Tax Administration:

More Criteria Needed on IRS' Use of Financial Status Audit Techniques

GGD-98-38: Published: Dec 30, 1997. Publicly Released: Dec 30, 1997.

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Pursuant to a congressional request, GAO reviewed the Internal Revenue Service's (IRS) use of financial status audit techniques to: (1) estimate how frequently IRS used financial status audit techniques in audits closed in tax years prior to the 1994 initiative (1992 and 1993) and in tax years following the 1994 initiative (1995 and 1996); (2) consider how IRS' need to contact taxpayers for additional taxpayer information when using financial status techniques might intrude on taxpayers; (3) estimate the audit results from using financial status audit techniques in terms of the amount of adjustments to reported income; and (4) determine how IRS applied its audit standards, quality controls, and measurement of audit quality to the use of financial status techniques.

GAO noted that: (1) on the basis of its review of samples of IRS audits completed before and after IRS reemphasized the use of financial status techniques, GAO found no statistically significant change in the frequency with which these techniques were used or in the types of returns for which the techniques were used; (2) during both periods, over 75 percent of the audits using financial status techniques involved individual returns with business or farm income--the types of taxpayers that IRS has historically found to be the most likely to underreport income; (3) financial status audit techniques vary in the need for taxpayer contact and how much additional burden or intrusiveness may be perceived by the taxpayer; (4) financial status audits have been criticized by tax professionals and others for, among other things, seeking information about financial status without having evidence of unreported income; (5) such intrusions into taxpayers' spending patterns could occur before the initial interview and during the initial interview; (6) IRS used the Personal Living Expense (PLE) form to inquire about expenses at the time of the notification letter in fewer than 5 percent of the audits for both the 1992 and 1993 and 1995 and 1996 periods; (7) the case files showed that auditors infrequently asked intrusive, financial status type questions at the initial interview; (8) concerning the results, auditors made no adjustments to the individual's reported income attributable to the use of financial status audit techniques in 83 percent of the audits in which these techniques were used; (9) IRS has three tools to oversee the use of financial status audit techniques: (a) audit standards to guide auditors; (b) supervisory review of auditors' adherence to the standards; and (c) a system to measure adherence to the standards; (10) while these tools offered important controls over the use of the financial status techniques, they each have limitations; and (11) on the basis of GAO's review of IRS audit workpapers, the lack of specific criteria may have contributed to the relatively large percentage of audits in which the use of financial status audit techniques resulted in no adjustments to income.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: IRS has revised the guidelines on using and evaluating (through EQMS) the use of financial status techniques. Audit Standard 3 covers use of the techniques. The EQMS reviewer guide provides criteria on using and evaluating the use of the techniques. The EQMS reviewer's form and guide contains the reason codes.

    Recommendation: To provide better assurance that financial status techniques are not overly burdensome and intrusive to taxpayers and that the most productive use is made of limited audit resources, the Commissioner of Internal Revenue should further pursue efforts to develop more specific criteria on when and to what extent to use financial status techniques. To help develop and refine these criteria, the Commissioner of Internal Revenue should ensure that these specific criteria on using the techniques are reflected in the instructions for interpreting the audit standards and the evaluations through the Examination Quality Measurement System and its reason codes of how well audits meet these standards.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  2. Status: Closed - Implemented

    Comments: IRS has created a form under EQMS to monitor the use of the techniques under the new criteria and guidelines. The form is to be used to track which technique was used and the amount of audit adjustments associated with the technique used.

    Recommendation: To provide better assurance that financial status techniques are not overly burdensome and intrusive to taxpayers and that the most productive use is made of limited audit resources, the Commissioner of Internal Revenue should further pursue efforts to develop more specific criteria on when and to what extent to use financial status techniques. To help develop and refine these criteria, the Commissioner of Internal Revenue should monitor the use of financial status techniques under the new criteria to identify factors associated with successful and unsuccessful usage in terms of when and to what extent to use the techniques as well as whether the usage identified unreported income and if so, in what amounts.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  3. Status: Closed - Implemented

    Comments: IRS has collected data on the use of financial status audit techniques during April to December 1999. On the basis of that data, IRS decided during April 2000 to provide more automated guidance and training to its auditors.

    Recommendation: To provide better assurance that financial status techniques are not overly burdensome and intrusive to taxpayers and that the most productive use is made of limited audit resources, the Commissioner of Internal Revenue should further pursue efforts to develop more specific criteria on when and to what extent to use financial status techniques. To help develop and refine these criteria, the Commissioner of Internal Revenue should use these monitoring results to evaluate whether to make further revisions to the criteria on using the techniques or in the system by which IRS monitors their use.

    Agency Affected: Department of the Treasury: Internal Revenue Service

 

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