Key Areas of Noncompliance Among Small Business and Self-Employed Taxpayers Could Be Addressed Through More Effective Use of Correspondence Examinations

 

November 2003

 

Reference Number:  2004-30-005

 

 

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.

 

November 5, 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 - Key Areas of Noncompliance Among Small Business and Self-Employed Taxpayers Could Be Addressed Through More Effective Use of Correspondence Examinations (Audit # 200230054)

 

This report presents the results of our review of the steps the Internal Revenue Service (IRS) has taken to ensure that the process used to select inventory for its Small Business/Self-Employed (SB/SE) Division Campus Correspondence Examination Program addressed key areas of SB/SE Division noncompliance. 

Correspondence examinations are conducted through the mail, with the IRS typically asking taxpayers for more support regarding one or two simple issues on United States Individual Income Tax Returns (Form 1040).  Correspondence examinations accounted for 73 percent (540,902) of the 743,417 individual income tax returns examined by the IRS in Fiscal Year (FY) 2001.

As the IRS reorganized to the business unit concept, the Correspondence Examination Program likewise underwent organizational changes.  The SB/SE Division Compliance Services function handles the SB/SE Division compliance activities not requiring face-to-face interaction with taxpayers, including correspondence examinations conducted at the IRS’ Brookhaven, New York; Cincinnati, Ohio; Memphis, Tennessee; Ogden, Utah; and Philadelphia, Pennsylvania, Campuses.  The SB/SE Division Compliance Policy Office of Centralized Workload Selection and Delivery develops the compliance work plan and selects the inventory for the Program.

In FY 2002, SB/SE Division executives announced that resources were being realigned to focus on the biggest areas of risk to the tax system, referred to as key areas of noncompliance.  The SB/SE Division workload was to be associated with strategic noncompliance priorities:  abusive tax schemes and promoter investigations; misuse of devices such as offshore accounts to hide or improperly reduce income; abusive corporate tax avoidance transactions; high-risk, high-income individuals; Unreported Income Discriminant Index Formula; and the National Research Program.

In summary, we found that correspondence examinations did not always address strategic noncompliance priorities and that the Correspondence Examination Program could be used more effectively to reduce the tax gap and increase coverage and voluntary compliance.  In addition, the IRS does not always use the most cost-effective method to examine tax returns, and the current Examination Workload Selection Process results in inequitable treatment of taxpayers.

In FY 2003, Earned Income Tax Credit (EITC) cases made up 33 percent of the SB/SE Division Campus Correspondence Examination Program inventory.  While the IRS cannot ignore the risks presented by EITC claims, the workload selected does not seem to be balanced against the compliance risks associated with other SB/SE Division taxpayers.  Program inventory included many examinations of “personal” issues on individual income tax returns (e.g., pension account distributions, alimony, contributions, and the Child Care Credit).  In effect, the SB/SE Division Correspondence Examination Program was largely covering types of tax issues also covered by the Wage and Investment Division.

The SB/SE Division Correspondence Examination Program could be used more effectively to reduce the tax gap and increase coverage and voluntary compliance in areas of egregious tax law abuse.  In 1998, SB/SE Division taxpayers were responsible for $141 billion (68 percent) of the $207 billion tax gap.  Sole Proprietors, who file a Form 1040 Profit or Loss From Business (Schedule C), accounted for 94 percent of the SB/SE Division tax gap.  However, we found that Schedule C examination issues were largely ignored when inventory was selected for the Correspondence Examination Program. 

The IRS selects inventory and allocates resources based on past practices and perceptions of what examination issues can best be handled by the various examination techniques, rather than on activity-based costing models.  In fact, IRS performance measures do not include costs.  Because the correspondence examination technique lends itself to automation, the Correspondence Examination Program is an efficient, cost-effective program that maximizes net revenue.  Correspondence examinations are a cost-effective way to increase the reporting of income by fostering the voluntary compliance of those contacted and, indirectly, the compliance of those not contacted.

The IRS has stated that the current Examination Workload Selection Process does not adequately identify cases with the greatest yield potential.  As a result, excessive resources are dedicated to less egregious noncompliant taxpayers rather than to the biggest areas of risk to the tax system.  This damages the IRS’ commitment to promoting the highest degree of voluntary compliance through a fair and equitable system for all taxpayers.  Achievement of this goal is further endangered when the function performing the majority of examinations does not always examine returns and schedules associated with the key areas of SB/SE Division noncompliance.  While SB/SE Division management plans to introduce some abusive tax scheme cases and increase the High Income Non-Filer and Frivolous Filer cases in the correspondence examination inventory for FY 2004, there does not appear to be an aggressive plan to rebalance the inventory selected for the various examination methods to ensure that correspondence examinations can address more key areas of noncompliance.

