Tax Gap
Limiting Sole Proprietor Loss Deductions Could Improve Compliance but Would Also Limit Some Legitimate Losses Gao ID: GAO-09-815 September 10, 2009Sole 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.
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.
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
September 2009:
Tax Gap:
Limiting Sole Proprietor Loss Deductions Could Improve Compliance but
Would Also Limit Some Legitimate Losses:
GAO-09-815:
GAO Highlights:
Highlights of GAO-09-815, a report to the Committee on Finance, U.S.
Senate.
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.
Figure: Percentage of Sole Proprietor Loss Returns Where Losses Were
Used to Offset Other Income and Percentage of Net Losses Used to Offset
Other Income, 2006:
[Refer to PDF for image: vertical bar graph]
Amount of loss reducing other income: None;
Sole proprietors: 5%;
Total losses offset: 0.
Amount of loss reducing other income: Some;
Sole proprietors: 3%;
Total losses offset: 5%.
Amount of loss reducing other income: All;
Sole proprietors: 92%;
Total losses offset: 78%.
Source: GAO analysis of 2006 cross-sectional SOI data.
[End of figure]
What GAO Recommends:
GAO recommends that IRS estimate the extent of sole proprietor not-for-
profit (hobby) activity noncompliance using its research data. GAO is
not recommending a loss limitation rule because the trade-off between
reducing noncompliant losses and allowing legitimate losses requires a
policy judgment.
In commenting on a draft of this report, IRS agreed to implement both
GAO recommendations.
View [hyperlink, http://www.gao.gov/products/GAO-09-815] or key
components. For more information, contact James R. White at (202) 512-
9110 or whitej@gao.gov.
[End of section]
Contents:
Letter:
Background:
Sole Proprietor Losses Are Substantial and Growing and Are a Compliance
Problem:
IRS's Examination Program and AUR Are Able to Address Only a Small
Portion of Sole Proprietor Expense Noncompliance:
A Loss Limitation Rule and Collecting Data on Not-for-Profit Activities
Could Help Address Expense Noncompliance, but a Limitation Rule Would
Also Adversely Affect Compliant Taxpayers:
Conclusions:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Examples of Current Income Tax Loss Limitation Rules for
Individual Taxpayers:
Appendix III: Comments from the Internal Revenue Service:
Appendix IV: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Estimated Percentage of Sole Proprietor Loss and Profit
Returns That Were Noncompliant, 2001:
Table 2: Selected Examples of Loss Limitation Rules for Individuals:
Figures:
Figure 1: Distribution of Sole Proprietor Returns and Their Net Profit
or Loss in 2006:
Figure 2: The Cumulative Percentage Change in Sole Proprietor Returns,
Net Profits, and Net Losses from 1998 through 2006:
Figure 3: Percentage of Sole Proprietor Returns in 2006 with Reported
Losses for Multiple Years from 1998 through 2006:
Figure 4: Percentage of Sole Proprietor Loss Returns Where Losses Were
Used to Offset Other Income and Percentage of Net Losses Used to Offset
Other Income, 2006:
Abbreviations:
AGI: adjusted gross income:
AUR: Automated Underreporter Program:
CDW: Compliance Data Warehouse:
EITC: Earned Income Tax Credit:
IMF: Individual Master File:
I.R.C.: Internal Revenue Code:
IRS: Internal Revenue Service:
NRP: National Research Program:
RGS: Report Generation Software:
SOI: Statistics of Income:
TIN: taxpayer identification number:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
September 10, 2009:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
The Internal Revenue Service's (IRS) most recent estimate of the
federal tax gap, for tax year 2001, is $345 billion. The gap is the
difference between what taxpayers should have paid and what they
actually paid on time. IRS also estimated that it would eventually
collect, through various enforcement efforts, about $55 billion of the
gap, leaving a net tax gap of $290 billion.
According to IRS, sole proprietors--persons who own unincorporated
businesses by themselves--are responsible for a large portion of the
tax gap. For 2001, IRS estimated that sole proprietors misreported 57
percent of their net business income and accounted for $68 billion of
the tax gap. A key reason for this misreporting 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.
We recently reported that sole proprietor tax returns included
substantial misreporting of both gross income and expenses. In that
report, we discussed the pros and cons of numerous options for reducing
the sole proprietor tax gap, including changes to record keeping, third-
party information reporting, relevant IRS compliance programs, and
IRS's use of resources.[Footnote 1]
Expressing your concern about the tax gap and business expense
misreporting, you asked us for additional information about sole
proprietors' expense noncompliance. Following up on our previous
report, we agreed to focus in this report on those sole proprietors
whose expenses were large enough to cause a net loss. Our objectives
were to (1) describe the population of sole proprietors who file
losses, their patterns of losses over time, and their level of
noncompliance; (2) assess whether IRS compliance programs are able to
correct a significant portion of sole proprietor expense and loss
noncompliance; and (3) identify what additional options are available
for IRS to close the tax gap for sole proprietor expenses and losses.
We used several approaches to analyze sole proprietor expense
noncompliance and to identify options for reducing this noncompliance.
Principally, we analyzed data from IRS's 2001 National Research Program
(NRP) to identify the extent of sole proprietor loss and expense
noncompliance. We also used IRS Statistics of Income (SOI) program data
to profile profits and losses for sole proprietors in 2006 and combined
these data with other IRS data to form panels of sole proprietor tax
returns from 1998 to 2006 in order to describe patterns of losses over
time. For estimates based on samples of taxpayers in this report, we
are 95 percent confident that the estimates are within 10 percent of
the population values for dollar amounts and counts and 3 percent of
population values for percentages, unless otherwise noted. We also
interviewed IRS officials on the operations and results of its
Examination and Automated Underreporter programs and reviewed case
files for a sample of examinations of sole proprietors filing losses
from the 2001 NRP, selected to reflect a range of income and
compliance.
We conducted this performance audit from July 2008 through September
2009 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit
to obtain sufficient, appropriate evidence to provide a reasonable
basis for our findings and conclusions based on our audit objectives.
We believe that the evidence obtained provides a reasonable basis for
our findings and conclusions based on our audit objectives. A more
detailed description of our methodology is in appendix I.
Background:
Sole proprietors are relatively numerous in terms of tax filers but
small as measured by receipts. In 2003, the most recent year for which
IRS data were available, sole proprietors constituted about 72 percent
of all businesses in the United States, while earning about 5 percent
of all business receipts. Sole proprietors engaged in a wide range of
businesses, including legal and consulting services, manufacturing, and
retail sales. A sole proprietor may engage in these activities full-or
part-time and the sole proprietorship may account for all or part of an
individual's income.
Sole proprietors report their business-related profit or loss on their
individual income tax returns--IRS Form 1040--through Schedule C,
Profit or Loss from Business. Schedule C requires sole proprietors to
report receipts and expenses to determine profits or losses. These
business profits or losses are combined with income, deductions, and
credits from other sources that are reported elsewhere on Form 1040 to
compute a taxpayer's overall individual tax liability. Thus, sole
proprietors who report losses on Schedule C can use their losses to
offset other categories of income on their returns, such as wages and
interest, in the year that they incur the loss.
Identifying which of a sole proprietor's payments qualify as business
expenses and the amount to be deducted can be complex. Deductible
business expenses must be "ordinary and necessary" and paid or incurred
during the tax year in carrying on a trade or business.[Footnote 2] Two
types of payments--costs of goods sold and capital improvements--must
be distinguished from other types of payments because they are treated
differently under tax rules. To identify the cost of goods sold,
businesses that manufacture or resell merchandise must follow tax rules
that require valuing their inventory at the beginning and end of the
tax year. Payments for capital improvements, such as start-up costs,
business assets, and improvements, usually are not fully deducted in
the current tax year but instead must be depreciated over a multiyear
period. Expenses that are used partly for business and personal
purposes can be deducted only to the extent they are used for business.
