oversight

Tax Administration: Changes to IRS's Schedule K-1 Document Matching Program Burdened Compliant Taxpayers

Published by the Government Accountability Office on 2003-05-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States General Accounting Office

GAO          Report to the Chair, Committee on Small
             Business and Entrepreneurship,
             U.S. Senate


May 2003
             TAX
             ADMINISTRATION
             Changes to IRS’s
             Schedule K-1
             Document Matching
             Program Burdened
             Compliant Taxpayers




GAO-03-667
             a
                                               May 2003


                                               INTERNAL REVENUE SERVICE

                                               Changes to IRS’s Schedule K-1
Highlights of GAO-03-667, a report to the      Document Matching Program Burdened
Committee on Business and
Entrepreneurship, United States Senate         Compliant Taxpayers



About $1 trillion in income was                IRS stopped issuing Schedule K-1 notices after complaints about the burden
distributed in 2001 by flow-through            the program imposed on compliant taxpayers. Originally, IRS intended to
entities such as partnerships and              focus the program on two categories of income--interest and dividends--
trusts. As shown below, these                  wherein matching was straightforward, and therefore the number of notices
entities do not pay taxes on flow-             sent to compliant taxpayers could be minimized. However IRS changed the
through income. They report it to IRS
on a Schedule K-1 and their partners
                                               matching program to cover additional categories of flow-through income
or beneficiaries pay any tax.                  without clearly informing taxpayers and tax preparers. Matching these
                                               additional categories of income was less straightforward. As a result, IRS
Concerned about underreporting,                sent notices about suspected noncompliance to more compliant taxpayers
IRS began matching the flow-                   than it intended. In fact, about two-thirds of the notices were sent to
through income reported on                     taxpayers later determined to be compliant. After taxpayers complained, and
Schedule K-1s with that reported               after sending out about 70 percent of the planned notices, IRS responded by
on individuals’ returns. In 2002, IRS          stopping the notices. IRS has assessed about $41.4 million in additional tax
began sending notices to taxpayers             from the notices that were sent and approximately $26.9 million was directly
about suspected noncompliance.                 attributable to Schedule K-1 underreporting.
After complaints that many notices
were going to compliant taxpayers,
IRS stopped sending notices.
                                               IRS did not timely implement two parts of the plans for managing the
                                               Schedule K-1 matching program. First, IRS did not test the feasibility of
Concerned about the burden, the                focusing the program on interest and dividend income until after
committee asked GAO to, among                  recommending such a focus and communicating the recommendation to
other things, (1) describe the                 taxpayers, preparers, and other stakeholders. Second, after changing the
burden caused by the notices and               plan, IRS did not clearly communicate the changes.
IRS’s rationale for stopping them,
(2) assess IRS’s management of the             IRS is taking steps to improve communications and reduce the burden on
program, and (3) describe the steps            compliant taxpayers. However, neither IRS nor GAO knows whether these
IRS will take to address any                   changes will improve communications and reduce burden while maintaining
problems.                                      the effectiveness of the Schedule K-1 matching program as a compliance
                                               tool.

                                               Illustration of the Taxation of Income That Flows Through Partnerships, S-corporation,
GAO is not making any                          Estates and Trusts
recommendations, but the
uncertainty about the effectiveness
of the steps IRS is taking to
improve the program highlight the
importance of IRS continuing to
monitor the impact of the program
on compliant taxpayers. In ongoing
work, requested by the Senate
Committee on Finance, GAO is
assessing the effectiveness of the
program.
www.gao.gov/cgi-bin/getrpt?GAO-03-667.

To view the full report, including the scope
and methodology, click on the link above.
For more information, contact James R. White
at (202) 512-9110 or whitej@gao.gov.
Contents


Letter                                                                                                  1
             Results In Brief                                                                          2
             Background                                                                                3
             Scope and Methodology                                                                     6
             IRS Stopped Issuing Schedule K-1 Notices after Complaints about
               Burden Imposed by Program Changes                                                        8
             IRS Did Not Timely Test Its Plans or Communicate Plan Changes
               to Stakeholders                                                                         11
             IRS Is Taking Steps Intended to Improve the Schedule K-1
               Matching Program in 2003                                                                14
             Conclusion                                                                                17
             Agency Comments                                                                           18

Appendix I   GAO Contact and Staff Acknowledgments                                                     19



Figures
             Figure 1: Illustration of the Taxation of Income That Flows through
                      Partnerships, S-corporations, Estates and Trusts                                  4
             Figure 2: General Underreporter Matching Process                                           5
             Figure 3: The Number of Schedule K-1 Underreporter Notices Sent
                      to Taxpayers                                                                     10
             Figure 4: Chronology of Key Events in IRS Implementation of the
                      Schedule K-1 Matching Program                                                    13




             This is a work of the U.S. Government and is not subject to copyright protection in the
             United States. It may be reproduced and distributed in its entirety without further
             permission from GAO. It may contain copyrighted graphics, images or other materials.
             Permission from the copyright holder may be necessary should you wish to reproduce
             copyrighted materials separately from GAO’s product.




