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Report to the Secretary of the Treasury: 

November 2005: 

Financial Audit: 

IRS's Fiscal Years 2005 and 2004 Financial Statements: 

GAO-06-137: 

GAO Highlights: 

Highlights of GAO-06-137, a report to the Secretary of the Treasury: 

Why GAO Did This Study: 

Because of the significance of Internal Revenue Service (IRS) 
collections to federal receipts and, in turn, to the consolidated 
financial statements of the U.S. government, which GAO is required to 
audit, and Congress’s interest in financial management at IRS, GAO 
audits IRS’s financial statements annually to determine whether (1) the 
financial statements IRS prepares are reliable and (2) IRS management 
maintained effective internal controls. We also test IRS’s compliance 
with selected provisions of significant laws and regulations and its 
financial management systems’ compliance with the Federal Financial 
Management Improvement Act of 1996 (FFMIA). 

What GAO Found: 

In GAO’s opinion, IRS’s fiscal years 2005 and 2004 financial statements 
were fairly presented in all material respects. Because of serious 
internal control and financial management systems deficiencies, 
however, IRS again had to rely extensively on resource-intensive 
compensating processes to prepare its financial statements. Due to 
these serious internal control and financial management deficiencies, 
IRS did not, in GAO’s opinion, maintain effective internal controls 
over financial reporting (including safeguarding of assets) or 
compliance with laws and regulations, and thus did not provide 
reasonable assurance that losses, misstatements, and noncompliance with 
laws material in relation to the financial statements would be 
prevented or detected on a timely basis. 

IRS has continued to make great strides in addressing its financial 
management challenges and has substantially mitigated several material 
weaknesses in its internal controls. In fiscal year 2005, IRS 
successfully implemented the first phase, or release, of its new 
Integrated Financial System (IFS), which is intended to replace the 
outdated financial management systems IRS used in recent years to 
process and report administrative (nontax) transactions. This first 
phase of IFS provides for improved audit trails and more timely 
information for such activities and transactions as travel, purchases 
of goods and services, and budgetary activities. In addition, IRS 
continued to make progress in its efforts to address its weaknesses in 
controls over hard-copy taxpayer receipts and data and over property 
and equipment. However, GAO continues to consider issues related to 
IRS’s controls over financial reporting, management of unpaid 
assessments, collection of revenue and issuance of tax refunds, and 
information security to be material weaknesses. In addition, IRS was 
not always in compliance with a law concerning the timely release of 
tax liens. 

IRS’s most serious financial management weaknesses are rooted in its 
continued reliance on outdated automated systems. The lack of a sound 
financial management system that can produce timely, accurate, and 
useful information needed for day-to-day decisions continues to present 
a serious challenge to IRS management. While implementation of the 
first phase of IFS during fiscal year 2005 was noteworthy, it is still 
several years away from achieving its full potential, which is 
contingent on future system releases and development of a means to 
integrate the new system with the systems IRS uses to support its tax 
administration activities. IRS’s present financial management systems, 
which do not substantially comply with FFMIA, inhibit IRS’s ability to 
address the financial management and operational issues that affect its 
ability to fulfill its responsibilities as the nation’s tax collector. 
Further, the continued and serious weaknesses in information security 
have significant implications for the reliability of information 
produced by the new financial management system being implemented. 
Solving IRS’s financial management problems depends largely on the 
ultimate success of IRS’s ongoing systems modernization effort. 

What GAO Recommends: 

In prior audits, GAO made recommendations to IRS to address issues that 
continued to persist during this year’s audit. GAO will monitor IRS’s 
progress in implementing the 84 recommendations that remain open as of 
the date of this report. IRS agreed with the report’s findings, noting 
that it fairly presented IRS’s progress and challenges. IRS cited its 
implementation of the first phase of its new financial systems and its 
planned initiatives to address its financial management challenges. IRS 
noted that it had established a strong commitment to improve financial 
management and to aggressively pursue process and systems improvements. 

www.gao.gov/cgi-bin/getrpt?GAO-06-137. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Steven J. Sebastian at 
(202) 512-3406 or sebastians@gao.gov. 

[End of section] 

Contents: 

Letter: 

Auditor's Report: 

Opinion on IRS's Financial Statements: 

Opinion on Internal Controls: 

Compliance with Laws and Regulations and FFMIA Requirements: 

Consistency of Other Information: 

Objectives, Scope, and Methodology: 

Agency Comments and Our Evaluation: 

Management Discussion and Analysis: 

Financial Statements: 

Balance Sheets: 

Statements of Net Cost: 

Statements of Changes in Net Position: 

Statements of Budgetary Resources: 

Statements of Financing: 

Statements of Custodial Activity: 

Notes to the Financial Statements: 

Supplemental Information: 

Appendixes: 

Appendix I: Material Weaknesses, Reportable Conditions, and Compliance 
Issues: 

Material Weaknesses: 

Reportable Conditions: 

Compliance Issues: 

Appendix II: Details on Audit Methodology: 

Appendix III: Comments from the Internal Revenue Service: 

Abbreviations: 

CADE: Customer Account Data Engine: 

CAP: Custodial Accounting Project: 

CFO Act: Chief Financial Officers Act of 1990: 

EITC: earned income tax credit: 

FFMIA: Federal Financial Management Improvement Act of 1996: 

FFMSR: Federal Financial Management System Requirements: 

FIA: Federal Managers' Financial Integrity Act of 1982: 

FISMA: Federal Information Security Management Act of 2002: 

FMS: Financial Management Service: 

IFS: Integrated Financial System: 

IRS: Internal Revenue Service: 

JFMIP: Joint Financial Management Improvement Program: 

OMB: Office of Management and Budget: 

P&E: property and equipment: 

Letter November 10, 2005: 

The Honorable John W. Snow: 
The Secretary of the Treasury: 

Dear Mr. Secretary: 

The accompanying report presents the results of our audits of the 
financial statements of the Internal Revenue Service (IRS) as of, and 
for the fiscal years ending, September 30, 2005 and 2004. We performed 
our audits in accordance with the Chief Financial Officers (CFO) Act of 
1990, as expanded by the Government Management Reform Act of 1994. This 
report contains our (1) unqualified opinions on IRS's financial 
statements, (2) opinion that IRS's internal controls were not effective 
as of September 30, 2005, and (3) conclusion that IRS was not in 
compliance with one provision of the laws and regulations we tested and 
that IRS's financial management systems were not in substantial 
compliance with the requirements of the Federal Financial Management 
Improvement Act of 1996. 

Our unqualified opinions on IRS's fiscal years 2005 and 2004 financial 
statements were made possible by the continued extraordinary efforts of 
IRS senior management and staff to compensate for serious internal 
control and financial management systems deficiencies. IRS is currently 
in the midst of a major business systems modernization effort that is 
ultimately intended to resolve its most serious financial systems 
challenges. However, this effort is not scheduled to be completed for 
several years. Until the modernization is accomplished, preparing 
reliable financial statements will continue to be a difficult challenge 
for IRS, requiring continued use of extraordinary compensating 
measures. To date, these measures have proved successful: for the sixth 
consecutive year, IRS has received an unqualified opinion on its 
financial statements and, for the fourth consecutive year, the audit 
was completed and the report issued by November 15. 

Over the last several years, IRS has made great strides in addressing 
its financial management challenges and has resolved or substantially 
mitigated several material weaknesses in its internal controls. 
However, IRS's most serious financial management weaknesses are rooted 
in its continued reliance on outdated automated systems, whose numerous 
limitations render IRS unable to develop cost-based performance or 
other information to support informed decision making throughout the 
year. Solving these problems depends largely on the ultimate success of 
IRS's ongoing systems modernization effort. In 1995, we designated 
financial management and systems modernization at IRS as high-risk 
areas.[Footnote 1] However, because resolution of IRS's most serious 
and intractable financial management issues largely depends on the 
success of IRS's business systems modernization efforts, in 2005 we 
combined these two previous high-risk areas into one Business Systems 
Modernization high-risk area.[Footnote 2] 

During fiscal year 2005, IRS successfully implemented the first phase, 
or release, of its new Integrated Financial System (IFS), which is 
intended to replace the outdated financial management system that IRS 
used in recent years to process and report administrative transactions. 
This first phase of IFS provides for improved audit trails and more 
timely information for such activities and transactions as travel, 
purchases of goods and services, and budgetary activities. However, 
full operational capability of IFS is several years away, and is 
contingent on the successful implementation of future system releases. 
Additionally, IRS will need to address how IFS will ultimately be 
integrated with those systems that support financial management of its 
tax administration functions to fully resolve many of its long-standing 
financial management challenges. 

Among the most serious financial management issues still remaining to 
be addressed are the continued significant weaknesses in IRS's 
information security. Consequently, as IRS continues its efforts to 
modernize its financial and operational systems, it is critical that 
IRS take actions to establish and maintain more effective information 
security controls on a continuing basis, through an ongoing cycle of 
risk management activities, to protect the processing, storage, and 
transmission of financial and sensitive data. Until IRS successfully 
manages its information security risks, management will not have 
assurance over the integrity and reliability of the information 
generated from the new financial management system, and IRS's 
opportunities for further improvements in financial management will be 
limited. 

We commend IRS for the improvements it has continued to make in its 
financial processes and operations. Nonetheless, IRS management and 
staff will continue to be challenged to sustain the level of effort 
needed to produce reliable financial statements until the agency is 
able to fully address the underlying systems and internal control 
issues that have made this process so time consuming and resource 
intensive. As we previously reported, IRS continues to lack accurate, 
useful, and timely financial information and sound controls with which 
to make fully informed decisions and to ensure ongoing accountability, 
which is a primary objective of the CFO Act. IRS has made significant 
progress in addressing its serious control and systems deficiencies and 
improving financial management during the past 9 years. It is important 
that these financial management initiatives continue in order to 
achieve comprehensive and lasting financial management reform. 

The agency also continues to face a significant challenge in 
strengthening its enforcement of the nation's tax laws, another 
challenge at IRS that we have designated as high risk.[Footnote 3] In 
recent years, the resources IRS has been able to dedicate to enforcing 
the tax laws have not kept pace with the increases it has seen in its 
enforcement workload. At the same time, IRS faces significant 
compliance-related issues, including combating abusive tax shelters and 
tax schemes, on which it is placing a high priority. Critical to IRS's 
efforts in improving enforcement and, ultimately, taxpayer compliance, 
is the need to have current information on the rate of compliance, both 
overall and by type of taxpayer. IRS recently completed a study of the 
rate of compliance with the nation's tax laws by individuals and some 
small business taxpayers, and is exploring approaches to developing 
compliance estimates for other groups of taxpayers. It is critical that 
such efforts be continued as, without current information on 
noncompliance, the challenge of targeting IRS enforcement resources to 
areas where they would prove most effective is problematic. 

The accompanying report also discusses other significant issues that we 
considered in performing our audit and in forming our conclusions, 
which we believe should be brought to the attention of IRS management 
and users of IRS's financial statements. 

We are sending copies of this report to the Chairmen and Ranking 
Minority Members of the Senate Committee on Appropriations; Senate 
Committee on Finance; Senate Committee on Homeland Security and 
Governmental Affairs; Senate Committee on the Budget; Subcommittee on 
Transportation, Treasury, the Judiciary, Housing and Urban Development 
and Related Agencies, Senate Committee on Appropriations; Subcommittee 
on Taxation and IRS Oversight, Senate Committee on Finance; 
Subcommittee on Oversight of Government Management, the Federal 
Workforce, and the District of Columbia, Senate Committee on Homeland 
Security and Governmental Affairs; House Committee on Appropriations; 
House Committee on Ways and Means; House Committee on Government 
Reform; House Committee on the Budget; Subcommittee on Transportation, 
Treasury, and Housing and Urban Development, the Judiciary, and the 
District of Columbia, House Committee on Appropriations; Subcommittee 
on Government Management, Finance, and Accountability, House Committee 
on Government Reform; and Subcommittee on Oversight, House Committee on 
Ways and Means. We are also sending copies of this report to the 
Chairman and Vice Chairman of the Joint Committee on Taxation, the 
Commissioner of Internal Revenue, the Director of the Office of 
Management and Budget, the Chairman of the IRS Oversight Board, and 
other interested parties. Copies will be made available to others upon 
request. In addition, the report is available at no charge on GAO's Web 
site at [Hyperlink, http://www.gao.gov]. 

This report was prepared under the direction of Steven J. Sebastian, 
Director, Financial Management and Assurance, who can be reached at 
(202) 512-3406 or [Hyperlink, sebastians@gao.gov]. If I can be of 
further assistance, please call me at (202) 512-5500. Contact points 
for our Offices of Congressional Relations and Public Affairs may be 
found on the last page of this report. 

Sincerely yours, 

Signed by: 

David M. Walker: 
Comptroller General of the United States: 

[End of section] 

Auditor's Report To the Commissioner of Internal Revenue: 

In accordance with the Chief Financial Officers (CFO) Act of 1990, as 
expanded by the Government Management Reform Act of 1994,[Footnote 4] 
this report presents the results of our audits of the financial 
statements of the Internal Revenue Service (IRS) for fiscal years 2005 
and 2004. The financial statements report the assets, liabilities, net 
position, net costs, changes in net position, budgetary resources, 
reconciliation of net costs to budgetary obligations, and custodial 
activity related to IRS's administration of its responsibilities for 
implementing federal tax legislation. The financial statements do not 
include an estimate of the amount of taxes that are owed the federal 
government but have not been reported by taxpayers or identified by 
IRS, often referred to as the tax gap,[Footnote 5] nor do they include 
information on tax expenditures.[Footnote 6] 

In its role as the nation's tax collector, IRS has a demanding 
responsibility in collecting taxes, processing tax returns, and 
enforcing the nation's tax laws. IRS is a large and complex 
organization, adding unique operational challenges for management. IRS 
employs tens of thousands of people in 10 service center campuses, 
three computing centers, and numerous other field offices throughout 
the United States. In each of fiscal years 2005 and 2004, IRS collected 
about $2.3 trillion and $2.0 trillion, respectively, in tax payments, 
processed hundreds of millions of tax and information returns, and paid 
about $267 billion and $278 billion, respectively, in refunds to 
taxpayers. 

One of the largest obstacles continuing to face IRS management is the 
agency's lack of an integrated financial management system capable of 
producing the accurate, useful, and timely information IRS managers 
need to assist in making day-to-day decisions. While progress is being 
made to modernize its financial management capabilities, IRS 
nonetheless continued to confront many of the pervasive internal 
control weaknesses that we have reported each year since we began 
auditing its financial statements in fiscal year 1992,[Footnote 7] 
though it continued to make strides in addressing its financial 
management challenges. In fiscal year 2005, for the sixth consecutive 
year, IRS was able to produce financial statements covering its tax 
custodial and administrative activities that are fairly stated in all 
material respects. Moreover, for the fourth consecutive year, IRS was 
able to issue its final audited financial statements only a month and a 
half after the end of the fiscal year. 

IRS's continued success in meeting this reporting date is a major 
accomplishment and, for fiscal year 2005, was all the more notable 
because IRS met this date while implementing the first phase of its new 
financial management system, which is ultimately expected to resolve 
its most serious financial management challenges. Nevertheless, many of 
IRS's long-standing systems and internal control weaknesses continued 
to exist, necessitating continued reliance on costly compensating 
processes, statistical estimates, external contractors, substantial 
adjustments, and monumental human efforts to prepare a set of reliable 
financial statements. These costly efforts would not be necessary if 
IRS's systems and controls operated effectively. 

During fiscal year 2005, IRS continued to make progress in its efforts 
to address its weaknesses in controls over financial reporting, 
property and equipment (P&E), and hard-copy taxpayer receipts and data. 
For example, as a result of its implementation of the first phase of 
its new financial management system, IRS improved the timeliness and 
accuracy of its recording of P&E acquisitions. Additionally, IRS 
implemented several initiatives to improve the safeguarding of, and 
accountability for, hardcopy taxpayer receipts and data at lockbox 
banks and taxpayer assistance centers. However, control deficiencies in 
P&E and physical security over taxpayer receipts and data continued to 
represent reportable conditions,[Footnote 8] requiring further 
attention by IRS management. Additionally, we continue to consider 
issues related to controls over financial reporting, management of 
unpaid assessments, and collection of revenue and issuance of tax 
refunds to be material weaknesses.[Footnote 9] These weaknesses are 
caused primarily by IRS's continued reliance on outdated automated 
systems to provide the financial information that management relies on 
to make decisions. In addition, we continue to consider issues related 
to information security to be a material weakness. The persistent, 
serious deficiencies in information security increase the risk that 
confidential IRS and taxpayer information will be compromised and have 
serious implications related to the reliability of financial management 
information produced by IRS's systems. 

IRS has made progress in improving its financial management, and the 
process changes IRS has instituted in the last several years represent 
good financial management practices. However, IRS's most serious 
remaining problems are caused by its inadequate automated systems, and 
these problems will continue to exist until its systems are replaced. 
In the interim, opportunities for further improvement will be limited. 
Until its systems are replaced, IRS will continue to be challenged to 
sustain the level of effort needed to produce reliable financial 
statements timely. Perhaps more important, IRS will continue to rely on 
processes that cannot produce the accurate, useful, and timely 
financial and performance information IRS needs for decision making on 
an ongoing basis, which is a primary objective of the CFO Act. These 
processes also cannot fully address the underlying financial management 
and operational issues that adversely affect IRS's ability to 
effectively fulfill its responsibilities as the nation's tax collector. 

IRS is currently installing a new financial management system intended 
to resolve many of the issues discussed in this report. During fiscal 
year 2005, IRS implemented a major component of this system--the first 
release of the Integrated Financial System (IFS). IFS is intended to 
replace the outdated financial management system IRS has used in recent 
years to process and report administrative transactions such as 
procurement and utilization of budgetary resources, and to provide IRS 
with a general ledger system that complies with the U.S. Government 
Standard General Ledger. During the fiscal year, IRS converted 
financial data from its previous financial system to IFS, verified that 
the information was converted properly, and closely monitored the 
conversion in an effort to ensure a successful transition to this first 
release of IFS. Replacing a financial system of this magnitude is an 
inherently difficult and complex effort that entails significant risks. 
IRS recognized this, and devoted significant resources to mitigate 
those risks. This, and earlier decisions to delay implementation to 
address issues that arose during the design of the system, enabled IRS 
to successfully implement the first phase of IFS with minimal 
disruptions to its financial activities. 

While IRS's progress with respect to the implementation of this first 
phase of IFS is noteworthy, it is important to recognize that 
substantial work remains to be done to complete the modernizing of 
IRS's financial management systems so as to achieve sound financial 
management. Presently, IFS serves as IRS's core financial management 
system for its administrative activities, and includes such 
functionality as accounts payable, accounts receivable, budget 
formulation and execution, and the general ledger. While IFS contains 
cost accounting capability, it will be several years before such 
capabilities can be fully and successfully utilized. Additionally, 
IRS's effort to bring the system online experienced significant 
problems and delays in the past, and this, coupled with funding 
constraints, led to a decision to indefinitely defer future releases of 
IFS, including those related to property management, procurement, and 
performance management functions. 

IRS also will have to address how IFS will ultimately be integrated 
with those systems that support financial management of IRS's tax 
administration functions, including its collection of tax revenue 
receipts, disbursement of tax refunds, and identification, management, 
and collection of outstanding federal taxes. During fiscal year 2005, 
IRS expanded processing of the less complex individual tax returns 
through the first phase, or release, of the Customer Account Data 
Engine (CADE), which is the system being designed to replace IRS's 
master files.[Footnote 10] CADE was to eventually provide tax 
information to IFS for reporting purposes through the Custodial 
Accounting Project (CAP), a system which was to support management 
needs for information related to tax operations for purposes of day-to- 
day decision making, performance management, and reporting. However, 
significant delays and problems, as well as budget constraints, 
resulted in first the deferral, and later the cancellation, of CAP. At 
this time, IRS is exploring options to implement alternative systems 
that would perform the functions that CAP had been intended to perform, 
but it remains unclear when IRS's new financial management systems will 
be fully implemented. Additionally, continuing and newly identified 
weaknesses in IRS's information security raise serious concerns about 
the integrity of information that will be generated from these 
modernized systems, as well as about future modernization efforts that 
support the preparation of IRS's financial statements. 

Opinion on IRS's Financial Statements: 

IRS's financial statements, including the accompanying notes, present 
fairly, in all material respects, in conformity with U.S. generally 
accepted accounting principles, IRS's assets, liabilities, net 
position, net costs, changes in net position, budgetary resources, 
reconciliation of net costs to budgetary activity, and custodial 
activity as of, and for the fiscal years ended, September 30, 2005, and 
September 30, 2004. 

However, misstatements may nevertheless occur in other financial 
information reported by IRS as a result of the internal control 
weaknesses described in this report. 

IRS's financial statements include tax revenues collected during the 
fiscal year as well as the total unpaid taxes for which IRS, the 
taxpayer, or courts agree on the amounts owed. Cumulative unpaid tax 
assessments for which there is no future collection potential or for 
which there is no agreement on the amounts owed are not reported in the 
financial statements. Rather, they are reported as write-offs and 
compliance assessments, respectively, in supplemental information to 
IRS's financial statements. Also, in conformity with U.S. generally 
accepted accounting principles, to the extent that taxes owed in 
accordance with the nation's tax laws are not reported by taxpayers and 
are not identified through IRS's various enforcement programs, they are 
not reported in the financial statements nor in supplemental 
information to the financial statements. Additionally, in conformity 
with U.S. generally accepted accounting principles, tax expenditures, 
which represent the amount of revenue the government forgoes resulting 
from federal tax provisions that grant special tax relief for certain 
kinds of behavior by taxpayers or for taxpayers in special 
circumstances, are not reported in the financial statements. 

Opinion on Internal Controls: 

Because of the material weaknesses in internal controls discussed 
below, IRS did not maintain effective internal controls over financial 
reporting (including safeguarding of assets) or compliance with laws 
and regulations, and thus did not provide reasonable assurance that 
losses, misstatements, and noncompliance with laws material in relation 
to the financial statements would be prevented or detected on a timely 
basis. Our opinion is based on criteria established under 31 U.S.C. § 
3512 (c), (d), commonly referred to as the Federal Managers' Financial 
Integrity Act of 1982 (FIA), and Office of Management and Budget (OMB) 
Circular No. A-123, Management Accountability and Control (revised June 
21, 1995).[Footnote 11] 

Despite its material weaknesses in internal controls and its systems 
deficiencies, IRS was able to prepare financial statements that were 
fairly stated in all material respects for fiscal years 2005 and 2004. 
Nonetheless, IRS continues to face the following key issues that 
represent material weaknesses in internal controls: 

* weaknesses in controls over the financial reporting process, 
resulting in IRS not (1) being able to prepare reliable financial 
statements without extensive compensating procedures and (2) having 
current and reliable ongoing information to support management decision 
making and to prepare cost-based performance measures; 

* weaknesses in controls over unpaid tax assessments, resulting in 
IRS's inability to properly manage unpaid assessments and leading to 
increased taxpayer burden; 

* weaknesses in controls over the identification and collection of tax 
revenues due the federal government and over the issuance of tax 
refunds, resulting in lost revenue to the federal government and 
potentially billions of dollars in improper payments; and: 

* weaknesses in information security controls, resulting in increased 
risk of unauthorized individuals being allowed to access, alter, or 
abuse proprietary IRS programs and electronic data and taxpayer 
information. 

The material weaknesses in internal controls noted above may adversely 
affect any decision by IRS's management that is based, in whole or in 
part, on information that is inaccurate because of these weaknesses. In 
addition, unaudited financial information reported by IRS, including 
performance information, may also contain misstatements resulting from 
these weaknesses. 

In addition to the material weaknesses discussed above, we identified 
two reportable conditions, which, although not material weaknesses, 
represent significant deficiencies in the design or operation of 
internal controls that could adversely affect IRS's ability to meet the 
internal control objectives described in this report. These conditions 
concern deficiencies in (1) controls over hard-copy tax receipts and 
taxpayer data, which increase the government's and taxpayers' risk of 
loss or inappropriate disclosure of taxpayer data, and (2) controls 
over P&E, which preclude IRS from readily reconciling its property 
records to its financial records. 

We have reported on these material weaknesses and reportable conditions 
in prior audits and have provided IRS recommendations to address these 
issues. Eighty-four of these recommendations were still open as of the 
date of this report.[Footnote 12] IRS continues to make strides in 
resolving these matters. We will follow up in future audits to monitor 
IRS's progress in implementing these recommendations. For more details 
on these issues, see appendix I. 

Compliance with Laws and Regulations and FFMIA Requirements: 

Our tests of compliance with selected provisions of laws and 
regulations disclosed one area of noncompliance that is reportable 
under U.S. generally accepted government auditing standards and OMB 
guidance. This area relates to IRS not timely releasing federal tax 
liens against taxpayers' property. 

Except as noted above, our tests for compliance with laws and 
regulations disclosed no other instances of noncompliance that would be 
reportable under U.S. generally accepted government auditing standards 
or OMB audit guidance. However, the objective of our audit was not to 
provide an opinion on overall compliance with laws and regulations. 
Accordingly, we do not express such an opinion. 

We also found that IRS's financial management systems did not 
substantially comply with the requirements of the Federal Financial 
Management Improvement Act of 1996 (FFMIA).[Footnote 13] 

For more details on these issues, see appendix I. 

Consistency of Other Information: 

IRS's Management Discussion and Analysis and required supplemental 
information contain a wide range of data, some of which are not 
directly related to the financial statements. We did not audit and do 
not express an opinion on this information. However, we compared this 
information for consistency with the financial statements and discussed 
the methods of measurement and presentation with IRS officials. Based 
on this limited work, we found no material inconsistencies with the 
financial statements or nonconformance with OMB guidance. Under OMB 
guidance for the financial statements of federal agencies, agencies are 
asked to strive to develop and report objective measures that to the 
extent possible, provide information about the cost-effectiveness of 
their programs. We found, however, that because of the noted internal 
control and systems limitations, IRS cannot report reliable cost-based 
performance measures relating to its various programs consistent with 
the Government Performance and Results Act of 1993.[Footnote 14] 

Objectives, Scope, and Methodology: 

Management is responsible for (1) preparing the annual financial 
statements in conformity with U.S. generally accepted accounting 
principles; (2) establishing, maintaining, and assessing internal 
control to provide reasonable assurance that the broad control 
objectives of 31 U.S.C. § 3512 (c), (d) (FIA) are met; (3) ensuring 
that IRS's financial management systems substantially comply with the 
requirements of FFMIA; and (4) complying with applicable laws and 
regulations. 

We are responsible for obtaining reasonable assurance about whether (1) 
the financial statements are presented fairly, in all material 
respects, in conformity with U.S. generally accepted accounting 
principles and (2) management maintained effective internal controls, 
the objectives of which are the following: 

* Financial reporting--transactions are properly recorded, processed, 
and summarized to permit the preparation of financial statements in 
conformity with U.S. generally accepted accounting principles and 
assets are safeguarded against loss from unauthorized acquisition, use, 
and disposition. 

* Compliance with laws and regulations--transactions are executed in 
accordance with laws governing the use of budget authority and with 
other laws and regulations that could have a direct and material effect 
on the financial statements and any other laws, regulations, and 
governmentwide policies identified by OMB audit guidance. 

We are also responsible for (1) testing whether IRS's financial 
management systems substantially comply with the three FFMIA 
requirements, (2) testing compliance with selected provisions of laws 
and regulations that have a direct and material effect on the financial 
statements and laws for which OMB audit guidance requires testing, and 
(3) performing limited procedures with respect to certain other 
information appearing in these annual financial statements. For more 
details on our methodology and the laws and regulations we tested, see 
appendix II. 

We did not evaluate all internal controls relevant to operating 
objectives as broadly defined by FIA, such as controls relevant to 
preparing statistical reports and ensuring efficient operations. We 
limited our internal control testing to testing controls over financial 
reporting and compliance with laws and regulations. 

We did not test compliance with all laws and regulations applicable to 
IRS. We limited our tests of compliance to those laws and regulations 
that had a direct and material effect on the financial statements or 
that were required to be tested by OMB audit guidance that we deemed 
applicable to IRS's financial statements for the fiscal years ended 
September 30, 2005 and 2004. We caution that noncompliance may occur 
and not be detected by these tests and that such testing may not be 
sufficient for other purposes. 

We performed our work in accordance with U.S. generally accepted 
government auditing standards and OMB audit guidance. 

Agency Comments and Our Evaluation: 

In responding to this report, IRS agreed that the report fairly 
presents the agency's financial management progress and remaining 
management and systems challenges. IRS noted that the agency's 
dedication to financial management improvement enabled it to achieve, 
for the sixth consecutive year, an unqualified opinion on its financial 
statements. Additionally, IRS cited a number of financial management 
improvements it had undertaken during fiscal year 2005, the most 
notable of which was its successful deployment of the initial release 
of its Integrated Financial System (IFS). In addition to the 
implementation of IFS, IRS noted other financial management 
improvements, such as (1) implementation of a crosswalk to convert the 
Interim Revenue Accounting Control System trial balance accounts into a 
format compliant with the United States Standard General Ledger, (2) 
centralization of all Small Business/Self-Employed Automated Trust Fund 
Recovery Penalty (TFRP) work to two campuses to improve efficiency and 
reduce TFRP assessment errors by improving the cross-referencing and 
posting of the payment process, and (3) development of Security and 
Internal Control Performance Measures for physical security, courier, 
personal security, and internal controls over receipts and receipt 
processing at lockbox banks. 

In its response, IRS also agreed with our findings and opinions related 
to information security, and indicated that it had developed an action 
plan to address deficiencies in access controls, rules of behavior, 
contingency planning and disaster recovery, audit trails, training, and 
certification and accreditation. IRS also recognized the need to 
continue to address identified problems and remain focused on its 
modernization efforts. IRS noted that the agency had established a deep 
and continuing commitment to improving financial management and its 
intention to aggressively pursue appropriate actions to improve 
processes and systems. 

The complete text of IRS's response is included in appendix III. 

Signed by: 

David M. Walker: 
Comptroller General of the United States: 

October 31, 2005: 

[End of section] 

Management Discussion and Analysis: 

INTERNAL REVENUE SERVICE: 

Management Discussion and Analysis For the Fiscal Year Ended September 
30, 2005: 

I. Introduction: 

The Internal Revenue Service (IRS) administers America's tax laws and 
collects the revenues that fund most government operations and public 
services. To do so, the IRS helps taxpayers comply with the tax system 
and ensures that those who are unwilling to comply pay their fair 
share. In a constantly evolving economy, this mission requires not only 
a sharp focus on service and enforcement, but also an increasingly 
flexible agency, one capable of smooth adjustment to 21st century 
change. 

The IRS' five-year Strategic Plan provides the blueprint to meet this 
challenge. This plan focuses on three key goals: improving taxpayer 
service, enhancing enforcement of the tax law and modernizing the IRS 
through its people, processes and technology. Fiscal Year (FY) 2005 
witnessed the IRS making significant progress toward each of these 
goals. 

The way taxpayers pay their taxes and access IRS information is 
changing. This year, for the first time, more than half of all 
taxpayers filed electronically and more than five million of these 
taxpayers filed for free though the Free File Alliance. Additionally, 
tens of millions of taxpayers visited the IRS website to obtain forms, 
publications and answers to their many tax questions. In FY 2005, as in 
prior years, IRS employees made millions of contacts with American 
taxpayers and businesses, improving service to them by reducing 
response times to taxpayer inquiries, improving communications with 
taxpayers, providing taxpayers and their paid prepares with needed 
resources and reducing the paperwork burden. 

The IRS has also increased enforcement with the aim of improving 
taxpayer compliance. The FY 2005 performance results confirm that the 
IRS is striking the right balance between service and enforcement. For 
FY 2005, the IRS met or exceeded the targets in 17 of its 21 [NOTE 1] 
measures (81% compared to 67% in FY 2004). Of particular note are the 
IRS' efforts to enhance criminal enforcement, use of civil injunctions 
to stop abusive tax schemes and investigate promoters and users of tax 
shelters. Two major settlement initiatives involving the use of abusive 
tax shelters generated over $4.7 billion in revenue. IRS enforcement 
actions also contribute to national security and homeland defense; the 
IRS has a unique role in combating the use of charitable organizations 
to raise funds for terrorist organizations. 

Business systems modernization remains a high priority for the IRS. A 
robust, secure and up-to-date infrastructure will improve services-both 
to taxpayers and to other government agencies-and will strengthen 
enforcement by giving IRS employees better tools. In FY 2005, the IRS 
implemented its new Integrated Financial System (IFS), designed to 
provide the IRS with more accurate and timely financial information and 
improved compliance with legislative and regulatory requirements. The 
major components of IFS are accounts payable, accounts receivable, 
budget formulation, budget execution, general ledger, financial 
statements and cost accounting. Today there are thousands of 
procurement commitments, obligations and receipt/acceptance documents 
being processed through the new IFS system. Another success includes 
the Customer Account Data Engine (CADE), the IRS' modernized database; 
CADE posted over 1.4 million returns for filing season 2005 and 
generated over $427 million in refunds. 

NOTE: 

[1] Data for the Earned Income Tax Credit measure will not be available 
until the close of Calendar Year 2005 and two information systems 
measures were discontinued this year. 

During FY 2006, the IRS will continue to seek efficiencies in 
delivering taxpayer service, bolster its enforcement efforts to improve 
compliance with the tax laws and modernize its infrastructure. The IRS 
will continue to research and evaluate information regarding taxpayer 
service needs, priorities, and preferences in order to improve delivery 
services. In the area of enforcement, the IRS will expand enforcement 
by targeting its case work and enforcement activities to more 
effectively deliver results and drive down the tax gap. Finally, the 
IRS will continue its modernization with the further development of 
CADE; Modernized e-File (MeF); and the Filing and Payment Compliance 
system, a system that analyzes tax collection cases to determine 
uncontested cases that no longer require IRS involvement and can be 
turned over to private collection agencies. 

