6 statement of john s. satagaj co-chair the coalition for fairness in tax compliance before the committee o

6
STATEMENT OF
JOHN S. SATAGAJ
CO-CHAIR
THE COALITION FOR FAIRNESS IN TAX COMPLIANCE
BEFORE
THE COMMITTEE ON THE BUDGET
UNITED STATES SENATE
JANUARY 23, 2007
FOR A HEARING ON
THE GROWING TAX GAP AND STRATEGIES FOR REDUCING IT
My name is John S Satagaj, and I am the President and General Counsel
of the Small Business Legislative Council (SBLC)*. I am appearing here
today on behalf of the Coalition for Fairness in Tax Compliance
(CFTC). I co-chair the coalition with my colleagues from the National
Federation of Independent Business** and the United States Chamber of
Commerce.***
Today, my goal is to address several important issues regarding the
tax gap. First, I will talk briefly about the CFTC and its mission in
addressing the tax gap. Second, I will share CFTC’s perspective of the
tax gap data and point out areas where the data can be improved in
order to allow for better-targeted proposals. Third, I will illustrate
a small component of the tax gap by examining the underreporting of
sole proprietors and the limited information we have in this area to
address the problem. Fourth, I plan to discuss the role that
enforcement, education, and simplification can play in closing the tax
gap. Finally, I will recommend using caution against harming the
compliant taxpayer at the expense of resolving the tax gap.
THE COALITION AND ITS MISSION:
The CFTC was recently formed in response to efforts by the executive
and legislative branches to address the "Tax Gap," the difference
between what the federal government is owed in taxes and what it is
actually paid. While it is the position of the CFTC that every
individual and business should pay in a timely manner their fair share
of taxes, and those taxpayers that do not fulfill this obligation
place compliant taxpayers at a disadvantage; regulatory and
legislative strategies to collect outstanding obligations can place
excessive and obtrusive burdens on the backs of honest taxpayers.
Honest small business taxpayers are especially at risk of being
subjected to needless and unwarranted regulatory burdens in an attempt
to capture the few "bad actors" that do not fulfill their tax
obligations. Small businesses already bear a disproportionate share of
the cost of regulation.
The CFTC is a coalition of small business organizations that will
fight for the rights of these honest small business taxpayers as the
executive and legislative branches develop strategies to address the
"Tax Gap." It is the mission of the Coalition for Fairness in Tax
Compliance to fight for the rights of tax compliant small business
owners by:
*
Supporting the accurate use and collection of information on the
source, size, and scope of the problem of tax non-compliance that
forms the foundation for policy decisions.
*
Supporting targeted, sensible, regulatory and legislative measures
that will reduce tax non-compliance without generating undue
burdens on the general small business community.
*
Encouraging tax compliance by developing tax simplification
proposals for sections of the tax code that are confusing and
complicated.
*
Opposing regulatory and legislative strategies proposed by
lawmakers in an attempt to increase tax compliance that impose
excessive and obtrusive burdens on honest small business owners.
We are eager to facilitate a dialogue. To that end, we have
established a website at www.taxcompliancefairness.org.
WHAT IS THE TAX GAP?
Before we can begin a discussion of the causes of the tax gap and
potential solutions, the first step is to establish the magnitude of
the gap. The Internal Revenue Service (IRS) has estimated the “Tax
Gap” to be approximately $345 billion. However $55 billion of this
amount is eventually collected. It is just a timing issue. The
appropriate starting number is $290 billion.
Other than making that point about the magnitude, we will leave it to
others to argue about the size, or even the existence of the “Tax
Gap.” We are prepared to deal with it as a reality. Whatever the
actual number, the “Tax Gap” covers a broad spectrum of business
activities and tax compliance activities. The sources of the gap, and
therefore the possible solutions for improvement, have to be
understood and evaluated as discrete, and often disparate, situations.
One solution does not fit all.
Underreporting by individuals has been identified as a problem area.
According to the IRS figures, $56 billion is attributable to
non-business income. Half of the $56 billion is attributable to
“other” non-business income, the other half is scattered among nine
different income categories.
Underreporting by individuals of business income is estimated at $109
billion. Some $68 billion is attributed to underreporting by sole
proprietorships. Rent and royalties underreporting is measured at $13
billion and underreporting by partnerships and S corporations is
measured at $22 billion.
Overstated deductions by individuals are estimated to contribute $32
billion to the tax gap.
Underreporting of income by corporations is estimated at $30 billion,
with $25 billion attributed to large corporations and the remainder to
small corporations.
Underreporting of employment taxes is estimated to contribute $64
billion to the “Tax Gap.” However, that estimate is largely dependent
on the re-characterization of the underreported income by individuals
as earned income.
When you look at the information available, two observations
immediately jump out. The aggregate "Tax Gap" is simply a collection
of dozens of tax-compliance functions, business activities, and
taxpayer profiles which have little or nothing in common. Solutions
must be up to the task of yielding tax revenues without placing a
disproportionate burden on the affected taxpayers. Second, the data
and research necessary to make informed decisions does not appear to
exist. There are so many questions we need to answer before we can
begin to craft solutions that will be effective and not burdensome.
