Fairness in Tax Compliance
Background:
The self-employed and micro-business communities face an overwhelming regulatory burden in complying with IRS regulations. According to the General Accounting Office, a small business owner faces more than 200 IRS forms and schedules that could apply in a given year. Vague and complex rules and forms can mean the demise of their business. According to a study by the Tax Foundation, in 2005 individuals, businesses and nonprofits spent an estimated 6 billion hours complying with the federal income tax code, with an estimated compliance cost of over $265.1 billion. Businesses bear the majority of tax compliance costs, totaling nearly $148 billion or 56 percent of total compliance costs.
Despite the time and cost spent on compliance, according to IRS data from the National Research Program (NRP), the nation’s tax gap, the difference between what taxpayers should pay and what they actually pay on a timely basis, is approximately $353 billion. The tax gap has three key components which include underreporting of income, underpayment of taxes and non-filing of returns. There have been numerous proposals by the Administration and in Congress regarding how to effectively increase compliance and minimize the tax gap.
Significant tax gap proposals include:
imposing withholding on non-employee payments, specifically payments made to independent contractors; increased information reporting by card companies to the IRS on the credit/debit card transactions of businesses; information reporting requirements on all payments of $600 or more to corporations; requiring businesses utilizing contractors to obtain and verify an accurate Taxpayer Identification Number (TIN) for those contractors receiving payments of $600 or more and creation of a voluntary withholding system.
In addition to commenting on the above proposals, the NASE will discuss the service versus enforcement paradigm within the I.R.S. as it relates to allocation of funding and resources and highlight alternate proposals which would assist in compliance yet be minimally burdensome and invasive to micro-business taxpayers. One key topic discussed is the complexity of worker classification regulations as an important issue affecting compliance.
Withholding on Independent Contractors and Non-Employee Payments:
The NASE feels that proposals regarding additional withholding are the most burdensome to the self-employed and micro-businesses. For sole proprietors and business owners hiring independent contractors, additional withholding in the range of two to five percent on payments made to contractors will only add to the compliance burden with a whole new set of perplexing and – for many – unmanageable and costly filing requirements.
There are significant concerns of potential requirements associated with the implementation of an additional withholding mechanism. Specifically, in regard to the requirement to withhold based on gross versus taxable income, a technical flaw that would overstate employers’ liability, since gross income often includes legitimately deductible business expenses. Also, the application of withholding on sole proprietors (Schedule C filers) only, which has been discussed by policymakers, would clearly discriminate against this type of legal business structure. Incorporated firms would not be held to this requirement.
The NASE feels that rather than adding to the burden of compliance faced by micro-business taxpayers through increased regulations, the goal should be to simplify the tax regulations. We currently have a reporting mechanism on independent contractors through the issuing of 1099 forms. We feel that rather than continue to shift both the cost and overall burden of compliance to business owners already fulfilling their tax responsibilities, the IRS should focus on fair and balanced education and enforcement efforts for those individuals that they have submitted 1099 forms on, yet have either unintentionally or willfully not complied with their tax liability.
Though the IRS Commissioner Mark Everson has stated in congressional hearings that he is not supporting the creating of an additional withholding mechanism at this time, there has been movement within Congress on expansion of withholding requirements.
In the 109th Congress, the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) was signed into law. Section 511 of this bill is a sweeping new requirement mandating that federal, state, and local governments withhold 3-percent from payments for goods and services. This new tax withholding requirement affects all government contracts as well as any payment to any person for a service or product provided to a government entity.
Though the NASE has a very small number of members which contract with the government, we are deeply concerned about the precedent this new withholding requirement sets for future regulations on business owners. For those micro-business owners that are government contractors, the withholding in this provision is based on revenues from gross payments by the government with no relationship to a companies’ taxable income and will impinge on company cash flows needed for day-to-day operations. Those small businesses interested in contracting with the government will be deterred due to this regulation. In addition, the costs to governments at all levels to administer the program will be substantial and the process exceedingly complicated to implement. The NASE is working with the Government Withholding Relief Coalition to repeal this provision.
