oversight

Management Report: Improvements Needed in Controls over IRS's Excise Tax Certification Process

Published by the Government Accountability Office on 2003-07-23.

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

United States General Accounting Office
Washington, DC 20548



          July 23, 2003


          The Honorable Mark W. Everson
          Commissioner of Internal Revenue

          Subject:     Management Report: Improvements Needed in Controls over IRS’s
                       Excise Tax Certification Process

          Dear Mr. Everson:

          The Internal Revenue Service (IRS), along with other components of the Department
          of the Treasury, collects and distributes excise tax receipts to government trust
          funds. As the nation’s tax collector, IRS plays a critical role in this process.
          Consequently, trust funds and their administrators depend on IRS to have sound
          procedures and controls over this process to ensure that excise taxes are
          appropriately distributed.

          This report is a follow-up to two reports we recently issued discussing procedures we
          performed to assist the Department of Transportation’s Office of Inspector General
          (Transportation IG) in ascertaining whether the net excise tax collections and excise
          tax certifications reported by IRS for the fiscal year ended September 30, 2002, were
          supported by underlying records.1 The agreed-upon procedures, along with our audit
                                                         2
          of IRS’s fiscal year 2002 financial statements, provided a sufficient basis to assist the
          Transportation IG in forming an opinion on the departmentwide financial statements
          and the financial statements of the trust funds administered by the department,
                                                                                       3
          including the Highway Trust Fund and the Airport and Airway Trust Fund.

          In our reports discussing the results of the agreed-upon procedures we performed in
          fiscal year 2002, we described errors we identified in the certification and distribution
          process. However, we did not discuss the underlying internal control weaknesses

          1
            U.S. General Accounting Office, Applying Agreed-Upon Procedures: Highway Trust Fund Excise
          Taxes, GAO-03-360R (Washington D.C.: Jan. 23, 2003) and Applying Agreed-Upon Procedures: Airport
          and Airway Trust Fund Excise Taxes, GAO-03-361R (Washington D.C.: Jan. 23, 2003).
          2
            U.S. General Accounting Office, Financial Audit: IRS’s Fiscal Years 2002 and 2001 Financial
          Statements, GAO-03-243 (Washington D.C.: Nov. 15, 2002).
          3
            Because GAO is responsible for auditing IRS’s financial statements, we performed agreed-upon
          procedures to assist the Transportation IG in assessing whether the net excise tax revenues
          distributed to the two trust funds for fiscal year 2002 were supported by underlying records. These
          agreed-upon procedures, in conjunction with additional testing by the Transportation IG, provided
          Transportation’s IG sufficient basis to opine on the department’s financial statements.



          Page 1                                            GAO-03-687R IRS Excise Tax Management Report
that allowed these errors to go undetected, nor did we discuss actions needed to
                           4
address these weaknesses. This report discusses these weaknesses and presents our
recommendations for corrective action.

Results in Brief

IRS’s internal controls over its process for certifying excise taxes for distribution to
federal government trust funds are not fully effective in ensuring that the appropriate
amounts are distributed to the trust funds. Our work identified several internal
control issues that affected the amounts distributed to trust funds quarterly and that
could have affected total fiscal year distributions if IRS had not corrected errors
resulting from these control issues after we brought them to its attention. The issues
we identified include the following:

•   IRS lacked effective procedures to timely detect errors made by employees when
    entering excise tax return information into its information systems. IRS did not
    detect such errors until months after they occurred. As a result, IRS understated
    certified collections to the Highway Trust Fund for the quarters ended December
    31, 2001, and March 31, 2002. Although IRS subsequently identified and corrected
    the errors, it would not have had adequate time to correct them if these errors had
    occurred later in the fiscal year. Had that been the case, the amount of excise
    taxes distributed to the Highway Trust Fund would have been less than it should
    have been for fiscal year 2002.

•   IRS lacked effective supervisory review to timely detect errors made in the
    preparation of excise tax certifications. As a result, amounts certified to trust
    funds were misstated for certain quarters during both fiscal years 2002 and 2001.
    IRS corrected the errors in the certifications after we brought them to its
    attention. Had we not identified the errors during our review and notified IRS, the
    amounts distributed to the Highway Trust Fund would have been approximately
    $81 million less than they should have been during fiscal year 2002 and
    approximately $1 million less than they should have been during fiscal year 2001.

•   IRS did not effectively coordinate with other components of Treasury involved in
    the excise tax distribution process when it implemented changes to its method for
    recording excise tax credits in fiscal year 2002. As a result, IRS’s system-
    generated certification data were not in a format usable by the Financial
    Management Service (FMS) or the Bureau of the Public Debt (BPD) to facilitate
    the recording of adjustments to trust funds. To make the data usable to FMS and
    BPD, IRS had to add steps to its certification process to generate the information
    in the previous reporting format. These added steps made IRS’s already complex
    certification process even more cumbersome, increasing both the likelihood that
    errors could be made and that they could go undetected by supervisory review.


4
 In performing the agreed-upon procedures, we conducted our work in accordance with attestation
standards established by the American Institute of Certified Public Accountants. These standards
stipulate that reporting on such engagements be in the form of procedures and findings only.


Page 2                                            GAO-03-687R IRS Excise Tax Management Report
In addition to these issues, we continued to find that IRS did not promptly certify
excise tax collections to the trust funds. Under IRS’s current certification process,
excise tax receipts for the fourth quarter of the fiscal year, which ends September 30,
are not certified until the following March. Because the Department of
Transportation’s financial statements are currently required to be issued by
                                   5
February 1 of the following year, adjustments to initial distributions of excise tax
receipts for the last quarter of the fiscal year, based on IRS’s certification, are not
recorded in time to be reflected in the trust funds’ financial statements. However,
this lag time in making final adjustments will become more of an issue this year.
Beginning with its fiscal year 2004 accountability report, the Department of
Transportation, along with the other CFO Act agencies, will be required to issue its
                                                                             6
report, including its audited financial statements, by November 15, 2004.

