Schedule C is the form that unincorporated sole proprietor businesses use to report their income and expenses as part of their individual tax returns. Schedule Cs have been center stage in recent IRS “tax gap” estimates.
The tax gap is defined as the amount of tax liability faced by taxpayers that is not paid on time. This past January they released the tax gap figures for 2006. You might say that 2006 was quite a ways back, but you have to remember returns are filed in the subsequent year and then the information must be compiled and analyzed. Thus, most Treasury reports based on filed tax returns are based on information from several years back.
The 2006 report essentially mirrors the 2001 report, except the tax gap has increased from $345 billion to $450 billion. Of that $450 billion, approximately $372 billion is attributed to under reporting in the following categories:
- Non-business under reporting 73
- Schedule C under reporting 193
- Overstated deductions, exemptions & credits 42
- Payroll taxes 20
- Corporate income tax 39
- Estate tax 5
- Personal Expenses – Over-deductions attributable to the inclusion of non-deductible personal expenses and the failure to allocate for personal use of a vehicle.
- Under reporting Income – Failure to include all income. To counter this problem, the IRS has initiated merchant card and third-party reporting that will provide the IRS with all income from credit card sales.
- Worker Misclassification - Misclassifying workers as independent contractors instead of treating them as W-2 employees, and thereby avoiding the employer’s share of payroll, unemployment, and other taxes. The IRS currently has a Voluntary Classification Settlement Program in effect that allows eligible taxpayers to voluntarily reclassify their workers for federal employment tax purposes. Voluntary programs usually precede more aggressive compliance measures.
- Failing to Issue Information Returns – Generally, businesses are required to issue 1099s for fees they pay to individuals other than employees or to corporations. This is a huge area of non-compliance and denies the IRS the ability to ensure the payees are properly reporting their income. In an audit where a 1099 should have been issued and was not, the IRS will generally disallow the deduction for those services. The 2011 Schedule C asks two catch-22 questions: “Did you make payments that would require you to file a Form 1099?” followed by “If yes, did you or will you file all required Forms 1099?”
- Hobby Losses – Some businesses are actually hobbies where there is no real intention of ever making a profit. Businesses deemed to be hobbies have special rules that limit the expense deductions to the income and require the deductions to be taken as an itemized deduction on Schedule A. Watch for a future article on hobby losses that will appear in the March newsletter.
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