IRS Should Target Individual Taxpayers Reporting Large Business Losses

The estimated annual “Tax Gap” exceeds $440 billion.  That is to say, the amount that U.S. taxpayers pay in taxes every year falls short of the amount actually owed by some $440-plus billion.  The Treasury Inspector General for Tax Administration—or, for those who prefer a more wieldy acronym, TIGTA—a government tax watchdog, has been engaged in an effort to determine how the IRS can make a meaningful dent in that ever-troubling Tax Gap.  The answer, in part, is more audits.  But more specifically, the right kinds of audits.  According to TIGTA, that means placing a particular focus on taxpayers who report “Schedule C” activity reflecting significant losses.

Schedule C Reporting

A sole proprietor engaged in a business is generally required to report the associated income and expenses on Schedule C of their Form 1040.  Much the same, an individual operating through a single-member limited liability company (LLC) is often required to report such business activity on a Schedule C.  Schedule C is used to calculate a sole proprietor’s business profits and losses.  While Schedule C often involves complex business expense deductions, there is often limited tax withholding or information reporting associated with Schedule C activities.  In other words, there are often limited third-party checks in the system, and thus it is not easy to validate or cross reference those deductions without conducting an audit.  

The IRS estimates that net misreporting with respect to Schedule C activities is as high as 55 percent when there is little information reporting or associated tax withholding.  The IRS estimates that underreporting contributes to approximately $352 billion of the annual Tax Gap, and that as much as 45% of this underreporting is attributable to individual business income associated with Schedule C.  So it comes as no surprise that TIGTA has drawn its attention to Schedule C reporting.  

The courts, for their part, have characterized the consistent, sizeable underreporting of income as a so-called “badge of fraud” that indicates tax fraud.  Recognizing this, TIGTA has recommended that the IRS should focus its efforts on systematically identifying Schedule C underreporting—a recommendation that it maintains will combat a significant source of repeat noncompliance. 

The Primary Target: Taxpayers Reporting Schedule C with No Gross Receipts and No Profit

TIGTA’s most recent study indicates that the IRS should zero in on tax returns with at least one Schedule C reflecting no profit.  TIGTA found that when the IRS audits tax returns with at least one Schedule C with no gross receipts and no profit, and where the return reflects a loss of $100,000 or more, the audit results in an average assessment in excess of $50,000.  In layman’s terms, the IRS gets a pretty big bang for its buck. 

TIGTA’s report was also critical of the IRS’s past failure to focus on, or even audit, Schedule C losses.  TIGTA noted that individual tax returns with a Schedule C reflecting losses present a high compliance risk and an opportunity for the IRS to realize a high return on investment when it comes to its enforcement budget.  

In an environment where government agencies will be seeking revenues to offset government deficits and program expenditures, taxpayers can expect to see an aggressive IRS in the coming months and years.  If TIGTA has its way, a significant part of that focus will involve future audits of individual taxpayers who report through Schedule C, particularly where their returns reflect outsized losses.  According to TIGTA, taxpayers with year over year Schedule C losses may have exposure to tax fraud penalties.  Such taxpayers may want to consider a preemptive voluntary disclosure or other mechanisms to fix past reporting deficiencies and decrease their risk, particularly as TIGTA pushes the IRS to focus its efforts on Schedule C taxpayers.

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