To help the transition to this earlier reporting date, the department is planning to
accelerate the issuance of its fiscal year 2003 accountability report to December 2003.
If the Department of Transportation accelerates its reporting date to December 2003
or earlier, certifications for the third and fourth quarters of the fiscal year would be
completed too late for any adjustment to distributions resulting from the
certifications to be made and reflected on the trust funds’ financial statements under
IRS’s existing process. As a result, the amount of annual excise tax revenue
distributed to the trust funds may not reflect the true amount that should have been
distributed, potentially resulting in significantly inaccurate distributions and, in the
case of the Highway Trust Fund, incorrect allocations of revenues to states.7

IRS has taken some actions to improve controls over the excise tax certification
process, but additional action is needed to address the internal control issues we
identified. We are making recommendations to further strengthen IRS’s verification
and review procedures to help ensure that trust funds receive the appropriate
allocation of revenue in a timely manner and to assist IRS in considering changes to
its procedures to accelerate the timing of its excise tax certifications.

In its comments, IRS generally agreed with our recommendations and described
actions it was taking or planned to take to address the internal control issues
described in this report. At the end of our discussion on each of these issues, we
have summarized IRS’s related comments and provided our evaluation.




5
  The Chief Financial Officers Act of 1990 (CFO Act), as expanded by the Government Management
Reform Act of 1994, requires the Department of Transportation to annually submit audited financial
statements to the Office of Management and Budget (OMB). OMB requires agencies to submit
financial statements for fiscal year 2003 no later than February 1, 2004.
6
  Office of Management and Budget, Memorandum for Chief Financial Officers and Inspectors General
(Washington D.C.: Oct. 18, 2002).
7
  The Transportation Equity Act for the 21st Century, Pub. L. No. 105-178, 112 Stat. 107 (1998), requires
highway program funds to be distributed to states on the basis of annual Highway Account receipts
information.



Page 3                                               GAO-03-687R IRS Excise Tax Management Report
Background

The federal government levies excise taxes on entities and individuals for the
purpose of financing general federal activities and specific government programs.
Several bureaus and offices within Treasury collected a total of about $69 billion in
excise taxes in fiscal year 2002. IRS accounted for the majority, collecting about $52
billion in excise taxes on the purchase, use, or inventory of various types of goods
and services, such as gasoline and airline tickets. The processing of excise tax
returns is centralized at IRS’s Cincinnati Campus. The various excise taxes
                                                           8
accounted for by IRS are deposited into the general fund of the Treasury and
subsequently into seven different trust funds, which are administered by six federal
agencies or entities. The largest of these trust funds are the Highway Trust Fund and
the Airport and Airway Trust Fund, both of which are administered by the
Department of Transportation. For fiscal year 2002, the Highway Trust Fund
received about $32.2 billion in excise tax revenues and the Airport and Airway Trust
Fund received about $8.9 billion.

Because it collects federal tax revenue and then distributes it to these government
trust funds, Treasury is considered a servicing organization by trust fund
administrators as well as by the auditors of these agencies. Consequently, the trust
fund administrators and their auditors need to rely on Treasury, through its various
bureaus and offices, including IRS, to properly account for and distribute amounts
transferred from the government’s general fund to their trust funds.

Payers of excise taxes generally are required to make semimonthly deposits to cover
their quarterly tax liability. The excise taxes are deposited into the general fund as
they are received. Taxpayers are not required to provide information at the time they
make their excise tax payments that would allow Treasury to immediately apply the
payments to the appropriate trust fund based on amount owed and paid. The
information that ultimately determines how these receipts are distributed is generally
                                                                               9
submitted by taxpayers on Form 720, Quarterly Federal Excise Tax Return. Because
data are not available to allocate excise taxes to the appropriate trust funds when
taxpayers make their excise tax deposits, Treasury uses a process to estimate the
initial distribution of excise taxes.

Treasury’s Office of Tax Analysis (OTA) prepares semimonthly estimates based on
historical IRS certification data and actual total current excise tax revenue
collections. FMS uses these estimates to prepare entries for the initial distributions
to the trust funds, which are recorded by BPD in the books and records of the trust
funds maintained by Treasury. Subsequent to this initial distribution, IRS certifies

8
  The general fund accounts for receipts that are not earmarked by law for specific purposes, the
proceeds of general borrowing, and the expenditure of these moneys for the general support of federal
government activities.
9
  Taxpayers file the quarterly excise tax return to report their excise tax liability. Form 720 is generally
due 30 days following the end of the quarter.



Page 4                                                GAO-03-687R IRS Excise Tax Management Report
quarterly the amounts that should have been distributed to the excise tax−related
trust funds based on the tax returns. FMS then uses these certifications to prepare
adjustments to the initial trust fund distributions for each quarter, and BPD records
the amounts on the trust fund books and records. Figure 1 provides an overview of
the entire process of collecting, distributing, and certifying excise tax revenue
reported to trust funds.

Figure 1: Overview of the Process for Distribution of Excise Tax Revenue to Trust Funds


       Taxpayer                   IRS                       OTA                FMS                   BPD
                                                                          Distribution/           Recordation/
     Payment/filing    Collection/accounting             Estimation       adjustments              accounting

                                                         Semimonthly
     Tax payments                          FMS           calculation of
                                                          estimates

                                                                          Prepare journal
                                                                          entries - record          Record entries
                      Record excise
                                                                             estimates              into trust fund
                      tax payments
                                          General fund                                                  records
                       in master file

                                                                          Prepare journal
     Quarterly tax    Record excise                                       entries - adjust
     return - Form    tax liability in                                     estimates to      Trust funds
         720           master file                                            actuals
                                                                                             1.   Highway
                                                                                             2.   Airport and Airway
                                                                                             3.   Aquatic Resources
                      Certification                                                          4.   Leaking Underground
                      Calculations and                                                            Storage Tanks
                       certification of                                                      5. Black Lung
                      actual amounts                                                         6. Vaccine Injury
                                                                                                Compensation
                                                                                             7. Inland Waterways



                                                                                                    Investments in
                                                                                                     special issue
                                                                                                  Treasury securities
Source: GAO.




