The Internal Revenue Service believes the small business sector is a major source of under-reported income. For the past four years, the agency has run a special independent office charged with finding how to encourage small business owners to report their earnings more accurately. The IRS finds sole proprietors especially challenging. Many operate on a cash basis – at least in part – and report income on their personal tax returns, making it difficult for the taxman to correctly identify the sources of their cash flow.

The research that has been conducted to date has brought forth some interesting statistics:

  • Estimates suggest that as much as 60 percent of small business revenue isn’t tracked on tax information documents submitted by third parties, though this is likely to change as technology advances;
  • Studies suggest that tax scofflaws are more likely to be found in certain areas of the United States such as California, Georgia, Texas and other Southern states;
  • Reports suggested that intentional under-reporting was less of a problem than under-reporting due to confusion about the tax code and/or poor record keeping;
  • Business owners who are caught by the IRS often become more compliant – but only for a few years – with many back-sliding into the bad habits that triggered an audit in the first place.

Small business owners would be well advised to pay attention to the IRS’ focus on entrepreneurs. The majority of audit candidates are not picked by random selection. The IRS makes use of an algorithm to try to identify taxpayers most likely to have unreported income. This algorithm appears to be a very effective way to sniff out tax offenders. Once a taxpayer is flagged, almost 90 percent ultimately prove to owe more money than they reported. However, the agency’s budget cuts have hit home, and it must be noted that only approximately 1.5 percent of self-employed taxpayers are audited each year.

Whether intentional or not, the IRS estimates unpaid tax revenue at more than $450 billion a year. Although audits are used more than any other tool to catch business owners who under-report their income, the discovery process is burdensome to the IRS. The amount of time, staff and money needed to conduct them makes audits a costly method of collecting taxes from scofflaws. It is seen as an increasingly inefficient way to close the tax gap.

This doesn’t mean that audits are going away, but it does mean that the IRS is actively trying to find new ways to encourage business owners to report earnings more accurately. Tax experts urge their small business clients to recognize that increasingly complicated reporting requirements make it crucial for entrepreneurs to seek professional tax help. The interconnectivity of technology in the finance and banking world means more transparency and less privacy for taxpayers. The odds might be slim, but business owners should be prepared for the possibility of an audit and be scrupulous in their documentation. Without a paper trail, even the most honest business owners are subject to a time-consuming and worrisome review. It’s simply not worth the risk.