| As anyone who has done it will tell you,
running a small business is difficult. Not only do you have to be able to do your work
well, but you also have to deal with all the formalities and paperwork involved in owning
and operating a business entity. Between licensing and permit requirements, taxes from
several levels of government, and dealing with suppliers and employees, it's sometimes
amazing that business owners ever get any client work done at all. Yet small businesses
are commonly seen as the backbone of the American economy, providing a significant
fraction of jobs for the labor force.
However, small businesses now face a threat of increased
scrutiny from the IRS. In a recent news conference, IRS Commissioner Mark Everson
indicated that the IRS will start focusing their audit activities on small businesses,
especially unincorporated businesses. Despite tax settlements involving big companies,
such as Eastman Kodak's (NYSE: EK - News) big tax refund last year and ServiceMaster's
(NYSE: SVM - News) $131 million agreement with the IRS, Everson claims that the largest
cause for shortfalls in tax collections is in individual taxpayers, especially sole
proprietors, failing to report all of their income. While wage earners have their income
amounts verified by their employers, there is sometimes no independent reporting of income
that small businesses receive; what the taxpayers put on their Schedule C attachments to
their tax return is the only information the IRS gets about the income and expenses of the
business.
Why it's a big deal
One likely reason why the IRS wants to crack down on
unincorporated businesses is because there are substantial amounts of potential lost
revenue involved. Employees who receive regular wage income have payroll taxes withheld
from their paychecks and then pay income tax through periodic withholding and on their
annual tax return. Owners of unincorporated businesses, on the other hand, pay both income
tax and payroll taxes in the form of self-employment tax. What this means is that if
unincorporated business owners choose not to report income, they not only reduce their
income tax at rates up to 35% but also eliminate revenue subject to self-employment tax
rates that cost as much as an additional 15.3%.
In addition, when evaluating the expenses of a small
business, it can be challenging to separate what the owner uses for business purposes from
personal items. While larger businesses usually have dedicated real estate, supplies, and
equipment that are clearly used solely for business purposes, small businesses often lack
the resources to maintain clearly delineated boundaries between business and personal use.
As a result, there's a greater danger that small business owners will claim business
deductions for expenses that are more personal in nature.
Is the IRS overreacting?
On the other hand, there are a number of factors that
probably produce greater amounts of tax for the IRS than the tax laws impose. Confusing
rules about legitimate business expenses, including the deduction for home office
expenses, lead many taxpayers simply to forego claiming tax deductions for fear that their
returns will be audited. While some business owners certainly overreach in the expenses
they choose to deduct, others are overly cautious to claim only those expenses about which
they feel most comfortable, even when it results in paying more tax than they should.
Doing what they can to avoid spending the time and money necessary to respond to an IRS
audit makes paying a bit of additional tax a small price to pay.
Moreover, many small businesses have income that is
independently verified by third parties. For those business owners who perform a
substantial amount of work for other businesses, much of their income will be reported by
their business clients on Form 1099-MISC, which is required for payments for services in
excess of $600 annually. Given the increasing trend among companies to treat workers as
independent contractors rather than employees, many workers that are treated as
unincorporated business owners have little or no ability to understate their income.
On the expense side, many small business owners likely are
offended by the notion that they are overstating their deductions. Many employees of large
businesses have expense accounts that give them considerable latitude to spend company
money on things that are only loosely connected to business activity; the largesse of
traveling employees with expense accounts is a well-document part of the corporate
culture. Small businesses, on the other hand, often can't afford to use their limited
financial resources on such lavish expenditures, instead saving them for the necessary
expenses of running their business. To scrutinize small business expenses while giving
large corporations carte blanche to deduct similar expenditures is insulting to small
business owners and runs counter to the idea that the government should encourage
entrepreneurs to create and grow small businesses.
Most people would agree that everyone deserves to pay their
fair share of income taxes and that those individuals and companies that flagrantly
violate tax laws should be punished severely. However, small business owners, who are
already overburdened by demanding administrative requirements, economic challenges, and
the day-to-day tasks of actually doing their jobs, are perhaps the least capable of taking
in stride the difficult work of facing an IRS audit. As the economy starts to show
possible signs of sinking into recession, increasing audit activity may prove to be the
death knell for small businesses that are already on the brink of collapse.
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