GAO-15-404SP: General government: 17. Tax Policies and Enforcement, 2015

General government > 17. Tax Policies and Enforcement, 2015

By more effectively using data to manage various enforcement programs, the Internal Revenue Service could bolster tax compliance and potentially collect hundreds of millions of dollars in additional revenue.

Why This Area Is Important

The Internal Revenue Service (IRS) has estimated that the gross tax gap—the difference between taxes owed and taxes paid on time—was $450 billion for tax year 2006 (the most recent year for which data were available). IRS estimated that it would eventually recover about $65 billion of this amount through late payments and enforcement actions, leaving a net tax gap of $385 billion. Because the net tax gap is so large and the effectiveness of various new IRS enforcement initiatives largely remains to be determined, tax law enforcement is on GAO’s High-Risk List.[1] The nation’s long-term fiscal challenges heighten the importance of reducing the tax gap. Given that individual income tax misreporting accounts for the largest portion of the tax gap, even small changes in IRS’s enforcement programs could result in hundreds of millions of dollars of increased revenue.



[1]GAO, High-Risk Series: An Update, GAO‑15‑290 (Washington, D.C.: Feb. 11, 2015).

What GAO Found

In a series of reports in 2014, GAO identified areas where IRS could improve its enforcement programs and collect additional tax revenue.

IRS Correspondence Audits: Better Management Could Improve Tax Compliance and Reduce Taxpayer Burden

Auditing tax returns is a critical part of IRS’s strategy to ensure tax compliance and address the tax gap. Most audits are correspondence audits, which are done by mail, where examiners review taxpayer correspondence and related documentation such as receipts, expense invoices, and payments. For audits closed in fiscal year 2012, correspondence audits accounted for

  • 1.1 million (76 percent) of the total 1.5 million individual tax return audits,  and
  • $9.2 billion (60 percent) of the total $15.3 billion in recommended additional taxes due and refunds disallowed for those audits.

However, in its June 2014 report, GAO found that unrealistic time frames included in IRS audit notices had contributed to taxpayer burden and IRS inefficiencies.[1] In recent years, IRS experienced backlogs in responding to taxpayers—dramatically increasing in 2013—causing taxpayer frustration and generating unnecessary phone calls.  For example, notices issued in 2013 stated that IRS would specify a date to respond, which was usually within 30 to 45 days of the date of the notice, but the agency consistently had taken several months to do so. In some cases, refunds were delayed. The unclear notices generated phone calls from taxpayers about audit time frames that IRS examiners were not prepared to answer, leaving examiners with less time to conduct the audits. IRS's subsequent revisions to the notices—which were intended to make the time frame more realistic--were not based on analysis of historical data, nor did IRS have plans to analyze data to ensure the agency is responding in a timely manner consistent with the revised notices.

In commenting on this submission, IRS noted that the timing of this audit coincided with delays caused by significant budget issues during fiscal years 2013 and 2014. According to IRS, the agency continues to recover from budget-related setbacks.  For example, IRS reports that the Small Businesses/Self-Employed division has improved its responsiveness to answering taxpayer replies within the timeframe stated in their acknowledgment letters. IRS also reports revising phone scripts to better inform taxpayers of delays in processing correspondence and initiating programming changes to allow for flexibility in providing taxpayers with more accurate response timeframes in acknowledgement letters. According to IRS, these letter changes will be effective in January 2016. GAO has asked IRS for more information and will continue to monitor progress on actions intended to reduce the need for taxpayer calls, ensure IRS is providing taxpayers with more realistic response time frames, and is using agency resources more efficiently.

