oversight

Tax Administration: Taxpayer Rights and Burdens During Audits of Their Tax Returns

Published by the Government Accountability Office on 1997-09-26.

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

                     United States General Accounting Office

GAO                  Testimony
                     Before the Subcommittee on Oversight, House Committee
                     on Ways and Means




For Release
on Delivery
Expected at
                     TAX ADMINISTRATION
10:00 a.m. EDT
Friday,
September 26, 1997
                     Taxpayer Rights and
                     Burdens During Audits of
                     Their Tax Returns
                     Statement of James White, Associate Director, Tax Policy
                     and Administration Issues, General Government Division




GAO/T-GGD-97-186
Summary

Tax Administration: Taxpayer Rights and
Burdens During Audits of Their Tax Returns

                  Taxpayers and Congress have expressed concerns with how the Internal
                  Revenue Service (IRS) treats taxpayers in audits and whether audits are too
                  burdensome. Based on its ongoing and previous work, GAO makes the
                  following points on these issues:

              •   IRS has limited data on both the treatment of taxpayers and the burdens
                  imposed on them during audits. IRS recently created a system to track
                  taxpayers’ complaints about improper treatment but IRS does not solicit
                  input on all improper treatment. Similarly, IRS has no comprehensive
                  definition of, and little data on, the burden its audits impose on taxpayers.
                  IRS has recently developed a survey that will ask individual taxpayers
                  about their satisfaction with various parts of the audit process but results
                  will not be available until 1998.
              •   IRS has various indicators and standards on audit performance. One
                  measure of audit performance is how much additional tax is
                  recommended. IRS does not have a corresponding measure on how much
                  of the recommended tax is ultimately collected after taxpayer appeals.
                  Without an indicator to balance taxes recommended against those
                  collected, IRS auditors could have an incentive to recommend taxes that
                  would be unlikely to withstand a taxpayer challenge. IRS has nine audit
                  standards. The standards focus on the efficient use of auditors’ time and
                  not on when they should use particular audit techniques. To ensure
                  adherence to the standards, IRS relies on oversight by the auditors’
                  managers. However, their workload limits their time for doing oversight.
              •   GAO’s work on one set of IRS audit techniques—those used in analyzing
                  taxpayers’ financial status to identify unreported income—showed that IRS
                  used these techniques in less than a quarter of the audits completed in the
                  time periods covered by GAO’s review. In about one-quarter of the audits in
                  which financial status techniques were used, IRS did not have to contact
                  the taxpayer to obtain information on the taxpayer’s financial status
                  beyond what was reported on the tax return. GAO also found that IRS’ use of
                  financial status techniques has not increased in recent years. Regarding
                  revenue impact, GAO found that in about 16 percent of the cases where
                  they were used, these techniques did help to identify significant amounts
                  of unreported income—$10,000 or more. However, in over three-quarters
                  of the total audits in which these techniques were used, no changes
                  resulting from the use of these techniques were made to the income
                  reported. Most of the audits did result in some tax change for other
                  reasons. Data are not available to permit GAO or IRS to determine the
                  additional burden imposed on taxpayers from the use of the techniques in
                  audits.




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    Summary
    Tax Administration: Taxpayer Rights and
    Burdens During Audits of Their Tax Returns




•   IRS is concerned that its ability to target the potentially most noncompliant
    taxpayers for audits is deteriorating. IRS’ concern arises because it has not
    been able to rely on its past approach for developing statistically valid
    research data that allowed IRS to create and periodically update formulas
    to target the returns with the most potential for noncompliance. IRS last
    collected these data through audits of a random sample of taxpayers for
    tax year 1988. IRS subsequently abandoned that approach due to concerns
    about its costs and to concerns from the public and Congress about the
    taxpayer burden involved with those audits.




    Page 2                                                       GAO/T-GGD-97-186
Statement

Tax Administration: Taxpayer Rights and
Burdens During Audits of Their Tax Returns

                  Madam Chairman and Members of the Subcommittee:

                  We are pleased to be here today to assist the Subcommittee in its inquiry
                  into the rights of taxpayers and their treatment during audits of their tax
                  returns by the Internal Revenue Service (IRS). Recently, taxpayers, tax
                  professionals, and Congress have expressed concerns about how IRS treats
                  taxpayers during audits and whether audits are overly burdensome. You
                  asked us to discuss IRS’ data on taxpayer complaints and the burden
                  imposed on taxpayers as well as IRS’ indicators for measuring audit
                  performance. You also asked us to discuss our ongoing work for the
                  Chairman of the House Committee on Ways and Means on IRS’ use of a
                  particular audit technique—reviews of taxpayers’ financial status (i.e.,
                  their flow of income and expenses)—and IRS’ methodology for selecting
                  tax returns for audit.

                  Today, I would like to make four points taken from this ongoing work as
                  well as from previous reports and testimonies.

