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How the Complexity of the Tax Code Hinders Small Businesses

Testimony of Keith Hall, National Tax Advisor
The National Association for the Self-Employed

House Committee on Small Business Subcommittee on Finance and Tax Hearing on
“How the Complexity of the Tax Code Hinders Small Businesses”

Chairman Schrader, Ranking Member Buchanan, and members of the subcommittee, I want to thank you for the opportunity to testify here today about the need to simply the tax code for small businesses.

I am a micro-business owner, a CPA who has assisted small businesses for over 25 years, and the National Tax Advisor for the National Association for the Self-Employed, an organization representing 250,000 micro-businesses all with ten employees or less.   I can tell you that in each of these hats I wear, confusion and complexity surrounding the tax code is one of the primary concerns expressed by small business owners.  During this testimony, I will discuss four areas where simplification of the tax code would greatly benefit micro-business owners by reducing their tax reporting burdens while also increasing tax compliance: 1) the Internal Revenue Service’s adoption of more simplified, “plain English” forms and documentation; 2) the establishment of a standard home office deduction; 3) clarification of the definition of an independent contractor; and 4) allowing sole proprietors to deduct their health insurance premiums in the same manner as larger corporations.  

The IRS is the federal agency that micro-businesses have the most contact with and of course, are most fearful of.  It is also the most infamous for its excessive paperwork and unclear instructions and forms.  Though, I will note that as a CPA I have been very pleased with the efforts made by the Internal Revenue Service over the past few years to become small business friendly.  The IRS’s enhanced outreach and educational efforts as well as their work in the Office of Burden Reduction to simplify and minimize paperwork have made positive strides.  Its commitment to its website and the availability of information has been very good and certainly recognized by the NASE and many small business owners.  

However, despite steps toward improvement, with over 1.4 million words, the tax code is so convoluted that it is extremely difficult for taxpayers, tax practitioners and the IRS to reliably and accurately comply with or enforce the breadth of tax regulations.  The IRS currently estimates that a self-employed taxpayer, one filing Form 1040 with corresponding Schedule C, will have to spend on average over 56.9 hours in preparation and filing of his/her return at an average cost of $440 dollars.   According to a 2006 Tax Foundation study, individuals, businesses and nonprofits spent an estimated 6 billion hours complying with the federal income tax code, with an estimated compliance cost of over $265.1 billion. Businesses bear the majority of tax compliance costs, totaling nearly $148 billion or 56 percent of total compliance costs.

The majority of NASE members are one to three person businesses with over half working from their home.  This is a very unique segment of the business population, in which many do their taxes on their own with assistance from tax preparation software.  Thus, the NASE wanted to find out what our micro-business members felt about the current tax code.  In March of 2007 we conducted a survey to determine which factor of the federal tax code they found most burdensome.  Overwhelmingly respondents indicated that it was the complexity of the tax code and tax forms.  Additionally, these members indicated that the simplification of the tax code is what they would most like to improve about our current system.  

Simplification of the tax code will not only ease the regulatory burden on small businesses, but will also improve compliance with IRS regulations. Despite the time and cost spent on compliance, according to IRS data from the National Research Program (NRP), the nation’s tax gap, the difference between what taxpayers should pay and what they actually pay on a timely basis, is approximately $353 billion.    The tax gap has three key components which include underreporting of income, underpayment of taxes and non-filing of returns.  There have been numerous proposals by the Department of Treasury and in Congress regarding how to effectively increase compliance and minimize the tax gap.  These proposals include imposing withholding on payments made to independent contractors, increasing withholdings on government contractor payments and increasing the reporting requirements on various financial transactions.

For small and micro-businesses, these proposals would only add to the tax compliance burden by creating a whole new set of perplexing and – for many – unmanageable and costly filing requirements.  Efforts to address the tax gap and compliance must focus on overall simplification, eliminating issues of inequity within the tax code, and enhancing taxpayer education and outreach.  The majority of small business taxpayers want to comply with existing tax laws, thus making tax regulations easier to understand is the most effective and equitable way to improve compliance and to reduce the tax gap.

In late March, the Administration announced the formation of a task force to propose ways to simplify the tax code, reduce evasion, close loopholes and reduce the tax gap.  Led by former Federal Reserve Chairman Paul Volcker, the task force plans to provide its recommendations to President Obama by December 4, 2009.  As Congress and the Administration review ways to reduce to the tax gap, we encourage lawmakers to focus on the great compliance benefits associated with tax simplification, rather than on proposals which increase the regulatory burdens placed on small businesses.