             Page i                                  GAO-03-667 IRS’s Schedule K-1 Matching Program
United States General Accounting Office
Washington, DC 20548




                                   May 30, 2003

                                   The Honorable Olympia J. Snowe
                                   Chair
                                   Committee on Small Business and Entrepreneurship
                                   United States Senate

                                   Dear Madame Chair:

                                   Approximately $1 trillion in income was distributed for tax year 2001,
                                   according to Internal Revenue Service (IRS), by flow-through entities such
                                   as partnerships, S-corporations, estates, and trusts. These entities, many of
                                   which are small businesses, do not pay taxes on income they pass through,
                                   whether or not the income is actually distributed to their partners,
                                   shareholders, or beneficiaries. The partners, shareholders, or beneficiaries
                                   report the income or losses received on their individual tax returns and
                                   pay any applicable tax.

                                   To facilitate compliance, the tax law requires flow-through entities to
                                   report the income passed through on Schedule K-1 and to send one copy
                                   of the schedule to IRS and another to partners, shareholders, or
                                   beneficiaries. While the law requires such reporting of flow-through
                                   income, IRS estimates that between 6 and 15 percent of such income is not
                                   reported on individuals’ returns.

                                   Because of the significant amount of income being distributed and the
                                   estimated noncompliance, IRS began in 2001 to match the tax year 2000
                                   Schedule K-1 information provided by flow-through entities against the
                                   flow-through income reported on individuals’ tax returns. IRS began
                                   notifying taxpayers of potential discrepancies between income reported
                                   on K-1 and individual tax returns in April 2002. However, after receiving
                                   complaints that notices were being sent to compliant taxpayers, IRS
                                   stopped sending notices in August 2002.

                                   Because of concerns about the burden the Schedule K-1 matching program
                                   was imposing on compliant taxpayers, including the time and expense of
                                   responding to the notices, you asked us to review IRS’s implementation of
                                   the program and determine what happened and why. Specifically, as
                                   agreed with your office, our objectives were to (1) describe the
                                   implementation of the Schedule K-1 matching program, the extent of the
                                   burden caused by the notices, IRS’s rationale for stopping the notices, and


                                   Page 1                            GAO-03-667 IRS’s Schedule K-1 Matching Program
                   any results the program achieved, (2) assess IRS’s management of the
                   Schedule K-1 matching program, and (3) describe the steps IRS is planning
                   to take to address any identified problems and improve Schedule K-1
                   reporting and matching.

                   To describe IRS’s Schedule K-1 matching program implementation, the
                   burden caused by the notices, IRS’s rationale for suspending the program,
                   and any results, we interviewed IRS officials and analyzed IRS data. To
                   assess IRS’s management of the program, we compared IRS’s management
                   plan to what was implemented. Finally, to describe the steps IRS plans to
                   take to improve the program, we reviewed IRS’s plans for continuing the
                   program in 2003 and reducing the burden on compliant taxpayers.


                   IRS stopped issuing Schedule K-1 notices after complaints about the
Results In Brief   burden imposed by program changes on compliant taxpayers. Originally,
                   IRS intended the Schedule K-1 matching program to focus on two
                   categories of income—interest and dividends—that are easily identified on
                   tax returns and would minimize the number of notices sent to compliant
                   taxpayers. However, IRS learned during testing that it could not separate
                   underreported K-1 interest and dividend income from the other
                   underreported interest and dividend income such as that paid by banks.

                   After the test, IRS expanded the Schedule K-1 matching program to cover
                   additional categories of income, including flow-through income from trade
                   or business activities. This created a burden for compliant taxpayers.
                   About two-thirds of the 69,097 notices sent to taxpayers under the
                   program were sent to taxpayers whom IRS later determined to be
                   compliant. Compounding the problem, the expansion of the program was
                   not clearly communicated to taxpayers or tax preparers. After complaints
                   from taxpayers and after sending out about 70 percent of the notices
                   intended, IRS stopped sending notices. IRS followed up on notices that
                   were sent and has resolved about 92 percent of those cases. About 62
                   percent of the cases were resolved with no change to the taxpayer’s
                   liability. In the other 38 percent of the cases, an additional $41.4 million in
                   taxes was assessed, of which $26.9 million was directly attributable to K-1
                   underreporting.

                   While detailed plans for managing the Schedule K-1 matching program
                   were developed, IRS did not timely implement two parts of the plans.
                   First, IRS did not test the feasibility of focusing the program on interest
                   and dividend income until after recommending such a focus and
                   communicating the recommendation to taxpayers, tax preparers, and


                   Page 2                             GAO-03-667 IRS’s Schedule K-1 Matching Program
             other stakeholders. Second, after changing the plan, IRS did not clearly
             communicate with taxpayers, tax preparers, and other stakeholders about
             the changes.

             For 2003, the focus of the program will be on the same categories of
             income as in 2002. IRS is taking several steps intended to improve the K-1
             matching program. IRS has been meeting with tax preparers and
             stakeholder groups in an effort to reestablish communication. Further, IRS
             has identified several program changes intended to reduce taxpayer
             burden by reducing the number of “no-change” notices sent to compliant
             taxpayers. Examples of these changes are more stringent screening
             criteria before notices can be sent and revisions to clarify forms and
             schedules. Neither IRS nor we know whether these changes will reduce
             the burden on compliant taxpayers while maintaining the effectiveness of
             the Schedule K-1 matching program as a compliance tool. We are not
             making recommendations in this report, but for the Senate Committee on
             Finance, we are assessing the program’s ability to detect and prevent
             noncompliance. IRS has a tracking system that should provide it
             information about the effectiveness of the changes before all the notices
             are sent out.

