The Internal Revenue Service Successfully Processed
Schedules K-1 for Its Matching Program, However, Tax Form Changes Would Reduce
Unnecessary Notices to Taxpayers
July
2002
Reference
Number: 2002-30-141
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.
July
30, 2002
MEMORANDUM FOR
COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
COMMISSIONER, WAGE AND
INVESTMENT DIVISION
FROM: Pamela J. Gardiner /s/ Pamela J. Gardiner
Deputy Inspector General for
Audit
SUBJECT: Final Audit Report – The Internal Revenue
Service Successfully Processed Schedules K-1 for Its Matching Program, However,
Tax Form Changes Would Reduce Unnecessary Notices to Taxpayers (Audit #
200130051)
This
report presents the results of our review of the processing of paper filed Beneficiary’s
Share of Income, Deductions, Credits, etc. (Form 1041, Schedule K-1); Partner’s
Share of Income, Credits, Deductions, etc. (Form 1065, Schedule K-1); and Shareholder’s Share of Income, Credits,
Deductions, etc. (Form 1120S, Schedule K-1) for purposes of matching with
individual income tax returns. The overall objective of this review was to determine if
the Internal Revenue Service (IRS) had controls in place to ensure accurate and
timely processing of these Schedules K-1.
Because of a mandate from the
Senate Committee on Finance, the IRS will match information reported to
taxpayers on Schedules K-1 to the taxpayers’ individual income tax
returns. The IRS estimates that in
2001, shareholders, beneficiaries, and partners will have approximately $850
billion reported to them on Schedules K-1.
The IRS further estimates that between 6 and 15 percent of these
taxpayers are omitting this income from their individual tax returns.
Tax professionals and others
have expressed serious concerns about the difficulty in matching information
from Schedules K-1 to individual income tax returns. Because of these concerns, the IRS must ensure Schedules K-1 are
accurately processed to reduce the risk of erroneous matching results, which
could both impair the IRS’ compliance efforts and lead to the issuance of
unnecessary notices to taxpayers.
Although we followed Government
Auditing Standards, we encountered a scope limitation by not having
sufficient, competent, relevant, and timely information to allow us to
confidently project the accuracy of data entered from Schedules K-1 to the IRS’
computer system.
In summary, we found that
Schedules K-1 were processed timely, and that the IRS had taken steps to
capture information to evaluate the effectiveness of the Schedule K-1 matching
process. Over 96 percent of Tax Year 2000
Schedules K-1 included in our judgmental sample were processed accurately;
however, we cannot confidently project this accuracy rate to the population of
Schedules K-1 overall. In cases
included in this sample where materially incorrect amounts had been entered in
the IRS’ database, the IRS’ Underreporter Program’s processing procedures
should mitigate the type of errors we identified and prevent incorrect notices
from being issued.
Minor changes to one tax
schedule could improve the matching process.
Over half of all income reported by partnerships and S Corporations is
from ordinary business and rental activities.
During the IRS’ Underreporter Program matching process, mismatches are
prone to occur on this type of income because of offsets such as depletion,
passive activity loss limits, and unreimbursed expenses that taxpayers take
before putting Schedule K-1 amounts on their individual Supplemental Income
and Loss (Form 1040, Schedule E).
Manual screening of mismatched returns with business or rental activity
income can sometimes detect these offsets, but this type of review is more time
consuming and increases the potential for error.
The IRS should make changes
to the Schedule E, as recommended in a July 2000 Illinois District Office
Research and Analysis study. The
changes recommended would require taxpayers to separately list the original
amounts reported on the Schedules K-1 and the amount by which they are
offsetting this income. By doing this,
more of the matching could be automated, manual screening would be easier and
more accurate, and the potential for unnecessary notices would be reduced.
Management’s
Response: The IRS’ Small Business/Self-Employed
Division agreed that they should consider changes to improve the automated
Schedules K-1 matching process. They
agreed to analyze the data collected from ongoing Schedules K-1 matching
efforts and establish a cross-functional work group to identify and evaluate
potential improvements to the Schedules K-1 matching process. The work group will consider changes to the
Schedule E as part of its mission.
Management’s complete response to the draft report is included as
Appendix IV.
Copies
of this report are also being sent to the IRS managers who are 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.
