About a quarter of all sole-proprietor businesses report losses on their tax returns, but many are doing so by understating their income or overstating their expenses, leading to billions of dollars in lost tax revenue, according to a new government report.

Linda Stiff

The Government Accountability Office said in the report that about 5.4 million, or 25 percent, of all sole proprietors reported losses in 2006. Ninety-five percent of these filers deducted some or all of their losses against other income, deducting a total of $40 billion.

According to the IRS’s most recent estimate, in 2001, 70 percent of the sole-proprietor tax returns that reported losses had losses that were either fully or partially noncompliant with tax laws. About 53 percent of aggregate dollar losses reported in 2001 were noncompliant. Sole proprietors underreported their net income by 57 percent, or $68 billion, for 2001.

The IRS’s compliance programs address only a small portion of sole-proprietor expense noncompliance, the GAO noted. Despite investing nearly a quarter of all revenue agents’ time in 2008, the IRS was able to audit only about 1 percent of the estimated noncompliant sole proprietors. Such exams were costly and yielded less revenue than exams of other categories of taxpayers, in part because sole proprietorships are small in terms of receipts.

"Another enforcement program that primarily uses third-party information to electronically verify compliance is not effective because little expense information is reported by third parties," said the GAO.

One approach for limiting sole proprietor loss noncompliance would impose a rule that limits losses that could be deducted from other income. The Tax Code has a number of such limitations, the GAO noted. However, the GAO report acknowledged that while loss limitation could reduce noncompliant losses, it would also limit the ability of sole proprietors to claim legitimate losses.

Another approach would improve the IRS’s estimates of the extent to which activities not engaged in for profit, such as hobbies, are contributing to noncompliant sole proprietor losses. Expenses associated with these activities are not deductible, but the IRS’s research on the causes of sole-proprietor noncompliance has not used the available data to estimate the extent of this type of noncompliance. Without such an estimate, the IRS could be missing an opportunity to reduce noncompliant sole proprietor losses, said the GAO.

The report recommended that the IRS estimate the extent of sole proprietor not-for-profit, or hobby, activity noncompliance using its research data. However, the GAO did not recommend a loss limitation rule because the trade-off between reducing noncompliant losses and allowing legitimate losses requires a policy judgment.

In response to the report, the IRS agreed to conduct research to determine the percentage of sole-proprietor returns in the total population that report activities not engaged in for profit and quantify the extent of noncompliance among those returns. The IRS also plans to capture and analyze similar information from its ongoing compliance programs.

“We agree that addressing noncompliance among sole proprietors is important because they are responsible for a large portion of the tax gap,” said IRS Deputy Commissioner Linda Stiff.