In that same 2014 report, GAO also found that IRS could benefit from more information on performance that is clearly linked to IRS’s strategic goals. IRS’s strategic plan includes goals for achieving compliance results at the lowest costs while minimizing taxpayer burden by using data to inform resource allocation decisions. Further, Standards for Internal Control in the Federal Government—as well as performance management practices—call for agencies to take the following actions: establish program objectives and performance measures that clearly link to agency-wide goals; use accurate and complete performance information and document resource allocation decisions; and promptly evaluate program review findings to determine appropriate actions in response to any improvement recommendations.[2] However, IRS

  • had no documented criteria on how staff are to use correspondence audit program data to make decisions, such as the number of audits to undertake or which tax issues to audit;
     
  • did not have documented program objectives or linkages between the performance measures  and IRS-wide strategic goals for compliance, cost, and taxpayer burden;
     
  • had incomplete correspondence audit measures and data; 
     
  • did not leverage some potentially useful, available decision-making data that could provide a more complete picture of audit compliance results and costs—such as data on actual revenue collections and costs related to answering taxpayer calls and collecting additional taxes assessed from audits; and
     
  • did not have a plan or time frames to evaluate whether it should act on the recommendations of a recent program review that may improve the selection of tax returns for audit and better allocate examiner resources.

Without tools—such as documented criteria, linkages between performance measures and strategic goals, complete data, and an established plan and evaluation timeline—IRS risks making poor resource decisions on how many audits to do overall and which specific compliance issues to audit. Further, because it does not have a reasonable assurance that it is making decisions cost effectively and taking action to make progress towards the agency’s goals, IRS risks missing noncompliance, unnecessarily burdening many taxpayers, and wasting resources.

Individual Retirement Accounts: IRS Could Bolster Enforcement on Multi-Million Dollar Accounts, but More Direction from Congress Is Needed

Congress has limited annual contributions to individual retirement accounts (IRA) to prevent the tax-favored accumulation of unduly large balances, but there is no total limit on IRA accumulations.[3] In its October 2014 report, GAO estimated that hundreds of taxpayers have accumulated tens of millions of dollars in their IRA balances, likely by investing in assets unavailable to most investors, such as private stocks—which may be initially valued very low and if successful, may offer high potential investment returns.[4] Individuals who invest in these assets using certain types of IRAs, such as Roth IRAs, can escape taxation on investment gains. In addition, hard-to-value, nonpublicly traded assets—particularly those under direct control of the IRA owner—also pose a higher risk of the IRA owner engaging in prohibited, nonretirement-related IRA transactions.

To move forward with a service-wide strategy to target enforcement efforts, IRS must first conduct research to understand how many taxpayers (and the amounts associated with IRA assets) are at risk of noncompliance. Research identifying the numbers and types of custodians and taxpayers holding such hard-to-value assets could also help IRS target outreach activities and strategies (such as reminder notices) for improving compliance with IRA asset valuation and prohibited transaction requirements. Beginning for tax year 2015, IRS will require IRA custodians to report additional data about hard-to-value nonpublic assets on annual information returns, Form 5498 IRA Contribution Information. Identifying these taxpayers (and amounts associated with such IRA assets) would provide data for use in examination selection.  However, efficient use of the new IRA asset-type data for examination selection depends on IRS approving its plan to digitize the data from paper forms.

IRS officials said IRA valuation cases are audit-intensive and difficult to litigate because of the subjective nature of valuation. In addition, an improper valuation made many years prior to its discovery by IRS may fall outside the 3-year statute of limitations for assessing taxes owed.[5] Furthermore, according to IRS, noncompliant activity and prohibited transactions are not reflected on any filed tax return and are also difficult to detect within the 3-year statute of limitation period.  As IRS gathers more information about IRA asset-type data from the Form 5498, it will be clearer whether the 3-year statute of limitations should be changed for tax assessments with regard to IRAs. 

Partnerships and S Corporations: IRS Needs to Improve Information to Address Tax Noncompliance

Income earned through partnerships and S corporations accounts for billions of dollars of unpaid taxes, and their share of business activity is growing.[6] In May 2014, GAO found that IRS does not know the full extent of partnership and S corporation income misreporting. Using IRS’s compliance research studies on flow-through income misreporting by individual taxpayers and considering various caveats and uncertainties, GAO estimated a rough order of magnitude of the misreporting to be $91 billion per year in lost tax revenue for tax years 2006 through 2009.