Accordingly, we recommended that the IRS restore the strength of the Compliance function and ensure fair and balanced treatment for all taxpayers by expanding the tax issues that can be selected for correspondence examination to ensure that more of the inventory addresses strategic noncompliance priorities.  We also recommended that the IRS initiate any necessary training programs, and select the most cost-effective examination techniques based on performance measures reflecting cost and yield data.

Management’s Response:  SB/SE Division management agreed that the Campus Correspondence Examination Program should work more cases dealing with strategic priorities and plans to expand the tax issues and types of SB/SE Division returns selected for the Correspondence Examination Program inventory after a period of adequate testing.  In addition, management agreed to initiate necessary training programs to ensure that Tax Examiners have the skills to examine additional types of SB/SE Division tax issues.  However, SB/SE Division management stated that the IRS Restructuring and Reform Act of 1998 (RRA 98) prevented them from using cost and yield information to measure program performance.  SB/SE Division management also disagreed with our assessment of their use of the most cost-effective examination technique and their fair and equitable treatment of taxpayers.  Management’s complete response to the draft report is included as Appendix IV.

Office of Audit Comment:  We disagree with SB/SE Division management’s opinion that the RRA 98 prevents them from using cost and yield information to measure program performance.  Regulations permit the use of tax enforcement records for purposes such as forecasting, financial planning, resources management, and the formulation of case selection criteria.  We also do not agree with SB/SE Division management’s assessment regarding their use of the most cost-effective examination techniques.  We are concerned that the current limitations placed on the types of cases selected for the Correspondence Examination Program may prevent the application of such an efficient examination technique to higher-priority SB/SE Division tax issues.  Finally, we believe that by not using the Correspondence Examination Program to address tax issues that fall solely under the domain of the SB/SE Division, the IRS is not maximizing its commitment to a fair and equitable system for all taxpayers. 

While we still believe that all of our recommendations are worthwhile, we do not intend to elevate our disagreement concerning these matters to the Department of the Treasury for resolution.

Copies of this report are also being sent to the IRS managers who are affected by the report recommendations.  Please contact me (202) 622-6510 if you have questions or Philip Shropshire, Director (Corporate and Customer Service), at (215) 516-2341.

 

Table of Contents

Background

Correspondence Examinations Did Not Always Address Strategic Noncompliance Priorities

Recommendation 1:

The Correspondence Examination Program Could Be Used More Effectively to Reduce the Tax Gap and Increase Coverage and Voluntary Compliance

Recommendations 2 and 3:

The Most Cost-Effective Method Is Not Always Used to Examine Tax Returns

Recommendation 4:

Recommendation 5:

The Current Examination Workload Selection Process Results in Inequitable Treatment of Taxpayers

Recommendation 6:

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

 

Background

Since 1996, Tax Examiners located at the Internal Revenue Service (IRS) campuses have conducted the vast majority of examinations of United States (U.S.) Individual Income Tax Returns (Form 1040) using the correspondence examination technique.  As the name implies, correspondence examinations are conducted through the mail, with the IRS typically asking taxpayers for more support regarding one or two simple issues on individual income tax returns (e.g., Earned Income Tax Credit (EITC), Self-Employment Tax, and alimony payments). 

During Fiscal Years (FY) 1992 to 2002, the annual number of correspondence examinations conducted by the IRS varied considerably, from just over 200,000 to about 1.2 million.  Correspondence examinations accounted for 540,902 (73 percent) of the 743,417 individual income tax returns examined by the IRS in FY 2001.

As the IRS reorganized to the business unit concept, the Correspondence Examination Program likewise underwent organizational changes.  The Small Business/Self-Employed (SB/SE) Division Compliance Services function is now responsible for handling SB/SE Division compliance activities not requiring face-to-face interaction with taxpayers, which includes correspondence examinations conducted by Tax Examiners at the IRS’ Brookhaven, New York; Cincinnati, Ohio; Memphis, Tennessee; Ogden, Utah; and Philadelphia, Pennsylvania, Campuses.  The SB/SE Division Compliance Policy Office of Centralized Workload Selection and Delivery is charged with developing the compliance work plan and selecting inventory for the Program. 

This audit was conducted at the IRS’ Brookhaven Compliance Site and included analyses of the Correspondence Examination Program inventory in the five SB/SE Division campuses from October 2002 through April 2003.  We interviewed IRS management in the SB/SE Division Headquarters, located in New Carrollton, Maryland, and at all SB/SE Division campuses, and reviewed IRS studies, reports, and records to obtain information about the Correspondence Examination Program.

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.

Correspondence Examinations Did Not Always Address Strategic Noncompliance Priorities

Based on the results of Compliance Risk Assessments begun in FY 2000, the IRS began to identify and refocus its resources on the biggest areas of risk to the U.S. tax system in a comprehensive strategy.  Toward the end of FY 2002, the IRS began realigning its resources to focus on key areas of noncompliance with U.S. tax law.

