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Problems and prospects for Schedule C preparers.

Three recently released documents highlight the increased importance that the federal government and IRS are placing on the intersection of tax preparers and Form 1040 tax returns that include Schedule C:

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* The Small Business and Work Opportunity Act of 2007 (P.L. 110-28, 121 Stat.112) was passed May 25, 2007. Among other provisions, the act expands the preparer penalties in IRC section 6694.

* The U.S. Government Accountability Office (GAO) Report to the Senate Finance Committee concerning the "tax gap" was released in July 2007. The GAO found that 61% of sole proprietors underreported business net income. The report explored the nature and causes of this underreporting (Tax Gap: A Strategy for Reducing the Gap Should Include Options Addressing Sole Proprietor Noncompliance; GAO-07-1014; www.gao.gov/ new.itemsAi071014.pdf).

* The 2007 annual report to Congress by the IRS National Taxpayer Advocate Nina E. Olson, released December 31, 2007, analyzed 26 serious taxpayer problems and offered recommendations on how to resolve them. Several of these problems are related to sole proprietors filing Schedule C (www.irs.gov/advocate/article/0,id=17730I,00.html).

All three documents highlight increased risks faced by all tax preparers, including those preparing Schedule C returns. At minimum, there is a trend toward increased focus on tax preparers in the effort to close the "tax gap"--that is, the difference between the amount of tax that is voluntarily reported and the amount that should have been reported. The tax gap attributed solely to Schedule C problems is estimated to be more than $68 billion.

Focus on Preparers

IRC section 6694, amended May 25, 2007, imposes monetary penalties on tax return preparers for understatements due to unreasonable positions and understatements due to willful or reckless conduct. The changes increased tax return preparer penalties (from $250 to the greater of $1,000 or 50% of the income derived from the return/claim preparation), expanded the application of the penalties to tax returns other than income tax returns (e.g., estate/gift tax, employment tax, excise tax), set a higher standard of conduct on undisclosed positions (now "more likely than not," or "greater than 50% likelihood of being sustained on its merits"), and set a higher standard of conduct on disclosed positions (from "not frivolous" to "reasonable basis for" disclosed position). There has been a great deal of debate on these new standards. Legislation bringing the accuracy-related preparer penalties in line with taxpayer penalties has been proposed.

Congress was clearly sending a message that preparer penalties are a matter to be taken seriously. Nevertheless, both the GAO report and the Taxpayer Advocate's report point out that the IRS is not currently assessing or collecting preparer penalties on a consistent basis.

According to the Taxpayer Advocate's report, in 2007, only about 25% of the preparer penalty assessments were actually collected. This statistic indicates a possible lack of appropriate IRS enforcement. Potential reasons for this low collection rate, according to the Taxpayer Advocate, include the following:

* The IRS may abate penalties based on consideration of the "preparer's individual financial condition." The result is that preparers without substantial assets are forgiven.

* The IRS has no formal program to pre vent preparers from continuing as an authorized IRS e-file provider when penalties are outstanding. The result is that preparers may not incur a sanction that would prevent them from practicing as usual.

* The IRS's Automated Suitability Analysis Program (ASAP) for reviewing a preparer's status uses limit checks on penal ty amounts to generate a weekly report. These limits are currently set too high and flag only very large penalty situations. Additionally, the IRS only selectively investigates the preparers actually flagged by the ASAP.

The IRS Taxpayer Advocate concluded that "given the multiplier effect of return preparer behavior on taxpayer compliance, the IRS needs to place top priority on assessing and collecting preparer penalties."

It is expected that the number of Schedule Cs being filed may increase in part due to the addition of IRC section 761(f) by the Small Business and Work Opportunity Act of 2007. IRC section 761(f) allows qualified joint ventures (e.g., a husband and wife are the only members of a trade or business in which both materially participate) to elect not to be treated as a partnership and instead file two Schedule Cs in lieu of a partnership return with two K-ls. An additional factor impacting the number of Schedule Cs filed is the perennial "employee versus independent contractor" issue. Every worker who is reported to be an independent contractor (instead of a W-2 employee) would likely have to file a Schedule C with a Form 1040.

