The Internal Revenue Service developed the concept of the tax gap as a way to gauge taxpayers' compliance with their federal tax obligations. The gross tax gap is the difference between the amount of tax that should have been paid, on a timely basis, and the amount actually received by the government for a specific tax year. Unfortunately, the IRS is egregiously targeting small business as the primary wrong-doer.

How Big is the Problem?

IRS develops its tax gap estimates by measuring the rate of taxpayer compliance -- the degree to which taxpayers fully and timely complied with their tax obligations. That rate is then used, along with myriad other assumptions, to estimate the dollar amount of taxes not timely and accurately paid. For instance, IRS recently estimated that for tax year 2001, nearly 17 percent of owed taxes were late or not paid at all, which translated into an estimated gross tax gap of $345 billion in taxes. The IRS recovered about $55 billion of this sum, leaving a net tax gap of $290 billion.

Components of the Tax Gap

The IRS divides the tax gap into three components: nonfiling, underreporting and underpayment. First, the nonfiling component is made up of taxpayers who do not file a tax return even though they are required to do so. Taxpayers who do not file do not pay their tax liability. Second, the underreporting component is made up of taxpayers who file their tax returns but either understate their income or overstate their deductions, exemptions and credits on timely filed returns. Third, the underpayment component is made up of taxpayers who file their tax return but do not make the required payment. According to the IRS, of these three components, underreporting of income tax, employment taxes and other taxes represents about 80 percent of the tax gap or roughly $166 billion. The IRS claims the single largest sub-component of underreporting involves individuals understating their incomes, taking improper deductions, overstating business expenses and erroneously claiming credits. Individual underreporting represents about half of the total tax gap. Individual income tax also accounts for about half of all tax liabilities. Of the $166 billion, IRS alleges that small businesses are responsible for $109 billion.

IRS Threat to Small Business

The IRS is hiring more auditors and is petitioning Congress for increased funding to audit more small businesses. In the last two years alone, audits of small corporations have increased 150 percent and there is every reason to believe that number will continue to rise. Small firms are being targeted and penalized by the IRS for small and unintentional transgressions. The IRS wants to place new burdens on businesses by forcing small businesses to give the IRS direct access to all business credit card records; give the IRS access to all business checking account records; and require businesses to report and withhold taxes on vendors and contractors. This is unfair and wrong!

NSBA Steps to Close the Tax Gap

None of the numbers examine the effects of external factors on tax compliance. The IRS failed to consider what percentage of tax gap is attributed to the complexity of the tax code. It also did not study what other external factors affect taxpayers behavior.

Addressing the tax gap must entail balancing the desire to collect taxes that are duly owed with the importance of minimizing intrusive and complicated reporting requirements and additional audits of small businesses.

Potential steps include:

1) Improve Services: Though the IRS has made strides in improving customer service, there needs to be a concerted effort to improve compliance assistance rather than enforcement. Additional improvements to customer service should facilitate tax paying while ensuring that unintentional errors are minimized, and not penalized.

2) Crack down on Tax Scams: A report by the Senate Permanent Investigations Subcommittee found that cheating on taxes now equals about four cents to seven cents on each dollar paid by honest taxpayers, or about $40 billion to $70 billion a year. NSBA supports efforts to curb tax cheats, but the IRS and Congress must take a certain level of responsibility for creating a complex, out-of-control tax code that enables the very kind of cheating they're trying to stop.

3) Simplify Taxes: Considering the legal ramifications of filing incorrect returns, much less the tax gap, the tax code desperately needs to be simplified. Reforms can include consolidating the number of tax breaks in the code, rationalizing and harmonizing definitions, and in general reducing the number of forms taxpayers are required to fill out each year. These changes could easily reduce the non-compliance rate and potentially raise tax revenues without an increase in tax rates.

Whatever approach Congress takes, the end goal should be to allow taxpayers to calculate their taxes on a single form, if possible, with just a few hours of preparation. That would go a long way toward reducing errors and making it tougher for individuals and businesses to evade taxes.