oversight

Tax Administration: IRS Preparer Penalty Data Inaccurate and Misleading

Published by the Government Accountability Office on 1990-08-15.

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

--~--   IJnit,eci S1.at.t~~General   Accorrnt.ing   Offiw

GAO     Report to the Commissioner, I&xnal
        Ikwenue Service



        TAX
        ADMINISTRATION
        IRS Preparer Penalty
        Data Inaccurate and
        Misleading

                                                                        2


                                                            Illllll I
                                                              142015
                       United States
‘GAO                   General Accounting Office
                       Washington, D.C. 20548

                       General Government          Division

                       B-239936

                       August 15,199O

                       The Honorable Fred T. Goldberg, Jr.
                       Commissioner
                       Internal Revenue Service

                       Dear Mr. Commissioner:

                       At the request of the Subcommittee on Private Retirement Plans and
                       Oversight of the Internal Revenue Service (IRS), Senate Committee on
                       Finance, we reviewed IRS’ administration of the return preparer penalty
                       program to determine whether IRS imposed preparer penalties appro-
                       priately and consistently. We are preparing a report to the Subcom-
                       mittee regarding our findings. During our review, we found that the
                       Individual and Business Master Pile data on preparer penalties did not
                       accurately reflect preparer penalty activity.* This report identifies the
                       inaccuracies we found, discusses their causes, and makes recommenda-
                       tions to you for improving the quality of IRS’ preparer penalty statistics.


                       Currently, IRS is not able to accurately determine the number, amount,
Results in Brief       or type of preparer penalty assessments and abatements. As a result, its
                       preparer penalty statistics do not accurately reflect preparer noncompli-
                       ance with the tax laws. This is because

                   . IRS has recorded multiple penalties on the master files as a single pen-
                     alty transaction. Thus, the master file data have understated the
                     number of return preparer penalties.
                   l IRS has excluded some penalty actions from being recorded on the
                     master files. Accordingly, the master file data have understated both
                     the number and amount of return preparer penalties.
                   . IRS has aggregated the penalties for preparer negligence and willful
                     understatement on the master file. Thus, IRS cannot use the master files
                     to differentiate between penalties assessed for two different types of
                     noncompliance.
                   . IRS has entered miscoded or erroneous assessment and abatement data
                     to the master files. These errors significantly distorted fiscal year 1987
                     preparer penalty statistics.



                       ‘The Individual and Business Master Files are comprehensive computerized files containing entity
                       and account information on taxpayers. Entity information includes the taxpayer’s name, address, and
                       filing status. Account information shows the different transactions related to a taxpayer’s filing and
                       payment of any tax liability.



                       Page 1                                                 GAO/GGD99-92      lRS Preparer   Penalty   Data
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                                                                                                   i
             B-239336




             Statistical information on the number, type, and amount of preparer
             penalty assessments and abatements could be a valuable management
             tool for IRS if the information is accurate and not misleading. With such
             data, IRS could make judgments on the extent of preparer noncompli-
             ance with the tax laws and on the level of enforcement efforts needed to
             deal with the preparer noncompliance.


             The Tax Reform Act of 1976 established two different preparer penal-
Background   ties in section 6694 of the Internal Revenue Code-a $100 penalty for
             negligent or intentional disregard of IRS rules and regulations, section
             6694(a), and a $600 penalty for a willful attempt to understate a tax-
             payer’s liability, section 6694(b). These penalties were designed to
             enable IRS to effectively deal with negligent and/or fraudulent
             preparers. When a preparer’s conduct as proscribed by section 6694
             causes an understatement of a taxpayer’s liability, IRS is to assess a
             preparer penalty. According to IRS, 3,474 civil preparer penalties were
             assessed against 1,37 1 preparers during fiscal year 1987, and 2,179 pen-
             alties were assessed against 1,150 preparers during fiscal year 1988.

             In November 1989, the Improved Penalty Administration and Compli-
             ance Tax Act was enacted as part of the Omnibus Budget Reconciliation
             Act of 1989. The new law, which is applicable to returns prepared after
             December 31, 1989, revised the definitions and the dollar amounts of the
             penalties. The $100 penalty has been increased to $250 and applies to
             returns with an understatement of tax liability where the preparer
             knew or reasonably should have known that a position taken did not
             have a realistic possibility of being sustained on its merits and such
             position was not disclosed or was frivolous. The $600 penalty for willful
             understatement has been increased to $1,000 and expanded to include
             cases of reckless or intentional disregard of rules and regulations by a
             preparer.

