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Reasons for preparer usage by small business owners: how compliant are they?

Research For Preparer Usage By Small Business Owners:

How Complaint Are They?

Small businesses, both sole proprietorships and small corporations, have been identified as major contributors to the income tax gap [Rice, 1990]. Although the compliance level of small business owners (SBOs) is recognized as a significant tax gap factor, little is known about their attitudes on tax compliance. This paper provides an exploratory analysis of the following questions related tax compliance by SBOs:

1. Why do SBOs use tax

practitioners? 12. How compliant are SBOs on tax

reporting decisions? 3. Do SBOs prefer to make the final

reporting decisions about

ambiguous tax items or would they

rather have such decisions made

for them by their tax

practitioners?

This article reports the results of a nationwide survey aimed att gaining a better understanding of their tax compliance attitudes. Over 1,500 questionnaires were mailed to small businesses. Although 427 completed questionnaires were returned, we analyzed the responses of only the 300 participants who actually owned some percentage of the business. The responses of these SBOs provide a basis on which future research about the tax compliance attitudes of SBOs can build.

Why Do Small Business Owners Use a Tax Practitioner?

Four potential motivations for using a tax practitioner were rated by SBOs on a scale of one ("strongly agree") to nine ("strongly disagree"). These motivations, suggested by pior studies of individual taxpayers, were:

1. To have the return prepared

correctly; 2. To pay the least tax required; 3. To avoid serious tax penalties;

and 4 To reduce the chances of being

audited. Table 1 presents overall

ratings of these motivations.

According to the respondents, the most important of the motivations for using a tax practitioner is to have the return prepared correctly. The average response was 2.03 (std. dev. = 1.99), with 88% of the respondents indicating some level of agreement with this statement. The second most important of the motivations was to avoid serious penalties. The average response was 3.05 (std. dev. = 2.53), with 75% of the respondents agreeing with this statement. Third, 65% agreed that paying the least tax required was an important reason to use a tax practitioner (mean = 3.63, std. dev. = 2.81). Lastly, 46% agreed (but 33% disagreed) that reducing the chances of being audited was an important reason to use a tax practitioner (mean = 4.68, std. dev. = 2.73). Paired t-tests indicate that the average ratings of the four potential motivations significantly differred from each other (p [isless than] .001).

The motivations for using tax practitioners appear to be consistent across respondents. Ratings of the motivations are not significantly related to whether the respondent currently uses a practitioner who is a CPA or the size of the practitioner's firm. In addition, the ratings do not vary with the respondent's revenue, net income, number of employees, industry, or other demographic variables (age, gender, education and household income). The ratings do, however, differ across the form of business used by SBOs. Owners of corporations indicated stronger agreement with the motivation of "having the return prepared correctly" than did sole proprietors. In addition, having the return prepared correctly and avoiding penalties were more important motivations for SBOs who did not own 100% of the company than to SBOs who owned the entire company. This suggests that shared ownership may provide an incentive to comply.

How Compliant Are Small Business Owners On Tax Reporting Decisions?

Measuring taxpayer compliance for any taxpayer is difficult. Self-reports are often criticized as untruthful, and government audits are often criticized as inaccurate. Even if all of the black and white errors were identified in the audit data, there would still be a myriad of gray tax issues in which the compliant position has not yet been defined by tax authority. This study presents results of direct self-reports of SBOs and on several indirect measures used to capture the respondents' tendencies toward aggressive tax reporting decisions.

Regarding actual noncompliance, SBOs were asked if their companies had ever knowingly failed to report some income in the past five years. Responses ranged from one ("never") to nine ("every year"). The average response was 1.78 (std. dev. = 1.80), with 75% of the respondents indicated that they had "never" knowingly failed to report income. This indicates potential underreporting of income by 25% of the SBOs. Similarly, 72% said their companies had never overstated deductions in the past five years, suggesting that 28% have (mean = 1.87, std. dev. = 1.82). When the two scales are combined, 62% deny any noncompliance; 21% admit to either underreporting income or overstating deductions; and 17% admit to both underreporting income and overstating deductions. These results are presented in Table 2.

The above results indicate that 38% of the respondents admit to some actual noncompliance on a past tax return (TOTALNC). When participants were asked to respond to a hypothetical tax reporting decision, 38% said they would not report the income (PRIZE). These two measures of noncompliance, TOTALNC and PRIZE, are significantly correlated (r = -.335, p < .01).