On July 30, 2002, former IRS Commissioner Charles Rossotti and SB/SE Division executives presented an overview of the new compliance strategies to the IRS Oversight Board and explained that FY 2003 would be a year of transition.  As existing examination inventories were closed, the new workload selected for SB/SE Division employees was to be associated with the new strategies. This new direction focused on seven priority areas:

·        Abusive tax schemes and promoter investigations.

·        Misuse of devices such as offshore accounts to hide or improperly reduce income.

·        Abusive corporate tax avoidance transactions.

·        High-risk, high-income individuals.

·        Offshore credit card abuses.

·        Unreported Income Discriminant Index Formula (UI DIF).

·        The National Research Program (NRP).

During this audit, we analyzed the SB/SE Division Examination Plan and the Correspondence Examination Program inventory at the SB/SE Division and Wage and Investment (W&I) Division campuses for FY 2003.  We found that approximately 59 percent of the combined SB/SE Division and W&I Division Correspondence Examination Program workload consisted of EITC cases.  EITC cases made up approximately 33 percent (94,981 cases) of the SB/SE Division Correspondence Examination Program inventory to be completed in FY 2003 (288,489 cases).

While the FY 2003 Examination Plan called for a decrease of 59 percent from the number of EITC cases the SB/SE Division campuses worked in FY 2002, EITC cases were still a significant part of their workload.  In fact, the Philadelphia Campus almost doubled the number of correspondence examination resources allocated to work EITC cases in FY 2003, as compared to the prior year. 

Tax Examiners at one SB/SE Division campus were even working W&I Division correspondence examination inventory.  IRS management indicated this occurred because of research projects or because W&I Division campuses could not handle their inventories.

Although there were some projects that potentially qualify as addressing key areas of noncompliance, such as 25,000 High Income Non-Filer (HINF) cases in the Memphis Campus correspondence examination inventory or 17,000 Frivolous Correspondence cases in the Ogden Campus correspondence examination inventory, we found that:

·        Correspondence examinations conducted by Tax Examiners at SB/SE Division campuses did not always address the strategic noncompliance priorities outlined by SB/SE Division executives.

·        The SB/SE Division Correspondence Examination Program inventory included many examinations of “personal” issues on taxpayers’ individual income tax returns, such as the Child Care Credit, 10 Percent Penalty, contributions, alimony payments, dependents, and duplicate Social Security Numbers.

·        Many of the tax issues examined by correspondence at the SB/SE Division campuses were the same types of issues as those examined by correspondence at the W&I Division campuses.

In recent years, the IRS has come under growing criticism for its focus on low-income taxpayers, especially due to the number of EITC examinations.  While the IRS certainly cannot ignore the risks presented by SB/SE Division taxpayers claiming the EITC, the workload selected for correspondence examinations, which is the largest component of the Examination Coverage Rate, does not seem to be balanced against the compliance risks associated with other SB/SE Division taxpayers. 

Currently, SB/SE Division management is working with the IRS Concept of Operations Project (CONOPS) researchers to help develop a noncompliance case selection model.  In addition, they plan to introduce some abusive tax scheme cases and increase the HINF and Frivolous Filer cases in the correspondence examination inventory for FY 2004.  However, there does not seem to be an aggressive plan to rebalance the inventory selected for the various examination methods and ensure that correspondence examinations can address more key areas of noncompliance.  The inventory selected for the SB/SE Division Correspondence Examination Program must change if the IRS plans to target limited resources at the most serious transgressions and threats to the tax system.

Recommendation

1.      The Director, Compliance, SB/SE Division, should ensure that more of the inventory selected to be worked in the SB/SE Division Correspondence Examination Program addresses strategic noncompliance priorities.

Management’s Response:  SB/SE Division management agreed that the Correspondence Examination Program should work more cases dealing with strategic priorities.  For FY 2004, they plan to increase the number of HINF and Frivolous Filer cases worked in the Program, and add more cases dealing with strategic priorities when identified.  While management stated that they considered most of the strategic priority work too complex to be handled through correspondence examinations, they also indicated that their intention is to shift more complex SB/SE Division work to the Correspondence Examination Program over time.

Office of Audit Comment:  In FY 2004, approximately one-third of the inventory worked in the SB/SE Division Correspondence Examination Program will involve EITC cases.  This casework is mandated and accomplished with appropriated funding.  This circumstance makes the selection of discretionary inventory that addresses the key areas of noncompliance even more crucial.  While increasing the number of HINF and Frivolous Filer cases in the inventory for FY 2004 is certainly a step in the right direction, it is up to SB/SE Division management to ensure that more of the Correspondence Examination Program inventory addresses key areas of noncompliance.

The Correspondence Examination Program Could Be Used More Effectively to Reduce the Tax Gap and Increase Coverage and Voluntary Compliance

The Federal income tax system operates largely on a self-assessment basis.  That is, the Federal Government expects taxpayers to determine their own tax obligations and to pay voluntarily whatever is due.  By placing the onus on the taxpayers, the Federal Government avoids the costly alternative of determining each individual’s tax liability and doing whatever it must to collect it.  However, one cost of relying so heavily on the voluntary compliance of taxpayers is that not all tax is voluntarily paid.