IRS currently certifies collections for each quarter approximately 5 and one-half
months after the end of the quarter. IRS relies on a combination of manual and
automated procedures to prepare its certification of excise taxes to be distributed to
the trust funds. This process is complex and cumbersome. IRS calculates the trust
fund distributions based on assessment, credit,10 and payment information in the
master file.11 When taxpayers make their excise tax deposits, IRS enters payment
information into the taxpayers’ master file accounts. As quarterly excise tax returns
are received, IRS enters the liability amounts by type of excise tax, such as gasoline
tax, into taxpayers’ master file accounts. The tax types are identified by certain
10
   An assessment represents the taxes owed by a taxpayer for a given period for a given tax. Typically,
for excise taxes, this is the amount reported by the taxpayer on the Form 720 excise tax return.
Taxpayers are allowed to claim excise tax credits for certain situations. For example, due to IRS’s
method for taxing fuel, there are situations when fuel could be taxed more than one time. Taxpayers
are allowed to claim a credit for the second time the fuel is taxed.
11
   The master file is a detailed database of taxpayer accounts.



Page 5                                                            GAO-03-687R IRS Excise Tax Management Report
numbers preprinted on the Form 720. IRS uses one set of numbers for tax
assessments, referred to as abstracts, and another set for tax credits, referred to as
credit reference numbers. For example, abstract 62 represents gasoline tax, and
credit reference number 362 represents a credit claimed on gasoline tax. IRS uses
these numbers to identify excise tax type information in its master file, and it is these
numbers that ultimately determine how amounts are distributed to the appropriate
trust funds.

IRS electronically transmits excise tax information from the master file to its
Collection Certification System. The Collection Certification System uses the
information to prorate12 collections among the different excise taxes. The system
then summarizes the amount of prorated collections, by tax type, on the Report of
Excise Tax Collection. IRS uses the information from these reports as the basis for
calculating the gross certified amount13 for each type of tax. IRS analysts enter the
information from the Reports of Excise Tax Collection onto a series of
interconnected electronic spreadsheets, which further combine prorated collection
data and then allocate the gross prorated amount, for each type of tax, among the
general fund, trust funds, and trust fund accounts.14 Analysts then record the
allocated amount for each tax onto excise tax distribution certification letters.

IRS submits the certification letter to FMS, which uses it to prepare adjustments to
                                                                               15
the initial distributions to bring them in line with the IRS-certified amounts. FMS
sends these adjustments to BPD, which records the entries in the books and records
of the trust funds maintained by Treasury. Figure 2 shows IRS’s process for
certifying trust fund distributions.




12
   IRS certifies to trust funds the amount of excise taxes actually collected. Because there are
occasions on which taxpayers have not paid their full tax liability at the time of IRS’s certification, IRS
must allocate the amount of payments actually received among the different excise taxes reported on
the taxpayer’s return. IRS’s Collection Certification System prorates a taxpayer’s payments among all
taxes reported owed on the tax return. For example, if a Form 720 indicates that the taxpayer owes $4
million for gasoline tax, $2 million for diesel fuel tax, and $1 million for gasohol tax, but the taxpayer
has paid IRS only $3.5 million at the time IRS performs its certification, the program prorates the $3.5
million in the following manner: $2 million to gasoline tax, $1 million to diesel fuel tax, and $500,000 to
gasohol tax.
13
   This is the total amount of certified collections for each tax (e.g., gasoline) prior to distribution
between the general fund and trust fund.
14
   The tax amounts for certain taxes, such as some motor fuel taxes, are allocated among the general
fund, the Highway Account of the Highway Trust Fund, and the Mass Transit Account of the Highway
Trust Fund.
15
   This adjustment is determined by taking the IRS-certified amount and subtracting from it the initial
distribution amount derived from the OTA estimate. If the resulting amount is positive, it is
transferred from the general fund to the trust fund. If the resulting amount is negative, it is transferred
out of the trust fund to the general fund.



Page 6                                                GAO-03-687R IRS Excise Tax Management Report
Figure 2: Overview of IRS Process for Certifying Excise Tax Collections

                                                       Martinsburg               IRS Centralized                       Office of
                              IRS tax return            Computer                Excise Tax Section                     Revenue
       Taxpayer              processing units            Center                (Cincinnati Campus)                     Systems
                     (Cincinnati Campus-Submission Processing)
                                                                              Compare information on
                                                                              Form 720 returns over                  Review master
                          Input assessment                                                                           file information
     Tax return                                                               $1 million with data in
                          data from Form 720                                                                         and advise
     Form 720                                           Master                master file
                          into master file                                                                           Cincinnati of
                                                         file
                                                                              Research apparent                      potential errors
                                                                              errors and correct as
                                                                              necessary


                                                                                                                        Collection
                         (All 10 IRS Campuses)
                                                            Quarterly downloads to Collection Certification System     Certification
                          Input payment data                                                                             System
     Payments             from payment
     (EFTPS, FTDs,        documents or
     etc.)                electronic sources                                                                           Report of
                          into master file                                                                             Excise Tax
                                                                                                                       Collection


                                                                                                                     Calculation of
                                                                                                                     certification
                                                                                                                     amounts using
                                                                                                                     electronic
                                                                                                                     spreadsheets



                                                                                                                      Certification
                                                                                                                      letters           FMS


Source: GAO.




