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entitled 'IRS's Use of Information on Taxpayers Claiming Many 
Allowances or Exemption From Federal Income Tax Withholding' which was 
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November 6, 2003:

The Honorable Mark W. Everson:

Commissioner of Internal Revenue:

Subject: IRS's Use of Information on Taxpayers Claiming Many Allowances 
or Exemption From Federal Income Tax Withholding:

Dear Mr. Everson:

In September 2003, we responded to a request from Representative Elton 
Gallegly to provide information on the number of taxpayers who claimed 
more than 10 withholding allowances and taxpayers who claimed exemption 
from federal income tax withholding. The Internal Revenue Service (IRS) 
calls such claims questionable Form W-4s. However, in the course of 
performing our work, we became concerned about the reliability of the 
information that IRS maintains on these taxpayers and decided that we 
could not use it to answer Representative Gallegly's questions. For 
background, see our letter to Representative Gallegly in enclosure 1.

The objectives of this letter are to summarize our findings about the 
reliability of the information IRS maintains on taxpayers who claimed 
more than 10 withholding allowances or exemption from federal tax 
withholding and to bring to your attention some resulting questions 
about the value of IRS continuing to collect the information.

Results:

We have two concerns about the information that IRS maintains on 
taxpayers who claimed more than 10 withholding allowances or exemption 
from federal tax withholding that precluded us from using it to respond 
to Representative Gallegly's questions. First, we are concerned about 
the completeness of the information because a significant number of 
employers may not send IRS the required forms. According to IRS's 
information, about 75 percent of the large employers with 1,000 or more 
employees in its Large and Medium-Size Business (LMSB) and Small 
Business/Self-Employed (SB/SE) divisions that filed employment tax 
returns in tax year 2001 did not send IRS any forms. Although the 
number of questionable Form W-4s IRS might receive from individual 
employers can vary, it seems unlikely that 75 percent of employers with 
1,000 or more employees could have no employees who submitted 
questionable Form W-4s. Second, some of the information may not be 
current--it may not reflect the current withholding status of some 
taxpayers. If an employee who previously claimed more than 10 
allowances or claimed exemption from federal income tax withholding 
submitted a new Form W-4 claiming 10 or fewer allowances or not 
claiming exemption from withholding, the database would continue to 
show the earlier information. There is no requirement for employers to 
submit Form W-4s other than those claiming 10 or more allowances or 
exemption. We could not quantify the significance of our concerns about 
the reliability of IRS's data; however, the uncertainty about how 
complete and current the data were precluded us from using them to 
respond to Representative Gallegly's questions.

While acknowledging the limitations of the information in the 
Questionable Form W-4 database, IRS's Wage and Investment (W&I) 
Division officials stated that the information in the database was 
useful to them for tax compliance purposes. The officials said that 
they use the database to identify useful leads in determining possible 
underwithholding issues that can lead to noncompliance. For example, 
tax examiners at IRS's Fresno Computing Center routinely review the 
withholding information of certain taxpayers to substantiate their 
claims. If the taxpayers cannot substantiate their claims, the 
examiners would require that the taxpayers' withholdings be adjusted to 
appropriate levels. According to the Treasury Inspector General for Tax 
Administration, about 70 percent of the cases closed by the examiners 
in fiscal year 2001 resulted in no changes to the taxpayers' 
withholding claims.[Footnote 1]

However, considering what we learned about the reliability of the data, 
questions may be raised about the value and fairness of IRS's 
enforcement efforts that rely on the database. One question is whether 
it is worth devoting IRS's resources to maintaining a database of 
questionable reliability. According to information IRS provided us in 
July 2003, 32 full time equivalent staff was dedicated to the 
Questionable Form W-4 program. A related question is whether it is 
worth the burden borne by those taxpayers who send IRS forms. Another 
question is about the evenhandedness of IRS's use of the database as a 
compliance tool. Taxpayers whose employers are not submitting 
questionable Form W-4s are less likely to face compliance checks under 
the program than taxpayers whose employers do submit the forms.

IRS has reengineering efforts underway to improve the Questionable Form 
W-4 database, which we discuss in our report to Representative 
Gallegly. Based on information from program officials, these efforts 
were being implemented when we were preparing this report. Although we 
did not assess IRS's reengineering plans, it was not clear to us that 
the plans would address the data reliability concerns we discussed in 
this report and in our report to Representative Gallegly. The 
reengineering efforts address database improvements to enhance 
compliance checks.

