Tax Returns With the Potential for Unreported Income Are Being Identified, but Some Challenges Still Exist With the Program
Reference Number: 2003-30-146
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.
2c = Law Enforcement
July 17, 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 Ė Tax Returns With the Potential for Unreported Income Are Being Identified, but Some Challenges Still Exist With the Program (Audit # 200230048)
This report presents the results of our review of the Unreported Income Discriminant Index Function (UI DIF) Program.† The overall objective of this review was to determine if the Internal Revenue Serviceís (IRS) UI DIF Program effectively identifies tax returns with unreported income for examination.
In May 2001, the Small Business/Self-Employed (SB/SE) Division initiated an in-depth effort to reengineer its examination processes, products, and services.† One of the recommendations of the reengineering team was the testing of the UI DIF.† The UI DIF Program was developed to identify the potential for unreported income on tax returns of individuals.
In summary, the SB/SE Division has been actively involved in implementing, reviewing, and making changes to improve the quality and productivity of the UI DIF Program.† The UI DIF Program has the potential to better identify tax returns with unreported income. However, we identified four areas where opportunities exist to further improve the Program.
The first area is that the UI DIF scoring technique may not reflect current income reporting practices of taxpayers.† The technique was developed using information captured from examinations of Tax Year 1988 tax returns.† The ways that small business taxpayers report income have changed since 1988.† The second area is that the criteria used for Fiscal Year 2003 to identify tax returns for potential UI DIF examinations did not place sufficient emphasis on individuals with businesses reporting high gross receipts. The third area is that examiners did not always perform adequate probes for unreported income when examining returns. Finally, the true impact of the Program will be difficult to capture because of the nature of UI DIF examinations. When tax returns report business losses, adjustments may not have a tax effect on the return being examined but could have important tax effect on other years.
We recommended that the SB/SE Divisionís Examination function management continue with their plans to update the UI DIF scoring technique, and consider modifying the identification criteria to place additional emphasis on tax returns of individuals with businesses that have total gross receipt of ****2c****.† Management should also continue with current efforts to improve the quality of examinations and consider using the Examination Information Report process to better measure future compliance.
Managementís Response:† The Commissioner, SB/SE Division, agreed with our analysis of the UI DIF process and with the recommendations.† The SB/SE Division plans to update the UI DIF formula based on the National Research Program results, and issue written instructions and revise the new automatic case selection process to emphasize selection of tax returns of individuals with business gross receipts of ****2c****.† In-process reviews of UI DIF cases will continue.† Also, training on techniques used on UI DIF cases will continue, and new training will be developed.† In addition, the SB/SE Division plans to explore ways to capture adjustments and deductions as indicators of success in examining these returns.† Managementís complete response to the draft report is included as Appendix V.
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 Richard J. Dagliolo, Director (Submission Processing), at (631) 654‑6028.
The Internal Revenue Service (IRS) estimates that the tax gap (i.e., the difference between the amount of tax owed and the amount of tax voluntary paid) due to underreporting of income for individuals is $119 billion annually.† The largest single contributor to the tax gap is unreported income by sole proprietors, estimated at $60 billion annually.†
Having an effective compliance program to examine the accuracy of tax returns is one method that the IRS uses to help reduce that gap.† In May 2001, the Small Business/ Self-Employed (SB/SE) Division initiated an in-depth effort to reengineer its examination processes, products, and services. One of the recommendations of the reengineering team to address the tax gap was the testing of the Unreported Income Discriminant Index Function (UI DIF).
The UI DIF methodology was designed based on the same principles as the scoring technique for the Discriminant Index Function (DIF) process, which is the automated system historically used for identifying tax returns for examination.† The DIF is a scoring technique designed to identify tax returns for examination that should have a high potential for tax change. The UI DIF score, on the other hand, indicates the potential that unreported income exists on a tax return, whether or not an adjustment would result in a tax change.† In both methods, the higher the score, the greater the potential for examination.
The SB/SE Division tested the UI DIF scoring technique by having experienced examiners review tax returns scored by the technique and other data related to the tax return to determine if their assessment of examination potential agreed with the potential indicated by the numeric score.† Testing is continuing by having field examiners perform examinations on the tax returns.† About one‑third of these pilot examinations were still in the examination process as of March 2003.† The initial report summarizing the results of these pilot examinations once they are closed is scheduled for release in July 2003.
The SB/SE Divisionís Examination function included UI DIF examinations in their business plan for Fiscal Year (FY) 2003.† The plan included completing examinations on 1,837 tax returns during FY 2003 and tentatively increasing the number to 11,797 in FY 2004.† This accounts for approximately 3 percent of the staff resources applied to examinations in FY 2003 and 7 percent in FY 2004.† However, it appears that the actual closures for FY 2003 will exceed the plan based on the number of UI DIF identified examinations in process at the end of the second quarter of the fiscal year.
