This is the accessible text file for GAO report number GAO-03-667 
entitled 'Tax Administration: Changes to IRS's Schedule K-1 Document 
Matching Program Burdened Compliant Taxpayers' which was released on 
July 09, 2003.

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GAO:

May 2003:

Tax Administration:

Changes to IRS's Schedule K-1 Document Matching Program Burdened 
Compliant Taxpayers:

GAO-03-667:

GAO Highlights:

Highlights of GAO-03-667, a report to the Committee on Business and 
Entrepreneurship, United States Senate 

Why GAO Did This Study:

About $1 trillion in income was distributed in 2001 by flow-through 
entities such as partnerships and trusts. As shown below, these 
entities do not pay taxes on flow-through income. They report it to 
IRS on a Schedule K-1 and their partners or beneficiaries pay any tax. 

Concerned about underreporting, IRS began matching the flow-through 
income reported on Schedule K-1s with that reported on individualsí 
returns. In 2002, IRS began sending notices to taxpayers about 
suspected noncompliance. After complaints that many notices were going 
to compliant taxpayers, IRS stopped sending notices.

Concerned about the burden, the committee asked GAO to, among other 
things, (1) describe the burden caused by the notices and IRSís 
rationale for stopping them, (2) assess IRSís management of the 
program, and (3) describe the steps IRS will take to address any 
problems.

What GAO Found:

IRS stopped issuing Schedule K-1 notices after complaints about the 
burden the program imposed on compliant taxpayers. Originally, IRS 
intended to focus the program on two categories of income--interest 
and dividends--wherein matching was straightforward, and therefore the 
number of notices sent to compliant taxpayers could be minimized. 
However IRS changed the matching program to cover additional 
categories of flow-through income without clearly informing taxpayers 
and tax preparers. Matching these additional categories of income was 
less straightforward. As a result, IRS sent notices about suspected 
noncompliance to more compliant taxpayers than it intended. In fact, 
about two-thirds of the notices were sent to taxpayers later 
determined to be compliant. After taxpayers complained, and after 
sending out about 70 percent of the planned notices, IRS responded by 
stopping the notices. IRS has assessed about $41.4 million in 
additional tax from the notices that were sent and approximately $26.9 
million was directly attributable to Schedule K-1 underreporting.

IRS did not timely implement two parts of the plans for managing the 
Schedule K-1 matching program. First, IRS did not test the feasibility 
of focusing the program on interest and dividend income until after 
recommending such a focus and communicating the recommendation to 
taxpayers, preparers, and other stakeholders. Second, after changing 
the plan, IRS did not clearly communicate the changes.

IRS is taking steps to improve communications and reduce the burden on 
compliant taxpayers. However, neither IRS nor GAO knows whether these 
changes will improve communications and reduce burden while 
maintaining the effectiveness of the Schedule K-1 matching program as 
a compliance tool.

What GAO Recommends:

GAO is not making any recommendations, but the uncertainty about the 
effectiveness of the steps IRS is taking to improve the program 
highlight the importance of IRS continuing to monitor the impact of 
the program on compliant taxpayers. In ongoing work, requested by the 
Senate Committee on Finance, GAO is assessing the effectiveness of the 
program.

www.gao.gov/cgi-bin/getrpt?GAO-03-667.

To view the full report, including the scope and methodology, click on 
the link above. For more information, contact James R. White at (202) 
512-9110 or whitej@gao.gov.

[End of section]

Contents:

Letter:

Results In Brief:

Background:

Scope and Methodology:

IRS Stopped Issuing Schedule K-1 Notices after Complaints about Burden 
Imposed by Program Changes:

IRS Did Not Timely Test Its Plans or Communicate Plan Changes to 
Stakeholders:

IRS Is Taking Steps Intended to Improve the Schedule K-1 Matching 
Program in 2003:

Conclusion:

Agency Comments:

Appendix I: GAO Contact and Staff Acknowledgments:

Figures:

Figure 1: Illustration of the Taxation of Income That Flows through 
Partnerships, S-corporations, Estates and Trusts:

Figure 2: General Underreporter Matching Process:

Figure 3: The Number of Schedule K-1 Underreporter Notices Sent to 
Taxpayers:

Figure 4: Chronology of Key Events in IRS Implementation of the 
Schedule K-1 Matching Program:

United States General Accounting Office:

Washington, DC 20548:

May 30, 2003:

The Honorable Olympia J. Snowe 
Chair 
Committee on Small Business and Entrepreneurship 
United States Senate:

Dear Madame Chair:

Approximately $1 trillion in income was distributed for tax year 2001, 
according to Internal Revenue Service (IRS), by flow-through entities 
such as partnerships, S-corporations, estates, and trusts. These 
entities, many of which are small businesses, do not pay taxes on 
income they pass through, whether or not the income is actually 
distributed to their partners, shareholders, or beneficiaries. The 
partners, shareholders, or beneficiaries report the income or losses 
received on their individual tax returns and pay any applicable tax.

