Business incomes, partnerships rife with unpaid taxes, experts say

The IRS is tasked with collecting hundreds of billions of dollars in unpaid taxes over the next decade, and tax experts say individuals’ business income is an untapped source of revenue.  

A report released by the agency in late October showed that the “tax gap” — the money owed but not paid to the IRS — increased to a net of $428 billion.    

The Democrat-passed Inflation Reduction Act allotted $80 billion to the IRS to be spent over 10 years to increase revenue.  

“The estimated net tax gap growing from $380 billion to $428 billion is powerful evidence of why the IRS must be properly funded to finally begin cracking down on wealthy tax scofflaws,” Rep. Bill Pascrell (D-N.J.) a member of the tax-writing Ways and Means Committee said at the time of the report’s release.  

Experts say that there are two lucrative ways that the agency could go about raking in more money.  

Former IRS Commissioner Charles Rossotti said Monday that personal business income presents a huge opportunity for the IRS to get some of the money it’s owed as it figures out how to spend its new big-ticket budget.

“Greater reporting on what’s called a 1099-K that deals with certain kinds of payments of things like short-term rental income from Airbnb, all kinds of other things like that — that is an enormous untapped opportunity,” he said at an event hosted by the Tax Policy Center, a think tank in Washington, D.C.

“There’s over $1.2 trillion of income that comes in from what are called pass-through businesses like partnerships and S corporations that’s supposed to be reported on individual returns. … The IRS doesn’t have any automated system to use any of that. It can use it if there’s an audit that comes up,” Rossotti said.

Rossotti cautioned that collecting unpaid taxes can be done more efficiently by the IRS by using data to find out where people are underreporting than by doing blanket audits of taxpayers.  

“The amount of auditing the IRS does, if you doubled it, it wouldn’t even make a dent in the tax gap. What really matters is the use of data to find places where there really is underreporting of income or noncompliance,” he said.

The tax gap was about 13 percent of the federal budget in 2015, roughly the same size as the deficit. It’s only measured retroactively every few years.

Of the $428 billion missing from public coffers in that period, $306 billion was from individual income tax and well over a third of that was due to business income, according to IRS data. That’s the largest single category blocked out in the agency’s latest report on federal tax compliance.

Divided up another way, underreported income accounts for nearly all of the tax gap at $398 billion. Audits and other enforcement activities retrieve around $68 billion, but that number could substantially increase due to the tax enforcement boost provided in the Inflation Reduction Act over the next decade.

“Another of the targets is partnerships,” Janet Holtzblatt, former tax policy chief at the Congressional Budget Office, said during the event, referring to a certain type of business that can range from a small business to a hedge fund.

Former IRS chief John Koskinen echoed Holtzblatt and said the popular conception of a partnership as a mom-and-pop shop or a small legal firm is way off.

“You can do things like audit large partnerships,” he said. “What most people don’t realize is, we think of partnerships as eight or 10 lawyers or doctors buying an office building. Today, many of these partnerships have thousands of partners, and some of those partners are partnerships with thousands of partners.”

“The ability of the IRS slush fund has been very limited to be able to analyze, with data, those partnership returns. They’re huge. And so basically a lot of partnerships just aren’t audited at all,” Koskinen added.

Partnerships and other types of pass-through businesses have exploded since 1980, according to a paper by Treasury economist Michael Cooper, Congressional Budget Office tax analyst John McClelland and others published in 2015 by the National Bureau of Economic Research.

The researchers argue that the legality around pass-through businesses is what has allowed an enormous division between the super-rich and regular Americans to emerge over recent decades.

“In 1980, pass-through entities accounted for 20.7 percent of U.S. business income; by 2011, they represented 54.2 percent. Over roughly the same period, the income share of the top 1 percent of income earners doubled. Previous research has shown that the two phenomena are linked: The growth of income from pass-through entities accounted for 41 percent of the rise in the income of the top 1 percent,” the researchers wrote.

Most U.S. business income is now made outside the traditional C corporate structure. It is earned by the pass-through entities, they found, noting that pass-through income is often taxed at lower rates.

The researchers also said they couldn’t even figure out who owns a lot of the income from partnerships and that the tax code encourages firms to organize in secret.

“The current U.S. tax code encourages firms to organize opaquely in partnership form in order to minimize tax burdens,” they wrote.

Tax expert Steve Rosenthal of the Tax Policy Center said in an interview that with the $80 billion in funding, the IRS may be able to effectively collect taxes from partnerships.

“The IRS does not enforce the tax law against partnerships effectively because the IRS simply cannot figure out what’s going on, but maybe with $80 billion they’ll be able to start figuring it out,” he said.

Partnerships have been a blind spot for the IRS for many years.  

In 2014, then-Sen. John McCain (R-Ariz.) called out pass-through businesses as a tax dodge.

“Large trading firms will always try to stay one step ahead of the game when it comes to pushing the envelope on the tax code to minimize paying taxes,” he said during a Senate hearing at the time.  

“Whatever practical impediments currently disable the IRS from auditing large partnerships that use these sorts of tax structures should be eased or eliminated,” he said.