IRS Return Selection:

Certain Internal Controls for Audits in the Small Business and Self-Employed Division Should Be Strengthened

GAO-16-103: Published: Dec 16, 2015. Publicly Released: Jan 13, 2016.

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What GAO Found

The Small Business/Self-Employed (SB/SE) division of the Internal Revenue Service (IRS) uses over 30 methods, called workstreams, to identify and review tax returns that may merit an audit. These returns were initially identified through seven sources which include referrals; computer programs that run filters, rules, or algorithms to identify potentially noncompliant taxpayers; and related returns that are identified in the course of another audit.

SB/SE's workstreams follow a general, multiphase process for identifying, reviewing (classifying), and selecting returns for audit. Within this general approach, the selection process varies across workstreams. Differences include the number of review steps and manual processes, which are greater for field audits compared to correspondence audits which generally focus on a single compliance issue and are identified using automated processes. For fiscal year 2013, IRS reported that SB/SE's primary workstream for field audits identified about 1.6 million returns as potentially most noncompliant. About 77,500 returns (5 percent) were selected for audit, a much smaller pool of returns than was initially identified.

SB/SE has control procedures for safeguarding data and segregating duties across the overall selection process, among others, but it has not implemented other key internal controls. The lack of strong control procedures increases the risk that the audit program's mission of fair and equitable application of the tax laws will not be achieved. Examples of internal control deficiencies include the following:

Program objectives and key term of fairness are not clearly defined. Fairness is specified in SB/SE's mission statement and referenced in IRS's procedures for auditors. However, IRS has not defined fairness or program objectives for audit selection that would support its mission of treating taxpayers fairly. GAO heard different interpretations of fairness from focus group participants. Not having a clear definition of fairness can unintentionally lead to inconsistent treatment of taxpayers and create doubts as to how fairly IRS administers the tax law. Further, the lack of clearly articulated objectives undercuts the effectiveness of SB/SE's efforts to assess risks and measure performance toward achieving these objectives.

Procedures for documenting and monitoring selection decisions are not consistent. SB/SE does not always require selection decisions and rationales to be documented. For example, SB/SE requires that some workstreams document survey decisions (when returns are not assigned for audit), rationale, and approval using a form. Other workstreams, such as its primary workstream for field audits, require a group manager stamp but do not require the rationale to be documented. Also, SB/SE does not always require classification decisions (when returns are assessed for audit potential and compliance issues) to be reviewed. Having procedures to ensure that selection decisions and rationale are consistently documented and reviewed can reduce the potential for error and unfairness.

Why GAO Did This Study

IRS audits small businesses and self-employed individuals to ensure compliance with tax laws. Audits can help improve reporting compliance and reduce the tax gap—the difference between taxes owed and those voluntarily paid on time, which is estimated at $385 billion annually after late payments and enforcement actions. Therefore, it is important that IRS makes informed decisions about how it selects taxpayers for audit.

GAO was asked to review IRS's processes and controls for selecting SB/SE taxpayers for audit. This report (1) describes these processes and (2) determines how well SB/SE's selection processes and controls support its mission to apply the tax law with integrity and fairness to all.

GAO reviewed IRS criteria, processes, and control procedures for selecting taxpayers for audit; assessed whether IRS control procedures followed Standards for Internal Control in the Federal Government ; and reviewed nonprobability samples of over 200 audit files. GAO also conducted eight focus groups with SB/SE staff who review or make audit selection decisions and interviewed IRS officials.

What GAO Recommends

GAO recommends that IRS take seven actions to help ensure that the audit selection program meets its mission, such as establishing and communicating program objectives related to audit selection and improving procedures for documenting and monitoring the selection process. In commenting on a draft of this report, IRS agreed with the recommendations.