To facilitate compliance, the tax law requires flow-through entities to 
report the income passed through on Schedule K-1 and to send one copy 
of the schedule to IRS and another to partners, shareholders, or 
beneficiaries. While the law requires such reporting of flow-through 
income, IRS estimates that between 6 and 15 percent of such income is 
not reported on individuals' returns.

Because of the significant amount of income being distributed and the 
estimated noncompliance, IRS began in 2001 to match the tax year 2000 
Schedule K-1 information provided by flow-through entities against the 
flow-through income reported on individuals' tax returns. IRS began 
notifying taxpayers of potential discrepancies between income reported 
on K-1 and individual tax returns in April 2002. However, after 
receiving complaints that notices were being sent to compliant 
taxpayers, IRS stopped sending notices in August 2002.

Because of concerns about the burden the Schedule K-1 matching program 
was imposing on compliant taxpayers, including the time and expense of 
responding to the notices, you asked us to review IRS's implementation 
of the program and determine what happened and why. Specifically, as 
agreed with your office, our objectives were to (1) describe the 
implementation of the Schedule K-1 matching program, the extent of the 
burden caused by the notices, IRS's rationale for stopping the notices, 
and any results the program achieved, (2) assess IRS's management of 
the Schedule K-1 matching program, and (3) describe the steps IRS is 
planning to take to address any identified problems and improve 
Schedule K-1 reporting and matching.

To describe IRS's Schedule K-1 matching program implementation, the 
burden caused by the notices, IRS's rationale for suspending the 
program, and any results, we interviewed IRS officials and analyzed IRS 
data. To assess IRS's management of the program, we compared IRS's 
management plan to what was implemented. Finally, to describe the steps 
IRS plans to take to improve the program, we reviewed IRS's plans for 
continuing the program in 2003 and reducing the burden on compliant 
taxpayers.

Results In Brief:

IRS stopped issuing Schedule K-1 notices after complaints about the 
burden imposed by program changes on compliant taxpayers. Originally, 
IRS intended the Schedule K-1 matching program to focus on two 
categories of income--interest and dividends--that are easily 
identified on tax returns and would minimize the number of notices sent 
to compliant taxpayers. However, IRS learned during testing that it 
could not separate underreported K-1 interest and dividend income from 
the other underreported interest and dividend income such as that paid 
by banks.

After the test, IRS expanded the Schedule K-1 matching program to cover 
additional categories of income, including flow-through income from 
trade or business activities. This created a burden for compliant 
taxpayers. About two-thirds of the 69,097 notices sent to taxpayers 
under the program were sent to taxpayers whom IRS later determined to 
be compliant. Compounding the problem, the expansion of the program was 
not clearly communicated to taxpayers or tax preparers. After 
complaints from taxpayers and after sending out about 70 percent of the 
notices intended, IRS stopped sending notices. IRS followed up on 
notices that were sent and has resolved about 92 percent of those 
cases. About 62 percent of the cases were resolved with no change to 
the taxpayer's liability. In the other 38 percent of the cases, an 
additional $41.4 million in taxes was assessed, of which $26.9 million 
was directly attributable to K-1 underreporting.

While detailed plans for managing the Schedule K-1 matching program 
were developed, IRS did not timely implement two parts of the plans. 
First, IRS did not test the feasibility of focusing the program on 
interest and dividend income until after recommending such a focus and 
communicating the recommendation to taxpayers, tax preparers, and other 
stakeholders. Second, after changing the plan, IRS did not clearly 
communicate with taxpayers, tax preparers, and other stakeholders about 
the changes.

For 2003, the focus of the program will be on the same categories of 
income as in 2002. IRS is taking several steps intended to improve the 
K-1 matching program. IRS has been meeting with tax preparers and 
stakeholder groups in an effort to reestablish communication. Further, 
IRS has identified several program changes intended to reduce taxpayer 
burden by reducing the number of "no-change" notices sent to compliant 
taxpayers. Examples of these changes are more stringent screening 
criteria before notices can be sent and revisions to clarify forms and 
schedules. Neither IRS nor we know whether these changes will reduce 
the burden on compliant taxpayers while maintaining the effectiveness 
of the Schedule K-1 matching program as a compliance tool. We are not 
making recommendations in this report, but for the Senate Committee on 
Finance, we are assessing the program's ability to detect and prevent 
noncompliance. IRS has a tracking system that should provide it 
information about the effectiveness of the changes before all the 
notices are sent out.

