Sole Proprietors Reporting Losses Likely To Be Noncompliant, IRS Told

Sole proprietorships are a popular choice of business entity, and also on the IRS's audit radar. A new study by the Government Accountability Office (GAO) could encourage the IRS and Congress to heighten oversight of sole proprietorships. The GAO recommended new rules to limit deduction of sole proprietor losses against other income. However, these would require approval by Congress. GAO's report was followed by an audit by the Treasury Inspector General for Tax Administration (TIGTA), which cautioned that the IRS also is failing to assess accuracy-related penalties in some high-dollar sole proprietor cases.

Profits and losses

One in four sole proprietors (5.4 million) reported a loss in 2006, the most recent year for which IRS data is available. Seventy-five percent (16.2 million) reported profits in 2006. Total reported losses were $49 billion and total reported profits were $330 billion.

The GAO mined the loss data to reveal that 85 percent of sole proprietor returns reported net profit or loss of less than $25,000. The 13 percent of sole proprietor returns with at least $25,000 in profits accounted for 72 percent of all reported profits. The one percent of sole proprietor returns with at least $25,000 in losses accounted for 47 percent of all reported losses.

Noncompliance

A large proportion of sole proprietors reporting losses in 2001 underpaid their taxes and a larger percentage of sole proprietors reporting losses were noncompliant than those reporting profits, according to GAO. Seventy percent of sole proprietor returns with net losses (three million returns) underreported net income by at least $100 compared to 52 percent of those with profits. Of these loss returns that were noncompliant by at least $100, 57 percent were fully noncompliant (the entire loss was disallowed) and the remaining 43 percent were partially noncompliant (some of the loss was disallowed). One can only speculate (and likely the IRS will) how much more noncompliant taxpayers may have become during the current economic downturn when pressures to survive as a business are significantly more intense.

Examinations

The GAO reported that approximately 25 percent of all revenue agent direct examination time is spent reviewing sole proprietor returns. However, the agency only examines approximately one percent of the total population of noncompliant sole proprietors.

Penalties

Shortly after GAO issued its report, TIGTA published an audit of the accuracy-related penalty and sole proprietor returns. TIGTA reviewed 356 sole proprietor returns from 2007. All of the cases involved understatements of $5,000 or more.

TIGTA estimated that the IRS failed to apply the accuracy-related penalty in approximately one-quarter of sole proprietor examinations. When projected over a five-year period, TIGTA estimated that sole proprietors would avoid penalty and interest assessments in the neighborhood of $15 million to $25 million.

(Limiting Sole Proprietor Loss Deductions Could Improve Compliance but Would Also Limit Some Legitimate Losses, GAO-09-815)