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entitled 'Tax Administration: IRS Should Take Steps to Improve the 
Accuracy of Schedule K-1 Data' which was released on November 01, 2004.

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Report to the Committee on Finance, U.S. Senate:

September 2004:

TAX ADMINISTRATION:

IRS Should Take Steps to Improve the Accuracy of Schedule K-1 Data:

GAO-04-1040:

GAO Highlights:

Highlights of GAO-04-1040, a report to the Committee on Finance, U.S. 
Senate: 

Why GAO Did This Study:

Over a trillion dollars in income was distributed in tax year 2002 by 
flow-through entities, such as partnerships, subchapter S corporations, 
and trusts, to their partners, shareholders, or beneficiaries, 
respectively. The Internal Revenue Service (IRS) estimates that from 6 
to 15 percent of such income is unreported on individual tax returns. 
This income is reported to both IRS and to the recipients on a Schedule 
K-1 (K-1). IRS uses K-1 data in its document-matching program to 
identify noncompliance and for other purposes. GAO was asked to (1) 
assess the accuracy of K-1 data, specifically transcription errors and 
taxpayer identification numbers (TIN); (2) determine whether any 
limitations in the availability or accuracy of K-1 data have affected 
IRSs ability to identify noncompliance; and (3) identify the benefits 
and challenges of increasing e-filing of K-1s.

What GAO Found:

The accuracy of paper-filed K-1 data is reduced by transcription 
errors; paper and e-filed K-1s have inaccurate TINs. IRS estimates that 
transcription errors for tax year 2002 ranged from 5 and 9.5 percent 
and is taking steps to address such errors. Although e-filed K-1s do 
not require transcription, for tax year 2002, the percentage of 
invalid TINs for e-filed K-1s and paper-filed K-1s were comparable (7 
and 6 percent, respectively). Due to potential burden on flow-through 
entities and resource constraints, IRS does not notify the entities of 
invalid TINs on K-1s for correction. If IRS did so, this would likely 
give e-filing entities enough time to correct invalid TINs before IRS 
runs its document-matching program.

Inaccurate or limited K-1 data have created problems for IRS 
researchers and examiners. IRS research staff indicated that inaccurate 
TINs adversely affected their analysis of flow-through entity networks. 
Further, because IRS captures limited data from flow-through entity 
returns, including the K-1, IRS staff lack data they consider helpful, 
such as Other Income to help identify tax shelters. In at least 40 
percent of closed examination cases we sampled, IRS examiners found 
errors with return line items not entered into IRSs databases when 
returns are received. If these lines were available up front, 
researchers say they would be able to better identify returns with 
potential noncompliance.

Increased e-filing of K-1s would provide benefits and challenges to 
both IRS and taxpayers. Benefits for IRS include faster, more complete 
information and millions in annual cost reductions. Benefits for 
taxpayers include fewer IRS contacts with them because IRS would have 
more accurate information in its systems. The primary challenge for 
IRS is its current inability to electronically process all flow-through 
entity returns and related forms, including the K-1. For taxpayers, 
the primary challenge is the cost of converting from paper to e-filing.
 
Paper K-1s: Lengthy Processing Yields Incomplete Data: 

[See PDF for image]

[End of figure]

What GAO Recommends:

To improve the availability and usefulness of K-1 data to IRS for 
detecting noncompliance, GAO recommends that IRS conduct a pilot study 
to determine the benefits and costs of obtaining corrected TINs from 
flow-through entities as soon as they are found to be invalid. 

IRS agreed with our recommendation. 

www.gao.gov/cgi-bin/getrpt?GAO-04-1040. 

To view the full product, including the scope and methodology, click 
on the link above. For more information, contact Michael Brostek at 
(202) 512-9110 or brostekm@gao.gov. 

