Tax Gap: A Strategy for Reducing the Gap Should Include Options for Addressing Sole Proprietor Noncompliance
Highlights
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.
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.
Recommendations
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Department of the Treasury | The Secretary of the Treasury should 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. |
As of February 2024, Treasury had taken no action to address this recommendation and had not provided GAO with plans to do so. To spur IRS action, we raised a matter in our October 2023 report (GAO-24-105281) for Congress to direct Treasury to implement this recommendation. In May 2021, Treasury officials said that the Administration's May 2021 plan to improve tax compliance and its budget proposal references compliance options that could affect sole proprietors. However, the May 2021 plan did not reference a strategy that includes a segment on improving sole proprietor compliance. Treasury officials pointed to their actions to address the tax gap, such as proposals for addressing the new reporting thresholds for 1099-Ks, adding financial information reporting, and increasing the accuracy of Taxpayer Identification Numbers. These officials said that they believe the proposals meet the definition of a strategy. They also stated that Treasury does not focus on sole proprietors because they often have similar compliance issues as other types of businesses, and proposals on the compliance of all taxpayers also address sole proprietor compliance. These officials did not provide documents to support these statements. GAO still believes that Treasury's actions are not part of a long term strategy to address sole proprietor noncompliance. In sum, Treasury's tax gap strategy does not cover sole proprietor compliance in detail while coordinating it with broader tax gap reduction efforts, as GAO recommended in July 2007. GAO maintains that without an overall strategy, Treasury has less assurance that IRS is using resources efficiently to promote sole proprietor compliance.
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