A Failed IRS Policy: Targeting SMBs to Fill the Tax Gap

The Internal Revenue Service's own great white whale, otherwise known as the "tax gap," is proving to be every bit as elusive as the fabled creature of Melville's classic novel.

Over the last few years, the agency has been attempting to step up tax audits, particularly of microbusinesses (with five or fewer employees) and sole proprietors. But a couple of new studies suggest that tax audits, even of major corporations, are yielding far less than might be expected.

In light of the findings, the IRS and National Taxpayer Advocate Nina Olson appear to be taking a more conciliatory view of the problem. That could finally take the heat off of small businesses if Congress also wises up.

You may recall Olson sparked the latest frenzy earlier this year in her annual report to Congress. She called the tax gap one of the "most serious problems" facing taxpayers. Since then, Senate Finance Committee Chairman Max Baucus, D-Mont., has been pressuring the IRS to commit to achieving a 90 percent compliance rate by 2017. The current compliance rate, the principal indicator of the tax gap, is 84 percent. It has hovered between 81 percent and 85 percent for the past 30 years.

The IRS believes that more than 80 percent of the gap is caused by underreported income, and says the self-employed report less than half (43 percent) of the money they earn. That's put the bull's-eye squarely on the back of small businesses. In FY 2006, for example, the IRS examined 17,871 small corporations, more than double the 7,294 small firms audited in 2004.

In the most recent Senate hearing earlier this month, however, the IRS conceded that no quick fixes exist. Any improvement, it stated, would only be realized "incrementally over a number of years." That's not exactly what the committee chairman expected to hear. But a recent report by the Government Accountability Office (GAO) illustrates why the agency may be reluctant to commit to anything more.

To search for small businesses that underreported income, the IRS uses a computer program that attempts to match information on tax returns with information submitted to the IRS from third parties, such as banks. At best, the program leads to some sort of contact -- audit or otherwise -- with less than 3 percent of noncompliant small businesses annually, according to the GAO.

What's more, the GAO found that among the nation's 1 million sole proprietors, the amount of understated income was minuscule; about half the understatements were for $900 or less, and only 10 percent were more than $6,200. Thus, finding those sole proprietors who are underreporting enough income to justify the cost of an audit or other IRS attention is tantamount to looking for the proverbial needle in a haystack.

But that hasn't stopped the IRS from trying. The number of hours IRS agents spent auditing companies with less than $250,000 in revenue rose by 45 percent between 2001 and 2006, according to a study by Syracuse University's Transactional Records Access Clearinghouse (TRAC), a research center that provides the public with information about federal staffing, spending, and the enforcement activities of the federal government. Yet a whopping 88 percent of these additional audit hours failed to yield an increase in tax payments.

Although not as sharp, the trend is similar for large corporations, historically the source of the lion's share of all audit dollars. Nonproductive audit hours increased by 40 percent for all corporations, even though the total number of audit hours remained roughly the same. "The number of corporate audit hours that bore no fruit is troubling primarily because the misdirection of the agency's enforcement resources ultimately could weaken the long-term interest of corporations in paying their taxes," the TRAC report concluded.

In recent testimony before Congress, IRS Commissioner Mark W. Everson has been touting the agency's stepped-up enforcement "in virtually every area." Yet the TRAC study noted that Everson has yet to address the quality of those efforts. The GAO report called the IRS's enforcement efforts "high risk" and questioned its effectiveness, noting that the tax gap has remained "massive" and "persistent." If the TRAC study suggests anything, it's that the IRS is wasting time and money by stepping up audits, especially of small companies.

In her most recent report to Congress in July, Olson also fretted that the IRS may be overreaching its enforcement efforts and courting a backlash from the public. The IRS's campaign, she noted, has flooded the Taxpayer Advocate Service with requests for assistance. Over the past two years, the service's caseload has grown by 43 percent, while the number of advocates has declined by 8 percent, she stated. The agency helps taxpayers resolve problems with the IRS.

Olson concluded that the IRS needs to go beyond efforts to collect more revenue and adopt a long-term plan that includes changing taxpayer behavior. In short, the IRS should be focusing more on educating small business owners rather than increasing audits or requiring more stringent reporting requirements.

Last April, the IRS recommended 16 measures to close the tax gap, all of which have been added to the president's FY 2008 budget. They include stepped-up audits and more stringent reporting requirements for small businesses. At best, however, the IRS estimates those efforts will close the tax gap by only $2.9 billion annually over the next 10 years, a minuscule 1 percent. Amid howls of protest from small business groups, Baucus sent the IRS back to the drawing board. Earlier this month the IRS sent a new report to Congress with several new strategies.

To its credit, the IRS's latest recommendations will improve its outreach to small firms. Other recommendations focus on enhancing services to curb unintentional errors and simplifying the tax law. That's the course it should be taking if it ever hopes to come to terms with its great white whale.