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

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cheat on taxes

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

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How the IRS Scandal Might Benefit Small Business

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A few weeks ago, the Internal Revenue Service (IRS) admitted that some of its employees improperly subjected to disproportionate scrutiny to conservative groups seeking to set up non-profit status.

While you might think that the scandal has little to do with small business, in the strange world of Washington — where everything influences everything else — the scandal has the potential to benefit small business owners in several ways.

The biggest potential gain for small business owners lies in the ammunition the scandal provides Republicans in their effort to challenge the Affordable Care Act (ACA). While the GOP has thus far failed to stop the new health care law, the scandal gives Republicans the opportunity to hinder the tax agency’s efforts to enforce the law. By hammering away at the theme that the IRS cannot be trusted, the GOP may be able deny the tax authority the funds it needs to administer the new law.

That, it turns out, will benefit small business owners, who tend to oppose the ACA. A Gallup Survey of small business owners conducted in April revealed that 48 percent think the new law will be bad for business, while only 9 percent think it will be good, and 39 percent think it will have no impact.

The cost of the new law, and the benefits of any reduced enforceability, will fall largely on small businesses because almost all big companies provide employee health insurance. In 2012, the Kaiser Family Foundation found that 98 percent of businesses with 200 or more employees offered employee health insurance, but only 61 percent of companies with fewer than 200 employees did.

The scandal also adds to the credibility of the Tea Party groups, who are major supporters of small business. Conservative organizations claimed months ago that they had been singled out for unfair treatment, but many were skeptical of their claims. Being the victim of the IRS has boosted the favorability of the Tea Party movement, a CNN/ORC International survey suggests. Between the March poll (before the news of the scandal broke) and the latest poll, the Tea Party’s favorability increased nine percentage points, CNN reports.

If the Tea Party can capitalize on the scandal to garner support in the mid-term elections, their electoral success should work to the advantage of small business owners. Tea Party supporters are more likely than other voters to believe that cutting taxes on small business is a good approach to job creation, a 2010 Winston Group survey revealed. Moreover, nearly two-thirds of small business owners believe in the Tea Party idea that the government is too expansive, as compared to less than half of all Americans, A Wall Street Journal/NBC poll showed.

Then there’s the effect of the scandal on IRS audits themselves. The tax agency might need to cut back on audits in the wake of the scandal, as it seeks to rebuild its trust with the American people. That would be a welcome respite for successful small business owners who have seen an increase in the rate of IRS examinations in recent years. According to the IRS’s annual data book, the audit rate for business returns of between $200,000 and $1 million jumped from 2.8 percent in 2008 to 3.7 percent in 2012.

Perhaps a corollary of the proposition that “politics makes strange bedfellows” should be: “politics creates unexpected linkages.”

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The Micro Business Home Equity Loan Crunch

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To obtain the capital they need to finance their business operations, some micro-business owners tap the equity in their homes by drawing on home equity lines of credit. But in recent years, this strategy has become more difficult for business owners, as banks have cut back on home equity lending.

Seventeen percent of businesses with less than $100,000 in sales use home equity lines of credit for business purposes, Barlow Research’s October 2012 Small Office/Home Office Opportunity study – a random sample of 100,000 small businesses with less than $100,000 in sales listed in Dun and Bradstreet – reveals.

That’s surprisingly high. The Federal Reserve’s 2010 Survey of Consumer Finances reveals, that 18 percent of the self-employed don’t own their own homes, so they can’t get home equity lines of credit. The National Federation Independent Business’s 2011 Annual Finance Survey shows that only 44 percent of businesses with fewer than 20 employees have a line of credit, whether drawn on their home or otherwise. Together these numbers suggest that just under half (47 percent) of micro business owners with homes and lines of credit made use of home equity to get the credit line.

In absolute terms, a lot of micro enterprises use home equity lines of credit for business purposes. The Internal Revenue Service estimates that there were approximately 25 million businesses with less than $100,000 in revenue in operation in the United States in 2008, the latest year data are available. Given Barlow Research’s estimate of the fraction with home equity lines of credit used for business purposes, that translates to more than 4 million micro business owners.