The difference between what taxpayers should pay and what they actually do pay voluntarily and timely is referred to as the tax gap.  The tax gap was estimated at $207 billion in 1998.  The IRS’ FY 2003-2004 Compliance Risk Assessment revealed that those areas of noncompliance associated with the tax gap – nonfiling, nonpayment, and underreporting – continue to widen. 

Direct effect of the Examination Coverage Rate

IRS enforcement programs identify and collect some of the tax gap directly from the taxpayers they contact.  This is a direct effect of the Examination Coverage Rate, which is the primary enforcement tool thought to influence voluntary compliance.

The Examination Coverage Rates for IRS correspondence and field examinations of individual income tax returns and nonindividual business returns have declined dramatically since FY 1996. 

This decrease in compliance activity was due to several factors, including budgetary constraints, the desire to provide increased customer service, and the need to implement and provide additional taxpayer protections and rights mandated by the IRS Restructuring and Reform Act of 1998 (RRA 98).

Voluntary compliance seems to have fallen concurrent with the decline in the Examination Coverage Rates.  Since it is estimated that only a fraction of the tax gap will eventually be collected through enforcement and other late payments, it is crucial for the IRS to effectively use its limited resources to improve voluntary compliance.

Indirect effect of the Examination Coverage Rate

According to a study published in 1996, IRS examinations also produce an indirect revenue effect, referred to as the “ripple effect,” by inducing some level of voluntary compliance in the population at large.  The study’s premise is that taxpayers perceive increased examinations by the IRS as an increase in their chances of being examined, and they improve their voluntary compliance as a result. 

An IRS study released in November 2002 stated that the indirect effect of increasing the Examination Coverage Rate would be to increase the deterrence factor (i.e., changing the public’s perceptions of the certainty, severity, and celerity (swiftness) of getting caught in noncompliance).  It could also involve education or shaping attitudes (e.g., changing the public’s perceptions of the extent to which the law is applied and enforced fairly).

This study claimed that IRS examinations have a strong, positive impact on reporting compliance and estimated that the average indirect effect of the examinations started in 1991 was about 11.7 times as large as the average adjustment directly proposed by examinations closed that year.  Moreover, if the Examination Coverage Rate had been 1 percentage point higher in 1991, the general population would have voluntarily reported an additional $56 billion of additional tax. 

Declining Examination Coverage Rates cause concern

During annual oversight hearings on the IRS, the Congress often raises questions about the declining Examination Coverage Rates and the possible effects on voluntary compliance.  Taxpayers’ willingness to voluntarily comply with tax laws depends in part on their confidence that friends, neighbors, and business competitors are paying their fair share of taxes.  The IRS programs to ensure compliance and to collect delinquent taxes are viewed by many as critical for maintaining the public’s confidence in our tax system.  Many experts feel that this declining trend in Examination Coverage Rates has the potential to undermine taxpayers’ motivation to fulfill their tax obligations.

SB/SE Division correspondence examinations could reduce the tax gap through increased coverage and voluntary compliance

SB/SE Division taxpayers are responsible for the majority of the tax gap.  Approximately $141 billion (68 percent) of the $207 billion tax gap in 1998 was attributed to SB/SE Division taxpayers.  Sole Proprietors, who file a Form 1040 with a Profit or Loss From Business (Schedule C), fall under the domain of the SB/SE Division and accounted for $132.5 billion (94 percent) of this $141 billion.  Corporate taxpayers were responsible for $8.3 billion (6 percent).

Because SB/SE Division taxpayers, and specifically Sole Proprietors, are responsible for such a large portion of the tax gap, it is imperative that the SB/SE Division compliance programs use their limited resources effectively to increase their direct examination coverage of this taxpayer segment.  This would also serve to increase the indirect or “ripple effect,” thereby increasing voluntary compliance and ultimately reducing the tax gap. 

Inventory selection criteria limit the Program’s potential

The Internal Revenue Manual requires that tax returns identified for examination be classified to ensure that all questionable issues on returns are examined and to determine whether the issues can be addressed through correspondence examinations or need to go to IRS field staff.  The IRS generally has one chance to examine a return.  If returns including complex schedules are not classified for potential examination issues, tax noncompliance is more likely to go undetected.

Currently, the IRS has established standards and requirements for selecting, conducting, and reviewing the quality of correspondence examinations.  The IRS uses computer programs to screen tax returns filed each year by individual taxpayers for examination potential.  The IRS campuses also have their own computer programs to identify returns with issues to be examined through correspondence.

According to IRS criteria, campus correspondence examinations are to exclude complicated tax issues, such as those on business and investment schedules.  Tax returns assigned to the Correspondence Examination Program are to involve only one or two simple tax issues that can be examined by Tax Examiners who are not trained to examine complex issues on business and investment schedules. 