We initiated this review as part of our continuing involvement in reengineering efforts as requested by the Commissioner, SB/SE Division.† We performed work in the SB/SE Division Headquarters in New Carrollton, Maryland; the SB/SE Division Research functionís office in Denver, Colorado; the Raleigh, North Carolina IRS office; and the San Francisco, Modesto, and El Monte, California IRS offices.† Our review was performed between September 2002 and April 2003 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.
Our observations and testing conducted by the SB/SE Divisionís Research function show that the UI DIF scoring techniques do identify tax returns that appear to have the potential for unreported income.† This was especially true for tax returns filed by individuals with business and farm entities reporting high gross receipts.
The scoring technique helps ensure that taxpayers are treated fairly and equitably.† All U.S. Individual Income Tax Returns (Form 1040) within the categories of tax returns for which the UI DIF formula has been developed receive a score.† The score is based on information included on various lines of the tax return.
The SB/SE Division is monitoring the UI DIF Program and identifying improvement opportunities. These opportunities include addressing improvements needed in the examination techniques and the overall quality of the examinations.† Many of the specific monitoring action items for the UI DIF Program are currently scheduled to continue until late in FY 2004.
Some actions being taken to monitor and improve the UI DIF Program include:
∑ Performing case reviews of UI DIF examinations to determine if the scoring technique is effective, the examination techniques are appropriate, and the income probes are adequate.
∑ Conducting refresher training for managers and examiners on topics related to income probes.
∑ Assigning responsibility, through action items, to monitor and improve the UI DIF Program to various SB/SE Division executives.
The first report from the review of open UI DIF examinations contained recommendations that are in various stages of implementation.† The recommendations included:
∑ Issuing a memorandum and updating the Internal Revenue Manual (IRM) to reemphasize examination techniques for conducting income probes.
∑ Defining the need for managerial involvement with the examiner at critical points during the examination process.
∑ Continuing to give attention to leveling group size, providing managers with a span of control that allows them to become involved with the examinersí workloads.
The SB/SE Division has also released internal and external communications about the new Examination function priorities, including the UI DIF Program.
Continued efforts in these areas should help the SB/SE Division improve, as well as address some concerns relating to the UI DIF Program.† SB/SE Division personnel working with the UI DIF Program share some of the same concerns that we mention in this report and are taking actions noted to address the concerns.
As mentioned above, efforts are currently underway to monitor and improve the UI DIF Program. This on‑line monitoring of the UI DIF Program provides an excellent opportunity for the SB/SE Division to gather and analyze data for use in reducing risks identified with the Program. This will help the SB/SE Divisionís Examination function further its efforts in promoting voluntary compliance by providing additional information and program effectiveness data to use in making UI DIF Program decisions.
While the UI DIF Program has the potential to better identify tax returns with unreported income, we identified four areas where opportunities exist to further improve the Program.† Some of the areas are already being addressed, at least in part, by actions of the SB/SE Division.
Data used to develop the scoring technique are not current
The UI DIF scoring technique may not be as effective as possible at identifying unreported income issues because current income reporting practices of taxpayers might not be reflected in the formulas.† This could hinder the effectiveness of the Examination function in carrying out its responsibility of promoting voluntary compliance by selecting tax returns most in need of examination.
The scoring technique was developed based on data accumulated from the most recent Taxpayer Compliance Measurement Program (TCMP).† That data was captured from examinations of Tax Year 1988 tax returns.† However, the ways that small business taxpayers report income have changed since 1988.† For example, the number of partnership tax returns filed has increased by 27 percent since that time, and small business corporate tax returns filed have increased by 239 percent.† Income and losses from these types of tax returns flow through to individuals and should be included on their Forms 1040.
The compliance data obtained from the TCMP are currently being updated through a revised process, called the National Research Program (NRP).† The SB/SE Division plans to revise the UI DIF formulas using the NRP data.
The criteria used for selecting UI DIF workload do not adequately emphasize high-income taxpayers
Increasing the number of examinations of higher income taxpayers is a current goal for the SB/SE Divisionís Examination function.† However, tax returns with activity codes indicating gross receipts of ****2c**** received essentially the same priority as returns with lower gross receipts.† (Appendix IV describes the five activity codes included in the UI DIF process.)
To a large extent, this occurred because tax returns from many of the other various examination workload priorities were not available for examination during the first quarter of FY 2003.† Therefore, the main source of returns for the field Examination function was those identified through the UI DIF Program, and there was not a sufficient workload available in the ****2c**** category in every territory office.