To measure subjects' tendency toward aggressive tax reporting, SBOs were asked how certain they would have to be (on a scale of from 0 to 100%) that the IRS would allow a deduction before they would claim an ambiguous deduction. In regards to ambiguous areas on the tax return, a variable labelled CERTAIN was analyzed to measure the subject's tendency toward aggressive tax reporting. The variable asked how certain (from 0 to 100%) the SBO would have to be before he/she would claim an ambiguous deduction. The average response was 70%, and the median was 75. Only 14% of the respondents said they would deduct an item when the level of certainty was below 50%. These numbers are conservative when compared to the ABA and AICPA's guidelines that material ambiguous items can be reported in the client's favor when a 33% chance of winning exists. Even though the responses to this measure of ambiguous tax rule decisions are conservative, they are significatly correlated with TOTALNC, admitted noncompliance (r = -.227, p < .01). See Table 3 for the correlations among these tax reporting variables. These correlations are essentially the same when UNDERINC and OVERDED are substituted in the dichotomous variables as well as when noncompliance is more strictly defined as a three or higher response on the two scales.

The aggressive reporting variable, CERTAIN, is of particular interest. Much of the preparer literature suggests that preparers contribute to taxpayer compliance in unambiguous areas, but contribute to noncompliance in ambiguous areas [Klepper and Nagin, 1987; Ayres et al, 1989]. Prior studies generally have referred to verbal expressions of certainty rather than percentage estimates as used in this study. For example, Westat [1987] classified CPAs and lawyers as obstacles to the IRS mission because of their agreement with certain statements. One of these statements addressed whether preparers should take a pro taxpayer position when there is a reasonable basis. Whether this statement indicates an overly aggressive stance depends on one's definition of "reasonable basis."

In this study, the SBOs were asked whether a tax practitioner should resolve all questionable items on a return in favor of the client if there is a reasonable basis. On a scale from one for strongly agree, to nine for strongly disagree, the mean was 2.98 (std. dev. = 2.25), and 72% agreed. The correlation between this measure (labeled ADVOCATE) and CERTAIN was significant (r = .164, p < .01). This indicates that the more one agrees with pro taxpayer positions because of a reasonable basis, the lower the required percentage certainty for ambiguous positions. Nonetheless, when the advocacy variable was dichotomized into those that agree with a reasonable basis position versus those who do not, those agreeing with the reasonable basis position had an average percentage certainty of 67% (std. dev. = 29.38) with a median response of 75%. Only 17% of the responses were below 50%. Hence, this indirect definition of a reasonable basis, 67% on average, would probably be construed in the courts as more than reasonable.

To further pursue this issue, some of the SBOs were asked several yes-no questions to determine if SBOs would want to claim a deduction:

1. When it is very probably going to

be allowed; 2. When it is more likely than not

going to be allowed; and 3. When there is a realistic possibility

of it being allowed; 4. When there is a reasonable chance;

and 4. When there is a slight chance of it

being allowed.

These questions, however, were only asked in one of the two data sets reported in this study (n = 151). The results are presented here to further explicate how SBOs equate percentage chances with verbal surrogates. When the deduction would very probably be allowed, 97% said they would claim it; 91% said they would claim it when it would more likely than not be allowed. When there was a realistic possibility, 85% were willing to claim the deduction, and 73% went along with a reasonable chance. Only 23% said they would claim the deduction when there was a slight chance of it being allowed.

For those who would only claim the deduction when it would very probably be allowed, their average response on CERTAIN was 83%. For SBOs who said they would claim the deduction only when it had at least a "more likely than not" chance, the mean response for CERTAIN was 90.56. For those indicating a desire to have at least a realistic possibility of success, CERTAIN averaged 85.76. CERTAIN was 69.72 on average for those who wanted at least a reasonable chance, and it was 52.10% for those who indicated they would claim a deduction when there was a slight chance of it being allowed.

The implication from these results is that SBOs who claim deductions using a "reasonable basis" criterion may be stereotyped as aggressive taxpayers. This stereotype appears unwarranted given that these same SBOs want an average 67% certainty that a deduction would be allowed before they would claim it. Moreover, if the percentage certainty responses are appropriate definitions of the verbal measures, then tax practitioners may be misinterpreting the level of aggressiveness on ambiguous issues that their clients desire. This result is consistent with the implications of a study by Hite and McGill [1991] in which taxpayers using paid preparers were a generally nonaggressive taxpaying clientele.