             We asked IRS to provide comments on our report but did not receive a
             response in time to include it with this report. However, IRS officials
             responsible for the program told us that they agree with the facts
             presented in this report.


             Partnerships, S-corporations, trusts, and estates are collectively known as
Background   “flow-through entities,” because they have the legal capacity to pass net
             income or loss through to their partners, shareholders, and beneficiaries
             untaxed. As shown in figure 1, these flow-through entities file tax returns
             with IRS that report the entities’ income and expenses with schedules
             showing all partners’, shareholders’, or beneficiaries’ shares of net income
             or loss. Flow-through entities also are required to provide each partner,
             shareholder, or beneficiary with a Schedule K-1 stating the individual
             share of net income or loss to be reported. These partners, shareholders,
             or beneficiaries are then responsible for reporting this income or loss on
             their individual income tax returns and paying any tax. According to IRS
             in tax year 2001, over 9 million flow-through entities reported passing
             through $998 billion to approximately 24 million partners, shareholders, or
             beneficiaries.




             Page 3                            GAO-03-667 IRS’s Schedule K-1 Matching Program
Figure 1: Illustration of the Taxation of Income That Flows through Partnerships, S-
corporations, Estates and Trusts




For reporting purposes flow-through income is broken into several
categories. These include income or loss from trade and business
activities, rental real estate, other rental activities, interest, dividends,
royalties and capital gains.

The purpose of the Schedule K-1 matching program is to compare the
information provided by flow-through entities to that reported by
individuals on their tax returns in order to ensure compliance. The
Schedule K-1 matching program is part of IRS’s general matching program,
the underreporter program. As shown in figure 2, the underreporter
program identifies potentially noncompliant taxpayers using information
from two primary data sources:

         •   income reported to IRS by taxpayers on their individual tax
             returns and
         •   income reported to IRS from third parties, such as employers,
             banks and other financial institutions, partnerships, S-
             corporations, estates, and trusts on forms such as the W-2,
             1099, and Schedule K-1.




Page 4                               GAO-03-667 IRS’s Schedule K-1 Matching Program
Figure 2: General Underreporter Matching Process




The third party data is matched with the individual taxpayer’s return data
to verify that all income is reported. In fiscal year 2002, the matching
process identified approximately 14 million cases where individual tax
return information did not match income information reported to IRS from
third party sources.

IRS does not follow up on all of these potential underreporter cases. In
2002, IRS selected 3 million of the 14 million potential underreporter cases
for further review. After the cases are selected from this inventory, tax
examiners perform a manual review, called “screening” of tax returns to
determine if the income or deductions in question can be identified on the
actual tax return. If so, the case is closed; however, if reasonable doubt
remains, the taxpayer is sent an underreporter notice.1 At this point,
taxpayers can choose to agree with the additional assessment, disagree
and provide reasons, or ask for an appeal.

In order for K-1 data to be used in the matching process, IRS had to input
or transcribe data from K-1 information returns filed on paper into its
information systems. For tax year 2000, 14.3 million paper K-1s were filed
with IRS and another 5 million were filed electronically. Until it began
transcription in 2001, IRS had not transcribed paper K-1 return information
since 1995.


1
 The underreporter notice informs taxpayers of a proposed change to tax liability because
of income that is not identifiable or apparently not fully reported on the return.




Page 5                                  GAO-03-667 IRS’s Schedule K-1 Matching Program
              Because IRS had not transcribed Schedule K-1 information since 1995, the
              agency suspected noncompliance among K-1 taxpayers was significant.
              Based on a small study conducted in July 2000, IRS estimated that
              between 6 and 15 percent of the Schedule K-1 returns attached to flow-
              through returns are omitted from individual tax returns. Therefore, to
              identify the taxpayers who were potentially noncompliant and collect
              additional tax, IRS began planning in 2000 to (1) match Schedule K-1
              income information from partnerships, etc., against income information on
              individual tax returns to identify potential discrepancies and (2) send
              underreporter notices to taxpayers suspected of noncompliance.

              In 2000, Congress funded the Staffing Tax Administration for Balance and
              Equity (STABLE) Initiative that provided funding for transcription and
              matching of K-1 information. IRS told us funding provided for K-1
              transcription was 378 full-time equivalent (FTE) staff, but transcription
              rates were higher than planned and 485 FTEs were actually expended. IRS
              pulled funding from other programs to cover the shortfall. The
              approximate cost of the K-1 transcription was about $20 million. STABLE
              also included 69 FTEs and about $3 million for screening of matched K-1
              cases.

              IRS had two primary goals for the K-1 matching program. The first goal
              was to increase voluntary reporting of flow-through income by taxpayers.
              Although the program will bring in some revenue directly from notices
              sent to taxpayers who underreported, IRS believes that the indirect effect
              on voluntary reporting could be more important. IRS believes that the
              knowledge that K-1s are being matched will have a positive impact on self-
              reporting of flow-through income.

              IRS’s other primary goal was to target K-1 related underreporter notices on
              noncompliant taxpayers to the extent possible. Responding to notices is
              burdensome for compliant taxpayers. Taxpayers and preparers are
              required to collect, organize, and submit information to IRS either by
              telephone or in writing to explain any discrepancy cited in the notice.
              Resolving notices sent to compliant taxpayers also forces IRS to divert
              scarce enforcement staff away from noncompliant taxpayers.


