Are we a nation of tax cheats? Duh. But if a recent report by the Government Accountability Office ("the investigating arm of Congress") is to be believed, small firms are particularly mendacious. In a study prepared at the behest of the Senate Finance Committee, the GAO found "at least 61 percent of sole proprietors underreported their net income by $93.6 billion in 2001." All told, American smallest businesses rounded down to the tune of $68 billion, which amounted to about a fifth of the total U.S. "tax gap" of $345 billion. For comparison, note that sole proprietors collected under five percent of total U.S. business receipts.
Of course, some lies were worse than others. A variant of the 80-20 rule applies here: the boldest ten percent—those whose "tax understatements" exceeded $6,200—accounted for 61 percent of lost revenue to the Treasury. According to IRS research, a tax cheat was nearly twice as likely to inflate expenses than to deflate gross income (though, interestingly, gross income "errors" cost the Treasury more money). The majority of inflated expenses resided in just four categories: car and truck expenses, depreciation, supplies, and the extremely flexible "other." So when you tell the IRS that 90 percent of the driving you do in that leased LS 460 is for business, know that the IRS is on to you.
Also maybe winking at you. The methods for finding underreported income are limited and often time-consuming. The IRS has automatic program to find discrepancies between information on a tax return and other forms, and contacts hundreds of thousands of taxpayers a year, typically recommending additional assessments in the range of $600-$700 million. But the GAO report notes that "because of resource constraints, IRS officials said they do not contact taxpayers in all cases" where they find a discrepancy. Moreover, most IRS examinations are done by correspondence, but, as the report notes, "Schedule C tax issues typically must be addressed in field examinations," which on average take about 20 hours. Finally, the IRS appears reluctant to slap violators with a negligence penalty, although a sole proprietor is more likely to get hit than other taxpayers.
The report included several options for narrowing the small business tax gap, but they face an uncertain future. The Treasury Department released what it called A Comprehensive Strategy for Reducing the Tax Gap last September, but the GAO found that at least in one area, it was not comprehensive at all. The strategy, the GAO says, "does not discuss sole proprietor noncompliance or specific options to address it."
The GAO study, which I first found at Paul L. Caron's TaxProf Blog is available through the GAO website as a PDF download.