For example, business use of the taxpayer's home or car requires
allocating the costs between business and personal use.
The general standard for measuring taxable income is to match receipts
and expenses as they occur, that is, their recognition should not be
limited or postponed. However, under certain conditions, the tax code
limits the extent to which losses can be deducted from other categories
of income. One of these limits is that an individual may not deduct
losses from activities that are not engaged in for profit against other
income. There are also limits when an individual did not materially
participate in the activity or for funds that the individual did not
put at risk.
Regulations specify a nine-factor test to help identify activities that
are not engaged in for profit.[Footnote 3] The losses an individual
incurs from activities not engaged in for profit are sometimes called
hobby losses. No single factor is determinative, and the regulations
state that factors other than the nine cited can be taken into account
when identifying a profit objective. However, taxpayers may still
deduct these expenses up to the limit of the income earned from an
activity not engaged in for profit. Additionally, activity not engaged
in for profit rules presume that the activity is engaged in for profit
if the activity produced a profit in at least 3 of the last 5 years or
for some activities 2 of the last 7 years.
IRS Compliance Programs:
IRS has three principal compliance programs covering various types of
taxpayers and various types of income and expenses. Two are used to
ensure that sole proprietors are properly reporting expenses.
* The Examination Program--examinations are often called audits--is the
principal compliance program for sole proprietor expenses and is
operated in three forms. Correspondence examinations are conducted
through the mail and usually cover one or two narrow issues. Office
examinations require taxpayers to go to an IRS office and are broader
than correspondence exams but still limited in scope. Field
examinations send revenue agents to taxpayers' homes or businesses and
cover all compliance issues regardless of complexity or scope. The
field examinations staff have the highest skill levels among staff in
IRS's compliance programs. In 2008, simple correspondence examinations
for sole proprietor returns required an average of 2 hours, while field
examinations, which may require more sophisticated analysis and
judgment, averaged 21 hours.
* The Automated Underreporter Program (AUR) matches an information
return with a related item on the tax return as reported by the
taxpayer. Information returns are prepared for certain types of
transactions, such as payment of interest on a bank account. If AUR
identifies a discrepancy between the information return and the
taxpayer's reporting for that item, AUR may send a notice to the
taxpayer, after the discrepancy is verified by an IRS examiner,
requesting payment of additional tax, interest, and penalties. If the
taxpayer disagrees with the notice, the taxpayer is asked to explain
the difference and may provide any other information, such as
supporting documents. The taxpayer's response is reviewed by an
examiner who determines whether the tax should be assessed. AUR staff
use some judgment and skill in their reviews, which require about half
an hour to complete.
* The Math Error Program verifies the accuracy of tax returns during
processing. It uses IRS computers to identify and generate notices to
contact taxpayers about obvious errors, such as mathematical errors,
omitted or inconsistent data, or other inconsistencies on the basis of
other data reported on their returns or to IRS. This compliance program
is not currently used to ensure that sole proprietors are properly
reporting expenses. IRS may use this program in specific instances as
authorized by Congress through the Internal Revenue Code. The errors
must be corrected to process the returns and ensure that all taxpayers
comply with tax rules. For example, during return processing, the Math
Error Program identifies whether all taxpayers have complied with
mathematical limits in the tax law, such as the $3,000 net capital loss
limitation. Since math errors are obvious, there is little review of
the error by IRS staff before adjustment notices are sent to the
taxpayers. The Math Error Program and its possible use in ensuring sole
proprietor expense noncompliance is discussed in more detail in later
sections of this report.[Footnote 4]
Compliance Measurement and the Tax Gap:
IRS estimates that a large portion of the gross tax gap, $197 billion,
is caused by the underreporting of income on individual tax returns. 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. The precise
proportion of the overall tax gap caused by sole proprietors is
uncertain because of sampling error and the exclusion from the estimate
of factors affecting the tax gap, such as sole proprietors' not paying
because of failing to file tax returns, underpaying the tax due on
income that was correctly reported, and underpaying employment taxes.
IRS estimates the tax gap caused by underreporting of individual income
from the NRP, IRS's compliance research program. For tax year 2001, the
NRP study used a detailed review and examination of a representative
sample of about 45,000 individual tax returns to compute estimates of
underreporting of income and taxes for all individual tax returns. The
NRP individual sample was designed to include a disproportionately
large number of sole proprietors because of their known compliance
issues.[Footnote 5] This allowed more detailed data to be collected
about the nature of sole proprietor compliance issues. However, the NRP
reviews could not detect all noncompliance. As a consequence, IRS
adjusted the NRP estimates to develop final estimates of income
misreporting and the resulting tax gap.
IRS has started work on an updated NRP study. The study will examine
about 13,500 randomly selected returns annually, starting with tax year
2006. According to IRS, after 3 years the combined sample will be
comparable to tax year 2001 and will allow for annual updates of
noncompliance estimates. IRS plans to issue a preliminary estimate of
the 2006 individual reporting tax gap by 2012.
Sole Proprietor Losses Are Substantial and Growing and Are a Compliance
Problem:
A noticeable proportion of sole proprietors reported a loss in tax year
2006. Of the 21.7 million sole proprietor returns in 2006, an estimated
5.4 million, or 25 percent, reported losses while 16.2 million, or 75
percent, reported profits.[Footnote 6] Total reported losses were $49
billion and total reported profits were $330 billion.
Most sole proprietors reported small amounts of profit or loss, but a
few reported substantial amounts. As figure 1 shows, 85 percent of sole
proprietor returns reported net profit or loss of less than $25,000. On
the other hand, the 13 percent of sole proprietor returns with at least
$25,000 in profits accounted for 72 percent of all reported profits.
Similarly, the 1 percent of sole proprietor returns with at least
$25,000 in losses accounted for 47 percent of all reported losses.
Figure 1: Distribution of Sole Proprietor Returns and Their Net Profit
or Loss in 2006:
[Refer to PDF for image: two vertical bar graphs]
Net loss per sole proprietor: -$25K;
Number of sole proprietors (in millions): 0.31.
Net loss per sole proprietor: -$10K > -$25K;
Number of sole proprietors (in millions): 0.84.
Net loss per sole proprietor: -$2500 > -$10K;
Number of sole proprietors (in millions): 2.
Net loss per sole proprietor: < 0 to > -$2500;
Number of sole proprietors (in millions): 2.29.
Net profit per sole proprietor: >0 to < $2500;
Number of sole proprietors (in millions): 4.574.
Net profit per sole proprietor: $2500 < $10K;
Number of sole proprietors (in millions): 5.03.
Net profit per sole proprietor: $10K < $25K;
Number of sole proprietors (in millions): 3.68.
Net profit per sole proprietor: $25K < $100K;
Number of sole proprietors (in millions): 2.4.
Net profit per sole proprietor: $100K+;
Number of sole proprietors (in millions): 0.56.
Net loss per sole proprietor: > -$25K;
Aggregate net profit or loss (in billions): -$22.8.
Net loss per sole proprietor: -$10K > -$25K;
Aggregate net profit or loss (in billions): -$12.9.
Net loss per sole proprietor: -$2500 > -$10K;
Aggregate net profit or loss (in billions): -$10.7.
Net loss per sole proprietor: $-2500;
Aggregate net profit or loss (in billions): -$2.3.
Net profit per sole proprietor: >0 to < $2500;
Aggregate net profit or loss (in billions): $4.6.
Net profit per sole proprietor: $2500 < $10K;
Aggregate net profit or loss (in billions): $29.2.
Net profit per sole proprietor: $10K < $25K;
Aggregate net profit or loss (in billions): $57.5.
Net profit per sole proprietor: $25K < $100K;
Aggregate net profit or loss (in billions): $112.1.
Net profit per sole proprietor: $100K+;
Aggregate net profit or loss (in billions): $126.9.
Source: GAO analysis of 2006 cross-sectional SOI data.