However, we found that because of these restrictions, the most egregious cases of tax law abuse (e.g., the Sole Proprietor Taxpayer Segment) were largely ignored when inventory was selected for SB/SE Division campus correspondence examinations.  Even when individual income tax returns with Schedules C attached were selected for examination in the Correspondence Examination Program, the issues examined rarely had anything to do with the Schedules C per se, but rather involved such things as the EITC or dependents claimed on the taxpayers’ individual income tax returns.

A U.S. General Accounting Office (GAO) report issued in 1999 concluded that an estimated 22 percent of the correspondence examinations closed in 1996 had Schedules C attached to the taxpayers’ individual income tax returns that were not examined.  Approximately 21 percent of the closed correspondence examinations had Schedules D, E, and/or F attached that likewise were not examined.  The report criticized the IRS for not referring returns with these attached schedules for field examination.  The GAO stated that because the IRS missed this window of opportunity, potential tax noncompliance on the attached schedules went undetected.

We agree with the GAO that potential tax noncompliance went undetected when attached schedules were not examined.  However, we believe that the IRS should use the SB/SE Division Correspondence Examination Program as part of a more focused approach to address the areas of key noncompliance.   

As stated earlier in this report, in FY 2001, 73 percent of all individual income tax returns were examined by correspondence.  If the IRS does not use the SB/SE Division Correspondence Examination Program more effectively to address the key areas of noncompliance, close the tax gap, and increase coverage and voluntary compliance, it will be difficult to reverse trends that have already undermined the fairness of the tax system and the attitude of compliant taxpayers toward their obligation to pay taxes.  Furthermore, growth in the economy will cause the tax gap to increase every year if actions are not taken to reverse the trend.

 Recommendations

The Director, Compliance, SB/SE Division, should:

2.  Expand the tax issues and types of SB/SE Division returns that can be included in inventory selected for the Correspondence Examination Program after a period of limited testing.

Management’s Response:  SB/SE Division management plans to expand the tax issues and types of SB/SE Division returns selected for the Correspondence Examination Program inventory after a period of adequate testing.  However, they stated this report did not make it clear that the SB/SE Division Correspondence Examination Program can influence only a part of the growth in the economic tax gap and that the SB/SE Division Correspondence Examination Program was not responsible for examining “73 percent of all individual income tax returns audited by correspondence.”

Office of Audit Comment:  We agree that the SB/SE Division Correspondence Examination Program can influence only a part of the growth in the economic tax gap.  As stated on page 3 of this report, the SB/SE Division Correspondence Examination Program was scheduled to complete 288,489 cases in FY 2003.  This represented approximately one-half of all the campus correspondence examinations scheduled to be completed by the IRS in FY 2003.  The other one-half was scheduled to be completed by the W&I Division Campus Correspondence Examination Program, which was not the subject of this report.   

3.  Initiate training programs to ensure that Correspondence Examination Program Tax Examiners have the necessary skills to examine additional types of tax issues and schedules filed by SB/SE Division taxpayers.

Management’s Response:  SB/SE Division management plans to hold continual training programs to ensure that Correspondence Examination Program Tax Examiners have the necessary skills to examine additional types of tax issues and schedules filed by SB/SE Division taxpayers.  They have also centralized certain types of returns/issues in certain campuses to maximize training resources and coverage levels.  They intend to obtain subject matter experts for Continuing Professional Education presentations and develop new courses for Tax Examiners as well as additional training for those campuses responsible for the CONOPS research returns.

The Most Cost-Effective Method Is Not Always Used to Examine Tax Returns

The IRS is responsible for collecting the proper amount of taxes at the least cost to the Federal Government and taxpayers.  To fulfill this responsibility, the IRS examines all types of tax returns to determine whether taxpayers have reported their correct tax liabilities.  The IRS spends over  $1 billion annually on its examination programs, including staff costs.  Based on its examinations, the IRS annually recommends that taxpayers pay additional taxes totaling tens of billions of dollars.

The range of size and complexity across tax returns affects the amount of time and resources the IRS uses to examine returns and resolve disputes over the assessment of recommended taxes.  Examinations of large corporations may take years, while for small, less-complex returns, the time is shorter, usually under a year.

To deal with this varying complexity, the IRS has three types of examiners that conduct examinations using different methods.

1.      Revenue Agents from IRS field offices visit individuals, corporations, and other types of taxpayers to address the most-complex tax returns.  They also work in teams to perform Coordinated Industry Case examinations of large corporations, and they fall in the highest pay grades. 

  1. Tax Auditors/Tax Compliance Officers usually perform examinations by meeting with taxpayers at field offices and fall in the middle range with respect to their pay grades and the complexity of their examinations. 

