Tax Administration: Status of IRS' Test of a Business Information Returns Program

Published by the Government Accountability Office on 1990-05-29.

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

                                                                                  ”   :
.“),   ~   IJnikd   States   General   Accounting   Office   ----.

GAO        Report to the Chairman, S$%committee
           on Commerce, Consumer, and Monetary
           Affairs, Committee on Government
           Operations, House of Represerdatives
May 1990
           Status of IRS’ Test of a
           Business Information
           Returns Program

             United States
             General Accounting Office
             Washington, D.C. 20548

             General   Government   Division


             May 29,199O

             The Honorable Doug Barnard, Jr.
             Chairman, Subcommittee on Commerce,
               Consumer, and Monetary Affairs
             Committee on Government Operations
             House of Representatives

             Dear Mr. Chairman:

             This is our second report in response to your May 6, 1987, request to
             monitor the Internal Revenue Service’s (IRS) plans, time frames, and
             accomplishments concerning its evaluation of a business document-
             matching program.’ Like the individual document-matching program,
             this program could be designed to computer-match businesses’ informa-
             tion returns to their income tax returns to identify those businesses that
             may have underreported their income (underreporters) or failed to file
             tax returns (nonfilers). Third-party sources, like banks, are required to
             file information returns with IRS to report payments, such as interest
             and dividends, that they made to individuals. IRSalso requires the filing
             of information returns on payments made to sole proprietorships and
             partnerships but does not require them on payments made to most cor-
             porations. In 1988, IRSreceived about 31 million information returns on
             payments made to businesses, including corporations, even though these
             returns were not required.

             As discussed in our first report, IRS officials recognized that more could
Background   be done to test the feasibility of a business document-matching program
             and developed an action plan to do so. The plan contains three initia-
             tives scheduled for completion by December 31, 1990. IRS plans to (1)
             develop a cross-reference file to help associate sole proprietors’ informa-
             tion returns with their tax returns, (2) evaluate the merits of using
             information returns to identify partnership and corporate nonfilers, and
             (3) determine the costs and benefits of a document-matching program
             that could be established if information returns are required for pay-
             ments made to corporations. This report discusses the progress IRS had
             made as of September 30, 1989, in completing these action plan

             Page 1                                GAO/GGD-9058 Information   Returns   Program
                   IRS met all of the scheduled completion dates for the first initiative con-
Results in Brief   cerning sole proprietors. It was 6 months late in completing the second
                   initiative on partnership and corporate nonfilers. Under the third initia-
                   tive, IRSwas 7 months late in completing work on an interim milestone
                   for the computer costs of a corporate document-matching program. Dur-
                   ing the Spring of 1990, IRS expects to issue interim benefit studies, which
                   were due in December 1989. IRS officials said resource constraints and
                   higher priority work contributed to these delays but that this slippage
                   would not affect the December 31, 1990, action plan completion date.

                   Under the first initiative, IRS successfully tested a cross-reference file
                   that will allow IRS to associate sole proprietors’ information returns filed
                   under their employer identification numbers (EIN) with income tax
                   returns filed under their Social Security numbers (SSN). Beginning in
                   1990, the file will allow IRSto use information returns to identify sole
                   proprietors who may have underreported their income or failed to file
                   income tax returns.

                   Under the second initiative, IRS concluded from its study of 1,610 poten-
                   tial nonfilers that field contact with potential business nonfilers identi-
                   fied with information returns was not cost effective because it obtained
                   only 16 delinquent tax returns per 100 cases. In comparison, IRS
                   obtained 32 returns per 100 cases in its business nonfiler program,
                   known as the stopfiler program. IRS’ study should not have included
                   cases for which it had not completed its investigations of potential
                   nonfilers or for which it had data showing that the business had filed a
                   return. Adjusting the results to exclude these cases yields a higher rate
                   of 22 returns per 100 cases. Accordingly, we concluded that using infor-
                   mation returns to identify potential business nonfilers would comple-
                   ment IRS’ stopfiler program, which does not use information returns.

                   In written comments on our draft report, the Commissioner of Internal
                   Revenue said IRS will continue to explore ways to use information
                   returns to identify business nonfilers and will test the productivity of
                   sending correspondence to potential business nonfilers that IRS identified
                   by using information returns.

                   Under the third initiative, IRS estimated that the computer costs for per-
                   sonnel, space, equipment, and operations would be $166 million over 7
                   years. These costs are in line with the costs of IRS’ individual document-
                   matching program. IRS is still examining corporate tax returns to obtain
                   the data needed to estimate program benefits. IRS plans to complete its

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                      costs and benefits studies on the feasibility of a corporate document-
                      matching program by December 31,199O.