These 4 million business owners have had a tough time with their financing strategy in recent years because of the declining home equity loan market. According to the Federal Reserve of New York’s Quarterly Report on Household Credit, the number of home equity lines of credit fell from 23.9 to 18.7 million between the fourth quarter of 2007 and the fourth quarter of 2012. Moreover, the amount of credit available on home equity lines of credit declined 39.3, and the balance on these loans 24.1 percent, percent in inflation adjusted terms, over the same period.

As I have argued before, small business credit markets are linked with the housing market. During the housing market boom, micro business owners had an easier time getting credit for their companies because they could tap rising home equity levels. Since housing prices have deflated, however, and banks have cut back on home equity loans, microbusiness owners who used home equity to finance operations have found credit more difficult to get. If policy makers want to help ensure that microbusiness owners have access to sufficient credit, then they need to keep a careful watch on the housing market.

Home Loan Photo via Shutterstock

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Why Small Businesses Have Trouble Getting Credit

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Only one third of small business owners were able to obtain all of the credit that their businesses need, a recent National Federation of Independent Business (NFIB) survey shows.

The survey’s finding is not surprising. Many economists, policy makers and small business advocacy groups have long explained that small businesses have a harder time obtaining credit than their larger counterparts. When it comes to accessing capital, size definitely matters.

Even among small businesses, the smaller the company, the lower the odds that it has a loan (see figure below) or a line of credit. Only 15.7 percent of businesses with one or fewer employees have a business loan and only 33.7 percent have a line of credit, the NFIB survey shows. By contrast, 56.8 percent of businesses with between 50 and 250 workers has a business loan and 65.4 percent has a line of credit.

Source: National Federation of Independent Business, 2011 finance survey Source: National Federation of Independent Business, 2011 finance survey

Rather than reveal some sinister motives among bankers, however, these patterns simply reflect the economics of business credit. Fewer small businesses have access to credit than larger companies because lending to them is riskier and more expensive than extending credit to larger companies.

Default risk is higher in the small business loan market. Small businesses fail at higher rates than big businesses and changes in the business cycle have a larger impact on their profits. Because lenders cannot always charge interest rates that are commensurate with a borrower’s default risk, the most risky small business borrowers are often unable to get credit.

Lending to small businesses is more expensive than lending to big companies. Part of the problem is the fixed cost of making a loan. Some costs are the same whether you make a $50,000 loan or a $5 million loan. Therefore, profit margins are higher on bigger loans. Of course, larger companies are more likely to need bigger loans than their smaller counterparts, which leads lenders to focus on larger customers.

Additionally, evaluating small business loan applications is often expensive. Little publicly available information on the financial condition of small companies exists, and small businesses’ financial statements are not always very detailed. Small business owners’ personal finances are sometimes intermingled with those of their businesses. The very large variety of small businesses and the way they use borrowed funds make it tough to apply general lending standards. Finally, monitoring the financial condition of small businesses often requires lenders to build personal relationships with small business owners.

These economic principles have important implications for those seeking to boost small businesses’ access to credit. Encouraging more lending will require policies that take into account the greater cost and risk of lending to small companies — and why small businesses have trouble getting credit.

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Stay Alive. It’s Good for Business

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Entrepreneurs: here’s something to add to the list of things academics have found will enhance the performance of your business.

Staying alive.

In a bit of novel research coming out of the United Kingdom, Professors Sascha Becker of the University of Warwick and Hans Hvide of the University of Aberdeen compared 341 private Norwegian companies where the majority owner passed away within the first ten years of company founding with similar companies started at the same time in which the owner remained alive. They found that the companies where the entrepreneur died performed worse in subsequent years.

The analysis showed that the companies whose founders passed away were 20 percent less likely than the others to be in operation two years later. Moreover, four years after the entrepreneur’s death, those companies whose founders had perished had only 40 percent of the sales of the businesses whose owner-operators were still kickin’.

The authors figured out that poor company performance didn’t kill the founders. (We await some other enterprising academics to explore that question!) The sales and employment of the companies whose founders passed on were just as good as the others before the entrepreneurs died. The death of the founder was the cause of the company’s problems, not the other way around.

