Paul L. Caron

Tuesday, October 13, 2009

GAO: IRS Should Improve Sole Proprietor Loss Deduction Compliance

The Government Accountability Office yesterday released Tax Gap:  Limiting Sole Proprietor Loss Deductions Could Improve Compliance but Would Also Limit Some Legitimate Losses (GAO-09-81):

About 5.4 million or 25% of all sole proprietors reported losses in 2006. 95% percent of these loss filers deducted some or all of their losses against other income, deducting a total of $40 billion. According to IRS estimates last made for 2001, 70% of the sole proprietor tax returns reporting losses had losses that were either fully or partially noncompliant. About 53% of aggregate dollar losses reported in 2001 were noncompliant. This noncompliance would correspond to billions of dollars of lost tax revenue.

IRS’s compliance programs address only a small portion of sole proprietor expense noncompliance. Despite investing nearly a quarter of all revenue agent time in 2008, IRS was able to examine (audit) about 1 percent of estimated noncompliant sole proprietors. These exams are 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.

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. A loss limitation could reduce noncompliant losses but would also limit the ability of sole proprietors to claim legitimate losses. Another approach would improve 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 IRS’s research on the causes of sole proprietor noncompliance has not used available data to estimate the extent of this type of noncompliance. Without such an estimate, IRS could be missing an opportunity to reduce noncompliant sole proprietor losses.

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I completely agee that limitations should be in place, such a treating a Sch C like a C Corp and have losses either carryover, or carryback if they've had profitable prior years in the same business. This would help reduce the motive of many of these so called "businesses" to create artificial losses.
It's also up to tax practioners to make reasonable inquires as to inflated deductions for T&E when they appear to be out of line with reality...keep in mind the recordkeeping that is required to allow such a deduction. Most t/p do not have these records, so it's easy not to allow them.

Posted by: Art D CPA | Oct 16, 2009 2:47:41 PM

I agree, I can't recall when I have declined to give a sole proprietor a deduction when it was questionable (especially questionable mileage and no mileage log).

Posted by: Susan Harke | Oct 14, 2009 9:10:05 PM

I am a Canadian accountant and we have the same experience here. A first step by the tax authorities would to follow closely all the multi level organizations in North America. These encourage individuals to start part time ventures and to take questionable or aggressive tax deductions. I have come accross people who think that they can deduct their pet dog.

Posted by: Eric Sonego | Oct 14, 2009 9:53:29 AM