IRS Releases New Tax Gap Estimates: 30% Attributable to Small Businesses

The IRS just released an update of its “tax gap” estimate, last revised in 2006 for the 2001 tax year.  This study found that in 2006 lost tax revenues amounted to $450 billion, up from $345 billion in 2001.  The “tax gap” is an important budget item as it represents the IRS’ estimate of the difference in tax that should be collected and that which is actually collected.   Of course, the causes of the tax gap are (i) nonfiling, (ii) underreporting and (iii) underpayment.

The single largest component of the $450 billion gap was pinned to the underreporting of business income on individual tax returns ($122 billion up from $109 billion in 2001); underreporting of business income by small corporations was estimated at $19 billion, up from $5 billion in 2001.  This means that the IRS tags small businesses with a bit over 30 percent ($138 of the total $450 billion) of the tax gap.

Earlier this year, we noted that the 2001 IRS tax gap study had come under scrutiny by the SBA Office of Advocacy in its report “An Examination of the 2001 IRS Tax Gap Estimates’ Effects on Small Businesses.”  It questioned the methodology used in determining the gap attributable to small businesses.  In its current report, the IRS notes that it employed new methodology that relies on more recent data in determining the gap attributable to corporate income taxes.   However, it is unclear as to whether CompTIA’s comments were addressed in the new report.

Clearly, there is a tax gap.  Some individuals and businesses are neither filing nor paying their taxes, and some are underreporting income.  Most likely, the IRS’ main push will be to require greater third-party reporting.  However, we need to be watchful that additional reporting requirements have a valid relationship to the underreported taxes.  For example, last year’s repeal of the Form 1099 reporting requirements must not be repeated; requiring small businesses to file a multiplicity of Form 1099 for purchases made from any corporate vendor was an overreaction that would have done little to address the tax gap.