TREASURY INSPECTOR GENERAL
FOR TAX ADMINISTRATION
THE INTERNAL REVENUE SERVICE NEEDS TO IMPROVE THE
IDENTIFICATION AND COLLECTION OF UNREPORTED
Reference No. 2000-30-151
The Internal Revenue Service (IRS) could assess and collect significant amounts of unreported self-employment taxes each year before tax refunds are issued to taxpayers. We estimate that over a 2-year period, taxpayers did not report $156 million in self-employment taxes; over 61 percent of these taxpayers received $51 million in tax refunds that could have been offset against the unreported self-employment taxes.
The self-employment tax is a Social Security and Medicare tax on the income of individuals who work for themselves. Funding of Social Security and its long-term viability have received considerable political attention in recent years.
The General Accounting Office recently reported that non-wage income has grown significantly since 1970 as a portion of total individual income. The number of tax returns that included self-employment income increased 138 percent from 1970 to 1990. Self-employment income was the largest portion of non-wage income included in the IRSí inventory of tax debts at the end of Fiscal Year 1993.
In a 1998 report, Compliance with Self-Employment Tax Requirements (Reference Number 083502, dated May 19, 1998), the Treasury Inspector General for Tax Administration (formerly IRS Internal Audit) recommended that the IRS take steps to improve its process of administering self-employment tax requirements. The objective of this audit was to determine whether the IRS had taken effective corrective actions in response to that report to improve the identification and collection of unreported
The IRS has taken some actions to address unreported self-employment taxes. Changes were implemented to the computer screening criteria used to identify tax returns with unreported self-employment taxes. The IRS also developed an educational letter which was sent to taxpayers filing these tax returns, requesting the taxpayers to review their tax returns and amend the returns by submitting Self-Employment Tax (Schedule SE) if they deemed it necessary. This letter was sent well after the tax returns had been processed.
Despite these efforts, significant amounts of self-employment taxes remain unassessed and uncollected each year. The IRS needs to take steps to further improve the identification and collection of these taxes. The ongoing "stand up" of the IRSí new Small Business/Self-Employed (SB/SE) Division presents an excellent opportunity to address these issues.
The Internal Revenue Service Could More Timely Identify and Collect Unreported Self-Employment Taxes
In our prior report, we recommended that the IRS identify taxpayers owing self-employment taxes when returns are processed and work those cases immediately in Correspondence Examination. The IRS has not implemented those recommendations.
Identifying unreported self-employment taxes as tax returns are processed and assessing self-employment taxes on those cases with available tax refunds would help the IRS:
By assessing unreported self-employment taxes before refunds are issued, the IRS could immediately collect self-employment taxes of $21 million each year owed by 78,000 taxpayers with self-employment income of $2,000 or more.
The Internal Revenue Service Needs to Reduce Certain Processing Errors to Further Improve the Computerized Identification of Unreported Self-Employment Taxes
The IRS made processing errors on tax returns and related documents, which caused its computers to erroneously identify some taxpayers as owing self-employment taxes. An estimated 30,000 taxpayers were erroneously identified in this way and sent self-employment tax education letters. These taxpayers had either: (1) claimed religious exemptions from self-employment tax requirements, (2) reported "Other Income" on the U.S. Individual Income Tax Return (Form 1040) line 21, or (3) indicated they were statutory employees by checking the appropriate box on Profit or Loss From Business (Schedule C).
Criteria for Prioritizing Self-Employment Tax Cases Need to Be Revised to Accurately Reflect Potential Unreported Self-Employment Taxes
The logic of the IRSí computer program to identify and prioritize tax returns with unreported self-employment taxes is flawed. As a result, tax returns with significantly varying amounts of unreported self-employment taxes can receive the same priority in the IRSí compliance program. This can lead to the ineffective use of scarce Examination function resources.
Educational Letters to Taxpayers Potentially Owing Self-Employment Taxes Could Be Improved
The educational letters sent to taxpayers appearing to owe self-employment taxes should be more specific and assertive, provide an explanation of the importance of the self-employment tax, and explain to taxpayers what will happen if they do not respond. If taxpayers are not convinced of the importance of taking action in response to an IRS letter, many will not respond.
Future plans are to send letters to all taxpayers with self-employment income of $2,000 or more that did not report self-employment taxes. During the implementation of the Self-Employment Tax National Strategy, letters were sent to all taxpayers with self-employment income of $1,000 or more. Letters to taxpayers with less than $2,000 resulted in gross self-employment tax revenue of approximately $3.3 million. Although these cases individually may not warrant follow-up by the IRS, they do warrant letters informing taxpayers of their self-employment tax obligation.
Summary of Recommendations
The IRS should identify unreported self-employment taxes during returns processing and assess these taxes before refunds are issued to taxpayers. To make this process more effective, the IRS should improve the accuracy of the information used to determine if taxpayers are liable for self-employment taxes. This information relates to applications for exemptions from self-employment taxes, income reported on line 21 of Form 1040, and the statutory employee indicator on Schedule C. In addition, the IRS should revise the formula for prioritizing self-employment tax cases and should improve the educational letters sent to taxpayers potentially owing self-employment taxes.
Managementís Response: In January 2001, the IRS will begin identifying, via computer, taxpayers with potential unreported self-employment taxes as the returns are processed. A project to hold refunds of a limited number of taxpayers who owe self-employment taxes will be tested. If the project is successful and if resources are available, the project will be expanded to all SB/SE Correspondence Examination sites by 2003. The IRS will forward copies of forms indicating taxpayers are exempt from self-employment taxes to the area responsible for processing that information to ensure that the applicable records are updated. The IRS will revise instructions for Form 1040, line 21 and will revise returns processing instructions to improve the accuracy of data indicating that taxpayers are statutory employees and not liable for self-employment taxes. The IRS will also revise the scoring formula used to identify and prioritize tax returns with potential unpaid self-employment taxes and will make changes to letters sent to taxpayers potentially owing self-employment taxes.
Office of Audit Comment: While we agree that sending different letters to taxpayers based on the amount of self-employment tax they owed would result in different treatment of taxpayers, in our opinion, the differing treatment is consistent with the way the IRS currently administers taxes. The IRS takes different actions when processing tax returns or when taking enforced collection actions based on the amount of tax involved.