              In order to describe IRS’s implementation of its Schedule K-1 matching
Scope and     program, reasons for suspending the issuance of notices, impact/burden
Methodology   on taxpayers, and results of the program, we:




              Page 6                           GAO-03-667 IRS’s Schedule K-1 Matching Program
         •   reviewed and analyzed IRS management plans, risk
             assessments, and other discussions of how the matching
             program would operate, including work group meeting minutes;
         •   interviewed IRS officials regarding the efforts required to plan
             and implement the program, including preliminary program
             testing, early plans for the program, changes made in program
             plans, problems with stakeholder communication, and the
             suspension of notices related to Schedule K-1 income;
         •   reviewed documents issued by external parties regarding
             concerns with the Schedule K-1 matching program;
         •   interviewed stakeholders from outside IRS, including enrolled
             agents and members of professional organizations, IRS advisory
             committees; and
         •   reviewed data and statistics resulting from the Schedule K-1
             matching program, including number of taxpayers sent notices
             and tax revenue assessed.

We assessed IRS’s management of the Schedule K-1 matching program by
reviewing the plans and risk assessment developed by IRS and then
comparing IRS’s implementation of the program to these plans.

To describe the steps IRS is taking to reduce burden and improve the
matching program, we:

         •   interviewed IRS officials regarding the changes being
             implemented for continuation of the Schedule K-1 matching
             program, including changes to reduce taxpayer burden;
         •   reviewed external stakeholder documents that offered
             suggestions for the future of the Schedule K-1 matching
             program;
         •   interviewed stakeholders from outside IRS regarding their
             suggestions for the Schedule K-1 matching program;
         •   observed a public meeting of the Information Reporting
             Program Advisory Committee (IRPAC); and
         •   observed a working group session of IRS and external program
             stakeholders.

The underreporter data presented in this report was produced by IRS, and
we did not independently verify its accuracy. However, we have used
underreporter program data in past reports and have found underreporter
summary statistics of the type used in this report to be reasonably
accurate. We performed our work from June 2002 through May 2003 in
accordance with generally accepted government auditing standards.



Page 7                             GAO-03-667 IRS’s Schedule K-1 Matching Program
                          In its original plan for the Schedule K-1 matching program, IRS intended to
IRS Stopped Issuing       focus on two categories of income: interest and dividends. IRS officials
Schedule K-1 Notices      believed that such a focus would enable IRS to minimize the number of
                          notices sent to compliant taxpayers. However, information system
after Complaints          limitations, along with a desire to direct resources towards K-1
about Burden              underreporter cases, caused IRS to expand this focus and include more
                          categories of income in the program. This change was not clearly
Imposed by Program        communicated to taxpayers or preparers and led to more compliant
Changes                   taxpayers receiving underreporter notices. In the face of complaints about
                          the burden imposed on compliant taxpayers, IRS stopped sending K-1
                          underreporter notices.


The Types of Income       Originally, IRS planned the Schedule K-1 matching program to focus on
Covered by the Schedule   two categories of flow-through income: interest and dividends. The plan
K-1 Matching Program      called for identifying underreporter cases with discrepancies between
                          interest and dividend income reported on a K-1 and what was reported on
Changed from IRS’s        an individual’s tax return.2 Notices would then be sent to the taxpayers
Original Plan             asking them to explain the discrepancies or pay the additional tax.

                          IRS chose to focus the Schedule K-1 matching program on interest and
                          dividend income to minimize the chances of compliant taxpayers receiving
                          notices about K-1 discrepancies. IRS based its decision on a risk matrix
                          that summarized the risk of sending a notice to a compliant taxpayer for
                          the various categories of flow-through income. Interest and dividend
                          income were identified as low risk because they are easily identified on
                          individuals’ tax returns. Short and long-term capital gains and royalties
                          were considered a moderate risk because the K-1 information was less
                          likely to be accurate or the income could be harder to locate on
                          individuals’ returns. Income from trade or business activities, rental real
                          estate, other rental activities, and guaranteed payments was considered
                          high risk because it could be much harder to isolate on individuals’
                          returns. For example, some taxpayers would reduce or net their flow-
                          through income in these four categories by subtracting carryover losses or
                          expenses. Although IRS’s tax form instructions caution against such




                          2
                           While the K-1 matching program was designed to select the underreporter cases with
                          discrepancies in interest and dividend income reported on the K-1s, a small sample of cases
                          with other types of K-1 income was also to be included.




                          Page 8                                  GAO-03-667 IRS’s Schedule K-1 Matching Program
netting, some taxpayers still do so, which can make flow-through income
appear to be underreported.

Starting in 2001, IRS began briefing representatives from stakeholder
groups on its plan for the Schedule K-1 matching program. IRS met with
two of its advisory committees, composed primarily of tax practitioners,
the Internal Revenue Service Advisory Committee (IRSAC) and the
Information Reporting Program Advisory Committee (IRPAC), and other
practitioner groups. During these discussions with stakeholders, IRS
informed them that underreported K-1 interest and dividend income would
be the focus of the K-1 matching program.

In October of 2001, IRS discovered during testing that the underreporter
computer system could not distinguish underreported K-1 interest and
dividend income from other interest and dividend income reported on
information returns such as Form 1099s. Because of a desire to direct the
69 FTEs allocated for screening K-1 underreporter cases to K-1 cases, IRS
decided to expand the focus of the K-1 matching program. IRS officials
told us they had wanted to direct the resources to K-1 cases exclusively in
order to be able to determine the results achieved with those resources.
The revised program included flow-through income from trade or business
activities, rental real estate, other rental activities, and guaranteed
payments. These four categories contained K-1 reported income
exclusively. As will be discussed in more detail later, IRS did not clearly
communicate the change to taxpayers, tax preparers, and other
stakeholders.

