Tax Administration: Better Coordination Could Improve IRS's Use of Third-Party Information Reporting to Help Reduce the Tax Gap

GAO-21-102 Published: Dec 15, 2020. Publicly Released: Jan 14, 2021.
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Fast Facts

How does the IRS ensure that your taxes are accurate?

The IRS gets information from employers, banks, and other third-parties about your income and other factors that can affect your tax bill. Mismatches between this information and what you report on your taxes can indicate errors or potential fraud.

The IRS processes billions of third-party information returns. But the system isn't managed strategically—returns come on paper and electronically, with different due dates, and are used by different compliance programs managed in different IRS offices.

Our recommendations are to increase coordination and improve IRS's use of information returns.

W-2 and W-3 tax forms

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Highlights

What GAO Found

Information returns are forms filed by third parties, such as employers and financial institutions that provide information about taxable transactions. These forms are submitted to the Internal Revenue Service (IRS), the Social Security Administration, and taxpayers. Fifty unique types of information returns provide information on individual taxpayers and have a variety of purposes, such as reporting on wages earned or amounts paid that qualify for a tax credit or deduction. IRS identifies mismatches between information returns and tax returns for potential additional review, including enforcement actions. According to IRS research, taxpayers are more likely to misreport income when little or no third-party information reporting exists than when substantial reporting exists.

Overview of Internal Revenue Service's (IRS) Process for Matching Information Returns

Overview of Internal Revenue Service's (IRS) Process for Matching Information Returns

IRS's ability to process and use information returns is limited by its outdated legacy information technology (IT) systems. In 2017, IRS developed a plan to modernize its information return processing systems; however, IRS paused its efforts due to, according to IRS, resource constraints. IRS has an opportunity to capitalize on prior planning efforts by re-evaluating and updating these efforts and integrating them into its broader IT modernization efforts.

IRS does not have a coordinated approach with cross-agency leadership that strategically considers how information reporting could be improved to promote compliance with the tax code. While information returns affect many groups across IRS and support multiple compliance programs, no one office has broad responsibility for coordinating these efforts. A formalized collaborative mechanism, such as a steering committee, could help provide leadership and ensure that IRS acts to address issues among the intake, processing, and compliance groups. For example, IRS has not undertaken a broad review of individual information returns to determine if thresholds, deadlines, or other characteristics of the returns continue to meet the needs of the agency.

Why GAO Did This Study

For tax year 2018, IRS received and processed more than 3.5 billion information returns that it used to facilitate compliance checks on more than 150 million individual income tax returns. By matching information reported by taxpayers against information reported by third parties, IRS identifies potential fraud and noncompliance.

GAO was asked to review IRS's use of information returns. This report provides an overview of information returns and assesses the extent to which IRS has a coordinated approach to identifying and responding to risks related to the use of information returns in the tax system, among other objectives.

GAO reviewed IRS documents and data on information returns filing, processing, and use, and interviewed cognizant officials. GAO compared IRS's efforts in this area to federal internal control standards, and IRS's strategic plan.

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Recommendations

GAO is making nine recommendations to IRS, including that IRS revise its modernization plans for its information returns processing systems and incorporate it into broader IT modernization efforts and develop a collaborative mechanism to improve coordination among IRS groups that use information returns. IRS neither agreed, nor disagreed with the recommendations; however, IRS outlined actions it plans to take to address the recommendations. Social Security Administration had no comments.

