Background

Source:  Treasury Inspector General for Tax Administration (TIGTA) sample of Employer Abatement Scheme cases in the FRP inventory.

The screening of potentially frivolous employment tax claims is the primary control against Employer Abatement Schemes.  Control activities should be effective and efficient in accomplishing an agency’s control objectives.  Such significant delays in processing potentially frivolous employment tax claims lessen the effectiveness and efficiency of this control. 

Several factors contributed to this condition:

·        Only one tax examiner in the Frivolous Return Program worked these cases, and he spent only part of his time on this Program.

·        Management had not established timeliness standards for working these cases and did not have a system to determine or monitor the ages of cases in inventory.

·        Many of these cases were not filed or were misfiled.  For example, in stacks of unfiled new receipts, we found 71 cases that had been screened and should have been sent for processing to IRS computers. In those same stacks, we found 79 cases that had been processed and needed letters sent to taxpayers.

·        Before letters were sent to taxpayers, cases were filed in Taxpayer Identification Number order with no consideration given to the dates the cases were received or the amounts of the refunds requested.

As a result, we found taxpayers filing what appeared to be legitimate employment tax claims who were significantly burdened by delays, and others who filed claims that may have been frivolous who could have benefited from the delays.  Please see Appendix IV for examples.

Potentially frivolous claims are not subject to control on the IRS’ Integrated Data Retrieval System (IDRS) until letters are issued to taxpayers; therefore, other IRS employees receiving correspondence or phone calls regarding one of these claims may not know that it is being reviewed by the Frivolous Return Program.  This increases the likelihood that a refund may be inappropriately released, particularly if screening of the claim is significantly delayed.

Recommendations

The Acting Director, Compliance, Small Business/Self-Employed (SB/SE) Division, should ensure that the following actions are taken:

1.      Develop procedures to control cases as they are received in the Frivolous Return Program and to monitor the age of cases in inventory. Consideration should be given to using the IDRS.

Management’s Response:  IRS management currently requires all cases identified as frivolous to be controlled on IDRS.  In addition, they will monitor their inventory for age as a standard operating procedure to ensure case movement and work continuity.

2.      Establish timeliness standards for working cases through each step of the screening process.

Management’s Response:  IRS management now requires potentially frivolous returns to be screened and forwarded for processing within 2 business days if they are determined to be valid claims.  The Internal Revenue Manual will be revised to reflect this new requirement.

3.      Analyze potential Employer Abatement Scheme workloads and determine an appropriate staffing level to allow cases to be worked timely.

Management’s Response:  IRS management increased staffing to address the growth of frivolous claims for refunds and will balance resources to address unanticipated spikes in receipts.

Many Cases Identified As Frivolous Employment Tax Claims Appear to Be Legitimate Claims

Twenty-eight (12 percent) of our sample of 231 claims that were in the Frivolous Return Program’s inventory of frivolous employment tax claims were clearly not frivolous claims. These 28 claims were at various stages of processing in the Frivolous Return Program.  More than half of them had already been screened by an employee in the Program, and either a letter had been sent to the taxpayer questioning the claim or a letter was waiting to be sent.  Most of the 28 claims fell in 1 of the following categories:

·        Taxpayer returns requesting the overpaid taxes be applied to other tax modules rather than be refunded.  In fact, some of these returns requested abatements that resulted in overpayments of nominal sums of money, which the taxpayers asked be applied to other modules.

·        Responses to an IRS notice informing taxpayers that payments had posted to their accounts, but no corresponding returns had posted.  This notice invites taxpayers to file returns requesting refunds of employment tax payments.  (This issue is discussed further later in this report.)

·        Claims for which taxpayers had attached logical explanations for the refunds that were not related to the I.R.C. 861 Position argument in any way.

·        Protective claims related to a pending tax court case regarding employment taxes paid on severance payments made to laid-off employees.

Accurately identifying potentially frivolous returns is key to taking successful compliance action against scheme participants and promoters and minimizing unnecessary burden on taxpayers filing legitimate claims. 