A variety of options have been proposed to close the Schedule C tax gap that would require IRS, Treasury Department, or congressional action. Tax professionals who prepare Schedule Cs should be aware of the options and prepared to address the changes that may occur.

Schedule C and the Tax Gap

The IRS data compiled from detailed examinations of a representative sample of 46,000 individual returns in 2001 was used to estimate that $68 billion of the $345 billion gross tax gap was attributable to sole proprietors filing Schedule C returns that underreported net taxable income. These Schedule C estimates represent the most recent reliable data from the IRS.

The underreporting of net income was caused by the misreporting of both revenues and expenses. From these examinations, the IRS estimated that 39% of sole proprietors misreported revenues and 73% misreported expenses. The misreporting percentages include both overstatements and understatements. The net effect of the revenue and expense misstatements is that 61% of sole proprietors filing Schedule C returns under-reported net business income (9% overreported, and 30% correctly reported). Given the tax burden, the complexity of the tax laws, and the prospects for being audited, this is not surprising news to most Schedule C preparers. Fortunately for taxpayers, more than half of these understatements were relatively small amounts: The average tax understatement was only $903.

The bulk of the tax gap is due to a relatively small portion of the total Schedule C filers. The top 10% of sole proprietors, based on the size of the understatement, had an average understatement of tax of $18,000. This top 10% constituted a large number of returns, about 1.25 million of the approximately 18.5 million nonfarm Schedule C returns filed in 2001.

The understatement of net income problem may be worsening. The' number of problem returns is likely increasing, because the number of Schedule Cs filed increased to more than 20.6 million in 2003, representing an increase of approximately 5% annually from 2001.

The tax problem is complicated, because Schedule C filers, in addition to their own federal income taxes, must also pay Social Security and Medicare taxes (Schedule SE) on their Schedule C income. Furthermore, they are also responsible for Social Security, Medicare, and federal and state unemployment taxes, as well as federal and state income tax withholding for employees.

There is some evidence that suggests the misreporting of expenses, though a large and increasing absolute amount, might be improving in relative terms. As shown in Exhibit 1,nonfarm sole proprietorship profits as a percentage of business tax receipts increased from 18.79% in 1988 to 22.07% in 2005, an increase of approximately 3% (computed in constant dollars). This means that expenses, as a percentage of business tax receipts, decreased 3% in relative terms.

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Compliance Problems

Noncompliance with the tax law may occur for any of the following reasons:

* Missing or incomplete documents

* Transcription mistakes

* Poor bookkeeping

* Multiple businesses and other income sources

* Misunderstanding of tax law or regulations

* Misclassification of employees as independent contractors

* Deliberate underreporting of revenues and overreporting of expenses

A skeptic might say that much of the nonintentional noncompliance is due to one reason, namely the complexity of the tax code. For example, taxpayers must use 20 common law factors to determine the status of workers as employees or independent contractors. Another example is that the instructions for tilling out a 1099-MISC are eight pages long, while the instructions for filling out all 1099 series information returns are 21 pages long.

For the 2001 tax year, the IRS estimated that 39% of sole proprietors misreported gross income in the form of about $53 billion net understatement, after netting overstatements and understatements. The proportion of taxpayers misreporting expenses was estimated to be 73%, with about $40 billion net overstatement, after netting overstatements and understatements. The gross income and expense misstatements resulted in an estimated $93 billion in understated Schedule C net income. The IRS adjusted the $93 billion net income understatement estimate significantly upward in order to correct nondetected net income understatements when it then subsequently estimated that the $68 billion total tax gap was attributed solely to Schedule C filers. The IRS recognized that its examinations detected significantly less than 100% of the misreported net income due to the difficulty of detecting omitted items, especially cash receipts.