Increasing Information Reporting on Payment Card Transactions:
Currently, most taxpayers are subject to some level of information reporting and withholding requirements. Employers on behalf of employees must report wages and withhold applicable payroll taxes and federal income taxes. Businesses must report payments made for services in connection with their trade or business of more than $600 per year. Banks must report payments of interest and dividends made to deposit holders. Almost everyone has some type of income that is reported to the IRS by their employer, their bank, or their clients. Each of these forms of reporting also include some form of backup withholding if the taxpayer fails to provide a taxpayer identification number or if the number is found to be inaccurate.
The Administration has proposed in their FY2008 budget an increase in information reporting by requiring credit and debit card issuers to report to the IRS annually on aggregate reimbursement payments made to businesses. Capturing information can have a positive impact particularly in light of those taxpayers who consciously choose to avoid reporting income. However, the NASE believes that this particular proposal could have a negative impact on the self-employed and small businesses. The main concern is what would be done with the information that is provided.
The IRS has indicated that this information could be utilized to create industry profiles, taking the total credit card receipts reported for a particular business and then extrapolating total income based on industry averages. If these profiles stemming from credit card receipts were then used to make judgments regarding other items on the tax return such as estimations on cash payments, problems will arise. The averages will only provide additional discrimination against those businesses that have higher than average credit card receipts. That higher average could be a function of the affluence of their community, their own efforts in managing the cash flow of their business and even their own decision of whether to accept a particular credit card. It will be very difficult to determine an applicable average for a particular small business that is relevant. Therefore, any action taken by the IRS based on these profiles such as examinations, requests for additional information or even tax assessments would be both burdensome to micro-business and most especially, could be irrelevant and frivolous.
Another concern regarding this proposal is that these amounts are most likely already reported anyway. The taxpayer who willingly underreports income would not knowingly choose to exclude credit card receipts since those items show up on their bank statements anyway. It is clear that the sales via credit cards are well documented and would be revealed upon review and therefore it is unlikely that those amounts would be the key source for intentional underreporting. Additionally, this new level of regulatory burden place on credit card issuers will likely lead to increased fees being passed on to businesses which conduct credit card transactions. Increased fees will have a negative impact on revenues and sales of micro-business owners.
Therefore, the NASE is concerned that this approach may not be targeting the source of underreporting and could serve to increase the costs associated with credit card usage without identifying any additional taxable income that would not have already been reported.
Information Reporting Requirements on Payments to Corporations:
Under our current system, corporations are exempt from our current Form 1099 information reporting system which requires all other taxpayers making payments of $600 or more for services to send a Form 1099 to the IRS. In the FY2008 Budget, the Administration proposes an expansion to the form 1099 filing system by requiring a business to file an information return on payments to corporations aggregating to $600 or more in a calendar year. The Department of Treasury maintains that the exemption of corporations under the current system has created compliance issues and this new proposal will level the playing field. Additionally, they are strong proponents of utilizing reporting requirements as a way to increase overall tax compliance.
The NASE has consistently supported creating a fair and level playing field for the business community in regards to tax regulations and encourages access to information with the express stipulation that the benefit outweighs the regulatory burden and cost to the taxpayer and government. This proposal will substantially increase the regulatory burden on all business, and the self-employed and micro-businesses would be particularly affected by this proposal. Additionally, we have concerns over the use of this data and the cost to the government in terms of infrastructure and staff to manage the influx of paperwork.
The burden to file an information return lies on the recipient of services. With the threshold triggering a reporting requirement at $600 or more, many daily operational activities that tend to be outsourced by small businesses will be affected such as ground and express mail services. For example, a micro-business owner who spends over $600 for express mail services by UPS would then have to prepare form 1099 and send a copy to the IRS and to UPS. This creates further paperwork burden for micro-business and could potentially enhance difficulties with compliance if the business has not been required to utilize the 1099 filing system previously.