The IRS profiled the returns and other correspondence related to those claims it had identified as being frivolous.  The results of this profiling were provided in an “alert” to employees processing the original and amended employment tax returns.  However, the profile information was so general it could apply to almost any employment tax return claiming no tax owed.  Because the profile did not clearly specify refund returns, tax returns requesting payment transfers to other accounts were identified as potentially frivolous.  Also, the alert did not provide any dollar tolerance for cases to be sent for screening.

At the time of our review, research procedures provided to employees in the Frivolous Return Program were not adequate to determine the legitimacy of a claim.  Subsequent to our review, draft desk procedures were developed.  However, those procedures were still very general.  More specific research steps could better distinguish between an employment tax claim that was potentially frivolous and a completely legitimate claim.  For example, employees could:

·        Review accounts on IRS computers for filing patterns before and after the period of the return in question.  Has the employer been compliant before and after?  Has the employer received refunds from other tax periods?

·        Review information returns filed for employers to determine if they are receiving income from outside sources (indicating the employers are still in business).

·        Review employers’ individual income tax accounts to determine if wages were included as expenses on Profit or Loss From Business (Schedule C) or to determine if an employer or partner paid self-employment taxes on payments mistakenly reported as wages.

Nonspecific procedures and instructions resulted in inconsistent research being performed on these cases.  For example, one tax examiner who worked the Program performed significant research on the IDRS to determine the prior and subsequent filing history of the taxpayer filing an employment tax claim, while another did only limited research before having a taxpayer’s refund frozen and sending correspondence to the taxpayer.

Further, the Frivolous Return Program did not compile program statistics that could be used as feedback to those employee groups referring potentially frivolous cases, and it did not use the feedback provided from the Compliance function regarding those cases that it referred for further review.

As a result, many taxpayers filing legitimate claims had refunds delayed, received unnecessary letters from the IRS questioning the legitimacy of their claim, and may have received unnecessary payment due notices because amounts were not timely transferred to other tax periods as they requested.  Because the letter sent to taxpayers specifically states that their returns “requested a refund of deposits they made for employment taxes,” taxpayers requesting that money be transferred to another account would be confused and frustrated by the IRS’ actions.

Recommendations

The Acting Director, Compliance, SB/SE Division, should ensure that the following actions are taken:

4.      Provide criteria for referring cases to the Frivolous Return Program which are much more specific.  Consider including a dollar tolerance in these criteria.

Management’s Response:  IRS management modified screening criteria based on dollar amounts in May 2003, and is currently developing supplementary criteria.

5.      Develop specific research procedures and criteria to identify truly “frivolous” employment tax claims and to ensure that legitimate claims receive prompt processing, and then update those procedures as experience in this area warrants.

Management’s Response:  IRS management has revised procedural guidelines to improve the accuracy of identifying frivolous claims.  They are also in the process of developing a computer program that will identify them systemically.  Both methods will be updated as new schemes are identified. 

6.      Develop performance measures to evaluate the success of this Program. Methods should be developed for using feedback from field Compliance functions on cases referred for action. Similar feedback should be provided to processing groups referring potentially frivolous claims to the Frivolous Return Program.

Management’s Response:  IRS management plans to develop performance measures and use feedback on cases referred to the program for action.  They currently provide feedback to referring offices.

Proper Responses to an Internal Revenue Service Notice Sometimes Appear to Be Frivolous Claims for Refunds

Six of the 28 cases that were clearly not frivolous employment tax claims had an IRS notice (Computer Paragraph 080) attached to the return.  At least one other had “not liable” written across the front of the return.  Computer Paragraph 080 is a notice issued by the IRS to taxpayers who have made tax payments but have not filed tax returns related to those payments.  The notice reminds taxpayers that they have money posted to their tax accounts but have not filed a tax return.  The notice gives taxpayers several options, one of which states that if taxpayers are not liable for filing a return for the tax period in question and they would like their payments refunded to them, they should write “not liable” across the front of a return, sign and date it, and send it to the IRS.  The notice states that the payments will be refunded to the taxpayers if they owe no other taxes or obligations. 

