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Report to the Secretary of the Treasury: 

November 2006: 

Financial Audit: 

IRS's Fiscal Years 2006 and 2005 Financial Statements: 

GAO-07-136: 

GAO Highlights: 

Highlights of GAO-07-136, a report to the Secretary of the Treasury 

Why GAO Did This Study: 

Because of the significance of Internal Revenue Service (IRS) 
collections to overall 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 are reliable and (2) IRS 
management maintained effective internal controls. GAO also tests IRS’s 
compliance with selected provisions of significant laws and regulations 
and its financial systems’ compliance with the Federal Financial 
Management Improvement Act of 1996 (FFMIA). 

What GAO Found: 

In GAO’s opinion, IRS’s fiscal years 2006 and 2005 financial statements 
are fairly presented in all material respects. Because of serious 
internal control and financial management systems deficiencies, IRS 
again had to rely extensively on resource-intensive compensating 
processes to prepare its financial statements. Because of 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. IRS made significant progress in 
developing its cost accounting module, which was part of the first 
phase of the Integrated Financial System (IFS), implemented in fiscal 
year 2005. IRS also improved the reliability of its property and 
equipment records, and we no longer consider this issue to be a 
reportable condition. However, because of budgetary concerns and 
advances in automated financial management system technologies, IRS is 
no longer committed to the future releases of IFS that were once 
intended to resolve many of its most serious financial management 
issues, and is currently considering alternatives. IRS has not yet 
committed to an alternative approach nor has funding been appropriated. 
Additionally, IRS has not determined how to resolve issues related to 
the lack of integration between IFS and its tax processing systems. 
Consequently, it is unclear how or when these issues will be resolved. 
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. Although IRS continued to make progress in 
addressing weaknesses in controls over hard-copy taxpayer receipts and 
data, GAO concluded that remaining issues related to this activity 
constituted a reportable condition. In addition, IRS was not always in 
compliance with a law concerning the timely release of tax liens. 

IRS management faces serious challenges from its continued use of 
obsolete financial management systems that do not substantially comply 
with FFMIA requirements. These challenges adversely affect IRS’s 
ability to fulfill its responsibilities as the nation’s tax collector 
because it is unable to obtain comprehensive, timely, accurate, and 
useful information for day-to-day decision making. Solving IRS’s 
financial management problems depends largely on the ultimate success 
of IRS’s ongoing systems modernization efforts. 

What GAO Recommends: 

In prior audits, GAO made numerous recommendations to IRS to address 
issues comprising the material weaknesses and reportable condition and 
compliance matters that persisted during fiscal year 2006. GAO will 
continue to monitor IRS’s progress in implementing the 72 
recommendations that remain open as of the date of this report. IRS 
agreed with the report's findings and that it fairly presents IRS’s 
progress and challenges. IRS said it had made significant progress in 
addressing financial management issues and noted that it had a strong 
management team to continue improving financial management with an 
increased focus on internal controls and information security. 

[Hyperlink, http://www.gao.gov/cgi-bin.getrpt?GAO-07-136]. 

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: 

Other Accompanying Information: 

Appendixes: 

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

Material Weaknesses: 

Reportable Condition: 

Compliance Issues: 

Appendix II:   Details on Audit Methodology: 

Appendix III:  Comments from the Internal Revenue Service: 

Abbreviations: 

CADE: Customer Account Data Engine: 

CDDB: Custodial Detailed Database: 

CFO: chief financial officer: 

EFDS: Electronic Fraud Detection System: 

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: 

IFS: Integrated Financial System: 

IPIA: Improper Payments Information Act of 2002: 

IRS: Internal Revenue Service: 

JFMIP: Joint Financial Management Improvement Program: 

OMB: Office of Management and Budget: 

P&E: property and equipment: 

PAR: performance and accountability report: 

SGL: U.S. Government Standard General Ledger: 

November 9, 2006: 

The Honorable Henry M. Paulson, Jr. 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, 2006 and 2005. 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, 2006, 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 2006 and 2005 financial 
statements were made possible in part 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, it is unclear when this effort will be 
completed or if it will be successful. In the interim, 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 
seventh consecutive year, IRS has received an unqualified opinion on 
its financial statements and, for the fifth consecutive year, the audit 
was completed and the report issued by November 15. 

IRS has made great strides over the last several years in addressing 
its financial management challenges and has resolved or substantially 
mitigated several material weaknesses and other reportable conditions 
in its internal controls. For example, during fiscal year 2006, IRS 
improved the accuracy and reliability of its property and equipment 
(P&E) accounting records by making enhancements to accounting code 
definitions that make it easier for users to select the proper 
accounting codes for recording a transaction, improving coordination 
among units involved in processing P&E activity, and streamlining its 
analysis of P&E transactions most susceptible to misclassification. 
These improvements, combined with progress we reported last year, 
enabled us to conclude that remaining issues related to P&E no longer 
constitute a reportable condition. 

During fiscal year 2006, IRS continued to expand its use of the 
capabilities contained in the first phase, or release, of its 
Integrated Financial System (IFS), which was implemented in fiscal year 
2005. For example, IRS has populated the system's cost module with 2 
years of data and made significant progress in defining how costs will 
be allocated to various internal organizations, and it has successfully 
used IFS to generate its statement of net cost for the first time. This 
release 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, IRS cannot fully address the financial management issues 
caused by the limitations of its automated systems without successful 
implementation of the additional capabilities that were originally 
planned to be provided by future releases of IFS, such as procurement 
and workload management. Because of ongoing technological advances and 
budgetary constraints, IRS is no longer committed to implementing 
additional releases of IFS, but rather is considering other options 
available to provide these capabilities, including utilizing a private 
shared service provider or a federal center of excellence.[Footnote 1] 
However, IRS has not decided what approach it will take or obtained 
approval for the necessary funding. It is therefore unclear how or when 
IRS will resolve the remaining related financial management systems 
limitations. In formulating its strategy for dealing with these issues, 
IRS will also need to address how IFS will ultimately be integrated 
with the systems that support financial management of its tax 
administration functions as well as addressing the limitations of those 
systems if it is to fully resolve many of its long-standing financial 
management challenges. 

To resolve these problems, IRS is depending on its ongoing systems 
modernization effort, which is intended to address the full range of 
problems caused by its outdated legacy information systems. In 1995, we 
designated financial management and systems modernization at IRS as 
high-risk areas.[Footnote 2] We continue to consider these issues as 
high risk and include them in our Business Systems Modernization high- 
risk area.[Footnote 3] 

Among the most serious financial management issues still remaining to 
be addressed is the continued material weakness in IRS's information 
security. 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. 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 10 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 4] As 
we have previously reported, 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 continues to face 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 has completed a study of the rate of compliance with the 
nation's tax laws by individuals and some small business taxpayers, and 
has begun a study of S-corporations' compliance.[Footnote 5] However, 
IRS has no approved plans to repeat its study on individual taxpayers, 
or to conduct research on other significant components of the tax 
gap.[Footnote 6] As we have noted before, 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; Subcommittee on Taxation and IRS Oversight, 
Senate Committee on Finance; House Committee on Appropriations; House 
Committee on Ways and Means; and House Committee on Government Reform. 
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 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: 

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 7] 
this report presents the results of our audits of the financial 
statements of the Internal Revenue Service (IRS) for fiscal years 2006 
and 2005. The financial statements report the assets, liabilities, net 
position, net costs, changes in net position, budgetary resources, 
financing, 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 paid by 
taxpayers, often referred to as the tax gap,[Footnote 8] nor do they 
include information on tax expenditures.[Footnote 9] 

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, 3 
computing centers, and numerous other field offices throughout the 
United States. In fiscal years 2006 and 2005, IRS collected about $2.5 
trillion and $2.3 trillion, respectively, in tax payments; processed 
hundreds of millions of tax and information returns; and paid about 
$277 billion and $267 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, which is a primary 
objective of the CFO Act. While progress continues to be made to 
modernize its financial management capabilities, IRS nonetheless 
confronted 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 10] though it continued to 
make strides in addressing its financial management challenges. In 
fiscal year 2006, for the seventh 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 fifth 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. However, until its systems are 
replaced, IRS will continue to be challenged to sustain the level of 
effort needed to produce reliable financial statements timely. 

Throughout fiscal year 2006, IRS continued to make significant progress 
in its efforts to address its weaknesses in controls over several 
areas, including accountability over property and equipment (P&E), 
management and reporting of unpaid assessments, reliability of 
financial reporting, and security over hard-copy taxpayer receipts and 
data. For example, IRS improved the accuracy and reliability of its P&E 
accounting records by (1) enhancing the accounting code definitions in 
its new financial management system to make it easier for users to 
select the proper accounting codes for recording transactions, (2) 
improving coordination among units involved in processing P&E activity, 
and (3) streamlining its analysis of P&E transactions most susceptible 
to misclassification. These improvements, combined with the progress 
reported in our prior year audit, enabled us to conclude that remaining 
issues related to P&E no longer constitute a reportable 
condition.[Footnote 11] 

IRS also successfully implemented the first phase of the Custodial 
Detailed Database (CDDB), which is intended to ultimately serve as a 
link between IRS's master files[Footnote 12] and its general ledger for 
tax administration activities. The first phase contains programs to 
analyze and classify for financial reporting purposes related taxpayer 
accounts associated with unpaid payroll taxes.[Footnote 13] Although 
IRS's use of CDDB in fiscal year 2006 improved its process for deriving 
estimates of its various unpaid assessment categories, IRS continues to 
lack a subsidiary ledger for unpaid assessments and must still use a 
labor-intensive manual compensating process to estimate the year-end 
balances of those various unpaid assessment categories for external 
reporting. Full operational capability of CDDB is several years away 
and depends on the successful implementation of future system releases. 
Additionally, CDDB continues to rely on IRS's master files for the 
information it contains. 

During fiscal year 2006, IRS continued to expand processing of the less 
complex individual tax returns through its Customer Account Data Engine 
(CADE), the system being implemented to replace IRS's master files. In 
its fiscal year 2006 Management Discussion and Analysis, IRS reported 
that during the fiscal year 2006 tax filing season,[Footnote 14] CADE 
processed over 7.3 million individual returns and over $3.4 billion in 
refunds. This represents an increase of nearly 6 million returns and $3 
billion in refunds processed by CADE compared to the same period last 
year. However, IRS's detailed plans for completion of the CADE project 
only extend through release 7, which is intended to replace the master 
file for individual tax returns.[Footnote 15] However, these plans do 
not include plans or schedules for additional CADE release(s) to 
replace the master file for business tax returns, and it is unclear 
when CADE will be fully implemented. 

IRS also improved its financial reporting capabilities in fiscal year 
2006 through expanded use of the capabilities of the Integrated 
Financial System (IFS), the first release of which was implemented in 
fiscal year 2005. IFS was originally intended to resolve many of the 
issues discussed in this report and replace the outdated financial 
management system IRS used previously to process and report 
administrative transactions, such as procurement and utilization of 
budgetary resources. During fiscal year 2006, IRS improved its 
financial reporting capabilities by populating the cost accounting 
module of IFS with another year of cost data, and by establishing a new 
cost allocation methodology to take advantage of the system's cost 
allocation capacity and defining how those costs will be allocated to 
various IRS units. However, opportunities for further improvement in 
IRS's financial reporting in the near term will be limited as IRS is 
not committed to future releases of IFS and is currently reevaluating 
its approach to achieving the objectives originally envisioned through 
implementation of these additional releases. IRS has not decided what 
approach it will take or obtained approval for the related funding 
necessary to bring it to fruition. In addition, IRS has not addressed 
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. It is therefore unclear how or when IRS will resolve its 
remaining related financial management systems limitations. 

While notable improvements were made throughout fiscal year 2006, 
control deficiencies over financial reporting, management of unpaid 
assessments, and collection of revenue and issuance of tax refunds 
continued to represent material weaknesses.[Footnote 16] These 
weaknesses are caused primarily by IRS's continued reliance on outdated 
automated systems to provide the financial information that management 
needs to make decisions, and similar weaknesses and problems will 
continue to exist until its systems are replaced. 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. Additionally, while we continued to note significant 
improvement, we still consider control deficiencies in physical 
security over taxpayer receipts and data to be a reportable condition 
requiring further attention by IRS management. 

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, 
financing, and custodial activity as of, and for the fiscal years 
ended, September 30, 2006, and September 30, 2005. 

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 and the 
taxpayers 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's Responsibility for Internal Control. 

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 2006 and 2005. 
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 
one reportable condition, which, although not a material weakness, 
represents a significant deficiency 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. This condition 
involves deficiencies in 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. 

We have reported on these material weaknesses and the reportable 
condition in prior audits and have provided IRS recommendations to 
address these issues. Seventy-two of these recommendations were still 
open as of the date of this report.[Footnote 17] 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. 

As part of our fiscal year 2006 financial audit, we evaluated IRS's 
implementation of OMB's revised Circular No. A-123, Management's 
Responsibility for Internal Control, which became effective on October 
1, 2005. Circular No. A-123 provides updated internal control standards 
and new requirements for the 24 major executive branch departments and 
agencies to follow in conducting management's assessment of the 
effectiveness of internal control over financial reporting. Based on 
this assessment, agency management is required to prepare an assurance 
statement on the effectiveness of internal controls over financial 
reporting to be included in the agency's performance and accountability 
report (PAR). These requirements are applicable to the 24 CFO Act 
agencies, including the Department of the Treasury (Treasury), of which 
IRS is a significant component. The objective of our review was to 
determine whether IRS appropriately planned and implemented the 
requirements of OMB Circular No. A-123, and to verify that IRS 
performed sufficient work to support its related assurance statement to 
Treasury, upon which Treasury would rely as a basis for its own 
assurance statement to be included in its fiscal year 2006 PAR. We 
found that IRS's assurance statement was adequately supported by the 
underlying work and appropriately reflected the state of its internal 
controls. However, we did identify opportunities for improvement in the 
execution and documentation of this work that we communicated to IRS 
during the course of the audit and that we will be reporting on 
separately. 

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.[Footnote 18] 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 19] 

For more details on these issues, see appendix I. 

Consistency of Other Information: 

IRS's Management Discussion and Analysis and required supplemental and 
other accompanying 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 20] 

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, 2006 and 
2005. 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 its financial management progress and remaining management and 
systems challenges. IRS noted its significant accomplishments in 
addressing financial management issues while also successfully 
implementing Appendix A of the revised OMB Circular No. A-123, 
Management's Responsibility for Internal Control. IRS affirmed its 
dedication to continuing to improve its financial management, and noted 
significant achievements including: (1) improvements in accountability 
over property and equipment that enabled us to eliminate it as a 
reportable condition through implementation of a first level 
procurement review, revision of material group codes, and 
implementation of a materiality threshold for capital asset review, (2) 
significant reductions in the numbers of matters for further 
consideration related to both safeguarding of taxpayer receipts and 
controls over administrative accounts, (3) acceleration of the 
quarterly excise tax certifications to the Department of the Treasury 
by 2 months, and (4) improvements to its cost allocation methodology 
and use of Integrated Financial System to generate its statement of net 
cost for fiscal year 2006. 

IRS also agreed with our findings concerning information security, and 
indicated that it is improving protection of sensitive information by 
expanding the use of encryption, increasing employee education and 
awareness, and improving IRS information security policies and 
procedures to ensure protection of taxpayer, employee, and IRS 
sensitive information. IRS also noted that it has established a 
Security Services and Privacy Executive Steering Committee to 
coordinate information security improvements and to leverage subject 
matter experts from the areas of information technology security, 
physical security, and privacy and identify theft. In addition, IRS 
recognized that while challenges remain, it has established its ability 
to consistently produce reliable financial statements, and believes it 
has a solid management team in place to continue to improve financial 
management. 

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, 2006: 

[End of section] 

Management Discussion and Analysis: 

Internal Revenue Service: 
Management Discussion and Analysis: 
For the fiscal year ended September 30, 2006: 

I.  Introduction

The Internal Revenue Service (IRS) administers America’s tax laws and 
collects the revenues that fund government operations and public 
services.  The IRS’ Taxpayer Service and Enforcement programs generate 
more than 96 percent of the total federal revenue collected for the 
United States Government.  In Fiscal Year (FY) 2006, the IRS collected 
more than $2.5 trillion in revenue, an 11 percent increase from FY 
2005. 

The IRS annually processes over 220 million tax returns and over 1.3 
billion information items related to tax returns, such as W-2s and 
1099s.  The IRS provides a wide range of taxpayer assistance through 
the internet, telephone service, and Taxpayer Assistance Centers, 
making it easier for taxpayers to fulfill their tax obligations.  The 
IRS continues to pursue opportunities to improve service to the 
taxpayer by simplifying tax filing processes and expanding options for 
electronic filing and payment. 

Of the more than $2.5 trillion the IRS collected during FY 2006, $48.7 
billion was collected through enforcement activities including 
individual and small business audits, collection contacts, corporate 
audits, settlement initiatives aimed at deterring the use of abusive 
tax shelters, and criminal prosecutions.  Over the past decade, the IRS 
has steadily improved its performance by refining its workload 
selection criteria, implementing streamlined and centralized work 
processes, increasing managerial involvement in casework, and reducing 
the time it takes from “start to finish” for its key examination and 
collection activities. 

The IRS’ mission, to “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,” is best 
demonstrated in the level of commitment and professionalism exhibited 
by the 100,000+ employees comprising the IRS workforce.  The IRS was 
one of six federal agencies featured in Business Week magazine’s “50 
Best Places to Launch a Career” report (September 2006), and IRS 
retention rates were highlighted as being among the best in the 
country.  

In June 2004, the IRS published its Strategic Plan for FYs 2005 through 
2009.  The Strategic Plan is a roadmap that reflects the priorities and 
direction of the IRS, setting its course for achieving measurable 
results that reduce the tax gap and balance service and enforcement.  
The FY 2006 performance summary and results sections in this document 
link to the Strategic Plan goals and objectives, and highlight the 
quantifiable performance measures and results the IRS uses to gauge its 
performance.  

In FY 2006, the IRS made significant progress in achieving its three 
strategic goals:  improving taxpayer service; enhancing enforcement of 
the tax law; and modernizing the IRS through its people, processes, and 
technology.  The following chart presents the portion of the IRS’ FY 
2006 budget used to fund programs that fulfill the IRS’ three strategic 
goals:

Figure: How the IRS used its resources?: 

[See PDF for Image] 

% may be off due to rounding. 

[End of Figure] 

FY 2006 brought many unanticipated and unprecedented challenges to the 
IRS.  The IRS responded quickly to assist the victims of the 2005 
hurricanes by providing assistance and information regarding tax 
responsibilities and by postponing filing and payment deadlines for all 
affected taxpayers in the hardest hit areas.  The IRS set up a 
dedicated toll-free disaster assistance line to provide “one-stop” help 
on tax issues and answered over one million assistance calls for 
Federal Emergency Management Agency (FEMA).  Also, in June 2006, severe 
flooding forced closure of the IRS headquarters building in Washington, 
D.C.  The Commissioner and the top-level executives immediately resumed 
business at alternate IRS locations, and within thirty days, over 2,200 
displaced employees returned to their normal duties.  There was no 
impact on service to the public. 

IRS’ financial statements, including the accompanying notes, present 
fairly, in all material respects, in conformity with U.S. generally 
accepted accounting principles, IRS’ 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. 

With its highly-skilled workforce dedicated to balancing service and 
enforcement, the IRS will continue to make progress on achieving its 
goals, accomplishing its mission, and meeting the public’s expectation.

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.

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.  

The following list summarizes the guiding principles that the IRS 
follows:

* Understand and solve problems from taxpayers' point of view: 
* Enable IRS managers to be accountable to taxpayers: 
* Use balanced measures of performance to evaluate progress in taxpayer 
satisfaction, business results, and employees' satisfaction: 
* Foster open, honest communications: 
* Insist on total integrity: 

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 focused on 
unique groups of taxpayers:  individual taxpayers, small business 
owners, large 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.  


* The organizational chart below shows these reporting relationships. 

Figure: Department of the Treasury: Internal Revenue Service 
Organization: 

[See PDF for Image] 

[End of Figure] 

Commissioner of the Internal Revenue Service: 

A number of functions support the IRS Commissioner. They set policies, 
provide leadership and direction for the IRS, 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. Appeals provides an independent channel for taxpayers who wish to 
dispute a recommended enforcement action, enhancing voluntary 
compliance and public confidence in the integrity and efficiency of the 
IRS. 

˛ Taxpayer Advocate Service (TAS) helps taxpayers with 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 have 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 is the chief legal advisor to the IRS 
Commissioner responsible for providing correct and impartial 
interpretation of the Internal Revenue laws and the highest quality 
legal advice and representation for the IRS. The Chief Counsel's 
principal customers are the IRS Commissioner, the operating divisions, 
the functional units, 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, other research 
organizations, the Department of the Treasury, and the general public 
by producing studies, program evaluations, and statistical analyses of 
taxpayer trends and data. RAS also provides 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: 

The 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 eight 
campuses perform tax processing services. Twenty-five sites provide 
account management services. Employees at five campuses perform 
compliance services, including examinations and automated underreporter 
matches, which focus on dependent exemptions, credits, filing status, 
and personal deductions. W&I Compliance also collects delinquent 
accounts through automated collection system (ACS) call sites and 
performs other collection work, including securing delinquent returns, 
by corresponding with taxpayers. W&I also provides face-to- face 
information, support and assistance to taxpayers in fulfilling their 
tax obligations at over 400 Taxpayer Assistance Centers. 

* Small Business and Self Employed Division (SB/SE) serves 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 IRS, allocating 94 percent of its resources to compliance 
activities. SB/SE is aligned along functional lines of Examination, 
Collection, Specialty Tax Programs, Compliance Services/Campus 
Operations, and the Fraud/Bank Secrecy Act Program. This structure 
provides a more focused approach to program delivery by efficient use 
of existing knowledge and experience, ensuring end-to-end 
accountability and specialized expertise of the workforce. 

* Large and Mid-Size Business Division (LMSB) administers taxes for the 
largest businesses in the United States, including corporations, sub- 
chapter S-Corps and partnerships with assets greater than $10 million, 
including over 6,100 publicly traded companies. LMSB taxpayers annually 
file approximately 176,000 income tax returns. LMSB 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 provides taxpayers with specialized, focused support on specific 
tax issues. LMSB's workforce consists largely of field-based employees, 
including revenue agents, international examiners, field specialists, 
technical experts and support personnel. Collectively, they deal with 
tax issues ranking among the most complex addressed by any division in 
the IRS. 

* Tax-Exempt and Government Entities Division (TE/GE) serves a broad 
array of entities with special tax status, including tax-exempt 
organizations, employee retirement plans, and government entities. The 
entities that comprise this customer base are subject to unique rules 
and have diverse needs, ranging from small community organizations and 
municipalities to major universities, pension funds, state and tribal 
governments, and tax-exempt bond issuers. TE/GE administers and 
enforces a complex body of law governing these entities to ensure that 
they properly adhere to the statutes applicable to their status. 

* Criminal Investigation (CI) investigates potential criminal 
violations of the Internal Revenue Code and related financial crimes in 
a manner that fosters confidence in the tax system and compliance with 
the law. 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. 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. 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: 

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

* Modernization and Information Technology Services (MITS), headed by 
the Chief Information Officer (CIO), delivers information technology 
solutions that anticipate and meet enterprise-wide needs by delivering 
customer-centered, systems, products, services, and support. The CIO 
advises all heads of offices on strategic technology planning, data 
administration, technology standards and privacy assurance, and 
telecommunications issues. 

* Agency-Wide Shared Services (AWSS) develops procedures and implements 
policy for the IRS' internal real estate and facilities management, 
Equal Employment Opportunity and Diversity, personnel, procurement, and 
customer support activities. 

* Chief Human Capital Officer (HCO) provides human capital strategies 
and tools for recruiting, hiring, developing, retaining, and 
transitioning a highly skilled and high performing workforce needed to 
support the IRS' mission, goals, and objectives. 

* Chief Financial Officer (CFO) oversees the IRS budget, 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 and Security Services (MA&SS) is responsible for 
the protection of taxpayer data and information systems and the 
continuing security of IRS personnel, facilities, and assuring the 
security and resilience of critical agency functions and business 
processes. 

II. Performance Goals and Results: 

The IRS uses performance measures to evaluate its effectiveness in 
meeting its three strategic goals. The IRS achieved an overall success 
rate of more than 68 percent for the second consecutive year, meeting 
the target for 15 of its 22[Footnote 15] performance measures. Of the 
seven IRS measures that did not meet targets; two related to electronic 
filing where performance set records for the second consecutive year, 
with individual electronic filing coming within 98 percent and business 
within 89 percent of meeting the target; and two related to delivery of 
tax products resulted from delayed by hurricane legislation. The fifth 
missed measure dealt with determination case closures in which 
inventory did not materialize. The sixth measure, examination coverage 
for businesses, was missed by one percent because the IRS was prevented 
from taking enforcement action on a significant number of partnership 
return examinations involving a tax shelter promoter. Also, partnership 
audits were not as productive as expected. As a result, the IRS has 
stopped opening these audits until the examination selection 
methodology is improved. The seventh measure, an efficiency measure 
which dealt with contacts resolved per staff year, came within less 
than one percent of being met. The performance information that follows 
highlights successes and challenges during FY 2006. 

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. 

[End of table] 

Major Results, Accomplishments, and Challenges: 

The IRS serves a constituency of more than 220 million filers. Improved 
service options for taxpayers and simplifying the tax process are key 
strategies under the IRS strategic goal to improve taxpayer service. 
The IRS allocates resources to education and outreach services to 
ensure taxpayers understand their obligations and voluntarily 
participate in the tax system. 