3.      Tax Examiners perform correspondence examinations of simple tax issues at IRS campuses and are in the lowest pay grade of the three types of examiners.

The IRS uses a screening and classification process previously outlined in this report to select returns for examinations, help identify specific tax issues to be examined, and choose which of the examination techniques described above will be used to conduct the examination.  The IRS allocates its inventory and examination resources based on preconceived perceptions of what the different types of examiners “are capable of examining” or what types of cases have traditionally been selected for their inventory, rather than on activity-based costing models.

The Correspondence Examination Program is an efficient, cost-effective, revenue-producing program

In 1994, the IRS Inspection Service issued a report on the IRS Service Center Correspondence Examination Program, which stated that the Correspondence Examination Program was an efficient, cost-effective, revenue-producing program.  Based on that review, it was concluded that Tax Examiners using the correspondence examination technique had much higher dollar per hour rates of return than Revenue Agents and Tax Auditors in the field.  Tax Examiners assessed an average of $2,130 per hour, as compared to $713 per hour for individual return examinations conducted by Revenue Agents and $485 for Tax Auditors. 

The report criticized the IRS for not capitalizing on the potential of the Correspondence Examination Program to increase revenues and the Examination Coverage Rate.  Despite the Correspondence Examination Program’s favorable cost, collectibility, and dollar per hour assessment statistics, the resources allocated to and the number of returns selected for correspondence examinations were declining. 

At that time, the IRS assigned low priority to the Correspondence Examination Program, and the Program’s favorable statistics were not variables included in the Examination Resource Allocation Methodology.  The Examination Cost Model used did not provide sufficient cost/yield data to ensure the efficient allocation of resources. 

One of the recommendations made in the 1994 report was that the Correspondence Examination Program should be used to examine Schedule C expense line items as well as other nontraditional type examination issues, such as Passive Losses and Fiduciary Income (Form 1041).  The report also advocated that Tax Examiners work more nonfiler cases themselves, rather than perform nonfiler case building for the field staff.

Additional research favors cost-effective examining

The IRS study, The Impact of the IRS on Voluntary Compliance:  Preliminary Empirical Results, previously referred to in this report, stated that:

The most cost-effective activity is the one that is most automated and therefore cheapest because that would have the highest marginal indirect revenue to cost ratio.  Automated activities have the greatest indirect yield to cost; examinations are among the activities with the largest indirect effect relative to their cost.  Some IRS activities that do not produce direct enforcement revenue seem to produce an indirect effect on voluntary compliance.

Basically, correspondence examinations are potent tools to increase the reporting of income by fostering the voluntary compliance of those contacted and indirectly fostering the voluntary compliance of those not contacted. 

Because the nature of the Correspondence Examination Program lends itself to automation improvements, these types of examinations help achieve the objective of maximizing net revenue – total revenue net of costs.  Moreover, since most returns are examined by this method, it follows that statistically the indirect effect of correspondence examinations is significantly larger than the direct revenue effect of the examinations.  Just by the sheer number of correspondence examinations conducted, there would tend to be a bigger indirect effect on voluntary compliance than by using other examination techniques. 

Reengineering efforts have increased the productivity of the Correspondence Examination Program

Through the ongoing Examination reengineering efforts, the IRS has made multiple automation improvements within the correspondence examination process that further increased the Program’s productivity and decreased operating costs.  For example, in FY 2002, the number of returns projected to be examined by correspondence examination was 575,216, and that number was expected to increase by 32 percent for FY 2003.  While a small portion (4 percent) of this increase is attributable to additional staffing devoted to correspondence examinations, systemic improvements in case creation and inventory delivery account for most of the anticipated increases in productivity. 

Other automation enhancements to the correspondence examination process will allow Tax Examiners to focus primarily on casework rather than spending time on clerical work.  While the number of cases opened will increase, most will be processed automatically.  Tax Examiners will be able to focus their efforts toward taxpayer responses, which truly require their expertise and attention.

IRS performance measures present an unbalanced picture

The IRS has traditionally measured the overall results of examinations by the amount of additional taxes recommended and the time charged directly to examinations by Examination function staff.  These measures do not employ other existing data that could more fully represent the revenues and costs associated with examinations. 

In 1998, the GAO issued a report criticizing existing IRS performance measures because: 

·        The measures did not report the dollar costs of the direct time charged to an examination or the indirect costs for the examination, settlement, and collection activities.

·        The measures did not report how much of the recommended taxes were actually assessed and collected. 

Measuring examination performance just by additional taxes recommended and direct examination staff time presents an unbalanced picture of the examination results.  The GAO recommended the IRS report examination revenues with associated costs so that a fuller, more balanced picture is available to enable IRS management to make better decisions when allocating examination resources. 

Furthermore, the GAO report stated the IRS needed performance measures that also took into consideration the indirect revenue effect of examinations (i.e., when examinations induced both examined and nonexamined taxpayers to be more voluntarily compliant and tax collections increased indirectly).

