Management Advisory Report: Comparing the Internal Revenue Service’s Verification of Income for Wage Earners and Business Taxpayers
September 2001
Reference Number: 2001-30-166
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.
September 25, 2001
MEMORANDUM FOR COMMISSIONER ROSSOTTI
FROM: Pamela J. Gardiner /s/ Pamela J. Gardiner
Deputy Inspector General for Audit
SUBJECT: Final Management Advisory Report - Comparing the Internal Revenue Service’s Verification of Income for Wage Earners and Business Taxpayers
This report presents the results of our review to evaluate the extent to which wage earners and businesses are subject to Internal Revenue Service (IRS) programs that help ensure the proper amount of tax is paid.
In summary, the IRS verifies the wage income reported by all wage earners through document matching programs, while business income is not subject to such matching. At the same time, while businesses are examined at a higher rate than wage earners, more examinations are conducted on wage earners than all small business, self-employed, and corporate taxpayers combined.
One of the IRS’ challenges is improving taxpayer compliance while ensuring that all taxpayers are treated fairly. The Wage and Investment Division characterizes its taxpayers as highly compliant, which it attributes to its document matching program. IRS data indicate that this group of taxpayers directly submits significantly less tax dollars to the federal government than do business taxpayers, primarily because the responsibility for remitting and reporting taxes withheld from wage earners rests with the employers.
Conversely, the Small Business/Self-Employed Division acknowledges that the largest part of the tax gap is attributed to the taxpayers it serves. In fact, IRS data indicate that this taxpayer group accounts for most of the taxes owed the federal government. The IRS’ reorganization in Calendar Year (CY) 2000 into four separate divisions focused on taxpayer groups represents both a risk of treating groups of taxpayers differently and an opportunity to use specialized knowledge to promote compliance among all taxpayers equitably.
In testimony before the Congress, you have expressed concerns about treating taxpayers fairly. You have testified that higher income taxpayers file more of the returns that contain items that cannot be verified by matching, while lower income taxpayers file more of the returns that can be verified. You are concerned this will lead to the perception that the tax system is unfair.
We share this concern as it relates to the different taxpayer groups serviced by the IRS’ new business divisions. We have previously reported weaknesses in the IRS’ verification of information on business returns for self-employed taxpayers and employers, which illustrate our concern. For example, the IRS uses data provided by a wage earner’s employer, such as Wage and Tax Statement (Form W-2), and financial institution data, such as Interest Income (Form 1099-INT), to ensure that wage earners report their income. When a taxpayer receives only wages and interest income, all income he or she reported on a tax return is verified through document matching. However, the same Form W-2 submitted by an employer that is used to verify a wage earner’s income on U.S. Individual Income Tax Return (Form 1040) is not used to verify taxes owed by the employer as reported on the Employer’s Quarterly Federal Tax Return (Form 941).
The IRS has planned a number of initiatives to ensure that business taxpayers accurately report income and the correct tax due. For example, beginning in CY 2002, the IRS plans to match the Partner’s Share of Income, Credits, Deductions, etc. (Schedule K-1) filed with partnership returns to the partners’ individual returns, and strategic plans call for focusing resources on corporate tax shelters and expanding examination coverage of business returns. The IRS has indicated to the Congress its commitment to treat all taxpayers equitably, and strategic plans indicate equitable treatment of taxpayers is a consideration in future work to promote compliance among business taxpayers. We believe that these initiatives, if effectively implemented, will help promote fairness in administering the tax system.
Management’s Response: Management’s response was due on September 21, 2001. As of September 24, 2001, management had not responded to the draft report.
Copies of this report are also being sent to key IRS managers of operations covered by this review. Please contact me at (202) 622-6510 if you have questions or your staff may contact Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs), at (202) 622-3837.
Businesses Remit the Largest Amount of Taxes and Have the Largest Amount of Accounts Receivable
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
In Calendar Year (CY) 2000, the Internal Revenue Service (IRS) underwent a significant reorganization, changing to an organization that is aligned around groups of taxpayers. The four new divisions that resulted from the reorganization are Wage and Investment (W&I), Small Business/Self-Employed (SB/SE), Large and Mid-Size Business (LMSB), and Tax Exempt and Government Entities.
The W&I Division serves approximately 88 million filers with wage and investment income only. The SB/SE Division serves about 45 million self-employed and small businesses. The LMSB Division serves 210,000 filers with assets over $5 million.
Prior to the reorganization, the IRS was organized geographically around functions. For example, there were national Collection, Examination, and Taxpayer Service functions with numerous offices around the country. They collected taxes, examined tax returns, and provided customer service for a particular geographic region. These functions still exist, but they are now organized to focus on taxpayer groups.