Filing Season: 

The IRS delivered a successful 2006 filing season in the midst of a 
very challenging year. Despite natural disasters that impacted a large 
number of taxpayers and required an unprecedented response, the IRS met 
or exceeded 50 percent (five out of ten) of its performance goals 
related to taxpayer service. The following highlights the IRS' 
performance in FY 2006: 

* Processed more that 134.7 million individual returns and issued more 
than 100 million refunds totaling over $277 billion during the 2006 
filing season (Tax Year 2005). 

* Processed 46.9 million returns for partnerships, corporations, 
employment taxes, and exempt organizations. 

* Increased use of the IRS.gov website and "Where's My Refund?," up 
more than 9.8 percent and 11.8 percent, respectively. 

Despite not meeting its aggressive electronic filing targets in FY 
2006, the IRS set another record for the number of returns filed 
electronically. For the second year in a row, more than half (72.8 
million) of all individual returns were filed electronically, 
representing a 6.6 percent increase over FY 2005. The IRS' most recent 
American Customer Satisfaction Index (ACSI) scores from 2005 also 
reflected higher satisfaction from e-filers (77) over paper filers 
(50). The 2006 ACSI scores will be available in December. The following 
highlights the IRS' performance related to electronic filing: 

* Home computer use to prepare and e-file tax returns increased 18.5 
percent to more than 20.2 million returns. 

* Tax preparation professional use of e-file increased 9.4 percent, 
with 52.1 million filing electronically. In its fourth year of 
operation, the Free File Alliance, the partnership between the IRS and 
a consortium of tax preparation software companies, had approximately 
four million taxpayers use the free service, a 22.6 percent decrease 
from last year due to a change in the eligibility requirements. 

* Nearly 14,000 large corporate taxpayers subject to the electronic 
filing mandate successfully e-filed their returns. The largest 
corporate taxpayers transmitted their returns predominately without 
delay or back log. The IRS processed this volume of very complex 
returns, and accepted and acknowledged receipt well within its 24-hour 
turnaround standard. 

* Customer use of on-line services continued to increase: 

- More than 1.3 billion web pages were viewed on the IRS.gov website, a 
four percent increase over FY 2005. 

- More than 24.7 million taxpayers used the web application "Where's my 
Refund?" to check the status of their refunds, an 11.8 percent increase 
from last year. 

* More than two million tax practitioners took advantage of the 
electronic services provided by the IRS' e-Services project. e-Services 
is a modernization project providing electronic services to promote the 
goal of conducting electronic transactions between the IRS and tax 
practitioners to reduce burden. In FY 2006: 

- Over one million participants used a new Internet-Employer 
Identification Number service, 

- One million requests for transcripts were processed through the IRS' 
Transcript Delivery System, and: 

- More than 168,000 practitioners enrolled in the IRS e-file program. 

Millions of taxpayers and tax professionals that visited IRS.gov during 
the 2006 filing season benefited from many of the features the IRS 
provides to simplify tax filing. Redesigned in November 2005, IRS.gov's 
search and navigation tools were completely revamped to make it easier 
and quicker for taxpayers to get information and answers to many of 
their questions while preparing their returns. As a result, customer 
satisfaction with the website increased five percentage points based on 
the ACSI. In addition to improved customer satisfaction, the e-Gov 
Institute awarded IRS.gov the 8TH Annual Government Solutions Center 
Pioneer Award for "Innovative Use of Technology in a Government 
Program." IRS.gov improvements came from listening to customers 
concerns, conducting usability studies, and translating feedback into a 
cohesive list of requirements. 

Education & Outreach: 

Helping the public to understand their tax reporting and payment 
obligations remains a vital part of maintaining public confidence in 
administering the tax laws. The IRS expanded its outreach by relying on 
partner organizations such as state taxing authorities and a cadre of 
volunteer groups to serve taxpayer needs. Through its 12,300 Volunteer 
Income Tax Assistance (VITA) and Tax Counseling for the Elderly (TCE) 
sites, the IRS provided free tax assistance to the elderly, disabled, 
and limited English proficient individuals and families. The 69,000 
volunteers located at the sites prepared approximately 2.3 million 
returns, a 7 percent increase over FY 2005. 

In addition to conducting its own outreach and education activities, 
the IRS participates in private partner education and outreach 
programs. During FY 2006, the IRS provided resources and support for 
over 290 Partner Coalitions, resulting in the electronic filing of 1.9 
million returns. One of the larger partnerships, Connect America, 
provides free tax assistance to disabled veterans and free tax 
preparation and asset building strategies for low-income families. The 
IRS was recognized in 2006 as the Connect America's Partner of the Year 
for 2005 for its efforts to provide free tax assistance to 
disadvantaged groups. The IRS is the first federal agency to receive 
this award. 

The IRS' nationwide marketing and education campaign, aimed at reducing 
Earned Income Tax Credit (EITC) error, reached a wide audience 
including taxpayers, tax practitioners, members of the media, and 
partner organizations. The IRS held grassroots events in New Orleans 
and Houston to focus on hurricane victims and in Denver and New York 
for certain limited English proficiency communities. These events 
provided information and free tax preparation to over 1,000 people and, 
through the help of volunteers, nearly 300 returns were prepared. Over 
1.5 million people viewed the EITC pages on IRS.gov. A million people 
used the EITC Assistant, a web-based application to help taxpayers 
determine eligibility, filing status, and estimate their EITC amount. 
Also, the IRS provided answers to more than 160,000 EITC questions 
through telephone assistance. 

The IRS implemented a communication strategy to educate taxpayers and 
employees about significant identity theft issues. Communication 
channels included DVDs, public service announcements, and presentations 
at the IRS' Tax Forums to educate tax professionals on requirements to 
secure taxpayer data. The IRS also provided similar educational 
services to persons with limited English proficiency. 

Customer Service: 

The IRS continues to improve quality, efficiency, and service delivery 
through increased service coverage to taxpayers and improved business 
processes. In October 2005, the IRS e-Services Project won the 
Government Computer News 2005 Agency award for innovation. Winners are 
chosen for their innovation, support of program or policy requirements, 
and improvement of service delivery. IRS e-Services provide a set of 
web-based business products for practitioners and other third parties. 
IRS e-Services such as the new Internet-Employer Identification Number 
(1.3 million) and Transcript Delivery Service (1.1 million), 
experienced significant usage. 

In December 2005, 43 state tax agency representatives, legally 
authorized to receive federal tax information for state tax purposes, 
were granted access to and trained on e-Services Transcript Delivery 
Service. This reduced the number of transcript requests from state 
agencies by 150,000. All 153 Low Income Tax Clinics were also given 
access to e-Services and incentive products to better serve their 
taxpayer customers. 

The IRS developed processes and procedures for administering 
telecommunications excise tax refunds (TETR) to more than 150 million 
taxpayers. To do this, the IRS modified all individual and business tax 
return forms to include TETR information; created a new form to be used 
by individuals who want to request a refund but who have no other tax 
filing requirement; and drafted a new form to be used by taxpayers who 
choose to request refunds based on their actual payments rather than 
use a standard amount set by the IRS. The IRS also launched an outreach 
campaign to external stakeholder groups, programmed IRS systems to 
accept form changes, developed TETR-related internal procedures (IRMs), 
and trained employees who will interact with taxpayers on the phone and 
at Taxpayer Assistance Centers. In addition, the IRS is developing a 
methodology that can be used by businesses and non-profits to estimate 
their TETR claims. 

Telephone assistance calls decreased as more taxpayers opted to use 
automated phone and Internet services. In FY 2006, the IRS answered 
32.7 million assistor telephone calls, compared to 33.4 in FY 2005, and 
completed more than 24.3 million automated calls, compared to 25.7 in 
FY 2005. With the availability of improved online service options to 
taxpayers, taxpayer visits to the Taxpayer Assistance Centers (TACs) 
were down 10 percent from 2005, while the usage of the IRS.gov website 
and the "Where's My Refund?" application were up 9.8 percent and 11.8 
percent, respectively. Also, productivity improvements reduced the 
resources needed to address account workload and taxpayer 
correspondence cases. The IRS correctly responded to 91 percent of tax 
law questions and 93 percent of account questions received via the 
telephone, and achieved an 82 percent level of service answering calls 
from taxpayers. 

All 400 TACs remained open and services were consistent with the 2005 
filing season. Additionally, wait time at the TACs was minimized with 
more than 80 percent of customers being served in 30 minutes or less. 
The accuracy of responses to tax law questions increased to 83 percent, 
compared to 75 percent in FY 2005. Approximately 12,300 VITA and TCE 
sites provided free tax assistance to the elderly, disabled, and 
limited English proficient individuals and families. The 69,000 
volunteers located at the sites prepared approximately 2.3 million 
returns, a 7 percent increase over FY 2005. 

In response to the hurricanes of 2005, emergency supplemental 
appropriations were enacted that required over 230 changes to 78 tax 
products. Despite passage late in the tax year, 83 percent of the 
critical filing season tax products and over 61.2 percent of other tax 
products were delivered to the public on time. The IRS plans to 
continue its efforts to simplify its tax forms and publications making 
them more user-friendly with the ultimate goal of providing all of its 
published products in electronic format. 

Burden Reduction: 

The IRS provides help to taxpayers to file accurate and timely tax 
returns in order to reduce burden. In addition, the IRS pursues tax 
form simplification and an increased effort to provide forms more 
suitable for a computer-based system. Taxpayer burden is measured by 
the amount of time and out-of-pocket expense taxpayers incur in meeting 
their tax responsibilities. The estimated FY 2006 burden was 6.7 
billion hours, compared with 6.4 billion hours in FY 2005, an increase 
of approximately 250 million hours. This increase reflects new forms 
and changes to existing forms dictated by the ten different pieces of 
legislation enacted in 2005. 

The IRS also partnered with external stakeholders, including taxpayers, 
practitioners, citizens and industry groups, software developers, and 
state and federal agencies to receive suggestions for reducing taxpayer 
burden. As a result, in FY 2006, the IRS launched a number of new forms 
and procedures designed to reduce burden without compromising the tax 
administration objectives. The following highlights some of these 
initiatives: 

* Redesigned unemployment tax returns (Form 940 and a new Form 944) to 
reduce filing burden for 950,000 small business owners and governmental 
entities. The new forms allow certain employment tax filers to file 
annually rather than quarterly and to make a single payment with the 
annual return. 

* Revised Schedule K-1 for Form 1041 to provide streamlined 
instructions for beneficiaries. The revised form can be scanned and 
will reduce the number of transcription errors. The new Schedule K-1 is 
expected to reduce 4.27 million hours of burden for 3.5 million 
taxpayers. 

* Launched an Alternative Minimum Tax (AMT) Calculator to assist 
taxpayers in determining whether they are subject to the AMT and if 
they need to complete the tax form (Form 6251). The AMT is calculated 
separately, eliminates many deductions and credits, and creates a tax 
liability for an individual who would otherwise pay little or no tax. 
By 2010, the AMT is expected to affect nearly 32 million taxpayers. 

* Simplified the process for requesting an extension of time to file an 
individual return on the original Form 4868 (extension request) and now 
automatically grants an additional six month extension to file. The 
redesign of the extension process allowed an additional two million 
taxpayers the ability to e-file/e-pay and eliminated five million 
duplicate filings. Similar changes were made to the extension process 
for corporate taxpayers. The automated process affected 15.5 million 
submissions, reduced taxpayer burden by nine million hours, and reduced 
processing costs by 50 percent. 

The IRS also provided assistance to corporate taxpayers in identifying 
and resolving potentially controversial disputes earlier in the 
examination process through its Pre-filing Agreement (PFA) and the 
Industry Issue Resolution programs. These programs reduce costs, 
burden, and delays because they enable corporations and the IRS to 
reach agreement on a contentious issue through a cooperative effort 
before a return is filed. In FY 2006, the IRS received over 230 PFA 
requests and accepted 152. Of these, 55 percent were closed with an 
agreement and 20 percent were withdrawn (either by the taxpayer or the 
IRS). Taxpayers reported an overall level of satisfaction with these 
programs of 4.7 and 4.6, respectively (on a 5 point scale). 

Disaster Assistance and Response: 

The IRS provided unprecedented tax relief in the wake of the hurricanes 
that occurred along the Gulf Coast in August and September of 2005. 
Within days of the storms, the IRS assisted FEMA with taking 
registrations on their toll-free line and provided emergency equipment 
to support four FEMA call sites to handle the increased call volume. 
From the end of August through October 31, 2005, the IRS responded to a 
total of 948,814 FEMA calls and assigned 5,000 IRS employees to augment 
staffing at FEMA call centers. In addition, the IRS provided assistance 
to the Small Business Administration (SBA) and the Department of Labor 
to expedite income verification for disaster loans and unemployment 
benefits. The IRS processed more than 1.3 million requests for tax 
information from the SBA, expediting the disaster claims process. 

The IRS responded to 49 disaster declarations, providing assistance and 
relief to the needs of disaster victims. Within 24 hours of the 
Presidential disaster declaration in the wake of Hurricane Katrina, the 
IRS formed a multi-functional policy group which worked closely with 
key federal agencies and external stakeholders to develop a number of 
substantive legislative proposals. The new legislative provisions 
included in the emergency supplemental appropriations to address 
hurricanes in the Gulf of Mexico were designed to provide broad relief 
to impacted taxpayers by postponing filing and payment deadlines, 
allowing penalty free withdrawals from retirement accounts, and 
claiming casualty losses. The legislation required changes to 78 tax 
products. Despite the passage of the statute late in the tax year, 83 
percent of the critical tax products and over 61.2 percent of other tax 
products were delivered to the public on time. 

To help disaster victims understand the numerous tax law provisions 
enacted as a result of the hurricanes, the IRS developed and 
distributed 424,147 Disaster Relief Kits to individuals and businesses 
and distributed more than 85,382 copies of Publication 4492. The IRS 
assisted over 288,000 taxpayers on the toll-free telephone lines 
providing hurricane victims with help on tax issues, provided 
substantial disaster information and resources on IRS.gov, and issued 
60 news releases and legal guidance documents announcing details on 
relief made available to hurricane victims. The IRS secured agreements 
with seven tax professional organizations to jointly provide assistance 
at local disaster relief centers and secured additional agreements with 
several practitioner organizations to provide free casualty loss tax 
return preparation for low income taxpayers. In addition, at least 257 
VITA sites remained open after April 17, 2006, to help disaster 
impacted taxpayers. 

In the aftermath, the IRS continued to provide assistance and education 
on administrative and legislative tax relief to individual and business 
taxpayers and practitioners. The IRS held more than 70 local outreach 
events to assist disaster victims and has planned additional events. 

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

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

Description: The relative success rate of taxpayers that call IRS toll- 
free services seeking assistance from a CSR. 

CSR Level of Service;  
FY 2003 Actual: 80.0%;  
FY 2004 Actual: 87.0%; 
FY 2005 Actual: 82.6%; 
FY 2006: Plan: 82.0%; 
FY2006: Actual:  82.0%. 

[End of table] 

FY 2006 Performance: Target Achieved. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS will continue to maintain CSR Level of Service at 
82 percent in FY 2007. The IRS expects an increase in telephone demand 
in FY 2007 from the Telecommunications Excise Tax Refund (TETR) 
initiative, and plans to increase staffing to meet the expected demand. 

Table 2: Customer Contacts Resolved per Staff Year: 

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

Customer Contacts Resolved per Staff Year; 
FY 2003 Actual: 8,318;  
FY 2004 Actual: 8,015; 
FY 2005 Actual; 7,585; 
FY 2006: Plan: 7,477; 
FY 2006: Actual:  7,414. 

[End of table] 

FY 2006 Performance: Target Not Achieved. Despite answering 2.7 million 
more contacts than planned, the IRS did not meet this target. 
Efficiencies expected from the reduction of Toll-free telephone service 
operating hours (from 15 to 12 hours per day) did not occur because the 
service operating hours were not reduced due to reduction in service 
concerns expressed by Congress. Staffing for the 15 hours required an 
additional 482 Full Time Equivalents (FTE) over plan. Overall, the IRS 
came within 99 percent of the goal, answering almost 2 million 
additional automated calls, 564,000 assistor calls, and completing over 
750,000 additional Web Services. Completing a web service is defined as 
providing a service requested by a taxpayer or tax practitioner through 
self-assist internet-based applications such as Internet Refund Fact of 
Filing ("Where's My Refund"), Transcript Delivery System, Preparer Tax 
Identification Number, Internet-EIN, Prior Year Earned Income Option, 
and Disclosure Authorizations. 

Future Plans: The IRS is expecting efficiency to increase as more 
taxpayers choose to use automated means to contact the IRS instead of 
traditional, labor intensive methods. 

Table 3: Percent of Eligible Taxpayers Who File for EITC: 

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

Percent of Eligible Taxpayers Who File for EITC; 

CY 2003 Actual: --; 
CY 2004 Actual: 80.0%; 
CY 2005 Actual: 80.0%; 
CY 2006: Plan: 80.0%*; 
CY 2006: Actual: Not yet available. 

*The participation rate is an estimate based on a methodology which 
includes underlying assumptions about the potential EITC eligible 
population. 

[End of table] 

CY 2006 Performance: Data to estimate the participation rate will be 
available late in 2007. 

Future Plans: The methodology for estimating the EITC participation 
rate is being validated using Census data in an effort to improve the 
accuracy of estimates. 

Table 4: Customer Accuracy -Tax Law Phones: 

Description: The percentage of correct tax law answers provided by a 
telephone assistor. The measure indicates how often customers receive 
the correct answer to their tax law inquiry based upon all available 
information and Internal Revenue Manual required actions. 

Customer Accuracy - Tax Law Phones; 
FY 2003 Actual: 82.0%; 
FY 2004 Actual: 80.0%; 
FY 2005 Actual: 89.0%; 
FY 2006: Plan: 90.0%; 
FY 2006: Actual: 90.9%. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: Incremental improvement in the performance is expected in 
FY 2007 and beyond from the completion of the Contact Recording 
project, a program to record customer contacts for quality review to 
help employees improve their skills, ease manager burden, and raise 
quality for customers. 

Table 5: Customer Accuracy - Accounts (Phones): 

Description: The percentage of correct answers provided by a telephone 
assistor. The measure indicates how often customers receive the correct 
answer to their account inquiry and/or had their case resolved 
correctly based upon all available information and Internal Revenue 
Manual required actions. 

Customer Accuracy - Accounts (Phones); 
FY 2003: Actual: 88.2%; 
FY 2004: Actual: 89.3%; 
FY 2005: Actual: 91.5%;
FY 2006: Plan: 92.0%; 
FY 2006: Actual:  93.2%.

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: Incremental improvement in performance is expected in FY 
2007 and beyond from continued improvement efforts such as the 
development of new online tools for assistors to research taxpayer 
questions. 

Table 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 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 20 (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 2006. 

Timeliness of Critical Filing Season Tax Products to the Public; 
FY 2003: Actual: --; 
FY 2004: Actual: 76.0%; 
FY 2005: Actual: 91.4%; 
FY 2006: Plan: 92.0%; 
FY 2006: Actual:  83.0%. 

[End of table] 

FY 2006 Performance: Target Not Achieved. The IRS did not meet the FY 
2006 target. In: 

FY 2006, the IRS shipped 166 of 200 (83 percent) Critical Filing Season 
tax products timely. Shipment of the remaining products was delayed 
intentionally to incorporate changes mandated in legislation enacted 
late in 2005, P.L. 109-73, Katrina Emergency Tax Relief Act of 2005 
(KETRA) and P.L. 109-135, Gulf Opportunity Zone Act of 2005 (GOZONE). 

Future Plans: The IRS expects to resume timely delivery of all tax 
products in FY 2007. 

Table 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 include business, Tax Exempt and Government Entities, and 
miscellaneous tax products. This measure contains two components: (1) 
percentage of paper tax products that meet the scheduled ship date 
within five business days of the actual date, and (2) percentage of 
scheduled electronic tax products that is available on the Internet 
within five business days of the scheduled print date. The intent is to 
have the tax products available to the public at least 30 days before 
the form is required to be filed. 

Timeliness of Critical Other Tax Products to the Public; 
FY 2003: Actual: --; 
FY 2004: Actual: 76.0%; 
FY 2005: Actual: 80.0%; 
FY 2006: Plan: 85.0%; 
FY 2006: Actual: 61.2%. 

[End of table] 

FY 2006 Performance: Target Not Achieved. The IRS did not meet the FY 
2006 target. Production schedules required modification to accommodate 
the delay in completion of the critical filing season tax products 
(discussed in measure 6. above), necessitating changes to the scheduled 
modification and ship dates for these non-critical tax products. 
Monthly timeliness results during early FY 2006 reflected this shift to 
the workplans. The IRS could not recover the lost production days, and 
as a result, could not meet the target. 

Future Plans: The IRS expects to resume timely delivery of all tax 
products in FY 2007. 

Table 8: Percent Individual Returns Processed Electronically: 

Description: The number of electronically filed individual tax returns 
divided by the total individual returns filed. 

Percent Individual Returns Processed Electronically; 

FY 2003: Actual: 40.0%; 
FY 2004: Actual: 46.5%; 
FY 2005: Actual: 51.1%; 
FY 2006: Plan: 55.0%; 
FY 2006: Actual: 54.1%; 

[End of table] 

FY 2006 Performance: Target Not Achieved. The IRS did not meet the FY 
2006 target. Although the January through June performance was at 55 
percent, a higher percentage of paper returns were received during July 
through September causing the fiscal year percentage of electronically 
filed returns to drop. 

The plan number is derived from semiannual filing projections prepared 
by the IRS Research organization, incorporating changes in filing 
patterns, economic and demographic trends, legislative requirements, 
and IRS administrative processes. The projections provide a basis for 
IRS workload estimates. 

Future Plans: E-file participation rates are projected to increase to 
58.2 percent in 2007 based on current experience, historical growth, 
increased advertising, marketing, and expanded e-file programs and do 
not reflect gains from any mandates. 

Table 9: Percent Business Returns Processed Electronically: 

Description: The number of electronically filed business returns 
divided by the total business returns filed. 

Percent Business Returns Processed Electronically;  
FY 2003: Actual: --; 
FY 2004: Actual: 17.4%; 
FY 2005: Actual: 17.8%; 
FY 2006: Plan: 18.6%; 
FY 2006: Actual: 16.6%. 

[End of table] 

FY 2006 Performance: Target Not Achieved. The IRS did not meet the FY 
2006 target. The plan number is derived from semiannual filing 
projections prepared by the IRS Research organization semiannually, 
incorporating changes in filing patterns, economic and demographic 
trends, legislative requirements, and IRS administrative processes. The 
projections provide a basis for IRS workload estimates. 

Future Plans: The IRS expects the percentage of business filers to 
increase in the future due to increased marketing and expanded business 
e-file programs, including the acceptance of new forms and schedules 
attached to employer, estates and trusts, and partnership filings, 
acceptance of amended returns, and acceptance of the new annualized 
employment tax return. The IRS will continue to pursue additional 
mandates for businesses to file electronically similar to the one 
recently imposed for corporations. 

Table 10: Taxpayer Self Assistance Rate: 

Description: The percent of contacts that are resolved by automated 
self-assistance applications. 

Taxpayer Self Assistance Rate; 
FY 2003: Actual: 51.0%; 
FY 2004: Actual: 46.4%; 
FY 2005: Actual: 42.5%; 
FY 2006: Plan: 45.7%; 
FY 2006: Actual:46.8%. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS expects performance to continue to increase as 
more taxpayers choose to use automated applications to resolve issues 
and questions instead of more traditional methods such as contact with 
the IRS by telephone and correspondence. 

Table 11: Refund Timeliness - Individual (Paper): 

Description: The percentage of refunds resulting from processing 
Individual Master File paper returns issued within 40 days or less. 

Refund Timeliness - Individual (Paper); 
FY 2003: Actual: 98.8%; 
FY 2004: Actual: 98.3%; 
FY 2005: Actual: 99.2%; 
FY 2006: Plan: 99.%; 
FY 2006: Actual:  99.3%. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS expects its performance for refund timeliness to 
remain stable under the current processing system and within resource 
constraints. 

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: 

Reducing the tax gap is at the heart of IRS' enforcement programs. The 
tax gap is the difference between what taxpayers should pay and what 
they actually pay due to not filing tax returns, not paying their 
reported tax liability on time, or failing to report their correct tax 
liability. The tax gap, about $345 billion for Tax Year (TY) 2001, 
based on updated FY 2006 estimates, represents the amount of 
noncompliance with the tax laws. Underreporting tax liability accounts 
for 83 percent of the gap, with the remainder almost evenly divided 
between non-filing (eight percent) and underpaying (nine percent). The 
IRS remains committed to finding ways to increase compliance and reduce 
the tax gap, while minimizing the burden on the vast majority of 
taxpayers who pay their taxes accurately and on time. 

The IRS uses its enforcement authority to assess and collect taxes that 
are due from people who do not fulfill their tax obligations, thus 
improving compliance. Noncompliance may not be deliberate and can stem 
from a wide range of causes, including lack of knowledge, confusion, 
poor recordkeeping, differing legal interpretations, unexpected 
personal emergencies, and temporary cash flow problems. However, some 
noncompliance is willful, even to the point of criminal tax evasion. 
For example, certain taxpayers invest in tax shelters, trusts, and 
other structured products knowing that the promised tax benefits are 
not in conformity with the law. The IRS has and will continue to 
enforce the law across all sectors, but is focusing on corrosive 
activities of corporations, high income taxpayers, and other major 
violators of the tax code. These efforts are having a positive impact 
on collecting additional tax revenue. Enforcement revenue from all 
sources was at a record level of $48.7 billion in FY 2006, a three 
percent increase. Targeting high-risk taxpayers improves IRS 
efficiency, reduces the burden on compliant taxpayers, and concentrates 
enforcement presence where it is most needed. 