              •   First, IRS has limited data on both the treatment of taxpayers and the
                  burdens imposed on them during audits. IRS recently created a system to
                  track taxpayers’ complaints about improper treatment but IRS does not
                  solicit input on all improper treatment. Similarly, IRS has no
                  comprehensive definition of, and little data on, the burden its audits
                  impose on taxpayers. IRS has recently developed a survey that will ask
                  individual taxpayers about their satisfaction with various parts of the audit
                  process but results will not be available until 1998. While recognizing the
                  difficulties in collecting data from taxpayers about treatment and burden,
                  we believe that this survey may have the potential to provide better
                  information than presently exists.
              •   Second, IRS’ Examination Division has various indicators and standards on
                  audit performance. One measure IRS uses for audit performance is how
                  much additional tax is recommended. IRS does not have a corresponding
                  measure on how much of the recommended tax is ultimately collected
                  after taxpayer appeals. Without an indicator to balance taxes
                  recommended against those collected, IRS auditors could have an incentive
                  to recommend taxes that would be unlikely to withstand a taxpayer
                  challenge. IRS has nine audit standards. The standards focus on the
                  efficient use of auditors’ time and not on when they should use particular
                  audit techniques. To ensure adherence to the standards, IRS relies on
                  oversight by the auditors’ managers. However, their workload limits their
                  time for doing oversight.




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                            Statement
                            Tax Administration: Taxpayer Rights and
                            Burdens During Audits of Their Tax Returns




                        •   Third, our work on one set of audit techniques—those used in analyzing
                            taxpayers’ financial status to identify any unreported income—provided
                            several interesting statistics. We estimated that IRS auditors used these
                            techniques in less than a quarter of the audits completed in the time
                            periods covered by our review. When used, financial status techniques
                            were always part of an audit that included other techniques or
                            methodologies. In about one-quarter of the audits in which financial status
                            techniques were used, IRS did not have to contact the taxpayer to obtain
                            information on the taxpayer’s financial status beyond what was reported
                            on the tax return. We also found that the use of financial status techniques
                            has not increased in recent years. Regarding revenue impact, we found
                            that in about 16 percent of the cases where they were used, these
                            techniques did help to identify significant amounts of unreported
                            income—$10,000 or more. However, of the total audits in which these
                            techniques were used, in over three-quarters no changes resulting from the
                            use of these techniques were made to the income reported, although most
                            of the audits resulted in some tax change for other reasons. Data are not
                            available to permit either us or IRS to determine the additional burden
                            imposed on taxpayers from the use of financial status techniques in audits.
                        •   Fourth, IRS is concerned that its ability to target the potentially most
                            noncompliant taxpayers for audits is deteriorating. IRS’ concern arises
                            because it has not been able to rely on its past approach for developing
                            statistically valid research data that allowed IRS to create and periodically
                            update formulas to target the returns with the most potential for
                            noncompliance. IRS last collected these data through audits of a random
                            sample of taxpayers for tax year 1988. IRS subsequently abandoned that
                            approach due to concerns about its costs and to concerns from the public
                            and Congress about the taxpayer burden involved with those audits. For
                            context, we note that from the 1960s, when IRS first created its
                            research-based audit formulas until it stopped gathering that research data
                            after 1988, it had reduced the rate to which its audits made no
                            recommended tax change from more than 40 percent to around 10 to
                            15 percent, depending on the type of return and the year of the audit.

                            I would like to discuss each of these points in more detail after providing
                            an overview on why IRS audits tax returns and how IRS is supposed to do
                            the audits.


                            IRS’
                               Examination Division audits tax returns to ensure that taxpayers
Overview of IRS             report and pay the amount of tax they owe. Because our tax system is
Audits of Tax Returns


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Statement
Tax Administration: Taxpayer Rights and
Burdens During Audits of Their Tax Returns




based on self-assessment, IRS also does audits to induce taxpayer
compliance and promote public confidence in the tax system.1

The income tax gap—the difference between taxes owed and taxes paid
voluntarily and on time—is one reason why IRS seeks to provide an audit
presence. Under IRS’ most recent estimate, the 1992 income tax gap for
individuals exceeds $90 billion, of which about two-thirds can be
attributed to individuals not reporting income on their tax returns.

In recent years, IRS has been auditing about one to two percent of the
100-million plus income tax returns filed annually by individual taxpayers.2
 IRS’ policies and procedures are generally directed at selecting returns that
appear to be most noncompliant. After selecting the returns, IRS audits
them either (1) through 1 of its 33 district offices by meeting with
taxpayers or their representatives or (2) through 1 of its 10 service centers
by corresponding with the taxpayers. Since fiscal year 1992, these audits
have been recommending between $5 billion to $8 billion in additional
taxes each year. Appendix I of my statement summarizes selected audit
statistics since fiscal year 1992.

IRS auditors are instructed to not only verify the eligibility and amounts for
various types of tax deductions, credits, and exemptions, but to also look
for any indications of unreported income. If auditors find such indications,
they are to exercise their judgment in deciding whether to do further
probes in an effort to determine whether the taxpayer underreported
income.

To guide auditors, IRS manuals and publications have identified the rights
of taxpayers during audits and the manner in which auditors should treat
taxpayers. For example, IRS documents say that taxpayers have the right,
among others, to know why IRS is asking for information about the tax
return and to authorize another person to represent them during the audit.
Through its documents and training programs, IRS instructs its audit staff
to explain these rights to the audited taxpayer and to protect those rights.
In addition, audit staff are instructed to protect taxpayers’ privacy as well
as treat them with professionalism and courtesy.


