percent of the returns, whichever is greater, from
each strata with more than 5 returns.  We were able to obtain and
review the workpapers for 190 of the sampled returns.  Of the 17
returns not reviewed, 2 did not involve a trucker because the auditor
had miscoded the industry type.  IRS could not provide workpapers for
the other 15 sampled returns. 

For the 190 tax returns, we analyzed the reasons for noncompliance by
reviewing TCMP data and the workpapers.  On the basis of these 190
tax returns, we analyzed a population of an estimated 251,836 tax
returns.  Table I.1 presents point estimates and confidence intervals
for estimates on variables involving the reasons for noncompliance in
the trucking industry. 



                          Table I.1
           
            Reasons for Noncompliance by Truckers


                                  Percent of
                               returns where
                                    variable   Lower   Upper
Reason for noncompliance            occurred   limit   limit
----------------------------  --------------  ------  ------
Apparently intentional tax              17.0    10.0    24.1
 avoidance
Books and records                       66.3    55.1    77.5
Problem caused by paid                  33.7    25.3    42.2
 preparer error
Technical issues                        10.4     5.3    15.6
Other or unknown                        15.8     9.1    22.7
------------------------------------------------------------
Source:  Random sample taken from IRS' 1988 TCMP database


   STATISTICAL ESTIMATES OF
   CASUALTY PAYMENTS BY INSURANCE
   COMPANIES
--------------------------------------------------------- Appendix I:2

On the basis of our review of TCMP workpapers, we were concerned that
insurance companies were not filing information returns to report
payments made directly to automobile body shops.  To determine how
often insurance companies were filing information returns with IRS,
we obtained information returns data for a judgmental sample of 10
insurance companies from those listed in IRS' Statistics of Income
database.  The 10 companies were selected because of their size and
location and because they had made payments for automobile damage
claims.  The information returns data consisted of transcripts, with
each page containing four information return entries.  The
transcripts showed information on the payor, the payee, and the type
and amount of the payment. 

For seven of the insurance companies, we reviewed all the information
return data provided by IRS.  Given the amount of data (over 95,000
pages), we selected a simple random sample from the remaining 3
companies and estimated the total amount paid.  To select the sample,
we first determined the number of pages that had relevant information
return data.  Starting from a randomly selected page, we selected a
sample of these pages.  Table I.2 provides information on this sample
selection for the three companies. 



                          Table I.2
           
           Estimated Amount of Payments Reported to
                  IRS by Insurance Companies


                       Estimated
                        payments
            Sample   reported to           Low          High
Company       size           IRS      estimate      estimate
----------  ------  ------------  ------------  ------------
1              447  $ 99,844,661  $ 98,606,587  $101,082,734
2              539   763,289,000   757,030,030   769,547,969
3              523   247,895,868   244,970,696   250,821,039
------------------------------------------------------------
Source:  IRS' Information Returns Master File. 


      STATISTICAL INFORMATION FOR
      ESTIMATES
------------------------------------------------------- Appendix I:2.1

Table I.3 and I.4 provide various statistical information on
estimates we cite in the report. 



                          Table I.3
           
            Statistical Information for Number and
                       Dollar Estimates

                    (Dollars in thousands)


                               Point       Lower       Upper
Description                 estimate       limit       limit
----------------------  ------------  ----------  ----------
Number of Schedule C     $13,417,055  $13,154,08  $13,680,02
 filers                                        1           9
Total taxpayers          104,345,615  104,338,50  104,352,72
                                               1           9
Sole proprietor            1,814,775   1,556,895   2,072,655
 nonfilers\
Underreported income    $39,042,552.  $37,052,94  $41,032,16
 for sole proprietors              3         3.9         0.8
Sole proprietors with        750,924     597,017     904,831
 no Schedule C
Number of sole             8,674,371   8,386,180   8,962,563
 proprietors who
 underreported income
Average amount of             $4.768      $4.565      $4.856
 understated income
Number of sole             1,400,231   1,272,940   1,527,521
 proprietors
 overstating income
Average amount of             $1.656      $3.722      $1.365
 overstated income
Underreported total      $98,722,878  $96,787,91  $100,657,8
 income for all                                0          47
 taxpayers
Number of taxpayers       34,352,258  33,628,362  35,076,154
 who underreported
 income
------------------------------------------------------------
Source:  IRS' 1988 TCMP databases for filers and nonfilers. 



