This review was conducted as a result of allegations that employees in the Internal Revenue Service (IRS) Atlanta Processing Center prematurely removed cases from inventory in July 1999 and then did not either send required letters to taxpayers or wait the required 30 days for them to respond. The taxpayers attempted to file a U.S. Income Tax Return for an S Corporation (Form 1120S), but the IRS claimed there was no record that the taxpayers had filed the required Election by a Small Business Corporation (Form 2553). Taxpayers are required by the IRS to file a Form 2553 to elect to be treated as a small business corporation.

The IRS instructs tax examiners to send letters to taxpayers that file Forms 1120S when there is no record of elections to file these returns. However, in these cases, the tax examiners were allegedly instructed to follow procedures generally used in "no response" situations to prematurely remove the cases from inventory. This primarily occurred in July 1999, allegedly to reduce inventory and make the work unit appear more productive.

Our overall objective was to determine if problems occurred in the processing of small business corporation returns that resulted in harm to taxpayers.

Some taxpayers that attempted to file a Form 1120S at the Atlanta Processing Center were harmed because necessary actions were not taken during July 1999 processing. IRS employees prematurely removed cases from inventory in July 1999 rather than either sending required letters or waiting the prescribed time period for taxpayers to respond. Also, the IRS did not always process these returns as small business corporation returns once it verified that the taxpayers had proper elections to file these returns.

The IRS sent required letters to taxpayers but did not allow the proper time period (30 days) for taxpayers to respond in approximately 59 percent of the cases we reviewed. Based on our statistically valid sample, we estimate that in July 1999, this involved 352 taxpayers. Letters were sent on the same date the case was closed or within 1 to 3 days of closing the case for most of these taxpayers. Because tax examiners removed cases from inventory without allowing the prescribed time period to receive and review taxpayers’ responses, these taxpayers could not be assured that any problems they may have had in filing Forms 1120S were properly and timely resolved.

Tax examiners did not send required letters to an estimated 227 small business corporate taxpayers, whose returns were processed in July 1999, to inform them that the IRS had no record of their elections to file Forms 1120S. As a result, these taxpayers were not given the opportunity to respond to the IRS either with verification that the IRS had previously granted the elections or with U. S. Corporation Income Tax Returns (Form 1120). Also, in those cases where an election form had not been filed on time, shareholders were not instructed to file amended individual returns when they reported Form 1120S losses or gains. Our review of a sample of cases showed that corporate shareholders could have been wrongfully taxed on their individual income tax returns for gains totaling $201,424, or could have been subject to Examination scrutiny for incorrect losses totaling $691,085, because business returns were not processed as Forms 1120S.

When Forms 1120S were not processed because it was believed that there was no record of elections to file these returns, the Forms 1120S were processed to taxpayers’ accounts as Forms 1120. When the IRS subsequently verified that taxpayers were granted elections to file Forms 1120S, the taxpayers’ accounts should have been adjusted to accurately reflect the filing of Forms 1120S. However, the IRS did not convert corporate income tax returns to small business corporation returns for an estimated 205 taxpayers with returns processed in July 1999, once the IRS had, in fact, verified that elections were granted. There was the potential for inconsistent treatment of taxpayers, incorrect and incomplete tax information on file, and unnecessary burden for both corporate taxpayers and shareholders in having to contact the IRS to abate taxes and ensuring that they have accurate returns on file.

This report is advisory in nature and is being provided for informational purposes for whatever actions that may be deemed necessary. Consequently, we are not making any recommendations.