In FY 2006, enhancing the IRS' enforcement presence remained a top 
priority. At the same time, the IRS focused its efforts on improving 
business processes and modernizing its information systems, both 
powerful enablers of the IRS business goals. For FY 2006, ten of the 
twelve enforcement performance targets were met. Focusing on more 
limited scope examinations and productivity enhancements, including 
improved analytics, workload identification, and selection systems that 
targeted high-risk cases resulted in: 

* 7 percent improvement in individual audits: 

* 18 percent increase in high income audits: 

* 8 percent increase in small-business audits: 

* 10 percent increase in automated underreporter closures: 

* 15 percent increase in collection case closures: 

* 9 percent increase in revenue received from collection activities: 

* 66 percent overall increase in the use of substitute for return 
authority (substitute for return authority allows the IRS to file a tax 
return for an individual or business when it does not file a required 
return), examiners prepared and filed 665,000 returns for individuals 
and 182,000 returns for businesses classified as non-filers: 

The IRS also met its coverage, efficiency, and embedded quality annual 
targets. Improvements in inventory management, decreases in cycle time, 
and enhanced training all contributed to increase productivity. 
Improved quality controls measuring critical elements of the 
examination, a reinforced focus on case quality to drive improvement 
efforts, and the delivery of business results, led to improved 
performance for the third consecutive year. Future efforts to reduce 
the tax gap will include strategies to ensure optimum balanced audit 
coverage, and improve resource allocation. 

In FY 2006, the IRS continued its efforts in streamlining and improving 
its examination process, resulting in considerably shortened cycle time 
for large corporate audits. By doing better analysis to focus on high 
risk issues, and planning jointly with the taxpayers on the audit cycle 
and information document requests, the cycle time was reduced 
substantially. In FY 2006, the time from assigning a large corporate 
return to a revenue agent until the final closing decreased more than 
18 percent, from 17.5 months to 14.3 months. The improvements to the 
examination process ultimately increased inventory turnover and 
closures. 

The IRS also implemented a new compliance assurance process where large 
corporate taxpayers and IRS work together to examine transactions in 
"real time" during the taxable year to: (1) reach agreement on the 
taxpayer's tax liability before the tax return is filed; and (2) fast 
track the appeal process by bringing the examination team and the 
taxpayer to the table to expedite the settlement of remaining issues of 
controversy. Under this new process, the IRS is able to determine the 
tax liability within months of filing. The process is beneficial to the 
taxpayer and the IRS because it reduces the taxpayers' compliance 
burden while increasing currency and allows for more efficient use of 
IRS resources. Tax Year (TY) 2006 was a pilot year with 34 
participants; 19 new and 15 carried over from TY 2005. With full 
implementation, however, the impact on compliance and the reduction in 
taxpayer burden is expected to be substantial. 

The IRS has developed a nationally coordinated program to combat 
abusive tax schemes. The primary focus is on the identification and 
investigation of the tax scheme promoters as well as those who play a 
substantial or integral role in facilitating, aiding, assisting, or 
furthering the abusive tax scheme (e.g., accountants, lawyers). 
Secondarily, but equally important, is the investigation of investors 
who participate in abusive tax schemes. The following highlights some 
of the initiatives: 

˛ The Partnership Option Portfolio Securities (POPS) initiative 
challenges the tax benefits derived from manipulating portions of the 
Internal Revenue Code for the purpose of generating permanent non- 
economic tax losses. To date, closing agreements have been received 
from 63 of the 107 partners agreeing to a settlement, totaling $556 
million in tax, penalties, and interest. 

˛ The Personal Investment Corp initiative challenged tax benefits 
derived from a type of transaction related to S-Corps rules. The 
transaction attempts to allocate the loss side of a foreign currency 
transaction to a tax shelter investor, but not the gain. Closing 
Agreements have been received from 103 of the 141 shareholders, 
totaling $592 million in tax, penalties, and interest. 

˛ Select Tax Shelter Promoters were given an opportunity to make an 
election agreeing to concede 100 percent of their allocable share of 
the penalty imposed for failing to register a tax shelter. In exchange, 
penalties for failing to maintain investor lists were waived, and the 
IRS agreed not to refer selected promoters for prosecution related to 
the transactions. The settlement initiative allowed faster case 
resolution, earlier receipt of investor and co-promoter information, 
and ensured future compliance by taxpayers. The settlement initiative 
is being offered in waves, beginning with 36 promoters in FY 2006. 

In the retirement plans arena, a global settlement initiative dealt 
with abusive transactions where taxpayers attempted to exclude business 
income using a combination of schemes that concentrate benefits among a 
small number of persons. Examinations of 182 potentially abusive plans 
are in process. In FY 2006, the IRS also started examinations on 262 
potentially abusive plans involving questionable life insurance 
policies. 

The IRS has a robust, balanced, and comprehensive plan to help reduce 
improper payments that include base compliance activities and redesign 
efforts. In FY 2006, the IRS conducted over 500,000 examinations, 
issued over 600,000 math error notices (math or other statistical 
irregularities are systemically identified during processing), and 
matched 300,000 information documents (e.g. W-2s, 1099s) from employers 
with information on the tax return. Collectively, these three 
enforcement activities prevented nearly $2 billion from being paid out 
erroneously. 

The IRS redesigned portions of its examination process. Improvements 
include: a process to score and select amended returns for examination; 
a risk-based scoring strategy to identify and select cases for 
examination that ensures the IRS works the most egregious and 
productive examination cases; systemic assignment of examination cases 
to campuses using new data such as capacity and risk-based scores; and 
integration of a decision support tool which automates issue 
identification, increases consistency in case documentation, and 
eliminates duplicative data entry when the case is closed. 

Focusing efforts in key areas improved the IRS' ability to address 
complex strategies employed by taxpayers to avoid payment of their 
taxes and contributed to meeting or exceeding all of the FY 2006 
collection performance targets: 

* Enhancing training to improve the skill sets needed to work complex 
issues; 

* Leveraging automation including securing new technology to help 
streamline collection processes; 

* Improving the support structures or business processes to improve 
efficiency and effectiveness of collection personnel; and: 

* Improving employee engagement and customer satisfaction to impact 
positively on reducing the underpayment portion of the tax gap. 

Enforcement of criminal statutes is an integral component of the IRS' 
efforts to enhance voluntary compliance of the tax laws. In FY 2006, 
abusive tax schemes and shelters remained a high investigative priority 
due to egregious corporate fraud and tax avoidance of high-income 
individuals. The IRS used parallel proceedings, one of its most 
effective tools, to combat abusive tax schemes. This tool enables the 
IRS to prevent promoters of abusive schemes from engaging in further 
promotion activity while the criminal investigation is proceeding. 

The IRS improved its fraud referral acceptance rate while working high 
quality cases. The FY 2006 referral acceptance rate of 71.8 percent 
exceeded the five-year high achieved in FY 2005 of 68.8 percent and the 
total number of referrals accepted (445) also was higher than last 
year. The IRS completed 4,157 criminal investigations, exceeding the 
IRS' FY 2006 target of 3,945. The incarceration rate of individuals 
sentenced for cases originating from a fraud referral was 81.7 percent 
in FY 2006, and the significant prison sentences (on average 20 months) 
handed down in cases originating from fraud referrals reflect their 
overall quality. The IRS continued to increase the publicity on tax 
prosecutions because of the positive effect on compliance. In FY 2006, 
the publicity rate on legal source tax cases remained high at 81.3 
percent with an overall publicity rate for all prosecutions of 75.6 
percent. 

The IRS also provides financial investigation expertise to the Federal 
Bureau of Investigation's Joint Terrorism Task Forces and the U.S. 
Attorney's Anti-Terrorism Advisory Council in disrupting and 
dismantling terrorist financing. The IRS works closely with Treasury to 
investigate and freeze accounts controlled by individuals and 
"charitable" organizations suspected of raising or facilitating the 
movement of funds used to support terrorism. In FY 2006, the IRS had 
212 terrorism related investigations in inventory, a 31 percent 
increase from last year. Fifty-two cases were recommended for 
prosecution to the Department of Justice, resulting in 44 indictments. 

The IRS also participated on the Joint International Tax Shelter 
Information Centre (JITSIC). The JITSIC, which consists of tax 
officials from the U.S., United Kingdom, Canada, and Australia, is 
scrutinizing tax arbitrage by multinational corporations. The combined 
detection and analytical capabilities of the JITSIC will better enable 
the IRS and other participating tax agencies to take action against 
those who plan, facilitate, or engage in abusive tax transactions in 
other countries. 

The IRS committed to strengthen its enforcement presence among those 
entities with special benefits that may attract fraud and abuse. The 
purpose of this scrutiny is to ensure the entity is legitimate when 
established, the operation remains compliant and the entity is not 
being misused by third parties for tax avoidance or other unintended 
purposes. In FY 2006, the IRS focused on: 

* Consumer credit counseling - Because of the changes in the way the 
credit counseling industry now operates, the IRS examined 63 tax-exempt 
credit counseling organizations, representing 56 percent of industry 
revenues. These examinations resulted in the revocation or proposed 
revocation of exempt status (under which a business can continue to 
operate as a for-profit corporation), for organizations comprising 41 
percent of the revenue in this industry. In addition to its vigilant 
examination program, the IRS halted the growth of abusive credit 
counseling organizations. Of more than 110 recently reviewed 
applications, only three met the requirements for tax-exempt status. 
The IRS also conducted compliance checks of the more than 700 remaining 
organizations to determine whether they are operating compliant credit 
counseling programs. 

* Pension funding - In the wake of several prominent bankruptcies which 
resulted in seriously under-funded pension plans, the IRS increased 
interagency coordination with the Department of Labor (DOL) and the 
Pension Benefit Guaranty Corporation (PBGC). A closing agreement in FY 
2006 with an employer in bankruptcy resulted in payment of $23 million 
and established a precedent for renewed assertion of claims. The IRS, 
DOL, and PBGC agreed to meet weekly to coordinate administrative 
actions on such plans. 

* Political activity - As a result of findings from examinations 
conducted during the 2004 election cycle, the IRS increased its 
vigilance concerning political campaign intervention by tax exempt 
501(c) (3) charitable organizations. Some level of prohibited political 
activity was found in three-quarters of the cases reviewed including 
violations such as distributing improper voting guides or printed 
materials favoring particular candidates, endorsing or opposing 
candidates from the pulpit, criticizing or supporting candidates on a 
charity's website, permitting certain candidates to speak at official 
functions, and making contributions to campaigns. In February 2006, the 
IRS issued new procedures for the 2006 election season to ensure that 
all referrals are reviewed expeditiously and consistently. The IRS also 
expanded its educational effort to ensure that charities understand 
what constitutes prohibited political intervention and how to stay in 
compliance with the tax law. 

* Down payment assistance - The IRS found that organizations claiming 
to be charities are funneling down-payment assistance from sellers to 
buyers through self-serving, circular financing arrangements. As a 
result, in FY 2006, an active outreach effort was launched and a 
vigorous audit program established to identify potential abusers. The 
IRS also issued formal guidance that shows the difference between a 
down-payment assistance organization operating in a manner consistent 
with requirements for qualifying as a charity with seller-financed 
arrangements that do not. In addition to its ongoing examination 
program, the IRS denied applications for exemption from 53 seller- 
financed down-payment assistance organizations. The revenue ruling and 
increased enforcement activity garnered considerable media attention 
and support from the Chairman of the Senate Finance Committee. 

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

Table 12: Examination Coverage - Individual (Revised Measure): 

Description: The sum of all individual returns closed by SB/SE, W&I, 
and LMSB (Field Examination and Correspondence Examination) divided by 
the total individual return filings for the prior calendar year. 

Examination Coverage - Individual; 
FY 2003: Actual: --; 
FY 2004: Actual: 0.8%; 
FY 2005: Actual: 0.9%; 
FY 2006: Plan: 0.9%; 
FY 2006: Actual:  1.0%. 

Note: In FY 2005, Automated Underreported (AUR) cases were included as 
part of this measure. In FY 2006, AUR is covered as a separate measure 
(see measure 7. - AUR Coverage). The new methodology was applied to 
prior year actual and the FY 2006 plan number. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS will continue to balance its audit coverage to 
emphasize reduction of the tax gap. Specific areas targeted for 
improvement include the workload identification processes, the audit 
selection criteria, and restructured examination training classes. 

Table 13:  Field Examination Embedded Quality (EQ) (Replaces 
Examination Quality - Field): 

Description: The number of EQ quality attributes that are scored as 
"met" by an independent centralized review staff divided by the total 
attributes measured ("mets" + "not mets") in a sample of closed Field 
Examination cases. All measured attributes have the same weight when 
calculating the score. Pending full implementation in FY 2007, only 
like attributes corresponding to those in the prior Examination Quality 
Measurement System (EQMS) (quality system preceding EQ) reviews were 
used in FY 2006. 

Field Examination Embedded Quality; 
FY 2003: Actual: N/A; 
FY 2004: Actual: N/A; 
FY 2005: Actual: N/A; 
FY 2006: Plan: Baseline; 
FY 2006: Actual:  Not yet available. 

[End of table] 

FY 2006 Performance: In FY 2006, a baseline year, the IRS converted to 
the EQ system of measuring quality by the national independent 
centralized review staff. Baseline data will be available December 1, 
2006. 

Future Plans: The IRS will complete the full implementation of EQ with 
the addition of the front-line manager phase. This phase directly links 
Critical Job Elements to the quality measurement system, improving the 
relationship between individual performance and organizational 
objectives. Full implementation of EQ is expected to help identify 
potential problem areas in need of process improvements or focused 
training, and ultimately, lead to reductions in examination cycle time. 

Table 14: Office Examination Embedded Quality (EQ) (Replaces 
Examination Quality - Office): 

Description: A percentage representing the number of EQ quality 
attributes that are scored as "met" within SBSE divided by the total 
attributes measured ("mets" + "not mets") in a sample of closed Office 
Examination cases. All measured attributes have the same weight when 
calculating the score. Pending full implementation in FY 2007, only 
like attributes corresponding to those in the prior EQMS reviews were 
used in FY 2006. 

Office Examination Embedded Quality; 
FY 2003: Actual: N/A; 
FY 2004: Actual: N/A; 
FY 2005: Actual: N/A; 
FY 2006: Plan: Baseline; 
FY 2006: Actual: Not yet available. 

[End of table] 

FY 2006 Performance: In FY 2006, the baseline year, the IRS converted 
to the EQ system of measuring quality at the national independent 
centralized review staff within SBSE level. Baseline data will be 
available December 1, 2006. 

Future Plans: The IRS will complete the full implementation of EQ with 
the addition of the front-line manager phase. This phase directly links 
employees' Critical Job Elements to the quality measurement system, 
improving the relationship between individual performance and 
organizational objectives. Full implementation of EQ is expected to 
help identify potential problem areas in need of process improvements 
or focused training and, ultimately, lead to reductions in examination 
cycle time. 

Table 15: Examination Coverage - Business (Corps. >$10M): 

Description: The number of Large and Mid-Size Business customer returns 
with assets greater than $10 million examined and closed during the 
current fiscal year, divided by filing of the same type returns from 
the preceding calendar year. 

Examination Coverage - Business (Corps. >$10M); 
FY 2003: Actual: --; 
FY 2004: Actual: 7.5%; 
FY 2005: Actual: 7.8%*; 
FY 2006: Plan: 7.5%; 
FY 2006: Actual:  7.4%. 

*Revised FY 2005 actual reflects updated case closure information from 
the Automated Inventory Management System (AIMS): 

[End of table] 

FY 2006 Performance: Target Not Achieved. The IRS did not meet the FY 
2006 target. The target was missed by .1 percentage point due to the 
IRS being prevented from taking enforcement action on a significant 
number of partnership return examinations involving a tax shelter 
promoter. Also, partnership audits were not as productive as expected 
so the IRS stopped opening these audits until improvement of the 
examination selection methodology. 

Future Plans: The IRS will continue to focus on the issues that pose 
the greatest compliance risk and to identify enterprises that appear to 
be non-compliant. The IRS' emphasis on streamlining and improving the 
examination process, coupled with better risk analysis, will continue 
to provide for early resolution of post-filing examination issues and 
enhance large business examination coverage. 

Table 16: Examination Efficiency - Individual (Revised Measure): 

Description: The sum of all individual returns closed by SB/SE, W&I, 
and LMSB (Field Examination and Correspondence Examination) divided by 
the Total Full Time Equivalents (FTE) expended in examining those 
individual returns. In FY 2005, Automated Underreporter (AUR) cases 
were included as part of this measure. In FY 2006, AUR Efficiency is 
covered as a separate measure (see measure 6. - AUR Efficiency). The 
new methodology was applied to prior year actual and the FY 2006 plan 
number. 

Examination Efficiency - Individual; 
FY 2003: Actual: N/A; 
FY 2004: Actual: N/A; 
FY 2005: Actual: 121; 
FY 2006: Plan: 121; 
FY 2006: Actual:  128. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. Record closures and stable FTE enabled the IRS to exceed its 
plan. 

Future Plans: The IRS will continue to provide balanced examination 
coverage for those individual return categories with the highest risk 
of non-compliance, focusing on both understatement of income and 
overstatement of offsets to income. Newly designed training supports 
this emphasis, with its focus on auditing techniques. 

Table 17: Automated Underreporter (AUR) Efficiency: 

Description: The total number of W&I and SB/SE contact closures (a 
closure resulting from a case where the IRS made contact with the 
taxpayer) divided by the total FTE. 

AUR Efficiency; 
FY 2003: Actual: --; 
FY 2004: Actual: 1,514; 
FY 2005: Actual: 1,701; 
FY 2006: Plan: 1,759; 
FY 2006: Actual:  1,832. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS will leverage the process improvements 
implemented in FY 2006 to improve workload selection and productivity, 
and reduce the number of cases closed without taxpayer contact. 

Table 18: Automated Underreporter (AUR) Coverage: 

Description: Total number of W&I and SB/SE contact closures (a closure 
resulting from a case where IRS made contact) divided by the total 
return filings from the prior year. 

AUR Coverage; 
FY 2003: Actual: --; 
FY 2004: Actual: 1.9%; 
FY 2005: Actual: 2.2%; 
FY 2006: Plan: 2.3%; 
FY 2006: Actual:  2.4%. 

[End of table] 

FY 2006 Performance: Target Achieved. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS plans to leverage the process improvements 
implemented in FY 2006 to improve workload selection and productivity, 
reducing the number of cases closed without taxpayer contact. 

Table 19: Examination Quality - Industry: 

Description: The average of the percentage of critical quality 
attributes passed on Industry cases (corporations, S-Corps (pass 
through corporations), and partnerships with assets over $10 million 
reviewed. 

Examination Quality - Industry; 
FY 2003: Actual: 74.0%; 
FY 2004: Actual: 74.0%; 
FY 2005: Actual: 77.0%; 
FY 2006: Plan: 80.0%; 
FY 2006: Actual:  85.0%. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS plans to identify areas that warrant further 
attention and improvement through its quality reviews. All examination 
training courses will expand modules on the identified improvement 
targets and incorporate pertinent information about the auditing 
standards used to measure case quality. The IRS will also continue its 
work with the Case Quality Improvement Council (CQIC) and its Industry 
contacts to drive quality improvement efforts. 

Table 20: Examination Quality - Coordinated Industry: 

Description: The average of the percentage of critical quality 
attributes passed on Coordinated Industry (the 900 largest 
corporations) cases reviewed. 

Examination Quality - Coordinated Industry; 
FY 2003: Actual: 89.0%; 
FY 2004: Actual: 87.0%; 
FY 2005: Actual: 89.0%; 
FY 2006: Plan: 92.0%; 
FY 2006: Actual:  96.0%. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS plans to identify areas that warrant further 
attention and improvement through its quality reviews. All examination 
training courses will expand modules on the identified improvement 
targets and incorporate pertinent information about the auditing 
standards used to measure case quality. The IRS will also continue its 
work with the CQIC and its Industry contacts to drive quality 
improvement efforts. 

Table 21: Collection Coverage - Units (Revised Measure): 

Description: The volume of collection work closed compared to the 
volume of collection work available. The new methodology for FY 2006 
includes balance due and delinquent return cases still in notice status 
whereas, the FY 2005 methodology only considered those accounts or 
investigations in delinquent status (Taxpayer Delinquent Account (TDA) 
and Taxpayer Delinquent Investigation (TDI) statuses). The new 
methodology was applied to recalculate the prior actual and the FY 2006 
plan number. 

Collection Coverage - Units; 
FY 2003: Actual: --; 
FY 2004: Actual: --; 
FY 2005: Actual: 53.0%; 
FY 2006: Plan: 52.0%; 
FY 2006: Actual: 54.0%. 

[End of table] 

FY 2006 Performance: Target Achieved. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS plans to continue to facilitate the process for 
allocating its resources and planning for program delivery through the 
Collection Governance Council. This will ensure enterprise-wide 
coordination of case selection and delivery decisions. 

Table 22: Collection Efficiency (Revised Measure): 

Description: Total work (delinquent accounts, investigations, offer- in-
compromise, automated substitution for return) divided by the total 
Full Time Equivalent (FTE) realized in field collection and in campus 
collection. The new methodology for FY 2006 includes balance due and 
delinquent return cases still in notice status whereas, the FY 2005 
methodology only considered accounts or investigations in delinquent 
status (Taxpayer Delinquent Account (TDA) and Taxpayer Delinquent 
Investigation (TDI) statuses). The new methodology was applied to 
recalculate the prior actual and the FY 2006 plan number. 

Collection Efficiency; 
FY 2003: Actual: --; 
FY 2004: Actual: --; 
FY 2005: Actual: 1,514; 
FY 2006: Plan: 1,650; 
FY 2006: Actual:  1,677. 

[End of table] 

FY 2006 Performance: Target Exceeded: The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS plans to continue its practice of allocating 
resources and planning for program delivery through the Collection 
Governance Council to ensure enterprise-wide coordination of case 
selection and program delivery decisions. 

Table 23: Field Collection Embedded Quality (EQ) - (Replaces Field 
Collection Quality of Cases Handled in Person): 

Description: This measure was baselined in FY 2006 and replaces the 
"Field Collection Quality of Cases Handled in Person" measure. The 
number of EQ quality attributes that are scored as "met" by an 
independent centralized review staff divided by the total attributes 
measured (mets + not mets) in a sample of closed cases. All measured 
attributes have the same weight when calculating the score. 

Field Collection Embedded Quality; 
FY 2003: Actual: N/A; 
FY 2004: Actual: N/A; 
FY 2005: Actual: N/A; 
FY 2006: Plan: Baseline; 
FY 2006: Actual: 84.2%. 

[End of table] 

FY 2006 Performance: In FY 2006, the baseline year, the IRS converted 
to the EQ system of measuring quality at the national independent 
centralized review staff level. 

Future Plans: The IRS will complete the full implementation of EQ with 
the addition of the front-line manager phase. This phase directly links 
employees' Critical Job Elements to the quality measurement system, 
improving the relationship between individual performance and 
organizational objectives. Full implementation of EQ is expected to 
help identify potential problem areas in need of process improvements 
or focused training and ultimately, lead to reductions in collection 
cycle time. 

Table 24: Automated Collection System (ACS) Accuracy: 

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

ACS Accuracy; 
FY 2003: Actual: --; 
FY 2004: Actual: 87.8%; 
FY 2005: Actual: 88.5%; 
FY 2006: Plan: 88.0%; 
FY 2006: Actual: 91.0%. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS will leverage the process improvements made to 
its Electronic Automated Collection Service Guide, a tool designed to 
further increase response accuracy. Also, the IRS will trend accuracy 
statistics to better focus managerial reviews. 

Table 25: Criminal Investigations Completed: 

Description: The total number of subject criminal investigations 
completed during the fiscal year, including those that resulted in 
prosecution recommendations to the Department of Justice as well as 
those discontinued due to a lack of prosecution potential. 

Criminal Investigations Completed; 
FY 2003: Actual: 3,766; 
FY 2004: Actual: 4,387; 
FY 2005: Actual: 4,104; 
FY 2006: Plan: 3,945; 
FY 2006: Actual:  4,157. 

[End of table] 

FY 2006 Performance: Target Exceeded. The IRS met/exceeded the FY 2006 
target. 

Future Plans: The IRS will continue to monitor Criminal Investigation's 
performance and adjust program focus as necessary to ensure efforts 
garner the greatest deterrent effect possible. 

Table 26: TE/GE Determination Case Closures: 

Description: Cases established and closed on the Employee Plans-Exempt 
Organizations Determination System (EDS) includes all types of tax 
exempt and employee plan application cases. 

TEGE Determination Case Closures; 
FY 2003: Actual: 171,812; 
FY 2004: Actual: 143,877; 
FY 2005: Actual: 126,481; 
FY 2006: Plan: 112,400; 
FY 2006: Actual:  107,761. 

[End of table] 

FY 2006 Performance: Target Not Achieved. The IRS did not meet the FY 
2006 target. The implementation of the new staggered amendment filing 
process for employee plans changed the FY 2006 inventory mix. Over 40 
percent of the 25,000 receipts were prototype plans that require more 
extensive review as they will subsequently be adopted by thousands of 
individual employers. These cases will not close until FY 2007, 
resulting in the closure of 3,600 fewer cases than originally planned. 
Additionally, recent increases in user fees for employee plan 
determinations resulted in a slight decrease in determination 
applications and ultimately 1,500 fewer projected closures. 