                      Sole proprietors report business income on Schedule C, Profit or Loss
Initiative 1:         From Business, and/or Schedule F, Farm Income and Expenses. They
Associating Sole      attach the schedules to their Form 1040, US. Individual Income Tax
Proprietors’          Return, which is filed under their SSN. IRSalso receives information
                      returns from third parties, such as banks, to report payments to sole
Information Returns   proprietors, either under the sole proprietors’ EIN or SSN. As discussed in
With Tax Returns      our prior report, IRSmet its January 1,1988, milestone for developing a
                      workable cross-reference file so that information returns received under
                      sole proprietors’ EINS could be matched with their tax returns. We tested
                      that file by reviewing 96 sole proprietor returns and found that all the
                      SSNS and EINS associated with these returns were accurately reflected on
                      the file. Examination officials advised us that IRS will use this cross-ref-
                      erence file in 1990 to identify sole proprietors who may have underre-
                      ported their income or failed to file tax returns for tax year 1988.

                          does not use information returns in its current program to identify
Initiative 2: Using   IRS
                      potential partnership and corporate nonfilers. This program-the
Information Returns   stopfiler program-only     identifies potential nonfilers when these types
to Identify           of businesses file tax returns in 1 year but not the next year or when
                      businesses receive EINS but do not file required returns. IRS’ stopfiler pro-
Partnership and       gram does not identify all businesses that never filed a required return,
Corporate Nonfilers   or may not identify businesses whose filing requirements are not prop-
                      erly reflected on IRS’ Business Master File-the file on which all busi-
                      nesses’ tax return requirements and transactions are maintained. IRS
                      could better identify these potential nonfilers if it used information
                      returns to supplement its current stopfiler program.

                      On June 16, 1989,6 months later than scheduled, IRS’ Collection Division
                      completed its test of using information returns to identify businesses
                      that did not file tax returns. The test was scheduled to be completed on
                      December 31,1988, but was delayed due to changes, some of which we
                      suggested, in the criteria for selecting sample cases, and problems in
                      writing computer programs for the test. Consequently, the nonfiler
                      investigations were not started until December 1988. The test used a
                      sample of 1,6 10 potential business nonfilers in nine district offices:
                      Atlanta, Cincinnati, Chicago, Cleveland, Des Moines, Jacksonville, Los
                      Angeles, San Francisco, and St. Louis.

                      Page 3                                 GAO/GGD3@38 Information   Returm Program
    To select the sample cases, IRS matched the calendar year 1986 informa-
    tion returns it had received from third parties to its Business Master File
    records. Potential nonfiler cases were created when the records showed
    that the business had not filed a required 1986 tax return. After the
    sample cases were selected, field staff (i.e. revenue officers) were to con-
    tact the businesses to determine whether they were required to file tax

    From the test, IRS Collection officials initially concluded that information
    returns should not be used to identify potential business nonfilers. IRS
    gave three reasons to support this conclusion: (1) the Collection Division
    did not obtain many delinquent returns from the test and, consequently,
    believed computer-matching information returns with tax returns would
    not be cost effective; (2) the Business Master File contains inaccurate
    information, like businesses having multiple EINS or the wrong filing
    requirements, which creates unproductive business nonfiler cases; and
    (3) because the law does not require. information return reporting for
    payments to corporations, document matching cannot be done for all

    From our review of IRS’ test, we concluded that even with the impedi-
    ments, information returns can be used to identify potential business
    nonfilers. Our review showed that IRS should not have used certain cases
    in its test. If the cases were eliminated, the test results would compare
    more favorably to the results IRS gets from its stopfiler program. Also,
    we believe that inaccuracies in the Business Master File and the fact
    that information returns are not required for payments to corporations
    should not prevent IRS from starting to use the information returns it
    receives to identify potential business nonfilers.

    IRS’test resulted in getting 262 delinquent tax returns from the 1,610
    sample cases. IRS Collection Division officials believed this yield was too
    marginal, both in the number of returns obtained and tax dollars col-
    lected, to warrant using information returns to identify business

    Our review of the 1,610 test cases showed that 394, or 24 percent of the
    cases, should have been eliminated from IRS’ test results. Specifically,
    the test results should not have included

l   266 cases that were selected for investigation, because the test’s criteria
    did not screen out all businesses that had filed tax returns on a fiscal
    year basis; and

    Page 4                                 GAO/GGD-90-38 Information   Returns Program

. 128 cases that were still being investigated by            IRS   when the test results
  were completed.