According to the General Accounting Office, a small business owner faces more than 200 IRS forms and schedules that could apply in a given year.  Many of these forms are complicated to understand. The IRS Form 4562, which relates to Depreciation and Amortization, and its corresponding publications are a prime example of vague forms and publications that would benefit from simplification and plain language.  A small business owner who purchases a $1,500 computer will have to read 16 pages of obscure instructions to fill out this two page form.  Additionally, the IRS indicates that the estimated burden for taxpayers who file this form is approximately 47 hours.  Let me reiterate: 47 hours to fill out a two page form.  

Minimizing the complexity of the tax code and paperwork burden faced by small business is one solution that policymakers and taxpayers alike have endorsed.  The first step in this effort to reduce confusion surrounding the tax code should be to ensure that all forms and publications are in clear, concise language that is easy to understand by all.  The National Association for the Self-Employed strongly supports H.R. 946, the “Plain Language Act of 2009.”  Use of plain language will allow all citizens to more accurately understand and comply with their responsibilities while also fostering more accountability within the federal government.  Most importantly, it will boost the bottom line for businesses and government alike.  Plain language will require less time and money spent on education, preparation and compliance.  

Micro-business owners do not have the luxury of an extensive accounting and human resources department which can focus their time on recordkeeping and complying with regulation.  Typically, the business owner is responsible for every aspect of their business taking on the role of CEO, HR manager, accountant and even janitor.  Every hour spent wrestling to understand complicated rules and regulations is less time spent managing and growing their business.  Every dollar they spend on experts and professional assistance is less money they have to reinvest into their business.

The home office deduction is a prime example of a provision of the tax code that needs simplification.  The forms and instructions are too complicated. The paperwork requires too much recordkeeping and takes too much time to complete. In addition, NASE members expressed a substantial fear that claiming the deduction will trigger an IRS audit. All of these obstacles cause many home-based business owners, who qualify, to avoid the deduction altogether.

The creation of a $1,500 standard home office deduction option as proposed in the “Home Office Deduction Simplification Act” (H.R. 1561) would address all of these barriers to utilizing the home office deduction.  In fact, we found in a May 2008 online poll that over 60% of those home-based businesses who were not currently employing the home office deduction would do so if they were offered a standard deduction option.   

Last year, the NASE nominated the home office deduction for the SBA Office of Advocacy’s Regulatory Review and Reform (r3) initiative.  As you may be aware, after review of over 80 nominated regulations the SBA Office of Advocacy selected the home office deduction as one of their Top 10 Rules for Review and Reform in 2008.  

Micro-business owners face stringent and confusing requirements to qualify for the home office deduction.  IRS publication 587, Business Use of Your Home, devotes five pages in an attempt to explain and clarify the key requirement for taking the deduction: exclusive and regular use of your home as your principal place of business.  While the IRS does its best to make clear what they mean by exclusive and regular, many assumptions are left to the business owner.  In addition, the overall qualifying provisions are very limited.

Once a small business owner qualifies for the deduction, he or she then faces the complexity of the IRS form.  A self-employed business owner must differentiate between direct and indirect expenses and also between deductible mortgage interest and excess mortgage interest.  Some of the expenses are deductible even if the business has a loss and some are not. Many small businesses who qualify for this important deduction do not take it because it is too onerous to fill out the form.

The lack of clarity present in the requirements to take the deduction and the preparation of the form enhances the concern of the self-employed owner that he or she may do something incorrectly. In a May 2008 survey conducted by the NASE, only 27% of members working from a home office took the home office deduction.  The fear of being “red-flagged” by the IRS for review and/or audit was the top reason why qualifying business owners did not utilize the home office deduction.  