We asked IRS to provide comments on our report but did not receive a 
response in time to include it with this report. However, IRS officials 
responsible for the program told us that they agree with the facts 
presented in this report.

Background:

Partnerships, S-corporations, trusts, and estates are collectively 
known as "flow-through entities," because they have the legal capacity 
to pass net income or loss through to their partners, shareholders, and 
beneficiaries untaxed. As shown in figure 1, these flow-through 
entities file tax returns with IRS that report the entities' income and 
expenses with schedules showing all partners', shareholders', or 
beneficiaries' shares of net income or loss. Flow-through entities also 
are required to provide each partner, shareholder, or beneficiary with 
a Schedule K-1 stating the individual share of net income or loss to be 
reported. These partners, shareholders, or beneficiaries are then 
responsible for reporting this income or loss on their individual 
income tax returns and paying any tax. According to IRS in tax year 
2001, over 9 million flow-through entities reported passing through 
$998 billion to approximately 24 million partners, shareholders, or 
beneficiaries.

Figure 1: Illustration of the Taxation of Income That Flows through 
Partnerships, S-corporations, Estates and Trusts:

[See PDF for image]

[End of figure]

For reporting purposes flow-through income is broken into several 
categories. These include income or loss from trade and business 
activities, rental real estate, other rental activities, interest, 
dividends, royalties and capital gains.

The purpose of the Schedule K-1 matching program is to compare the 
information provided by flow-through entities to that reported by 
individuals on their tax returns in order to ensure compliance. The 
Schedule K-1 matching program is part of IRS's general matching 
program, the underreporter program. As shown in figure 2, the 
underreporter program identifies potentially noncompliant taxpayers 
using information from two primary data sources:

* income reported to IRS by taxpayers on their individual tax returns 
and:

* income reported to IRS from third parties, such as employers, banks 
and other financial institutions, partnerships, S-corporations, 
estates, and trusts on forms such as the W-2, 1099, and Schedule K-1.

Figure 2: General Underreporter Matching Process:

[See PDF for image]

[End of figure]

The third party data is matched with the individual taxpayer's return 
data to verify that all income is reported. In fiscal year 2002, the 
matching process identified approximately 14 million cases where 
individual tax return information did not match income information 
reported to IRS from third party sources.

IRS does not follow up on all of these potential underreporter cases. 
In 2002, IRS selected 3 million of the 14 million potential 
underreporter cases for further review. After the cases are selected 
from this inventory, tax examiners perform a manual review, called 
"screening" of tax returns to determine if the income or deductions in 
question can be identified on the actual tax return. If so, the case is 
closed; however, if reasonable doubt remains, the taxpayer is sent an 
underreporter notice.[Footnote 1] At this point, taxpayers can choose 
to agree with the additional assessment, disagree and provide reasons, 
or ask for an appeal.

In order for K-1 data to be used in the matching process, IRS had to 
input or transcribe data from K-1 information returns filed on paper 
into its information systems. For tax year 2000, 14.3 million paper K-
1s were filed with IRS and another 5 million were filed electronically. 
Until it began transcription in 2001, IRS had not transcribed paper K-
1 return information since 1995.

Because IRS had not transcribed Schedule K-1 information since 1995, 
the agency suspected noncompliance among K-1 taxpayers was significant. 
Based on a small study conducted in July 2000, IRS estimated that 
between 6 and 15 percent of the Schedule K-1 returns attached to flow-
through returns are omitted from individual tax returns. Therefore, to 
identify the taxpayers who were potentially noncompliant and collect 
additional tax, IRS began planning in 2000 to (1) match Schedule K-1 
income information from partnerships, etc., against income information 
on individual tax returns to identify potential discrepancies and (2) 
send underreporter notices to taxpayers suspected of noncompliance.

In 2000, Congress funded the Staffing Tax Administration for Balance 
and Equity (STABLE) Initiative that provided funding for transcription 
and matching of K-1 information. IRS told us funding provided for K-1 
transcription was 378 full-time equivalent (FTE) staff, but 
transcription rates were higher than planned and 485 FTEs were actually 
expended. IRS pulled funding from other programs to cover the 
shortfall. The approximate cost of the K-1 transcription was about $20 
million. STABLE also included 69 FTEs and about $3 million for 
screening of matched K-1 cases.

IRS had two primary goals for the K-1 matching program. The first goal 
was to increase voluntary reporting of flow-through income by 
taxpayers. Although the program will bring in some revenue directly 
from notices sent to taxpayers who underreported, IRS believes that the 
indirect effect on voluntary reporting could be more important. IRS 
believes that the knowledge that K-1s are being matched will have a 
positive impact on self-reporting of flow-through income.

