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Testimony: 

Before the Committee on Finance, U.S. Senate:

For Release on Delivery Expected at 10:00 a.m. EDT Tuesday, October 21, 
2003:

Internal Revenue Service:

Challenges Remain in Combating Abusive Tax Shelters:

Statement of Michael Brostek Director, Tax Issues:

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-104T] GAO-04-
104T:

GAO Highlights:

Highlights of GAO-04-104T, a testimony to the Committee on Finance, 
U.S. Senate 

Why GAO Did This Study:

Recent scandals involving corporations, company executives, and 
accounting, law, and investment banking firms heightened awareness of 
abusive tax shelters and highlighted the importance of the Department 
of the Treasury and the Internal Revenue Service (IRS) addressing 
them. During 1999, Treasury issued a report indicating that abusive 
shelters were a large and growing problem, involving billions of 
dollars of tax reductions. Treasury was concerned that abusive 
shelters could ultimately undermine the integrity of the voluntary 
compliance tax system. 

GAOís statement today is based on work done at the request of the 
Chairman and the Ranking Minority Member of the Senate Committee on 
Finance to examine IRSís strategy for dealing with abusive tax 
shelters. In reporting on abusive shelters, GAO is describing 

* their nature and scope, 

* IRSís strategy and enforcement mechanisms to combat them and the 
performance goals and measures IRS uses to track its major effort in 
that area, and 

* the decision-making process IRS used and the plans it has to devote 
more resources to addressing abusive shelters.

What GAO Found:

By their nature, abusive tax shelters are varied, complex, and 
difficult to detect and measure. Abusive shelters manipulate many 
parts of the tax code or regulations and may involve steps to hide the 
transaction within a tax return. In recent years, IRS has been 
accumulating information about them and, although it does not have a 
reliable measure of the size of the abusive shelter problem, has come 
to believe that abusive shelters deserve substantially increased 
attention. IRS continues to gather more information to better define 
the scope of the problem and has data sources, all with their own 
limitations, that suggest abusive tax shelters total tens of billions 
of dollars of potential tax losses over about a decade.

IRSís broad-based strategy for addressing abusive shelters included:

* targeting promoters to head off the proliferation of shelters; 

* making efforts to deter, detect, and resolve abuse; 

* offering inducements to individuals and businesses to disclose their 
use of questionable tax practices; and

* using performance indicators to measure outputs and some outcomes 
and intending to go down the path it has started and develop long-term 
performance goals and measures linked to those goals. Without these 
latter elements, Congress would find gauging IRSís progress difficult.

In allocating resources to shelters, IRS used a systematic decision-
making process that relied on admittedly limited information. It 
planned to shift significant resources in fiscal years 2003 and 2004 
to address abusive shelters but faces challenges, especially in the 
near term, in addressing abusive shelters due to a growing workload 
and limited information on how long it takes to examine shelter cases. 
IRSís understanding of how many staff will be needed to address the 
problem over what period will continue to evolve as it gains a better 
understanding of the problemís scope.

What GAO Recommends:

www.gao.gov/cgi-bin/getrpt?GAO-04-104T.

To view the full product, including the scope and methodology, click 
on the link above. For more information, contact Michael Brostek at 
(202) 512-9110 or brostekm@gao.gov.

[End of section]

Mr. Chairman and Members of the Committee:

I appreciate the opportunity to testify on the Internal Revenue 
Service's (IRS) efforts to deal with abusive tax shelters. I am using 
the term "abusive shelters" to describe very complicated transactions 
promoted to corporations and wealthy individuals to exploit tax 
loopholes and provide large, unintended tax benefits. Recent scandals 
involving corporations, company executives, and accounting, law, and 
investment banking firms heightened awareness of abusive shelters and 
highlighted the importance of the Department of the Treasury and IRS 
addressing the problem. During 1999, Treasury issued a report 
indicating that abusive shelters were a large and growing problem, 
involving billions of dollars of tax reductions.[Footnote 1] Treasury 
was concerned that abusive shelters could ultimately undermine 
voluntary compliance by eroding the integrity of the tax system. In 
response to information pointing to the rapid growth of abusive 
shelters, IRS formalized a strategic initiative in fiscal year 2000 to 
strengthen its capacity to deal with abusive corporate shelters. One 
element of IRS's initiative involved creating a central office within 
the Large and Mid-Size Business (LMSB) Division to coordinate and guide 
efforts to curb the growth of abusive shelters.

My statement today is based on work we have done at the request of the 
Chairman and the Ranking Minority Member. In examining abusive 
shelters, we focused on (1) their nature and scope, (2) IRS's strategy 
and enforcement mechanisms to combat them and the performance goals and 
measures IRS uses to track its major effort in that area, and (3) the 
decision-making process IRS used to allocate resources to abusive 
shelters and the plans it has to devote more resources to addressing 
abusive shelters. We were also asked to provide information on IRS's 
Schedule K-1 document matching program, which we are including in 
appendix I.

To do our work, we: 

* analyzed IRS's and other shelter reports, publications, data, and 
other documentation providing insight into the characteristics, 
complexity, size, and type of the problem;[Footnote 2]

* reviewed IRS's planning documents with information on its strategies, 
measures, and resources;

* compared the contents of IRS's planning documents to Government 
Performance and Results Act of 1993 (GPRA)[Footnote 3] criteria for 
what elements strategic planning should include; and:

* interviewed agency officials about their views on, among other 
things, the problem's nature and scope and IRS's strategy.

We did our work from September 2002 through August 2003 in accordance 
with generally accepted government auditing standards. As agreed, we 
are also discussing the related problem of abusive tax schemes in a 
report to be released in the near future. Abusive tax schemes are used 
more by individuals than by large businesses and encompass such 
distortions of the tax system as falsely describing the law (saying, 
for example, that the income tax is unconstitutional), misrepresenting 
facts (for instance, promoting the deduction of personal expenses as 
business expenses), and using trusts or offshore bank accounts to hide 
income. The boundary between what we are calling an abusive tax shelter 
and an abusive scheme is not always clear. Organizationally, although 
IRS's LMSB Division has lead responsibility for combating abusive 
shelters, abusive shelters are pursued by IRS's Small Business/Self-
Employed Division when they are used by businesses with assets of less 
than $10 million or by high-wealth individuals with complicated tax 
returns.

My statement today will make the following points:

* By their nature, abusive shelters are varied, complex, and difficult 
to detect and measure. Abusive shelters manipulate many parts of the 
tax code or regulations and may involve steps to hide the transaction 
within a tax return. In recent years, IRS has been accumulating 
information about abusive shelters and the extent that they were 
promoted, and it has come to believe that abusive shelters deserve 
substantially increased attention. Suffice it to say, although they do 
not have a reliable measure of the size of the abusive shelter problem, 
Treasury and IRS believe that tens of billions of dollars of taxes are 
being improperly avoided and the potential for the proliferation of 
abusive shelters is strong. IRS continues to gather more information to 
better define the scope of the problem and has several data sources, 
each with certain limitations, that point to billions in tax losses. As 
of September 30, 2003, a database on shelter transactions that IRS has 
publicly declared to be tax avoidance transactions suggested the 
potential tax loss to be about $33 billion, the majority of which was 
concentrated from tax year 1993 through the present. This database 
included only transactions disclosed to or discovered by IRS. In 
addition, an IRS contractor estimating annual tax gaps resulting from 
abusive shelters estimated that the annual average of foregone taxes 
between 1993 and 1999 could have been as small as about $11.6 billion 
or as large as about $15.1 billion. However, Treasury, IRS, the 
contractor, and we all have concerns about the reliability of the 
contractor's estimates because of methodological and data constraints 
that the contractor faced.

