DLO / Thursday, March 1, 2007 / Categories: Springfield Business Journal Article, Blog Post The Tax Gap What is it and what does it mean to you? The Internal Revenue Service defines the "tax gap" as the difference between the amount of tax that taxpayers should pay for a given year and the amount that is paid voluntarily and timely. The IRS continually tries to calculate and reduce the tax gap. A recent National Research Program determined that the tax gap for 2001 was $345 billion. In addition, the IRS has found that (1) over 70% of the tax gap is attributable to individual income tax, which is the largest single source of Federal receipts, (2) over 80% of the tax gap is caused by underreporting of tax (i.e., by underreporting income or overstating deductions and credits), with roughly half this amount (including self-employment tax) attributable to underreporting of net business income by individuals, (3) 18% of the tax gap is attributable to underpayments of taxes or failure to file tax returns, and (4) noncompliance is highest among taxpayers whose income is not subject to third party information reporting or withholding requirements. Based on these findings, the IRS has designed a plan to reduce the tax gap. One major tactic used by the IRS to reduce the tax gap is increased, targeted audits. Because 70% of the tax gap comes from individual income tax, the IRS first focused on small businesses which report income on Schedule C of the individual income tax return (Form 1040). The IRS audited more than 46,000 Schedule C taxpayers as part of its tax gap efforts. David Drendel, a CPA at Eck, Schafer & Punke, says that he is "seeing increased audits with tax payers of adjusted gross income of $100,000 and more, especially with small business owners. This trend is consistent with Congress increasing the IRS budget to $10.68 billion late in 2005, which included an increase in money earmarked for enforcement activities." The tax gap audits are comprehensive because they not only verified income and deductions that were reported, they searched for unreported income. In trying to determine unreported income, the IRS will look at cash transactions, your lifestyle and payment records for your lifestyle, bank statements and any other relevant information. The IRS also looks for bartering transactions. Many people do not realize that bartering creates taxable income. For example, if I provide legal services to my accountant in exchange for tax services rather than payment, we each nevertheless have taxable income. I am required to report as income the value of the accounting services I received, and my accountant is required to report the value of the legal services he received. Although the IRS will continue to audit Schedule C taxpayers, it has indicated that its next focus will be S Corporations. These are corporations which have made an election to be taxed similar to partnerships. If your business is an S corporation, you should be aware of the increased audit risk and make sure that your books and records are complete and current. A second major IRS initiative is increased third party reporting which can be seen in Forms 1099. You have probably noticed that you receive many more 1099s than you did in the past. The number of required 1099s has increased significantly because, according to the IRS, "experience shows that taxpayers are much more likely to report their income when they receive third-party notification of payments they received." This is the same reason that W-2s are issued for wages. The government does not want to trust you to tell it how much you earned. And this may be with good reason. IRS reports show that "non-farm sole proprietorships, which seldom receive third-party payer notifications, underreport about 57% of their business income on Schedule C. By contrast, wage earners who receive Form W-2, Wage and Tax Statement, underreport only about 1% of their wages." So what are the requirements for 1099s? You are only required to issue 1099s for payments made in the course of your trade or business. You do not need to issue 1099s for personal payments. Some of the most common required 1099s are for: (1) payments of $600 or more for services performed by persons who are not treated as employees, such as subcontractors, attorneys or accountants; (2) rent payments of $600 or more; (3) royalty payments of $10 or more; (4) sales of $5,000 or more of consumer products to a person for resale anywhere other than in a permanent retail establishment; and (5) any payments from which federal income tax has been withheld under backup withholding rules. There are exceptions. Form 1099 is generally not required for payments to a corporation, for merchandise, telephone, freight, storage and similar items, of rent to a real estate agent or a tax-exempt organization, or to the government. The bottom line is that tax cheats should beware but small business owners also should beware. Even if you are doing nothing wrong, an audit can be time consuming and expensive. Implement a system for your business that keeps adequate records and allows you to access them easily when they are needed. Previous Article 1031 Exchanges Next Article The Governor's Gross Tax Proposal Print 485