Letter Report: Additional Controls Are Necessary to Ensure that All Businesses Are Classified by Their Principal Business Activity
Reference Number: 2001-30-117
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
August 2, 2001
MEMORANDUM FOR COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED
COMMISSIONER, WAGE AND INVESTMENT DIVISION
FROM: Pamela J. Gardiner /s/ Pamela J. Gardiner
Deputy Inspector General for Audit
SUBJECT: Final Letter Report – Additional Controls Are Necessary to Ensure that All Businesses Are Classified by Their Principal Business Activity
This report presents the results of our review of Principal Business Activity (PBA) codes. Our objective was to determine the effectiveness of Internal Revenue Service (IRS) efforts to identify businesses by their PBA code.
In summary, the IRS successfully adopted the new North American Industry Classification System, which uses the new six-digit PBA code. However, the IRS has not taken advantage of the opportunity to immediately identify taxpayers’ PBA codes when the taxpayers are first established on the IRS’ computer system. Also, processing controls are not sufficient to ensure that a valid PBA code is identified for all business-related tax returns filed.
We recommended that management identify business taxpayers by their principal business activity from information provided by the taxpayer when an Application for Employer Identification Number (Form SS-4) is filed. Early identification by PBA code would allow the IRS to include these new businesses in market segment analyses to identify the need for educational or compliance assistance. We also recommended that management implement processing controls to identify Individual Masterfile tax returns with invalid or missing PBA codes and Business Masterfile tax returns with invalid PBA codes for research and correction during processing.
The Commissioner, Small Business/Self-Employed (SB/SE) Division, agreed that efforts could be made to identify the PBA code when a taxpayer applies for an Employer Identification Number and will determine the cost/benefit of implementing such programming and procedural changes. He also plans to determine what additional resources would be needed to implement procedures to perform the validity and correction process and will perform a cost/benefit analysis to make certain that the benefits justify the costs. His staff will consider the availability of funding for these changes and any adverse impact on returns processing or other areas. Management’s comments have been incorporated into the report where appropriate, and the full text of their comments is included in Appendix IV.
We considered the request of the Commissioner, SB/SE Division, in the response to the draft report, concerning the number of taxpayer accounts impacted. We reduced our estimate of the number of tax accounts impacted from 3.5 million to 2.8 million. Appendix III contains details of our computation of the number of taxpayer accounts impacted.
Copies of this report are also being sent to the IRS managers who are being affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs), at (202) 622-3837.
Objective and Scope
The objective of this review was to determine the effectiveness of Internal Revenue Service (IRS) efforts to identify taxpayer businesses by their Principal Business Activity (PBA) code.
Using attribute-sampling techniques, we selected two statistically valid samples (one with no PBA codes and one with invalid PBA codes) from the total population of U.S. Individual Income Tax Returns with Profit or Loss from Business (Schedule C) and/or Profit or Loss from Farming (Schedule F) attached, filed during calendar year 2000, to:
We also contacted the Large and Mid-Size Business (LMSB) and the Small Business/Self-Employed (SB/SE) Divisions to determine:
We conducted the review at the Brookhaven IRS Campus from November 2000 through February 2001 in accordance with Government Auditing Standards. The scope included a review of statistics for nationwide data processed to the IRS’ Masterfile during calendar year 2000 and a review of sampled accounts processed between January and August 2000.
Major contributors to this report are listed in Appendix I. Appendix II contains the Report Distribution List.
The Statistics of Income (SOI) programs have historically relied upon PBA codes to classify businesses by type of activity. These codes were originally based on the Standard Industrial Classification (SIC) Index and were used exclusively through 1998 by the IRS. As of 1999, the four-digit SIC-based number was changed to a six-digit number based on the NAICS. The NAICS was developed through a cooperative effort among the governments of the United States, Canada and Mexico. This system was designed with more than 1,000 codes, of which the IRS has adopted approximately 400 for its use. The IRS’ Masterfile currently accepts both SIC and NAICS codes.
