oversight

IRS Audits: Weaknesses in Selecting and Conducting Correspondence Audits

Published by the Government Accountability Office on 1999-03-31.

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

                United States General Accounting Office

GAO             Report to the Chairman, Subcommittee
                on Oversight, Committee on Ways and
                Means, House of Representatives


March 1999
                IRS AUDITS
                Weaknesses in
                Selecting and
                Conducting
                Correspondence
                Audits




GAO/GGD-99-48
      United States

GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division



      B-276687

      March 31, 1999

      The Honorable Amo Houghton
      Chairman, Subcommittee on Oversight
      Committee on Ways and Means
      House of Representatives

      Dear Mr. Chairman:

      This report responds to your request that we review the Internal Revenue Service’s (IRS)
      program to audit income tax returns through correspondence. We provide information on the
      number, results, and duration of correspondence audits as well as the characteristics of the
      audited returns and examine the processes and requirements that IRS has put in place to
      govern correspondence audits. This report also includes our recommendations on improving
      the correspondence audit program.

      We are sending copies of this report to Representative William J. Coyne, Ranking Minority
      Member, Subcommittee on Oversight, House Committee on Ways and Means; Senator
      William V. Roth, Jr., Chairman, and Senator Daniel Patrick Moynihan, Ranking Minority
      Member, Senate Committee on Finance; various other congressional committees; The
      Honorable Robert E. Rubin, Secretary of the Treasury; The Honorable Charles O. Rossotti,
      Commissioner of Internal Revenue; The Honorable Jacob Lew, Director, Office of
      Management and Budget; and other interested parties. Copies will also be made available to
      others upon request.

      This report was prepared under the direction of Thomas D. Short, Assistant Director. Other
      major contributors are listed in appendix VI. If you have any questions about this report,
      please call me or Mr. Short on (202) 512-9110.

      Sincerely yours,




      James R. White
      Director, Tax Policy
        and Administration Issues




      Page 1                                                  GAO/GGD-99-48 IRS’ Correspondence Audits
Executive Summary


                   Between 1992 and 1997, the Internal Revenue Service (IRS) audited
Purpose            between 1 and 2 million individual income tax returns per year. Audits are
                   one of the enforcement tools used by IRS in its efforts to close the tax
                   gap—the amount of taxes owed but not voluntarily paid. IRS’ most recent
                   estimate put the tax gap for individuals at over $125 billion for 1992. IRS
                   also estimates that it eventually collects about one-quarter of the gross tax
                   gap through its enforcement efforts.

                   Since 1996, the most common type of IRS audit of individual taxpayers has
                   been the correspondence audit conducted through IRS’ 10 service centers.
                   As the name implies, these audits are conducted through the mail, with IRS
                   typically asking taxpayers for more support regarding one or two simple
                   issues on a tax return. Audits of more complex tax issues are done at IRS’
                   33 district offices.

                   In recent years, Congress has been concerned about IRS’ use of its
                   enforcement tools, particularly about whether the tools are used fairly and
                   in a manner that does not impose excessive burdens on taxpayers.
                   Concerns such as these led, in part, to the passage of the IRS Restructuring
                   and Reform Act of 1998. The act included provisions affecting audits.

                   In keeping with the Committee’s oversight responsibilities for IRS
                   enforcement activities, the Chairman of the House Committee on Ways
                   and Means, Subcommittee on Oversight, asked GAO to review
                   correspondence audits and IRS’ processes for conducting these audits.
                   Accordingly, this report (1) provides information on the number, results,
                   and duration of correspondence audits as well as the characteristics of the
                   audited returns and (2) examines the processes and requirements that IRS
                   has had for years to govern correspondence audits. GAO’s analysis is
                   based on computerized IRS data on audits closed during fiscal years 1992-
                   97, a study population of traditional correspondence audits closed in 1996
                   from which we drew a sample, and surveys from compliance officials at
                   IRS’ 10 service centers.

                   GAO found several weaknesses in IRS’ correspondence audit processes.
Results in Brief   These weaknesses, individually or in combination, can erode the integrity
                   of the correspondence audit processes, which are designed to help ensure
                   that taxpayers pay the correct tax amounts and are treated properly.

                   During fiscal years 1992-97, the annual number and results of
                   correspondence audits conducted by IRS varied considerably. The number
                   ranged annually from just over 200,000 to about 1.1 million audits. The rate
                   at which IRS auditors closed audits without recommending additional



                   Page 2                                 GAO/GGD-99-48 IRS’ Correspondence Audits
             Executive Summary




             taxes (the no-change rate) ranged from 13 percent to 46 percent. When
             they did recommend additional taxes, the average amounts ranged from
             $1,300 to $2,800. The rate at which taxpayers did not respond to these
             recommended additional taxes after being requested to do so by IRS (the
             default rate) ranged from 29 percent to 63 percent. These variations
             resulted, in part, from an increase in the number of correspondence audits
             of returns claiming an earned income credit (EIC).

             For the traditional correspondence audits closed in fiscal year 1996, the
             time between the filing of a return and the start of the correspondence
             audit averaged 10 months. It then took 11 more months before IRS
             assessed any taxes that were recommended during the audits. As for the
             characteristics of these 1996 returns, an estimated 75 percent had reported
             adjusted gross incomes of less than $15,000. In part, this percentage
             reflects the correspondence audit’s focus on simple tax issues and EIC.

             IRS had weaknesses in implementing the correspondence audit
             requirements for four processes. First, not all of the traditional
             correspondence audits closed in 1996 were manually reviewed (or
             classified) to identify all issues for audit, as required by IRS. Further, the
             classification of returns that included complex business and investment
             schedules was not always done by qualified personnel in district offices, as
             required. Second, support for recommended audit findings was not
             adequately documented in the audit workpaper files, as required, for about
             one-third of the audits. Third, the taxpayer documentation that was
             required to justify EIC claims varied from service center to service center.
             Fourth, GAO found weaknesses in the reviews that IRS did on a sample of
             closed audits to measure their quality. For example, some service centers
             excluded certain types of correspondence audits that are required to be
             included in the sample.

             In addition to the weaknesses in implementing the requirements, IRS
             allowed service centers to exclude certain types of audits that did not have
             all required documentation from being measured against the audit
             standard on workpaper documentation. Further, more than 50 percent of
             the taxpayers who were audited by correspondence did not respond to
             IRS’ letters, and IRS has not analyzed why. GAO is making a number of
             recommendations to deal with these and other weaknesses in the
             correspondence audit process.

             Each year, IRS checks all individual income tax returns filed for
Background   compliance with the tax laws using a variety of tools. These compliance
             checks include reviews of some required information, such as signatures



             Page 3                                  GAO/GGD-99-48 IRS’ Correspondence Audits
Executive Summary




and Social Security numbers, at the time a return is filed; computerized
corrections of what IRS labels “math errors;” computerized matching of
information, such as income, with the corresponding information reported
to IRS by third parties; and audits.

Auditors seek additional support from taxpayers for questionable items on
tax returns—which IRS calls tax issues. IRS may raise tax issues regarding
any of the items on a return, such as exemptions, income, deductions, and
credits.

IRS does two types of audits of returns filed by individual taxpayers:
correspondence and district office audits. Correspondence audits deal
with simpler issues through correspondence sent from one of IRS’ service
centers. District office audits deal with more complex issues, such as those
on business or investment schedules that are attached to tax returns,
usually through face-to-face meetings in an IRS office or a taxpayer’s place
of business. Correspondence audits are conducted by tax examiners
trained in simple tax issues, while district office audits are conducted by
revenue agents and tax auditors trained in more complex tax issues.

IRS has established audit quality standards and requirements for selecting,
conducting, and reviewing the quality of correspondence audits. The
standards require actions such as considering all significant issues for
audit and adequately documenting audit recommendations. During audit
selection, tax returns should be reviewed (classified) by IRS personnel
qualified to identify all questionable issues for audit, particularly complex
issues on business and investment schedules. Further, classification
should determine whether the issues can be addressed through
correspondence audits or through district office audits. In conducting
audits, IRS also requires tax examiners to adequately support their audit
recommendations and to document that support and audit steps in the
workpaper files. When auditing claims for tax credits, such as EIC, tax
examiners are required to substantiate these claims using third-party
verification, such as school records. In reviewing audits, IRS has
established two levels of review. The first is to be carried out by the tax
examiners’ supervisors, who are to review some examiners’ work while
the audit is in progress. The second review is to be performed on a sample
of closed audits by quality assurance staff within each service center to
measure adherence to the audit standards.

To start the correspondence audit process, IRS is to send a notice to the
taxpayer that the return has been selected for audit. This notice is to
request certain information or documents needed to support the issues



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                             Executive Summary




                             identified for audit through classification. If the taxpayer responds with
                             such support, the tax examiner is to recommend closing the audit with no
                             changes to the reported tax liability (no-change audit) and notify the
                             taxpayer through a letter. If the taxpayer does not provide support, the tax
                             examiner is to recommend changes to the tax liability and similarly notify
                             the taxpayer. If the taxpayer does not respond to the recommended tax
                             changes within 30 days, the tax examiner is to notify the taxpayer that the
                             recommended tax will be assessed. If the taxpayer does not respond to
                             this tax assessment notice within 90 days, the tax examiner is to close the
                             audit as a default by the taxpayer, meaning the tax assessment becomes
                             final and the taxpayer is liable for the additional taxes.


Principal Findings

IRS’ Use of Correspondence   During fiscal years 1992-97, the annual number of correspondence audits
                             conducted by IRS varied considerably from year to year. The fewest
Audit                        number of audits—232,000—were closed in 1993. Between 1994 and 1995,
                             the number of correspondence audits tripled from about 353,000 to about
                             1.1 million but then decreased to 758,000 between 1996 and 1997. The
                             increase between 1994 and 1995 was due, in large part, to increased
                             emphasis on auditing returns claiming EIC in response to congressional
                             concerns about EIC noncompliance. The decrease in 1997 was due to
                             moving many of the EIC returns from the correspondence audit program
                             to the math-error program.

                             During fiscal years 1992-97, correspondence audit results—such as the no-
                             change rates, amount of taxes recommended per audited return, and
                             default rates—also varied considerably from year to year. For example, the
                             no-change rate increased through 1995 to a high of 46 percent and then
                             decreased by 1997 to a low of 13 percent. In contrast, the amount of taxes
                             recommended per audited return declined between 1992 and 1995 to a low
                             of $1,282 and then increased in 1997 to a high of $2,835. Similarly, the
                             default rate decreased by 1995 to a low of 29 percent and then increased in
                             1997 to a high of 63 percent.

                             For the correspondence audits closed in fiscal year 1996, GAO found an
                             overall average of 21 months elapsed from the time the returns were filed
                             until IRS assessed any taxes recommended during the audit. The time
                             between the filing of a return and the start of the correspondence audit
                             averaged 10 months. It then took an average of 11 more months before IRS
                             assessed any taxes recommended during the audits. Audits of returns for



                             Page 5                                 GAO/GGD-99-48 IRS’ Correspondence Audits
                       Executive Summary




                       which the taxpayers never responded to IRS’ letters usually took longer to
                       do than other returns.

                       GAO’s review of characteristics of the audited returns during fiscal year
                       1996 showed that an estimated 75 percent of the returns had reported
                       adjusted gross incomes of less than $25,000. In part, this percentage
                       reflects the correspondence audit’s focus on simple tax issues and EIC.
                       Specifically, these correspondence audits dealt primarily with a few types
                       of issues reported on individual tax returns, such as EIC and self-
                       employment taxes, as well as taxpayers who did not appear to have filed
                       the required tax returns. Further, an estimated 20 percent of the audited
                       returns included complex schedules, such as business and investment
                       schedules. Such schedules included those filed by individuals to report
                       business net profits or losses generated through self-employment and to
                       report capital gains or losses.