Mission and Goals: 

Provide America's taxpayers top-quality service by helping them 
understand and meet their tax responsibilities and by applying the tax 
law with integrity and fairness to all. 

This mission statement reflects the IRS' priorities of supporting 
taxpayers in fulfilling their tax obligations, providing high quality 
services and information and applying and enforcing the tax laws with 
the highest standards of fairness and integrity. 

In fulfilling its mission, the IRS focuses on achieving three 
overarching strategic goals: 

Improve Taxpayer Service: 

Enhance Enforcement of the Tax Law: 

Modernize the IRS through Its People, Processes and Technology: 

Each strategic goal is supported by operational objectives and annual 
performance measures. The operational objectives reflect IRS' business 
priorities; the performance measures reflect the IRS' plans to evaluate 
its ongoing success in meeting its stated objectives. 

Organization: 

The IRS continues to transform its programs and activities to keep pace 
with the changing environment, taxpayer demands and new mandates. The 
IRS' primary operations are supported by four business units centered 
on unique groups of taxpayers: individual taxpayers, small business 
owners, corporations and tax-exempt and government entities. The IRS 
Commissioner and two Deputy Commissioners have oversight for all agency 
operations, as described on the following pages. 

Direct Reports to the Commissioner: 

A number of business units and functions report directly to the IRS 
Commissioner. They set policies, provide leadership and direction for 
the Internal Revenue Service and provide support for strategic decision-
making activities needed to fulfill the IRS' mission in administering 
the nation's tax laws. 

* The Office of Appeals resolves tax controversies between taxpayers 
and the IRS without litigation on a basis that is fair and impartial to 
both the Government and the taxpayer. Appeals provides an independent 
channel for taxpayers who wish to dispute a recommended enforcement 
action. 

* Taxpayer Advocate Service (TAS) helps taxpayers resolve problems that 
have not been resolved through regular IRS channels. TAS is an 
independent function headed by the National Taxpayer Advocate. Each 
state and IRS Service Center has at least one local Taxpayer Advocate 
who operates independently and reports directly to the National 
Taxpayer Advocate. Local Taxpayer Advocates work directly with 
operating divisions to identify and recommend solutions to systemic 
problems. 

* Communication and Liaison (C&L) oversees and manages the IRS' 
external communications activities with the news media, members of 
Congress and their staffs, tax professionals and practitioners as well 
as internal communications with employees. C&L also coordinates 
marketing and advertising activities on behalf of the IRS and 
establishes policies and guidelines governing communications throughout 
the IRS. 

* The Office of Chief Counsel provides correct and impartial 
interpretation of the Internal Revenue laws and the highest quality 
legal advice and representation for the Internal Revenue Service. The 
Chief Counsel's principal customers are the IRS Commissioner, the 
operating divisions, the functional units and the Department of the 
Treasury and the Department of Justice. Litigation and legal advice are 
the largest programs provided by Chief Counsel field office attorneys 
and support staff. Published guidance, advance case resolution and 
legal advice are the largest programs provided by attorneys and support 
staff in the National Office. 

* Research, Analysis, and Statistics (RAS) supports IRS senior 
management, operating divisions, functional units, and various research 
organizations, the Department of the Treasury and the general public by 
producing studies, program evaluations and statistical analyses of 
taxpayer trends and data and by providing research and reference tools 
for front line IRS employees. 

* Equal Employment Opportunity and Diversity (EEO&D) educates IRS 
employees about diversity and helps them understand their EEO rights 
and responsibilities, ensuring that the IRS applies civil rights laws 
with integrity and fairness to all. 

Deputy Commissioner for Services and Enforcement: 

IRS tax operations are aligned into four Operating Divisions, Criminal 
Investigations and the Office of Professional Responsibility, each 
focusing on specific taxpayer constituencies and business issues. They 
report to the Deputy Commissioner for Services and Enforcement. 

* Wage and Investment Division (W&I) manages tax processing and 
customer service for all individual and business taxpayers and provides 
compliance services to individual taxpayers. Employees at nine campuses 
perform tax processing services. Twenty five sites provide account 
management services. Employees at five campuses perform compliance 
services, which tend to focus on dependent exemptions, credits, filing 
status and personal deductions. W&I's field operations provide 
information, support and assistance to taxpayers in fulfilling their 
tax obligations. 

In FY 2005, the IRS consolidated its Customer Account Services (CAS) 
units, making better use of resources and streamlining and enhancing 
communications. Consolidating the top level management structure 
allowed the IRS to continue the successes of high levels of service, 
decreased inventory and cycle times and deployment of successful web 
applications for customers while eliminating redundancies and 
duplication. 

* Small Business and Self Employed Division (SB/SE) serves partially or 
fully self-employed individuals with income from rents, royalties, 
pensions, annuities, partnerships, estates and trusts; small 
businesses, including corporations and partnerships, with assets up to 
$10 million; and others who file employment, excise, estate, gift, 
fiduciary and international tax returns. SB/SE has the largest 
compliance and enforcement presence in the Service, allocating 93% of 
its resources to compliance activities. SB/SE is aligned along 
functional lines of Examination, Collection, Specialty Tax Programs, 
Compliance Services/Campus Operations and Fraud/Bank Secrecy Act to 
provide a more focused approach to program delivery by making the best 
use of existing knowledge and experience, ensuring end-to-end 
accountability and leveraging the specialized expertise of the 
workforce. 

* Large and Mid-Size Business Division (LMSB) is the branch of the IRS 
charged with administering taxes for the largest corporations and 
partnership entities in the United States - multinational businesses 
with assets of over $10 million. LMSB serves about 54,600 corporate 
taxpayers and related entities with a combined annual tax liability 
approaching $200 billion. Its workforce is structured around five 
"industry" groupings that include Communications; Technology and Media; 
Financial Services; Heavy Manufacturing and Transportation; Natural 
Resources and Construction; and Retailers, Food, Pharmaceuticals and 
Healthcare. Operating within this structure, LMSB is able to provide 
taxpayers with specialized, focused support on specific tax issues. 
LMSB's six thousand person workforce consists largely of field-based 
employees, including revenue agents, international examiners, field 
specialists, technical experts and various support personnel. 
Collectively, they deal with tax issues ranking among the most complex 
addressed by any division in the Internal Revenue Service. 

* Tax-Exempt and Government Entities Division (TE/GE) serves a wide 
range of customers including small local community organizations, 
municipalities, major universities, pension funds, state governments, 
Indian tribal governments and tax exempt bond issuers. TE/GE 
administers and enforces a variety of complex laws governing tax-exempt 
organizations and entities. TE/GE employees ensure that these tax- 
exempt entities properly adhere to applicable statutes. 

* Criminal Investigation (CI) enforces the criminal provisions of 
Internal Revenue Code and related statutes. Tax investigations 
encompass a wide variety of sophisticated schemes including abusive tax 
schemes, employment tax fraud, refund crimes and the failure to file 
required returns (non-filers). Further, Ci's unique statutory 
jurisdiction and expertise enable it to investigate diverse crimes 
including money laundering, corporate fraud, narcotics related crimes 
and terrorist financing. Criminal Investigation is organized in 31 
field offices grouped in five areas. Each field office is headed by a 
Special Agent in Charge (SAC) who reports to a Director of Field 
Operations (DFO) responsible to the National Headquarters. Successful 
prosecutions are important to the success of the Service's overall 
compliance strategies. 

* Office of Professional Responsibility (OPR) fosters excellence in tax 
professional services to taxpayers by setting, communicating and 
enforcing standards of competence, integrity and conduct. 

Deputy Commissioner for Operations Support: 

IRS support functions are aligned into five support units. Each 
provides specific services, systems and processes that support tax 
operations. Support units also help facilitate efficiency improvements 
and implementation of best practices throughout the IRS. The support 
units report to the Deputy Commissioner for Operations Support. 

* Chief Information Officer (CIO) leads the Modernization and 
Information Technology Services (MITS) organization, which delivers 
information technology solutions that anticipate and meet enterprise- 
wide needs by empowering employees to deliver customer-centered, 
systems, products, services and support. The CIO advises the Deputy 
Commissioner for Operations Support on strategic technology planning, 
data administration, technology standards and privacy assurance and 
telecommunications issues. 

* Agency-Wide Shared Services (AWSS) delivers shared services 
throughout the IRS, including space acquisition and management, 
acquisition planning and the Employee Resource Center. 

* Human Capital Officer (HCO) supports all IRS Divisions and Functions 
in attracting, motivating and retaining quality employees to meet the 
needs of America's taxpayers and the tax administration system. HCO 
also oversees labor relations programs and various human resources 
functions, including the employee pre-complaint processing and 
prevention, and alternative dispute resolution services. 

* Chief Financial Officer (CFO) oversees the IRS' financial management, 
financial systems, strategic planning, performance measurement and 
internal controls. The CFO accounts for over $2 trillion in taxpayer 
receipts and the IRS' $10 billion annual operating budget. 

* Mission Assurance (MA) is responsible for the protection of taxpayer 
data and information systems and the continuing security of IRS 
personnel and facilities. 

The organizational chart below shows these reporting relationships. 

[See PDF for image] 

[End of figure] 

II. Performance Goals and Results: 

The IRS uses performance measures to determine its effectiveness in 
meeting its three strategic goals. The FY 2005 performance information 
that follows is organized by the IRS' strategic goals, highlighting 
successes and challenges. 

Strategic Goal 1: Improve Taxpayer Service: 

Objectives: 

* Improve service options for the tax-paying public; 

* Facilitate participation in the tax system by all sectors of the 
public; 

* Simplify the tax process. 

Major Results, Accomplishments, and Challenges: 

Taxpayer Service and Burden Reduction: 

Assisting the public to understand their tax reporting and payment 
obligations is the cornerstone of taxpayer compliance. For FY 2005, the 
IRS met or exceeded performance for all (8 of 8) of its performance 
targets related to taxpayer service. The following highlights the IRS' 
performance in FY 2005: 

* Processed more than 130 million individual returns and issued more 
than 99 million refunds totaling over $210 billion during the 2005 
filing season (Tax Year 2004). 

* Achieved an 82.6% level of service on answering toll-free calls from 
taxpayers, above the target of 82%. 

* Answered 33.4 million assistor telephone calls and completed nearly 
25.7 million automated calls. 

* Correctly responded to 89% of tax law questions and 91.5% of account 
questions received via the telephone. 

For FY 2005, the IRS set a record for the number of returns filed 
electronically. For the first time, more than half (68 million) of all 
individual taxpayers filed electronically, representing an 11% increase 
over FY 2004. The IRS also received a higher satisfaction rating from e-
filers. The 2004 NOP World rating was 52%, an increase from 49% in 2003 
and a substantial increase over its lowest point of 32% in 1998. For FY 
2005, the IRS exceeded all of its performance targets related to 
electronic filing including: 

* Home computer usage to prepare and e-file tax returns increased 17.3% 
to more than 17.1 million returns. 

* Tax preparation professional use of e-file increased 11%, with 47.6 
million filing electronically. 

* In its third year, the Free File Alliance, the public private 
partnership between the IRS and a consortium of tax software companies, 
saw 5 million taxpayers use the free service, a 43% increase from last 
year. 

The IRS now requires many businesses and tax-exempt organizations to 
file their returns electronically. The IRS introduced new forms for 
filing extensions for corporations and information returns for private 
foundations to the suite of electronic forms offered. The IRS 
electronically received more than 143,000 business returns from nearly 
6,000 participating providers, twice the number participating in FY 
2004. 

The IRS remains committed to making it easier for all taxpayers to 
understand their filing requirements. The IRS simplified tax forms and 
instructions to allow taxpayers to fulfill their reporting obligations 
more quickly and with less frustration. As an example, Schedule C-EZ 
was designed to allow taxpayers with a small home business to report 
business expenses at a higher threshold and in a simplified format. By 
giving taxpayers an alternative to the more complex Schedule C, more 
than 500,000 small business owners were able to save time and money in 
meeting reporting requirements. Similar design and procedural changes 
were made in partnership returns, unemployment tax deposits and 
quarterly withholding tax reporting requirements. The simplified forms 
and procedures also assist taxpayers by decreasing pre-filing 
preparation errors and reducing the need for post-filing error notices. 

Internet access to online forms and publications makes it easier for 
taxpayers to secure forms and find instructions. More than 4.8 billion 
"hits" registered in FY 2005 on the award-winning website, IRS.gov, a 
20% increase over FY 2004. This increase was largely due to improved 
website functionality and an expanded selection of electronically- 
provided services. Internet tools such as the "IRS Withholding 
Calculator' give the taxpayer self-service access to information 
previously reported in a lengthy publication. More than 22 million 
taxpayers used the popular "Where's my Refund?" application to check on 
the status of their refunds this past filing season, 49% more than last 
year. A new feature of the refund inquiry application allowed taxpayers 
to generate replacement checks if the first one was lost or 
undeliverable due to an out-of-date address. The IRS also expanded 
electronic tax products for businesses through increased marketing and 
business e-file programs. In addition, the IRS expanded the suite of 
products and services geared toward Spanish speaking taxpayers 
including new marketing flyers, tax forms, and publications; toll free 
assistance; and accessibility through web links. 

The IRS is striving to make the Earned Income Tax Credit (EITC) easier 
to claim by eligible taxpayers. In FY 2005, the IRS deployed the EITC 
Assistant on IRS.gov. EITC Assistant is a web-based application to help 
taxpayers determine eligibility, filing status and estimated EITC 
amount. The EITC Assistant is available in English and Spanish and 
reflects the EITC tax law changes, including new income limits for EITC 
eligibility as well as the option to include nontaxable combat pay in 
earned income for the earned income credit. The IRS also deployed 
telephone and web self-service applications on IRS.gov to help 
taxpayers determine their certification status and explain 
determinations made during the certification process. IRS enhanced the 
EITC Online Toolkit for tax professionals and launched EITC messages on 
Housing and Urban Development (HUD) kiosks in over 100 locations 
nationwide. 

Modernizing the IRS' antiquated business systems and identifying new 
opportunities to provide taxpayers with e-Government functionality are 
key components of taxpayer service. A robust and secure infrastructure 
will improve services - both to taxpayers and other government agencies 
and will give the IRS the speed, security, and functionality to keep 
pace with a modern and increasingly electronic economy. 

The IRS continues to provide alternative services to assist taxpayers 
that do not have Internet access or are not in close proximity to 
established walk-in Taxpayer Assistance Centers. The IRS, through its 
partners, operates 38 self-help kiosks in 20 states and increases 
service options during the filing season by offering service in 
alternate locations such as shopping malls, libraries and other 
government offices. The Volunteer Income Tax Assistance (VITA) and Tax 
Counseling for the Elderly (TCE) partner programs provide Internet 
access to participants as part of their services. In FY 2005, the 
VITA/TCE partnerships experienced a 10% (71% to 78%) increase over FY 
2004 in e-file usage with almost 86% of VITA returns and nearly 70% of 
TCE returns filed electronically. 

During FY 2006, the IRS will continue to seek alternative, less costly 
ways to address the challenge of improving taxpayer service. The 
following discussion addresses two of the most significant challenges 
for the IRS. 

Delivering cost effective and efficient services needed to meet the 
demands of diverse taxpayer segments remains a challenge for the IRS, 
particularly in today's constrained budget environment. The IRS will 
employ highly integrated and targeted service, balancing accessibility 
and ease of use to reduce taxpayers' burden in complying with the tax 
laws through continued research and evaluation of taxpayer service 
needs, priorities, and preferences for obtaining information or 
services. The IRS will seek opportunities to invest in technology, 
process improvement and training to achieve consistent quality of 
service with reduced unit delivery costs. 

Achieving the goal of having taxpayers submit 80% of all filings, 
information, and returns, electronically by FY 2007 remains a 
significant challenge. While the e-filing rate continues to increase, 
it is only this past year in FY 2005, that more than half of all 
individual tax returns were filed electronically. The IRS is 
considering mandating e-filing for certain groups, by regulation or 
legislation, to ensure increased e-filing. Also, the Administration's 
proposal to extend the April filing date for electronically-filed tax 
returns to April 30, if enacted, may also increase electronic filing. 
But without a legislative change to mandate electronic filing, the 
challenge remains one of identifying options to encourage more of the 
taxpaying public to e-file. For example, many taxpayers use tax 
preparation software to prepare their returns, but then print out and 
mail in the return. The IRS must develop additional strategies to 
induce more of these taxpayers and preparers to take the next step and 
file electronically. 

Hurricane Katrina Support: 

IRS assisted taxpayers following the wake of Hurricane Katrina by 
granting tax filing and payment relief to all affected taxpayers. Over 
4,100 IRS employees helped FEMA register hurricane victims by opening a 
dedicated toll-free disaster phone line and providing a special 
information section on the IRS web site. As of September 30, 2005, IRS 
employees have answered more than 706,246 registration calls for FEMA, 
more than 30,000 calls on the special IRS toll-free line and provided 
over 163,864 disaster relief kits. 

Following are key indicators the Service uses to measure success in 
improving taxpayer service from the IRS Strategic Plan for 2005 through 
2009. 

Customer Satisfaction Data: 

The IRS determines its customers' overall level of satisfaction of its 
programs and services primarily through telephone and mail surveys. 
Data are also captured for the IRS by the University of Michigan 
Business School's National Quality Research Center for the American 
Customer Satisfaction Index and by NOP World, formerly Roper Starch 
Worldwide, a public opinion polling firm. 

On the 2004 American Customer Satisfaction Index Survey (ACSI), the IRS 
received an overall score of 64 out of a possible 100 for All 
Individual Tax Filers, a 25% increase over the 1999 score of 51. This 
survey reports satisfaction with IRS variables, such as timeliness, 
accessibility, courtesy and professionalism. Individual taxpayers are 
significantly more satisfied with the e-file return process than with 
paper filing. The 2004 annual rating for IRS in the NOP World 
favorability survey (the percentage of the public that has a favorable 
opinion of the IRS as compared with most federal agencies) was 52%, up 
from 49% in 2003 and a substantial increase over its lowest point of 
32% in 1998. 

Rate of Accuracy: 

Customer Accuracy measures how often customers received the correct 
answer to their inquiry and/or had their case resolved correctly based 
upon all available information and Internal Revenue Manual (IRM) 
required actions. 

The IRS exceeded its performance targets for both Toll Free Tax Law and 
Toll Free Account accuracy measures in FY 2005, with Tax Law measuring 
89% and Accounts measuring 91.5%. Improvements in the scores are 
attributed to numerous process changes implemented in FY 2005 such as 
an improved Probe and Response Guide, the roll-out of Contact Recording 
(recording of calls for manager/employee feedback) and training 
assistors on the full scope of accounts-related inquiries. 

Level of Service: 

The IRS measures Level of Service as the relative success rate of 
taxpayers that call for toll-free services seeking assistance from a 
Customer Service Representative (CSR). Improved efforts in training and 
modernizing raised the level of service for those taxpayers who want to 
speak to an assistor to 82.6%. The IRS will continue to staff toll free 
call sites to achieve the CSR Level of Service target of 82% based on 
the number of calls it expects to answer. 

Rate of Electronic Interaction: 

The IRS measures the rate of interaction for both individual and 
business returns. For the first time, over half of individual returns 
were filed electronically, an 11% increase from the previous year. FY 
2005 performance for business returns achieved a 17.8% participation 
rate and is expected to grow further as more filing choices are 
developed for business tax return filers. 

Timeliness of Responding to Customer Inquiries: 

The IRS measures the time taxpayers wait on the telephone when calling 
the IRS about their accounts, inquiring about tax laws when preparing 
tax returns, as well as the time from account creation to disposition 
for taxpayers needing account resolution assistance. Additional 
measures calculate the response time for those taxpayers who 
communicate electronically with the IRS. 

In FY 2005, the IRS customer assistance call centers received over 59 
million calls. Improvement efforts such as replacing paper processes 
with electronic ones reduced calls and lessened the need for contacting 
the IRS. This, plus quality control revisions, raised the level of 
service for the taxpayers who speak to an assistor to an unusually high 
87% in FY 2004. For FY 2005, the IRS achieved the target of 82%, a 
reasonable target that is more in line with previous performance while 
continuing to reflect gradual improvement. Although the average time 
callers spent waiting for telephone assistance has dropped steadily 
over the last few years, the IRS experienced an increase in call 
waiting times based on increased demand and its plan to stabilize 
resources dedicated to telephone services. 

IRS measures reported in the IRS, annual performance budget and 
included in the Treasury Performance Reporting System are discussed 
below. 

1. Customer Service Representative (CSR) Level of Service: 

Description: The measure is reported as the percentage of taxpayers 
that are calling IRS toll-free services and speak to an assistor. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS will continue to properly staff toll free call 
sites in order to maintain the CSR Level of Service target of 82% based 
on the number of calls it expects to answer. 

2. Customer Contacts Resolved per Staff Year: 

Description: The number of Customer Contacts resolved in relation to 
time expended based on staff usage. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS expects performance to continue to increase as 
more taxpayers choose to use automated and electronic means to contact 
the IRS instead of traditional, less efficient methods such as paper 
correspondence and speaking to live assistors. 

3. Percent of Eligible Taxpayers Who File for EITC: 

Description: The number of taxpayers who actually claim the Earned 
Income Tax Credit (EITC) compared to the number of taxpayers who appear 
to be eligible for the EITC. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Data to calculate the actual results will be 
available after the close of Calendar Year (CY) 2005 for TY 2004. 

Future Plans: The IRS is refining the methodology for estimating the 
percent of eligible taxpayers claiming EITC by developing an advanced 
regression alternative. The IRS is also considering researching an 
alternative methodology to compare current population survey data and 
EITC tax data. Once the analysis is complete, the IRS will assess each 
methodology and make a decision on the best method to use in estimating 
participation. 

4. Customer Accuracy - Toll-Free Tax Law: 

Description: The percentage of a live assistor giving the correct 
answer with the correct resolution to taxpayers' tax law inquiries. It 
measures how often the customer received the correct answer to their 
tax law inquiry and/or had their case resolved correctly based upon all 
available information and Internal Revenue Manual (IRM) required 
actions. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The type and complexity of tax law questions changes each 
year as new and often complex tax laws are enacted. 

5. Customer Accuracy-Toll-Free Accounts: 

Description: Percentage of a live assistor giving the correct answer 
with the correct resolution to the taxpayer. It measures how often the 
customer received the correct answer to their account inquiry and/or 
had their case resolved correctly based upon all available information 
and Internal Revenue Manual (IRM) required actions. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: Incremental improvement in performance is expected in FY 
2006 and beyond with the implementation of Contact Recording 
deployment. 

6. Timeliness of Critical Filing Season Tax Products to the Public: 

Description: The percentage of Critical Filing Season tax products made 
available to the public in a timely fashion. Critical Filing Season tax 
products are those forms, schedules, instructions, publications, tax 
packages and certain notices normally filed between January 1 through 
April 15 that are mailed to taxpayers. This measure contains two 
components: (1) percentage of paper tax products shipped no later than 
December 19 (December 27 for tax packages) and (2) the percentage of 
scheduled electronic tax products available on the Internet no later 
than the first five business days of January 2005. 

Timeliness of Critical Filing Season Tax Products to the Public: 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS expects performance to increase slightly for FY 
2006 as a result of efficiencies from locating IRS employees on-site at 
print vendors' facilities to monitor the quality and timeliness of 
printed tax products and implementing tighter inventory control by 
holding managers to higher standards for better determining tax 
products publication status. 

7. Timeliness of Critical Other Tax Products to the Public: 

Description: The percentage of Critical Other Tax Products, paper and 
electronic, made available to the public timely. Critical Other Tax 
Products are business tax products, Tax Exempt and Government Entities 
and miscellaneous tax products. This measure contains two components: 
(1) percentage of paper tax products that meet the scheduled start to 
ship date within five business days of the actual start to ship date 
and (2) percentage of scheduled electronic tax products that is 
available on the Internet within five business days of the ok-to-print 
date. The intent is to have the tax products available to the public 30 
days before the form is required to be filed: 

Timeliness of Critical Other Tax Products to the Public: 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS expects performance to increase for FY 2006. 
Standardized and measurable processes will be used to manage the 
quality and timeliness of tax product revision resulting from new or 
late legislation. 

8. Percent Individual Returns Processed Electronically: 

Description: Number of electronically filed individual tax returns 
divided by the total individual returns filed. Includes all returns 
where electronic filing is permitted (practitioner e-file, Telefile, 
VITA [Volunteer Income Tax Assistance], On-Line Filing, Federal/State 
returns, etc.). 

Percent Individual Returns Processed Electronically: 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: E-file participation rates are expected to increase to 
over 55% in 2006, based on current experience, historical growth, 
increased advertising, marketing and expanded e-file programs, 
including free Internet filing through the Free File Alliance. 

9. Percent Business Returns Processed Electronically: 

Description: The percentage of total number of business returns 
accepted electronically (posted to Business Master File) divided by the 
total returns received through all sources at IRS sites. 

Percent Business Returns Processed Electronically: 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS expects the percent of business filers to 
increase in the future due to increased marketing; expanded business e-
file programs, including the acceptance of new forms and schedules 
attached to employer, estates and trusts, and partnership tax returns; 
acceptance of amended returns; and acceptance of the new annualized 
employment tax return. 

Strategic Goal 2: Enhance Enforcement of the Tax Law: 

Objectives: 

* Discourage and deter non-compliance with emphasis on corrosive 
activity by corporations, high-income individual taxpayers and other 
contributors to the Tax Gap: 

* Ensure that attorneys, accountants and other tax practitioners adhere 
to professional standards and follow the law: 

* Detect and deter domestic and offshore-based tax and financial 
criminal activity: 

* Deter abuse within Tax-Exempt and Governmental Entities and misuse of 
such entities by third parties for tax-avoidance or other unintended 
purposes: 

Major Results, Accomplishments, and Challenges: 

Tax Revenue Collected: 

The majority of the revenue the IRS collects is paid voluntarily. In FY 
2005, the IRS collected more than two trillion dollars in revenue with 
a record $47.3 billion collected through enforcement activities, a 9.7% 
increase from FY 2004. The $47.3 billion in enforcement revenue was 
collected through concerted efforts by the IRS to detect and deter non- 
compliance with the tax code. 

Reducing the tax gap (the difference between what taxpayers should pay 
and what they actually pay) is at the heart of the IRS' renewed 
emphasis on enforcement and serves as a means to reducing our nation's 
deficit. The tax gap measures the extent to which taxpayers do not pay 
their correct tax liability on time, either because they do not file a 
required tax return on time, do not pay on time the amount of tax that 
they report on their timely return, or most importantly, fail to 
accurately report their correct tax liability on their timely return. 

Underreporting of income taxes, employment taxes and other taxes 
represents about 80% of the tax gap as noted in the March 2005 release 
of the IRS' preliminary tax gap estimates for Tax Year 2001. The single 
largest sub-component of underreporting involves the individual income 
tax, with individuals understating their incomes, taking improper 
deductions, overstating business expenses or erroneously claiming 
credits. The National Research Program (NRP) study further confirmed 
that the majority of understated income comes from business activities, 
not wage or investment income. By the end of December 2005, the IRS 
expects to provide detailed estimates of individual income tax non- 
compliance based largely on an analysis of the NRP data. 

The IRS is primarily focusing its attention on corrosive activities 
conducted by corporations, high income taxpayers and other major 
contributors to the tax gap. The IRS will use data collected from the 
NRP study on individual taxpayers to ensure its audits of individuals 
are focused on the most noncompliant returns. Targeting high-risk 
taxpayers should improve IRS efficiency and reduce the burden on 
compliant taxpayers. It will also increase and focus the IRS' 
enforcement presence where it is most needed. 

Reducing the tax gap is the IRS' most significant challenge. In FY 
2006, the IRS will continue to target its case work and enforcement 
activities to more effectively deliver results and drive down the tax 
gap. The IRS will focus its analysis of tax information and data from 
compliance research studies to better define and quantify the tax gap. 
The IRS will use the results of these efforts to better understand and 
counter the methods and means of those taxpayers who fail to report or 
pay what they owe. 

Enforcement Activities: 

The IRS met or achieved 69% (9 of 13) of its enforcement-related 
performance targets in FY 2005. These results were achieved through 
streamlining and centralizing work processes, improving workload 
selection techniques and increasing managerial involvement in casework. 
The IRS emphasized efficiency and implemented initiatives to reduce 
cycle time, such as refining case selection criteria. Closely 
monitoring resources and inventories, a focus on case quality and the 
use of embedded quality reports and data to drive improvement efforts 
also contributed to this success. As a result, the IRS completed over 
215,000 high-income audits (taxpayers earning $100,000 or more) in FY 
2005, 10% more than the previous year and more than twice as many than 
in FY 2001. Total audits of all taxpayers exceeded 1 million in 2005 
for the second consecutive year, a 20% increase from FY 2004. 

The IRS audited 81% more small business and 15% more corporations in FY 
2005, a significant achievement given the size (more than $10 million) 
and complexity of these corporate entities. The IRS also expanded 
examination coverage by increasing its focus on identification of 
limited non-compliant corporate returns and the development of 
strategies to address issues at the entity level instead of the return 
level. A reinforced focus on case quality helped the IRS deliver 
improved business results for the second consecutive year. 

Prominent settlement initiatives (offered to taxpayers before the IRS 
initiated an audit) generated more than $4.7 billion in additional 
revenue in FY 2005. One significant tax shelter case worth noting was 
the Son of Boss, in which more than 1,200 qualified taxpayers elected 
to participate in a settlement offer. The taxes, interest and penalties 
collected from the Son of Boss settlement offer have exceeded $3.7 
billion. A second settlement initiative is underway, in cooperation 
with the Securities and Exchange Commission. This abusive tax 
transaction involves the transfer of executive stock options or 
restricted family stock to family-controlled entities for the personal 
benefit of executives. At least 42 companies and 700 executives 
participated in this abusive practice, resulting in the collection of 
$1 billion through September 2005. 

The IRS increased audit coverage of those responsible for the promotion 
and use of abusive tax schemes and avoidance transactions. During the 
past five years, the IRS identified more than 200,000 questionable 
returns prepared by practitioners on behalf of their clients. These 
returns claimed over $700 million in refunds. Since August 2002, the 
IRS completed more than 98,000 audits and assessed more than $200 
million in additional tax as a result of the on-going return preparer 
investigations. 

The IRS Criminal Investigation Division (CID) leveraged its 
Counterterrorism Program effectively to achieve its core mission, while 
simultaneously supporting the war on terrorism. The IRS participated in 
interagency counter-terrorism efforts, providing technical assistance 
in terrorism-related investigations, examining foreign grants, and 
matching third party information. The IRS also undertook a study of tax-
exempt organizations with foreign grants and operations to determine 
how well internationally-oriented U.S. charities are protecting their 
assets from diversion and compliance with tax laws. In FY 2005, CID 
recommended 86 cases for prosecution, of which 67 resulted in 
indictments or other forms of action. Approximately 50% of CID's 
inventory of terrorism related cases has a tax related violation under 
investigation. 

In FY 2005, the IRS also improved its collection performance by 
improving workload selection techniques, reengineering outdated 
processes to account for improved case selection tools, deploying 
centralized processing to reduce overhead in the internal support 
functions and increased managerial presence in review of case 
decisions. Improved case selection tools including risk-based modeling 
are a critical component for ensuring timely processing of appropriate 
cases of the Collection Program's inventory. For example, employment 
taxes (also known as trust fund or payroll) are at high risk for non- 
compliance and one of IRS' collection priorities due to rapid 
pyramiding of quarterly employment tax liabilities. Risk based modeling 
reveals the best opportunity for bringing an employer with multiple 
delinquent quarters (pyramiding) back into full compliance is early 
intervention. Collection's inventory delivery system factored 
pyramiding into case assignment rules, ensuring earlier assignment of 
cases meeting these criteria and to stem growth in the overall 
collection inventory. The IRS also reduced its inventory growth through 
timely and appropriate filing of Notices of Federal Tax Lien. Educating 
taxpayers about lien subordination, discharge, posting bonds or other 
collateral where appropriate has aided taxpayers in satisfying their 
outstanding liabilities, increasing compliance. As a result of these 
efforts, the IRS collected 14% more revenue and closed 12% more cases 
compared to FY 2004. 

Moving forward in FY 2006 and beyond, the IRS will continue to identity 
effective enforcement strategies necessary to target growing and 
increasingly complex corrosive tax schemes. 

An enforcement priority for the IRS is to deter and prevent abusive tax 
avoidance transactions or tax motivated transactions that are corrosive 
to the equity and the fairness of the tax law for all taxpayers. 
Vigorous enforcement of the criminal provisions of the Internal Revenue 
Code, coupled with appropriate civil sanctions, materially contributes 
to maintaining voluntary compliance and public confidence in the 
fairness of the tax system. Tax shelter promoters continue to modify 
schemes, making it difficult to detect patterns and identify 
participants on a timely basis. Because these types of transactions 
present unacceptable tax avoidance behavior, the IRS needs to continue 
efforts to identify them timely and to make the public aware of the 
IRS' concerns. 

Recent trends indicate that the tax shelter population will continue to 
expand to small to mid-size corporations where the issues will be more 
difficult to identify and examine. Large corporate taxpayers are 
increasingly engaging in structured transactions designed individually 
for them, thereby avoiding some of the provisions allowing early 
identification. These structured transactions involve highly complex 
fact patterns and large dollar issues. Promoters of tax shelters are 
migrating from the large accounting firms to firms and businesses that 
specialize in tax shelters. These promoters are less compliant for 
registration and less stable in their business operations, making it 
more difficult to pursue them for information and for penalties. 