1
 IRS also induces compliance through taxpayer assistance, third-party reporting to IRS of payments
(such as wages and interest) made to taxpayers, computer matching of tax returns to third-party data,
income tax withholding, and penalties for noncompliance.
2
 IRS also annually audits tens of thousands of income tax returns filed by corporations and
partnerships as well as thousands of other types of returns such as those filed to report estate tax, gift
tax, employment tax, and excise tax.



Page 5                                                                              GAO/T-GGD-97-186
                          Statement
                          Tax Administration: Taxpayer Rights and
                          Burdens During Audits of Their Tax Returns




                          Recently, taxpayers, tax professionals, and Congress have criticized IRS for
IRS Data on Audit         treating taxpayers improperly and imposing unnecessary burdens during
Burden and Taxpayer       audits. At a general level, these criticisms have asserted that auditors
Complaints About          lacked sufficient experience, training, motivation, or competence. Specific
                          criticisms have focused on a range of asserted IRS behaviors, including:
Treatment
                      •   subjecting compliant taxpayers to unnecessary audits, resulting in no
                          change to the tax liability reported on the tax returns;
                      •   wasting taxpayers’ time during the audit by asking for irrelevant
                          documentation or by delving into issues that are minor or personal; and
                      •   treating taxpayers unprofessionally or abusively, regardless of whether
                          they underpaid their taxes, by lying, making threats, applying pressure,
                          and the like.

                          IRShas limited data for use in responding to such assertions. With respect
                          to unprofessional or improper treatment, in 1994 and 1996, we reported
                          that IRS lacked comprehensive data on the nature and magnitude of the
                          complaints as well as their resolutions.3 Nor did IRS have clear definitions
                          that allowed it to determine whether these complaints indicated auditor
                          behaviors that were “abusive” or “unnecessary.”

                          Since our 1996 report, IRS has developed a definition and tracking system
                          for complaints about improper treatment. IRS defines a complaint as an
                          allegation by taxpayers or their representatives that an IRS employee
                          violated the law, regulation, or IRS rules of conduct or used inappropriate
                          behavior (e.g., rude, overzealous, discriminatory, intimidating) or that an
                          IRS system failed to function properly or within the prescribed time frame.


                          IRS’
                             complaint tracking system does not systematically solicit input from
                          taxpayers on their treatment during audits; rather, it records only those
                          complaints initiated by taxpayers. As a result, neither we nor IRS have
                          representative data on the extent to which auditors treat taxpayers
                          improperly across the roughly 2 million audits.

                          Nevertheless, IRS does report the data the system collects on taxpayer
                          complaints. For the first quarter of fiscal year 1997, IRS reported that
                          taxpayers initiated 1,203 complaints, of which 290 (25 percent) involved
                          audit staff. Of the 290 audit-related complaints, almost half involved
                          assertions of inappropriate behavior by an auditor and about one-quarter
                          of these complaints were addressed through counseling or administrative

                          3
                           Tax Administration: IRS Can Strengthen Its Efforts to See That Taxpayers Are Treated Properly
                          (GAO/GGD-95-14, Oct. 26, 1994), and Tax Administration: IRS Is Improving Its Controls for Ensuring
                          That Taxpayers Are Treated Properly (GAO/GGD-96-176, Aug. 30, 1996).



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                      Statement
                      Tax Administration: Taxpayer Rights and
                      Burdens During Audits of Their Tax Returns




                      action or through the employee leaving IRS; for the remaining
                      three-quarters of the complaints, IRS concluded that the employee’s
                      behavior was appropriate or that information provided by the taxpayer
                      was not complete enough to take disciplinary action against the employee.

                      With respect to taxpayer burden, IRS has limited data on the
                      burden—whether necessary or not—imposed by audits. For example, in
                      fiscal year 1996, IRS tax auditors made no changes to 14 percent of the
                      individual tax returns. However, IRS does not know the amount of burden
                      imposed by these or other audits.

                      Data on burden can be difficult to collect for various reasons. Neither IRS
                      nor its stakeholders have clear definitions or agreement on what
                      constitutes audit burden as well as unnecessary burden. Further, our work
                      has shown that taxpayers do not keep records on the amount of audit
                      burden in terms of time or money.4

                      IRShas recently developed a survey that will ask individual taxpayers
                      about their satisfaction with the audit process. Results will not be
                      available until 1998. Recognizing the difficulties in collecting data about
                      treatment and burden, we believe that this survey may begin to provide
                      better information about taxpayer treatment and burden but its usefulness
                      will need to be evaluated.


                      IRShas established some indicators for measuring its audit performance.
IRS’ Indicators to    However, existing indicators primarily focus on interim results without
Measure the Impacts   also considering final results from the audits. Similarly, IRS has established
of Audits             nine audit standards to guide its auditors. However, the standards do not
                      provide objective criteria on when to use particular audit techniques.