IRS's other primary goal was to target K-1 related underreporter 
notices on noncompliant taxpayers to the extent possible. Responding to 
notices is burdensome for compliant taxpayers. Taxpayers and preparers 
are required to collect, organize, and submit information to IRS either 
by telephone or in writing to explain any discrepancy cited in the 
notice. Resolving notices sent to compliant taxpayers also forces IRS 
to divert scarce enforcement staff away from noncompliant taxpayers.

Scope and Methodology:

In order to describe IRS's implementation of its Schedule K-1 matching 
program, reasons for suspending the issuance of notices, impact/burden 
on taxpayers, and results of the program, we:

* reviewed and analyzed IRS management plans, risk assessments, and 
other discussions of how the matching program would operate, including 
work group meeting minutes;

* interviewed IRS officials regarding the efforts required to plan and 
implement the program, including preliminary program testing, early 
plans for the program, changes made in program plans, problems with 
stakeholder communication, and the suspension of notices related to 
Schedule K-1 income;

* reviewed documents issued by external parties regarding concerns with 
the Schedule K-1 matching program;

* interviewed stakeholders from outside IRS, including enrolled agents 
and members of professional organizations, IRS advisory committees; 
and:

* reviewed data and statistics resulting from the Schedule K-1 matching 
program, including number of taxpayers sent notices and tax revenue 
assessed.

We assessed IRS's management of the Schedule K-1 matching program by 
reviewing the plans and risk assessment developed by IRS and then 
comparing IRS's implementation of the program to these plans.

To describe the steps IRS is taking to reduce burden and improve the 
matching program, we:

* interviewed IRS officials regarding the changes being implemented for 
continuation of the Schedule K-1 matching program, including changes to 
reduce taxpayer burden;

* reviewed external stakeholder documents that offered suggestions for 
the future of the Schedule K-1 matching program;

* interviewed stakeholders from outside IRS regarding their suggestions 
for the Schedule K-1 matching program;

* observed a public meeting of the Information Reporting Program 
Advisory Committee (IRPAC); and:

* observed a working group session of IRS and external program 
stakeholders.

The underreporter data presented in this report was produced by IRS, 
and we did not independently verify its accuracy. However, we have used 
underreporter program data in past reports and have found underreporter 
summary statistics of the type used in this report to be reasonably 
accurate. We performed our work from June 2002 through May 2003 in 
accordance with generally accepted government auditing standards.

IRS Stopped Issuing Schedule K-1 Notices after Complaints about Burden 
Imposed by Program Changes:

In its original plan for the Schedule K-1 matching program, IRS 
intended to focus on two categories of income: interest and dividends. 
IRS officials believed that such a focus would enable IRS to minimize 
the number of notices sent to compliant taxpayers. However, information 
system limitations, along with a desire to direct resources towards K-
1 underreporter cases, caused IRS to expand this focus and include more 
categories of income in the program. This change was not clearly 
communicated to taxpayers or preparers and led to more compliant 
taxpayers receiving underreporter notices. In the face of complaints 
about the burden imposed on compliant taxpayers, IRS stopped sending K-
1 underreporter notices.

The Types of Income Covered by the Schedule K-1 Matching Program 
Changed from IRS's Original Plan:

Originally, IRS planned the Schedule K-1 matching program to focus on 
two categories of flow-through income: interest and dividends. The plan 
called for identifying underreporter cases with discrepancies between 
interest and dividend income reported on a K-1 and what was reported on 
an individual's tax return.[Footnote 2] Notices would then be sent to 
the taxpayers asking them to explain the discrepancies or pay the 
additional tax.

IRS chose to focus the Schedule K-1 matching program on interest and 
dividend income to minimize the chances of compliant taxpayers 
receiving notices about K-1 discrepancies. IRS based its decision on a 
risk matrix that summarized the risk of sending a notice to a compliant 
taxpayer for the various categories of flow-through income. Interest 
and dividend income were identified as low risk because they are easily 
identified on individuals' tax returns. Short and long-term capital 
gains and royalties were considered a moderate risk because the K-1 
information was less likely to be accurate or the income could be 
harder to locate on individuals' returns. Income from trade or business 
activities, rental real estate, other rental activities, and guaranteed 
payments was considered high risk because it could be much harder to 
isolate on individuals' returns. For example, some taxpayers would 
reduce or net their flow-through income in these four categories by 
subtracting carryover losses or expenses. Although IRS's tax form 
instructions caution against such netting, some taxpayers still do so, 
which can make flow-through income appear to be underreported.

Starting in 2001, IRS began briefing representatives from stakeholder 
groups on its plan for the Schedule K-1 matching program. IRS met with 
two of its advisory committees, composed primarily of tax 
practitioners, the Internal Revenue Service Advisory Committee (IRSAC) 
and the Information Reporting Program Advisory Committee (IRPAC), and 
other practitioner groups. During these discussions with stakeholders, 
IRS informed them that underreported K-1 interest and dividend income 
would be the focus of the K-1 matching program.

