oversight

Reliability of Information on Taxpayers Claiming Many Withholding Allowances or Exemption from Federal Income Tax Withholding

Published by the Government Accountability Office on 2003-09-15.

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

United States General Accounting Office
Washington, DC 20548

          September 15, 2003


          The Honorable Elton Gallegly
          House of Representatives

          Subject:       Reliability of Information on Taxpayers Claiming Many Withholding
                         Allowances or Exemption from Federal Income Tax Withholding

          Dear Mr. Gallegly:

          When taxpayers claim more withholding allowances than they are entitled to or
          improperly claim exemption from withholding, either no tax or too little tax is
          withheld from their wages. As a result, some taxpayers end up owing the Internal
          Revenue Service (IRS) additional taxes, and if the taxes are not paid on time, they
          become delinquent. This report responds to your request for information on these
          taxpayers.

          Specifically, you asked that we provide you with information on (1) how many
          taxpayers claimed more than 10 allowances for federal income tax withholding
          purposes and (2) how many taxpayers claimed exemption from federal income tax
          withholding and, of those taxpayers, what proportion did not file federal income tax
          returns and had invalid Social Security numbers. However, because of concerns
          about the completeness and currency of the information reported to IRS on taxpayers
          who claimed more than 10 withholding allowances or taxpayers who claimed
          exemption from withholding, we could not use it to respond to your questions. This
          report discusses why we could not use IRS’s information to answer your questions
          and briefly describes IRS’s proposals to help address this problem. To perform our
                                                                                       1
          work, we analyzed information from IRS’s Questionable Form W-4 database and
          interviewed IRS officials responsible for managing the Questionable Form W-4
          program. Further details on our scope and methodology are provided later in this
          report.

          Results in Brief

          We have two concerns about the information that IRS maintains on taxpayers who
          claimed more than 10 withholding allowances or exemption from federal tax
          withholding that preclude us from using it to answer your questions. First, we are
          concerned about the completeness of the information because a significant number
          of employers may not send IRS the required forms. Second, some of the information
          may not be current—it may not reflect the current withholding status of some
          1
              This refers to IRS’s Questionable Form W-4 Case Control System.


                                                GAO-03-913R Reliability of IRS’s Form W-4 Information
taxpayers. While acknowledging the limits of the information for answering your
questions, IRS officials told us that the information is useful for tax compliance
purposes. Also, the officials said that IRS has efforts under way intended to influence
employers to comply with the reporting requirement. IRS provided oral comments on
a draft of this report stating that it generally agreed with our findings. IRS’s
comments are summarized later in this report.

Background

Section 3402 of the Internal Revenue Code requires employers to withhold income
tax from wages and other forms of income. It outlines the basis for claiming
withholding allowances or exemption from withholding and specifies the general
content of the IRS Form W-4—Employee’s Withholding Allowance Certificate (Form
W-4) that employees submit to employers when making their withholding allowance
claims.

Each employee is required to submit a completed Form W-4 to his or her employer.
Employees are to use the worksheet attached to the Form W-4 to determine the
number of withholding allowances they should claim. The worksheet’s instructions
consider, among other things, a taxpayer’s filing status, number of dependents he or
she claims on the tax returns, and eligibility for the child tax credit. For example, a
married taxpayer filing a joint tax return who has four dependent children and large
itemized deductions may be eligible to claim more than 10 allowances. Some
taxpayers not claiming a specific number of allowances may claim exemption from
federal income tax withholding. Generally, taxpayers can claim exemption from
withholding if they had no tax liability for the previous year and expect to have none
in the current year.

Treasury regulations2 require that employers send IRS “questionable Form W-4s.”3
According to IRS, a questionable Form W-4 is any Form W-4 on which a taxpayer
claims more than 10 withholding allowances or claims exemption from withholding
with over $200 per week in wages. The information that IRS receives from employers
on questionable Form W-4s is maintained in the Questionable Form W-4 database.

