November 26, 2014

Which Sole Proprietors Cheat on Their Taxes (According to the IRS)?

tax cheats

If you are non-native-English-speaking man who runs a construction or real estate rental business, hires a tax preparer rather than doing his own taxes, and thinks that making money enhances social status, beware. Research by the Internal Revenue Service (IRS) indicates that you are among the sole proprietors most likely to cheat on your personal income taxes.

Running your own business is one of the best ways to pay less in taxes than you owe, a recent New York Times article explained. The IRS knows this, of course, reporting that sole proprietors disclose only 43 percent of their income on their returns.

To figure out which taxpayers might be underpaying their taxes and be worthy of a second look from its auditors, the IRS’s computers assign a Discriminant Function System score (DIF) to each tax return filed. These scores use information from the IRS’s database of past tax filings to predict whether a taxpayer is likely to have under reported income.

Determining which sole proprietors might be underreporting income isn’t easy. Most business pay all that they owe. Even if the IRS reassigned everyone currently responsible for evaluating non-profit status applications for all politically conservative organizations (a little topical humor here), the agency would still lack the resources needed to audit all sole proprietors. For returns filed in 2011, the tax authority “only” audited 1.6 percent of individual returns with business income.

That’s why the IRS contracted with Russell Research to conduct a survey of sole proprietors in the first quarter of 2012. The investigators divided a representative sample of sole proprietors into the most and least “compliant” (IRS-speak for willing to pay all of the taxes they owe) on their DIF scores for their 2009 tax returns. They then compared the most and least compliant fifths on the basis of their answers to a range of survey questions.

The results, which were published in a study released earlier this year, provide insight into which sole proprietors are most likely to be tax cheats:

  • Men were less likely than women to be “compliant.” While males made up 59 percent of the more compliant taxpayers, they composed 65 percent of the less compliant ones.
  • Twice the fraction of sole proprietors who speak a language other than English at home were less compliant in paying taxes (14 percent versus 7 percent).
  • Owners of companies with more employees were less compliant (average employment of 6.6 versus 3.6).
  • Owners of professional, scientific and technical service businesses, health care and social assistance, and arts, entertainment and recreation businesses were more likely to be compliant than owners of construction, and real estate and rental and leasing businesses.
  • Owners of businesses with lower sales tended to be more compliant (average sales of $47,000 versus $87,000).
  • Owners of businesses with lower expenses tended to be more compliant (average expenses of $12,000 versus $50,000).
  • Owners who complete their own tax returns tended to be more compliant (32 percent of the more compliant sole proprietors do their own taxes versus only 21 percent of the less compliant ones).
  • People who indicated that they were more willing to take financial risks, and those who reported that overall status depends on finances, tended to be less compliant.
  • People who were more cynical about the tax system, those who had more negative attitudes about the IRS, and those who were more skeptical about the value of government activity, tended to be less compliant.

Note to those of you at the IRS who read my posts: I abhor risk; am very positive about the government and the tax system; and think you are doing a fine job, despite recent news reports.

Just thought you’d want to know.

taxes Photo via Shutterstock

2 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.

2 Reactions

  1. I’m very positive about the tax system as well.

    I’m also totally confused by it and don’t know how any SMB owner can still do their own taxes.

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