* The broad-based strategy reflected in IRS planning documents included 
various features as well as elements of strategic planning:

* targeting promoters to head off the proliferation of shelters;

* making efforts to deter, detect, and resolve abuse;

* coordinating efforts throughout IRS;

* offering inducements to individuals and businesses to disclose their 
use of questionable tax practices; and:

* using performance indicators to measure outputs and some outcomes and 
intending to continue down the path it has started and develop long-
term performance goals and measures linked to those goals. Without 
these latter elements, Congress would find gauging IRS's progress 
difficult.

* In developing this strategy, IRS has had to make decisions about 
staffing allocations and what can be accomplished on the basis of 
admittedly limited information. After using a systematic process to 
determine staffing priorities, IRS planned a significant shift in 
resources to address abusive shelters in fiscal years 2003 and 2004. 
However, it faces challenges, especially in the near term, in 
addressing abusive shelters due to a growing workload and limited 
information on how long it takes to examine shelter cases. IRS's 
understanding of how many staff will be needed to address the problem 
over what period will continue to evolve as IRS gains a better 
understanding of the problem's scope.

Background:

Although IRS has no single, authoritative definition of abusive 
shelters, IRS generally characterizes abusive shelters as very 
complicated transactions that sophisticated tax professionals promote 
to corporations and wealthy individuals, exploiting tax loopholes and 
reaping large and unintended tax benefits. As the Joint Committee on 
Taxation has said, "taxpayers and tax administrators have struggled in 
determining the line between legitimate 'tax planning' and unacceptable 
'tax shelters.'" Even though, it continued, "there is no uniform 
standard as to what constitutes a tax shelter Ö there are statutory 
provisions, judicial doctrines, and administrative guidance that 
attempt to limit or identify transactions in which a significant 
purpose is the avoidance or evasion of income tax."[Footnote 4]

Abusive shelters have been promoted by some accounting firms, law 
firms, and investment banks. Investors in these abusive shelters range 
from large and small corporations to wealthy individuals. IRS 
approaches the tax shelter enforcement problem from both the promoter 
and investor perspectives. IRS promoter investigations are designed to 
learn (1) what abusive shelters have been promoted, if the shelters are 
registered,[Footnote 5] and possibly how much they cost investors, (2) 
who purchased the shelters and what tax savings the investors expect, 
and (3) whether promoters should pay penalties for their activities. 
IRS examines investor and other tax returns to see if income, expenses, 
taxes, and credits are accurately reported.

In a June 2002 letter, Treasury responded to congressional questions 
about whether Treasury had a comprehensive strategy for combating tax 
avoidance. In his letter to the then Ranking Member of the Committee on 
Finance, then Secretary of the Treasury O'Neill addressed the actions 
being taken to combat abusive shelters, referring to Treasury's March 
20, 2002, enforcement proposals on the topic. The proposals said that 
IRS had made significant organizational improvements to coordinate its 
response to ongoing abusive tax shelters. Treasury, all of IRS's 
operating divisions, and IRS's Office of Chief Counsel are involved in 
combating abusive shelter activity.

Within IRS, LMSB has primary responsibility for combating abusive tax 
shelter activity. LMSB's OTSA was created in February 2000 to 
centralize and coordinate the IRS response nationwide. As shown in 
figure 1, OTSA is the focal point for IRS shelter activities, 
overseeing promoter tax shelter registrations; taxpayer disclosures of 
tax shelters; hotline tip analysis and referral; and issue coordination 
and interface between the Office of Chief Counsel, Treasury, the Tax 
Shelter Committee, the 6700 Committee (referring to section 6700 of the 
Internal Revenue Code), and external stakeholders.[Footnote 6] The Tax 
Shelter Committee oversees LMSB's tax shelter program. The committee is 
composed of the Commissioner and Deputy Commissioner of LMSB, the 
Director of Pre-Filing and Technical Guidance, LMSB Division Counsel, 
five Industry Directors, the Director of International, and the 
Directors of Field Specialists and Research and Program Planning. The 
6700 Committee serves under the Tax Shelter Committee and approves all 
LMSB tax shelter promoter activities. The financial services' industry 
director chairs this committee. IRS's appeals function receives and 
evaluates taxpayer objections to IRS examination determinations and may 
agree with those determinations or reduce or eliminate changes to tax 
returns resulting from them. The Office of Chief Counsel plays an 
integral role in combating shelters through summons enforcement and 
targeted litigation. By litigating, IRS establishes case law supporting 
IRS enforcement programs and aims to diminish the incentives taxpayers 
find for investing in tax avoidance transactions by increasing the 
risks and costs of IRS discovery.

Figure 1: OTSA's Role in Coordinating IRS Work on Abusive Shelters:

[See PDF for image]

[End of figure]

Nature of Abusive Shelters Is Varied and Complex:

Abusive shelters are complex transactions that manipulate many parts of 
the tax code or regulations and are typically buried among "legitimate" 
transactions reported on tax returns. Because these transactions are 
often composed of many pieces located in several parts of a complex tax 
return, they are essentially hidden from plain sight, which contributes 
to the difficulty of determining the scope of the abusive shelter 
problem. Often lacking economic substance or a business purpose other 
than generating tax benefits, abusive shelters are promoted by some tax 
professionals, often in confidence, for significant fees, sometimes 
with the participation of tax-indifferent parties, such as foreign or 
tax-exempt entities. They may involve unnecessary steps and flow-
through entities, such as partnerships, which make detection of these 
transactions more difficult.

When a transaction has certain abusive characteristics defined by 
section 6111 of the Internal Revenue Code, the promoter or other tax 
shelter organizer is required to register it, describing the 
transaction and its tax benefits to the Secretary of the Treasury. This 
registration requirement enables Treasury and IRS to identify and 
evaluate questionable transactions. Under recently issued Treasury 
regulations,[Footnote 7] effective February 28, 2003, there are six 
categories of transactions for which promoters must maintain lists of 
investors who have entered into the transactions, and investors must 
disclose the transactions into which they have entered. The rules are 
designed to allow IRS to use information from investors to identify 
promoters who do not register transactions and to use promoter 
registrations and investor lists to identify investors who fail to 
disclose transactions. The six categories are:

* transactions offered under conditions of confidentiality,

* transactions including contractual protections to the investor,

* transactions resulting in specific amounts of tax losses,

* transactions generating a tax benefit when the underlying asset is 
held only briefly,

* transactions generating differences between financial accounts and 
tax accounts greater than $10 million, and:

* "listed transactions.":

A "listed transaction" is a transaction that is the same as or similar 
to one of the types of transactions IRS has determined to be a tax 
avoidance transaction. For a transaction to be a listed transaction, 
IRS must issue a notice, regulation, or other form of published 
guidance informing taxpayers of the details of the transaction. As of 
mid-August 2003, IRS had listed 27 kinds of abusive tax shelter 
transactions, a number that, as figure 2 shows, has grown more quickly 
in recent years than it had grown earlier.