Variations in Aggressiveness

Jackson and Milliron [1986] summarized much of the literature on taxpayer noncompliance. They reported mixed results on the effects of education and income on noncompliance. In addition, most studies found a significant correlation between compliance and age as well as between compliance and gender with males tending to be more noncompliant. These demographics are examined in the present study for SBOs, and the results are presented in Table 4.

Age is significantly correlated with three measures of noncompliance. First, younger SBOs report more past noncompliance due to overstating deduction than older SBOs (NCD). Interestingly, age is not significantly correlated with noncompliance from understating income (NDI). Similarly, education is significantly correlated (r = .142, p < .01) for admissions of overstating deductions but not on underreporting income (r = -.004). Second, younger SBOs are associated with hypothetical noncompliance (PRIZE). Third, the age relationship does not vary with percentage certainty desired before claiming an ambiguous deduction. Gender, however, is associated with CERTAIN (r = -.171, p < .01). Males tended to report lower percentages of desired certainty. In addition, percentage certainty was negatively associated with education (r = -.194, p < .01) and household income (r = -.2243, p < .01).

Industry and entity effects on aggressive tax reporting decisions of small business owners have not been established in prior literature. Information is presented in Table 5 to provide a background for future research.

Note that the retail industry has significantly more admissions of underreporting income than does the service, wholesaling or manufacturing, ([X.sup.2] = 5.46, p = .019), but this is not true for overstating deductions ([X.sup.2] = .011, p = .915). It is likely that the opportunity for cash receipts in the retail industry leads to higher occurrences of underreported income. The industry effect was not significant on hypothetical income reporting (PRIZE), nor on desired percentage certainty for ambiguous areas (CERTAIN).

Admissions of past noncompliance were not affected by whether the entity was a corporation, sole proprietorship or a partnership. Also, type of entity did not vary with PRIZE, but it did vary with CERTAIN (F = 5.02, p = .026). Those operating as a sole proprietorship or as a partnership had an average percentage certainty of 74.01 (std. dev. = 27.84), which was significantly higher than the average percentage desired by corporate entities (mean = 66.93, std. dev. = 28.59).

Should Practitioners Ask Clients to Make Decisions?

In the taxpayer study by Hite and McGill [1991], only 45% of the respondents thought preparers should ask clients to make tax reporting decisions. In contrast, 64% of the entrepreneurs in the current study agreed that they should be asked to make the final reporting decisions for ambiguous items. The implication is that entrepreneurs are more concerned with being in control of their tax returns.

Given this tendency to want to be involved in the tax reporting decisions, a related question arises as to why the entrepreneurs want to be involved. The preparer literature [Coyne 1987; and Kinsey 1987] suggests that aggressive clients push preparers towards pro taxpayer reporting decisions. Hence, in this paper we identify the frequency of desired taxpayer involvement with aggressive tax reporting measures.

Three measures of aggressive tax reporting are examined -- admitted past noncompliance, hypothetical noncompliance and percentage certainty desired for claiming ambiguous deductions (See Table 2). The question is whether reespondents making aggressive tax reporting judgments are more likely to want to be involved in making decisions about ambiguous items. Table 6 reports chi square analyses of the frequencies in which respondents who want to be involved also tend to report aggressive tax decisions.

On two of the three aggressive tax reporting measures, wanting the preparer to ask clients for the final decision was not significantly associated with aggressive tax decisions, but admitted past noncompliance was significant ([X.sup.2] = 13.84, p = .000). Overall, 64% thought that preparers should ask clients about ambiguous items. However, 76% of the noncompliers thought that preparers should ask clients, as opposed to 56% of the compliers. Nonetheless, it would be erroneous to conclude that noncompliers are the ones wanting to be asked. Of the 64% that want to be asked, 55% are self-reported compliers, and the other 45% are noncompliers.

If noncompliers were identified based on their responses to PRIZE, the hypothetical reporting scenario, then the conclusion would be that noncompliers are not more likely to want practitioners to ask them to decide ambiguous tax issues ([X.sup.2] = 0.47, p = .829). Similarly, if noncompliers were identified as those who would claim an ambiguous deduction when there was less than a 50% chance of being correct, then these aggressive taxpayers also would not be more likely to want practitioners to ask for their opinions ([X.sup.2] = 0.19, p = .659).