  By basing its test on the remaining 1,216 cases (1,610 minus 394 cases),
  IRS would have more accurately assessed the usefulness of information
  returns because it had completed the investigations on these cases and
  was able to establish whether the businesses were nonfilers. The 262
  delinquent tax returns that were obtained from these 1,216 cases show
  that information returns can be used for identifying potential business
  nonfilers. Obtaining 22 delinquent returns for every 100 businesses
  would supplement IRS’ current business stopfiler program in which IRS
  obtains 32 delinquent returns for every 100 businesses.

  Moreover, IRScan improve its results as it eliminates inaccurate Master
  File data, such as the wrong business filing requirements or multiple
  EINS, that create unproductive cases. IRS’ actions to correct these inaccu-
  rate data are based, in part, on recommendations that we made in a May
  1988 report on the stopfiler program.2 We found that in about 16 per-
  cent of the stopfiler cases we reviewed, IRS had not updated the Master
  File with the results of its stopfiler investigations. We also found that in
  16 percent of the stopfiler cases we reviewed, IRS had erroneously issued
  multiple EINS to the businesses. We recommended that IRS (1) use the
  results of stopfiler investigations to correct inaccurate filing require-
  ments on its Business Master File and (2) better research its files to iden-
  tify businesses with previously issued EINS and better control the
  issuance of new EINS so that businesses will not be issued more than one.
  IRS agreed with our recommendations and is taking actions that should
  reduce the number of unproductive business stopfiler cases that would
  be generated by matching information returns to the Business Master

  Because information returns are not required on payments made to cor-
  porations, IRS will be limited in the extent to which it can use computer-
  matching to identify potential business nonfilers and underreporters.
  This legal impediment could be overcome with legislation, such as the
  bill you introduced in May 1988, to require information return filing for
  interest, dividends, and other income paid to corporations. However, the
  lack of this requirement should not prevent IRS from starting to use the
  estimated 31 million information returns filed on businesses for calendar
  year 1988.

  ‘TAX ADMINISTRATION: IRS Could Reduce the Number of Unproductive Business Nonfiler Investi-
  gations (GAO/GGD -88 -77 , May 24,1988).

  Page 5                                          GAO/GGD90-38 Information    Retums Program

                                ”             d

                        We discussed our observations with Collection officials. They agreed
                        that (1) their test results included cases that should not have been used
                        to evaluate the usefulness of information returns, (2) they need to con-
                        tinue to correct the Business Master File, and (3) the information
                        returns currently received could be used to identify businesses that
                        failed to file tax returns. However, these officials said IRS has experi-
                        enced serious budget shortfalls for fiscal years 1989 and 1990, and may
                        not be able to pursue this or any other new program initiative right now.

                        Nevertheless, IRS has agreed to explore ways to use information returns
                        to complement its current program for identifying potential business
                        nonfilers. IRS will test the productivity of sending correspondence to
                        those who appear, on the basis of information returns, to be nonfilers.

                        IRS Examination officials assured us that they will continue to develop
Initiative 3:           the costs and benefits estimates for a corporate document-matching pro-
Determining Costs and   gram. They said the estimates would be based on information returns
Benefits of a           being filed on payments made to corporations, The officials anticipated
                        that they will be able to complete these estimates, in spite of budget
Document-Matching       shortfalls, because the cost estimates are not going to take much more
Promam for              money and the benefit estimates are to be based on examinations that
                        will still be done.
                        Under this corporate document-matching program initiative, IRS is doing
                        one study to determine the potential costs and three studies to deter-
                        mine the potential benefits of such a program. These studies cover cor-
                        porations with assets of (1) $100 million and over, (2) $10 million to
                        $100 million, and (3) under $10 million. These costs and benefits studies
                        are scheduled to be completed by December 31, 1990.

                        IRS completed its estimates of the various computer costs on August 3,
                        1989,-7 months later than the scheduled December 3 1,1988, comple-
                        tion date. According to IRS officials, this delay was due to staff being
                        diverted to handle unexpected and urgent problems that arose in other

                        IRS estimated that the computer costs for personnel, space, equipment,
                        and operations would be about $166 million, including $66 million in
                        start-up costs, over 7 years- from fiscal year 1991 through fiscal year

                        Page 6                                GAO/GGD9038   Information   Returns Program

    1997.” IRS based these costs on the assumption that this computer-
    matching program would be implemented in fiscal year 1994, starting
    with the processing of information returns for tax year 1993. The cost
    estimates also assumed that legislation would be passed in 1991 to
    require information returns reporting on interest, dividends, rents, roy-
    alties, and capital gain income earned by corporations. IRS estimates that
    if all payers of this income comply with the reporting requirements, it
    will receive an additional 216 million business information returns. IRS
    currently receives about 1 billion information returns for individuals
    and sole proprietors.