Weaknesses in IRS’     IRS had weaknesses in its processes for implementing correspondence
                       audit requirements as well as for seeking taxpayers’ responses.
Correspondence Audit   Specifically, IRS did not consistently implement all requirements in its
Processes              processes for (1) classifying returns to identify issues for audit, (2)
                       documenting the audit steps and support for audit recommendations, (3)
                       justifying EIC claims, and (4) reviewing the quality of audits. Also, IRS did
                       not know why over half the taxpayers audited by correspondence did not
                       respond during the audit. Although GAO did not measure the effects of
                       these weaknesses, each weakness can, individually or in combination,
                       erode the integrity of the correspondence audit processes, which are
                       designed to help ensure that taxpayers pay the correct tax amounts and
                       are treated properly.

                       First, service centers did not follow IRS’ requirements for classifying
                       returns for audits and referring returns with complex business or
                       investment schedules to districts. IRS’ manual requires tax returns
                       identified for audit to be classified so that all questionable issues are
                       audited. However, excluding nonfilers, an estimated 69 percent of the
                       workpapers in the audits closed in 1996 had no evidence of classification.
                       When classification did occur, tax examiners classified most returns, some
                       involving complex schedules for which they were not trained. IRS officials
                       at both the National Office and the service centers said that classification
                       was not needed for all correspondence audits but could be needed for
                       returns having complex schedules.

                       GAO found evidence that less than an estimated 1 percent of the returns
                       with complex schedules were referred, as required, to revenue agents and



                       Page 6                                  GAO/GGD-99-48 IRS’ Correspondence Audits
Executive Summary




tax auditors in the district offices. Such referrals are important because
IRS generally has one chance to audit a return. If these complex schedules
are not classified for potential audit issues, tax noncompliance is more
likely to go undetected.

Second, the workpapers for the 1996 correspondence audits showed that
up to about one-third of the audits had little or no evidence of how the tax
examiner did the audit or supported any recommended taxes. IRS’ manual
requires that tax examiners adequately support their audit
recommendations and document that support in the audit workpaper files.
Analyses showed that the less time spent on the audit, the less
documentation appeared in the workpapers. When supporting
documentation is lacking, it can create uncertainty about the additional
taxes recommended in those audits.

Third, the type of taxpayer documentation that was accepted to justify EIC
claims varied from service center to service center. Tax examiners in at
least three service centers did not follow IRS’ requirement to substantiate
EIC claims through third-party verification. On the basis of interviews at
one of these service centers, GAO found that this weakness occurred when
service center management eased requirements because of an
inexperienced tax examiner work force. Examiners at the other seven
centers generally required third-party verification when auditing EIC
claims. GAO could not tell from analyzing IRS’ audit workpapers from any
service center whether taxpayers received an earned income credit to
which they were not entitled or were denied a claim to which they were
entitled.

And fourth, IRS’ two audit quality reviews were unlikely to identify
weaknesses in the audits. The workpapers for the 1996 traditional
correspondence audits had evidence of supervisory review in an estimated
6 percent of the audits. IRS officials said that one reason for this low
percentage is that IRS does not require supervisors to document their
reviews.

Further, although IRS had weaknesses in classifying and documenting
support for correspondence audits, IRS’ quality measurement reviews gave
high ratings in these areas. IRS’ higher ratings can be explained, in part, by
two types of exclusions from IRS’ reviews, which usually occurred when
taxpayers did not respond to IRS’ request for information. First, some
service centers excluded such audits (as well as those not recommending
tax changes) from the quality measurement review samples, even though
the audits are required to be included. Second, IRS allowed service centers



Page 7                                  GAO/GGD-99-48 IRS’ Correspondence Audits
                    Executive Summary




                    to exclude certain audits from being measured against the quality standard
                    on workpaper documentation. These audits closed with no responses from
                    the taxpayer and no documentation of the audit steps or support for the
                    audit recommendations. According to IRS requirements, the workpapers
                    still are to document the rationale for recommending additional taxes,
                    even if taxpayers did not respond.

                    In addition, over half the taxpayers in the traditional correspondence
                    audits did not respond to IRS’ audit letters. Without taxpayers’ responses,
                    IRS cannot be as certain about actual tax liabilities. IRS had not collected
                    data on why taxpayers did not respond. IRS officials believed that
                    taxpayers were less likely to respond to standardized letters that are not
                    audit-specific and contain legal language that some taxpayers may not
                    understand. Tax examiners use standardized letters and do not spend time
                    crafting audit-specific letters, given the number and simple nature of the
                    audits. Taxpayers who did not respond to these letters were less likely to
                    pay their additional tax assessments. Further, we estimated that 75 percent
                    of the taxpayers who asked IRS to reconsider these assessments—or redo
                    these audits—months after the audit closed had not responded to IRS’
                    letters during the audit.

                    GAO recommends that the IRS Commissioner improve controls to better
Recommendations     ensure that IRS’ correspondence audit processes adhere to existing audit
                    requirements and standards on

                  • classifying filed returns, and in particular, referring returns with complex
                    schedules that may have potential tax changes to staff with sufficient
                    knowledge to classify them;
                  • documenting the support for audit findings and recommendations in the
                    audit workpaper files;
                  • ensuring consistency in the treatment of audited EIC claims by collecting
                    and using the information required, including verification from third
                    parties, to justify the claims; and
                  • including all types of closed audits across the 10 service centers in the
                    samples for measuring audit quality.

                    GAO also recommends that the IRS Commissioner

                  • require supervisors in the service centers to document their reviews of
                    audit workpapers;
                  • eliminate the discretion that service centers have to exclude audits that
                    lack documentation on the audit steps and support for audit




                    Page 8                                  GAO/GGD-99-48 IRS’ Correspondence Audits
                    Executive Summary




                    recommendations from the calculations IRS does to measure adherence to
                    the audit quality standard on workpaper documentation; and
                  • determine the reasons, through statistically valid and cost-effective means,
                    for taxpayers’ not responding to IRS’ audit letters, so that IRS can identify
                    ways to encourage more taxpayers to respond.

                    We requested comments on a draft of this report from the Commissioner
Agency Comments     of Internal Revenue. Officials representing the Assistant Commissioner for
                    Customer Service and the IRS Commissioner’s Office of Legislative Affairs
                    provided IRS’ comments in a February 23, 1999, meeting. IRS also
                    documented these comments in a letter dated March 12, 1999, which is
                    reprinted in appendix V.

                    Overall, IRS concurred with all of our recommendations and agreed to
                    take efforts to implement them. IRS officials provided elaboration on our
                    recommendation involving IRS’ requirement to classify returns,
                    particularly returns with complex schedules. Given that the number of
                    returns audited through correspondence that include complex schedules is
                    relatively low, Customer Service officials said that they would work with
                    the Assistant Commissioner (Research and Statistics of Income) on ways
                    to isolate returns with complex schedules so that they are not
                    automatically selected for correspondence audits. This would provide
                    district offices with the opportunity to first look at these returns before
                    they are audited through correspondence.




                    Page 9                                 GAO/GGD-99-48 IRS’ Correspondence Audits
Contents



Executive Summary                                                                                2


Chapter 1                                                                                       12
                      Screening and Classification of Tax Returns                               12
Introduction          The Correspondence Audit Process                                          14
                      Audit Quality Reviews                                                     16
                      Objectives, Scope, and Methodology                                        16


Chapter 2                                                                                       19
                      Number of Returns Audited and the Results of the                          19
Correspondence          Correspondence Audits
Audits From 1992 to   Time Taken to Conduct Correspondence Audits                               21
                      Profile of Tax Issues Audited Through Correspondence                      22
1997                  Profile of Tax Returns Audited Through Correspondence                     23


Chapter 3                                                                                       25
                      Most Tax Returns Audited Through Correspondence                           25
Weaknesses in           Were Not Classified
Processes and         Audits Did Not Always Have Adequate Documentation                         26
                      Some Service Centers Accepted Differing Levels of                         28
Requirements for        Justification for EIC Claims
Selecting and         Limited Supervisory Reviews and Audit Quality Reviews                     29
                      Minimal Contact With Nonresponsive Taxpayers                              31
Conducting            Conclusions                                                               33
Correspondence        Recommendations                                                           35
                      Agency Comments and Our Evaluation                                        36
Audits
Appendixes            Appendix I: Overview of Audit Processes at Service                        38
                        Centers and District Offices
                      Appendix II: IRS' Auditing Standards and Key Elements                     41
                        for Correspondence Audits
                      Appendix III: Sampling and Data Analysis Methodology                      42
                      Appendix IV: Additional Comparisons of IRS Service                        45
                        Center Workloads
                      Appendix V: Comments From the Internal Revenue                            48
                        Service
                      Appendix VI: Major Contributors to This Report                            52


Tables                Table 2.1: Number of Returns Audited and Additional                       19
                        Taxes Recommended for Correspondence Audits



                      Page 10                              GAO/GGD-99-48 IRS’ Correspondence Audits
          Contents




          Table 2.2: Frequency of Audit Closures for                                  21
            Correspondence Audits in Total, Fiscal Years 1992-97
          Table 2.3: Comparison of Annual Incomes of Taxpayers                        24
            Audited Through Correspondence to All Taxpayers
            Filing Tax Returns
          Table 3.1: Extent to Which Workpaper Files Had an Audit                     27
            Trail and Supporting Documentation on Audited Issues
            for Returns in Our 1996 Study Population
          Table II.1: IRS’ Audit Standards and Key Elements for                       41
            Correspondence Audits
          Table IV.1: Correspondence Examination Workload by                          45
            Service Center for Fiscal Year 1992
          Table IV.2: Correspondence Examination Workload by                          45
            Service Center for Fiscal Year 1993
          Table IV.3: Correspondence Examination Workload by                          46
            Service Center for Fiscal Year 1994
          Table IV.4: Correspondence Examination Workload by                          46
            Service Center for Fiscal Year 1995
          Table IV.5: Correspondence Examination Workload by                          47
            Service Center for Fiscal Year 1996
          Table IV.6: Correspondence Examination Workload by                          47
            Service Center for Fiscal Year 1997


Figures   Figure 1.1: Simplified Overview of the Correspondence                       15
            Audit Process
          Figure 2.1: Percentage of Time That Each Issue Occurred                     23
            in Traditional Correspondence Audits, Fiscal Year 1996
          Figure I.1: Process for Selecting Individual Tax Returns                    40
            for Audit




          Abbreviations

          AIMS          Audit Information Management System
          CEQMS         Correspondence Examination Quality Management System
          DIF           Discriminant function
          EIC           Earned Income Credit
          IRS           Internal Revenue Service
          TEFRA         Tax Equity and Fiscal Responsibility Act of 1982




          Page 11                                GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 1

Introduction


                        Using a variety of tools, IRS checks all individual income tax returns filed
                        each year for compliance with the tax laws. These compliance checks
                        include reviews of some required information, such as signatures and
                        social security numbers, at the time a return is filed; computerized
                                                                       1
                        corrections of what IRS labels “math errors;” computerized matching of
                        information, such as income, with the corresponding information reported
                        to IRS by third parties; and audits.

                        IRS audits individual income tax returns to help ensure that taxpayers pay
                        their proper tax liability. Audits are one of the enforcement tools used by
                        IRS in its efforts to close the tax gap—the amount of taxes owed but not
                        voluntarily paid. IRS’ most recent estimate put the individual tax gap at
                        over $125 billion for 1992. IRS also estimates that it eventually collects
                        about one-quarter of the gross tax gap through its enforcement efforts.

                        The audits account for a small share of the returns filed annually—about 1
                        or 2 percent. Between 1992 and 1997, IRS audited between 1 million and 2
                        million individual income tax returns per year. In 1996, when about 119
                        million individual income tax returns were filed, IRS audited 1.9 million
                        returns—1.1 million at its 10 service centers and about 760,000 at its 33
                        district offices. In selecting returns to audit, IRS attempts to identify those
                        that are most likely to have errors—or audit potential—owing to
                        questionable tax issues such as income, deductions, exemptions, and
                        credits. IRS’ process for selecting returns with the highest audit potential
                        is important because audits can be costly for both taxpayers and IRS.

