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State efforts: small business.

We at the state level of taxation are just beginning to recognize the great need that small businesses have for special help. We have recognized that helping a business comply is cheaper, and brings in more revenue, than waiting until a mistake is made. But we face some special challenges in implementing these changes. For one, we need more research into small business' special needs in order to help us better target our resources. And we're still struggling with how to manipulate our own budgets to pay for these new ideas. Alternatives to Enforcement may bring in more revenue in the long run. But the sad truth is, most states today still need every penny they can scrape together just to get returns processed and money deposited in the bank. Essentially, we're trying to save money for a new roof when we can hardly afford to buy a pan to put under the leak in the old roof.

As you will see later, these challenges haven't stopped state efforts to help small business. We have a problem with small businesses, and we have to help them. They are a special kind of taxpayer, one that needs special care and handling. The tax profile of a mom-and-pop bookstore in Bangor, Maine, can't be compared to the tax profile the Trump's Taj Mahal in Atlantic City.

The Small Business Problem Has Many Layers

Small businesses are special taxpayers because there are so many of them. They generate small liabilities. The time and effort they put into paying taxes is disproportionate to the return it generates to the business, so their incentive to comply is reduced. Our routine enforcement mechanisms are not realistic. Let me explain a little about each of these unique problems.

States must deal with large numbers of small businesses. Generally, the federal government has developed a dependence on income and employment taxes. States have a heavy reliance on sales and excise taxes -- about two-thirds of state revenue is from sales and excise taxes such as lodging, alcohol and automobile rentals. So states must deal with individual retailers and business entrepreneurs, rather than working farther up the revenue stream with the manufacturers and wholesalers. They're also dealing with cash businesses, with no third-party reporting. And when you factor in the employment taxes paid to states by sole proprietors and the service sector -- ophthalmologists, tree surgeons, day care centers, car mechanics, franchise owners -- you can see that states are dealing with very large numbers of fairly small-dollar taxpayers.

Small-dollar taxpayers generate small liabilities. In Illinois, 60% of the Accounts Receivable is due from sales tax. Two of the largest categories in that 60% are gas stations and restaurants -- again, small cash businesses. Consider that under most sales taxes, each PTA, Girl Scout troop, Boy Scout pack and other charitable organizations which sell anything for charitable purposes from cookies to bake sales have to collect sales tax. It is not uncommon for the largest 5% of taxpayers to account for 50% of total liabilities, and for the smallest 50% to account for 10% of total liabilities.

Small businesses don't have enough resources to deal with their tax responsibilities. The incredible demands of a small business, both in terms of capital and time, usually outstrip the business person's resources. It's been a slow month. Do you pay your employees? Your suppliers? Your utility companies? Your taxes? Time itself is a problem, too. A retailer has reporting responsibilities for federal and state income taxes, employment information, excise taxes, sales taxes, licensing, retirement plans and more. This information goes to tax agencies, to commerce departments, to the Social Security Administration, to licensing and registration agencies. Each marches to its own drummer, and we expect the businessperson to somehow keep time with them all. But the small business persons are not even in the parade. They're pretty busy trying to build a practice, rent videos and cook breakfast. What they don't already know, they're unlikely to ever learn.

There may be no statistics to back up that point, but I've heard it from nearly every state official I've talked with on this subject, so it's at least good enough for a working hypothesis: many small business people don't read. They won't even keep copies of the bulletins and advisories we send. And it isn't just a matter of time. To quote one official: "We're having a real problem lately dealing with some of our new entrepreneurs in the cities. To put it bluntly, these are all those young people who haven't been doing so well on their SAT scores."

According to all this, we can anticipate the shortage of resources for small business owners to get worse.

This contributes to low compliance among small businesses. An IRS study on the legal sector of the federal tax gap shows that small corporations have a compliance rate of about 75%. Sole proprietors and other types of small business people have a compliance rate of about 41%. Depending on how you define small businesses, they account for one-quarter to one-third of the federal tax gap.

Routine enforcement is not a realistic alternative. We don't need statisticians to tell us that when you have many small businesses, a massive enforcement effort is not the answer. According to the IRS' own Compliance 2000 report, no more than 30% of the tax gap can ever be collected through enforcement, even if it had adequate resources, because the gap is made of so many taxpayers in such small amounts. It simply is not cost-beneficial. Instead, Compliance 2000 recommends focusing on encouraging and rewarding citizen support of and participation in the tax system -- enhancing voluntary compliance, or Alternatives to Enforcement.

This small business problem is costly to taxpayers and tax agencies alike.

It costs real money, because non-compliance is high. It costs in taxpayer burden, because we're demanding more than small business owners can given. And it costs tax agencies time and money to deal with these accounts.