Under the revised matching program, IRS selected for screening by the 69
dedicated FTEs a total of 141,000 underreporter cases that appeared to
have only underreported K-1 income from the four categories as shown in
figure 3. In addition IRS selected another 237,000 cases that appeared to
have both underreported K-1 income and underreported income from
other sources. After manual screening, IRS determined that 97,200 cases
raised sufficient questions about the accuracy of the amount reported on
the individual tax returns to merit sending a notice of the potential
discrepancy to the taxpayers. IRS began sending notices about the
discrepancies to taxpayers in April 2002.




Page 9                           GAO-03-667 IRS’s Schedule K-1 Matching Program
The Revised Schedule K-1    Because of the change in focus of the program, more compliant taxpayers
Matching Program            received underreporter notices than IRS had originally intended. As shown
Burdened More Compliant     in figure 3, of the over 63,000 cases closed through March 2003, about 62
                            percent or 39,153 were closed with no change to the tax liability. The
Taxpayers Than Originally   compliant taxpayers or their preparers who responded to the notices were
Intended                    required to submit information to IRS in writing or via telephone that
                            explained how they reported the flow-through income on their tax return.

                            Figure 3: The Number of Schedule K-1 Underreporter Notices Sent to Taxpayers




                            Some of these compliant taxpayers were burdened because they
                            improperly reported net amounts on their returns. As discussed
                            previously, IRS instructions tell taxpayers to list K-1 income without
                            netting. Nevertheless, according to IRS, many taxpayers reported net
                            amounts, making it appear that they had underreported. After the
                            discrepancies were explained to IRS, about 62 percent of the notices
                            resulted in no change in the tax liability.



                            Page 10                            GAO-03-667 IRS’s Schedule K-1 Matching Program
Because of Taxpayer         Taxpayers, tax preparers, and various external stakeholder groups
Complaints, IRS Stopped     complained about the notices for two reasons. First, as discussed
Sending Schedule K-1        previously, the notices imposed a burden on compliant taxpayers. Though
                            some of these taxpayers may have improperly reported net amounts on
Underreporter Notices       their returns, the taxpayers argued that they had been filling out their
                            returns this way for years without incident. Second, they were not
                            expecting underreporter notices related to flow-through income about
                            trade or business activities, rental real estate, other rental activities, and
                            guaranteed payments.

                            IRS responded by stopping the K-1 matching program notices as of August
                            1, 2002. As shown in figure 3, IRS sent 69,097 notices to taxpayers before
                            that date.


IRS Followed Up on          As of March 2003, IRS data shows that nearly 92 percent or 63,084 of the
Schedule K-1 Program        Schedule K-1 notices issued were closed, or resolved to IRS’s satisfaction,
Notices Sent to Taxpayers   as shown in figure 3. In nearly 38 percent or 23,931 of the closed cases,
                            taxpayers agreed that the notices were correct, that the Schedule K-1
                            income was misreported, and that they owed more taxes. These cases
                            resulted in about $41.4 million of additional taxes assessed of which
                            $26.9 million related exclusively to Schedule K-1 income. IRS estimates
                            that about 90 percent of the assessed tax will be collected.

                            In addition to the revenue resulting directly from the notices, IRS expects
                            that K-1 matching will have a psychological impact on taxpayers,
                            encouraging voluntary compliance. IRS did not have data at the time the
                            program was being planned to allow it to estimate the likely impact on
                            voluntary compliance. Nor does IRS have any data on the actual impact on
                            voluntary compliance. IRS did project that a one percent improvement in
                            K-1 reporting levels would result in approximately $1.7 billion in additional
                            tax reported.


                            IRS developed a plan for the Schedule K-1 matching program that,
IRS Did Not Timely          according to IRS, relied on established project management principles.
Test Its Plans or           However, IRS did not timely implement two parts of the plan. First, IRS
                            did not test the feasibility of focusing the program on interest and dividend
Communicate Plan            income until after recommending such a focus and communicating the
Changes to                  recommendation to taxpayers, tax preparers, and other stakeholders.
                            Second, after changing the plan, IRS did not clearly communicate with
Stakeholders                taxpayers, tax preparers or other stakeholders about the changes. Failure


                            Page 11                            GAO-03-667 IRS’s Schedule K-1 Matching Program
                           to timely implement these two parts of the plan led to compliant taxpayers
                           being surprised and burdened by the notices they received and ultimately
                           resulted in IRS halting the Schedule K-1 notification process before all
                           97,200 notices were sent to taxpayers.


IRS Developed Plans for    In planning the Schedule K-1 matching program, IRS officials said they
Testing and                relied on established principles from its Enterprise Life Cycle (ELC)
Communicating about the    project management approach, the same strategy IRS has used for
                           planning and implementing its ongoing information systems modernization
Schedule K-1 Matching      efforts. IRS developed a series of K-1 matching program management
Program                    plans including those covering transcription and compliance management,
                           risk management, and internal and external stakeholder communications.
                           The K-1 compliance management plan called for performing two tests
                           before selecting cases for the K-1 matching program. The first test was of
                           underreporter program procedures and was intended to determine needs
                           such as computer system and training updates in order to accommodate
                           Schedule K-1 data. The second test was a review of underreporter program
                           processes more generally. The K-1 communication plan called for
                           communicating with internal and external stakeholders about the project
                           status in order to address questions and concerns and manage
                           expectations.