                        In recent years, Congress has been concerned about IRS’ use of its
                        enforcement tools, particularly about whether the tools are used fairly and
                        in a manner that does not impose excessive burdens on taxpayers.
                        Concerns such as these led, in part, to the passage of the IRS Restructuring
                        and Reform Act of 1998. The act included provisions affecting audits.

                        IRS uses both computer technology and manual review to select returns
Screening and           for audit. This selection process results in a determination of whether a
Classification of Tax   return has audit potential. If the return does, the process helps identify
Returns                 specific tax issues to be audited (audit issues) and the audit technique to
                        be used—correspondence sent to taxpayers from IRS’ service centers or
                        meetings with taxpayers or their representatives through IRS’ district
                        offices.


                        1
                         For returns with math errors, IRS notifies taxpayers about the errors and the adjusted tax liabilities
                        through computer-generated letters. The letters are similar to those used for correspondence audits.




                        Page 12                                               GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 1
Introduction




IRS uses computer programs to screen tax returns filed each year by
individual taxpayers for audit potential. One program utilizes a
computerized series of discriminant function (DIF) formulas to compute a
score for each return. The higher the score, generally speaking, the greater
the likelihood that the return’s reported tax would be changed if audited.
Districts have used DIF scores as a primary source to select most of the
returns they audited. Service centers rarely use DIF scores because
centers usually focus on one audit issue, whereas DIF focuses on returns
with multiple, more complex issues.

Service centers have their own computer programs to identify returns with
issues to be audited through correspondence. The types of issues to be
audited vary from year to year as Congress, IRS, and the local district
offices and service centers focus on particular aspects of the tax law. For
example, in recent years, earned income credit (EIC) claims and individual
retirement account penalties have been highlighted by the service centers.

Once the screening programs have identified tax returns with audit
potential, the returns are to be reviewed (or “classified”) by qualified staff
for each district office and service center. IRS requires the returns to be
classified to determine which can be accepted as filed and, if not accepted,
                                       2
to identify all potential audit issues. IRS allows tax returns to be classified
by different types of auditors, depending on the complexity of the returns
and the issues. Returns with more complex audit issues that require
personal contacts with the taxpayers are to be reviewed by revenue agents
or tax auditors. Returns with less complex issues that can be audited
through correspondence are to be sent to service centers to be reviewed
by tax examiners. (See app. I for detailed explanations of screening and
classification.) Once returns are classified and selected for audit, any
identified audit issue is to be documented in the audit workpaper file.

The IRS staff who do the classification have varying degrees of training
and audit experience. Revenue agents are the highest graded auditors and
are required to have at least 24 hours of college-level accounting courses
to audit the most complex tax returns from corporations, other businesses,
and higher income individuals. Tax auditors, who usually have some
accounting education, audit less complex issues by meeting with taxpayers
at the district offices. Service centers use tax examiners to audit the
simpler individual issues. Tax examiners, who are not required to have any
2
 Identifying all potential audit issues is important because the Internal Revenue Code, section 7605(b),
provides for only one inspection of a taxpayer’s books or records per tax year unless the taxpayer
requests another inspection or unless the Secretary of the Treasury notifies the taxpayer in writing that
an additional audit is necessary.




Page 13                                              GAO/GGD-99-48 IRS’ Correspondence Audits
                     Chapter 1
                     Introduction




                     accounting education, audit simple issues through correspondence and are
                     not trained to audit complex issues on business and investment schedules
                     attached to tax returns.

                     According to IRS, tax returns assigned to the service centers are to involve
The Correspondence   only one or two simple tax issues, such as EIC claims, that can be audited
Audit Process        through correspondence. Correspondence audits are to exclude
                     complicated tax issues, such as those on business and investment
                     schedules, and are designed to quickly review a taxpayer’s support for the
                     tax issues.

                     The time needed to audit returns and establish the appropriate tax liability
                     depends, in large part, on the number of letters IRS sends to taxpayers and
                     the sufficiency of the taxpayers’ responses. IRS typically sends two
                     letters—one asking for information or documentation and at least one
                     reporting any changes to the tax liability reported on the tax return as a
                     result of the audit. (See fig. 1.1.)

                     IRS service centers send an initial letter to notify taxpayers of the issues
                     on the return to be audited and to request information on those issues
                     within 30 days. If the taxpayer provides the information requested, a tax
                     examiner is to determine whether it supports the audit issues. If it does
                     provide the support, the tax return can be accepted as filed and the audit
                     closed with no change in the reported tax liability. If the information does
                     not support the issues, the tax examiner can request further clarification
                     or documentation. After reviewing all the submitted information, the tax
                     examiner determines whether additional taxes are warranted. Should the
                     taxpayer not provide information to support the audit issues, the tax
                     examiner is to treat the issues as unsubstantiated and recommend
                     additional taxes.

                     Whether or not the taxpayer responds to IRS’ initial letter, IRS is to notify
                     the taxpayer in writing of the results of the audit, such as whether the tax
                     examiner is recommending any changes to the reported tax liability and, if
                     so, the amount of change. This IRS letter also gives taxpayers a 30-day
                     period to agree or disagree with the recommended results. If the taxpayer
                     agrees, any recommended tax changes are to be assessed as taxes owed. If
                     the taxpayer disagrees, IRS is required to inform the taxpayer of the right
                     to file a protest with IRS’ Appeals Office to determine whether the
                                                                3
                     recommended taxes should be assessed.

                     3
                      IRS’ Appeals Office is charged with trying to settle tax disputes without litigation on the basis of what
                     is fair to the government and the taxpayer.




                     Page 14                                                GAO/GGD-99-48 IRS’ Correspondence Audits
                                         Chapter 1
                                         Introduction




Figure 1.1: Simplified Overview of the Correspondence Audit Process




                                         a
                                          Based on the information provided, the examiner can close the audit with no changes to the tax
                                         liability.
                                         b
                                          Taxpayers can agree or disagree with any proposed changes to their tax liability. If taxpayers
                                         disagree, they can ask IRS’ Appeals Office to determine whether the recommended tax amounts
                                         should be addressed as an additional tax liability.
                                         c
                                         For various reasons, not all recommended tax amounts are assessed and not all assessed tax
                                         amounts are collected, regardless of the type of IRS audit.
                                         Source: GAO summary of IRS data.




                                         Page 15                                            GAO/GGD-99-48 IRS’ Correspondence Audits
                         Chapter 1
                         Introduction




                         Taxpayers who do not respond to these 30-day letters are to be sent
                         another notice giving them an additional 90 days to respond before the
                         recommended taxes are formally assessed. If the taxpayer does not
                         respond to this 90-day letter, the recommended taxes are to be assessed,
                                                                                       4
                         and the matter is to be referred to IRS’ Collection Division.

                         In addition to the formal appeals process, IRS allows taxpayers who
                         disagreed with the audit results or who did not respond to IRS’ audit
                         letters to ask for a reconsideration of any additional taxes that were
                         assessed as a result of an audit. IRS extends this option to taxpayers who
                         provide new information about these assessed taxes, including those who
                         bypassed opportunities to resolve their disputes in IRS’ Appeals Office or
                         the Tax Court.

                         IRS has two quality review functions to see whether correspondence
Audit Quality Reviews                                                        5
                         audits comply with its requirements and standards. The audit standards
                         include such requirements as adequate consideration of all significant
                         audit issues and workpaper support for all audit findings. (See app. II,
                         which describes each standard.)

                         The first review is to be carried out by supervisors who are to periodically
                         review the tax examiners’ work during the audits. The results of these
                         reviews are to be used in the tax examiners’ performance evaluations, but
                         IRS does not require supervisors to document the results in the audit
                         workpaper files.

                         The second review is to be performed by quality assurance staff within the
                         service centers. The staff are to review a sample of all closed audits for
                         adherence to IRS’ requirements and audit standards. The results of these
                         reviews are to be entered into the Correspondence Examination Quality
                         Management System (CEQMS) database and used to identify procedural
                         and systemic weaknesses and to develop improvements where needed.

                         In response to a request from the Chairman, Subcommittee on Oversight,
Objectives, Scope, and   House Committee on Ways and Means, this report (1) provides information
Methodology              on the number, results, and duration of correspondence audits as well as
                         the characteristics of the audited returns and (2) examines the processes


                         4
                          Upon receipt of the 90-day letter, the taxpayer may petition the Tax Court to resolve the disputed tax
                         liability.
                         5
                          IRS also does “Action 61” reviews to determine whether tax examiners are responsive with taxpayer
                         inquiries. These reviews consider such items as professionalism, timeliness, and language used.




                         Page 16                                              GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 1
Introduction




and requirements that IRS has had for years to govern correspondence
audits.

To provide information on the number, results, and duration of
correspondence audits, we gathered data from various IRS sources. We
gathered detailed data on audits closed in fiscal years 1992-97 from IRS’
Audit Information Management System (AIMS), including the number of
audits, amount of additional taxes recommended, and type of audit
closures (e.g., no tax changes). For the duration and other characteristics,
we gathered data from a statistically valid sample of traditional
correspondence audits closed in fiscal year 1996 by reviewing audit
                                                     6
workpaper files and IRS’ individual masterfile data. We did not check the
reliability of IRS’ data in AIMS and the masterfile.

In selecting the 1996 sample, we sought traditional correspondence audits,
which required us to exclude certain types of workload. According to
Customer Service officials, most returns audited in fiscal year 1996 were
not the traditional correspondence workload. Rather, they included work
on EIC returns that misreported Social Security numbers—which IRS
transferred out of the audit program to the math-error adjustment program
        7
in 1997. Therefore, with the concurrence of the Customer Service officials,
we excluded these and other types of tax returns from our sample to allow
                                                            8
us to analyze more traditional correspondence audit work.

This adjusted the fiscal year 1996 total of 1.1 million tax returns audited to
335,050 returns, from which we randomly selected 502 returns. We
stratified our sample by whether (1) the taxpayer responded to IRS’ letters
and (2) a tax change was recommended. IRS located 446 of the 502 tax
returns and related audit workpapers for us to analyze. (See app. III for a
detailed description of our sampling methodology.)

To examine IRS’ processes and requirements for correspondence audits,
we collected documentation and did interviews at IRS on those processes
and requirements. We then used three methodologies. First, we reviewed
6
 Because our review pertains to traditional correspondence audits closed in 1996, all results are subject
to sampling errors. Unless otherwise noted, all estimates of percentages in this report have a 95-
percent confidence interval of less than plus or minus 10 percentage points.
7
Congress created EIC in 1975 to help workers offset payroll taxes and stay off welfare. In 1994,
Congress expanded EIC eligibility.
8
 For example, we also excluded audits of certain types of partnership returns as defined under the Tax
Equity and Fiscal Responsibility Act (TEFRA). In these audits, tax adjustments flowed through service
centers to allow necessary adjustments to be made to individual partners’ accounts on the basis of
audits by district office auditors of the partnership.




Page 17                                              GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 1
Introduction




the 446 tax returns in our sample and related audit workpaper files. For
these returns, IRS’ Fresno Service Center also provided masterfile account
data on what happened to the additional taxes assessed as of April 1998.
Second, we received written comments to a survey from all 10 service
center Compliance chiefs on the processes and requirements. And third,
we interviewed Examination officials at the National Office, as well as the
Directors, Compliance chiefs, Examination chiefs, and selected
Examination officials in 4 of IRS’ 10 service centers: Andover, MA; Fresno,
CA; Kansas City, MO; and Memphis, TN. (See app. IV for a comparison of
workloads at the service centers.)

