Of this  amount, IRS estimates that $68 billion is caused by sole proprietors  underreporting their net business income, which can stem from either  understated receipts or overstated expenses. Most Sole Proprietors with Losses Deducted Them against Other Categories of Income

As shown in figure 4, of the 5.4 million sole proprietors with losses in 2006,  92 percent deducted all of their reported losses from other categories of  income, while 5 percent were unable to deduct any of the losses. In terms of aggregate dollars, based on NRP results, about $15 billion of  the $28 billion in losses reported in 2001, or about 53 percent, were  noncompliant. IRS’s Examination Program and AUR Are Able to Address Only a Small Portion of Sole Proprietor Expense Noncompliance

During fiscal year 2008, IRS used about 2.8 million staff hours to examine  sole proprietor returns, about 23 percent of all revenue agent direct  examination time. One major reason that little information reporting on sole proprietor  expenses exists is because of the difficulty of identifying third-party  payees upon whom a reporting requirement could be enforced without  undue burden on both the third parties and IRS. A rule limiting deductions for sole proprietor losses would also reduce  IRS’s costs. A rule could limit the ability to deduct sole proprietor losses  deductions from other, non-sole proprietor income. Further, while 53  percent of the dollars of sole proprietor losses in 2001 were noncompliant,  55 percent of the dollars that would have been affected by a $3,000 limit  were noncompliant losses. A  significant proportion of sole proprietors who reported losses could avail  themselves of a carry forward or back rule, but analysis of IRS data  showed that these sole proprietors were not less likely to be  noncompliant. Without adding this code to RGS, IRS  cannot use the NRP sample to estimate the extent of noncompliance with  the activities not engaged in for profit and the extent to which such  improper losses contribute to noncompliant sole proprietor losses. Conclusions

The large number of relatively small sole proprietorships limits IRS’s  opportunity to ensure their compliance through its regular compliance  programs. IRS’s Enforcement Programs

We used several data sources to analyze the extent to which IRS’s  enforcement programs address the types of sole proprietor  noncompliance found by IRS’s most recent research. Losses have  been limited for several reasons, including preventing tax avoidance,  reducing noncompliance, restricting deductibility of losses against other  sources of income to reduce tax shelters, and disallowing personal  expenses or losses that are not related to the production of income (such  as activities not engaged in for profit or the loss of value on the disposition  of personal property, including residences). Several current tax rules limit losses to increase equity and reduce tax  shelters and noncompliance.
Why GAO Did This Study

Sole proprietors, who own unincorporated businesses by themselves, underreported their net income by 57 percent or $68 billion for 2001, according to the Internal Revenue Service's (IRS) most recent estimate. The underreporting includes both understated receipts and overstated expenses and may result in losses that can be deducted against income from other sources, such as wages. GAO was asked to (1) describe sole proprietor losses and the extent to which the losses are noncompliant, (2) assess how well IRS addresses the noncompliance, and (3) identify any options to better limit noncompliant losses. To meet its objectives, GAO analyzed IRS research databases, case files, and examination results data and met with IRS officials.

What GAO Found

About 5.4 million or 25 percent of all sole proprietors reported losses in 2006. Ninety-five percent of these loss filers deducted some or all of their losses against other income, deducting a total of $40 billion. According to IRS estimates last made for 2001, 70 percent of the sole proprietor tax returns reporting losses had losses that were either fully or partially noncompliant. About 53 percent of aggregate dollar losses reported in 2001 were noncompliant. This noncompliance would correspond to billions of dollars of lost tax revenue. IRS's compliance programs address only a small portion of sole proprietor expense noncompliance. Despite investing nearly a quarter of all revenue agent time in 2008, IRS was able to examine (audit) about 1 percent of estimated noncompliant sole proprietors. These exams are costly and yielded less revenue than exams of other categories of taxpayers, in part because sole proprietorships are small in terms of receipts. Another enforcement program that primarily uses third-party information to electronically verify compliance is not effective because little expense information is reported by third parties. One approach for limiting sole proprietor loss noncompliance would impose a rule that limits losses that could be deducted from other income. The tax code has a number of such limitations. A loss limitation could reduce noncompliant losses but would also limit the ability of sole proprietors to claim legitimate losses. Another approach would improve IRS's estimates of the extent to which activities not engaged in for profit, such as hobbies, are contributing to noncompliant sole proprietor losses. Expenses associated with these activities are not deductible, but IRS's research on the causes of sole proprietor noncompliance has not used available data to estimate the extent of this type of noncompliance. Without such an estimate, IRS could be missing an opportunity to reduce noncompliant sole proprietor losses.