Smart TaxesSmart Taxes

Big tax cheats: Small businesses

Businesses small enough that their income is reported on owners' returns account for the greatest amount of underpaid taxes. Only 1% of those are audited.

By MSN Money Partner Feb 6, 2012 3:02PM

This post is by Michelle Hirsch at The Fiscal Times.


When large companies such as General Electric and Bank of America are "outed" over their microscopic tax payments to the federal government, the press and the public pile on in outrage.


They may be shooting at the wrong target. Internal Revenue Service data shows large corporations are not the only ones gaming the tax system.  Although big companies expertly maneuver the tax code to whittle down their bills legally, small businesses are evading taxes en masse.


The nation’s tax gap -- or the difference between what the IRS is owed and what it collects -- grew from $290 billion in 2001 to $385 billion in 2006. Businesses that log income on individual returns, which are largely small businesses and farms, accounted for the single largest portion of that: $122 billion. 


As lawmakers struggle to agree on ways to control the nation’s $1.3 trillion deficit, while funding a vast array of domestic programs, it stands to reason that collecting that missing revenue would be a top priority. But an increasingly tricky web of politics and logistics surrounding small-business tax matters virtually eliminates any likelihood of a serious crackdown on these diverse entities.  (Post continues below video.)

The political rhetoric on both sides of the aisle hails small business as the primary engine of job creation and economic growth, even though that is debatable. As a result, any policy change that might burden or disrupt small businesses has become taboo. President Barack Obama recently called for the Small Business Administration to be elevated from agency-level to Cabinet-level "to make sure that small-business owners have their own seat at the table."


While there’s no denying that America’s million small businesses are a seismic, often beneficial force within the U.S. economy, a large proportion of owners successfully underreport their income to dodge taxes. "There really is money there, but you are talking about getting millions of influential citizens angry at you if you say or do anything that’s perceived as stifling small business," said Martin Sullivan, a contributing editor at Tax Analysts and a former Treasury official.


It’s much easier for small-business owners to conceal income from the IRS, since they aren’t required to report their income on a W-2 form, don’t have taxes automatically withheld from their wages and don’t have IRS agents stationed in their workplace looking over their shoulder, as is the case with large corporations such as Boeing. "Corporate employees receive regular paychecks, and it’s the easiest thing in the world for the IRS to find out if you underreport your income because it’s right there," Sullivan said. "But for small business, it’s like the Wild West."


Small businesses can structure themselves as subchapter S corporations, partnerships or pass-through entities (LLCs), or sole proprietorships -- the most common classification, which accounts for about three-quarters of small businesses. The total number of small businesses in these categories combined shot up to 27 million in 2007 from 18.4 million in 1997, according to the Census Bureau. Currently, more than 21 million of the country’s 27 million small businesses have no employees other than the owner. 


Under the law, anyone who collects business receipts or income and doesn’t file a W-2 form -- from independent contractors to part-time writers, consultants, craftspeople, repairmen and even individuals who sell items on eBay -- count as small businesses.


Income not reported


"These people all are supposed to report their income in April, but lots don’t and continue on just fine," Sullivan said. That’s partly because, as of late, the IRS has focused its resources on wealthier businesses and individuals. The IRS has audited only about 1% of businesses and individuals with $200,000 in earnings or less in recent years, compared with 12% of those who earn $1 million or more, according to a January report. 


That shift is intentional and unlikely to change anytime soon, said Mark Luscombe, a tax attorney and principal analyst at CCH, a tax publisher. "With small business, the problem is, you’ve got a million little guys hiding a couple of dollars in taxes. That’s a lot harder to devote resources to and get a big bang for your buck, when you can focus on the handful of guys hiding a million dollars in taxes. If you’re a small business hiding a little, it’s easy to see how you would think you would be more likely to slide under their radar screen." 


To be sure, small businesses pay more to comply with the tax law on a per-employee basis than do corporations. According to a March 2011 Small Business Administration study, businesses with fewer than 20 employees spent $1,584 per worker on tax returns, compared with the $571 average per-worker cost that companies with 500 or more employees paid. "An economy where people are struggling with their businesses may create more incentives to try and save a little bit on taxes," Luscombe said.


Tax experts say the two key ways to prompt better small-business tax compliance are to ramp up enforcement at the IRS and to subject businesses to additional third-party reporting requirements. Those solutions are all but impossible, since the IRS budget has been cut and Congress has repeatedly voted to repeal new reporting rules set to take effect this year. 


Cuts in IRS staff


Last fall Congress repealed a law that would have required federal, state and local governments to withhold 3% of small-business payments to vendors starting this year, and last spring it repealed part of the Affordable Care Act called the 1099 provision, which would have required businesses to report transactions in excess of $600 a year to the IRS. One reason for the repeals: the increased amount of paperwork required to comply with the new laws.