[End of figure]
Sole Proprietor Losses Are Growing:
Total sole proprietors' losses, after adjusting for inflation, grew by
69 percent from 1998 to 2006.[Footnote 7] As figure 2 shows, losses
grew faster than both profits and the number of sole proprietor returns
in each year except 2005. Over the same period, expense deductions
reported for loss returns grew about four times as fast as expense
deductions reported for returns showing a profit.[Footnote 8]
Figure 2: The Cumulative Percentage Change in Sole Proprietor Returns,
Net Profits, and Net Losses from 1998 through 2006:
[Refer to PDF for image: multiple line graph]
Cumulative percentage change (dollars inflation adjusted to 2009):
Fiscal year: 1998;
Net profits: 0%;
Net losses: 0%;
Number of returns: 0%.
Fiscal year: 1999;
Net profits: 1.7%;
Net losses: 4.9%;
Number of returns: 1%.
Fiscal year: 2000;
Net profits: 4.6%;
Net losses: 23.1%;
Number of returns: 2.8%.
Fiscal year: 2001;
Net profits: 4.2%;
Net losses: 29.2%;
Number of returns: 5.3%.
Fiscal year: 2002;
Net profits: 5.3%;
Net losses: 40.1%;
Number of returns: 8.7%.
Fiscal year: 2003;
Net profits: 7.9%;
Net losses: 47%;
Number of returns: 13.2%.
Fiscal year: 2004;
Net profits: 13.2%;
Net losses: 58.2%;
Number of returns: 18.3%.
Fiscal year: 2005;
Net profits: 18.8%;
Net losses: 60%;
Number of returns: 23.3%.
Fiscal year: 2006;
Net profits: 19.5%;
Net losses: 68.5%;
Number of returns: 26.8%.
Sources: GAO analysis of SOI studies, tax year 1996 to 2006.
[End of figure]
Many Sole Proprietors Reported Losses in Multiple Years:
As figure 3 shows, based on data from a panel we constructed, 26
percent of all sole proprietor returns in 2006 reported losses in 2 or
more years from 1998 through 2006.[Footnote 9] However, when only sole
proprietors who reported losses in 2006 are considered, the frequency
of multiple loss years increases. Seventy percent of these sole
proprietor returns reported losses in 2 or more years during this
period.[Footnote 10]
Figure 3: Percentage of Sole Proprietor Returns in 2006 with Reported
Losses for Multiple Years from 1998 through 2006:
[Refer to PDF for image: vertical bar graph]
Number of years filing losses from 1998 through 2006:
No losses reported:
Percentage of sole proprietors: 57%.
Losses reported for 1 year:
Percentage of sole proprietors: 16%.
Losses reported for multiple years: 2 years:
Percentage of sole proprietors: 9%.
Losses reported for multiple years: 3 years:
Percentage of sole proprietors: 5%.
Losses reported for multiple years: 4 years:
Percentage of sole proprietors: 4%.
Losses reported for multiple years: 5 years:
Percentage of sole proprietors: 3%.
Losses reported for multiple years: 6 years:
Percentage of sole proprietors: 2%.
Losses reported for multiple years: 7 years:
Percentage of sole proprietors: 1%.
Losses reported for multiple years: 8 years:
Percentage of sole proprietors: 1%.
Losses reported for multiple years: 9 years:
Percentage of sole proprietors: 1%.
Source: GAO analysis of 2006 SOI cross-sectional data and 1998-2006
Compliance Data Warehouse data.
[End of figure]
In terms of dollars, a large portion of 2006 losses were reported by
sole proprietors with losses in multiple years. Seventy-seven percent
of the losses reported in 2006 by the sole proprietors in our panel
were reported on sole proprietor returns that also reported 2 or more
years of losses from 1998 through 2006. Thirty-five percent of total
2006 losses were reported on sole proprietors' returns that reported 5
or more years of losses.[Footnote 11]
Losses in multiple years can occur for many reasons. Situations that
may result in multiple years of reported losses include starting a
business, developing a new product, or facing unfavorable economic
conditions. Reported losses may also be due to noncompliance, caused by
either understated receipts or overstated expenses. IRS regulations
cite examples of compliant businesses that have profit objectives and
several years of losses before realizing profits. In one example, a
chemist works developing a new product that could have extensive uses
and could generate substantial profits if it is successful. In this
example, IRS finds that the chemist is engaged in activities for
profit, and the losses can be deducted against other categories of
income.[Footnote 12]
Sole proprietors with a history of losses are less likely to recover
their losses through sole proprietorship profits in other years. Of
sole proprietor returns reporting a loss in 2001 but not in previous
years, 45 percent earned an overall profit from 1998 through 2006.
[Footnote 13] However, of the sole proprietor returns reporting a loss
in 2001 and 2 previous years of reported losses, 16 percent earned an
overall profit. In contrast, 95 percent of sole proprietor returns with
profits in 2001 earned an overall profit from 1998 through 2006.
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.[Footnote 14] In terms of dollars, of the $49 billion of total
losses reported in 2006, 78 percent was fully deducted against other
income and another 5 percent was partially deducted. In total, $40
billion was deducted against other categories of income.
Figure 4: Percentage of Sole Proprietor Loss Returns Where Losses Were
Used to Offset Other Income and Percentage of Net Losses Used to Offset
Other Income, 2006:
[Refer to PDF for image: vertical bar graph]
Amount of loss reducing other income: None;
Sole proprietors: 5%;
Total loss offset: 0%.
Amount of loss reducing other income: Some;
Sole proprietors: 3%;
Total loss offset: 5%.
Amount of loss reducing other income: All;
Sole proprietors: 92%;
Total loss offset: 79%.
Source: GAO analysis of 2006 cross-sectional SOI data.
[End of figure]
Most reported losses were a small proportion of the sole proprietors'
other income. Among those sole proprietor returns where losses offset
other income, 61 percent had deductions from sole proprietorship losses
that were less than 10 percent of their other income, and 92 percent
had deductions from sole proprietorship losses that were less than 50
percent of their other income.
Sole Proprietors Reporting Losses Were Likely to Be Noncompliant:
A large proportion of sole proprietors reporting losses in 2001, the
most recent year data were available, underpaid their taxes and a
larger percentage of sole proprietors reporting losses were
noncompliant than those reporting profits. As shown in table 1, IRS
estimated in its 2001 NRP study that 70 percent of sole proprietor
returns with net losses (3 million returns) underreported net income by
at least $100 compared to 52 percent of those with profits. Further, of
these loss returns that were noncompliant by at least $100, 57 percent
were fully noncompliant (i.e., the entire loss was disallowed) and the
remaining 43 percent were partially noncompliant (i.e., some of the
loss was disallowed).
Table 1: Estimated Percentage of Sole Proprietor Loss and Profit
Returns That Were Noncompliant, 2001:
Sole proprietor returns with: Net losses;
Percentage underreporting net income by at least $100: 70;
Percentage underreporting net income by at least $1,000: 55.
Sole proprietor returns with: Net profits;
Percentage underreporting net income by at least $100: 52;
Percentage underreporting net income by at least $1,000: 40.
Source: GAO's analysis of IRS's 2001 NRP.
[End of table]
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.[Footnote 15] Assuming 2001 was not unusual, this
translates into billions of dollars of unpaid taxes each year because
of noncompliant loss claims by sole proprietors. In addition to
noncompliant losses, sole proprietors reporting losses also failed to
report about $12 billion in net profits.[Footnote 16]
Three examples from our NRP case file review illustrate how sole
proprietors with a range of incomes used noncompliant losses and
expenses to reduce the taxable income they reported on their tax
returns.
* On a joint return, one taxpayer was employed and the other reported
operating a sole proprietorship described as providing investment
advisory services. The taxpayers had over $1 million of adjusted gross
income (AGI) for 2001 with reported sole proprietorship losses over
$25,000. In 2001, based on a statement from the taxpayer, the
examination file noted that the sole proprietorship did not have a
business purpose, and IRS disallowed the sole proprietorship loss.