Future Plans: To stabilize the flow of determination receipts and 
mitigate the significant swings in workload experienced prior to FY 
2006, the IRS will continue its roll-out of the staggered amendment 
process. The IRS also plans to test and pilot (with external partners) 
a new interactive software application for preparing determination 
applications designed to improve the quality of determination requests 
and establish the foundation for future 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: 

The IRS must strategically manage its resources, business processes, 
and technology systems to effectively and efficiently support its 
service and enforcement mission. "Modernization" includes technology 
projects with which taxpayers are not directly involved, such as 
replacement of the master file system, upgrading accounting systems, 
and enhancing the modernized technological infrastructure on which 
existing and all future applications will depend. Modernization also 
applies to the work processes and preparing the IRS workforce to meet 
the challenges of the 21st century, including replenishing a maturing 
workforce, improving workforce skills, and ensuring a continual 
leadership cadre for the future. The IRS strives to become a "first 
choice" employer where talented people want to work and can excel in a 
culture of high performance, empowerment, and a quality work 
environment. 

Human Capital Accomplishments: 

To ensure the IRS builds a highly productive and engaged workforce, the 
Human Capital Strategic Implementation Plan was introduced in FY 2006. 
The plan aligns Treasury's Human Capital (HC) Strategic Goals, the IRS' 
Strategic Goals, and the IRS' HC Strategic Goals, and establishes 
performance monitoring against objectives, processes, and projects. 

Throughout FY 2006, the IRS ensured the appropriate and necessary 
investments were made in human capital, its most valuable resource. A 
multi-year recruitment and marketing plan was developed to target a 
diverse applicant pool. A comprehensive assessment strategy to identify 
applicants with the knowledge, skills, and abilities (competencies) 
necessary to support core job responsibilities positioned the IRS to 
meet its current, and plan to meet its future, business needs. 
Additionally, the IRS increased the use of workforce planning tools to 
develop a more robust link between business plans (i.e., examination 
plan) and workforce replenishment. More directly, the following areas 
were targeted: 

* Linking pay with performance to maximize the workforces' 
contributions to the IRS core mission and goals. About 5,700 front-line 
managers transitioned to a new pay band and 2,000 senior managers and 
department managers transitioned to a redesigned, step-less pay band. 

* Developing an IRS-wide pay for performance framework to move 90,000 
employees into a performance-based pay environment. 

* Delivering customized training electronically. For example, 
electronic delivery of mandatory briefings (computer security, 
unauthorized access) saved the IRS $1.6 million for 75,000 employees. 

* Assembling a highly trained cadre of recruiters responsible for 
maintaining an IRS recruiting presence at educational institutions, 
particularly for the IRS' enforcement occupations. The cadre 
established partnerships with over 200 colleges and universities and 
attended 800 campus and commercial events across the country. 

The IRS used competition as an incentive to improve IRS business 
processes, reshape its workforce, and further its strategic goals. The 
IRS conducted its first full and open standard competition to evaluate 
work performed at three Area Distribution Centers (ADCs) and to 
recommend improvements. ADCs provide warehousing, inventory, and 
management services for more than 12,000 publications and process about 
five million customer orders annually. The ADCs occupy 550,000 square 
feet of combined leased warehouse space and employ 400 FTE positions. A 
bid solicitation for the competition, developed in partnership with the 
National Treasury Employees Union, resulted in seven proposals: six 
from well-known private sector organizations and one from the in-house 
team, called the Most Efficient Organization, which won the 
competition. 

The competitive sourcing competition for the Submission Processing 
Files function resulted in a decision to award a contract to an 
experienced vendor. The IRS reached its award decision after evaluating 
all proposals including the Government's Most Efficient Organization 
proposal, private vendor proposals, and public reimbursable proposals. 
After careful and accurate technical and cost evaluations, the IRS 
found the vendor's proposal to be the lowest-priced, technically 
acceptable proposal, and awarded a five-year contract consisting of a 
base period of one year and four optional years. 

Business Systems Modernization: 

The Business Systems Modernization (BSM) program combines best 
practices and expertise in business solutions and internal management 
from IRS, business, and technology sectors to develop a world-class tax 
administration system that fulfills the revenue collection requirements 
of the United States as well as taxpayer's needs and expectations. 

The IRS executed its BSM projects with a degree of sustained success 
not seen since program inception. Successful program delivery during 
the past two years demonstrates that the IRS' BSM program has 
established a foundation of disciplined project delivery and 
accomplishment. Overall, the program delivered within the target of +/
-10 percent variance for both cost and schedule components for major 
release and sub-release milestones, a significant achievement that 
validates BSM program management effectiveness. This accomplishment is 
especially noteworthy in that the program achieved this while 
transitioning from a contractor-led program to an IRS-led program. 

A key success factor has been the IRS' increased focus managing 
contractor performance and leveraging IRS resources. This approach was 
outlined in the Modernization Vision & Strategy (MV&S) efforts, a 
comprehensive vision for IRS' future operations. The MV&S establishes a 
plan that drives investment decisions, addressing the priorities for 
modernizing front-line tax administration, and establishes technical 
capabilities provided by infrastructure and security. The MV&S reflects 
the priorities across the IRS and serves as a guide for focusing 
investment by mandating development of a prioritized list of proposed 
IRS modernization projects for a given year. Whenever possible, the 
MV&S approach leverages existing systems, and, as necessary, the 
program includes new development to optimize capacity, manage program 
costs, and deliver functionality in smaller and more frequent releases. 
The IRS expects this approach to deliver business value sooner and at a 
lower risk. 

Information technology solutions are the most effective and efficient 
means of increasing the number of IRS contacts with taxpayers and 
offers faster alternatives for taxpayers to meet their tax obligations. 
Information technology solutions also enhance the IRS' ability to 
identify non-compliance and to combat tax avoidance schemes that 
contribute to the tax gap. The following highlights the IRS' efforts in 
FY 2006: 

* Stabilized and institutionalized program management improvements, 
meeting scope expectations for implemented functional and technical 
capability. The BSM program expanded its financial and schedule 
management capabilities to include greater detail and controls than 
previously available in past expenditure plans. 

* Implemented Release 3.2 of its Modernized e-File (MeF) project, which 
expanded the electronic filing of both federal and state (Forms 1120 
and 1120-S) Corporate Income Tax Returns and is mandatory for certain 
corporations. Corporate tax returns typically include hundreds, or even 
thousands, of pages and receiving the data electronically from these 
voluminous and complex returns speeds the examination process. 
Electronic capture of return information allows the IRS to quickly 
deliver the data to analysts and agents for compliance risk assessment 
and action. MeF processed 375,000 corporate returns. The IRS plans to 
expand the MeF taxpayer base to include Partnership Income tax returns 
(Form 1065), eventually enabling nearly 2.7 million small business and 
self-employed taxpayers to benefit from electronic filing. 

* Introduced new Customer Account Data Engine (CADE) capabilities for 
the 2006 filing season. CADE supported faster refunds to taxpayers, 
issuing direct deposit refunds between one and seven days faster and 
paper refunds four to thirteen days faster than refunds generated by 
the legacy system. CADE processed over 7.3 million returns - more than 
a 400 percent increase over the previous year, and issued 7 million 
refunds totaling in excess of $3.4 billion. CADE improved taxpayer 
service by allowing access to current information up to seven days 
sooner, increasing the likelihood of single telephone call resolution 
and allowed faster issue detection and more timely account settlement. 
CADE is expected to process an estimated 33 million returns in 2007. 

* Completed the first release of the Filing and Payment Compliance 
(F&PC) strategy. F&PC functionality analyzes tax collection cases and 
separates cases that require direct IRS involvement from those that can 
be handled by Private Collection Agencies (PCAs). The introduction of 
PCAs is expected to: 

- Assist the IRS by addressing the volume of delinquent taxpayers that 
exceeds the IRS' capacity to work, approximately 250,000 cases per 
year. 

- Eliminate backlogs in the large number of outstanding tax 
liabilities, which have grown by 118 percent over the last 12 years, 
increasing tax revenue and reducing the tax gap. 

- Allow the IRS to close 2.4 million more collection cases each year, 
improving the collection case closure rate from 53 percent (as of FY 
2005) to 97 percent by 2016. 

Business Process Reengineering: 

The IRS continued to improve quality, efficiency, and service delivery 
through a wide-range of initiatives designed to increase service 
coverage to taxpayers and implemented new and improved business 
processes. Processes were put in place to better integrate business and 
technology strategies and manage out-of-cycle information technology 
requests and budget changes. Examples of successful initiatives 
include: 

* Reengineered the examination function to streamline the process, 
increase effectiveness and timeliness in examining returns, resolve 
taxpayer issues, and reduce and redirect resources to improve 
operational results. 

* Reengineered collection functions to improve workload selection, 
reduce cycle time, improve casework quality, and improve customer and 
employee satisfaction. The focus on collection activities yielded 
positive results, ensuring timely initial contacts by Revenue Officers 
and reduced activity lapses in casework. 

* Implemented the Desktop Integration (DI) System, replacing the old 
Integrated Case Processing system. DI allows call center assistors to 
determine the status of a taxpayer's account reducing the amount of 
time needed for account resolution, and allows the assistor to provide 
timely, quality responses to the taxpayer. The DI System was 
successfully deployed to over 30,000 users. 

* Developed and implemented a Phishing Web Site to provide guidance to 
internal and external stakeholders. "Phishing" is the act of sending an 
e-mail to a user falsely claiming to be a legitimate enterprise in an 
attempt to scam the user into surrendering private information that 
could be used for identity theft. The IRS phishing e-mail box at 
phishing@irs.gov was established so internal and external stakeholders 
could send phishing e-mails to the IRS for evidence gathering and 
developing countermeasures. 

* Completed the development phase of Contact Recording Release 4.0 for 
use in IRS Taxpayer Assistance Centers (TACs). Contact Recording 
provides functionality to record a taxpayer call for training purposes 
and is expected to increase quality and accuracy of taxpayer responses 
and improve productivity. Deployment added an additional 33 sites to 
the existing 14 sites. By January 2007, the IRS plans to have contact 
recording deployed to approximately 130 TACs representing an assortment 
of small, medium, and large sites in 37 of the 50 states. Contact 
Recording will be deployed to all 400 TACs by early FY 2009. 

* Designed an imaging network to scan and electronically warehouse, 
paper tax returns for large and mid-size businesses. This "just-in-
time" inventory of returns will reduce the examination start time from 
12 -18 months from filing date, to under 90 days. The benefits of 
reduced cycle times include earlier identification of emerging issues, 
faster closing of returns at the completion of an audit, and reduction 
of taxpayer burden. 

* Launched an on-line installment agreement tool for taxpayers 
(individual return filers) via the IRS.gov website. Taxpayers can now, 
at their convenience, self qualify for an installment agreement and 
apply for and receive notification of approval during an on-line 
session. The IRS processing costs are also reduced. 

* Implemented an Enterprise Queue of toll-free calls in the Automated 
Collection System (ACS), Examination and Automated Underreporter call 
sites. Enterprise queuing allows toll-free callers to be placed in a 
central queue for an available representative anywhere in the IRS 
enterprise system. Customers can now be assisted by the first available 
assistor trained in their specific topic. 

Security and Protection of Data: 

In response to the challenge of protecting the taxpayer and employee, 
the IRS took steps to improve protection of sensitive information. The 
issuance of Memorandum M-06-16, Protection of Sensitive Agency 
Information, issued by the Office of Management and Budget, established 
requirements the IRS put in place to increase protection for networks, 
laptops, and other mobile computing devices. Additional policies and 
procedures are being implemented to bring the IRS in line with the 
requirements of the memorandum. The IRS is deploying a three-pronged 
strategy focusing on technology solutions (encryption), employee 
education and awareness, and critical analysis of IRS policies and 
procedures. The IRS also established a Security Services and Privacy 
Executive Steering Committee to coordinate efforts and to leverage 
subject matter experts from the areas of information technology 
security, physical security, privacy, and identify theft. 

During FY 2006, the IRS developed Information Protection Training for 
employees and stakeholders. The training integrated the domains of 
privacy, computer security, disclosure, and unauthorized access (UNAX). 
In the future, the IRS education and awareness programs will be 
expanded to focus attention on enhancing information protection 
practices in daily operations. 

The IRS continued progress toward the implementation of Business 
Resumption Plans (BRP) at all IRS facilities. In FY 2006, the IRS 
deployed business resumption plans during recovery from the Gulf Coast 
hurricanes and again when operations were quickly resumed after heavy 
rains late in June 2006 caused severe flooding and forced closure of 
the IRS headquarters building in Washington, D.C. The Commissioner and 
all of the top level executives immediately resumed business at an 
alternate IRS location. Through extraordinary coordination, within 
thirty days, over 2,200 displaced employees returned to their normal 
duties. There was no impact on service to the public. In all of the 
recent instances, BRPs were fully executed and Incident Commanders 
received support from designated organizations to stand up operations 
quickly and in priority order. 

Safety of Employees: 

During FY 2006, the IRS Continuity of Operations (COOP) Plan was 
updated to maintain compliance by adding annexes that address surrender 
of power to local authorities by the Federal Government, and pandemic 
influenza. The IRS participated in the planning and execution of the 
government-wide COOP exercise, Forward Challenge 06. During the 
exercise, several scenarios, including a cyber attack on IRS tax 
systems and a physical attack on a campus facility were simulated and 
worked by the team. A number of lessons learned were documented that 
will provide the direction for further improvement of the COOP Plan and 
the IRS' overall approach to COOP preparedness. The IRS also continued 
high levels of emphasis on ensuring Occupant Emergency Plans (OEP) and 
Shelter in Place (SIP) Plans are current for all IRS Facilities. 

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

Table 26: BSM Project Cost Variance by Release/Subrelease - (Replaces 
the Cost portion of the Contracted Program Cost and Schedule Variance 
Measure): 

Description: Percent variance by release/sub-release of a BSM funded 
project's initial, approved cost estimate versus current, approved cost 
estimate. Cost variances less than or equal to +/-10 percent are 
categorized as being within acceptable tolerance thresholds. Cost 
variances greater than +/-10 percent of the variance are categorized as 
being outside of acceptable thresholds. 

FY 2006 BSM Project Cost Variance by Release/Subrelease. 

Cost Variance for Project Segments Completed in FY 2006. 

[See PDF for Table] 

[End of table] 

FY 2006 Performance: In FY 2006, the baseline year, the IRS used an 
improved methodology for determining project cost variance by release/ 
subrelease. Cost variance is reported separately for each major 
release/subrelease. Overall, the BSM program delivered nearly half of 
project segment cost within target, and is meeting target expectations 
for nearly all project segments currently in-progress. In some cases, 
BSM cost targets exceeding a -10 percent threshold are attributed to 
reducing project scope. Note: For a detailed variance explanation by 
project segment, refer to the FY 2006/FY 2007 BSM Expenditure Plan. 
Aggressively managing and monitoring contractor performance and 
leveraging resources were key factors contributing to this year's 
success in meeting the targets for cost variance. 

Future Plans: The IRS will continue reporting on cost schedule measures 
in accordance with the agreed upon performance methodology. Variance 
exceeding the +/-10 percent threshold is subject to IRS change 
notification process review, Executive Steering Committee approval and, 
if applicable, Modernization and Information Technology Services 
Enterprise Governance Committee approval. Cost variances exceeding +/- 
10 percent or $1 million require Congressional notification. At each 
review juncture, management ensures that proposed project changes as 
reported in the BSM expenditure plan are valid and that mitigation 
plans are in place when applicable. 

Table 27:  BSM Project Schedule Variance by Release/Subrelease - 
(Replaces the Schedule portion of Contracted Program Cost and Schedule 
Variance Measure): 

Description: Percent variance by release/sub-release of a BSM funded 
project's initial, approved schedule estimate versus current, approved 
schedule estimate. Schedule variances less than or equal to +/-10 
percent will be categorized as being within acceptable tolerance 
thresholds. If schedule variances are greater than +/-10 percent, the 
variance will be categorized as being outside of acceptable thresholds. 

FY 2006 BSM Project Schedule Variance by Release/Subrelease. 

Schedule Variance for Project Segments Completed in FY 2006. 

Project: F&PC; 
Release: R1.2; 
Milestone: 3; 
Planned Finish Date: 02/28/06; 
Current Finish Date: 02/28/06; 
Variance (days): 0; 
Variance(%): 0%; 
Within acceptable tolerance: yes. 

Project: F&PC; 
Release: R1.2; 
Milestone: 4a; 
Planned Finish Date: 06/30/06; 
Current Finish Date: 07/10/06; 
Variance (days): 5; 
Variance(%): 6%; 
Within acceptable tolerance: yes. 

Project: MeF(FED/State project); 
Release: R3.2; 
Milestone: 4; 
Planned Finish Date: 03/31/06; 
Current Finish Date: 03/22/06; 
Variance (days): -7; 
Variance(%): -2%; 
Within acceptable tolerance: yes. 

Project: MeF; 
Release: R4; 
Milestone: 3; 
Planned Finish Date: 06/30/05; 
Current Finish Date: 12/09/05; 
Variance (days): 111; 
Variance(%): 59%; 
Within acceptable tolerance: No. 

Project: CADE; 
Release: R1.3.2; 
Milestone: FS06; 
Planned Finish Date: 12/31/05; 
Current Finish Date: 12/31/05; 
Variance (days): 0; 
Variance(%): 0%; 
Within acceptable tolerance: yes. 

Project: CADE; 
Release: R2.1; 
Milestone: 4; 
Planned Finish Date: 08/10.06; 
Current Finish Date: 08/25/06; 
Variance (days): 11; 
Variance(%): 7%; 
Within acceptable tolerance: yes. 

[End of table] 

FY 2006 Performance: In FY 2006, the baseline year, the IRS used an 
improved methodology for determining project schedule variance by 
release/subrelease. Schedule variance is reported separately for each 
major release/subrelease. The BSM program delivered most (5 out of 6) 
project segments within schedule variance. (Note: For a detailed 
variance explanation by project segment, refer to the FY 2006/FY 2007 
BSM Expenditure Plan.) 

Future Plans: The IRS will continue reporting on schedule measures in 
accordance with the agreed upon performance methodology. Variance 
exceeding the +/-10 percent threshold is subject to IRS change 
notification process review, Executive Steering Committee approval and, 
if applicable, Modernization and Information Technology Services 
Enterprise Governance Committee approval. Cost variances exceeding +/- 
10 percent or $1 million require Congressional notification. At each 
review juncture, management ensures that proposed project changes as 
reported in the BSM expenditure plan are valid and mitigation plans are 
in place when applicable. Aggressively managing and monitoring 
contractor performance and leveraging resources were key factors 
contributing to this year's success in meeting the targets for schedule 
variance. 

New Measures: 

The following measures are reported for the first time in the IRS' FY 
2006 MD&A: 

* Taxpayer Self Assistance Rate: 

* Refund Timeliness - Individual (paper): 

* Automated Underreporter Efficiency: 

* Automated Underreporter Coverage: 

Revised Measures: 

The following measures were developed based on a revised methodology 
and were renamed to reflect the new approach. The table below shows the 
renamed measure along with its replacement. 

FY 2006 Measure Name: Field Examination Embedded Quality; 
FY 2005 Measure Name: Examination Quality - Field. 

FY 2006 Measure Name: Office Examination Embedded Quality; 
FY 2005 Measure Name: Examination Quality - Office. 

FY 2006 Measure Name: Field Collection Embedded Quality; 
FY 2005 Measure Name: Field Collection Quality of Cases Handled in 
Person. 

FY 2006 Measure Name: BSM Project Cost Variance by Release and 
Subrelease; 
FY 2005 Measure Name: Contracted Program Cost and Schedule Variance 
(The project cost component). 

FY 2006 Measure Name: BSM Project Schedule Variance by Release and 
Subrelease; 
FY 2005 Measure Name: Contracted Program Cost and Schedule Variance 
(The project schedule component). 

[End of table] 

The components for calculating the following measures have changed, but 
the names of the measures remain the same. The year-end actual and 
projected targets reflected in Section II, Performance Goals and 
Results have been adjusted accordingly. 

* Examination Coverage - Individual: 

* Examination Efficiency - Individual: 

* Collection Coverage - Units: 

* Collection Efficiency - Units: 

Deleted Measure: 

Contracted Requirements Stability and Contracted Requirements 
Delivered: 

III. Systems Controls and Legal Compliance: 

Federal Managers' Financial Integrity Act (FMFIA): 

During FY 2006, the IRS complied with the internal control requirements 
of the FMFIA, the Federal Financial Management Improvement Act (FFMIA), 
the Office of Management and Budget (OMB) Circular A-123, and the 
Reports Consolidation Act of 2000. The IRS organizations are operating 
in accordance with the procedures and standards prescribed by the 
Comptroller General and OMB guidelines. 

The systems of management control 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; and: 

* financial management systems are in compliance with Federal financial 
systems standards, i.e., FMFIA Section 4 and FFMIA. 

The IRS has four open material weaknesses. Because the IRS has 
remaining material weaknesses and its 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 2006. This assurance is 
provided relative to Sections 2 and 4 of FMFIA. 

The material weaknesses are: 

* 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, 2006, the IRS' 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. 

During FY 2006, the IRS continued to improve and enhance its Integrated 
Financial System (IFS), receiving a clean financial statement audit 
opinion in the first year of operations. Also, additional functionality 
was implemented including budget and cost accounting user reports, 
production of an automated Statement of Net Cost and incorporation of 
mandated changes by oversight entities and agency management. 

Also, during FY 2006, the IRS implemented Release 1 of the Custodial 
Detail Data Base (CDDB) to improve custodial accounting. Release 1 is 
the first step toward creating a subsidiary ledger for unpaid 
assessments to the Interim Revenue Accounting Control System General 
Ledger and captures cross-reference information on certain Trust Fund 
Recovery Penalty (TFRP) cases, thus reducing reclassifications. 
Additional milestones for Releases 2 and 3 were incorporated into the 
material weakness and FFMIA remediation action plans. 

Lien Release Non-Compliance Issue: 

As of September 30, 2006, the IRS did not consistently comply with 
section 6325 of the Internal Revenue Code regarding the timely release 
of federal tax liens. The IRS developed a new action plan to address 
issues identified in the April 2006 review of the filing and release of 
tax liens and all issues identified by the Government Accountability 
Office (GAO) and the Treasury Inspector General for Tax Administration 
(TIGTA). The Financial and Management Controls Executive Steering 
Committee is monitoring this plan. 

Reports Consolidation Act of 2000: 

In accordance with the Reports Consolidation Act of 2000, the IRS 
provides assurance that its Critical Performance Measures are reliable. 
Internal Revenue Manual 1.5, "Managing Statistics in a Balanced 
Measurement System Handbook," provides a detailed 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: 

The IRS continues to improve its enterprise-wide information technology 
security program to bring the IRS in full compliance with the 
requirements of the Federal Information Security Management Act 
(FISMA). IRS efforts in FY 2004 and FY 2005 focused on the 
accomplishment of security certification and accreditation of the 
network infrastructure systems, which was achieved at the end of FY 
2005. In FY 2006, the IRS updated its security plans and completed the 
certification and accreditation for one-third of its systems to comply 
with new process guidance issued by OMB and the National Institute of 
Standards and Technology. The remaining systems will be updated in FY 
2007 and FY 2008. 

OMB Circular A-123, Management's Responsibility for Internal Control: 

The IRS conducted the required evaluation of the effectiveness of the 
internal control over financial reporting in accordance with OMB 
Circular A-123 through the following activities: 

* Tested internal control sets for the 45 transaction processes 
identified by Treasury that are material to its Consolidated Financial 
Statements. These tests included 35 administrative processes covering 
material portions of the IRS' $10 billion in annual administrative 
transactions, and 10 custodial tax-related processes, covering material 
portions of IRS' over $2 trillion in tax revenues processed annually. 
Based on IRS' testing, the internal controls were operating effectively 
and no material weaknesses, other than the ones identified above in the 
FFMIA part of this document, were found in the design or operation of 
the internal controls. 

* Reviewed controls over IRS' financial reporting, specifically 
Treasury Information Executive Repository reporting, and determined 
controls are in place and effective. 

* Conducted a self-assessment of the internal control environment using 
GAO's Abbreviated Internal Control Evaluation Checklist. 

* Reviewed IRS compliance with laws and regulatory requirements 
regarding financial reporting and internal control, specifically 
compliance with FFMIA, FMFIA, FISMA, Improper Payments Information Act, 
and the CFO Act, determining that the IRS is in compliance except for 
the issues cited in this document. 

* Reviewed GAO and TIGTA audit reports and findings during the test 
plan development stage and at the end of the A-123 reporting period, 
and determined that the IRS is making progress toward completing 
corrective actions to the auditors' findings. 

Based on the results of this evaluation, the IRS provided qualified 
assurance that its internal control over financial reporting was 
operating effectively as of June 30, 2006. The qualified assurance is 
based on the condition that the IRS has four material weaknesses, as 
reported by GAO in the IRS' FYs 2004 and 2005 audited financial 
statements. GAO, however, acknowledged in its report that the IRS has 
developed compensating procedures to produce financial statements that 
are fairly stated and issued an unqualified opinion. 

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 OMB, 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: 

The great majority of Americans pay their fair share of taxes, but 
there is still a significant tax gap created by those taxpayers who 
don't pay the hundreds of billions in taxes they owe. The tax gap is 
the difference between what taxpayers should pay and what they actually 
pay due to: 

* taxpayers not filing tax returns; 

* not paying their reported tax liability on time; or: 

* failing to report their correct tax liability. 

The IRS' current estimate of the overall gross tax gap is about $345 
billion. It is the need to address the tax gap to ensure voluntary 
compliance that drives much of what the IRS does. The IRS enforcement 
activities, such as examination and collection, directly target tax gap 
elements, while IRS taxpayer services enhances compliance by providing 
the information taxpayers need to calculate their taxes, file tax 
forms, pay balances or receive refunds. 

The IRS enforcement programs yield direct and indirect return on 
investment. Each dollar invested yields at least four dollars for the 
Federal Treasury. The link between taxpayer services and increased 
federal receipts, however, isn't as measurable, but is positive. It is 
important to understand that the complexity of the nation's current tax 
system is a significant reason for the tax gap. It is easy for even 
sophisticated taxpayers to make honest mistakes. Accordingly, helping 
taxpayers understand their obligations under the tax law is a critical 
part of addressing the tax gap. The IRS remains committed to assisting 
taxpayers in both understanding the tax law and paying the proper 
amount of tax. 

