Underreporting of farm income to avoid taxes

One of the largest benefits of owning a small business is that a small business can easily hide income and thereby avoid taxes.

How large is this problem? That's very hard to tell.

Here's John Berry from Bloomberg:

According to Internal Revenue Service research, the tax gap isn’t the result of high-rollers hiding income in offshore accounts. Most of it is the underreporting of income by proprietors of small businesses and farmers and the failure to pay employment taxes related to that income. Also not reported: an estimated half of all income from rents and royalties.
...

In 2006, the IRS reported the results of a three-year study of individual income tax returns for 2001. It found a gross tax gap of $345 billion, or 16 percent of taxes due. Enforcement activity plus other late payments recovered $55 billion of that, leaving a gap of $290 billion.

That figure, as large as it is, doesn’t include income of the deeply underground economy, including most criminal enterprises. That’s certainly hundreds of billions more, and no tinkering with the tax code is going to bring it into the light of day.

...

In 2001, according to the IRS review, only about one-fourth of farm income was acknowledged. For 2006, only 550,000 farmers reported positive net income, totaling $7.7 billion, while 1.4 million farmers reported losses of $23 billion, according to the latest figures available.

Well, it's hard to assess those IRS reviews. My understanding is that these numbers come from an extrapolation of audits selected at random (most audits target returns with likely errors or underreporting).

Also, with regard to Berry's last commentary, keep in mind that in 2006 there were probably only about 550,000 farms where anyone was trying to make a living from the farm income. The other farms are mostly hobby farms, not intended for profit at all. But they do make for a nice occasional tax deduction, not necessarily illegal.

Anyway, John Berry is writing about Obama's efforts to close loopholes. I think this one will be a tough to enforce without more auditing, which is expensive. Audits may be worth the cost if underreporting is becoming more prevalent. I haven't seen data showing a clear trend up in underreporting, but I wouldn't be surprised.