Small Business Tax Cheats: A $122 Billion Problem
Business + Economy

Small Business Tax Cheats: A $122 Billion Problem

iStockphoto/The Fiscal Times

When large companies like General Electric and Bank of America are 'outed' over their microscopic tax payments to the federal government, the press and the public pile on in outrage.   But they may be shooting at the wrong target.  Recently updated IRS data shows large corporations are not the only ones gaming the tax system.  Although big companies expertly maneuver the tax code to whittle down their bills legally, small businesses are actually evading taxes en masse.

The nation’s tax gap—or the difference between what the IRS is owed and what it collects—grew from $290 billion in 2001 to $385 billion in 2006.  Businesses that log income on individual returns, which are largely small businesses and farms, accounted for the single largest portion of that: $122 billion. 

As lawmakers struggle to agree on ways to control the nation’s $1.3 trillion deficit, while funding a vast array of domestic programs, it stands to reason that collecting that missing revenue would be a top priority.   But an increasingly tricky web of politics and logistics surrounding small business tax matters virtually eliminates any likelihood of a serious crackdown on these diverse entities.  

The political rhetoric on both sides of the aisle hails small business as the primary engine of job creation and economic growth, even though that  notion is highly debatable.  As a result, making any policy change that might burden or disrupt small businesses has become taboo.  President Obama joined the chorus last week, calling for the Small Business Administration to be elevated from agency-level to cabinet-level “to make sure that small-business owners have their own seat at the table.”

"If you underreport your income [in a large corporation] it’s right there. But for small business, it’s like the Wild West."

While there’s no denying that America’s million small businesses are a seismic, often beneficial force within the U.S. economy, a large proportion of owners successfully under-report their income to dodge taxes.   “There really is money there, but you are talking about getting millions of influential citizens angry at you if you say or do anything that’s perceived as stifling small business,” said Martin Sullivan, a contributing editor at Tax Analysts and a former Treasury official.

It’s much easier for small business owners to conceal income from the IRS, since they aren’t required to report their income on a W-2 form, don’t have taxes automatically withheld from their wages, and certainly don’t have IRS agents stationed in their workplace looking over their shoulder, as is the case with large corporations such like Boeing.  “Corporate employees receive regular paychecks, and it’s the easiest thing in the world for the IRS to find out if you underreport your income because it’s right there,” Sullivan said.  “But for small business, it’s like the Wild West.”

Small businesses can structure themselves as subchapter S corporations,  partnerships or pass-through entities (LLCs) , or sole proprietorships —the most common classification which accounts for about three-quarters of small businesses.  The total number of small businesses under these categories combined has shot up to 27 million in 2007 from 18.4 million in 1997, according to the Census Bureau.  Currently, more than 21 million of the country’s 27 million small businesses have no employees other than the owner. 

Under the law, anyone who collects business receipts or income and doesn’t file a W-2 form—from independent contractors to part-time writers, consultants, crafts-people, repairmen, and even individuals who sell items on eBay—count as small businesses. “These people all are supposed to report their income in April but lots don’t and continue on just fine,” Sullivan said.  That’s partly because, as of late, the IRS has focused its manpower policing wealthier businesses and individuals.  The IRS has only audited about 1 percent of businesses and individuals with $200,000 in earnings or less in recent years, compared to 12 percent of those who earn $1 million or more, according to a January report. 

"You’ve got a million little guys hiding a couple of dollars in taxes. That’s harder to devote resources to when you can focus on guys hiding a million dollars."

That shift is intentional, and unlikely to change anytime soon, said Mark Luscombe, a tax attorney and principle analyst at CCH, a tax publisher.  “With small business, the problem is you’ve got a million little guys hiding a couple of dollars in taxes.  That’s a lot harder to devote resources to and get a big bang for your buck, when you can focus on the handful of guys hiding a million dollars in taxes,” he said.  “If you’re a small business hiding a little, it’s easy to see how you would think you would be more likely to slide under their radar screen.” 

To be sure, small businesses pay more to comply with the tax law on a per-employee basis than do corporations.  According to a March 2011 Small Business Administration study, businesses with fewer than 20 employees spent $1,584 per worker on tax returns, compared to the $571 average per worker cost companies with 500 or more employees paid.  “An economy where people are struggling with their businesses may create more incentives to try and save a little bit on taxes,” Luscombe said.

Tax experts say the two key ways to prompt better small business tax compliance are to ramp up enforcement at the IRS and to subject businesses to additional third-party reporting requirements.  Those solutions are all but impossible, since the IRS budget has been cut and Congress has repeatedly voted to repeal new reporting rules set to take effect this year. 

Last fall Congress repealed a law that would have required federal, state and local governments to withhold 3 percent of small business payments to vendors starting this year, and last spring they repealed part of the Affordable Care Act called the 1099 provision, which would have required businesses to report transactions in excess of $600 a year to the IRS.  One reason for the repeals--the increased amount of paperwork required to comply with the new laws.

In a report released to Congress this month, National Taxpayer Advocate Nina Olson said the top issue harming the IRS’ ability to raise revenue, enforce the law and serve taxpayers is funding cutbacks, —which totaled 2.5 percent of the agency’s budget in 2012.   In 2010, the IRS employed 84,761 workers, compared to 116,673 in 1992. “Certainly, cutting the IRS budget is not going to increase tax revenues, decrease the tax gap, or help the situation,” said Mark Robyn, an economist at The Tax Foundation, a business-oriented think tank.  Many of the job cuts, which run the gamut from auditors to desk employees, are the result of electronic filing and software that replaces manual handling of tax returns.  

But business groups say revamping the tax code to make filing less onerous for small businesses is a more surefire way to capture revenue than hiking the IRS budget.  “Over the last 20 years we’ve had a tougher IRS, we’ve had a gentler IRS, we’ve had one that gave more taxpayer education and ramped up enforcement.  Yet we still have the same percentage of a tax gap.  That should tell you something,” said Giovanni Coratolo, Vice President of Small Business Policy at the U.S. Chamber of Commerce. 

Tax simplification won’t deter small business owners who choose to collect payments off the books, Sullivan said.   “If you’re the repairman running around collecting cash from individuals, you probably don’t have a very complicated return to begin with, so complexity is not the problem here.  It’s an unwillingness to fork over the cash and a feeling that you can get away with it.”