IRS Did Not Test the       IRS did not test whether its original case selection process, focused on
Schedule K-1 Case          interest and dividend income, was feasible before recommending it. As
Selection Process before   shown in figure 4, IRS began planning the Schedule K-1 matching program
                           in January 2001. As previously discussed, in July 2001, IRS recommended
Recommending It            selecting for review by tax examiners all underreporter cases with K-1
                           interest and dividend income. An IRS official told us that internal
                           discussions led IRS to believe that this was possible--that the
                           underreporter computer system could distinguish cases with interest and
                           dividend income reported on K-1s from that reported on other information
                           returns. Consequently, the feasibility of focusing the K-1 program on
                           interest and dividend income was not tested before the recommendation
                           was made.




                           Page 12                          GAO-03-667 IRS’s Schedule K-1 Matching Program
                           Figure 4: Chronology of Key Events in IRS Implementation of the Schedule K-1
                           Matching Program




                           The second test in IRS’s plan was conducted in October 20013 and revealed
                           that system limitations would prevent IRS from focusing the K-1 program
                           on interest and dividend income. IRS discovered that the underreporter
                           computer system could not distinguish K-1 interest and dividend income
                           from interest and dividend income reported on other information returns
                           such as Form 1099s. As a result, the focus of the Schedule K-1 matching
                           program was changed. As discussed earlier, the revised program covered
                           underreported trade or business, rental real estate, other rental activity,
                           and guaranteed payment flow-through income.


IRS Did Not Communicate    Although the program communication plan called for communicating with
Matching Program           internal and external stakeholders, IRS failed to inform taxpayers, tax
Changes to Taxpayers and   preparers, and other stakeholders of the changes it made to the matching
                           program and the potential for the changes to increase burden on
External Stakeholders      compliant taxpayers. An IRS official responsible for the K-1 program
                           stated that a communication breakdown resulted in mixed messages being
                           shared with stakeholders about the type of cases that would be selected
                           for the K-1 matching program. IRS officials were unable to show us any
                           documentation in which they communicated the changes to the plan. An



                           3
                            During the Case Preview, information return documents are sampled to test the quality of
                           the information and to identify potential problems with the underreporter system.




                           Page 13                                 GAO-03-667 IRS’s Schedule K-1 Matching Program
                        IRSAC member told us they only became aware of the change to the
                        program after taxpayers began receiving notices.

                        Tax preparers and stakeholders were critical of the fact that IRS failed to
                        inform them of the changes made in the Schedule K-1 matching program
                        and the effect those changes would have on compliant taxpayers. They
                        believed compliant taxpayers were unfairly burdened by having to respond
                        to K-1 notices since, according to an IRSAC member, preparers had not
                        been required to submit any explanatory documents with their tax returns
                        in the past.


                        As was the case with the revised Schedule K-1 matching program in 2002,
IRS Is Taking Steps     for 2003, interest and dividend income reported on K-1s will be included in
Intended to Improve     the underreporter program; however, the 69 FTEs devoted to K-1 matching
                        will again focus on the four flow-through income categories including
the Schedule K-1        income from trade or business activities, rental real estate, other rental
Matching Program in     activities, and guaranteed payments. As of April 2003, IRS has started
                        issuing notices related to discrepancies in tax year 2001. Also this year,
2003                    IRS is taking steps intended to reestablish communication with external
                        stakeholders and reducing the burden on compliant taxpayers. At this
                        time, the effectiveness of these steps is unknown.


IRS Is Working to       For 2003, the Schedule K-1 matching program will have the same focus as
Reestablish             the revised program in 2002. Therefore, during the 2003 Schedule K-1
Communications with     matching effort, it is no longer necessary for IRS to test this case selection
                        approach in the underreporter system.
External Stakeholders
                        IRS is working to reestablish clear communications with external
                        stakeholders. Since notices were stopped in August 2002, IRS has kept
                        external stakeholders informed of program developments and held
                        meetings with these stakeholders to consider a number of suggestions for
                        improving the Schedule K-1 matching program. For example, in the 2
                        months following the notice stoppage, IRS briefed both IRSAC and its own
                        Oversight Board on reasons for notice suspension, data collected, and
                        plans for continuing the program with external stakeholder input.

                        IRS also held public meetings with IRSAC in October 2002 and IRPAC in
                        November 2002 during which it obtained the committees’ comments and
                        suggestions for the Schedule K-1 matching program. In addition, IRS held a
                        meeting in December 2002 with representatives of various practitioner and
                        other stakeholder groups to discuss various aspects of the program. In this


                        Page 14                            GAO-03-667 IRS’s Schedule K-1 Matching Program
                            meeting, IRS presented results of the case studies it conducted after
                            suspension of the notices and solicited from the stakeholders ideas for
                            improving the program in the areas of forms, matching, education and
                            outreach, tax preparation software, and legislative changes.