We requested comments on a draft of our report. IRS provided comments
in a meeting on February 23, 1999, and a letter dated March 12, 1999.

We have incorporated these comments as appropriate. We have also
summarized the comments at the end of chapter 3 and have reprinted the
letter in appendix V.

We performed our audit work between September 1997 and August 1998 in
accordance with generally accepted government auditing standards.




Page 18                               GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 2

Correspondence Audits From 1992 to 1997


                                          During fiscal years 1992-97, the correspondence audit program
                                          experienced distinct shifts. IRS tripled the number of returns audited from
                                          1992 to 1994-95 before reducing its correspondence audit inventory in
                                          1997. A higher percent of the audits closed with no tax changes during
                                          fiscal years 1994-96, and the percent of audits that closed with no response
                                          from taxpayers more than doubled from 1995 to 1997.

                                          In terms of the characteristics for the traditional correspondence audits
                                          closed in 1996, an average of about 11 months elapsed between the start of
                                          the audit and the assessment of any taxes recommended during the audit.
                                          Many of the audited returns included complicated business and investment
                                          schedules that were not audited. Because so many of the correspondence
                                          audits in our study population year dealt with EIC claims, the reported
                                          income of most of the audited taxpayers was below $15,000.

                                          The number of correspondence audits and their results varied
Number of Returns                                                                                         1
                                          considerably between 1992 and 1997, with three distinct periods. As
Audited and the                           discussed with Customer Service officials and shown in table 2.1, these
Results of the                            periods were 1992-94, 1995-96, and 1997.
Correspondence
Audits
Table 2.1: Number of Returns Audited and Additional Taxes Recommended for Correspondence Audits
                              Number of                     Direct audit               Additional taxes                       Recommended
                                 audited Direct audit         hours per                  recommended                                taxes per
                                         a                                                               b
Fiscal year                      returns          hours return audited Staff years (dollars in millions)                       return audited
1992                             339,120        273,744              0.8     3,224                $740.1                               $2,182
1993                             232,237        245,692              1.1     3,107                  576.7                               2,483
1994                             352,596        336,992              1.0     3,223                  621.4                               1,762
1995                           1,054,573        703,848              0.7     3,969               1,368.6                                1,298
1996                           1,113,646        749,058              0.7     3,536               1,765.9                                1,586
1997                             757,670        572,957              0.8     3,048               2,170.5                                2,865
                                          a
                                              These figures do not include TEFRA returns.
                                          b
                                           IRS does not assess or collect all of these additional recommended taxes. Our earlier work shows,
                                          as of September 1997, that IRS assessed 76 percent and collected 43 percent of the additional taxes
                                          recommended in service center correspondence audits that closed in fiscal year 1997. See Tax
                                          Administration: IRS Measures Could Provide a More Balanced Picture of Audit Results and Costs
                                          (GAO/GGD-98-128, June 23, 1998).
                                          Source: GAO analysis of IRS data.

                                          In the first period (fiscal years 1992-94), the number of tax returns IRS
                                          audited through correspondence totaled a few hundred thousand annually.
                                          Comparing 1992 to 1994, the amount of taxes recommended overall and

                                          1
                                          The number of returns audited and the results of correspondence audits also varied by service center.
                                          Appendix IV provides these numbers and results across the 10 service centers for fiscal years 1992-97.




                                          Page 19                                             GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 2
Correspondence Audits From 1992 to 1997




per audited return declined. According to Customer Service officials, these
3 fiscal years represented IRS’ traditional practices for doing
correspondence audits.

In the second period (fiscal years 1995-96), IRS’ correspondence audit
inventory increased to over 1 million returns annually because of an
increase in audits of returns that claimed EIC. Almost 800,000 of the audits
that closed in 1996 involved EIC returns with missing or invalid Social
                    2
Security numbers. This increased audit focus on EIC arose from
congressional concerns about EIC noncompliance. With the threefold
increase in audits, the amount of recommended taxes more than doubled.
As a result, the tax amounts recommended per audited return declined by
                                                              3
as much as about half (from $2,483 in 1993 to $1,298 in 1995).

In the third period (fiscal year 1997), IRS decreased the correspondence
audit inventory to about 758,000. Customer Service officials told us that
IRS moved over 700,000 EIC returns with misreported Social Security
numbers to its math-error adjustment program. To partially substitute for
these transferred audits, the officials said IRS began auditing more
                                                         4
individual retirement accounts and potential nonfilers. With this shift in
the audit inventory in 1997, the number of audited returns and staff years
decreased and the amounts of taxes recommended overall and per audited
return increased compared to 1996. With the new types of tax issues being
audited, the audits were more likely to recommend tax changes in higher
amounts compared to audits of other types of issues such as EIC.

The large number of audited EIC returns also affected audit closures.
From 1992 to 1994, less than 25 percent of the audits closed with no
changes to tax liability. Further, the default rate—that is, the rate at which
audits closed when taxpayers did not respond to tax assessment notices—
remained relatively constant at around 40 percent. With the inclusion of
EIC returns in 1995, the no-change rate doubled to 46 percent, and the
default rate initially dropped to 29 percent. After the EIC returns were
transferred to the math-error adjustment program in 1997, the no-change
rate decreased to the 1992 level, but the default rate more than doubled
2
 Although our study population for fiscal year 1996 excluded this type of EIC return from the audit
inventory, IRS still audited many other types of EIC claims.
3
 A contributing factor was that many of these EIC audits recommended either no change to the tax
liability or lower amounts of tax changes compared to audits of other tax issues.
4
 Potential nonfilers, as the name implies, are those who may not have filed returns. When IRS is unable
to find a return that matches financial information reported by employers or financial institutions, it
prepares a tax return for the nonfiler (an SFR or Substitute for Return) and computes the tax liability
based on the reported information.




Page 20                                              GAO/GGD-99-48 IRS’ Correspondence Audits
                                          Chapter 2
                                          Correspondence Audits From 1992 to 1997




                                          compared to 1995, reaching 63 percent. Table 2.2 shows these shifts in
                                          audit closures over the three time periods.


Table 2.2: Frequency of Audit Closures for Correspondence Audits in Total, Fiscal Years 1992-97
                                                           Audited returns closed as
                                                                                           a                                     b               c
Fiscal year                   Agreed        Unagreed         No change             Default                     Undeliverable              Total
1992                              28%               3%                13%              41%                                14%              100%
1993                              27                4                 16               43                                  9               100
1994                              31                4                 23               36                                  6               100
1995                              17                1                 46               29                                  6               100
1996                              15                2                 36               43                                  4               100
1997                              15                4                 13               63                                  6               100
                                          a
                                           IRS closed the audit with a recommended tax assessment, and the taxpayer did not respond to IRS’
                                          letter on the assessment.
                                          b
                                           IRS closed the audit with a recommended tax assessment when the letter on the audit
                                          recommendations was returned to IRS.
                                          c
                                              Percentages may not sum to 100 due to rounding.
                                          Source: GAO analysis of IRS data.

                                          In the correspondence audit process, many audits are started soon after
Time Taken to Conduct                     the returns are filed, while others are started a year or more later. For
Correspondence                            returns involving EIC claims, beginning the audit soon after the return is
Audits                                    filed increases the likelihood that the issues can be examined before any
                                          tax refunds are released. For other returns filed in the spring, the audits
                                                                                         5
                                          often do not begin until the following winter. Audits of taxpayers who do
                                          not file tax returns may take a year or more to begin.

                                          For traditional correspondence audits closed in 1996, we found that the
                                          time between the filing of the return and the start of the audit averaged 10
                                          months, and the time between the start of the audit and the assessment of
                                          any additional taxes took, on average, over 11 more months. The length of
                                          the audit varied, depending on whether taxpayers responded and how it
                                                                                                      6
                                          was closed. On the one hand, audits took about 7 months when taxpayers
                                          responded to IRS’ notice of audit and the audits closed without
                                          recommending additional taxes. On the other hand, when taxpayers did
                                          not respond to IRS’ 90-day letters notifying them of any additional tax
                                          assessments and the audits closed with the taxpayer defaulting, audits
                                          took much longer. For example, an average of about 13 months elapsed
                                          between the start of the audit and the assessment of any additional taxes.


                                          5
                                           This delay is often necessary to allow IRS to enter return data into its computers, associate tax returns
                                          with information returns (e.g., Forms W-2 and 1099), process returns filed after April 15, and classify
                                          returns for audit potential.
                                          6
                                          The 95-percent confidence interval for this estimate ranges from a low of 185 days to a high of 248
                                          days.




                                          Page 21                                               GAO/GGD-99-48 IRS’ Correspondence Audits
                        Chapter 2
                        Correspondence Audits From 1992 to 1997




                        Seven months of this time were spent simply waiting for the taxpayers to
                        respond to one or more of IRS’ letters.

                        For these audits, the average time that elapsed from the filing of the return
                        to the additional tax assessment was 21 months. This elapsed time is
                        significant in two respects. First, IRS collects 27 percent of taxes assessed
                        through correspondence audits before the assessment becomes final and
                                                                                       7
                        another 49 percent within 15 weeks of the final assessment. Second,
                        Congress’ 1998 legislation to restructure IRS contains provisions that
                        suspend the accrual of interest and some penalties if IRS fails to notify the
                        taxpayer of additional tax liabilities within 18 months after a return is
                              8
                        filed. After 2003, suspension will begin 12 months after the tax return is
                        filed. Delays in completing the audit, therefore, could reduce revenue from
                                                            9
                        penalty and interest assessments.

                        Aside from these considerations, the time to assess any recommended
                        taxes in these audits may be extended if taxpayers choose to exercise their
                        right to appeal these audit recommendations. For audits being appealed or
                        otherwise disputed by the taxpayer, a long amount of time can elapse
                        before a determination on the tax assessment can be reached.

                        The traditional correspondence audits closed in 1996 dealt with a few
Profile of Tax Issues   types of simpler tax issues rather than the more complex business and
Audited Through         investment tax issues on individual returns. The types of tax issues audited
Correspondence          through correspondence primarily included EIC claims and self-
                        employment tax. On average, each traditional correspondence audit dealt
                        with two tax issues. As figure 2.1 shows, EIC and related issues, such as
                        the taxpayer’s filing status and dependent exemptions, accounted for over
                        half of these audited tax issues.




                        7
                        Percentages are taken from an earlier analysis of correspondence audits closed in fiscal year 1992. See
                        GAO/GGD-98-128, June 23, 1998.
                        8
                         The legislation is not explicit, however, on which IRS letter—the one recommending additional tax
                        assessments or the one notifying taxpayers of the tax assessment—will serve to notify the taxpayer.
                        9
                         According to Customer Service officials, to reduce the time to identify any additional assessments
                        through audits as well as to give taxpayers more options, four service centers will be testing during
                        fiscal year 1999, the impact of a new letter that combines the initial letter and the 30-day letter. This
                        new letter will give taxpayers the choice of agreeing to pay a specific amount of tax and interest (as
                        well as any penalty amount) at the start of the audit. If taxpayers do not agree to pay, they can respond
                        by providing information in support of the original tax amount that they reported.




                        Page 22                                               GAO/GGD-99-48 IRS’ Correspondence Audits
                                      Chapter 2
                                      Correspondence Audits From 1992 to 1997




Figure 2.1: Percentage of Time That
Each Issue Occurred in Traditional
Correspondence Audits, Fiscal Year
1996




                                      Source: GAO summary of IRS data.