GAO found that IRS has limited information on the effectiveness of its examinations in detecting income misreporting by partnerships. For example, IRS estimated that 3 percent to 22 percent of identified misreporting by partnerships was double counted due to income flowing from one partnership to another or to other related parties. Further, IRS does not know how income misreporting by partnerships affects taxes paid by partners. As a result, IRS does not have reliable information about its compliance results to fully inform decisions about allocating examination resources across different types of businesses. Without reliable information on the extent of partnership misreporting, or the results of its partnership examinations, IRS cannot make fully informed decisions about whether its allocation of enforcement resources across business types is justified and whether or not to update one of its major partnership examination selection tools, the discriminate income function formula.

IRS’s processes for selecting returns to examine could also be improved. IRS officials told GAO that having more return information available electronically might improve examination selection; however, not all partnership and S corporation line items from paper returns are digitized. Further, enhancing digitization of paper-filed partnership and S corporation returns would involve costs to IRS. In the absence of funding for transcription, one way to increase digitization is a statutory mandate requiring increased electronic filing (e-filing) of tax and other returns.[7] Expanding the mandate would increase digitized data available for examination selection. Improving IRS’s selection of partnership and S corporation returns to examine would also benefit compliant taxpayers whose returns may otherwise be selected for examination and would reduce IRS’s tax return processing costs.

Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency

In September 2014, GAO found that IRS audits few large partnerships and most audits result in no change to the partnership's return.[8] For those large partnership audits that did result in a change to the partnership’s return, the aggregate amount across all audits was minimal. According to IRS auditors, the audit results may be due to challenges such as finding the sources of income within multiple tiers while meeting the administrative tasks required by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) within specified time frames.[9] For example, IRS auditors said that it can sometimes take months to identify the partner authorized to represent the partnership in the audit, therefore reducing time available to conduct the audit (TEFRA does not require large partnerships to identify this partner on tax returns). Also under TEFRA, unless the partnership elects to be taxed at the entity level (which few do), IRS must pass audit adjustments through the ultimate partners. IRS officials stated that the process of determining each partner's share of the adjustment is paper and labor intensive. When hundreds of partners' returns have to be adjusted, the costs involved limit the number of audits IRS can conduct. Adjusting the partnership return instead of the partners' returns would reduce these costs; however, without legislative action, IRS's ability to do so is limited.

Understanding the reasons for the poor audit results is difficult because IRS (1) does not have activity codes that track audits of large partnerships returns, and (2) does not break out the audit results because the activity codes are not specific enough to identify large partnerships by asset and partner size.[10] Addressing these issues could help IRS officials better allocate audit resources.  In addition, IRS does not distinguish between field audits (which examine the partnership’s tax return and supporting documentation) and campus audits (which pass through any audit adjustments as a result of the field audit to the partners’ tax returns) when counting the number of large partnership audits. Instead, IRS counts both field audits and campus audits when calculating its audit rate for all partnerships, which misrepresents the number of audits that actually verify information reported on tax returns. According to Standards for Internal Control in the Federal Government, managers need accurate and complete information to help ensure efficient and effective use of resources.[11] A single, consistently applied definition could assist IRS in establishing agreement on the scope of large partnership audit efforts and in ensuring that audit results can be assessed. Likewise, modifying IRS’s current activity codes in order to identify large partnership returns, and breaking out field and campus audit rate data in order to accurately measure audit results, would allow IRS to analyze and plan resource usage for large partnership audits more efficiently and effectively.

IRS 2015 Budget: Return on Investment Data Needed to Better Set Priorities

In June 2014, GAO found that IRS does not calculate actual Return on Investment (ROI) to evaluate the performance of its initiatives once they are implemented; consequently, it does not have that data to inform decisions about allocating resources to those initiatives in the future. According to IRS officials, one reason they do not calculate actual ROI for enforcement initiatives is because it is difficult to determine which staff have actually worked on a particular initiative over a multiyear period.  In addition, IRS officials cite difficulties in tracking ROI-related information on funded initiatives because of difficulties in matching information between IRS systems for formulating and executing its budget. Given these difficulties and the need to make numerous assumptions, the officials believe that any feasible estimates would be too uncertain to be useful.

