A debtor is a person or business that incurs financial liability and owes money to another person or business, which is considered the creditor. When debtors cannot meet financial obligations to their creditors, debtors can petition (file) for bankruptcy with the Federal Bankruptcy Court. During Fiscal Year (FY) 2000, approximately 1.27 million individuals and businesses filed for bankruptcy. While the Internal Revenue Service (IRS) is not a creditor for each debtor filing for bankruptcy protection, a significant number of the debtors have outstanding tax liabilities. For FY 2000, IRS data show approximately 523,000 debtors entered bankruptcy status owing the IRS about $3.1 billion in taxes, penalties, and interest.

The Bankruptcy Code provides a structured approach for the fair distribution of the debtor’s assets to the creditors. The IRS’ Insolvency Unit is responsible for preparing a proof of claim, which is the creditor’s assertion of a right to payment from the debtor or debtor’s property. The Insolvency Unit is also responsible for monitoring payment plans approved by the Bankruptcy Court and for monitoring compliance while the taxpayer’s bankruptcy case is open and under the jurisdiction of the Bankruptcy Court.

Our overall objective was to determine if the IRS effectively administers its bankruptcy program to achieve its goal of protecting the Government’s interests by securing maximum collections from bankruptcy proceedings.

Overall, the IRS effectively protects the Government’s interests by timely filing proofs of claim and accurately reflecting bankruptcy payment information on the taxpayers’ accounts on the IRS Masterfile. The IRS was effectively manually monitoring and evaluating post-petition non-compliance on businesses involved in bankruptcy proceedings. However, based on our discussions with the IRS Office of Information Technology Services, they initiated a Masterfile programming change to correct an error affecting automated monitoring of non-compliance. In addition, controls in the Insolvency Unit could be improved to ensure that proofs of claim are accurate. The Insolvency Unit also needs to improve monitoring efforts to ensure that payments are sent to the IRS as required by the Bankruptcy Court’s approved payment plan.

The Insolvency Unit was manually monitoring most businesses to verify that the businesses were filing tax returns and paying tax liabilities as appropriate. In 36 (45 percent) of 80 cases that we sampled, taxpayers had not filed and/or paid the proper taxes that were due after the businesses filed their bankruptcy petitions. In most cases (94 percent), the Insolvency Unit had obtained payment, secured returns, filed administrative claims, or had begun these actions to protect the Government’s interests.

While the Insolvency Unit’s actions were effective, the three offices reviewed were not aware of a Masterfile programming error affecting the input of a code used in an automated monitoring process. The Insolvency Unit technicians input to a taxpayer’s Masterfile account both a transaction code (TC 136) and a code representing the tax amount on the most recently filed trust fund return, called the Employer’s Quarterly Federal Tax Return (Form 941). We determined that the last return amount code was not transferred from the Integrated Data Retrieval System (IDRS) to the Masterfile after January 1, 2000, due to a programming error. We discussed this issue with the IRS Office of Information Technology Services, and they corrected the error for transactions input after March 25, 2001. As a result, Masterfile analysis may not accurately identify business taxpayers that do not remain current on tax obligations after the bankruptcy filing. This affects transactions input between January 1, 2000, and March 25, 2001.

The amount of the liability listed on the proof of claim needs to be accurate so the IRS receives the proper amount of taxes owed by the debtor. Our review of 81 proofs of claim cases found that the Insolvency Unit timely filed claims in 77 (95 percent) of the cases reviewed. However, we identified 36 (44 percent) cases which contained inaccurate amounts and/or inaccurate classification of the priority of certain items. The errors represented $243,000 (7 percent) of the total $3.5 million that was due on the 36 cases. Some errors were caused by technicians not properly identifying amounts due, while others were caused by technicians not using the proper IDRS research tools to identify the correct amount of penalty and interest amounts owed.

Payments from bankruptcy cases need to be applied properly to taxpayer accounts, and receipts need to be monitored to ensure that the IRS receives all amounts provided for through the bankruptcy payment plans. Our review of 90 payments received by the Insolvency Unit found that the payment information was accurately applied to the taxpayers’ accounts on the Masterfile. However, our review of cases from delinquency reports determined that the Insolvency Unit did not take timely actions during case reassignments or during the approaching retirement of an employee on 11 (24 percent) of 45 Chapter 11 cases. In addition, two of three offices reviewed were not monitoring Chapter 13 cases on an ongoing basis because local management relied upon the trustees to make proper distributions and take action when debtors defaulted on plan payments.

The Commissioner, Small Business/Self-Employed (SB/SE) Division, needs to notify local management of possible inaccuracies in the automated process to identify business taxpayers that do not remain current on tax obligations after the bankruptcy filing. He also needs to issue guidelines to ensure that proper research tools are used when technicians prepare proofs of claim. Finally, he needs to reinforce requirements for timely actions on delinquent bankruptcy payments and provide specific guidance for expectations on monitoring payments for Chapter 13 bankruptcies.

Management’s Response: SB/SE Division management agreed with all of our recommendations. They plan on issuing an advisory to the field of the programming error on TC 136 and will include instructions for alternative means of identifying cases with post-petition non-compliance. They will also work with the programmers for the Automated Insolvency System to identify cases for re-input of the TC 136.

SB/SE Division management issued a memorandum to the field on March 6, 2001, which included an instructional guide for using the new IDRS command code INTSTB to correctly compute interest and penalty on a proof of claim. The Director, Filing and Payment Compliance, will work with the Director, Compliance Services, and the Insolvency Area managers to reinforce the need for local Insolvency management to monitor Chapter 11 payment compliance with the Confirmed Plan Monitoring Report and provide specific guidance on expectations for monitoring Chapter 13 plan payments.