In 1997, the Congress enacted legislation that was considered the most extensive and complicated the Internal Revenue Service (IRS) faced since 1986. Close to half of the 300 new provisions of the Taxpayer Relief Act of 1997 were effective for Tax Year 1998. Taxpayers experienced problems preparing 1998 individual income tax returns, and the IRS experienced problems processing tax returns impacted by some of these new provisions.

The objectives of this audit were to evaluate the effectiveness of the IRS’ implementation efforts as well as to evaluate actions taken during the filing season to ensure that tax returns affected by significant new legislative provisions were processed correctly.

The IRS put forth significant effort to prepare for the filing season, and has established processes such as the testing of some newly developed forms, by taxpayer focus groups, to ensure that new legislation was effectively implemented. The IRS also conducted functional reviews of Internal Revenue Manual instructions, systems acceptability testing of new computer programs, and training of IRS employees. Overall, these efforts resulted in taxpayers receiving information regarding new tax law provisions necessary to properly file tax returns. The IRS properly processed most tax returns affected by these provisions. However, taxpayers experienced problems understanding some of the new legislative provisions and related forms and instructions. The IRS also experienced problems processing tax returns impacted by some new legislative provisions. This report discusses steps the IRS should take to timely identify and resolve these problems in the future. Recommendations in this report could result in the following:

• The IRS could avoid losing over $7 million of revenue each year to taxpayers claiming dependent exemptions to which they were not entitled.
• The IRS could also avoid losing over $33 million of revenue each year to taxpayers receiving tax credits to which they were not entitled.
• The IRS could avoid improperly denying deductions totaling over $32 million per year for contributions taxpayers made to Individual Retirement Accounts (IRA).
• Burden could be reduced on approximately 900,000 taxpayers if the IRS clarified tax forms and instructions or notices issued to these taxpayers regarding new tax provisions.
• Burden could be reduced on another 239,000 taxpayers if the IRS corrected inaccurate names and taxpayer identification numbers (TIN) on taxpayers’ returns rather than disallowing taxpayers’ credits and exemptions.
• The IRS could avoid improperly denying the Child Tax Credit to significant numbers of taxpayers, and could avoid improperly allowing the Child Tax Credit to other taxpayers.

As taxpayers’ income tax returns are processed by the IRS, computers analyze and recompute information on the returns to identify potential errors. These potential errors are resolved by employees in the Error Resolution function. If the IRS makes changes to figures the taxpayers entered on their returns, employees send taxpayers notices informing them of the changes.

Many changes the IRS made to taxpayers’ returns involving four new legislative provisions were incorrect. These errors resulted in significant losses of funds to both the Government and to taxpayers. The IRS did not timely identify and take action to address significant error rates involving the following four new legislative provisions:

• Child Tax and Additional Child Tax Credit
• Farmers Income Averaging
• Changes to the Calculation of Modified Adjusted Gross Income Used to Determine the Earned Income Tax Credit (EITC)
• Increased Adjusted Gross Income Limits for Contributions to an IRA

If reviews had been performed and trended by tax provision, they may also have revealed needed clarifications to tax forms and instructions.

Because of limited programming resources and extensive priority programming requirements, the IRS postponed or cancelled programming to identify potential taxpayer errors relating to two new tax law provisions. (See Appendix V for a detailed discussion of these missing programs.) As a result of these programs not being written, taxpayers mistakenly received the benefit from provisions in the tax law or received tax credits that they were not entitled to.

These taxpayers were not informed of their errors and are likely to repeat them. Also, these errors, if later identified by the IRS, could result in significant burden to taxpayers as they could be subject to penalties and interest in addition to any underpaid taxes.

Notices for the following four new tax provisions did not clearly or adequately explain the taxpayers’ errors, or the actions necessary:

• Child Tax and Additional Child Tax Credit
• EITC Recertification
• Changes to the Calculation of Modified Adjusted Gross Income for Purposes of Determining the EITC
• Increased Adjusted Gross Income Limits for Contributions to an IRA

If taxpayers do not receive complete, clear notices, they are likely to repeat errors in subsequent years, or to contact the IRS for clarification.

In over 31 percent of 403 notices sampled, the IRS had the correct information elsewhere on its computer system when it sent notices telling taxpayers their Child Tax Credit was disallowed because the name or TIN (usually a social security number) for their child on their 1998 tax return did not match IRS or Social Security Administration records.

If IRS employees performed computer research, the IRS could have prevented significant numbers of notices from being issued, and reduced the related burden to taxpayers. The IRS would experience additional returns processing costs to provide this service. However, some costs would be recovered because fewer taxpayers would need to contact the IRS to resolve their incorrect name or TINs.