Attachment
Limited Review
of Paper Schedules K-1 Found No Indication of Significant Processing
Inaccuracies
Forms Should Be Changed to Separately
List Amounts as Originally Reported on Schedules K-1
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Management’s Response to the Draft Report
Beneficiary’s Share of
Income, Deductions, Credits, etc. (Form
1041, Schedule K-1); Partner’s Share of
Income, Credits, Deductions, etc. (Form 1065, Schedule K-1); and Shareholder’s Share of Income, Credits,
Deductions, etc. (Form 1120S, Schedule K-1) are information returns filed
by fiduciaries, partnerships, and S Corporations. They report the share of income, losses, deductions, and credits
attributable to each beneficiary, partner, or shareholder. The majority of Schedules K-1 received are
associated with individual taxpayers, who report the amounts flowing through on
their U. S. Individual Income Tax Return (Form 1040).
Beginning in Fiscal Year 2001, Schedules K-1 not filed electronically
were entered into Internal Revenue Service (IRS) computers for use in the IRS’
Information Returns Program (IRP). The
main justification for the cost incurred to enter the data from these schedules
is the compliance benefits that will be achieved through the Underreporter
Program, where the Schedule K-1 information will be matched against the tax
returns of the individual partners, shareholders, and beneficiaries. In addition, the information should benefit
the examination and correspondence examination programs, collection programs,
and taxpayer education and outreach programs.
The IRS has not processed paper Schedules K-1 since 1995,
when a percentage of these returns were included in its Underreporter
Program. However, the IRS has since received
a mandate from the Senate Committee on Finance to process all Schedules K-1 for
inclusion in the matching program. In
March 2001, Senator Charles E. Grassley, then Chairman of the Committee on
Finance, urged Commissioner Rossotti to make a priority of having a computer
program in place to match income reported on the Schedules K-1. He also stressed the risks caused by
extensive use of partnerships and other flow-through entities in the area of
tax schemes. At the same time, tax
professionals and oversight organizations have expressed serious concern about
the difficulty in matching Schedule K-1 information with tax returns. They believe taxpayers will suffer
significant burden resolving erroneous notices that are likely to be issued by
the IRS. Because of these conflicting
concerns, the IRS must ensure Schedules K-1 are accurately processed to reduce
the risk of erroneous matching results, which could both impair the IRS’
compliance efforts and lead to the issuance of unnecessary notices to
taxpayers.
The IRS estimates that in Tax Year 2001, 8.5 million of these
flow-through returns will report $850 billion to approximately 19 million
shareholders, beneficiaries, and partners on Schedules K-1. They also estimate that between 6 and 15
percent of the taxpayers are currently omitting their taxable flow-through
income from their individual returns.
In evaluating the costs and benefits of the Schedule K-1 processing and
matching program, the IRS projects that a 1 percent change in the voluntary
compliance level will make a difference of approximately $500 to $750 million
in tax annually, which would justify the cost of the Schedule K-1 processing
and matching program.
The project completion date for transcribing the Schedules
K-1 was December 15, 2001. Initial
matching against individual taxpayer returns is already in progress.
This audit was conducted in accordance with Government
Auditing Standards between August 2001 and March 2002 at the Ogden
Submission Processing Center and the IRS National Headquarters. Although
we followed Government Auditing Standards, we encountered a scope
limitation by not having sufficient, competent, relevant, and timely
information to allow us to confidently project the accuracy of data entered
from Schedules K-1 to the IRS’ computer system.
Detailed information on our audit objective, scope, and
methodology is presented in Appendix I.
Major contributors to the report are listed in Appendix II.
Based on our review of the IRS’ processing statistics, it
appears that Schedules K-1 were processed in a timely manner. The IRS’ production reports showed that
approximately 14.6 million returns were transcribed and entered in the IRS’
computer system as of December 22, 2001.
These information returns have been incorporated into the IRS’ IRP
database for use in the Underreporter Program, currently in progress.
The IRS’ Compliance functions identified information that
they needed to monitor and evaluate the effectiveness of the Schedule K-1
matching process. A letter of
understanding was drafted with programmers in the Underreporter Section at the
Western Development Center in Ogden, Utah, to ensure this information is
captured. This should provide the IRS
with information associated with the processing of related Schedule K-1
Underreporter cases to evaluate the effectiveness and efficiency of that
portion of the program.
For the IRS’ matching program to be successful, data must be
entered accurately from Schedules K-1 to the IRS’ computer system. Erroneous data entered into IRS computers
from Schedules K-1 could have significant impact on taxpayers and on the IRS’
compliance programs. Accordingly, we
reviewed a judgmental sample of 118 Tax Year 2000 Schedules K-1 to determine
the accuracy of the payee/payer information and the related tax data. As discussed in Appendix I, we were not able
to obtain a statistically valid sample and, accordingly, we cannot make any
projections from our results to the entire universe of Schedules K-1. However, the results of our review of these
cases were generally positive.