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

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: IRS agreed to incorporate a definition of fairness into the Internal Revenue Manual (IRM), which serves as a single point of reference for guidance to IRS auditors. In February 2016, IRS developed the following three-part definition of fairness in the audit process: 1) pursuing those who fail to voluntarily comply or otherwise meet their tax obligations, 2) using an equitable process that selects returns for audit based on the likelihood of reporting errors across all areas of potential noncompliance, and 3) respecting and adhering to the rights of taxpayers. IRS shared this definition of fairness to all enforcement employees through various postings on the IRweb, including a communication from the Deputy Commissioner of Services and Enforcement. In January 2017, IRS issued interim guidance to incorporate this definition into its IRM. According to IRS, the interim guidance is considered official policy until the IRM is updated, no later than January 2019. We deferred closing this recommendation until IRS determined how the definition would be applied to three related recommendations. These recommendations focused on communicating examples of fairness and developing objectives and measures to evaluate how well IRS is meeting its mission of applying the tax law with integrity and fairness to all. IRS approved the examples and objective in March 2017 and the related measure in September 2017.

    Recommendation: To help ensure SB/SE's audit selection program meets its mission and selects returns fairly, the Commissioner of Internal Revenue should clearly define and document the key term "fairness" for return selection activities.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  2. Status: Closed - Implemented

    Comments: IRS agreed to communicate examples of fairness to managers and examiners involved in selecting tax returns for audit. In March 2017, the Director of IRS Small Business/Self Employed (SB/SE) Examination-Headquarters issued a memo to SB/SE examination directors that included examples illustrating the fairness definition in audit return selection. The examples were to be shared with directors, management, and examiners involved in selection. We deferred closing this recommendation until IRS determined how the fairness definition would be applied to two related recommendations. These recommendations focused on developing program objectives and measures assessing fairness in audit return selection. IRS approved an objective for audit selection fairness in March 2017 and a related measure in September 2017.

    Recommendation: To help ensure SB/SE's audit selection program meets its mission and selects returns fairly, the Commissioner of Internal Revenue should clearly communicate examples of fair selections to staff to better assure consistent understanding.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  3. Status: Closed - Implemented

    Comments: IRS agreed to review its objectives for the SB/SE examination program and found that an additional program-level objective to evaluate fairness in audit return selection was necessary. The new objective is "Ensure examinations are initiated based on indicators of noncompliance or on other criteria (such as selection for the National Research Program), identified in the Internal Revenue Manual (IRM). In addition, ensure a review of the decisions to survey a return (i.e., not initiate an examination) are based on upon factors outlined in the Internal Revenue Manual and approved by an appropriate level of management." In March 2017, IRS issued interim guidance communicating the new objective, which was sent to Examination Directors. The guidance and objective were also posted on the IRweb, which is available to all IRS employees. IRS officials said that the interim guidance is considered final until it can be incorporated into the IRM, which should be done within 2 years of when the interim guidance is issued. We deferred closing this recommendation until IRS addressed a related recommendation on developing a measure for this selection objective. IRS approved that measure in September 2017.

    Recommendation: To help ensure SB/SE's audit selection program meets its mission and selects returns fairly, the Commissioner of Internal Revenue should develop, document, and implement program-level objective(s) to evaluate whether the return selection process is meeting its mission of applying the tax law with integrity and fairness to all.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  4. Status: Closed - Implemented

    Comments: IRS agreed to develop, document, and implement additional performance measures if new objectives related to fair audit return selection were implemented. In March 2017, IRS developed a new objective on fair return selection and said that it was working on performance measures related to this new objective. In September 2017, IRS approved a measure that is linked to the new objective. The performance measure adds a secondary review to ensure that SB/SE managers appropriately approved selection decisions, including the number of decisions reviewed and that decisions were documented. IRS developed a template for these managers to use in recording their decision.

    Recommendation: To help ensure that SB/SE's audit selection objective(s) on fairness are used and met, the Commissioner of Internal Revenue should develop, document, and implement related performance measures that would allow SB/SE to determine how well the selection of returns for audit meets the new objective(s).