There has also been no indication regarding the uses of this data. We are uncertain if these returns will enter the Form 1099 matching system currently utilized by the IRS or if they will simply be filed for review if necessary. Also, the NASE has concerns about whether the current infrastructure and staffing levels of the IRS is adequate to handle the surge of paper that this and other proposals will create. There has been no indication of the cost to the federal government of instituting this proposal.
The NASE is requesting more detailed information on this proposal. Based on preliminary review, we encourage the Department of Treasury and the IRS to consider creating a program that would allow individual corporations to apply to obtain an exemption from this regulation. For example, as per our previous example, UPS would be able to go through a process and apply for exemption from this new requirement and thus, businesses utilizing their services would not have to file information returns. The purpose of this is to mitigate regulatory burden while also assuring tax compliance, since companies receiving exemption would be vigorously reviewed by the IRS. An alternative proposal would be allowing a higher threshold (i.e. $2500) for corporations to triggering information reporting.
Requirement on Businesses to Obtain and Verify a Certified Taxpayer Identification Number for Contractors:
Under the current system, businesses that pay contractors (non-employee providers) $600 or more for services in a calendar year are required to file an information return (Form 1099) to the IRS and contractor at the end of the year. The information on that return is not verified by the IRS.
In the FY2008 Budget, the Administration recommends that a contractor be required to furnish to the business (on Form W-9) the contractor’s certified Taxpayer Identification Number (TIN). The business would then be required to verify the contractor’s TIN with the IRS, which would be authorized to disclose for this purpose only, whether the certified TIN-name combination matches the IRS records. If the contractor fails to furnish an accurate certified TIN, the business would be required to withhold a flat rate percentage of gross payments to that contractor.
The NASE supports the requirement of a TIN number to be furnished by the contractor to the business on Form W-9. However, we have trepidation regarding the requirement on businesses to verify a contractor’s TIN and withhold if it is inaccurate. Our concern lies in the lack of specifics as to what type of system the IRS plans to set up for businesses to fulfill this requirement. A system with substantial paperwork for requests and long wait times to receive needed approvals would impair businesses and self-employed contractors. If the IRS produces a user friendly, quick response TIN-name match system via online or phone, then the NASE would have minimal objections to this proposal. However, the NASE feels that there is still the potential for increased compliance issues due with this system. The Department of Treasury is asking business owners to be in part IRS compliance officers, a role for which they are not trained for. The additional regulatory burden could cause an increase in unintentional errors if Taxpayer Identification Numbers or names are accidentally reported inaccurately by business owners, contractors and the IRS.
Voluntary Withholding at the Request of Contractors:
Included in the above proposal, is the creation of a voluntary withholding system. Contractors receiving payments of $600 or more in a calendar year from a business could require the business to withhold a flat rate percentage of their gross payments, with the flat rate of 15, 25, 30, or 35 percent being selected by the contractor.
The extensive regulatory burden and compliance hurdles this provision would create would significantly hurt the micro-business community and create a disincentive to utilize contractors. Additionally, this voluntary withholding system would undermine the quarterly estimated tax payments system currently in place for independent contractors and transfers the compliance burden from the contractor to another business owner. The NASE opposes implementation of this provision and believes this would further hurt rather than enhance compliance amongst the micro-business and self-employed communities.
Worker Classification Issues:
Employee vs. independent contractor classification is an example of an IRS regulation that is exceedingly burdensome to the micro-business and self-employed communities and where simplification can assist in compliance. A majority of micro-businesses and the self-employed either utilize independent contractors or are themselves independent contractors. Disputes about who is an employee and who is an independent contractor have cost small businesses more than three-quarters of a billion dollars in IRS penalties and back-taxes during the past 10 years.