The number of fraudulent refund claims continues to escalate. For the 
2005 processing year, the IRS identified approximately $451 million of 
fraudulent refund claims for individuals. Return preparer fraud 
continues to be one of the IRS' key investigative priorities as well. 
The current inventory of return preparer investigations represents a 
five-year high. As of August 2005, subject criminal investigation 
initiations increased approximately 22% over the same time period in 
2004. For tax return processing year 2005, IRS fraud detection centers 
identified more than 33,000 questionable client returns associated with 
unscrupulous tax return preparers, claiming approximately $103 million 
in refunds. Key to effective detection and deterrence of these 
fraudulent claims is the need to invest in new technology. 

Following are the key indicators the Service uses to measure success in 
enhancing enforcement of the tax law from the IRS Strategic Plan for 
2005 through 2009. 

Percent of Priority Guidance List Items Published: 

The 2004-2005 Guidance Priority List (GPL) included 283 projects, 
focusing resources on guidance items most important to taxpayers and 
tax administration. Sixty-six additional items were added during the 
course of the plan year (July 1, 2004-June 30, 2005). The IRS' 2005 
goal was to publish 76% of the Guidance Priority List; final 
performance shows 211 items were published, 75% of the original and 60% 
of the final GPL. 

The IRS did not meet its goal in part due to a shift in priorities 
necessitated by enactment (October 2004) of the American Jobs Creation 
Act of 2004 (AJCA) which required immediate implementation. The AJCA 
made sweeping changes in corporate and international taxation and 97% 
of the provisions were effective before, on, or within six months of 
the date of enactment. One hundred seventy eight new provisions 
required IRS to issue guidance to help taxpayers understand key 
concepts of the act. 

The Office of Chief Counsel will continue to monitor and prepare for 
legislation resulting from the President's tax reform initiative. 
Fundamental reform would affect all aspects of the economy and all 
taxpayers. The IRS and Counsel will support the Treasury Department in 
its efforts to craft and evaluate different reform options by assessing 
administrative and technical issues. 

Percent of Americans Who Think it is OK to Cheat on Taxes: 

The IRS Oversight Board conducts an annual NOP World survey to assess 
the public's perceptions about tax compliance. The survey was initially 
conducted in 1999 and has been repeated each year since 2001. Results 
from the 2005 survey are expected in January 2006. In 2004, 86% of 
taxpayers (up five points from 2003), continued to believe that it is 
"not at all" acceptable to cheat on income taxes. More taxpayers (73%, 
up 4 points from 2003 and down 8 points from the 1999 high point) 
completely agreed that it is everyone's civic duty to pay their fair 
share of taxes and that everyone who cheats should be held accountable 
(62%, up 2 points from 2003). 

Average Cycle Time: 

A measure of the length of time from receipt of a case for audit or 
collection until the audit or collection activity is completed; average 
cycle time is computed on audits of individuals, small and large 
business entities and tax-exempt entities. 

The IRS' principal strategy is reducing the Months-In-Group cycle time; 
i.e., the portion of the overall cycle time when the return is actually 
under examination within a field group. Over the past two years, the 
IRS has realized an 18% improvement in Industry Months-In-Group cycle 
time and a 15% improvement in Coordinated Industry Months-In-Group 
cycle time. Several new initiatives, such as the Appeals/LMSB Joint 
Cycle Time Measure, increased Fast Track Appeals, more limited scope 
examinations and electronic filing, are underway or in place to reduce 
overall cycle time. 

The mix of examination inventory is complex, with growing numbers of 
tax shelter, partnership and joint committee returns, which have longer 
cycle times than less risky return categories. The IRS uses several 
strategies, such as Modernized e-Filing, better return risk assessment 
and Months-in-Group cycle time to counteract the negative influence of 
these long cycle time, high-risk return categories on overall cycle 
times. 

The IRS' Field Collection organization has made great strides in 
reducing cycle time in FY 2005. For non-payment cases, the cycle time 
was reduced from 42 weeks to 36 weeks, a 16% reduction. 

Rate of Reporting Compliance: 

The Rate of Reporting Compliance or the Voluntary Reporting Rate (VRR) 
is defined as the amount of individual income tax that is reported on 
timely-filed returns for a given tax year, expressed as a percentage of 
the amount of tax liability that should have been reported on those 
returns. The IRS has made preliminary estimates of the Tax Year 2001 
VRR based on the recently completed National Research Program study of 
individual income tax reporting compliance. Preliminary estimates range 
from 82% to 85%, roughly consistent with estimates from similar studies 
for earlier years. Final estimates are due at the end of 2005. 
Estimates of the amount of Tax Year 2001 individual income tax that was 
underreported range from $150 billion to $187 billion. 

Rate of Filing Compliance: 

The timely filing rate is the percentage of required returns that are 
filed timely for a given tax year. This rate for individual taxpayers 
is computed by dividing the estimated number of required returns filed 
on time for a given tax year by the estimated number of all individual 
returns required to be filed for that year. The IRS' latest estimate of 
the timely filing rate was 88.9% for Tax Year 2001. 

Rate of Payment Compliance: 

The voluntary payment compliance rate is the percentage of the total 
tax liability reported on timely filed returns that is paid in a timely 
manner. The voluntary payment compliance rate is 98.9 percent for Tax 
Year 2003, which is a slight improvement over Tax Year 2002. 

IRS measures reported in the IRS, annual performance budget and 
included in the Treasury Performance Reporting System are discussed 
below. 

1. Examination Coverage - Individual: 

Description: The sum of all individual returns closed for Field 
Examination, Office Examination, Correspondence Examination and 
Automated Underreporter programs divided by the total individual return 
filings for the prior calendar year. 

Examination Coverage - Individual: 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS will use the National Research Program (NRP) 
results for developing improved analytics and workload identification 
and selection of the types of cases it selects for review and 
examination. Additionally, based on the NRP data, the IRS will 
highlight requisite skill sets and determine if a fundamental change in 
recruitment and training processes should be explored. Areas of 
emphasis include Abusive Promotions, High Income Taxpayers, Schedule C 
filers and Fraud. 

2. Examination Quality - Field: 

Description: The score awarded to a reviewed Field Examination case by 
a Quality Reviewer using the Examination Quality Measurement System 
(EQMS) quality standards. 

Examination Quality - Field: 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS will continue to focus on improving the quality 
of all facets of the examination process, including timeliness of 
actions, proper consideration of related and multi-year returns, 
appropriate use of income probes, fraud indications are properly 
pursued and developed, and application of report writing procedures to 
improve future performance. In FY2006, Field Examination is converting 
to the Embedded Quality (EQ) system of measuring quality. EQ directly 
links the examiners Critical Job Elements to the quality measurement 
system, improving the relationship between individual performance and 
organizational objectives. 

3. Examination Quality-Office: 

Description: The score awarded to a reviewed Office Examination case by 
a Quality Reviewer using the Examination Quality Measurement System 
(EQMS) quality standards. 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS will continue to focus on improving the quality 
of all facets of the examination process, including timeliness of 
actions, proper consideration of related and multi-year returns, 
appropriate use of income probes, appropriate fraud indications are 
properly pursued and developed. In FY2006, Field Examination is 
converting to the Embedded Quality (EQ) system of measuring quality. EQ 
directly links the examiners Critical Job Elements to the quality 
measurement system, improving the relationship between individual 
performance and organizational objectives. 

4. Examination Coverage - Business: 

Description: Large and Mid Size Business "customer base" returns 
(returns filed by large corporations), examined and closed during the 
current Fiscal Year, divided by filing of the same type returns for the 
preceding calendar year. 

Examination Coverage - Business: 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS plans to expand examination coverage for 
corporations through innovative approaches such as pre-filing 
initiatives (such as the Compliance Assurance Process), Limited Issue 
Focus Examinations (LIFE) and the Currency Initiative. Through improved 
modeling and the use of targeted specialized teams, the IRS will focus 
its resources on the issues that pose the greatest compliance risk and 
begin to identity enterprises that appear to be non-compliant. 

5. Examination Efficiency-Individual: 

Description: The sum of all individual returns closed (Field 
Examination, Correspondence Examination and Automated Underreporter) 
divided by the total FTEs expended in relation to those individual 
returns. 

Examination Efficiency -Individual: 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: Future strategies to improve performance include 
improvements to the work stream through better case identification and 
classification, including leveraging NRP data to improve Exam's ability 
to select the best workload for examination. Emphasis will continue to 
be placed on multi-year non-compliance, reduced cycle time, streamlined 
automation and utilization of risk analysis/assessment in all business 
processes. 

6. Examination Quality-Industry: 

Description: The average of the percentage of critical elements passed 
on Industry cases reviewed. 

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[End of table] 

FY 2005 Performance: Target Not Achieved. The IRS did not meet its FY 
2005 target due to several factors related to the examination planning 
process, specifically identification of material issues. Contributors 
to the lower rate include lack of documentation of the initial risk 
analysis in which material issues are considered and documentation of 
mandatory referrals to specialists. While improved from last year, the 
preparation and proper use of the Administrative Procedures Document 
(documentation regarding exam techniques such as interviews; 
reconciliation of books to tax returns; inspection of prior, subsequent 
and related tax returns; and tour of taxpayers' business) continues to 
be a concern. Revenue Agents and managers are not including the 
document in the case file or properly sign it as required. Preparation 
and inclusion of the No-Change report in the file when a case is closed 
without adjustment is an area that continues to affect quality scores. 

Future Plans: To facilitate immediate corrective action and eliminate 
recurring errors, LQMS reviewers will provide written feedback on all 
reviewed cases to the case manager and agent who worked the 
examination. The written feedback provided will provide a detailed 
explanation of the results for each quality element and will stress 
areas that warrant improvement so field teams will correct identified 
process deficiencies in future examinations. Specific tools have been 
developed to address quality improvement, such as media devices 
(training materials on compact disc) that highlight the necessary 
actions needed to improve quality and identity partnering opportunities 
with industry contacts, the training office and the Case Quality 
Improvement Council. 

7. Examination Quality-Coordinated Industry: 

Description: The average of the percentage of critical elements passed 
on Coordinated Industry cases reviewed. 

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[End of table] 

FY 2005 Performance: Target Not Achieved. The IRS did not meet its 2005 
target despite renewed focus on identification of material issues 
during the planning process and documentation of them during the 
initial risk analysis. Root cause analysis revealed filing and 
compliance requirements for corporate directors and officers are not 
being verified and documented. In addition, procedures used during the 
examination are not being identified and documented during the planning 
process, a critical element of case quality. While improved from last 
year, adherence to the requirements outlined in the Administrative 
Procedures Document, continues to be a concern. Revenue Agents and 
managers are still failing to complete the document or provide a copy 
of the document to the reviewer during the opening review conference. 
Also, Examination teams need to ensure the taxpayer's and the IRS' 
position is fully documented in the case file. 

Future Plans: To facilitate immediate corrective action and eliminate 
recurring errors, LQMS reviewers will provide written feedback on all 
reviewed cases to the case manager and agent who worked the 
examination. The feedback will detail the results for each quality 
element and will stress areas that warrant improvement so field teams 
will correct identified process deficiencies in future examinations. 
Specific tools have been developed to address quality improvement, such 
as media devices (training materials on compact disc) that highlight 
the necessary actions needed to improve quality and partnering 
opportunities with industry contacts, the training office and the Case 
Quality Improvement Council. 

8. Collection Coverage - Units: 

Description: The volume of collection work disposed (closed) compared 
to the volume of collection work available. 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: Building on more effective case selection and refinement 
of Business Master File (BMF) case selection criteria is expected to 
result in improvements in case cycle time, freeing up resources that 
will be devoted to casework. In addition, a newly established Corporate 
Collection Governance Board of senior leaders from collection operating 
units in the IRS will guide development of new strategies and 
approaches to collection techniques including sponsoring a study on the 
effects of the collection notice stream. 

9. Collection Efficiency - Units: 

Description: Total work (delinquent accounts, investigations, offer- in-
compromise, automated substitution for return) disposed (closed) over 
the total FTE (full-time equivalent) realized in field collection and 
in campus collection. 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: To further reduce case cycle time, the IRS will focus on 
two key quality timeliness attributes: (1) reducing activity lapses and 
taking timely follow-up actions and (2) reengineering efforts being 
piloted such as a pre-populated financial statement and automated 
adjustments. In addition, a newly established Corporate Collection 
Governance Board of senior leaders from the collection operating units 
in the IRS will develop strategies and approaches to the collection 
activities including sponsoring a study on the effects of the 
collection notice stream. 

10. Field Collection Quality of Cases Handled in Person: 

Description: The score awarded to a reviewed Collection case by a third-
party reviewer who uses the Collection Quality Measurement System 
(CQMS) quality standards. CQMS composite score is computed based on 19 
quality standards taken from the CQMS check sheet. Each standard has a 
value of four points. However, four of these standards have been 
designated as critical and are weighted more heavily. Failure to meet 
any one of the critical standard results in the deduction of 24 points 
from the overall composite score. 

Field Collection Quality of Cases Handled in Person: 

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[End of table] 

FY 2005 Performance: Target Not Achieved. The IRS did not meet its FY 
2005 target. Although performance improved in standards such as 
Publication One, Rights Notification and Case File Documentation, 
declines in other standards overshadowed gains. Also impacting the 
overall score was the IRS' emphasis on getting the inventory current by 
focusing on aged case inventories. Because older cases have increased 
chance for errors due to increased handling time, the need for 
repetitive actions such as re-issue of notices, and potential for more 
activity lapses, older cases adversely impact quality scores. 

Future Plans: The IRS is currently piloting the Embedded Quality (EQ) 
System to replace CQMS beginning in FY 2006. EQ creates a way of doing 
business that builds commitment and capability among all individuals to 
continually improve customer service, employee satisfaction and 
business results by aligning quality measures and individual 
performance. EQ standards are linked directly to employee Critical Job 
Elements (CJEs) enabling employees to see how individual performance 
impacts objectives. EQ results will be baselined during FY 2006. 

The IRS will place specific attention on quality attributes of setting 
clear action dates, setting clear expectations for taxpayers, timely 
follow-up actions and reducing activity lapses to improve quality and 
increase efficiency. 

11. Automated Collection System (ACS) Accuracy: 

Description: Captures the percent of taxpayers who receive the correct 
answer to their ACS question. 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: The IRS' focus on process and performance reviews coupled 
with the feedback loop and identification of training needs will 
continue to drive accuracy scores up and help improve the taxpayer's 
experience. 

12. Criminal Investigations Completed: 

Description: Cumulative count of the number of all Subject Criminal 
Investigations (SCI) completed during the fiscal year by IRS Criminal 
Investigation Division. It includes investigations that resulted in a 
criminal prosecution recommendation to the Department of Justice as 
well as investigations that were discontinued due to a lack of evidence 
or to a finding that the original allegation was false. 

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[End of table] 

FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005 
target. 

Future Plans: Criminal Investigation will continue to aggressively 
enforce the criminal statutes of the Internal Revenue Code (IRC), the 
Bank Secrecy Act and the anti-money laundering statutes by devoting 
resources and special emphasis on investigations that have a strong tax 
administration nexus. Criminal Investigation will maintain 
relationships with key shareholders to continue to improve the fraud 
referral program and to facilitate the identification of areas of non- 
compliance adversely impacting tax administration. Specific priorities 
encompass such serious or chronic compliance challenges as abusive tax 
schemes and shelters, high income non-filers, employment tax fraud and 
refund crimes. Furthermore, the critical national law enforcement 
priorities of Corporate Fraud and Terrorism continue to be important 
areas of emphasis. 

Through its Refund Crimes Program, CI will continue to identify and 
pursue fraudulent return preparer and questionable refund schemes 
involving individual as well as business returns. CI will also increase 
its efficiency in verifying wages and identifying questionable claims 
by fully utilizing the National New Hire Database (maintained by the 
Department of Health and Human Services). 

13. TE/GE Determination Case Closures: 

Description: Cases established and closed on the Tax Exempt and 
Government Entities Determination System (EDS) regardless of type of 
case or type of closing (e.g. employee plan, exempt organization or 
government entity): 

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[End of table] 

FY 2005 Performance: Target Not Achieved. The IRS fell short of its FY 
2005 target due to increased responsibility for certain correspondence 
previously worked out of the call site and a substantial investment in 
training this year. To mitigate these impacts, the Exempt Organization 
office has taken steps to maximize the number of cases that can be 
closed on merit with minimal additional information requests. 

Future Plans: The IRS targeted additional resources late in FY 2005 to 
hire 26 new revenue agents for determination work. These new resources 
are expected to help offset the increased workload in FY 2006. 

The IRS is restructuring the Employee Plan determination letter process 
to stabilize the receipt flow. Although the mix of receipts will change 
annually, the new approach will dramatically reduce the workload swings 
previously experienced in this program, improving program management 
and eliminating the need to pull resources from enforcement activities 
to support determination work during peak periods. The IRS is also 
developing a new interactive application for determination requests 
that will improve the quality of determination requests and enable the 
electronic filing of these applications. 

Strategic Goal 3: Modernize the IRS through its people, processes and 
technology: 

Objectives: 

* Increase organizational capacity to enable full engagement and 
maximum productivity of employees: 

* Modernize information systems to improve service and enforcement: 

* Ensure the safety and security of people, facilities and information: 

* Modernize business processes and align the infrastructure support to 
maximize resources devoted to front-line operations: 

Major Results, Accomplishments and Challenges: 

Ensuring Organizational Effectiveness: 

The IRS faces high expectations for the level of service and 
enforcement required for the fair and uniform application of tax laws. 
Each year, IRS employees contact millions of taxpayers. In each of 
these contacts, the IRS strives to maintain a level of professionalism 
and integrity that will assure taxpayers of competent, efficient and 
respectful treatment. The IRS is improving accuracy of responses to 
taxpayer inquiries, increasing the clarity of communications and 
providing taxpayers and their paid preparers with requested resources 
on a timely basis. 

Workforce planning is a significant challenge. With a diverse 
population of more than 100,000 employees and more than 700 duty 
stations across the country, the IRS works continuously to ensure that 
its employees are in the right place at the right time and have the 
skills and competencies needed to accomplish the IRS mission. The 
expansion of pay-for-performance provides a higher degree of 
accountability in the workforce and numerous training and leadership 
programs improve the overall level of professionalism. The IRS 
established a trained core recruitment group that is responsible for 
attracting excellence in potential employees. This cadre works to 
maintain partnerships with many colleges and universities and attends 
campus and commercial events around the country to promote the benefits 
of becoming an IRS employee. 

The IRS continued its workforce restructuring to achieve both the 
optimum mix of skills within the IRS and the optimum number of 
employees that directly support tax processing, administration and 
compliance functions. The IRS continues to ensure an adequate talent 
pool to administer the tax law as a primary component in maintaining 
the integrity and excellence of the workforce. In FY 2005, the IRS 
achieved efficiencies in filing technology and in overhead functions. 
More importantly, the percentage of the IRS workforce engaged in 
compliance-related work increased from 48% to 50% of the workforce in 
FY 2005. This shift was possible because of cost reductions provided by 
increased electronic filing and through the restructuring of 
administrative areas. While the number of IRS employees has decreased 
overall, the IRS has been able to maintain or increase employment in 
the key compliance occupations of revenue agents, revenue officers, and 
special agents. 

The IRS recognizes that its workforce is maturing and that significant 
numbers of employees will soon be eligible to retire. Analysis of 
workforce data shows that the most problematic area is the projected 
attrition of senior leadership. To ensure continuity of leadership, the 
IRS launched a comprehensive leadership succession planning initiative. 
The first phase of the initiative included an assessment of 103 
executives to measure and benchmark competency strengths and 
weaknesses. Additional efforts to address the aging workforce challenge 
include hiring initiatives to ensure that the IRS maintains the 
appropriate level of employees in mission-critical occupations 
necessary to achieve its mission. 

Modernization: 

The IRS successfully deployed the new Integrated Financial System (IFS) 
at the start of FY 2005. The IFS serves as the "core" administrative 
financial management system. The major components of IFS are accounts 
payable, accounts receivable, budget formulation, budget execution, 
general ledger, financial statements and cost accounting. The IFS is a 
fully integrated, customized commercial off-the-shelf (COTS) software 
package designed to provide IRS with more accurate and timely financial 
and cost information and improved compliance with legislative and 
regulatory requirements. Today there are thousands of procurement 
commitments, obligations and receipt/acceptance documents being 
processed through the new IFS system. The IRS successfully maintained 
its record of submitting the monthly SF-224 and the monthly Treasury 
Information Executive Repository (TIER) files to Treasury on time since 
going live. 

The IRS Business Systems Modernization (BSM) program improved its 
success in delivering projects, attaining cost and schedule targets, 
realizing benefits to taxpayers and improving BSM program management 
capabilities. After re-baselining in late 2004, the BSM program 
delivered most projects and releases in FY 2005 on time, on budget and 
met or exceeded the scope of expectations. 

In FY 2005, the IRS modernization efforts focused on three key tax 
administration systems that provided additional benefits to taxpayers 
and IRS employees, specifically: the Customer Account Data Engine 
(CADE) project; Modernized e-File; and Filing and Payment Compliance 
(F&PC). 

CADE replaces the IRS' antiquated system called the Master File, which 
is the repository of taxpayer information. CADE allows faster refunds 
(CADE processes refunds on a daily basis), improved taxpayer service, 
faster issue detection, more timely account settlement, and a robust 
foundation for integrated and flexible modernized systems. More than 
1.4 million returns were posted with more than $427 million in refunds 
generated. Next year, CADE should be able to process over twice as many 
returns. It will be the single authoritative repository for account and 
return data. 

Modernized e-File (MeF) deployed Form 7004 (filing extension for 
corporations) as well as Form 990PF (information return for private 
foundations). This allowed the IRS to establish regulations requiring 
large corporations and tax-exempt organizations to electronically file 
their income tax or annual information returns. Through September 2005, 
MeF is processing 1120 and 990 returns at higher-than-expected volumes 
while still achieving performance goals -a significant reduction in 
burden and time for corporate and tax-exempt taxpayers. 

The IRS completed architecture engineering analysis and development of 
a limited functionality release for Filing & Payment Compliance (F&PC) 
Release 1.1 designed to separate complex cases requiring direct IRS 
involvement from those that can be handled by private collection 
agencies (PCAs). This release will provide initial capabilities for 
competitive outsourcing of collection activities in FY 2006. 

In 2004, Congress passed the American Jobs Creation Act, a provision of 
which allows the IRS to use Private Collection Agencies (PCAs). The 
current volume of delinquent taxpayers exceeds the IRS' capacity and 
results in a serious backlog of collection cases that cannot be 
adequately addressed with current resources. This backlog represents 
lost revenue opportunities and undermines the fairness of the tax 
system. The legislation authorized the IRS to augment its collection 
efforts by using PCAs to pursue undisputed, uncollectible tax 
liabilities. PCAs will not have enforcement authority and will only 
contact delinquent taxpayers to arrange voluntary, full-payment 
installment agreements. 

In FY 2005, the IRS implemented new network management software, an off-
the-shelf product called "CiscoWorks." Results of the new network 
management tools include: 

* Improved service and network performance to all customers through 
reduced configuration errors, enhanced security and network management 
capabilities; 

* Streamlined access to troubleshooting reports that a year ago would 
usually have required multiple logons and hours of time; 

* Reduced cost of audits; 

* Increased efficiency through improved configuration controls; and: 

* Assurance of stable and predictable network performance for all 
business units. 

To address its modernization challenges, the IRS updated a strategic 
vision for the BSM's future beyond 2007 and setting goals for the year 
2010 that align with and support the IRS Strategic Plan. The FY 2006 
BSM portfolio will focus on delivery of three major tax administration 
projects (highlighted below), along with infrastructure initiatives and 
continued improvement to program management operations. Each Tax 
Administration project will address a core IRS strategic priority. 
Program operations will continue to focus on improving program 
performance; improving and streamlining management process disciplines; 
and ensuring delivery of projects on time, on budget, and on scope by 
taking a greater ownership and leadership role in managing the BSM 
program. 

* The IRS will expand CADE to increase the number of tax returns 
processed and taxpayers served, targeting 33 million returns to be 
processed during 2007. 

* Modernized e-File (MeF) continues engineering development to prepare 
for the expanding taxpayer base served through combined Federal and 
State processing of tax returns. BSM also continues working on access 
capabilities for disabled taxpayers through e-Services upgrade of the 
PeopleSoft Commercial Off-the-Shelf application. 

* The IRS will develop the first release of the Filing and Payment 
Compliance system to analyze tax collection cases to determine 
uncontested cases that no longer require direct IRS involvement and can 
be turned over to private collection agencies. 

Following are the key indicators the Service uses to measure success in 
modernizing the IRS through its people, processes and technology from 
the IRS Strategic Plan for 2005 through 2009. 

Level of Employee Engagement: 

The Level of Employee Engagement measures the number of IRS employees 
who feel they are in the right job, are managed well and are 
productive. Data used to determine this result is taken from the IRS' 
annual employee satisfaction survey. 

In 2005, more than 57,000 employees participated in the annual Employee 
Engagement Survey. The scores improved on all questions. The IRS uses 
the response to the following question, "Considering everything, how 
satisfied are you with your job?" as a broad indicator of employee 
satisfaction. In 2005, over 64% of employees were very satisfied or 
extremely satisfied with their job compared to 60% in 2004. 

The IRS continued its strong improvement on survey items especially the 
categories of receiving recognition and feedback on progress. The IRS 
will provide results of "SURVEY2005" to employees for discussions in 
workgroups, with subsequent action plans developed to ensure continued 
improved working conditions. Responses to questions about training and 
development also continued to improve. 

For the second year in a row, over 65% of employees who took the survey 
reported that they participated in team feedback and action planning 
sessions. Team feedback and action planning sessions are a crucial part 
of the employee satisfaction process. Employees who participated in 
these meetings also reported much higher levels of satisfaction than 
employees who did not. Each IRS business unit is encouraged to identify 
one or two specific areas of the survey that will be the focus of 
concentrated improvement actions. In prior years, this approach proved 
to be very beneficial for a number of business units. 

The addition to the employee scholarship program targeted at key 
staffing needs reinforces the IRS' commitment to employee development. 
The Human Resources Investment Fund (HRIF), established in response to 
earlier employee feedback about training needs, also continues as a 
complement to the scholarship program. 

Index of Employee Perceptions of Performance Management System: 

This is an index based on how employees responded to specific questions 
on the Federal Human Capital Survey (FHCS) conducted annually by the 
Office of Personnel Management. The questions relate to employee 
perceptions regarding how well the organization rewards good 
performance and addresses poor performance. The IRS has developed 
target levels for this index and a 2005 goal from which to assess its 
current performance. The IRS has not received the results of the latest 
survey as of the date of this report. 

Ratio of Mission-Critical Occupations (MCO) Employees to Non-MCO 
Employees This is the proportion of staff employed in mission critical 
areas, those that support tax processing, administration and 
compliance, compared to non-mission critical areas. This indicator will 
help the IRS determine if its staffing and employee development 
initiatives result in the appropriate level of talent assigned to MCOs 
in support of the IRS' mission and goals. The IRS has developed target 
levels for this indicator which it uses to assess its actual 
performance. 

The target MCO/non-MCO ratio for FY 2005 is 64%. The ratio reported at 
the end of FY 2005 was 62.9%. 

Benchmark IT Services and Development to Private Industry Standards for 
Cost, Scheduling, and Functionality: 

MITS has developed performance measures that will be monitored from the 
CIO level down to the operational levels. These measures will provide 
comprehensive management information to executives to monitor success 
at meeting performance targets keyed to industry best practices. This 
measures development effort has been far more comprehensive than any 
ever conducted in MITS and includes over 250 measures and metrics at 
various organizational levels. In addition, MITS established a 
comprehensive time reporting system/work planning and control system 
and has undertaken the development of a comprehensive cost accounting 
system. Presently, the IRS is halfway through the decomposition phase 
on this effort and will ultimately quantify the relationship between 
all MITS products and services and their related costs. 

IRS measures reported in the IRS' annual performance budget and 
included in the Treasury Performance Reporting System are discussed 
below. 

1. Contracted Program Cost and Schedule Variance: 

Description: Contracted Program Cost and Schedule Variance measures the 
improvement in the program's ability to accurately estimate cost and 
period of performance. The measure is derived from the program's two 
efficiency measures: Fiscal Year Estimated Contract Cost Variance and 
Fiscal Year Contract Period of Performance Variance. By calculating the 
efficiency rating (percentage) for the current fiscal year and 
comparing it to the efficiency rating of the previous fiscal year, the 
measure compares the two performance ratings for cost and period of 
performance estimation, individually, to determine the degree of 
improvement. The measure is reported as the lower of the two ratings. 
As long as the reported rating is at or above the target, the program 
is improving satisfactorily. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Discontinued The IRS has discontinued this measure 
and will no longer report on it either internally or externally. 

Future Plans: In FY 2006, this performance measure will be split into 
two measures: Contracted Program Costs Variance and Contracted Program 
Schedule Variance. 

2. Contracted Requirements Stability and Contracted Requirements 
Delivered: 

Description: Contracted Requirements Stability and Contracted 
Requirements Delivered measures the improvements in the program's 
ability, first, to stabilize the growth of requirements during the life 
of a project/release and, second, to deliver those requirements for 
which it has contracted. The measure is derived from the program's two 
outcome measures: Contract Business Requirements Stability and Contract 
Business Requirements Delivered. 

[See PDF for image] 

[End of table] 

FY 2005 Performance: Discontinued. The IRS has discontinued this 
measure and will no longer report on it either internally or 
externally. 

Future Plans: Business Systems Modernization is committed to managing 
the cost and schedule of its projects, although the methodology for 
their respective calculations is under revision. 

New Measures: 

The following measures are reported for the first time in the FY 2005 
MD&A: 

* Timeliness of Critical Other Tax Products to the Public; 
* Percent Business Returns Processed Electronically; 
* Examination Coverage - Individual; 
* Examination Coverage - Business; 
* Examination Efficiency-Individual; 
* Collection Coverage-Units Collection Efficiency-Units; 
* Field Collection Quality of Cases Handled in Person. 

Discontinued Measures: 

In the first quarter of FY 2005, the Department of the Treasury 
launched a process to streamline its current set of performance 
measures. Its purpose was to increase the value of the information 
provided to stakeholders, respond to congressional requests, focus 
priorities and reduce administrative burden. Results of the process 
indicated a 60-70% reduction in the number of performance measures 
overall at the Treasury level. At the bureau level, measures that are 
no longer included in the budget submission are classified as 
"discontinued," and are indicated as such. These measures are only 
discontinued for external reporting purposes; the IRS will continue to 
internally collect and monitor these measures. 

* Customer Accuracy-Customer Accounts Resolved (Adjustments); 
* Percent Tickets Resolved on Time; 
* Field Assistance Accuracy of Tax Law Contacts; 
* Percent Resolution at First Contact; 
* Toll Free Customer Satisfaction; 
* Field Assistance Customer Satisfaction; 
* Field TDA Closures; 
* Field TDI Closures; 
* Field Collection Customer Satisfaction; 
* Compliance Services Collection Operation Accuracy; 
* ACS (TDA and TDI Closures); 
* ACS Customer Satisfaction; 
* Automated Underreporter Case Accuracy; 
* Automated Underreporter-Cases Closed; 
* Correspondence Examination non EITC Returns Examined; 
* Correspondence Exam - Customer Satisfaction; 
* Correspondence Exam Accuracy; 
* Business Returns Examined; 
* Individual Returns Examined (> $100,000 and < $100,000); 
* Examination Customer Satisfaction (SBSE); 
* Examination Customer Satisfaction (LMSB); 
* EP/EO Examination Case Quality; 
* EP/EO Customer Satisfaction; 
* Number of TEGE Compliance Contacts; 
* Appeals Closure to Receipt Ratio; 
* Taxpayer Advocate Closure to Receipt Ratio; 
* Contracted Program Cost & Schedule Variance (* not reported 
internally or externally); 
* Contracted Requirements Stability & Contracted Requirements Delivered 
(*). 

III. System Controls and Legal Compliance: 

Federal Managers' Financial Integrity Act (FMFIA): 

During FY 2005, the Internal Revenue Service (IRS) complied with the 
control requirements of the Federal Managers' Financial Integrity Act 
(FMFIA) and the Reports Consolidation Act of 2000. The IRS also 
complied with the review requirements of the Federal Financial 
Management Improvement Act (FFMIA). The systems of management controls 
for the IRS organizations are designed to ensure that: 

* Programs achieve their intended results; 
* Resources are used consistent with the overall mission; 
* Programs and resources are free from waste, fraud, and mismanagement; 
* Laws and regulations are followed; 
* Controls are sufficient to minimize improper and erroneous payments; 
* Performance information is reliable; 
* System security is in substantial compliance with all relevant 
requirements; 
* Continuity of operations planning in critical areas is sufficient to 
reduce risk to reasonable levels. 

The number of open material weaknesses for IRS is five. Because the IRS 
has remaining material weaknesses and the IRS' financial management 
systems do not substantially comply with FFMIA, the IRS provides 
qualified assurance that the above listed systems of management control 
objectives were achieved by the IRS during FY 2005. This assurance is 
provided relative to Sections 2 and 4 of FMFIA. 