                                      Although IRS’ traditional correspondence audits closed in 1996 usually
Profile of Tax Returns                addressed simpler tax issues, an estimated 65 percent of the audited
Audited Through                       returns had at least one schedule attached. Many of these schedules (such
Correspondence                        as C, D, E, and F) reported more complex business and investment tax




                                      Page 23                                   GAO/GGD-99-48 IRS’ Correspondence Audits
                                           Chapter 2
                                           Correspondence Audits From 1992 to 1997




                                           issues that were not audited. For the audited returns with schedules, an
                                           estimated

                                         • 61 percent had schedules supporting their EIC claims;
                                         • 26 percent had a schedule A or B to report itemized deductions or interest
                                           and dividend income;
                                         • 22 percent had a schedule C to report business income from self-
                                           employment;
                                         • 10 percent had a schedule D to report capital gains or losses;
                                         • 8 percent had a schedule E to report gains or losses from rental property,
                                           partnerships, and other entities; and
                                         • 3 percent had a schedule F to report income from farming.


                                           In addition, the individual taxpayers subjected to traditional
                                           correspondence audits that closed in 1996 usually reported annual
                                           incomes of less than $15,000 on their audited returns. In fact, as table 2.3
                                           shows, an estimated 76 percent of the audited returns reported taxable
                                           incomes of less than $15,000. However, 44 percent of all income tax
                                           returns filed by individuals in 1996 reported taxable incomes of less than
                                           $15,000. The returns audited through correspondence tend to report
                                           income below $15,000 because they also report simpler tax issues and EIC
                                           claims, both of which can be associated with lower amounts of income.


Table 2.3: Comparison of Annual Incomes of Taxpayers Audited Through Correspondence to All Taxpayers Filing Tax Returns
                                                               Percent of individual tax returns
                                                                                                                           a
                                    1996 traditional audit population by                 1996 data on filed tax returns by
Range of reported income       Adjusted gross income         Taxable income       Adjusted gross income        Taxable income
$0 < $15,000                                         55%                   76%                          34%                   44%
$15,000 < $25,000                                    20                     6                           18                    17
$25,000 < $50,000                                    13                    12                           25                    24
$50,000 < $100,000                                    9                     4                           17                    11
$100,000 and over                                     3                     2                             5                    4
Total                                               100%                 100%                           99%b                 100%
                                           a
                                            1996 represents the filing year and not the year the audits were closed.
                                           b
                                            Percentages may not sum to 100 due to rounding.
                                           Source: GAO analysis of results from our study population and IRS data.

                                           It is important to recognize that table 2.3 does not compare all taxpayers
                                           with audited returns to all taxpayers who filed returns. Taxpayers with
                                           higher annual incomes and more complex tax issues are typically audited
                                           through IRS district offices using other types of audit methods than
                                           correspondence audits.




                                           Page 24                                              GAO/GGD-99-48 IRS’ Correspondence Audits
Chapter 3

Weaknesses in Processes and Requirements
for Selecting and Conducting Correspondence
Audits
                      The correspondence audit process is one of the tools IRS uses to help
                      ensure that taxpayers pay their proper tax liability. It is designed to audit,
                      through the mail, all questionable issues identified on less complicated tax
                      returns. However, our work pointed to a number of weaknesses in the
                      processes for implementing requirements for selecting returns to audit and
                      for auditing those returns.

                      We found that service centers did not follow IRS’ requirements for
Most Tax Returns      classifying returns and referring returns with complex business or
Audited Through       investment schedules to district offices. IRS manuals state that after being
Correspondence Were   identified for audit, tax returns should be classified to ensure that all
                      issues worth auditing are identified. Returns with complex issues and
Not Classified        schedules are to be classified by revenue agents or tax auditors who have
                      the training and experience with complex tax issues. Returns with less
                      complicated issues can be classified by tax examiners. However, service
                      centers used tax examiners to classify most returns, some of which
                      involved complex schedules, and rarely referred returns with complex
                      schedules to an IRS district office.

                      In examining the administrative files and audit workpapers for the
                      traditional correspondence audits closed in 1996, we found that, excluding
                      nonfilers, an estimated 69 percent did not have any evidence of
                      classification as required. When returns are not classified by trained staff,
                      potential noncompliance may go undetected. Moreover, the lack of
                      classification can lead to IRS’ unnecessarily auditing returns or issues and
                      thus burdening taxpayers.

                      For the returns that had been classified, we found indications that tax
                      examiners did most of the classification. Having tax examiners classify one
                      or two issues on simpler tax returns is to be expected. However, in 1996,
                      an estimated 20 percent of the tax returns traditionally audited through
                                                                                                 1
                      correspondence included complex business and investment schedules.
                      Specifically, IRS requires returns with more than one business schedule or
                      schedules C or F to be referred to district offices for classification and
                      possible audit. We found referrals of such returns to IRS district offices in
                      less than an estimated 1 percent of the traditional correspondence audits.

                      We reviewed a judgmental sample of about 30 files with these complex
                      returns and found that one-third could have merited referral to a district.

                      1
                       We estimate that 50 percent of the workpapers for these returns with complex schedules (schedules
                      C, D, E, or F) had no evidence of classification. The 95-percent confidence interval for this estimate
                      ranges from 38 to 62 percent.




                      Page 25                                              GAO/GGD-99-48 IRS’ Correspondence Audits
                        Chapter 3
                        Weaknesses in Processes and Requirements for Selecting and Conducting Correspondence
                        Audits




                        For example, we found complex business returns that deducted sizable
                        expense amounts compared to the reported business income but no
                        evidence that anyone at IRS looked at the audit potential of these
                        deductions. Without a control such as classification of returns with
                        complex schedules by IRS tax auditors or revenue agents with
                        commensurate training and experience, IRS could not verify whether
                        returns slated for correspondence audits should have been referred to
                        district offices.

                        We surveyed compliance chiefs at all 10 service centers, who confirmed
                        that not all returns are classified and that tax examiners do most
                        classifications. For example, five chiefs noted that their service centers
                        usually classify less than one-third of the returns they audit. When
                        classification occurs, tax examiners classify 85 percent or more of the
                        returns according to six compliance chiefs; the other four centers use tax
                        examiners but also use tax auditors or revenue agents. Two compliance
                        chiefs added that tax examiners are trained to audit simple issues and are
                        not ideal for classifying returns with complex issues. Also, many chiefs
                        noted that service centers might not have referred returns with complex
                        issues because they believed the returns would not meet district office
                        criteria. They said service centers tend to receive returns because
                        computerized criteria targeted a simpler issue to audit, usually before
                        districts began their classification of returns.

                        In our follow-up on the classification practices, Customer Service officials
                        told us that not all tax returns needed to be classified to identify all
                        potential audit issues. They said that correspondence audits were designed
                        for quickly auditing one or two issues through the mail and then moving on
                        to other audits with similar types of issues. As a result, these officials said
                        that a fuller classification beyond the one or two issues is unnecessary for
                        simple returns, which most of the audit workload comprises. However,
                        these officials also said that such a fuller classification might be useful for
                        returns with complex issues and schedules.

                        IRS’ manuals and audit quality standards require that tax examiners
Audits Did Not Always   adequately support their audit recommendations in the audit workpaper
Have Adequate           files. Officials at the four service centers we visited told us that documents
Documentation           with information on the case history, audit issue development, and support
                        for recommended taxes are key documents in developing an audit trail on
                        the examiners’ actions as well as in documenting support. Without an audit
                        trail or documented support, neither IRS nor the taxpayer can be assured
                        of the basis for any additional taxes recommended.




                        Page 26                                     GAO/GGD-99-48 IRS’ Correspondence Audits
                                          Chapter 3
                                          Weaknesses in Processes and Requirements for Selecting and Conducting Correspondence
                                          Audits




                                          Our analysis of these and other documents in the workpaper files for
                                          traditional correspondence audits closed in 1996 showed that about one-
                                          third of the audits had little or no evidence of documents to explain the
                                          audit trail. Furthermore, about one-fourth of the issues audited had little or
                                          very little support in the workpaper files for the recommended additional
                                          taxes. In making our determination, we looked for these key documents or
                                          any evidence to show what the tax examiners did or how they arrived at
                                          certain tax recommendations. When any evidence was in the files, we
                                          assessed the extent to which it documented the tax examiners’ actions,
                                          ranging from none or a very little extent to a very great extent. Kansas City
                                          Service Center staff confirmed our determinations for files with none or a
                                          very little extent. (See table 3.1.)

Table 3.1: Extent to Which Workpaper                                                                    a                                         b
Files Had an Audit Trail and Supporting   Extent                                          Audit trail        Supporting documentation
Documentation on Audited Issues for       Very great                                               7%                               9%
Returns in Our 1996 Study Population      Great                                                   28                               27
                                          Some                                                    31                               38
                                          Little                                                  25                               17
                                                                                                        c
                                          Very little                                                                               8
                                                                                                                                                  c
                                          None                                                      9
                                          Total                                                   100                                        99
                                          Note: Percentages may not sum to 100 due to rounding.
                                          a
                                           This analysis is based on an estimated 335,050 tax returns in the traditional correspondence audits
                                          closed in 1996.
                                          b
                                           This analysis is based on an estimated 776,200 audited issues on tax returns in the traditional
                                          correspondence audits for which an indication of supporting documentation was given.
                                          c
                                              Not applicable.
                                          Source: GAO analysis of results from our study population.


                                          In attempting to determine the reasons for this lack of documentation, our
                                          analyses showed a direct relationship between the amount of time charged
                                          and degree of documented support. That is, the less time charged to an
                                          audit, the less the workpapers documented the audit findings. (See app. III
                                          for a detailed description of our analyses.) It is possible that some audits
                                          may be so brief that documentation to a little extent may be enough. For
                                          example, Customer Service officials said that audits of nonfilers or in
                                          which taxpayers did not respond might have less documentation.
                                          However, these officials could not describe an audit for which no or very
                                          little documentation would be acceptable.

                                          At two of the four service centers we visited, we found that management
                                          affected how much time tax examiners spent documenting their work. For
                                          example, the Andover Service Center management told us they
                                          encouraged tax examiners to document their work in the files. We found



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                          that Andover examiners spent 1.2 hours per audited return in 1996 and
                          were generally consistent in documenting their work in the files. However,
                          the Fresno Service Center management eased documentation
                          requirements in 1996 because of the increase in EIC work. As such, Fresno
                          tax examiners spent 0.6 hours per audited return and had a larger
                          proportion of audit files with little or no audit trail or documented support
                          for the additional taxes recommended.

                          Compliance chiefs in the four service centers we visited told us that the
                          significant increase in the number of audits during 1995 and 1996 added
                          pressure on tax examiners to respond to taxpayers within prescribed time
                          frames and to close the audits as quickly as possible. They said service
                          centers with the greatest increase in workload had even more pressure to
                          quickly audit the returns. As a result, they said the tax examiners had
                          difficulty documenting their audit work when they were expected to
                          quickly audit so many returns.

                          In addition to the increased workload, the four chiefs also indicated that
                          service center management diverts tax examiners from their audit work to
                          assist in nonaudit duties, such as answering telephone calls during the
                          filing season. According to various service center officials, the filing
                          season is a critical time for tax examiners because most of the EIC
                          workload is done then. Thus, they said these diversions placed additional
                          pressure on the tax examiners to work quickly.

                          Because the traditional correspondence audits that closed in 1996
Some Service Centers      contained a large number of returns claiming EIC, we determined whether
Accepted Differing        the service centers adhered to IRS’ seven-point eligibility test, including
Levels of Justification   third-party verification to support the EIC claims. For example, taxpayers
                          claiming EIC are required to provide information on the children being
for EIC Claims            served by EIC, such as their birth dates, Social Security numbers, and
                          school records. IRS sends taxpayers a questionnaire with the initial letter
                          to solicit documentation, including information from third parties, that
                          justifies their EIC claims.

