IRS Targets Small-Business Owners

The Internal Revenue Service is exploring several new approaches to make businesses pay up.

March 14, 2006--In an effort to collect more of the money that is actually owed by taxpayers, the IRS is targeting one group it identifies as particularly problematic -- small-business owners.

Some of the new tactics being discussed in Washington include seeking third-party reporting from credit-card companies and changing requirements for independent contractors.

The IRS estimated in January that the gross 2001 federal tax gap -- the difference between taxes owed and taxes paid -- was about $345 billion ($290 billion after late payments and enforcement efforts). In the first study the IRS has conducted on the subject since 1988, small business appeared to be one of the main culprits. Despite an overall compliance rate of 82%, individual taxpayers only reported an estimated 57% of business income.

Earlier this year, President Bush announced strategies for reducing the tax gap in his 2007 budget proposal.

In order to strengthen enforcement, Bush calls for a $137 million increase in the IRS’s $47.3 billion budget. Of the $6.6 billion currently spent on enforcement, 41% goes to small business, compared to 17% spent on large corporations and 11% spent on criminal activity.

A further measure would require third-party reporting from credit-card companies, compelling them to report the receipts of small businesses. The IRS study found that compliance rates are as high as 96% when third-party reporting is involved. But critics question whether the potentially onerous third-party reporting is worth it -- reported estimates only predict a $3.6 billion reduction over 10 years.

Another approach is through tax withholding. Wage earners, whose taxes are withheld, have a 99% compliance rate. “The IRS should devote more effort to studying the causes of noncompliance,?? said Nina Olson, the IRS’s National Taxpayer Advocate, pointing to the difficulty those exempt from withholding have when it comes to saving money to for taxes.

In a Feb. 15 statement to the Senate Budget Committee, Olson proposed monthly debiting of checking accounts to help self-employed people stay on track and lessen the need to save up for Tax Day.

Olson also suggested special requirements for historically noncompliant taxpayers and stricter reporting requirements for small corporations. “Under current law, an individual taxpayer can escape information reporting by incorporating,?? she said. “For [miscellaneous income] reporting, there should be no distinction between taxpayers merely because one has incorporated and another has not.?? Olson pointed to Form 1099-MISC requirements for incorporated taxpayers with 50 or fewer shareholders.

Stricter reporting requirements, however, could put a strain on small businesses with limited resources for hiring payroll processors, attorneys, and accountants.

Another possible reform entails placing withholding requirements on independent contractors -- the sometimes-blurry distinction between employees (who have their taxes withheld) and independent contractors (who do not) contributes significantly to what Olson calls the “cash economy?? of unreported payments.

However, Giovanni Coratolo, director of small business policy for the U.S. Chamber of Commerce, warned that “the danger there is withholding beyond their margins of profit,?? tying up cash flow essential to the operation of their businesses. “Small businesses tend to be undercapitalized, and this would be taking away even more,?? he said.

“Some of these proposals would have horrendous effects for small business,?? Coratolo added. Although he sympathizes with what Congress is trying to do, he maintained that “the burden shouldn’t be on the backs of small business.??

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