In addition to its certification of excise tax receipts to trust funds, IRS performs a
quarterly reclassification of excise tax refunds and credits. As part of its normal
processing procedures, IRS initially records some excise tax refunds and credits as
personal or corporate refunds and credits. These are refund and credit claims made
by corporations or individuals who do not normally file excise tax returns but are
entitled to claim excise tax−related credits on their corporate or personal income tax
         16
returns. IRS must subsequently reclassify these credit claims to properly reflect
them as excise tax credits. IRS refers to these reclassifications as the excise tax
refund/credit certification. IRS compiles the certification based on information from
submission processing campus17 systems. IRS submits refund/credit certification
letters to BPD, which uses them to prepare adjustments to reduce distributions to
trust funds.




16
   Petroleum producers, who usually are assessed fuel excise taxes and pay them to IRS, pass on these
taxes to consumers in the form of higher prices. Consumers who use the fuel for a tax-exempt
purpose, such as farming, can claim a credit for the excise taxes on their personal or corporate income
tax return.
17
   IRS has 10 submission processing campuses, which receive and process tax returns.


Page 7                                                                GAO-03-687R IRS Excise Tax Management Report
Objectives, Scope, and Methodology

The objective of the agreed-upon procedures work was to assist the Transportation
IG in ascertaining whether the net excise tax collections and excise tax certifications
reported by IRS for the fiscal year ended September 30, 2002, were supported by the
underlying records. The objectives of this report are to (1) discuss the underlying
internal control issues that allowed errors identified in the agreed-upon procedures
work to occur, (2) discuss timing issues that have the potential to affect the accuracy
of excise tax distributions, and (3) provide recommendations for effectively
addressing these issues.

We conducted our work primarily from March 2002 through January 2003, with some
follow-up work through April 2003, in accordance with U.S. generally accepted
government auditing standards. We requested comments on a draft of this report
from the Commissioner of IRS. We received written comments from the Deputy
Commissioner for Operations Support and have reprinted the comments in enclosure
I of this report. Further details on our scope and methodology are contained in
enclosure II of this report.

Data Entry Errors Continue to Go Undetected

In conducting the agreed-upon procedures review for fiscal year 2002, we found that
IRS made data entry errors affecting the accuracy of taxpayer account information in
IRS’s master file, and that these errors were not detected by existing review
procedures. The lack of effective review procedures over the entry of excise tax data
increases the risk that erroneous information will be used to prepare the quarterly
excise tax certifications, resulting in incorrect distributions to trust funds.

GAO’s Standards for Internal Control in the Federal Government requires agencies
to implement internal control procedures to ensure the accurate and timely recording
                           18
of transactions and events. It also states that internal controls should be designed to
ensure that ongoing monitoring occurs in the course of normal operations.

In a previous review,19 we reported weaknesses in IRS’s procedures for detecting data
entry errors related to information reported on Form 720 excise tax returns. We
recommended that IRS establish review procedures to ensure the accuracy of excise
tax information entered into the master file. In response, IRS established post-input
review procedures for excise tax returns that report a tax liability of $1 million or
more to verify that information on the returns matches data entered into the master
file. However, IRS does not have comparable procedures for reviewing excise tax



18
   U.S. General Accounting Office, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: November 1999).
19
   U.S. General Accounting Office, Excise Taxes: Internal Control Weaknesses Affect Accuracy of
Distributions to the Trust Funds, GAO/AIMD-99-17 (Washington D.C.: Nov. 9, 1998).



Page 8                                             GAO-03-687R IRS Excise Tax Management Report
data entered using another excise tax−related form, Form 8849, Claim for Refund of
              20
Excise Taxes.

On January 1, 2002, IRS implemented new procedures for recording excise tax
refunds and credits claimed by taxpayers. As part of this change, IRS established a
new set of credit reference numbers to identify the type of excise tax refund or credit
within a taxpayer’s master file account. For example, a claim for a $200,000 refund
on gasoline tax would be recorded as $200,000 to credit reference number 362.
Under IRS’s prior procedures, it would have recorded this refund as a negative
$200,000 under the abstract number 62. This new procedure affected how IRS
recorded and summarized credit information necessary for excise tax certifications,
but did not change how the credits should affect the taxpayer’s ultimate excise tax
liability.

However, in testing a statistical sample of excise tax collections from the first 6
months of fiscal year 2002, we identified 17 instances in which IRS personnel entered
the credit information into the taxpayer’s master file account using both the old and
new method, which resulted in IRS counting these credits twice in the certification
process. We estimate that the net most likely error associated with counting credits
twice is an understatement of $14.1 million, but the understatement could be as high
as $198.2 million. Although we projected the effect of these errors on the population
of items tested, we are not able to project the effect on the certification results
because of the additional procedures IRS performs on the data to derive certified
amounts. However, the effect of double-counting credits resulted in distributing
smaller amounts to the Highway Trust Fund than should have been distributed for the
quarters ended December 31, 2001, and March 31, 2002.

Although IRS ultimately detected and corrected these errors, they were detected
months later by personnel at IRS headquarters and not by reviewers at IRS’s
Cincinnati Compliance Campus. According to IRS, the errors were attributable to
one individual in the Cincinnati Compliance Campus’s Excise Tax Unit who did not
fully comprehend the new procedures. We found that IRS did not have effective
controls in its Cincinnati Excise Tax Unit to timely detect and correct such data entry
errors. Some of these errors went uncorrected for 5 months or longer, and the
corrections were not fully reflected until IRS completed its certification to the
Highway Trust Fund for the quarter ending June 30, 2002. Thus, for the quarters
ended December 31, 2001, and March 31, 2002, these errors resulted in amounts IRS
certified to the Highway Trust Fund being understated. Because IRS made these
corrections in time for their inclusion on the final certification reflected in the trust
fund’s fiscal year-end financial statements, there was no net effect on distributions to
the Highway Trust Fund for fiscal year 2002. Had these errors occurred later in the
year, IRS would not have had the time to make corrections, and the amount of excise
taxes distributed to the Highway Trust Fund would have been less than they should
have been for fiscal year 2002.