High non-compliance -- that's the real-money price we pay for complexity. For the most part, the non-compliance is not intentional, but results from a lack of understanding. They simply don't know any better. A large chemical company is likely to have a room full of tax attorneys to render advice on use tax liabilities. How is a recently graduated optometrist, just opening her own small practice, supposed to find out about the use tax that's due on testing equipment? How should a video store owner determine whether to collect sales tax or pay use tax on a video that will be rented for awhile, then may be sold? How does the owner of a bed-and-breakfast determine how much of the bill is for lodging and how much for breakfast, because they are taxed differently? They generally guess. And if they guess a little on the low side, as has been known to happen, the state loses tax revenue.

Taxpayers pay a price in time and frustration. It isn't easy to become knowledgeable in tax law, even if you had proper resources. These small businesses are hardly equipped to deal with the complexities in our combined state and federal tax laws. Sales tax is one of the most complex creatures ever invented. Take 5% of the purchase price, and send it in? In your dreams. Until sales tax simplification passed in Illinois, which was an act of mercy for the taxpayer and the department alike, the sales tax return required 164 lines to complete. You have to consider whether each purchase you've made is exempt or non-exempt. Are any of your purchasers exempt from sales tax? Which of the products you've sold is exempt, and which are non-exempt? How do you account for returns and refunds? To which number do you apply your merchant's discount for timely payment? Does the discount have to be adjusted because of a credit you just received for overpayment of last month's tax?

This is where the burden to the tax agency become visible. Just fixing the math errors on these returns takes tremendous resources. Fixing errors isn't an enforcement effort, and it doesn't help the taxpayer, it just eats up manpower. It's a tremendous burden on us. In the case of the old complex Illinois sales tax return, one-third of the returns were submitted with errors that had to be corrected.

So we recognize the small business problem, and we see the high cost of ignoring it. Where do we go from there?

Again, evidence backs up what our common sense tells us: the taxpayers are trying, so the key is to help them do a better job.

Washington State produced a study about a year ago which showed 93.7% of its businesses voluntarily reported the tax due. Almost half of the noncompliance that does exist is from registered businesses -- those on the books, filing returns -- which underreported their taxes. And the number one reason for underreporting given by the state auditors themselves when they discovered these underpayments is ignorance. Almost half of underreporting was caused by ignorance. The rest is due to errors, fraud and differences of opinion.

The report says, "Ignorance of tax laws and rules appears to be a particular problem for newer and smaller firms and business partnerships." It also shows that smaller firms, those with less than $100,000 in gross income, have greater non-compliance as a percentage of tax liability. These small firms underreported their taxes by 30% of liability. The largest firms underreported by 1.5%. We're also learning that ignorance and complexity are inextricably linked, and both lead to non-compliance.

The General Accounting Office, in its report "Efforts to Prevent, Identify and Collect Employment Tax Delinquencies," says that, "We believe that some employers may be delinquent because they do not understand the deposit rules, and simplification would probably prevent some delinquencies. The complexity of the rules may be part of the reason that about one-third of the nation's employers are assessed at least one penalty annually for failure to comply with the deposit requirements."

Another GAO report, "Profiles of Major Components of the TaxGap," calculates that the tax gap for sole proprietors and small corporations is attributed to the complexity of tax laws, and intentional noncompliance to survive in competitive business environments.

So failure to pay the correct tax tends to come from not understanding the law, not knowing how to complete a form correctly, not having time to read the bulletins and newsletters, and from dealing with tax laws that are too complex.

Thus, states have developed a basic, traditional approach to the problems facing small businesses. They're trying to educate taxpayers, modify forms, write better and provide more training.

Almost all states have a wide number of programs to reach taxpayers in general and often, small business persons in particular -- toll-free assistance numbers, bulletins and newsletters, and plenty of walk-in assistance in most major cities. Illinois has a dedicated toll-free line just for small business owners. Virtually every state tries to reach small business owners by joining with either the Small Business Administration or the IRS in their small business workshops.

Most states participate in general speeches, seminars and workshops designed to help the taxpayer. The majority of these seminars and workshops are directed toward the new business person or the small business owner. Some go farther. Arizona has begun special training sessions for sales tax filers, and is trying to blanket the state with this special assistance. Washington State has just begun a new business outreach seminar. Utah has started a new business sales tax workshop.

Each state also has at least a few publications that explain general filing responsibilities. Increasingly, states such as Minnesota, Iowa, Texas, Hawaii and Utah are developing specialized publications developed for individual industries -- and again, these are publications for small businesses, for florists and contractors, not banks and airlines. Iowa is currently simplifying its industry-specific publications. Among others, Alabama, California, Florida and Utah have publications dedicated to small or new businesses, and if I may put in a plug, Utah's publication for new businesses is one of the most comprehensive and easiest to comprehend and most attractive of its kind.

Arizona last year administered $24.5 million in penalties and interest, which is a lot for a moderately populated state. Arizona believed this high number indicated taxpayers didn't understand their obligations, and it has rewritten the regulations to explain the law more simply.