The adverse effects of the founder’s demise weren’t the same for all businesses. The performance drops triggered by the founder’s passing were worst for the youngest companies and for the businesses where the deceased entrepreneur had a large ownership stake.

In short, the study shows clear evidence that entrepreneurs matter for the performance of their companies.

But how?

Unfortunately, this study doesn’t tell us about the impact of entrepreneur death. However, other studies suggest the myriad of ways that entrepreneurs matter. In some cases, company founders are very good leaders. Their passing is problematic because it puts someone less charismatic in charge of the company.

In other cases, the entrepreneur is a great sales person. Without him or her, the company just isn’t as good at generating revenue.

In still other businesses, the founder has better control over costs or operations and keeps the business humming along more efficiently than those who follow in the CEO slot.

The performance decline documented in this study, however, needn’t have occurred because the founder was more talented than the people who followed him or her. The founder’s death could simply have disrupted the business in ways that made it hard for the companies to recover. Competitors might have swooped in and taken away customers while the firms were transitioning to new CEOs. Or creditors or suppliers might have become jittery and imposed stricter terms on the companies, raising their costs and hurting their performance.

You know, Apple’s stock price has dropped a lot since Steve Jobs passed away. Maybe that’s just the typical performance effect these authors found, just with a lot more zeros tacked on.

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Reality is Weighing on Small Business Optimism

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business optimism

Small business owners are an optimistic lot, with studies showing that they tend to have a rosier outlook than other people. Yet four years into the economic recovery, surveys show them in a relative funk.

What gives?

It’s pretty simply, really. Small business owners’ relative pessimism reflects reality. Despite an economy that has been expanding since mid-2009, conditions remain relatively poor for the typical small business owner.

Let’s start with small business owners’ attitudes. The most recent Wells Fargo Small Business Index clocked in at 16 in April. While that’s higher than the -1 it recorded in the second quarter of 2009, when the economy was pulling out of the worst economic downturn since the Great Depression, the Index remains far below the 99 it recorded in the fourth quarter of 2007 before the Great Recession began.

Other indices are also below their pre-recession levels. The longest running measure – the Small Business Optimism Index from the National Federation of Independent Business – was at 97.3 in March of 2007. In March of 2013, it was at 89.5.

As much as small business owners try to see the bright side, many measures show that small business owners are worse off today than they were at the end of 2007. Consider the following:

  • Fewer small businesses are doing well financially. Approximately, 58 percent of small business owners told surveyors from Wells Fargo that their company’s financial situation was “good” in April. While that’s better than the 50 percent who said it was good in the first quarter of 2009 when the economy was still in recession, it is lower than the 72 percent who reported it as good in the fourth quarter of 2007 before the economic downturn hit.
  • Small business owners face concerns about their cash flow. Fifty-nine percent of small business owners told interviewers from the American Express Open Small Business Monitor that they had cash flow concerns, ten percentage points higher than the 49 percent who described having cash flow problems in September 2007.
  • Revenues remain soft. In April only 37 percent of small business owners told Wells Fargo’s surveyors that their business’s revenue rose of the prior 12 months. In the first quarter of 2007, 45 percent of small business owners said their revenue had gone up over the previous 12 months.
  • Employment is down. In April the Intuit Small Business Employment Index was 4.9 percent below its December 2007 level, indicating over 1 million fewer people employed by companies with fewer than 20 workers now than before the Great Recession.
  • Households hold less equity in private companies. Data from the Federal Reserve of New York’s Quarterly Report on Household Credit shows that in the fourth quarter of 2007 households held 17 percent less equity in non-corporate businesses than they did in the fourth quarter of 2007.
  • Fewer Americans are in business for themselves. According to Bureau of Labor Statistics data, the percentage of the civilian non-institutionalized population that was self-employed dropped from 7.0 percent in March 2007 to 5.9 percent in March 2013.

Given the numbers, I am surprised at how positive the small business confidence measures are. It’s testimony to the optimistic nature of small business owners that their views are this upbeat.