20
 Taxpayers use the Form 8849 to claim certain fuel-related refunds, such as nontaxable uses or tax
paid on the resale of fuel previously taxed.



Page 9                                             GAO-03-687R IRS Excise Tax Management Report
Having effective procedures to timely detect and correct data entry errors is essential
to maintaining accurate excise tax information in IRS’s master file. Since the excise
tax data from IRS’s master file serve as the basis for its certification of receipts to
trust funds, the lack of these procedures could lead to erroneous excise tax data in
IRS’s master file, resulting in inaccurate certifications and distributions to trust funds.

Recommendation

We recommend that you direct IRS management to develop and implement post-input
review procedures to verify the accuracy of excise tax credit information in the
master file. In establishing these procedures, IRS could consider establishing a dollar
threshold, similar to the threshold it established for its reviews of excise tax
assessment information on the Form 720 excise tax returns, that would trigger post-
input verification of excise tax credit information.

IRS’s Comments and Our Evaluation

IRS agreed with our recommendation. In its response, IRS stated that it was working
with the Cincinnati Compliance Campus to develop and implement post-input review
procedures to verify the accuracy of excise tax credit information posted to the
master file. We will evaluate the effectiveness of IRS’s efforts in conjunction with our
fiscal year 2003 agreed-upon procedures review.

Excise Tax Certification Errors Continue to Go Undetected

In conducting the agreed-upon procedures review for fiscal year 2002, we identified
errors on IRS’s excise tax certifications that were not detected by supervisory review.
The lack of effective supervisory review increases the risk that errors will be made in
the preparation of excise tax certifications and that such errors will not be detected
on a timely basis, resulting in incorrect excise tax distributions to the trust funds.
GAO’s Standards for Internal Control in the Federal Government requires agencies
to implement internal control procedures to ensure the accurate and timely recording
of transactions and events. In addition, Standards for Internal Control in the
Federal Government requires that qualified and continual supervision be provided to
ensure that internal control objectives are achieved.

As discussed previously, IRS relies on a combination of manual and automated
procedures to prepare its excise tax certifications. This process is very complex,
                                                     21
cumbersome, and prone to error. In prior reviews, we reported weaknesses in IRS’s
controls over its certification process. At that time, we recommended that IRS (1)
develop, document, and implement detailed written procedures for summarizing data
used to prepare trust fund certifications, (2) establish procedures requiring IRS
personnel to review distribution rates provided by OTA before those rates are used in
the certification, and (3) implement review procedures over its process for
21
 GAO/AIMD-99-17 and U.S. General Accounting Office, Internal Revenue Service: Recommendations
to Improve Financial and Operational Management, GA0-01-42 (Washington D.C.: Nov. 17, 2000).


Page 10                                        GAO-03-687R IRS Excise Tax Management Report
summarizing data used in its certifications. In response to our prior
recommendations, IRS created a checklist to guide reviewers and document the
review of the certification results. In addition, IRS finalized written procedures for its
certification process in November 2002.

Although the checklist assists IRS reviewers in identifying simple mathematical
errors, we continued to find logical and analytical errors in fiscal year 2002 that were
not detected by supervisory review. For example, a report used by an IRS analyst to
prepare the refund certification for the quarter ended December 31, 2001, contained
erroneous amounts for gasohol and bus diesel fuel tax refunds. As a result, IRS
overstated its refund certification for the Highway Trust Fund for the quarter by
approximately $81 million. We readily identified the error because the reported
amounts for one of these taxes varied significantly from previous quarters.
Nevertheless, IRS did not detect the error even though the certification results passed
through multiple levels of review. Had IRS not made a correction after we brought
the matter to its attention, distributions to the Highway Trust Fund would have been
approximately $81 million less than they should have been in fiscal year 2002.

In another instance, we discovered that IRS reported refund amounts as credits and
credit amounts as refunds on its refund/credit certification letters for both the
Highway Trust Fund and the Airport and Airway Trust Fund for the quarter ended
September 30, 2002. Generally, IRS-certified refunds for the Highway Trust Fund are
one and a half times as large as the certified credits for the fund. To have a situation
where the opposite occurred should have alerted the reviewer to a potential error.
Although we readily identified the errors during our review of the schedule
accompanying the certification letter, IRS did not detect the errors through its review
process. These errors did not affect the accuracy of the distributions to the Highway
Trust Fund or the Airport and Airway Trust Fund in fiscal year 2002 because BPD
adjusts trust fund distributions using the combined amount of refunds and credits.
However, this is an example of a logical error that was not detected by IRS reviews.

We had identified similar problems in our fiscal year 2001 review. Specifically, IRS
also reported refunds as credits and credits as refunds on its refund/credit
certification for the quarter ended March 31, 2001. Also, in our fiscal year 2001
review, we found that IRS used the wrong excise tax and distribution rates for 10
percent gasohol on its Highway Trust Fund receipt certification for the quarter ended
March 31, 2001. The IRS analyst used the excise tax and distribution rate table that
was in effect on December 22, 2000, rather than the rate table that became effective
on January 1, 2001. Consequently, IRS misstated certified collections to both the
Highway Account and the Mass Transit Account of the Highway Trust Fund, resulting
in about $1 million less being distributed to the Highway Trust Fund.

In response to our finding that it had reversed reported refund and credit amounts in
2002, IRS added another step to the review checklist to prevent this error. However,
while the checklist can assist reviewers in verifying certification results, it cannot
substitute for an in-depth understanding of the certification process. For example,
although the checklist contains a specific procedure to verify that the analyst used
the correct tax and distribution rate for each type of taxable good or service (e.g., for


Page 11                                      GAO-03-687R IRS Excise Tax Management Report
gasohol), it does not assist a reviewer in determining whether the analyst used the
correct rate table (e.g., for the correct time period). Adding another step to the
checklist each time a new problem surfaces will not ensure that proper reviews of the
certification results are conducted.