Providing taxpayer service over multiple channels to align service 
content, delivery, and resources with taxpayer and partner expectations 
will be achieved by the implementation of the Taxpayer Assistance 
Blueprint (TAB). Elements of the TAB are designed to reduce taxpayer 
burden, increase voluntary compliance, and improve workforce 
performance by establishing a credible taxpayer/partner baseline of 
needs, preferences, and behaviors. Institutionalizing key research, 
operational, and assessment activities will help the IRS manage and 
improve service delivery. 

The IRS has a robust, balanced, and comprehensive plan to help reduce 
improper payments. The plan includes base compliance activities and 
redesign efforts to identify, test, and implement new and enhanced 
business processes; an outreach component to educate taxpayers and 
preparers on Earned Income Tax Credit eligibility requirements; and a 
research strategy that supports the IRS Strategic Plan. 

The manner and means by which individuals deploy fraudulent refund 
schemes is constantly evolving and is becoming more complex and 
sophisticated. The Questionable Refund Program (QRP) and the Return 
Preparer Program (RPP) will continue to serve an important tax 
administration purpose by enabling the IRS to identify and stop the 
payment of fraudulent refund claims, as well as identify and 
investigate unscrupulous return preparers. 

The Electronic Fraud Detection System (EFDS) is one of several tools 
used by the IRS. All refund returns are scrutinized by EFDS, which 
results in the identification of a substantial proportion of false 
returns. The EFDS automates the review process including screening, 
income verification, scheme development, and scheme inventory 
management. As new schemes are identified, the computer system is 
programmed to identify them to maximize the efficiencies of the 
automated systems. The IRS must overcome the system failures that 
prevented the use of the EFDS during the 2006 filing season to make the 
legacy client/server system operational for the 2007 filing season. 

Moving forward, the IRS must continue to focus on technology to ensure 
it uses technological advances to optimize both taxpayer service and 
enforcement programs. The IRS plans to continue the implementation of 
its revised Business Systems Modernization strategy, emphasizing the 
incremental release of projects to deliver business value sooner and at 
a lower risk. Modernization efforts will continue to focus on three key 
tax administration systems that provide additional benefits to 
taxpayers and the IRS employees: Customer Account Data Engine project; 
Modernized e-file; and Filing and Payment Compliance. 

Recognizing the responsibility for safeguarding Americans' most 
sensitive financial information, the IRS is taking aggressive steps to 
improve taxpayer and employee information protection. The IRS will 
continue to focus on technological solutions (encryption), employee 
education and awareness, and critical analysis of IRS policies and 
procedures. 

Targeted training, activities to promote retention, and engagement of 
employees are key elements of the IRS Strategic Plan, and necessary to 
sustaining an engaged and productive workforce. To meet changing 
business and technological demands, the IRS will focus efforts on 
implementing retention and training programs that identify targeted 
occupations, skill sets, and hard to fill positions. Features of the 
program include integrating all training, recruitment, hiring, and 
compensation efforts along with developing new and improved methods of 
predicting future attrition through retirements. Developing activities 
specifically targeted toward mitigating the impact of retirements 
through training, and those necessary to attract and retain new hires 
with advanced skills will be key to achieving the IRS' business goals. 

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 Business Operating Divisions 
is shown below. 

Management Challenge or; High Risk Area; Business Operating Divisions. 

[See PDF for Table] 

[End of table] 

The following pages summarize each Management Challenge and High-Risk 
issue, FY 2006 accomplishments, and actions identified for completion 
in FY 2007 and beyond: 

Modernization of the Internal Revenue Service (Computerized Systems and 
Business Structure) and IRS Business Systems: 

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 (FY 2006): 

* Continued to move the IRS towards realizing its technology 
modernization strategy through the Customer Account Data Engine (CADE), 
which provides key taxpayer benefits such as processing of refunds 
faster, daily posting of transactions and account updates. (Ongoing): 

- Delivered Release 1.3.2, which added Form 1040 and Form 1040A returns 
(without schedules) to the established baseline of Form 1040EZs. (01/ 
2006): 

- Posted 7.3 million returns for filing season 2006 resulting in the 
issuance of 7 million refunds to eligible taxpayers totaling $3.4 
billion. (01/2006): 

- Deployed CADE Release 2.1, which added Form 1040 Schedules A, B, and 
R and Form 1040A Schedules 1 and 3. (09/2006): 

* Delivered full functionality for Filing & Payment Compliance (Release 
1). Functionality provides for the identification of cases to be issued 
to Private Collection Agencies (PCAs). The system identified and 
delivered 12,500 cases with the three PCAs awarded contracts in March 
2006. (09/2006): 

* Implemented mandatory electronic filing for large corporations (those 
with assets greater than $50 million that file at least 250 returns a 
year) and certain exempt organizations. The IRS received more than 
12,500 returns from required corporations. Also, for the first time, 
over 10,000 exempt organizations electronically filed 990-series 
returns (annual forms). (09/2006): 

* Automated the Statement of Net Cost in the Integrated Financial 
System. (09/2006): 

Actions Planned or Underway (FY 2007 and beyond): 

* Complete the Logistical Data Model and Logical Design for CADE 
Release 3.0. Complete Customer Technical Review and Life Cycle State 
reviews for CADE Release 3.0. (11/2006): 

* Establish Modernized e-File (MeF) as primary interface for all 
business filings. MeF will remedy the electronic filing limitations (e-
File) within the current legacy systems including those that prevent 
partnerships with complying. (01/2007): 

* Process TY 2006 U.S. Return of Partnership Income (1065 returns) 
through MeF. (01/2007): 

* Deploy CADE Release 2.2 to add 1040 Schedules C, E, F, (without EINs) 
and/or SE, D, and update for 2006 tax law changes, including guidance 
IRS established for implementing the Telephone Excise Tax Refund that 
eligible taxpayers can request on their 2006 Federal income tax return. 
(01/2007): 

* Expand mandatory electronic filing for large corporations (those with 
assets greater than $10 million that file at least 250 returns a year) 
and certain other exempt organization returns. (01/2007): 

* Deploy the Correspondence Examination Automation Support (CEASrev1) 
application to increase efficiency and effectiveness of operations 
through improved inventory, workload and resources management. (02/ 
2007): 
* Continue operation of the computer data security web site that 
provides information and guidance to assist employees in complying with 
all IRS data security requirements. (Ongoing): 

* Deploy the Filing and Payment Compliance Release 1.2 which will 
provide automated inventory management tools with additional volumes 
provided to the selected PCAs, increase caseload to 350,000 cases, 
improve review queue process and information flow, and become EA 
compliant. (09/2007): 

The current version of IFS software will no longer be supported by the 
COTS vendor effective December 2009. The IRS has provided Treasury and 
OMB an initial alternatives analysis that examines several options for 
a "go forward" strategy for the financial system. Further alternative 
analysis is ongoing that includes evaluating cost, benefits, and risks 
associated with federal Center of Excellence (COE) and private Shared 
Service Provider (SSP) options. IRS has requested FY 2008 funding to 
upgrade the financial system in FY 2010. The upgrade will include 
increased federal functionality and vendor-supported system software. 

Tax Compliance Initiatives and Enforcement of Tax Laws: 

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. 
Address the evolving challenge of unpaid taxes and continuing Earned 
Income Tax Credit (EITC) noncompliance. 

Actions Taken (FY 2006): 

* Implemented the first phase of the Private Debt Collection (PDC) 
initiative that allows the IRS to use Private Collection Agencies 
(PCAs) to collect delinquent tax debts. (01/2006): 

* Implemented major programming changes to EITC examination inventory 
management and expanded abilities of the EITC Dependent Database 
selection process. Expanded test of Soft Notice treatment to reach 
taxpayers who are likely to self-correct behavior identified by the new 
scoring models. (Ongoing): 

* Developed and administered two EITC survey instruments in conjunction 
with the Taxpayer Advocate and Low Income Taxpayer Clinics. The first 
survey instrument identified correspondence audit barriers experienced 
by EITC Taxpayers with results available at the end of the calendar 
year. The second will identify EITC taxpayers' information needs and 
how effectively these needs are currently being met. (09/2006): 

* Updated EITC multi-year return preparer study that addresses paid 
preparer non-compliance and gathers data on the effects of these 
efforts on paid preparers as well as taxpayers. (Ongoing): 

* Developed the withholding compliance program, an alternative 
treatment to influence non-compliant taxpayers to establish an adequate 
withholding behavior to promote future compliance. Developed outreach 
and educational initiatives to increase withholding compliance in the 
retired military population. (10/2005): 

* Elevated the priority of the Federal Employee/Retiree Delinquency 
Initiative by centralizing inventory in a specific site so cases can be 
worked by employees with specialized training. (Ongoing): 

* Began using the Return Preparer Analysis Tool to more effectively 
identify egregious preparer returns for examination potential. (05/ 
2006): 

* Upgraded the Bank Secrecy Act (BSA) workload database. Upgrades will 
provide a more complete record of the affected banks tagged as 
potentially non-compliant and integrate results from research projects 
on the attributes that may predict non-compliance. (Ongoing): 

* Continued data exchange with state taxing organizations to leverage 
limited government resources: (09/2006): 

- Initiated the State Revenue Agent Report project to identify non-
filers and under-reporters based on state audit reports. 

- Enhanced the multifunctional non-filer strategy to provide a more 
rigorous and specific data matching processing for IRS and state audit 
reports and uniform record layout for more efficient data exchange. 

- Piloted the State Reverse File Match Initiative which emphasizes the 
identification of federal non-filers by matching against state filing 
databases. 

* Initiated the Attributed Tip Income Program, a tip reporting and 
education program offered to small to medium size employers in the food 
and beverage industry to help improve the tip income reporting of 
employees with minimal burden on the employer. Benefits include 
reduction in industry recordkeeping burden, simple enrollment 
requirements, and improved reporting of tips on Federal income tax 
returns. (07/2006): 

* Secured and improved tip income reporting agreements for 90 percent 
of major casinos, providing more consistent tip reporting among the 
expanding number of Gaming Industry tipped employees. Planned 
enhancements will increase the accuracy of casino reported year-end- 
data on tips, reducing potential reporting errors, and reducing burden 
for participating employee-taxpayers. (08/2006): 

* Conducted simultaneous civil and criminal actions to stop abusive tax 
promotions and prevent their proliferation by high income taxpayers who 
frequently employ complex, multi-layered transactions. (Ongoing): 

* Doubled the number of taxpayers (17 in FY 2005 to 34 in FY 2006) in 
the Compliance Assurance Program (CAP), a process in which corporate 
taxpayers and IRS agents work together to examine transactions in "real 
time" during the taxable year to reach agreement on the taxpayer's tax 
liability before the tax return is filed. (Ongoing): 

* Continued the Pre-Filing Agreement program that provides corporate 
taxpayers and Revenue agents with an opportunity to examine and resolve 
potential issues before tax returns are filed. (Ongoing): 

* Substantially completed a major effort to curb abuse by non-profit 
credit counseling organizations resulting in revocation of exempt 
status or termination of organizations found to be non-compliant. (05/ 
2006): 

* Increased vigilance concerning political campaign intervention by 
Section 501(c) (3) charitable organizations by issuing new procedures 
for the 2006 election season to ensure that all referrals are reviewed 
expeditiously and consistently. The IRS has also expanded educational 
effort to ensure that charities understand what constitutes prohibited 
political intervention and how to stay compliant with the tax laws. 
(02/2006): 

* Implemented an inventory management system to assign high-risk 
examination cases using capacity and a risk-based scoring system. (01/ 
2006): 

* Established Issue Management teams to address tax shelter and other 
high risk issues and improve the IRS' ability to report on issue 
trends, enhance risk analysis, and improve return selection. (09/2006): 

* Implemented improvements to improve EITC participation and reduce 
errors: 

- Completed analysis of EITC overclaim rate ranges to identify changes 
in the rate due to improved taxpayer compliance. (09/2005): 

- Tested the use of a National Directory of New Hires database match in 
the IRS Criminal Investigation EITC Fraud Detection Centers. (01/2006): 

- Developed new strategies to prevent duplicate claims of qualifying 
children. (12/2005): 

- Launched second phase of EITC return preparer study to track EITC 
filing volume and return math error accuracy through outreach campaigns 
and volunteer tax return preparation. (12/2005): 

- Developed pilot projects with New York and Massachusetts to leverage 
partnership opportunities with states that offer tax credits comparable 
to EITC. (06/2006): 

- Designed Dependent's Database check to systemically classify and 
select EITC amended returns for examination to reduce the amount of 
erroneous payments by providing the same scrutiny to original returns 
processing. (07/2006): 

- Initiated survey of taxpayers who participated in the Qualifying 
Child Certification Proof of Concept to identify specific strategies 
and improvements for the EITC Program. (09/2006): 

- Completed launch of over 500,000 new start examinations of EITC 
returns based on enhanced scoring and selection methodology. (09/2006): 

- Initiated research to assess changes in taxpayer EITC filing volume 
and track EITC return math error accuracy as a result of outreach 
campaigns and volunteer tax return preparation. (Ongoing): 

- Developed annual enterprise research strategy in partnership with 
internal and external organizations to better focus EITC compliance and 
outreach activities. (Ongoing): 

- Identified non-compliant EITC return preparers for due diligence 
visits and case treatment using the Return Preparer Analysis Tool. 
(Ongoing): 

- Built a multi-dimensional database that tracks EITC claimants and 
qualifying children over a period of years for use in future research 
projects. (Ongoing): 

- Developed and distributed materials to educate taxpayers and 
practitioners on EITC eligibility rules and compliance issues. 
(Ongoing): 

- Completed implementation of new EITC examination business processes 
and technology changes including: (12/2005): 

--Enhanced examination selection criteria and scoring of amended 
returns to filter cases for EITC qualifications and information about 
taxpayer/ child relationship: 

--Identified select returns for pre-refund v. post-refund audit and 
soft notice treatment: 

--Integrated expanded decision support tool for examiners to assist 
with determinations and to document work papers: 

-- Improved self-service web and phone applications to assist taxpayers 
and tax preparers: 

- Continued EITC outreach activities that included managing the 
delivery of marketing and advertising campaigns, and creating EITC 
specific tools for use by tax preparers using multiple 
communication/media channels. (Filing Season): 

Actions Planned or Underway (FY 2007 and beyond): 

* Continue to expand the implementation of Issue Management teams to 
address high risk tax shelter issues and improve the IRS' ability to 
report on issue trends, enhance risk analysis, and enhance return 
selection. (09/2007): 

* Develop enhancements to the multifunctional non-filer strategy to 
improve outreach and compliance efforts and develop alternative 
treatments to influence non-filing taxpayers to file and remain 
compliant. (Ongoing): 

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

* Develop recommendations for a multi-year return preparer strategy 
that includes managing the delivery of marketing and advertising 
campaigns, and creating specific tools for use by tax preparers, using 
multiple communication/media channels. (09/2007): 

* Complete the 1120-S phase of the National Research Project (NRP). 
Results of the project will provide data to revise workload selection 
criteria. Most NRP 1120-S audits will be complete by October 2007. 
Analysis of the data will be completed during 2008. (10/2008): 

˛ Develop initiatives to improve participation and reduce overclaims in 
existing EITC Programs. (Ongoing): 

- Continue to analyze changes in taxpayer EITC filing volume and track 
EITC return math error accuracy through outreach campaigns and 
volunteer tax return preparation. (Ongoing): 

- Produce survey instruments that will identify correspondence audit 
barriers experienced by EITC taxpayers, identify EITC taxpayers' 
information needs, and assess how effectively these needs are currently 
being met. (Ongoing): 

- Complete second phase of EITC return preparer's compliance study 
designed to identify and deter preparers of large numbers of erroneous 
EITC claims. (02/2007): 

- Continue three-year Qualifying Child test to reduce EITC overclaims. 
(10/2007): 

- Assess the 2007 EITC marketing/awareness campaigns that target the 
EITC eligible population and refine/focus as necessary to increase 
overall participation and improve compliance. (03/2007): 

- Conduct Longitudinal Study that looks at specific EITC claimants over 
a period of years, studying behavior patterns. (Ongoing): 

- Actively research cost-effective approaches to improve EITC 
participation and minimize errors. (Ongoing): 

- Educate EITC taxpayers through partnerships with key stakeholders and 
a public service campaign. (Ongoing): 

- Evaluate the effect of an EITC certification requirement both on the 
level of erroneous payments and participation by eligible taxpayers. 
(Ongoing): 

- Explore additional partnering options with state agencies to improve 
EITC compliance and prevent erroneous payments. (Ongoing): 

- Test use of requests for voluntary adjustments to returns identified 
as likely to contain errors (soft notices) as an alternative to the 
traditional examination process. (04/2007): 

- Study characteristics of returns where more than one taxpayer claims 
the same qualifying child for EITC purposes and recommend new solutions 
to reduce duplicate claims. (11/2008): 

* Expand Schedule M-3 corporate filing requirements to enhance ability 
to identify compliance risks in book-to-tax differences. (09/2007): 

* Continue the State Income Tax Levy Program process of solicitation to 
participate in the program. (Ongoing): 

* Continue to identify other federal payor agencies to participate in 
the Federal Payment Levy Program and negotiate agreement. (09/2007): 

* Validate the Taxpayer Assistance Blueprint service recommendations 
through extensive research with taxpayers. (10/2006): 

* Continue to conduct Fraud/Bank Secrecy Act Program Examinations 
(Ongoing): 

- Complete full development of workload database that provides a more 
complete record of banking institutions. (09/2008): 

- Integrate results from the identification of attributes to better 
predict which entities have a greater probability of non-compliance. 
(09/2008): 

- Develop and implement BSA requirements for the insurance industry and 
dealers in precious metals, gems, and jewels. (06/2007): 

* Continue to emphasize collection of large dollar assessments, one of 
the highest priorities in case assignment. (Ongoing): 

* Continue efforts to strengthen the Fraud Referral Program to foster 
voluntary compliance through the recommendation of a criminal 
investigation and/or civil penalties. (Ongoing): 

* Enhance methods of identifying promoters operating in tax havens. 
(Ongoing): 

* Continue to identify and investigate high-impact, corporate fraud. 
(Ongoing): 

˛ Continue to aggressively develop high-income, high-impact, non-filer 
cases covering a broad spectrum of occupations and professions. 
(Ongoing): 

˛ Develop improved criteria for identifying unscrupulous return 
preparers, especially those with high income clients and those 
promoting abusive tax avoidance schemes. (Ongoing): 

˛ Continue making improvements to the Return Preparer Analysis Tool 
(analyzes characteristics of return preparers) to identify more 
effective compliance treatments for return preparers including the 
development of return preparer and questionable refund policies. (10/ 
2007): 

* Assess the withholding compliance process to determine the usefulness 
of letters sent to employers and employees who under withhold federal 
income tax from their wages (lock-in letters). (09/2007): 

˛ Implement toll-free phone system for Innocent Spouse operations. (01/ 
2007): 

˛ Support development of the Correspondence Examination Automated 
System (CEAS) system to expand electronic case assignment and 
reassignment among the Campuses. (Ongoing): 

˛ Implement the Electronic Filing of Federal Tax Liens (e-Lien), 
automating the filing of Notices of Federal Tax Liens and Certification 
of Release electronically, along with the electronic transmission of 
recording data. (10/2009): 

˛ Pursue access to the International Trade Data System warehouse to 
enhance identification of federal excise tax on imports. Under 
development by US Customs and implementation date is predicated on the 
completion of the Customs project. (Ongoing): 

* Continue to develop methods to detect and deter non-compliance and 
overstated claims. For example, statistical information from an outside 
vendor for will be used in calculating estimates of telephone expenses 
for businesses and individuals. (Ongoing): 

* Re-establish the Electronic Fraud Detection System legacy (client/ 
server) system for use during the 2007 filing season. (Ongoing): 

* Implement corporate strategies to ensure optimum, balanced audit 
coverage as well as improve enterprise-wide resource allocations and 
the use of alternative resolution strategies. (Ongoing): 

* Continue focus on registration activity under the American Jobs 
Creations Act of 2004, identifying potential non-filers and inaccurate 
filers through reconciliation and comparison of ExSTARS data. 
(Ongoing): 

Security of the Internal Revenue Service: 

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

Actions Taken (FY 2006): 

˛ Completed mitigation of General Support Services' weaknesses 
identified during certification to upgrade systems from Interim 
Authority to Operate status to Full Authority to Operate. (09/2006): 

˛ Updated the security certification and accreditation of IRS business 
applications to comply with the process guidance issued by OMB and the 
National Institute of Standards and Technology. Security plans and 
certification and accreditation for one third of IRS systems were 
updated to the standards. (09/2006): 

˛ Completed design and first phase of development of a back-up for the 
IRS incident response capability to reduce geographic vulnerability. 
(09/2006): 

˛ Continued to improve Federal Information Security Management Act of 
2002 (FISMA) compliance by further increasing business owner 
participation in all areas including monitoring, review, mitigation and 
reporting activities. (Ongoing): 

˛ Assumed Departmental leadership for Presidential Directive 12 (HSPD- 
12), which mandates a uniform approach to employee authentication and 
access government-wide. (Multi-year): 

˛ Continued to refine both the IRS' Continuity of Operations Plan 
(COOP) activities and the IRS' contribution to Department/government- 
wide COOP activities. Fully participated in the planning and execution 
of the government-wide COOP exercise, Forward Challenge 06. (09/2006): 

* Conducted certification and accreditation update activities to meet 
government-wide guidelines for information systems certified. The IRS 
is 96 percent compliant, 33 percent are already certified under the 
new, more stringent National Institutes of Standards and Technology 
guidelines. (09/2006): 

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

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

* Began an agency-wide Risk Assessment for vulnerabilities to identity 
theft. Interviewed over 100 executives and performed 20 data gathering 
workshops that resulted in the development of 69 remediation 
strategies. (Ongoing): 

* Partnered with the Treasury Inspector General for Tax Administration 
to develop and implement the IRS Phishing Web Site to provide guidance 
to internal and external stakeholders. Established e-mail box so 
internal and external stakeholders could send phishing e-mail to IRS 
for evidence gathering and developing countermeasures. (03/2006): 

Actions Planned or Underway (FY 2007 and beyond): 

* Complete migration of information technology security compliance 
reviews to the more structured self-assessments detailed in NIST 
Special Publication 800-53. (09/2007): 

* Complete the implementation of the agency-wide strategy for IT 
systems disaster recovery, including conducting annual exercises in 
major computing environments. (09/2007): 

* Complete development phases and begin implementation of a back-up for 
the IRS incident response capability. (09/2007): 

* Continue to improve FISMA compliance by solidifying gains in business 
owner participation in all areas including monitoring, review, 
mitigation and reporting activities. (Ongoing): 

* Establish Disaster Recovery processes for the IRS' 25 Critical 
Business Processes. Continue to implement a nationwide Disaster 
Recovery Plan including all major computing facilities. (09/2007): 

* Continue to advance HSPD-12 program development, including 
development of IT infrastructure and deployment of Department-wide 
policies and practices. (09/2007): 

Using Performance and Financial Information for Program and Budget 
Decisions: 

Issue: The absence of accurate and complete management information 
hinders the IRS' ability to produce timely, accurate and useful 
information needed for day-to-day decisions. 

Actions Taken (FY 2006): 

* Introduced a suite of enterprise-wide long-term measures which link 
directly to the IRS Strategic Plan goals. (01/2006): 

* Used results from the OMB Program Assessment Rating Tool (PART) to 
make the following improvements: (02/2006): 

- New long-term and annual performance measures were developed for the 
Criminal Investigation Program. 

- Used annual performance plan to improve transparency in budget and 
PART narratives and show data correlation between budget and 
performance. 

* Finalized an implementation plan for Budget-Performance Integration 
(BPI) that identified the actions necessary to formulate and execute 
fully-costed performance. (1ST and 2ND quarter 2006): 

* Developed automated Statement of Net Cost from Integrated Financial 
System. (08/2006): 

* Implemented FMIS enhancement, Custodial Detail Database (CDDB): 

- Implemented Release 1 of CDDB, the enhancement to FMIS, and is the 
first step toward creating a subsidiary ledger for Unpaid Assessments 
and improved reporting for Trust Fund Recovery Penalty cases. (03/ 
2006): 

- Submitted the programming requirements to complete the CDDB design 
phase, programming, and unit and integration testing to feed custodial 
accounting information to the Interim Revenue Accounting Control System 
(IRACS). (06/2006): 

- Performed analysis and decided to use new CDDB unpaid assessment 
files for the FY 2006 audit. (05/2006): 

- Finalized programming requirements for CDDB Release 2B, which creates 
the sub-ledger for revenue receipts and refunds. (06/2006): 

* Continued to meet Treasury's Information Executive Repository (TIER) 
3- day close financial reporting requirements. (Quarterly): 

* Maintained clean audit opinion on FY 2005 financial statements, the 
first year of the Integrated Financial System operations. (11/2005): 

Actions Planned or Underway (FY 2007 and beyond): 

* CDDB Planned Actions: 

- Create CDDB to Interim Revenue Accounting System (IRACS) interface. 
(03/2007): 

- Begin test of CDDB Release 2 revenue data base. (06/2007): 

- Further enhance FMIS by developing the CDDB to be compliant with 
Federal Financial Management Improvement Act of 1996 requirements. The 
CDDB will add revenues and refund transactions to begin the creation of 
subsidiary ledgers (Releases 2 and 3). (FY 2008): 

* Fully implement the use of cost accounting data for resource 
allocation decisions. (FY 2008): 

Complexity of the Tax Law: 

Issue: Simplifying the tax process within current laws while at the 
same time modernize IRS systems and processes to reduce tax complexity 
for individual and business taxpayers. 