One SB/SE Division executive indicated that the FY 2004 UI DIF workload priority would probably more heavily emphasize examinations of Activity Codes ****2c**** and ****2c**** tax returns (****2c****).
Initial UI DIF examination results show that the tax adjustment amounts are higher for Activity Code ****2c**** tax returns than other categories of tax returns.† If the productivity rates for the initial UI DIF examinations continue, the examination of these returns could help improve tax compliance and better reduce the tax gap.† In addition, tax returns with larger gross receipt amounts might be considered more challenging and rewarding by examiners, which could help improve examination quality and productivity.
The search for unreported income was not adequate on some examinations
The IRM requires that an examination of gross income on a business return include an analysis to determine if reported income is sufficient to support the taxpayerís financial activities.† We reviewed 80 closed pilot UI DIF examinations and determined that the examinerís probe to identify unreported income was not adequate in 9 cases.† The amount of income reported on the nine tax returns was not sufficient to pay business and living expenses, or the examiner did not address questionable income related issues.† These cases were closed without an adjustment to income or expenses.
The SB/SE Divisionís review of open UI DIF examinations also identified issues relating to the quality of some UI DIF examinations.† The report showed that the examiners were not always preparing a preliminary cash transaction account, or reconciling the tax return to the taxpayerís books and records.† These are two fundamental steps that should be completed when trying to identify unreported income during an examination.
Several factors could cause examiners to be reluctant to conduct income probes.† First, the IRS Restructuring and Reform Act of 1998 (RRA 98) added a requirement to determine that there is a reasonable indication that unreported income exists before examiners can use financial status or economic reality examination techniques.† In addition, taxpayers can file claims that an employee is harassing them.† An employee violation could lead to reprimand, disciplinary action, or removal.††
Further evidence of this issue can be found in a recently issued General Accounting Office (GAO) report containing results of its survey of compliance employees on the impact of some RRA 98 provisions. Some employees responded that the RRA 98 decreased the likelihood that they would assess a taxpayerís liability or contact third parties.† Third-party contacts can be a source of information when searching for the existence of unreported income.
Another factor that could affect the depth of the income probe could be the long held Examination function expectation that examinations should result in an increase in tax. Many of the UI DIF identified tax returns have a business or farm that shows a loss.† An examination could result in lowering the loss on the return but have no effect on the tax for that year.† However, losses can be carried to other years and affect the tax on those years, so it is important that these losses be examined.
Changing attitudes and perspectives is difficult, especially in a large and wide‑spread organization like the SB/SE Divisionís Examination function.† However, the SB/SE Division has been working towards addressing these concerns by issuing memoranda about UI DIF and Examination function priority workload, updating and emphasizing instructions for using income probe techniques, and conducting training on issues relating to income probes. Continuing these efforts should help effect the change needed to improve the quality and depth of the income probes.
The true impact of the UI DIF Program will be difficult to capture
Some productivity measures for the Examination function are based on tax adjustment amounts and hours spent on examinations.† These do not capture the true impact of the UI DIF Program because of the nature of UI DIF examinations.† Various SB/SE Division managers working with the Program agree with this concern, but are frustrated with trying to develop measures that would be more effective. Data from the analysis of performance measures and indicators are needed when comparing various programs and making program-related decisions.
As noted in the preceding section, UI DIF examinations may not result in an increase in tax on the tax return being examined.† In addition, these are more complex examinations that require substantial staff hours to perform, especially when in‑depth income probes are necessary. Combining the impact of these issues might produce results that would not appear as effective as those of other programs based on the measures currently in place, such as dollars assessed per return.† In addition, the primary benefit of improving future compliance is not captured in the short term.
One source of information about future compliance by taxpayers that were the subject of UI DIF examinations could be the Examination Information Report (Form 5346) process. While we did not review the process, if used as provided for in the IRM it could be a source of information about future compliance on UI DIF Program examinations.
The Chief, Centralized Workload Selection and Delivery, SB/SE Division, should:
1. Continue with current plans to update the UI DIF scoring technique after more current compliance information is obtained through the NRP.
Managementís Response:† SB/SE Division management plans to update the UI DIF formula based on NRP results.
2. Consider adjusting the UI DIF selection plan to concentrate on examinations of tax returns of individuals with total gross receipts ****2c**** (Activity Codes ****2c**** and ****2c****).
Managementís Response:† SB/SE Division management will issue new written instructions to the field on assignment of strategic priority UI DIF cases.† The SB/SE Division is revising the new automatic case selection process by activity code and UI DIF score.† The FY 2004 Work Plan will emphasize examinations of Activity Code ****2c**** and ****2c**** UI DIF returns.