[End of section]

Contents:

Letter:

Results in Brief:

Background:

Data Transcription Errors and Erroneous TINs Reduce the Accuracy of K-
1 Data:

K-1 Data Accuracy and Availability Pose Problems in Research and 
Examination Efforts:

Increasing E-Filing of K-1s Would Provide Benefits and Challenges for 
IRS and Taxpayers:

Conclusions:

Recommendation for Executive Action:

Agency Comments and Our Evaluation:

Appendixes:

Appendix I: Objectives, Scope, and Methodology:

Appendix II: Comments from the Internal Revenue Service:

Table:

Table 1: Percentage of Invalid Schedule K-1 TINs That Were Not 
Corrected and Corrected by IRS for Tax Year 2002 by Type of Entity 
Return:

Figures:

Figure 1: IRS's Program to Match Flow-Through Income Reported by 
Partnerships with Income Reported on a Partner's Federal Income Tax 
Return:

Figure 2: Processing Flowchart for Paper and E-Filed Schedule K-1:

Figure 3: How Inaccurate TINs May Prevent IRS from Tracking Flow of 
Income through a Chain of Financial Transactions:

Letter September 30, 2004:

The Honorable Charles Grassley: 
Chairman: 
The Honorable Max Baucus: 
Ranking Minority Member: 
Committee on Finance: 
United States Senate:

Over a trillion dollars in income was distributed in tax year 2002 by 
entities such as partnerships, subchapter S corporations (S-Corp), and 
trusts that distribute net income--as well as losses--to partners, 
shareholders, and beneficiaries.[Footnote 1] Such entities, called 
flow-through entities, are required to report distributed income 
annually to the Internal Revenue Service (IRS) on a Schedule K-1, thus 
providing IRS with a way to determine whether individuals are reporting 
the income on tax returns.[Footnote 2] IRS estimates that from 6 to 15 
percent of such income is unreported on individual tax returns. In 
addition, IRS is concerned about flow-through entities claiming 
improper expenses or otherwise being used to evade tax liabilities. 
Thus, IRS is concerned both with potential noncompliance by individuals 
who fail to properly report income from flow-through entities and by 
flow-through entities themselves, which ultimately leads to improper 
income reporting by individuals as well.

Schedule K-1s are one of several forms and schedules included in the 
annual return filed by a flow-through entity. Partnerships with more 
than 100 partners are currently required by law to file their annual 
returns, including all Schedule K-1s,[Footnote 3] electronically. Those 
with 100 partners or less, as well as S-Corps and trusts, are not 
required to do so.

The annual returns of flow-through entities are used to report the 
income, deductions, gains, losses, and so forth of the respective 
entities. These returns, including the K-1s, enable IRS to identify 
compliance issues that may require an examination of the flow-through 
entities' books and records. Further, during 2001, IRS began matching 
K-1 information with information included on individual tax returns to 
identify potential underreporting of income by individuals. To use K-1 
information not filed electronically in its document-matching 
program,[Footnote 4] IRS must first transcribe the data for use in its 
computer systems. As reported in 2003, this is a costly and error-prone 
process that can result in taxpayer burden.[Footnote 5]

Because of concerns about IRS's ability to effectively use K-1 data to 
detect noncompliance, you asked us to assess IRS's current use of this 
information. Specifically, our objectives were to (1) evaluate the 
accuracy of K-1 data used by IRS, specifically transcription errors and 
invalid TINs; (2) determine whether any limitations in the availability 
or accuracy of K-1 data have affected IRS's ability to identify 
noncompliance; and (3) describe the benefits and challenges of 
increasing electronic filing (e-filing) of K-1s.[Footnote 6]

To meet our first objective, we discussed and obtained estimates from 
IRS staff concerning the type of IRS transcription errors for paper-
filed K-1s. We also assessed IRS's procedures related to the processing 
and transcription of K-1 information. In addition, we obtained and 
analyzed the IRS K-1 database for tax year 2002[Footnote 7] to 
identify, among other things, the size and type of entities that file 
K-1s, the frequency of inaccurate taxpayer identification numbers 
(TIN)[Footnote 8] included on these schedules, and the amount of income 
associated with inaccurate TINs. On the basis of our data reliability 
review of IRS's K-1 database, we determined that the data were 
sufficiently reliable to enable us to identify the extent to which K-1s 
have invalid TINs.

To address our second objective, we determined what portion of flow-
through entities' returns, including K-1s, is transcribed by IRS. We 
also discussed with IRS staff and research consultants from MITRE 
Corporation[Footnote 9] how IRS currently uses K-1 information and 
whether and how data availability and accuracy affect their ability to 
use these data. We also reviewed a projectable sample[Footnote 10] of 
partnership and S-Corp closed examination files to determine the 
compliance issues IRS identified, the related line items that were 
adjusted, and whether having additional K-1 line items available would 
help to identify potential noncompliance. We subsequently discussed our 
findings with IRS classification[Footnote 11] and examination staff.