Figure 2: Cumulative Number of Listed Transactions over Time, 1990-mid-
August 2003, and Transaction Descriptions:

[See PDF for image]

[End of figure]

Disputes between IRS and taxpayers about the abusive nature of a 
transaction may be litigated. In some, but not all, cases, the courts 
have upheld the government position. The following cases illustrate 
features of abusive shelters:

* In 1993, a corporation began a company-owned life insurance (COLI) 
program in which the company purchased whole-life insurance on 36,000 
employees for which the company was the sole beneficiary. The company 
then borrowed money against the policies at interest rates that 
averaged 11 percent and deducted the interest expense and 
administrative fees from income on its tax returns. Over 60 years, the 
interest costs and administrative fees would have exceeded the cash 
surrender value of the policies and benefits paid by several billion 
dollars. IRS disallowed the deductions and the case was litigated. 
Despite the fact that the money the company made on this arrangement 
may have been used to fund the company's benefits program, or for other 
business purposes, the court found that the function of the program 
itself was only to generate tax deductions. As a result, the Tax Court 
sustained the IRS disallowance of deductions and concluded that the 
COLI program was a sham.[Footnote 8] The Eleventh Circuit Court of 
Appeals affirmed the Tax Court's decision.

* A company had a sizable gain from the sale of a subsidiary and wanted 
to avoid or minimize paying tax on the gain. An investment bank 
proposed forming an offshore partnership with a foreign corporation (a 
tax-indifferent party) for the express purpose of sheltering the 
capital gains of its corporate client. The partnership purchased and 
quickly resold notes in a contingent installment sale transaction. The 
partnership earned a large capital gain, most of which it allocated to 
the foreign corporate partner. Later, related losses were allocated to 
the U.S. corporation, generating an approximate $100 million capital 
loss for the investment bank's client. The corporation used this 
capital loss to shelter its U.S.-based capital gains. Both the Tax 
Court and the Third Circuit Court of Appeals ruled that the transaction 
lacked economic substance.[Footnote 9] The Third Circuit, in addition 
to requiring economic substance, held that a transaction must have a 
subjective nontax business motive to be respected for tax 
purposes.[Footnote 10] For this transaction, the investment bank was to 
earn a fee of $2 million. This was one of 11 such partnerships formed 
over a 1-year period from 1989 to 1990 by the investment bank.

Several Sources Indicate That the Scope of Abusive Shelters Is in the 
Tens of Billions of Dollars, Though All Are Based on Limited Data:

IRS has information that suggests the scope of abusive shelters totaled 
tens of billions of dollars over about a decade,[Footnote 11] but those 
estimates are based on limited data. This information comes from an 
OTSA database, examinations of large corporations, and a contractor 
study. Information contained in the OTSA database includes transactions 
disclosed to or discovered by IRS and estimates of potential tax 
losses. The tax loss estimates vary from being IRS officials' 
recommended taxes based on examining some transactions to taxpayer 
judgments regarding potential losses in cases where examinations have 
not been done. In addition to being based on judgments, the database 
does not include any reductions resulting from examination, appeal, 
litigation, or other sources. Information from examinations of the 
largest corporations, which may overlap information in the OTSA 
database, shows proposed income adjustments in the tens of billions of 
dollars before reductions, but data were not available from IRS on the 
results of examinations of smaller corporations, partnerships, trusts, 
S corporations, or individuals. Information from IRS's contractor study 
estimates an annual tax gap due to abusive shelters but has data and 
methodological limitations.

OTSA Database:

As shown in table 1, as of September 30, 2003, an OTSA database 
included estimated potential tax losses of about $33 billion from 
investments in listed transactions, before considering any reductions 
resulting from examination, appeal, litigation, or other sources and 
another $52 billion in potential tax losses from nonlisted transactions 
with some characteristics of abusive shelters. This database contains 
information on promoters and investors and the amount of potential tax 
savings resulting from listed and nonlisted transactions. Nonlisted 
transactions are transactions that needed to be registered because they 
have some characteristics of abusive shelters but were not, at least 
yet, determined to be abusive. According to an IRS official, IRS was 
studying nonlisted transactions with about $12 billion in potential tax 
losses for possible listing. The database only includes information on 
abusive or possibly abusive transactions that had been disclosed to or 
discovered by IRS.

Table 1: IRS's Compilation of Tax Shelter Amounts as of January 14, 
2003, and September 30, 2003:

[See PDF for image]

Source: IRS OTSA database.

[A] The potential tax loss covers a multiyear period and does not 
consider reductions that may result from examination, appeal, 
litigation, or other sources.

[B] The numbers do not add to the total due to rounding.

[End of figure]

The estimated tax losses contained in the OTSA database cover a wide 
range of years from at least as far back as tax year 1989 and extending 
even to future tax years since, for instance, improperly claimed 
deductions may be used in some cases to reduce future taxes. For the 
$29 billion in estimated tax losses associated with listed transactions 
contained in the January 14, 2003, database, about 82 percent of the 
potential tax losses were concentrated in the period from 1993 through 
2002.

According to data IRS provided in mid-October 2003, OTSA had 
information on almost 300 firms that had possibly promoted abusive 
shelters as well as other tax planning products that contain at least 
some features of abusive transactions. It was also aware of about 6,400 
investors, including individuals and corporations that bought abusive 
shelters and other aggressive tax planning products.

Examinations of Large Corporations:

IRS has proposed shelter-related adjustments to large corporations' 
income in examinations it has closed and in examinations still open as 
of early May 2003. In cases closed between October 1, 2001, and May 6, 
2003, IRS proposed about $10.6 billion in abusive shelter-related 
adjustments to the income of 42 large corporations for tax years 1992-
2000. These proposed adjustments would result in about $3.5 billion in 
tax revenue if the adjustments were not reduced. The corporations were 
in what is known as the Coordinated Industry Case (CIC) program, which 
includes the nation's largest corporations.[Footnote 12] They agreed 
with about $1.2 billion of the $10.6 billion in proposed adjustments to 
income.[Footnote 13] As of early August 2003, Appeals research showed 
that few of the issues comprising the $9.4 billion unagreed amount had 
been resolved yet by Appeals or through a settlement initiative, 
although the database did not track all of them.[Footnote 14] For the 
141 large corporations with cases still open in early May 2003, the 
amount of proposed shelter-related income adjustments was $47.6 
billion, translating to about $16 billion in tax if not reduced. IRS 
did not have similar information for smaller corporations. Also, since 
one of the sources of information in the OTSA database is shelter-
related adjustments proposed in examinations, the proposed adjustments 
in the CIC program may overlap the information in the OTSA database.

Contractor Study:

In July 2003, an IRS contractor estimated the tax gap resulting from 
abusive shelters for different years. For 1993 through 1999, based on 
the contractor's estimates, the average annual tax gap could have been 
as small as about $11.6 billion or as large as about $15.1 billion of 
forgone tax. However, the reliability of the contractor's estimates is 
questionable because of methodological and data constraints the 
contractor faced when developing them.

The estimates followed a September 2001 recommendation by the Treasury 
Inspector General for Tax Administration (TIGTA) that LMSB obtain a 
more precise estimate of the shelter problem to lay a better foundation 
for its strategy for addressing abusive shelters.[Footnote 15] In 
response, IRS contracted for models to predict the likelihood of 
finding abusive shelters within certain tax returns and to estimate the 
annual "tax gap" due to abusive shelters. Both IRS and contractor 
officials believe the contract results are more useful to predict 
returns with abusive shelters than they are to value the size of the 
abusive shelter problem.

