The Process for Notifying Taxpayers Regarding Their
Elections to File As Small Business Corporations Should Be Improved
September 2003
Reference Number:
2003-30-197
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
26, 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 Process for Notifying Taxpayers Regarding
Their Elections to File As Small Business Corporations Should Be Improved (Audit
# 200330002)
This report presents the results of our review of the process for notifying taxpayers regarding their elections to file as small business corporations. The audit was performed to provide information regarding the effectiveness of the election notification process and to contribute additional information to the Internal Revenue Service (IRS) task force that is working on related issues.
In summary, more needs to be
done to improve the IRS election notification process:
§
The IRS has no
assurance that taxpayers are being notified whether their elections were
accepted or denied.
§
The IRS is not fully
educating first-time filers of small business corporate returns on how to
comply with tax laws and obtain available relief.
§
The IRS’ ability to
resolve unprocessable small business corporate returns is inhibited by a new
processing procedure.
As a result, the IRS cannot
reasonably ensure that approximately 604,000 taxpayers (over a 5-year period)
have been notified of the acceptance or denial of their elections. Unclear instructions regarding the filing of
elections and related relief provisions may prevent taxpayers from making
elections and obtaining the tax benefits of filing a small business corporate
return.
Accordingly, we recommended
that the Director, Customer Account Services, Small Business/Self-Employed
Division, improve controls and revise procedures to ensure that all taxpayers
who submit elections are notified as to the status of their elections. We also recommended that notification
letters be clarified and instructions improved to better inform taxpayers that
their elections were acknowledged, accepted, denied, or revoked and to provide
clear instructions regarding compliance with IRS tax laws and relief provisions
relating to elections. Finally, we
recommended that the Director revise procedures to allow taxpayers time to
respond to letters requesting information needed for processing elections.
Management’s Response:
Management’s response was due on September 22, 2003. As of September 24, 2003, management had not
responded to the draft report.
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 Parker F. Pearson, Director (Small
Business Compliance), at (410) 962-9637.
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Outcome Measures
Appendix V – Relief Provisions Cited on Instructions for Form 2553 (Revision December
2002)
Business entities that wish the Internal Revenue Service (IRS) to consider them small business corporations so they can file a United States (U.S.) Income Tax Return for an S Corporation (Form 1120S) must first file an Election by a Small Business Corporation (Form 2553). The IRS evaluates the election and notifies the taxpayer either that it has been accepted and when it will take effect, or that it has been denied. The IRS’ Cincinnati, Ohio, and Ogden, Utah, Campuses are responsible for processing elections and notifying taxpayers of their acceptance or denial.
The major advantages of filing as a small business corporation are, generally, that the small business pays no corporate tax and that profits or losses are passed through to the shareholders to be reported on their individual income tax returns. In contrast, a regular corporation that files a U.S. Corporation Income Tax Return (Form 1120) pays corporate tax on its profits, and its shareholders cannot claim corporate losses on their individual returns. According to the IRS, S Corporations (also known as small business corporations) currently represent more than one-half of all corporate entities filing tax returns.
In a recent Treasury Inspector General for Tax Administration report, we indicated that the election notification process may be one of the factors that is hampering first-time filers from filing their Forms 1120S. The IRS’ response to the report included the formation of a multifunctional task force that is in the process of initiating many actions to address the findings.
We conducted this review to provide information regarding the effectiveness of the election notification process and to contribute additional information to the IRS task force that is working on related issues. We performed the audit at the Brookhaven IRS Campus from February through June 2003. Our audit work included a review of transactions for the Cincinnati and Ogden IRS Campuses and discussions with staff from the offices of Compliance Services and Customer Account Services, Small Business/Self-Employed (SB/SE) Division, in New Carrollton, Maryland. The audit was conducted 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.
Currently, the IRS cannot ensure that all taxpayers who submit elections to file Form 1120S are notified of the acceptance or denial of their elections. This primarily occurs because:
·
The IRS does
not currently maintain records that show all small business taxpayers
who submit elections and the specific notifications that are sent to these
taxpayers to inform them that their elections have been accepted or denied, or
that the IRS needs additional information.
·
Information
relating to taxpayer notification is not always maintained as a permanent
record.
The time period between submitting an election and filing the initial Form 1120S can be greater than 1 year. This time gap is a key reason why there is a need for a permanent record of notices and letters. A permanent record would enable the IRS to effectively ensure that it is notifying taxpayers of the status of their elections.
Recordkeeping issues that need to be addressed
· The IRS records only the volume of elections received and notices/letters sent each week and does not identify specific taxpayers.