To meet our third objective, we discussed with both IRS officials and 
officials from seven organizations that represent the taxpayer 
community the costs, benefits, and challenges of requiring increased e-
filing of K-1s. We selected the organizations based on prior GAO 
knowledge and referrals from some of the organizations that we 
contacted. We also contacted the software companies that offer e-filing 
for flow-through entities to obtain their current fees for preparing 
and e-filing flow-through entity returns, including K-1s.

Our work was done from May 2003 through August 2004 in accordance with 
generally accepted government auditing standards. (App. I describes our 
overall objectives, scope, and methodology.)

Results in Brief:

The accuracy of K-1 data is reduced by IRS transcription errors on 
paper-filed K-1s and by flow-through entities submitting invalid TINs 
on both paper and e-filed K-1s. IRS estimates that the overall 
transcription error rate for the almost 18 million tax year 2002 paper-
filed K-1s ranged from 5 to 9.5 percent based on its quality reviews. 
E-filed returns are not transcribed and thus do not have these errors. 
IRS is taking steps to reduce the transcription error rate, such as 
implementing a bar-coding process that bypasses the transcription 
process and taxpayer education and outreach efforts. In tax year 2002, 
IRS processed almost 1.5 million K-1s with invalid TINs. The combined 
income on these K-1s totaled $57.3 billion. IRS was able to correct the 
TINs on about half of the K-1s with income totaling $20.6 billion. The 
remaining 50 percent that had income of $36.6 billion could not be 
corrected and thus could not be used in the document-matching program. 
Regarding TIN accuracy, the percentage of invalid TINs for tax year 
2002 e-filed K-1s was 7 percent, which was comparable to the 6 percent 
invalid TIN rate on paper-filed K-1s. IRS is not notifying flow-through 
entities of invalid TINs so they can take corrective actions due to 
concern over taxpayer burden on flow-through entities and resource 
constraints. If this were done, it would more likely give e-filing 
entities enough time to correct many invalid TINs before IRS runs its 
document-matching program because IRS could send error notices to e-
filers more quickly than to paper filers.

Inaccurate or limited K-1 data have created some problems in IRS's 
research and examination efforts. IRS research staff studying flow-
through entity relationships indicated that missing or inaccurate TINs 
have affected their ability to build more effective computer models to 
analyze flow-through networks that may be used for tax evasion. In 
addition, because of the limited number of line items captured from the 
flow-through entity return, including the K-1, research and examination 
staff lack certain data fields, such as "Other Income/(Loss)," that 
would be helpful to identify compliance issues and better target 
resources. Based on our sample of closed examination cases, in at least 
40 percent of the examinations, IRS auditors corrected line items on 
entities' returns that are not currently being transcribed.[Footnote 
12] If these line items were available before IRS classifiers select 
returns for examination, IRS researchers could use the data to support 
more effective computer modeling and thereby focus examination 
classifiers' attention on returns that are more likely to involve 
noncompliance.

Increasing e-filing of K-1s from the current rate of about 24 percent 
would provide benefits and challenges for IRS and taxpayers. For IRS, 
the benefits include faster and more comprehensive information as well 
as cost reductions due to the lack of transcription costs for e-filed 
returns. For example, in fiscal year 2002, IRS spent over $13 million 
for processing and transcribing paper-filed K-1s, much of which would 
be eliminated. For taxpayers, the benefits of e-filing include the 
receipt of an IRS acceptance acknowledgment; the quicker receipt of 
rejection notices that would allow the taxpayers to correct problem 
returns faster; and more accurate information in IRS databases due to 
the lack of transcription errors, thus reducing the potential for 
erroneous and burdensome taxpayer notices. IRS's primary challenge in 
mandating increased e-filing of K-1s is its current inability to 
electronically process all the other forms that may accompany the flow-
through entity return. IRS is scheduled to have this capability by 
2007. The primary challenge for taxpayers is the cost of converting 
from paper filing to e-filing. However, based on a limited review of 
flow-through entity returns, most K-1s are currently computer 
generated, which is a prerequisite for e-filing. Also, all of the 
software companies that offer e-filing that disclosed their fees (about 
half of those we contacted) do so for less than a dollar per K-1 or at 
no additional cost. Both IRS and Congress are considering various 
administrative and legislative proposals to increase mandatory e-filing 
of information and tax returns, including those filed by flow-through 
entities.