                      IRS’Examination Division has used additional tax recommended as an
                      important indicator of audit performance (see app. II for the fiscal year
                      1997 indicators).5 We expressed concerns in previous work that
                      overreliance on additional taxes recommended as an indicator of
                      performance could create undesirable incentives for auditors (and other
                      Examination staff) to recommend taxes that would be unlikely to

                      4
                      Tax System: Issues in Tax Compliance Burden, (GAO/T-GGD-96-100, Apr. 3, 1996) and Tax System
                      Burden: Tax Compliance Burden Faced by Business Taxpayers, (GAO/T-GGD-95-42, Dec. 9, 1994).
                      5
                       Taxpayers do not necessarily have to pay the recommended taxes. Taxpayers may challenge them
                      through administrative channels within IRS or the courts. If they win the challenge, the recommended
                      taxes will not be assessed as owed. If they lose or raise no challenge, the recommended taxes are
                      assessed.



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                        Statement
                        Tax Administration: Taxpayer Rights and
                        Burdens During Audits of Their Tax Returns




                        withstand a taxpayer challenge.6 While we recognize the complexity of the
                        Internal Revenue Code and the difficulties faced by both IRS and the
                        taxpayer in determining the “correct tax,” the fact remains that audit
                        recommendations that do not withstand such a challenge may have
                        imposed an unnecessary burden on the taxpayer. For this reason, in our
                        previous work, we supported the need to measure taxes recommended but
                        advocated balancing that indicator with others such as taxes ultimately
                        collected.

                        Our work also pointed out that developing an indicator of taxes ultimately
                        collected from audits would be challenging. For example, the time lag
                        between an audit and the ultimate tax collected makes linking the two
                        problematic. IRS is working on developing a way of determining the
                        ultimate taxes collected.

                        In addition to indicators of audit performance, IRS also has nine audit
                        standards to provide guidance to auditors on minimizing the time spent on
                        an audit, checking large and unusual claims on tax returns, probing for
                        unreported income, and preparing adequate audit workpapers (see app. III
                        for all nine standards). These nine standards do not address the proper
                        treatment of taxpayers. Further, although the standards provide guidance
                        on the proper depth and breadth of audits given the time available, they
                        provide little objective guidance to auditors on when to use particular
                        audit techniques such as those related to an analysis of a taxpayer’s
                        financial status.

                        To ensure adherence to the standards, IRS relies on managers’ oversight of
                        auditors. However, according to IRS officials, these managers cannot
                        review all audits because their workloads limit the time available for
                        review. As audits close throughout the year, separate groups of IRS staff
                        supplement the managerial review process by reviewing a small sample of
                        audits to measure adherence to the nine standards (see appendix III for
                        measurement results in fiscal years 1992 through 1996).


                        Given recent complaints about the asserted burdens and intrusions
IRS’ Use of Financial   associated with IRS’ financial status audit techniques, the Chairman of the
Status Techniques       House Committee on Ways and Means asked us to report on the frequency
                        and results of IRS’ use of these techniques. IRS uses these techniques to
                        identify unreported income. During our analyses of audits done in 1992-93

                        6
                         Tax Administration: Compliance Measures and Audits of Large Corporations Need Improvement
                        (GAO/GGD-94-70, Sept. 1, 1994) and Tax Administration: Factors Affecting Results From Audits of
                        Large Corporations (GAO/GGD 97-62, Apr. 17, 1997).



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Tax Administration: Taxpayer Rights and
Burdens During Audits of Their Tax Returns




and 1995-96, we found that IRS relied primarily on two financial status
techniques:7

1)Cash transaction analysis (or cash-T), in which the auditor uses the tax
return and other sources to ensure that adequate income has been
reported on the return to cover expenses. In deciding to use this
technique, auditors may first do a preliminary cash-T. It differs from the
regular cash-T in that the auditor does it before meeting with taxpayers,
relying on information reported on tax returns.

2)Bank deposit analysis, in which the auditor verifies that the taxpayer’s
bank deposits are consistent with the income reported on the tax return.

To do our work, we randomly sampled from the universe of audits closed
in IRS districts in which IRS scheduled meetings with taxpayers to review
their records. These samples covered 1992-93 and 1995-96 and were both
projectable to universes of about a half million audits.

On the basis of our analysis of these two samples, we estimate that the use
of financial status techniques had not increased over the time frames we
reviewed—the techniques were used in about one-quarter of the audits in
each of our two universes. Financial status techniques were never used
alone; they were always part of audits that included other audit techniques
to explore issues other than unreported income, such as overstated
deductions.

These techniques imposed no or little additional burden on taxpayers in
some of the audits where they were used. For example, IRS auditors used
just the preliminary cash-T in 23 percent of the 1995-96 audits that used
financial status techniques. The preliminary cash-T technique imposes no
additional burden on the taxpayer because the auditor relies on the
information on the tax return and does not have to contact the taxpayer to
obtain additional information or explanations to complete this technique.

We found that use of the financial status techniques in some cases helped
to identify significant amounts of unreported income—$10,000 or
more—that IRS would not have otherwise found. However, over
three-quarters of the audits in which these techniques were used resulted
in no changes that were directly attributable to the use of these


7
 Other techniques include an analysis of (1) a taxpayer’s net worth and (2) a business taxpayer’s
reported cost of goods sold and data on average markups within the specific business to estimate
gross receipts generated by that taxpayer.



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                        Statement
                        Tax Administration: Taxpayer Rights and
                        Burdens During Audits of Their Tax Returns




                        techniques, even though IRS did find noncompliance in most of these
                        audits through other techniques.