SOLE PROPRIETORS, FOR EXAMPLE
Both observations noted above can be illustrated by examining one
component of the “Tax Gap”—underreporting by sole proprietors. Small
businesses organized as sole proprietorships are unincorporated
business. For tax purposes, the income from their business “flows
through” to their personal income tax calculations. They report their
income on the Form 1040. The business income and expenses are reported
on Schedule C, a form that accompanies the Form 1040.
As noted above, the “Tax Gap” report issued by the IRS identifies
underreporting of income by Schedule C filers as a significant source
of the “Tax Gap.” What do we know about them?
In tax year 2004, 20.6 million individual tax returns reported
non-farm income on the Schedule C. Approximately 13 million of these
businesses had gross receipts of $25,000 or less. This is an important
point that I will come back to with regard to realistic, not
burdensome solutions.
Of the 20.6 million returns, the number with any net income was 15
million. Of that number, 3.7 million filed on a Schedule C-EZ, meaning
they had business expenses of $5,000 or less, used the cash accounting
method; had no inventories; did not report a deficit from the
business; had only one business as a sole proprietor; had no
employees, did not itemize depreciation; claimed no deduction for home
business expenses; and had no prior year disallowed passive activity
losses from business.
Although we do not know much about the causes of the “Tax Gap,” there
is already some discussion of solutions such as more third-party
reporting or the withholding of tax from income payments. I generally
hold to the axiom, “Don’t ask a question that you don’t know the
answer to.” I will break my rule today. Do we know if there is a
difference in underreporting in business to business transactions
versus consumer to business transactions?
As you know, businesses that engage the services of sole proprietors
have to issue a 1099 for amounts over $600. For years, the debate has
focused on business to business (B2B) service transactions. Some
suggest the current information reporting system is not working. What
is the problem with the current system? Are the bulk of B2B
transactions under $600? Or is there a failure to file 1099s? Are
there statistics on the amount of underreporting when 1099s have been
issued? For that matter, do we know how many sole proprietors receive
a 1099? How many receive multiple 1099s? Can we break that information
down by business activity? It seems to us if we had answers to some of
these data questions, we might be able to get a better handle on the
sole proprietor underreporting situation.
In recent years I have come to think the underreporting problem, to
the extent it may exist, might be more prevalent in the direct
consumer to business transactions. In such situations, there is no
information reporting, and it does not lend itself to withholding.
But, I have not seen an analysis that drills down below the
generalization that sole proprietors underreport.
If a sole proprietor is primarily engaged in providing services to
consumers, it will be difficult to impose a “traditional” income
reporting and/or withholding requirement to close the “Tax Gap.” As
the recipient of the service, a consumer would be the party required
to report or withhold. On a theoretical level, it is not likely this
kind of new tax compliance burden would be well received. On a
practical level, the number of transactions could be astounding.
Without knowledge of how many sole proprietors provide services
primarily to business or primarily to consumers, different solutions
to closing the tax gap will have to be identified and developed. So I
circle back to my questions: How many of the approximately 21 million
Schedule C filers are engaged primarily in transaction with consumers?
When you look at some of the business activity sectors of sole
proprietors, it also raises the question of whether one solution fits
all.
Selected Sectors
Number of Schedule Cs
Construction
Specialty Trade Contractors portion
2.6 Million
2.1 Million
Wholesale Trade
350, 0000
Retail Trade
Non-store Retailer portion
Miscellaneous Store Retailers portion
2.4 Million
990, 000
551,143
Real Estate
1.2 Million
Transportation
980,000
Finance and Insurance
670,000
Professional, Scientific, and Technical
Legal Services portion
Accounting Services portion
Architectural, Engineering portion
Management, Scientific, Technical Consulting portion
2.9 Million
353,000
407,000
291,000
735,000
Administrative and Support
2 Million
Health Care and Social Assistance
Ambulatory Health Services (e.g. doctors’ offices) portion
Child Care portion
1.8 Million
869,000
694,000
Arts, Entertainment, and Recreation
1.1 Million
Other Services
Personal & Laundry Services portion
2 Million
1.3 Million
Another way to look at the sole proprietor sector is by size based on
net income. The following are the top three sectors.
Total Sole Proprietorships Net Income
$247 billion
Top Three Sectors by Aggregate Net Income
Professional, Scientific, and Technical
56.9 billion
Health Care and Social Assistance
42 billion
Real Estate
27.9 billion
Again, at the risk of repeating myself, what I see in those statistics
are a lot of sole proprietors potentially providing services to
consumers. How can we consider solutions such as third-party reporting
or withholding until we have a firm understanding of how large a role
a consumer plays in the transaction?