* Another taxpayer's 2001 joint return reported over $50,000 of AGI and
included a sole proprietorship loss from competitive athletics. This
loss totaled over $5,000. The IRS examiner stated that the taxpayer
provided no documentary support for the sole proprietorship receipts
and expenses and found that the taxpayer's reported sole proprietorship
activity was recreational and not engaged in for profit. IRS
reclassified the sole proprietorship receipts as miscellaneous income
and did not allow deduction of the undocumented expenses.
* Tax year 2001 was the taxpayer's first year in a construction-related
business. The taxpayer had an AGI of over $4,000, which included wages
from employment. The return reported no income tax liability after
including a sole proprietorship loss of over $4,000. To examine the
2001 return, the IRS staff had to reconstruct the sole proprietorship
records from bank account data because books and records were not
available from the taxpayer. Based on the examination, the taxpayer
owed over $10,000 of income tax. The tax liability following the
examination included the recapture of over $1,000 of Earned Income Tax
Credit (EITC) paid to the taxpayer because the postexamination AGI was
above the $32,121 EITC earning limit in 2001.
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.[Footnote 17] However, even with this
relatively large investment, IRS examined about only 1 percent of the
estimated noncompliant population of sole proprietors.[Footnote 18]
Most sole proprietor examinations are field examinations because, as
our recent report found, sole proprietor issues are generally too
complex to examine through IRS's lower-cost correspondence program.
[Footnote 19] IRS officials cited several reasons why field
examinations are more appropriate than correspondence examinations for
sole proprietors. Examination at the taxpayer's place of business,
which is often also the taxpayer's residence, expedites the
determination of whether unallowable personal expenses have been
deducted on the sole proprietorship return. Examining sole proprietor
expenses often involves complex auditing and legal issues, such as
identifying which payments qualify as "ordinary and necessary," which
requires the high skill levels of revenue agents (rather than those of
the less skilled and less trained correspondence examiners) and
interaction with the taxpayers to understand their books and records.
As a practical matter, taxpayer records can be voluminous and are
therefore best reviewed at the sole proprietor's place of business.
Sole proprietor examinations take longer to complete and have a lower
average assessed tax per examination hour than examinations of other
categories of taxpayers. For fiscal year 2008, examinations of sole
proprietor returns took 40 percent more time to complete and yielded 43
percent fewer dollars per hour of examination time as compared to other
small business income tax examinations.[Footnote 20] Despite the
relatively low productivity, some sole proprietor examinations may be
worth conducting because, as IRS officials told us, they strive for
balanced coverage of the taxpayer population along with additional
focus on taxpayer groups with high levels of noncompliance, regardless
of the yields per hour. However, because most sole proprietors report
small amounts of income, greatly increasing the number of examinations
may not be cost-effective.
AUR Does Not Focus on Expense Compliance, and Expanding Coverage Faces
Significant Obstacles:
Little sole proprietor expense noncompliance is detectable from
existing information returns. We estimated that at least 91 percent of
such noncompliance is in expense categories not reported on information
returns. Only one expense item, mortgage interest, is included in AUR.
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. For example, there is
no third party who could verify the business use of cars or trucks by
sole proprietors.
Furthermore, IRS officials have concerns about expanding use of
information returns for expenses. AUR is designed to check, through
computer matching, that amounts reported on information returns are
transferred to the appropriate line of a tax return by taxpayers.
Unless all of the business expenses on a given line were subject to
information reporting, taxpayers could properly report more expenses
than shown on information returns. In such cases, IRS's computers would
show a mismatch. According to the IRS staff, resolving these mismatches
could be considered a correspondence examination because IRS staff
probably would need to examine a taxpayer's records to accept the
expenses. However, this defeats the purpose of AUR (relying on computer
matching to avoid costly examinations) and may prohibit IRS from
completing additional reviews of the taxpayer's return.[Footnote 21]
The program is intended to provide automated, and therefore low-cost,
compliance checks to avoid high-cost examinations of taxpayers'
records.
A Loss Limitation Rule and Collecting Data on Not-for-Profit Activities
Could Help Address Expense Noncompliance, but a Limitation Rule Would
Also Adversely Affect Compliant Taxpayers:
A rule limiting taxpayers from deducting sole proprietor losses against
other income would involve trade-offs. The primary benefit would be
limiting the ability of taxpayers to use noncompliant sole proprietor
losses to reduce the amount of tax they owe on their other income.
Assuming the 2006 compliance rate is the same as the estimated 2001
compliance rate based on NRP data, an estimated $26 billion of reported
sole proprietor losses in 2006 would have been noncompliant.[Footnote
22] As a result, a rule limiting deductions for sole proprietor losses
could have a significant impact on noncompliance, raise significant
revenue from noncompliant losses, and correspondingly reduce the tax
gap.
A rule limiting deductions for sole proprietor losses would also reduce
IRS's costs. Because losses are clearly identified on the return, the
rule could be administered as part of the returns filing process
through the Math Error Program. This could enable IRS to immediately
disallow deductions not allowed by the rule without having to resort to
costly examinations.
However, disadvantages of a rule limiting sole proprietor loss
deductions could be significant. Such a rule would reduce the fairness
of the tax system by limiting loss deductions for compliant taxpayers.
The extent would depend upon the specifics of how the rule is
structured, as discussed below. The rule could also introduce economic
distortions by (1) creating disincentives for starting or running a
sole proprietorship[Footnote 23] and (2) creating incentives to form
other types of businesses, such as S corporations, where the tax
treatment of some losses may be more beneficial.[Footnote 24]
The Internal Revenue Code (I.R.C.) already contains limitation rules
for many types of deductions. These rules are structured in several
ways, including absolute ceilings, ceilings linked to AGI or other
information from the return, and carrybacks and carryforwards that
allow deductions over the limit to be carried back or forward to
previous or future returns to be used as deductions. For example, only
$3,000 of capital losses over the amount of capital gains may be
deducted from income. In addition, losses from passive activity are
normally deductible only against passive income.[Footnote 25] The
legislated limits have been enacted for a variety of compliance
reasons, including preventing taxpayers from manipulating the timing of
realizing gains and losses to reduce tax owed, in the case of the
capital loss limitation, and addressing the prevalence of tax shelters,
in the case of the passive income limitation.[Footnote 26] Appendix II
provides additional examples of loss limitations rules.
A rule limiting the deduction of sole proprietor losses could contain
various mechanisms to mitigate some of the disadvantages. The
possibilities include the following:
* Targeting. A rule could limit the ability to deduct sole proprietor
losses deductions from other, non-sole proprietor income. This limit
could either be an absolute amount (e.g., up to $3,000 from other
income) or an amount determined by formula (e.g., filers may only
deduct sole proprietor losses up to a certain percentage of their other
income). Our analysis showed that targeting could improve the fairness
of a loss limitation rule by better focusing the rule on noncompliance.
For example, while 70 percent of sole proprietor returns with losses
were estimated to be noncompliant, 82 percent of returns in 2001 that
would have been affected by a $3,000 limit on sole proprietor loss
deductions were noncompliant.[Footnote 27] 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.[Footnote 28]
* Carry forward or back rule. A carry forward or back rule would allow
taxpayers reporting sole proprietor losses to offset sole proprietor
income earned in other years. This would prevent taxpayers from
deducting noncompliant losses against other income, but would allow
sole proprietors with profits in other years to deduct their losses.
