Background

Millions of Taxpayers Are Filing Unnecessary Underpayment of Estimated Tax Forms

Appendix I – Detailed Objective, Scope, and Methodology

Appendix II – Major Contributors to This Report

Appendix III – Report Distribution List

Appendix IV – Outcome Measures

Appendix V – Management’s Response to the Draft Report

Background

Taxpayer burden is currently a matter of considerable focus by both the Internal Revenue Service (IRS) and the Congress. In its first-ever annual report on tax law complexity, the IRS noted the following relationship between burden and complexity:

In October 1999, the Department of the Treasury’s Office of Tax Policy released a study of interest and penalty provisions that was required by the IRS Restructuring and Reform Act of 1998. The report discussed whether the penalty and interest provisions encourage voluntary compliance, operate fairly, deter undesired behavior, and promote efficient and effective tax administration by the IRS. In regard to the complexity of the estimated tax (ES) payment rules and the corresponding penalties, the study stated:

Generally, taxpayers are not liable for ES penalties if either: (1) their current year’s tax liability minus their withholding is less than $1,000, or (2) their withholding covered at least 90 percent of their current year’s tax liability or 100 percent of the prior year’s tax liability. Taxpayers who underpay can choose either to have the IRS calculate the penalty they owe or to compute it themselves. Taxpayers who decide to compute their own penalty are directed to use Underpay-ment of Estimated Tax by Individuals, Estates, and Trusts (Form 2210). This form allows taxpayers to see if they owe the penalty and, if they do, to figure the amount of the penalty. Taxpayers who wish to request a waiver due to special circumstances (which are specified in the Instructions for Form 2210) must also file Form 2210.

The Form provides two methods - a short method and a regular method - to determine the ES penalty amount. Only taxpayers who either made no ES payments or made four equal ES payments on time can use the short method to compute the penalty. Almost all wage earners and most retired individuals with fixed, foreseeable incomes would qualify for the short method. This method requires taxpayers to make entries or calculations on a maximum of seven lines in order to determine their ES underpayment. They must then apply a percentage rate (shown on the Form 2210) to the underpayment to determine the actual penalty. The regular method requires taxpayers to make numerous complex calculations in order to compute the underpayment and penalty separately for each required quarterly ES payment.

We performed this audit from November 2000 to May 2001 at the Brookhaven IRS Campus. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.

Millions of Taxpayers Are Filing Unnecessary Underpayment of Estimated Tax Forms

For Tax Year (TY) 1998, taxpayers could have avoided filing an estimated 1.84 million Forms 2210. These forms were unnecessary and, in fact, current IRS return processing procedures repeated the same calculations.

For TY 1998, approximately 4.50 million taxpayers submitted a tax return where the taxpayer or his/her representative had computed the ES penalty and the penalty was not subsequently abated. Over 230,000 of these taxpayers had either met a specific exception identified on Form 2210 or had met the IRS’ reasonable cause criteria and received a waiver. These returns had been flagged with a special computer processing code (Computer Command Code P) in order to suppress the normal automated calculation and assessment of the ES penalty. We considered these taxpayers to be "mandatory" Form 2210 filers since the determination to grant the taxpayer relief from the ES penalty could not have been made without a Form 2210 present. Therefore, we limited our analysis to the remaining 4.27 million taxpayers.

We selected a valid statistical sample of 456 taxpayers from the 4.27 million taxpayers identified above and reviewed their TY 1998 tax returns. We determined that 292 (64 percent) of the returns had a Form 2210 attached. Taxpayers calculated the ES penalty using the short method on 197 (67 percent) of these Forms 2210. A preparer’s signature was present on 92 percent of all returns with a Form 2210 and on almost 100 percent of those using the short method calculation.

The following table presents a projection of the sample results to the population of 4.27 million taxpayers.

Based on Figure 1 above, 67 percent (1.84 million out of 2.73 million) of all taxpayers who submitted a Form 2210 with their return used the short method. These taxpayers did not receive any specific benefit for their efforts and only duplicated calculations that the IRS’ normal processing procedures would have performed anyway. The Department of the Treasury study on interest and penalties noted that:

This duplication of taxpayers’ efforts resulting from the use of Form 2210 makes a significant contribution to taxpayers’ compliance burden through the loss of leisure time. In addition, some of these taxpayers may incur additional out-of-pocket expenses, such as the costs of employing the services of a return preparer.