In addition to summarizing our concerns, our letter to Representative 
Gallegly contains details of the scope and methodology of the work that 
we performed from October 2002 through June 2003 in accordance with 
generally accepted government auditing standards.

Conclusions and Recommendation:

We have questions about the value and fairness of using the 
Questionable Form W-4 program database for compliance purposes because 
of uncertainties about the extent that the data are complete and 
current.

Because of these questions we recommend that you assess the value of 
IRS's Questionable Form W-4 program and determine whether the program 
should continue in its current form.

Agency Comments and Our Evaluation:

On October 28, 2003, we received comments from the Commissioner of 
Internal Revenue on a draft of this report. The Commissioner agreed 
with our recommendation, stating that he will undertake a comprehensive 
review of the Questionable Form W-4 Program to determine its 
effectiveness and relevancy in the current environment. Further, he 
said that the Commissioner of the W&I Division is to lead the effort. 
The Commissioner's comments are reprinted in enclosure 2.


This report contains a recommendation to you. The head of a federal 
agency is required by 31 U.S.C. 720 to submit a written statement on 
actions taken on this recommendation. You should send your statement to 
the Senate Committee on Governmental Affairs and the House Committee 
on Government Reform within 60 days after the date of this report. 
A written statement also must be sent to the House and Senate 
Committees on Appropriations with the agency's first request for 
appropriations made over 60 days after the date of this report.

We are sending copies of this report to the Secretary of Treasury and 
to interested congressional committees. This report will also be 
available at no charge on GAO's Web Site at http:www.gao.gov.

If you have any questions about this report, please contact me at (202) 
512-9110 or by E-mail at whitej@gao.gov. Key contributors to this 
assignment were Charlie Daniel and Arthur L. Davis.

Sincerely yours,

James R. White:

Director, Strategic Issues:

Signed by James R. White:

Enclosures:

Enclosure 1: Report to Representative Elton Gallegly:

September 15, 2003:

The Honorable Elton Gallegly:

House of Representatives:

Subject: Reliability of Information on Taxpayers Claiming Many 
Withholding:

Allowances or Exemption from Federal Income Tax Withholding:

Dear Mr. Gallegly:

When taxpayers claim more withholding allowances than they are entitled 
to or improperly claim exemption from withholding, either no tax or too 
little tax is withheld from their wages. As a result, some taxpayers 
end up owing the Internal Revenue Service (IRS) additional taxes, and 
if the taxes are not paid on time, they become delinquent. This report 
responds to your request for information on these taxpayers.

Specifically, you asked that we provide you with information on (1) how 
many taxpayers claimed more than 10 allowances for federal income tax 
withholding purposes and (2) how many taxpayers claimed exemption from 
federal income tax withholding and, of those taxpayers, what proportion 
did not file federal income tax returns and had invalid Social Security 
numbers. However, because of concerns about the completeness and 
currency of the information reported to IRS on taxpayers who claimed 
more than 10 withholding allowances or taxpayers who claimed exemption 
from withholding, we could not use it to respond to your questions. 
This report discusses why we could not use IRS's information to answer 
your questions and briefly describes IRS's proposals to help address 
this problem. To perform our work, we analyzed information from IRS's 
Questionable Form W-4 database[Footnote 1] and interviewed IRS 
officials responsible for managing the Questionable Form W-4 program. 
Further details on our scope and methodology are provided later in this 
report.

Results in Brief:

We have two concerns about the information that IRS maintains on 
taxpayers who claimed more than 10 withholding allowances or exemption 
from federal tax withholding that preclude us from using it to answer 
your questions. First, we are concerned about the completeness of the 
information because a significant number of employers may not send IRS 
the required forms. Second, some of the information may not be current-
-it may not reflect the current withholding status of some taxpayers. 
While acknowledging the limits of the information for answering your 
questions, IRS officials told us that the information is useful for tax 
compliance purposes. Also, the officials said that IRS has efforts 
under way intended to influence employers to comply with the reporting 
requirement. IRS provided oral comments on a draft of this report 
stating that it generally agreed with our findings. IRS's comments are 
summarized later in this report.

Background:

Section 3402 of the Internal Revenue Code requires employers to 
withhold income tax from wages and other forms of income. It outlines 
the basis for claiming withholding allowances or exemption from 
withholding and specifies the general content of the IRS Form W-4--
Employee's Withholding Allowance Certificate (Form W-4) that employees 
submit to employers when making their withholding allowance claims.

