Corporations with assets of $10 million or more voluntarily report billions of dollars in taxes each year. To determine whether corporations comply with tax laws, the Internal Revenue Service (IRS) examines these large corporations under one of two programs.

Approximately 1,700 of the largest and most complex corporations are selected for examination under the Coordinated Examination Program (CEP). In the CEP, the IRS uses a scoring system to select returns for examination. Corporate returns selected for the CEP generally report assets that exceed $250 million and are examined by a team of IRS revenue agents.

This review focused on the approximately 56,000 other large corporations that may be selected for examination under the IRS’ General Examination Program. Unlike the scoring system and team approach used in the CEP, these returns are generally selected for examination using a screening system conducted by experienced revenue agents. The returns are then assigned to other agents for examination.

Approximately one out of every three large corporate returns examined in the general program in the last several years was closed without any additional recommended tax. Consequently, the IRS has been studying ways to improve its selection process. The objective of our audit was to evaluate these IRS efforts to improve its methods for selecting large corporate returns for examination.

Examinations that are closed without any additional recommended taxes can result in the ineffective and inefficient use of both IRS and corporate resources. The IRS believes that its current study efforts could lead to assessing an additional billion dollars or more in taxes each year. While we agree that some improvements in the return selection process may result from these studies, we also identified various problems in how the studies were conducted which indicate that results on this scale may not be realized.

Further, other problems concerning audit results will not be addressed by the results of these studies. These other problems involve conducting examinations with the most recently filed return and better preparing revenue agents to conduct large corporate examinations.

Since 1995, the IRS has been studying ways to improve methods to select large corporate returns for examination. During this period, the IRS completed a Net Operating Loss (NOL) Study that expended approximately 34,000 hours (over $1 million in salaries) examining corporations that reported a NOL deduction. In addition, the IRS is now in the second of four phases of the Discriminate Analysis System (DAS) Study. The DAS Study involves developing and testing a complex mathematical formula to identify more productive returns for examination. The Examination function believes its efforts could lead to assessing a billion dollars or more in taxes. However, various study methodological problems raise questions about whether this much revenue will be realized and whether the examinations associated with the ongoing DAS Study will successfully validate the DAS scoring system.

During Fiscal Years (FY) 1998 and 1999, examinations of large corporate returns were started, on average, 388 days after the returns were available to be examined. These delays in starting examinations, combined with legal and program deadlines, can add pressure to close cases before issues are identified and/or fully developed.

In FYs 1998 and 1999, 47 percent of the large corporate examinations included 2 or more returns. In 60 percent of these multi-year examinations, the corporation had already filed the next return that was due before the examination on the first return filed was started. If the Examination function audited the most recently filed return, there could be more time to either identify and develop issues or examine other corporations. Starting examinations with the most recently filed return could also further reduce the burden on corporate taxpayers that are subjected to multi-year examinations.

The Large and Mid-Size Business Division’s (LMSB) vision is to improve service to the approximately 210,000 corporations and partnerships it serves through a highly skilled staff of experienced revenue agents trained in unique industry tax accounting practices and issues. Industry specific skills will provide corporate customers with better customer service and can allow for more efficient and effective audits.

However, although the IRS provided the 231 revenue agents in our universe with 64,139 hours of training between 1997 and 1999, more training could have been given to these revenue agents on industry issues and accounting practices. Specifically, less than half of these training hours (26,265) dealt with business income tax practices. Moreover, the 26,265 hours that were devoted to business income tax practices included only 1,991 hours of specific industry-related topics.

In the near term, the Commissioner, LMSB, should delay the next phase of the DAS Study until certain problems with the study can be resolved. The LMSB Division should also encourage revenue agents to initiate more examinations on the most recently filed returns instead of ones that have been in the examination stream for extended periods of time.

In the long term, we recommend that the LMSB Division develop a consistent approach and provide guidance to its staff when studying ways to improve work processes. The LMSB Division should also ensure revenue agents receive additional training about the unique accounting practices and issues in the industries in which they are working.

Management’s Response: LMSB Division management agreed with our recommendation and delayed the next phase of the DAS Study. They are currently in the process of developing an action plan to validate the DAS formulas that will include the use of outside academic experts. LMSB Division management has directed field personnel to select returns for examination that are currently in the service centers which are the most recently filed returns.

In addition, LMSB Division management believes that under the new organization configuration their Office of Strategy, Research and Planning will be able to establish a consistent approach for evaluating and improving the Division’s workload selection process. The LMSB organization structure concentrates its technical expertise around business segments, which will allow it to improve its ability to offer training in industry-specific accounting practices and issues.

Management’s complete response to the draft report is included as Appendix IV.