                          Table I.4
           
            Statistical Information for Percentage
                          Estimates


                                       Point   Lower   Upper
Description                         estimate   limit   limit
--------------------------------  ----------  ------  ------
Reporting rate for sole                 75.2    71.4    79.1
 proprietor net income
Sole proprietor underreported           39.6    37.5    41.6
 net income as a percent of
 underreported total income
Voluntary reporting percent for         98.0    93.0   103.0
 nonbusiness total income
Percent of noncompliant sole            64.6    61.3    67.9
 proprietors
Sole proprietors as a percent of        12.9    12.6    13.1
 the population
Percent of all taxpayers who            32.9    30.8    35.0
 underreported income
------------------------------------------------------------
Source:  IRS' 1988 TCMP database for filers. 


CHARACTERISTICS OF SOLE PROPRIETOR
COMPLIANCE
========================================================== Appendix II



                                    Table II.1
                     
                        Reporting Rate by Primary Business
                     Activity--With at Least 100 Observations

                        (Understated net income dollars in
                                    millions)

                                         Percent                  Sampling error
                                  sampling error   Dollar amount      for income
Primary business  Reporting rate        (plus or  of understated        (plus or
activity             (percent)\a        minus)\b     net income\        minus)\b
----------------  --------------  --------------  --------------  --------------
Antique dealers             32.7            67.3           $93.1           $46.3
Eating places               39.2            21.7         1,309.6           363.5
Grocery stores              45.9            16.6           711.5           191.9
Used car dealers            50.4            40.4           386.5           220.4
General auto                55.2            16.2           605.5           199.0
 repairs
Lumber and wool             56.5            17.3           505.5           202.1
 products
Door to door                57.3            18.8           586.3           156.3
 sales
Sales--                     58.3            23.9           516.3           322.3
 nondurable
 goods
Specialty auto              59.2            15.5           509.4           151.7
 repairs\c
Landscaping                 60.8            18.8           471.1           161.5
Other retail                61.5            32.2           478.9           151.2
 stores
Plumbing,                   63.6            15.4           720.5           281.1
 heating, and
 air
 conditioning
Other building              64.3            13.0           987.3           261.7
 trades
Trucking                    64.5            12.9         1,568.5           367.3
Painting                    64.6            12.8           771.2           304.7
Residential                 65.8            13.6         1,118.0           401.0
 building
Performers                  66.1            31.8           420.2           156.2
Other personal              66.3            14.1         1,083.1           265.2
 services
Unable to                   66.9            32.6           454.4           263.9
 classify
Janitorial                  67.4            13.8           627.6           210.0
Service stations            68.6            26.2           417.8           149.7
Roofing                     69.1            22.4           380.5           132.3
Sales--durable              69.4            22.7           706.7           496.2
 goods
Child day care              70.1            26.7           321.2           112.8
Carpentry                   71.2             9.1         1,572.4           323.7
Other equipment             71.9            22.5           277.7           116.8
 repair
Other                       72.1            40.9           154.9            61.5
 recreational
 services
Electrician                 72.1            21.7           415.9           151.6
Masonry                     73.1            17.0           642.8           187.5
Beauty shop                 76.9            14.8           432.9           128.9
Other business              77.0            12.5         2,017.9           475.8
 services
Other real                  79.3            21.3           521.4           265.4
 estate
Teaching                    80.7            31.8           198.0            78.6
Realtors                    82.1            11.9         1,404.5           274.2
Computer/data               83.3            31.8           234.1           111.7
 processing
Engineering                 83.9            19.6           549.3           259.6
Agent--durable              85.9            18.8           387.3           171.0
 goods
Insurance                   86.7            13.6           762.0           256.1
Management                  87.8            16.7           771.6           290.2
 consulting
Ministers                   88.7            17.7           229.8           112.3
Other health                88.7            22.5           235.7            85.1
 services
Accounting                  89.9            22.2           238.8            84.6
Attorneys                   90.7            19.1           751.5           290.0
Dentists                    92.1            16.7           321.3            98.5
Oil and gas                 93.8            93.8           158.9            99.8
Doctors                     95.0            15.1           602.9           333.3
All Schedule C              75.3             \\d     $39,042,535        $1,820.7
 filers
--------------------------------------------------------------------------------
\a The reporting rate is the reported net business income as percent
of net business income found by the IRS auditor. 

