Tax Administration:

IRS Should Take Steps to Improve the Accuracy of Schedule K-1 Data

GAO-04-1040: Published: Sep 30, 2004. Publicly Released: Nov 1, 2004.

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Over a trillion dollars in income was distributed in tax year 2002 by flow-through entities, such as partnerships, subchapter S corporations, and trusts, to their partners, shareholders, or beneficiaries, respectively. The Internal Revenue Service (IRS) estimates that from 6 to 15 percent of such income is unreported on individual tax returns. This income is reported to both IRS and to the recipients on a Schedule K-1 (K-1). IRS uses K-1 data in its document-matching program to identify noncompliance and for other purposes. GAO was asked to (1) assess the accuracy of K-1 data, specifically transcription errors and taxpayer identification numbers (TIN); (2) determine whether any limitations in the availability or accuracy of K-1 data have affected IRS's ability to identify noncompliance; and (3) identify the benefits and challenges of increasing e-filing of K-1s.

The accuracy of paper-filed K-1 data is reduced by transcription errors; paper and e-filed K-1s have inaccurate TINs. IRS estimates that transcription errors for tax year 2002 ranged from 5 and 9.5 percent and is taking steps to address such errors. Although e-filed K-1s do not require transcription, for tax year 2002, the percentage of invalid TINs for e-filed K-1s and paper-filed K-1s were comparable (7 and 6 percent, respectively). Due to potential burden on flow-through entities and resource constraints, IRS does not notify the entities of invalid TINs on K-1s for correction. If IRS did so, this would likely give e-filing entities enough time to correct invalid TINs before IRS runs its document-matching program. Inaccurate or limited K-1 data have created problems for IRS researchers and examiners. IRS research staff indicated that inaccurate TINs adversely affected their analysis of flow-through entity networks. Further, because IRS captures limited data from flow-through entity returns, including the K-1, IRS staff lack data they consider helpful, such as "Other Income" to help identify tax shelters. In at least 40 percent of closed examination cases we sampled, IRS examiners found errors with return line items not entered into IRS's databases when returns are received. If these lines were available up front, researchers say they would be able to better identify returns with potential noncompliance. Increased e-filing of K-1s would provide benefits and challenges to both IRS and taxpayers. Benefits for IRS include faster, more complete information and millions in annual cost reductions. Benefits for taxpayers include fewer IRS contacts with them because IRS would have more accurate information in its systems. The primary challenge for IRS is its current inability to electronically process all flow-through entity returns and related forms, including the K-1. For taxpayers, the primary challenge is the cost of converting from paper to e-filing.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendation for Executive Action

    Recommendation: To improve the availability and usefulness of Schedule K-1 data to IRS for detecting noncompliance, IRS should conduct a pilot study to determine the benefits and costs of requiring flow-through entities to correct invalid TINs on K-1s as soon as it has been determined that the TINs cannot be "perfected" via IRS's TIN validation program.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Implemented

    Comments: From January 2005 to July 2006, IRS conducted a study to determine whether some recipients of Schedules K-1 (K-1) with invalid payee taxpayer identification numbers (TIN) were reporting flow-through income on their tax returns and whether there were indications of other types of noncompliance that a matching program would not detect. The study found that, for the population it studied, some compliance risk exists for individuals either not filing or underreporting K-1 income, but the level of noncompliance was consistent with that found in the population of recipients of K-1s with valid payee TINs. The study also found no clear patterns of deliberate misreporting to avoid income tax. In August 2006, IRS estimated the maximum potential revenue from a K-1 TIN perfection program to be nearly $2 million. According to IRS, the benefits calculated were limited to measurable benefits from the IRS document matching and non-filer programs and did not include immeasurable benefits, such as improving data for research or examination purposes. In September 2006, IRS reported several options for perfecting TINs, with costs ranging from $521,000 to $3,300,000. In November 2006, IRS executives and program managers concluded that estimated costs were high relative to potential benefits and decided not to implement any changes at that time but would consider other options in the future, as appropriate.

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