Tax Gap Surges to $688 Billion: What Small Business Owners Need to Know

The Internal Revenue Service (IRS) unveiled new tax gap projections for the years 2020 and 2021, highlighting a significant increase in the amount of taxes unpaid or underpaid by taxpayers. According to the newly released data, the tax gap soared to $688 billion in 2021, marking an upsurge of over $192 billion compared to the 2014-2016 period.

What is the tax gap, and why should small business owners care?

Understanding the Tax Gap

Simply put, the tax gap is the difference between the total tax amounts that are due to the government and the amount that’s actually received on time. The tax gap encompasses three critical areas:

Nonfiling: taxes not timely paid by non-filers
Underreporting: taxes understated on timely filed returns.
Underpayment: reported taxes that are not paid on time.

For small business owners, understanding these categories is essential, as they could face hefty penalties or even legal consequences for non-compliance.

Why the Surge?

The projected gross tax gap of $688 billion for 2021 witnessed significant hikes across its components:

Nonfiling rose to $77 billion from $41 billion in 2017–2019.
Underreporting reached $542 billion, up from $445 billion in the same period.
Underpayment increased marginally to $68 billion from $64 billion.

The latest figures underscore the IRS’s renewed emphasis on bolstering compliance, especially targeting high-income individuals, partnerships, and corporations. “This increase in the tax gap underscores the importance of increased IRS compliance efforts on key areas,” said IRS Commissioner Danny Werfel.

The Role of Economic Growth

It’s noteworthy for small business owners to understand that a considerable chunk of this increase in tax liability and the tax gap can be attributed to economic growth. As businesses thrive and grow, it becomes increasingly crucial to ensure that they remain compliant with their tax obligations.

Voluntary Compliance: A Closer Look

With a voluntary compliance rate of around 85% for 2020 and 2021, taxpayers are largely consistent with their tax responsibilities. Post-IRS interventions, this figure goes up to 86.3% for 2021, albeit slightly lower than the 87% for 2014–2016. Small business owners should note the vital role of third-party reporting in enhancing voluntary compliance. Such measures, combined with withholding mechanisms, can significantly reduce the likelihood of underreporting.

IRS’s Response

Leveraging the Inflation Reduction Act resources, the IRS aims to boost voluntary compliance. In 2022 alone, the IRS garnered more than $4.9 trillion from taxes, penalties, and other charges. Through partnerships, educational programs, and new technological tools, the IRS is reinforcing its commitment to narrowing the tax gap.

Small Business Implications

For small businesses, the evolving tax landscape underscores the importance of staying updated on compliance requirements. With the IRS increasingly focusing on compliance, small businesses cannot afford any lapses. A proactive approach towards understanding tax obligations and ensuring timely payments can stave off penalties and ensure smoother business operations.

While the tax gap projections offer insights into taxpayer behaviors and compliance, small business owners must remain vigilant and informed. The changing tax landscape, coupled with the increasing IRS focus on compliance, requires businesses to be proactive in their tax strategies and obligations.

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