Because the notice does not ask taxpayers to include an explanation of why they are not liable for employment taxes, a return filed by the taxpayer requesting the refund of previously paid amounts meets the profile the Frivolous Return Program established for potentially frivolous employment tax claims.  Taxpayers responding to one IRS notice exactly as they were instructed to do get a letter asking for a further explanation before their refund request can be granted.  The IRS letter also explains the pitfalls of participating in an Employer Abatement Scheme.

The IRS is in the process of changing Computer Paragraph 080.  The proposed changes will completely eliminate the option discussing what taxpayers should do if they are not liable for filing a return and will add the wording, “You must file a return to claim any refund due you.” However, any employment tax return filed by the taxpayer showing zero tax and claiming a refund of previously paid amounts will most likely result in the return being identified as potentially frivolous.  Therefore, the taxpayer will still receive a second notice from the IRS asking for additional information and implying that the taxpayer may be participating in a scheme.  This increases burden on these taxpayers and will result in taxpayer dissatisfaction with the IRS.

Recommendation

7.      The Acting Director, Compliance, SB/SE Division, and the Director, Customer Account Services, Wage and Investment Division, should work together to develop revisions to Computer Paragraph 080 and/or to Frivolous Return Program screening procedures to ensure that taxpayers responding to one IRS notice do not receive another regarding the same issue which also implies that the taxpayer may be participating in a scheme.

Management’s Response:  IRS management will evaluate the notice for necessary content changes.

Frivolous Employment Tax Claims Could Be Identified by Computer

Potentially frivolous claims for employment tax refunds might be more effectively identified using computers.  After reviewing processing instructions for original Forms 941, we determined that all the information necessary to identify one of these Forms as warranting screening in the Frivolous Return Program was entered into IRS computers.  Therefore, computer programs could be written to identify potentially frivolous claims filed on these Forms before they post to the IRS’ Business Master File. The computer programs would be essentially the same as programs we wrote during a previous audit to identify frivolous claims for reparations credits. 

For this audit, we wrote a computer program to identify potentially frivolous Forms 941c and amended Forms 941.  We identified 6,460 claims processed to the IRS Business Master File for all tax periods in 1997 through 2001 for which employers were claiming refunds of all employment tax payments made totaling $1,000 or more.  Refunds totaling over $61 million had been issued for these 6,460 claims.  We selected a judgmental sample of 100 of these returns and determined that all 100 met Frivolous Return Programs criteria for referral for initial screening, and 17 warranted letters to taxpayers.  The Frivolous Return Program concurred with our determination on these 17 returns. We could not determine if any of the cases identified by our computer run had been screened and released by the Frivolous Return Program.  Most of the cases identified by our computer program were refunded prior to the establishment of the database in the Frivolous Return Program to control potentially frivolous employment tax claims.

The accurate identification of potentially frivolous returns is key to taking successful compliance action against scheme perpetrators and is also key to minimizing unnecessary burden on taxpayers filing legitimate claims.  As mentioned earlier, the IRS relies on employees who process original and amended employment tax returns to manually identify frivolous claims.  As a result, legitimate claims may be delayed and frivolous claims may be missed.

Recommendation

8.      The Acting Director, Compliance, SB/SE Division, should consider using computer programming to identify both original and amended employment tax returns that may be part of Employer Abatement Schemes.

Management’s Response:  IRS management has begun the process of developing a computer program to more easily identify frivolous claims.  This program is scheduled for implementation in January 2004.  They are also pursuing an external contract that will improve the identification of frivolous claims by using advanced computer techniques.

Appendix I

Detailed Objective, Scope, and Methodology

The objective of the review was to determine whether the Internal Revenue Service (IRS) has controls in place to identify and stop frivolous claims for refunds of previously paid employment taxes.  To accomplish our objective, we:

I.                    Identified the controls the IRS has implemented to ensure frivolous refund claims for employment taxes are identified and stopped from refunding.

A.     Determined the filing criteria the IRS has set for businesses wanting to obtain refunds of prior employment tax deposits.

B.     Reviewed the Internal Revenue Manual and training manuals that outline the proper processing procedures for these claims and determined the controls in place to identify frivolous claims.

