Written Testimony Submitted by
The National Association for the Self-Employed

House Committee on Ways & Means
Subcommittee on Oversight

"Internal Revenue Service Operations and the Tax Gap"

March 20, 2007

Introduction

As we begin to take a hard look at our government’s fiscal state, we must take the necessary steps to make certain the path we choose to readjust our financial priorities is balanced and effective, rather than detrimental to those sectors contributing most significantly to our economic stability and growth. The micro-business community is one of these important sectors, rich in job opportunities and the capacity for revenue growth.

The Internal Revenue Service and the micro-business community are well acquainted with each other. A chief complaint of the self-employed and micro-businesses is the lack of a fair and level playing field, which would allow them to compete equitably with other businesses. Equity in the tax code, clear and simple regulations, and accurate tax reporting and compliance is extremely important to micro-business. They cannot compete with those receiving additional benefits or deductions via the tax code, those able to afford accountants or a whole team of tax specialists, or those willfully disregarding their tax liability. Thus, our community also has an interest in addressing the issue of the tax gap and increased tax compliance.

Currently, the self-employed and micro-business communities face an unfair tax code which gives preference to larger businesses and specific industries. Additionally, the cost and overwhelming regulatory burden in complying with complex IRS regulations negatively affects their business. 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, a tax gap still exits and there have been numerous proposals by the Administration and in Congress regarding how to effectively increase compliance and minimize the tax gap. The National Association for the Self-Employed would like to highlight some pros and cons of a few of these proposals and include alternate recommendations to increasing compliance.

The NASE would like to note that current tax gap proposals presented in the Administration’s FY2008 budget are frameworks and that it is imperative for specific details of the these proposals be presented to Congress and the public in order to ascertain their potential effectiveness and impact.

Increasing Information Reporting on Payment Card Transactions:

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, based on the information at hand on this recommendation, 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 or any provision instituting additional withholding regulations and believes this would further hurt rather than enhance compliance amongst the micro-business and self-employed communities.

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 supports increased funding for the IRS to allow to properly enforce current tax regulations and provide taxpayer compliance assistance. Our concern is with the large scale 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. The more taxpayer education 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.

Conclusion

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.

Additionally, the Internal Revenue Services is not subjected to the Regulatory Flexibility Act, which is intended to ensure that the interests of the small business community are taken into account before the federal government issues any significant rules and regulations. It requires a public comment period for pending regulations and most importantly, economic impact (cost/benefit) analysis be undertaken for potential regulations. While it is not likely that their will be a change in law requiring the IRS be subjected to SBREFA, we feel it is important the any proposal being considered to address the tax gap undergo cost/benefit analysis in order to determine the effectiveness of the recommendation. All of the Administration’s proposals create increased paperwork and manpower burden on the IRS and some even require the creation of new systems. The expansion of infrastructure and staff will likely be costly and may outweigh any benefits.

The NASE supports proposals that are fair and reasonable to address the issues of the tax gap and to increase tax compliance. We believe 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.