The material weaknesses are: 

* Collection of Unpaid Taxes; 
* Improve Modernization Management Controls and Processes; 
* Financial Accounting of Revenue-Custodial; 
* Earned Income Tax Credit Non-Compliance; 
* Computer Security; 
* Federal Financial Management Improvement Act (FFMIA); 
* As of September 30, 2005, the Service's financial management systems 
did not substantially comply with the FFMIA. Remediation Plans for 
Custodial and Administrative Financial Systems are in place to resolve 
this condition. The IRS has improved its financial management systems' 
compliance with FFMIA. In FY 2005, the IRS implemented the Integrated 
Financial System which corrected many administrative accounting 
deficiencies. The IRS developed a plan to improve custodial accounting 
through the Custodial Detail Data Base project. 

Laws and Regulations: 

As of September 30, 2005, the IRS did not always comply with section 
6325 of the Internal Revenue Code regarding the release of federal tax 
liens. An action plan to address the non compliance issue is being 
monitored by the Financial and Management Controls Executive Steering 
Committee. 

Reports Consolidation Act of 2000: 

In accordance with the Reports Consolidation Act of 2000, the IRS 
provides assurance that the critical performance measures are reliable. 
Internal Revenue Manual 1.5, "Managing Statistics in a Balanced 
Measurement System Handbook," provides a detailed measures template 
that documents each measure's definition, formula, reliability, and 
reporting frequency. These controls ensure the data are consistently 
and accurately collected over time. 

Continuity of Operations: 

During FY 2005, the IRS took action to enhance the compliance of IRS 
computer systems with the Federal Information Security Management Act 
(FISMA). The IRS established FISMA project offices in each business 
unit and focused attention on resolution of the computer security 
material weakness and other system security weaknesses. Substantial 
progress was made in this area, as over 90 percent of IRS general 
support systems completed full certification and accreditation by 
September 1, 2005. In addition, the IRS initiated a major effort to 
update the security documentation and complete rigorous security 
testing on all Service systems. This effort will continue through FY 
2006. 

Limitations of the Financial Statements: 

The principal financial statements have been prepared to report the 
financial position and results of operations of the entity, pursuant to 
the requirements of 31 U.S.C. 3515(b). While the statements have been 
prepared from the books and records of the entity in accordance with 
generally accepted accounting principles (GAAP) for Federal entities 
and the format prescribed by the Office of Management and Budget, the 
statements are in addition to the financial reports used to monitor and 
control budgetary resources, which are prepared from the same books and 
records. The statements should be read with the realization that they 
are for a component of the U.S. Government, a sovereign entity. 

IV. Future Challenges: 

As the IRS begins FY 2006, it is faced with challenges, both from 
within and outside of its organization. The following discussion 
identifies some of the most significant challenges. 

Abusive Tax Shelters: 

Abusive Tax Avoidance Transactions (ATAT) remain a challenge and a high 
enforcement priority for the IRS. These tax motivated transactions are 
corrosive to the equity and the fairness of the tax law for all 
taxpayers. Specifically, the prevalence and proliferation of ATAT 
impacts the achievement of the IRS' mission, goals, objectives, and the 
success of its major strategies by impeding the IRS' ability to make 
gains in compliance and interfering with allocation of workforce 
resources. Vigorous enforcement of the criminal provisions of the 
Internal Revenue Code, coupled with appropriate civil sanctions, 
materially contributes to maintaining voluntary compliance and public 
confidence in the fairness of the tax system. 

Tax shelter promoters continue to modify schemes, making it difficult 
to detect patterns and identify participants on a timely basis. Because 
these types of transactions present unacceptable tax avoidance 
behavior, the IRS needs to continue efforts to identify them timely and 
to make the public aware of the IRS' concerns. 

Recent trends indicate that the tax shelter population will continue to 
expand to small to mid-size corporations where the issues will be more 
difficult to identify and examine. Large corporate taxpayers are 
increasingly engaging in structured transactions designed for them 
individually thereby avoiding some of the provisions allowing early 
identification. These structured transactions involve highly complex 
fact patterns and large dollar issues. Promoters of tax shelters are 
migrating from the large accounting firms to firms and businesses that 
specialize in tax shelters. These promoters (boutique promoters) are 
less compliant for registration and less stable in their business 
operations, making it more difficult to pursue them for information and 
for penalties. 

Taxpayer Service Challenges: 

Delivering cost effectively and efficiently valued and effective 
information and services to taxpayers while meeting demands to reduce 
the complexity of tax law, be responsive to large and diverse taxpayer 
segments, and provide preferred means of delivery within budget 
limitations remains a challenge for the IRS. A successful approach will 
employ highly integrated and targeted service avenues, balancing 
accessibility, ease of use, content complexity, and delivery cost. The 
IRS will continue to research and evaluate information regarding 
taxpayer service needs, priorities, and preferences in order to improve 
delivery services that support taxpayer preferable approaches for 
obtaining information or services. The IRS will seek opportunities to 
invest in technology, process improvement, and training to achieve 
consistent repeatable quality service with reduced unit delivery costs. 
The IRS' long-term service measures will include the impact on taxpayer 
qualitative experience and behavior. 

Technology Modernization Projects: 

From FY 2002 to FY 2005, the IRS has taken steps to balance the scope 
and pace of its technology modernization program with the management 
capacity of the IRS and the modernization contractor consortium. Since 
then, the IRS improved both its cost and scheduling performance 
including those projects that were not re-baselined. While these 
improvements do not completely eliminate all risk, they mitigate a 
major risk and demonstrate that the steps the IRS took in 2004 to 
improve program performance are having a positive impact. As a result, 
FY 2004 and FY 2005 marked a reverse in trend of cost overruns that 
plagued the IRS in previous years. 

In FY 2005, Business Systems Modernization (BSM) continues to build and 
improve upon its 2004 success by delivering projects, attaining cost 
and schedule targets, realizing benefits to taxpayers, and improving 
BSM program management capabilities. With the exception of the 
Integrated Financial System, BSM delivered the majority of projects and 
releases planned on time, within budget, and met or exceeded scope 
expectations. 

Customer Account Data Engine continues to develop the expansion of the 
number of tax returns processed and taxpayers served, targeting 33 
million returns to be processed during 2007. Modernized e-File (MeF) 
continues engineering development in preparation for expansion of the 
taxpayer base served through combined Federal and State processing of 
tax returns. BSM also continues working on access capabilities for 
disabled taxpayers through e-Services upgrade of the PeopleSoft 
Commercial Off-the-Shelf application from Version 8.1 to 8.8. BSM will 
develop the first release of the Filing and Payment Compliance system 
to analyze tax collection cases to determine uncontested cases that no 
longer require direct IRS involvement and can be turned over to private 
collection agencies. 

The FY 2006 BSM portfolio will focus on delivery of three major tax 
administration projects (CADE, MeF and F&PC), along with infrastructure 
initiatives and continued improvement to program management operations. 
Each Tax Administration project will address a core IRS strategic 
priority. Program operations will continue to focus on improving 
program performance, improving and streamlining management process 
disciplines, and ensuring delivery of projects on time, on budget, and 
on scope by taking a greater ownership and leadership role in managing 
the BSM program. 

In addition, the IRS is developing a vision for BSM's future beyond 
2007 and setting goals for the year 2010 that align with and support 
the IRS Strategic Plan. The IRS established a team of IT and business 
specialists to develop an IT modernization roadmap showing how the IRS 
can effectively meet IT modernization goals in an incremental approach 
that provides near-term value. 

Achieving 80 Percent e-Filing: 

Achieving the goal of having taxpayers submit 80% of all filings, 
information, and returns, electronically by FY 2007 continues to be a 
significant challenge. While the e-filing rate continues to increase, 
it is only this past year in FY 2005, that more than half of all 
individual tax returns were filed electronically. The IRS is 
considering mandating e-filing for certain groups, by regulation or 
legislation, to ensure increased e-filing. Also, the Administration's 
proposal to extend the April filing date for electronically-filed tax 
returns to April 30, if enacted, may also increase electronic filing. 
But without a legislative change to mandate electronic filing, the 
challenge remains one of identifying options to encourage more of the 
taxpaying public to e-file. For example, many taxpayers use tax 
preparation software to prepare their returns, but then print out and 
mail in the return. The IRS needs to induce more of these taxpayers and 
preparers to take the next step and file electronically. 

The Tax Gap: 

Reducing the tax gap is at the heart of the IRS' renewed emphasis on 
enforcement. The IRS will continue to expand enforcement by targeting 
its case work and enforcement activities to more effectively deliver 
results and drive down the tax gap. The IRS will continue to analyze 
tax information and data from compliance research studies to better 
define and quantify the tax gap. The IRS will use the results of these 
efforts to better understand and counter the methods and means of those 
taxpayers who fail to report or pay what they owe. The IRS is focusing 
on discouraging and deterring non-compliance with the emphasis on 
corrosive activity by corporations, high-income individual taxpayers, 
and other contributors to the tax gap. 

The Complexity of the Tax Code: 

The December 2004 Report to Congress required by the Internal Revenue 
Service Restructuring and Reform Act of 1998 identifies the complexity 
of the Internal Revenue Code as the most serious problem facing 
taxpayers and the IRS alike. The Code contains well over a million 
words, bedeviling individual taxpayers with provisions such as the 
alternative minimum tax and the earned income tax credit. Business 
taxpayers must grapple with a patchwork of rules that cover the 
depreciation of equipment; numerous and overlapping filing requirements 
for employment taxes; and vague factors that govern the classification 
of workers as either employees or independent contractors. The IRS must 
explain the Code in a way that taxpayers can understand. 

Tax Reform: 

In January 2005, President Bush established an Advisory Panel on 
Federal Tax Reform to devise options to reform the tax code and make it 
simpler, fairer, and more pro-growth to benefit all Americans. The 
Advisory Panel will submit to the Secretary of the Treasury a report 
containing revenue neutral policy options for reforming the Federal 
Internal Revenue Code. These options will: 

* Simplify the tax laws to reduce the costs of compliance and to make 
it easier for taxpayers to plan for the future and manage their 
affairs; 

* Share the burdens and benefits of the tax system in an appropriately 
fair and progressive manner while recognizing the importance of 
homeownership and charity in American society; and: 

* Promote long-run economic growth, higher wages and job creation by 
encouraging work effort and increased saving and investment to 
strengthen the competitiveness of the United States in the global 
marketplace. 

Major Management Challenges and High-Risk Areas: 

Over the last several years the Government Accountability Office (GAO), 
the Treasury Inspector General for Tax Administration (TIGTA) and the 
Office of the Inspector General (OIG) for Treasury have identified 
several Management Challenges and High-Risk Areas facing the IRS. The 
IRS has identified specific steps and actions to address these issues 
through its existing program activities. Measures of these program 
activities serve to show progress in addressing the management 
challenges and high-risk areas. A crosswalk showing the relationship 
between management challenges and the IRS Operating Divisions is shown 
below. 

[See PDF for image] 

[End of table] 

The following pages summarize each Management Challenge and High-Risk 
issue, FY 2005 accomplishments, and actions identified for completion 
in FY 2006 and beyond: 

IRS Business Systems Modernization: 

Issue: Bring the IRS' business systems and financial systems to a level 
that provides management current and reliable information to support 
informed decision making. GAO in its FY 2005 High Risk series has 
consolidated IRS Business Systems Modernization and IRS Financial 
Management into one Business Systems Modernization high-risk area. 

Actions Taken: 

* Customer Account Data Engine (CADE) (implemented in 2004) expanded 
its capacity, processing more than 1.4 million of the basic 1040 EZ tax 
returns during the 2005 filing season. Further expanded functionality 
will accept returns received with an address change, allowing more 
returns to be processed through CADE. 

* Completed architecture engineering analysis and development of a 
limited functionality release for Filing & Payment Compliance (F&PC) 
Release 1.1 designed to separate complex cases requiring direct IRS 
involvement from those that can be handled by private collection 
agencies (PCAs). This release will provide initial capabilities for 
competitive outsourcing of collection activities in FY 2006. 

* Implemented the Integrated Financial System (IFS) as the IRS internal 
accounting system of record. IFS replaced the IRS' core legacy 
financial systems. Version 4.6C deployed expenditure controls, some of 
IRS' accounts payable, accounts receivable, general ledger, budget 
formulation, purchasing controls, 3-year rolling forecast, and 
statements of net cost. 

* Deployed Modernized e-File (MeF) Release 3.1 which processed 7004 
(corporations), 990PF (tax-exempt organizations) and tax law changes 
for filing season 2004. In FY 2005, MeF processed 1120 and 990 returns 
at higher than expected volumes while still achieving performance 
goals. The MeF platform speeds turnaround time for tax return 
submissions and uses the latest, secure Internet technology. This 
project is key to achieving the 80% e-filing goal mandated by Congress 
and is an integral part of the Administration's move towards an all- 
electronic government. 

* Completed Modernized e-File re-sequencing plan to support Disaster 
Recovery requirements. 

* Developed and published e-Strategy for Growth: Expanding e-Government 
for Taxpayers and Their Representatives. This product serves as a 
strategy providing IRS' plans for electronic tax administration and 
will be used as a communication tool for both internal and external 
customers. 

Actions Planned or Underway: 

* Modernized e-File (MeF) will become the primary interface for all 
business filings. During FY 2006, MeF will deliver electronic filing 
capabilities for 1065 forms (Partnership Income), enabling nearly 2.7 
million small business and self-employed taxpayers to be served. MeF 
will remedy Legacy electronic filing limitations (e- File) which do not 
allow partnerships to comply with the Taxpayer Relief Act of 1997 
without having to seek waivers to avoid financial penalties. 

* The Filing & Payment Compliance (F&PC) project is a key element of 
the Enforcement strategy, which will develop systems to analyze tax 
collection cases and separate cases requiring direct IRS involvement 
from those that can be handled by private collection agencies (PCAs). 
In FY 2006, the F&PC will stand up initial capabilities for competitive 
outsourcing of collection activities. 

* The Customer Account Data Engine (CADE) will continue to move the IRS 
towards realizing its Technology Modernization strategy by establishing 
phased replacement of components that can no longer sustain today's tax 
laws, policy and taxpayer needs. In FY 2006, CADE will expand the type 
and number of 1040 family of returns processed on modernized systems 
beyond the current base of 1040EZ forms. This will provide key taxpayer 
benefits such as processing refunds faster, submitting daily postings 
of transactions and updating accounts, which will significantly improve 
customer service. 

* Continue process improvement and development of metrics for software 
development. 

* Modernize infrastructure components per Enterprise Architecture. 

* Maintain the successful track record on on-schedule, on-budget 
release upgrades for the major modernization application to include 
CADE, IFS, MeF and e-Services. 

* Accelerate modernization to maximize modernization potential and 
promote operational efficiencies and strengthen transition of Business 
Systems Modernization (BSM) systems into the operating environment. 

Tax Compliance Initiatives: 

Issue: Administer programs to deal with tax gap issues especially those 
resulting from corporate and high-income individual taxpayers as well 
as domestic and off-shore tax and financial criminal activity. 

Actions Taken: 

* Addressed key areas of noncompliance with enhanced enforcement of tax 
laws through: 

- Increased examinations of the small business corporate segment by 
81%; 

- Increased examination and collection on the high-income non-filer 
segment; 

- Initiated settlement initiatives, such as Son of Boss, which alone 
resulted in the collection of $3.7 billion in enforcement revenue in FY 
2005; 

- Partnered with states on abusive transactions leads; 

- Initiated educational outreach with practitioners through e-File 
seminars and professional responsibility (Circular 230) presentations; 
and: 

- Standardized criteria for obtaining state revenue agent reports and 
established centralized classification point for making IRS assessments 
based on the data. 

* Deployed new Automated Underreporter (AUR) EITC selection methodology 
including business rules for selecting and excluding EITC cases in AUR 
and including Schedule C cases. 

* Strengthened Field Assistance enforcement programs to increase 
voluntary compliance and reduce the risk of noncompliance. During the 
third quarter of FY 2005, an additional 245 Tax Resolution 
Representatives (TRR) and their managers were trained for Collection 
case work. 

* Developed new models for Individual Master File (IMF) to assist in 
selecting the most productive work. This effort eliminates duplicate 
selection codes, facilitates the identification of the "Next Best Case" 
for case creation, and simplifies programming. 

* Continued to identify flow-through entities used to disguise 
questionable structured transactions by high-income taxpayers. 
Identified those engaging in abusive tax practices through enforcement, 
full implementation of K-1 matching, education and research. 

* Continued the enhancements of risk-based compliance approaches by: 

- Coding new algorithms that help determine the most appropriate 
treatment for cases identified by the Dependent Database so the IRS can 
more effectively select inventory for specific and appropriate 
treatment streams, and: 

- Focusing on long-term solutions that meet legal requirements, are 
compatible with technological capabilities, and have the greatest 
potential to deter non-compliance. (Ongoing). 

* Released updated tax gap estimates for Individual Income Tax 
Reporting Compliance. Preliminary findings indicate that the gross tax 
gap was between $312 billion and $353 billion in Tax Year (TY) 2001. 
Underreporting noncompliance is the largest component of the tax gap 
and accounts for more than 80% of the total, with non-filing and 
underpayment at about 10% each. Individual income tax is the single 
largest source of the tax gap, accounting for about two-thirds of the 
total. For individual underreporting, more than 80% stems from 
understated income, not overstated deductions. 

* Delivered final TY 2003 Voluntary Payment Compliance Rates (VPCR) by 
type of tax, tax year and operating division. The VPCR, which is the 
percentage of the total tax liability reported on timely-filed returns 
that is paid in a timely manner, provides a valid assessment of the 
overall level of payment compliance and facilitates the proper 
allocation of resources for enforcement activities. 

* Provided an estimate of the overall improper payment level (overclaim 
estimates) for EITC based on National Research Program individual 
reporting compliance data. Data will be used to help refine and 
evaluate EITC initiatives to reduce inappropriate claims and improve 
the program's effectiveness. 

* Established the Office of Fraud/Bank Secrecy Act (BSA) which has end- 
to-end accountability for BSA policy formation, operations and data 
management, recognizing the importance of the IRS' role in the fight 
against terrorism and money laundering. Over 300 examiners and managers 
are trained and dedicated full-time to the BSA program. 

* Completed a model Federal and State Memorandum of Understanding 
(MOU), which provides both the IRS and the participating state the 
opportunity to leverage resources for BSA examinations, outreach and 
training. 

* Expanded examinations of self-employment income by earners in U.S. 
Possessions (Puerto Rico, Guam, etc ... ), closing over 10,000 Form 
1040s in FY 2005. 

* Made efficiency gains in the Offer-In-Compromise (OIC) program. 
Declining receipts and improvements in timely closures of OIC permitted 
reassignment of approximately a quarter of field offer specialists back 
to the general collection program. 

* Focused criminal enforcement resources on key areas of noncompliance, 
including the promotion of abusive schemes such as offshore accounts to 
hide or improperly reduce income, the use of abusive corporate tax 
avoidance transactions and high-income individuals underreporting of 
income and/or failure to file returns. 

Actions Planned or Underway: 

* Upgrade the Bank Secrecy Act (BSA) workload database to provide a 
more complete record of these institutions and to better predict which 
entities have a greater probability of non-compliance. 

* Continue the enhancements of risk-based compliance approaches by 
implementing major programming changes to inventory and incorporating 
cost-benefit of Dependent Database selection process. (01/2006). 

* Finalize plans for Tax Year 2006 Earned Income Tax Credit (EITC) 
compliance study to assess changes in taxpayer EITC filing volume and 
track EITC return math error accuracy. 

* Charter EITC research efforts to identify ways to reduce EITC 
erroneous payments, as well as identify trends in the diverse EITC 
taxpayer population. Use the results of these studies for strategic 
planning of the EITC program. (Ongoing). 

* Develop enhancements to the multifunctional non-filer strategy that 
will target outreach and compliance efforts; develop alternative 
treatments to influence non-filing taxpayer behavior and promote 
compliance. (09/2006). 

* Continue the Federal Employee/Retiree Delinquency Initiative (FERDI) 
to reduce non-compliance of federal employees and retirees. (Ongoing 
through 09/2006). 

* Utilize Individual Master File (IMF) data to track production, return 
characteristics and error information on volunteer-prepared returns. 
(Ongoing through 09/2006). 

* Perform a study to establish the compliance characteristics of 
volunteer-prepared returns. (09/2006). 

* Initiate a Qualitative Assessment Study that analyzes the effects on 
taxpayer attitudes towards EITC participation and compliance. (09/ 
2006). 

* Initiate an 1120-S full reporting compliance study to analyze the 
accuracy of S-corporation tax returns and estimate the voluntary 
reporting compliance of subchapter S-corporations. (Ongoing). 

* Enhance data exchange opportunities and implement national 
initiatives with state taxing organizations to leverage limited 
government resources. 

* Focus on securing State Income Tax Levy program (SITLP) agreements 
with remaining non-participating income tax states. 

* Enter into tip reporting agreements with more than 90% of gaming 
casinos. (12/2005). 

Strengthen Information Security; Security of the IRS: 

Issue: Strengthening the security infrastructure and the applications 
that guard sensitive data. 

Actions Taken: 

* Updated and strengthened security plans for tax payment lockbox sites 
for tax payment processing at the IRS campuses. 

* Completed certifications and accreditations of IRS redefined General 
Support Systems (GSS); took steps to thoroughly review the security 
controls of its networks and other critical information technology 
assets and to correct any weaknesses that exist. 

* Improved Federal Information Security Management Act of 2002 
reporting process to fully and actively engage business management in 
meeting and reporting on security requirements for the systems within 
their purview. 

* Participated with the Department of the Treasury in disaster 
simulations designed to test continuity of operations plans. 

* Provided executives, managers and staff (including personnel with 
essential security roles) with relevant security-related training. 

* Implemented program-level security controls disseminated by Mission 
Assurance & Security Services. 

* Established a multi-agency working group including representatives 
from the Department of the Treasury, the Federal Trade Commission 
(FTC), the Social Security Administration (SSA) and the Department of 
Homeland Security (DHS) to better enable Federal agencies to provide 
consistent information and services to assist victims of identity 
theft: 

- Collaborated with the Social Security Administration (SSA) to improve 
a multi-agency process called "Scramble SSN" to dramatically reduce the 
time required to resolve duplicate Social Security Number (SSN) usage; 

- Updated information used in correspondence with taxpayers who are 
impacted by identity theft including interim updates on the status of 
their case; 

- Developed standards for documentation to be used to validate the 
identity of the taxpayer, the taxpayer's address and the fact of the 
theft that are consistent with those established by the FTC and the 
SSA; 

- Established tracking codes to monitor taxpayer cases impacted by 
identity theft to develop or enhance outreach activities and 
communication vehicles; 

- Established process to protect the SSNs of IRS employees by 
eliminating the use of the SSN as a unique employee identifier on IRS 
systems; and: 

- Established an Identity Theft Program office to update internal 
processes impacted by identity theft, to reduce taxpayer burden and to 
provide consistent treatment among taxpayers. 

* Completed build out of the incident command structure. 

* Expanded the IRS' ability to respond to emergencies through more 
frequent exercise of Continuity of Operations Plan (COOP) and other 
emergency response actions. 

* Completed business resumption plans in response to changes in threat 
conditions. 

* Fully supported government-wide and Departmental emergency response 
initiatives. 

Actions Planned or Underway: 

* Complete mitigation of General Support Services (GSS) weaknesses 
identified during certification and other review activities sufficient 
to upgrade GSS with Interim Authority to Operate status to Full 
Authority to Operate. (09/2006). 

* Conduct certification and accreditation update activities to meet 
government-wide guidelines for percentage of information systems 
certified. (09/2006). 

* Define an enterprise-wide strategy for IT systems disaster recovery, 
including implementation of strategic testing of disaster recovery 
plans. (09/2006). 

* Develop a back-up for the IRS incident response capability to reduce 
geographic vulnerability. (09/2006). 

* Continue to improve Federal Information Security Management Act 
(FISMA) compliance by further increasing business owner participation 
in all areas including monitoring, review, mitigation and reporting 
activities. (Ongoing). 

* Develop a physical security technology "roadmap" for the IRS to 
improve uniformity and cost effectiveness of security technologies at 
IRS sites. (05/2006). 

* Support Homeland Security Presidential Directive 12 (HSPD-12), which 
mandates a uniform approach to employee authentication and access 
government-wide. HSPD-12 requirements contain a timeline for all 
agencies to follow and requirements for meeting the objectives of the 
Directive. (Multi-year). 

* Continue to refine both the IRS' Continuity of Operations Plan (COOP) 
activities and the IRS' contribution to Department/government-wide COOP 
activities. (09/2006). 

Establish Measures Comparable Over Time and Collect Sufficient 
Performance Data; Integrating Performance and Financial Management: 

Issue: Establish long-term goals and integrate performance into 
decision-making and resource allocation processes to completely achieve 
an integrated performance budget. 

Actions Taken: 

* The IRS budget submission for FY 2007 includes programmatic long-term 
goals (LTG) that combined with the program-related efficiency and 
outcome measures will be used as indicators of the program's long-term 
objectives. In FY 2005, the IRS aligned its budget programs with the 
objectives outlined in the IRS Strategic Plan 2005 through 2009. 

* Draft long-term goals, indicating optimal performance and targets 
through FY 2009, were developed for each Taxpayer Service program and 
for a majority of the Enforcement programs. 

* The IRS' Integrated Financial System (IFS) was deployed in FY 2005 to 
provide timely access to accurate and consistent financial data 
including cost data that is used to develop cost-based performance 
measures. The IRS cost module has captured data for 10 months of FY 
2005 enabling the IRS to view direct expense data (labor, supplies, 
travel, etc), FTE and on-rolls data captured at the lowest cost center 
(group or work unit) level. In addition, the IRS developed and 
implemented allocation methodology to distribute support costs to the 
operational business units. 

* The IRS completed three Program Assessment Rating Tool (PART) 
evaluations for the FY 2007 budget cycle: examination, criminal 
investigation and submission processing. All three programs received 
"moderately effective" ratings from OMB. 

* The Chief Financial Officer and Modernization & Information 
Technology Services have proposed and developed a concept of enhancing 
the current Financial Management Information System (FMIS) to 
substantially comply with the requirements of FFMIA. 

Actions Planned or Underway: 

* The IRS will continue to analyze the cost data obtained through the 
Integrated Financial System to further develop robust cost-based 
performance measures for its major programs. 

* In FY 2006 the IRS will introduce a suite of enterprise-wide goals 
which link directly to the IRS Strategic Plan goals of Improve Taxpayer 
Service, Enhance Enforcement of the Tax Laws, and Modernize the IRS 
Through People, Processes and Technology. The enterprise-wide goals 
will be consistent with the measures represented in the IRS budget. The 
new goals are intended to provide focus and rigor to measuring the 
outcome of the nation's self-assessment tax system: Improve Voluntary 
Compliance in all areas. 

* For the FY 2008 budget cycle, the IRS will submit its non-revenue 
generating programs to OMB for a PART assessment. Based on the 
performance improvements the IRS has shown for the collection program, 
the IRS plans to request reassessment and removal of the prior PART 
rating of "Results Not Demonstrated." 

* Financial Management Information System (FMIS) enhancements are 
planned through four releases beginning in 2006. FMIS is currently 
working on Release 1, which is the development of the Unpaid Assessment 
and Trust Fund Recovery Penalty (TFRP) data base. 

Complexity of the Tax Law: 

Issue: Simplifying the tax process by developing legislative 
recommendations to clarify tax instructions or forms and computer 
modernization. 

Actions Taken: 

* Provided Congress with legislative recommendations in the upcoming 
National Taxpayer Advocate 2004 Annual Report to Congress (December 31, 
2004), including elimination of the Alternative Minimum Tax; 
simplification of provisions to encourage education; and simplification 
of provisions to encourage retirement savings. 

* Finalized the Taxpayer Rights Impact Statement, which is an 
assessment of an IRS program or policy by the National Taxpayer 
Advocate with respect to its impact on taxpayer rights. 

* Participated in research initiatives such as "Abusive Tax Schemes: 
The 'Tipping Point' Study;" The Impact of Representation on the Outcome 
of Earned Income Tax Credit (EITC) Audits, Federal Case Registry Study; 
EITC Certification Test; EITC Pre-certification Test; EITC 
Recertification; Downstream Effects of Compliance Initiatives. 

Actions Planned or Underway: 

* Continue to work with the Treasury Department on revisions to the 
regulations under Internal Revenue Code 7216, relating to the use and 
disclosure of tax return information by tax returns preparers. 
(Ongoing). 

* Examine the possibility of a Unified Family Credit that will combine 
the provisions of the EITC, Child Tax Credit, and Dependency Exemption, 
thereby further reducing taxpayer compliance burdens associated with 
claiming these provisions. (Ongoing). 

* Legislative proposal to issue regulations specifying returns that 
must be filed electronically. Expanding the scope of returns that are 
required to be filed electronically would help the IRS meet its 80% 
goal set by Congress. 

* Legislation is being proposed to issue regulations that would extend 
the due date to file and pay individual taxes by April 30th, provided 
the taxpayer files the return electronically and pays the entire 
balance due electronically by the due date. 

* Legislation is being proposed to expand authority of the IRS to 
require businesses (including corporations, partnerships and other 
business entities) and exempt organizations to file their returns 
electronically. 

Providing Quality Customer Service Operations: 

Issue: Providing top quality service to every taxpayer in every 
transaction is an integral part of the IRS' strategic and modernization 
plans. 

Actions Taken: 

* Established new Queuing Management (Q-Matic) codes to enhance the 
data captured at the walk-in sites to provide additional feedback on 
outreach efforts involved in the EITC Qualifying Child Certification 
Test. This will enable the IRS to learn about taxpayer problems with 
certification as well as the potential burden a certification 
requirement could impose on IRS field assistance sites. 

* Completed Phase 1 of Q-Matic to facilitate customer traffic and 
workload planning. 

* Developed the electronic installment agreement initiative to enable 
taxpayers meeting certain criteria to request and set-up their own 
installment agreements over the Internet on IRS.gov. 

* Completed a successful pilot of Contact Recording initiative to 
enable synchronized voice/data recordings to monitor face-to-face 
interactions in Taxpayer Assistance Centers (TACs) to assess quality as 
well as trends. 

* Completed 108 Taxpayer Assistance Center Model projects, thus far, to 
retrofit TACs to provide adequate space to accommodate customer 
traffic, provide modernized workstations, integrate technology 
enhancements, improve privacy and enhance security. 

* Deployed new Automated UnderReporter (AUR) EITC selection methodology 
to more precisely select cases that have a high probability of 
misreported income. 

* Revised the e-Services incentive products minimum returns filed 
threshold to five (down from 100) for all return types supported by e- 
File or Modernized e-File (MeF) to allow more Electronic Return 
Originators (EROs) to use electronic incentive products such as 
Disclosure Authorization, Transcript Delivery System and Electronic 
Account Resolution. 

* Improved and enhanced the availability of online services such as 
Internet Employer Identification Number (EIN), Centralized 
Authorization File (CAF), and Practitioner Priority Services (PPS). 

* Continued work with private industry providers to expand Free File. 

* Enhanced research to maximize the best use of resources for the 
Volunteer Income Tax Assistance (VITA) site identification, partnership 
development and return preparation. 

* Expanded Internet Refund-Fact of Filing to include Refund Trace and 
Change of Address capabilities for lost and/or stolen refunds. 

Actions Planned or Underway: 

* Expand the web-based learning program (Link and Learn Taxes) that 
provides online training in tax return preparation. (Ongoing through 
09/2006). 

* Refine "Life Cycle Products" line of publications designed to educate 
taxpayers about the tax impact of significant life events. (Ongoing 
through 09/2006). 

* Incorporate multi-year Volunteer Return Preparation Program (VRPP)- 
Quality Improvement Process (QIP) plan to promote quality assurance for 
the VITA program. (Ongoing through 09/2006). 

* Utilizing pilot models developed in FY 2005 to implement a national 
rural strategy that provides outreach, free tax return preparation and/ 
or financial literacy education to rural America. (09/2006). 

* Continue expansion of Internet Refund Fact of Filing (IRFOF) 
application to reduce toll-free demand and offer customers alternative 
methods of service. (09/2006). 

* Develop a TeleFile and Internet electronic funds withdrawal (Direct 
Debit) application for notice payments. (09/2006). 

* Develop an electronic funds withdrawal (Direct Debit) application for 
installment agreements. (09/2006). 

* Complete Phase II rollout of Queuing Management (Q-Matic) which will 
automate the process of tracking employee activity and contribute to 
improve customer traffic and workload planning. (09/2006). 

* Continue to educate EITC taxpayers through partnerships with key 
stakeholders and a public service campaign. (Ongoing). 

* Assess the overall EITC marketing/awareness campaigns that target the 
eligible EITC non-claimant population and refine/refocus as necessary 
to improve compliance and increase overall participation. (Ongoing). 

* Continue to improve the quality and clarity of computer-generated 
notices issued to taxpayers to reduce the number of telephone contacts 
and make it easier for taxpayers to understand and comply with their 
tax requirements. (Ongoing). 

* Establish the Virtual Translation Office to develop new and revised 
Spanish-language tax products. (09/2006). 

* Continue conducting surveys and focus groups to obtain feedback from 
taxpayers and tax practitioners about ways to improve tax forms, 
instructions and publications. (Ongoing). 

* Complete an additional 25 TAC Model projects. (09/2006). 

* Roll-out Contact Recording in the TACs piloted in 2005 to an 
additional 100 locations in FY 2006 and continuing through FY 2008 
until all TACs are equipped with contact recording. 

Processing Returns and Implementing Tax Law Changes During the Filing 
Season Issue: Tax law changes from prior years that have not been 
correctly implemented. 

Actions Taken: 

* Developed secure access for taxpayers who file electronically to 
enable them to review their account electronically. 

