The Internal Revenue Service Acted on Recommendations to
Help Farmers Receive the Intended Benefit of the Farm Income Averaging
Provision
July 2003
Reference Number: 2003-30-142
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
3, 2003
MEMORANDUM FOR
COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Gordon C. Milbourn III /s/ Gordon C.
Milbourn III
Assistant Inspector General
for Audit (Small Business and
Corporate Programs)
SUBJECT: Final Audit Report - The Internal Revenue
Service Acted on Recommendations to Help Farmers Receive the Intended Benefit
of the Farm Income Averaging Provision (Audit # 200330001)
This
report presents the results of our review to determine whether the Internal
Revenue Service (IRS) effectively informed taxpayers about retroactive changes
it made to regulations regarding the “Farm Income Averaging” provision of the
tax law and whether farmers filed amended tax returns to benefit from the
changed regulations.
A
provision in the Taxpayer Relief Act of 1997 allowed farmers to elect to
compute their tax liabilities by averaging farm income over a 3-year
period. This provision was designed to
smooth out the economic disparities that farmers experience from year to
year.
The
IRS originally interpreted the farm income averaging provision of the tax law
to exclude negative income from the calculations. However, members of the Senate issued a letter to the IRS stating
that this interpretation was inconsistent with the intent of the Congress and
recommending that proposed IRS regulations be amended to clarify that “taxable
income” may be negative for the purpose of farm income averaging. The IRS responded by making the necessary
changes to the regulations to enable farmers to use negative taxable income in
their averaging computations. These
changes were implemented for Tax Year (TY) 2000 and were made retroactive to TY
1998. However, farmers were required to
file amended tax returns to claim any refund of tax for TYs 1998 or 1999.
In summary, we estimate that
more than 4,200 farmers excluded negative amounts in their averaging
calculations for TY 1999 because of the IRS’ interpretation of the farm income
averaging provision, but did not amend their returns. We estimate these farmers’ tax accounts were overpaid by more
than $4.4 million.
Because the preliminary
results of our review indicated many farmers did not know about the opportunity
to amend their tax returns for refunds, we brought this issue to the attention
of the IRS before completing our review.
We issued a memorandum to the IRS in February 2003, less than 2 months
before the statute of limitations for amending TY 1999 returns was to
expire. We recommended that the IRS
explore the feasibility of issuing notices to affected taxpayers and that it
explore ways to allow these taxpayers more time to amend their tax
returns.
Our draft report contained
information not included in our memorandum regarding the cause of the finding,
as well as the benefit our recommendations would have on tax
administration. Because the IRS had
responded to our memorandum and had taken adequate corrective actions, we
invited IRS management’s comments regarding this additional information but did
not require an additional response. The
IRS determined that no additional comments were warranted.
Copies of this
report are also being sent to the IRS managers affected by the report
findings. Please contact me at (202)
622-6510 if you have questions or
Richard J.
Dagliolo, Director (Submission Processing), at (631) 654-6028.
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Outcome Measures
Appendix VI – Management’s Response to Memorandum #1
A provision in the Taxpayer Relief Act of 1997 allowed farmers to elect to compute their tax liabilities by averaging farm income over a 3-year period. This provision was designed to smooth out the economic disparities that farmers experience from year to year. The Internal Revenue Service (IRS) designed Farm Income Averaging (Schedule J) for calculating tax liabilities using the averaging method.
The IRS originally interpreted the farm income averaging provision of the tax law to exclude negative income from the calculations. However, members of the Senate issued a letter to the IRS stating that this interpretation was inconsistent with the intent of the Congress and recommending that proposed IRS regulations be amended to clarify that “taxable income” may be negative for the purpose of farm income averaging. The IRS responded by making the necessary changes to the regulations to enable farmers to use negative taxable income in their averaging computations. These changes were included in the Schedule J instructions for Tax Year (TY) 2000 and were made retroactive to TY 1998. However, farmers were required to file amended tax returns to claim any refund of tax for TYs 1998 or 1999. We initiated this review because taxpayers/farmers affected by the IRS’ original interpretation of the law may not have been aware of the retroactive changes made to the tax regulations in subsequent years and may not have received refunds to which they were entitled.