This issue is important because our society has been experiencing a significant change in the workplace over the past few years, with an increasing emphasis on independent business relationships. According to the Bureau of Labor Statistics, in 2005 there were 10.3 million people working as independent contractors, accounting for 7.4 percent of the employed. Reasons for this shift:
New technology allowing for telecommuting, virtual offices, etc. Corporate downsizing and lack of growth opportunity in companies has created an environment where many skilled individuals, whether out of necessity or in hopes of new opportunities, have become entrepreneurs. Individuals are no longer able to provide for families on one income, forcing creative solutions to strike a balance between paying the bills and raising a family. In order to obtain the ability to spend time with their children, create a second income, and avoid costly childcare expenses, many individuals are moving towards home-based businesses.
The issues plaguing worker classification stem from the fact that classification of an individual into an employee or an independent contractor is subjective under the tax code. The IRS has a complicated 20-point checklist the can be used as a guideline in determining whether or not an individual is an employee or an independent contractor. Yet, using this checklist does not guarantee that a person is correctly classified. Other IRS materials published to assist in classification are equally as convoluted. Micro-business owners and self-employed individuals have indicated that when utilizing the IRS’s tax assistance help line on this issue, they have received different answers from different agents on this same issue. A large part of the problem is that there is no one, single, homogenous definition of the term "employee." Thus, there is no clear and concise manner for a self-employed individual or micro-business owner to easily determine when an individual should be classified as an independent contractor or an employee.
To further exacerbate matters, an IRS reclassification of worker status can occur two or three years after a tax return was filed. When forced to reclassify an independent contractor to an employee the business must pay the back payroll taxes the IRS says should have been paid in the prior years, as well as interest and penalties.
With more and more individuals conducting a business out of their home as "independent contractors" and the economic incentive to employers to use independent contractors rather than employees, the issue of worker reclassification continues to be a key area for the recovery of revenue by the IRS despite its recent efforts to become more small business friendly. Due to the regulations vagueness and complexity it is very easy for the IRS to arbitrarily reclassify workers and thus, require micro-business owners to pay enormous sums of back taxes and penalties, which ultimately force them to go out of business. Reclassification of 10 independent contractors to the classification of employee, with taxes, penalties and interest can net 100 times more revenue than auditing an individual. (Willingham & Coté, 2001)
The predicament lies in the need for us to protect both micro-businesses who make a good faith effort to classify workers and independent contractors who choose to have the independence and entrepreneurial freedom under that classification, while also protecting employees from potential abuse by employers.
The NASE supports legislation that would clarify worker classification by creating a general test and incorporation test. The general test requires that to be classified as an independent contractor, the business and/or contractor must demonstrate:
The incorporation test qualifies LLCs and corporations as independent contractors as long as there is:
As long as businesses and independent contractors file Form 1099 each year, they qualify for protection by the safe harbor provisions found in section 530 of the 1978 Revenue Act if reclassified by the IRS.
Compliance will be improved because the written contract between the independent contractor and business will make clear their tax responsibilities, the new rules will not apply if the business does not comply with reporting requirements, and also Form 1099s will be issued to individuals who perform services. An independent contractor operating through his/her own corporation of limited-liability company must file all required income and employment tax returns in order to be protected.
The NASE is working to educate legislators on this issue in the 110th Congress and encourage legislation which would amend the tax code to simplify and clarify the definition of independent contractor.
Less Burdensome Approaches to Compliance:
The overall goal of the Administration and Congress is to increase tax compliance and minimize the tax gap. It is not possible to completely close the tax gap. There will always be those who employ tax shelters, willfully non comply, or inaccurately report their income. The goal should be to find ways to increase compliance without negatively affecting businesses to the extent that they are unable to manage cost and regulatory burden and must close their doors.
Key elements of the tax gap are the underreporting of income and concern of the accuracy of cash payments reported on tax returns, particularly amongst sole proprietors. Under current practices, checks made out to corporations must be deposited and cannot be cashed. The NASE recommends extending that practice to sole proprietor requiring that payments they receive for goods and services in the form of a check must be deposited and cannot be cashed at financial institutions. The expansion of this practice would increase the documentation of revenues and lessen potential underreporting.