Nevertheless, as table 2 shows, the contractor produced estimates of 
the size of the problem for each year from 1993 through 1999. Yearly 
low-end estimates ranged from $9.0 billion of foregone tax in 1993 to 
$14.5 billion in 1999. On the other hand, the high-end estimates ranged 
from $12.1 billion in 1993 to $18.4 billion in 1999.[Footnote 16] 
Averaging the estimates over time results in the $11.6 billion to $15.1 
billion range cited earlier.

Table 2: Contractor Estimates of the Size of the Abusive Shelter 
Problem (Dollars in Billions):

Year: 1993; Lower bound: $ 9.0; Upper bound: $12.1.

Year: 1994; Lower bound: 9.5; Upper bound: 12.7.

Year: 1995; Lower bound: 10,3; Upper bound: 13.6.

Year: 1996; Lower bound: 11.4; Upper bound: 14.9.

Year: 1997; Lower bound: 12.7; Upper bound: 16.4.

Year: 1998; Lower bound: 13.6; Upper bound: 17.3.

Year: 1999; Lower bound: 14.5; Upper bound: 18.4.

Year: 1993-1999 average; Lower bound: 11.6; Upper bound: 15.1.

Source: Report provided by IRS.

Note: As computed by the contractor, the lower and upper bounds are the 
boundaries of 90 percent confidence intervals associated with the 
estimates.

[End of table]

The tax gap model used three different kinds of data: (1) IRS's 
Statistics of Income data for the largest U.S. companies, those with 
assets over $250 million falling within the CIC program, (2) Standard 
and Poor's Compustat financial data, and (3) surveys of IRS field 
offices. IRS conducted surveys from 1999 through 2001 that asked field 
managers to identify abusive tax shelters in their open inventory of 
examinations--relying on each manager's understanding of what an 
abusive tax shelter is. Since survey data are included in the OTSA 
database, some of the same information used by the contractor appears 
in the OTSA information cited earlier.

Treasury, IRS, the contractor, and we have concerns about the 
contractor estimates. First, it is difficult to determine whether these 
estimates might be overstating or understating the true extent of the 
tax gap because of the uncertainties in the underlying data and the 
elusive nature of the problem. In identifying abusive shelters in the 
IRS surveys, field managers might have anticipated that some abusive 
shelters existed where there were none or where the assertion of abuse 
might not be sustained. On the other hand, they might not have 
identified all the abusive shelters in their open inventory of 
examinations because their definitions of abusive shelters might have 
differed from each other. Finally, the data might not be representative 
of all transactions, especially those that closed, because survey 
responses were only to include open cases.

Second, the Statistics of Income data only included U.S. corporations 
with assets of over $250 million falling within the CIC program. Many 
shelters may be reflected in tax returns of smaller corporations, 
partnerships, Subchapter S corporations, and wealthy individuals and 
were not included in this study. Since these transactions were not 
included in the contractor's estimate, the resulting tax gap estimate 
is incomplete.

Third, the estimates are based on known shelters. They were developed 
using 1990s' ideas of what constituted abusive shelters. Since then, 
more shelters have been disclosed or identified by IRS and still others 
are under consideration for listing. Since the definition of an abusive 
shelter can change over time, and the data cannot reflect unknown or 
unidentified shelters, the operational definition of abusive shelters 
was a conservative one.

While the last two concerns argue that the contractor's estimates 
understate the true level of abusive shelters for recent years, the 
contractor's estimates and other indicators of the problem's size based 
on past data may also be of limited use as guides to current and future 
activity for other reasons. According to Treasury and IRS officials, 
the legal and economic environment has changed since the data for this 
study were developed. First, they said, IRS has taken many 
administrative actions to address abusive shelters. For instance, it is 
their belief that nothing puts more of a damper on taxpayer 
participation in a particular type of transaction than IRS listing it. 
Similarly, although corporate-owned life insurance transactions may 
heavily influence the contractor's estimates, legislation addressed the 
problem in 1996 and 1997, and therefore current and future estimates 
would not reflect that problem--although they could reflect problems 
not identified in the period covered by the contractor's study. Second, 
court cases have largely supported IRS's assertions about the need for 
business purpose requirements and about requirements for economic 
substance in transactions. Third, today's economy is not as robust as 
the economy in the late 1990s, generating less profit to protect. 
Finally, the publicity surrounding numerous corporate scandals may 
create a chilling effect in the market for aggressive transactions. 
Countering these points, however, are other opinions appearing in the 
press that (1) the courts could uphold some tax shelters and (2) IRS's 
capacity to stem abusive shelters is limited.

IRS Strategy to Combat Abusive Shelters Is Broad-Based but Generally 
Has No Long-Term Performance Goals or Measures Linked to Goals:

IRS developed a broad-based strategy for combating abusive shelters 
that included various features as well as elements of strategic 
planning. Deeming it a strategic initiative, IRS is executing a 
strategy incorporating four principal elements: (1) an emphasis on 
promoters, (2) efforts to deter, detect, and resolve abuse, (3) 
coordination of efforts throughout IRS, and (4) inducements provided 
for taxpayers to come forward and expedite case resolution. IRS is 
implementing a variety of initiatives designed to reduce taxpayer 
incentives to participate in abusive transactions and discourage 
promoters from marketing these transactions. Although IRS documents 
outline an overall strategy for combating abusive shelters, IRS has 
generally not yet defined long-term performance goals for the effort 
and the measures it would use to track progress in achieving those 
goals.[Footnote 17] However, IRS is planning to establish such goals 
and measures when it has more information on the abusive shelter 
activities it is currently tracking.

IRS Is Actively Pursuing Promoters:

IRS is actively pursuing abusive promoters to ensure (1) that tax 
strategies containing characteristics of potentially abusive shelters 
are registered, (2) that information about transactions is disclosed to 
IRS as required by sections 6111 and 6112 of the Internal Revenue Code, 
and (3) that, according to IRS's OTSA manager, those who generate 
noncompliance change their behavior or go out of business. With 98 
abusive shelter promoters approved for investigation as of June 30, 
2003, IRS uses investigations to gain access to lists of the clients 
who buy promoters' products and devise a roadmap to audit shelters 
included in the tax returns of the investors. IRS is also using 
promoter investigations to enforce the transaction registration 
requirements, which, in turn, assist in its efforts to understand, 
track, and close abusive shelters. IRS announced the completion of 
three large promoter investigations in 2001 through July 2003. They 
resulted in, among other things, three substantial payments and 
promoter promises to work with IRS to ensure ongoing compliance with 
shelter registration and list maintenance requirements.

IRS Efforts Are to Deter, Detect, and Resolve:

IRS focuses its efforts on deterring future marketing and sales of 
abusive tax shelters and on detecting and resolving existing shelters. 
TIGTA described IRS's abusive shelter approach along the lines of 
deter, detect, and resolve in September 2001.[Footnote 18] IRS 
considers its efforts to provide guidance as early as possible to 
taxpayers and promoters in the form of recently proliferating IRS and 
Treasury determinations, notices, and rulings on abusive transactions 
and of registration, list maintenance, disclosure, and other 
requirements to be a key deterrent. (See fig. 2.) Also designed to 
deter abusive tax shelters, accuracy-related penalties aim at investors 
who use abusive shelters to substantially undervalue true tax 
liability. Other penalties are for promoters who market shelters that 
aid and abet the understatement of tax liability or who fail to 
register shelters. IRS's Examination Returns Control System showed IRS 
assessing 21 investor penalties totaling about $73 million between July 
1, 2002, and May 1, 2003, which taxpayers had not necessarily agreed to 
pay. During our review, Treasury included proposed legislation in the 
Administration's revenue proposals to strengthen the penalties that 
could be used in abusive shelter situations.