* Deployed the Transcript Delivery System (TDS) to improve efficiency 
by implementing a "One-click process" for servicing transcript 
requests. From May to September 2005, 610,000 transcripts were mailed 
to taxpayers. 

* Completed the ramp-down of the Memphis Submission Processing Center 
(MSPC). 

* Ensured the Corporate Filing Season Readiness Process is operational 
for filing seasons 2005 and 2006 and covers all aspects of the filing 
season, including the Annual Readiness Certification. Filing Season 
2005 was timely certified and the Filing Season Readiness committee is 
in place for filing season 2006. 

* Set a record for electronic filing, reaching 68 returns, an increase 
of approximately 11% from 2004. 

Actions Planned or Underway: 

* Automate the financial statement of net cost in IFS. 

* Pilot an automated adjustment document to make a change or correction 
to a taxpayer account, reducing adjustment time and increasing the 
quality of required adjustments. 

* Pilot Embedded Quality Review System (EQRS), establishing common 
attributes and review tools for evaluating organizational performance 
and individual performance. 

* Begin development of strategies to smoothly transition and 
consolidate the Philadelphia Submission Processing Center. (Multi-year 
initiative). 

* Complete deployment of Transcript Delivery System (TDS) by December 
2005. 

Taxpayer Protection and Rights: 

Issue: The IRS has made significant progress in complying with RRA '98 
and most provisions have been implemented. Significant management 
attention is still required to ensure that all issues situations have 
been addressed. 

Actions Taken: 

* Reduced procedural barriers by making refinements to both third party 
notification and collection due process procedures. 

* Administered an EITC survey as part of the EITC Qualifying Child 
Certification Test, consisting of questions regarding the time and cost 
associated with the certification and making an EITC claim. The survey 
was conducted to gather information to better understand claimants' 
experience with the certification process and to determine the impact 
of EITC certification on taxpayer participation in the EITC program. 

* Implemented several EITC notice redesign efforts (CP-75 notice 
series, initial audit contact letters, Publication 3498-A, The 
Examination Process: Examinations by Main. The redesign of the notices 
will enable taxpayers to better understand their responsibilities and 
entitlements under a very complicated section of tax law. 

* Improved the CP 09 (Earned Income Credit-You May Be Entitled to EIC) 
and 027 (EIC Potential for Taxpayer Without Qualifying Children), which 
notifies taxpayers who have not claimed EITC that they may be eligible. 
Simplified the CP 09 and 027 language to improve understanding and 
improved the determination checklist to make the notices more user 
friendly. 

* Improved the EITC recertification and two-and ten-year ban notices, 
making them easier to understand and clearly explaining the 
consequences of the two-and ten-year bans, including the tax years to 
which the bans apply. 

* Implemented a solution for encrypting electronic return data during 
the transmission process from electronic return transmitters. 

* Developed a new workload methodology that will focus on those areas 
of the filing population constituting the greatest increase in 
compliance risk with a high probability of unreported income. This 
strategy will promote fairness of our tax system by identifying 
potential noncompliance from taxpayers who would not otherwise be 
subject to matching document reviews. 

* Rolled out the Taxpayer Assistance Center (TAC) model, as it is 
critical to maintaining taxpayers' privacy and confidentiality, 
particularly as the IRS becomes more involved in compliance activities. 

* Reviewed IRS training to ensure that employees, particularly in 
compliance functions, are properly and regularly trained on the 
protection of taxpayer rights. 

* Pursued abuses in the consumer credit counseling industry, targeting 
for audit 60 firms representing 50% of revenue in this industry. 

Actions Planned or Underway: 

* Focus on taxpayer groups that are at higher risk of noncompliance to 
maintain confidence in the integrity of the tax administration program. 
(Ongoing). 

* Continue to educate EITC taxpayers through partnerships with key 
stakeholders and a public service campaign. As of June 2005, the public 
education campaign, through the media and grassroots community 
partnerships, generated almost one billion potential contacts. 
(Ongoing). 

* Continue efforts to enhance EITC systemically generated notices. 

* Ensure protection of taxpayer information entered at return 
preparation sites and local offices. (Ongoing). 

* Refine procedures to certify compliance with requirements of Title VI 
of the Civil Rights Act of 1964 to provide equal access and non- 
discriminatory services to all eligible taxpayers. (Ongoing). 

* Work under auspices of the Electronic Tax Administration Policy 
Council (ETAPC) to establish security policy and address issues. 
Complete additional reviews requested by ETAPC of the authentication 
methods. Continue to implement new website functionality requested by 
the Business Operating Divisions. (Ongoing). 

* Continue systems modernization efforts to enhance the IRS' security 
program. (Ongoing). 

* Develop and implement the Taxpayer Rights Impact Statement to help 
the IRS incorporate awareness and consideration of taxpayer rights into 
its program planning and implementation. (Ongoing). 

* Work with preparers to design a program that enables the majority of 
taxpayers to feel confident that their preparers are competent to 
prepare their taxes and that the IRS will take appropriate enforcement 
action on preparers when they perform negligently or recklessly. 
(Ongoing). 

* Advocate enforcement of existing penalties for paid preparers as well 
as the strengthening and enhancement of penalties by Congress. 
(Ongoing): 

Human Capital: 

Issue: The IRS' ability to meet program requirements and the 
expectations of both external and internal customers. 

Actions Taken: 

* Streamlining operations resulted in moving personnel from non- 
enforcement to enforcement positions during FY 2005 and cost savings 
from centralizing case processing will be directed to enforcement hires 
for FY 2006. 

* Submitted to the IRS Oversight Board the final draft of the 2005-2009 
Human Capital Strategic Plan, the primary guidance vehicle for 
strategic management of human capital in the IRS. 

* Implemented an IRS-wide human capital governance structure, including 
representatives from the IRS business units, support functions and 
specialized units, that provides a forum for all IRS entities to 
jointly address and propose solutions to human capital issues and 
challenges resulting from the implementation of large-scale human 
capital programs, policies and initiatives and ensures consistent and 
fair treatment of employees impacted by workforce change initiatives. 

* Continued work on Mission Critical Occupations (MCOs): 

- Refined competency models for MCOs as part of the IRS' ongoing effort 
to improve its ability to field a workforce with the full range of 
competencies necessary for high quality performance; 

- Implemented an automated recruitment solution, CareerConnector, for 
external hiring of selected MCOs, increasing the IRS' ability to fill 
vacancies within 45 days from the vacancy announcement; and: 

- Improved the talent pool of external Mission Critical Occupation 
hires and provided management greater flexibility to select the most 
qualified candidates through the expanded use of category ratings to 
stratify the available applicant pool and also simulated job situation 
assessments. 

* Implemented an IRS-wide Enterprise Learning Management System (ELMS), 
a web-based application that managers, employees, and the Learning and 
Education community will use to manage training and development. 

* Negotiated a new recruitment marketing contract because previous 
contract, including option years, had expired. Maintained an active 
print and internet media campaign, produced new multi-media job 
previews and updated the IRS Careers website. A recruiter cadre 
continued to foster partnering relationships with over 200 colleges and 
universities across the country as part of the IRS' ongoing effort to 
improve recruiting performance, particularly the recruitment of 
applicants to fill Mission Critical Occupations. 

* To support workforce restructuring initiatives and to mitigate impact 
on employees involved in restructuring, the IRS used all available 
tools, including VERA (early outs) and VSIP (buyouts) and relocation 
bonuses throughout the year to support workforce restructuring 
initiatives and to mitigate impact on employees involved in 
restructuring. 

* Developed a Human Capital Office (HCO) Concept of Operations that 
articulates HCO's vision, mission, values and role in the IRS human 
capital community as well as HCO's various Lines of Business, i.e., 
major categories of human capital work within the IRS. 

* Executed Service Level Agreements with customers which describe the 
services HCO has agreed to provide, HCO and customer commitments 
relating to delivery of HCO services and how HCO's performance will be 
measured. 

* Evaluated each new human capital initiative for workforce impact to 
determine effective and appropriate mitigation strategies to address 
the results. 

* Implemented a multi-year recruitment and marketing strategy that 
includes the expansion of the Internet employment website, a complete 
print media advertising campaign, market research and an extensive 
Internet media advertising campaign. 

* Used competency models and occupational studies to identify and 
target competencies necessary for successful performance in all 
frontline occupations; targeted competencies in the recruitment and 
hiring process and the individual and employee training process to 
address skill gaps. 

* Developed a Career-Pathing process that focuses on training, 
application, assessment and feedback to provide opportunities to 
develop technical expertise needed for senior professional positions. 

* Expanded QuickHire, an Internet-based tool that automates the hiring 
process, to include additional occupations. 

Actions Planned or Underway: 

* Deploy the Learning Content Management System (LCMS) to permit more 
efficient development of training materials and ensure more consistency 
in training across the Service. (09/2006). 

* Complete the conversion of all its Mission Critical Occupation (MCO) 
application processes to the CareerConnector system and begin the 
conversion of the non-MCO occupations. (09/2006). 

* Complete development of the Human Capital Strategic Implementation 
Plan (HCSIP) to: 

- Identify specific human capital programs and initiatives for the next 
two years needed to execute the strategies and achieve the goals 
outlined in the Human Capital Strategic Plan; 

- Provide accountability for performance of programs and initiatives 
through a systematic corporate monitoring and reporting process; and: 

- Integrate the budget process with human capital strategies. 
(Ongoing). 

* Conduct a study of all leadership courses (Executive Readiness 
Program, Senior Manager Course/Senior Manager Readiness Program, and 
Frontline Manager Course) to focus on delivering content in an 
effective and efficient manner as well as identifying and attracting 
"high talent"and "high potential" for leadership development. (09/ 
2006). 

* Design continuous training for managers using tailored case studies, 
simulations in training and work-out sessions to provide hands-on 
experience to realize the "stepping stone" approach. (Ongoing). 

* Continue the selective use of Voluntary Employee Retirement Authority 
(early-outs) and Voluntary Separation Incentive Payments (buyouts) to 
support organizational restructuring and workforce reshaping 
initiatives. (Ongoing). 

* Extend partnerships with key colleges and universities. (Ongoing). 

* Improve recruiting performance through expansion of category ratings 
and the increased use of simulations in assessing job applicants- 
particularly in front-line occupations. (Ongoing): 

Enforcement of Tax Laws: 

Issue: Address the evolving challenge of unpaid taxes and continuing 
Earned Income Credit noncompliance. 

Actions Taken: 

* Improved collection processes resulted in increases in productivity, 
dollars collected, enforcement activity and customer satisfaction along 
with decreases of time between return filing and assignment and 
decrease of time between assignment and case closure. Adoption of clear 
guiding principles including revisions to key Internal Revenue Manual 
sections on enforcement activity, coupled with improved electronic 
research and guidance tools and enhancement of managerial consultations 
contributed to overall improvements. 

* Implemented key recommendations identified by the Federal Tax 
Compliance Task Force (FCTC) to improve the levy process for Department 
of Defense (DoD) Contractors through the Federal Payment Levy Program. 
Actions include: 

- Implemented 100% levy actions on 100% of the largest DoD payment file 
in April and the remaining DoD payment systems in July 2005; 

- Increased data exchanges with DoD resulting in the acceleration of 
7,550 Collection Due Process notices; and: 

- Added additional DoD payment systems to the Treasury Offset Program 
(TOP). To date, 18 of the 20 Defense Finance and Accounting Service 
(DFAS) Commercial Pay Systems have been implemented, which represents 
99.7% of the total annual disbursements. 

* Improved Automated Collection System (ACS) levy process by 
identifying new sources from Electronic Filed Returns, State Employment 
Commissions and through Information Return Master File and the 
Remittance Processing System. 

* Partnered with 27 states to levy individual state refunds for 
outstanding federal income tax liabilities through the State Income Tax 
Levy Program (SITLP). An encryption software purchase for states will 
allow transmission of levy payment into the Electronic Federal Tax 
Payment System (EFTPS). 

* Developed a multi-year strategy through the Federal Employee Retiree 
Delinquency Program (FERDI) to provide outreach and education to assist 
military retirees with understanding their obligations and improving 
compliance. 

* Other than the Earned Income Tax Credit (EITC) Program, the IRS has 
no high-risk programs that require baseline and annual error rate 
measures or the development of a reduction plan with annual targets. 
Therefore, the IRS' focus on eliminating improper payments is placed on 
the Earned Income Tax Credit Program. EITC is a refundable federal 
income tax credit for low-income working individuals and families. In 
FY 2004, nearly 22 million people received almost $38 billion from the 
credit, making the EITC the nation's largest anti-poverty program. 

* To better administer EITC, the IRS developed a detailed, long-term 
EITC business plan in the form of a Concept of Operations with a focus 
on a balanced EITC Program - one that reduces erroneous payments while 
increasing participation by eligible taxpayers. In keeping with the 
goals of the EITC program throughout FY 2005 and into FY 2006, the IRS 
will implement new, technology-enabled business process improvements as 
well as continue to test and evaluate new approaches to reduce improper 
payments. The IRS will use these tests to make data driven decisions 
about improvements to each segment of the program including customer 
service, outreach and compliance. 

* The EITC business plan is consistent with the IRS Commissioner's five-
point initiative announced in June of 2003 to reduce burden on 
taxpayers, improve the IRS audit processes, increase outreach efforts, 
address unreported income and test new approaches to reducing EITC 
error. The IRS' continued efforts to improve EITC compliance activities 
have enabled it to decrease the amount of time it takes to complete an 
EITC examination by 6.4%, or 12 days and to reduce the volume of aged 
EITC cases in inventory by 38% during last year. 

* As part of the Commissioner's initiative, in FY 2005, the IRS 
continued several tests to evaluate new ways of reducing erroneous EITC 
payments while maintaining participation by eligible taxpayers: 

- Qualifying Child Test: Requires certain EITC claimants to certify 
that they meet the qualifying child residency requirement before paying 
out the refund. Initial testing results showed that a certification 
requirement had a significant effect on improper EITC claims; 

- Filing Status Test: Reviews filing status claims to ensure they are 
correct. The IRS selected claimants whose filing status had changed to 
one that increased the value of the credit (generally, from married 
filing joint to head of household). The first test indicated that the 
IRS needed to modify its selection methodology to ensure a better focus 
on non-compliant taxpayers; and: 

- Misreporting Income (Automated Underreporter) Test: Enhances error 
detection through the Automated Underreporter program. This test 
focused on improved selection methodologies and showed successes in a 
lower no change rate and changes to the credit. 

* Based on the results of the Misreporting Income (Automated 
Underreporter) test, in early FY 2005 the IRS implemented the improved 
selection methodologies for Automated Underreporter cases. During 2006, 
the IRS will complete the last part of the Qualifying Child test and 
evaluate the effects of the Filing Status and Qualifying Child tests on 
reducing erroneous EITC payments and maintaining participation by 
eligible taxpayers before making decisions to implement either on a 
broader scale. 

* Other FY 2005/FY 2006 activities include a program to focus education 
and compliance efforts, as appropriate, on EITC paid preparers. As a 
part of the EITC Return Preparer Strategy, the IRS completed over 400 
due diligence compliance visits to paid tax preparers with a 
probability/record of preparing erroneous EITC returns. The IRS has 
also implemented the selection of amended EITC returns for examination 
using the Dependent Database. 

* The IRS is also striving to make the EITC easier to claim by eligible 
taxpayers. To reduce taxpayer burden, the IRS is improving 
communications to taxpayers, making the credit clearer and easier to 
understand and providing potential claimants and their paid preparers 
with resources to help them determine whether they are eligible. During 
FY 2005, the IRS launched the EITC Assistant, a web-based eligibility 
calculator on irs.gov; implemented enhancements to the EITC Online 
Toolkit for tax professionals for FY 2005 and FY 2006; delivered EITC 
messages on Housing and Urban Development kiosks in 106 locations 
nationwide; and distributed EITC educational materials to 3,300 Western 
Union agent locations in New York, Los Angeles, Atlanta, and San 
Antonio. Also in FY 2005, IRS partnerships and coalitions prepared 
nearly two million tax returns for low-income families, in addition to 
making countless taxpayer contacts through an array of EITC educational 
products and messages. 

Actions Planned or Underway: 

* Launch final portion of the qualifying child certification test. 

* Complete compliance analysis of TY 2001 returns claiming EITC 
(National Research Program). 

* Develop and distribute materials to educate taxpayers and 
practitioners on EITC eligibility rules and compliance issues. 

* Test and report the results of the National Directory of New Hires 
database match. 

* Plan for a FY 2007 compliance study. 

* Continue to leverage partnership opportunities with states that offer 
tax credits comparable to EITC. 

* Implement new Automated Case Selection and Assignment and Decision 
Support Tools. (01/2006). 

* Implement new Amended Returns process. (03/2006). 

* Launch additional Risk-Based Scoring Strategy and inventory 
management capability to improve selection and assignment of EITC 
returns for examination. (03/2006). 

* Enhance methodology to improve the selection of EITC amended returns 
for examination. 

* Expand the Questionable Refund Program to include prisoner returns. 
The IRS will continue to coordinate with prison officials to acquire 
complete and accurate information on the prison population to maximize 
the effectiveness of its automated systems in promptly identifying 
questionable returns filed by inmates. Furthermore, the IRS will ensure 
all Fraud Detection Centers have procedures in place to coordinate 
fraud prevention efforts with the prisons in the states they serve. 

* Enhance IRS' Electronic Fraud Detection System to improve its 
efficiency in detecting fraudulent refund schemes involving individual 
as well as business returns. 

* Integrate the Decision Support Tool into the Reporting Compliance 
Case Resolution workflow. (06/2006). 

* Develop joint W&I and SB/SE Reporting Compliance Concept of 
Operations and system concept for coordinated workload management and 
resolution system to manage and move case inventory (this replaced 
EITC's Corporate Inventory Management Routing & Integration project). 
(12/ 2005). 

* Identify new ways to administer EITC by partnering with states (New 
York, Massachusetts, and New Jersey) through the use of proactive 
research initiatives. (12/2005). 

* Use data-driven scoring and selection methods to select cases for 
examination and apply the right compliance treatments to address 
taxpayers. (01/2006). 

* Test new selection tools to determine more effective compliance 
treatments for return preparers. (03/2006). 

* Initiate research to assess changes in taxpayer EITC filing volume 
and track EITC return math error accuracy through outreach campaigns 
and volunteer tax return preparation. (Ongoing). 

* Develop multi-year return preparer strategy that addresses paid 
preparer non-compliance and gather data on the effects of these efforts 
on paid preparers as well as taxpayers. (Ongoing). 

* Test the use of a National Directory of New Hires (NDNH) database 
match in the IRS' Criminal Investigation EITC Fraud Detection Centers. 
(12/2006). 

Bring Treasury's Financial Management Systems into compliance with 
Federal Financial Management Improvement Act (FFMIA) of 1996: 

Issue: The IRS' financial management systems remain a challenge, 
despite producing combined financial statements covering tax custodial 
and administrative activities for the seventh consecutive year. Also, 
the IRS has achieved an unqualified audit opinion from the Government 
Accountability Office (GAO) on all financial statements since FY 2000. 
IRS' current financial systems alone cannot produce reliable 
information necessary to prepare financial statements in accordance 
with federal accounting standards. The data produced from the current 
financial system has to be reconciled with other subsidiary systems to 
produce reliable financial statements. The IRS lacks the timely, 
accurate, and useful information needed to make informed management 
decisions on an ongoing basis. 

Actions Taken: 

* Custodial Accounting Project (CAP) was shutdown due to funding 
shortfalls. 

* Implemented the Integrated Financial System (IFS) as the IRS' 
internal accounting system of record. 

* The IRS developed a strategy concept to enhance the current Financial 
Management Information System (FMIS) to be compliant with FFMIA 
requirements. 

* FMIS enhancement concept was accepted by the Financial and Management 
Controls Executive Steering Committee and has been presented to 
Treasury CFO, OMB, and GAO. 

* The IRS developed a less costly alternative strategy to downgrade 
custodial reporting weakness via implementation of new custodial 
database project. 

Actions Planned or Underway: 

* FMIS enhancements are planned to be accomplished through four 
releases beginning in 2006 through 2008. 

* MITS is currently developing on Release 1 which is the Unpaid 
Assessment and Trust Fund Recovery Penalty (TFRP) database and sub- 
ledger functions. 

* Full funding requirements for the FMIS enhancements have been 
included in the FY 2007 E-300 submission. 

Success is measured by a set of key milestones for each project 
identified in the detailed project plans developed for all Tier A 
projects. Success is also measured by the Office of Management and 
Budget through the President's Management Agenda. The IRS receives 
scores for both Plan and Status on a quarterly basis. 

V. Financial Highlights: 

Stewardship Information Analysis: 

a. Overview of Revenue and Administrative Accounts: 

The IRS' financial statements and footnotes received an unqualified 
audit opinion for the sixth consecutive year for administrative 
accounts and the ninth consecutive year for revenue accounts. 
Administrative accounts reflect resources used and expenses incurred in 
administering the tax laws. Revenue accounts reflect net taxes 
receivable and net taxes collected to support the federal government. 

The Balance Sheet reflects total assets of $27 billion. Of these 
assets, 77.8% are Federal Taxes Receivable. These receivables are the 
amounts expected to be collected from past due accounts. The increase 
in assets of $1.4 billion is primarily attributable to increases in the 
amounts due from Treasury for tax refunds due taxpayers, taxpayer 
deposits for unpaid assessments and federal taxes receivable. The 
majority of the liabilities, 83.7%, consist of amounts due to Treasury 
related to Federal Taxes Receivable. 

The Statement of Custodial Activity shows that IRS programs resulted in 
$2.267 trillion in Federal receipts. IRS collections constitute 96% of 
the Federal Government receipts, as shown in the chart below. 

Total Federal Receipts - (Percent): 

[See PDF for image] - graphic text: 

Pie chart with two items. 

IRS Collections: 96%; 
Non-IRS Collections: 4%. 

[End of figure] 

b. Financing Sources: 

The IRS receives the majority of its funding through annual and multi- 
year appropriations which are available for use within certain 
specified statutory limits. There are three major and two minor 
operating appropriations. The Processing, Assistance and Management 
appropriation funds the processing of tax returns and related 
documents, assistance for taxpayers in the filing of their returns and 
paying taxes due, matching information with returns, conducting 
internal audit reviews and security investigations and managing 
financial resources. The Tax Law Enforcement appropriation provides 
funds for the examination of tax returns and the administrative and 
judicial settlement of taxpayer appeals of examination findings, as 
well as providing resources for expanded customer service and 
education, strengthened enforcement and enhanced research to reduce 
valid claims and erroneous filings associated with the Earned Income 
Tax Credit (EITC) program. The Information Services appropriation funds 
costs for data processing and information and telecommunications 
support for the Service's activities. The Business Systems 
Modernization Account is the most significant of the minor operating 
appropriations and funds capital asset acquisitions of information 
technology systems. The Health Coverage Tax Credit appropriation (HCTC) 
funds necessary expenses to implement the program. 

[See PDF for image] 

[End of figure] 

Besides appropriations, the Service utilizes other financing sources. 
These include net transfers from other federal agencies, User Fees for 
direct services provided to customers (for example, installment fees, 
photocopy fees, and letter rulings and determinations fees) and imputed 
financing (subsidies from other federal funds that cover specific 
expenses such as retirement benefits). 

c. Use of Resources: 

The Statement of Net Cost reflects the use of resources in carrying out 
the agency's major programs. 

How the Service Used Its Resources - (Percent): 

[See PDF for image] 

[End of figure] 

The major programs are Pre-filing, Filing and Account Services, 
Compliance and Administration of Tax Credit Programs (EITC and HCTC). 
Pre-filing activities include taxpayer education and outreach, pre- 
filing agreements and tax publication issuance and distribution. Filing 
and Account Services activities include the filing of tax returns, 
current account status and processing of taxpayer information. 
Compliance activities include document matching, audits, and criminal 
investigation activities. Administration of the Tax Credit programs 
includes EITC pre-filing, filing and account services, and compliance 
activities and HCTC health insurance tax credit program activities. 

Revenue and Refund Trend Information: 

Federal tax revenues are collected through six major classifications: 
individual income, corporate income, excise taxes, estate and gift 
taxes, railroad retirement, and Federal unemployment taxes. Overall 
revenue receipts ($2.267 trillion) for FY 2005 increased by 
approximately 12% from FY2004 to FY2005. Individual income taxes, which 
include both FICA and SECA taxes, increased by 10%. Corporate income 
taxes increased by 33%. Collections from all other tax sources 
increased 3% from FY2004 to FY2005. 

Gross combined individual income tax and employment tax withholding 
increased as wages and salaries grew. Gross combined individual non- 
withheld and SECA receipts increased due to the increase in final 
payments on calendar year 2004 liabilities. Contributing factors 
include the higher 2004 incomes, lower 2004 deductions and a higher 
effective tax rate on 2004 taxable income reported in Fiscal Year 2005. 
Net corporate receipts increased due to the growth in gross corporate 
tax receipts and the decrease in refunds. Net IRS excise tax receipts 
increased in line with the expansion of the economy. 

Federal tax refund activity, which includes tax, interest, payments for 
Earned Income Tax Credit and Child Care Tax Credit in excess of the tax 
liability was $267 billion. In fiscal year 2005, the Service issued $62 
million in advance payments of the Earned Income Tax Credit. Overall 
refund disbursements decreased by 4%u from FY2004 to FY2005. 

Analysis of Unpaid Assessments Most Unpaid Assessments Are Not 
Receivables and Are Largely Uncollectible: 

This unpaid assessment balance represents assessments resulting from 
taxpayers filing returns without sufficient payment; as well as from 
the Service's enforcement programs such as Examination, Underreporter, 
Substitute for Return and Combined Annual Wage Reporting. As reflected 
in the supplemental information to the IRS' fiscal year 2005 Financial 
Statements, the unpaid assessment balance was about $230 billion as of 
September 30, 2005. 

Under federal accounting standards, unpaid assessments require taxpayer 
or court agreement to be considered federal taxes receivable. 
Assessments not agreed to by taxpayers or the courts are considered 
compliance assessments and are not considered federal taxes receivable. 
Assessments considered to have no future collection potential are 
called write-offs. 

Components of the IRS' $230 Billion of Unpaid Assessments: 

[See PDF for image] 

[End of figure] 

Of the $230 billion balance of unpaid assessments, $98 billion 
represents write-offs. Write-offs include amounts owed by defunct 
corporations with no assets and include many failed financial 
institutions assisted by the Resolution Trust Corporation (RTC) and the 
Federal Deposit Insurance Corporation (FDIC). The remaining amounts are 
owed by taxpayers with extreme economic and/or financial hardships, 
deceased taxpayers, and taxpayers who are insolvent due to bankruptcy. 
Write-offs at September 30, 2005 ($98 billion) decreased about 15% from 
September 30, 2004 ($115 billion) due primarily to the expiration of 
the statute for collections on amounts owed by defunct corporations and 
failed financial institutions. In FY2005, statutes expired for $21 
billion of failed financial institution unpaid assessment accounts 
assisted by the RTC and the FDIC. 

Components of the IRS' $98 Billion of Write-offs: 

[See PDF for image] 

[End of figure] 

The $44 billion of the unpaid assessments representing compliance 
assessment are amounts that have not been agreed to by either the 
taxpayer or a court. These assessments result primarily from various 
Service enforcement programs promoting voluntary compliance. Due to the 
lack of agreement, they have less potential for future collection than 
the unpaid assessments considered federal taxes receivable. 

The remaining $88 billion of unpaid assessments represent federal taxes 
receivable. About $67 billion (76%) of this balance is estimated to be 
uncollectible due primarily to the taxpayer's economic situation, 
including individual taxpayers who are unemployed, are currently in 
bankruptcy or have other financial problems. However, under certain 
conditions, the IRS may continue collection actions for 10 years after 
the assessment. Thus, these accounts may still ultimately have some 
collection potential if the taxpayer's economic condition improves. 

About $21 billion (24%) of federal taxes receivable is estimated to be 
collectible. Components of the collectible balance include installment 
agreements with estates and individuals, confirmed payment plans 
through bankruptcy and some newer amounts due from individuals and 
businesses with a history of compliance. The taxes receivable amount 
from September 30, 2004 ($89 billion) to September 30, 2005 ($88 
billion) decreased by $1 billion. The percent estimated to be 
collectible at September 30, 2005 (24%), increased from September 30, 
2004 (22%). 

Components of the IRS' $88 Billion of Taxes Receivable: 

[See PDF for image] 

[End of figure] 

It is important to note that the unpaid assessment balance contains 
unpaid assessed tax, penalty, and interest and accrued penalty and 
interest computed through September 30, 2005. 

About $136 billion (59%) of the unpaid assessment balance as of 
September 30, 2005, consists of interest and penalties and is largely 
uncollectible. 

Unpaid Taxes and Interest and Penalty Components of $230 Billion in 
Unpaid Assessments: 

[See PDF for image] 

[End of figure] 

Interest and penalties are such a high percentage of the balance of 
unpaid assessments because the IRS must continue to accrue them through 
the 10-year statutory collection date, regardless of whether an account 
meets the criteria for financial statement recognition or has any 
collection potential. For example, interest and penalties continue to 
accrue on write-offs, such as FDIC and RTC cases, and on exam 
assessments where taxpayers have not agreed to the amount assessed. The 
overall decrease in unpaid assessments during fiscal year 2005 was 
mostly attributable to expiration of the statute for collections on 
amounts owed by failed financial institutions assisted by the RTC and 
the FDIC. 

FY 2005 Management Discussion and Analysis: 

ADDENDUM: President's Management Agenda Scorecard: 

The IRS made steady progress on the President's Management Agenda (PMA) 
this year, earning "Green" in progress and status on Competitive 
Sourcing, and "Green" in progress on Human Capital and Budget and 
Performance Integration. The IRS adjusted its "getting to green plans" 
to reflect the new "proud to be" criteria to achieve these goals during 
2005. In FY 2005, Eliminating Improper Payments became a separate 
initiative in the President's Management Agenda. Eliminating Improper 
Payments is geared toward reducing erroneous payments in the Earned 
Income Tax Credit (EITC) program. EITC is a refundable Federal income 
tax credit for low-income working individuals and families and is the 
IRS' only program impacted by the Improper Payments and Information Act 
of 2002 (IPIA). 

IPIA requires agencies to annually review programs and activities to 
identify those susceptible to significant erroneous payments. Under 
implementing OMB guidance, "Significant" means the estimated error rate 
and dollar amount exceed the threshold of 2.5% of program payments and 
$10 million. Once agencies identify high-risk programs, a method for 
systematically reviewing them is developed using statistically valid 
sampling to determine error rates. If those rates, when applied to 
total program funding, result in a level of improper payments greater 
than or equal to $10 million, then an action plan is developed for 
resolving identified problems and reducing errors. 

The table below summarizes OMB's scorecard for Treasury for FY 2005. 

[See PDF for image] 

[End of figure] 

FY 2005 Management Discussion and Analysis: 

Major Accomplishments and Future Plans: 

Human Capital: 

Accomplished: 

* Drafted for implementation, pending the IRS Oversight Board approval, 
the 2005-2009 Human Capital Strategic Plan, which will serve as primary 
guidance for strategic management of human capital in the IRS. 

* Continued workforce restructuring and transition initiatives to 
achieve optimum mix of skills and optimum ratio of employees in Mission 
Critical Occupations (MCOs) that directly support tax processing, 
administration and compliance to non-MCO employees. 

* Refined MCO competency models to improve ability to field a high- 
performing workforce; incorporated results into recruitment marketing; 
and used results to evaluate competency of MCO applicants. 

* Implemented automated recruitment solution CareerConnector for 
external hiring of selected MCOs enabling the IRS to meet, for certain 
vacancies, OPM-recommended 45 day standard for filling vacancies. 

* Improved talent pool of external MCO hires and provided management 
greater flexibility to select most qualified candidates through 
expanded use of category ratings and simulated job situation 
assessments. 

* Partnered with OPM's Go Learn initiative to implement web-based 
Enterprise Learning Management System that managers, employees, and the 
Learning & Education community will use to manage training and 
development. 

* Launched comprehensive leadership succession planning initiative- 
first phase of initiative included assessment of 103 executives 
Servicewide to measure and benchmark competency strengths and 
weaknesses. 

* Implemented human capital governance structure to address issues 
resulting from large-scale human capital initiatives and to ensure fair 
treatment of impacted employees. 

* Executed new recruitment marketing contract, maintained active media 
campaign, produced new multi-media job previews, updated the IRS 
careers website and continued fostering partnering relationships with 
over 200 colleges and universities. 

* Used all available tools (e.g., early outs, buyouts) and developed 
new tools (e.g., relocation bonuses) to support and mitigate impacts of 
workforce restructuring. 

* Developed, at direction of the Chief Human Capital Officer, HCO 
Concept of Operations that articulates HCO's vision, mission, values, 
role, responsibilities and Lines of Business. 

* Executed Service Level Agreements with internal customers describing 
services HCO will provide, HCO and customer commitments and measurement 
of HCO performance. 

Planned: 

* Develop Human Capital Strategic Implementation Plan to include 
significant human capital programs that will implement IRS' Human 
Capital Strategic Plan over the next two years and provide 
accountability for program performance. 

* Continue study of leadership development training to ensure training 
provides leadership with skills and knowledge needed to be effective in 
today's environment, focusing on curriculum and content delivery, 
attracting employees with high leadership potential, and building a 
supportive learning environment. 

* Deploy a Learning Content Management System that will permit more 
efficient development of training materials and ensure more consistency 
in training across the IRS. 

* Complete the conversion of all MCO application processes to the 
CareerConnector system and begin the conversion of the non-MCO 
occupations. 