In October of 2001, IRS discovered during testing that the 
underreporter computer system could not distinguish underreported K-1 
interest and dividend income from other interest and dividend income 
reported on information returns such as Form 1099s. Because of a desire 
to direct the 69 FTEs allocated for screening K-1 underreporter cases 
to K-1 cases, IRS decided to expand the focus of the K-1 matching 
program. IRS officials told us they had wanted to direct the resources 
to K-1 cases exclusively in order to be able to determine the results 
achieved with those resources. The revised program included flow-
through income from trade or business activities, rental real estate, 
other rental activities, and guaranteed payments. These four categories 
contained K-1 reported income exclusively. As will be discussed in more 
detail later, IRS did not clearly communicate the change to taxpayers, 
tax preparers, and other stakeholders.

Under the revised matching program, IRS selected for screening by the 
69 dedicated FTEs a total of 141,000 underreporter cases that appeared 
to have only underreported K-1 income from the four categories as shown 
in figure 3. In addition IRS selected another 237,000 cases that 
appeared to have both underreported K-1 income and underreported income 
from other sources. After manual screening, IRS determined that 97,200 
cases raised sufficient questions about the accuracy of the amount 
reported on the individual tax returns to merit sending a notice of the 
potential discrepancy to the taxpayers. IRS began sending notices about 
the discrepancies to taxpayers in April 2002.

The Revised Schedule K-1 Matching Program Burdened More Compliant 
Taxpayers Than Originally Intended:

Because of the change in focus of the program, more compliant taxpayers 
received underreporter notices than IRS had originally intended. As 
shown in figure 3, of the over 63,000 cases closed through March 2003, 
about 62 percent or 39,153 were closed with no change to the tax 
liability. The compliant taxpayers or their preparers who responded to 
the notices were required to submit information to IRS in writing or 
via telephone that explained how they reported the flow-through income 
on their tax return.

Figure 3: The Number of Schedule K-1 Underreporter Notices Sent to 
Taxpayers:

[See PDF for image]

[End of figure]

Some of these compliant taxpayers were burdened because they improperly 
reported net amounts on their returns. As discussed previously, IRS 
instructions tell taxpayers to list K-1 income without netting. 
Nevertheless, according to IRS, many taxpayers reported net amounts, 
making it appear that they had underreported. After the discrepancies 
were explained to IRS, about 62 percent of the notices resulted in no 
change in the tax liability.

Because of Taxpayer Complaints, IRS Stopped Sending Schedule K-1 
Underreporter Notices:

Taxpayers, tax preparers, and various external stakeholder groups 
complained about the notices for two reasons. First, as discussed 
previously, the notices imposed a burden on compliant taxpayers. Though 
some of these taxpayers may have improperly reported net amounts on 
their returns, the taxpayers argued that they had been filling out 
their returns this way for years without incident. Second, they were 
not expecting underreporter notices related to flow-through income 
about trade or business activities, rental real estate, other rental 
activities, and guaranteed payments.

IRS responded by stopping the K-1 matching program notices as of August 
1, 2002. As shown in figure 3, IRS sent 69,097 notices to taxpayers 
before that date.

IRS Followed Up on Schedule K-1 Program Notices Sent to Taxpayers:

As of March 2003, IRS data shows that nearly 92 percent or 63,084 of 
the Schedule K-1 notices issued were closed, or resolved to IRS's 
satisfaction, as shown in figure 3. In nearly 38 percent or 23,931 of 
the closed cases, taxpayers agreed that the notices were correct, that 
the Schedule K-1 income was misreported, and that they owed more taxes. 
These cases resulted in about $41.4 million of additional taxes 
assessed of which $26.9 million related exclusively to Schedule K-1 
income. IRS estimates that about 90 percent of the assessed tax will be 
collected.

In addition to the revenue resulting directly from the notices, IRS 
expects that K-1 matching will have a psychological impact on 
taxpayers, encouraging voluntary compliance. IRS did not have data at 
the time the program was being planned to allow it to estimate the 
likely impact on voluntary compliance. Nor does IRS have any data on 
the actual impact on voluntary compliance. IRS did project that a one 
percent improvement in K-1 reporting levels would result in 
approximately $1.7 billion in additional tax reported.

IRS Did Not Timely Test Its Plans or Communicate Plan Changes to 
Stakeholders:

IRS developed a plan for the Schedule K-1 matching program that, 
according to IRS, relied on established project management principles. 
However, IRS did not timely implement two parts of the plan. First, IRS 
did not test the feasibility of focusing the program on interest and 
dividend income until after recommending such a focus and communicating 
the recommendation to taxpayers, tax preparers, and other stakeholders. 
Second, after changing the plan, IRS did not clearly communicate with 
taxpayers, tax preparers or other stakeholders about the changes. 
Failure to timely implement these two parts of the plan led to 
compliant taxpayers being surprised and burdened by the notices they 
received and ultimately resulted in IRS halting the Schedule K-1 
notification process before all 97,200 notices were sent to taxpayers.