· It is difficult to determine whether the letters pertain to Form 1120S election issues because the letters are used for multiple purposes. For example, Form 8832, Entity Classification Election Accepted or S Corporation Election (F2553) Acknowledged/Accepted (Letter 385 C, referred to as 385 C letter) is used for Form 1120S as well as the unrelated Entity Classification Election (Form 8832).
· Information about notices and letters issued regarding the acceptance or denial of elections is not always available because it is maintained only a short time and then dropped from the IRS online computer system.
The General Accounting Office’s Standards for Internal Controls in the Federal Government state that internal controls and all transactions need to be clearly documented and the documentation should be readily available for examination. All documentation and records should be properly managed and maintained.
Because the current record keeping system is not adequate, the IRS cannot reasonably ensure that approximately 604,000 taxpayers, over a 5-year period, have been notified regarding the acceptance or denial of their elections. There is an increased risk that taxpayers will continue to file Forms 1120S without accepted elections. Also, taxpayers will be burdened with additional and unnecessary correspondence to substantiate accepted elections because the IRS requests them to send copies of acceptance letters that should be a part of the IRS records.
The Director, Customer Account Services, SB/SE Division, should:
1. Revise the Internal Revenue Manual (IRM) to be more specific as to the controls over elections received by the IRS and the required record keeping to ensure that all taxpayers who submit elections are notified of the status of their elections. A management information system should be developed to enable the IRS to have a permanent record of all taxpayers who submitted elections and the specific types of notification sent to them regarding the status of their elections.
Management’s Response: Management’s response was due on September 22, 2003. As of September 24, 2003, management had not responded to the draft report.
2. Revise the format of the various letters related to elections to be more specific and to limit their use. Letters should be created solely for Forms 2553, and additional letters should be created specifically for Forms 8832. Also, separate letters should be created to inform taxpayers if their elections were acknowledged, accepted, denied, or revoked.
Part of the SB/SE Division’s mission is to educate and inform small business taxpayers and their representatives about their tax obligations and to develop educational products and services to help these taxpayers understand and comply with tax laws.
Based on our review of the IRS tax returns and
instructions, we determined that the IRS is not fully educating first-time
filers of small business corporate returns regarding compliance with the tax
laws and relief provisions for elections.
Specifically, we found that:
· Instructions to taxpayers for both Forms 1120S and 2553 do not clearly provide guidance on how to file their initial Forms 1120S when the IRS did not notify them that their elections had been granted. Also, there were no instructions on how shareholders should proceed with the filing of their related U.S. Individual Income Tax Returns (Form 1040).
· Instructions for Forms 1120S and 2553 do not clearly indicate that taxpayers should have evidence of IRS notification that their elections were accepted before filing their Forms 1120S. Instead, if they were not notified, taxpayers are left to decide whether their elections were granted.
·
IRS instructions provide no guidance regarding the
acceptable proof of filing for elections that were faxed to the IRS. Current instructions for Form 2553 provide
for faxing the form to the Cincinnati or Ogden IRS Campus. However, no mention is made of the proof needed
to substantiate that faxed elections were timely made.
·
Form 2553 election instructions do not contain clear and concise
information about relief provisions.
These instructions contain the references “Rev. Proc. 2002-1, 2002-1
I.R.B. 1 (or its successor),” and “Rev. Proc. 98-55” without explaining their
content. Also, the instructions cite
user fees without providing dollar amounts and instruct taxpayers to obtain Regulations
1.1362-6(b)(3)(iii) (how to obtain relief for an inadvertent invalid election
when shareholders did not file timely consents). The instructions are confusing, contain jargon, and do not
provide information that is easy for taxpayers to understand to obtain needed
relief. See Appendix V for the complete
relief instructions.
·
Letters sent to taxpayers when there was no record of
an election do not always contain the necessary information about the
shareholders’ need to file amended individual income tax returns. A review of available Form 8832, Entity
Classification Election Rejection/Denial, or S Corporation Return Incomplete
for Processing: Form 1120S (Letter 429 C, referred to as 429 C letter) sent to
taxpayers showed that in 36.6 percent of the cases, small business taxpayers
were not informed that shareholders should file amended individual returns when
they reported Form 1120S gains or losses, and they did not have timely
elections filed. These cases involve
gains reported in the amount of $2.3 million and losses of approximately
$32,000.
Unclear instructions regarding the filing of elections and related relief provisions can result in:
· Taxpayers filing small business tax returns without timely filed elections.
· Taxpayers being prevented from substantiating that a faxed election was timely made.
· Taxpayers not obtaining relief to which they may be entitled.