Competitive Sourcing: 

Accomplished: 

* Received the 2004 President's Quality Award for Innovation in 
Competitive Sourcing (CS). 

* Recognized in March 2005 with the 2004 NISH organization's Government 
Award for Services for Service-wide Mail and Toll Free Forms Taxpayer 
virtual call center contracts issued under the Javits-Wagner-O'Day Act 
providing work opportunities for disabled individuals including first 
time home-based employment for people with disabilities. 

* Implemented National Distribution Center (NDC) competitive sourcing 
initiative enabling the IRS to cancel leases releasing approximately 
395,000 square feet and reducing rent by $4.1 million. 

* Launched Competitive Sourcing Internet knowledge sharing content at 
www.irs.gov and Share A-76. 

* Developed "Managing an Effective Competitive Sourcing Program" DVD 
training sponsored by the Federal Acquisition Institute. 

* Completed 2005 FAIR Act Inventory for all of Treasury on schedule. 

* Implemented Microsoft Project Server enhancing project management 
discipline across all support functions-HR, Procurement, Business 
Divisions, etc. 

* Implemented virtual team rooms using SharePoint software improving 
team knowledge sharing through secure shared document creation and 
version control. 

* Participated in the HR Connect System walkthrough activity leading to 
the use of HR Connect for FY 2006 FAIR Act inventory. 

* Awarded Campus Files competition to IRS employees who were deemed 
Most Efficient Organization (MEO). 

* Awarded Building Designation contract to private contractor. 

Planned: 

* Conduct Preliminary Planning on Seat Management and Fuel Compliance. 

* Continue Business Case Analysis (BCA): Real Estate and Facilities 
Management. 

* Announce Solicitation: Logistics. 

* Develop Learning and Education Business Process Re-engineering 
design. 

* Implement approved Shared Services recommendations. 

* Lead the development of the second Competitive Sourcing Training DVD. 

* Brief the Strategy and Resource Council on proposed potential CS 
projects to begin BCA planning schedules. 

* Capture baseline costing in COMPARE and verify projected economic 
savings. 

* Continue Expert Contractor Delivery of Competitive Sourcing Training 
(all phases) to IRS employees and managers. 

Budget & Performance Integration: 

Accomplished: 

* Improved Program Assessment Rating Tool (PART) rating to "Moderately 
Effective" for Submission Processing Program. 

* Received PART rating of "Moderately Effective" for Criminal 
Investigation and Examination Programs. 

* Used IFS cost module capabilities to capture cost data for FY 2005, 
enabling the IRS to analyze direct expense data (labor, supplies, 
travel, etc), FTEs and on-rolls data from the lowest cost center. 

* Completed allocation to distribute support costs to the operational 
business units. 

* Improved performance and efficiency for over half of IRS programs. 

* Included programmatic long-term goals in FY 2007 budget submission. 

* Developed draft set of strategic long-term goals. 

Planned: 

* Reach agreement with the Administration and the Appropriators on the 
structure of the FY 2007 budget request. 

* Link resource needs with expected performance and long term goals in 
the FY 2007 Congressional Justification. 

* Continue to assess and use the cost data obtained through IFS to 
further develop robust cost-based performance measures for major 
programs. 

* Continue efforts to identify long-term goals for Regulatory 
Compliance and Research. 

* Introduce enterprise-wide goals linking directly to the IRS Strategic 
Plan. 

* Expand the pay for performance system to frontline managers linking 
performance results with salary increases. 

* Develop FY 2008 congressional request linking resource needs with 
expected performance and long term goals. 

* Submit remaining programs to OMB for an initial PART assessment. 

E-Government: 

Accomplished: 

* Processed over five million Free File returns in 2005, representing a 
43% increase over the prior year. 

* Expanded support of electronic filing of business forms by completing 
agreements with New York and Georgia to link state registration 
applications to the federal Internet Employer Identification Number 
(EIN) application for a one-stop experience. 

* Expanded electronic filing of additional business forms: 1120, 990, 
and 94X series. 

* Actively supported other e-gov initiatives, such as Business Gateway, 
grants.gov, and GovBenefits.gov. 

* Implemented an eCatalog (eCat) pilot program to begin an Integrated 
Acquisition Environment which will use Contract Optimization and 
Strategic Contracts as tools to incur savings. 

* Identified IFS alternative from Line of Business Initiative to 
implement as the IFS Go Forward Strategy. 

* Completed the security certification and accreditation of its network 
infrastructure general support systems making substantial progress in 
improving the Federal Information System Management Act (FISMA) 
compliance status of all IRS information systems. 

* Developed General Support Systems (GSS) and Major Applications' Plans 
of Actions and Milestones (PoAMs) to manage, monitor and track 
corrective actions. 

Planned: 

* Ensure all GSS certification and accreditations and Major 
Applications conform to IRS and National Institute of Standards and 
Technology (NIST) standards. 

* Develop and test an Enterprise Information Technology Contingency 
(Disaster Recovery) Strategy. 

* Monitor GSS and Major Applications' Plans of Actions and Milestones 
quarterly for identified corrective actions. 

* Participate in Business Gateway Advisory and Governance Boards to 
come to agreement on scope and next steps for Business Gateway 
components. 

* Define high level resource requirements and timeline for the IFS Go 
Forward Strategy. 

* Ensure that all Non Major Applications attain NIST compliant 
Certification and Accreditation. 

Financial Performance: 

Accomplished: 

* Continued to meet Treasury's TIER 3-day close financial reporting 
requirements. 

* Achieved full operating capability for Release 1.0 of the Integrated 
Financial System (IFS). 

* Developed a Computer Security material weakness plan that addresses 
deficiencies in access controls, rules of behavior, contingency 
planning and disaster recovery, audit trails, training and 
certification and accreditation. 

* Maintained clean audit opinion on FY 2004 financial statements. 

* Performed a cross-walk of the Interim Revenue Accounting Control 
System (IRACS) to a compliant US Standard General Ledger (US SGL) 
structure for year-end financial statements. 

* Identified and assigned financial information executives need to 
facilitate critical decision making. 

* Continued implementation of NIST compliant training program. 

* Conducted IFS Cost workshop to gather operational needs and establish 
process for reports development August 2005. 

Planned: 

* Meet administrative financial statement reporting deadlines through 
IFS. 

* Complete IFS Milestone 5 and implement plan to transition from PRIME 
to the IRS. 

* Develop and test a new data base to store Trust Fund Recovery Penalty 
(TFRP) and Unpaid Assessment data which will become the foundation of 
the Custodial Detailed Data Base (CDDB) and the subsidiary ledger for 
all unpaid assessments. 

* Put the CDDB revenue transaction database into production and test 
reports. 

* Maintain current parallel processes and implement changes as needed 
to ensure a clean audit opinion on the Statement of Custodial Activity. 

* Identity systems that enable us to link cost to performance. 

* Produce the automated Statement of Net Cost in IFS. 

Eliminating Improper Payments: 

Accomplished: 

* Developed a detailed, long-term EITC business plan, a Concept of 
Operations, based on a balanced approach. 

* Developed an estimate of the overall EITC error rate. 

* Completed FY 2004 qualifying child certification and Filing Status 
test. 

* Finalized new participant selection methodology for FY 2005 
qualifying child certification test. 

* Completed final report to Congress on results of FY 2004 qualifying 
child certification and filing status tests. 

* Evaluated research initiatives and assessed prior year studies to 
improve EITC outreach, compliance initiatives, program delivery and 
measurement strategies. 

Planned: 

* Launch the final phase of the qualifying child certification test- 
focus on improved selection methodology. 

* Complete compliance analysis of TY 2001 returns claiming EITC 
(National Research Program). 

* Continue to develop and distribute materials to educate taxpayers and 
practitioners on EITC eligibility rules and compliance issues. 

* Report results of the National Directory of New Hires database match 
test. 

* Plan for TY 2006 compliance study. 

* Launch integrated decision support tool for EITC examiners. 

* Launch new risk-based scoring strategy and inventory management 
capability to improve selection and assignment of EITC returns for 
examination. 

* Complete evaluation of FY 2004 certification, filing status and 
income misreporting tests. 

* Test new selection tools to determine more effective compliance 
treatments for return preparers. 

* Complete evaluation of FY 2005 certification and filing status tests. 

* Launch significantly enhanced methodology to improve the selection of 
EITC amended returns for examination. 

* Update EITC Strategy and Program plan and identity EITC education and 
outreach targets based on results from FY 2004, FY 2005 and FY 2006 
tests. 

[End of Management Discussion and Analysis] 

Financial Statements: 

Balance Sheets: 

Internal Revenue Service Balance Sheet As of September 30, 2005 and 
2004: 

(In Millions): 

[See PDF for image] 

[End of table] 

Statements of Net Cost: 

Internal Revenue Service Statements of Net Cost As of September 30, 
2005 and 2004: 

[See PDF for image] 

[End of table] 

The accompanying notes are an integral part of these statements. 

Statement of Changes in Net Position: 

Internal Revenue Service Statement of Changes in Net Position For the 
Years Ended September 30, 2005 and 2004: 

(In Millions): 

[See PDF for image] 

[End of table] 

The accompanying notes are an integral part of these statements. 

Statement of Budgetary Resources: 

Internal Revenue Service Statement of Budgetary Resources For the Years 
Ended September 30, 2005 and 2004: 

(In Millions): 

[See PDF for image] 

[End of table] 

The accompanying notes are an integral part of these statements. 

Statement of Financing: 

Internal Revenue Service Statement of Financing For the Years Ended 
September 30, 2005 and 2004: 

(In Millions): 

[See PDF for image] 

[End of table] 

The accompanying notes are an integral part of these statements. 

Statements of Custodial Activity: 

Internal Revenue Service Statement of Custodial Activity For the Years 
Ended September 30, 2005 and 2004: 

(In Billions): 

[See PDF for image] 

[End of table] 

The accompanying notes are an integral part of these statements. 

Notes to the Financial Statements: 

INTERNAL REVENUE SERVICE: 

Notes to the Financial Statements For the Years Ended September 30, 
2005 and 2004: 

Note 1. Summary of Significant Accounting Policies: 

A. Reporting Entity: 

The Internal Revenue Service (the Service) is a bureau of the U.S. 
Department of the Treasury (Treasury). The Service originated in 1862, 
when Congress established the Office of the Commissioner of the 
Internal Revenue. In 1952, the Bureau was reorganized by Congress and 
became the Internal Revenue Service (IRS) in 1953. 

Currently, the organization consists of: 

* Four operating divisions -Wage and Investment (WAGE) addresses the 
needs of taxpayers with wage and investment income only. Small Business 
and Self-Employed (SBSE) serves self-employed individuals and small 
businesses. Tax-Exempt and Government Entities (TEGE) supports employee 
plans, tax exempt organizations, and government entities. Large and Mid-
Size Business (LMSB) serves corporations, sub-chapter S corporations, 
and partnerships with assets greater than $5 million. 

* Functional support-Appeals, Criminal Investigation, Taxpayer Advocate 
and Chief Counsel are independent of the operating divisions and other 
units of the Service. Taxpayer Advocate reports directly to Congress 
and Chief Counsel reports to the Secretary of the Treasury. 

* National Headquarters fills the role of setting broad policy, 
providing executive oversight, reviewing plans and goals of the 
operating units, and developing major improvement initiatives. 

* Two cross-servicing organizations - Modernization and Information 
Technology Services (NITS) and Agency Wide Shared Services (AW SS) 
provide central support to all areas of the Service. 

The mission of the Service is to provide America's taxpayers with top- 
quality service by helping them understand and meet their tax 
responsibilities and by applying the tax law with integrity and 
fairness to all. 

B. Basis of Accounting and Presentation: 

The financial statements have been prepared from the accounting records 
of the Service in conformity with accounting principles generally 
accepted in the United States (GAAP) and the Office of Management and 
Budget (OMB) Circular A-136, Financial Reporting Requirements. 
Accounting principles generally accepted for federal entities are the 
standards prescribed by the Federal Accounting Standards Advisory Board 
(FASAB). FASAB is recognized by the American Institute of Certified 
Public Accountants as the official accounting standards-setting body of 
the Federal Government. 

These financial statements are provided to meet the requirements of the 
Government Management Reform Act of 1994. They consist of the Balance 
Sheet, the Statement of Net Cost, the Statement of Changes in Net 
Position, the Statement of Budgetary Resources, the Statement of 
Financing, and the Statement of Custodial Activity. The statements and 
the related notes are prepared in a comparative form to present both FY 
2005 and FY 2004 information. 

Balance Sheet, Statement of Changes in Net Position: 

These statements are presented on the accrual basis of accounting. 
Under the accrual method, revenues are recognized when earned, and 
expenses are recognized when costs are incurred or goods or services 
are received, without regard to receipt or payment of cash. 

Statement of Net Cost: 

This statement is presented on the accrual basis of accounting. The 
Statement of Net Cost presents the costs incurred by the Service in 
performing its mission, net of related exchange revenues. These costs 
include direct costs, indirect costs assigned in a manner that reflects 
direct consumption of resources, and a proportionate share of other 
indirect costs. 

Program costs are aggregated across divisional lines into broad-based 
cost centers-pre-filing, filing, compliance and administration of tax 
credit programs described below. 

Pre-Filing Taxpayer Assistance and Education: 

Provides services to taxpayers before returns are filed to assist 
taxpayers in preparing correct returns. Primary activities include 
interpretations, preparing and disseminating tax publications and 
information, taxpayer education programs, researching customer needs, 
pre-filing agreements and determinations, and initiatives to promote 
electronic tax filing. Exchange revenues include user fees from the pre-
filing agreements and determinations, letter rulings, and enrolled 
agent fees. 

Filing and Account Services: 

Performs accounts maintenance functions of processing tax returns, 
recording tax payments, issuing refunds, and maintaining taxpayer 
accounts. The scope extends to all tax returns and taxpayer accounts 
regardless of type and method of filing. Program activities also 
include providing field assistance in preparing tax returns and 
supplying tax forms to the public. Exchange revenues include user fees 
from photocopy services. Exchange revenues also include reimbursable 
revenues from services provided to other federal agencies. 

Compliance Services: 

Administers compliance activities after a return is filed in order to 
identify and correct possible errors or underpayments. This program 
includes field collection activities, document matching, examination of 
returns, criminal investigation, and tax litigation. Exchange revenues 
include installment agreement fees and offers in compromise. Exchange 
revenues also include reimbursable revenues from services provided to 
other federal agencies. 

Administration of Tax Credit Programs: 

Administers the Earned Income Tax Credit (EITC) and Health Coverage Tax 
Credit (HCTC) programs. EITC includes expanded customer service, public 
outreach, enforcement, and research efforts to reduce claims and 
erroneous filings associated with the program. EITC comprises pre- 
filing, filing and account services, and compliance activities. EITC 
payments actually refunded to individuals or credited against other tax 
liabilities are not included in program costs. HCTC includes activities 
focused on implementing the health insurance tax credit program set out 
in the Trade Act of 2002. 

Statement of Budgetary Resources: 

The Statement of Budgetary Resources is presented using the budgetary 
basis of accounting. Budgetary accounting facilitates compliance with 
legal constraints and controls over the use of federal funds. This 
financial statement is in addition to the reports prepared by the 
Service throughout the year pursuant to OMB directives for purposes of 
monitoring and controlling the Service's obligation and expenditure of 
budgetary resources. 

Statement of Financing: 

The Statement of Financing is presented using both an accrual and a 
budgetary basis of accounting as a means to facilitate understanding of 
the differences between the two accounting bases. 

Statement of Custodial Activity: 

The Statement of Custodial Activity is presented on the modified cash 
basis of accounting. This method initially reports revenue in the 
financial statements on the cash basis, which is then adjusted by the 
change in net federal taxes receivable --net of the change in refunds 
payable --during the current fiscal year. This adjustment effectively 
converts the cash basis revenue and refunds to a full accrual amount. 
The related distribution of all such collections to the Treasury is 
similarly reported on the cash basis. It is then adjusted to the 
accrual basis by the net change during the fiscal year in uncollected 
amounts due to Treasury. 

Refunds of taxes and interest are reported on the cash basis. Refunds 
include payments of earned income tax credits (EITC), health coverage 
tax credits (HCTC), and child care credits, as well as overpayments of 
taxes. 

C. Financing Sources and Exchange Revenue: 

The Service receives the majority of its funding through annual, multi- 
year, and no-year appropriations that are available for use within 
statutory limits for operating and capital expenditures. Appropriations 
are recognized as financing sources when the related expenses are 
incurred. The following are the different types of operating 
appropriations: 

Processing, Assistance, and Management: 

This appropriation provides funds for processing tax returns and 
related documents, assisting taxpayers in the filing of their returns 
and in paying taxes that are due, strategic planning and oversight, 
finance, human resources, and agency-wide shared services. 

Tax Law Enforcement: 

The purpose of this appropriation is to provide funds for the 
enforcement of Internal Revenue Laws, examination of tax returns, 
administration of taxpayer appeals, collection of unpaid accounts, and 
securing unfiled tax returns and payments. It also provides for issuing 
technical rulings, monitoring employee pension plans, qualifying exempt 
organizations, examining exempt tax returns, and compiling statistics 
of income and compliance research. 

Information Systems: 

This appropriation funds costs for data processing and information and 
telecommunication support for the Service's activities, including 
developmental information systems and operational information systems. 
The operational systems are located in a variety of sites including the 
Martinsburg Computing Center, the Detroit Computing Center, the 
Tennessee Computing Center, and in field offices and service centers. 

Other: 

These budgetary accounts consist of an aggregate of smaller multi- 
functional funds that support the Service's mission to collect the 
proper amount of tax and provide improved customer service to the 
taxpayer. The Business Systems Modernization (BSM) appropriation is the 
largest of these funds and may be obligated as Congress approves 
expenditure plans. The Health Insurance Tax Credit Administration 
appropriation funds necessary expenses to implement the health 
insurance tax credit and was included in the Trade Act of 2002. 

In addition, the Service incurs certain costs that are paid in total or 
in part by other federal entities, such as pension costs administered 
by the Office of Personnel Management and legal judgments paid by the 
Treasury Judgment Fund. These constitute subsidized costs and are 
recognized by the Service on its Statement of Changes in Net Position 
and Statement of Financing as imputed financing sources equal to the 
cost paid by other federal entities. Pursuant to FASAB Interpretation 
Number 6 of the Statement of Federal Financial Standards Number 4, in 
fiscal year 2005, the Service began recording additional imputed 
financing sources for costs that are paid in total or in part by other 
entities within the Department of Treasury, notably Financial 
Management Services for electronic funds transfers. 

D. Fund Balance with Treasury: 

The fund balance with Treasury is the aggregate amount of funds in the 
Service's accounts, including appropriated funds, from which the 
Service is authorized to make expenditures and pay liabilities, as well 
as funds in deposit, suspense, and clearing accounts. 

E. Other Assets - Accounts Receivable and Advances: 

Intragovernmental accounts receivable consist of amounts due from 
federal agencies. Accounts receivable are recorded, and reimbursable 
revenues are recognized, as the services are performed and costs are 
incurred. Accounts receivable are also recorded, and transfers-in are 
recognized, when notices are received from official representatives of 
the Treasury Forfeiture Fund (TFF) advising IRS of the amount and 
availability of planned discretionary nonreciprocal distributions of 
TFF assets to IRS. The allowance for uncollectible accounts is based on 
an annual review of groups of accounts by age and includes accounts 
receivable balances older than one year. 

Advances to government agencies primarily represent funds paid to the 
Treasury Working Capital Fund (WCF). Amounts in the fund are available 
for expenses of operating and maintaining common administrative 
services of Treasury that can be performed more economically as a 
centralized service. Centralized services funded through the WCF for 
the Service consist primarily of telecommunications services, payroll 
processing, and depreciation of property and equipment owned by the 
WCF. 

The majority of advances to the public are for investigations and 
employee travel advances, which are expensed upon receipt of employees' 
expense reports. 

F. Property and Equipment: 

The net book values of Property and Equipment as of September 30, 2005 
and 2004 consist of the following components: 

Property and Equipment Acquisitions: 

Property and equipment is recorded at historical cost. The Service 
acquires property and equipment through direct purchase, construction, 
development of software and systems, and through capital lease 
agreements. Property and equipment consists of tangible assets and 
software that are intended for use by the Service and have an estimated 
life of two years or greater. Other than limited exceptions noted 
below, property and equipment is capitalized regardless of acquisition 
cost. The Service depreciates property and equipment on a straight line 
basis with a half year depreciated in the first and final years. 
Disposals are recorded when deemed material. 

The Service classifies property and equipment into the following 
classes: ADP equipment, non-ADP equipment, furniture, investigative 
equipment, vehicles, major systems, internal use software, and 
leasehold improvements. 

ADP Equipment: 

ADP Equipment consists of five types of equipment: 1) mainframe 
computers and related equipment, 2) minicomputers and related 
equipment, 3) local area network (LAN) servers and related equipment, 
4) desktop and laptop computers and related equipment, and 5) 
telecommunications equipment. ADP equipment includes all related 
software, including commercial off-the-shelf software, except as 
separately stated under Internal Use Software discussed below. 
Mainframe computers and related equipment, minicomputers and related 
equipment, and telecommunications equipment have an estimated useful 
life of seven years. LAN servers and equipment have an estimated useful 
life of four years. Desktop and laptop computers and related equipment 
have an estimated useful life of three years. 

Office Equipment and Furniture, Investigative Equipment, and Vehicles: 

The Service capitalizes office equipment and furniture, investigative 
equipment, and vehicles, with an individual-asset acquisition cost of 
$5,000 or more. The estimated useful life of office equipment and 
investigative equipment is ten years. Furniture has an estimated useful 
life of eight years, and vehicles have an estimated useful life of five 
years. 

Major Systems: 

Prior to FY 2001, the Service capitalized certain costs of large-scale 
computer software systems as major systems. Subsequently, such costs 
are included in internal use software. Only projects exceeding $20 
million were considered major systems. Major systems capitalized prior 
to September 30, 2000, had an estimated useful life of seven years, and 
continue to be depreciated over their remaining useful lives. 

Internal Use Software: 

In accordance with Statement of Federal Financial Accounting Standards 
No. 10 (SFFAS No. 10), Accounting for Internal Use Software, beginning 
in FY 2001, the Service capitalizes all internal use software projects 
recognized and authorized by management as major development projects. 
Only projects with useful lives of two years or more and recognized as 
major development projects by the Modernization and Information 
Technology Services Executive Governance Council are capitalized. 

The Service capitalizes direct and indirect costs of internal use 
software incurred in the development phase of a project as defined in 
the SFFAS No. 10. Direct costs include direct salaries and benefits of 
IRS employees assigned to the projects, consultant fees, and 
contracting costs. Related infrastructure and project management costs 
are allocated to the projects. Direct costs exclude maintenance 
contracts in effect at any time during development or thereafter. 

The Service applies indirect overhead to internal use software projects 
using a three-year average rate of overhead costs. The overhead rate is 
applied only to salaries and benefits of IRS employees directly 
assigned to the internal use software projects. 

In accordance with SFFAS No. 10, costs incurred for the development 
phase of a project are capitalized, while costs incurred for design 
(prior to the development phase) and operations (after the development 
phase) are expensed. The design phase, defined by Standard No. 10, 
includes conceptual formulation of alternatives, determination and 
testing of alternatives, determination of existence of needed 
technology, and final selection of alternatives. The development phase 
includes developing the software configuration and interfaces, coding, 
installation of hardware and software, and testing. The operational 
phase begins upon successful completion of testing. 

Internal use software's capitalized costs are accumulated in work in 
process until final acceptance and testing are successfully completed. 
Once completed, the costs are transferred to depreciable property. 
Internal use software has an estimated useful life of seven years with 
no residual value, and is depreciated using the straight-line method 
with a half-year convention in the fast and final years. 

In accordance with SFFAS No. 10, disposals are recognized when software 
is determined to be obsolete or nonfunctional. The IRS treats 
terminated projects and/or subprojects as 100% obsolete. Obsolete 
projects are adjusted to reduce both the asset and accumulated 
depreciation accounts, and record any losses as a result of the 
disposal. 

Leasehold Improvements: 

All leasehold improvement projects are capitalized regardless of cost. 
Leasehold improvements have an estimated useful life often years. 

G. Capital Lease Liability: 

Capital lease liability includes amounts for non-ADP equipment and 
computer software leased under software licensing agreements. The 
liability reported represents the lesser of the net present value of 
future lease payments or the fair market value of the asset acquired. 
The liability for non-ADP equipment acquired under a capital lease is 
included in funded liabilities. The liability for software licenses is 
generally included in Liabilities Not Covered by Budgetary Resources. 

H. Permanent and Indefinite Funds: 

The Service uses a special class of funds, designated as "permanent and 
indefinite", to disburse tax refund principal and related interest. 
These permanent and indefinite funds are not subject to budgetary 
ceilings set by Congress during the annual appropriation process. 
Because Congress permanently funds tax refunds from a budgetary 
standpoint, tax refunds payable at year-end are fully funded. The asset 
"Due from Treasury" designates this approved funding to pay year-end 
tax refund liabilities, which are reflected in the funds used for 
refund of federal taxes on the Statement of Custodial Activity along 
with tax refund payments for the year. 

Although funded through the appropriation process, refund activity is 
reported as a custodial activity of the Service. This presentation is 
appropriate because refunds are, in substance, a custodial revenue- 
related activity. Federal tax revenue received from taxpayers is not 
available for use in the operation of the Service and is not reported 
on the Statement of Net Cost. Likewise, the resultant refunds of 
overpayments are not available for use by the Service in operations. 
Consequently, to present refunds as an expense of the Service on the 
Statement of Net Cost with related appropriations used would be 
inconsistent with the reporting of the related federal tax revenue and 
would materially distort the costs incurred by the Service in meeting 
its strategic objectives. 

I. Tax Assessments and Abatements: 

Under the Internal Revenue Code 26 USC Section 6201, the Secretary of 
the Treasury is authorized and required to make inquiries, 
determinations, and assessments of all taxes that have been imposed and 
accruing under any internal revenue law but have not been duly paid 
(including interest, additions to the tax, and assessable penalties). 
The Secretary has delegated this authority to the Commissioner of the 
IRS. Unpaid assessments result from taxpayers filing returns without 
sufficient payments, as well as from the Service's enforcement 
programs, such as examination, under-reporter, substitute for return, 
and combined annual wage reporting. 

The Commissioner of the IRS also has authority to abate the paid or 
unpaid portion of an assessed tax, interest, and penalty. Abatements 
occur for a number of reasons and are a normal part of the tax 
administration process (abatements may be allowed for a qualifying 
corporation that claimed a net operating loss which created a credit 
that can be carved back to reduce a prior year's tax liability, amend 
tax returns, and to correct an assessment from an enforcement program, 
taxes discharged in bankruptcy, accepted offers in compromise, penalty 
abatements for reasonable cause, contested assessments made due to 
mathematical or clerical errors, and assessments contested after the 
liability has been satisfied). Abatements may result in claims for 
refunds or a reduction of the unpaid assessed amount. 

J. Federal Taxes Receivable: 

Federal taxes receivable and the corresponding liability, "Due to 
Treasury", are not accrued until related tax returns are filed or 
assessments made by IRS and agreed to by either the taxpayer or the 
court and prepayments netted against liabilities. Accruals are made to 
reflect penalties and interest on taxes receivable through the balance 
sheet date. 

Taxes receivable consist of unpaid assessments (taxes and associated 
penalties and interest) due from taxpayers for which the Service can 
support the existence of a receivable through taxpayer agreement, such 
as filing of a tax return without sufficient payment, or a court ruling 
in favor of the Service. Taxes receivable are shown on the balance 
sheet net of an allowance for doubtful accounts. The allowance for 
doubtful accounts reflects an estimate of the portion of total taxes 
receivable deemed to be uncollectible. 

Compliance assessments are unpaid assessments for which neither the 
taxpayer nor a court has affirmed that the taxpayer owes amounts to the 
Federal Government. Examples include assessments resulting from an IRS 
audit or examination in which the taxpayer does not agree with the 
results. These amounts are not reported on the balance sheet; however, 
statutory provisions require that these accounts be maintained until 
the statute for collection expires. 

Write-offs consist of unpaid assessments for which the Service does not 
expect further collections due to factors such as taxpayers' 
bankruptcy, insolvency, or death. These amounts are also not reported 
on the balance sheet; however, statutory provisions require that these 
accounts be maintained until the statute for collection expires. 

Note 2. Fund Balance with Treasury (In Millions): 

Fund balance with Treasury as of September 30, 2005 and 2004, consist 
of the following: 

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[End of table] 

The Business Systems Modernization (BSM) fund represents $297 million 
and $340 million of the appropriated fund balance as of September 30, 
2005 and 2004, respectively. BSM funds can only be obligated pursuant 
to an expenditure plan approved by Congress. Other funds primarily 
consist of suspense, deposit, and clearing funds. 

Note 3. Cash and Other Monetary Assets (In Millions): 

Cash and other monetary assets with the public as of September 30, 2005 
and 2004, consist of the following: 

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[End of table] 

Imprest funds are maintained by Headquarters and field offices in 
commercial bank accounts. 

Other custodial assets primarily represent voluntary deposits received 
from taxpayers, pending application of the funds to unpaid tax 
assessments. This category also includes seized monies of less than $1 
million as of September 30, 2005 and $1 million as of September 30, 
2004, which are held pending the results of criminal investigations. As 
described in Note 13, other custodial assets are classified as "Non- 
entity Assets" and are offset by an equal liability in other custodial 
liabilities. 

Note 4. Other Assets (In Millions): 

Other assets as of September 30, 2005 and 2004, consist of the 
following: 

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[End of table] 

Note 5: Federal Taxes Receivable, Net: 

Federal taxes receivable (gross) were $88 billion and $89 billion as of 
September 30, 2005 and 2004, respectively, and consisted of tax 
assessments, penalties, and interest that were not paid or abated, and 
which were agreed to by the taxpayer and the Service, or upheld by the 
courts. 

Federal taxes receivable (net) equaled $21 billion and $20 billion as 
of September 30, 2005 and 2004, respectively, and are the portion of 
federal taxes receivable (gross) estimated to be collectible. It is 
based on projections of collectibility from a statistical sample of 
taxes receivable. An allowance for doubtful accounts of $67 billion and 
$69 billion was established in FY 2005 and FY 2004, respectively, for 
the difference between the gross federal taxes receivable and the 
portion estimated to be collectible. Due to Treasury is the offsetting 
liability to federal taxes receivable, representing amounts to be 
transferred to Treasury when collected. 

Note 6. Property and Equipment (In Millions): 

Property and Equipment as of September 30, 2005 and 2004, is shown in 
the schedule below. The Cost column primarily represents the actual 
cost of property and equipment, net of disposals. The cost basis for FY 
2005 and FY 2004 is $3,502 million and $3,422 million, respectively. 
Accumulated depreciation for FY 2005 and FY 2004 is $2,080 million and 
$1,647 million, respectively. 

[See PDF for image] 

[End of table] 

Prior to FY 2001, the Service captured the costs of major systems 
consulting and contractual services in the category "Major Systems". 
The Service has ten systems it considers major systems as of September 
30, 2005 and 2004. As of September 30, 2005, major systems consisted 
largely of costs associated with re-engineering the Martinsburg and 
Tennessee Computing Centers, known as the Mainframe Consolidation 
project, and a system to convert paper tax documents and remittances 
into electronic records, known as the Integrated Submission and 
Remittance Processing System. 

Major systems consist of the following: 

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[End of table] 

After FY 2000, the Service captured development of major systems as 
Internal Use Software. As of September 30, 2005 and 2004, the Service 
has 15 internal use software projects, including deployed and work in 
process. Several projects are being deployed in phases (releases) as 
those releases become functional and are placed into service. Deployed 
projects include Customer Account Data Engine (Release 1), E-Services, 
Modernized E-File (Releases 1, 2, and 3.1), Security and Technology 
Infrastructure Release (STIR), Integrated Financial System (IFS), 
Internet Refund Fact of Filing, Enterprise Systems Management (ESM), 
and Customer Communications. CADE is a project to replace the Service's 
master file for taxpayer accounts. E-Services is a project to develop 
web-based products and services to communicate with the public and 
expand electronic filing of returns and requests. Modernized E-File is 
an electronic filing system for corporate tax returns. STIR is a 
project to modernize and standardize the information technology 
security infrastructure throughout the Service. IFS is an 
administrative financial system that was deployed at the start of 
fiscal year 2005. Internet Refund Fact of Filing is a project to allow 
taxpayers to review the status of their refund. ESM is a project that 
created a new information technology infrastructure, and Customer 
Communications is a customer service telephone system. 

Deployed internal use software projects consist of the following: 

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[End of table] 

Until deployed, internal use software projects are carried as work in 
process. Major projects in process include Customer Account Data Engine 
(Release 2) (CADE Release 2) and Modernized E-File Release 3.2. All 
development work on Custodial Accounting Project (CAP), a project that 
was in work in process, was stopped in fiscal year 2005 due to funding 
issues. The costs accumulated in work in process for CAP were $143 
million when the project ended. These costs have been recognized as a 
loss on disposal in the current fiscal year. 

The costs of internal use software - work in process consist of the 
following: 

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[End of table] 

Equipment and software licenses acquired through capital leases are 
included in the categories below. Disclosures concerning associated 
capital lease liabilities are provided in Notes 7 and 8. 

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[End of table] 

Note 7. Other Liabilities (In Millions): 

Other liabilities as of September 30, 2005 and 2004, consist of the 
following: 

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[End of table] 

Other custodial liabilities (the offsetting liability to other 
custodial assets) primarily consist of liabilities to taxpayers for 
deposits pending application of the funds to outstanding tax 
deficiencies and liability for seized monies. 