                        While neither we nor IRS know the actual burden imposed on taxpayers,
                        our review of IRS’ workpapers illustrated some conditions under which use
                        of certain techniques may impose additional burdens. For example, a bank
                        deposit analysis can be very burdensome if the auditor asks for records on
                        many bank accounts and asks many questions about the deposits in those
                        accounts. A regular cash-T may or may not be very burdensome,
                        depending on the number of contacts with taxpayers to request
                        information and the amount of information requested.


                        As discussed in previous reports, IRS is concerned about its ability to
Barriers to Selecting   objectively select tax returns so that it focuses on the most noncompliant
the Most                taxpayers.8 IRS’ concerns arise because it has not been able to rely on its
Noncompliant Tax        past approach for developing statistically valid research data that allowed
                        IRS to create and periodically update formulas to target the returns with
Returns for Audit       the most potential for noncompliance. IRS refers to these as discriminant
                        function (DIF) formulas, which have served as the major method for
                        selecting returns for audit.9 IRS fears that its DIF formulas have become
                        imprecise because the formulas use outdated statistical data.

                        In past years, IRS collected the statistically valid research data under its
                        Taxpayer Compliance Measurement Program (TCMP). TCMP involved
                        full-scale audits of a random sample of tax returns—usually for about
                        50,000 individual taxpayers every 3 years. In 1995, IRS abandoned this
                        approach due to concerns about its costs and to concerns from the public
                        and Congress about the taxpayer burden involved with those audits. As a
                        result, IRS’ last TCMP covered tax year 1988.

                        In a 1996 report, we discussed IRS’ need for compliance data that are
                        statistically valid and more current.10 IRS needs the data not only to update


                        8
                         Tax Research: IRS Has Made Progress But Major Challenges Remain, (GAO/GGD-96-109, June 5,
                        1996); Tax Administration: Alternative Strategies to Obtain Compliance Data (GAO/GGD-96-89, Apr.
                        26, 1996); Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy Needed
                        (GAO/GGD-94-123, May 11, 1994); and Tax Administration: IRS’ Plans to Measure Tax Compliance Can
                        Be Improved (GAO/GGD-93-52, Apr. 5, 1993).
                        9
                         Tax Administration: Audit Trends and Results for Individual Taxpayers (GAO/GGD-96-91, Apr. 26,
                        1996). IRS has up to 40 methods for identifying returns to audit. Appendix IV summarizes the number
                        of audits selected by the major methods for fiscal years 1992 through 1996.
                        10
                         Tax Administration: Alternative Strategies to Obtain Compliance Data (GAO/GGD-96-89, Apr. 26,
                        1996).



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its DIF formulas but also to support most of its compliance programs.
Accordingly, we recommended that IRS develop a cost-effective, long-term
strategy to ensure the continued availability of such compliance data.

Since IRS started to use DIF in the 1960s to better target its audits through
fiscal year 1996, IRS has reduced the rate at which its auditors made no tax
changes from more than 40 percent of the audited returns to around 10 to
15 percent, depending on the type of return and the year of the audit. IRS is
concerned that as time passes, DIF’s precision in identifying noncompliant
returns may decrease unless IRS updates the formulas with valid data, and
that as a result, more and more compliant taxpayers will be unnecessarily
burdened with an audit. We are now designing a study of this issue at the
request of the Chairman of the House Committee on Ways and Means.


Madam Chairman, this concludes my testimony. I would be pleased to
answer any questions you or other members of the Subcommittee may
have.




Page 11                                                      GAO/T-GGD-97-186
Appendix I

Selected Information About the Returns
Filed and Examined and Recommended
Additional Taxes (Fiscal Years 1992-96)

Description                                    1992                  1993                   1994                    1995                     1996
Number of returns
  Filed                              152,031,900             153,453,600            152,732,800             154,293,700             155,279,600
  Examined                              1,452,009               1,300,230             1,426,573                2,100,144               2,136,819
  Percent coverage                               .96                   .85                    .93                    1.36                     1.38
Recommended additional tax                  $26.9                    $23.1                 $23.9                    $27.8                    $28.1
and penalties (in billions)
  Individual returns                             6.3                   5.7                    6.2                     7.8                     $7.6
  Corporate returns                            18.1                   14.7                   15.1                    17.7                    $18.0
  All othera                                     2.5                   2.7                    2.6                     2.3                     $2.5
Average tax and penalty per return examined by
  Revenue agent for non-CEPb             $25,161                  $24,704               $18,177                  $21,237                 $24,407
  Revenue agent for CEP                 3,940,148               2,700,352             3,279,298                4,032,528               3,998,409
  Tax auditor                               2,280                    2,625                 3,113                    3,497                    3,051
  Service center                            2,541                    2,934                 1,945                    1,427                    1,733
                                           a
                                            Other includes fiduciary, estate, gift, employment, excise, windfall profit, and miscellaneous
                                           taxes.
                                           b
                                               CEP = Coordinated Examination Program, under which IRS audits the largest corporations.




                                           Page 12                                                                          GAO/T-GGD-97-186
Appendix II

IRS Examination Division Measures for 1997


              Basic measures across Examination activities include

              1.Amount of additional tax and penalties recommended.