The incorrect reporting was not all in the direction of lowering the taxable income: The IRS estimates that 9% of the 2001 Schedule C filers overreported their net income. This statistic tends to support the argument that a significant amount of the misreporting is due to the complexity of the tax law.

The IRS 2001 data revealed that 55% of total expense misreporting was concentrated in four categories. The following is the percentage of returns with errors, by category:
* Car and truck  50%
* Depreciation   42%
* Supplies       41%
* Other          55%


The previous 2001 IRS data is supported by Exhibit 2, which shows that in 2005 these categories comprised four of the six largest Schedule C reporting categories.
EXHIBIT 2
Nonfarm Sole Proprietorship Total Business Expenses, Tax Year 2005

Travel                                                           2.0
Total interest                                                   2.2
Office expenses                                                  2.3
Advertising expenses                                             2.6
Repairs                                                          2.7
Commissions                                                      2.8
Taxes paid                                                       3.0
Insurance                                                        3.4
Utilities                                                        4.1
Contract labor                                                   5.1
Suplies                                                          5.2
Depreciation                                                     7.0
Rent paid on machinery, equipment, and other business property   7.1
Car and truck expenses                                          12.8
Salaries and wages                                              13.5
Other business deductions                                       24.2

Source: Curry and Bryan, p.10, www.irs.gov/pub/irs-soi/05solep.pdf

Note: Table made from bar graph.


IRS Enforcement Actions

The IRS currently has two main enforcement programs applicable to all taxpayers, including sole proprietors. These programs are applied to less than 5% of total returns filed, however, and only about 3% of Schedule C filers.

One major enforcement program is the Automated Underreporter Program (AUP), in which a computer matches tax return information with information submitted to the IRS by third parties, such as Form 1099s. The AUP program annually contacts only about 3% of noncompliant sole proprietors.

Another enforcement program is the Examination Program (EP), which consists of IRS personnel auditing data submitted by taxpayers. The program reaches less than 2% of noncompliant sole proprietors. The actual number of Schedule C audits has been going up, from 128,062 in 2001 to 297,626 in 2006.

Most of the examinations are field examinations, rather than correspondence examinations, due to the complexity of Schedule C tax issues. In 2006, it took the IRS, on average, more than 27 hours to examine returns with Schedule C forms. The IRS tax yield on these audits was actually less than the tax yield of returns without Schedule C attachments and also less than 18 other types of returns.

One final surprising statistic is that just 62% of sole proprietors who had a 100% or more tax change amounting to $10,000 or more were actually assessed a penalty.

Proposed Changes

In 2007, the GAO proposed more than 20 possible options to improve sole proprietorship tax compliance. The following are the six most significant suggestions:

Require sole proprietors to utilize a separate business checking account. The logic behind this is it would help proprietors distinguish their business transactions from personal ones. The disadvantages include the cost of maintaining an additional checking account, which would be burdensome to Schedule C filers who do not regularly operate a business but have intermittent Schedule C transactions. Preparers might recommend this to clients with business activity above a certain threshold (e.g., $10,000), as it would simplify return preparation.

Require sole proprietors to obtain a Tax Identification Number (TIN) in lieu of using a Social Security number. This option would probably improve the IRS computer matching program and make audits easier. Given the problem of identity theft, tax preparers might recommend individuals use a TIN for business transactions as a way of minimizing use and disclosure of Social Security numbers.

* Repeal limitations in the law that prevent the IRS from providing guidance on classifying workers. As noted by Rebecca Smith in 2007 testimony to the House Ways and Means Committee (waysandmeans.house.gov/hearings.asp?formmode=view&id=5874), Section 530 of the Budget Act of 1978 was a "safe harbor" provision that restricted the IRS from attempting to collect employment taxes from individuals who "reasonably" misclassified workers as independent contractors. Section 530(b) also prohibited the IRS from issuing any regulations or rulings "clarifying the employment status of individuals for purposes of employment taxes." Many employers with independent contractors believe removing the restrictions on the IRS would require a high degree of trust in the IRS and would prefer legislative clarification with safe harbor and transition provisions.

