Focusing on business income underreporting
The tax gap, defined as the difference between taxes owed, and taxes paid voluntarily and timely for any given tax year, includes everything from sales tax to employment taxes to property taxes. The Internal Revenue Service (IRS) estimates that individual income tax is the largest source of the annual federal tax gap. It is also the largest source of California's tax gap. A U.S. Government Accountability Office Report (GAO-06-453T, February 15, 2006) indicates that for 2001, the federal tax gap was estimated at approximately $345 billion. The individual income tax portion was estimated to be approximately $197 billion, or 57 percent of the tax gap overall. California's tax gap is estimated at $6.5 billion, based on the federal estimates.
A lot of attention is focused on the underground economy and nonfilers. However, the largest component of the tax gap is underreporting, which includes understated income and overstated deductions. Common examples include:
- Unreported income from cash transactions.
- Claiming excessive business deductions.
- Overstating personal charitable contributions.
Of the $197 billion attributed to individual income tax, the IRS estimates that $109 billion comes from underreported business income, such as sole proprietor, informal supplier, and farm income. Sole proprietors are associated with the highest percentage of underreported personal income tax. Both FTB and the IRS have recently focused their attention on sole proprietors. Audits have revealed that noncompliance is frequently due to:
- Lack of knowledge of the tax law.
- Underreporting gross income.
- Improper documentation.
- Deducting personal expenses.
These findings have prompted us to perform more audits of sole proprietorships to strengthen compliance in reporting income and expenses.
We will provide more information on how we are bridging the tax gap in future issues of Tax News, as we address such topics as income, expenses, and audit efforts.