IRS Is Taking Other Steps   At least in part as a result of the stakeholder meetings discussed above,
Intended to Reduce          IRS has begun implementing steps intended to improve Schedule K-1
Taxpayer Burden             matching and clarify reporting requirements. IRS has adopted a new goal
                            of eliminating as many no-change notices as possible and increasing the
                            overall effectiveness of the Schedule K-1 matching program. IRS’s strategy
                            for reducing no-change notices relies on more rigorous screening of cases
                            by examiners before notices are sent. IRS estimates that the program
                            changes discussed below should reduce the number of no-change notices
                            by about 50 percent from the 2002 levels. At this time, IRS does not have
                            an estimate of the number of notices to be sent out or of what it expects
                            the no-change rate to be.

                            For 2003, IRS has adopted a revised set of standards for screening cases
                            for review in its Schedule K-1 matching program, with the intent of
                            minimizing taxpayer burden by reducing the number of no-change notices
                            sent. In particular, IRS will issue notices to taxpayers if K-1 income
                            information is completely missing from a return. Also, if a taxpayer
                            received a notice in 2002 for tax year 2000 K-1 items and agreed with the
                            changes proposed by that notice, the taxpayer will receive a notice for any
                            underreported K-1 income identified this year in the tax year 2001 return.
                            If income appears underreported for a taxpayer who received a notice that
                            resulted in a no-change last year, that taxpayer will not receive a notice
                            this year, with the possible exception of particularly large discrepancies.
                            In addition, if a taxpayer received no notice last year or received a notice
                            that contained no K-1 items, this taxpayer will be sent a notice if a large
                            discrepancy is identified. The revised screening standards will be applied
                            to all K-1 flow-through income discrepancies.

                            IRS is also trying to educate taxpayers and practitioners about the proper
                            way of reporting flow-through income, carryover losses, and deductions in
                            order to reduce the need to send notices to compliant taxpayers about
                            apparent mismatches. For example, in March 2003, IRS issued a news
                            release that provided tips and reminders for K-1 filing. These tips covered
                            topics such as proper reporting of Schedule K-1 income on individual
                            returns, avoiding netting of income and expenses, reporting losses carried
                            forward, and steps for reporting income when the Schedule K-1 has not yet
                            been received.


                            Page 15                          GAO-03-667 IRS’s Schedule K-1 Matching Program
Also in March 2003, an IRS official participated in a webcast program
geared to the practitioner community to discuss requirements of Schedule
K-1 reporting and field questions from practitioners. In addition, the
agency will present sessions on how to report flow-through items at each
of its tax forums during the summer of 2003. The agency also seeks to
further educate taxpayers through outreach programs to be run by the
Taxpayer Education and Communication unit, a part of IRS’s Small
Business/Self-Employed operating division.

Further, IRS is changing certain forms and/or schedules in order to make
reporting compliance easier for the taxpayer. In a report issued March
2003, the Treasury Inspector General for Tax Administration (TIGTA)
stated the lack of detailed information reported by taxpayers and/or
practitioners may have been a significant reason for the number of K-1-
related notices that were sent. TIGTA then recommended that IRS revise
Form 1040 Schedule E to classify and report flow-through income in a
manner that would allow an easier comparison with Schedule K-1. In
response, an IRS official has stated that, for the 2003 filing season, the
agency would issue a revised Form 1040 Schedule E that would alert
practitioners to pay special attention to the written instructions on the
reporting of certain losses and expenses. The desired effect of this change
is to make taxpayers less likely to improperly net income and expenses
being reported on Schedule E.

Finally, an IRS task force is studying the possibility of simplifying the
Schedule K-1 and its instructions for different tax situations. The intent
would be to reduce both pre- and postfiling burden. However, the analysis
needed for the form redesign will likely not be completed until mid-2003,
and it would take about 2 years total for the redesign to actually be
implemented.

By fiscal year 2005, through the outreach efforts and Form 1040 Schedule
E revisions discussed in the previous paragraphs, IRS believes that it can
eliminate the need for the special screening procedures instituted this
year. In addition to the outreach efforts and form changes mentioned
above, IRS has also discussed other efforts that could be used to help
make the program more automated, such as working with software
vendors to make any necessary changes to electronic tax preparation
programs.

While IRS intends that these changes will reduce the number of no-change
notices regarding flow-through income, at this time the effectiveness of
the changes is unknown. More specifically, it is not known how ambitious


Page 16                          GAO-03-667 IRS’s Schedule K-1 Matching Program
             IRS’s goal to reduce notices sent to compliant taxpayers by at least 50
             percent is nor is it known whether IRS can reduce notices sent to
             compliant taxpayers while maintaining the ability to act against
             noncompliant taxpayers.

             For the K-1 matching notices being sent in 2003, IRS will be able to track
             the number closed with no-change through tracking reports issued every 2
             weeks. These tracking reports also contain the number of notices with an
             assessment that the taxpayer agreed to, unreported income identified
             through notices, and additional taxes assessed through the notices. The
             reports, which IRS has begun preparing for its tax year 2001 K-1 data
             match, are prepared for IRS management. Officials told us that they would
             also be made available to outside stakeholders.

             The tracking reports should give IRS management information before all
             notices are sent out about the effectiveness of the changes made to the
             program. With respect to the overall effectiveness of the K-1 matching
             program, one IRS official told us that he sees the level of voluntary
             compliance with K-1 reporting requirements as a key measure of the
             program’s effectiveness. This official also told us that IRS plans to
             annually review the number of K-1 returns filed to determine if more K-1
             income is being reported. He said that more reporting of K-1 income could
             be seen as a measure of program effectiveness. Our ongoing work for the
             Senate Committee on Finance will assess IRS’s efforts to detect and
             address noncompliance by taxpayers receiving flow-through income.