Form 2210 has not been changed since 1986, and it does not provide clear instructions to taxpayers regarding their option to allow the IRS to compute the penalty. The Instructions for Form 2210 state that: the purpose of the form is to see if you owe a penalty for underpaying your estimated tax and, if you do, to figure the amount of the penalty. The instructions go on to say, Because Form 2210 is complicated, we strongly encourage you to let us figure the penalty.

The instructions do not mention that taxpayers do not need to submit the form with their return. Form 2210 itself contains a statement at the top which says: NOTE: In most cases, you do not need to file Form 2210…File Form 2210 only if one or more boxes in Part I apply to you. However, once taxpayers begin the computations, there are no additional reminders or highlights to alert taxpayers that further calculations are unnecessary.

The IRS is currently working with PricewaterhouseCoopers to develop an improved method for measuring taxpayer compliance burden. The new IRS definition of taxpayer compliance burden - the cost to the taxpayer of compliance with the regulations and laws related to the payment of taxes - is the sum of two elements: tax liability and excess burden. Excess burden consists of four separate components, which include out-of-pocket expenses incurred to comply with taxes and leisure time forgone to comply with taxes.

As noted in the Instructions for Form 2210, the IRS has already estimated the amount of time a taxpayer will spend, on average, for various activities involved with this form (see Figure 2).

We used the same method the IRS uses in calculating the total annual reporting/recordkeeping burden estimate applicable to Form 2210 that is required to be submitted to the Office of Management and Budget (OMB) every 3 years. By applying the 61 minutes to the projected total short method population of 1.84 million taxpayers, we have estimated that taxpayers unnecessarily spent 1.87 million hours in 1999 in fulfilling their ES penalty responsibilities. We made a second set of computations working with the premise that taxpayers who allow the IRS to compute the penalty may spend the basic time allotted for record keeping and learning about the law/form. These 12 minutes were removed, and the total time was recalculated to arrive at a new total estimate of over 1.5 million hours spent unnecessarily. Either of these figures is indicative of a significant unnecessary compliance burden on taxpayers.

The IRS does not presently have a means to translate the time burden into a dollar value. Research in this area found that many studies have been done on the cost of tax compliance, and that the use of a taxpayer’s time has been given the term "opportunity cost" in relation to laws and regulations. The OMB develops an Information Collection Budget (ICB) annually. In this document, the OMB uses a figure of $26.50 per burden hour as an established value for tax paperwork. If we apply this $26.50 figure to the 1.87 million lost hours for 1999, the total monetary cost to taxpayers would project to almost $49.6 million per year. By using the reduced figure for total burden hours of approximately 1.5 million, we would project a monetary cost of almost $40 million dollars per year.

The IRS cannot assess the extent of this taxpayer burden issue because it does not have any statistical data available. The IRS does not currently have an information system that would provide any data regarding the number of taxpayers who self-assess an ES penalty or a breakdown of which method was used to compute the penalty. Use of a Masterfile analysis could identify the "mandatory" Form 2210 filers, but it would not provide any data regarding the remaining projected 2.73 million taxpayers who had used Form 2210. We became aware of this when we looked at the current extension request the IRS had submitted for OMB approval to collect public information regarding Form 2210.

One of the primary duties of the OMB is to keep the Congress fully and currently informed of major activities under the Paperwork Reduction Act of 1995 and to report on agencies’ progress toward reducing paperwork. To do so, the OMB develops the ICB by gathering data from agencies on the total number of burden hours stated on their approved collection requests. The data supplied with the July 2000 request in regard to the estimated number of taxpayers using the Form 2210 was the same as the data on the previous request of June 1997. However, this estimate of 900,000 taxpayers represents only about 30 percent of the projected number of 2.97 million taxpayers actually using the Form 2210 annually.