Actions Taken (FY 2006): 

* EITC Actions: 

- Updated EITC Assistant to accommodate the Gulf Opportunity Zone Act 
of 2005 to have nontaxable combat pay included in earned income 
(Hurricanes Katrina, Rita and Wilma), the extension of the election for 
EITC, and the Uniform Definition of Child provisions enacted in the 
Working Families Relief Act of 2004 impact to EITC and filing Status. 
(01/2006): 

- Unified Family Credit that combines the provisions of the EITC, Child 
Tax Credit, and Dependency Exemption, to reduce taxpayer compliance 
burdens associated with claiming these provisions. (Ongoing): 

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

* Updated all tax law forms, processes, IRMs, and employee guidance 
related to late legislation in 2005. (December 2005 through January 
2006): 

Actions Planned or Underway (FY 2007 and beyond): 

˛ Release Tax Year 2006 version of EITC Assistant incorporating user 
recommendations and tax law updates. (01/2007): 

˛ Develop a compliance strategy to identify and prevent erroneous 
Telecommunications Excise Tax Refunds. The goal is to design the least 
burdensome procedures to enable all eligible taxpayers to claim the 
right refund. (01/2007): 

˛ Expand Modernized E-file to other forms, including flow-through 
returns for partnerships and Subchapter S-Corps. (09/2008): 

* Implement an option for taxpayers to be able to split refunds into as 
many as three separate accounts, by updating forms, programming, IRMs, 
and employee guidance. (Ongoing, implement in 01/2007): 

* Begin final stages of returns processing in Philadelphia by rerouting 
new work to other campuses by July 2007, and complete processing of 
inventories by the end of FY 2007, thereby ceasing processing 
operations in September 2007. (09/2007): 

* Redesign Form 1040 and create a new Schedule O for processing year 
2008; thereby, simplifying taxpayers' reporting of certain adjustments 
to income, credits, taxes, and payments. (Ongoing): 

* Continue to look for new ways in Accounts Management to resolve 
quality and productivity issues through use of the Lean Six Sigma 
process and the "Extreme Breakthrough Performance" process. (Ongoing 
through 09/ 2007): 

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 (FY 2006): 

* Used 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. (Ongoing): 

- Partnered with the U.S. Department of Health and Human Services to 
sponsor workshops statewide, which connect organizations with common 
goals of helping low-income families. 

- Formed a partnership with the largest funder of rural activities in 
the United States, and secured commitment to fund the rural strategy in 
seven states in FY 2007: Louisiana, Michigan, West Virginia, 
Mississippi, Arkansas, New Mexico, and Montana. 

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

* Incorporated multi-year Quality Improvement Process Plan (VRPP-QIP) 
including web-based learning to improve quality for the VITA program. 
(09/2006): 

* Refined and tested "Life Cycle Products" line of publications 
designed to educate taxpayers about the tax impact of significant life 
events. (09/2006): 

* Developed new and revised Spanish-language tax products. (09/2006): 

* Conducted focus groups at the Nationwide Tax Forums to obtain 
feedback from taxpayers and tax practitioners on ways to improve tax 
forms, instructions and publications. (2006 forums): 

* Tested all significant tax form and notice changes with taxpayers and 
external stakeholders prior to implementing the changes. (Ongoing): 

* Delivered the Taxpayer Assistance Blueprint (TAB) (Phase I) report to 
Congress. Phase I includes options to provide taxpayer service over 
multiple channels to align content, delivery, and resources with 
taxpayer and partner expectations to reduce burden, improve workforce 
performance, and increase voluntary compliance. TAB establishes a 
credible taxpayer/partner baseline of needs, preferences, and 
behaviors. (04/2006): 

* Actions taken to improve service to those taxpayers filing for the 
Earned Income Tax Credit included: 

- Developed a service-wide integrated marketing strategy aimed at 
reducing EITC error that reached 141 million contacts including 
taxpayers, tax practitioners, members of the media, and partner 
organizations. (06/2006): 

- Assessed the overall EITC marketing/awareness campaigns that target 
eligible claimants to increase overall participation and improve 
compliance. (Ongoing): 

- Partnered with the Ogden Usability Lab to expand the testing of EITC 
notices and forms. (09/2006): 

* Installed Contact Recording in 47 Taxpayer Assistance Centers (TACs). 
Contact recording provides immediate performance feedback to employees 
to improve the quality and completeness of responses. (07/2006): 

* Completed the Phase II rollout of Queuing Management (Q-Matic), a 
web- based system that captures the number and types of customer 
contacts in the TACs and automates the process of tracking employee 
activity. (09/ 2006): 

* Developed TeleFile and Internet electronic funds withdrawal (Direct 
Debit) applications for notice payments and installment agreements. 
(09/2006): 

* Doubled the number of taxpayers (17 in FY 2005 to 33 in FY 2006) in 
the Compliance Assurance Program (CAP), a process in which large 
corporations and IRS agents work together to examine transactions in 
"real time" during the taxable year to reach agreement on the 
taxpayer's tax liability before the tax return is filed. (01/2006): 

* Continued to work with stakeholders to improve the sixteen Collection 
notices with a combined annual volume of 46 million. (Ongoing): 

Actions Planned or Underway (FY 2007 and beyond): 

˛ Continue expansion of IRFOF ("Where's my refund?) to add more math 
error explanations, accommodate split refund inquiries, and provide 
inquiry capability for those taxpayers filing for telecommunications 
excise tax refunds. (2006 filing season and beyond): 

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

˛ Expand the web-based learning program (Link and Learn Taxes) that 
provides online training in tax return preparation for Stakeholder 
Partnerships, Education and Communication Partners and Volunteers. (09/ 
2007): 

˛ Expand the "Life Cycle Products" line of publications designed to 
educate taxpayers about the tax impact of significant life events. 
(Ongoing through 09/2007): 

˛ Install Contact Recording in 83 TACs locations in FY 2007 and in the 
remaining 270 TACs in FY 2008 and FY 2009. (Ongoing): 

* Expand the use of Q-Matic, the web-based system that captures the 
number and types of customer contacts in the TACs and automates the 
process of tracking employee activity, to the remaining TAC sites. (09/ 
2007): 

* Complete planned actions to improve service to those taxpayers filing 
for the Earned Income Tax Credit: 

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

- Develop targeted EITC partner and compliance-oriented outreach and 
assistance activities for 2007 filing season. (01/2007): 

* Incorporate multi-year Volunteer Return Preparation Program-Quality 
Improvement Process (VRPP-QIP) plan to promote quality assurance for 
the Volunteer Income Tax Assistance program. 

- Test the new quality forms by conducting volunteer return preparation 
session. (09/2007): 

˛ Continue development of Issue Management System (a streamlined and 
structured process that facilitates corporate issue identification, 
resolution and feedback) designed to gather data on emerging issues, 
detect trends, monitor issues, and provide resolutions and 
communications with greater effectiveness. (Ongoing): 

˛ Continue to expand participation in the Compliance Assurance Process. 
(09/2007): 

Processing Returns and Implementing Tax Law Changes During the Filing 
Season: 

Issue: The filing season remains a critical IRS program that impacts 
every American taxpayer. Many programs, activities and resources have 
to be planned and managed effectively for the filing season to be 
successful. 

Actions Taken (FY 2006): 

* Updated all tax law forms, processes, Internal Revenue Manuals 
(IRMs), and employee guidance related to the emergency supplemental 
appropriations act to address hurricanes in the Gulf of Mexico, which 
was enacted late in 2005. (01/2006): 

* Piloted an automated adjustment document to make a change or 
correction to a taxpayer account, reducing adjustment time and 
increasing the quality of required adjustments. (09/2006): 

* Developed strategies to transition and consolidate the Philadelphia 
Submission Processing Center. (Multi-year initiative): 

* Completed deployment of Transcript Delivery System. (12/2005): 

* Developed processes and procedures for administering 
telecommunications excise tax refunds (TETR) to more than 150 million 
taxpayers by: 

- Modifying all individual and business tax return forms to include 
TETR information; 

- Creating a new form (1040EZ-T) to be used by individuals who want to 
request a refund, but who have no other tax filing requirement; 

- Drafting a second new form (8913) to be used by taxpayers who choose 
to request refunds based on their actual payments rather than use a 
standard amount set by the IRS; 

- Developing a methodology that can be used by businesses and non-
profits to estimate their TETR claims; 

- Launching an outreach campaign to external stakeholder groups; 

- Programming IRS systems to accept form changes; 

- Developing TETR-related procedures (IRMs); and: 

- Conducting training for employees who will interact with taxpayers on 
the phone and at Taxpayer Assistance Centers. (05/2006 and Ongoing 
leading up to the filing season): 

Actions Planned or Underway (FY 2007 and beyond): 

* Administer the Telecommunications Excise Tax Refund program by 
providing additional services to taxpayers claiming the credit 
including answering taxpayer questions received via telephone, 
correspondence and through the TACs. (01/2007): 

* Assist taxpayers who use IRS Field Assistance and VITA sites to claim 
the credit. (01/2007): 

* Conduct a targeted compliance effort to minimize excise tax refund 
over-claims. (01/2007): 

* Work with community-based organizations to educate low-income 
taxpayers without a filing requirement and to encourage them to request 
their telecommunications excise tax refunds. (01/2007): 

* Redesign Form 1040 (Individual Income Tax) and create a new Schedule 
O for processing year 2008 to simplify the reporting of certain 
adjustments to income, credits, taxes, and payments. (Ongoing): 

* Implement an option for taxpayers to be able to split refunds. (01/ 
2007): 

* Begin final stages of returns processing in Philadelphia, rerouting 
new work to other campuses and complete processing of inventories. (09/ 
2007): 

* Continue expansion of Modernized E-file requirements and the increase 
of business electronic return processing. (Ongoing): 

* Scan and image paper returns for large corporate returns that do not 
meet e-file dollar or volume requirements to expedite assessments. (09/ 
2007): 

Taxpayer Protection and Rights: 

Issue: The IRS has made significant progress in complying with the 
Internal Revenue Service Restructuring and Reform Act of 1998 and most 
provisions pertaining to taxpayer protection and rights have been 
implemented. Significant management attention is still required to 
ensure that remaining issues have been addressed. 

Actions Taken (FY 2006): 

* Developed and implemented the Taxpayer Rights Impact Statement to 
incorporate awareness and consideration of taxpayer rights into all 
program planning and implementation. (Ongoing): 

* Refined 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): 

* Designed an education and awareness program with tax preparer 
partners to: (1) educate taxpayers about the need to ensure preparers 
they choose to prepare their tax returns are competent, and (2) stress 
enforcement actions the IRS will take on those preparers found to be 
negligent or reckless. (Ongoing): 

* Continued emphasis on the Return Preparer Program and increasing 
Program Action Cases (PACs) against preparers who file incorrect or 
fraudulent returns by focusing on assertion and collection of penalties 
and employing other enforcement options such as injunctions. Continued 
discussions with Treasury, OMB, and Congress to increase maximum 
penalty amounts. (Ongoing): 

* Established process and procedures to minimize the effects of 
questionable refunds on the taxpayer when a refund is held to resolve 
issues. Included appropriate taxpayer notification procedures including 
creation of notice explaining the circumstances of the refund hold or 
denial. (Ongoing): 

Actions Planned or Underway (FY 2007 and beyond): 

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

* Complete the implementation of the agency-wide strategy for IT 
systems disaster recovery, including conducting annual exercises in 
major computing environments. (09/2007): 

* Continue to study the Questionable Refund Program workflow processes 
to identify areas where additional improvements can be made, 
particularly in the area of refund freezes. (Ongoing): 

Human Capital: 

Issue: The IRS' ability to meet expectations outlined by the 
President's Management Agenda in personnel management area such as 
recruiting, training, and retaining employees. 

Actions Taken (FY 2006): 

* Completed development of the IRS Human Capital Strategic 
Implementation Plan, which outlines the strategies the IRS will follow 
in addressing the challenges to achieving the desired state of human 
capital in the IRS. (01/2006): 

* Deploy the Learning Content Management System (LCMS) to permit more 
efficient development of training materials and consistency in training 
across the Service to improve the skills of current employees and to 
prepare them for the workforce of tomorrow. (09/2006): 

* New training courses offered include enhanced computer skills, 
desktop integration, purchase card and approver, and electronic 
installment agreements. (FY 2006): 

˛ Complete conversion of all Mission Critical Occupation (MCO) 
application processes to the CareerConnector system (provides resume 
builder functionality for applicants, and a recruitment system that 
identifies well-qualified candidates for vacancies) and begin the 
conversion of the non-MCO occupations. (09/2006): 

* Improved CareerConnector system recruiting for front-line occupations 
through expansion of category (qualified, best qualified, etc.) ratings 
and use of simulations in assessing job applicants. (Ongoing): 

* Resolved protest issues/ concerns and issued an award decision for 
Campus Files Activity to IAP World Services, Inc. 

- Implemented a well-orchestrated communications strategy that included 
notification of the award decision to employees, NTEU, Congress, 
Treasury, OMB, and the media. (05/2006): 

* Developed an approach to identify business processes that leverage 
the tools, templates, best practices, and successes of Competitive 
Sourcing to create a structure that can be used as an alternative to 
conducting a public-private competition and for certification of high 
performing organization status. (Ongoing): 

* Conducted leadership interviews to determine talent needs, and 
incorporated results into the Succession Plan, which was rolled out in 
FY 2006. Talent assessments and creation of a review toolkit are being 
tested in the W&I and MITS organization. (09/2006): 

* Conducted a study of all leadership courses (Executive Readiness 
Program, Senior Manager Course/Senior Manager Readiness Program, and 
Frontline Manager Course) to focus on: (09/2006): 

- Delivering content in an effective and efficient manner: 

- Identifying and attracting and retaining "high talent" and "high 
potential" employees for leadership development. 

* Designed new management training using tailored case studies, 
simulations in training and work-out sessions to provide hands-on 
experience, critical to enhancing employee skills. (Ongoing): 

* Continued 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): 

* Extended recruiting partnerships with key colleges and universities. 
(Ongoing): 

* Modified the employee engagement program to focus on balanced 
measures at the workgroup level and to the identification of barriers 
to delivery of the IRS' goals and objectives such as tools, technology 
and improved processes. (01/2006): 

Actions Planned or Underway (FY 2007 and beyond): 

* Continue the design of management training using tailored case 
studies, simulations in training and work-out sessions to provide hands-
on experience in order to develop and retain qualified managers. 
(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): 

* Utilize the approach developed in FY 2006 to identify business 
processes that leverage the tools, templates, best practices, and 
successes of Competitive Sourcing. (Ongoing): 

* Continue a multi-year recruitment and marketing plan to target a 
diverse applicant pool in recruitment and hiring of mission-critical 
talent. Expand the number and type of colleges and universities 
included in recruiting partnerships established. (Ongoing): 

* Use competency models to identify the general and technical 
knowledge, skills and abilities essential to current and new employee 
performance in a position. (Ongoing): 

* Analyze results of Succession Planning tests and continue rolling out 
process to additional sites. Determine if test should be expanded to 
include Management Officials. (Ongoing): 

V. Financial Highlights: 

Stewardship Information Analysis: 

a. Overview of Revenue and Administrative Accounts: 

The IRS' Fiscal Year (FY) 2006 financial statements received an 
unqualified audit opinion for the seventh consecutive year. 

The Balance Sheet reflects total assets of $26 billion. Of these 
assets, 79.8 percent are Federal Taxes Receivable. These receivables 
are the amounts expected to be collected from past due accounts. The 
decrease in assets of $.7 billion is primarily attributable to 
decreases in the amounts due from Treasury for tax refunds due 
taxpayers and taxpayer deposits for unpaid assessments. The majority of 
the liabilities, 86 percent, consist of amounts due to Treasury related 
to Federal Taxes Receivable. 

The Statement of Custodial Activity shows that IRS programs collected 
$2.514 trillion in federal receipts. The IRS' collections constitute 96 
percent of the Federal Government receipts, as shown in the chart 
below. 

Total Federal Receipts - (Percent): 

[See PDF for Image] 

% may be off due to rounding: 

[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 processing tax returns and related documents, 
assistance for taxpayers in filing returns and paying taxes due, 
matching information with returns, and managing financial resources. 
The Tax Law Enforcement appropriation provides funds for examination of 
tax returns, collection of balances, the administrative and judicial 
settlement of taxpayer appeals of examination findings, as well as 
providing resources for strengthened enforcement 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 telecommunications support for the IRS' 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. 

Budget Fiscal Year 2006 Financing Sources - (Percent): 

[See PDF for Image]  

% may be off due to rounding: 

[End of Figure] 

Besides appropriations, the IRS used other financing sources. These 
included net transfers from other federal agencies, and revenue from 
user fees for direct services provided to customers (for example, 
installment fees, photocopy fees, and letter rulings and determinations 
fees). 

c. Use of Resources: 

The Statement of Net Cost reflects the use of resources in conducting 
the IRS' major programs. 

How the IRS used its resource - Percent:  

[See PDF for Image] 

% may be off due to rounding: 

[End of Figure] 

The major programs are Pre-filing Taxpayer Assistance and Education, 
Filing and Account Services, Compliance Services, and Administration of 
Tax Credit Programs (EITC and HCTC). Pre-filing Taxpayer Assistance and 
Education activities include taxpayer education and outreach, pre-
filing agreements, and tax publication issuance and distribution. 
Filing and Account Services activities include filing tax returns, 
maintaining customer accounts, and processing taxpayer information. 
Compliance Services activities include document matching, examination, 
collection, and criminal investigation activities. Administration of 
the Tax Credit programs includes costs for EITC 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. FY 2006 
revenue receipts ($2.514 trillion) increased by approximately 11 
percent from FY 2005 to FY 2006. Individual income taxes increased by 9 
percent and include both Federal Insurance Contributions Act (FICA) and 
Self-Employment Contributions ACT (SECA) taxes. Corporate income taxes 
increased by 24 percent. Collections from all other tax sources 
increased 4 percent from FY 2005 to FY 2006. 

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 2005 liabilities. Contributing factors 
include the higher 2005 incomes, lower 2005 deductions and a higher 
effective tax rate on 2005 taxable income reported in FY 2006. Net 
corporate receipts increased due to the growth in gross corporate tax 
receipts and the decrease in refunds. 

Federal tax refund activity, which includes tax, interest, payments for 
EITC and Child Care Tax Credit in excess of the tax liability, was $277 
billion. In FY 2006, the IRS issued $59 million in advance payments of 
the EITC. Overall refund disbursements increased by 4 percent from FY 
2005 to FY 2006. 

Excise Tax Trust Fund: 

The Quarterly Federal Excise Tax Return, Form 720, reports liability 
for excise taxes. Taxpayers make periodic deposits in advance of filing 
the return. These deposits are classified as Federal Excise Tax. After 
the IRS receives and processes the returns, the IRS certifies amounts 
for several Trust Funds. Amounts reported on the Statement of Custodial 
Activity are for fiscal year collections, i.e., October 1 through 
September 30. Because Form 720 reporting requirements are completed 
after receipt of most of the deposits, the certification amounts will 
not match the amounts collected in the fiscal year. The table below 
shows receipts certified to the Airport and Airway Trust Fund, Black 
Lung Disability Trust Fund and the Highway Trust Fund for the eight 
liability quarters from December 2003 through September 2005. The 
Treasury Department's Financial Management Service and the Bureau of 
Public Debt prepare the warrants and allocations to the various Trust 
Funds. 

The unpaid assessment balance includes amounts owed by taxpayers who 
file returns without sufficient payment as well as amounts assessed 
through the IRS enforcement programs. As reflected in the supplemental 
information to the IRS' FY 2006 Financial Statements, the unpaid 
assessment balance was about $245 billion as of September 30, 2006. 

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' $245 Billion of Unpaid Assessments: 

[See PDF for Image] 

% may be off due to rounding: 

[End of Figure] 

Taxes receivable represent $91 billion of unpaid assessments. About $70 
billion (77 percent) 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. Except for bankruptcy situations, 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 (23 percent) of taxes receivable ($91 billion) is 
estimated to be collectible. The collectible balance includes 
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, 2005 ($88 billion) to September 30, 2006 ($91 
billion) increased by $3 billion. The percent estimated to be 
collectible at September 30, 2006 (23 percent), decreased from 
September 30, 2005 (24 percent). 

Components of the IRS' $91 Billion of Taxes Receivable: 

[See PDF for Image] 

% may be off due to rounding: 

[End of Figure] 

Compliance assessments of $57 billion represent amounts that have not 
been agreed to by either the taxpayer or a court. These assessments 
result primarily from various IRS 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. 

Write-off amounts of $97 billion include amounts owed by defunct 
corporations with no assets and 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. 

Components of the IRS' $97 Billion of Write-offs: 

[See PDF for Image] 

% may be off due to rounding: 

[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, 2006. 

About $139 billion (57 percent) of the unpaid assessment balance as of 
September 30, 2006, consists of interest and penalties and is largely 
uncollectible. 

Unpaid Taxes and Interest and Penalty Components: 

[See PDF for Image] 

% may be off due to rounding: 

[End of Figure] 

Interest and penalties are a high percentage of the balance of unpaid 
assessments because the IRS must continue to accrue them through the 
ten-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 Federal Deposit Insurance Corporation and 
Resolution Trust Corporation cases, and on examination assessments 
where taxpayers have not agreed to the amount assessed. 

[End of section] 

Financial Statements: 

Balance Sheets as of September 30, 2006: 

[See PDF for image] - graphic text: 

[End of figure] - graphic text: 

Statements of Net Cost for the years ended September 30, 2006 and 2005: 

[See PDF for image] - graphic text: 

[End of figure] - graphic text: 

Statements of Changes in Net Position for the years ended September 30, 
2006 and 2005: 

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Statements of Budgetary Resources for the years ended September 30, 
2006 and 2005: 

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Statements of Financing for the years ended September 30, 2006 and 
2005: 

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Statements of Custodial Activity for the years ended September 30, 2006 
and 2005: 

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Notes to the Financial Statements: 

The accompanying notes are an integral part of these statements. 

Internal Revenue Service: 

Notes to the Financial Statements For the Years Ended September 30, 
2006 and 2005: 

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 (MITS) and Agency Wide Shared Services (AWSS) 
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 generally accepted accounting 
principles (GAAP) in the United States 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 
2006 and FY 2005 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. Effective October 1, 2005, the Service modified its 
method of allocating functional support and indirect costs in the 
Statement of Net Cost. The Service transitioned from its manual 
processes and utilized the cost module of the Integrated Financial 
System (IFS) to systemically allocate support costs to its operational 
organizations either by directly attributing costs to the organizations 
or cost centers (e.g., labor) or by allocating them based on a 
predetermined factor such as headcount, hours worked, units produced or 
causal relationships (e.g., rent). The allocation methodology, which 
goes through a formal approval process each year, enables the Service 
to more accurately identify and view the operational organizations' 
direct and indirect costs and to improve the overall quality and 
availability of essential cost information to support the management of 
Service operations and day-to-day decision making. 

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: 

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. The FY 2005 Statement of Budgetary Resources has 
been modified to conform with the FY 2006 presentation of the 
statement. 

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), and child care 
credits, as well as overpayments of taxes. 

C. Financing Sources and Imputed Costs: 

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 Appropriations and Allocation Account: 

Other appropriations 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 included in the Trade Act of 2002. 

In FY 2006, the Service provided services to the Department of 
Transportation's Federal Highway Administration for the development, 
operation, and maintenance of electronic systems for the collection of 
motor fuel and other highway use taxes. The costs for these services 
are reported through the use of an allocation account. The Department 
of Transportation reports all activity for the Service in their 
financial statements. 

Imputed Costs: 

The Service incurs certain costs that are paid in total or in part by 
other federal entities. These are pension costs administered by the 
Office of Personnel Management, legal judgments paid by the Treasury 
Judgment Fund, and costs of processing payments and collections by the 
Financial Management Service. These costs are recognized by the Service 
on its Statement of Changes in Net Position and Statement of Financing 
as imputed financing sources. 

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: 

Accounts Receivable: 

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. 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: 

Advances to government agencies primarily represent funds paid to the 
Treasury Working Capital Fund (WCF) and the Department of Interior 
GovWorks. Centralized services funded through the WCF consist primarily 
of telecommunications services, payroll processing, and depreciation of 
property and equipment owned by the WCF. Activities funded through 
GovWorks consist of the acquisition of furniture. 

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: 

Property and equipment is recorded at historical cost. It consists of 
tangible assets and software. 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 over its estimated useful life. A half year depreciation is taken 
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 assets along with related 
equipment: 1) mainframe computers, 2) minicomputers, 3) local area 
network (LAN) servers, 4) desktop and laptop computers, and 5) 
telecommunications equipment. ADP equipment includes all related 
software, including commercial off-the-shelf software, except as 
separately stated under Internal Use Software. 

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. 

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. 

Internal Use Software: 

Beginning in FY 2001, the Service capitalizes direct and indirect costs 
of internal use software in accordance with Statement of Federal 
Financial Accounting Standards No. 10, Accounting for Internal Use 
Software. 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. Maintenance is excluded. 

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. 

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. 
Disposals are recognized when software is determined to be obsolete or 
nonfunctional. The IRS treats terminated projects and/or subprojects as 
100% obsolete. 

Leasehold Improvements: 

All leasehold improvement projects are capitalized regardless of cost. 

G. 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. 

H. 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. 

Under the Internal Revenue Code (26 USC) Section 6404, 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 carried 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. 

I. 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 are 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, 2006 and 2005, consist 
of the following: 

Fund Balance: Appropriated funds and other; 
2006: $2,066; 
2005: $1,990. 