             Better targeting the Schedule K-1 matching program notices on
Conclusion   noncompliant taxpayers matters for two reasons. Sending underreporter
             notices to compliant taxpayers wastes taxpayers’ time and money.
             Similarly, IRS’s scarce enforcement resources are wasted to the extent
             they are used to resolve notices sent to compliant taxpayers.

             While no compliance program can perfectly target noncompliant
             taxpayers, IRS’s goal of reducing the number of Schedule K-1 matching
             program underreporter notices sent to compliant taxpayers is laudable.
             However, at this time, no one--neither IRS nor external stakeholders--
             knows how effective IRS’s proposed actions will be. Consequently, IRS’s
             tracking of the no-change rate is very important, both for internal
             management and congressional oversight. Because IRS has begun tracking
             the no-change rate every 2 weeks, we are not making recommendations in
             this report. As noted earlier, we will be looking at opportunities to



             Page 17                          GAO-03-667 IRS’s Schedule K-1 Matching Program
                  improve the overall effectiveness of the Schedule K-1 matching program in
                  our ongoing work for the Senate Committee on Finance.


                  We asked IRS to provide comments on a draft of our report but did not
Agency Comments   receive a response in time to include it with this report. However, IRS
                  officials responsible for the program told us that they agree with the facts
                  presented in this report.


                  As arranged with your office, we will not distribute this report until 30
                  days from its issue date unless you publicly announce its contents earlier.
                  After that period, we will send copies to the Chairman and Ranking
                  Minority Member, House Committee on Ways and Means; Chairman and
                  Ranking Minority Member, House Subcommittee on Oversight, House
                  Committee on Ways and Means; Chairman and Ranking Minority Member,
                  House Committee on Small Business; Chairman and Ranking Minority
                  Member, Senate Committee on Finance; and the Ranking Minority
                  Member, Senate Committee on Small Business and Entrepreneurship. We
                  will also send copies to Secretary of the Treasury, the Commissioner of
                  Internal Revenue, and other interested parties. We will make copies
                  available to others on request. In addition, the report will be available on
                  the GAO web site at http://www.gao.gov.

                  If you have any questions, please contact me at (202) 512-9110. Key
                  contributors to this report are acknowledged in appendix I.

                  Sincerely yours,




                  James R. White
                  Director, Tax Issues




                  Page 18                           GAO-03-667 IRS’s Schedule K-1 Matching Program
                  Appendix I: GAO Contact and Staff
Appendix I: GAO Contact and Staff
                  Acknowledgments



Acknowledgments


GAO Contacts      James R. White, (202) 512-9110


Staff             In addition to the contact above, Marvin McGill, Adam Couvillion,
                  Amy Rosewarne, and Joseph Jozefczyk made key contributions to
Acknowledgments   this report.




(440154)
                  Page 19                             GAO-03-667 IRS’s Schedule K-1 Matching Program
                         The General Accounting Office, the audit, evaluation and investigative arm of
GAO’s Mission            Congress, exists to support Congress in meeting its constitutional responsibilities
                         and to help improve the performance and accountability of the federal
                         government for the American people. GAO examines the use of public funds;
                         evaluates federal programs and policies; and provides analyses,
                         recommendations, and other assistance to help Congress make informed
                         oversight, policy, and funding decisions. GAO’s commitment to good government
                         is reflected in its core values of accountability, integrity, and reliability.


                         The fastest and easiest way to obtain copies of GAO documents at no cost is
Obtaining Copies of      through the Internet. GAO’s Web site (www.gao.gov) contains abstracts and full-
GAO Reports and          text files of current reports and testimony and an expanding archive of older
                         products. The Web site features a search engine to help you locate documents
Testimony                using key words and phrases. You can print these documents in their entirety,
                         including charts and other graphics.
                         Each day, GAO issues a list of newly released reports, testimony, and
                         correspondence. GAO posts this list, known as “Today’s Reports,” on its Web site
                         daily. The list contains links to the full-text document files. To have GAO e-mail
                         this list to you every afternoon, go to www.gao.gov and select “Subscribe to daily
                         E-mail alert for newly released products” under the GAO Reports heading.


Order by Mail or Phone   The first copy of each printed report is free. Additional copies are $2 each. A
                         check or money order should be made out to the Superintendent of Documents.
                         GAO also accepts VISA and Mastercard. Orders for 100 or more copies mailed to a
                         single address are discounted 25 percent. Orders should be sent to:
                         U.S. General Accounting Office
                         441 G Street NW, Room LM
                         Washington, D.C. 20548
                         To order by Phone:     Voice:    (202) 512-6000
                                                TDD:      (202) 512-2537
                                                Fax:      (202) 512-6061


                         Contact:
To Report Fraud,
                         Web site: www.gao.gov/fraudnet/fraudnet.htm
Waste, and Abuse in      E-mail: fraudnet@gao.gov
Federal Programs         Automated answering system: (800) 424-5454 or (202) 512-7470


                         Jeff Nelligan, Managing Director, NelliganJ@gao.gov (202) 512-4800
Public Affairs           U.S. General Accounting Office, 441 G Street NW, Room 7149
                         Washington, D.C. 20548