The IRS Sets Its Sights on Small-Biz

The taxmen have stepped up their audits on small businesses, and that has many entrepreneurs crying foul

by Jeffrey Gangemi

The tax gap in the U.S., which the IRS defines as the missing amount from taxpayers who don't file their tax returns and pay the correct tax on time, currently stands at around $345 billion. Mark Everson, the IRS commissioner, has been working to reduce the gap since he took office in March, 2003.

"To make sure that there's an impression of fairness…," Everson says he first focused on high-income individuals and larger corporations, but now the IRS is stepping up its audits of small businesses.

In fact, the IRS enforcement increase has already begun in earnest. In 2005, audits of the roughly 5.7 million small businesses the IRS recognizes to be organized as corporations increased significantly, with 17,867 audits, up from 7,294 a year earlier.

Unfair Targeting?

Audits of corporations with assets over $10 million also increased in 2005, but by a much smaller percentage: up 14% from the previous year, to 10,878. Everson says he expects 2006 to reach an even greater rate of small-business enforcement.

Both the IRS and business taxpayers agree that some fraud exists for small businesses and individuals reporting their taxable income. But in response to the IRS crackdown, small-business owners and advocacy groups are crying foul, claiming smaller firms are being targeted with unfair audits that could penalize them for small or unintentional transgressions.

Everson, who's serving a five-year term, says cracking down on small businesses now will minimize the national deficit and avoid an eventual tax increase. "There's agreement on both sides of the aisle that if you reduce the tax gap, then what you're doing is getting more money into the national treasury, reducing the deficit, and there's not a tax increase," he says. Roughly 80% of the tax gap comes from under-reporting of income, and he says small businesses account for the majority of that under-reporting.

Time Is Money

But some small-business owners feel that larger companies already have an unfair advantage by being able to hire highly-paid accountants. "If we made the large corporations pay their just taxes instead of finding loopholes, there wouldn't be such a deficit," says Carolyn Pesci, owner of Rockwell American Services, a Houston-based provider of emergency response equipment.

Pesci says that already disadvantaged small companies are further hampered by unwarranted audits. "It takes a tremendous amount of time away from actually doing the business," she says.

During Everson's term, enforcement has taken center stage in the effort to strengthen the agency. Since 2001, the IRS increased its enforcement revenues by nearly 40%, from $33.8 billion in 2001 to $47.3 billion in 2005. Audits of individuals earning $100,000 or more topped 221,000 in fiscal year 2005, the highest number in the past 10 years. Total audits of all taxpayers (individuals and businesses included) topped 1.2 million in 2005, a 20% jump from the prior year.

Overboard on Enforcement

Though the IRS often more than earns back the dollars it spends on enforcement, targeting small businesses could mean smaller gains and less bang for the agency's buck, say experts. "There is at least some chance that they spend extra money on enforcement and they don't end up getting a whole lot of revenue," says Austan Goolsbee, professor of economics at the University of Chicago Graduate School of Business.

Though enforcement is a necessary part of the tax system, some small-business advocates say spending should be funneled toward education about an increasingly complex tax code, rather than increased audits. "It's not [the IRS's] fault necessarily that tax laws get more complex, but it is their responsibility to educate. It's not just about enforcement, and they're heading in the direction [of going overboard]," says Todd McCracken, the president of the National Small Business Association (NSBA), a Washington, D.C.-based advocacy group.

The IRS is also working to decrease the percentage of "no-change" audits—those in which the auditor assesses no additional taxes or penalties—they perform by better targeting their enforcement activities. To better target fraudulent or underreported returns, Everson and the IRS want a law change so that third-party credit card providers and banks report the aggregate revenue of small businesses that flows through their accounts.

Finding a Quota

They say third-party reporting at once discourages under-reporting of income and exposes inconsistencies in self-reported income. But economists and small business advocacy groups fear those proposals won't get to the heart of the problem. "If you really want to crack down on small-business tax evasion, you have to get buy-in from financial institutions. But that still doesn't address the cash-based businesses. It's a financial cat-and-mouse game," says Goolsbee.

And since the tax code is so complex, just about any return can be interpreted in multiple ways. "Pressure is being applied to find the money that they claim is there, but what if it isn't there? Think of the pressure which that puts on the IRS to get tougher. You don't want to be the person that gets audited the day after that message goes out. It's like saying 'We couldn't find a problem, so find one,'" says Paul Hense, a certified public accountant and chair of the NSBA.

But Everson says small business owners have nothing to fear, as long as they do their best to report accurate income numbers. "I don't want people to be alarmed. It's just that we're steadily doing more in this area. Please don't make this seem overly dramatic, like we're suddenly going to arrive at everybody's doorstep. That's not correct," says Everson. Many small-business owners might feel like this is still attention they don't need, though.

Jeffrey Gangemi is a freelance writer based in Mendoza, Argentina.