We are making a recommendation that IRS implement a pilot study to 
determine the benefits and costs of requiring flow-through entities to 
correct invalid TINs on K-1s as soon as it has been determined that the 
TINs cannot be "perfected" via IRS's TIN validation program. The 
Commissioner of Internal Revenue agreed with our recommendation and 
said that IRS plans to study a number of options to ensure that TINs 
included on Schedule K-1s are accurate.

Background:

Partnerships, S-Corps, and trusts are commonly referred to as flow-
through entities, as they do not generally pay taxes on income. 
Instead, they distribute net income--as well as losses--to partners, 
shareholders, and beneficiaries, respectively, who are subsequently 
required to report the net income or loss on their individual tax 
returns and to pay any applicable taxes. Distributed income is reported 
to IRS on a K-1, which is included in the annual return filed by the 
flow-through entity. Copies of the Schedule K-1 are provided to 
partners, shareholders, and beneficiaries for use when filing their 
respective annual returns. Partners receive a Form 1065 Schedule K-1, 
"Partner's Share of Income, Credits, Deductions, etc."; shareholders 
receive a Form 1120S Schedule K-1, "Shareholder's Share of Income, 
Credits, Deductions, etc."; and beneficiaries receive a Form 1041 
Schedule K-1, "Beneficiary's Share of Income, Deductions, Credits, 
etc."

As shown in figure 1, as part of its overall underreporter program, IRS 
has a specific K-1 document-matching program in which selected K-1 
information reported by flow-through entities is compared to 
information reported by individuals on their tax returns in order to 
determine whether distributed income has been reported as required.

Figure 1: IRS's Program to Match Flow-Through Income Reported by 
Partnerships with Income Reported on a Partner's Federal Income Tax 
Return:

[See PDF for image]

[End of figure]

In like manner, income reported to IRS on a K-1 by S-Corps and trusts 
can be matched with income reported on tax returns by shareholders and 
beneficiaries, respectively.[Footnote 13] The purpose of this program 
is to increase voluntary reporting of flow-through income by taxpayers 
and to target K-1 related underreporter notices to noncompliant 
taxpayers. IRS identified about $4.1 billion in underreported income 
for tax years 2000 and 2001 via the K-1 matching program and assessed 
about $110 million in additional taxes.[Footnote 14]

In addition to use in the matching program, IRS can also use K-1 
information to aid in selecting flow-through entity returns for 
examination. For example, IRS can use K-1 information to aid in 
identifying flow-through entities involved in potential tax evasion 
schemes and to develop computer models that may enable IRS to more 
effectively select returns for examination with the greatest likelihood 
for a tax change.[Footnote 15]

In order for IRS to use K-1 information in its matching program, the 
information must either be e-filed by a flow-through entity or, if 
filed via paper, transcribed by IRS staff for use in its computer 
systems. Currently, only partnerships with over 100 partners are 
required by law to e-file their annual returns, including any related 
K-1s. As a result, for tax year 2002, less than one-quarter of 1 
percent of partnerships was required to e-file.

Figure 2 illustrates that an e-filed K-1 goes through two basic steps 
before the information is input into the Information Returns Master 
File (IRMF). At Step A, the K-1 undergoes up-front checks prior to 
final acceptance by IRS, whereby the K-1 data must pass specific checks 
or the entire flow-through entity return is to be rejected until 
corrected by the entity. The up-front checks include verifying the tax 
year and proper formatting of names, addresses, and TINs. For example, 
the partner's TIN on a K-1 filed by a partnership must be within a 
specific range established by IRS; if not, the entire partnership 
return is to be rejected. The only other step for an e-filed K-1 prior 
to its going through IRS's document-matching program is the TIN 
validation process, in which the TIN and name on the K-1 are 
electronically matched with information in IRS's files to determine 
whether the TIN is valid. Generally, this validation occurs several 
months after IRS accepts the e-filed return.

Figure 2: Processing Flowchart for Paper and E-Filed Schedule K-1:

[See PDF for image]

Note: Does not reflect the processing changes to paper K-1s that IRS 
began testing in April 2004 with the introduction of bar coding and 
scanning.

