Executive Summary

Objective and Scope

Background

Results

Conclusion

Appendix I – Detailed Objective, Scope, and Methodology

Appendix II – Major Contributors to This Report

Appendix III – Report Distribution List

Executive Summary

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.

Objective and Scope

Our overall objective was to determine if problems occurred in the processing of U.S. Income Tax Returns for an S Corporation (Form 1120S) that resulted in harm to taxpayers. To assess whether small business taxpayers were harmed, we reviewed employee allegations, held discussions with Internal Revenue Service (IRS) management at the Atlanta Processing Center, and reviewed tax returns and related IRS files to identify instances in which taxpayers may have been harmed.

The review was conducted from January to April 2001 at the Atlanta Processing Center and included transactions for the period July 1999. The review began promptly after the Treasury Inspector General for Tax Administration’s Office of Investigations requested our assistance on allegations that they were investigating. We conducted this review in accordance with the President’s Council on Integrity and Efficiency’s Quality Standards for Inspections.

Details of our objective, scope, and methodology are presented in Appendix I. Major contributors to this report are listed in Appendix II.

Background

We conducted the review based on allegations that employees in the Atlanta Processing Center prematurely removed cases from inventory in July 1999, then did not either send required letters (429C Letters) to taxpayers or wait the required time period (30 days) for them to respond. If a taxpayer files a Form 1120S and the IRS has no record of the required Election by a Small Business Corporation (Form 2553) being filed, the Form 1120S cannot be processed to the taxpayer’s account.

The Internal Revenue Manual (IRM) instructs tax examiners to send taxpayers 429C Letters in an attempt to resolve the filing of Forms 1120S that cannot be processed to taxpayers’ accounts. The 429C Letter informs taxpayers that:

• The IRS is unable to process the return using the Form 1120S.
• The IRS has no record of the Form 2553 election to be treated as an S corporation.
• The taxpayer needs to inform all shareholders to amend their individual income tax returns for the year involved if they reported the Form 1120S income or loss.
• The Form 1120S will be processed as a U.S. Corporation Income Tax Return (Form 1120), unless the taxpayer can provide documentation that he/she was granted the election to file a Form 1120S.
• Their account may reflect incomplete or incorrect information if a response is not received within 30 days from the date of the letter.

At the Atlanta Processing Center, the tax examiners were allegedly instructed to follow a procedure 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 unit appear more productive.

Results

We found that, as alleged, in July 1999 employees prematurely removed cases from inventory at the Atlanta Processing Center and did not either send required letters to taxpayers or wait the required 30 days for taxpayers to respond. The taxpayers attempted to file Forms 1120S, but the IRS claimed there was no record of required elections to file these returns. The Forms 1120S were generally processed as Forms 1120 because taxpayers were not always given the opportunity to provide documentation to indicate whether they were granted the elections to file Forms 1120S.

Managers did not always ensure that required procedures were being followed and that all necessary actions were taken, nor did they request permission to deviate from IRS procedures. Because necessary actions were not taken, taxpayers were harmed by:

• Not being given the opportunity to respond to the IRS with verification that the election was granted by the IRS.
• Not being allowed to respond with a Form 1120, if they were not granted an election, to prevent their tax accounts from reflecting inaccurate or incomplete information.
• Along with shareholders, having to respond to the IRS to have taxes abated and ensure that they had an accurate and proper return on file.

Tax Examiners Sent Required Letters But Did Not Wait for Taxpayers to Reply in More Than Half of the Cases Reviewed

The IRS sent required 429C 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 a 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.

The initial allegation was that the premature closing of these cases was done to reduce inventory and make the unit appear more productive. Managers indicated that this practice primarily occurred in July 1999 and ended after a month.

Taxpayers were not given the prescribed time period to respond to the letters before the IRS treated them as "no response" cases. Because tax examiners removed cases from inventory without allowing time for the receipt and review of taxpayers’ responses, taxpayers could not be assured that any problems they may have had in filing Forms 1120S were properly and timely resolved.

In some cases, it took anywhere from a month to a year after the IRS sent taxpayers the 429C Letters for them to be granted the elections to file Forms 1120S. In other cases, elections to file Forms 1120S had already been granted for subsequent tax periods, but taxpayers had to submit Forms 1120 for the tax years not covered by the elections to ensure that their accounts reflected accurate and complete information. We could not determine if the delays in granting the elections were caused by the premature closing of the cases.

Tax Examiners Did Not Always Send Required Letters to Taxpayers that Filed Forms 1120S to Inform Them There Was No Record of Their Elections to File Forms 1120S

Tax examiners did not send required 429C 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. This occurred in approximately 18 percent of the cases that we reviewed (31 of 176). The initial allegation had indicated that required letters were not being sent to taxpayers.

Managers did not always ensure that all required letters were being sent to these taxpayers, nor did they request permission to deviate from procedures. Because 429C Letters were not sent in these 31 cases:

• Taxpayers did not get the opportunity to respond to the IRS with verification that the Forms 2553 were accepted and timely filed.
• Taxpayers were not given the opportunity to file Forms 1120 to ensure that their information filed with the IRS was complete and correct.
• Shareholders were not instructed to file amended individual returns when they reported Form 1120S losses or gains but did not have timely elections filed. As a result, corporate shareholders could have been wrongfully taxed on gains totaling $201,424 or could have incorrectly received tax benefits on their individual income tax returns from losses of $691,085 reported on Forms 1120S that were not processed.