             To assess these penalties, IRS enters an assessment transaction to the
             preparer’s account on the appropriate master file-either the Business
             or Individual Master File-charging the preparer for the amount of the
             penalty. A separate civil penalties module is set up as part of the
             preparer’s individual tax account to reflect nonreturn civil penalty
             transactions for each tax period involved. For example, a preparer who
             has received three preparer penalties for returns related to 3 different
             tax years has one account, but three modules-one for each year and
             each containing one penalty assessment transaction. On the other hand,
             a preparer who has received three preparer penalties for returns related


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                        B-233335




                        to the same tax year would have one module containing three penalty
                        assessment transactions. Subsequent penalties assessed against those
                        preparers would be added, as separate transactions, to the appropriate
                        tax year module.

                        If, after a preparer penalty has been assessed, IRS or a US. district
                        court determines that a penalty is not warranted, the penalty will be
                        cancelled (abated). An abatement transaction is entered into the
                        preparer’s module cancelling the assessed penalty.


                        The Subcommittee on Private Retirement Plans and Oversight of IRS
Objective, Scope,and    requested that we review IRS’ administration of preparer penalties to
Methodology             determine whether IRS imposed preparer penalties appropriately and
                        consistently. During that review, we found that the Individual and Busi-
                        ness Master File data on preparer penalties did not accurately reflect
                        preparer penalty activity.

                         To determine the extent of the problems identified, we reviewed IRS’
                       iyprocedures for recording preparer penalty assessments and abatements
                         on the master files. We also reviewed all available information related to
                         fiscal year 1987 assessment and abatement transactions from five dis-
                         tricts” -Baltimore, Denver, Ft. Lauderdale, St. Louis, and San Fran-
                         cisco-to determine if the master file data accurately reflected the
                         information on the source documents.3 We selected these districts
                         because they were geographically dispersed and had a level of preparer
                         penalty activity that would allow us to review 100 percent of the case
                         files. We also reviewed all available information pertaining to fiscal year
                         1987 abatement transactions and their related assessment transactions
                         for the Phoenix District to determine if the master file data accurately
                         reflected the information. We added the,Phoenix District because it
                         accounted for over two-thirds of the total dollar amount of abatements
                         nationwide. In total, we reviewed 474 assessment transactions and 103
                         abatement transactions from the 6 districts.

                        In addition, we identified two districts-Dallas and Manhattan-with
                        Non-Master File (NMF) assessments4 Because these assessments are not

                        %iscal year 1987 data were the latest available at the time of our review.
                        3Weoriginally selected these districts aa part of a review of whether IRS Imposed preparer penalties
                        appropriately and consistently.
                        41RS NMF is the manual system used to record transactions not recorded on IRS computerized
                        master files.



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                                 B-239336




                                 reflected in IRS statistics, we reviewed the information related to these
                                 assessments to determine the extent to which these assessments
                                 affected the accuracy of the preparer penalty activity reported by IRS.

                                 We did our work between February and March 1990 in accordance with
                                 generally accepted government auditing standards.


Reported Statistics Do We   identified four factors that contribute to IRS’ preparer penalty sta-
                       tistics not accurately reflecting preparer noncompliance. The four fac-
Not Accurately Reflect tors were (1) multiple penalties in one transaction, (2) omission of NMF
                       assessments, (3) no differentiating between penalties, and (4) miscoded
Preparer      ”        or erroneous data entered into master files.
Noncompliance

Multiple Penalties in One        IRS procedures require that examiners consolidate multiple penalty
Transaction                      assessments into one transaction, whenever possible, to prevent mul-
                                 tiple notices being sent to the preparer. IRS procedures also allow mul-
                                 tiple penalties to be abated in one trgnsaction.

