Almost 20 percent (an estimated $68 billion) of the roughly $345 billion in unpaid taxes owed to the federal government is due to sole proprietors who misreport their income. An estimated 6 out of 10 sole proprietors underreport their income, although only a handful account for the bulk of lost tax revenue attributable to the group, according to a Government Accountability Office (GAO) report. According to the GAO report, sole proprietors misreported 57 percent of their business income in 2001 (the latest data available). As a group, sole proprietors are responsible for a larger part of the tax gap than any other group, the IRS estimates.

The IRS has pledged to increase audits of Schedule C filers, such as sole proprietors, over the next two years. The IRS plans to increase the number of Schedule C audits by seven percent, which will grow by an additional five percent by September 30, 2009. Interestingly, audit examiners of other taxpayer groups such as corporations and estates were not given percentage goals.

According to the GAO, the high rate of noncompliance among sole proprietors stems largely from the fact that sole proprietors are not subject to tax withholding requirements and only a portion of their income is reported to the IRS by third parties. In comparison, the rate of misreporting wage and interest income, which is subject to withholding, by financial institutions is low (approximately only 1 and 4 percent respectively). The GAO report made no particular recommendations to the IRS on how to increase accurate reporting by sole proprietors.

The GAO report also concludes that the sole proprietor tax gap cannot be closed by IRS enforcement programs alone, which are limited and costly. Underreporting, for both gross income and expenses, is spread among more than 12 million sole proprietors, often in small amounts. Thus, increased focus on sole proprietor reporting compliance will most likely increase costs and burdens of small businesses, third parties and the IRS. However, it does take less resources to audit a small business or self-employed individual than a multi-national corporation.

(GAO-07-1814)