3. Continue with current efforts to conduct reviews of the UI DIF Program and provide training that reinforces appropriate use of income probe techniques.
Managementís Response:† SB/SE Division management stated it would develop and issue summary reports as part of its UI DIF Area reviews conducted during March, April, and May.† In-process UI DIF case reviews were scheduled to be conducted throughout the nation starting in June 2003.† Training will be scheduled for July 2003 to address delay tactics, procrastination, investigative techniques, and Income Probe methodology.† In addition, Toolkit training for managers will continue to be rolled out, and Toolkit training for Examiners will be developed.† The IRM section on Income Probes is also being revised to stress key required actions.
4. Consider capturing future compliance data from the Form 5346 process for UI DIF examinations and continue efforts to identify other means of capturing UI DIF Program effectiveness.
Managementís Response:† SB/SE Division management plans to explore ways to capture unreported income adjustments to taxable income reported, and net operating loss adjustments and deductions as indicators of success in examining these returns.
The overall objective of this review was to determine if the Internal Revenue Serviceís (IRS) Unreported Income Discriminant Index Function (UI DIF) Program effectively identifies tax returns with unreported income for examination.† To accomplish our objective, we:
I. Determined if the UI DIF scoring technique provides for fair and equitable treatment of taxpayers.
A. Obtained and analyzed the programming routine for the UI DIF score.
B. Discussed the theory behind the Program with programmers that developed the concept and effect that the National Research Program (NRP) results would have on the formulas.
II. Determined if UI DIF testing accurately portrayed examination techniques and the effect when the concept was implemented.
A. Discussed UI DIF testing and pilot project management with Small Business/Self-Employed (SB/SE) Division personnel.
B. Reviewed the test process used during the classification testing of UI DIF returns.
C. Obtained and analyzed reports of UI DIF studies.
D. Discussed the current status of UI DIF testing and the potential recommendations resulting from the testing.
E. Reviewed the effect of the UI DIF Program in the Examination Plan.
III. Determined how the Examination function assessed the pilot results.
A. Reviewed the database used to capture pilot examination results and discussed how the results would be analyzed.
B. Reviewed the results of the UI DIF formula tests.
C. Reviewed a judgmental sample of 80 pilot examinations closed as of December 2002 to assess the UI DIF examination results and the potential for unreported income on the tax returns.† The sample was taken from closed cases for which the SB/SE Division Research functionís office in Denver, Colorado, had received copies of examination workpapers.† The sample included cases from all activity codes (see Appendix IV for definitions of examination activity codes) and types of closing codes.† The judgmental sample method was used because this was an ongoing pilot and only a small portion of the pilot cases were closed.
D. Analyzed the results of the pilot examinations by examination issue and activity code of the tax return.
E. Discussed the effect of UI DIF examinations with three Revenue Agents and the group manager in each of four examination groups (three area offices), with Planning and Special Programs (PSP) personnel located in one area office, and with the West Territory PSP Manager.
IV. Determined the effect on the public of conducting UI DIF examinations and how the IRS addressed the issue.
A. Reviewed publicity released by the IRS about UI DIF examinations.
B. Discussed how SB/SE Division addressed the potential for dealing with uncooperative taxpayers during UI DIF examinations.
C. Reviewed the length of time being spent on UI DIF examinations compared to Discriminant Index Function (DIF) examinations.
D. Discussed plans for including the UI DIF score in routine processing and the effect of including both the DIF and UI DIF scores on tax returns of individuals.
Richard J. Dagliolo, Director
Parker F. Pearson, Director
Amy L. Coleman, Audit Manager
Philip A. Smith, Senior Auditor
Joseph P. Snyder, Senior Auditor
Deputy Commissioner for Services and Enforcement† N:SE
Acting Deputy Commissioner, Small Business/Self-Employed Division† S
Director, Compliance, Small Business/Self-Employed Division† S:C
Director, Compliance Policy, Small Business/Self-Employed Division† S:C:CP
Director, Reporting Compliance, Small Business/Self-Employed Division S:C:CP:RC
Chief, Centralized Workload Selection and Delivery, Small Business/Self-Employed
Director, Office of Research, Analysis and Statistics† N:ADC:R
Director, Office of Research† N:ADC:R:R
Director, Strategy, Research and Performance Management, Small Business/Self-
Employed Division† S:SF:S:R:R
Director, Research, SRPM, Small Business/Self-Employed Division† S:SF:S:R:R
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:C:CP:I
Activity Code Definition
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.