The IRS reworded its mission statement to capture the essence of the new organization. The mission statement reads, "Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all."
Recently, the IRS Commissioner testified before the Congress that he is concerned about treating taxpayers fairly. We have previously reported weaknesses in the IRS’ verification of information on business returns for self-employed taxpayers and employers, which illustrate this concern. For example, the IRS compares data provided by a wage earner’s employer such as Wage and Tax Statement (Form W-2), and financial institution data, such as Interest Income (Form 1099-INT), to that reported on the wage earner’s tax return to ensure he or she reported the income. When a taxpayer files a tax return with only wages and interest income, his or her entire return is checked in this way for accuracy.
Wage earners and businesses having income from the sale of an asset have entries on their tax returns that cannot be verified by using a third party document. An examination would therefore be required if the IRS wished to verify the amount on the return.
The IRS Commissioner has testified that higher income taxpayers file more of the returns that contain items that can not be verified by matching, while lower income taxpayers file more of the returns that can be verified. He is concerned this will lead to the perception the tax system is unfair. For example, the IRS’ inability to use document matching to verify certain investment income, as well as business income, could create the perception the tax system is unfair.
Establishment of the IRS’ four business divisions represents both a risk and an opportunity in verifying income. The risk is that as the four divisions act independently, each taxpayer group could be treated differently. On the other hand, the IRS has an opportunity to use specialized knowledge to equitably promote full compliance with the tax code.
We performed this review at the National Headquarters and the Brookhaven IRS Campus from December 2000 to June 2001. This review was conducted in accordance with the President’s Council on Integrity and Efficiency’s Quality Standards for Inspections. Detailed information of our review objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
All Wage Income Reported by Wage Earners Is Verified, While Business Income Is Not Subject to Matching
Recently, the IRS has come under scrutiny regarding its examination rates, and there is concern regarding the completeness and fairness of its income matching programs. All wage earners whose employers file Forms W-2 have their income matched, while the owners of small businesses and the self-employed, as well as large and mid-size businesses, are not subject to income matching on their business income.
The IRS’ Automated Underreporter (AUR) Program is designed to identify wage earners that do not report all of their income on their U.S. Individual Income Tax Return (Form 1040). The Program compares the income wage earners report on their Forms 1040 to the income reported by their employers on Forms W-2. If the documents do not match, the taxpayers could be contacted to explain the discrepancy. AUR Program management has indicated that the Program is essentially designed to verify wage earners’ income and not income for businesses.
Ideally, the total wages and federal income tax on all of the Forms W-2 issued by an employer should equal the amount filed on the Employer’s Quarterly Tax Return (Form 941) for the year. However, the same Form W-2 that is used to verify a wage earner’s income on the Form 1040 is not used to verify amounts reported by the business on the Form 941.
In addition to a wage earner’s income being verified, the IRS verifies his or her interest and dividends using a
Form 1099-INT or Form 1099-DIV provided by a bank or brokerage. The Internal Revenue Code does not require these Forms 1099 to be issued to corporations.
In the future, the IRS plans on performing additional matches, including matching the Partner’s Share of Income, Credits, Deductions, etc. (Schedule K-1) to each partner’s Form 1040. This will help ensure that the partners report all of their partnership income on their Forms 1040. However, this match would not verify the income of the partnership entity, which would require an examination.
More Wage Earners Are Examined Than Small Businesses, the Self-Employed, and Large Businesses Combined
The W&I Division characterizes its taxpayers as highly compliant, which it attributes to its document matching program. The SB/SE Division, on the other hand, acknowledges that the largest part of the tax gap can be attributed to the taxpayers it serves.
In the future, the IRS will need to decide how many taxpayers in each division should be examined. Although we did not review how the IRS currently assesses risks, it is essential that the IRS consider the risk of non-compliance in choosing the taxpayers that should be examined. The General Accounting Office (GAO) recently reported that the IRS does not have a current measure of voluntary reporting compliance, which the IRS Commissioner believes is needed to assess how well the IRS is accomplishing its mission.
Wage earners that have already had their income and other items on their tax returns matched through the AUR Program may not be as high a risk as some business taxpayers that do not have their income and other items on their returns matched. However, examinations of wage earner returns will always be necessary to ensure voluntary compliance. For example, wage earners with improper Earned Income Credit or other credits and deductions, as well as wage earners with certain investment income, would continue to need examination coverage by the IRS.
Figure 1 shows the number of taxpayers examined by each business division for Fiscal Year (FY) 2000.
Figure 1. Number of Examinations
Figure 1 was removed due to its size. To see Figure 1, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.
Figure 2 indicates the chances of being examined are greater for a small business than for a wage earner and significantly greater for a large or mid-size business.