Fund Balance: Fund Balance with Treasury; 
2006: $2,066; 
2005: $1,990. 

Status of Fun Balance with Treasury: Unobligated balances: Available; 
2006: $192; 
2005: $252. 

Status of Fun Balance with Treasury: Unobligated balances: Unavailale; 
2006: 360; 
2005: 236. 

Status of Fun Balance with Treasury: Obligated balances not yet 
disbursed; 
2006: 1,520; 
2005: 1,508. 

Status of Fun Balance with Treasury: Other funds; 
2006: (6); 
2005: (6). 

Status of Fun Balance with Treasury: Fund balance with Treasury; 
2006: 2,066; 
2005: 1,990. 

[End of table] 

The Business Systems Modernization (BSM) fund represents $268 million 
and $297 million of the appropriated fund balance as of September 30, 
2006 and 2005, 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, 2006 
and 2005, consist of the following: 

Imprest fund; 
2006: $4; 
2005: $4. 

Other custodial assets; 
2006: 48; 
2005: 462. 

Total Cash and Other Monetary Assets; 
2006: $52; 
2005: $466. 

[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, 2006 and 2005, respectively, 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, 2006 and 2005, consist of the 
following: 

Advances; 
2006: Intragovernmental: $187; 
2006: With the public: $9; 
2005: Intragovernmental: $130; 
2005: With the public: $8. 

Accounts receivable, net; 
2006: Intragovernmental: $14; 
2006: With the public: $7; 
2005: Intragovernmental: $16; 
2005: With the public: $7. 

Federal tax lien revolving fund; 
2006: Intragovernmental: [Empty]; 
2006: With the public: $4; 
2005: Intragovernmental: [Empty]; 
2005: With the public: $2. 

Suspense; 
2006: Intragovernmental: $4; 
2006: With the public: (5); 
2005: Intragovernmental: $4; 
2005: With the public: (5). 

Total Other assets; 
2006: Intragovernmental: $205; 
2006: With the public: $15; 
2005: Intragovernmental: $150; 
2005: With the public: $12. 

[End of table] 

Note 5. Federal taxes Receivable, net. 

Federal taxes receivable (gross) were $91 billion and $88 billion as of 
September 30, 2006 and 2005, 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 as of September 30, 
2006 and 2005, 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 $70 billion and $67 
billion was established in FY 2006 and FY 2005, 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, 2006 and 2005, is shown in 
the schedule below. The Cost column represents the historical cost of 
property and equipment, net of disposals. The cost basis for FY 2006 
and FY 2005 is $3,529 million and $3,502 million, respectively. 
Accumulated depreciation for FY 2006 and FY 2005 is $2,249 million and 
$2,080 million, respectively. 

Category: ADP Assets; 
Useful Life(Years): 3 to 7; 
Cost: $1, 733; 
Accumulated Depreciation: $(1,234); 
2006 Net Book Value: $499; 
2005 Net Book Value: $502. 

Category: Furniture and non-ADP equipment; 
Useful Life(Years): 8 to 10; 
Cost: 61; 
Accumulated Depreciation: (46); 
2006 Net Book Value: 15; 
2005 Net Book Value: 20. 

Category: Investigative equipment; 
Useful Life(Years): 10; 
Cost: 10; 
Accumulated Depreciation: (8); 
2006 Net Book Value: 2; 
2005 Net Book Value: 3. 

Category: Vehicles; 
Useful Life(Years): 5; 
Cost: 76; 
Accumulated Depreciation: (58); 
2006 Net Book Value: 18; 
2005 Net Book Value: 26. 

Category: Major systems; 
Useful Life(Years): 7; 
Cost: 423; 
Accumulated Depreciation: (391); 
2006 Net Book Value: 32; 
2005 Net Book Value: 89. 

Category: Internal use software; 
Useful Life(Years): 7; 
Cost: 721; 
Accumulated Depreciation: (242); 
2006 Net Book Value: 479; 
2005 Net Book Value: 508. 

Category: Internal use software- work in progress; 
Useful Life(Years): [Empty]; 
Cost: 41; 
Accumulated Depreciation: [Empty]; 
2006 Net Book Value: 41; 
2005 Net Book Value: 35. 

Category: Leasehold improvements; 
Useful Life(Years): 10; 
Cost: 443; 
Accumulated Depreciation: (264); 
2006 Net Book Value: 179; 
2005 Net Book Value: 202. 

Category: Assets under capital lease; 
Useful Life(Years): 4 to 10; 
Cost: 21; 
Accumulated Depreciation: (6); 
2006 Net Book Value: 15; 
2005 Net Book Value: 37. 

Category: Total property and equipment; 
Useful Life(Years): [Empty]; 
Cost: 3,529; 
Accumulated Depreciation: (2,249); 
2006 Net Book Value: 1,280; 
2005 Net Book Value: 1,422. 

[End of table] 

As of September 30, 2006 and 2005, the Service has 12 internal use 
software projects, including deployed and work in process. Customer 
Account Data Engine (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 for tax practitioners and the public. 
Modernized E-File is an electronic filing system for tax returns. 
Security and Technology Infrastructure Release (STIR) is a project to 
modernize and standardize the information technology security 
infrastructure throughout the Service. Integrated Financial System 
(IFS) is an administrative financial system. Internet Refund Fact of 
Filing is a project to allow taxpayers to review the status of their 
refund. Enterprise Systems Management (ESM) is a project that created a 
new information technology infrastructure. Customer Communications is a 
customer service telephone system. Filing & Payment Compliance is a 
project to resolve payment and filing compliance issues, including 
enabling private debt collection. 

Deployed internal use software projects consist of the following: 

[See PDF for table]  

[End of table] 

Until deployed, internal use software projects are carried as work in 
process. Major projects in process include future releases of CADE, 
Modernized E-File, and Filing & Payment Compliance. 

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

Category: CADE; 
2006: $10; 
2005:  $18. 

Category: Modernized E-file; 
2006: $16; 
2005:  $15. 

Category: Filing and payment compliance; 
2006: $15; 
2005:  $2. 

Category: Totals; 
2006: $41; 
2005:  $35. 

[End of table] 

Note 7. Other Liabilities (In Millions): 

Other liabilities as of September 30, 2006 and 2005, consist of the 
following: 

[See PDF for Image] 

[End of table] 

Note 8. Leases (In Millions): 

The capital lease liability as of September 30, 2006 and 2005, is $5 
million and $26 million, respectively, for photocopiers, ADP Equipment 
and software licenses. Future payments due on capital leases are as 
follows: 

Photocopiers; 
Total: $1; 
2007: $1; 
2008: [Empty]; 
2009: [Empty]. 

ADP equipment; 
Total: $5; 
2007: $1; 
2008: $1; 
2009: $3. 

Total lease obligations; 
Total: $6; 
2007: $2; 
2008: $1; 
2009: $1. 

Less: imputed interest; 
Total: (1); 
2007: (1); 
2008: [Empty]; 
2009: [Empty]. 

Present value of lease payments; 
Total: $5; 
2007: $1; 
2008: $1; 
2009: $3.  

[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. Commitments and Contingencies: 

The Service is subject to contingent liabilities involving litigation 
of cases whose ultimate disposition is unknown. Management has 
determined that it is probable that some of these proceedings and 
actions will result in losses. As of September 30, 2006 and 2005, the 
estimated liability for these cases was $2 million and $0, 
respectively. 

There are also legal actions pending for which management is unable to 
determine the likelihood of losses. Adverse decisions in these cases 
may, individually or in the aggregate, have a material effect on the 
financial statements. As of September 30, 2006 and 2005, there were 
three cases for which management is unable to determine the likelihood 
or establish a range of potential losses. 

As of September 30, 2006 and 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, 2006 
and 2005, consist of the following: 

Workers' Compensation; 
2006: Intrageovernmental: $96; 
2006: With the public: $487; 
2005: Intragovernmental: $92; 
2005: With the Public: $520. 

Accrued annual leave; 
2006: Intrageovernmental: [Empty]; 
2006: With the public: $478; 
2005: Intragovernmental: [Empty]; 
2005: With the Public: $462. 

Capitol lease liability; 
2006: Intrageovernmental: [Empty]; 
2006: With the public: [Empty]; 
2005: Intragovernmental: [Empty]; 
2005: With the Public: $23. 

Contingent liability; 
2006: Intrageovernmental: [Empty]; 
2006: With the public: $2; 
2005: Intragovernmental: [Empty]; 
2005: With the Public: [Empty]. 

[End of Table] 

Workers' compensation, accrued annual leave, and contingent liabilities 
are also reported in Components Requiring or Generating Resources in 
Future Periods in the Statement of Financing. 

Note 11: Appropriations Received: 

Appropriations received reported in the Statement of Budgetary 
Resources in FY 2006 and FY 2005 include $101 million and $90 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, 2006 and 2005, in the Statement 
of Budgetary Resources, are as follows: 

Undelivered orders -unpaid; 
2006: $ (932); 
2005:  $ (941). 

Budgetary accounts payable; 
2006: (605); 
2005: (587). 

Budgetary accounts receivable; 
2006: 15; 
2005: 17. 

Total obligated balances; 
2006: (1,522); 
2005: (1,511). 

[End of table] 

Note 13. Non-entity Assets (In Millions): 

Non-entity 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. Non-entity assets 
as of September 30, 2006 and 2005, consist of the following: 

Due from Treasury; 
2006: Intragovernmental: $ 1,685; 
2006: With the public: $ [Empty]; 
2005: Intragovernmental: $1,946; 
2005: With the public: $ [Empty]. 

Federal taxes receivable, net of allowance for doubtful accounts; 
2006: Intragovernmental: [Empty]; 
2006: With the public: 21,000; 
2005: Intragovernmental: [Empty]; 
2005: With the public: 21,000. 

Other custodial assets; 
2006: Intragovernmental: [Empty]; 
2006: With the public: 48; 
2005: Intragovernmental: [Empty]; 
2005: With the public: 462. 

[End of table] 

Due from Treasury represents tax refunds due to taxpayers but not 
disbursed as of September 30, 2006 and 2005. 

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): 

The Budget of the United States Government that will include FY 2006 
actual budgetary execution information will not be published until 
January 2007. Accordingly, the disclosure information required by 
Statement of Federal Financial Accounting Standard No. 7, Accounting 
for Revenue and Other Financing Sources and Concepts for Reconciling 
Budgetary and Financial Accounting, is not available at the time of 
publication of these financial statements. 

Balances reported in the FY 2005 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. 

[See PDF for Image] 

[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. 

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, 2006 and 2005, and by tax year for fiscal 
year ended September 30, 2006, is as follows: 

[See PDF for Image] 

* Includes other collections of $492 million. 

** Includes tax year 2007 corporate income tax receipts of $10 billion. 

[End of Figure] 

In FY 2006, Individual income, FICA/SECA, and other taxes include $71 
billion in payroll taxes collected from other federal agencies. Of this 
amount, $12 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, 
2006 and 2005, and by tax year for fiscal year ended September 30, 
2006, is as follows: 

[See PDF for Image] 

[End of table] 

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

Note 17. Intragovernmental Costs and Exchange Revenue (In Millions): 

Gross cost and earned revenue for the Service are categorized as 
follows: 

[See PDF for Image] 

[End of table] 

Note 18. Obligations Incurred: 

In FY 2006, the Service incurred $10,634 million in obligations funded 
by direct appropriations and $88 million funded by reimbursable revenue 
and transfers from the Treasury Asset Forfeiture Fund. 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. Obligations incurred 
are reported by the Service under Apportionment Category B which 
distributes budgetary resources for the entire fiscal year. Resources 
for Business Systems Modernization are distributed by projects. 

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

Spending authority from offsetting collections as of September 30, 2006 
and 2005, in the Statements of Budgetary Resources and Financing, is as 
follows: 

Reimbursable revenue; 
2006: $71; 
2005: $142. 

REceipts for Tax Lien Revolving Fund; 
2006: 8; 
2005: 5. 

Refunds for Vendors; 
2006: 8; 
2005: [Empty]. 

Treasury asset Forfeiture Fund Transfers; 
2006: 17; 
2005: 14. 

Total spending authority from offsetting collections; 
2006: 104; 
2005: 161. 

[End of Table] 

[End of section] 

Supplemental Information: 

Supplemental Information - Unaudited For the Years Ended September 30, 
2006 and 2005: 

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 2006, the total 
estimated payout (including principal and interest) for claims pending 
judicial review by the Federal courts is $14.8 billion and by Appeals 
is $7.1 billion. In FY 2005, the total estimated payout (including 
principal and interest) for claims pending judicial review by the 
Federal courts was $11.9 billion and by Appeals was $11.1 billion. 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, 2006 and 2005, were as 
follows: 

Total unpaid assessments; 
2006: $245; 
2005: $230. 

Less: Compliance assessments write-offs; 
2006: (57); 
2005: (44). 

Gross federal taxes receivable; 
2006: 91; 
2005: 88. 

Less: allowance for doubtful accounts; 
2006: (70); 
2005: (67). 

Federal taxes receivable, net; 
2006: 21; 
2005: 21. 

[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 $9 billion as of 
September 30, 2006 and $13 billion as of September 30, 2005, 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 2006, the Service issued 
$36 billion in EITC refunds. In FY 2005, the Service issued $35 billion 
in EITC refunds. An additional $5.4 billion and $5.3 billion of the 
EITC was applied to reduce taxpayer liability for FY 2006 and FY 2005, 
respectively. 

Social Security and Medicare Taxes: 

The Federal Insurance Contributions Act (FICA) provides for a federal 
system of old-age, survivors, disability, and hospital insurance 
benefits. Payments to trust funds established for these programs are 
financed by payroll taxes on employee wages and tips, employers' 
matching payments, and a tax on self-employment income. 

A portion of FICA benefits involve old-age, survivors, and disability 
payments. These benefits are funded by the "social security tax" which 
is currently 6.2% of wages and tips up to $94,200 and an employer 
matching amount of 6.2% bringing the total rate to 12.4%. These 
benefits are also funded by a self-employment tax of 12.4% on self 
employment income up to $94,200. For FY 2005, the income ceiling for 
both wages and tips and self-employment income was $90,000. Remaining 
benefits under FICA pertain to hospital benefits (referred to as 
"Medicare") and are funded by a separate 1.45% tax on all wages and 
tips (there is no wage limit) and the employer matching contribution of 
1.45% bringing the total rate to 2.9%. Self-employed individuals pay a 
Medicare tax of 2.9% on all self employment income. Social Security 
taxes collected by the IRS were estimated to be approximately $614 
billion and $583 billion in FY 2006 and FY 2005, respectively. Medicare 
taxes collected by the IRS were estimated to be approximately $178 
billion and $167 billion in FY 2006 and FY 2005, respectively. 

INTERNAL REVENUE SERVICE: 

Supplemental Information - Unaudited For the Years Ended September 30, 
2006 and 2005: 

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

Fiscal Year 2006: 

[See PDF for Image] 

[End of table] 

Supplemental Information - Unaudited For the Years Ended September 30, 
2006 and 2005: 

Fiscal Year 2005: 

[See PDF for Image] 

[End of table] 

[End of section] 

Other Accompanying Information: 

Other Accompanying Information - Unaudited: 

For the Years Ended September 30, 2006 and 2005: 

Child Tax Credit: 

The child tax credit provided under Internal Revenue Code (26 USC) 
Section 24 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 2006, 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 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. 

Tax Gap: 

The tax gap is the difference between what taxpayers should pay and 
what they actually pay due to not filing tax returns, not paying their 
reported tax liability on time, or failing to report their correct tax 
liability. The tax gap, about $345 billion based on updated FY 2006 
estimates, represents the amount of noncompliance with the tax laws. 
Underreporting tax liability accounts for 83 percent of the gap, with 
the remainder almost evenly divided between non-filing (eight percent) 
and underpaying (nine percent). The estimate is based on a study of 
individual returns filed for tax year 2001. It does not include 
underpayments by corporate taxpayers or taxes that should have been 
paid on income from the illegal section of the economy. 

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 tax gap arises from the 
three types of noncompliance: not filing required tax returns on time 
or at all (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. Obviously, some of the tax gap arises 
from intentional (willful) noncompliance, and some of it arises from 
unintentional mistakes. 

The collection gap is the cumulative amount of tax, penalties, and 
interest that has been assessed over many years, but has not been paid 
by a certain point in time, and which 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): 

Average Individual Income Tax Liability And Average Adjusted Gross 
Income (AGI) Tax Year 2004: 

[See PDF for Image] 

[End of Figure] 

Individual Income Tax Liability As A Percentage Of AGI Tax Year 2004: 

Income tax as a percentage of AGI: 

[See PDF for image] 

[End of figure] 

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

Corporation Tax Liability As A Percentage Of Taxable Income Tax Year 
2003 Data: 

[See PDF for Image] 

[End of Figure] 

[End of section] 

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

Material Weaknesses: 

During our audits of the Internal Revenue Service's (IRS) fiscal years 
2006 and 2005 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 IRS's 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 21] 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 2006, 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 2006, IRS (1) did not have an adequate general ledger 
system for financial reporting purposes, (2) could not reliably report 
the specific amount of revenue collected for each of several of the 
federal government's largest revenue sources, and (3) was unable to 
readily determine the costs of its activities and programs and did not 
have cost-based performance information to assist in making or 
justifying resource allocation decisions. Although labor-intensive 
compensating procedures yielded financial statements that were fairly 
stated as of September 30, 2006 and 2005, they do not afford real-time 
data needed to assist in managing operations on a day-to-day basis and 
to assist in making or justifying resource allocation decisions. 

As we noted in last year's report,[Footnote 22] during fiscal year 
2006, 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 23] or the requirements of the 
Federal Financial Management Improvement Act of 1996 (FFMIA). Further, 
IRS's use of two separate, nonintegrated 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. 

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. 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. Additional key components were originally planned to be 
implemented with future releases of IFS, such as property management, 
procurement, and a workload management system. However, technological 
improvements and budgetary constraints have led IRS to reconsider its 
commitment to future releases of IFS while it reviews other available 
options, such as acquiring alternate software or utilizing the services 
of a shared service provider. IRS has not yet decided which course of 
action to take or obtained necessary funding. It is therefore unclear 
how or when IRS will attain the functionality originally planned for 
future releases of IFS. 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. 

In previous years, IRS had difficulty determining the specific amount 
of revenue it actually collected for three of the federal government's 
four largest revenue sources--Social Security, hospital insurance, and 
individual income taxes. During fiscal year 2006, IRS performed an 
analysis to estimate the amounts collected for Social Security and 
hospital insurance. However, IRS is not yet confident of the 
reliability of these amounts, and consequently reported them in its 
unaudited supplemental information rather than the audited financial 
statements. 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 
results in the federal government depending on a complex, multistep 
process to distribute excise taxes to the recipient trust funds that 
continues to be susceptible to error. 

IRS's inability to timely report specific amounts of excise tax revenue 
to recipient trust funds is significant for these funds and their 
administrators. Since fiscal year 2004, when all federal agencies were 
required to begin meeting the Office of Management and Budget's (OMB) 
stipulated reporting date of November 15, the annual excise tax 
receipts reported by recipient trust funds include 6 months of 
estimated receipts. The trust funds must report 6 months of estimated 
receipts because, under its existing processes, IRS takes 5-˝ 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 24] 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 3 
years to determine the extent to which an acceleration of the process 
would affect the amounts distributed to the trust funds. Based on IRS's 
analysis of the precertifications, which has indicated no significant 
variances between precertified and actual certified amounts for each 
quarter for the past 3 years, the Department of the Treasury (Treasury) 
Excise Tax Working Group[Footnote 25] has decided to accelerate the 
actual certification to the precertification timeline, which will 
accelerate the certification by approximately 2 months. The accelerated 
certification will begin with the second quarter (September 30, 2006, 
liability quarter) that is certified in fiscal year 2007. As a result 
of the acceleration, beginning with the fiscal year 2007 reporting 
year, the annual excise tax receipts reported by recipient trust funds 
will include only 3 months of estimated receipts. 

During fiscal year 2005, we reported that IRS implemented a cost 
accounting module as part of the first release of IFS but that it 
required improvements or additional components, such as a workload 
management system, before its full potential would be realized. During 
fiscal year 2006, IRS further improved its cost accounting capabilities 
by developing and implementing a methodology for allocating its costs 
of operations to its business units. This methodology utilizes the new 
cost accounting module of IFS and allows IRS to accumulate the full 
costs of operating each business unit and facilitates financial 
reporting. For example, in fiscal year 2006 IRS was able, for the first 
time, to generate its statement of net cost directly from IFS. While 
these are positive steps, IRS has not yet determined what the full 
range of its cost information needs are or how best to utilize the cost 
module's existing capabilities to satisfy 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 at the 
activity or program level. Without this detail, IRS is unable to either 
readily determine the costs of activities and programs that involve 
activities in multiple business units, such as the Automated 
Underreporter Program, or segregate the costs for each activity in 
cases where multiple activities, such as the processing of different 
types of tax returns, are performed by a single business unit. 
Consequently, at this time, IRS cannot rely on the system as a 
significant planning and decision-making tool. It will likely require 
several years and implementation of additional components, such as a 
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 
for attaining efficiencies and enhancing effectiveness will continue to 
be hampered by a lack of meaningful underlying cost information. 

Despite progress made during fiscal year 2006, the continued existence 
of these financial reporting weaknesses once again compelled IRS to 
expend more time and effort to maintain its accounting records and 
generate financial management information than would otherwise have 
been necessary. Further, despite these monumental efforts, IRS 
continued to lack reliable and timely financial information to assist 
in managing operations throughout fiscal year 2006. 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 2006, we continued to find serious internal control 
issues that affected IRS's management of unpaid assessments. 
Specifically, we continued to find that (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 26] 

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. In fiscal year 2006, IRS began a 
phased-in implementation of its Custodial Detailed Database (CDDB). One 
of the key objectives of CDDB is to ultimately serve as a subsidiary 
ledger for IRS's tax administration activities, including tax revenue 
receipts, refund disbursements, and unpaid tax debt, by linking account 
information in IRS's master files[Footnote 27] with its general ledger 
for tax administration activities. The first phase of CDDB primarily 
consisted of implementing computer programs that analyze and classify 
related taxpayer accounts from IRS's master file that are associated 
with unpaid payroll taxes. Although IRS successfully implemented the 
first phase of CDDB during fiscal year 2006, full operational 
capability of CDDB is still several years away and depends on the 
successful implementation of future system releases planned through 
2009. As a result, IRS continues 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 continue to apply statistical sampling and estimation 
techniques to data in its master files to estimate the balances at year-
end. While the first release of CDDB refined this process by analyzing 
and classifying taxpayer accounts from IRS's master files that are 
associated with unpaid payroll taxes, the process continued to take 
several months to complete; required adjustments totaling billions of 
dollars; and produced amounts that after adjustments, were only 
reliable as of the last day of the fiscal year. Consequently, the lack 
of a subsidiary ledger inhibits IRS's ability to timely develop 
reliable financial and management reports useful for ongoing management 
decisions. 

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 erroneously recorded a 
taxpayer's reported tax of $1,694 as $169 million in its systems, and 
sent the taxpayer two erroneous notifications to pay this amount due 
plus penalties and interest of nearly $200 million. Upon receipt of 
these notices, the taxpayer obtained the services of a certified public 
accountant to resolve the matter with IRS; IRS ultimately corrected the 
error after several months. In another example, IRS incorrectly 
recorded a taxpayer's amended payroll tax return for one tax period in 
a different tax period.[Footnote 28] This resulted in IRS erroneously 
assessing the taxpayer over $4 million in taxes that were not owed. IRS 
ultimately corrected the error several months later, after erroneously 
notifying the taxpayer and requiring the taxpayer to provide additional 
information. 

We also identified some taxpayers that were assessed excess penalties 
because of an error in IRS's computer program that calculates and 
records penalty assessments. IRS increases the penalty rate assessed 
against taxpayers for failing to pay taxes owed from one-half of 1 
percent to 1 percent when the taxpayer fails to pay the tax debt 
following repeated notification of the taxes due. If the taxpayer then 
fully pays the amount owed, IRS is required to reset the penalty rate 
back to one-half of 1 percent if it assesses additional taxes against 
the taxpayer at a later time. However, IRS's penalty calculation 
program did not recognize instances where this situation occurred and 
continued to assess penalties at the higher penalty rate on subsequent 
tax assessments. IRS determined that this error affected over 62,000 
taxpayers with over 69,000 accounts, but IRS had not corrected these 
accounts as of September 30, 2006.[Footnote 29] 

On the other hand, some input errors and posting delays can cost the 
government money. For example, IRS found a corporate officer liable for 
not remitting federal tax withholdings from employees' salaries to IRS. 
When recording the assessment on the officer's master file account for 
one tax period, IRS erroneously recorded a second assessment for the 
same amount. IRS attempted to correct the mistake by reversing the 
duplicate transaction several weeks later. However, IRS erroneously 
reversed both the original and duplicate assessments. Consequently, 
there was no longer any assessment on the officer's master file account 
for this tax period. IRS did not identify its error until our current 
audit, and the statutory period for assessing new taxes on this 
specific tax period had expired.[Footnote 30] As of September 30, 2006, 
IRS had not determined whether it could still legally pursue payment of 
these taxes from this officer. 