              2.Percentage of additional recommended amounts plus interest amounts
              that were collected before IRS issued the second notice on the amounts
              that were assessed.

              3.Average number of days that an audit case remains open.

              4.Amount of additional tax and penalty recommended as well as the
              amount of tax protected in audits divided by the total full-time-equivalent
              staffing invested.

              For the Coordinated Examination Program (CEP), additional measures
              include

              1.Average number of tax years for tax returns filed by a CEP taxpayer that
              have not yet been audited.

              2.Amount of additional tax and penalty recommendations that CEP
              taxpayers agreed to pay minus amount overassessed divided by the total
              full-time-equivalent staffing invested.

              3.Amount of total adjusted revenues divided by the total
              full-time-equivalent staffing invested.




              Page 13                                                     GAO/T-GGD-97-186
Appendix III

IRS’ Examination Quality Measurement
System

                                           The Office of Compliance Specialization, within IRS’ Examination Division,
                                           has responsibility for Quality Measurement Staff operations and the
                                           Examination Quality Measurement System (EQMS). Among other uses, EQMS
                                           measures the quality of closed audits against nine IRS audit standards. The
                                           standards address the scope, audit techniques, technical conclusions,
                                           workpaper preparation, reports, and time management of an audit. Each
                                           standard includes additional key elements describing specific components
                                           of a quality audit. Table III.1 summarizes the standards and the associated
                                           key elements.


Table III.1: Summary of IRS’ Examination Quality Measurement System (EQMS) Auditing Standards (as of October 1996)
No.             Standard          Key elements                 Purpose                      Overview
1              Considered large, A.Balance sheet and Schedule     Measures whether                   This standard encompasses,
               unusual, or        M considered                    consideration was given to the     but is not limited to, the
               questionable items B.Income, deduction, and        large, unusual, or questionable    following fundamental
                                  credit items considered         items in both the precontact       considerations: absolute dollar
                                  C.Scope of examination was      stage and during the course of     value, relative dollar value,
                                  appropriate                     the examination.                   multiyear comparisons, intent
                                                                                                     to mislead, industry/business
                                                                                                     practices, compliance impact,
                                                                                                     and so forth.
2              Probes for        A.Consideration of internal       Measures whether the steps        Gross receipts were probed
               unreported income controls for all business returns taken verified that the proper    during the course of
                                 B.Consideration of books and      amount of income was reported.    examination, regardless of
                                 records                                                             whether the taxpayer
                                 C.Consideration of financial                                        maintained a double entry set
                                 status                                                              of books. Consideration was
                                 D.Appropriate use of indirect                                       given to responses to interview
                                 methods                                                             questions, the financial status
                                                                                                     analysis, tax return information,
                                                                                                     and the books and records in
                                                                                                     probing for unreported income.
3              Required filing    A.Consideration of prior and    Measures whether                   Required filing checks consist
               checks             subsequent year tax returns     consideration was given to         of the analysis of return
                                  B.Consideration of related      filing and examination potential   information and, when
                                  returns                         of all returns required by the     warranted, the pick-up of
                                  C.Compliance items considered   taxpayer, including those          related, prior, and subsequent
                                                                  entities in taxpayer’s sphere of   year returns. In accordance
                                                                  influence/responsibility.          with Internal Revenue Manual
                                                                                                     4034, examinations should
                                                                                                     include checks for filing
                                                                                                     information returns.

                                                                                                                          (continued)




                                           Page 14                                                                GAO/T-GGD-97-186
                                    Appendix III
                                    IRS’ Examination Quality Measurement
                                    System




No.   Standard             Key elements                       Purpose                           Overview
4     Examination depth A.Adequate interviews                 Measures whether the issues       The depth of the examination
      and records       conducted                             examined were completed to        was determined through
      examined          B.Adequate exam techniques            the extent necessary to provide   inspection, inquiry, interviews,
                        used                                  sufficient information to         observation, and analysis of
                        C.Fraud adequately                    determine substantially correct   appropriate documents,
                        considered and developed              tax.                              ledgers, journals, oral
                        D.Issues sufficiently developed                                         testimony, third-party records,
                                                                                                etc., to ensure full development
                                                                                                of relevant facts concerning the
                                                                                                issues of merit. Interviews
                                                                                                provided information not
                                                                                                available from documents to
                                                                                                obtain an understanding of the
                                                                                                taxpayer’s financial history,
                                                                                                business operations, and
                                                                                                accounting records in order to
                                                                                                evaluate the accuracy of books
                                                                                                or records. Specialists
                                                                                                provided expertise to ensure
                                                                                                proper development of unique
                                                                                                or complex issues.
5     Findings             A.Correct technical or factual     Measures whether the              This standard includes
      supported by law     conclusions reached                conclusions reached were          consideration of applicable
                                                              based on a correct application    law, regulations, court cases,
                                                              of tax law.                       revenue rulings, etc., to
                                                                                                support technical or factual
                                                                                                conclusions.
6     Penalties properly   A.Recognized, considered,      Measures whether applicable           Consideration of the
      considered           and applied correctly          penalties were considered and         application of appropriate
                           B.Penalties computed correctly applied correctly.                    penalties during all examination
                                                                                                is required.
7     Workpapers           A.Fully disclose audit trail and   Measures the documentation of Workpapers provided the
      support              techniques                         the examination’s audit trail and principal support for the
      conclusions          B.Legible and organized            techniques used.                  examiner’s report and
                           C.Adjustments in workpapers                                          documented the procedures
                           agree with 4318, 4700, and                                           applied, tests performed,
                           reports                                                              information obtained, and the
                           D.Activity record adequately                                         conclusions reached in the
                           documents exam activities                                            examination.
                           E.Disclosure
8     Report writing       A.Applicable report writing        Measures the presentation of      Addresses the written
      procedures           procedures followed                the audit findings in terms of    presentation of audit findings in
      followed             B.Correct tax computation          content, format, and accuracy.    terms of content, format, and
                                                                                                accuracy. All necessary
                                                                                                information is contained in the
                                                                                                report, so that there is a clear
                                                                                                understanding of the
                                                                                                adjustments made and the
                                                                                                reasons for those adjustments.
                                                                                                                     (continued)




