The 1099 Fracas and Income Tax Evasion 101

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We are a nation of tax cheats. In 2001, the difference between what Americans and businesses owed in taxes and what they actually paid voluntarily was $345 billion.

The enormous amount, known as the “tax gap” has been vexing politicians and IRS bureaucrats ever since it was quantified in 2005. Of course, one way to increase U.S. tax revenue is to raise taxes; another way is to better collect taxes already due.

The most effective tool in the government’s quiver to do the latter is not an IRS agent – it’s information dissemination. Creating paper trails and telling people and businesses that the government has a copy of those paper trails is amazingly effective in curbing cheating. Sen. Max Baucus, chairman of the Senate Finance Committee, which has jurisdiction over tax policy, said in a floor speech on Tuesday, “research demonstrates that voluntary compliance doubles when information reporting is in place. The rate rises from 46 percent compliance to 95 percent compliance.”

And this is what the current fight over small businesses, health reform and 1099 forms is all about.

The new Affordable Care Act (ACA) includes a provision requiring that all businesses send a 1099 tax form to any vendor from whom they purchase at least $600 in goods and services in a year. A copy of this 1099 also goes to the IRS. The provision has nothing to do with health care, except that the $17 billion in revenue generated by this new paper trail will help pay for costs associated with the new law. The idea is basically to remind vendors that hey, the government knows you sold $600 or more in goods and services, so you better pay the applicable income tax.

Health reform critics have blasted the new requirement, saying it will cost small businesses time, money and jobs. The U.S. Chamber of Commerce, a reliable ACA foe, says these new reporting rules amount to “oppressive regulations” that will lead to “an avalanche of new paperwork for small business owners.”

But there’s nothing in the 1099 rule that would affect small businesses specifically. In addition, even before the Affordable Care Act, Democrats and Republicans – including George W. Bush – were looking for ways to help close the tax gap with the use of 1099s. Under the Bush Administration, a rule existed requiring businesses to file 1099s for cumulative annual purchases over $600, but the rule only applied to services – not goods – and excluded purchases from corporate entities. All the Affordable Care Act did was eliminate these two exceptions.

A Senate Democratic aide said lawmakers didn’t except the new rule would cause a backlash, figuring since companies – including small businesses – already had systems in place to issue 1099s for services, adding a few new categories wouldn’t be very onerous. Since the ACA was passed, however, lawmaker have realized just how many businesses were out of compliance with the old rule, making the new expanded rule doubly hassling. (This is why the tax gap is so very vexing.)

“We found out that a lot of people didn’t even know about it,” said the aide. It’s hard to understand why this was such a mystery. A January 2009 GAO report said:

The Internal Revenue Service (IRS) does not know to what extent payers fail to submit required 1099-MISCs, but various sources point to the possibility of a significant problem. For tax year 2005, 8 percent of the approximately 50 million small businesses with assets under $10 million submitted 1099-MISCs, but IRS does not know how many of the other 92 percent were required to report payments but did not. Many business payments, such as payments to corporations, are not subject to 1099-MISC reporting. If even a small share of the businesses that did not submit a 1099-MISC should have, millions of 1099- MISCs could be missing with significant amounts of unpaid taxes by payees.

Amid the backlash of the ACA’s tighter 1099 rules, two senators introduced related amendments this week. One from Republican Sen. Mike Johanns would have repealed the provision altogether; another introduced by Democratic Sen. Bill Nelson would have exempted businesses with 25 or fewer workers and raised the reporting threshold from $600 to $5,000. Both amendments were defeated. According to Politico, a third 1099 amendment has already been filed by Democrat Sen. Mark Begich that would repeal the new rule.

The 1099 fracas is interesting for two reasons. First, it represents a glimmer of bipartisanship in an age when such a thing is elusive at best. Senators from both sides of the aisle agree the new 1099 rule puts a burden on small businesses. Second, the new rule seems destined to be at least scaled back. Baucus, who voted in favor of the Nelson amendment, said yesterday, “We do need to address this requirement…The bottom line is this: We have heard the concerns of small businesses. And we intend to work diligently to address and mitigate those concerns..” The White House has also said it supports scaling back the rule.

This amounts to conceding that, despite an annual tax gap equal to half of the Pentagon’s entire budget, closing it completely is just too hard and will never happen. In other words, we will remain a nation of tax cheats unless the tax code itself becomes simpler, cleaner and easier to comply with.

“Those who are going to cheat on their taxes are still going to do it,” says Giovanni Coratolo, vice president of small business policy for the Chamber. “When you impose Draconian measures on the backs of compliant taxpayers, in their minds, they can be justified in trying to cut corners.”