We found few errors, and those we did find will be mitigated
by Underreporter Program matching procedures designed to correct the type of
errors we encountered and prevent incorrect notices from being issued. Of the 118 Schedules K-1 reviewed, only 4
(3.4 percent) had material errors in the dollar amounts entered into the IRS’
computer system by IRS employees. Most
of the errors were the result of a positive amount being entered when the
actual amount should have been a negative figure.
We discussed the errors involving incorrect positive values
with the Underreporter analyst at the Ogden Submission Processing Center. The Ogden Underreporter function had
previewed a small number of cases and had also identified two cases that
appeared to be the result of this type of input error. The IRS is taking actions to help prevent
these types of errors, and their adverse consequences, in the future.
·
Changes to next year’s processing procedures should
reduce the number of these cases. First
year procedures required tax examiners in the Code and Edit function to bracket
negative amounts. In our error cases,
the tax examiners had not bracketed the negative figures, so data transcribers
subsequently input positive amounts. In
the future, data transcribers will determine the correct value (i.e., positive
or negative) and input it accordingly, rather than rely on the Code and Edit
function to bracket negative amounts during pre-input reviews.
·
Underreporter screening instructions help ensure that
erroneous notices do not go to taxpayers when the IRS makes such input errors.
Another error occurred because the IRS employee entered less
than the correct income amount. This
year’s matching is focusing on understated income. If the taxpayer in this situation properly reported the Schedule
K-1 income, the difference would appear to be an overstatement of income and no
notice would be generated.
Because of data limitations, we could not confidently
project the quality of input for the entire population of processed Schedules
K-1. However, our judgmental sample did
not indicate a significant problem with quality that would result in inaccurate
notices. Because even a small
percentage error rate in processing these 14 million Schedules K-1 could result
in numerous erroneous notices being issued, the IRS should still monitor the
quality of notices issued and take corrective actions as soon as possible,
should any problems become apparent.
For the matching program to be effective, the IRS needs to
be able to readily determine whether amounts from Schedules K-1 are reported on
individual tax returns. This process is
most efficient when the match can be performed by computer with little or no
manual screening required.
Significant numbers of Schedules K-1 contain some interest
or dividend income. The places where
taxpayers may report such income on their individual returns are limited, making
these items relatively easy to match during the IRS’ Underreporter Program
matching process. Interest and dividend
income shown on Schedule K-1 is combined with the interest and dividend income
from other sources and compared to amounts on the individual tax returns. Similar matching is performed for other
forms of portfolio income, such as capital gains and royalties.
However, over half of all income reported by partnerships
and S Corporations is from ordinary business and rental activities. Various income and loss amounts can often be
summed and compared to corresponding totals on Supplemental Income and Loss
(Form 1040, Schedule E). Mismatches are
prone to occur on this type of income as the result of offsets due to passive
activity loss limits, depletion, or unreimbursed partner expenses that
taxpayers take before putting Schedule K-1 amounts on their Schedules E. In addition, details regarding the Schedule
K-1 information, if any, are often on supplemental schedules provided by tax
preparers. Manual screening of
mismatched returns with business or rental activity income can sometimes detect
these offsets, but this type of review is more time consuming and increases the
potential for error.
Because of this difficulty in identifying Schedule K-1 business
and rental income on taxpayers’ individual Schedules E, the IRS estimates these
cases will require a higher percentage of taxpayers to be contacted than cases
for other sources of income, such as wages and interest. They expect approximately 60 percent of the
notices issued on these Schedule K-1 cases will be “no change” cases, as
compared to the 25 percent “no change” rate for other Underreporter Program
cases.
An Illinois District Office Research and Analysis (DORA)
study (Project ID Number 50.13, dated July 2000) recom-mended making changes to
Form 1040, Schedule E to address the cause of this problem by clarifying
reporting and facilitating verification of Schedules K-1. Basically, by changing Schedule E to
separately list the original amount reported on the Schedule K-1 and the amount
by which this income is offset, much of the matching could be automated. The Underreporter Analyst at the Ogden
Submission Processing Center also believes manual screening of cases would be
easier and more accurate if these changes were made to the Schedule E. By resolving more cases automatically and by
reducing the potential for errors during the screening process, the number of
unnecessary (erroneous) notices would be reduced for Schedule K-1 related income
mismatches. This is especially
significant because of the high dollar amount reported in this section of the
Schedule E (over $240 billion for Tax Year 1998).
1.