IRS uses information in the database to identify potential noncompliance with its
withholding guidelines. IRS’s tax examiners at the Fresno Computing Center review
selected questionable Form W-4 cases to determine if the withholding is appropriate
based on the taxpayer’s filing history and may contact the taxpayer if additional
information is needed to substantiate the withholding allowances claimed. If the tax
examiners determine that the withholding allowances claimed are incorrect or if
taxpayers do not respond to IRS contacts, the tax examiners mail “lock-in” letters to
the taxpayers’ employers directing them to disregard the taxpayers’ Form W-4s as
filed and to withhold at the rate for a single person with zero allowances or at some
other rate determined by the tax examiners.



2
 Treasury Regulation §31.3402(f)(2)-1(g)(1)-(2).
3
 If a new employee does not give the employer a completed Form W-4, the employer is to withhold tax
as if the employee is single, with no withholding allowances.


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Findings

Because of concerns about the completeness and currency of the information in IRS’s
Questionable Form W-4 database, we cannot respond to your questions. According
to our guidance for assessing the reliability of computer-processed data,4 we cannot
use data that are significantly incomplete, inaccurate, and not up to date and
subsequently could lead to an unintentional or incorrect message.

We are concerned about whether the information in IRS’s Questionable Form W-4
database is sufficiently complete because some employers likely do not send IRS
withholding information on employees who claim more than 10 allowances or claim
exemption from federal income tax withholding, as required. IRS program officials
told us that they do not know the extent to which employers might not be sending in
                          5
questionable Form W-4s. However, IRS’s analysis of large employers with 1,000 or
more employees that sent in questionable Form W-4s provides some evidence that a
significant number of large employers may not be reporting Form W-4 information to
IRS. This analysis showed that 25 percent of the employers with 1,000 or more
employees in its Large and Medium-Size Business (LMSB) and Small Business/Self-
Employed (SB/SE) divisions that filed employment tax returns in tax year 2001 sent
in questionable Form W-4s to IRS (1,933 of 7,713 employers). Similarly, 16 percent of
the employers with 1,000 or more employees in IRS’s Tax Exempt/Government
Entities Division had submitted questionable Form W-4s (610 of 3,888 employers).
Although the number of questionable Form W-4s IRS might receive from individual
employers can vary, we question whether 75 percent of large employers with 1,000 or
more employees in IRS’s LMSB and SB/SE divisions could have no employees who
submitted questionable Form W-4s. Information from IRS showed that IRS received
about 800,000 questionable Form W-4s from 33,000 employers in calendar year 2002
or, on average, about 25 forms from each employer who submitted. This average
includes many employers with fewer than 1,000 employees.

Under current law, IRS does not have statutory authority to impose a penalty to
enforce employer compliance with the reporting requirement. The reporting
requirement was promulgated in Treasury regulations.

In addition, IRS’s questionable Form W-4 database may not accurately reflect the
current withholding status of some taxpayers. In particular, if an employee who
previously claimed more than 10 allowances or claimed exemption from federal
income tax withholding submitted a new Form W-4 claiming 10 or fewer allowances
or not claiming exemption from withholding, the database would continue to show
the earlier information. This is because employers are only required to send




4
  U.S. General Accounting Office, Applied Research and Methods: Assessing the Reliability of
Computer-Processed Data (External Version 1), GAO-03-273G (Washington, D.C.: October 2002).
5
  IRS conducted questionable Form W-4 compliance checks in the 1980s based on a representative
sample of 3,331 employers. Less than 50 percent of the questionable Form W-4s received by employers
were reported to IRS.


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questionable Form W-4s to IRS.6 There is no requirement for employers to forward to
IRS new Form W-4s that do not meet the questionable Form W-4 criteria.

IRS officials acknowledged the limitations of IRS’s Questionable Form W-4 database
for answering your questions. However, the officials said that the database provides
IRS with useful leads in determining possible underwithholding issues that may lead
to noncompliance. They told us that they use the database for identifying taxpayers
who may be underwithholding taxes since those taxpayers also may not file tax
returns. IRS’s tax examiners review certain questionable Form W-4s to substantiate
                               7
taxpayers’ withholding claims. When the taxpayers’ claims cannot be substantiated,
the tax examiners issue “lock-in” letters to both the taxpayers’ employers and the
taxpayers stating that the taxpayers’ withholdings are to be adjusted based on IRS’s
investigation.