Recommendations

The Commissioner, Small Business/Self-Employed Division (SB/SE), should:

1. Evaluate the design and clarity of Form 2210 and its instructions in order to alleviate the excess taxpayer burden.
2. Coordinate any redesign of Form 2210 with both the practitioner and tax software communities.

Management’s Response: As part of SB/SE’s burden reduction strategy, the Taxpayer Education and Communication (TEC) Operating Unit will evaluate the design and clarity of Form 2210 and its instructions with the intent of minimizing taxpayer burden. The TEC organization in SB/SE will develop a strategy to obtain feedback from practitioner and software groups regarding the redesign of Form 2210. TEC will coordinate the implementation of these changes with the IRS’ Tax Forms and Publications organization.

Detailed Objective, Scope, and Methodology

The objective of this audit was to evaluate the complexity of complying with the Internal Revenue Service’s (IRS) requirements regarding the estimated tax (ES) penalty and the burden it places on taxpayers.

To accomplish the objective, we analyzed tax return information, interviewed IRS personnel, and reviewed documentation from the IRS’ Office of Program Evaluation and Risk Analysis. Our audit work was performed at the Brookhaven IRS Center. However, our analysis included data taken nationwide from tax returns posted to the IRS’ Individual Masterfile. Due to the large volume of tax return information, we selected a sample from nationwide data using statistically valid sampling techniques. Specifically, we performed the following audit tests:

1. Analyzing all tax modules with both a self-assessed ES penalty and a Computer Condition Code P (CCC P) which indicates the presence of a required Form 2210.
2. Identifying and counting the number of modules for these taxpayers.

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

Bernard Kelly, Senior Auditor

Philip Peyser, Senior Auditor

James E. Adkisson, Computer Specialist

Report Distribution List

Commissioner N:C

Deputy Commissioner, Small Business/Self-Employed Division S

Director, Compliance, Small Business/Self-Employed Division S:C

Deputy Director, Compliance Policy, Small Business/Self-Employed Division S:C

Director, Reporting Compliance, Small Business/Self-Employed Division S:C

Director of Communications, Small Business/Self-Employed Division S:COM

Director of Internal/External Stakeholder, Small Business/Self-Employed Division S:C:CP:I

Director, Legislative Affairs CL:LA

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

Chief Counsel CC

National Taxpayer Advocate TA

Office of Management Controls N:CFO:F:M

Audit Liaison: Commissioner, Small Business/Self-Employed Division S

Outcome Measures

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:

• Taxpayer Burden - Potential; $49.6 million per year. Over 5 years, $247.8 million (see page 2).

Taxpayers have the option to self-assess their estimated tax (ES) penalty or have the Internal Revenue Service (IRS) compute it for them. Our Masterfile extract identified 4.50 million taxpayers who had submitted returns where they had computed the penalty themselves and did not have the penalty reduced or removed later. Within this population we identified over 230,000 taxpayers whose returns had received a special computer processing code in regard to their ES penalty. We considered these taxpayers to be "mandatory" Form 2210 filers and did not perform any further analysis on them.

We took a statistical sample of 456 of the 4.27 million tax returns involved (based on attribute sampling with a 95 percent confidence level and a precision level of +/- 2 percent) and found that 64 percent of the taxpayers used Underpayment of Estimated Tax by Individuals, Estates, and Trusts (Form 2210). From the statistical sample of 456 tax returns, we also identified 197 taxpayers who: (1) submitted a Form 2210 with their tax return, and (2) used the short method to calculate the penalty. Tax Year 1998 IRS instructions estimated that a taxpayer would spend 61 minutes in total on a Form 2210 using the short method. We used the data from the sample to estimate the number of taxpayers affected (1.84 million) and applied the IRS time figure to estimate the total time (in hours) spent on Form 2210 short method ES penalty calculations (1.87 million hours).

To calculate the dollar value of the taxpayer time, we used the amount of $26.50 per burden hour as established by the Office of Management and Budget for the value of tax paperwork time. By applying this dollar figure to the 1.87 million hours, we arrived at a total dollar value of taxpayers’ time of almost $49.6 million dollars.

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.