* A carry forward or back rule could mitigate both the risk to business
formation and the inequities that can arise from the loss limitation. 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. An estimated 36 percent of sole proprietorships reporting
losses on returns in 2001 would have been able to use their entire loss
to offset either previous or future sole proprietor income, and another
10 percent would have been able to use part of their loss.[Footnote 29]
* Elective document review or examination. A rule limiting sole
proprietor loss deductions could include an option for sole proprietors
to request an IRS review of documents provided by the taxpayer, either
pre-or postfiling. For example, new sole proprietors could include
their business plans and other evidence of their intent to make a
profit. The IRS staff could review these documents in the relatively
lower-cost compliance center environment. IRS does something similar in
its Innocent Spouse program, which makes a complex determination
regarding liability for a tax debt based on a document review, in most
cases, in the compliance center environment. If IRS judges it to be
helpful (for example, to ensure that documents are valid and
supportable), this option could require the sole proprietor extend the
statute of limitations for the returns filed with a sole proprietorship
loss so that IRS would have more time to examine the taxpayer.[Footnote
30]
Elective reviews would create administrative costs for IRS and some
compliance burden for taxpayers, but targeting might reduce the number
of reviews significantly. Assuming that only sole proprietors with
compliant losses of $100 or more would apply for review and assuming
that the compliance rate in 2006 is the same as in 2001, we estimated
that there were 3 million sole proprietor returns with compliant losses
of at least $100 in 2006.[Footnote 31] Targeting the rule to those with
losses above about $7,000 (the top 25 percent of loss filers by the
size of filed loss in 2001) could reduce the number of affected returns
for which taxpayers might apply for review to about 870,000. Targeting
the rule further to only affect those who filed previous losses or
exempting those who have gone through a recent review could further
reduce the number of reviews. If taxpayers behave differently than our
assumptions, the effectiveness and cost of the option would be
different.
IRS Has Not Estimated the Extent of Noncompliance with Rules for
Activities Not Engaged in for Profit:
Neither the 2001 NRP study nor the ongoing NRP study, which started
with tax year 2006 returns, collected data on examinations that
resulted in additional assessed tax based on noncompliant losses from
activities not engaged in for profit (hobby losses). As we noted in the
Background section of this report, to be compliant losses must result
from business activities with legitimate profit objectives. Without the
data from NRP, IRS could not estimate the extent of noncompliance with
activities not engaged in for profit in tax year 2001 and will not be
able to do so for 2006. The ongoing tax year 2006-2008 NRP added a code
for activities not engaged in for profit when the tax return was
assigned to the examiner, indicating whether NRP managers thought the
issue must be reviewed during the examination.[Footnote 32] However,
neither the 2001 study nor the ongoing study included a specific code
in IRS's Report Generation Software (RGS) to identify whether the
examinations found activities not engaged in for profit or whether an
adjustment was made to the return because of noncompliance with the
rules.[Footnote 33] 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.
The same problem exists for IRS's regular examination program. The
examination program, which also uses the RGS system, does not collect
data on the how often issues related to activities not engaged in for
profit were classified during examinations or how often those issues
resulted in an adjustment to a return. A minimal RGS system update
could include a specific code for activities not engaged in for profit
classification and adjustment issues. More detailed revisions could
include specific reasons why activities not engaged in for profit
issues were examined or not examined, such as likely strength of the
case or likely tax change when compared to additional examination
costs. Without these data, IRS cannot monitor how often the current
compliance program addresses activities not engaged in for profit and
the connection to noncompliant sole proprietor losses, and will not
have the data to improve its examination program.
Conclusions:
The large number of relatively small sole proprietorships limits IRS's
opportunity to ensure their compliance through its regular compliance
programs. On the other hand, based on the NRP analysis from 2001, over
half of losses reported by sole proprietorships are not valid losses,
and those losses are often used to reduce the taxes owed on other
income.
One alternative approach to avoid the obstacles faced by IRS's
enforcement programs would be a rule limiting deduction of sole
proprietor losses against other income. However, such a rule would
treat all sole proprietors with losses, compliant and noncompliant, the
same. In considering such a rule, policymakers would have to trade off
reducing noncompliance against disallowing some legitimate losses.
Because this is a policy judgment, we are not making a recommendation
to implement such a rule.
Short of such a policy change, however, there are steps IRS could take
that have the potential to help mitigate noncompliant sole proprietor
losses. Our review of IRS case files suggests that a portion of
noncompliant filers reporting sole proprietor losses that have been
examined may have had their losses disallowed because of activities not
engaged in for profit. However, because IRS does not estimate a
compliance rate for activities not engaged in for profit or how often
these provisions are applied in regular examinations, IRS lacks
information that could be useful for improving its enforcement approach
and reducing the portion of the tax gap caused by sole proprietor
noncompliant losses.
Recommendations for Executive Action:
In order to better assess whether changes are needed in the way IRS
administers activities not engaged in for profit provisions, we
recommend that the Commissioner of Internal Revenue take steps to:
* estimate the extent of activities not engaged in for profit
noncompliance from its ongoing research programs and:
* collect information on examinations of activities not engaged in for
profit issues from the compliance program.
Agency Comments:
In commenting on a draft of this report IRS agreed to implement both
recommendations and stated that our report covers a timely and
important topic because of the potential for increasing sole proprietor
losses.
IRS's comment letter is reprinted in appendix III.
As agreed with your offices, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
after the report date. At that time, we will send copies to the
Commissioner of Internal Revenue and other interested parties. This
report also will be available at no charge on GAO's Web site at
[hyperlink, http://www.gao.gov].
If you or your staff have any questions about this report, please
contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our
Offices of Congressional Relations and Public Affairs may be found on
the last page of this report. Key contributors to this report are
listed in appendix IV.
Signed by:
James R. White:
Director, Tax Issues Strategic Issues:
[End of section]
Appendix I: Scope and Methodology:
In conducting our work, we employed multiple methodologies, including
analyzing data from the Internal Revenue Service's (IRS) National
Research Program (NRP), Statistics of Income (SOI) samples, and
Individual Master File (IMF); examining a sample of NRP case files;
interviewing IRS officials, and reviewing related legislation,
regulations, and guidance.[Footnote 34]
For all of the analysis of NRP, SOI, and IMF data for this report, we
analyzed the net profit or loss reported on line 12 of Form 1040. This
line contains the sum of all sole proprietor income reported on line 31
of any Schedule C attached to the return. Because line 12 of Form 1040
is a sum of sole proprietorship income from potentially several sole
proprietorships, individual sole proprietorships could have had losses
while the net sole proprietorship income that we analyzed was positive,
if the other sole proprietorships on the return had profits. We did not
analyze data from Schedule F, Profit and Loss from Farming, or from
corporate taxpayers electing treatment as small business corporations
under Subchapter S.
For estimates based on samples of taxpayers in this report, we are 95
percent confident that the estimates are within 10 percent of the
population values for dollar amount and counts and 3 percent of
population values for percentages, unless otherwise noted.
SOI Data:
We used IRS SOI data to describe the population of sole proprietors and
construct a panel of sole proprietors to analyze their reporting of
profits and losses over a 9-year period from 1998 through 2006. To
describe the population of sole proprietors, including those who file
losses, we analyzed tax return data from SOI's stratified random sample
of 320,987 individuals, including 81,588 sole proprietors, for tax year
2006--the most recent data available. In the data analysis in this
report, the term sole proprietor refers to a taxpayer who files a 1040
return with one or more Schedule C forms attached regardless of the
filing status of the taxpayer. Therefore, for example, a joint return
with two Schedules C forms attached is considered a single sole
proprietor.
To examine sole proprietors' profits and losses over time, we created
two panel data sets based on tax return data from SOI's tax years 2006
and 2001 stratified random samples of taxpayers. The panels followed
tax returns with one or more Schedule C forms attached as the unit of
analysis. Because the SOI data are a random sample, returns that appear
in the 2006 or 2001 sample may not appear in the samples taken in other
years. Therefore, to construct the panel, we matched the returns in the
2006 and 2001 samples with the same taxpayers' returns in other years
as stored in another IRS database. Specifically, we obtained tax return
data from 1998 through 2006 from IMF, a copy of which is stored in
IRS's Compliance Data Warehouse (CDW) for access and analysis for
research purposes. We matched data from IMF to the data from SOI by
taxpayer identification number (TIN) and were able to obtain matching
data in the base year from IMF for 99.9 percent of the individuals in
the SOI 2006 sample and 99.9 percent of the individuals in the SOI 2001
sample.