                                    Page 15                                                                  GAO/T-GGD-97-186
                                     Appendix III
                                     IRS’ Examination Quality Measurement
                                     System




No.     Standard            Key elements                   Purpose                            Overview
9       Time span or time   A.Examination time             Measures the utilization of time   Time is an essential element of
        charged             commensurate                   as it relates to the complete      the auditing standards and is a
                            B.Exam initiation              audit process.                     proper consideration in
                            C.Examination activities                                          analyses of the examination
                            D.Case closing                                                    process. The process is
                                                                                              considered as a whole and at
                                                                                              examination initiation,
                                                                                              examination activities, and
                                                                                              case-closing stages.

                                     Source: IRS data.




                                     EQMS quality reviewers use the key element definitions to determine
Standard Success                     whether an audit adhered to the standard. Thus, adherence to audit quality
Rate                                 is measured by the presence or absence of associated key elements. For a
                                     standard to be rated as having been met, each of the associated key
                                     elements must also be rated as met or not applicable. If the audit does not
                                     demonstrate the characteristics described by one of the key elements,
                                     then the standard is rated as not met.

                                     One measure that IRS uses to evaluate the audit quality is the standard
                                     success rate. It measures the percentage of cases for which all the
                                     underlying key elements of each standard are rated as having been met.
                                     According to IRS, this measure is useful for determining whether a case is
                                     flawed and in what area. Figures III.1 and III.2 show the standard success
                                     rates for each of the standards for fiscal years 1992-96 for office and field
                                     audits, respectively.




                                     Page 16                                                               GAO/T-GGD-97-186
                                                                                                                0%
                                                                                                                                             100%




                                                                                                                     20%
                                                                                                                           40%
                                                                                                                                 60%
                                                                                                                                       80%
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                                                                                                 na ua




                                                                          Standards
                                                                                                   bl l,
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                                                                                                       ite
                                                                                                          m




                                       1996
                                              1995
                                                     1994
                                                            1993
                                                                   1992
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                                                                                                   d sf
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                                                                                                           e




                                                                                                                                                    Percentage of standard success rates
                                                                                                  R
                                                                                             fili eq
                                                                                                 ng uir
                                                                                                    ch ed
                                                                                                      ec
                                                                                                        ks
                                                                                 an Exa
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                                                                                            ex dep




Page 17
                                                                                              am th
                                                                                                in
                                                                                                  ed
                                                                                                                                                                                                                                                                           Appendix III




                                                                                        su




                   Source: IRS data.
                                                                                          pp F
                                                                                            or in
                                                                                              te din
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                                                                                                                                                                                           Figure III.1: Standard Success Rates for Office Audits (Fiscal Years 1992-96)




                                                                                                ns ltie
                                                                                                  id s
                                                                                                    er
                                                                                                      ed
                                                                                                                                                                                                                                                                           IRS’ Examination Quality Measurement




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                                                                                                     ge
                                                                                                       d




GAO/T-GGD-97-186
                                                  Appendix III
                                                  IRS’ Examination Quality Measurement
                                                  System




Figure III.2: Standard Success Rates for Field Audits (Fiscal Years 1992-96)

Percentage of standard success rates
100%




80%




60%




40%




20%




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           1992
           1993
           1994
           1995
           1996


                                                  Source: IRS data.



                                                  IRSalso uses the key element pass rate as a measure of audit quality. This
Key Element Pass                                  measure computes the percentage of audits demonstrating the
Rate                                              characteristics defined by the key element. According to IRS, the key
                                                  element pass rate is the most sensitive measurement and is useful when
                                                  describing how an audit is flawed, establishing a baseline for
                                                  improvement, and identifying systemic changes. Figures III.3 and III.4
                                                  show the pass rates for the key elements of standard 2 for fiscal years 1992
                                                  through 1996 for office and field audits, respectively.



                                                  Page 18                                                                       GAO/T-GGD-97-186
                                              Appendix III
                                              IRS’ Examination Quality Measurement
                                              System




Figure III.3: Key Element Pass Rates for Key Elements of Standard 2 for Office Audits (Fiscal Years 1992-96)

Percentages of key element pass rates

100%




80%




60%




40%




20%




 0%
                          s




                                                      s




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        Key Elements of Standard 2, Probes for unreported income


               1992
               1993
               1994
               1995
               1996


                                              Source: IRS data.