While we do not specifically know why IRS’s supervisory review procedures failed to
detect these errors, we did note a lack of consistency in the supervisory review
responsibility. Specifically, during fiscal year 2002, four different officials were
responsible for reviewing the certifications. A comprehensive understanding of IRS’s
certification process is essential to detecting logical and analytical errors made by
analysts. Absent this understanding, officials responsible for reviewing excise tax
certifications may continue to lack the ability to perform an effective review of the
certifications. Given the errors we continue to find in our review of IRS’s
certification process and their potential to significantly affect the accuracy of the
associated distributions to trust funds, more needs to be done to ensure that
supervisory reviews over the certifications are effective.

Recommendations

We recommend that you direct IRS management to
•      investigate why certification errors continue to go undetected through IRS’s
       review procedures and
•      develop and implement an action plan to improve the certification review process.

IRS’s Comments and Our Evaluation

IRS agreed with our recommendations. In its response, IRS stated that it has a new
management team in place to review the current excise tax certification process and
to develop an action plan for improving the certification reviews. We will evaluate
the effectiveness of IRS’s efforts in conjunction with our fiscal year 2003 agreed-upon
procedures review.


Changes to Certification Process Were Not Effectively Coordinated

As discussed earlier, the collection, distribution, and certification of excise tax
revenues to trust funds are performed by four component entities within Treasury–--
OTA, FMS, BPD, and IRS. Coordination among these entities is essential to ensure
the proper distribution of excise tax revenue to trust funds. In a prior review, we
reported a deficiency in IRS’s procedures for using OTA information in its
certification process. Specifically, we reported that IRS used tax and distribution
rates from OTA without first verifying their accuracy.22 In response, IRS established
an informal working group within Treasury specifically to discuss and coordinate
issues related to trust fund tax revenue distributions. However, in conducting our


22
     GAO/AIMD-99-17.


Page 12                                       GAO-03-687R IRS Excise Tax Management Report
agreed-upon procedures review for fiscal year 2002, we noted that effective
coordination was not always achieved.

As we previously discussed, IRS, as part of its receipt certification process in prior
years, deducted credits claimed by taxpayers from their excise tax liability before
applying their payments to the liability amount. Thus, IRS-certified excise tax
receipts were reduced by credit claims. However, IRS believed that the information
would be more useful, both internally and to the Department of Transportation, if it
summarized and reported these credits separately rather then applying them against
the tax liability amount. Therefore, in fiscal year 2002, IRS developed changes to the
way it records credit information in its computer systems, as well as to the way it
accounts for and reports this information in its certifications.

On January 1, 2002, IRS implemented these procedural and system changes to its
method for recording and summarizing excise tax credits, including changes to its
procedures for recording taxpayer refund claims submitted on Form 8849. Although
IRS officials told us that they had notified the Treasury working group of the planned
changes, this notification was not documented in the form of a letter, memorandum,
or minutes to the Treasury working group meeting. Further, IRS did not obtain
written affirmation from FMS or BPD that these entities understood the effect these
changes would have on the information reported to them. In fact, FMS and BPD were
unable to use the revised form of certification information to make necessary
adjustments to the trust fund distributions. Consequently, IRS had to add steps to its
certification process to revert to its previous reporting format in order to make its
certification data usable to these entities. As a result, IRS further complicated its
already complex certification process. Although we did not identify any certification
errors directly attributable to the changes in procedure, the added complexity
increases the likelihood that errors could be made and go undetected by IRS’s current
review procedures.

Recommendation

We recommend that you direct IRS management to communicate in writing any
potential changes in IRS’s certification process to other Treasury entities that use the
certification information, and to obtain concurrence from these entities prior to
implementing such changes.

IRS’s Comments and Our Evaluation

IRS agreed with our recommendation. In its response, IRS stated that it plans to
provide documented recommendations to the excise tax working group for potential
changes to the certification process. We will evaluate the effectiveness of IRS’s
actions in conjunction with our fiscal year 2003 agreed-upon procedures review.




Page 13                                     GAO-03-687R IRS Excise Tax Management Report
Certification Time Frame Will Not Accommodate Accelerated Reporting

As discussed previously, under IRS’s current certification process, IRS certifies
collections for each quarter about 5 and one-half months after the quarter ends. As a
result of this delay, excise tax receipts for the fourth quarter of fiscal year 2002,
which ended September 30, 2002, were not certified until March 2003. Consequently,
adjustments to initial distributions of excise tax receipts for the fourth quarter that
were based on IRS’s certification were not recorded in time to be reflected in the
trust funds’ financial statements for fiscal year 2002, which OMB required to be
issued by February 1, 2003.

Beginning with agencies’ fiscal year 2004 performance and accountability reports,
OMB will require the issuance of these reports, including the agencies’ audited
financial statements, by November 15. To prepare for this, the Department of
Transportation is planning to accelerate its fiscal year 2003 reporting date to
December 2003. This accelerated reporting date will exacerbate the effects of the lag
between the collection of excise tax receipts and their subsequent certification by
IRS. As a result, under the current certification time frame, IRS’s certification for the
third quarter, historically completed in December, would not be completed in time
for any adjustments to the initial distribution to the trust funds to be made and
reflected on the trust funds’ financial statements for fiscal year 2003. Because the
certification of fourth quarter excise tax receipts also would not be completed prior
to the issuance of the financial statements, this means that 6 months of excise tax
distributions reported in the trust funds’ financial statements would not have been
certified by IRS, increasing the potential for significantly inaccurate distributions.

We believe the opportunity exists for IRS to accelerate the timing of its excise tax
receipt certifications. IRS has indicated that it needs the 5 and one-half month period
between the end of a quarter and completion of the certification to allow for
submission and processing of returns and for recording, reviewing, and analyzing
payment and tax return data. However, our review of IRS’s certification data for 4
quarters23 shows IRS has historically received and recorded at least 90 percent of the
Form 720 excise tax returns related to the Highway Trust Fund and the Airport and
Airway Trust Fund 2 months prior to its cutoff for initiating the certification. Our
analysis further shows that fewer than 100 of the largest payers of excise taxes—
those with liabilities of $10 million or more per quarter—account for over 91 percent
of certified receipts to the Highway Trust Fund and over 85 percent of certified
receipts to the Airport and Airway Trust Fund.