Additionally, the NASE recommends modifying the Form 1040 Schedule C form in a manner that may encourage further compliance. First, in Part 1 of the form, alter line item 1 for gross receipts/sales to request two separate line items: one gross receipts/sales for credit/debit card transactions and the other gross receipts/sales for check and cash transactions. Visibly requiring the taxpayer to list separately their cash/check transactions may trigger the necessity for them to accurately track these payments and incorporate them into their tax return. Additionally, it offers to the IRS additional data on the types of transactions being conducted by businesses.
Second, in Part 2 of Form 1040 Schedule C, line 11 allows sole proprietors to include and deduct the payments they made to contractors over the year. We recommend the inclusion of a check box accompanied by a statement indicating that they have complied with the 1099 filing reporting requirement (i.e. “Check the box if you have filed Form 1099’s for all contractors which have provided $600 or more in services to your business this year.”) If business taxpayers do not check the box, they are not allowed the deduction for contract labor.
These two minor adjustments to the Form 1040 Schedule C would encourage additional compliance, increase pertinent data for the IRS and minimally burden micro-business owners.
Service vs. Enforcement:
The IRS has made positive changes over the past years through enhancement of taxpayer education and outreach efforts, which have had positive affects. The NASE’s concern is with the shifting of resources from taxpayer education and services to enforcement. In the FY2008 budget proposed by the Administration, the IRS will receive additional funding for enforcement services. We have already seen in the previous two years an adjustment of financial resources and manpower by the IRS from education to enforcement. IRS Commissioner Mark Everson has indicated that the IRS model is education plus enforcement equals compliance. However, we feel that the balance between education and enforcement is clearly changing to focus more heavily on enforcement.
The NASE feels that any recommendations seeking to increase compliance and lessen the tax gap should also seek to refrain from increasing the regulatory burden on taxpayers. We believe that ensuring comprehensive, effective taxpayer services is essential to accomplish taxpayer compliance.
Accurate tax reporting and compliance is extremely important to small business. Those who make a good faith effort, yet are inaccurately complying should be assisted through education and tax simplification efforts. Those willfully disregarding their tax liability should be held accountable. The more assistance offered to taxpayers and the simpler it is to understand and comply with tax laws, the more taxpayers will accurately meet their tax obligations. However, increased enforcement at the expense of taxpayer education will not in the long term accomplish sustained, improved compliance.
The NASE supports the utilization of federal programs such as the Small Business Development Center program, the Women Business Center program and SCORE to assist in taxpayer education services. These programs provide direct assistance to current business owners and future entrepreneurs and could play an invaluable role in efforts to increase tax compliance.
The NASE Position:
It is important to note that in review of current proposals to address the tax gap, we see that they solely focus on business to business transactions. Business to business transactions are already highly regulated and have substantial reporting requirements. A large area of potential non compliance and under reporting stems from business to consumer transactions. These dealings are currently not subject to reporting requirements and the creation of those requirements would likely be prohibitive to consumers and politically unappealing to legislators. However, the NASE feels that it is not possible to have a striking change in the tax gap without addressing business to consumer transactions.
The NASE supports proposals that are fair and reasonable to address the issues of the tax gap and to increase tax compliance. In the fervent drive by Congress to recoup revenues for our fast depleting federal coffers, we must take the necessary steps to make certain the path we choose is balanced and effective, rather than detrimental. The NASE believes that the collective focus should be on supporting efforts for survival, growth and innovation of micro-businesses and the self-employed as a foundation for long-term economic vitality.
The complexity of the IRS tax code is particularly troublesome for the self-employed business owner and is a snare for unintentional noncompliance. Vague rules and poorly defined regulations understandably result in mistakes. We believe efforts to address the tax gap and compliance must focus on overall simplification, eliminating issues of inequity within the tax code, and enhancing taxpayer education and outreach. The majority of small business taxpayers want to comply with existing tax laws, thus making tax regulations easier to understand is the most effective and equitable way to improve compliance and to reduce the tax gap.
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