We conducted our audit at the IRS’ Ogden Campus and offices of the IRS’ Small Business/Self-Employed (SB/SE) Division located in New Carrollton, Maryland, and near Cincinnati, Ohio. This audit was performed 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.
Using computer analysis, we identified 4,398 taxpayers who most likely calculated the taxes on their TY 1999 individual income tax returns using Schedule J and had not amended their tax returns. (See Appendix IV for the selection criteria we used in our computer analysis.)
We selected a statistical sample of 70 returns for these taxpayers and found the following:
§ All 70 had calculated their taxes using Schedule J.
§ Sixty-eight (97 percent) of these 70 taxpayers had excluded negative amounts in their averaging calculations.
§ These 68 taxpayers had overpaid their taxes by an average of $1,039.
It is likely that taxpayers were not aware that the IRS had made retroactive changes to the farm income averaging provision. The IRS did not perform education or outreach activities to disseminate this information to farmers or their tax preparers. On the other hand, the IRS did publish information regarding the retroactive changes in the TYs 2000, 2001, and 2002 instructions for Schedule J, as well as in Farmer’s Tax Guide (Publication 225) and Highlights of 2000 Tax Changes (Publication 553).
However, the IRS did not include information about the change in the instructions for Profit or Loss From Farming (Schedule F), which in our view would have been the single most effective place to publish the information. Every farmer (or his or her tax preparer) would likely refer to Schedule F every year. Farmers might not file or even refer to Schedule J in TY 2000 if they had just averaged their income in TY 1999. The same is true of information included in Publication 225. This publication, over 100 pages long, would be less likely to be referred to if farmers had just averaged their income in the prior year.
Based on the results of our sample, we estimate that more than 4,200 farmers excluded negative amounts in their averaging calculations for TY 1999 because of the IRS’ interpretation of the farm income averaging provision. We estimate these farmers’ tax accounts were overpaid by more than $4.4 million.
Because the preliminary results of our review indicated many farmers did not know about the opportunity to amend their tax returns for refunds, we brought this issue to the attention of the IRS before completing our review. We issued a memorandum to the IRS in February 2003, less than 2 months before the statute of limitations for amending TY 1999 returns was to expire (see Appendix V). We recommended that the IRS explore the feasibility of issuing notices to affected taxpayers and that it explore ways to allow these taxpayers more time to amend their tax returns.
In response, the SB/SE Division’s Customer Account Services, Accounts Management function took extraordinary steps to send notices to the affected taxpayers, informing them about the issue and how to file amended returns before the statute of limitations expired. The IRS also provided taxpayers with a method to obtain more time to file the amended returns for TY 1999, but advised us that it had no authority to revive a statute that had expired, so it could take no corrective action for TY 1998 returns. In addition, employees from the SB/SE Division’s Taxpayer Education and Communication function disseminated information regarding this issue to tax preparer groups and farmer groups. (See Management’s Response to Memorandum #1 in Appendix VI.)
Appendix I
Detailed Objective, Scope,
and Methodology
The overall objective of this review was to determine whether the Internal Revenue Service (IRS) effectively informed taxpayers about retroactive changes it made to regulations regarding the “Farm Income Averaging” provision of the tax law and whether farmers filed amended tax returns to benefit from the changed regulations.
To accomplish our objective, we:
I. Identified all taxpayers that had positive income from farming during Tax Year (TY) 1999 as well as negative taxable income in any of the 3 prior years.
A. Wrote a computer program to identify tax returns on the IRS’ Individual Master File that met the criteria above.
B. Randomly selected 20 returns identified by our computer program to verify whether they met the criteria requested.
1. Researched these returns on the IRS’ Integrated Data Retrieval System (IDRS) to confirm whether the data in the database were accurate.