Reality Check Photo via Shutterstock

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Housing Rebound Should Help Small Business

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Housing prices are on the upswing, increasing 9.3 percent between February 2012 and February 2013, the Wall Street Journal reported last week.

That’s not just good news for America’s homeowners. It’s also welcome information to America’s small business owners.

The drop in home prices has crimped some small companies’ access to credit. According to Barlow Research’s Quarterly Economic Pulse Survey, 26 percent of small businesses with between $100,000 and $10 million in annual sales used the home equity of the company’s owner or largest shareholder for business purposes in the third quarter of 2012. That fraction was nearly identical to the one recorded in 2007 when Barlow’s survey showed that 25 percent of small businesses in this size range tapped home equity for business purposes.

While the fraction of small business owners using their homes as a source of credit for their businesses is the same now as before the housing bust, financial crisis, and Great Recession, the amount that small business owners are able to borrow against the equity in their homes has dropped substantially.

Business owners are seeking to borrow against homes that are worth considerably less than before the housing bust. According to the Federal Reserve’s Survey of Consumer Finances, the typical home owned by a household headed by a self-employed person decreased 14.1 percent in inflation-adjusted terms between 2007 and 2010.

The amount of small business owners’ home equity has likely fallen. While information on the value of business owners’ equity is not broken out separately in any government statistics the way that home values are, they have likely followed decline similar to that for all homeowners’ equity. According to analysis of data from the Federal Reserve’s Flow of Funds Accounts, “homeowners’ equity in household real estate” decreased 28.2 percent between 2007 and 2012, when measured in inflation-adjusted terms.

Not surprisingly, the value of outstanding home mortgages has declined alongside the value of homeowners’ equity. The Fed’s Flow of Funds Accounts data show a 19.2 percent drop in real terms over the same period.

The one quarter of small business owners who rely on home equity to finance business operations have been forced to cut their home equity borrowing as the value of that equity has shrunk in recent years. While the fall in home values is not the only factor constraining small business borrowing, it has contributed tight credit conditions in the small business sector – conditions that may account for weak hiring and contribution of the sector to economic growth in recent years.

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Where In The World Are Small Business Owners Trusted?

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american entrepreneurs

Message to small business owners around the world: If you want to be loved, move to America.

In the United States, small business owners are held in high esteem. A 2010 Pew Foundation survey found that 71 percent of Americans see small business as a positive influence “on the way things are going in this country” – a larger fraction, in fact, than see religious organizations as a positive factor. In the United States, small businesses are viewed more favorably than most institutions.

However, the top ranking of small business isn’t true the world over. Consider the situation in China. For its 2013 Trust Barometer, public relations firm Edelman surveyed over 25,000 people in 26 nations in the fall of 2012.

The survey showed that 86 percent of U.S. respondents trust small business “a great deal,” while only 55 percent of them trust big business “a great deal.” In China, by contrast, only 65 percent of respondents trust small business “a great deal,” while 89 percent trust big business that much.

Edelman’s survey reveals an interesting contrast between industrialized and developing nations. In industrialized countries, respondents trusted small business more than big business: 76 percent to 53 percent. In developing countries, they trusted big business more than small business: 79 percent to 70 percent.

Of course, there’s another way to look at these data. People around the world generally trust businesses. In the United States, big business has squandered some of that trust, while small business has held on to it.

 

Editor’s Note:  We’ve embedded the Edelman Trust Barometer report below. Jump to slide 16 to see the variations between small businesses and larger businesses in selected areas.

American Entrepreneurs Photo via Shutterstock

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How to Get a Startup Visa Act Passed

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For the past few years, a number of prominent U.S. venture capitalists have been trying to convince Congress to modify the U.S. UB-5 visa program. Currently, the program allows foreigners who invest $1 million in a U.S. business and create 10 or more jobs to get a visa; the investors want Washington to include those entrepreneurs who attract funds from venture capitalists or business angels. While the bill’s advocates have gotten it introduced into the House and Senate, the effort has stalled.