Because the filing unit can change over time because of marriage or
divorce, an accurate population estimate cannot be calculated for those
tax returns. Therefore, we excluded from analysis those tax returns
that had a change in marital status from 1998 through 2006. This is a
common method for analyzing taxpayer data over time, which conforms to
SOI's practice. For the 2006 panel, 20.4 percent of the returns
included in the 2006 SOI stratified random sample and 20.9 percent of
the estimated net sole proprietorship income was excluded because of a
change in marital status from 1998 through 2006. For the 2001 panel,
17.9 percent of returns in the 2001 SOI sample and 16.3 percent of the
estimated net sole proprietorship income was excluded.
Based on several analyses of the data, we concluded that the panels
sufficiently represent the population of sole proprietors. To assess
how representative the panel is, we compared filing status and average
Schedule C income as computed from the panel and from the SOI sample
for both 2001 and 2006. Regarding filing status, we found similar
percentages in the panel and sample data of taxpayers reporting the
same status. Approximately 54 percent of returns in the 2006 panel had
joint filers, while approximately 60 percent of returns in the 2006 SOI
sample had both a primary and secondary taxpayer. Similarly,
approximately 63 percent of returns in the 2001 panel had joint filers,
while approximately 64 percent of returns in the 2001 SOI sample had
joint filers. We also found very similar average income amounts. For
2006, the average estimated Schedule C income in the panel is $13,000
compared to $12,800 in the sample, and for 2001, the average estimated
Schedule C income in the panel is $12,200 compared to $11,800 in the
sample.
As a final test, we compared adjusted gross income amounts (AGI),
return by return, for the years for which we had data for sole
proprietorship returns from both SOI and IMF (2001 and 2006). Again,
the results supported the accuracy of our panel data. Ninety-eight
percent of the returns had AGI that matched within $100 between the two
data sets, and 99 percent of the returns data sets had total Schedule C
income that matched within $100 between the two data sets. For analyses
that required data from multiple years, we used the IMF data from each
year for consistency.
NRP Data:
To assess sole proprietor compliance, we used data from IRS's
compliance research program (NRP). We used these data to profile the
compliance of Schedule C taxpayers, assess the relationship between
sole proprietor compliance and filing history, assess qualitative
information on sole proprietor compliance, and analyze options for a
loss limitation targeting rules. The 2001 NRP study was a detailed
review and examination of a representative sample of 44,768 individual
tax returns from tax year 2001, 20,868 of which reported sole
proprietorship income. Unless otherwise noted, we define a taxpayer as
noncompliant if the NRP examination revealed that the taxpayer
underreported income by $100 or more.
To assess the relationship between sole proprietor compliance and
filing history, we created a panel data set based on NRP data. The
panel followed tax returns with one or more Schedule C forms attached
as the unit of analysis. For the sole proprietor returns in the NRP
sample, we obtained tax return data from 1998 through 2006 from IMF in
CDW. We matched data from IMF to the data from NRP by TIN, and were
able to obtain matching data from IMF for 99.9 percent of the
individuals in the NRP 2001 sample. Using the same methodology that we
used for the SOI panels, we excluded from analysis those tax returns
that indicated a change in marital status from 1998 through 2006. For
the NRP panel, 11.8 percent of the returns included in the 2001 NRP
sample and 10.2 percent of the estimated net sole proprietorship income
was excluded because of a change in marital status from 1998 through
2006. Comparing the differences in estimates between the returns
included in the panel and those in the NRP sample, approximately 60
percent of returns in the panel had both a primary and secondary
taxpayer, while approximately 65 percent of returns in the NRP sample
had joint filers. The average estimated Schedule C income in the panel
is about $12,800 compared to the NRP sample estimate of about $12,600.
For 2001, the year for which we had data for individuals from both NRP
and IMF, 97 percent of the returns had AGI that matched within $100
between the two data sets, and 99 percent of the returns had total
Schedule C income that matched within $100 between the two data sets.
For analyses that used data from multiple years, we used the IMF data
from each year for consistency.
To provide qualitative information on sole proprietors filing losses
and assess how not-for-profit activity issues are considered during
exams, we reviewed a sample of NRP examination case files with Schedule
C losses. We selected a sample of NRP cases for review that while not
intended to allow us to make generalizations to the entire population
of sole proprietors, did include sole proprietors of various AGI and
Schedule C income levels and both compliant and noncompliant returns.
Some cases were selected based on the dollar amount of the Schedule C
noncompliance, and some were randomly selected. We requested a total of
234 cases and reviewed 49 cases, ensuring that the cases reviewed
represented a range of cases from all income levels.
To determine whether targeting a rule limiting Schedule C loss
deductions to a subset of the population could increase the percentage
of affected filers and dollars that would be noncompliant, we analyzed
items on the return that would be available to the Math Error Program
and that could reasonably be used to identify noncompliant returns.
IMF Data:
To assess the reliability of IMF data, we reviewed the steps IRS took
to create a data set at our request, assessed IRS's use of IMF data,
and compared the data to NRP and SOI data to ensure consistency. Based
on these steps, we determined that the data were sufficiently reliable
for our review.
While we were compiling the three panels of IMF data (the panel based
on 2006 SOI data, the panel based on 2001 SOI data, and the panel based
on NRP data), an IRS official notified us that about 2,000 returns, all
from either 1998 or 1999, which were less than 1 percent of the returns
requested, could not be provided from the copy of IMF in CDW because
the source data for those returns had been lost. We determined that the
unavailable data would not materially affect our findings.
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. We reviewed instructions for
filing sole proprietor returns, regulations for activities not engaged
in for profit, as well as examination program procedures. We analyzed
program results data collected from the Automated Underreporter Program
(AUR) and data on examination results. The exam data were extracted
from IRS's Examination Operational Automation Database. We also
interviewed IRS staff on the operations and results of AUR and the
correspondence, office, and field examination programs. We reviewed
examination plans and Internal Revenue Manual procedures and other
instructions to IRS staff describing program procedures.
For our previous report on sole proprietors, we used tax gap, NRP, SOI,
AUR, and examination data. We determined that the data were
sufficiently reliable for our review based on assessments done for
those and previous reports, the fact that many of these sources are
public and widely used, and additional testing we did to ensure that we
were properly interpreting individual data elements.
Our work was completed in accordance with generally accepted government
auditing standards from July 2008 through September 2009 at IRS
Headquarters in Washington, D.C.
[End of section]
Appendix II: Examples of Current Income Tax Loss Limitation Rules for
Individual Taxpayers:
The general standard for measuring income is to recognize all sources
of gross income less expenses and losses as they occur. Taxable income
is computed following this basic principle with some exceptions. In
general, gross income from all sources is included when computing
taxable income, with some exclusions, such as gifts, inheritances, and
some death benefits. Deductions are typically allowed only for expenses
related to activities intended to produce income, such as those related
to a trade or business, or nonbusiness investment expenses, though some
personal expenses can also be deducted to a limited extent.[Footnote
35]
When expenses exceed income, the resulting loss can be disallowed,
limited to a certain amount, or deferred to other tax years. 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. In 1969, the activities not engaged in
for profit provisions were enacted, in part, because of the perception
that individuals invested in certain aspects of farm operations solely
to obtain losses to reduce their tax on other income.[Footnote 36]
Before 1986, taxpayers could realize losses in excess of their actual
amounts at risk, typically through limited partnerships, and deduct
those losses from other sources of income.[Footnote 37] The Tax Reform
Act of 1986 included several provisions to limit transactions that
reduced income. Examples include the following:
* Tax shelters. Passive activity losses were limited to prevent
taxpayers from using losses from real estate and other investments in
which they had minimal participation to offset other sources of income,
such as wages, salaries, and capital gains. Similarly, at-risk rules
were enacted to limit losses to the actual amount of money invested
because of the prevalence of tax sheltering.