In a report released to Congress this month, National Taxpayer Advocate Nina Olson said the top factor harming the IRS’ ability to raise revenue, enforce the law and serve taxpayers is funding cutbacks -- which totaled 2.5% of the agency’s budget in 2012. In 2010, the IRS employed 84,761 workers, down from 116,673 in 1992.


"Certainly, cutting the IRS budget is not going to increase tax revenues, decrease the tax gap or help the situation," said Mark Robyn, an economist at the Tax Foundation, a business-oriented think tank. Many of the job cuts, which run the gamut from auditors to desk employees, are the result of electronic filing and software that replaces manual handling of tax returns.  


But business groups say revamping the tax code to make filing less onerous for small businesses is a more surefire way to capture revenue than hiking the IRS budget. "Over the last 20 years, we’ve had a tougher IRS, we’ve had a gentler IRS, we’ve had one that gave more taxpayer education and ramped up enforcement. Yet we still have the same percentage of a tax gap. That should tell you something," said Giovanni Coratolo, the vice president of small-business policy at the U.S. Chamber of Commerce. 


Tax simplification won’t deter small-business owners who choose to collect payments off the books, Sullivan said. "If you’re the repairman running around collecting cash from individuals, you probably don’t have a very complicated return to begin with, so complexity is not the problem here. It’s an unwillingness to fork over the cash and a feeling that you can get away with it."


More from The Fiscal Times and MSN Money: 


Feb 13, 2012 6:36PM

The article misses the point when it comes to large corporations like GE. I think it is unfair for them to enjoy the benefits that the US offers such as manpower and technology in a foreign country, sell those products and as long as those profits remains abroad the company pays zero tax. There is something wrong with that picture. I also do not think workers going abroad should not have to pay federal income taxes provided they follow the time restraints set by the IRS. Let's quit giving tax breaks to companies and employees that leave this country.


Another shameful fact is that there hundred if not thousands of federal employees that are tax dodgers and evaders. Before Uncle Sam starts looking at the private sector, they need to clean up their own house. The Obama administration and Democrats have shown us they have no shame in avoiding taxes.

Feb 19, 2012 1:48PM

Another problem surfaces when these 'off the books' businesses suddenly have a problem and want federal, state or local government assistance to help them.  Witness the fiasco with the businesses affected by the BP oil leak in the Gulf a couple of years ago.  When BP and the Feds asked for tax returns from previous years to help determine how much of an impact there had been, ( by how much  the lack of business had lowered the income of these people) it was discovered that they had been making money off the books for years.  And now they wanted BP and Uncle Sam ( you and me) to jump in and rescue them.  When they couldn't prove that their business had suffered because they couldn't prove how much income they had then  (because they had pocketed the money and not reported it)  they were angry because they couldn't qualify for assistance.


These will be the same people who will be angry when they don't qualify for disability or retirement Social Security after NOT having paid into it over the years like the rest of us.  As ye sow, so shall ye reap.....

Feb 13, 2012 7:24PM
Couldn't agree more with this article. I have worked for several small businesses doing bookkeeping and other office tasks. Everyone has a scam going from regular unreported cash income (a significant amount of which comes from people who don't want others to know that they have the cash), bartering goods and services, to paying "independent contractor" employees under the table.  Business to business transactions can be done with a wink and a nod.   The big one in my experience has been watching owners write off practically all personal expenses off thru the business(es).  Cars, "toys", houses, vacations, groceries, appliances, etc.  Buy a couple pieces of equipment and use the depreciation-then sell the assets off the books.  Oh, and by the way, never ever get married.  That opens up more options.  I will definitely take this route in my next life.
Apr 12, 2012 5:00PM
Iacarnut: Yea right, like it's the good old republicans faithfully paying their taxes. Most of the tax breaks that give "special" breaks to the very rich are republican sponsored. Romney's made it plain he wants to extend the 15% tax for hedge fund operators and eliminate all inheritance tax instead of the current 5 million cap. Obama paid a 30+ % tax rate, Romney less than 15% on a much larger amount.
Apr 12, 2012 4:53PM
   Article focuses on off the books income but what i learned from a friend with a small business years ago it isn't the income that's easiest to hide it's the expenses. With a small or as article indicates 21 million small business owners with no employees it's easy to write off almost all personal expenses. As long as you keep receipts there's no way the IRS can tell where items are used from vehicles claimed to be used 90% for business that isn't at all or the hundreds of small items from computers for the kids, light bulbs, toilet paper etc.
Please help us to maintain a healthy and vibrant community by reporting any illegal or inappropriate behavior. If you believe a message violates theCode of Conductplease use this form to notify the moderators. They will investigate your report and take appropriate action. If necessary, they report all illegal activity to the proper authorities.
100 character limit
Are you sure you want to delete this comment?


Copyright © 2014 Microsoft. All rights reserved.

Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.