Small Business Owners: The IRS Says You Are Tax Cheats

tax cheatSmall business does a lot for America, accounting for roughly half of private sector GDP and employment.

Their economic contributions probably account for part of the reason that small business is our country’s most trusted group. A recent Pew Foundation survey revealed that 71 percent of Americans held a positive view of small business, 8 percentage points higher than churches and religious organizations and 10 percentage points higher than colleges and universities.

But small business owners aren’t saints. They are also America’s top tax cheats, according to Internal Revenue Service (IRS) taxpayer advocate Nina Olson. Not all of them, of course, but, on average, small business owners are much more likely than other Americans to underpay their taxes.

Their cheating is substantial. The IRS reported that the United States Treasury faced a tax gap – the amount it was owed less what it was paid – of $385 billion in 2006, the most recent year data are available. The largest chunk of this gap – $122 billion – is unreported business income on individual income tax returns.

But just as we shouldn’t look at the Pew Foundation survey and think that more trustworthy people become small business owners than politicians, bankers, ministers or college professors, we shouldn’t look at the IRS figures and conclude that dishonest types start companies. Small business owners aren’t less honest than the rest of us. They are just better able to get away with cheating on their taxes.

People don’t under report their wages because their employers report their earnings to the IRS. Knowing that, the IRS knows what’s in your paycheck keeps most people from lying about the amount they are paid. Therefore, only 1 percent of wages go unreported.

By contrast, the IRS has no idea how much cash sole proprietors are taking in. That’s why the IRS estimates that a whopping 56 percent of sole proprietors’ cash receipts are not disclosed to the tax authorities.

The IRS doesn’t think checking up on most small businesses is worth their time. While they regularly audit giant corporations like Apple or General Motors, coming through the records of a bunch of tiny companies doesn’t yield enough unpaid taxes to justify the costs.

A small business owner earning $155,000 per year faces an average tax rate of 20.5 percent, the nonpartisan Tax Foundation tells us. If the IRS catches the business owner under reporting income by 25 percent, that yields only $7,800 in lost income. Therefore, it’s not surprising that the IRS audits only 1 percent of taxpayers earning less than $200,000 per year, but 12 percent of those earning more than $1 million.

Moreover, the IRS knows that a chunk of small business under reporting isn’t deliberate. It comes from the difficulty of figuring out what one actually owes. Fear of punishment might motivate small business owners not to purposefully misstate their income, but it does little to help them calculate the right numbers under a maddeningly complex tax code.

Finally, our elected officials inadvertently preserve small business tax cheating when they try to avoid burdening small business owners with costly tax reporting requirements. The IRS and many tax experts explain that small business owners would reduce under reporting if third parties provided the IRS with more information. But Congress has repeatedly voted down third party reporting requirements for small businesses as too burdensome.

Whatever the combination of causes, a recent New York Times article summed up the outcome succinctly. The best way to cheat on your taxes is to “run your own company. More specifically… be the sole proprietor of a Schedule C business.”

Hiding Money Photo via Shutterstock

9 Comments ▼

Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

9 Reactions

  1. This doesn’t surprise me actually. I know of a few small biz owners who are friends of mine who’ve admitted to underpaying their taxes.

  2. I would point out that averages lie. I believe that most SMB owners report their income to the best of their knowledge and a few bad apples can quickly skew statistics like these.

    And don’t even get me started on the complexity of the tax code. The previous Secretary of the Treasury underpaid his taxes and they still appointed him.

  3. I’m with Mr. Brady. Most SMB owners do the best they can to get their taxes right. Some cheating, however, does occur with businesses that take cash. Now should we talk about how our governments cheat us? Much of our tax money goes into a black hole of mismanagement and, yes, corruption. Now that would be an interesting study!

  4. we are VERY small Business owners grossing under 11,000 per year. We are trying to build it up. We are getting an actual refund this year cause we made so little and have IEC for a child and a child tx credit. I don’t need an audit I hope I did it right… I did special paper work for someone who made so little they did not report it, but are reporting every penny we made now. reporting what we made was beneficial cause the EIC was higher for us :)

  5. The REAL tax cheats the the IRS should go after is CORPORATE America. Apple paid 1.9% taxes on its $56b in profits, (http://www.theatlanticwire.com/business/2012/11/how-apple-avoids-paying-billions-taxes/58681/), GE 0%, Bank of America 0%, Exxon, 0%, Chevron 1%, Boeing 0%.

    Thats what the IRS should worry about, not the little guy running his Pizzeria not declaring his $500 in cash sales.

  6. Taking any data from the IRS, or any federal entity, from the president on down, better be done with a strong sense of doubt, to be kind. We all know the IRS is full of political appointees who jump to the tune of the ruling party and the rest of them is made up of employees of the last resort.
    Therefore, trying to coax meaningful data from theirs is akin to proving down is up and vice versa.
    In addition, it is a citizen’s duty to prevent the government, at any level, from taking more money than they lawfully are entitled to. If a rule is open to interpretation, tax-wise, the proper path for the taxpayer is to take the one that leads to less tax being due. ( I can see now the NSA aided gov’t thugs coming to my door.)

  7. I don’t and wont give them anything. They don’t work 14 hour days like I do. And they wont help me out when I need cash. Well I don’t want their help and they can’t have my money.

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