                                              Page 19                                                            GAO/T-GGD-97-186
                                               Appendix III
                                               IRS’ Examination Quality Measurement
                                               System




Figure III.4: Key Element Pass Rates for Key Elements of Standard 2 for Field Audits (Fiscal Years 1992-96)
Percentages of key element pass rates

100%




 80%




 60%




 40%




 20%




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                         s




                                                                                                               ds
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         Key Elements of Standard 2, Probes for unreported income


                1992
                1993
                1994
                1995
                1996

                                               IRS data.




                                               Page 20                                                          GAO/T-GGD-97-186
Page 21   GAO/T-GGD-97-186
Appendix IV

Number and Percent of Individual Returns
Audited by Audit Source (Fiscal Years
1992-96)

                                                  Fiscal year 1992
              Audit sources                       Number             Percent
              DIF/DIF related                     452,445               38%
              Nonfilers                           119,865                 10
              Tax shelter related                 101,453                  8
              Self-employment tax                  71,126                  6
              Regular classification               52,528                  4
              State information                    48,418                  4
              Service center studies and tests     43,333                  4
              Compliance projects                  40,403                  3
              Claims for refund                    33,163                  3
              Return preparers                     27,706                  2
              Non-DIF multiyear                    26,866                  2
              Unallowable items                    13,117                  1
              Other sources                       175,596                 15
              Total                              1,206,019             100%




              Page 22                                        GAO/T-GGD-97-186
                              Appendix IV
                              Number and Percent of Individual Returns
                              Audited by Audit Source (Fiscal Years
                              1992-96)




Fiscal year 1993          Fiscal year 1994                       Fiscal year 1995                    Fiscal year 1996
 Number        Percent     Number            Percent              Number             Percent        Number             Percent
 372,116           35%     239,557                  20%           263,200                  14%       351,867                  18%
 190,809           18      402,435                  33            410,612                  21        212,226                  11
  48,070            5       29,687                   2             27,473                    1        20,300                      1
  46,310            4       43,032                   4             48,578                    3        40,601                      2
  50,709            5       47,170                   4             46,637                    2        48,534                      3
   3,564            0        4,573                   0               3,210                   0        71,582                      4
  20,059            2       22,825                   2             25,026                    1        18,684                      1
  44,267            4       41,959                   3             38,624                    2        45,680                      2
  37,203            4       26,412                   2             23,175                    1        31,495                      2
  28,231            3       27,708                   2             26,542                    1        33,637                      2
  29,373            3       26,742                   2             24,926                    1        29,927                      2
  12,099            1      134,007                  11            761,886                  40        824,721                  42
 176,156           16      179,600                  15            219,548                  11        212,306                  11
1,058,966          100%   1,225,707               100%          1,919,437                 100%     1,941,560                  100%
                              Note 1: For this table, we used the format from our 1996 report on audit trends (GAO/GGD-96-91,
                              Apr. 1996). That format listed the top 10 sources for each of the fiscal years 1992 through 1994.
                              Using that format, we updated the numbers and percentages for those categories for fiscal years
                              1995 and 1996.

                              Note 2: See next page for definitions of terms used in this table.

                              Note 3: Percentages are the percent of total audits for the year and have been rounded to the
                              nearest whole percent.

                              Source: GAO analysis of IRS data.




                              Page 23                                                                        GAO/T-GGD-97-186
Appendix V

Definitions of Audit Sources


Claims for Refund            Ammended returns audited because of taxpayers’ claims for refunds.

Compliance Projects          Returns identified through IRS’ information gathering projects.

DIF/DIF Related              Returns selected on the basis of a computer-generated score (the scoring
                             is based on an analysis technique known as discriminant function). Also
                             included are related returns identified during an audit of a DIF-source
                             return and related returns from prior or subsequent years for the same
                             taxpayer.


Non-DIF Multiyear            Related returns from prior or subsequent years for the same taxpayer,
                             when the initial source was other than a DIF-source return.


Nonfilers                    Audits initiated against known taxpayers who did not file a return with IRS.

Other Sources                Over 25 other audit sources, such as referrals from other IRS Divisions,
                             which were not one of the 10 largest sources during the period of our
                             review.


Regular Classification       Manually selected returns for audit that do not result from other specified
                             audit sources.


Return Preparers             Returns identified for audit due to questionable tax preparers.

Self-Employment Tax          Returns involving self-employment tax issues identified by IRS service
                             center examination staff.


Service Center Studies and   Returns identified through service center projects initiated by the IRS
Tests                        National Office.

State Information            Returns identified from various state sources, generally under exchange
                             agreements between IRS and the states.




                             Page 24                                                      GAO/T-GGD-97-186
                      Appendix V
                      Definitions of Audit Sources




Tax Shelter Related   Related returns of partners, grantors, beneficiaries, and shareholders
                      identified during audits of either partnerships, fiduciaries, or Subchapter S
                      corporations involving potential tax shelter issues.


Unallowable Items     Returns involving refundable credits and dependency exemptions, such as
                      the Earned Income Tax Credit, identified by service center examination
                      staff.




(268819)              Page 25                                                      GAO/T-GGD-97-186
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