Recently, Canada announced that it will launch a “start-up visa” program this spring. For the next five years, our neighbor to the north will make 2,750 visas available annually to entrepreneurs who have received a $200,000 funding commitment from an approved venture capitalist or $75,000 from an approved business angel.

The Canadian government’s announcement has gotten U.S. start-up visa advocates upset. In a recent online column, Brad Feld, one of the advocates of a similar program in the United States, expressed frustration that Canada had beaten the U.S. to the punch.

Rather than bemoan their political difficulties, however, advocates of the law should change their strategy. They should replace their “we-need-immigrant-entrepreneurs-to-save-America” argument with the following approach: Giving out visas is a better and cheaper way to get small companies to move here than than offering tax breaks.

The advocates’ current argument is economically suspect and politically problematic. Proponents of a start-up visa argue that immigrants are better entrepreneurs than non-immigrants. But, as I have explained before, there’s plenty of evidence that the native born entrepreneurs are as good, if not better, at entrepreneurship than immigrants.

More importantly, the immigrants-are-better argument is a political nightmare. What Congressman wants to tell his constituents that he needs to support a start-up visa bill because the voters who elected him aren’t as good at entrepreneurship as foreigners?

The best argument for a start-up visa is the same argument for giving foreign companies tax breaks to start or expand their U.S. operations: it shifts wealth and jobs from overseas to the United States. If venture capitalists fund a start-up in San Paolo, for example, most of the jobs created and taxes paid by the new company occur there. But if the investors fund the same new business in San Francisco, most of the jobs and taxes end up in the United States.

Even if the entrepreneurs would create more jobs and wealth if they established their businesses in their home countries, the law would make sense for the United States. Creating 1000 American jobs is better for those who live here than creating 2000 foreign ones.

Offering the entrepreneurs visas as a way to get them to start companies here is a cheap and effective way to attract companies. Unlike the case with big companies considering locating a plant elsewhere, U.S. tax breaks aren’t much of an attraction to foreign entrepreneurs. But American residency is.

Framed as a program to get foreign businesses to move to America, a start-up visa is a political “no brainer” for Congress. Without spending a cent of taxpayers’ money, we get non-U.S. companies to set up shop here. If the businesses succeed, create jobs and pay taxes, then American voters win.

The only “losers” in the deal are people in the entrepreneurs’ native lands who don’t get the jobs and tax revenue from the successful businesses. However, those people don’t vote in American elections, so their welfare matters little to those in Congress.

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Washington, D.C. Could Help Small Business by Doing Less

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washington dc small business

Washington wants to be seen as helping small business. With approval ratings hovering around 25 percent, Congress wants to associate itself with one of America’s most popular institutions – small business – which 95 percent of Americans report viewing positively in a November 2012 Gallup Organization survey of 1040 randomly selected adults.

To aid small business, Congress has established small contracting set asides, written legislation to facilitate small company access to credit, sought to protect small business owners who use consumer credit products in their business operations, and put in place a number of other policies to support small business.

Small business owners don’t want to sound ungrateful. But they’d prefer something else from Washington.

The vast majority of small business owners would gladly trade Washington’s help for more policy predictability. The 4th quarter 2012 Small Business Outlook Study – a survey of approximately 1,500 small business executives conducted every three months by Harris Interactive on behalf of the U.S. Chamber of Commerce – revealed that nine out of every ten small business leaders would prefer less assistance and more certainty from our federal officials.

Small business sees much of what Washington does as harmful. For example, as part of the January 2012 Wells Fargo Small Business Index – a survey of a representative sample of 600 small business owners conducted by the Gallup Organization – 80 percent of respondents said that federal taxes are hurting their small businesses. Similarly, 72 percent said government regulations were having an adverse effect on their companies’ operations.

The pattern is repeated with other surveys. More than three quarters of small business owners surveyed by Harris Interactive said that federal regulation, taxation and other legislation are holding them back from hiring. Nearly three quarters reported that the Affordable Care Act deters them from hiring.

Assistance is usually most valuable when the helper does something that the recipient finds useful. Our elected officials might want to think about that the next time they are looking to “help” small business owners.

Washington DC Photo via Shutterstock

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