                                 However, when multiple penalty actions are included in one transaction,
                                 the master file does not indicate the number of penalties assessed or
                                 abated and reflects the transaction as one penalty action. Therefore,
                                 although the amount assessed or abated is correct, the number of penal-
                                 ties assessed or abated is understated. For example, when 10 preparer
                                 negligence penalties are assessed in one $1,000 transaction, the master
                                 file data reflects this as an assessment of 1 penalty, rather than as an
                                 assessment of 10 penalties. Because IRS cannot identify the number of
                                 penalties in each transaction, the number of preparer penalties is under-
                                 stated. Specifically, for fiscal year 1987, IRS reported 590 penalties
                                 assessed and 107 abated for the 6 districts where we reviewed penalty
                                 activity recorded on the master files. Multiple penalties in a single trans-
                                 action caused these statistics to understate the total number assessed
                                 and abated by 676 (49 percent) and 132 (66 percent), respectively.

                                 To ensure that the master file data more accurately reflect preparer
                                 penalty activity, IRS needs to create a master file indicator by which IRS
                                 can identify the actual number of penalties in each assessment and
                                 abatement transaction.




                                 Page 4                                   GAO/GGD-90-92   IRS Preparer   Penalty   Data
Non-Master File            Another factor that causesIRS to understate the number and amount of
AssessmentsOmitted         penalties assessedis the omission of NMF assessmentsfrom master file
                           data. A module on the master files can accept a limited number of trans-
                           actions, When a module on the master files reachescapacity, all subse-
                           quent assessmentsare recorded on NMF and are not reflected in the
                           master file data.
                           In our review of NMF preparer penalty activity in two districts, we
                           found three preparer accountsthat had been transferred to the NMF.
                           TheseNMF accountsincluded 227 assessments,totaling $116,400, that
                           were not reflected in the fiscal year 1987 master file data or in IRS pen-
                           alty statistics. For these two districts, IRS had reported 361 penalties
                           assessed,totaling $68,426, for fiscal year 1987. The omission of the
                           NMF assessmentscausedthese statistics to understate the number and
                           amount of penalties assessedby 39 percent and 63 percent, respectively.
                           These penalty assessmentsshould be included in preparer penalty sta-
                           tistics to accurately reflect preparer penalty activity.


No Differentiating         From the master file data, IRS cannot determine the number of negligent
Between Penalties          or intentional disregard, section 6694(a), and willful understatement
                           penalties, section 6694(b), assessedand abated becauseone penalty
                           cannot be differentiated from another. Although specific codesare
                           assignedto penalty transactions in the master files to identify the type
                           of penalty, these two penalties are assignedthe samecode,Therefore,
                           the codecannot be used to differentiate between section 6694(a) and
                           section 6694(b) penalty actions,

                           Additionally, the amount of a transaction may not indicate the penalty
                           type because,as indicated above,multiple penalty actions might be
                           included in one transaction, For example, a $600 transaction may
                           represent five section 6694(a) penalties or one section 6694(b) penalty.
                           Until IRS establishesa meansto differentiate between the two penalties
                           on the master files, IRS managementwill not have information about the
                           type of preparer noncomplianceexperienced.


Miscoded or Erroneous      In addition to the factors discussedabove,we found inaccuraciesin the
Data Entered Into Master   fiscal year 1987 data that resulted from input errors. Theseerrors
                           included miscodedpenalties, erroneous assessments,and erroneous
Files         v            abatements.




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                         B-239935




                         According to IRS statistics for the 6 districts we reviewed, 690 penalties
                         had been assessed for $2,490,675 during fiscal year 1987. We found that
                         four nonpreparer penalties that were miscoded as preparer penalties
                         caused the amount of penalties assessed to be overstated by $2,039,175.
                         We also found 29 penalties, totaling $3,600, that were erroneously
                         assessed. These included duplicate assessments, assessments resulting
                         from incorrect information on the assessment form, assessments
                         resulting from data being entered incorrectly into the master file, and
                         assessments entered to bring the interest due up to date. Our review
                         showed that these input errors caused the reported statistics to over-
                         state the number and amount of penalties assessed by 6 percent and 556
                         percent, respectively.

                         IRS also reported that during fiscal year 1987, 107 penalties totaling
                         $179,600 were abated by the districts we reviewed. We found two abate-
                         ments, totaling $16,000, that were inadvertently entered into the master
                         file, although no decision to abate had been made. These erroneous
                         abatements caused an overstatement of 2 percent in the number of pen-
                         alties abated and 10 percent in the amount abated.