Comparing projected ROI to actual ROI is consistent with project management concepts, internal control standards, Office of Management and Budget guidance, and GAO’s prior work on performance management.[12] In December 2012, GAO demonstrated how IRS planners could review actual ROI across different enforcement programs and across different groups of cases within these programs to better inform resource allocation decisions.[13] GAO also recommended IRS identify research efforts that would enhance its ability to estimate ROI for specific enforcement activities, including initiatives.[14] In addition, IRS established “funded program codes” (previously known as internal order codes) as a mechanism to track specific initiatives—such as merchant card and cost basis reporting—which could be used when estimating the ROI of future initiatives.  While not the only factor in making resource decisions, actual ROI could provide useful insights on an initiative’s productivity.



[1] GAO, IRS Correspondence Audits: Better Management Could Improve Tax Compliance and Reduce Taxpayer Burden, GAO‑14‑479 (Washington, D.C.: June 5, 2014).

[2] GAO, Auditing and Financial Management: Standards for Internal Control in the Federal Government, GAO/AIMD‑00‑21.3.1 (Washington, D.C.: Nov. 1, 1999).

[3] IRAs serve dual roles by (1) providing a way for individuals not covered by a pension plan to save for retirement and (2) providing a place for retiring workers or individuals changing jobs to roll over, or transfer, their employer-sponsored plan balances. Two types of IRAs are geared toward individuals—each with its own federal income tax benefits: traditional IRAs and Roth IRAs. Traditional IRA contributions, subject to certain limitations, can be deducted from taxable earnings. Taxes on earnings are deferred until distribution. In contrast, Roth IRA contributions, also subject to certain limitations, are made after tax and distributions are tax free.

[4] GAO, Individual Retirement Accounts: IRS Could Bolster Enforcement on Multimillion Dollar Accounts, but More Direction from Congress Is Needed, GAO‑15‑16 (Washington, D.C.: Oct. 20, 2014).

[5] Generally, IRS has 3 years from the date a return is filed (whether the return is filed on time or not) to make an assessment of tax liability. 26 U.S.C. § 6501(a). The statute of limitations is extended in certain situations, including when a taxpayer submits a fraudulent return or omits reporting a certain amount of gross income on the return.

[6] Partnerships and S corporations are flow-through entities, which are entities that generally do not pay taxes themselves on income, but instead, pass income or losses to their partners and shareholders, who must include that income or loss on their income tax returns.

[7] Currently, certain large partnerships and S corporations are required by statute to e-file. 26 U.S.C. § 6011(e)(2) and 26 C.F.R. § 301.6011-5. About 65 percent of partnerships and S corporations e-filed in 2011.

[8] GAO defines large partnerships as those with 100 or more direct and indirect partners and $100 million or more in assets. Direct partners are partners that have a direct interest in the large partnership during the tax year. Direct partners may include taxable partners (such as a corporation or individual) and nontaxable partners (such as a partnership) that also have direct partners. Indirect partners are partners that have an interest in a partnership through interest in another partnership or other form of pass-through entity.

[9] Pub. L. No. 97-248, §§ 401–407, 96 Stat. 324, 648–671 (1982).

[10] These activity codes focus on whether a partnership reported having less or more than 11 partners, as well as reported gross receipts above or below $100,000. IRS has two activity codes for partnerships that pay an entity-level tax at the end of an IRS audit, and that had returns processed prior to January 1988.

[12] Office of Management and Budget (OMB), Preparation and Submission of Strategic Plans, Annual Performance Plans, and Annual Program Performance Results, OMB Circular A-11 (Washington, D.C.: June 2008); OMB, Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs, OMB Circular A-94 (Washington, D.C.: undated); GAO, Tax Administration: IRS Needs to Further Refine Its Tax Filing Season Performance Measures, GAO‑03‑143 (Washington, D.C.: Nov. 22, 2002).

[13] GAO,Tax Gap: IRS Could Significantly Increase Revenues by Better Targeting Enforcement Resources, GAO‑13‑151 (Washington, D.C.: Dec. 05, 2012).

[14] One important research effort is to estimate the revenue and costs associated with “marginal” enforcement cases—cases that would not have been worked if slightly fewer resources had been devoted to a particular enforcement activity.