Why did admitted past noncompliance increase the likelihood of desired taxpayer involvement, while hypothetical unambiguous noncompliance and desired certainty failed to increase it? Future research will need to answer this question, but one potential explanation is the increased risk for the total return. Klepper and Nagin [1989] found that anticipated noncompliance was affected by the relative size of other items on the return. Hence, having misreported unambiguous items may increase the need for careful consideration of an ambiguous item that could increase one's audit probabilities.

Another explanation is the tenuous definition of aggressive tax reporting. For example, if percentage certainty required for claiming ambiguous deductions was defined as "aggressive" at a higher level (i.e., approximately 70%), then those willing to claim ambiguous deductions when the certainty of allowance is less than 70% do have a higher tendency toward wanting to give their opinions to practitioners.

The problem with this latter approach, however, is that legal precedence allows for reporting items that are "more likely than not" correct. Hence, those indicating less than 70% certainty may simply be more tolerant of ambiguity. In principal, the theoretically correct reporting decision is the one that has at least a 50% chance of winning. Consequently, those choosing less than 50% were deemed aggressive for the above analysis and these aggressive respondents were not more likely to want to make the final reporting decisions.

The end result is that based on admitted past noncompliance, noncompliers are more likely to want to make the final decision regarding ambiguous items. However, the desire to be involved in that decision is not dominated by noncompliers.

Conclusion

Similar to previous taxpayer studies, entrepreneurs believed that the most important reason to use a tax practitioner was to help ensure correct return preparation. The second most important reason was to reduce potential penalties. Third, SBOs wanted to pay the least tax that was legally required; and lastly, entrepreneurs had mixed beliefs about using practitioners to reduce their audit probabilities.

Approximately 75% of the respondents indicated they had never "knowingly failed" to report income in the past five years, suggesting that 25% indicated some level of noncompliance. For deductions, 72% reported having never "knowingly overstated" deductions. Thus, the remaining 28% were considered noncompliers. When the self-reports were combined, 38% reported some level of past noncompliance; 21% admitted to either underreporting income or overstating deductions, and 17% admitted to both.

On a hypothetical compliance question, 38% indicated they would not voluntarily report raffle prizes. Thus, the noncompliance was 38% for both past and hypothetical noncompliance and the correlation between the two measures was -.335 (p < .01).

The correlation between past noncompliance, TOTALNC, and percentage certainty, CERTAIN, was -.325 (p < .01). In other words, those who tended to evade also tended to avoid. However, the standard for avoidance was far above the 1 in 3 chance required by the ABA and AICPA for material items. On average, SBOs required a 70% chance of being correct before they would deduct an ambiguous item. The entrepreneurs indicated a pro taxpayer attitude of claiming favorable items when there was a "reasonable chance." These same "pro taxpayer" respondents who are often labeled as aggressive wanted an average percentage certainty of 67%.

Previous research has suggested that practitioners believe their clients pressure them into taking aggressive positions. This survey found that 64% of the SBOs thought practitioners should ask the clients to make final reporting decisions about claiming ambiguous items. However, of these 64% who wanted to be asked (n = 212), 45% admitted to some past noncompliance, 52% indicated potential noncompliance in hypothetical raffle income, and only 14% were willing to claim ambiguous items with less than a 50% chance of being correct.

If one considers both the high percentage who want to be involved in making reporting decisions about ambiguous tax items and the high percentage certainty desired for ambiguous items for the SBOs, the implication is that practitioners should let the taxpayers decide whether to report the ambiguous item. Based on the SBOs indirect definition of reasonable basis (67% certainty), practitioners may better serve themselves and their clients if they would communicate to the taxpayers how tenuous the ambiguous items are in terms of percentage certainty rather than abstract descriptors such as "reasonable basis."