IRS's ability to detect abusive shelters increased in the last 3 years 
due to OTSA's hotline, through which callers provide tips about 
transactions or investors; disclosure, registration, and list 
maintenance requirements; increased attention by IRS management; and 
increased use of IRS examination resources to look for shelter 
irregularities. For instance, between May 31, 2000, and July 30, 2003, 
the hotline received 729 shelter-related telephone calls and e-mails, 
some of them leading IRS to new listed transactions, promoters, and 
investors. As another example, IRS expanded its disclosure requirements 
in June 2002 to include noncorporate taxpayers. Finally, as evidence of 
increased management attention, IRS established a new senior position 
reporting to the IRS Chief Counsel to supervise staff and lead task 
force initiatives to more quickly identify and deal with abusive 
shelters.

Cases may be resolved at the examination level if taxpayers agree with 
IRS findings. If taxpayers do not agree, cases are resolved at the 
appeals level, through litigation, or by alternative dispute 
resolution.

In addition to these detection and case resolution efforts, IRS is 
using Schedule K-1 data to research better methods of detecting abusive 
shelters that involve multiple levels of flow-through 
entities.[Footnote 19] These complex structures of related entities 
pose challenges in analyzing tax compliance by creating opportunities 
for taxpayers to disguise noncompliance. In the future, IRS hopes to 
use advanced data analysis tools such as link analysis and graph-based 
data mining to identify potential abusive shelters. Link analysis is 
the process of building networks of related entities, such as flow-
through entities and Schedule K-1 recipients, in order to expose 
patterns and trends. Graph-based data mining, a form of link analysis, 
is intended to enable IRS to identify structures of known abusive 
shelters and find similar patterns in the population of flow-through 
networks to discover previously undisclosed potential abusive shelter 
transactions. IRS has paid a contractor $200,000 so far to assess the 
feasibility of these technologies and plans to spend $575,000 over the 
next 1.5 to 2 years to develop these concepts into models.

IRS Emphasizes Internal Coordination:

Coordination within IRS and interface with Treasury on abusive shelters 
is a core objective in IRS's plans for addressing those shelters. OTSA 
is the focal point for all shelter-related activity performed in the 
Tax Shelter Committee, the 6700 Committee, Counsel, Appeals, and LMSB. 
For example, if a taxpayer discloses an investment in a tax shelter to 
IRS, OTSA is to enter the transaction into its database, and OTSA 
reviews the transaction in collaboration with IRS technical advisors 
and counsel. OTSA may also forward it to LMSB examiners for compliance 
action.

At the IRS-wide level, an executive steering committee provides a forum 
for coordinating work on both abusive shelters and abusive schemes. It 
meets monthly and includes participants from LMSB, the Small Business/
Self Employed Division, Appeals, Counsel, and other organizations. It 
operates under the auspices of IRS's Enforcement Committee, which was 
chartered in July 2003. Chaired by the Deputy Commissioner for Services 
and Enforcement, a new position created in May 2003, the Enforcement 
Committee is to guide IRS-wide enforcement strategies, focusing on 
high-visibility issues involving many divisions or potentially having 
significant compliance impact.

Although we did not systematically measure whether coordination is 
facilitated by these mechanisms, we did review minutes of selected 
executive steering committee meetings. In doing so, we saw such 
evidence of coordination as the discussion of an LMSB and SB/SE working 
group on who would work a corporate officer case when LMSB works on a 
corporation.

IRS Offers Inducements for Taxpayers to Disclose Shelters and Expedite 
Case Resolution:

LMSB attempts to leverage its limited resources by using inducements to 
achieve compliance. These tools include penalty relief, "fast track" 
issue resolution, and various structured settlement programs that allow 
participating taxpayers to keep a percentage of a shelter's benefits in 
exchange for conceding most benefits and expediting case resolution. 
For example, under a disclosure initiative that expired on April 23, 
2002, taxpayers who revealed shelters and their respective promoters 
avoided accuracy-related penalties. IRS's aim was to more readily 
identify promoters who had not registered shelters and, through the 
promoters, find taxpayers who had not disclosed their shelter 
participation. As a result of this initiative, IRS received 1,664 
disclosures from 1,206 taxpayers, disclosing tens of billions of 
dollars of losses and deductions.

IRS offered taxpayers various alternative dispute resolution mechanisms 
as inducements to settle abusive shelter issues with IRS, mitigating 
the hazards of litigation for both sides and moving more cases through 
the administrative system quickly. For example, from October 2001 
through April 7, 2003, 17 taxpayers agreed with IRS on their respective 
shelter issues in the Fast Track Issue Resolution program, resolving 
about $1.6 billion in proposed adjustments to income (potentially about 
$540 million in tax). In another example, IRS announced initiatives in 
October 2002 to resolve disputes related to three shelters: COLI, 
basis-shifting shelters, and contingent liability shelters.[Footnote 
20] In these initiatives, if taxpayers agreed to settle their cases 
with IRS by a certain date, with the last initiative closing March 5, 
2003, they would pay a large percentage of the full amount IRS 
disallowed. A summary as of early May 2003 of the number of investors 
involved in the three settlement initiatives and the potential tax 
dollars conceded or to be conceded appears in table 3.[Footnote 21]

Table 3: Investors Accepting Abusive Shelter Settlement Initiative 
Offers and Potential Tax Dollars Conceded or to Be Conceded as of Early 
May 2003:

Settlement initiative: COLI; Number of taxpayers accepting IRS 
settlement offer: 24; Number of taxpayers for whom IRS had information 
on taxes conceded or to be conceded: 14; Potential tax dollars 
conceded or to be conceded (billions): $0.2.

Settlement initiative: Basis shifting; Number of taxpayers accepting 
IRS settlement offer: 267; Number of taxpayers for whom IRS had 
information on taxes conceded or to be conceded: 33; Potential tax 
dollars conceded or to be conceded (billions): 0.6.

Settlement initiative: Contingent liability; Number of taxpayers 
accepting IRS settlement offer: 62; Number of taxpayers for whom IRS 
had information on taxes conceded or to be conceded: 62; Potential 
tax dollars conceded or to be conceded (billions): 2.8[A].

Settlement initiative: Total; Number of taxpayers accepting IRS 
settlement offer: 353[B]; Number of taxpayers for whom IRS had 
information on taxes conceded or to be conceded: 109[B]; Potential 
tax dollars conceded or to be conceded (billions): $3.6.

Source: Compiled by GAO from IRS data.

[A] GAO estimated this number using an average of certain capital loss 
percentages to be conceded.

[B] We do not know if a particular taxpayer was involved in more than 
one type of settlement initiative.

[End of table]

Generally IRS Does Not Have Long-Term Performance Goals or Measures 
Linked to Goals:

Although IRS has outlined and begun to implement a multipart strategy 
for combating tax shelters, it has not yet generally defined 
performance goals for the effort and established the measures it would 
use to track progress in achieving those goals. Performance goals 
define what an organization is trying to achieve over time, preferably 
focusing on the outcome desired rather than activities or outputs. To 
date, according to IRS officials, their shelter-related goals cover the 
number of staff years to be devoted to shelter examinations and the 
number of shelter examinations to be closed. Also, LMSB planning 
documents have a few short-term goals. For example, LMSB had a short-
term goal to begin compliance actions on all voluntary shelter 
disclosures by June 30, 2003, a goal IRS officials told us was met. IRS 
management officials recognize that developing other performance goals 
and associated measures to track progress is desirable but point to 
challenges they face in assessing the scope of the abusive shelter 
problem. Nonetheless, IRS intends to establish such goals in the future 
when it has more information on activities it is currently tracking.