Actions Needed

GAO suggests that Congress should consider the following:

  • Revisiting the use of IRAs to accumulate large balances and considering ways to improve the equity of the existing tax expenditure on IRAs. Options could include limits on (1) the types of assets permitted in IRAs, (2) the minimum valuation for an asset purchased in an IRA, or (3) the amount of assets that can be accumulated in IRAs and employer-sponsored plans that get preferential tax treatment.
     
  • Expanding the mandate that partnerships and S corporations electronically file their tax returns in order to cover a greater share of filed returns.
     
  • Altering the TEFRA audit procedures to require partnerships that have more than a certain number of direct and indirect partners to pay any tax owed due to audit adjustments at the partnership level.

In its June 2014 report, GAO recommended that the Commissioner of Internal Revenue

  • collect data to analyze whether IRS is responding to taxpayers within the time frames cited in the revised audit notices;
  • further revise IRS notices (if delays continue) to provide more realistic response times based on the data and take other appropriate actions to ensure efficient use of IRS tax examiner resources;
  • establish formal program objectives;
  • ensure that the program measures reflect those objectives;
  • clearly link those measures with strategic IRS-wide goals for ensuring compliance in a cost-effective way while minimizing taxpayer burden;
  • document how decisions are to be made using performance information;
  • track and use other program data that have not been used; and
  • develop a plan and timeline for implementing recommendations to improve the selection of correspondence audit workload and allocation of examiner resources, or develop justifications for not implementing the recommendations.

In its October 2014 report, GAO recommended that the Commissioner of Internal Revenue take the following actions:

  • Approve plans to fully compile and digitize the new data from electronic and paper-filed Form 5498s to ensure the efficient use of the information on nonpublicly traded IRA assets.
     
  • Conduct research using the new Form 5498 data to identify IRAs holding nonpublic asset types and use that information for an IRS-wide strategy to target enforcement efforts.
     
  • Build on research data regarding IRAs holding nonpublic assets, and identify options to provide outreach targeting taxpayers with nonpublic IRA assets and their custodians, such as reminder notices that engaging in prohibited transactions can result in loss of the IRA’s tax-favored status.
     
  • Add an explicit caution in the IRA publication for taxpayers about the potential risk of committing a prohibited transaction when investing in nonpublicly traded assets or directly controlling IRA assets.
     
  • Work in consultation with the Department of the Treasury on a legislative proposal to expand the statute of limitations on IRA noncompliance to help IRS pursue valuation-related misreporting and prohibited transactions that may have originated outside the current statute’s 3-year window.

In its May 2014 report, GAO recommended that the Commissioner of Internal Revenue take the following actions:

  • Develop and implement a strategy to better estimate (1) the extent and nature of partnership misreporting, and (2) the effectiveness of partnership examinations in detecting this misreporting.
     
  • Use the better information on noncompliance and program effectiveness to determine whether (1) the differences in examination rates across different types of business entities are justified, and (2) an improved tool for selecting partnerships for examination should be developed.

In its September 2014 report, GAO recommended that the Commissioner of Internal Revenue

  • track the results of large partnership audits by (1) defining a large partnership based on asset size and number of partners; (2) revising the activity codes to align with the large partnership definition; and (3) accounting separately for field audits and campus audits.

In its June 2014 report, GAO recommended that the Commissioner of Internal Revenue

  • calculate actual ROI for implemented initiatives, compare the actual ROI to projected ROI, and provide the comparison to budget decision makers for initiatives where IRS allocated resources; and
  • use actual ROI calculations as part of resource allocation decisions.

IRS could collect additional revenue and generate other cost savings which GAO believes could be achieved by implementing its recommendations; for example, by using better data to target correspondence audits, as even a small percentage increase of additional taxes due could result in hundreds of millions of dollars of additional revenue. Further, more efficient use of the new IRA asset-type data could improve examination selection of IRAs that have accumulated tens of millions of dollars in balances. Other actions, such as developing a strategy to better estimate the extent of partnership misreporting and effectiveness of partnership examinations, could generate additional cost savings by achieving program efficiencies and better enforcing tax laws.