    IRS estimated that for fiscal year 1995-the     first full year of program
    operations-these     computer costs will be about $22 million. These costs
    include all relevant computer-matching cost elements, like computer
    equipment and personnel costs, that IRS incurs in the individual docu-
    ment-matching program. About $9.5 million of the $22 million estimate
    is for program enhancements, like automating the underreporter pro-
    gram process, that are not included in IRS’ individual computer-matching
    program costs. Factoring out these enhancements shows that the com-
    puter costs are in line with the costs of the individual program. IRS offi-
    cials estimate that computer costs for the individual document-matching
    program in tax year 1984-the most current year for which cost figures
    are available-were     about $14.5 million.

    IRSis scheduled to complete its final cost estimates for the entire corpo-
    rate document-matching program by December 31, 1990. IRS officials
    said they expect to meet this deadline. They also said they would be
    meeting with representatives from the securities and banking industries
    to obtain additional data and views on the impacts on these industries if
    information returns were required on payments made to corporations.
    IRSExamination officials said they would consider getting the views of
    representatives of corporations and the tax preparer community on any
    difficulties in complying with tax return changes that would be needed
    for a document-matching program. For example, taxpayers filing on a
    fiscal year basis may have to complete a schedule that reconciles their
    calendar year information return income to the same income on their
    fiscal year tax returns.

    “According to IRS officials, these costs do not account for IRS’ Tax System Modemlzation effort,
    which is scheduled for the 1990s. This effort’s potential impacts on the computer costs are not

    Page 7                                              GAO/GGD-99-38 Information      Returns Program

To measure benefits, IRS is doing two studies of corporations with assets
of $10 million and over-one on those with assets of $10 million to $100
million and the other on those with assets of $100 million and over.
These studies are using returns from IRS’ ongoing corporate examina-
tions. IRS is treating these as regular examinations, except that the reve-
nue agents have to determine whether the taxpayers reported the
income shown on information returns that third-party sources had vol-
untarily filed. The amount of unreported income the revenue agents
identify from reviewing the information returns in these examinations
will be used to estimate the benefits of a corporate document-matching

According to the action plan, IRS was to submit a final report on the
results of its examination of corporations with $10 million to $100 mil-
lion in assets and an interim report on corporations with assets of $100
million and over by December 31, 1989. IRS officials said these reports
will not be finished until the Spring of 1990 because of problems with
the computer databases used in these studies.

IRS officials said the other benefit study, which required an interim
report by December 31,1989, and involves tax returns from about
13,000 corporations with assets of less than $10 million, is also expected
to be finished during the Spring of 1990. This study is based on IRS’ peri-
odic Taxpayer Compliance Measurement Program-a program through
which IRS estimates taxpayers’ compliance with the tax laws by thor-
oughly examining a statistical sample of tax returns.

To monitor IRS’progress on the benefit studies, we reviewed 100 cases to
determine how well the revenue agents documented their examinations
to show whether the corporations reported the income shown on their
information returns. We found that 12 of the 50 cases (24 percent) with
assets of $10 million and over, and 32 of the 50 cases (64 percent) with
assets of less than $10 million had no information returns associated
with the cases being examined. Since these benefit studies are to iden-
tify noncompliance by using information returns, we suggested to IRS
Examination officials that they analyze cases that have no information
returns separately from cases that have information returns. The offi-
cials agreed to do a separate benefit analysis on cases with information
returns. They also said they are gathering data on the amount of unre-
ported income that revenue agents found in cases for which the agents
had no information returns. As a result, these officials said they will be
able to analyze these cases to determine how much unreported income

Page 8                                GAO/GGD-90-38 Information   Returns Program


                           could have been detected if they had information returns on this unre-
                           ported income.

                           To monitor IRS’ progress in developing a business document-matching
Objective, Scope,and       program, we
                       . interviewed IRS officials responsible for the plan’s three initiatives;
                       . reviewed a judgmentally selected sample of 96 of the 369 sole proprie-
                         tors’ income tax returns that IRSused in testing the accuracy of its file
                         for cross-referencing sole proprietors’ EINS and SSNS, to determine if IRS’
                         evaluation of the test results was accurate;
                       . reviewed 1,610 business nonfiler investigations that IRSstudied in decid-
                         ing on the merits of using information returns for identifying business
                         nonfilers, to determine whether the results supported IRS’ conclusions;
                       . reviewed IRS estimates of the potential computer costs for a corporate
                         document-matching program and compared these estimates to the costs
                         of IRS’individual document-matching program; and
                       . analyzed 100 closed corporate examination cases that IRS is using to esti-
                         mate the benefits of a corporate document-matching program, to deter-
                         mine whether the examinations followed up on all information return

