FALL INTO THE GAP!

The Internal Revenue Service has released a new set of tax gap estimates for tax year 2006.  The $300 Billion number for net uncollected tax that we had been using now looks like closer to $400 Billion.  

“The new tax gap estimate represents the first full update of the report in five years, and it shows the nation’s compliance rate is essentially unchanged from the last review covering tax year 2001.

The voluntary compliance rate — the percentage of total tax revenues paid on a timely basis — for tax year 2006 is estimated to be 83.1 percent. The voluntary compliance rate for 2006 is statistically unchanged from the most recent prior estimate of 83.7 percent calculated for tax year 2001.”

The IRS suggests taxpayers did not pay $450 Billion on time in 2006. The tax agency eventually collects around $65 Billion was collected via audits and late payments.  The result is a net tax gap for 2006 of $385 Billion, $95 Billion higher than the $290 Billion previously estimated for 2001.

The increased gap is largely due to “the growth in total tax liabilities. In addition, some growth in the tax gap estimate is attributed to better data and improved estimation methods.”

According to the Service -

"As was the case in 2001, the underreporting of income remained the biggest contributing factor to the tax gap in 2006."   

The complete breakout:

 •Under-reporting accounted for an estimated $376 Billion of the gross tax gap in 2006, up from $285 Billion in 2001.

•Tax non-filing accounted for $28 Billion in 2006, up from $27 Billion in 2001.

•Underpayment of tax increased to $46 Billion, up from $33 Billion in the previous study.

The IRS found -

“Overall, compliance is highest where there is third-party information reporting and/or withholding. For example, most wages and salaries are reported by employers to the IRS on Forms W-2 and are subject to withholding. As a result, a net of only 1 percent of wage and salary income was misreported. But amounts subject to little or no information reporting had a 56 percent net misreporting rate in 2006.”

So increased 1099 reporting is to be expected, which has already begun with the new Form 1099-K.

The biggest single component, representing 27% of the $450 Billion estimate, is “business income” for individuals (on the Form 1040), which accounted for $122 Billion of the under-reporting amount – and area where there is minimal third-party reporting.  “Small corporations” (assets less than $10 Million) under-reporting was only $19 Billion.  I expect most of this is from under-reporting on Schedule C.

There is no doubt from these findings that Schedule Cs will be an audit target, especially those with consistent losses. 

However – I still believe it is bad advice to tell ALL taxpayers who have a Schedule C business to incorporate.

As I have said in the past –

“The decision to incorporate a business requires careful review of all the specific facts and circumstances of the individual situation. And taxes are not the only consideration. In a majority of cases it is not financially beneficial, either in the short or long term, to incorporate.

While incorporating will certainly reduce one's 1040 audit risk, it is very often not the best idea for the average sole proprietorship. Incorporation can generate much more paperwork, recordkeeping, federal and state tax filings, costs, and general all-round "agita" than it is worth.

The advice that one should incorporate solely for the purpose of avoiding an audit seems to me to be saying, ‘If you want to cheat on your taxes you can incorporate and the IRS will not audit you’. It is not good tax or financial advice.

An IRS audit is not something that should be avoided at all costs. Tax returns should be prepared, and decisions about choosing a business entity should be made, in such a manner as to generate the absolute least amount of federal, state and local taxes (income and payroll) within the parameters of federal and state laws. If you will pay less tax (income and payroll), fees and other costs by filing a Schedule C you should do so, honestly and ethically, and not worry about being audited. 

If you are reporting all of your income, deducting only legitimate and documented expenses, and keeping good records then any audit should result in “no change”.

Besides, as I previously reported – less than ½ of 1% of 1040s are actually chosen for a “sit down” audit.

PS - Click here to see a larger version of the above map.

TTFN