IRS has already started down this road by developing several measures 
that, while not tied to longer-term performance goals, are to be used 
in tracking its progress in combating abusive tax shelters. It devised 
these measures for fiscal year 2003 responding to a September 2001 
TIGTA recommendation to develop performance measures so managers could 
better target problem areas, highlight successes, evaluate 
alternatives, and track whether OTSA is achieving desired outcomes. IRS 
is mostly tracking outputs related to case management, such as the 
number of tax shelter examinations closed and tax shelter return cycle 
time, and is using output measures of IRS program activities, such as 
published guidance issued and hotline contacts. IRS is also using some 
measures that track tax enforcement outcomes, namely adjustments 
proposed to tax returns from disallowing abusive shelters and tax 
shelter penalties proposed.[Footnote 22] Since fiscal year 2003 was the 
first year IRS used these measures, it had no baseline data with which 
to evaluate its performance measures. However, LMSB plans to evaluate 
its measures over time to assess their usefulness.

Resource Shifts Are Significant but IRS Faces Challenges in Addressing 
Abusive Shelter Workload:

Using admittedly limited information, IRS used a systematic decision-
making process in deciding to shift a large portion of LMSB examination 
staff resources toward addressing abusive shelters. From fiscal year 
2002 through fiscal year 2004, LMSB expected to increase the portion of 
its examination resources devoted to combating abusive shelters from 3 
percent in 2002 to 20 percent in 2004. In doing so, it will have 
shifted resources out of examining the category of cases including such 
areas as net operating losses and claims for refunds. Even so, IRS 
faces challenges, especially in the near term, in addressing expected 
increases in its shelter workload because of the growing number of 
shelter cases and limited information it has on how long it takes to 
conduct shelter examinations. As will be described, GAO has previously 
raised questions about IRS's ability to shift compliance resources as 
planned.

IRS Used Systematic Planning and Budgeting Process to Determine 
Staffing Priorities:

At an agencywide level, IRS decided staffing resource levels to be 
devoted to addressing abusive shelters through a systematic planning 
and budgeting process based on experience and professional judgment 
because IRS did not and does not have a reliable measure of the abusive 
shelter problem. Early in calendar year 2002, IRS's divisions completed 
strategic assessments in which they studied trends, issues, and 
priorities affecting their operations. In April 2002, IRS's senior 
management team, including the Commissioner, Deputy Commissioner, 
division heads, and others used two rounds of considering IRS's 
programs to rank the needs for new or redirected funding for fiscal 
year 2004. Of 33 programs considered, the program including tax 
shelters received the third most votes. According to an IRS official, 
this process also informed how funds already requested for fiscal year 
2003 would actually be spent. After the senior management team reached 
consensus, the Commissioner issued overall planning guidance for fiscal 
years 2003 and 2004 to reflect the jointly set strategic direction, and 
the divisions wrote fiscal year 2003 and 2004 "strategy and program 
plans" outlining staffing resources needed.

IRS Shifts Significant Levels of Examination Resources to Shelters:

In 2002, LMSB put forward plans to increase its work on abusive 
shelters from 3 percent of its examination resources to 20 percent 
between fiscal years 2002 and 2004, assuming congressional funding. To 
support this shift in examination resources, LMSB needed to allocate 
examination resources away from other areas. One area to receive less 
audit coverage was 
industry audits.[Footnote 23] As shown in table 4, from fiscal year 
2003 to fiscal year 2004, IRS planned to move resources away from 
specific types of mandatory examinations and from some high-risk 
nonmandatory returns.[Footnote 24] IRS's strategy is to mitigate the 
impact of resource reallocations away from nonshelter areas by using 
such issue management strategies as fast-track resolution and prefiling 
agreements, thereby requiring less staff time to close cases and 
freeing staff to be used in other areas.

Table 4: Percentage of LMSB Examination Resources in Different 
Examination Areas:

Examination area: Shelters; FY 2002[A]: 3%; FY 2003: 15%; FY 2004: 20%.

Examination area: Other mandatory examinations (including coordinated 
industry,[B] claims for refunds, net operating losses, compliance 
initiative projects, and flow-through entities related to wealthy 
individuals); FY 2002[A]: N/A; FY 2003: 55%; FY 2004: 54%[C].

Examination area: Related returns; FY 2002[A]: N/A; FY 2003: 5%; FY 
2004: 4%[C].

Examination area: High-risk, nonmandatory returns; FY 2002[A]: N/A; FY 
2003: 15%; FY 2004: 13%.

Examination area: Nonreturn examination activities; FY 2002[A]: N/A; FY 
2003: 10%; FY 2004: 10%.

Examination area: Total; FY 2002[A]: --; FY 2003: 100%; FY 2004: 
100%[D].

Source: LMSB September 20, 2002, presentation to the IRS Oversight 
Board, as amended after the presentation.

[A] Information for most of the rows in this column was not available, 
as the presentation to the Oversight Board did not include it.

[B] Coordinated industry cases are examinations of the nation's largest 
corporations, those under continual IRS audit.

[C] At the time of the September 20, 2002, presentation to the 
Oversight Board, the 54 and 4 percent were 52 and 5 percent, 
respectively.

[D] The column does not add to 100 percent because of rounding.

[End of table]

In addition to LMSB examination staff, IRS has managers, attorneys, and 
others who work on abusive shelters. For instance, in February 2003, 
OTSA and its parent body, the Office of Pre-Filing and Technical 
Guidance, had 39 full-time and 34 part-time technical experts, program 
analysts, and managers. Also at that time, a contact list for listed 
transactions included 17 attorneys. These numbers did not include many 
of the IRS legal resources involved with abusive shelters. In addition, 
as of September 30, 2003, LMSB had assigned about 1,900 abusive and 
potentially abusive shelter transactions involving non-LMSB taxpayers 
to IRS's Small Business/Self-Employed Division, which supplies 
examination staff resources of its own.

IRS Faces Challenges in Addressing Increasing Shelter Workload:

Although IRS appeared to be on track to shift planned resources to 
shelter work in fiscal year 2003, it faces challenges in addressing the 
abusive shelter workload, especially in the near term. This is because 
of (1) the growing numbers of transactions and promoters to be examined 
and (2) limited information on how long it takes to conduct shelter 
examinations.

From fiscal year 2002 through fiscal year 2004, LMSB planned to use 
1,879 full-time equivalents (FTE) to address abusive shelters. During 
fiscal year 2002, LMSB used 239 FTEs to address tax returns that 
included abusive shelters.[Footnote 25] According to IRS's fiscal year 
2004 congressional budget justification, LMSB planned to allocate 691 
and 949 FTEs in fiscal years 2003 and 2004, respectively. In a draft 
strategy and program plan dated September 2003, LMSB projected it would 
actually use 615 FTEs for shelter work in fiscal year 2003, or 88 
percent of the planned amount and an increase of 157 percent over the 
fiscal year 2002 FTE level including this work.