2. Confirmed whether the taxpayers in the database had not filed an amended return to recover taxes paid for TY 1999.
C. Analyzed the entire database to identify taxpayers that had farm income in TY 1999 of $500 or more, taxable income in TY 1999 of $500 or more, an amount present in the field “Tentative tax – ERS verified,” taxable income losses in any of the prior 3 tax years (1998, 1997, 1996), and no amended return for TY 1999. This analysis resulted in the identification of a total of 4,398 taxpayers.
D.
Reviewed a statistical sample of 70 of the 4,398
returns identified above (95 percent confidence level, precision level of +\- 4
percent, expected error rate of 3 percent) to determine whether the taxpayers
used the Schedule J, whether the taxpayers excluded negative taxable income in
their tax calculations, and what effect this had on their tax liabilities. Recalculated the tax liabilities for TY 1999
with the revised Schedule J instructions allowing them to use negative income
in averaging the farm income. Requested
that IRS employees with experience working the Schedule J review the first 17
cases we had completed to ensure our calculations were accurate.
E. Developed the overall effect for the remainder of the database from the results of step I.D. by calculating the average change in tax and applying this to the number of taxpayers in the database identified as excluding negative income from their original income averaging calculations.
II. Identified the IRS’ efforts to notify taxpayers of the change to the averaging calculation.
A. Reviewed News Releases and Bulletins to determine what effort was made to contact taxpayers that should file amended returns.
B. Reviewed the efforts to contact taxpayers concerning the need to file an amended return and determined if these efforts were sufficient.
C. Interviewed IRS officials to determine the efforts that were made to inform taxpayers of the averaging change.
Appendix II
Major Contributors to This Report
Richard J. Dagliolo, Director
Kyle R. Andersen, Acting Director
Bill R. Russell, Acting Audit Manager
L. Jeff Anderson, Senior Auditor
W.
George Burleigh, Senior Auditor
Roy E. Thompson, Senior Auditor
James E. Adkisson, Computer Specialist
Appendix III
Commissioner N:C
Deputy Commissioner for Services and Enforcement N:DC
Acting Deputy Commissioner, Small Business/Self-Employed Division S
Director, Customer Account Services, Small Business/Self-Employed Division S:CAS
Director, Taxpayer Education and Communication, Small Business/Self-Employed Division S:T
Director, Accounts Management, Small Business/Self-Employed Division S:CAS:AM
Deputy Director, Accounts Management, Small Business/Self-Employed Division S:CAS:AM
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:AR:M
Audit Liaison: Commissioner, Small Business/Self-Employed
Division S
Appendix IV
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. This benefit will be incorporated into our Semiannual Report to the Congress.
Type and Value of Outcome Measure:
· Taxpayer Rights and Entitlements – Potential; $4,432,374 in overpaid tax from 4,266 taxpayer accounts (see page 2).
Methodology Used to Measure the Reported Benefit:
We used computer analysis to develop a database containing 4,398 Tax Year (TY) 1999 individual income tax returns meeting the following criteria:
· Income of $500 or more from farming in TY 1999.
· Taxable income of $500 or more in TY 1999.
· Amount present in “Tentative tax – ERS verified” for TY 1999.
· Negative taxable income in any of the prior 3 tax years.
· No amended return for TY 1999.
We reviewed a statistical sample of 70 of these 4,398 returns (95 percent confidence level, precision level of +\- 4 percent, expected error rate of 3 percent) and found that all 70 had calculated their tax using a Schedule J. Sixty-eight (97 percent) of these 70 taxpayers had excluded negative amounts in their averaging calculations. The average overpayment for these 68 cases was $1,039. Based on these results, we estimate that 4,266 taxpayer accounts (4,398 x .97) contained overpaid income taxes totaling $4,432,374 (4,266 accounts x $1,039).
Appendix V
Memorandum #1: Farmers
Who Averaged Their Income Did Not Receive the Full Intended Benefit Because of
the Internal Revenue Service’s Interpretation of the Farm Income Averaging Provision
Memorandum #1
was removed due to its size. To see Memorandum
#1, please go to the Adobe PDF version of the report on the TIGTA Public Web
Page.
Appendix VI
Management’s Response to Memorandum #1 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.