                          We found that the 10 service centers accepted differing levels of
                          documentation to justify EIC claims. For the traditional correspondence
                          audits that closed in 1996, at least three service centers allowed EIC claims
                          based on assurances from the taxpayers but without documentation or
                          third-party verification. Officials at one of the three service centers stated
                          that the documentation requirements were eased because the center’s tax
                          examiner work force was inexperienced and unable to otherwise audit the
                          large volume of returns within the prescribed time frames. As taxpayers



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                      responded to IRS’ letters, service center management pushed the tax
                      examiners to provide timely responses. To do this as quickly as possible,
                      the service center eased the documentation requirements. We did not ask
                      IRS to check these EIC claims to determine whether any of these
                      taxpayers received an EIC to which they were not entitled or were denied
                      a claim to which they were entitled.

                      The other seven service centers required varying degrees of taxpayer and
                      third-party justification. Of these seven service centers, at least three
                      required taxpayers to submit documentation, such as birth certificates and
                      Social Security cards or third-party residency verification from schools or
                      day care providers.

                      IRS has two levels of review to check whether correspondence audits
Limited Supervisory   adhered to established requirements and audit standards. The first review
Reviews and Audit     is to be performed by the tax examiners’ supervisors while the audits are
Quality Reviews       being conducted. A second review is to be conducted on a sample of
                      closed audits by each service center’s audit quality staff to measure
                      adherence to the audit quality standards.

                      We found evidence of supervisory review in an estimated 6 percent of the
                      workpaper files for the traditional correspondence audits. In searching
                      these files, we counted any supervisory comment that pertained to the
                      quality of the audits and the support for the auditor’s recommendation. We
                      also found that the requirement for supervisory review varied by service
                      center. For example, one center required supervisors to review all the “no-
                      change” audits plus the audit workload of each tax examiner monthly.
                      Another center required supervisors to review eight audits per tax
                      examiner per quarter. A third center required reviews of six audits per
                      examiner for an entire year.

                      Customer Service and service center officials told us that supervisors
                      could not have reviewed all of the 1.1 million audits that were closed in
                      1996. They explained that the number of audits that can be reviewed
                      depends on the supervisor’s workload, which typically includes overseeing
                      between 10 and 15 tax examiners, with each examiner having roughly 50
                      audits ongoing at any given time. The officials said they believed that the
                      supervisors reviewed more than 6 percent of the closed audits. It may be
                      possible that some supervisors did reviews but just did not document
                      them. IRS does not require supervisors to document their reviews against
                      the audit quality standards in the audit workpapers. Even so, after we
                      shared the results of our analyses of the 1996 audits, Andover Service




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Center officials said they would implement a control to ensure that
supervisory reviews were documented in the workpapers.

As for the reviews to measure audit quality, IRS requires each service
center to review a sample of all its correspondence audits closed annually,
regardless of how they closed, for adherence to IRS’ audit standards. For
this sample, service centers are required to rate adherence to audit
standards, such as the existence of documentation in the workpapers on
the audit steps, and support for audit recommendations, such as additional
taxes. The results of these reviews are to be entered into the
Correspondence Examination Quality Management System (CEQMS) and
analyzed to measure the extent of adherence to each quality standard and
                           2
to identify problem areas.

Further, we found some disparities between the CEQMS data and our
results. For example, the CEQMS data for the correspondence audits
closed in 1996 showed that almost 100 percent of the audits had been
appropriately classified and that 96 percent of the audits met IRS’
standards for workpaper documentation. However, as stated earlier, our
review of the workpapers for traditional correspondence audits closed in
1996 found that, excluding nonfilers, an estimated 69 percent had no
evidence of classification, and an estimated 34 percent had little or no
evidence of documents to explain the audit trail. We asked IRS officials
about these disparities. Customer Service officials had no opinions about
the reasons for the disparities. Officials at 6 of IRS’ 10 service centers
attributed the disparities to unreliable CEQMS data because service
centers are excluding certain types of audits from the review sample and
from being measured against the audit standard on workpaper
documentation.

In following up with service center officials about CEQMS data reliability,
we found that not all service centers were following IRS’ requirements for
drawing the review samples. For example, according to these officials,
some centers’ samples excluded closed audits in which the taxpayers did
not respond to IRS’ letters because there were few workpapers to review.
Even when taxpayers do not respond, the audit recommendations still
need to be supported. Similarly, some service centers also excluded audits
that recommended no tax changes. Even when recommending no tax
changes, examiners are still required to follow IRS’ audit quality standards
and document adherence to those standards.

2
 We found evidence of such a quality review for less than 1 percent of the traditional correspondence
audits closed in 1996.




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                       We also found a similar exclusion when taxpayers did not respond with
                       information about the tax issue being audited. IRS allowed service centers
                       to exclude such audits from being measured against the audit standard on
                       workpaper documentation. Customer Service officials told us that service
                       centers might instruct their quality reviewers to record “not applicable” for
                       the documentation standard when required documentation is missing if
                       taxpayers do not respond. Regardless of the issue being audited, less
                       documentation of the audit trail or audit support would be expected when
                       taxpayers do not respond. Even so, the service centers had some reason
                       for contacting the taxpayers about the potential for additional tax
                       liabilities, and they are required to document that reason along with the
                       support for the additional taxes that are to be recommended when
                       taxpayers do not respond.

                       For the traditional correspondence audits closed in 1996, an estimated 57
Minimal Contact With   percent of taxpayers did not respond to IRS’ audit letters. IRS has not
Nonresponsive          identified the reasons why these taxpayers did not respond. We found that
Taxpayers              tax examiners sometimes tried to contact these nonresponsive taxpayers
                       beyond the minimal requirements for correspondence audits—an initial
                       letter and a final letter to close the audit. Examination officials at the four
                       service centers we visited stated that additional contacts would increase
                       the time spent on such audits, with no guaranteed results, and would
                       prevent tax examiners from auditing more returns.

                       We asked Customer Service and service center officials why so many
                       taxpayers did not respond. They said they have not studied the reasons but
                       offered three possible explanations. First, some taxpayers might be
                       overwhelmed or intimidated by IRS’ letters and be uncomfortable with
                       responding. Second, some taxpayers might not understand IRS’ letters and
                       not know how to respond. Third, other taxpayers might know that they
                       owe the additional tax but hope that their nonresponsiveness would
                       discourage IRS from trying to collect that tax.

                       For the traditional correspondence audits closed in 1996, some IRS letters
                       might have been overwhelming or confusing to taxpayers. For example,
                       some letters made blanket, standardized requests for information without
                       specifying the reason for IRS’ concerns; one letter requested up to 14
                       pieces of information on an alimony issue without stating the specific
                       information needed. Further, we determined that almost half the letters
                       might have been hard to understand because they were written in generic
                       language. An estimated 11 percent of the letters were tailored to a specific
                       audit; in the other audits, either the letters had both generic and tailored




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language or the workpaper files did not have the letters for us to make a
determination.

Customer Service and service center officials acknowledged that their
letters were generic and contained legal language that many taxpayers
might not be able to understand. The officials also stated that tax
examiners tend to rely on this generic language because it is readily
accessible in IRS’ computers and expedites the audit. They said that
preparing letters tailored to each taxpayer takes more time and thus limits
the number of audits that can be processed.

We talked to various Customer Service officials about any plans to gather
information from taxpayers on why they do not respond. Although these
officials identified some efforts, as of January 1999, these efforts either
were not implemented or had not provided any data on why taxpayers did
                                   3
not respond to IRS’ audit letters. Customer Service officials told us that
gathering information from these taxpayers could be difficult, but the
benefits of the information collected from them would more than likely be
cost-effective. Without knowing the reasons for nonresponsiveness, IRS
cannot know the extent to which the clarity of its correspondence, or
other factors, contributed to taxpayers’ not responding to IRS’ audit
letters.

Without taxpayer responses, IRS’ determinations of the correct tax liability
are less certain. When taxpayers do not respond, service centers are to
assess any additional taxes that they think are owed. Our analyses of
correspondence audits closed in 1996 also identified other negative effects
when taxpayers did not respond. The audits usually took longer to
complete, and additional taxes owed took longer to collect compared to
audits where taxpayers responded. Those not responding paid less of their
recommended tax assessment than taxpayers who responded. As of April
                                                             4
1998, taxpayers who responded paid an estimated 79 percent of the
additional taxes, while those not responding paid an estimated 31 percent.

Further, an estimated 72 percent of those asking IRS to reconsider the
                                                           5
recommended taxes had not responded to IRS’ final letter. Occurring
3
 The Memphis Service Center proposed a study in 1996 to gather information on why taxpayers were
not responding to IRS’ audit letters. According to Customer Service officials, they have not approved
this proposal because it was not specific enough. In January 1999, Customer Service officials also said
that a customer satisfaction survey might have some information on why taxpayers do not respond.
4
    The 95-percent confidence interval for this estimate ranges from 66 to 92 percent.
5
 An estimated 29 percent of all taxpayers with traditional correspondence audits closed in 1996 asked
IRS to reconsider their recommended taxes.




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              months after the audits closed—usually when IRS took action to collect
              these assessments—audit reconsiderations cause IRS to redo all or part of
              the audit, adding to the time for IRS and taxpayers to determine the
              correct tax liability. With the added time, taxpayers also incur additional
              interest charges on the unpaid assessments that remain after the
              reconsideration. We found that IRS closed an estimated 72 percent of the
              reconsiderations without reducing the assessments. These effects might
              have been minimized if the taxpayers had responded during the audit or
              had acted on their appeal rights at the close of the audit.

              Customer Service officials described their efforts to improve
              responsiveness. Customer Service officials told us they initiated an effort
              to revise the correspondence audit letters in August 1998. They also
              indicated that IRS is contracting with a private firm to improve the clarity
              of various IRS letters, starting with collection notices. These officials said
              the correspondence audit letters eventually would be covered under this
              contract. Finally, they said that IRS plans to test a toll-free phone system in
              1999 to encourage taxpayers who receive audit letters to call for
              clarification if needed. Customer Service officials also shared their plans to
              measure the effects of each effort on taxpayer responsiveness. However,
              Customer Service officials did not know whether these efforts would
              improve taxpayer responsiveness because the efforts were in the initial
              stages.

              IRS uses audits to help ensure that taxpayers pay their proper tax liability.
Conclusions   In reviewing IRS’ correspondence audit processes and requirements, we
              found weaknesses that undermine its ability to (1) identify and audit all
              questionable tax issues on tax returns, (2) support its audit
              recommendations for additional taxes, (3) consistently accept justification
              for EIC claims, (4) review adherence to audit requirements and quality
              standards, and (5) solicit taxpayers’ responses about the tax issues being
              audited.

              Tax returns that are slated for correspondence audits are to be reviewed
              by knowledgeable staff to identify all questionable issues and to ensure
              that returns with more complex audit issues have been forwarded to the
              appropriate auditors. Such a classification is important because IRS
              generally has one chance to audit a tax return. In reviewing the
              correspondence audits closed in 1996, we found that an estimated 69
              percent had not been classified. When returns were classified, tax
              examiners usually served as the classifiers. Tax examiners are not trained
              to identify or audit complex issues, such as investments and business
              deductions. However, some of the returns we analyzed included complex



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schedules, and less than 1 percent of these returns had been referred to
district offices, where revenue agents and tax auditors are trained to
classify and audit the more complex issues. As a result, these complex
returns may have had questionable issues that were neither classified nor
audited.

We found that the workpaper files for about one-third of the traditional
correspondence audits closed in 1996 provided little or no audit trail for
the tax examiners’ actions, and about one-fourth of the issues audited had
little or very little support in the workpaper files for the recommended
additional taxes. Without proper documentation of the workpapers,
neither IRS nor taxpayers can be assured that the recommended additional
taxes are accurate and supported.

Our analyses indicated that as the time spent by tax examiners on each
audit decreased, so did the amount of support in the audit workpaper files.
IRS officials said that the large volume of returns that had to be audited
pressured the tax examiners to work quickly. Adding to this pressure has
been the diversion of tax examiners to nonaudit work during each filing
season.