The combination of (1) excise taxes reported in tax returns with liability amounts
below $10 million that are received and recorded by IRS 2 months prior to its
certification cutoff and (2) excise taxes reported in tax returns with liability amounts

23
 We reviewed data from IRS’s Collection Certification System and master file from the quarters ended
June 30, 2001, September 30, 2001, December 31, 2001, and March 31, 2002. IRS had made these data
available to us for our fiscal years 2002 and 2001 agreed-upon procedures reviews and IRS financial
statement audits.



Page 14                                           GAO-03-687R IRS Excise Tax Management Report
of $10 million or more accounts for more than 96 percent of the taxes IRS certified to
both the Highway Trust Fund and the Airport and Airway Trust Fund for those
quarters. Therefore, IRS could accelerate the timing of its certifications of excise tax
receipts to the Highway Trust Fund and the Airport and Airway Trust Fund by at least
2 months by implementing procedures to ensure that it has timely received and
recorded tax returns from the largest payers of excise taxes.

In each of the 4 quarters we reviewed, IRS data indicate that it has generally received
over 70 percent of the large returns 2 weeks after the return due date. By taking a
more proactive approach—tracking the status of these taxpayers’ returns, following
up with those who have not filed timely to encourage filing, and ensuring prompt
processing of large returns—we believe IRS should be able to accelerate completion
of its certification of excise tax receipts without significantly increasing the potential
for large amounts of quarterly receipts to go uncertified.

Unless IRS establishes procedures to allow it to significantly accelerate its
certification of excise tax revenues to trust funds, the amount of annual excise tax
revenues reported by the Department of Transportation for the Highway Trust Fund
and the Airport and Airway Trust Fund for fiscal year 2003 and beyond will include 6
months of excise tax revenue distributions based on estimates. To the extent these
estimates differ significantly from the actual amounts that should have been
distributed to the trust funds, the result could be both significantly inaccurate
distributions and, in the case of the Highway Trust Fund, incorrect allocations of
                    24
revenues to states.

Recommendations

To enable IRS to accelerate its excise tax receipt certification process, we
recommend that you direct IRS management to implement procedures to proactively
ensure the timely receipt and recording of the largest excise tax returns. Specifically,
IRS management should develop and implement procedures at the Cincinnati
Campus to

•    annually identify excise taxpayers with the largest excise tax liabilities affecting
     the Highway Trust Fund and the Airport and Airway Trust Fund. In identifying
     these taxpayers, IRS should consider the potential effect on trust fund
     distributions if one or more of these taxpayers’ returns were omitted from its
     certification;
•    track the status of tax return filings for the largest payers of excise taxes and
     contact these taxpayers if the submission processing campus has not received
     their tax returns by 2 weeks after the due date; and


24
 The Transportation Equity Act for the 21st Century, Pub. L. No. 105-178, 112 Stat. 107 (1998) enhanced
the link between the amount of funds received by states and the amount of tax receipts credited to the
Highway Trust Fund by requiring that highway program funds be distributed to states on the basis of
annual highway account receipts.



Page 15                                             GAO-03-687R IRS Excise Tax Management Report
•   monitor the receipt and processing status of these large returns to ensure that
    they are promptly recorded in IRS’s master file prior to certifying excise tax
    distributions.

IRS’s Comments and Our Evaluation

IRS agreed with this issue and indicated that it is taking action to address our
findings. In its response, IRS stated that it would identify and provide a list of the top
100 excise taxpayers to the Cincinnati Submission Processing and Compliance
Campuses for the identification and expedited processing of these taxpayers’ returns.
Additionally, IRS stated it was working with the Cincinnati Compliance Campus to
implement additional monitoring of the top 100 excise taxpayers to ensure timely
receipt of excise tax returns and will conduct an analysis of these taxpayers’ receipt
pattern to support modifying IRS’s current timeline for contacting the taxpayers for
submission of their returns.

While IRS does not plan to accelerate its certification of excise tax receipts to trust
funds for the third quarter of fiscal year 2003, it stated that it would conduct “mock”
nonpublished certifications to determine the impact of an accelerated 4-month
certification on all trust funds. In our discussions with IRS officials, they have stated
that IRS plans to share this information with the Department of Transportation’s
auditors so that they can determine the extent to which adjustments may be required
to reported excise tax revenues on the trust funds’ fiscal year 2003 financial
statements. We will evaluate IRS’s actions in conjunction with our fiscal year 2003
agreed-upon procedures review.

                                          -----

This report contains recommendations to you. The head of a federal agency is
required by 31 U.S.C. 720 to submit a written statement on actions taken on these
recommendations. You should send your statement to the Senate Committee on
Governmental Affairs and the House Committee on Government Reform within 60
days after the date of this report. A written statement also must be sent to the House
and Senate Committees on Appropriations with the agency’s first request for
appropriations made over 60 days after the date of this report.

