by Roger Russell

The Internal Revenue Service is pursuing high-dollar abusive tax schemes and low-dollar earned income tax credit noncompliance, but it is neglecting the broad area in the middle, according to National Taxpayer Advocate Nina Olson.

The government’s failure to aggressively enforce the tax laws with respect to self-employed persons ranks among the top problems confronting the Internal Revenue Service, and may require a system of withholding on payments to self-employed persons, she said.

Since income earned by self-employed persons is not reported to the IRS on a Form W-2, and often is not reported at all, it is not surprising that self-
employed persons account for the largest share of the known tax gap — the amount of improperly unpaid tax each year — which now is estimated at a whopping $310 billion annually.

Olson said that she is highlighting the problem in her annual report to Congress because it impacts compliant taxpayers, who are negatively affected by the large tax gap attributable to sole proprietor taxpayers. “Not only must compliant taxpayers pay more taxes in order to make up for a revenue collection shortfall, but their confidence in the system is shaken,” she said.

“How should a W-2 taxpayer, who has taxes taken out of her paycheck each week, feel when the freelance carpenter making small improvements on her home brags about not reporting these private homeowner payments? Or her children’s day care provider wants to be paid in cash?” she asked.

“How can a fair and balanced tax system justify ignoring an issue that impacts many more taxpayers in their daily lives than either of those high-profile compliance problems? If an effective response to the sole proprietorship tax gap requires additional resources, including more revenue agents and revenue officers in the field, then the IRS should make the case for those resources,” she said. “It should not use the lack of resources as justification for a lack of response.”

Olson proposed amending Internal Revenue Code Section 3402(o) to expand withholding on non-wage payments to include any payment “aggregating $600 or more during a calendar year made by a service recipient engaged in a trade or business to any person for services performed.”

“While this recommendation is sure to be controversial and the specifics can certainly be refined,” she said, “I believe it represents a good starting point for discussions about the issue, and its primary virtue is that it sidesteps the age-old and intractable debate about which standards to apply in distinguishing between employees and independent contractors.”

“I agree that non-filers and underreported income affects compliant taxpayers,” said Chuck McCabe, president of Richmond, Va.-based People’s Income Tax. “But you have to ask how much ‘Big Brother’ do you need — what’s the cost and how does it impact small businesses that don’t have the manpower to handle that additional accounting? It could be good for our business, but that’s self-serving — if I were engaged in another kind of business I don’t think I would be happy about it.”

Although the initial proposal would only apply to service recipients engaged in a trade or business, this could be just the beginning, according to some tax professionals.

“Eventually they would try to get homeowners involved, and the states will piggyback on top of it,” said Larry Novick, a Holliston, Mass.-based enrolled agent. “The effect is to make them unpaid agents, because if they don’t file a 1099 for a payment of $600 or more they would be liable for the penalty for failure to file, and the recipient would be liable if the money was not remitted in a timely manner the same as payroll taxes.”

“The other side of the coin is that it doesn’t apply to corporations,” he said. “You can incorporate yourself, and the service recipient wouldn’t have to file a 1099 because there are no 1099s for corporations — until the IRS decides to have 1099s go to corporations as well.”

“The only thing this would accomplish is to make the underground economy bigger,” said Novick. “A national sales tax would help relieve the debt because everyone pays it — even drug dealers and prostitutes who don’t pay tax. But it won’t fly because it puts an extra burden on everyone.”

“But the proposal is good for another 5,000 pages of code and regs to explain it,” he continued, “and it will drive more business to accountants.”

For Tony Bardi, a Gresham, Ore.-based enrolled agent, there are a number of problems with the proposal. “We remind people in a trade or business that if they engage a worker and pay out more than $600 they should send a Form 1099, but landlords and small businesses have difficulty because they’re not set up to do it. If they have to start withholding, there could be less compliance with Form 1099 requirements than otherwise.”

“I can’t see where people who don’t normally do withholding all of a sudden have to start withholding federal taxes as well as issue a Form 1099,” he said. “It would be better to get people who are supposed to issue Form 1099s to do so.”

John Santora, a CPA and director of systems support and development for Fiducial, agreed. “The focus of this is all wrong,” he said. “Essentially what she’s saying is that the people who are doing their best to comply with the law, in addition to running their businesses, are now going to have an extra burden placed on them because we want them to do our enforcement.”

“The problem is that many small businesses are not set up to do withholding,” he said. “A large percentage have no employees or employee identification number. They would have to register, withhold, remit on a regular schedule, and prepare 1099s. We’re asking them to do something way beyond what they’re doing now and there’s no benefit to them for doing this.”

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