The PBA codes became a high priority to the IRS after its reorganization to unique business operating divisions. The new LMSB and SB/SE Divisions rely on the PBA codes to profile taxpayers by industry or "market segment." In particular, the IRS’ educational and compliance programs are now based on identifying the taxpayers by industry or market segment. In addition, the SOI function continues to rely upon PBA code information to collect, tabulate, and publish industry data from various tax forms.
The IRS successfully converted from the SIC Index to the NAICS. The NAICS codes adopted for IRS use were sufficient to allow the taxpayers to accurately code their tax returns by principal business activity.
However, the IRS has not taken advantage of the opportunity to immediately identify taxpayers’ PBA codes when they request EINs and their accounts are first established on the IRS’ Masterfile. Also, the IRS does not have sufficient controls to identify and correct all business-related tax returns filed with an invalid or missing PBA code.
As a result, the IRS:
Business Taxpayers Are Not Identified by Their Principal Business Activity at the Earliest Opportunity
Presently, the IRS cannot identify taxpayers by industry or market segment until the taxpayers provide valid PBA codes with the filing of a U.S. Individual Income Tax Return containing a Schedule C or F, a U.S. Partnership Return of Income, or one of the various U.S. Corporation Income Tax Returns. Therefore, newly established businesses cannot be placed in industries or market segments based on their PBA codes, nor can they be targeted for pre-filing outreach or compliance activities, until they file tax returns with valid PBA codes. With approximately 2 million EINs issued annually, this problem affects a great many newly established businesses.
Although the PBA information is available, the IRS had not yet taken the opportunity to use it. When taxpayers file an Application for Employer Identification Number (Form SS-4), their accounts are established on the IRS’ Masterfile. Even though the principal business activity is described on the Form SS-4, taxpayers are not required to enter PBA codes, nor does the IRS use the taxpayer’s description of the business to identify the code for entry to the Masterfile at that time.
The PBA codes became a high priority to the IRS after its reorganization to unique business divisions. The LMSB and SB/SE Divisions rely on knowledge of taxpayers’ principal business activities for possible inclusion in educational and compliance programs.
A survey of top managers in the SB/SE and LMSB Divisions indicated that identifying taxpayers by PBA code information at the time the Form SS-4 is processed would enable the IRS to:
Management’s Response: The Commissioner, SB/SE Division, agreed that efforts could be made to identify the PBA/NAICS code at the time of processing Forms SS-4. However, the SB/SE Division is concerned that when taxpayers subsequently file returns, they may not use the code established via the Form SS-4, and thus the code on the return, if valid, would override the prior code, possibly year after year. The Division will look into the advisability of implementing programming to compare the codes. When codes do not match, the SB/SE Division would have to take steps to determine if either PBA code is accurate. The Division will determine the cost/benefit of implementing such programming and procedures.
Business Taxpayers Were Not Always Identified by Their Principal Business Activity When Tax Returns Were Filed
Filing instructions for tax returns with Schedule C and/or Schedule F attached, and for corporations or partnerships, required the taxpayers to code the returns with the PBA code.
The IRS could not identify the principal business activity for approximately 3.5 million tax returns that were filed during calendar year 2000. These tax returns were processed with either missing or invalid PBA codes.
PBA code processing of Individual Masterfile tax returns
There were insufficient controls for handling both missing and invalid PBA codes on Individual Masterfile (IMF) tax returns. Although the IRS had statistical reports identifying the number of invalid and missing PBA codes for IMF tax returns with a Schedule C or Schedule F, the IRS does not have Internal Revenue Manual (IRM) instructions to identify or correct the PBA codes.
Our review of a sample of 615 Individual Income Tax Returns that were processed without a PBA code or with an invalid PBA code present showed that there were sufficient descriptions of the business activities on 491 (80 percent) of the tax returns. Use of this information would have allowed the IRS to determine and enter the proper PBA codes for an estimated 2.8 million of the more than 3.5 million IMF and Business Masterfile (BMF) tax returns filed without a valid PBA code during calendar year 2000.
PBA code processing of Business Masterfile tax returns
The IRS established effective controls for handling business tax returns with missing PBA codes, but not for handling invalid codes. IRM instructions provide for determining the PBA codes for BMF tax returns when the taxpayers do not provide them. This control was effective, as there were no tax returns identified without a PBA code on IRS statistical reports.