IRS Developed Plans for Testing and Communicating about the Schedule K-
1 Matching Program:

In planning the Schedule K-1 matching program, IRS officials said they 
relied on established principles from its Enterprise Life Cycle (ELC) 
project management approach, the same strategy IRS has used for 
planning and implementing its ongoing information systems modernization 
efforts. IRS developed a series of K-1 matching program management 
plans including those covering transcription and compliance management, 
risk management, and internal and external stakeholder communications. 
The K-1 compliance management plan called for performing two tests 
before selecting cases for the K-1 matching program. The first test was 
of underreporter program procedures and was intended to determine needs 
such as computer system and training updates in order to accommodate 
Schedule K-1 data. The second test was a review of underreporter 
program processes more generally. The K-1 communication plan called for 
communicating with internal and external stakeholders about the project 
status in order to address questions and concerns and manage 
expectations.

IRS Did Not Test the Schedule K-1 Case Selection Process before 
Recommending It:

IRS did not test whether its original case selection process, focused 
on interest and dividend income, was feasible before recommending it. 
As shown in figure 4, IRS began planning the Schedule K-1 matching 
program in January 2001. As previously discussed, in July 2001, IRS 
recommended selecting for review by tax examiners all underreporter 
cases with K-1 interest and dividend income. An IRS official told us 
that internal discussions led IRS to believe that this was possible--
that the underreporter computer system could distinguish cases with 
interest and dividend income reported on K-1s from that reported on 
other information returns. Consequently, the feasibility of focusing 
the K-1 program on interest and dividend income was not tested before 
the recommendation was made.

Figure 4: Chronology of Key Events in IRS Implementation of the 
Schedule K-1 Matching Program:

[See PDF for image]

[End of figure]

The second test in IRS's plan was conducted in October 2001[Footnote 3] 
and revealed that system limitations would prevent IRS from focusing 
the K-1 program on interest and dividend income. IRS discovered that 
the underreporter computer system could not distinguish K-1 interest 
and dividend income from interest and dividend income reported on other 
information returns such as Form 1099s. As a result, the focus of the 
Schedule K-1 matching program was changed. As discussed earlier, the 
revised program covered underreported trade or business, rental real 
estate, other rental activity, and guaranteed payment flow-through 
income.

IRS Did Not Communicate Matching Program Changes to Taxpayers and 
External Stakeholders:

Although the program communication plan called for communicating with 
internal and external stakeholders, IRS failed to inform taxpayers, tax 
preparers, and other stakeholders of the changes it made to the 
matching program and the potential for the changes to increase burden 
on compliant taxpayers. An IRS official responsible for the K-1 program 
stated that a communication breakdown resulted in mixed messages being 
shared with stakeholders about the type of cases that would be selected 
for the K-1 matching program. IRS officials were unable to show us any 
documentation in which they communicated the changes to the plan. An 
IRSAC member told us they only became aware of the change to the 
program after taxpayers began receiving notices.

Tax preparers and stakeholders were critical of the fact that IRS 
failed to inform them of the changes made in the Schedule K-1 matching 
program and the effect those changes would have on compliant taxpayers. 
They believed compliant taxpayers were unfairly burdened by having to 
respond to K-1 notices since, according to an IRSAC member, preparers 
had not been required to submit any explanatory documents with their 
tax returns in the past.

IRS Is Taking Steps Intended to Improve the Schedule K-1 Matching 
Program in 2003:

As was the case with the revised Schedule K-1 matching program in 2002, 
for 2003, interest and dividend income reported on K-1s will be 
included in the underreporter program; however, the 69 FTEs devoted to 
K-1 matching will again focus on the four flow-through income 
categories including income from trade or business activities, rental 
real estate, other rental activities, and guaranteed payments. As of 
April 2003, IRS has started issuing notices related to discrepancies in 
tax year 2001. Also this year, IRS is taking steps intended to 
reestablish communication with external stakeholders and reducing the 
burden on compliant taxpayers. At this time, the effectiveness of these 
steps is unknown.

IRS Is Working to Reestablish Communications with External 
Stakeholders:

For 2003, the Schedule K-1 matching program will have the same focus as 
the revised program in 2002. Therefore, during the 2003 Schedule K-1 
matching effort, it is no longer necessary for IRS to test this case 
selection approach in the underreporter system.