Taxpayers who have been denied the EITC as a result of an IRS audit are not eligible to claim the credit in subsequent years unless they provide information to demonstrate their eligibility on Information to Claim Earned Income Credit After Disallowance (Form 8862).

Based on the tax return instructions, we anticipated that taxpayers would be confused about when to file Form 8862. The computer programs prepared by the IRS did not take into consideration that some taxpayers would file the form unnecessarily, and would have caused these taxpayers’ refunds to be delayed. We reported this issue to the IRS, and it immediately revised its programs. During the filing season, approximately 6,500 taxpayers unnecessarily filed Form 8862. Left uncorrected, the incorrect computer programs would have caused refunds for these taxpayers, totaling approximately $12.8 million ($8.8 million of which was the EITC) to be delayed unnecessarily. (See Appendices VIII and IX.)

Early in the filing season, refunds totaling over $218,000 ($143,000 of which was the EITC) were issued to 74 taxpayers whose refunds should have been stopped because they were required to recertify with the IRS before they could receive the EITC. Computer programs to stop these refunds were not functioning as intended.

We brought this problem to the IRS’ attention in a memorandum and the IRS took immediate corrective action. (See Appendices X and XI.) Left uncorrected throughout the filing season, this programming error would have resulted in approximately 29,000 disqualified taxpayers receiving the EITC totaling over $50 million.

Taxpayers claimed amounts consistent with the Child Tax Credit on the Child Care Credit or Education Credit line of their tax returns, and did not attach the required schedules for these credits. Although these were obviously misplaced Child Tax Credit entries, the IRS sent these returns back to, or corresponded with, taxpayers and requested that they supply additional schedules.

Taxpayers could have been confused and frustrated when they received their tax returns back or received correspondence requesting additional information to support credits they did not intend to claim.

We brought this issue to the IRS’ attention in a memorandum and the IRS took corrective action. (See Appendices XII and XIII.)

The IRS should take several steps to ensure that legislative changes are properly implemented. Included among these are: initiating a post review of Error Resolution cases impacted by specific legislative provisions; ensuring that computer programming necessary to identify taxpayer errors related to two new tax law provisions (detailed in Appendix V) are completed by the 2001 filing season; and ensuring that notices issued to taxpayers are technically accurate, clearly address the taxpayers’ errors, and clearly inform taxpayers what to do.

The IRS should also consider the feasibility and cost effectiveness of conducting limited computer research to correct inaccurate names and TINs entered on tax returns.

Management’s Response: IRS management agreed to implement our recommended actions to ensure that legislative changes are properly implemented. The Assistant Commissioner (Forms and Submission Processing) has initiated a post review of Error Resolution cases impacted by specific legislative provisions. The results of these reviews will be used to identify needed changes to tax forms and instructions. Submission Processing has prepared and will submit requests for computer programming to identify potential errors made by taxpayers relating to two new tax provisions. Submission Processing and Customer Service will establish a formal clearance process to ensure that notices issued to taxpayers are effective, technically accurate, and clearly address taxpayers’ errors.

IRS management did not implement our recommendation to correct inaccurate names and TINs on returns rather than disallowing related exemptions and credits. They expressed concern that such action would not benefit taxpayers in the long run. Since taxpayers would not be informed of the changes made on their returns, they would continue to use the wrong TINs in the future. The returns would be directed to the Error Resolution function year after year, thus steadily increasing the volume of returns requiring research, and unnecessarily delaying the processing of all returns.

Office of Audit Comment: We disagree with the IRS’ response regarding correcting names and TINs on returns rather than disallowing related exemptions and credits. Correcting a taxpayer’s return does not preclude the IRS from issuing a notice to the taxpayer (when applicable) explaining the taxpayer’s mistake and encouraging the taxpayer to ensure that the TINs they enter on their tax returns are correct in succeeding years. Issuing such a notice would address IRS’ concern of a steadily increasing volume of returns requiring research and correction.

The IRS has spent a significant amount of taxpayer dollars developing computer systems which can provide instant access to taxpayers’ accounts in the name of providing "one-stop" service to taxpayers. The ability to perform the research we have recommended (which only takes a matter of seconds) resulted from these efforts. Some of the invalid names and TINs identified are the result of mistakes by IRS employees when entering the numbers into IRS computers. Performing the recommended research would allow the IRS to avoid sending erroneous notices to the taxpayers affected by these IRS errors, and would demonstrate the IRS’ commitment to "one-stop" service and taxpayer education.