United States: IRS Discovers Tax Gap In E-Commerce Businesses With Assets Under $10 Million

The newly-reorganized Internal Revenue Service ("IRS") has a new electronic commerce department (within its Large and Mid-Size Business operating division) to manage and coordinate the tax compliance of e-commerce businesses in all of the IRS’s operating divisions. One of the early initiatives undertaken by the department was to conduct a study of small Internet businesses. This preliminary study included Internet businesses with assets under $10 million. The study disclosed that there are tax compliance problems among this market sector, including some underreporting of income and a lack of proper registration. The companies chosen for the study were randomly picked by a computer from a group of 18,000 World Wide Web sites. The computer chose 1,600 possibilities from the 18,000 and then the IRS selected 426 companies to include in the study.

Although the study has not yet been released, an IRS official has stated that six Internet markets were looked at as a sample for the study:

• Internet service providers
• Computer sales and service
• Financial services
• Business services
• Retail and wholesale operations
• Adult entertainment, such as gambling and pornography

The study examined the 1997 tax compliance of these market sectors. It uncovered $6.2 million in unreported and unpaid tax among the 426 companies that were included in the study. 57% of the unpaid taxes was attributable to the adult entertainment sector and 30% was attributable to the computer sales and service business.

Because the study has not yet been released, we do not know the methods used by the IRS to identify the compliance problems or compute their tax effect. However, a number of important points can still be made. First, the IRS is aggressively studying tax non-compliance among start-up e-commerce businesses and will continue to do so on a broader scale. Second, although the results of the preliminary study are not conclusive, it is likely that the magnitude of non-compliance has grown proportionately with the size of the e-commerce universe. The preliminary study, based on information from three years ago, is undoubtedly the tip of the iceberg today. Third, it can be anticipated that the IRS will take some action to address the tax gap it identifies. This action could take the form of outreach education programs, tax enforcement (such as audits or investigations), tax delinquency examinations of non-filers or a combination of these approaches. Finally, as the economy slows and some smaller start-up companies face difficult financial times or struggle for survival, there will be a greater temptation to cut corners on tax compliance and more pressure to underreport taxable income. As with more established old economy businesses, these financial pressures often lead to failing to file tax returns and to employment tax problems, with businesses favoring creditors other than the IRS when it comes to paying bills or remitting payroll taxes.

If the IRS conducts an audit and finds unreported income, a failure to pay over withholding taxes or other failure to properly comply with the tax laws, the results can be costly. The IRS can assess the tax, penalties (20%-40%) and interest attributable to negligent or substantial underreporting. If it finds fraud, the penalty rises to 75% of the additional tax, plus interest. If the circumstances are egregious and the underreporting is intentional, moreover, the IRS can pursue the corporation and those who participated in the tax fraud for criminal prosecution. If employment tax non-compliance is found, the persons responsible for failing to pay over the taxes can be held liable personally for paying them. If this employment tax non-compliance amounts to tax evasion, those responsible can be prosecuted. Over the past three years, the IRS’s Criminal Investigation Division has won 137 indictments in employment tax evasion cases. On average, 85 percent of those prosecuted go to jail. If the tax non-compliance is in an industry like adult entertainment and gaming, the likelihood of a criminal tax investigation, rather than a purely civil tax audit, increases.

In summary, e-commerce businesses are being scrutinized and evaluated by the IRS. Therefore, it is prudent for an Internet business to examine its tax compliance policies and practices now, before the IRS further identifies problems and targets these businesses for focused audit initiatives. If any non-compliance is identified by the business, this fact should be discussed with an attorney so that the safest and most effective course of action can be taken to secure the Company’s future.

We at Greenberg Traurig can help you evaluate these problems and chart a course of corrective action to achieve a favorable solution.

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