We’ve been hearing about the tax gap for a long time, long before the Internal Revenue Service released its 2001 tax gap estimates back in 2006. The release of those estimates seemed to simply add numbers to what everybody “knew”: small business owners who are not subject to either involuntary withholding or third party reporting don’t pay their taxes. But it turns out that the IRS may have been doing small business owners a serious injustice over the past five years, according to the findings of a new research report released by the SBA Office of Advocacy late last month. The tax gap, you will recall, is the difference between the amount of revenue the IRS believes it should receive from taxpayers and the amount it actually does receive. The 2001 tax gap has been estimated by the IRS to be $345 billion; the net tax gap, after late payments and enforcement activities, is estimated at $290 billion. In spite of the fact that journalists (including yours truly) and IRS officials have been repeating those familiar numbers for years now, the fact is that it really is only a guess and, for certain reasons, it is a misleading guess

For starters, the tax gap is not actually based on what IRS auditors found during reviews of 2001 individual income tax returns. Rather, those estimates were based on what auditors did not find during those examinations and what the IRS assumed about those non-findings. For example, auditors did not find evidence of the so-called “underground economy” in anyone’s tax returns. Unfortunately, the IRS attributes numbers to the small business share of the tax gap that includes the underground economy. By aggregating those numbers, it looks as if small business noncompliance is a much bigger problem than it is. In addition, there is no attempt to offset the portion of the tax gap attributable to small businesses with the amount of overreporting of income caused by small business owners who do not take advantage of all the tax benefits available to them. There’s more but I think you’re getting the point. One can only hope that the relevant parties will review this report and perhaps be inspired to stop trying to balance the budget on the backs of small business owners.