	Background

Sole proprietors own unincorporated businesses by themselves. Most Sole Proprietors Underreported Business Income, but a Small Proportion Accounted for the Bulk of Unpaid Taxes

The significant amount of sole proprietor noncompliance reported in IRS’s  tax gap estimates is caused by underreporting of net business income,  including the misreporting of both gross business income and expenses. These NRP results showed that an  estimated 61 percent of Schedule C filers underreported their net income  and 9 percent overreported. After these adjustments, IRS estimates that sole proprietors misreported  57 percent of their net business income in 2001 and that the tax gap caused  by this misreporting of sole proprietor net business income in 2001 was  $68 billion. Taxpayers misreport income and expenses for a variety of reasons. The taxpayer should not  have filed a Schedule C.

		Although a Small Proportion of Sole Proprietors, More Than 1 Million Accounted for the Majority of Understated Taxes

Understated taxes are spread unevenly among the population of sole  proprietors, and slightly more than 1 million sole proprietors accounted  for most of the understatements. Enforcement Programs Have Limited Reach over Sole Proprietors but Still Make Billions of Dollars in Recommended Assessments

IRS’s two main programs for addressing sole proprietor reporting  compliance— AUR and Examination—have limited reach over  noncompliant sole proprietors, although they annually contact hundreds  of thousands of taxpayers and recommend billions of dollars in  assessments. AUR Is Limited by a Lack of Resources, Expense Matching, and Examination Authority

Because of resource constraints, IRS officials said they do not contact  taxpayers in all cases where AUR finds a mismatch between what was  reported on an information return and what was reported on a tax return. Second, third-party information generally is not required on  sole proprietor expenses. In fiscal year 2006, IRS examined  about 3 percent of the Schedule C categorized returns. Current Treasury Tax Gap Strategy Discusses Neither Sole Proprietor Noncompliance nor the Many Options That Could Address It

The tax gap strategy issued by Treasury in September 2006 does not  discuss sole proprietor noncompliance or specific options to address it. IRS’s  annual budget requests include specific compliance program proposals. IRS has other compliance objectives in addition to sole  proprietor compliance. For example,  information reporting invariably imposes some costs on the third parties  required to report, but no objective criteria exist for assessing when third- party costs are excessive. Judgments would have to be made based on  qualitative information. Because underreporting is spread among  more than 12 million sole proprietors, much of it in small amounts,  because the underreporting is for both gross income and expenses, and  because IRS’s enforcement programs are limited and costly, the sole  proprietor tax gap cannot be closed by IRS enforcement alone. Key contributors to this report are listed in appendix VII. Appendix I: Scope and Methodology

To describe the nature and extent of the noncompliance associated with  sole proprietors, we analyzed the Internal Revenue Service’s (IRS)  National Research Program (NRP) results, tax gap estimates, and  Statistics of Income (SOI) data, and interviewed IRS officials. 2. 3. 6. 10. This option envisions new information reporting by organizations but also  by consumers. 18.
Why GAO Did This Study

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.

What GAO Found

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.