As of this month, Texas is allowing business owners to file their sales tax returns electronically.

In one of the most exciting new developments, South Dakota has a special program involving special visits to new taxpayers to make sure they have been filing from the beginning and to help them understand their filing responsibilities. This licensee review program is designed to reach people who are ordinarily overlooked by the audit and collections programs.

We in the United States aren't the only tax administrators forging down this trail. Revenue Canada has a "small business liaison" in the "small business programs" group. They're in the market now for ideas on programs which would benefit small businesses. Some of the provisions of Canada's new Goods and Services tax -- the Canadian version of a consumption tax -- allows for simplified accounting measure to minimize record-keeping and tax-reporting for small businesses. The introduction to one Revenue Canada publication reads, "We have worked very hard in order to make this guide simple and easy to read."

These basic approaches have had some salutary effect. But we're always going to be working on the margin with education, training and assistance. We need to expand our vision and take a more systemic approach.

We need to step back and look at the system as a whole, and tackle the root causes of problems. We have to simplify our systems. We have to get rid of the blocks to compliance. We need programs such as the federal tax simplification legislation, which with a big push from the Service is well on its way to passing through Congress, and National Wage Reporting, which has been described by Mr. Goldberg as simply, "a concept that an awful lot of people think is a good idea." An awful lot of people think Compliance 2000 is a good idea, too. The result of Compliance 2000 has been that tax administrators everywhere are beginning to think in terms of helping taxpayers comply, rather than sitting back and daring them to make a mistake.

States have begun to take some steps in this direction, particularly in the area of simplification. Illinois' recent massive reworking of its sales tax system resulted in its return being reduced from 164 lines to 28 lines. The agency devoted an entire year to saturating the state with seminars and workshops to explain the new, simpler system. Minnesota has undergone similar simplification of sales tax. California is beginning a study on how to simplify its sales tax form.

It would be an overstatement to suggest that the states have completely turned the corner and are approaching this in a systematic fashion. Not many states have gone down this road to the extent the Service has. In part, this is because we need more information.

These all seem like good ideas, and worthy efforts. How much money do they bring in? We haven't a clue. Do they work? Well, we certainly think so, but there is little data to prove the point.

Even the IRS seems to be looking for statistics to quantify the gain from these types of programs. The IRS has just announced it is working to develop new ways to measure success. It wants to figure out how much improved compliance is worth. An Internal Revenue Service group doing research on small business compliance is attempting to measure such things as whether a small business newsletter increases the accuracy of returns and whether a tax calendar increase timeliness.

On both these regards, the IRS is ahead of state efforts. Attempts to measure or quantify our successes have been few. We're just not systematically looking at what's causing the problem with small businesses.

Minnesota tells me that it knows businesses such as bars and restaurants are poor sales tax filers, but they haven't got to the point of figuring out what to do about it. Utah wished its auditors could at least reviews the audits for the last five years and see where the common problems were, to give the agency a way to target its education programs. California says the recession there makes it impossible to know if its programs are really working. The money isn't coming in, but they don't know if it's a compliance problem or there are just no sales.

We have no great conclusions for you today. We have just enough data to indicate that emphasis has to be on voluntary compliance because of the economies of scale aren't there otherwise, and this puts a premium on alternatives of education, training, taxpayer assistance, simplification of both laws and our systems, and similar alternative efforts.

What I do have for you is a challenge. This is a field ripe for research. Help us figure out what small businesses really need in order to pay the correct amount of tax -- other than being threatened with a beating.

Harley T. Duncan was appointed Executive Director of the Federation of Tax Administrators(*) in August 1988. He has served the previous five years as Secretary of the Kansas Department of Revenue. Prior to that, he was the Assistant Director of the Kansas Division of the Budget. He has held positions with South Dakota state government, the Advisory Commission on Intergovernmental Relations and the National Governors' Association. He has a BA in political science from South Dakota State University and a Master of Public Affairs degree from the Lyndon B. Johnson School of Public Affairs at the University of Texas (1978). He is the author or co-author of serveral articles and papers on state and local taxation, and public budgeting. Verenda C. Smith has been the Governemnt Associate with the Federation of Tax Administrators(*) since November 1990. Her state tax experience includes five years with the Illinois Department of Revenue, three as a Public Information Officer in Springfield, Illinois, and two years as a communications specialist based in Washington, DC. She has a bachelors degree from Western Kentucky University in Mass Communications and a master's degree from Sangamon State University in Illinois in Business Communications.

(*)The Federation of Tax Administrators is an association of the principal tax and revenue collection agencies in the 50 states, District of Columbia, New York City and the Provinces of Ontario and Qeubec, Canada. The views expressed herein are those of the author and do not represent the position of the Federation or any of its members.
COPYRIGHT 1992 National Society of Public Accountants
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Duncan, Harley T.; Smith, Verenda C.
Publication:The National Public Accountant
Date:Feb 1, 1992
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