Figure 2. Percentage of Taxpayers Examined Within IRS Business Division Populations
Figure 2 was removed due to its size. To see Figure 2, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.
Figures 1 and 2 do not include 1.4 million taxpayers contacted for discrepancies found in the AUR Program, most of whom are wage earners. The number of examinations performed on taxpayers in each division, as well as the percentage of examinations performed, will contribute to the taxpayers’ perception of fairness.
One of the IRS’ challenges is determining the effective placement of its resources. The IRS’ Strategic Plan recognizes the dilemma in allocating resources. The Plan indicates it is essential that the IRS’ limited resources be applied to reduce non-compliance while ensuring fairness, observing taxpayer rights, and reducing the burden on those taxpayers that do comply with the tax law.
Businesses Remit the Largest Amount of Taxes and Have the Largest Amount of Accounts Receivable
As Figure 3 shows, the largest amount of dollars is remitted to the IRS by the small business, self-employed, and large and mid-size business taxpayers. Small business and self-employed taxpayers paid $790 billion to the IRS, while large and mid-size business taxpayers paid $712 billion, including withholding. In contrast, wage and investment taxpayers paid only $46 billion. Wage earners directly submit significantly fewer dollars to the federal government than do business taxpayers, primarily because the responsibility for paying and reporting taxes withheld from wage earners rests with their employers.
Figure 3. IRS Receipts From Each Taxpayer Group
Figure 3 was removed due to its size. To see Figure 3, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.
We did not evaluate how the IRS allocates compliance resources or whether each taxpayer group’s contribution to the federal Treasury is a consideration in the allocation. However, it is clearly important that business taxpayers be compliant because they remit most of the government’s receipts.
Accounts receivable data are one measure of taxpayer compliance. As Figure 4 illustrates, the largest portion of the IRS’ accounts receivable as of March 2001 is attributed to small business and self-employed taxpayers.
Figure 4. Accounts Receivable
Figure 4 was removed due to its size. To see Figure 4, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.
Small business and self-employed taxpayers accounted for nearly $168 billion (64 percent) of the IRS’ accounts receivable; wage and investment taxpayers accounted for $74 billion (28 percent); and large and mid-size business taxpayers accounted for $21 billion (8 percent).
The Internal Revenue Service Has Indicated a Commitment to Treat All Taxpayers Equitably and Consider It in Future Work to Promote Compliance Among Business Taxpayers
The IRS has indicated, both in writing and in oral testimony before the Congress, its commitment to treating all taxpayers equitably. The IRS’ Strategic Plan lays out goals to promote compliance among business taxpayers.
The IRS has an ambitious Strategic Plan that addresses areas of noncompliance among businesses. The SB/SE Division has identified operational priorities and improvement projects in such areas as employment tax reporting and increasing examination coverage of partnerships, trusts, and small business corporations. The LMSB Division plans to focus resources on corporate tax shelters within its taxpayer segment.
Beginning in CY 2002, the IRS plans to match Schedules K-1 filed with partnership returns to the partners’ individual returns. Preparation for this began in CY 2001 with the receipt of more U.S. Return of Partnership Income (Forms 1065) and Schedules K-1 electronically and the transcription of data from paper-filed Schedules K-1.
The IRS intends to implement the strategy by stabilizing the field examination staff. In addition, it will centralize the case selection at the national level to increase fairness to taxpayers. The document matching program selection criteria will be changed so the same documents are not matched every year. For example, some years the emphasis will be on Forms W-2 and other years the emphasis will be on Forms 1099-INT.
One of the IRS’ challenges is improving taxpayer compliance while ensuring all taxpayers are treated fairly. We believe that by effectively implementing these initiatives and others the IRS will help promote fairness in administering our tax system.
Appendix I
Detailed Objective, Scope, and Methodology
The overall objective was to evaluate the extent to which wage earners and businesses are subject to Internal Revenue Service (IRS) programs that help ensure the proper amount of tax is paid.
To accomplish our objective, we:
Appendix II
Major Contributors to This Report
Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs)
Richard J. Dagliolo, Director
John Chiappino, Senior Auditor
Carol Gerkens, Auditor
Steve Wybaillie, Auditor
Appendix III
Deputy Commissioner N:DC
Commissioner, Large and Mid-Size Business Division L
Commissioner, Small Business/Self-Employed Division S
Commissioner, Wage and Investment Division W
Chief Counsel CC
National Taxpayer Advocate TA
Director, Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk Analysis N:ADC:R:O
Office of Management Controls N:CFO:F:M
Audit Liaisons:
Commissioner, Large and Mid-Size Business Division L
Commissioner, Small Business/Self-Employed Division S
Commissioner, Wage and Investment Division W