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Aruba, June 16, 2016 - Sizing up the honesty of small-business owners is one of the Internal Revenue Service’s most vexing problems. The agency estimates that it collects $458 billion a year less in taxes from all Americans than the government is actually due. Most of that “tax gap” is income that goes unreported, and the biggest chunk of it, by far — $125 billion — is individual business income.
Taxpayers in this category, primarily sole proprietors, pay taxes on the money their operations make through their personal returns. Thus, their cash flows can be particularly opaque.

Take owners like Rebeca Mojica, a chainmaille jewelry designer in West Hollywood, Calif., who was audited in 2011. Her sales fluctuate significantly from year to year, and she takes some payments in cash. Were she so inclined, she could easily hide a chunk of that income.

The dreaded audit is the main way the I.R.S. catches scofflaws and ferrets out unreported income, but it is a time-consuming and imperfect tool. Short on resources, the agency collected just $7.3 billion from audits last year, its lowest total in 13 years.

What the I.R.S. really wants is for business owners to voluntarily pay more of what they owe. But 63 percent of “low visibility” income, the kind that isn’t captured by outside parties on tax information documents, is not disclosed on tax forms, the agency says.

So for the last four years, the Taxpayer Advocate Service, an independent office within the I.R.S., has been running studies to help it figure out how more small-business owners who pay their taxes can be persuaded to report their earnings more accurately.
One finding suggests that audits, the agency’s most powerful compliance tool, seem to have little lasting deterrent effect on tax cheats, and could even backfire for honest taxpayers. That discovery, and others, could help inform the agency’s future collection techniques.

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