\b Sampling errors calculated at the 95-percent confidence level. 

\c Includes automobile body repair shops. 

\d Not available; sampling error not calculated for total population. 

Source:  1988 TCMP database. 



                          Table II.2
           
             Amount of Understated Net Income for
                Noncompliant Sole Proprietors


Amount of
understated net       Number of sole       Lower       Upper
income                 proprietors\a       limit       limit
--------------------  --------------  ----------  ----------
$1 to $500                 2,330,758   2,148,873   2,512,643
$501 to $1,000             1,086,032     968,329   1,203,735
$1,001 to 5,000            3,204,854   3,024,114   3,385,595
$5,001 to $10,000            980,150     898,404   1,061,895
Over $10,000               1,072,578     998,468   1,146,687
============================================================
Total                      8,674,372   8,600,372   8,748,372
------------------------------------------------------------
\a The remaining 4,757,999 sole proprietors had either no changes on
their Schedule C or overstated their net income. 

Source:  1988 TCMP database. 



                          Table II.3
           
            Reasons Given by IRS Examiners for the
            Primary Type of Noncompliance by Sole
                         Proprietors

                                            Sampling
                                               error  Percen
                                             returns       t
                             Number of      (plus or      of
Reason for noncompliance       returns        minus)   total
--------------------------  ----------  ------------  ------
Lack of substantiation       1,582,896       133,123    27.5
Wrong accounting or          1,253,694       103,855    21.8
 computation procedures
Tax preparer error           1,119,726       106,658    19.4
Lacked tax law knowledge     1,022,246       114,572    17.7
Multiple interpretations       316,289        53,606     5.5
 possible
Some other reason              448,578        76,597     7.8
============================================================
Total changes without       5,743,429\            \b  100.0\
 penalty                             a
------------------------------------------------------------
\a The remaining 7,686,403 sole proprietors had either no changes on
their tax returns or were assessed penalties. 

\b Not available, sampling error not calculated for total percent. 

Source:  1988 TCMP database. 



                          Table II.4
           
            Comparison of Sole Proprietor Returns
           With and Without Increases in Net Income
                  Resulting From TCMP Audits

Description                      Compliant\a  Noncompliant\a
------------------------------  ------------  --------------
Average gross receipts               $28,425         $55,892
Sampling error (plus or minus)         3,154           1,484
Average net income                     7,388          14,180
Sampling error (plus or minus)         1,257             414
Average Schedule C income as a         16.7%           33.9%
 percent of adjusted gross
 income
Sampling error (plus or minus)          0.6%            0.5%
------------------------------------------------------------
\a Compliant taxpayers are those whose reported Schedule C net income
was equal to or greater than that found by IRS during the TCMP
audits.  Noncompliant taxpayers are those whose net income was less
than that found by IRS. 

Source:  1988 TCMP database. 



                                    Table II.5
                     
                         Estimate of Voluntary Reporting
                         Percentage and Dollar Amount of
                      Noncompliance for Selected Schedule C
                                    Line Items

                                                                  Sampling error
                       Voluntary  Sampling error                      in dollars
                       reporting   percent (plus     Understated        (plus or
Line item              percent\a     or minus)\b   dollar amount          minus)
----------------  --------------  --------------  --------------  --------------
Gross income                94.6             3.0         $19,931         $16,087
Deductions
Advertising                107.3             6.3             352             435
Bad debts                  145.1            37.0             194             198
Bank charges               113.0            16.6              81              81
Car and truck              118.3             4.2           2,650             827
 expenses
Commissions                103.9            16.1             245           1,498
Depletion                   99.7            58.6             (1)             395
Depreciation               108.8             4.7           1,869           1,350
Dues and                   112.6             5.7             232             141
 publications
Employee benefit           114.5            31.4              82             236
 programs
Freight                    102.3            40.1              28             666
Insurance                  115.0             4.1           1,525             547
Mortgage                   110.0            14.0             431             819
 interest
Other interest             109.6            15.6             507           1,169
Laundry and                127.8            13.2             197             127
 cleaning
Legal and                  117.7             8.7             638             420
 professional
Office expenses            113.6             5.8             587             332
Pension and                108.5            42.5              34             236
 profit sharing
 plans
Rent                       107.3             4.6           1,103           1,001
Repairs                    114.9             6.3             946             546
Supplies                   109.9             6.5             828             733
Taxes                      104.5             7.2             377             833
Travel                     126.8             8.7             800             349
Meals and                  129.3             8.2             739             279
 entertainment
Utilities                  110.0             3.5           1,157             106
Wages                      100.1             6.4              30           3,565
Jobs credit                 82.1            64.4             (3)              16
Other expenses\c           108.7             9.1           3,406           4,932
Net profit or               75.2             3.8          39,043           8,634
 loss
--------------------------------------------------------------------------------
\a Voluntary reporting percent equals amounts reported on tax returns
divided by amounts that should have been reported.  Deductions have
been overstated (i.e., noncompliance) if this percentage exceeds 100
percent. 