As an aside, I thought it interesting that the Information Reporting
Program Advisory Committee (IRPAC), the group that advises the IRS on
reporting burdens, recommended that the reporting threshold (currently
$600 on a Form 1099 Misc.) for health care professionals should be
increased to $5,000. The IRPAC said, “We believe this change in the
reporting threshold will not adversely impact the tax gap since it is
our understanding, and our expectation that most, if not all, of the
medical providers are compliant taxpayers. This understanding is based
upon the nature of the business that they conduct as licensed and
regulated medical service providers.”
I do not know if their conclusion is correct or not, but if you look
at the tables above, this sector is a rather large segment of the sole
proprietor community by number or by net income. It is hard to
reconcile these various observations without a comprehensive research
analysis.
The sole proprietor sector is just one example. I believe you will
find we really do not know enough yet about the causes of
underreporting to craft solutions.
ENFORCEMENT, EDUCATION OR SIMPLIFICATION
Now, as I promised, back to the gross receipts statistics for sole
proprietors. Thirteen million are reporting less than $25,000 in gross
receipts. Thirteen million. When I look at the number what comes to my
mind is that we cannot “audit our way out of this.” Yes, there will be
anecdotal information about the need for better and more audits, but
there is simply no way we can allocate the resources to reach the very
taxpayers whom the aggregate “Tax Gap” data has identified. This would
suggest we need to find non-enforcement solutions.
Even then, when we do identify the causes, we still need to find
non-burdensome solutions. Thirteen million sole proprietors with less
than $25,000 in gross receipts. Even if we make a wild assumption that
they are only reporting half of their income, what solutions can we
find that will produce new revenues that won’t impose extraordinary
burdens on the smallest of small businesses?
Taxpayer education must remain one of our primary tools. We believe
the IRS has made significant headway since it was given the mandate
almost a decade ago to pursue more aggressive education outreach. It
will take a long time to reach the 20 million or more small businesses
(indeed as most of us in the trade association world know, one cannot
get discouraged about how many we reach with our message), but we
would submit it is not only appropriate, but essential that we
continue to try. Success is hard to measure but I suppose, ultimately,
if we can get the “Tax Gap” reduced, and education is a primary
component, then we know we have been successful.
I would be remiss if I did not state again our belief that tax
simplification would reduce the “Tax Gap.” For small businesses,
particularly the sole proprietors, the challenges of divining the
purpose and meaning of the tax code are formidable. Does the IRS have
any figures on how much income is underreported because people do not
understand the tax code? It is important to understand why there is
noncompliance with the tax code. The complicated and often
contradicting laws that make up the tax code form a barrier in many
cases to compliance with the tax code. Inadvertent errors and
confusion are often caused by complex laws. These same complex laws
also contribute to intentional noncompliance. Many who do not
understand the tax code may perceive unfairness in the code. Studies
have shown that these same people use this feeling of unfairness to
justify their noncompliance to themselves.
RESPECT
Finally, it is incumbent upon all of us to make sure we treat the
compliant taxpayer with respect. After all, the vast majority of our
revenues are collected through voluntary cooperation with a high
compliance rate of 86 percent. It is important that we reserve the
label “Tax Gap” for only those proposals which are truly related to
addressing the “Tax Gap.” We fear we will see various revenue offsets
labeled as “Tax Gap” closers. In many cases, the revenue offsets alter
long time policies upon which compliant taxpayers have fairly and
honestly relied. What message do we send to the compliant taxpayer to
label these items as “Tax Gap” closers?
Conversely, we must make certain “Tax Gap” initiatives are enacted for
that purpose, not for the sake of revenue raising. A prime example of
a “Tax Gap” initiative that spiraled out of control was the enactment
of withholding on government contractors. A lot of compliant taxpayers
got pinned with a cash flow penalty under that proposal in the name of
“closing the tax gap.”
In conclusion, we look forward to working with the Administration,
Congress, and others to understand the nature of the “Tax Gap” and to
find reasonable, effective non-disproportionately burdensome
solutions. However, we view this challenge as a long-term project.
Thank you.
* SBLC is a permanent, independent coalition of nearly 60 trade and
professional associations that share a common commitment to the future
of small business. Our members represent the interests of small
businesses in such diverse economic sectors as manufacturing,
retailing, distribution, professional and technical services,
construction, transportation, and agriculture. Our policies are
developed through a consensus among our membership. Individual
associations may express their own views.
**NFIB is the leading advocacy organization representing small and
independent businesses. A nonprofit, nonpartisan organization founded
in 1943, NFIB represents the consensus views of its members in
Washington and all 50 state capitals. NFIB's mission is to promote and
protect the right of our members to own, operate and grow their
businesses.
***The U.S. Chamber of Commerce is the world's largest business
federation, representing more than three million businesses and
organizations of every size, sector, and region. More than 96 percent
of the Chamber's members are small businesses with 100 or fewer
employees, 70 percent of which have 10 or fewer employees. Yet,
virtually all of the nation's largest companies are also active
members. We are particularly cognizant of the problems of smaller
businesses, as well as issues facing the business community at large.

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