A second area of the tax code that creates considerable confusion and is excessively burdensome for micro-businesses relates to the definitions of “employee” and “independent contractor.”  A majority of micro-businesses and the self-employed either utilize independent contractors or are themselves independent contractors. Confusion about who is an employee and who is an independent contractor has cost small businesses more than three-quarters of a billion dollars in IRS penalties and back-taxes during the past 10 years.  
The issues plaguing worker classification stem from the fact that classification of an individual into an employee or an independent contractor is subjective under the tax code.  The IRS has a complicated 20-point checklist the can be used as a guideline in determining whether or not an individual is an employee or an independent contractor. Yet, using this checklist does not guarantee that a person is correctly classified.  Other IRS materials published to assist in classification are equally as convoluted.  Micro-business owners and self-employed individuals have indicated that when utilizing the IRS’s tax assistance help line on this issue, they have received different answers from different agents on this same issue.  A large part of the problem is that there is no one, single, homogenous definition of the term "employee." Thus, there is no clear and concise manner for a self-employed individual or micro-business owner to easily determine when an individual should be classified as an independent contractor or an employee.
To further exacerbate matters, an IRS reclassification of worker status can occur two or three years after a tax return was filed. When forced to reclassify an independent contractor to an employee the business must pay the back payroll taxes the IRS says should have been paid in the prior years, as well as interest and penalties.
With more and more individuals conducting a business out of their home as "independent contractors" and the economic incentive to employers to use independent contractors rather than employees, the issue of worker reclassification continues to be a key area for the recovery of revenue by the IRS despite its recent efforts to become more small business friendly.  Due to the regulations vagueness and complexity it is very easy for the IRS to arbitrarily reclassify workers and thus, require micro-business owners to pay enormous sums of back taxes and penalties, which ultimately force them to go out of business. Reclassification of 10 independent contractors to the classification of employee, with taxes, penalties and interest can net 100 times more revenue than auditing an individual. (Willingham & Coté, 2001)
The predicament lies in the need for us to protect both micro-businesses who make a good faith effort to classify workers and independent contractors who choose to have the independence and entrepreneurial freedom under that classification, while also protecting employees from potential abuse by employers.
The NASE supports legislation that would clarify worker classification by creating a general test and incorporation test.  The general test requires that to be classified as an independent contractor, the business and/or contractor must demonstrate:


•    Economic independence;
•    Workplace independence; and
•    A written contract between the independent contractor and the business (service recipient).

The incorporation test qualifies LLCs and corporations as independent contractors as long as there is:

•    A written contract; and
•    The contractors provide for their own benefits.

As long as businesses and independent contractors file Form 1099 each year, they qualify for protection by the safe harbor provisions found in section 530 of the 1978 Revenue Act if reclassified by the IRS.  

Compliance will be improved because the written contract between the independent contractor and business will make clear their tax responsibilities, the new rules will not apply if the business does not comply with reporting requirements, and also Form 1099s will be issued to individuals who perform services. An independent contractor operating through his/her own corporation or limited-liability company must file all required income and employment tax returns in order to be protected.
The NASE is working to educate legislators on this issue in the 111th Congress and encourage legislation which would amend the tax code to simplify and clarify the definition of independent contractor.
 The final issue I would like to discuss is one not only of tax simplification, but also one of tax fairness.  Sole proprietors are not able to deduct the cost of their health insurance premiums for the purposes of self-employment tax. Self-employment tax is FICA tax for the self-employed. The self-employed pay FICA at a rate equivalent to employees and employers for a total of 15.3 percent. While 100 percent deductibility of health insurance premiums has been phased in, it does not solve this tax inequity.  Sole proprietors are required to pay two types of taxes on their annual tax returns: income tax and self-employment tax. One hundred percent deductibility relates only to income tax and not self-employment tax.

Sole proprietors are the only business entity that does not receive a full deduction for health care costs. All other business entities receive a deduction for health insurance premiums as an ordinary and necessary business expense for all employees, including owners.  Employees and the owner pay for their health insurance premiums pre-tax, and therefore they are not subject to FICA taxes.  However, sole-proprietors (Schedule C filers) do not receive this “business deduction” for health insurance premiums.  The premiums are not paid with pre-tax dollars and are exposed to self-employment tax. Accordingly, the sole proprietor pays this tax (15.3 percent on self-employment income up to $106,000) on his insurance premiums.

The most recent Kaiser Family Foundation study indicated that the self-employed pay on average $12,106 annually for family health coverage.  Because they cannot deduct these premiums as an ordinary business expense, they are required to pay $1,852.22 in additional taxes that no other business entity must pay.  This is money that NASE members tell us they would use to reinvest into their business, or utilize to offset the rising premium costs they face each year so they may hold on to their coverage a little longer.  In these difficult financial times, removing this inequity would be a significant economic stimulus for the self-employed.    

The NASE has endorsed the “Tax Equity for our Nation’s Self Employed Act of 2009,” H.R. 1470. This legislation would correct this inequity in the tax code and also make it easier for micro-businesses to afford health insurance.  We encourage Congress to pass this legislation.

Complex and inequitable tax regulations only make it more difficult for the self-employed community to comply with the tax code.  This burden imposed on micro-business is disproportionate to that of larger businesses because smaller firms do not have accounting and legal departments at their disposal to decipher and comply with the maze of tax regulation. On behalf of the NASE’s 250,000 micro-business owners, I encourage you to help streamline complicated tax forms and procedures, pass a standard home office deduction, clarify the definition of an independent contractor and allow sole proprietors to fully deduction their health insurance costs in the same manner as larger corporations.  

Thank you very much for the opportunity to testify before the subcommittee today.