                         Although the number of input errors was not substantial, the $2,042,776
                         in miscoded and erroneous assessments significantly overstated the dol-
                         lars assessed for fiscal year 1987. We do not know whether the input
                         errors we identified will occur in the same magnitude in all years.
                         Regardless, IRS should evaluate the feasibility of developing methods to
                         identify, correct, and exclude instances where miscoded or erroneously
                         entered data are significantly overstating preparer penalty activity.


                         Statistical information on the number, type, and amount of preparer
Master File Statistics   penalty assessments and abatements could be a valuable management
Should Accurately        tool for IRS if the information is accurate and not misleading. With such
Reflect Preparer         data, IRS could make judgments about the extent of preparer noncompli-
                         ante and the level of enforcement efforts needed to deal with the non-
Penalty Activity         compliance. Given the current condition of the master file data,
                         however, IRS has little or no indication of the extent to which preparers
                         are not compliant with the tax laws. For example, recording multiple
                         penalty assessments and abatements in a single transaction, as opposed
                         to individual transactions, can cause the reported statistics to be mis-
                         leading. If, during 1 year, IRS recorded 10 penalties in a single transac-
                         tion, the reported statistics would indicate only 1 penalty assessment for
                         the year. If, in another year, IRS recorded 10 penalties in separate trans-
                         actions, the reported statistics would indicate 10 separate penalties.


                         Page 6                                   GAO/GGD-90-92   IRS Preparer   Penalty   Data
                  B239936




                  Comparison of the statistics for the 2 years could imply that (1) IRS
                  increased its efforts to identify and penalize noncompliant preparers
                  and/or (2) preparer noncompliance increased. Either assumption could
                  be misleading because, in fact, the number of preparer penalties did not
                  change.


                  Preparer penalty statistics reported by IRS should accurately reflect
Conclusions       preparer noncompliance. However, we found the reported data to be
                  inaccurate because (1) multiple penalties in one transaction are reflected
                  as one penalty action; (2) assessments recorded on the manual NMF
                  system are omitted from reported penalty activity; (3) preparer negli-
                  gence and the willful understatement penalties are assigned the same
                  reference code; and (4) miscoded and erroneous assessment or abate-
                  ment data are inadvertently input to the master files,


                  To ensure that master file statistics more accurately reflect preparer
Recommendations   penalty activity, we recommend that the Commissioner of Internal
                  Revenue

                  create an indicator to identify the number of penalties included in each
                  transaction;
                  identify and establish a means to include assessments made on the
                  manual system with the master file statistics;
                  establish a means to differentiate between preparer penalty activity as
                  defined in Internal Revenue Code sections 6694(a) and 6694(b); and
                  evaluate the feasibility of developing methods to identify and correct
                  miscoded or erroneously entered data, and exclude these assessments
                  and abatements from IRS’ reported statistics.


                  In providing informal comments on this report, IRS officials generally
Agency Comments   agreed with the information contained in the report, the conclusion
                  reached, and the recommendations.


                  We are sending copies of this report to the Joint Committee on Taxation;
                  the Subcommittee on Private Retirement Plans and Oversight of IRS;
                  Senate Committee on Finance; Subcommittee on Oversight, House Com-
                  mittee on Ways and Means; and other interested parties. We will also
                  make copies available to others on request.



                  Page 7                                  GAO/GGD90-92   IRS Preparer   Penalty   Data
E.239936




Major contributors to this report are listed in the appendix. Please con-
tact me on 272-7904 if you have any questions concerning the report.

Sincerely yours,




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




Page g                                   GAO/GGD-00-02 IRS Preparer   Penalty   Data
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            Page 9   GAO/GGDQO-02   If@ Preparer   Penalty   Data
Appendix

Major Contributors to This Report


                        Lynda Willis, Assistant Director, Tax Policy and Administration           Issues
General Government      Ronda Rogers, Evaluator
Division, Washington,              -
DC.
           -            Terry Tillotson, Evaluator-in-Charge
Kansas City Regional    Mary Graves, Evaluator
Office                  To< Walters, Advisor




               Y




(saerae)                 Page 19                                 GAO/GGD90-92   Iit!3 Preparer   Penalty   Data
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