Recommendations

The Director, Compliance, SB/SE Division, should ensure that:

4.  Examinations of tax returns are performed using the most cost-effective examination technique.

Management’s Response:  SB/SE Division management stated that while they agreed that returns needed to be examined using the most cost-effective examination technique, they believe that they are accomplishing this through the automation of certain discretionary program inventory worked in the Correspondence Examination Program (i.e., Alternative Minimum Tax, Self-Employment Tax, and 10 Percent Penalty cases).  They also stated that, through the CONOPS research projects, the SB/SE Division is actively exploring emerging noncompliance issues and existing issues suitable for correspondence examinations.

Office of Audit Comment:  We are concerned that the current limitations placed on the types of cases selected for the Correspondence Examination Program may prevent the application of such an efficient examination technique to higher-priority SB/SE Division tax issues.  The three tax issues that IRS management points to in their response – the Alternative Minimum Tax, Self-Employment Tax, and 10 Percent Penalty – are not new tax issues for the Correspondence Examination Program.  Many of the CONOPS research projects conducted in FY 2003 (e.g., charitable contributions and the Child Care Credit) did not address key areas of SB/SE Division noncompliance.  Likewise, projects planned for FY 2004 (e.g., home office expenses and gambling losses) will not identify new types of inventory for the Correspondence Examination Program.

5.  Examination Program Performance Measures reflect cost and yield information for Revenue Agents, Tax Auditors/ Tax Compliance Officers, and Tax Examiners.

Management’s Response:  SB/SE Division management stated that they disagreed with this recommendation because it would be a violation of the RRA 98 to use cost and yield information to measure performance.

Office of Audit Comment:  We are not suggesting that the cost and yield information be used to evaluate employee performance, but rather that the records of tax enforcement results be used for purposes such as financial planning, resources management, and the formulation of case selection criteria.  The regulations contained in Part 801 of 26 CFR. Ch. 1 (1999) implement the provisions of RRA 98 §§ 1201 and 1204.  These regulations specifically state that records of tax enforcement results may be used for purposes such as forecasting, financial planning, resources management, and the formulation of case selection criteria.  In fact, one of the examples contained in Part 801.6 (f) states that “a headquarters unit may use records of tax enforcement results to develop methodologies and algorithms for use in selecting tax returns to audit.”

The Current Examination Workload Selection Process Results in Inequitable Treatment of Taxpayers

On March 1, 2002, the IRS issued its FY 2003-FY 2004 Small Business/Self-Employed Strategic Assessment Report.  This report stated that the Examination and Collection Workload Identification Systems are antiquated and inefficient, and, as a result, the SB/SE Division does not have adequate workload identification systems and processes in place on which to base workload selection. 

The IRS stated that Examination workload selection does not adequately identify cases with the greatest yield potential.  As a result, excessive resources are dedicated to less egregious, noncompliant taxpayers rather than the biggest areas of risk to the U.S. tax system.  The current workload selection system damages the IRS’ commitment to a fair and equitable system for all taxpayers.

The concept of coverage is to examine sufficient returns of all classes to assure all taxpayers of equitable consideration and to make the most efficient use of Examination staffing and other resources, with the objective of promoting the highest degree of voluntary compliance.  Achievement of this objective is endangered when the function within the IRS that performs the majority of examinations does not always examine returns and schedules associated with the key areas of SB/SE Division noncompliance.

While SB/SE management plans to introduce some abusive tax scheme cases and increase the HINF and Frivolous Filer cases in the correspondence examination inventory for FY 2004, there does not appear to be an aggressive plan to rebalance the inventory selected for the various examination methods to ensure that correspondence examinations can address more key areas of noncompliance.

The growth of the SB/SE Division taxpayer segment (2.5 percent) is projected to exceed that for the W&I Division (1 percent) from FYs 2001 to 2007.  Most of this growth is attributable to the growth in Schedule C filers (2.3 percent) for that period.  Numerous demographic factors may be driving this growth, especially the proliferation of home-based and nonemployer businesses and the growth in immigrant entrepreneurs.  Since multiple risk assessments identified Schedule C filers as major contributors to the tax gap, and new IRS projections point to accelerated growth among these Sole Proprietors, this creates an expectation of deepening compliance problems and the need to rebalance compliance efforts.

During this period of refocusing compliance efforts and Examination reengineering, the IRS needs to restore the strength of the Compliance function.  Continuing to allocate resources to traditional methods of examination so that more of the same kind of inventory can be examined, in the same way as in the past, will not ensure that all taxpayers are treated equally and assume their fair share of the tax burden.

Recommendation

6.  The Director, Compliance, SB/SE Division, should ensure that the workload selection process ensures fair and balanced treatment for all classes of taxpayers.