How GAO Conducted Its Work

The information contained in this analysis is based on findings from the products in the related GAO products section. For the related products listed, GAO analyzed agency documents and interviewed officials from the Department of the Treasury, IRS, and other parties. GAO analyzed budget data from IRS and related budget documents. GAO also analyzed relevant federal laws, regulations, and procedures.

Agency Comments & GAO Contact

In commenting on the five reports issued in May, June, September, and October of 2014 on which these analyses are based, IRS agreed with 13 of the 17 recommendations presented, but did not state whether it agreed or disagreed with 4. For those 13 it agreed with, IRS said it is taking action to address them or further action is contingent on funding. For example, in its response to GAO’s recommendation to establish formal program objectives for correspondence audits while ensuring that the program measures reflect those objectives, and clearly link those measures with strategic IRS-wide goals, IRS agreed to ensure that the program objectives and measures established would be linked with the IRS-wide goals. Thus, if implemented effectively, IRS’s action should address the intent of these three recommendations.

IRS did not agree or disagree with four of GAO’s recommendations, but acknowledged related actions it is taking to address three of these four recommendations. First, in response to GAO’s recommendation that IRS develop a plan and timeline for implementing recommendations to improve the selection of correspondence audit workload and allocation of examiner resources, IRS responded it will pursue efforts to improve its workload selection and maximize resource usage, but it did not comment on whether it would develop a plan and timeline for implementing the recommendations.  IRS recently noted that the Office of Compliance Analytics has developed a planning tool to optimize distribution of planned starts based on several weighted measures.  According to IRS, the tool is being tested in fiscal year 2015. GAO continues to believe it is important that IRS develop a plan and timeline for implementing these recommendations or document and justify its reasons for not doing so. As noted in GAO’s June 2014 report, without timely follow-up on the recommendations, it will be difficult to hold IRS managers accountable for ensuring that any improvements needed are made. Furthermore, IRS may delay or miss opportunities to better select workload, allocate resources, reduce taxpayer burden, or otherwise improve the correspondence audit results without implementing these recommendations. 

Second, in response to GAO’s recommendation to calculate ROI for implemented initiatives, compare the actual ROI to projected ROI and provide the comparison to budget decision makers, IRS agreed that ROI is one of several factors relevant to making resource allocation decisions. However, IRS noted that determining the impact of an initiative will always rely on estimates, as the results of an initiative are the difference between actual results and what would have occurred in the absence of the initiative, which cannot be measured. Given the difficulty IRS has in attributing revenues to specific employees hired under an initiative, officials believe that any  feasible estimate would need to be based on numerous assumptions and, therefore would be too uncertain to be useful.  For this reason, IRS does not consider this additional analysis an effective use of its scarce research resources.  GAO agrees that any post-implementation assessment of an initiative’s results would be an estimate. The difficulty and reliability of such assessments would likely vary depending on the specifics of each initiative. GAO’s previous recommendation--that IRS undertake research to improve all of its enforcement resource allocation decisions--would also enhance its ability to estimate initiative results.[1] In the interim, IRS should be able to provide some information of use to Congress, such as whether funds that were requested for initiatives were actually used in the manner that IRS originally proposed.

Third, in response to GAO’s recommendation to develop and implement a strategy to better estimate the extent and nature of partnership misreporting, and the effectiveness of partnership examinations in detecting this misreporting, IRS stated that it had not fully evaluated GAO’s recommendations and expressed concern regarding actions requiring a significant expenditure of resources.

Fourth and finally, IRS reiterated this same point concerning GAO’s recommendation to use the better information on noncompliance and program effectiveness to determine whether the differences in examination rates across different types of business entities are justified, and whether an improved tool for selecting partnerships for examination should be developed. However, IRS reported it would consider all of GAO’s recommendations and would identify appropriate actions while keeping resource limitations in mind. It is these very resource limitations—which were noted in GAO’s May 2014 report—that underscore the importance of GAO’s recommendations to develop better information for making resource allocation decisions.

GAO provided a draft of this report section to IRS for review and comment.  IRS provided comments, which were incorporated as appropriate.



[1] GAO‑13‑151.

For additional information about this area, contact James R. McTigue, Jr. at (202) 512-9110 or mctiguej@gao.gov.

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