Note 8. Leases (In Millions): 

The capital lease liability as of September 30, 2005 and 2004, is $26 
million and $52 million, respectively, for photocopiers and software 
licenses. In FY 2005 and FY 2004, photocopiers were leased under Lease- 
To-Ownership-Plans (LTOPs). The terms of the LTOPs provide for 48 to 60 
monthly payments for photocopiers. Under each LTOP, the equipment is 
owned as of the last monthly payment. Capital lease treatment is 
accorded to computer software leased under software licensing 
agreements. These licensing agreements provide for payments over 
periods ranging from four to six years. During 2005, final payments 
were made on two leases for software licenses. In FY 2005, ADP 
Equipment was acquired under a 48 month capital lease, with payments in 
the fast and second year of the agreement. The ADP equipment will be 
returned to the vendor after the end of the 48 months. Interest rates 
for capital leases range from 6 to 15 percent. 

Future payments due on capital leases are as follows: 

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[End of table] 

The Service leases office space, vehicles and equipment under annual 
operating leases. These leases are cancelable or renewable on an annual 
basis at the option of the Service. They do not impose binding 
commitments on the Service for future rental payments on leases with 
terms longer than one year. 

Note 9. Contingencies: 

The Service is subject to contingent liabilities involving litigation 
cases whose ultimate disposition is unknown. Based on the information 
currently available, however, it is management's opinion that the 
expected outcome of these matters, either individually or in the 
aggregate, will not have a material effect on the financial statements. 

As of September 30, 2005, the Service does not have contractual 
commitments for payments on obligations related to canceled 
appropriations. 

Note 10. Liabilities Not Covered by Budgetary Resources (In Millions): 

Liabilities not covered by budgetary resources as of September 30, 2005 
and 2004, consist of the following: 

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[End of table] 

Note 11. Appropriations Received: 

Appropriations received reported in the Statement of Budgetary 
Resources in FY 2005 and FY 2004, include $90 million and $84 million, 
respectively, in user fees received from the public for services 
provided and retained by the agency to reduce its net cost of 
operations. 

Note 12. Obligated Balances (In Millions): 

Obligated balances as of September 30, 2005 and 2004, in the Statement 
of Budgetary Resources are as follows: 

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[End of table] 

Note 13. Nonentity Assets (In Millions): 

Nonentity assets arise from the Service's custodial duty to collect 
taxes, disburse tax refunds and maintain proper accounting for these 
activities in the books and records of the Service. Nonentity assets as 
of September 30, 2005 and 2004, consist of the following: 

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[End of table] 

Due from Treasury represents tax refunds due to taxpayers but not 
disbursed as of September 30, 2005 and 2004. 

Federal taxes receivable are transferred to Treasury upon receipt. An 
amount equal to federal taxes receivable has been recognized as an 
offsetting intragovernmental liability-Due to Treasury. Federal taxes 
receivable is described in more detail in Note 5. 

Other custodial assets, also discussed in Note 3, primarily relate to 
seized monies and the deposits received from taxpayers, pending 
application of the funds to unpaid tax assessments. 

Note 14. Comparison of Statement of Budgetary Resources and the 
President's Budget (In Millions): 

Statement of Federal Financial Accounting Standards No. 7, Accounting 
for Revenue and Other Financing Sources and Concepts for Reconciling 
Budgetary and Financial Accounting, calls for explanations of material 
differences between budgetary resources available, status of those 
resources and outlays as presented in the Statement of Budgetary 
Resources (SBR) to the related actual balances published in the Budget 
of the United States Government. However, the Budget of the United 
States Government that will include FY 2005 actual budgetary execution 
information has not yet been published. The Budget of the United States 
Government is scheduled for publication in January 2006. Accordingly, 
information required for such disclosure is not available at the time 
of publication of these financial statements. 

Balances reported in the FY 2004 Statement of Budgetary Resources and 
the related President's Budget are shown in the following table for 
each of the major appropriations and the Business Systems Modernization 
fund. The table does not include other minor appropriations. 

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[End of table] 

There are significant differences between the SBR and the President's 
Budget, which are attributable to differing Treasury and OMB 
requirements. The differences are primarily due to expired and 
unexpired appropriations: the SBR includes both unexpired and expired 
appropriations, while the President's Budget discloses only unexpired 
budgetary resources that are available for new obligations. Outlays are 
reported the same in both statements. 

Note 15. 

Collections of Federal Tax Revenue (In Billions): 

The Service transfers total tax collections to the U.S. Treasury. 
Collection activity, by financial statement line item for the fiscal 
years ended September 30, 2005 and 2004, and by tax year for fiscal 
year ended September 30, 2005, is as follows: 

[See PDF for image] 

* Includes other collections of $574 million. 

** Includes tax year 2006 corporate income tax receipts of $9 billion. 

[End of table] 

In FY 2005, Individual income, FICA/SECA, and other taxes include $68 
billion in payroll taxes collected from other federal agencies. Of this 
amount, $11 billion represents the portion paid by the employers. 

Note 16. Federal Tax Refund Activity (In Billions): 

Refund activity, broken out similarly to collection activity by 
financial statement line item for the fiscal years ended September 30, 
2005 and 2004, and by tax year for fiscal year ended September 30, 
2005, is as follows: 

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[End of table] 

Individual income, FICA/SECA, and other refund amounts include EITC and 
child tax credit refunds. 

Note 17. 

Net Cost By Budget Functional Classification (In Millions): 

Gross cost and earned revenue for the Service are classified under the 
budget functional classification of General Government under the 
President's Budget. Gross cost and earned revenue are categorized as 
follows: 

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[End of table] 

Note 18. Obligations Incurred: 

Each fiscal year, the Office of Management and Budget apportions the 
Service's budgetary resources under apportionment Category B by 
activities and/or projects. In FY 2005, the Service incurred: 

$10,429 million in obligations funded by direct appropriations and $155 
million funded by reimbursable revenue and transfers from the Treasury 
Asset Forfeiture Fund. In FY 2004, the Service incurred $10,256 million 
in obligations funded by direct appropriations and $165 million funded 
by reimbursable revenue and transfers from the Treasury Asset 
Forfeiture Fund. 

Note 19. Spending Authority from Offsetting Collections (In Millions): 

Spending authority from offsetting collections as of September 30, 2005 
and 2004, in the Statements of Budgetary Resources and Financing is as 
follows: 

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[End of table] 

[End of Financial Statements] 

Supplemental Information: 

INTERNAL REVENUE SERVICE: 

Supplemental Information - Unaudited For the Years Ended September 30, 
2005 and 2004: 

Statement of Net Cost by Responsibility Segment (In Millions): 

[See PDF for image] 

[End of table] 

Other Claims for Refunds: 

Management has estimated amounts that may be paid out as other claims 
for tax refunds. This estimate represents an amount (principal and 
interest) that may be paid for claims pending judicial review by the 
Federal courts or, internally, by Appeals. In FY 2005, the total 
estimated payout (including principal and interest) for claims pending 
judicial review by the Federal courts is $11.9 billion and by Appeals 
is $11.1 billion. In FY 2004, the total estimated payout (including 
principal and interest) for claims pending judicial review by the 
Federal courts was $1.7 billion and by Appeals was $6.7 billion. 
Although these refund claims have been deemed to be probable, they do 
not meet the criteria in SFFAS No. 5 for reporting the amounts in the 
balance sheet or for disclosure in the notes to the financial 
statements; however, they meet the criteria in SFFAS No. 7 for 
inclusion as supplemental information. To the extent judgments against 
the government in these cases prompt other similarly situated taxpayers 
to file similar refund claims, these amounts could become significantly 
greater. 

Federal Taxes Receivable, Net (In Billions): 

In accordance with SFFAS No. 7, some unpaid assessments do not meet the 
criteria for financial statement recognition as discussed in Note 1 to 
the financial statements. Although compliance assessments and write- 
offs are not considered receivables under federal accounting standards, 
they represent legally enforceable claims of the IRS acting on behalf 
of the federal government. There is, however, a significant difference 
in the collection potential of these categories. 

The components of the total unpaid assessments and derivation of net 
federal taxes receivable as of September 30, 2005 and 2004, were as 
follows: 

[See PDF for image] 

[End of table] 

The Service cannot reasonably estimate the amount of allowance for 
doubtful accounts pertaining to its compliance assessments, and thus 
cannot determine their net realizable value or the value of the pre- 
assessment work-in-process. 

To eliminate double-counting, the compliance assessments reported above 
exclude trust fund recovery penalties, totaling $13 billion as of both 
September 30, 2005 and 2004, that were assessed against officers and 
directors of businesses who were involved in the non-remittance of 
federal taxes withheld from their employees. The related unpaid 
assessments of those businesses are reported as taxes receivable or 
write-offs, but the Service may also recover portions of those 
businesses' unpaid assessments from any and all individual officers and 
directors against whom a trust fund recovery penalty is assessed. 

Earned Income Tax Credit: 

The EITC is a special credit for employed taxpayers whose earnings fall 
below the established allowance ceiling. In FY 2005, the Service issued 
$35 billion in EITC refunds. In FY 2004, the Service issued $33 billion 
in EITC refunds. An additional $5.3 billion and $5.2 billion of the 
EITC was applied to reduce taxpayer liability for FY 2005 and FY 2004, 
respectively. 

Intra-Governmental Assets (In Millions): 

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[End of table] 

Intra-Governmental Liabilities (In Millions): 

[See PDF for image] 

[End of table] 

Schedule of Budgetary Resources by Major Budget Accounts (In Millions): 

Fiscal Year 2005: 

[See PDF for image] 

[End of table] 

Fiscal Year 2004: 

[See PDF for image] 

[End of table] 

Child Tax Credit: 

The child tax credit was originally authorized by the Taxpayer Relief 
Act of 1997 (Public Law 105-34). The child tax credit is a special 
credit for taxpayers who work, whose earnings fall below the 
established allowance ceiling, and who have a qualifying child. In FY 
2005, the Service issued $15 billion in child tax credit refunds. An 
additional $32 billion of child tax credits were applied to reduce 
taxpayer liability. In FY 2004, the Service issued $9 billion in child 
tax credit refunds. An additional $23 billion of child tax credits were 
applied to reduce taxpayer liability. 

Tax Gap: 

The tax gap is the aggregate amount of tax (i.e., excluding interest 
and penalties) that is imposed by the tax laws for any given tax year 
but is not paid voluntarily and timely. The Service currently projects 
that the annual Federal gross tax gap is somewhere between $312 billion 
and $353 billion. This estimate is based on the preliminary results of 
the National Research Program (NPR). The NPR was a study conducted to 
measure the compliance rate of individual filers based on examination 
of a statistical sample of their filed returns for tax year 2001. The 
tax gap arises from three types of noncompliance: not filing timely tax 
returns (the nonfiling gap), underreporting the correct amount of tax 
on timely-filed returns (the underreporting gap), and not paying on 
time the full amount reported on timely-filed returns (the underpayment 
gap). Of these three components, only the underpayment gap is observed; 
the nonfiling gap and the underreporting gap must be estimated. Each 
instance of noncompliance by a taxpayer contributes to the tax gap, 
whether or not the IRS detects it, and whether or not the taxpayer is 
even aware of the noncompliance. Some of the tax gap arises from 
intentional (willful) noncompliance, and some arises from unintentional 
mistakes. The tax gap does not include underpayments by corporate 
taxpayers or include taxes that should have been paid on income from 
the illegal sector of the economy. 

Of the three components, underreporting of income tax, employment taxes 
and other taxes represents about 80 percent of the tax gap. The single 
largest sub-component of the underreporting involves individuals 
understating their incomes, taking improper deductions, overstating 
business expenses and erroneously claiming credits. Individual 
underreporting represents about half of the total tax gap. Individual 
income tax also accounts for about half of all tax liabilities. 

The collection gap is the cumulative amount of assessed tax, penalties, 
and interest that the Service expects to remain uncollectible. In 
essence, it represents the difference between the total balance of 
unpaid assessments and the net taxes receivable reported on the 
Service's balance sheet. The tax gap and the collection gap are related 
and overlapping concepts, but they have significant differences. The 
collection gap is a cumulative balance sheet concept for a particular 
point in time, while the tax gap is like an income statement item for a 
single year. Moreover, the tax gap estimates include all noncompliance, 
while the collection gap includes only amounts that have been assessed 
(a small portion of all noncompliance). 

Tax Burden and Tax Expenditures: 

The Internal Revenue Code provides for progressive rates of tax, 
whereby higher incomes are generally subject to higher rates of tax. 
The graphs that follow present the latest available information on 
income tax and adjusted gross income (AGI) for individuals by AGI level 
and for corporations by size of assets. For individuals, the 
information illustrates, in percentage terms, the tax burden borne by 
varying AGI levels. For corporations, the information illustrates, in 
percentage terms, the tax burden borne by these entities by various 
sizes of their total assets. The graphs are only representative of more 
detailed data and analysis available from the Statistics of Income 
(SOI) office. 

Total tax expenditures are the foregone federal revenue resulting from 
deductions and credits provided in the Internal Revenue Code. Since tax 
expenditures directly affect funds available from government 
operations, decisions to forego federal revenue are as important as 
decisions to spend federal revenue. 

(All figures are estimates and based on samples provided by the 
Statistics of Income (SOI) Office): 

[See PDF for image] 

[End of figure] 

(All figures are estimates and based on samples provided by the 
Statistics of Income (SOI) Office): 

[See PDF for image] 

[End of figure] 

[End of Supplemental Information] 

[End of section] 

Appendixes: 

Appendix I: Material Weaknesses, Reportable Conditions, and Compliance 
Issues: 

Material Weaknesses: 

During our audits of the Internal Revenue Service's (IRS) fiscal years 
2005 and 2004 financial statements, we continued to identify four 
material weaknesses in internal controls. These material weaknesses 
have given rise to significant management challenges that have (1) 
impaired management's ability to prepare financial statements and other 
financial information without extensive compensating procedures, (2) 
limited the availability of reliable information to assist management 
in effectively managing operations on an ongoing basis, (3) reduced 
IRS's effectiveness in enforcing the Internal Revenue Code, (4) 
resulted in errors in taxpayer accounts, (5) increased taxpayer burden, 
and (6) reduced assurance that data processed by its information 
systems are reliable and appropriately protected. The issues that we 
have identified and discuss in this report relate to IRS's controls 
over (1) financial reporting, (2) unpaid assessments, (3) federal tax 
revenue and refunds, and (4) information security. We reported on each 
of these issues last year[Footnote 15] and in prior audits. We 
highlight these issues in the following sections. Less significant 
matters involving IRS's system of internal controls and its operations 
will be reported to IRS separately. 

Financial Reporting: 

In fiscal year 2005, as in prior years, IRS did not have financial 
management systems adequate to enable it to accurately and timely 
generate and report the information needed to both prepare financial 
statements and manage operations on an ongoing basis. To overcome these 
systemic deficiencies with respect to preparation of its annual 
financial statements, IRS was compelled to employ extensive 
compensating procedures that were costly and labor intensive. During 
fiscal year 2005, IRS (1) did not have an adequate general ledger 
system for financial reporting purposes, (2) could not determine and 
report on the specific amount of revenue collected for each of several 
of the federal government's largest revenue sources, and (3) did not 
have timely and reliable cost information related to its activities and 
programs. Although labor-intensive compensating procedures yielded 
financial statements that were fairly stated as of September 30, 2005 
and 2004, they do not afford real-time data needed to assist in 
managing operations on a day-to-day basis, such as cost-based 
performance information to assist in making or justifying resource 
allocation decisions. 

As we noted in last year's report,[Footnote 16] during fiscal year 
2005, IRS's general ledger system was not supported by adequate audit 
trails or integrated with its supporting records for material balances, 
including federal tax revenue, federal tax refunds, taxes receivable, 
and property and equipment (P&E). Because of these deficiencies, IRS's 
general ledger system does not conform to the U.S. Government Standard 
General Ledger (SGL) at the transaction level as required by the Core 
Financial System Requirements of the Joint Financial Management 
Improvement Program (JFMIP)[Footnote 17] or the requirements of the 
Federal Financial Management Improvement Act of 1996 (FFMIA). Further, 
IRS's use of two separate general ledgers, one to account for its tax 
administration activities and another to capture the costs of 
conducting those activities, greatly complicates efforts to measure the 
cost of IRS's tax administration efforts. During fiscal year 2004, we 
also reported that IRS's general ledger for its tax administration 
activities did not use the standard federal accounting classification 
structure, which is documented in the SGL. In fiscal year 2005, IRS 
implemented an SGL crosswalk for its general ledger for tax 
administration activities, and this has brought this general ledger 
into conformance with the SGL classification structure at the account 
level. 

In November 2004, IRS implemented the first release of the Integrated 
Financial System (IFS), which now serves as IRS's core administrative 
financial management system. IRS expects that IFS will ultimately 
provide it with an integrated financial management system to account 
for and control resources. However, this will be achieved only with the 
implementation of all four of the planned releases of IFS and its 
integration with the financial management systems that account for its 
tax administration activities. The major components of this first 
release of IFS are accounts payable, accounts receivable, budget 
formulation, budget execution, general ledger, financial reporting, and 
cost accounting. The remaining future releases of IFS are planned to 
include property management, procurement, a workload management system, 
software and functional upgrades, and significant cost accounting 
enhancements. 

If successfully implemented as originally planned, and if integrated 
with IRS's tax administration activities, IFS may enable IRS to address 
many of its most long-standing financial management issues, such as the 
inability to perform meaningful cost benefit analysis to support 
decision making. However, IRS has indefinitely deferred future releases 
of IFS due to funding constraints and pending resolution of issues 
related to implementation of the first phase of IFS, such as ensuring 
ongoing maintenance support. IRS also experienced technical 
difficulties recording some types of transactions in IFS during fiscal 
year 2005. In addition, implementing such a large and complex automated 
financial system entails substantial learning for personnel responsible 
for using the system, and this familiarization will take time to 
accomplish. Consequently, while IRS has begun to see some of the 
benefits of IFS, such as more readily accessible detailed transaction 
information and improved audit trails for significant balances, 
obstacles remain to be overcome before the full potential of the system 
can be realized. In addition, to account for and report on over $2 
trillion in annual tax-related transactions, IRS continues to rely on 
legacy financial management systems that do not interface with IFS or 
benefit from its implementation.[Footnote 18] 

In prior years, we reported that IRS did not timely record taxes 
receivable and the related balances due to Treasury in its general 
ledger. During fiscal year 2005, IRS began calculating taxes receivable 
on a monthly basis and reported the balances on its interim financial 
statements. However, these amounts are derived through statistical 
projections and do not reflect the total of actual transactions 
throughout the year.[Footnote 19] 

During fiscal year 2005, IRS continued to be unable to determine the 
specific amount of revenue it actually collects for three of the 
federal government's four largest revenue sources--Social Security, 
hospital insurance, and individual income taxes. In addition, IRS 
continued to be unable to determine, at the time payments are received, 
collections for other trust funds that receive excise tax receipts, 
such as the Highway Trust Fund. This is primarily because the 
accounting information needed to validate the taxpayer's liability and 
record the payment to the proper trust fund is provided on the tax 
return, which is received months after the payment is submitted. 
Further, the information on the tax return pertains only to the amount 
of the tax liability, not how to distribute the amount previously 
collected among the appropriate trust funds. IRS does not require 
taxpayers to submit information identifying the type of tax at the time 
of payment because it has taken the position that imposing such a 
requirement would create an additional burden to those particular 
taxpayers. In addition, IRS's systems cannot at present routinely 
capture and report the information it does receive. IRS is working on 
systems improvements to accommodate this type of information. However, 
IRS will continue to be unable to timely report the specific amount of 
revenue it actually collects for these large revenue sources until it 
has the systems capability to record, and requires taxpayers to 
provide, this information. This condition also makes the federal 
government reliant on a complex, multistep process to distribute excise 
taxes to the recipient trust funds that continues to be susceptible to 
error. 

Now that all federal agencies are required by OMB to meet a reporting 
date of November 15, IRS's inability to timely report specific amounts 
of excise tax revenue to recipient trust funds is even more significant 
for these funds and their administrators. The annual excise tax 
receipts reported by recipient trust funds now include 6 months of 
estimated receipts. The trust funds must report 6 months of estimated 
receipts because, under its existing processes, IRS takes 5 ½ months to 
complete its certification of excise tax receipts and, therefore, does 
not complete the certifications for the third and fourth quarters of 
the fiscal year until after November 15. To the extent that these 
estimates differ from the certified amounts, inaccurate distributions 
to the trust funds could result and, in the case of the Highway Trust 
Fund, allocations of revenues to states could be done 
incorrectly.[Footnote 20] In July 2003, we made recommendations to IRS 
for accelerating its certification process. In response to our 
recommendations, IRS has performed precertifications for the past 2 
years to determine the extent to which an acceleration of the process 
would affect the amounts distributed to the trust funds. Our comparison 
of the precertification and actual certification amounts for the 
Highway Trust Fund and the Airport and Airway Trust Fund, which are the 
two largest trust funds receiving excise tax distributions, showed that 
over the past 2 years there was little difference between 
precertification amounts and actual certification amounts.[Footnote 21] 
This indicates that the certification timeline could be accelerated 
without significantly affecting the accuracy of excise tax 
distributions to these trust funds, thereby reducing reliance on 
estimates and the inherent risk that actual collections will be 
materially different. 

During fiscal year 2004, we reported that IRS did not have a cost 
accounting system (1) capable of accurately and timely tracking and 
reporting the costs of IRS's programs and projects to assist it in 
managing its costs and (2) meeting the JFMIP System Requirements for 
Managerial Cost Accounting.[Footnote 22] During fiscal year 2005, IRS 
implemented a cost accounting module as part of the first release of 
IFS. Although this module has much potential and has begun accumulating 
cost information, IRS management has not yet determined what the full 
range of its cost information needs are or how best to utilize the 
module's existing capabilities to serve those needs. IRS has also not 
yet implemented a related workload management system intended to 
improve IRS's ability to effectively manage its large workforce and to 
provide the cost module with detailed labor cost information. In 
addition, because the cost module was implemented in fiscal year 2005, 
it does not yet contain the historical cost information needed to 
support meaningful future estimates and projections. Consequently, IRS 
cannot yet rely on this system as a significant planning and decision- 
making tool. It will likely require several years and implementation of 
additional components of IFS, such as the workload management system, 
as well as integration with its tax administration activities, before 
the full potential of IRS's cost accounting module will be realized. In 
the interim, IRS decision making will continue to be hampered by a lack 
of meaningful underlying cost information. 

As a result of these financial reporting weaknesses, IRS was compelled 
to expend far more time and effort to maintain its accounting records 
and generate financial management information than would otherwise have 
been necessary, and despite these monumental efforts, IRS continued to 
lack reliable and timely financial information to assist in managing 
operations throughout fiscal year 2005. Addressing the financial 
reporting deficiencies discussed above would enhance this process by 
providing management the reliable and timely information that it needs 
to support informed decision making without having to resort to costly 
and time-consuming procedures to compensate for information system 
deficiencies. 

Unpaid Tax Assessments: 

During fiscal year 2005, we continued to find serious internal control 
issues that affected IRS's management of unpaid assessments. 
Specifically, we continued to find (1) IRS lacked a subsidiary ledger 
for unpaid assessments that would allow it to produce accurate, useful, 
and timely information with which to manage and report externally and 
(2) errors and delays in recording taxpayer information, payments, and 
other activities. These conditions continued to hinder IRS's ability to 
effectively manage its unpaid assessments.[Footnote 23] 

IRS's management of unpaid assessments is hindered by a lack of 
effective supporting systems. IRS continues to lack a detailed listing, 
or subsidiary ledger, that tracks and accumulates unpaid assessments 
and their status on an ongoing basis. As a result, IRS must continue to 
rely on a costly, labor-intensive manual compensating process for 
external reporting. Specifically, to report balances for taxes 
receivable and other unpaid assessments in its financial statements and 
supplemental information, IRS must apply statistical sampling and 
estimation techniques to data in its master files[Footnote 24] to 
estimate the balances at year-end. While IRS continues to refine this 
process, it continued to take several months to complete, required 
adjustments totaling tens of billions of dollars, and produced amounts 
that, after adjustments, were only reliable as of the last day of the 
fiscal year. Consequently, this information is not useful for ongoing 
management decisions. In addition, the lack of a subsidiary ledger 
inhibits IRS's ability to timely develop reliable financial and 
management reports and promptly identify and focus collection efforts 
on accounts most likely to prove collectible. 

IRS's management of unpaid assessments also continued to be hindered by 
inaccurate tax records. We continued to find errors and omissions in 
taxpayer records resulting from IRS's failure to accurately and timely 
record information. Errors in IRS records can cause frustration to 
taxpayers who either do not owe the debt or owe significantly lower 
amounts. 

For example, during our audit we found that IRS assessed over $2 
million in penalties and interest against a business for failing to 
provide a required supporting schedule along with its quarterly payroll 
tax return. When IRS reviewed this case as part of the fiscal year 2005 
financial audit process, it determined that the required schedule was 
in fact attached to the return. However, IRS had sent out a notice of 
taxes due to the business and, at the time of our testing, this amount 
was recorded as a valid tax assessment in IRS's records. In another 
example, IRS assessed over $48 million in interest against the estate 
of a deceased taxpayer for tax year 2005. When IRS reviewed the case as 
part of the fiscal year 2005 financial audit process, it determined 
that the interest assessment should have been about $1 million. 
However, as of September 30, 2005, IRS had not corrected this error on 
the taxpayer's account. 

Some input errors and posting delays can cost the government money. For 
example, IRS erroneously abated[Footnote 25] the entire amount of a 
$26,000 penalty assessment when only $6,000 of the assessment should 
have been abated. When the taxpayer made a subsequent payment of 
$20,000 to satisfy the tax liability, IRS erroneously refunded the 
$20,000 to the business. IRS found this error as part of the fiscal 
year 2005 financial audit process and was ultimately able to recover 
this amount from the taxpayer. 

As in prior years,[Footnote 26] the most prevalent errors we continued 
to find involved IRS's failure to properly record payments to all 
related taxpayer accounts associated with unpaid payroll 
taxes.[Footnote 27] IRS's current systems continued to be unable to 
automatically link each of the multiple assessments made for the one 
tax liability. Consequently, if the business or an officer of that 
business paid some or all of the outstanding taxes, IRS's systems were 
unable to automatically reflect the payment as a reduction in the 
amounts owed on any related accounts. Over the past several years, IRS 
has taken several steps to compensate for the lack of an automated link 
between related accounts. For example, IRS manually inputs a code in 
each account that cross-references it to other related accounts. In 
addition, in August 2001, IRS established new procedures to more 
clearly link each penalty assessment against an officer to a specific 
tax period[Footnote 28] of the business account. In July 2003, IRS also 
began phasing in the use of an automated trust fund recovery penalty 
system that is intended to properly cross-reference payments received 
and thus eliminate the opportunity for errors that plague the current 
manual process. 

Although IRS is making improvements in its processes for recording 
trust fund recovery penalties, our work in fiscal year 2005, as in 
prior years, continued to find errors. In our testing of 80 
statistically selected payments recorded on trust fund recovery penalty 
accounts established since August 2001, we found 6 instances in which 
IRS did not properly record payments received on all related taxpayer 
accounts. Of these 6 payments, 5 were not properly recorded in all 
related accounts even though the accounts contained the required cross- 
referencing at the time that the payments were made. Based on our 
testing, we estimate that 7.5 percent of trust fund recovery payment 
transactions posted to accounts established since August 2001 and still 
outstanding during fiscal year 2005 could contain 
inaccuracies.[Footnote 29] 

Although IRS has implemented a number of compensating procedures, the 
ultimate solution to many of the issues related to IRS's management of 
unpaid assessments, such as the lack of a subsidiary ledger and the 
lack of an automated link between related accounts, continues to be the 
successful modernization of IRS's systems. 

Tax Revenue and Refunds: 

During fiscal year 2005, we continued to find that IRS's controls were 
not fully effective in maximizing the federal government's ability to 
collect what is owed and in minimizing the risk of payment of improper 
refunds. IRS recognized this in its fiscal year 2005 Federal Managers' 
Financial Integrity Act of 1982 (FIA) assurance statement to the 
Treasury, in which it reported material weaknesses in the collection of 
unpaid taxes and in earned income tax credit (EITC) noncompliance. 
IRS's taxpayer compliance programs identify billions of dollars of 
potentially underreported taxes and erroneous EITC claims each year. 
However, due in large part to perceived resource constraints, IRS 
selects only a portion of the questionable cases it identifies for 
follow-up investigation and action. In addition, IRS often does not 
initiate follow-up on the cases it selects until months after the 
related tax returns have been filed and any related refunds disbursed, 
adversely affecting its chances of collecting amounts due on these 
cases. Consequently, the federal government is exposed to potentially 
significant losses from reduced revenue and disbursements of improper 
refunds. 

The options available to IRS in its efforts to identify and pursue the 
correct amount of taxes owed and to ensure that only valid refunds are 
disbursed continue to be limited. For example, third-party information, 
such as the data provided on IRS 1099 forms,[Footnote 30] that can 
corroborate the amount of income reported by taxpayers is not required 
to be filed until after the start of the tax filing season.[Footnote 
31] Consequently, comparison of such information with tax return data 
is problematic because IRS does not have time to prepare the third- 
party data for matching prior to the receipt of individual tax returns. 
Additionally, while it processes hundreds of millions of tax returns 
each filing season, IRS must issue refunds within statutory time 
constraints or be subject to interest charges.[Footnote 32] 

As we previously reported, IRS has some preventive controls that help 
to reduce the magnitude of underreported taxes owed and improper 
refunds issued. For example, IRS's Examination Branch is responsible 
for performing examinations on tax returns with potentially erroneous 
EITC claims to determine the validity of the claims.[Footnote 33] When 
performed before refunds are disbursed, these examinations are an 
important control to prevent disbursement of improper refunds. However, 
in some cases these examinations are performed after any related 
refunds are disbursed, which negates their effectiveness as a 
preventive control and instead serves only as a basis for pursuing 
recovery after the fact. 

In its guidance to heads of federal agencies issued in accordance with 
the Improper Payments Information Act of 2002 (IPIA),[Footnote 34] OMB 
identified the EITC as a program subject to IPIA and required that 
Treasury accordingly report estimates of EITC-related improper payments 
to the President and Congress. EITC claims totaled approximately $40.3 
billion in fiscal year 2005, of which approximately $35 billion was 
refunded to taxpayers and approximately $5.3 billion was used to reduce 
assessed taxes. During fiscal year 2005, IRS used the preliminary 
results of the National Research Program study of tax year 2001 data to 
estimate the level of compliance of individual filers. Based primarily 
on the results of the study, IRS estimated that from 23 percent to 28 
percent of the value of EITC payments disbursed during fiscal year 2005 
were improper. This error rate indicates that of the approximately $35 
billion of EITC-related refunds disbursed during fiscal year 2005, at 
least $8 billion, and potentially as much as $9.8 billion, was likely 
to have been improper. 

Due to time and other constraints noted above, IRS relies extensively 
on detective controls, such as automated matching of tax returns with 
third-party data such as W-2s (wage and tax statements), to identify 
for collection underreported taxes and improper refunds. However, these 
programs are not run until months after the returns have been filed 
and, as a result, cannot be used to prevent improper refunds from being 
disbursed. In addition, although IRS's matching program for individual 
tax returns identifies billions of dollars of potentially underreported 
taxes each year, IRS only follows up on a portion of these cases to 
determine how much tax is actually due and to pursue collection of 
those amounts. For example, for tax year 2003, IRS's matching program 
for individuals identified 14.5 million individual tax returns, with 
potential underreported taxes totaling $15 billion.[Footnote 35] 
Because the volume of cases IRS can follow up on depends on resource 
availability, IRS conducts an analysis that identifies case 
characteristics that have historically yielded greater assessments as a 
result of follow-up efforts. In deciding which or how many cases to 
pursue, IRS does not consider historical collection experience or the 
costs incurred to work the related cases. Based on its analysis for tax 
year 2003, IRS investigated 4.1 million (28 percent) of these returns, 
which accounted for about $10.1 billion (67 percent) of the total 
potential underreported taxes. There are factors that affect IRS's 
ability to accelerate the timing of its automated matches, such as the 
limitations of its current automated systems and the timing of filing 
requirements for preparers of third-party documents, some of which are 
beyond IRS's control. Nonetheless, the information from IRS's automated 
matching program suggests that a substantial amount of additional 
revenue might be realized if additional resources, coupled with more 
timely receipt of information and more effective systems to compare 
such information, were devoted to follow-up efforts. At present, 
billions of dollars in underreported taxes could remain uncollected and 
improper refunds could be disbursed. 

Information Security: 

To effectively fulfill its tax processing responsibilities, IRS relies 
extensively on interconnected computer systems to perform various 
functions, such as collecting and storing taxpayer data, processing tax 
returns, calculating interest and penalties, generating refunds, and 
providing customer service. Consequently, weaknesses in controls over 
its information systems could impair IRS's ability to perform these 
vital functions and increase the risk of unauthorized disclosure, 
modification, or destruction of taxpayer data. 

Information security weaknesses--both old and new--continue to impair 
the agency's ability to ensure the confidentiality, integrity, and 
availability of financial and other sensitive data. During our fiscal 
year 2005 audit, we identified continuing and new serious information 
security weaknesses in IRS's general controls intended to protect 
computing resources such as networks, computer equipment, software 
programs, data, and facilities. For example, access controls did not 
adequately prevent unauthorized access to taxpayer and other sensitive 
data by users granted access to IRS computer systems. Further, 
monitoring activities over critical computer systems were not 
adequately performed to record and track security-related events. As a 
result, sensitive data and computing resources are at increased risk of 
unauthorized use, modification, loss, and disclosure, possibly without 
detection. 

