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Push to ‘Correct’ IRS Small Business Rule Ignores Tax-Gap Data

A year ago, Congress had instructed the Internal Revenue Service to improve small businesses’
compliance with tax laws and created rules to make it more difficult for entrepreneurs to hide their income.
Now, rules requiring businesses to report to the IRS transactions with vendors may become collateral damage in a political fight over the health-care law. President Barack Obama in his State of the Union address on Jan. 25, backed an effort to “correct” the “unnecessary bookkeeping burden” before the rules take effect in 2012, forgoing an estimated $1.9 billion annually to pay for the overhaul of the health-care system.
The about-face is designed to appease congressional Republicans and business groups such as the U.S. Chamber of Commerce that have criticized the rules along with the broader health-care law. It also shows how difficult it is to take steps to close the tax gap among small businesses, which data show have lower tax payment rates than corporations and salaried workers.
“Small businesses have an apple-pie quality and it’s difficult for elected officials to point to the rampant tax cheating that goes on,” said Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities, a Washington research group that often sides with Democrats. “As a group, sole proprietors pay taxes on less than half of their income because they don’t report half their income.”

Unpaid Taxes

The IRS estimates that about $345 billion in taxes owed are unpaid every year. Auditors recover about $55 billion of that, leaving $290 billion that goes uncollected, a figure known as the tax gap. The agency attributes $109 billion of the gap to underreported business income earned by individuals. The IRS estimates that this group also fails to pay about $39 billion in self-employment taxes.
The figures are drawn from a study of 2001 tax returns and are likely higher today, according to the Congressional Research Service.
The IRS says small businesses are able to underreport their taxes because many business-to-business transactions aren’t reported independently to the government as wages and investment income are. By contrast, about 98 percent of salaried workers pay what they owe because their employers report their wages to the IRS.
The Bush administration, in response to demands from Senate Finance Committee Chairman Max Baucus, a Montana Democrat, in
2008 proposed requiring businesses to report to the IRS when they pay vendors more than $600 for goods. Similar requirements exist for purchases of services.

Paperwork Burden

Baucus, who in 2007 called himself a “leader in efforts to close the $345 billion tax gap” in 2009 added the Bush administration proposal to Obama’s health legislation, which he was drafting. A year after enactment, the tax rule has been singled out for criticism by business groups.
“In an effort to make the health care-law appear ‘paid for,’ a number of provisions were included that do nothing to improve health care, but make it harder to run a business. The
1099 paperwork mandate is a great example,” Scott Womack, the owner of 12 Indiana and Ohio franchises of the International House of Pancakes Inc., told the House Ways and Means Committee last week.
Womack, whose 1099 reference relates to the IRS form used, testified on behalf of the U.S. Chamber of Commerce. IHOP is owned by Glendale, California-based DineEquity Inc.
The nonpartisan Congressional Research Service on Jan. 21 wrote that while there is “considerable uncertainty” about the costs businesses face to comply with the reporting rules, “the costs to businesses may be lower than many argue.”

Proposed Exemptions

For one thing, the CRS said, many businesses have infrastructure in place to comply with some of the related rules for reporting payments to vendors of services. The added costs of compliance would decline over time, the CRS said.
Also, the CRS noted, the IRS has proposed exempting transactions in which goods are purchased with a credit card or debit card. The Small Business Administration says small businesses make extensive use of such cards.
Still, the outcry has prompted Baucus to lead legislative efforts for a reversal. Efforts to undo the rule requirement failed in the Senate on procedural votes.
Baucus and Senate Majority Leader Harry Reid of Nevada have introduced a new bill to eliminate the requirement.
“We have heard small businesses loud and clear and are responding to their concerns,” Baucus said in a statement.
“Closing the tax gap is important, but so are small business owners in Montana and across the country,” Finance Committee Spokeswoman Erin Shields said.
Marr, of the CBPP, said the rush to kill the reporting rule hurts small businesses that comply with the law because they will pay more to offset the revenue lost to non-compliance.
“Wouldn’t an honest small business be better off having to file a few more forms but also knowing their competitors pay their taxes?” Marr said. “You wish honest people would speak up.”