* Create a new Form 1099-NEC. Current law requires that nonemployee compensation (NEC) information be filed with the IRS on Form 1099-MISC if payments exceed certain thresholds for various categories of payments (e.g., payments to contractors that exceed $600). The major advantage of segregating this information on a new Form 1099-NEC would be that the IRS could refine its computer matching and enforcement efforts. Common sense would indicate that, rather than creating a new type of Form 1099, it would be less confusing and less burdensome to simply modify the existing 1099 form for essential information that might currently be missing. Preparers should consider lobbying for the latter approach.

* Require withholding by those who make payments to noncertified sole proprietors. This proposal is intended to induce sole proprietors to pay more of the taxes they owe. The current system requires "backup withholding" when the IRS informs the payor, often a year or more after submission, that a TIN is invalid. The current system does not mandate withholding for noncompliant sole proprietor payees. The proposal changes this to up-front universal tax withholding for payments to sole proprietor payees unless either the TIN were certified by the IRS or the sole proprietor payee was certified as compliant by the IRS. The problems with this proposal include the fact that the IRS may not be able to promptly certify TINs--thus creating withholding whether needed or not, raising the issue of how much should be withheld, and potentially placing a burden on businesses that do not currently have systems for withholding and remitting to the IRS.

* Simplify the IRS process for assessing penalties. Equality in treatment dictates that the IRS should treat taxpayers in similar circumstances in a similar fashion. IRS penalty assessment is currently very inconsistent. One problem with setting up a more rigid and uniform process would be that a rigid system might result in high penalties for inadvertent problems, such as a computer glitch, that could affect many information returns. More rigid standards might make it harder for preparers to argue for nonassessment due to lack of intent.

Advice to Preparers

It is difficult to predict what the future will hold. Past experience, however, indicates the following:

* The IRS may try to close the tax gap by requesting a number of new or increased reporting requirements, even though this would increase the compliance burden for taxpayers.

* Congress may lift legal restrictions that currently prohibit the IRS from issuing either regulations or interpretations (via private letter rulings) on independent contractor status. This would facilitate the reclassification of some current independent contractors to employees.

The number of Schedule C audits has been increasing. This trend is likely to continue.

The IRS has been criticized for not assessing enough penalties in Schedule C audits. They will likely respond by increasing assessment and collection efforts for both taxpayer and preparer penalties.

Given the current legal position on preparer penalties, careful consideration should be given to disclosure when tax positions are considered. If a preparer is not confident (i.e., more likely than not) that a position is the correct one, disclosure on Form 8275 or 8275R should be considered.

* The final regulations for Circular 230 (TD 9359) require a preparer to inform a taxpayer of any penalties that are reason ably likely to apply to the client with respect to a position taken on a tax return if the preparer either advised the client with respect to the position or prepared or signed the tax return. Documentation of this disclosure should also be maintained.

* As in all cases dealing with tax matters, documentation is becoming more crit ical. Engagement letters and other efforts toward documenting communications with taxpayers should be carefully maintained.

The bottom line is that preparers will have to be even more vigilant when preparing Schedule C returns. Tax professionals may also want to consider providing input on any proposed changes that are put forward by the IRS or Congress.

Thomas E. McKee, PhD, CPA, CMA, CIA, is a professor at the Medical University of South Carolina, Charleston, S.C. Linda J. B. McKee, PhD, CPA, is an associate professor in the department of accounting and legal studies at the College of Charleston, Charleston, S.C.
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Title Annotation:federal taxation
Author:McKee, Thomas E.; McKee, Linda J.B.
Publication:The CPA Journal
Date:Oct 1, 2008
Words:2941
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