\b Sampling errors are computed at the 95-percent confidence
interval. 

\c The TCMP database did not identify what "other" included. 

Source:  IRS' 1988 TCMP database. 


IRS' EMERGING COMPLIANCE
STRATEGIES
========================================================= Appendix III

IRS is currently revising some of its compliance systems and
processes, taking advantage of the capabilities that will be
available as TSM is completed.  Examples include developing a
Compliance Research Information System (CRIS), a new TCMP, and a
program to develop specialized market segment audit skills.  These
projects have not yet been fully implemented, so we could not
determine how they would affect sole proprietor compliance. 


   COMPLIANCE RESEARCH INFORMATION
   SYSTEM
------------------------------------------------------- Appendix III:1

Under TSM, IRS is designing CRIS--an information system for
researching and analyzing compliance.  IRS will attempt to use CRIS
to

  gather data for identifying noncompliance by market segment,

  analyze data to determine underlying causes of noncompliance,

  develop baseline measures of compliance, and

  track results of compliance strategies. 

According to IRS officials, this system will be completed by fiscal
year 1996.  Thereafter, IRS will annually pull a sample of 7 to 10
million taxpayer accounts from its masterfile to identify and profile
market segments, recommend actions to improve voluntary compliance,
and update workload selection and management systems. 

Information from CRIS will be available to each of IRS' District
Office Research and Analysis (DORA) sites.  As part of CRIS, each
DORA site will have access to hardware and software for use in
measuring compliance at the local level. 


   TAXPAYER COMPLIANCE MEASUREMENT
   PROGRAM
------------------------------------------------------- Appendix III:2

IRS is planning major changes in the TCMP.  TCMP consists of
comprehensive audits of a randomly selected sample of tax returns. 
Traditionally, each TCMP focused on a single type of return.  IRS
grouped returns for individuals into 10 exam classes based on the
type of return (Forms 1040, 1040 Schedule C, or 1040 Schedule F) and
the income level of the taxpayer. 

The new TCMP will examine all types of returns, including individual,
partnership, small corporation, and subchapter S corporations. 
Returns will be divided into 30 market segments that are mutually
exclusive and comprehensive across all types of returns.  For
example, market segments focusing on businesses could include Forms
1040 Schedule C, as well as Forms 1120, 1120S, and 1065.  IRS will
use these data to build and meet the objectives of its new CRIS. 


   MARKET SEGMENT SPECIALIZATION
   PROGRAM
------------------------------------------------------- Appendix III:3

The Market Segment Specialization Program (MSSP) is an Examination
program created under the umbrella of Compliance 2000.  Market
segment specialization calls for increasing the level of expertise of
examiners by setting up teams to conduct an in-depth study of a
particular market segment, such as an industry or profession.  The
knowledge gained from these audits will be used to develop written
guidelines specific to the business environment.  Currently, IRS has
audit guides available in about 15 industries and has projects under
way in more than 60 others.  Examiners nationwide will participate in
MSSP by becoming market segment specialists or by using audit guides
prepared by others.  IRS plans to use market segment specialization
to examine returns in the new TCMP. 




(See figure in printed edition.)Appendix IV
COMMENTS FROM THE INTERNAL REVENUE
SERVICE
========================================================= Appendix III



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix V

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Al Stapleton, Assistant Director, Tax Policy and Administration
Issues
Tom Short, Assistant Director

SAN FRANCISCO REGIONAL OFFICE

Ralph Block, Assistant Director
Lou Roberts, Evaluator-in-Charge
Susan Malone, Evaluator
Samuel H.  Scrutchins, Technical Advisor
Eduardo N.  Luna, Evaluator
Hans Bredtfeldt, Operations Research
 Specialist