Each employee is required to submit a completed Form W-4 to his or her 
employer. Employees are to use the worksheet attached to the Form W-4 
to determine the number of withholding allowances they should claim. 
The worksheet's instructions consider, among other things, a taxpayer's 
filing status, number of dependents he or she claims on the tax 
returns, and eligibility for the child tax credit. For example, a 
married taxpayer filing a joint tax return who has four dependent 
children and large itemized deductions may be eligible to claim more 
than 10 allowances. Some taxpayers not claiming a specific number of 
allowances may claim exemption from federal income tax withholding. 
Generally, taxpayers can claim exemption from withholding if they had 
no tax liability for the previous year and expect to have none in the 
current year.

Treasury regulations[Footnote 2] require that employers send IRS 
"questionable Form W-4s."[Footnote 3] 
According to IRS, a questionable Form W-4 is any Form W-4 on which a 
taxpayer claims more than 10 withholding allowances or claims exemption 
from withholding with over $200 per week in wages. The information that 
IRS receives from employers on questionable Form W-4s is maintained in 
the Questionable Form W-4 database.

IRS uses information in the database to identify potential 
noncompliance with its withholding guidelines. IRS's tax examiners at 
the Fresno Computing Center review selected questionable Form W-4 cases 
to determine if the withholding is appropriate based on the taxpayer's 
filing history and may contact the taxpayer if additional information 
is needed to substantiate the withholding allowances claimed. If the 
tax examiners determine that the withholding allowances claimed are 
incorrect or if taxpayers do not respond to IRS contacts, the tax 
examiners mail "lock-in" letters to the taxpayers' employers directing 
them to disregard the taxpayers' Form W-4s as filed and to withhold at 
the rate for a single person with zero allowances or at some other rate 
determined by the tax examiners.

Findings:

Because of concerns about the completeness and currency of the 
information in IRS's Questionable Form W-4 database, we cannot respond 
to your questions. According to our guidance for assessing the 
reliability of computer-processed data,[Footnote 4] we cannot use data 
that are significantly incomplete, inaccurate, and not up to date and 
subsequently could lead to an unintentional or incorrect message.

We are concerned about whether the information in IRS's Questionable 
Form W-4 database is sufficiently complete because some employers 
likely do not send IRS withholding information on employees who claim 
more than 10 allowances or claim exemption from federal income tax 
withholding, as required. IRS program officials told us that they do 
not know the extent to which employers might not be sending in 
questionable Form W-4s.[Footnote 5] However, IRS's analysis of large 
employers with 1,000 or more employees that sent in questionable Form 
W-4s provides some evidence that a significant number of large 
employers may not be reporting Form W-4 information to IRS. This 
analysis showed that 25 percent of the employers with 1,000 or more 
employees in its Large and Medium-Size Business (LMSB) and Small 
Business/Self-Employed (SB/SE) divisions that filed employment tax 
returns in tax year 2001 sent in questionable Form W-4s to IRS (1,933 
of 7,713 employers). Similarly, 16 percent of the employers with 1,000 
or more employees in IRS's Tax Exempt/Government Entities Division had 
submitted questionable Form W-4s (610 of 3,888 employers). Although the 
number of questionable Form W-4s IRS might receive from individual 
employers can vary, we question whether 75 percent of large employers 
with 1,000 or more employees in IRS's LMSB and SB/SE divisions could 
have no employees who submitted questionable Form W-4s. Information 
from IRS showed that IRS received about 800,000 questionable Form W-4s 
from 33,000 employers in calendar year 2002 or, on average, about 25 
forms from each employer who submitted. This average includes many 
employers with fewer than 1,000 employees.

Under current law, IRS does not have statutory authority to impose a 
penalty to enforce employer compliance with the reporting requirement. 
The reporting requirement was promulgated in Treasury regulations.

In addition, IRS's questionable Form W-4 database may not accurately 
reflect the current withholding status of some taxpayers. In 
particular, if an employee who previously claimed more than 10 
allowances or claimed exemption from federal income tax withholding 
submitted a new Form W-4 claiming 10 or fewer allowances or not 
claiming exemption from withholding, the database would continue to 
show the earlier information. This is because employers are only 
required to send questionable Form W-4s to IRS.[Footnote 6] There is no 
requirement for employers to forward to IRS new Form W-4s that do not 
meet the questionable Form W-4 criteria.