We asked IRS officials if they had plans to improve employers’ compliance with the
reporting requirement. IRS officials told us that they have initiated reengineering
efforts to improve the existing system and database, allowing them to, among other
things, improve the integration of other compliance databases to detect
noncompliance and expedite the issuance of lock-in letters. In February 2003, all of
IRS operating divisions and a panel of external stakeholders participated in a Form
W-4 compliance summit. During the summit, the participants identified a number of
suggestions to improve employer and taxpayer compliance with withholding
requirements, including improvements to forms, on-line information, and services
such as W-4 calculator and development of frequently asked questions for IRS’s Web
site. The officials also said that IRS’s divisions will continue to work together to
identify outreach and educational strategies to educate employers, stem
noncompliance, and encourage voluntary employer reporting of potential abusive
schemes related to withholding evasion. Because the activities were new or being
implemented, we did not evaluate them to determine their effectiveness in improving
employers’ compliance with the reporting requirement.

Concluding Observations

Considering what we learned about the reliability of the data, questions may be raised
about the value of IRS’s efforts to maintain the Questionable Form W-4 database. For
this reason, we are sending a separate letter to the Commissioner of Internal Revenue
describing what we learned and recommending that he assess whether IRS’s
Questionable Form W-4 program should continue in its current form.

Agency Comments and Our Evaluation

We asked IRS to provide us oral comments on a draft of this report. On August 27,
2003, we received comments from the Director of Filing and Payment Compliance,
Wage and Investment Division. The Director generally agreed with our findings and

6
  The database also includes information on employees whose questionable Form W-4s were reviewed
by IRS tax examiners and were subsequently adjusted to levels below the criteria for submission to
IRS.
7
  IRS’s tax examiners were reviewing cases of taxpayers who have histories of noncompliance, that is,
nonfilers and balance due taxpayers.


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acknowledged the limitations of the Questionable Form W-4 database in providing
information we could use to respond to your questions. IRS stated that although the
database did not meet our standards for responding to your questions, it believes that
the database serves its intended purpose of housing data to facilitate its efforts to
address underwithholding at its source, thereby increasing compliance early and
preventing future delinquencies that can be both costly for IRS to resolve and
burdensome to taxpayers. The comments also stated that reengineering efforts were
recently initiated to improve the Questionable Form W-4 program as we mentioned
earlier in our report.

Scope and Methodology

To perform our work, we interviewed IRS’s W&I Operating Division staff, who were
responsible for managing the Questionable Form W-4 program, and IRS Detroit
Computing Center staff, who were responsible for maintaining the Questionable
Form W-4 database. Based on these contacts, we obtained an understanding of how
the program operates, determined how IRS monitors employers’ compliance with
Form W-4 reporting requirements to help us assess the reliability of the Questionable
Form W-4 database, and obtained relevant documentation.

We analyzed IRS’s Questionable Form W-4 database to determine what information
IRS maintains on taxpayers who claimed more than 10 withholding allowances or
claimed exemption from federal income tax withholding. According to IRS, the
database primarily covers a 4-year period. The database we reviewed primarily
covered tax years 1998-2002. We assessed the reliability of IRS’s Questionable Form
W-4 database by performing electronic testing, reviewing existing information about
the data and the system IRS created, and interviewing agency officials knowledgeable
about the data and the system. As stated in the report, we determined that the data
were not sufficiently reliable to answer your questions.

In addition, we reviewed various IRS documents and publications pertaining to tax
withholding that indicate the responsibilities of taxpayers and employers. We also
reviewed IRS and Treasury Inspector General for Tax Administration reports related
to IRS’s questionable Form W-4 program. We conducted our work from October 2002
through June 2003 in accordance with generally accepted government auditing
standards.

                                       - - - - -



We are sending copies of this report to the Commissioner of Internal Revenue and
other interested parties. We will make copies available to others upon request. This
report will also be available at no charge on GAO’s Web site at http://www.gao.gov.




Page 5                        GAO-03-913R Reliability of IRS’s Form W-4 Information
If you have any questions about this report, please contact me at (202) 512-9110 or by
E-mail at whitej@gao.gov. Key contributors to this report were Charlie Daniel and
Arthur L. Davis.

Sincerely yours,




James R. White
Director, Strategic Issues




(440170)


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