A key reason for IRS's information security weaknesses was that it has 
not yet fully implemented an agencywide information security program to 
ensure that controls are effectively established and maintained. In 
December 2002, Congress enacted the Federal Information Security 
Management Act of 2002 (FISMA),[Footnote 36] which is intended to 
strengthen the information security of federal information and systems 
by requiring agencies to develop, document, and implement agencywide 
information security programs. Some of the information security program 
elements required by FISMA are: 

* periodic testing and evaluation of the effectiveness of information 
security policies, procedures, and practices; 

* security awareness training for agency personnel, including 
contractors; 

* a process for planning, implementing, evaluating, and documenting 
remedial action to address information security deficiencies; and: 

* plans and procedures to ensure continuity of operations for 
information systems that support the operations and assets of the 
agency.[Footnote 37] 

Although IRS had begun implementing elements required by FISMA, we 
identified several shortcomings. For example, (1) certain system tests 
and evaluations were insufficient, (2) security awareness training was 
not consistently established across the agency, (3) remedial plans to 
address information security deficiencies were lacking, and (4) 
disaster recovery and business resumption plans for critical systems 
were not completed. IRS has taken actions to improve information 
security management; however, it still needs to take additional steps 
to address all key elements of an information security program. Such a 
program is critical to provide IRS with a solid foundation for 
resolving existing information security problems and continuously 
managing information security risks. 

While IRS has corrected many previously identified information security 
weaknesses, we continued to observe weaknesses identical or very 
similar to those we previously identified, in addition to several new 
ones. Collectively, these problems represent a material weakness in 
IRS's internal controls over information systems and data. 
Specifically, the continuing and newly identified weaknesses increase 
the risk that data processed by IRS's computer systems are not 
reliable. If IRS does not adequately mitigate these weaknesses, 
unauthorized individuals could gain access to critical hardware and 
software, where they may intentionally or inadvertently add, alter, or 
delete sensitive data or computer programs, possibly without being 
detected. These individuals could also obtain personal taxpayer 
information and use it to commit financial crimes using taxpayers' 
names (identity fraud), such as fraudulently establishing credit and 
running up debts. Until IRS successfully manages its information 
security risks, management will not have assurance of the integrity and 
reliability of the information generated from the new financial 
management systems. We will be issuing a separate report on issues we 
identified regarding information security at IRS. 

Reportable Conditions: 

In addition to the material weaknesses discussed above, we identified 
two reportable conditions concerning weaknesses in IRS's internal 
controls over (1) hard-copy tax receipts and taxpayer information and 
(2) P&E, both of which we have reported on in prior audits. 

Hard-Copy Tax Receipts and Taxpayer Information: 

IRS manually processes hundreds of billions of dollars of hard-copy 
taxpayer receipts and related taxpayer information at its service 
center campuses and field offices and at commercial lockbox banks that 
operate under contract with Treasury's Financial Management Service 
(FMS) to provide tax receipt processing services on behalf of IRS. In 
previous audits, we reported that weaknesses in IRS's controls designed 
to safeguard these taxpayer receipts and information increase the risk 
that receipts in the form of checks, cash, and the like, could be 
misappropriated or that the information could be compromised.[Footnote 
38] IRS has continued to take actions to address these weaknesses, such 
as conducting periodic security reviews of receipt processing areas and 
improving its policies and procedures. For example, to enhance security 
over disposal of taxpayer information at lockbox banks, IRS changed its 
policy during fiscal year 2005 to require that the shredding of such 
information be conducted on bank premises rather than at the premises 
of an offsite contractor, as had been common practice. However, during 
our testing in fiscal year 2005, we continued to find that IRS's 
controls over receipts and related hard-copy taxpayer information 
received from taxpayers were inadequate to sufficiently limit the risk 
of theft, loss, or misuse of such funds and information. This condition 
resulted primarily from inconsistencies in the establishment and 
implementation of, and compliance with, policies at IRS service center 
campuses, field offices, and lockbox banks.[Footnote 39] Specifically, 
we found the following: 

* Weaknesses in physical security controls designed to prevent 
unauthorized access to IRS's receipt processing facilities. For 
example, during our audit we observed (1) weaknesses in physical 
safeguards intended to control access to IRS facilities (at one lockbox 
bank and one service center campus) and to the facility itself (at one 
lockbox bank); (2) alarms that were either not working or not working 
properly (at one lockbox bank, one service center campus, and one 
taxpayer assistance center); and (3) security guards who did not 
respond timely to door alarms during our tests (at two service center 
campuses and one lockbox bank). These weaknesses increase the risks 
that the integrity of IRS facilities and the taxpayer receipts and 
information they process may be compromised. 

* Weaknesses in the implementation and execution of procedural 
safeguards and controls designed to account for, control, and protect 
taxpayer receipts and related taxpayer information while they are being 
processed within IRS facilities. For example, during our audit we found 
(1) inadequate segregation of duties in that the tasks of receiving 
payments from taxpayers, logging them in for internal control purposes, 
and preparing documents to record the payments in IRS's records were 
often performed by the same person (at six of the eight taxpayer 
assistance centers we visited);[Footnote 40] (2) inadequate security 
over mail containing taxpayer receipts and related taxpayer information 
and over the security of this information once extracted from the 
envelopes (at four Small Business/Self-Employed groups, three service 
center campuses, two taxpayer assistance centers, and one Tax Exempt/ 
Government Entities group); and (3) weaknesses in controls over access 
to controlled or restricted areas in which taxpayer receipts are 
received and processed (at four taxpayer assistance centers and one 
service center campus). These weaknesses increase the risk that 
taxpayer receipts and information may be compromised during processing 
at IRS facilities. 

* Weaknesses in controls designed to safeguard hard-copy taxpayer 
receipts and related taxpayer information during transport between IRS 
business units and to or from third parties, such as depository 
institutions and post offices. For example, during our audit we found 
internal control weaknesses relating to (1) couriers who physically 
deliver hard-copy taxpayer receipts and related taxpayer information to 
IRS from post offices and between lockbox banks and associated service 
center campuses, and who deliver receipts to depository institutions 
(at three lockbox banks and one service center campus); (2) compiling 
and preparing taxpayer receipts and related taxpayer information for 
shipment to the associated service center campuses (at three taxpayer 
assistance centers); and (3) tracking hard-copy taxpayer receipts and 
related taxpayer information shipped to the service centers for 
processing or archiving, and verifying that they are received by the 
respective service center campuses (at all eight taxpayer assistance 
centers we visited, 18 Small Business/Self Employed groups, four Large 
and Mid-Sized Business groups, and two Tax-Exempt/Government Entities 
groups). These weaknesses increase the risk that taxpayer receipts may 
be lost, misappropriated, or delayed in transit between offices and 
that their loss, misappropriation, or delayed arrival may not be timely 
detected. 

These internal control weaknesses increase IRS's vulnerability to theft 
or loss and expose taxpayers to increased risk of losses from financial 
crimes committed by individuals who inappropriately gain access to 
taxpayer receipts and confidential information entrusted to IRS. While 
IRS has made progress in this area, our findings from our fiscal year 
2005 audit indicate that much more remains to be done to effectively 
address these matters, which are critical to IRS's success in meeting 
its customer service goals. 

During fiscal year 2005, IRS implemented two initiatives to help 
address weaknesses at its lockbox banks and taxpayer assistance 
centers. In conjunction with FMS, IRS developed and implemented a joint 
pilot program of lockbox performance measures aimed at providing 
quantitative measures of performance in, and holding bank management 
more accountable for, among other areas, physical security, courier and 
other personnel security, and internal controls over receipts and 
receipt processing. IRS also implemented a pilot program at the field 
office taxpayer assistance centers with the objective of improving 
internal controls and creating, where feasible, segregation of duties 
over receiving, preparing the posting documents, reviewing, and 
transmitting taxpayer receipts and related taxpayer information to the 
service center campuses. These initiatives, if effectively implemented, 
could improve IRS's controls over hard-copy taxpayer receipts and data 
at these offices in future years. 

Property and Equipment: 

In prior years, we identified significant internal control deficiencies 
that hampered IRS's ability to have reliable and timely information on 
its balance of P&E throughout the year.[Footnote 41] Over the past 
several years, IRS has made substantial progress in addressing internal 
control deficiencies related to its P&E. In fiscal year 2005, we noted 
further improvements in IRS's controls and procedures that enhanced its 
ability to account for P&E. Specifically, IRS improved the timeliness 
of recording P&E activity in its accounting system. However, 
fundamental deficiencies in IRS's financial management system continued 
to exist, which precluded IRS from generating detailed property records 
that reconcile to the financial records. 

Prior to the implementation of the first release of IFS in November 
2004, IRS recorded all property purchases as operating expenses and 
later extracted the costs of property acquisitions from operating 
expenses by recording adjustments to remove property purchases from 
expenses and capitalize them as P&E. IRS performed this analysis and 
updated the P&E accounting records monthly. With implementation of the 
first release of IFS, IRS is now able to record the majority of P&E 
activities as assets at the time of acquisition. However, because of 
funding constraints, IRS deferred indefinitely implementation of a 
property management module of IFS. This module was intended to generate 
detailed property records that reconcile to the financial records. Due 
to uncertainty over implementation of a property management module, IRS 
continues to refine its compensating procedures to address the lack of 
an integrated accounting and property system. However, significant and 
costly efforts are required to perform these compensating procedures. 
For example, IRS must still go through a labor-intensive and time- 
consuming process to link the detailed property records to the 
financial records. In addition, some P&E activity, such as internal use 
software projects, are still initially recorded as expenses and later 
extracted and capitalized as P&E because of the complexity of measuring 
the full costs of the projects.[Footnote 42] An integrated accounting 
and property system would provide management with the ability to 
maintain control over P&E to ensure that assets are properly accounted 
for and safeguarded. 

Compliance Issues: 

Our tests of compliance with selected provisions of laws and 
regulations disclosed one area of noncompliance that is reportable 
under U.S. generally accepted government auditing standards and OMB 
guidance. This area relates to the release of federal tax liens against 
taxpayers' property. We also found that IRS's financial management 
systems do not substantially comply with the requirements of FFMIA. 

Release of Federal Tax Liens: 

The Internal Revenue Code grants IRS the power to file a lien against 
the property of any taxpayer who neglects or refuses to pay all 
assessed federal taxes. The lien becomes effective when it is filed 
with a designated office, such as a courthouse in the county where the 
taxpayer's property is located. The lien serves to protect the interest 
of the federal government and as a public notice to current and 
potential creditors of the government's interest in the taxpayer's 
property. For example, federal tax liens are disclosed in credit 
reports of individuals. Under section 6325 of the Internal Revenue 
Code, IRS is required to release a federal tax lien within 30 days 
after the date the tax liability is satisfied or has become legally 
unenforceable or the Secretary of the Treasury has accepted a bond for 
the assessed tax. 

In each year beginning with our audit of IRS's fiscal year 1999 
financial statements, we found that IRS did not always release the 
applicable federal tax lien within 30 days of the tax liability being 
either paid off or abated, as required by the Internal Revenue 
Code.[Footnote 43] We found that this condition continued to exist in 
fiscal year 2005. Specifically, in our testing of 59 statistically 
selected tax cases with liens in which the taxpayers' total outstanding 
tax liabilities were either paid off or abated during fiscal year 2005, 
we found 13 instances in which IRS did not release the applicable 
federal tax lien within the statutorily mandated 30 days. The time 
between satisfaction of the liability and release of the lien ranged 
from 36 days to 233 days. In 4 cases, the lien still had not been 
released at the time of our review. In 1 of these cases, it had been 
269 days since the taxpayer had fully satisfied the tax liability. 
Based on our work, we estimate that for 22 percent of unpaid tax 
assessment cases in which IRS had filed a tax lien that were resolved 
in fiscal year 2005, IRS did not release the lien within 30 
days.[Footnote 44] 

In at least 5 of the 13 cases in which liens were not released timely, 
the release was delayed because IRS did not properly credit all of the 
taxpayer's outstanding accounts when the taxpayer sent in one payment 
to satisfy the tax liability of multiple tax accounts. Consequently, 
one or more of the taxpayer's accounts remained open even though the 
taxpayer had fully satisfied the total tax liability. This, in turn, 
prevented initiation of the lien release process for these cases. We 
issued a report in January 2005 that discusses other issues that 
contribute to IRS's failure to timely release federal tax liens, along 
with our recommendations to address those issues.[Footnote 45] The 
failure to promptly release tax liens could cause undue hardship and 
burden to taxpayers who are attempting to sell property or apply for 
commercial credit. 

Financial Management Systems' Noncompliance with FFMIA: 

In fiscal year 2005, we continued to find that IRS's financial 
management systems did not substantially comply with the requirements 
of FFMIA. Specifically, IRS's systems did not comply with Federal 
Financial Management System Requirements (FFMSR), applicable federal 
accounting standards (U.S. generally accepted accounting principles), 
and the SGL at the transaction level. We found that IRS (1) cannot rely 
solely on information from its general ledger to prepare its financial 
statements; (2) lacks a subsidiary ledger for its unpaid assessments; 
and (3) lacks an effective audit trail from its general ledger back to 
detailed records and transaction source documents for material 
balances, such as tax revenues and tax refunds. IRS's implementation of 
the first release of IFS represents a major step forward. If fully 
implemented as planned, it has the potential to address many of the 
issues IRS has experienced in the past with its automated financial 
management systems, such as the inability to provide current, reliable 
information for managers' use to support decision making. However, as 
noted earlier in this report, primarily because of funding constraints, 
IRS has put on hold future releases of IFS that were to include 
features essential to IRS's ability to realize the system's full 
potential. Additionally, IRS continues to rely on obsolete legacy 
systems to process tax revenues, tax refunds, and unpaid tax 
assessments. These systems do not interface with IFS, which accounts 
for and reports only IRS's nontax administrative activities. 

This noncompliance with FFMIA ties in with our earlier discussions of 
material weaknesses related to the inability of IRS's financial 
management systems to produce auditable financial statements and 
related disclosures that conform with U.S. generally accepted 
accounting principles without substantial compensating processes and 
significant adjustments. These weaknesses also indicate that IRS's 
systems cannot routinely accumulate and report the full cost of its 
activities. Since IRS's systems do not comply with FFMSR, U.S. 
generally accepted accounting principles, and the SGL, they also do not 
comply with OMB Circular No. A-127, Financial Management Systems 
(revised July 23, 1993). In its FIA assurance statement to Treasury, 
IRS reported that its financial management systems did not 
substantially comply with the requirements of FFMIA in fiscal year 
2005. 

IRS has established a remediation plan to address the conditions 
affecting its systems' ability to comply substantially with the 
requirements of FFMIA. This plan outlines the actions to be taken to 
resolve these issues, but future corrective actions are on hold and are 
currently unfunded. Due to the long-term nature of IRS's systems 
modernization efforts, which IRS expects will resolve many of the most 
serious issues, many of the planned time frames exceed the 3-year 
resolution period specified in FFMIA. However, for these instances IRS 
has received a waiver from this requirement from OMB, as authorized by 
FFMIA. 

[End of section] 

Appendix II: Details on Audit Methodology: 

To fulfill our responsibilities as the auditor of the Internal Revenue 
Service's (IRS) financial statements, we did the following: 

* Examined, on a test basis, evidence supporting the amounts and 
disclosures in the financial statements. This included selecting 
statistical samples of unpaid assessment, revenue, refund, accrued 
expenses, payroll, nonpayroll, property and equipment, accounts 
payable, and undelivered order transactions. These statistical samples 
were selected primarily to substantiate balances and activities 
reported in IRS's financial statements. Consequently, dollar errors or 
amounts can and have been statistically projected to the population of 
transactions from which they were selected. In testing these samples, 
certain attributes were identified that indicated either significant 
deficiencies in the design or operation of internal control or 
compliance with provisions of laws and regulations. These attributes, 
where applicable, can be and have been statistically projected to the 
appropriate populations. 

* Assessed the accounting principles used and significant estimates 
made by management. 

* Evaluated the overall presentation of the financial statements. 

* Obtained an understanding of internal controls related to financial 
reporting (including safeguarding assets), compliance with laws and 
regulations (including the execution of transactions in accordance with 
budget authority), and performance measures reported in the Management 
Discussion and Analysis. 

* Tested relevant internal controls over financial reporting (including 
safeguarding assets) and compliance, and evaluated the design and 
operating effectiveness of internal controls. 

* Considered the process for evaluating and reporting on internal 
controls and financial management systems under 31 U.S.C. § 3512 (c), 
(d), commonly referred to as the Federal Managers' Financial Integrity 
Act of 1982. 

* Tested compliance with selected provisions of the following laws and 
regulations: Anti-Deficiency Act, as amended (31 U.S.C. § 1341(a)(1) 
and 31 U.S.C. § 1517(a)); Purpose Statute (31 U.S.C. § 1301); Release 
of lien or discharge of property (26 U.S.C. § 6325); Interest on 
underpayment, nonpayment, or extensions of time for payment of tax (26 
U.S.C. § 6601); Interest on overpayments (26 U.S.C. § 6611); 
Determination of rate of interest (26 U.S.C. § 6621); Failure to file 
tax return or to pay tax (26 U.S.C. § 6651); Failure by individual to 
pay estimated income tax (26 U.S.C. § 6654); Failure by corporation to 
pay estimated income tax (26 U.S.C. § 6655); Prompt Payment Act (31 
U.S.C. § 3902(a), (b), and (f) and 31 U.S.C. § 3904); Pay and Allowance 
System for Civilian Employees (5 U.S.C. §§ 5332 and 5343, and 29 U.S.C. 
§ 206); Federal Employees' Retirement System Act of 1986, as amended (5 
U.S.C. §§ 8422, 8423, and 8432); Social Security Act, as amended (26 
U.S.C. §§ 3101 and 3121 and 42 U.S.C. § 430); Federal Employees Health 
Benefits Act of 1959, as amended (5 U.S.C. §§ 8905, 8906, and 8909); 
Transportation, Treasury, and Independent Agencies Appropriations Act, 
2004, Pub. L. No. 108-199, div. F, tit. II, 118 Stat. 314 (Jan. 23, 
2004); and Transportation, Treasury, Independent Agencies, and General 
Government Appropriations Act, 2005, Pub. L. No. 108-447, div. H, tit. 
II, 118 Stat. 3235 (Dec. 8, 2004). 

* Tested whether IRS's financial management systems substantially 
comply with the three requirements of the Federal Financial Management 
Improvement Act of 1996 (Pub. L. No. 104-208, div. A, § 101(f), title 
VIII, 110 Stat. 3009, 3009-389 (Sept. 30, 1996). 

[End of section] 

Appendix III: Comments from the Internal Revenue Service: 

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

DEPUTY COMMISSIONER: 

November 7, 2005: 

Mr. David M. Walker: 
Comptroller General: 
U.S. Government Accountability Office: 
441 G Street, N.W.
Washington, D.C. 20548: 

Dear Mr. Walker: 

Thank you for the opportunity to review and comment on your draft 
report titled, Financial Audit. IRS' Fiscal Years 2005 and 2004 
Financial Statements. We agree that your report fairly presents our 
financial progress and our remaining management and systems challenges. 
We are pleased that your report recognizes that the IRS continues to 
make great strides in addressing financial management, and our 
dedication to improvement has earned the IRS an unqualified opinion on 
our combined financial statements for a sixth consecutive year. This is 
an extremely satisfying achievement for the IRS this year because we 
accomplished this while deploying a new internal core financial 
management system. Our record clearly demonstrates to our stakeholders 
that the Service can consistently account for the approximately $2.3 
trillion in revenue receipts, $267 billion in refunds, and $11 billion 
in appropriated funds. 

We appreciate your recognition of our efforts in successfully deploying 
the Integrated Financial System (IFS) this year. The initial release of 
IFS provides capability for general ledger management, budget 
execution, budget formulation, accounts payable, accounts receivable, 
cost management, and financial and tax reporting. IFS enhances the 
accuracy, timeliness, and availability of data. It reduces 
reconciliation and produces subsidiary ledgers with audit trails to the 
transaction level. We recognize this first phase of IFS is the 
cornerstone for building a fully integrated financial management system 
and agree that additional enhancements will be required to meet all our 
financial management objectives. 

We recognize that we need to continue to address identified problems 
and focus on our modernization efforts. Our commitment to enhance our 
financial management is demonstrated by the numerous improvements that 
we have undertaken over the years. During fiscal year (FY) 2005, we 
instituted a number of financial management reforms and improvements: 

Implemented a crosswalk to convert the Interim Revenue Accounting 
Control System trial balance accounts into the United States Standard 
General Ledger compliant account format, 

* Implemented statistical projections to calculate taxes receivable on 
a monthly basis, and reported these balances on our interim financial 
statements, 

* Developed an alternative to the Custodial Accounting Project to 
remediate the custodial financial weaknesses over the next several 
years, 

* Centralized all Small Business/Self Employed Automated Trust Fund 
Recovery work in September 2005 to two campuses to improve efficiency 
and reduce TFRP assessment errors by improving the cross-referencing 
and posting of the payments process, 

* Increased the functionality in the Customer Account Data Engine to 
post accounts on a daily basis resulting in faster refunds, and to 
accept Form 1040EZ tax returns with address changes, and to detect 
fraudulent returns and unpostable conditions, 

* Developed Security and Internal Control Performance Measures for 
physical security, courier, personal security, and internal controls 
over receipts and receipt processing at Lockboxes. 

We agree with the Government Accountability Office's (GAO) findings and 
opinions related to information security. We have developed an action 
plan to address deficiencies in access controls, rules of behavior, 
contingency planning and disaster recovery, audit trails, training, and 
certification and accreditation. We have also made progress in 
correcting many of the issues identified during the audit. Because of 
its importance, improving information security will continue to be a 
priority for the IRS. 

I appreciate GAO's acknowledgement of our significant improvements over 
the last several years. We wish to recognize GAO's dedication and 
professionalism throughout this year's audit process, especially as our 
staffs and executives worked to meet the requirements of the audit 
process during the first year operation of our new financial system. We 
thank you for your support of our efforts, your excellent counsel, and 
your willingness to work with us to promote the highest standard of 
financial management in the IRS. 

In closing, while challenges remain, I believe the IRS has demonstrated 
its ability to consistently produce accurate and reliable financial 
statements. We have a deep and continuing commitment to improving 
financial management and will aggressively pursue appropriate actions 
to improve processes and systems. 

Sincerely, 

Signed by: 

John M. Dalrymple: 

[End of section] 

(196031): 

FOOTNOTES 

[1] GAO, High-Risk Series: An Overview, GAO/HR-95-1 (Washington, D.C.: 
February 1995). 

[2] GAO, High-Risk Series: An Update, GAO-05-207 (Washington, D.C.: 
January 2005). 

[3] GAO-05-207. 

[4] CFO Act of 1990, Pub. L. No. 101-576, 104 Stat. 2838 (Nov. 15, 
1990); Government Management Reform Act of 1994, Pub. L. No. 103-356, 
108 Stat. 3410 (Oct. 13, 1994). 

[5] IRS includes an estimate of the tax gap in the tax gap disclosures 
contained in the other accompanying information to the financial 
statements. This estimate is based on a recently completed study by IRS 
on the rate of compliance with the tax laws by individuals and some 
small business taxpayers. IRS is exploring approaches to developing 
compliance estimates for other groups of taxpayers. 

[6] Tax expenditures are revenue losses--the amount of revenue that the 
government forgoes--resulting from federal tax provisions that grant 
special tax relief for certain kinds of behavior by taxpayers or for 
taxpayers in special circumstances. Under U.S. generally accepted 
accounting principles, tax expenditure amounts are not required to be 
disclosed as part of federal agencies' financial statements, but 
certain information on tax expenditures can be included as other 
accompanying information to the financial statements. 

[7] GAO, Financial Audit: Examination of IRS' Fiscal Year 1992 
Financial Statements, GAO/AIMD-93-2 (Washington, D.C.: June 30, 1993). 

[8] Reportable conditions are matters coming to our attention that, in 
our judgment, should be communicated because they represent significant 
deficiencies in the design or operation of internal controls that could 
adversely affect IRS's ability to meet the objectives described in this 
report. 

[9] A material weakness is a reportable condition that precludes the 
entity's internal controls from providing reasonable assurance that 
material misstatements in the financial statements would be prevented 
or detected on a timely basis. 

[10] IRS's master files contain detailed records of taxpayer accounts. 

[11] A reexamination of internal control requirements for financial 
reporting by federal agencies was initiated in light of the new 
internal control requirements for publicly traded companies contained 
in the Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 
(July 30, 2002). On December 21, 2004, OMB issued a revision of 
Circular No. A-123, Management's Responsibility for Internal Control, 
which will become effective in fiscal year 2006. In the interim, OMB 
has instructed federal agencies to continue to follow the 1995 
revision. 

[12] This number does not include open recommendations related to 
information security. These recommendations, because of their sensitive 
nature, are contained in a series of Limited Official Use Only reports 
that we have issued to IRS over the past several years. 

[13] Pub. L. No. 104-208, div. A, § 101(f), title VIII, 110 Stat. 3009, 
3009-389 (Sept. 30, 1996). 

[14] Pub. L. No. 103-62, § 4(b), 107 Stat. 285, 287 (Aug. 3, 1993) 
(codified at 31 U.S.C. § 1115). 

[15] GAO, Financial Audit: IRS's Fiscal Years 2004 and 2003 Financial 
Statements, GAO-05-103 (Washington, D.C.: Nov. 10, 2004). 

[16] GAO-05-103. 

[17] JFMIP, Core Financial System Requirements, JFMIP-SR-02-01 
(Washington, D.C.: November 2001). JFMIP was originally formed under 
the authority of the Budget and Accounting Procedures Act of 1950 as a 
cooperative undertaking of the Office of Management and Budget (OMB), 
the Department of the Treasury, the Office of Personnel Management, 
GAO, and operating agencies to improve financial management practices 
in the federal government. On December 1, 2004, JFMIP ceased to exist 
as a separate organization, with OMB's Office of Federal Financial 
Management assuming many JFMIP functions. 

[18] IRS is also in the process of implementing the Customer Account 
Data Engine (CADE). CADE is intended to ultimately replace the legacy 
master file, which is the database of taxpayer account information. 
However, during fiscal year 2005, CADE was still in the early stages of 
implementation and processed less than $1 billion in refunds related to 
simple individual returns. IRS does not have detailed plans or 
schedules for completion of this project, and it is unclear when it 
will be fully implemented. 

[19] At the end of each fiscal year, IRS uses statistical sampling 
techniques to estimate the portion of its total balance of unpaid 
assessments that should be classified as compliance assessments, write- 
offs, and taxes receivable, and to estimate the portion of the taxes 
receivable balance that is likely to be collectible. Throughout the 
following year, the resultant rates derived through the sampling 
process are applied monthly to the total unpaid assessment balance to 
update these amounts for reporting purposes. 

[20] The Transportation Equity Act for the 21ST Century, Pub. L. No. 
105-178, 112 Stat. 107 (June 9, 1998), enhanced the link between the 
amount of funds received by states and the amount of tax receipts 
credited to the Highway Trust Fund by requiring that highway program 
funds be distributed to states on the basis of annual highway account 
receipts. 

[21] In implementing the American Jobs Creation Act of 2004, IRS issued 
guidance providing a one-time filing extension of 1 month for tax 
returns affecting the Highway Trust Fund and the Airport and Airway 
Trust Fund for the quarter ended March 31, 2005. See I.R.S. Notice 2005-
4, § 4(i), 2005-2 I.R.B. 296-97 (Jan. 10, 2005); see also Pub. L. No. 
108-357, § 853, 118 Stat. 1418, 1609 (Oct. 22, 2004). Therefore, the 
quarter ended March 31, 2005, was not included in our comparison. 

[22] Joint Financial Management Improvement Program, System 
Requirements for Managerial Cost Accounting (Washington, D.C.: February 
1998). 

[23] Unpaid assessments consist of (1) federal taxes receivable, which 
are taxes due from taxpayers for which IRS can support the existence of 
a receivable through taxpayer agreement or a favorable court ruling; 
(2) compliance assessments where neither the taxpayer nor the court has 
affirmed that the amounts are owed; and (3) write-offs, which represent 
unpaid assessments for which IRS does not expect further collections 
due to factors such as the taxpayer's death, bankruptcy, or insolvency. 
Of these three classifications of unpaid assessments, only federal 
taxes receivable are reported on the principal financial statements. 

[24] IRS's master files contain detailed records of taxpayer accounts. 
However, the master files do not contain all the details necessary to 
properly classify or estimate collectibility for unpaid assessment 
accounts. 

[25] Abatements are reductions to taxpayers' tax liabilities that can 
either result in reducing or eliminating a taxpayer's outstanding tax 
liability and, in some cases, may generate a refund to the taxpayer. 
IRS is authorized to abate assessments under certain conditions. For 
example, section 6404 of the Internal Revenue Code authorizes IRS to 
abate erroneous assessments, which can be caused by either IRS or 
taxpayer error. 

[26] GAO-05-103. 

[27] When a company does not pay the taxes it withholds from employees' 
wages, such as Social Security or individual income tax withholdings, 
IRS has the authority to assess all responsible officers individually 
for the taxes withheld from employees. Although assessed to multiple 
parties, the liability need only be paid once. Thus, IRS may record 
assessments against each of several individuals for the employee- 
withholding component of the payroll tax liability of a given business 
in an effort to collect the total tax liability of the business. The 
assessments made against business officers are known as trust fund 
recovery penalties. 

[28] A tax period is the period over which the tax liability was 
created. For payroll taxes, this period is typically a calendar 
quarter. 

[29] We are 95 percent confident that the error rate does not exceed 
14.3 percent. 

[30] IRS 1099 forms are used by third parties, such as financial 
institutions, to report taxpayers' interest income, dividend 
distributions, and other miscellaneous income. 

[31] The tax filing season for individuals primarily occurs from 
January 1 through April 15 of each year. 

[32] By statute, IRS must pay interest on refunds not paid within 45 
days of receipt or due date, whichever is later (26 U.S.C. § 6611). 

[33] Because it is a refundable tax credit, an EITC claim always 
results in a reduction of the taxpayer's calculated tax liability. 
However, depending on the taxpayer's amount of taxes withheld, and the 
amount of tax due on the taxpayer's return before application of any 
credits, it may or may not result in a refund for a particular tax 
year. 

[34] Pub. L. No. 107-300, 116 Stat. 2350 (Nov. 26, 2002). IPIA requires 
the head of each federal agency to annually review all programs and 
activities the federal agency administers to identify those that may be 
susceptible to significant improper payments and to estimate the amount 
of improper payments in those susceptible programs in accordance with 
guidance prescribed by OMB. Agencies are required to submit these 
estimates to Congress before March 31 of the following applicable year. 
OMB, Implementation Guidance for the Improper Payments Implementation 
Act of 2002, P. L. 107-300, M-03-13 (Washington, D.C.: May 21, 2003). 

[35] Tax year 2003 is the most recent year for which complete matching 
program results are available. 

[36] FISMA was enacted as title III of the E-Government Act of 2002, 
Pub. L. No. 107-347, 116 Stat. 2946 (Dec. 17, 2002). 

[37] See 44 U.S.C. § 3544. 

[38] GAO, Internal Revenue Service: Status of Recommendations from 
Financial Audits and Related Financial Management Reports, GAO-05-393 
(Washington, D.C.: Apr. 29, 2005); Management Report: Improvements 
Needed in IRS's Internal Controls, GAO-05-247R (Washington, D.C.: Apr. 
27, 2005); IRS Lockbox Banks: More Effective Oversight, Stronger 
Controls, and Further Study of Costs and Benefits Are Needed, GAO-03- 
299 (Washington, D.C.: Jan. 15, 2003); Financial Audit: IRS's Fiscal 
Years 2002 and 2001 Financial Statements, GAO-03-243 (Washington, D.C.: 
Nov. 15, 2002); and Internal Revenue Service: Progress Made, but 
Further Actions Needed to Improve Financial Management, GAO-02-35 
(Washington, D.C.: Oct. 19, 2001). 

[39] IRS's field office structure includes service center campuses, 
which process tax returns and payments submitted by taxpayers and 
deposit tax payments in depository institutions; taxpayer assistance 
centers, which accept payments from and provide assistance directly to 
taxpayers; and other business operating divisions that provide taxpayer 
audit and assistance services. These other business operating divisions 
are organized along the following business lines: Large and Mid-Size 
Businesses, Small-Business/Self-Employed, and Tax Exempt/Government 
Entities. In addition, commercial lockbox banks operate under contract 
with FMS to provide tax receipt processing services on behalf of IRS. 

[40] Many taxpayer assistance centers are operated at times by only one 
IRS employee, or tasks are performed by Revenue Agents or Officers 
working away from the field office. In these situations, segregation of 
these duties is problematic. IRS recognized these situations and is 
considering potential solutions. 

[41] GAO-05-103. 

[42] For internal use software, capitalized costs include direct costs, 
such as salaries of IRS employees assigned to the project and 
contractor fees, and indirect costs, such as overhead incurred during 
the development phase. The development phase includes developing the 
software configuration and interfaces, coding, installing the software 
to the hardware, and testing. 

[43] GAO-05-103. 

[44] We are 95 percent confident that the percentage of cases in which 
the lien was not released within 30 days does not exceed 33 percent. 

[45] GAO, Opportunities to Improve Timeliness of IRS Lien Releases, GAO-
05-26R (Washington, D.C.: Jan. 10, 2005). 

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