    Agency Affected: Department of the Treasury: Internal Revenue Service

  5. Status: Closed - Implemented

    Comments: IRS agreed to consider any new objectives related to fair return selection within SB/SE's current risk management process framework. In March and April 2017, SB/SE included the fair audit selection objective (and related activities) into its risk register by using its Risk Acceptance Form and Tool. IRS provided documentation from the Exam Risk Council meeting that they have discussed and assessed the risk. IRS decided that the risk was manageable, especially with its ongoing efforts to ensure fair audit selection. In October 2017, IRS also added the new objective to Internal Revenue Manual subsection 4.1.1.1 on ensuring fair return selection. In May 2018, IRS updated its Quarterly Case Selection Review form with a risk assessment question, a reminder that all staff and managers are responsible for discussing and assessing risk, and a link to IRS policy and resources related to risk management. The updated form ensures that the selection process will continue to be analyzed for risks on a regular basis as part of the secondary level review of selection decisions.

    Recommendation: To help ensure that SB/SE's audit selection objective(s) on fairness are used and met, the Commissioner of Internal Revenue should incorporate the new objective(s) for fair return selection into the SB/SE risk management system to help identify and analyze potential risks to fair selections.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  6. Status: Closed - Implemented

    Comments: IRS agreed to evaluate the need to improve its documentation of audit return selection decisions and the review and approval process. In March 2017, IRS functions completed templates showing the status of audit selection documentation requirements. They found that they could improve the consistency and clarity in documentation, approval, and review requirements across audit workstreams by clearly defining procedures and ensuring they are formally documented in the Internal Revenue Manual (IRM). The Director of Exam Case Selection issued a memo directing that documentation requirements be made consistent in the IRM. In April 2017, IRS revised IRM section 1.4.40.4.6.2 regarding surveys (non-selection) of returns slated for audit. The revision requires managers to document survey decisions with various codes after doing a risk analysis to ensure that the survey decision is justified. In August 2017 and September 2017, IRS approved and issued nine interim guidance documents with revised documentation requirements for selection decisions and their review and approval. The interim guidance covered various workstreams such as campus audits, field audits, and information return audits. The guidance serves as official policy and will be incorporated in the IRM within 2 years of approval.

    Recommendation: The Commissioner of Internal Revenue should develop and implement consistent documentation requirements to clarify the reasons for selecting a return for audit and who reviewed and approved the selection decision.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  7. Status: Closed - Implemented

    Comments: IRS agreed to review its current procedures for monitoring audit return selection decisions and coding used to select returns. For monitoring selection decisions, in September 2016, IRS completed an analysis of the dollar threshold used to select returns for campus audits. Based on this analysis, in February 2018, IRS updated its Internal Revenue Manual (IRM) to require an annual threshold review. This review determines the minimum deficiency amount to be used to select returns for SB/SE campus audit. In addition, in August 2017 and September 2017, IRS approved and issued nine interim guidance documents on reviewing selection decisions. The guidance serves as official policy and will be incorporated in the IRM within 2 years of approval. For monitoring codes used to select returns for audit, in August 2016, IRS completed an analysis of its source codes. IRS uses source codes to plan and monitor its audits. IRS found various inconsistencies or inaccuracies in how source codes were described or used in its audit guidance and reference materials. Based on this analysis, in March 2017, IRS issued interim guidance to update the definitions of 2 source codes. The guidance serves as official policy and will be incorporated in the IRM within 1 year of approval. In addition, the IRM requires monitoring and validating key data elements, including source codes, through a process called inventory validation. In January 2018, IRS issued a data collection instrument (DCI) to document a secondary review of how managers review and document selection decisions. The DCI allows IRS to measure progress towards its new objective on fair selection of returns for audit.

    Recommendation: The Commissioner of Internal Revenue should develop, document, and implement monitoring procedures to ensure that decisions made and coding used to select returns for audit are appropriate.

    Agency Affected: Department of the Treasury: Internal Revenue Service

 

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