As an outgrowth of this emphasis on working quickly, some service
centers eased the documentation requirements for claiming EIC. At least
three service centers allowed EIC claims without the third-party
verification of the taxpayer’s eligibility. The other service centers required
more extensive verification than these three centers. We could not
determine from the workpapers whether these audits allowed any
taxpayers to claim an EIC to which they were not entitled.

IRS’ two types of quality reviews were unlikely to identify such
weaknesses in the correspondence audit process. We found little evidence
of supervisory review for the traditional correspondence audits closed in
1996. IRS does not require supervisory reviews to be documented.
Although we found weaknesses in classifying and documenting support,
IRS’ quality measurement reviews of closed correspondence audits gave
these areas high ratings. The discrepancies between our findings and IRS’
measurements can be explained, in part, by some service centers’ not
following IRS’ requirement to include all types of audit closures in the
review samples. Further, service centers were allowed to exclude audits in
which taxpayers did not respond and that lacked required documentation
on the audit steps and support for recommended taxes from being
measured against the audit standard on workpaper documentation.




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                    Finally, in over half of the traditional correspondence audits closed in
                    1996, the taxpayers did not respond to IRS’ queries during the audit. IRS
                    officials had not determined the reasons but believed that the language in
                    their letters might be a factor. Audit letters often had generic and legal
                    language that was difficult to understand. Because of pressures to process
                    large audit workloads, tax examiners were not likely to take the time to
                    tailor letters to a specific audit. And when taxpayers did not respond, IRS
                    had to assess the additional taxes under audit without knowing for sure if
                    all these taxes were owed. Further, taxpayers who did not respond paid
                    less of their recommended taxes owed. Without knowing the reasons for
                    taxpayers’ not responding, IRS cannot know the extent to which its letters,
                    or other factors, contributed to their nonresponsiveness.

                    We did not attempt to measure the specific effects of the weaknesses we
                    found. Nevertheless, each weakness can, individually or in combination,
                    erode the integrity of IRS’ correspondence audit processes, which are
                    designed to help ensure that taxpayers pay the correct tax. Improving
                    controls over the audit processes as well as collecting more information
                    about the weaknesses would help to accomplish these ends.

                    GAO recommends that the IRS Commissioner improve controls to better
Recommendations     ensure that IRS’ correspondence audit processes adhere to existing audit
                    requirements and standards on

                  • classifying filed returns, and in particular, referring returns with complex
                    schedules that may have potential tax changes to staff with sufficient
                    knowledge to classify them;
                  • documenting the support for audit findings and recommendations in the
                    audit workpaper files,
                  • ensuring consistency in the treatment of audited EIC claims by collecting
                    and using the information required, including verification from third
                    parties, to justify the claims; and
                  • including all types of closed audits across the 10 service centers in the
                    samples for measuring audit quality.

                    GAO also recommends that the IRS Commissioner

                  • require supervisors in the service centers to document their reviews of
                    audit workpapers;
                  • eliminate the discretion that service centers have to exclude audits that
                    lack documentation on the audit steps and support for audit
                    recommendations from the calculations IRS does to measure adherence to
                    the audit quality standard on workpaper documentation; and



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                      • determine the reasons, through statistically valid and cost-effective means,
                        for taxpayers’ not responding to IRS’ audit letters, so that IRS can identify
                        ways to encourage more taxpayers to respond.

                        We requested comments on a draft of this report from the Commissioner
Agency Comments and     of Internal Revenue. Officials representing the Assistant Commissioner for
Our Evaluation          Customer Service and the IRS Commissioner’s Office of Legislative Affairs
                        provided IRS’ comments in a meeting on February 23, 1999. IRS also
                        documented these comments in a letter dated March 12, 1999, which is
                        reprinted in appendix V.

                        Overall, IRS concurred with all of our recommendations and agreed to
                        take efforts to implement them. IRS officials provided elaboration on our
                        recommendation involving IRS’ requirement to classify returns,
                        particularly returns with complex schedules. Given that the number of
                        returns audited through correspondence that include complex schedules is
                        relatively low, Customer Service officials said that they will work with the
                        Assistant Commissioner (Research and Statistics of Income) on ways to
                        isolate returns with complex schedules so that they are not automatically
                        selected for correspondence audits. This would provide district offices
                        with the opportunity to first look at these returns before they are audited
                        through correspondence.

                        IRS also provided us with a technical comment on figure 1.1 to clarify at
                        what point recommended taxes become assessed. We have incorporated
                        this comment into the report.




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Page 37   GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix I

Overview of Audit Processes at Service
Centers and District Offices

                         This appendix illustrates the differences between the audits conducted at
                         IRS’ service centers and district offices.

                         Approximately 119 million individual taxpayers filed returns in 1996. Some
Processes to Screen      returns are likely to have errors or misinterpretations of the tax laws. IRS’
and Select Tax Returns   process for identifying returns with the most significant errors or
for Audit                misinterpretations is important because only 1.9 million, or less than 2
                         percent, of the returns are audited. IRS uses computer programs to select
                         many of the returns for audit and manual reviews of the returns (known as
                         classification) to identify tax issues for audit. The selection and
                         classification processes help IRS to choose an auditing technique—
                         correspondence sent from service centers or face-to-face meetings at the
                         district offices.

                         For fiscal year 1996, service centers did two-thirds of the 1.9 million audits
Differences Between                                                             1
                         under the Compliance Branch of Customer Service. The remaining audits
Service Center and       were done through district offices under IRS’ Examination Division. Audits
District Office Audits   at the service centers differ from those at the district offices in terms of
                         the (1) audit techniques being used and complexity of tax issues being
                         audited (i.e., audit issues) and (2) selection of the audited returns.

                         First, service center audits generally involve one or two audit issues that
                         are simple enough to be audited through correspondence, such as the self-
                         employment tax. District office audits generally involve multiple audit
                         issues that are complex enough to require face-to-face meetings with
                         taxpayers. Complex issues include gains and losses from various kinds of
                         investments as well as business income and deductions.

                         Second, the methods to screen and select returns with audit potential
                         because of apparent noncompliance differ somewhat at the districts
                         compared to the service centers. These methods include using various
                         sources to identify returns with audit potential and classifying those
                         returns to check not only whether they should be audited but also what
                         issues should be audited. For example, although centers and district
                         offices use computer programs to identify tax returns for audit, these
                         programs differ in scope. The programs usually identify returns with one
                         audit issue for service centers and with multiple, more complex issues for
                         district offices.


                         1
                          Correspondence audits were conducted under the Examination Division until about 1995. At that time,
                         IRS transferred this audit program to the Collection Division until 1996, when it was moved to
                         Customer Service.




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In addition to computer screening, IRS uses about 30 other sources to
                                    2
select returns with audit potential. District offices tend to use these
sources more than service centers. Sources include referrals from inside
and outside IRS; a program on tax preparers who are associated with
noncompliant returns; projects on groups of taxpayers that are known or
suspected to be noncompliant; returns that are related in the same or
different tax year to a noncompliant return; and information filed by third
parties, such as banks or employers.

Service centers also do audit work that is discretionary, allowing each
center to identify returns with audit issues for its local area. Each service
center may apply audit resources to discretionary programs, which can
vary from year to year, as a center finishes its mandated audit workload,
                              3
such as audits involving EIC. For example, local programs may involve the
exchange of tax information with states. At least one service center
analyses a variety of database extracts for its area to determine potentially
noncompliant issues, such as the individual retirement account penalty.

After identifying returns with audit potential, the next step in the selection
process is a review to classify returns that have been identified as having
issues worth auditing. IRS requires the returns to be manually classified to
either accept the return as filed or to identify all potential audit issues on
the return. Identifying all potential audit issues is important because IRS
generally has one opportunity to audit a tax return. Classification is also
important in determining whether to audit through correspondence or a
face-to-face meeting.

IRS’ processes of checking and requesting individual returns for audit is
shown in figure I.1.




2
 Beyond these sources, decisions about which returns to audit involve taking into account the number
and type of auditors, existing workload by type of audit, and planned audit rate across groups of
taxpayers. The scope of our work did not cover these decisions and factors.
3
 In fiscal years 1992 and 1993, the discretionary workload was much larger than the mandated
workload. During fiscal years 1995 and 1996 (when service centers did many EIC audits), mandated
audits accounted for 75 percent of all workload. In fiscal years 1994 and 1997, discretionary and
mandatory workloads were almost equal.




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                                            Overview of Audit Processes at Service Centers and District Offices




Figure I.1: Process for Selecting Individual Tax Returns for Audit




                                            Source: GAO summary of IRS data.




                                            Page 40                                        GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix II

IRS' Auditing Standards and Key Elements for
Correspondence Audits

                                           This appendix shows IRS’ auditing standards as addressed in IRM 4015.5,
                                           Exhibit 4010-2, Center Examination Quality Measurement Rating Guide.
                                           These standards are used to define the “quality” of completed casework
                                           and to measure the accuracy and effectiveness of the correspondence
                                           examination process.

Table II.1: IRS’ Audit Standards and Key
Elements for Correspondence Audits         Audit standard               Key elements
                                           1. Adequate consideration of All classified items considered.
                                              significant items         Scope of examination appropriate to include all significant
                                                                        items for determination of tax liability.
                                                                        Prior- and subsequent-year returns considered.
                                           2. Examination depth and     Adequate examination and sampling techniques used,
                                              conclusions reached       proper source documents requested and evaluated, and
                                                                        taxpayer and third-party contacts made as needed.
                                                                        Correct conclusion reached from developed facts and
                                                                        circumstances.
                                           3. Workpapers support        Examination procedures, audit trail, findings, and
                                              conclusions               conclusions fully disclosed.
                                                                        Workpapers are clear, concise, legible, labeled, dated,
                                                                        organized, and indexed.
                                                                        Adjustments in workpapers agree with examination report.
                                                                        Examination activities adequately documented in the case
                                                                        file.
                                           4. Report writing procedures Appropriate report writing procedures followed.
                                              followed                  Tax computation was correct and used the method of
                                                                        most benefit to the taxpayer.
                                           5. Penalties properly        The case file reflected consideration of and appropriate
                                              considered                assertion or abatement of all applicable penalties as
                                                                        necessary.
                                                                        If they were necessary, penalties computed correctly.
                                           6. Timely actions and time   Time charges are relevant to the issues raised and
                                              charged appropriate       documented in the case file, as are other problems that
                                                                        affect use of time.
                                                                        All examination actions, such as requests for documents
                                                                        and information were timely.
                                           7. Case administration       Appropriate and correct correspondence used to respond
                                                                        to or notify taxpayer.
                                                                        Statute controls followed.
                                                                        Case properly assembled in accordance with local
                                                                        procedures.
                                                                        Case accurately completed with proper forms, closing
                                                                        instructions, and computer research and updates in
                                                                        accordance with local procedures.
                                                                        Power of attorney and disclosure procedures followed.
                                           Source: GAO summary of IRS data.




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Appendix III

Sampling and Data Analysis Methodology


                   This appendix describes how we identified the study population of
                   correspondence audits closed during fiscal year 1996 and our sampling
                   methodology. In addition, it discusses our methodology for analyzing
                   Individual Master File data for the tax returns in our study population.

                   We identified a population of tax returns related to correspondence audits
Sample Selection   that closed during fiscal year 1996. We chose that year because it was the
Methodology        latest completed fiscal year at the time we began our effort. Our computer
                   analysis of IRS’ databases identified a total population of 1.1 million
                   correspondence audits closed during fiscal year 1996. With the
                   concurrence of Customer Service Compliance Branch officials, we
                   excluded the EIC audits with missing or invalid Social Security numbers
                   that are no longer in the correspondence audit program. These officials
                   also advised us to exclude Tax Equity and Fiscal Responsibility Act
                   (TEFRA) flow-through returns from our population because these returns
                   were actually audited in district offices, and service centers only made
                   adjustments to taxpayers’ accounts. By excluding the EIC math-error and
                   TEFRA cases, our study population of tax returns audited was 335,050.
                   The Compliance Branch officials told us that this population more closely
                   represented traditional correspondence audit tax returns.