· Potential double taxation on gains if small business taxpayers, without filed elections, are not informed of the need to have shareholders file amended individual income tax returns when gains were reported on their unprocessable Forms 1120S.
The Director, Customer Account
Services, SB/SE Division, should:
3.
Provide specific instructions to taxpayers regarding
the steps to take if they were not notified that their elections were accepted
or rejected.
4.
Determine the acceptable level of proof to substantiate
timely faxed elections. The Director
should also develop instructions for taxpayers and revise IRM instructions to
describe the acceptable level of proof for timely faxed elections.
5. Eliminate jargon and clarify instructions for Forms 2553 and 1120S regarding how to obtain needed relief.
6. Revise procedures to ensure that the shareholders’ responsibility for filing amended individual income tax returns is printed on the 429 C letter.
The 429 C letter requests that taxpayers provide additional information to enable the IRS to process Forms 1120S. The taxpayers generally are asked to provide this information within 30 days from the date of the letter.
Instead of waiting the 30 days for the taxpayers to reply to the initial correspondence, the IRS revised its procedures to treat these unprocessable returns as though no reply will be received and began to convert the originally filed Forms 1120S to Forms 1120. As a result of this revision, there is an increased risk that the IRS will lose control of the taxpayers’ replies or will ignore taxpayers’ requests to resolve unprocessable Forms 1120S.
The IRS explained the revision to the procedures as follows:
These procedures allow the unpostable tax returns to be sent to the
rejects section prior to the normal suspense time. Historically, only 25 percent of the taxpayers ever respond to
the Service’s [IRS’] correspondence.
The amount of time required to process these unpostable tax returns to
the rejects section approximates the amount of time given to taxpayers to
respond to the Service’s correspondence.
Taxpayers are not harmed by these deviations.
These revisions appear questionable and potentially harmful to taxpayers because:
· Taxpayers were not given sufficient time to respond to the 429 C letters. In a limited test of 30 cases, we found that, in 17 cases, the IRS converted the unprocessable Form 1120S to a Form 1120 before the taxpayer could reply with verification of a timely filed election. In these 17 cases, 8 were converted before the IRS sent the 429 C letter and 9 were converted within 14 days of the letter being sent. The 429 C letter generally indicates that taxpayers have 30 days to reply.
· In some cases, there was no indication of a tax return being processed. In 8 (3.7 percent) of the 215 cases reviewed, there was no record of any tax return in the intended tax period, even though there were instructions to renumber the Forms 1120S filed by the taxpayers.
· The IRS task force is considering including information regarding relief provisions in the 429 C letter, which may increase the response rate.
· Lost returns and taxpayer information can cause additional IRS/taxpayer correspondence and embarrassment to the IRS. Not associating taxpayers’ replies could also impede resolution of the unpostable condition and prevent relief to these taxpayers.
The Director, Customer Account Services, SB/SE Division, should:
7.
Revise the IRM and reinstate suspense procedures to
allow time for taxpayers to respond to 429 C letters.
Appendix I
Detailed Objective, Scope,
and Methodology
The overall objective was to evaluate the Internal Revenue Service (IRS) notification process for taxpayers who filed elections to be treated as small business corporations. To accomplish this objective, we:
I.
Identified problems and trends in the notification
process for the filing of Elections by a Small Business Corporation (Form
2553).
A.
Analyzed
statistics for 5 consecutive calendar years (1998 - 2002). We analyzed the volume of Forms 2553 filed,
the volume of notices sent to taxpayers, the volume of United States (U.S.)
Income Tax Returns for an S Corporation (Form 1120S) that could not be
processed to the IRS computerized records of tax accounts (unpostables), and
the volume of letters related to the acceptance and rejection of elections.
B.
Determined
whether any problems and solutions were identified by the National Taxpayer
Advocate concerning the election notification process.
C.
Reviewed
the legal requirements for filing Forms 2553 and 1120S. We reviewed instructions to taxpayers for
filing elections to determine whether instructions were clear, complete, and
easy to understand.
II. Determined whether policies and procedures were established to ensure that the IRS notified small business taxpayers that their elections were accepted or rejected.
A. Reviewed IRS written instructions to determine the required procedures in the election notification process.
B. Held discussions with national and local management officials regarding any actions taken or contemplated by the task force, accounting for Form 2553 elections, the types of notification, and any IRS procedural changes that affected the election notification process.
III. Determined whether required letters were sent to taxpayers to notify them that the IRS had no record of an election on file and could not process their initial Forms 1120S.