IRS is working to reestablish clear communications with external 
stakeholders. Since notices were stopped in August 2002, IRS has kept 
external stakeholders informed of program developments and held 
meetings with these stakeholders to consider a number of suggestions 
for improving the Schedule K-1 matching program. For example, in the 2 
months following the notice stoppage, IRS briefed both IRSAC and its 
own Oversight Board on reasons for notice suspension, data collected, 
and plans for continuing the program with external stakeholder input.

IRS also held public meetings with IRSAC in October 2002 and IRPAC in 
November 2002 during which it obtained the committees' comments and 
suggestions for the Schedule K-1 matching program. In addition, IRS 
held a meeting in December 2002 with representatives of various 
practitioner and other stakeholder groups to discuss various aspects of 
the program. In this meeting, IRS presented results of the case studies 
it conducted after suspension of the notices and solicited from the 
stakeholders ideas for improving the program in the areas of forms, 
matching, education and outreach, tax preparation software, and 
legislative changes.

IRS Is Taking Other Steps Intended to Reduce Taxpayer Burden:

At least in part as a result of the stakeholder meetings discussed 
above, IRS has begun implementing steps intended to improve Schedule K-
1 matching and clarify reporting requirements. IRS has adopted a new 
goal of eliminating as many no-change notices as possible and 
increasing the overall effectiveness of the Schedule K-1 matching 
program. IRS's strategy for reducing no-change notices relies on more 
rigorous screening of cases by examiners before notices are sent. IRS 
estimates that the program changes discussed below should reduce the 
number of no-change notices by about 50 percent from the 2002 levels. 
At this time, IRS does not have an estimate of the number of notices to 
be sent out or of what it expects the no-change rate to be.

For 2003, IRS has adopted a revised set of standards for screening 
cases for review in its Schedule K-1 matching program, with the intent 
of minimizing taxpayer burden by reducing the number of no-change 
notices sent. In particular, IRS will issue notices to taxpayers if K-
1 income information is completely missing from a return. Also, if a 
taxpayer received a notice in 2002 for tax year 2000 K-1 items and 
agreed with the changes proposed by that notice, the taxpayer will 
receive a notice for any underreported K-1 income identified this year 
in the tax year 2001 return. If income appears underreported for a 
taxpayer who received a notice that resulted in a no-change last year, 
that taxpayer will not receive a notice this year, with the possible 
exception of particularly large discrepancies. In addition, if a 
taxpayer received no notice last year or received a notice that 
contained no K-1 items, this taxpayer will be sent a notice if a large 
discrepancy is identified. The revised screening standards will be 
applied to all K-1 flow-through income discrepancies.

IRS is also trying to educate taxpayers and practitioners about the 
proper way of reporting flow-through income, carryover losses, and 
deductions in order to reduce the need to send notices to compliant 
taxpayers about apparent mismatches. For example, in March 2003, IRS 
issued a news release that provided tips and reminders for K-1 filing. 
These tips covered topics such as proper reporting of Schedule K-1 
income on individual returns, avoiding netting of income and expenses, 
reporting losses carried forward, and steps for reporting income when 
the Schedule K-1 has not yet been received.

Also in March 2003, an IRS official participated in a webcast program 
geared to the practitioner community to discuss requirements of 
Schedule K-1 reporting and field questions from practitioners. In 
addition, the agency will present sessions on how to report flow-
through items at each of its tax forums during the summer of 2003. The 
agency also seeks to further educate taxpayers through outreach 
programs to be run by the Taxpayer Education and Communication unit, a 
part of IRS's Small Business/Self-Employed operating division.

Further, IRS is changing certain forms and/or schedules in order to 
make reporting compliance easier for the taxpayer. In a report issued 
March 2003, the Treasury Inspector General for Tax Administration 
(TIGTA) stated the lack of detailed information reported by taxpayers 
and/or practitioners may have been a significant reason for the number 
of K-1-related notices that were sent. TIGTA then recommended that IRS 
revise Form 1040 Schedule E to classify and report flow-through income 
in a manner that would allow an easier comparison with Schedule K-1. In 
response, an IRS official has stated that, for the 2003 filing season, 
the agency would issue a revised Form 1040 Schedule E that would alert 
practitioners to pay special attention to the written instructions on 
the reporting of certain losses and expenses. The desired effect of 
this change is to make taxpayers less likely to improperly net income 
and expenses being reported on Schedule E.

Finally, an IRS task force is studying the possibility of simplifying 
the Schedule K-1 and its instructions for different tax situations. The 
intent would be to reduce both pre-and postfiling burden. However, the 
analysis needed for the form redesign will likely not be completed 
until mid-2003, and it would take about 2 years total for the redesign 
to actually be implemented.