The Director, Compliance, Small Business/Self-Employed (SB/SE)
Division, should work with the Director, Tax Forms and Publications, Wage and
Investment Division, to make changes to the Form 1040, Schedule E as
recommended in the DORA study. Consideration
should be given to classifying and reporting pass through income to facilitate easier
comparisons to Schedules K-1 and to make the matching program more effective
and less subject to extensive manual screening.
Management’s
Response:
The SB/SE Division agreed that they
should consider changes to improve the automated Schedules K-1 matching
process. They will continue to focus
their efforts on improving the processing and reducing the transcription
errors. During the ongoing matching
process, the SB/SE Division will collect data to discover why cases identified
with a mismatch during computerized matching are subsequently screened-out
during manual screening or not changed after a notice is issued. The Division will establish a
cross-functional work group to identify and evaluate potential improvements to
the Schedule K-1 matching process. This
work group will consider changes to the Schedule E as part of its mission.
Appendix I
Detailed Objective, Scope, and Methodology
Our overall objective was to determine if the Internal
Revenue Service (IRS) had controls in place to ensure the accuracy and
timeliness of paper filed Beneficiary’s
Share of Income, Deductions, Credits, etc. (Form 1041, Schedule K-1); Partner’s
Share of Income, Credits, Deductions, etc. (Form 1065, Schedule K-1); and Shareholder’s Share of Income, Credits,
Deductions, etc. (Form 1120S, Schedule K-1) processed for purposes of
matching with taxpayer returns.
To accomplish our objective we:
I. Evaluated
the quality of transcribed Schedule K-1 data on the Information Return (IRMF)
portion of the IRS’ Master File.
A.
Reviewed relevant Internal Revenue Manual (IRM) sections to
determine the adequacy of controls over transcription accuracy.
B.
Discussed transcription controls with IRS personnel.
C.
Obtained a computer file containing approximately 850,000
Schedules K-1 input to the IRS’ IRMF.
We reviewed a judgmental sample of 118 of these Schedules K-1. We compared data input for these 118
Schedules K-1 to the original return (Form 1041, 1065, or Form 1120S) filed by
the taxpayer to determine processing accuracy.
(We selected our sample by using computer software to identify 280 cases
at random and reviewed all cases for which we had received tax returns by our
fieldwork completion date. See scope
limitation on page 9.)
D.
Determined the number of invalid Taxpayer Identification
Numbers eliminated from the pool of matchable returns.
II. Determined
whether transcription of Schedules K-1 was completed in a time frame that
allowed timely filed Schedules K-1 to be included in the Information Returns
database used for matching against individual returns.
A.
Monitored
the IRS’ production reports to determine the number of Schedules K-1 processed.
B.
Determined
whether the majority of processed Schedules K-1 were available for
Underreporter Program matching routines.
III. Determined
what tests had been conducted to ensure the usability of transcribed Schedule
K-1 data.
A.
Discussed
with IRS personnel the Schedule K-1 data used in the Underreporter Program and the results of Schedule K-1
usability tests.
B. Reviewed a letter of understanding to ensure that the IRS was
developing information to track the results of the Schedule K-1 matching.
IV.
Determined if Schedule K-1 matching program results could be
evaluated to ensure costs associated with processing Schedules K-1 were outweighed
by the benefits.
A.
Discussed plans to evaluate
underreporter results of Schedule K-1 related cases with Underreporter Program
analysts and reviewed work schedule.
B.
Reviewed the Letter of Understanding regarding information
that would be obtained to evaluate results of Schedule K-1 matching.
·
The data to be tested was obtained from the IRS’
computer input files, which were created over several months. Some of the input files were erased before
we could access them.
·
Some of the information we did obtain was taken from an
error file, rather than an initial input file.
·
The time required to obtain data from other sources,
which could be used to select a statistically valid sample, was significant,
and we believed it was more important to communicate the results we had than to
delay the report to obtain new data.
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
Kyle
R. Andersen, Audit Manager
L. Jeff Anderson, Senior Auditor
Greg Schmidt, Senior Auditor
W. George Burleigh, Auditor
Layne D. Powell, Computer Specialist
Appendix III
Commissioner N:C
Deputy
Commissioner N:DC
Deputy
Commissioner, Small Business/Self-Employed Division S
Deputy Commissioner,
Wage and Investment Division W
Director,
Compliance, Small Business/Self-Employed Division S:C
Director, Customer
Account Services, Small Business/Self-Employed Division S:CAS
Director, Customer
Account Services, Wage and Investment Division
W:CAS
Director,
Tax Forms and Publications, Wage and Investment Division W:CAR:MP:FP
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, Small
Business/Self-Employed Division S
Commissioner, Wage and Investment
Division W
Appendix IV
The response was removed due to its size. To see the complete response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.