Why Small Businesses Won’t Stop Underpaying Taxes


Why Small Businesses Won’t Stop Underpaying Taxes

Photograph by Michael Lewis/Gallery Stock

There’s a way for Congress to lower the federal budget deficit to less than $1 trillion, maintain the Bush tax cuts for everyone, and abstain from making a single dollar of spending cuts. While this sounds like the kind of have-your-cake-and-eat-it-too solution our elected officials fantasize about, no one in Congress is suggesting it, nor are they likely to anytime soon. That’s because the solution requires getting small business owners to stop underpaying their taxes.

Before you ask why I’m discussing such a political nonstarter, know that small business underpayments add up. The IRS estimates (PDF) that $179 billion annually in unpaid federal taxes comes from individuals underreporting business income on their personal returns from what are known as pass-through entities and underpayment of self-employment tax. We could eliminate 16 percent of the budget deficit if this subset of American taxpayers paid all the taxes they owe.

Congress couldn’t raise this kind of money by going after big corporations. The IRS estimates that underreporting by large corporations (those with more than $10 million in assets) amounted to $48 billion in 2006, the latest year for which data are available. Add the $19 billion that small corporations underreport to the $179 billion mentioned earlier, and you can see that small business accounts for about four times as much of the tax gap as large corporations.

(I’m not talking about minimizing taxes legally here the way some large companies do. I’m talking about failing to pay the taxes that people legally owe. Whether we should close the loopholes that allow big business to keep their tax rates low is a different question.)

It would obviously be political suicide to go after entrepreneurs. Americans love small business and dislike Congress. A 2010 Pew Research Center survey found that 71 percent of Americans think small business has a positive “effect on the way things are going in this country,” while only 24 percent think Congress does. Knowing they will have to face voters again, Congress isn’t going to risk upsetting the American public by attacking beloved small business owners.

Among the several tax compliance bills that the 112th Congress introduced, only one became law—and that’s the one that repealed the 1099 reporting requirement, which would have given the IRS more information to catch tax cheats. In a nutshell, the provision obligated businesses to once a year report to the IRS payments of more than $600 a year to any vendor, prompting vociferous outcries from lobbyists.

Stopping small business from underreporting would be difficult because many owners underreport a little. And the bulk of underreporting may have more to do with the complexity of the rules than dishonesty. The U.S. Government Accountability Office notes (PDF) that the typical sole proprietor underreports income by less than $1,000. IRS tax advocate Nina Olson told Congress in 2006 that most underpayment in general comes from taxpayer error. That means underpayment of taxes can’t be cut substantially without fixing our complicated tax system.

Many small business owners are worried that Congress’s response to the federal deficit will throw the country into recession in 2013. Ironically, they have the ability to keep the economy from hurtling over the fiscal cliff come January. While Congress won’t force them to help, small business owners can reduce the federal deficit by paying all the taxes they actually owe.