Recommendations for Executive Action

Agency Affected Recommendation Status
Internal Revenue Service The Commissioner of Internal Revenue should expedite final planning efforts and implement the expansion of IRS's capacity to allow for additional transcription of K-1 Schedules. (Recommendation 1)
Closed – Implemented
IRS originally neither agreed nor disagreed with this recommendation. However, in response to our recommendation, in January 2022, IRS added 17 elements to the transcription of Schedule K-1. In April 2022, IRS submitted documentation that the work was completed. As a result, IRS is now able to collect critical tax information from Forms 1065, Schedule K-1 submitted on paper. These forms are used to report a partner's share of income, deductions, and credits for their individual tax return. Having additional information from these forms transcribed and accessible to IRS compliance systems will enhance IRS's ability to cost-effectively identify and select the cases for further review.
Internal Revenue Service
Priority Rec.
This is a priority recommendation.
The Commissioner of Internal Revenue should research, evaluate, and develop potential recommendations to expand third-party information reporting to include more information on sole proprietor's income and expenses. (Recommendation 2)
Open
IRS neither agreed nor disagreed with this recommendation. IRS officials reported that IRS will further research and evaluate the tax administration benefits and taxpayer burdens of expanding third-party information reporting for sole proprietors' income and expenses. As of April 2022, IRS officials reported that the agency is compiling a list of ideas that were proposed in the past but were never adopted, and soliciting additional ideas within IRS. According to IRS, two key recommendations from IRS's actions have already been addressed by statute. The first is a reduction in the reporting thresholds for Form 1099K; and the second clarifying third-party reporting related to virtual currency. Continued efforts to research expanding third-party reporting will help IRS develop additional recommendations. Upon conclusion of its research and evaluation, IRS will also prepare a briefing document for Treasury and offer its support in developing any recommendations that Treasury chooses to pursue. To fully implement this recommendation, IRS needs to complete its research on options to increase information reporting for sole proprietorships. Without options to help improve compliance for sole proprietorships, IRS is missing an opportunity to help address a significant part of the tax gap.
Internal Revenue Service The Commissioner of Internal Revenue should evaluate characteristics of late information return filers to determine the effect of penalty assessment for late and incorrect information returns on third-party information reporting compliance. (Recommendation 3)
Closed – Implemented
IRS originally neither agreed nor disagreed with this recommendation. However, in September 2021, IRS provided us with its analysis of the effects of asserting penalties on late filers. Our review of the study found that it evaluated characteristics of late information return filers and compared data from a baseline year to subsequent years to determine if a trend in repeat filers existed for systemic penalty assessments. The study concluded that the information return penalty program is effective at encouraging information return filers to file returns timely and correctly. This is because the recidivism rate illustrates that once an information return penalty is assessed against a filer, that filer is less likely to be noncompliant in the future. IRS also considered reasonable cause waiver and abatement percentages and found that many filers who were initially considered to be noncompliant acted in a responsible manner to avoid the failure. By completing this assessment, IRS has determined that its penalty program is effective at promoting voluntary compliance. Additionally, in January, 2022, IRS completed a second phase of the study to provide additional data to be used internally. Our review of this study found that it provided trends, analysis, and recommendations to the Information Return Penalty Program. In conjunction, these two studies have provided IRS with additional information and internal recommendations the agency can use to strengthen the penalty program to help improve compliance with information return filing requirements.
Internal Revenue Service The Commissioner of Internal Revenue should reassess the risks described and recommendations made in its internal 2016 report related to information returns and identify potential new risks and recommendations as a result of changes to the tax administration environment. (Recommendation 4)
Open
IRS neither agreed nor disagreed with this recommendation. However, IRS took action to implement the recommendation. In July 2021, IRS reported that it had begun reviewing the remaining risks in the 2016 internal report. At that time, IRS reported that most items identified in the 2016 report had been addressed and that some outstanding items cannot be addressed due to legal or technological constraints. In February 2022, IRS reported that it had completed its review of items in the 2016 report that would not require legislative or technological changes. These included reviewing recordkeeping systems and realigning some internal compliance units. IRS stated that the agency had decided not to pursue these items because IRS is in the process of restructuring its compliance units pursuant to the Taxpayer First Act and expects to consolidate recordkeeping systems as part of that process. In addition, in July 2021, IRS reported the creation of an information returns working group comprised of IRS staff from various business operating divisions. In February 2022, IRS reported that this working group had met twice to discuss risks, possible opportunities to better use information returns, and how IRS might make organizational improvements to maximize the agency's use of information returns. The group has compiled two lists of potential improvements which we have reviewed; one that would not require significant organizational, IT, or legislative changes and one that would require such changes. The working group provided these recommendations to the IRS NEXT Office, which was established to implement the Taxpayer First Act. IRS plans to implement this recommendation by October 2022. We will continue to monitor IRS's progress. Until IRS completes these actions, it may be missing an opportunity to help ensure that identified risks are mitigated on a timely basis.
Internal Revenue Service The Commissioner of Internal Revenue should prioritize and develop a timeline for implementing the remaining recommendations from its internal 2016 report related to information returns, along with any newly identified recommendations. (Recommendation 5)
Open
IRS originally neither agreed nor disagreed with this recommendation. However, in July 2021, IRS reported agreement with the recommendation. In February 2022, IRS reported that it had compiled and submitted a list of any risks and recommendations to the IRS NEXT office for consideration during its reorganization of compliance areas impacting information returns. Officials expect these steps to be completed by October 2022. Until IRS reassesses the issues identified in the report and develops a timeline to implement the remaining recommendations, IRS may be missing an opportunity to help ensure that the risks are mitigated on a timely basis.