However, when there were invalid PBA codes on BMF returns, there were no IRM instructions for either correcting them or for corresponding with taxpayers to determine the correct codes.
The SB/SE and LMSB Divisions rely on the PBA code information to assist them in achieving their missions of providing customer service through education while helping taxpayers to understand and comply with the tax laws. For example, NAICS was recently used to identify employers in the beauty and barber industry to analyze tip wage compliance. When valid codes are present, tax returns can be more accurately profiled by industry or market segment, especially for focusing education and compliance programs.
Both education and compliance activities are now focused by industry or market segment. With increased knowledge of industry filings and potential compliance problems, pre-filing initiatives can be developed to foster compliance and eliminate more costly and intrusive post-filing enforcement actions. Further, understanding the characteristics of the filing population could improve the process of allocating IRS resources. Finally, the SOI Division relies on the accuracy of the PBA code data to produce reports on which many government agencies rely.
Management’s Response: The Commissioner, SB/SE Division, stated that the Division would need additional resources to perform the validity and correction process. The SB/SE Division will perform a cost/benefit analysis to make certain the benefits would justify the cost to perform this work and, ultimately, whether such funding is available. In its analysis, it will consider any impact which may delay the processing of returns, thus adversely impacting customer service. The SB/SE Division will also address concerns raised by the SOI, including whether it will have access to the original codes designated by the taxpayer after the correction process.
The IRS successfully converted to the NAICS. However, the IRS is not fully effective in its efforts to identify taxpayers by their principal business activities. Taxpayers are not initially identified by their PBA codes when they obtain EINs, and processing controls do not ensure that every tax return is processed with a valid PBA code. As a result, newly established businesses are not identified by their business activity for outreach or compliance activity. Also, approximately 3.5 million business returns were processed with either a missing or invalid PBA code in calendar year 2000.
Major Contributors to This Report
Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs)
Richard J. Dagliolo, Director
Robert K. Irish, Audit Manager
Daniel A. Zaloom, Senior Auditor
Paul R. Baker, Auditor
Margaret Filippelli, Auditor
Layne Powell, Computer Specialist
Report Distribution List
Deputy Commissioner N:DC
Commissioner, Large and Mid-Size Business Division LM
Chief Counsel CC
Deputy Commissioner, Large and Mid-Size Business Division LM
Deputy Commissioner, Small Business/Self-Employed Division S
Deputy Commissioner, Wage and Investment Division W
Director, Communications, Small Business/Self-Employed Division S: COM
Director, Internal External Stakeholders, Small Business/Self-Employed Division S:C:CP:I
Director, Office of Program Evaluation and Risk Analysis N:ADC:R:O
National Taxpayer Advocate TA
Office of Management Controls N:CFO:F:M
Director, Legislative Affairs CL LA
Commissioner, Large and Mid-Size Business Division LM
Commissioner, Small Business/Self-Employed Division S
Commissioner, Wage and Investment Division W
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. These benefits will be incorporated into our Semiannual Report to the Congress.
Type and Value of Outcome Measure:
Reliability of Information – Actual; 2,800,421 taxpayer accounts impacted (see page 6).
Methodology Used to Measure the Reported Benefit:
Review of an Internal Revenue Service (IRS) report containing statistics for all missing and invalid Principal Business Activity (PBA) codes for tax returns filed in calendar year 2000 showed that the IRS was unable to identify the Principal Business Activity:
During our review we identified an 80 percent correction rate for IMF tax returns processed with invalid codes or processed without codes by determining the principal business activity from information found on tax returns with missing or invalid PBA codes. It is our opinion that the 80 percent correction rate for BMF tax returns filed with invalid PBA codes would be approximately the same.
We applied the 80 percent correction rate to the IMF universe of 2,782,358 as shown above, to arrive at a total of 2,225,886 tax returns that could have been corrected. We also applied the 80 percent correction rate to the BMF universe of 718,169 as shown above, based on the IMF test results, to arrive at a total of 574,535 tax returns that could have been corrected.
Therefore, the estimated total number of tax returns that could have been corrected was 2,800,421.
Management’s Response to the Draft Report
The response was removed due to its size. To see the response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.