IRS officials acknowledged the limitations of IRS's Questionable Form 
W-4 database for answering your questions. However, the officials said 
that the database provides IRS with useful leads in determining 
possible underwithholding issues that may lead to noncompliance. They 
told us that they use the database for identifying taxpayers who may be 
underwithholding taxes since those taxpayers also may not file tax 
returns. IRS's tax examiners review certain questionable Form W-4s to 
substantiate taxpayers' withholding claims.[Footnote 7] When the 
taxpayers' claims cannot be substantiated, the tax examiners issue 
"lock-in" letters to both the taxpayers' employers and the taxpayers 
stating that the taxpayers' withholdings are to be adjusted based on 
IRS's investigation.

We asked IRS officials if they had plans to improve employers' 
compliance with the reporting requirement. IRS officials told us that 
they have initiated reengineering efforts to improve the existing 
system and database, allowing them to, among other things, improve the 
integration of other compliance databases to detect noncompliance and 
expedite the issuance of lock-in letters. In February 2003, all of IRS 
operating divisions and a panel of external stakeholders participated 
in a Form W-4 compliance summit. During the summit, the participants 
identified a number of suggestions to improve employer and taxpayer 
compliance with withholding requirements, including improvements to 
forms, on-line information, and services such as W-4 calculator and 
development of frequently asked questions for IRS's Web site. The 
officials also said that IRS's divisions will continue to work together 
to identify outreach and educational strategies to educate employers, 
stem noncompliance, and encourage voluntary employer reporting of 
potential abusive schemes related to withholding evasion. Because the 
activities were new or being implemented, we did not evaluate them to 
determine their effectiveness in improving employers' compliance with 
the reporting requirement.

Concluding Observations:

Considering what we learned about the reliability of the data, 
questions may be raised about the value of IRS's efforts to maintain 
the Questionable Form W-4 database. For this reason, we are sending a 
separate letter to the Commissioner of Internal Revenue describing what 
we learned and recommending that he assess whether IRS's Questionable 
Form W-4 program should continue in its current form.

Agency Comments and Our Evaluation:

We asked IRS to provide us oral comments on a draft of this report. On 
August 27, 2003, we received comments from the Director of Filing and 
Payment Compliance, Wage and Investment Division. The Director 
generally agreed with our findings and acknowledged the limitations of 
the Questionable Form W-4 database in providing information we could 
use to respond to your questions. IRS stated that although the database 
did not meet our standards for responding to your questions, it 
believes that the database serves its intended purpose of housing data 
to facilitate its efforts to address underwithholding at its source, 
thereby increasing compliance early and preventing future delinquencies 
that can be both costly for IRS to resolve and burdensome to taxpayers. 
The comments also stated that reengineering efforts were recently 
initiated to improve the Questionable Form W-4 program as we mentioned 
earlier in our report.

Scope and Methodology:

To perform our work, we interviewed IRS's W&I Operating Division staff, 
who were responsible for managing the Questionable Form W-4 program, 
and IRS Detroit Computing Center staff, who were responsible for 
maintaining the Questionable Form W-4 database. Based on these 
contacts, we obtained an understanding of how the program operates, 
determined how IRS monitors employers' compliance with Form W-4 
reporting requirements to help us assess the reliability of the 
Questionable Form W-4 database, and obtained relevant documentation.

We analyzed IRS's Questionable Form W-4 database to determine what 
information IRS maintains on taxpayers who claimed more than 10 
withholding allowances or claimed exemption from federal income tax 
withholding. According to IRS, the database primarily covers a 4-year 
period. The database we reviewed primarily covered tax years 1998-2002. 
We assessed the reliability of IRS's Questionable Form W-4 database by 
performing electronic testing, reviewing existing information about the 
data and the system IRS created, and interviewing agency officials 
knowledgeable about the data and the system. As stated in the report, 
we determined that the data were not sufficiently reliable to answer 
your questions.

In addition, we reviewed various IRS documents and publications 
pertaining to tax withholding that indicate the responsibilities of 
taxpayers and employers. We also reviewed IRS and Treasury Inspector 
General for Tax Administration reports related to IRS's questionable 
Form W-4 program. We conducted our work from October 2002 through June 
2003 in accordance with generally accepted government auditing 
standards.