Table 1 Descriptive Statistics and Paired T-Tests of Small Business Owners' Reasons For Using A Tax Practitioner(*)
 STD
Variable (Code = percentage Frequency) Mean Dev
CORRECT An important reason to use a tax 2.03 1.99
 practitioner is to have the tax
 return prepared correctly.
 (1=66)(2=12)(3=7)(4=3)(5=4)(6=1)
 (7=2)(8=1)(9=4)
AVOIDPEN An important reason to use a tax 3.05 2.53
 practitioner is to keep from
 getting serious tax penalties.
 (1=41)(2=15)(3=13)(4=6)(5=9)(6=2)
 (7=4)(8=2)(9=8)
LEASTTAX An important reason to use a tax 3.63 2.81
 practitioner is that he/she will
 make sure you legally pay the
 least tax required.
 (1=34)(2=15)(3=11)(4=5)(5=11)(6=4)
 (7=5)(8=4)(9=11)
DECRAUD An important reason to use a tax 4.68 2.73
 practitioner is that it will
 reduce your chances of getting
 audited.
 (1=18)(2=7)(3-13)4=8)(5=21)(6=4)
 (7=7)(8=6)(9=16)


Paired T-Tests(**)

CORRECT < AVOIDPEN < LEASTTAX < DECRAUD

(*)1 = Strongly Agree, 9 = Strongly disagree. LEASTTAX and DECRAUD were reverse coded for presentation purposes. (**)All four variables significantly differed from each other (p. < .001).

Table 3 Correlation Matrix For Measures of Aggressiveness On Tax Reporting Decisions
 NCI(a) NCD TOTALNC PRIZE
NCD(a) .469(**)
TOTALNC .8522(**) .8622(**)
PRIZE -.267(**) -.3022(**) -.335(**)
CERTAIN -.227(**) -.329(**) -.325(**) .2253(**)


(a)See Table 2 for the continuous measure underlying these variables. The continuous scales, UNDERINC and OVERDED, were dichotomized into zero for never and one for the other eight responses. This dichotomy was chosen because of the discrepancy between the labels used in the two data sets. See the appendix for the exact wording in each study. (**)significant at p < .01.

Table 4 Correlation Matrix For Demographic Variables and Aggressive Tax Reporting Decisions
 Household
 Age Gender Education Income
NCI -.096 .047 -.004 -.029
NCD -.168(**) .058 .142(**) .111(*)
TOTALNC -.156(**) .061 .082 .050
PRIZE .171(**) -.0220 -.046 -.097
CERTAIN -.019 -.171(**) -.194(**) -.243(**)


(*)significant at p < .05 (**)significant at p < .01. When nonparametric correlations were computed, the correlation between TOTALNC and AGE was no longer significant at p < .05 (r = -.127) nor was the correlation between NCD and HOUSEHOLD INCOME (r = .127).

NCI = responses for noncompliance due to underreporting income. NCD = responses for noncompliance due to overstating deductions. TOTALNC = combined responses for NCD and NCI. PRIZE = responses to question about whether respondent would report a

prize, when the amount was not reported to the IRS.

CERTAIN = responses to a question asking for the percentage certainty that
 the IRS would allow the deduction required by the respondent
 to deduct an ambiguous item on the tax return.


Table 5 Industry and Entity Effects On Aggressive Tax Reporting Positions

CHI SQUARE Analyses
 Industry Entity
 Retail Service Corp. 100%
NCI(b) 5.46 .763 .784 .432
 (.019) (.382) (.376) (.511)
NCD .011 .897 .708 1.94
 (.915) (.344) (.400) (.164)
TOTALNC 2.02 .265 1.55 2.70
 (.364) (.876) (.460) (.260)


ANOVA Analyses
 Industry Entity
 Retail Service Corp. 100%
PRIZE .01 .89 2.54 .20
 (.914) (.346) (.112) (.656)
CERTAIN(c) .38 .81 5.02 .48
 (.540) (.369) (.026) (.487)


(a)The respective statistics for the crosstabs analyses and the F statistics for the ANOVAs are are shown. The numbers in parentheses are the p values for significance level. (b)Cell frequencies for RETAIL are 156 51/45 29. Hence, 29 of the 80 retailers admitted to past income noncompliance while only 45 of 201 other industries admitted to past noncompliance. (c)Cell means for ENTITY are 74.01 for sole proprietorships and partnerships,and 66.93 for S and C Corporations. [Table Data Omitted]
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Author:Hite, Peggy A.; Stock, Toby; Cloyd, C. Bryan
Publication:The National Public Accountant
Date:Feb 1, 1992
Words:3861
Previous Article:Small business non-compliance: a view from the trenches.
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