Management’s Response:  SB/SE Division management has taken a number of steps to identify different types of examination issues; these include establishing a team to identify unique SB/SE Division inventory other than the traditional inventory worked in prior years, coordinating with the National Headquarters Office of Research on a Risk-Based Selection CONOPS, coordinating with the Criminal Investigation function to identify potential inventory, and including more strategic priority work where possible.  Management agreed to test the feasibility of introducing Schedule C expense examinations to the Correspondence Examination Program inventory, and they continue to work to circumvent the issue of non-transcribed lines on Schedules C and Forms 2106.

However, IRS management stated that the fact that the SB/SE and W&I Divisions cover the same tax issues does not make their treatment of taxpayers unfair or inequitable.

Office of Audit Comment:  We agree with the steps SB/SE Division management has taken and plans to take to identify and introduce different types of examination issues into the Correspondence Examination Program inventory.  However, as stated in this report, the IRS declared in the FY 2003-FY 2004 Small Business/Self-Employed Strategic Assessment Report that:

The Examination & Collection Workload Identification Systems are antiquated and inefficient and, as a result, the SB/SE Division does not have adequate workload identification systems and processes in place on which to base workload selection.   The Examination workload selection does not adequately identify cases with the greatest yield potential.  As a result, excessive resources are dedicated to less egregious, non-compliant taxpayers rather than the biggest areas of risk to the U.S. tax system.  …The current workload selection system damages the IRS’ commitment to a fair and equitable system for all taxpayers.

We agree with this assessment.  The fact that both the SB/SE and W&I Divisions cover the same tax issues is not what makes the system inequitable.  It is the fact that certain tax issues fall solely under the domain of the SB/SE Division, and those issues are largely ignored when inventory is selected for the SB/SE Correspondence Examination Program. 

 

Appendix I

 

Detailed Objective, Scope, and Methodology

 

The overall objective of this audit was to determine what steps the Internal Revenue Service (IRS) has taken to ensure that the process used to select inventory for its Small Business/Self-Employed (SB/SE) Division Campus Correspondence Examination Program addressed key areas of SB/SE Division noncompliance.  We also evaluated the workload selection process to determine how and what SB/SE Division cases were currently being selected for correspondence examinations at SB/SE Division campuses.  To achieve our objective, we performed the following steps:

I.                    Determined what role the IRS campus correspondence examinations have in helping to achieve the SB/SE Division’s new compliance strategy.

A.     Gathered and reviewed pertinent information related to the new SB/SE Division compliance strategy to determine what key areas of noncompliance the IRS hoped to address.

1.      Interviewed SB/SE Division headquarters staff to obtain information and documentation regarding the newly announced compliance strategy and the related initiatives intended to address key areas of noncompliance.

2.      Obtained information, reports, and documents regarding management’s plans for the correspondence examinations conducted at the SB/SE Division campuses and their role in the overall compliance strategy.

B.  Interviewed SB/SE Division management analysts to determine if they had any problems or concerns regarding the level and/or type of inventory selected for SB/SE Division correspondence examinations, the results of any pilot projects involving campus correspondence examinations, and any future plans for the Program.

II.            Determined the effects of the organizational redesign and reengineering efforts on the overall workload selection process for the SB/SE Division correspondence examination inventory and determined if IRS management had ensured that the inventory selected addressed the key areas of noncompliance identified in the new compliance strategy.

A.     Interviewed SB/SE Division Compliance Services and Compliance Policy management analysts to determine how the overall workload selection process changed with regard to selection of inventory for the SB/SE Division Correspondence Examination Program as a result of the redesign and reengineering efforts.

B.     Reviewed the Internal Revenue Manual criteria and other documents regarding the selection of SB/SE Division inventory for correspondence examinations at IRS campuses.

C.     Obtained the Fiscal Year 2003 SB/SE Division Examination Plan and evaluated the number of cases and types of issues scheduled to be selected for correspondence examination and the level of resources allocated to accomplish this work.  We compared this information to the inventory worked at the Wage and Investment Division campuses and the resources allocated for the same period of time.

D.  Using the information obtained from IRS inventory reports, determined the levels and types of correspondence examination inventory.

 

Appendix II

 

Major Contributors to This Report

 

Richard J. Dagliolo, Director

Parker F. Pearson, Director

Robert K. Irish, Audit Manager

Margaret F. Filippelli, Senior Auditor

Carol Gerkens, Senior Auditor

Kathleen A. McFadden, Senior Auditor

 

Appendix III

 

Report Distribution List

 

Commissioner  C

Office of the Commissioner – Attn: Chief of Staff  C

Deputy Commissioner for Services and Enforcement  SE

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

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

Director, Communications and Liaison, Small Business/Self-Employed Division  SE:S:MS:CL

Staff Assistant, Small Business/Self-Employed Division  SE:S

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  N:CFO:AR:M

Audit Liaison:  Commissioner, Small Business/Self-Employed Division  SE

 

Appendix IV

 

Management’s Response to the Draft Report

 

The response was removed due to its size.  To see the response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.