* Limitations on interest. Another example is limiting the deduction of
investment interest to the amount of investment income to prevent
"taxpayers from sheltering or reducing tax on other, non-investment
income by means of the unrelated interest deduction."[Footnote 38]
Personal interest was disallowed as a deduction because it enabled
taxpayers to avoid taxes by purchasing consumables rather than
purchasing assets that produce taxable income.
* Capital losses. Limitations on capital losses were implemented to
reduce the reward for timing loss and gain transactions to avoid paying
taxes. Taxpayers can control when they realize a gain or a loss,
thereby minimizing tax liabilities. The limitations on deducting
capital losses are different for corporate and noncorporate taxpayers.
For noncorporate taxpayers, capital losses can be carried forward
indefinitely, but corporate taxpayers are limited to a 3-year carryback
and 5-year carryforward, with some exceptions. For corporations,
capital losses can only be allowed up to the amount of capital gains,
and individuals are allowed an additional $3,000 loss above the amount
of capital gains.
In some cases, taxpayers have losses that exceed their gross income,
resulting in a negative income flow or a net operating loss. When this
occurs, taxpayers do not owe income tax for that year and can deduct
the net operating loss against taxable income by carrying the losses
back or forward to profitable years in which they paid taxes or would
owe taxes. These deductions allow taxpayers to smooth out business
income and taxes over business cycles. Some taxpayers would attempt to
avoid paying taxes by purchasing stock or assets of a business that had
incurred a net operating loss and using the carryover loss to offset
expected future profits. To reduce such tax avoidance, Congress enacted
legislation that limited corporations from deducting net operating
losses when there is a change in ownership.
Table 2 summarizes examples of common loss limitation rules.
Table 2: Selected Examples of Loss Limitation Rules for Individuals:
Loss: Net operating loss;
Loss limitation rule: Limited to extent of taxable income. Can be
carried back 2 years or forward 20 years with other carryback periods
allowed for eligible losses, such as from casualty, theft, disaster, or
farming. There also are rules for limiting what can be deducted for
figuring a net operating loss. Items such as personal exemptions,
capital gains, and nonbusiness deductions may be adjusted when figuring
a net operating loss.
Loss: Capital loss;
Loss limitation rule: Limited to extent of capital gains plus $3,000,
which can be carried forward indefinitely.
Loss: Personal expenses;
Loss limitation rule: Some are disallowed (e.g., personal interest,
primary residence sales, living expenses) while some are limited (e.g.,
personal property taxes, medical expenses, charitable donations).
Loss: Passive activity losses and credits;
Loss limitation rule: Generally limited to extent of passive activity
income. Exceptions include a phaseout of the limitation if the taxpayer
actively participates in the passive rental income and has AGI from
$100,000 to $150,000. Also, there is an exemption for real estate
professionals who materially participate in the activity.
Loss: Gambling;
Loss limitation rule: Limited to extent of gambling gains. Cannot be
carried forward or back to other tax years.
Loss: Not-for-profit activity;
Loss limitation rule: Losses cannot be offset against other income if
the activity is not engaged in for profit. Additionally, the not-for-
profit activity rules presume that the activity is engaged in for
profit if it has produced a profit in at least 3 of the last 5 years or
for some activities 2 of the last 7 years.
Source: GAO analysis.
[End of table]
[End of section]
Appendix III: Comments from the Internal Revenue Service:
Department Of The Treasury:
Internal Revenue Service:
Deputy Commissioner:
Washington, D.C. 20224:
September 4, 2009:
Mr. James R. White:
Director, Tax Issues:
United States Government Accountability Office:
Washington, D.C. 20548:
Dear Mr. White:
Thank you for the opportunity to review your draft report entitled "Tax
Gap: Limiting Sole Proprietors Loss Deductions Could Improve
Compliance, but Would Also Limit Some Legitimate Losses (GAO-09-815)."
This is a timely and important topic due to the current economic
environment, which we expect will increase sole proprietor losses.
We agree that addressing noncompliance among sole proprietors is
important because they are responsible for a large portion of the tax
gap. As the report acknowledges, we have compliance programs to ensure
that sole proprietors are properly reporting expenses.
We concur with both of your recommendations and we expect they will
help strengthen our existing programs. We will conduct research to
determine the percentage of sole proprietor returns in the total
population which report activities not engaged in for profit and
quantify the extent of the noncompliance among those returns. We will
also capture and analyze similar information from our on-going
compliance programs.
A detailed response to your specific recommendations is attached. We
appreciate the continued and valuable support from you and your staff
on this issue. If you have any questions, or would like to discuss this
response in more detail, please contact Christopher Wagner,
Commissioner, Small Business/Self-Employed Division at (202) 622-0600.
Sincerely,
Signed by:
Linda E. Stiff:
Enclosure:
[End of letter]
Enclosure:
GAO Recommendations and IRS Responses to GAO Draft Report:
Tax Gap: Limiting Sole Proprietors Loss Deductions Could Improve
Compliance, but Would Also Limit Some Legitimate Losses:
Recommendation 1:
In order to better assess whether changes are needed in the way IRS
administers activities not engaged in for profit provisions, we
recommend that the Commissioner of the IRS take steps to estimate the
extent of activities not engaged in for profit noncompliance from its
ongoing research programs.
Comment:
IRS Research, Analysis and Statistics and Small Business/Self-Employed
Research will conduct research to determine the percentage of sole
proprietor returns in the total population which report activities not
engaged in for profit and use National Research Program data to
quantify the extent of the noncompliance among those returns.
Recommendation 2:
In order to better assess whether changes are needed in the way IRS
administers activities not engaged in for profit provisions, we
recommend that the Commissioner of the IRS take steps to collect
information on examinations involving activities not engaged in for
profit issues from the compliance program.
Comment:
Small Business/Self-Employed Examination will make recommendations on
modifying the Report Generation Software to add new reason codes
allowing for additional data from all regular income tax examinations
to be captured and subsequently analyzed.
[End of section]
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
James R. White, (202) 512-9110 or whitej@gao.gov:
Acknowledgments:
In addition to the contact named above, Kevin Daly, Assistant Director;
Michele Fejfar, Leon Green, Shirley Jones, Edward Nannenhorn, Karen
O'Conor, Erin Saunders-Rath, Sabrina Streagle, and Ethan Wozniak made
key contributions to this report.
[End of section]
Footnotes:
[1] GAO, Tax Gap: A Strategy for Reducing the Gap Should Include
Options for Addressing Sole Proprietor Noncompliance, [hyperlink,
http://www.gao.gov/products/GAO-07-1014] (Washington, D.C.: July 13,
2007).
[2] Ordinary means that the expense is common and accepted in the sole
proprietor's industry. Necessary means that the expense is helpful and
appropriate for the sole proprietor's industry. Generally, to be a
trade or business the sole proprietor has to demonstrate that he or she
has a profit motive and the scope of the business's activities is
considerable, regular, and continuous.
[3] Treasury Regulation 1.183-1 and 2. The regulations' nine factors
consider (1) the manner in which the taxpayer carries on the activity;
(2) the expertise of the taxpayers or his or her advisors; (3) the time
and effort expended by the taxpayer in carrying on the activity; (4)
the expectation that assets used in the activity may appreciate in
value; (5) the success of the taxpayer in carrying on other similar or
dissimilar activities; (6) the taxpayer's history of income or losses
with respect to the activity; (7) the amount of occasional profits, if
any, that are earned; (8) the financial status of the taxpayer; and (9)
the elements of personal pleasure or recreation associated with the
activity.