• Gains totaling $201,424 resulted in taxes of $32,676 being assessed on 9 corporations, and corporate shareholders could have also been taxed on these gains if amended individual returns were not filed.
• Shareholders of 18 corporations could have incorrectly received tax benefits and been subjected to Examination scrutiny for incorrect losses totaling $691,085, if amended individual returns were not filed. These losses appeared on the originally filed Forms 1120S. However, when Forms 1120S could not be processed to the taxpayers’ accounts, the IRS converted the Forms 1120S to Forms 1120. Consequently, related losses cannot be included on the individuals’ returns.
• Four cases involved inactive corporations showing no income or losses.

The Internal Revenue Service Did Not Always Process Returns as Forms 1120S Once It Verified that the Elections Were Granted To File These Returns

Once the IRS verified that elections to file Forms 1120S were granted, it did not convert corporate income tax returns back to small business corporation returns for an estimated 205 taxpayers in July 1999. This represented approximately 41 percent of the cases we reviewed. We could not readily determine if this resulted directly from the premature closing of cases.

These taxpayers attempted to file Forms 1120S that could not be processed to their accounts because the IRS had no record of the required Form 2553 elections being filed. When the IRS determined that these returns could not be processed, the Forms 1120S were converted to Forms 1120 and processed to taxpayers’ accounts. When the IRS subsequently received verification that the taxpayers were granted the elections to file Forms 1120S, the taxpayers’ accounts should have been adjusted to accurately reflect the filing of the Forms 1120S.

There were 68 cases in our sample that were granted the elections to be treated as small business corporation returns, and 28 (41 percent) were not converted to Forms 1120S as of August 2000. Only 34 were processed as Forms 1120S; the remaining 6 involved prior year returns and cases where the elections were terminated or reversed.

Of the 28 cases that were not converted to Forms 1120S, 16 cases showed total taxes assessed of $117,887; $105,609 was subsequently abated on the corporate tax returns. Taxes due after abatements totaled $12,278. Eleven of the 28 cases involved losses claimed totaling $169,288, and 1 case showed no tax due.

Initial indications showed that controls may have to be strengthened to ensure that the IRS adjusts the account to accurately reflect the filing of the Form 1120S once it grants the election with an effective date covering the original return. We plan to address this issue in a subsequent review.

As a result, there is the potential for:

• Inconsistent treatment of taxpayers.
• Incorrect and incomplete tax information on file.
• Unnecessary taxpayer burden for both corporate taxpayers and shareholders in having to contact the IRS to abate taxes and ensuring that the IRS has an accurate return on file.

Conclusion

As alleged, in July 1999, tax examiners prematurely removed cases from inventory at the Atlanta Processing Center rather than send required letters and wait for taxpayers to respond. Because necessary actions were not taken, some business taxpayers were harmed.

Detailed Objective, Scope, and Methodology

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

1. Held discussions with management at the Atlanta Processing Center to identify the controls over processing U.S. Income Tax Returns for an S Corporation (Form 1120S) that could not be processed. The Forms 1120S could not be processed to the Internal Revenue Service’s (IRS) computer system because there was no record of an Election by a Small Business Corporation (Form 2553) on file.
2. Obtained and reviewed Internal Revenue Manual instructions regarding the criteria for closing cases that could not be processed to the IRS Masterfile (the IRS’ main computer system of tax accounts).
3. Reviewed the historic file of returns that could not be processed to the Masterfile (Unpostable Code 310) for January 1999 through December 1999 and identified 18,983 tax returns for the Atlanta Processing Center. From this population, we identified 1,290 tax returns that were processed in July 1999. This was the time period about which an allegation had been made that employees at the Atlanta Processing Center prematurely removed cases from inventory rather than send required letters to taxpayers or wait the required period of time for them to respond.
4. Selected and reviewed a statistically valid sample of 176 of the 1,290 tax returns. Using attribute sampling, we determined the sample size of 176 by using a 95 percent confidence level, a 5 percent expected rate of occurrence, and a precision rate of a plus or minus 3 percent.
5. Reviewed tax returns, computer transcripts, etc., to identify instances in which taxpayers may have been harmed.

Major Contributors to This Report

Gordon C. Milbourn III, Associate Inspector General for Audit (Small Business and Corporate Programs)

Richard J. Dagliolo, Director

Robert K. Irish, Audit Manager

Michael D. Luongo, Senior Auditor

Carol Gerkens, Auditor

Report Distribution List

Commissioner N:C

Deputy Commissioner C:D

Director of Communications S:COM

Director of Internal/External Stakeholders S:C:CP:I

Chief Counsel CC

Director, Legislative Affairs CL:LA

Office of Management Controls N:CFO:F:M

Director, Office of Program Evaluation and Risk Analysis N:ADC:R:O

National Taxpayer Advocate TA

Audit Liaisons:

Commissioner, Small Business/Self-Employed Division S

Commissioner, Wage and Investment Division W