Because (1) the known abusive shelter workload has increased, (2) IRS 
has limited experience to judge how many resources will be needed to 
work the cases for how long a period, and (3) the workload may continue 
to increase, it remains uncertain whether the substantial shift of 
resources to shelter work will enable IRS to examine in a timely manner 
the growing workload associated with shelters. For instance, the number 
of potential examinations of listed transactions disclosed has grown 
since the inception of OTSA, adding significantly to IRS resources 
required to address the problem. Table 5 shows the number of listed 
transactions disclosed by taxpayers grew from 51 to 2,182 between 
December 31, 2000, and September 30, 2003, and other transactions 
disclosed to IRS grew from none to 663. The total of all listed and 
nonlisted LMSB-related transactions in the OTSA database, not only 
those disclosed by taxpayers, as of September 30, 2003, was 4,897.

Table 5: Taxpayer Disclosures of Listed and Other Reportable 
Transactions between 2000 and September 30, 2003:

Section 6011 disclosures: Listed transactions disclosed; Calendar year 
(CY) 2000: 51; CY 2001: 63; CY 2002: 1,251; CY 2003 through September 
30: 817; Total: 2,182.

Section 6011 disclosures: Other reportable transactions disclosed; 
Calendar year (CY) 2000: 0; CY 2001: 214; CY 2002: 308; CY 2003 through 
September 30: 141; Total: 663.

Source: IRS.

[End of table]

IRS workload from promoter investigations has also grown since May 
2002. At that time, IRS planned that 7 promoter investigations would be 
ongoing in fiscal year 2003. As of June 30, 2003, IRS had 98 promoter 
investigations approved. Based on early promoter investigations, an IRS 
official stated that promoter investigations can take thousands of 
hours to develop, and several have been litigated, each requiring a 
large expenditure of resources.

LMSB has limited information on the amount of time required to examine 
abusive shelter cases. LMSB developed estimates of the amount of 
examination time required for such cases based on its experience 
examining various types of shelters but acknowledged that examiners can 
spend hundreds or thousands of hours depending on the type of shelter 
examined and the facts and circumstances of the case. For example, 
according to an LMSB official, based on personal experience, OTSA 
estimated that it would take about 800 hours to examine a potentially 
abusive transaction reflected in the return of a CIC corporation 
although LMSB had little data to support the estimate. During fiscal 
year 2003, IRS began collecting data on examination time that it plans 
to use for estimating the resources needed to address its abusive 
shelter workload.

The future abusive shelter workload also could increase, at least in 
the short term. For example, as IRS learns more about the use of 
shelters, it may identify and list new kinds of transactions as being 
abusive. As IRS conducts the 98 promoter investigations approved as of 
June 2003, more investors are likely to be identified, and investor 
cases could lead to identifying more promoters. In addition, IRS 
expanded the types of taxpayers subject to disclosure requirements to 
include taxpayers like individuals, partnerships, and S corporations. 
According to IRS officials, disclosures from these types of taxpayers 
are first due to IRS for filing year 2003 and generally do not yet 
appear in the OTSA database.

In the longer term, what happens to the abusive shelter workload is 
less certain. To the extent that IRS actions and other factors reduce 
the size of the abusive shelter problem, IRS might not need to continue 
devoting as large a percentage of its examination resources to abusive 
shelters. How much and how soon such a drop may occur in abusive 
shelter cases is uncertain.

We have previously raised questions about IRS's ability to shift 
compliance resources as planned. We recently testified that many 
parties have expressed concern about declining IRS compliance--
especially audit--and collection trends for their potential to 
undermine taxpayers' motivation to fulfill their tax 
obligations.[Footnote 26] Concerned about these trends, IRS has sought 
more resources, including increased staffing for compliance and 
collections since fiscal year 2001. Despite receiving requested budget 
increases, staffing levels in key occupations were lower in 2002 than 
in 2000. These declines occurred for reasons such as unbudgeted 
expenses consuming budget increases and other operational workload 
increases. Based on past experience and uncertainty regarding some 
expected internal savings, fiscal year 2004 anticipated staff increases 
might not fully materialize. Thus, if IRS carries through with its 
intentions to increase resources devoted to abusive shelters, it may 
not have the desired level of resources in other areas of compliance.

Concluding Observations:

Abusive tax shelters represent a potentially significant, although 
imprecisely understood, loss in tax revenues. IRS developed and is 
following a broad-based, multifaceted strategy to combat abusive 
shelters even though it had limited data on the full scope of the 
problem. IRS's strategy generally does not contain long-term 
performance goals and associated measures that can help Congress 
evaluate IRS's progress. Although establishing performance goals and 
measures is inherently difficult since the scope and nature of abusive 
shelters is elusive, the need for such goals and measures is heightened 
because IRS is shifting large amounts of examination staff resources to 
support combating abusive shelters. IRS's initial decisions on shifting 
resources might need to be reevaluated as IRS develops better 
information on the size of the abusive shelter problem and the amount 
of time it takes to examine abusive shelter cases. We encourage IRS to 
continue its efforts to obtain a better analytic basis for determining 
the resources needed to address schemes and shelters-while providing 
sufficient attention to other tax compliance areas-and to develop goals 
and measures that it and Congress can use to gauge IRS's progress.

:

Mr. Chairman, this concludes my prepared statement. I would be happy to 
respond to any questions you or other Members of the Committee may have 
at this time.

Contact and Acknowledgements:

For further information on this testimony, please contact Michael 
Brostek at (202) 512-9110 or [Hyperlink, brostekm@gao.gov] b 
[Hyperlink, brostekm@gao.gov] rostekm@gao.gov. Individuals making key 
contributions to this testimony include Ralph Block, Elizabeth Fan, Amy 
Friedheim, Lawrence Korb, Signora May, and James Ungvarsky.

[End of section]

Appendix I: IRS Compliance and Research Programs Using the Schedule K-1:

Schedule K-1s are information returns that link flow-through entities 
with their income recipients and therefore can be used for various 
compliance and research purposes, such as the automated underreporter 
(AUR) program[Footnote 27] and profiling potential nonfilers.

Partnerships, S corporations, trusts, and estates are collectively 
known as flow-through entities because they can legally pass net income 
or loss through to their partners, shareholders, and beneficiaries. 
Flow-through entities are required to provide IRS and each partner, 
shareholder, or beneficiary with a Schedule K-1 stating the individual 
share of net income or loss to be reported. These individuals are then 
responsible for reporting this income or loss on their individual 
income tax returns and paying any applicable tax. According to IRS in 
tax year 2001, over 9 million flow-through entities reported passing 
through almost $1 trillion to approximately 24 million partners, 
shareholders, or beneficiaries. IRS research efforts suggest that 6 to 
15 percent of the K-1s attached to flow-through returns are currently 
being omitted from beneficiary, partner, and shareholder returns. To 
better detect such noncompliance, IRS began transcribing 
nonelectronically submitted Schedule K-1s for tax year 2000 at a cost 
of about $20 million.