A. Selected and reviewed a statistical sample of 215 taxpayer accounts to determine if the IRS notified the taxpayers that their returns could not be processed. We used attribute sampling at a 95 percent confidence level and an expected error rate not over 10 percent, with a precision level of +/- 4 percent. We used a computer extract to determine the volume (71,931) of unprocessable small business corporate returns (Unpostable Code 310 with Reason Codes 2, 4, 5, and 6, which relate primarily to Forms 1120S) that were resolved with an Unpostable Resolution Code 8 (URC) for Calendar Year 2002. We then identified the 49,999 returns for tax period 2001 that were worked by the Cincinnati, Ohio, and Ogden, Utah, IRS Campuses. We used the 49,999 population to select the statistically valid sample of 215 cases.
B.
Reviewed IRS records for each of the 215 cases in our
sample to determine whether the required Form 8832, Entity Classification
Election Rejection/Denial, or S Corporation Return Incomplete for Processing:
Form 1120S (Letter 429 C, referred to as 429 C letter) was sent to taxpayers
when required, prescribed procedures ensured that taxpayers were allowed
sufficient time to respond to the 429 C letters, Forms 1120S were processed to
accounts, and notices were sent to taxpayers.
C. Analyzed information gathered to determine if there were any trends or patterns to indicate that the IRS needed to provide clearer instructions to taxpayers to facilitate the filing of their initial Forms 1120S.
Appendix II
Major Contributors to This Report
Parker F. Pearson, Director (Small Business
Compliance)
Richard J. Dagliolo, Director
Kyle R. Andersen, Acting Director
Robert K. Irish, Audit Manager
John J. Chiappino, Acting Audit Manager
Bernard F. Kelly, Senior Auditor
Michael
D. Luongo, Senior Auditor
Philip Peyser, Senior
Auditor
Appendix III
Commissioner C
Deputy Commissioner for Services and Enforcement SE
Commissioner, Wage and Investment Division SE:W
Acting Deputy Commissioner, Small Business/Self-Employed Division SE:S
Deputy Commissioner, Wage and Investment Division SE:W
Director,
Compliance, Small Business/Self-Employed Division SE:S:C
Director, Customer Account Services, Small Business/Self-Employed Division SE:S:CAS
Director, Strategy and Finance, Wage and Investment Division SE:W:S
Director, Communications and Liaison, Small
Business/Self-Employed Division
SE:S:MS:CL
Director, Tax Forms and Publications, Wage and Investment Division SE:W:CAR:MP:T
Chief Counsel CC
National Taxpayer Advocate TA
Director, Office of Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk
Analysis RAS:O
Office of Management Controls OS:CFO:AR:M
Audit Liaisons:
Commissioner, Small Business/Self-Employed Division SE: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 Burden – Potential; 604,000 taxpayer accounts affected (see page 2).
Methodology Used to Measure the Reported Benefit:
Internal Revenue Service (IRS) records showed that, during the last 5 calendar years (1998 - 2002), the IRS received from taxpayers approximately 2.6 million elections to be treated as small business corporations. During the same 5 years, approximately 2.1 million taxpayers received notices that they could file a United States Income Tax Return for an S Corporation (Form 1120S). However, less than 13,000 taxpayers received notices that their requests for elections had been denied, and IRS records of notices to taxpayers do not indicate how the other 604,000 accounts were resolved. The IRS has no assurance that these taxpayers received notices informing them that their elections were accepted or denied. The computation is as follows:
CALENDAR
YEARS 1998 - 2002
Elections Received (Election
by a Small Business
Corporation
(Form 2553)) 2,634,940
Taxpayers Informed by
Notices That:
Elections Accepted: 2,018,138
Elections Denied:
12,918
Total
Notifications by Notices: 2,031,056
Volume
of Taxpayers Who May Not Have Been Notified
That Their Elections Were Accepted or Denied:
603,884
Appendix V
Instructions concerning relief provisions appear on page 2 of the Election by a Small Business Corporation (Form 2553) instructions. The instructions are as follows:
To request relief for a late
election, the corporation generally must request a private letter ruling and
pay a user fee in accordance with Rev. Proc. 2002-1, 2002-1 I.R.B. 1 (or its
successor). But if the election is
filed within 12 months of its due date and the original due date for filing the
corporation’s initial Form 1120S has not passed, the ruling and user fee
requirements do not apply. To request
relief in this case, the taxpayer should write “FILED PURSUANT TO REV. PROC.
98-55” at the top of page 1 of Form 2553, attach a statement explaining the
reason for failing to file the election on time, and file Form 2553 as
otherwise instructed. See Rev. Proc.
98-55 for more details.
See Regulations section 1.1362-6 (b)(3)(iii)
for how to obtain relief for an inadvertent invalid election if the corporation
filed a timely election, but one or more shareholders did not file a timely
consent.