- - - - -:

We are sending copies of this report to the Commissioner of Internal 
Revenue and other interested parties. We will make copies available to 
others upon request. This report will also be available at no charge on 
GAO's Web site at http://www.gao.gov.

If you have any questions about this report, please contact me at (202) 
512-9110 or by E-mail at whitej@gao.gov. Key contributors to this 
report were Charlie Daniel and Arthur L. Davis.

Sincerely yours,

James R. White:

Director, Strategic Issues:

Signed by James R. White:

(440170):

FOOTNOTES

[1] This refers to IRS's Questionable Form W-4 Case Control System.

[2] Treasury Regulation 31.3402(f)(2)-1(g)(1)-(2).

[3] If a new employee does not give the employer a completed Form W-4, 
the employer is to withhold tax as if the employee is single, with no 
withholding allowances.

[4] U.S. General Accounting Office, Applied Research and Methods: 
Assessing the Reliability of Computer-Processed Data (External Version 
1), GAO-03-273G (Washington, D.C.: October 2002).

[5] IRS conducted questionable Form W-4 compliance checks in the 1980s 
based on a representative sample of 3,331 employers. Less than 50 
percent of the questionable Form W-4s received by employers were 
reported to IRS.

[6] The database also includes information on employees whose 
questionable Form W-4s were reviewed by IRS tax examiners and were 
subsequently adjusted to levels below the criteria for submission to 
IRS.

[7] IRS's tax examiners were reviewing cases of taxpayers who have 
histories of noncompliance, that is, nonfilers and balance due 
taxpayers.

[End of section]

Enclosure 2: Comments from the Internal Revenue Service:

COMMISSIONER:

DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE WASHINGTON, D.C. 
20224:

October 28, 2003:

Mr. James R. White: 
Director, Tax Issues: 
U.S. General Accounting Office 
441 G Street, N W 
Washington, D.C. 20548:

Dear Mr. White:

Thank you for the opportunity to provide comments regarding this 
report. Withholding compliance is a vital component of our voluntary 
tax administration system. We believe that by addressing under-
withholding at its source, we increase compliance early in the process, 
preventing future delinquencies that can be both costly to the Service 
to resolve and burdensome to the taxpayers.

During the 1980s, regulations were established that required employers 
to submit to the IRS, any Form W-4 on which an employee claimed more 
than 10 withholding allowances, or claimed exemption from withholding 
and wages were expected to be over $200 per week. The Questionable Form 
W-4 (QW-4) program was implemented as a vehicle to intervene on 
instances of improper withholding through issuance of a lock-in 
letter.[NOTE 1] This program and the related regulations were designed 
to respond to abusive schemes that had emerged in particular industries 
where there were widespread instances of employees opting out of the 
voluntary tax administration system by claiming excessive withholding 
allowances and/or exempt status.

Your report raises valid questions regarding the current state of the 
QW4 program. Given that this program evolved in the 1980s, it could 
certainly benefit from a comprehensive review to determine its 
effectiveness and relevancy in the current environment. I have asked 
Henry Lamar, Commissioner Wage and Investment Division, to lead this 
effort. This will include a review of the filing and processing 
requirements, the use and impact of lock-in letters, and potential 
alternatives to identify and address withholding noncompliance. During 
fiscal year 2004, the resources applied to the QW4 program are being 
directed to this review, including testing and evaluating potential 
improvements. Your findings and concerns will be a valuable resource as 
we assess the program. We look forward to sharing our progress with 
you.

If you have any questions, or if you would like to discuss this 
response in more detail, please contact Floyd Williams, Director, 
Legislative Affairs, at (202) 622-3720.

Sincerely,


Mark W. Everson:

Signed for Mark W. Everson:

NOTES: 

[1] If tax examiners determine that the withholding allowances claimed 
are incorrect or if taxpayers do not respond to IRS contacts, the tax 
examiners mail "lock-in" letters to the taxpayers' employers directing 
them to disregard the taxpayers' Form W-4 as filed and to withhold at a 
rate for a single person with zero allowances or at some other rate 
determined by the tax examiners.



(450248):

FOOTNOTES

[1] Treasury Inspector General for Tax Administration, Improvements to 
the Questionable Form W-4 Program Are Needed to Determine Program 
Impact on Taxpayer Compliance, Reference Number: 2003-40-006 
(Washington, D.C.: October 2002).