Internal Revenue Service
Priority Rec.
This is a priority recommendation.
The Commissioner of Internal Revenue should revise the 2017 Information Returns Systems Modernization plans by evaluating changes in the environment, assessing risks to systems and programs, and detailing how the agency plans to address issues in the intake, processing, and use of information returns across business units. (Recommendation 6)
Open
IRS neither agreed nor disagreed with recommendations 6 and 7, which are related. Officials reported that IRS will submit an Information Return System Modernization plan to Congress that leverages the 1099 Internet Platform required by section 2102 of the Taxpayer First Act as the foundation of information return modernization efforts. As of April 2022, IRS reported that the original design of this platform was expanded to include a modernized view of the information returns pipeline from submission to processing. IRS expects that it will implement the first phase of this platform by February 2023. Additionally, its Information Technology office is in the process of designing future phases of this modernization effort and determining how these efforts will be integrated into broader IT modernization planning efforts within IRS. As part of the agency's broader modernization effort, it is important that IRS can explain to Congress and other decision makers the critical need to modernize the information reporting system, as well as the proposed scope, schedule, and resource requirements needed to implement such a project. To fully implement these recommendations, IRS should establish a plan that provides an overall picture of what IRS is investing in as well as the benefits expected from such an investment. Since some of the costs being incurred by IRS today are for foundational modernization efforts, it is even more important that the agency develop a strategy explaining the long-term benefits expected from this work.
Internal Revenue Service
Priority Rec.
This is a priority recommendation.
The Commissioner of Internal Revenue should submit a revised information returns system modernization plan to Congress that describes how it integrates with IRS's broader IT modernization efforts, the resources needed to achieve effective and timely modernization, and the proposed schedule and scope of the effort. (Recommendation 7)
Open
IRS neither agreed nor disagreed with recommendations 6 and 7, which are related. Officials reported that IRS will submit an Information Return System Modernization plan to Congress that leverages the 1099 Internet Platform required by section 2102 of the Taxpayer First Act as the foundation of information return modernization efforts. In April 2022, IRS reported that the original design of this platform was expanded to include a modernized view of the information returns pipeline from submission to processing. IRS expects that it will implement the first phase of this platform by February 2023. Additionally, the Information Technology office is in the process of designing future phases of this modernization effort and determining how these efforts will be integrated into broader IT modernization planning efforts within IRS. As part of the agency's broader modernization effort, it is important that IRS can explain to Congress and other decision makers the critical need to modernize the information reporting system, as well as the proposed scope, schedule, and resource requirements needed to implement such a project. To fully implement these recommendations, IRS should establish a plan that provides an overall picture of what IRS is investing in as well as the benefits expected from such an investment. Since some of the costs being incurred by IRS today are for foundational modernization efforts, it is even more important that the agency develop a strategy explaining the long-term benefits expected from this work.
Internal Revenue Service
Priority Rec.
This is a priority recommendation.
The Commissioner of Internal Revenue should develop a plan and schedule to systematically evaluate the suite of information returns with a goal of improving compliance, and reducing fraud and reporting burden. The evaluation should consider factors such as filing requirement thresholds, deadlines for filing, corrections and amendment data, and the potential to consolidate similar forms and include recommendations for needed changes. (Recommendation 8)
Open
IRS neither agreed nor disagreed with this recommendation. However, in July 2021, IRS agreed to conduct an evaluation of a select group of third-party submitted information returns. IRS plans to use the results of the study to determine if these forms continue to provide value and if changes to the current form revision processes are needed. For each of the selected returns, IRS will examine the revisions IRS considered and those it made, and categorize each of them according to the factors we recommended. As of March 2022, IRS expects to complete this evaluation by October 2022. To fully implement this recommendation, IRS needs to complete its review of the selected returns and establish a systematic review of the remaining suite of information returns. Without completing this comprehensive evaluation of information returns or their characteristics, IRS risks gathering information that it cannot use effectively in some areas and burdening filers and taxpayers and not gathering enough information for enhancing compliance in other areas.
Internal Revenue Service
Priority Rec.
This is a priority recommendation.
The Commissioner of Internal Revenue should develop a collaborative mechanism to coordinate among the internal stakeholders who are responsible for the intake, processing, and use of information returns, as well as to improve outreach to external stakeholders in relation to information returns. (Recommendation 9)
Open
IRS neither agreed nor disagreed with this recommendation. In July 2021, IRS reported that the new organizational structure described in its January 2021 Taxpayer First Act Report to Congress would provide for collaboration and coordination on the delivery of IRS-wide programs, such as those involving information returns. According to the report, IRS will consolidate compliance functions currently dispersed across multiple business units into a single division, which may help identify compliance related trends across taxpayer segments. IRS aims for this consolidation to reduce duplicative activities related to case selection and performance monitoring, among others. As of March 2022, IRS plans to complete its compliance reorganization in August 2024. IRS reported that in the interim, the Deputy Commissioner for Services and Enforcement is to facilitate coordination among internal stakeholders. Until IRS implements a collaborative mechanism with a coordinated approach to using information returns, IRS risks missing opportunities to improve the effectiveness of its development, intake, processing, and use of information returns.

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