                           We did our work from April through September 1989 at the IRS National
                           Office in Washington, DC., the Fresno Service Center, and the San Fran-
                           cisco District Office using generally accepted government auditing

                           The Commissioner of Internal Revenue commented on a draft of our
Agency Comments and        report in an April 6, 1990, letter, in which he stated his general agree-
Our Evaluation             ment with its content. He said IRS will continue to explore how informa-
                           tion returns can be used to identify business nonfilers. He said that
                           because of concerns about the costs and benefits of assigning field staff
                           to contact potential business nonfilers, IRS first will test whether
                           attempting to contact nonfilers by correspondence would be productive.
                           Further, he proposed that we change our title to clarify that IRS is still
                           testing the corporate document-matching program. He said any deci-
                           sions on establishing the program will not be made until IRS completes its
                           cost-benefit analysis of document matching for corporate information
                           returns. The report has been updated to reflect these comments.

                           Page 9                               GAO/GGD90-38 Information   Returns Program
                                                                      I                  II
                                                                                /        /

We support IRS’proposed test of corresponding with potential business
nonfilers, We look forward to working with agency staff responsible for
designing the test and for exploring ways that information returns could
supplement IRS’current program to identify certain business nonfilers.

As agreed, unless you publicly announce its contents earlier, we plan no
further distribution of this report until 30 days from the issuance date.
At that time, we will send copies to IRS,interested congressional commit-
tees, and other interested parties upon request.

We will continue to monitor IRS’ progress in assessing the feasibility of a
business document-matching program and will keep the Subcommittee
apprised of the status of IRS’ action plan initiatives.

Major contributors to this report are listed in appendix II. If you have
any questions, please contact me on 272-7904.

Sincerely yours,

Paul L. Posner
Associate Director, Tax Policy
  and Administration Issues

Page 10                               GAO/GGDW38   Information   Retums Program
Page 11   GAO/GGD9@3S Information   Returns Program


Appendix I
Comments From the
Internal Revenue

Appendix II                                                                                              16
Major Contributors to   General Government Division, Washington, D.C.                                    15
                        San Francisco Regional Office                                                    15
This Report


                        EIN       employer identification number
                        IRS       Internal Revenue Service
                        SSN       Social Security number

                        Page 12                             GAO/GGD90-38 Information   Returns Program

    Page 13   GAO/GGD-90-38 Information   Returns Program
Appendix I                                                                                                                            ,1/.
CommentsFrom the Internd RevenueService ’

                                          DEPARTMENT             OF THE TREASURY
                                               INTERNAL         REVENUE           SERVICE
                                                  WASHINGTON,             D.C.    20224

             Mr. Richard      L. Fogel
             Assistant      Comptroller      General
             United    States    General     Accounting                          Office
             Washington,      D.C.      20548

             Dear    Mr.     Fogel   :

                    We have reviewed          your recent    draft                             report   entitled,      “Tax
             Administration:          Status     of IRS’ Efforts                               to Establish       a Business
             Information      Returns      Program”    and are in                              general    agreement     with
             the report’     8 content.

                      Regarding        the feasibility          of a non-filer         program        using
             voluntarily         filed      information       returns      pertaining        to businesses,
             we will       continue       to explore        how these      returns     can be used.
             Current       information          indicates     that    assignment       of these         cases for
             field      contact      may not be cost          beneficial.           However,     we plan to
             redesign        the test       in order      to attempt       to contact        non-filers       by

                    We would also       propose      that   the title       of the report      be
             changed   to reflect       that   we are testing         rather     than establishing                                    a
             Business    Information       Returns      Program.      Until    we have completed
             the cost/benefit        analysis      of a corporate        document     matching
             program,    we cannot      determine       whether    it is feasible       to establish
             such a program.

                     Thank     you       for     the      opportunity               to      provide        our   comments.

                     Best     regards.


                                                                                            Fred      T.   Goldberg,

                    Page 14                                                               GAO/GGD-99-38 Information          Retums Program
Appendix   II

lV!fajorContributors to This Report

     overnment          Gerald Stankosky, Assistant Director, Tax Policy and Administration
Division. Washington,   Mark J. Gillen, Assignment Manager
                        Tom Short, Evaluator

                        Ralph T. Block, Evaluator-in-Charge
San Francisco           Kathleen E. Seymour, Evaluator
Regional Off ice


(268402)                Page 15                               GAO/GGDSO-SS Iniormath   iMum   Prognm


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