Tax Gap Grows and Small Business Is Blamed

According to the IRS’ annual enforcement report, the tax gap — the spread between what the government thinks it should collect and what it actually collects — grew to $385 billion in 2006 (up from $290 in 2001). The report claims that $122 billion of the tax gap, or nearly one-third, is attributable to unreported income from small businesses on Schedule C (for sole proprietors and one-member LLCs) and Schedule F (for farmers).

However, the numbers for 2006 were for activities from more than five years ago and may not be reflective of what is happening today. The reasons:

  • New merchant card reporting (Form 1099-K) will tell the IRS about transactions made on credit and debit cards, and with electronic payments. This reporting of merchant transactions will be reflected on 2011 returns.
  • IRS audit activities have increased, especially for higher-income taxpayers.
  • The IRS has been continually expanding its audit guide for cash intensive businesses. It contains strategies for auditors to find undisclosed income and to weed out revenue from the underground economy. It applies to such businesses as bail bonds, beauty shops, convenience stores, laundromats, and car washes, but is not limited to these enumerated businesses.
  • There is more governance of tax return preparers. They face high penalties for failing to exercise due diligence in preparing returns, so they are required to inquire about income as well as support for deductions that clients want to claim.

Bottom line
Most small businesses owners I know want to do the right thing when it comes to taxes. They don’t try to hide income but instead seek to take advantage of every legal tax break they’re entitled to. Still, the numbers don’t lie, and there surely are businesses skirting the law. If you want to make certain that other businesses are paying their fair share of taxes and reporting their income like you do, only pay through credit cards and/or electronic transfers (e.g., PayPal) that will be reported to the IRS; payments by cash or checks can still slip through the tax cracks.

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