C.     Interviewed management personnel responsible for processing refund claims and determined methods in place for identifying and disallowing the frivolous claims.  This included determining statistics maintained to evaluate the Frivolous Return Program and enforcement actions available to the IRS.

D.     Reviewed a judgmental sample of 231 employment tax claims from a total of 2,255 that were in the Frivolous Return Program’s inventory at various stages in the screening process as of January 2003 (the sample was chosen by selecting the first case at random then choosing every n^th one).  The claims were reviewed to determine the types of cases within the inventory and the age of the inventory.

II.                 Tested and evaluated the controls the IRS has in place to identify frivolous claims for refunds of previously deposited employment taxes and determined whether current controls are effective or whether additional controls are needed.

A.     Using a computer program, identified business taxpayers that filed amended returns requesting refunds of prior employment tax deposits.  The computer program identified 6,460 returns claiming refunds of at least $1,000 from 1997 through 2001.  We tested the computer data to ensure it met our criteria.

B.     Reviewed and analyzed a judgmental sample of 100 returns identified by the computer program as claiming refunds of prior employment tax deposits (to pull the sample, we used a computer program which randomly selected each case).  The returns were reviewed and analyzed to determine whether they met frivolous return criteria and whether they were processed appropriately.

C.     Determined whether computer programs could be written to identify potentially frivolous claims before they post to the IRS’ Business Master File.

Appendix II

Major Contributors to This Report

Parker Pearson, Director

Richard J. Dagliolo, Director

Kyle R. Andersen, Audit Manager

Scott D. Critchlow, Senior Auditor

Bill R. Russell, Senior Auditor

James E. Adkisson, Computer Specialist

Appendix III

Report Distribution List

Commissioner  N:C

Deputy Commissioner for Services and Enforcement N:SE

Acting Deputy Commissioner, Small Business/Self-Employed Division  S

Deputy Commissioner, Wage and Investment Division W

Staff Assistant, Small Business/Self-Employed Division  S

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

Director, Customer Account Services, Wage and Investment Division  W:CAS

Chief Counsel  CC

National Taxpayer Advocate  TA

Director, Office of 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 Liaisons:

            Commissioner, Small Business/Self-Employed Division  S

            Commissioner, Wage and Investment Division  W

Appendix IV

Case Examples

During the audit, we found taxpayers filing what appeared to be legitimate employment tax claims who were significantly burdened by delays, and others who filed claims that may have been frivolous who could have benefited from the delays.  Examples are provided below.

Case Example #1

A taxpayer filed an original Employer’s Quarterly Federal Tax Return (Form 941) in May 2001 claiming no wages and asking for the employment tax payments made (which totaled less than $300) to be applied to a subsequent tax return.  The return was mistakenly identified as a potential Employer Abatement Scheme case and received in the Frivolous Return Program that same month.  The Internal Revenue Service (IRS) sent the taxpayer a letter 1 year after receipt in the Frivolous Return Program asking for an explanation of why the return (1) reflected no wages and (2) requested a refund of the deposits made for employment taxes (however, the return did not actually request a refund).  The letter also implied that the taxpayer might be participating in an Employer Abatement Scheme.  One month later, the taxpayer responded with a valid explanation for the claim.  At the end of September 2002, the taxpayer finally received a refund, but the Frivolous Return Program did not seem to be aware of it since it was part of the Program’s open inventory as of January 2003.

Case Example #2

A taxpayer filed a Form 941 in January 2002.  Attached to the Form was a note explaining that the same Form had been originally sent in October 2001 but apparently had not been received by the IRS.  The Form 941 met the general criteria for an Employer Abatement Scheme and was routed to the Frivolous Return Program.  The return was screened and identified as a potentially frivolous claim, and the taxpayer’s refund was frozen.  However, no subsequent action was taken on the case. As of January 2003 (1 year after the taxpayer filed the second claim), no letter had been sent to the taxpayer. In the meantime, the taxpayer received a refund in May 2002.  Had this case been an Employer Abatement Scheme case, the delays in taking action would have allowed an erroneous refund to be issued.

Appendix V

Management’s Response to the Draft Report

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.