                   We selected a stratified random sample of 502 audits from IRS’ AIMS file.
                   The strata were defined by whether the taxpayer responded to IRS’ final
                   letter and the additional taxes recommended from the audits. These strata
                   variables were selected because we believed there might be a relationship
                   between them and the issues we were studying, such as the number of
                   audits, the time to do the audits, and the results of the audits.

                   To allocate the sample, audits were first separated into three groups: (1)
                   those taxpayers who responded to IRS’ letters, (2) those taxpayers who
                   did not respond to IRS’ letters, and (3) those tax returns closed with no
                   change in the reported tax liability. The number of sample audits allocated
                   to each group was approximately proportional to the number of audits in
                   the group. For audited tax returns in the first two groups, the number of
                   audits sampled in each stratum was a compromise between a proportional
                   allocation of the number of taxpayers in each stratum and a proportional
                   allocation based on absolute dollar amounts represented by audits in that
                   stratum.

                   Within each stratum, we sorted audits by IRS service center, and we
                   systematically selected audits for inclusion in the sample. This ensured
                   that tax returns audited by all 10 service centers were included in our




                   Page 42                                GAO/GGD-99-48 IRS’ Correspondence Audits
                     Appendix III
                     Sampling and Data Analysis Methodology




                     sample. However, our sample was not designed to statistically project to
                     the practices of specific service centers.

                     We received 446 audit files from the 502 tax returns in our sample, or an
Response Rates       89-percent response rate. The difference is partly due to the fact that some
                     audit files were being used by IRS projects and others could not be
                     located. Sampling weights, which included nonresponse adjustments, were
                     assigned to each tax return in our sample. As such, the 446 sampled tax
                     returns are statistically projectable to the 335,050 tax returns audited
                     nationwide during fiscal year 1996.

                     Because our study population results come from samples, all results are
Sampling and         estimates that are subject to sampling errors. We calculated sampling
Nonsampling Errors   errors for all of the study population results presented in this report. These
for Key Estimates    sampling errors measure the extent to which samples of these sizes and
                     structure can be expected to differ from their total populations. Each of
Used in the Report   the sample estimates is surrounded by a 95-percent confidence interval.
                     This interval indicates that we are 95-percent confident that the results for
                     the total population fall within this interval. Except where noted, the 95-
                     percent confidence intervals for proportions do not exceed 10 percentage
                     points. All numeric estimates other than proportions have sampling errors
                     smaller than 10 percent of the value of those estimates, unless otherwise
                     noted.

                     In addition to the reported sampling errors, the practical difficulties of
                     conducting any case study may introduce other types of errors, commonly
                     referred to as nonsampling errors. For example, differences in how a
                     particular question is interpreted, in the sources of information that are
                     available, or in the types of files not available, introduce unwanted
                     variability into the study population results. We included steps in our audit
                     to minimize such nonsampling errors. For example, we carefully pretested
                     the data collection instrument, discussed our study population results with
                     officials responsible for these audits at the National Office and four service
                     centers we visited, and made follow-up requests to all of the compliance
                     chiefs at the 10 service centers nationwide to help us accurately interpret
                     the data.

                     To assess the strength of association between the degree of documented
Data Analysis        support and other characteristics of the audit, such as the amount of audit
                     time charged and the assessed amount of the correspondence audit, we
                     conducted correlation and regression analyses. We also reviewed
                     scatterplots of the relationships between the variables. We found a
                     relationship between the amount of audit time charged and the degree of



                     Page 43                                  GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix III
Sampling and Data Analysis Methodology




documented support. However, we did not find a statistically significant
relationship between the assessed amount of a correspondence audit and
the degree of documented support of the audit.




Page 44                                  GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix IV

Additional Comparisons of IRS Service Center
Workloads

                                  This appendix shows, by IRS service center, correspondence audit
                                  workload by number of returns, dollars recommended and direct audit
                                  hours for fiscal years 1992 through 1997. The following tables exclude the
                                  service center TEFRA workload because correspondence audit officials
                                  indicated that these cases are atypical and do not reflect the traditional
                                  correspondence audit workload. The data come from IRS’ AIMS closed
                                  case database. The service center listing is IRS’, which goes from the
                                  Northeast to the West.

Table IV.1: Correspondence
Examination Workload by Service                                                 Additional
Center for Fiscal Year 1992                                                          taxes
                                  Service center          Returns Percent   recommended Percent       Hours Percent
                                  Andover                  26,267       8      $41,490,702    6       28,465     10
                                  Brookhaven               28,728       8       87,083,199   12       30,026     11
                                  Philadelphia             20,062       6       40,867,034    5       11,196      4
                                  Atlanta                  42,126      12       76,690,155   10       25,958      9
                                  Memphis                  29,290       9       75,105,888   10       27,176     10
                                  Cincinnati               31,796       9       75,996,439   10       27,285     10
                                  Kansas City              30,640       9       91,533,907   12       28,122     10
                                  Austin                   18,422       5       53,103,406    7       16,731      6
                                  Ogden                    29,900       9       85,334,668   12       51,701     19
                                  Fresno                   81,889      24      112,859,555   15       27,084     10
                                  Total                   339,120     100     $740,064,953  100      273,744    100
                                  Source: GAO analysis of IRS data.




Table IV.2: Correspondence
Examination Workload by Service                                                 Additional
Center for Fiscal Year 1993                                                          taxes
                                  Service center          Returns Percent   recommended Percent       Hours Percent
                                  Andover                  18,657       8      $28,419,988    5       22,047      9
                                  Brookhaven               25,855      11       70,660,954   12       32,277     13
                                  Philadelphia             10,500       5       12,025,126    2        7,036      3
                                  Atlanta                  21,546       9       85,547,848   15       20,355      8
                                  Memphis                  20,716       9       37,425,722    6       21,240      9
                                  Cincinnati               28,280      12       51,125,797    9       36,571     15
                                  Kansas City              22,782      10       59,825,149   10       22,400      9
                                  Austin                   40,009      17      101,576,093   18       36,776     15
                                  Ogden                    16,031       7       41,278,786    7       30,783     13
                                  Fresno                   27,861      12       88,840,216   15       16,205      7
                                  Total                   232,237     100     $576,725,679  100      245,690    100
                                  Source: GAO analysis of IRS data.




                                  Page 45                                     GAO/GGD-99-48 IRS’ Correspondence Audits
                                  Appendix IV
                                  Additional Comparisons of IRS Service Center Workloads




Table IV.3: Correspondence
Examination Workload by Service                                                 Additional
Center for Fiscal Year 1994                                                          taxes
                                  Service center          Returns Percent   recommended Percent        Hours Percent
                                  Andover                  23,250       7      $32,291,962    5        34,456     10
                                  Brookhaven               26,514       8       48,404,805    8        30,974      9
                                  Philadelphia             26,459       8       47,026,981    8        25,092      7
                                  Atlanta                  21,218       6       64,637,249   10        22,871      7
                                  Memphis                  16,635       5       21,335,944    3        28,247      8
                                  Cincinnati               30,364       9       38,977,595    6        49,037     15
                                  Kansas City              22,193       6       49,113,827    8        29,525      9
                                  Austin                   44,380      13       97,056,666   16        41,844     12
                                  Ogden                    24,414       7       50,020,761    8        34,576     10
                                  Fresno                  117,169      33      172,534,464   28        40,372     12
                                  Total                   352,596     100     $621,400,254  100       336,994    100
                                  Source: GAO analysis of IRS data.




Table IV.4: Correspondence
Examination Workload by Service                                                 Additional
Center for Fiscal Year 1995                                                          taxes
                                  Service center        Returns Percent     recommended      Percent  Hours Percent
                                  Andover                 49,781      5        $56,199,233         4 59,808       8
                                  Brookhaven             105,246     10         94,756,307         7 57,184       8
                                  Philadelphia           113,970     11        132,568,342        10 61,950       9
                                  Atlanta                 60,844      6        118,095,996         9 51,800       7
                                  Memphis                 41,346      4         38,893,068         3 46,507       7
                                  Cincinnati              54,926      5        103,448,080         8 44,518       6
                                  Kansas City             75,131      7         97,576,557         7 47,811       7
                                  Austin                  91,562      9        112,925,152         8 72,009      10
                                  Ogden                   97,826      9         90,330,991         7 62,908       9
                                  Fresno                 363,941     35        523,562,111        38 199,354     28
                                  Total                1,054,573    100     $1,368,355,837       100 703,851    100
                                  Source: GAO analysis of IRS data.




                                  Page 46                                      GAO/GGD-99-48 IRS’ Correspondence Audits
                                  Appendix IV
                                  Additional Comparisons of IRS Service Center Workloads




Table IV.5: Correspondence
Examination Workload by Service                                                Additional
Center for Fiscal Year 1996                                                         taxes
                                  Service center        Returns Percent    recommended      Percent  Hours Percent
                                  Andover                 52,882      5       $72,162,081         4 61,133       8
                                  Brookhaven              92,375      8       175,271,688        10 51,680       7
                                  Philadelphia            93,406      8       142,672,368         8 63,367       8
                                  Atlanta                 84,519      8       167,652,022         9 77,920      10
                                  Memphis                 64,150      6        85,741,692         5 45,269       6
                                  Cincinnati              57,164      5       155,350,831         9 52,933       7
                                  Kansas City             85,704      8       135,828,778         8 41,258       6
                                  Austin                 135,078     12       155,873,552         9 74,807      10
                                  Ogden                  113,862     10       160,284,785         9 77,872      10
                                  Fresno                 334,506     30       515,079,489        29 202,819     27
                                  Total                1,113,646    100    $1,765,917,286       100 749,058    100
                                  Source: GAO analysis of IRS data.




Table IV.6: Correspondence
Examination Workload by Service                                                Additional
Center for Fiscal Year 1997                                                         taxes
                                  Service center        Returns Percent    recommended      Percent  Hours Percent
                                  Andover                55,477       7      $156,542,174         7 46,582       8
                                  Brookhaven             74,246      10       180,023,302         8 59,003      10
                                  Philadelphia           50,561       7       141,764,403         7 37,202       7
                                  Atlanta                43,527       6       163,020,469         8 42,868       8
                                  Memphis                51,960       7       162,861,282         8 20,355       4
                                  Cincinnati             60,763       8       299,380,616        14 65,066      11
                                  Kansas City            52,220       7       156,219,970         7 29,728       5
                                  Austin                 48,987       6        97,644,618         4 45,553       8
                                  Ogden                 100,115      13       231,952,120        11 70,788      12
                                  Fresno                219,814      29       581,062,259        27 155,811     27
                                  Total                 757,670     100    $2,170,471,213       100 572,957    100
                                  Source: GAO analysis of IRS data.




                                  Page 47                                     GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix V

Comments From the Internal Revenue Service




              Page 48       GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix V
Comments From the Internal Revenue Service




Page 49                                      GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix V
Comments From the Internal Revenue Service




Page 50                                      GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix V
Comments From the Internal Revenue Service




Page 51                                      GAO/GGD-99-48 IRS’ Correspondence Audits
Appendix VI

Major Contributors to This Report


                        Sidney Schwartz, Senior Mathematical Statistician
General Government      Patricia McGuire, Senior Computer Specialist
Division, Washington,   Susan Baker, Computer Specialist
D.C.                    Elizabeth W. Scullin, Communications Analyst

                        Kirk Boyer, Evaluator-in-Charge
Kansas City Field       Joseph F. Lenart, Jr., Senior Evaluator
Office                  Thomas Bloom, Senior Computer Specialist
                        Marge Vallazza, Evaluator




                        Page 52                              GAO/GGD-99-48 IRS’ Correspondence Audits
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