[4] For more information on the Math Error Program, see GAO, Tax
Administration: IRS's 2008 Filing Season Generally Successful Despite
Challenges, although IRS Could Expand Enforcement during Returns
Processing, [hyperlink, http://www.gao.gov/products/GAO-09-146]
(Washington, D.C.: Dec. 12, 2008), and Tax Administration: IRS Should
Continue to Expand Reporting on Its Enforcement Efforts, [hyperlink,
http://www.gao.gov/products/GAO-03-378] (Washington, D.C.: Jan. 31,
2003).
[5] NRP's oversampling is corrected for statistically in order to make
valid population estimates.
[6] This estimate of the number of sole proprietors in 2006 includes
only those returns reporting a profit or loss. The total above excludes
about 400,000 returns reporting no profit or loss. If these were
included, the total number of sole proprietors in 2006 would be 22.1
million.
[7] Inflation adjustments were made using the gross domestic product
price index because sole proprietors cover a broad group of goods and
services.
[8] From 1998 to 2006, after accounting for inflation, business
deductions for loss returns increased by about 43 percent as compared
to a roughly 9 percent increase for profit filers.
[9] We dropped from our 2006 sole proprietor panel returns where
taxpayers changed marital status and a small number of returns where
data were not available. As a result, our panel represents about 17.2
million of the estimated 21.7 million returns with sole proprietorship
income in 2006. See appendix I for an explanation of the panel data and
methodology.
[10] Sole proprietors may not file Schedule C each year and may file
multiple years of losses or zero profit out of the 9 years that we
reviewed in the panel data. We examined the frequency of filing for
2006 sole proprietor returns. About 83 percent filed Schedule C in at
least 1 prior year. Nearly half of 2006 sole proprietors have a filing
history of less than 5 years. Another 29 percent filed all 9 years, and
62 percent of 2006 sole proprietors filed for 2 or more consecutive
years ending in 2006 with no gaps between filing.
[11] This estimate is based on the 1.2 million 2006 sole proprietor
returns with net losses and a total of 5 or more years of reported
losses from 1998 through 2006. These sole proprietors may not have
filed Schedule C each year and may have filed only 5 years of losses
and no profits out of the 9 years reviewed.
[12] Treasury Regulation 1.183-2.
[13] As in the case of the 2006 panel, we dropped from our 2001 sole
proprietor panel returns where taxpayers changed marital status and a
small number of returns where data were not available. As a result, our
panel represents about 14.9 million of the estimated 18.3 million
returns with sole proprietorship income in 2001. We adjusted dollar
amounts for inflation using the gross domestic product price index when
calculating the percentage of sole proprietor returns that earned an
overall profit from 1998 through 2006. The confidence interval for the
estimate of the percentage of returns that reported a loss in 2001 but
not in previous years that earned an overall profit from 1998 through
2006 is +/-3.1 percent.
[14] Some sole proprietors could not deduct allowable losses because
they did not have enough other income to deduct the losses against.
However, these taxpayers may claim a net operating loss if their
adjusted gross income net of itemized deductions or the standard
deduction is negative. Generally, taxpayers can use their net operating
loss from one year to offset income in other years. We could not
examine the extent to which this is occurring with the data available
from IRS.
[15] The confidence interval for the estimate of the percentage of
losses that were noncompliant in 2001 is +/-3.3 percent.
[16] The confidence interval for the estimate of the amount of profits
sole proprietors with losses failed to report is +/-10.8 percent.
[17] For fiscal year 2008, IRS used 2.77 million revenue agent
examination hours to examine sole proprietors. Based on revenue agents
using 58 percent of their time for examinations (called direct time)
with 10,080 revenue agents assigned to examinations rather than support
functions, sole proprietors' examinations used 23 percent of direct
revenue time.
[18] Of the 22.1 million sole proprietor returns filed for tax year
2006, as reported by SOI, 165,000 sole proprietor returns were examined
in fiscal year 2008. Assuming that these returns were noncompliant at
about the same rate as tax year 2001 sole proprietor returns (70
percent) examined in the 2001 NRP study and that 90.5 percent of the
noncompliant sole proprietor returns were accurately selected
(corresponding to the 9.5 percent no change rate in 2008), then about 1
percent of the noncompliant returns were examined.
[19] [hyperlink, http://www.gao.gov/products/GAO-07-1014], 22.
[20] These rates are for all examinations within IRS's Small Business
and Self-Employed Division, which examines, for example, sole
proprietors, individuals with business or farm income, partnerships,
and small corporations.
[21] IRS is prohibited by law from completing more than one examination
of any taxpayer during any tax year. Therefore, IRS may need to
determine whether any additional issues on the return need to be
examined before concluding the contact with reviewing sole proprietor
expenses through the AUR program.
[22] As reported earlier, the NRP estimated that $15 billion of
reported sole proprietor losses were noncompliant in 2001. We estimated
the amount of noncompliant losses in 2006 assuming that the same
percentage (53 percent) of dollars of sole proprietor losses reported
in 2006 was noncompliant as in 2001.
[23] However, significant sole proprietor noncompliance has also
created a distortion that encourages sole proprietor formation.
[24] Taxpayers are allowed to fully deduct allowable losses from S
corporations against other income. See Internal Revenue Code § 1366.
[25] An exception to the passive activity rule is the case of passive
rental activity wherein $25,000 in losses over the amount of passive
rental income may be deducted. This $25,000 deduction limit is
gradually reduced to zero dollars from AGI of $100,000 to $150,000. See
I.R.C. § 469.
[26] Sole proprietorships that are noncompliantly offsetting other
income are effectively tax shelters.
[27] The $3,000 ceiling is approximately the median Schedule C loss in
2001, according to NRP data.
[28] The confidence interval for the estimate of the percentage of
losses that were noncompliant in 2001 is +/-3.3 percent and the
confidence interval for the estimate of the percentage of losses that
would have been affected by a $3,000 limit in 2001 is +/-4.3 percent.
[29] This analysis assumes that these taxpayers had not filed before
1998 because we did not have data for years before 1998. Also, we
assumed that the rule had been in effect since at least 1998, and the
taxpayers had already offset as much income as possible from previous
years' losses. Finally, we assumed that taxpayers would carry losses
back to previous years if possible before carrying them forward.
[30] I.R.C. § 183(e) authorizes a taxpayer to elect a deferral of a
determination of the profit motive. However, with the election the
taxpayer agrees to extend the statute of limitations for the period of
the deferral for up to 2 years after the due date of the return for the
last year of the deferral period.
[31] Forty-eight percent of taxpayers filing losses in 2001 were found
to have at least $100 in compliant loss by the NRP examination, giving
a population of about 2 million taxpayers in 2001 with compliant
Schedule C losses of at least $100 in 2001. For the 2006 estimate, we
assumed that the percentage of those filing Schedule C losses that have
at least $100 in compliant losses remains stable over time.
[32] The process of identifying issues or return line items for
examination is called classification. If an item is classified, the
examiner must audit this issue and document the results of this work in
the examination workpapers.
[33] RGS is used to prepare examination reports, propose adjustments,
and complete examination closing documents. It also provides a taxpayer
with a report on tax law and interest computation resulting from an
examination.
[34] IMF is IRS's authoritative data source for individual tax account
data, including assessed tax liabilities, refunds sent, and tax
payments due.
[35] Some personal expenses can be deducted if the taxpayer itemizes
deductions, such as charitable contributions, mortgage interest, or
medical expenses. These deductions may have a minimum allowed amount
(such as amounts greater than 7.5 percent of a taxpayer's AGI for
medical expenses), or a maximum amount (such as charitable
contributions in excess of 20 percent, 30 percent, or 50 percent of
AGI, depending on the type of contribution), or they may be reduced or
disallowed for taxpayers with higher incomes.
[36] S. Rep. No. 552, 91st Cong. 1st Sess., 103 (1969), U.S. Code Cong.
& Admin. News 1969, 1969-3C.B. 635.
[37] Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085.
[38] Joint Committee on Taxation, General Explanation of the Tax Reform
Act of 1986 (Washington, D.C., May 4, 1987), 263.
[End of section]
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