By fiscal year 2005, through the outreach efforts and Form 1040 
Schedule E revisions discussed in the previous paragraphs, IRS believes 
that it can eliminate the need for the special screening procedures 
instituted this year. In addition to the outreach efforts and form 
changes mentioned above, IRS has also discussed other efforts that 
could be used to help make the program more automated, such as working 
with software vendors to make any necessary changes to electronic tax 
preparation programs.

While IRS intends that these changes will reduce the number of no-
change notices regarding flow-through income, at this time the 
effectiveness of the changes is unknown. More specifically, it is not 
known how ambitious IRS's goal to reduce notices sent to compliant 
taxpayers by at least 50 percent is nor is it known whether IRS can 
reduce notices sent to compliant taxpayers while maintaining the 
ability to act against noncompliant taxpayers.

For the K-1 matching notices being sent in 2003, IRS will be able to 
track the number closed with no-change through tracking reports issued 
every 2 weeks. These tracking reports also contain the number of 
notices with an assessment that the taxpayer agreed to, unreported 
income identified through notices, and additional taxes assessed 
through the notices. The reports, which IRS has begun preparing for its 
tax year 2001 K-1 data match, are prepared for IRS management. 
Officials told us that they would also be made available to outside 
stakeholders.

The tracking reports should give IRS management information before all 
notices are sent out about the effectiveness of the changes made to the 
program. With respect to the overall effectiveness of the K-1 matching 
program, one IRS official told us that he sees the level of voluntary 
compliance with K-1 reporting requirements as a key measure of the 
program's effectiveness. This official also told us that IRS plans to 
annually review the number of K-1 returns filed to determine if more K-
1 income is being reported. He said that more reporting of K-1 income 
could be seen as a measure of program effectiveness. Our ongoing work 
for the Senate Committee on Finance will assess IRS's efforts to detect 
and address noncompliance by taxpayers receiving flow-through income.

Conclusion:

Better targeting the Schedule K-1 matching program notices on 
noncompliant taxpayers matters for two reasons. Sending underreporter 
notices to compliant taxpayers wastes taxpayers' time and money. 
Similarly, IRS's scarce enforcement resources are wasted to the extent 
they are used to resolve notices sent to compliant taxpayers.

While no compliance program can perfectly target noncompliant 
taxpayers, IRS's goal of reducing the number of Schedule K-1 matching 
program underreporter notices sent to compliant taxpayers is laudable. 
However, at this time, no one--neither IRS nor external stakeholders--
knows how effective IRS's proposed actions will be. Consequently, IRS's 
tracking of the no-change rate is very important, both for internal 
management and congressional oversight. Because IRS has begun tracking 
the no-change rate every 2 weeks, we are not making recommendations in 
this report. As noted earlier, we will be looking at opportunities to 
improve the overall effectiveness of the Schedule K-1 matching program 
in our ongoing work for the Senate Committee on Finance.

Agency Comments:

We asked IRS to provide comments on a draft of our report but did not 
receive a response in time to include it with this report. However, IRS 
officials responsible for the program told us that they agree with the 
facts presented in this report.

As arranged with your office, we will not distribute this report until 
30 days from its issue date unless you publicly announce its contents 
earlier. After that period, we will send copies to the Chairman and 
Ranking Minority Member, House Committee on Ways and Means; Chairman 
and Ranking Minority Member, House Subcommittee on Oversight, House 
Committee on Ways and Means; Chairman and Ranking Minority Member, 
House Committee on Small Business; Chairman and Ranking Minority 
Member, Senate Committee on Finance; and the Ranking Minority Member, 
Senate Committee on Small Business and Entrepreneurship. We will also 
send copies to Secretary of the Treasury, the Commissioner of Internal 
Revenue, and other interested parties. We will make copies available to 
others on request. In addition, the report will be available on the GAO 
web site at http://www.gao.gov.

If you have any questions, please contact me at (202) 512-9110. Key 
contributors to this report are acknowledged in appendix I.

Sincerely yours,

James R. White 
Director, Tax Issues:

Signed by James R. White: 

[End of section]

Appendix I: GAO Contact and Staff Acknowledgments:

GAO Contacts:

James R. White, (202) 512-9110:

Staff Acknowledgments:

In addition to the contact above, Marvin McGill, Adam Couvillion, Amy 
Rosewarne, and Joseph Jozefczyk made key contributions to this report.


FOOTNOTES

[1] The underreporter notice informs taxpayers of a proposed change to 
tax liability because of income that is not identifiable or apparently 
not fully reported on the return. 

[2] While the K-1 matching program was designed to select the 
underreporter cases with discrepancies in interest and dividend income 
reported on the K-1s, a small sample of cases with other types of K-1 
income was also to be included.

[3] During the Case Preview, information return documents are sampled 
to test the quality of the information and to identify potential 
problems with the underreporter system.

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