As in prior years,[Footnote 31] we continued to find errors involving 
IRS's failure to properly record payments to all related taxpayer 
accounts associated with unpaid payroll taxes.[Footnote 32] 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 any 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, since August 
2001, IRS has established procedures to more clearly link each penalty 
assessment against an officer to a specific tax period 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 2006, as in 
prior years, continued to find deficiencies in this process, leading to 
errors in taxpayers' accounts. In our testing of 80 statistically 
selected payments recorded on trust fund recovery penalty accounts 
established since August 2001, we found 9 instances in which IRS did 
not properly record payments received on all related taxpayer accounts. 
Of these 9 payments, 4 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 11.3 percent of trust fund recovery payment 
transactions posted to accounts established since August 2001 and still 
outstanding during fiscal year 2006 could contain 
inaccuracies.[Footnote 33] 

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 2006, 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 2006 Federal Managers' 
Financial Integrity Act of 1982 (FIA) assurance statement to Treasury, 
in which it reported material weaknesses in earned income tax credit 
(EITC) noncompliance and financial accounting of revenue. IRS's 
taxpayer compliance programs identify billions of dollars of 
potentially underreported taxes and erroneous EITC claims each year. 
However, largely because of 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 34]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 
35] 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 36] 

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 37] 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. Another preventive control that IRS has relied 
on in the past is the Electronic Fraud Detection System (EFDS), which 
is IRS's primary source for identification of leads on fraudulently 
filed tax returns. With EFDS fully operational, IRS stopped over $412 
million in improper refunds during processing year[Footnote 38] 2005. 
However, during processing year 2006, IRS took the original EFDS off- 
line to install a new Web-based version, but encountered problems with 
the Web version and stopped all related system development activities 
before it became operational. As a result, IRS did not have the 
services of EFDS to prevent fraudulent refunds during processing year 
2006. The actual amount of improper refunds disbursed during fiscal 
year 2006 as a result of EFDS being off-line is unknown. However, the 
Treasury Inspector General for Tax Administration estimated that as 
much as $318 million in improper refunds may have been disbursed during 
processing year 2006 while EFDS was off-line.[Footnote 39] 

In its guidance to heads of federal agencies issued in accordance with 
the Improper Payments Information Act of 2002 (IPIA),[Footnote 40] 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 $41 
billion in fiscal year 2006, of which approximately $36 billion was 
refunded to taxpayers and approximately $5 billion was used to reduce 
assessed taxes. 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 for fiscal year 2006. 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 2006 
were improper. This error rate indicates that of the approximately $36 
billion of EITC-related refunds disbursed during fiscal year 2006, at 
least $8 billion, and potentially as much as $10 billion, was likely to 
have been improper. 

Because of 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; consequently, they do not prevent improper refunds from 
being disbursed. IRS's matching program for individual tax returns 
identifies billions of dollars of potentially underreported taxes each 
year. IRS follows up on a portion of these cases identified to 
determine how much tax is actually due and to pursue collection of 
those amounts. 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 recent years, IRS has increased the 
number of returns investigated and the dollar amount of the total 
potential underreported taxes. For example, for tax year 2001, IRS 
identified discrepancies in 15.7 million tax returns, with potential 
underreported taxes totaling $17.2 billion, but only investigated 3 
million (19 percent) of these tax returns, which accounted for about 
$7.7 billion (45 percent) of the total potential underreported 
taxes.[Footnote 41] By contrast, for tax year 2004, IRS identified 
discrepancies in 15 million tax returns with potential underreported 
taxes totaling $16 billion, and investigated 4.6 million (31 percent) 
of these tax returns, which accounted for about $12.7 billion (78 
percent) of the total potential underreported taxes.[Footnote 42] 

However, as these figures also illustrate, IRS continues to pursue only 
a portion of the potential underreported taxes it identifies. In 
addition, 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, which could further improve IRS's net return on the 
cases it does elect to pursue. 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 responsibility, IRS relies 
extensively on computerized systems to support its financial and 
mission-related operations. Effective information system controls are 
essential to ensuring that taxpayer and financial information is 
adequately protected from inadvertent or deliberate misuse, fraudulent 
use, improper disclosure, or destruction. Ineffective system controls 
can impair the accuracy, completeness, and timeliness of information 
used by management and increase the potential for undetected material 
misstatements in the agency's financial statements. 

IRS has made progress in implementing information security for its 
financial and tax processing systems and information by addressing many 
of its previously reported security weaknesses. For example, among 
other things, IRS implemented stronger password settings regarding 
expiration and complexity and improved controls over data sharing among 
mainframe users. IRS also improved employee training on recovering 
critical systems in the event of a disaster. 

Although IRS has made progress toward correcting previously identified 
information security weaknesses, significant weaknesses in electronic 
access and other information security controls continued to exist 
during fiscal year 2006. Corrective actions had not been completed for 
some of the previously identified weaknesses. For example, the security 
software configurations on the mainframe system, which supports IRS's 
general ledger for tax administration activities, continued to contain 
numerous invalid and obsolete entries, leaving IRS with a system that 
is overly complicated and difficult to secure, especially in terms of 
monitoring actual access privileges. We also identified new weaknesses. 
For example, we found that IRS's procurement system, which processed 
about $3.9 billion in fiscal year 2006, was vulnerable to a well-known 
exploit whereby database commands can be inserted into the application 
through a user input screen that is available to everyone on the 
agency's network. The significance of this vulnerability is compounded 
by the fact that IRS had granted administrative privileges to the 
database account used by the application, allowing anyone who exploits 
this vulnerability to have powerful database privileges, including the 
ability to change data. In addition, IRS had not fully employed 
mitigating controls used to detect malicious activity, such as logging 
and monitoring user activity. The agency also stored user IDs and 
passwords in mainframe files that could be read by every mainframe 
user. This information could provide a malicious user access to IRS's 
data retrieval system, which contains taxpayer information. Weaknesses 
also existed in other areas, such as physical security, configuration 
management, segregation of duties, and personnel security. If IRS does 
not adequately mitigate these weaknesses, unauthorized individuals 
could gain access to critical systems, where they may intentionally or 
inadvertently read, modify, 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, such as identity theft. Previously reported weaknesses that 
have not been corrected, and the new weaknesses identified during our 
fiscal year 2006 financial audit, increase the risk that data processed 
by the agency's financial management and tax administration systems are 
not reliable. 

A key reason for the information security weaknesses in IRS's financial 
and tax processing systems was that it has not yet fully implemented a 
security program[Footnote 43] to ensure that controls are effectively 
established and maintained. Although IRS continues to make important 
progress in developing a framework for its information security 
program, we identified instances in which the program had not been 
fully or consistently implemented for its information systems. For 
example, the system that supports IRS's general ledger for tax 
administration activities did not have a documented security plan. In 
addition, although IRS was periodically testing security controls on 
the systems we reviewed, it did not always take remedial action to 
address deficiencies identified through these tests. For example, in 
March 2006, IRS identified a vulnerability in the process that manages 
network connectivity to its procurement system database server; this 
condition continued to exist at the time of our review 4 months later. 
Further, one of the systems we reviewed did not have an alternate 
backup facility in place in the event of a disaster. Until IRS takes 
additional steps to fully implement key elements of its information 
security program, its facilities and computing resources and the 
information that is processed, stored, and transmitted on its systems 
will likely remain vulnerable, and management will not have assurance 
of the integrity and reliability of the information generated. 

The new information security deficiencies we identified in fiscal year 
2006 and the unresolved deficiencies from prior audits represent a 
material weakness in IRS's internal controls over its procurement, 
asset management, and tax administration accounting systems. 
Collectively, these deficiencies reduce IRS's ability to secure its 
financial and taxpayer information. We plan to issue a separate report 
on the newly identified weaknesses and the status of previously 
identified weaknesses. 

Reportable Condition: 

In addition to the material weaknesses discussed above, we identified a 
reportable condition concerning weaknesses in IRS's internal controls 
over hard-copy tax receipts and taxpayer information. 

In our previous report on the results of our audit of IRS's fiscal year 
2005 financial statements, we discussed the presence of a reportable 
condition with respect to weaknesses in IRS's internal controls over 
P&E. Over the past several years, IRS has made substantial progress in 
strengthening internal controls and procedures that enhanced its 
ability to account for P&E. In fiscal year 2006, IRS made further 
improvements over recording P&E transactions in its accounting records. 
Although IRS continues to lack an integrated property management 
system, the improvements made in fiscal year 2006, combined with 
progress made over the past several years, have mitigated this issue. 
Thus, we no longer consider the lack of an integrated accounting and 
property system to constitute a reportable condition. 

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, field office taxpayer assistance centers, other field 
office units, 

and commercial lockbox banks.[Footnote 44] In previous audits, we have 
reported that weaknesses in IRS's controls designed to safeguard 
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 45] During our fiscal 
year 2006 audit, we identified actions IRS has taken to address some of 
these weaknesses. For example, IRS issued guidance to its large-and 
midsized taxpayer assistance centers that enhanced managerial and 
supervisory review requirements and provided for segregation of duties 
between preparation and review activities relating to documents that 
accompany shipments of taxpayer receipts and information to affiliated 
IRS service center campuses for processing. Additionally, we observed 
that at one service center campus, IRS had taken corrective actions to 
address several physical security vulnerabilities, which, if left 
uncorrected, could have resulted in unauthorized access to the 
facility. Also, during fiscal year 2006, IRS and the Financial 
Management Service continued implementation of a joint lockbox 
performance measurement system begun in fiscal year 2005, which was 
designed to address deficiencies in internal controls, such as those 
identified in our prior audits, by establishing strict standards and 
accountability for adherence to these standards. Because the lockbox 
performance measurement system was not fully implemented during fiscal 
year 2006, we could not assess the overall impact it will have on 
improving the effectiveness of internal controls at the lockbox banks. 
However, the system focuses on increased oversight by requiring 
quarterly reviews relating to physical security and internal controls 
over receipts and receipt processing, and subsequent reporting of the 
reviews' results to bank management officials. In addition, a bank 
receiving a cautionary rating, indicating notable deficiencies in 
overall performance, may be subject to the following punitive actions 
if performance does not improve: (1) ineligibility to bid on new work 
or receive additional volume, (2) placement in a probationary status 
for no less than 90 days, and (3) loss of existing work. This system 
has the potential to significantly improve internal controls at the 
lockbox bank facilities. 

However, despite the improvements we found at IRS's taxpayer assistance 
centers, service center campuses, and lockbox banks, IRS's controls 
over receipts and related hard-copy taxpayer information did not 
sufficiently limit the risk of theft, loss, or misuse of such funds and 
information. 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 fiscal year 2006 audit, we observed that (1) the 
external perimeter was vulnerable to external intrusions (at five 
service center campuses); (2) guards did not respond timely to alarms 
(at two service center campuses and one taxpayer assistance center), 
and (3) security cameras did not provide for 360 degree coverage of the 
building exterior or the facility's external perimeter (at two service 
center campuses and three lockbox banks). These weaknesses increase the 
risk that the integrity of IRS facilities and the taxpayer receipts and 
information they process may be compromised. 

* Weaknesses in procedural safeguards and controls designed to account 
for, control, and protect taxpayer receipts and related taxpayer 
information. For example, during our fiscal year 2006 audit, we found 
that (1) sensitive taxpayer information in electronic form sent off- 
site for storage was not encrypted to prevent potential unauthorized 
access (at three lockbox banks), (2) there was no documentation that 
vendors with off-site possession of actual or potential sensitive 
taxpayer information had received required background investigations 
(at two service center campuses and one lockbox bank), and (3) mail 
potentially containing taxpayer receipts was not adequately secured to 
prevent potential tampering or theft (at two service center campuses). 
These weaknesses increase the risk that taxpayer receipts and 
information may be compromised during processing at IRS facilities and 
lockbox banks. 

* 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 fiscal year 2006 
audit, we found that (1) there was no evidence that IRS employees 
sending packages containing taxpayer receipts and information followed 
up with responsible parties at the recipient location when document 
transmittal forms used to specifically identify the contents of the 
packages shipped remained unacknowledged by the recipient (at one 
service center campus and five Small Business/Self-Employed units); (2) 
packaging and shipping procedures used by IRS employees did not 
adequately secure taxpayer receipts and information to prevent 
potential tampering or unauthorized access (at one service center 
campus and two Small Business/Self-Employed unit); and (3) there was no 
evidence documenting managerial review of transfer-related 
documents[Footnote 46] (at three service center campuses, two lockbox 
banks, two taxpayer assistance centers, and four Small Business/Self- 
Employed units). 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. IRS's 
progress in addressing these issues has been hampered by a tendency, at 
times, to focus corrective actions on the issues we identify at the 
specific locations where we find them, versus proactively addressing 
potential weaknesses at other comparable locations to determine the 
full scope of the issues across all IRS receipt processing facilities 
potentially affected. For example, during our fiscal year 2005 
financial audit, we identified a physical security weakness in a 
perimeter fence at one service center campus, which IRS subsequently 
corrected. However, IRS did not concurrently follow up to assess 
whether similar issues existed at other service center campuses. During 
our fiscal year 2006 audit, we found that similar vulnerabilities 
existed at two additional service center campuses. The recurrence of 
this issue might have been avoided if IRS had been more proactive in 
its use of the information we provided in fiscal year 2005. While IRS 
has made significant progress in this area, the issues identified 
during our fiscal year 2006 audit indicate that more remains to be done 
to effectively address these matters, which are critical to IRS's 
success in meeting its customer service goals. 

Compliance Issues: 

Our work on 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.[Footnote 47] 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 federal tax liens 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 48]We found that this condition continued to exist in 
fiscal year 2006. 

In prior audits, we tested a statistical sample of tax cases with liens 
in which the taxpayers' total outstanding tax liabilities were either 
paid off or abated during the fiscal year under audit. In fiscal year 
2006, IRS performed its own test of the effectiveness of its lien 
release process as part of implementing the requirements of the revised 
OMB Circular No. A-123. Consequently, we reviewed and validated IRS's 
test results. 

In its testing of 84 statistically selected tax cases with liens in 
which the taxpayers' total outstanding tax liabilities were either paid 
off or abated during fiscal year 2006, IRS found 26 instances in which 
it 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 44 days to 638 days. In 4 
cases, the lien still had not been released at the time of IRS's 
review. Based on these results, IRS estimates that for 31 percent of 
unpaid tax assessment cases in which it had filed a tax lien that were 
resolved in fiscal year 2006, IRS did not release the lien within 30 
days.[Footnote 49] 

In 13 of the 26 cases in which liens were not released timely, the 
delay in the lien release was caused by IRS's failure to timely record 
information on the taxpayer's account to show that the taxpayer had 
satisfied or was otherwise relieved of the tax liability. In 6 of these 
cases, 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 the 
initiation of the lien release process for these cases. In 5 of the 
other cases, IRS did not timely update the taxpayer's account to 
reflect that the taxpayer had been discharged of the taxes in 
bankruptcy court. In the remaining 2 cases, IRS did not timely update 
the taxpayer's account to indicate the taxpayer had satisfied all the 
conditions of an offer-in-compromise. IRS's delay in timely recording 
this information also prevented the initiation of the lien release 
process. 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. 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 50] 

Financial Management Systems' Noncompliance With FFMIA: 

In fiscal year 2006, 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), 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 represented a major step forward and has 
provided significant benefits, such as enhanced audit trails and a cost 
module. However, as noted earlier in this report, IRS is no longer 
committed to the future releases of IFS that were to include additional 
features essential to IRS's ability to realize the system's full 
potential, such as workload and procurement management. Since IRS does 
not yet have a viable alternative planned, it is unclear how or when 
IRS will obtain these capabilities. 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 
2006. 

IRS has established a remediation plan to address the conditions 
affecting its systems' inability to comply substantially with the 
requirements of FFMIA. This plan outlines the actions to be taken to 
resolve these issues, but many future corrective actions are on hold 
and currently unfunded. Because of 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 IRS's 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, P&E, 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 the existence and completion assertions related 
to 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 IRS's 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, and OMB Circular No. A-123, Management's Responsibility 
for Internal Control. 

* 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, Independent Agencies, and General Government 
Appropriations Act, 2005, Pub. L. No. 108-447, div. H, tit. II, 118 
Stat. 2809, 3199 (Dec. 8, 2004); and Department of the Treasury 
Appropriations Act, 2006, Pub. L. No. 109-115, div. A, tit. II, 119 
Stat. 2396, 2432 (Nov. 30, 2005). 

* 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 6, 2006: 

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 comment on the draft report titled, 
Financial Audit. IRS' Fiscal Years 2006 and 2005 Financial Statements. 
We are pleased that the Internal Revenue Service (IRS) received an 
unqualified opinion on the combined financial statements for a seventh 
consecutive year. The unqualified opinion demonstrates that the IRS 
accurately accounts for approximately $2.5 trillion in tax revenue 
receipts, $277 billion in tax refunds, and $11 billion in IRS 
appropriated funds. 

The report recognizes the significant accomplishments the IRS made this 
year in addressing outstanding audit issues while also implementing the 
requirements of Appendix A of the Office of Management and Budget (OMB) 
Circular A-123, Management's Responsibility for Internal Control. The 
IRS met the new provisions of OMB A-123 and Treasury mandates, a 
significant and highly visible challenge due to the complexity and need 
to create an entirely new process. The IRS tested internal control sets 
for 45 transaction processes and over 200 internal controls identified 
by Treasury that are material to its consolidated financial statements. 

We are dedicated to continuing to improve financial management at the 
IRS, as evidenced by the following significant fiscal year (FY) 2006 
achievements: 

* Eliminated property and equipment reportable condition through 
implementation of a first level procurement review, revision of 
material group codes, and implementing a materiality threshold for 
capital asset review: 

* Reduced Matters for Further Consideration (MFCs) for the safeguarding 
of taxpayer receipts by 60 percent from FY 2005: 

* Reduced MFCs in administrative accounting by 40 percent from FY 2005: 

* Accelerated the quarterly excise tax certifications to the Department 
of the Treasury by two months and disclosed more detailed information 
on Social Security tax and the three largest Excise Tax Trust Funds 
revenues as supplemental information to the FY 2006 financial 
statements and in the Management Discussion and Analysis: 

* Improved cost allocation methodology and generated FY 2006 Statement 
of Net Cost from the Integrated Financial System (IFS): 

* Automated the obligation adjustment process in IFS: 

* Implemented Release 1 of the Custodial Detail Data Base, creating a 
subsidiary ledger for unpaid assessments that was used for audit 
sampling, one year ahead of schedule: 

Improving information security continues to be a priority for the IRS. 
The IRS is improving protection of sensitive information by expanding 
the use of encryption, increasing employee education and awareness, and 
improving IRS information security policies and procedures to ensure 
protection of taxpayer, employee, and IRS sensitive information. The 
IRS established a Security Services and Privacy Executive Steering 
Committee to coordinate information security improvements and to 
leverage subject matter experts from the areas of information 
technology security, physical security, and privacy and identity theft. 

I want to recognize the Government Accountability Office's support 
throughout the FY 2006 audit and assistance as the IRS implemented the 
new requirements of OMB Circular A-123. While challenges remain, the 
IRS has established its ability to consistently produce accurate and 
reliable financial statements. We have a solid management team in place 
to continue to improve financial management, and we continue to 
increase the focus on information security and internal controls while 
improving financial reporting. 

Sincerely, 

Signed by: 

John M. Dalrymple: 

[End of Section]  

(196088): 

FOOTNOTES 

[1] A shared service provider is an organization that performs a 
service, such as electronic data processing, for multiple customers 
from a central location. A federal center for excellence is a federally 
owned shared service provider that serves multiple federal 
organizations. 

[2] GAO, High-Risk Series: An Overview, GAO/HR-95-1 (Washington, D.C.: 
February 1995). 

[3] GAO, High-Risk Series: An Update, GAO-05-207 (Washington, D.C.: 
January 2005). 

[4] GAO-05-207. 

[5] An S-corporation is a corporation with a limited number of 
stockholders (100 or fewer) that elects not to be taxed as a regular 
corporation and meets certain other requirements. 

[6] The tax gap is an estimate of the amount of taxes for a given tax 
year that are owed to the federal government but have not been paid by 
taxpayers. IRS estimates the fiscal year 2006 tax gap to be about $345 
billion. 

[7] 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). 

[8] IRS includes an estimate of the tax gap in its Management 
Discussion and Analysis and in the other accompanying information to 
the financial statements. This estimate is based on a study conducted 
to measure the compliance rate of individual filers based on an 
examination of a statistical sample of tax returns filed for tax year 
2001. 

[9] 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. 

[10] GAO, Financial Audit: Examination of IRS'Fiscal Year 1992 
Financial Statements, GAO/AIMD-93-2 (Washington, D.C.: June 30, 1993). 

[11] 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. 

[12] IRS's master files contain detailed records of taxpayer accounts. 

[13] 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. See 26 U.S.C. § 6672 and implementing IRS guidance 
in the Internal Revenue Manual at § 4.23.9.13, Trust Fund Recovery 
Penalty (Mar. 1, 2003). 

[14] The tax filing season for individuals primarily occurs from 
January 1 through April 15 of each year. 

[15] In addition to the 22 measures, data to estimate the Earned Income 
Tax Credit measure will be available late in 2007 and five measures 
were baselined in FY 2006. 

[16] Department of the Treasury, Internal Revenue Service, Business 
Systems Modernization Fiscal Year 2006 & 2007 Expenditure Plan (August 
2006). 

[17] 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. 

[18] 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. 

[19] Tax law requires IRS 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. 

[20] Pub. L. No. 104-208, div. A, § 101(f), title VIII, 110 Stat. 3009, 
3009-389 (Sept. 30, 1996). 

[21] Pub. L. No. 103-62, § 4(b), 107 Stat. 285, 287 (Aug. 3, 1993) 
(codified at 31 U.S.C. § 1115). 

[22] GAO, Financial Audit: IRS's Fiscal Years 2005 and 2004 Financial 
Statements, GAO-06-137 (Washington, D.C.: Nov. 10, 2005). 

[23] GAO-06-137. 

[24] Joint Financial Management Improvement Program, 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, the Department of the Treasury, the 
Office of Personnel Management, and GAO, working in cooperation with 
each other and with 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. 

[25] 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. 

[26] The Treasury Excise Tax Working Group consists of Treasury 
agencies with trust fund responsibilities (IRS, Office of the Fiscal 
Assistant Secretary, Bureau of the Public Debt, Financial Management 
Service, and Office of Tax Analysis). The working group meets to 
discuss and coordinate issues related to excise tax trust fund 
distributions. 

[27] 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 
because of 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. 

[28] 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. 

[29] A "tax period" varies by tax type. For example, the tax period for 
payroll and excise taxes is generally one quarter of a year. The 
taxpayer is required to file quarterly returns with IRS for these types 
of taxes, but payment of the taxes occurs throughout the quarter. In 
contrast, for income, corporate, and unemployment taxes, a tax period 
is 1 year. 

[30] The balance of unpaid assessments from the affected taxpayers' 
accounts totaled approximately $745 million. We were unable to 
determine the exact amount by which the error overstated the account 
balances but know that the amount is significantly less than the total. 
Additionally, we were unable to determine whether any of the affected 
taxpayers had already paid the excess penalties assessed. 

[31] The statutory period for assessing new taxes is generally 3 years 
from when a tax return is either filed or due, whichever is later. 
I.R.C. Section 6501(a). 

[32] GAO-06-137. 

[33] 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. See 26 U.S.C. § 6672 and implementing IRS guidance 
in the Internal Revenue Manual at § 4.23.9.13, Trust Fund Recovery 
Penalty (Mar. 1, 2003). 

[34] We are 95 percent confident that the error rate does not exceed 
18.9 percent. 

[35] IRS 1099 forms are used by third parties, such as financial 
institutions, to report taxpayers' interest income, dividend 
distributions, and other miscellaneous income. 

[36] The tax filing season for individuals primarily occurs from 
January 1 through April 15 of each year. 

[37] 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). 

[38] 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. 

[39] A processing year is the calendar year in which tax returns and 
related data are processed. During processing year 2006, IRS is 
processing primarily 2005 tax returns. 

[40] Treasury Inspector General for Tax Administration, The Electronic 
Fraud Detection System Redesign Failure Resulted in Fraudulent Returns 
and Refunds Not Being Identified, 2006-20-108 (Washington, D.C.: Aug. 
9, 2006). 

[41] 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. 
Office of Management and Budget, Implementation Guidance for the 
Improper Payments Implementation Act of 2002, P. L. 107-300, M-03-13 
(Washington, D.C.: May 21, 2003). 

[42] GAO, Financial Audit: IRS's Fiscal Year 2003 and 2002 Financial 
Statements, GAO-04-126 (Washington, D.C.: Nov. 13, 2003). 

[43] Tax year 2004 is the most recent year for which complete matching 
program results are available. 

[44] In December 2002, Congress enacted the Federal Information 
Security Management Act of 2002 (FISMA), which requires agencies to 
develop, document, and implement an information security program. FISMA 
was enacted as title III of the E-Government Act of 2002, Pub. L. No. 
107-347, 116 Stat. 2946 (Dec. 17, 2002). This requirement was enacted 
in section 301(b)(1) of FISMA, which is now codified at 44 U.S.C. § 
3544(b). 

[45] IRS's receipt processing facilities include 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; commercial lockbox banks that operate under 
contract with the Financial Management Service to provide tax receipt 
processing and deposit services on behalf of IRS; and other business 
operating divisions that provide taxpayer audit and assistance centers. 
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. 

[46] GAO, Internal Revenue Service: Status of Recommendations from 
Financial Audits and Related Financial Management Reports, GAO-06-560 
(Washington, D.C.: June 6, 2006); Management Report: Improvements 
Needed in IRS's Internal Controls, GAO-06-543R (Washington, D.C.: May 
12, 2006); and GAO-06-137. 

[47] Transfer-related documents include courier, mail, and deposit logs 
and forms 795 and 3210, which accompany taxpayer receipts and other 
information shipped to other IRS locations. 

[48] 26 U.S.C. §§ 6321, 6323. 

[49] GAO-06-103. 

[50] IRS is 97.5 percent confident that the percentage of cases in 
which the lien was not released within 30 days does not exceed 41 
percent. 

[51] GAO, Opportunities to Improve Timeliness of IRS Lien Releases, GAO-
05-26R (Washington, D.C.: Jan. 10, 2005). 

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