TREASURY INSPECTOR GENERAL
FOR TAX ADMINISTRATION
More Consideration Is Needed During Examinations to Identify Potential Fraud Issues and Refer Cases to Criminal Investigation
Reference No. 2001-30-063
The Internal Revenue Service (IRS) mission is to provide taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all. When taxpayers do not comply with tax laws, enforcement actions (such as the examination of their tax returns) are appropriate. When IRS employees examine returns and identify potential fraudulent issues, such as significant amounts of unreported income, they are to refer the cases to Criminal Investigation (CI). CI then decides whether to accept the cases and conduct investigations to determine whether the taxpayers criminally violated federal tax laws.
One of the Small Business/Self-Employed (SB/SE) Divisionís strategies to improve compliance with tax laws is to reenergize the Fraud Referral Program. CI has also made changes to its organization and has given a high priority to working cases involving income from legitimate sources (as opposed to illegal source cases, such as the selling of drugs). Many of these legitimate source cases could come from referrals from the Examination function within the SB/SE Division.
The overall objective of this audit was to determine whether Examination function employees refer cases with potential fraud issues to CI when appropriate.
Over the past few years, Examination function and CI executives have been concerned with the Fraud Referral Program and have attempted to identify ways to increase the number of quality fraud referrals. Efforts included a multi-function (Examination function and CI) task force and the implementation of its recommendations. Despite these efforts, fraud referrals from the Examination function to CI have continued to decline steadily over the past few years. The number of investigations per year resulting from referrals from the Examination function has declined from a high of 1,223 in Fiscal Year (FY) 1996 to only 256 in FY 2000. We learned several reasons for the decline during the audit.
The most current IRS effort to improve the Fraud Referral Program is to place groups of fraud specialists within the SB/SE Division area offices. This will increase the resources assigned to assist examiners in developing potential fraud cases. However, the SB/SE Division and CI can do more to help these fraud specialists and management improve the Fraud Referral Program.
Indicators of Fraud Are Not Always Recognized and Cases Are Not Always Referred to Criminal Investigation When Appropriate
Examination function managers and employees are not always recognizing and developing potential fraud issues, and therefore, are not referring some cases to CI when appropriate. We reviewed 100 closed Examination cases with total liabilities of approximately $9 million to determine if potential tax fraud issues existed, in which event they should have been referred to CI. Our review identified 11 (11 percent) that met the criteria to be referred as potential criminal fraud cases; however, these cases had not been referred to CI. In addition, in 82 percent of the cases, the examiners did not document in the case file, as required, whether potential fraud was recognized and considered. The majority of these cases involved understated income. In addition, cases with understated income greater than $10,000 require management involvement. However, management involvement in the cases related to documenting whether fraud was considered was not sufficient in 64 of the 80 cases in which the return had understated income over $10,000.
Examiners and managers gave three overall reasons for not making referrals:
If the IRS does not address tax fraud among those who do not comply, the potential exists for decreased taxpayer compliance among those taxpayers who generally do comply. Based on our statistically valid sample of the 100 cases, we estimate that an additional 381 cases nationwide had potential fraud issues that could have been referred to CI during our 16-month sample period. We also estimate that during our 16-month sample period there could have been approximately $21.8 million in additional revenue from assessing civil fraud penalties on the cases with potential fraud issues that did not already have the penalty asserted. Civil fraud penalties are asserted on the additional tax liability for cases with fraud issues.
Summary of Recommendations
We recommend that the Commissioner, SB/SE Division, enhance the processes that identify cases with potential fraud issues through various methods, such as requiring certain cases to be discussed with fraud specialists. The Commissioner, SB/SE Division, should also adjust the mix of cases being examined to include more returns that have historically yielded fraud potential. In addition, the Commissioner, SB/SE Division, and the Chief, CI, should show front-line employees their commitment to the Fraud Referral Program by regularly emphasizing its priority and setting clearer guidelines on what constitutes a successful fraud referral.
Managementís Response: SB/SE Division management agreed with the recommendations. They plan to have the fraud referral specialists work with examiners on open cases, identify trends and patterns of non-compliance, and identify training needs. They also plan to set a dollar threshold for cases that are required to be discussed with the fraud referral specialists and remind managers to document involvement in potential fraud cases. The Commissioner, SB/SE Division and the Chief, CI, will issue a joint memorandum emphasizing the importance of the program, and CI will provide feedback to the SB/SE Division on successful fraud referrals and assist in training the fraud referral specialists. SB/SE Division management also will be increasing the time allocated to high-income filers, including those filing Schedule C and F returns.
SB/SE Division management did not agree with the projection of potential referrals and lost revenue. Managementís complete response to the draft report is included as Appendix VI.
Office of Audit Comment: Although management did not agree with the projection in the report, we believe that our review of cases identified sufficient evidence of badges of fraud in the 11 cases we used as a basis for our projection.