This report is intended for use by the management of IRS. We are sending copies to
the Chairmen and Ranking Minority Members of the Senate Committee on
Appropriations; Senate Committee on Finance; Senate Committee on Governmental
Affairs; Senate Committee on the Budget; Subcommittee on Transportation, Treasury
and General Government, Senate Committee on Appropriations; Subcommittee on
Taxation and IRS Oversight, Senate Committee on Finance; and the Subcommittee on
Oversight of Government Management, the Federal Workforce, and the District of
Columbia, Senate Committee on Government Affairs. We are also sending copies to
the Chairmen and Ranking Minority Members of the House Committee on
Appropriations; House Committee on Ways and Means; House Committee on
Government Reform; House Committee on the Budget; Subcommittee on
Transportation, Treasury, and Independent Agencies, House Committee on


Page 16                                      GAO-03-687R IRS Excise Tax Management Report
Appropriations; Subcommittee on Government Efficiency and Financial Management,
House Committee on Government Reform; and the Subcommittee on Oversight,
House Committee on Ways and Means. In addition, we are sending copies of this
report to the Chairman and Vice Chairman of the Joint Committee on Taxation, the
Director of the Office of Management and Budget, the Secretary of the Treasury, the
Secretary of Transportation, and the Inspector General of the Department of
Transportation. Copies will be made available to others upon request. The report is
also available at no charge on GAO’s Internet site, at http://www.gao.gov.

We acknowledge and appreciate the cooperation and assistance provided by IRS
officials and staff during our fiscal year 2002 review. If you have any questions or
need assistance in addressing these matters, please contact Charles Payton, Assistant
Director, at (213) 830-1084.

Sincerely yours,




Steven J. Sebastian
Director
Financial Management and Assurance




Page 17                                    GAO-03-687R IRS Excise Tax Management Report
Enclosure I

Comments from the Internal Revenue Service




Page 18                            GAO-03-687R IRS Excise Tax Management Report
Page 19   GAO-03-687R IRS Excise Tax Management Report
Page 20   GAO-03-687R IRS Excise Tax Management Report
Enclosure II

Objectives, Scope, and Methodology

The objective of the agreed-upon procedures work was to assist the Inspector
General of the Department of Transportation in ascertaining whether the net excise
tax collections and excise tax certifications reported by IRS for the fiscal year ended
September 30, 2002, were supported by the underlying records. We did not perform
work on excise taxes collected by other Treasury bureaus, such as the Customs
Service and the Bureau of Alcohol, Tobacco, and Firearms.

In performing the agreed-upon procedures, we gained an understanding of the
internal controls over the excise tax collection and certification process. The
objectives of this report were to (1) discuss the underlying internal control issues that
allowed errors identified in the agreed-upon procedures work to occur, (2) discuss
timing issues that have the potential to affect the accuracy of excise tax distributions,
and (3) provide recommendations for effectively addressing these issues.

To accomplish our objectives, we examined, on a test basis, evidence supporting the
net excise tax collection amounts related to the Highway Trust Fund and the Airport
and Airway Trust Fund reported in the Collection Certification System.
We used dollar unit sampling to select a sample of 94 prorated Highway Trust
Fund−related excise tax collections from the audit files25 for the first 6 months of
fiscal year 2002, using a confidence level of 80 percent, a test materiality of $315
million, and an expected error amount of $94.5 million.

We selected a sample of 62 prorated Airport and Airway Trust Fund−related excise
tax collections from the audit files for the first 6 months of fiscal year 2002, using a
confidence level of 80 percent, a test materiality of $91 million, and an expected error
amount of $27.3 million.

For each prorated excise tax collection sampled, we

• checked to see that the assessment amount on the tax return for the sampled
     abstract agreed with the amount recorded in IRS’s master file,
•    checked the mathematical accuracy of the taxpayers’ calculations on the tax
     returns for the related abstract, and
•    recomputed the prorated collection amount based on information from the master
     file and compared this amount to the sample items selected from the Collection
     Certification System audit file.

We also performed detailed testing on the population of collections not designated as
related to the Highway Trust Fund or the Airport and Airway Trust Fund to determine


25
 The Collection Certification System produces what IRS refers to as “audit files.” These audit files
contain the individual prorated collections, by abstract and taxpayer identification number, that make
up the certified total amounts for each abstract.


Page 21                                             GAO-03-687R IRS Excise Tax Management Report
if they contained any Highway Trust Fund or Airport and Airway Trust Fund excise
tax collections.

Further, we performed the following procedures on IRS’s certifications:

• We verified the mathematical accuracy of the totals on the certification letters for
  the Highway Trust Fund and Airport and Airway Trust Fund.
• We traced certified amounts for selected excise taxes from the certification letters
  through summary schedules to the supporting reports.

To determine the percentages of amounts certified to the Highway Trust Fund and
Airport and Airway Trust Fund that are accounted for by excise tax returns with
liabilities of $10 million or more and the amounts from other excise tax returns
received and recorded in IRS’s master file 2 months earlier than the certification
cutoff, we analyzed IRS’s Collection Certification System and master file data. IRS
made these sources available to us for our fiscal years 2002 and 2001 agreed-upon
procedures reviews and fiscal years 2002 and 2001 IRS financial statements audits.
These included the audit support files from the quarters ended June 30, 2001,
September 30, 2001, December 31, 2001, and March 31, 2002. Using these data, we

•   identified excise tax returns by tax period and categorized excise taxes for the tax
    returns identified that related to the Highway Trust Fund and the Airport and
    Airway Trust Fund using data from IRS’s audit support file, and
•   summed the amounts related to the Highway Trust Fund and the Airport and
    Airway Trust Fund for all tax returns with tax liabilities of $10 million or more and
    amounts related to tax returns with liabilities below $10 million that had been
    recorded in IRS’s master file 2 months earlier than the certification date.

We conducted our work primarily from March 2002 through January 2003, with some
follow-up work through April 2003, in accordance with U.S. generally accepted
government auditing standards.

We requested comments on a draft of this report from the Commissioner of IRS. We
received written comments from the Deputy Commissioner for Operations Support.




Page 22                                      GAO-03-687R IRS Excise Tax Management Report
Enclosure III

GAO Contacts and Staff Acknowledgments

GAO Contacts

Charles E. Payton, (213) 830-1084
Ted Hu, (213) 830-1108

Acknowledgments

Staff making key contributions to this report were David Elder, Gail Luna, Esther
Tepper, Julia Matta, and Sharon Byrd.




(196005)




Page 23                                    GAO-03-687R IRS Excise Tax Management Report
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