IRS compliance studies - ensuring fairness for all.

The IRS has a deep appreciation for the critical role small business men and women play in the U.S. economy. Small businesses represent more than 99% of all employers. They employ half of all private-sector workers and create two-thirds of the net new jobs in the economy. The IRS does not want to do anything to deter the entrepreneurial spirit that drives individuals to start up small businesses and to grow them.

The IRS has an important role in ensuring all small businesses play by the same rules. Small businesses face enough difficult challenges without having to deal with competitors that are willfully not paying their fair share of taxes. It has an obligation to compliant small businesses to ensure that competitors are also onboard. This is not only a matter of fairness, but also a way of supporting compliant small businesses in their effort to remain in good standing.

NRP 

The most recent individual income tax gap estimates are based on a National Research Program (NRP) study of individual 2001 returns. It is the first such comprehensive study done since 1988. The tax gap is the difference between the amount of tax imposed on taxpayers for a given year and the amount that is paid voluntarily and timely. The tax gap represents, in dollar terms, the annual amount of noncompliance with current tax laws.

The NRP study estimates the overall tax gap for all types of tax to be approximately $345 billion; under-reporting constitutes nearly 83% of the gross tax gap. The NRP study also states that compliance rates are higher on returns that include income (e.g., wages and salaries) subject to both third-party reporting and withholding, and is thus the most "visible." As expected, amounts not subject to withholding or third-party information reporting (e.g., sole proprietor income and the "other income" line on Form 1040) are the least "visible" and thus are most likely to be misreported; the misreporting estimate for "other income" is 64%.

The newest NRP study will focus on S corporations and is part of a strategy to conduct reporting compliance studies each year. The IRS decided to study S corporations for a number of reasons. Since 1985, S corporation filings have increased dramatically. In that year, there were over 720,000 Form 1120S returns filed by companies with less than $10 million in assets. By 2002, that number had grown by four times, to over 3.1 million. Over that same period, other corporate return filings actually declined by approximately 450,000. In fact, by 1997, S corporations became the most common corporate entity. In 2003, nearly 3.4 million S corporations filed tax returns, accounting for over 58% of all corporate returns fried that year. The last time the IRS conducted an S corporation study was 1984. Since then it does not have reliable reporting compliance data for S corporations.

In FY 2004, the IRS examined 6,402 S corporation returns--less than one-fifth of 1% of all S corporation returns filed. (That coverage rate is one of the lowest for any type of tax return examined by the IRS.) In comparison, the IRS examined 17,097 C corporation returns and 6,226 partnership returns in FY 2004, producing coverage rates of 0.71% and 0.26%, respectively.

The current NRP reporting compliance study involves approximately 5,000 Form 1120S returns from a nationwide random sample. The IRS used asset size of the S corporation in the return selection process. Even with the increased focus from the NRP study, the overall audit rate for S corporation returns remains below that of C corporations.

In designing the S corporation NRP study, the primary consideration was to balance the need for reliable estimates for reporting compliance against the burden of collecting compliance data. The IRS wants to learn as much as possible about the extent of S corporation noncompliance and its causes so that it can devise cost-effective ways to increase compliance with current tax laws. The Service will use the NRP results to more effectively manage compliance programs and design pre-filing activities that help taxpayers comply with the law. Perhaps the greatest value of the NRP study is that it should give the IRS the ability to identify returns that merit further examination and to avoid examining compliant taxpayers.

Conclusion

Closing the tax gap will require continued diligence, not only by the IRS, but by the tax professional community. The American tax system can be administered fairly through a combination of burden reduction--to assist those who are willing to comply--and an enlightened, focused approach to enforcement--to address those who are not. Tax professionals have helped the IRS by identifying obstacles to compliance and pointing out areas of potential abuse. This cooperative effort continues to strengthen the tax system, as well as help the IRS to be more responsive to the needs of the American people.

FROM LINDA STIFF, DIVISION COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DMSION, IRS, WASHINGTON, DC