In 2001, IRS added Schedule K-1 document matching to its AUR program. 
It began matching Schedule K-1 data to individual tax returns to 
identify taxpayers who had underreported flow-through income and had 
consequently underpaid their taxes. IRS estimated that K-1 matching 
program costs would be about $23.5 million total for both K-1 
transcription and AUR program operations and that program yield would 
be $36 million in direct tax assessed. IRS also estimated that if 
voluntary compliance improved one percent due to the matching program, 
approximately $1.23 billion of additional tax would be generated 
annually. In the first year of the program, IRS issued about 69,000 
notices to taxpayers and assessed about $29 million in additional taxes 
directly attributable to Schedule K-1 underreporting.[Footnote 28] GAO 
estimates that when program assessments are compared to the costs of 
the program's AUR operations, the return per dollar of the K-1 matching 
program was about $9.31. If the cost of transcribing the K-1 data is 
included, the return per dollar decreases to about $1.25.[Footnote 29] 
Both of these assessment-to-cost ratios are substantially lower than 
that for the AUR program as a whole.[Footnote 30] The AUR program 
returned about $25 for every dollar spent in tax year 2000.[Footnote 
31]

IRS has also used Schedule K-1 data to determine characteristics of 
potentially noncompliant taxpayer populations. Its preliminary 
profiling efforts identified over 227,000 business entities with almost 
$64 billion in Schedule K-1 income for tax year 2000 that potentially 
did not file tax returns. As of September 2003, IRS had begun to 
discuss ways of analyzing these cases to determine whether these 
businesses were required, but failed, to file returns, or whether 
inaccuracies in Schedule K-1 data produced false nonfiler leads. In 
addition, in response to a Treasury Inspector General for Tax 
Administration report issued in September 2002,[Footnote 32] the agency 
has begun to research the effectiveness of using information returns, 
such as the K-1, to identify business nonfilers.

(440158):

:

:

FOOTNOTES

[1] Department of the Treasury, The Problem of Corporate Tax Shelters 
(Washington, D.C.: July 1999).

[2] As part of this work, we tested the tax shelter database maintained 
by the Office of Tax Shelter Analysis (OTSA) by reviewing related 
documentation, interviewing knowledgeable agency officials, and doing 
electronic testing, finding that the required data elements were 
sufficiently reliable for the purposes of our work. This finding does 
not mean, however, that the database contains all the information that 
would be needed to estimate the full size of the abusive shelter 
problem.

[3] Pub. L. No.103-62.

[4] Joint Committee on Taxation, Background and Present Law Relating to 
Tax Shelters, JCX-19-02 (Washington, D.C.: Mar. 19, 2002).

[5] A promoter or other tax shelter organizer must register a tax 
shelter with the Secretary of the Treasury by describing it and its tax 
benefits. The Secretary assigns the shelter an identification number.

[6] Section 6700 covers penalties for promoters of abusive shelters.

[7] Treas. Reg. Sec. 301.6112-1 and Treas. Reg. Sec. 1.6011-4.

[8] Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999), 
aff'd, 254 F. 3d 1313 (11TH Cir. 2001).

[9] ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), 
aff'g, 73 T.C.M. 2189 (1997), cert. denied, 526 U.S. 1017 (1999).

[10] Id. at 248.

[11] For the decade from 1993 through 2002, corporations paid almost $2 
trillion in income taxes.

[12] Under the CIC program, IRS continually audits about 1,100 of the 
nation's largest corporations, all of which have assets of more than 
$250 million.

[13] IRS did not track the additional tax payments these corporations 
actually made related just to the shelter-related adjustment. However, 
according to data provided by IRS, they paid about an additional $552 
million in taxes related to all issues raised by IRS, including the 
abusive shelter issues.

[14] In mid-August 2003, IRS gave us information showing that for the 
14 abusive shelter transactions Appeals had closed in fiscal year 2003 
for CIC and other cases, Appeals sustained about 71 percent of the 
dollar amounts proposed as adjustments to income. Similar information 
was not available for earlier years.

[15] TIGTA, Management Advisory Report: The Strategy for Curbing 
Abusive Corporate Tax Shelter Growth Shows Promise but Could Be 
Enhanced by Performance Measures, Report Number 2001-30-159 
(Washington, D.C.: Sept. 13, 2001).

[16] Because the contractor found that estimating the problem's size 
was difficult and problematic, it applied a statistical technique to 
the estimates and produced other estimates for each year. However, 
because it did not believe the statistical technique improved the 
original estimates, we are not including the second set of estimates 
here.

[17] Although GPRA is generally applied to agencywide strategic plans, 
its framework is useful to guide any type of planning. GPRA requires 
long-term strategic and annual performance goals and associated 
measures, preferring measures relating to outcomes (results) versus 
outputs (activities). The Office of Management and Budget says that 
strategic plans set out long-term goals, outlining planned 
accomplishments and their implementation schedule.

[18] TIGTA, Report Number 2001-30-159.

[19] Appendix I describes the Schedule K-1, flow-through entities, and 
other compliance efforts using Schedule K-1 data.

[20] IRS Notice 2001-51 identifies certain listed transactions. It 
describes basis-shifting transactions as "certain redemptions of stock 
in transactions not subject to U.S. tax in which the basis of the 
redeemed stock is purported to shift to a U.S. taxpayer." It describes 
contingent liability transactions as "transactions involving a loss on 
the sale of stock acquired in a purported [Internal Revenue Code 
section] 351 transfer of a high basis asset to a corporation and the 
corporation's assumption of a liability that the transferor has not yet 
taken into account for federal income tax purposes."

[21] Some of these investors are also included in the fast track 
program just described.

[22] LMSB called the tracking of adjustments a "record of tax 
enforcement results." IRS does not use performance measures for outcome 
measures like these because the IRS Restructuring and Reform Act of 
1998 prohibited it from using tax enforcement results to evaluate any 
employee or to impose or suggest production quotas or goals.

[23] IRS defines an "industry" case return as the return of an 
organization with assets of more than $10 million but without being 
part of the largest corporations that are under continual IRS audit.

[24] According to LMSB officials, mandatory examinations are those LMSB 
knows it will do, such as those for abusive shelters and promoters. 
Nonmandatory examinations are what remain after mandatory work is 
accommodated. High-risk nonmandatory examinations are those in the 
nonmandatory category that have the highest probability that a taxpayer 
needs compliance activity.

[25] According to LMSB officials, the fiscal year 2002 FTEs include 
time spent on the entire returns containing shelters, not on the 
shelter issues alone. The estimates for fiscal years 2003 and 2004 are 
focused more on the shelter issues.

[26] U.S. General Accounting Office, Compliance and Collection: 
Challenges for IRS in Reversing Trends and Implementing New 
Initiatives, GAO-03-732T (Washington, D.C.: May 7, 2003).

[27] The AUR program matches information return data, such as Forms W-
2 and 1099 and Schedule K-1, with individual tax return data to verify 
that all income is reported.

[28] IRS began notifying taxpayers of potential discrepancies between 
income reported on the K-1 and individual tax returns in April 2002. 
However, after receiving complaints that notices were being sent to 
compliant taxpayers, IRS stopped issuing notices in August 2002. IRS 
data on number of notices sent and tax assessed were provided in August 
2003.

[29] To increase efficiency and improve the accuracy of K-1 data, IRS 
is exploring two-dimensional bar coding of Schedule K-1s. Instead of 
transcribing K-1 data, IRS would scan a bar code on the K-1 and 
electronically upload the information.

[30] Because the Schedule K-1 document matching program is new, its 
return on investment may be low compared to mature AUR programs.

[31] Information about the AUR program is based on IRS data from 
December 28, 2002. 

[32] Treasury Inspector General for Tax Administration, The Internal 
Revenue Service Should Evaluate the Feasibility of Using Available 
Documents to Verify Information Reported on Business Tax Returns, 
Report Number 2002-30-185 (Washington, D.C.: Sept. 18, 2002).