Many businesses may soon find they cannot obtain or renew a license unless they are current with both their state and federal taxes.

According to a new report from the Government Accountability Office, a recent California requirement that three types of businesses comply with their federal employment tax obligations in order to obtain state business licenses has shown promise in improving federal tax compliance.

Of 7,194 businesses that applied for a California business license one or more times from calendar years 2006 through 2008, about 24 percent had to file employment tax returns or pay overdue taxes to come into compliance with federal employment taxes. California businesses filed 441 employment tax returns, and the IRS collected nearly $7.4 million in current dollars in employment taxes in calendar year 2006 and the first eight months of 2007. The GAO estimated that the IRS incurred about $331,348 to operate the data-sharing arrangement for this period. Using this cost estimate, the return on investment for this arrangement was 22:1.

The GAO also identified 2,017 businesses that applied for business licenses in calendar year 2006 only and found that 315 of these businesses had unpaid assessments as of Sept. 18, 2006. By Aug. 18, 2008, 165 of these businesses had resolved or lowered their unpaid assessment debt by $1,925,162. All but one of the 350 businesses that had unpaid assessments when they applied for business licenses in calendar year 2006 were small businesses. The GAO’s analysis, although showing a promising ROI, did not take into account certain factors, such as whether other tax collection activities were in process for the businesses that applied for licenses, however.

According to the IRS, arrangements exist with 13 states that require compliance with one or more federal taxes to qualify for a state business license. Many more states require that businesses are current with their state taxes in order to renew their licenses. The GAO contacted revenue officials in every state and the District of Columbia to ask whether their states require tax compliance for business licenses. Of the 48 respondents, 20 revenue officials said that their states require compliance with state taxes to obtain a state business license, and that these requirements exist for one or more industries. Twenty said that their states do not have such a requirement, and eight said that their states have no business license requirement at the state level.

Leaders of the Senate Finance Committee, which requested the GAO report, called for greater federal-state cooperation in improving tax compliance.

“This report confirms my initial thinking that we can improve tax compliance through better cooperation between the IRS and state licensing boards,” said committee chairman Max Baucus, D-Mont. “Checking to ensure that taxpayers seeking a business license are up to date on their tax obligations is a common-sense approach to improving tax compliance. These are taxes already legally owed, so it’s not raising taxes on anyone. Partnering with state authorities could begin to reduce the burden on honest taxpayers who shoulder the billions of legally owed but unpaid dollars every year and help to fund priorities like health care.”

He expects the IRS to follow up on recommendations to evaluate state-licensing requirements and work with the states to expand these arrangements.

“This program has made a big difference in compliance with federal employment tax obligations in California,” said ranking member Charles Grassley, R-Iowa. “It seems to have done so without costing a lot of money or taking up other state and federal resources. As the report recommends, it makes sense for the IRS to approach other states and spread the word about this idea.”

Grassley confessed that he was puzzled that the Treasury Department’s hadn’t included the idea in a recently updated plan for closing the estimated $345 billion tax gap. “I hope the department is pursuing every good option to collect taxes that are owed,” he said.

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