[End of figure]

In contrast, a paper-filed K-1 goes through several manual steps, 
including some of the up-front checks conducted electronically for e-
filed K-1s, before TIN validation takes place and the information can 
be input into the IRMF. These steps, particularly transcription, can 
take up to 6 months to complete, with transcription beginning in May. 
For example, at Step 4, IRS staff are to edit the flow-through entity 
return and contact the taxpayer if a required K-1 is missing. At Step 
8, IRS staff are to transcribe selected K-1 line items. During the 
transcription process, the computer conducts checks on select aspects 
of the keypunched data, such as correlating zip code and state 
information, and creates an error record for correction. Subsequently, 
other IRS staff are to compare a sample of the transcribed K-1 data to 
the original paper-filed K-1 to determine whether the data were 
accurately transcribed. The TIN on a paper-filed K-1, as on an e-filed 
K-1, is not computer validated until it reaches the stage where 
electronic TIN validation occurs, generally several weeks or months 
after the return was filed.

IRS's program to electronically validate TINs matches the TIN and name 
on the K-1 to taxpayer identity information in its files. If there is 
no match, IRS will attempt to "perfect" or correct an incorrect TIN/
name combination via a TIN validation process, which entails matching 
the TIN and name control--the first four characters of an individual's 
last name or the first four characters of a business name--with (1) a 
file which contains all Social Security numbers (SSN) ever issued and 
all name controls ever associated with them and (2) a file that 
contains all employer identification numbers (EIN) ever issued and all 
name controls associated with them. This TIN validation process occurs 
four times per year, beginning about a month and a half after the end 
of the filing season.

Data Transcription Errors and Erroneous TINs Reduce the Accuracy of K-
1 Data:

Data transcription errors made by IRS on paper-filed K-1 data and 
invalid TINs submitted by flow-through entities on both paper-filed and 
e-filed K-1s lower the accuracy of K-1 data. IRS transcription errors, 
which occur only for paper-filed K-1s, ranged from 5 to 9.5 percent for 
tax year 2002, and IRS is taking steps to reduce these errors. The 
percentage of invalid TINs for e-filed K-1s is comparable to that for 
paper-filed K-1s. However, due to potential taxpayer burden and 
resource constraints, IRS is not notifying flow-through entities of 
invalid TINs so they can take corrective actions, a step which would 
likely give e-filing entities enough time to correct many invalid TINs 
before IRS runs its document-matching program. Paper-filing entities 
may not have sufficient time to correct invalid TINs before document 
matching occurs.

Data from Paper-Filed K-1s Contain Transcription Errors, but IRS Is 
Taking Steps to Reduce These Errors:

According to IRS K-1 quality reviews conducted at two IRS locations, 
the overall K-1 transcription error rate for tax year 2002 ranged from 
5 to 9.5 percent--errors that by definition are not made in e-filed 
returns. The most frequent errors dealt with names and addresses. IRS 
also found transcription errors in dollar amounts and TINs. Errors 
detected during quality reviews are corrected before the K-1s are 
posted to the IRMF, which IRS uses to detect potential underreporters 
and nonfilers. However, less than 2 percent of all K-1s are selected 
for the K-1 quality review. Transcription errors on all other K-1s are 
included when the data are posted to the IRMF. Consequently, data from 
an estimated 18 million tax year 2002 paper K-1s that were entered into 
databases used by IRS for research and enforcement purposes have 
transcription error rates from 5 to 9.5 percent.[Footnote 16] For 
example:

* IRS's K-1 database for tax year 2002 included 16 paper-filed K-1s 
each of which showed interest income of over $1 billion. These interest 
income amounts appeared to be transcription errors. One partnership 
filing paper K-1s had 73 partners. For 72 of the partners, the K-1 
interest recorded in the IRMF was under $200,000. The remaining 
partner's interest as recorded in the IRMF was $85.3 billion.[Footnote 
17]

* According to an IRS data quality review of tax year 2001 K-1 
document-matching cases, about 5 percent of the cases that were either 
screened out before taxpayers were contacted or resulted in no change 
to taxpayers' tax liabilities after an erroneous underreporter notice 
was sent to the taxpayer were due to transcription errors. The 
transcription errors included misplaced decimal points and positive 
money amounts that were transcribed as negative numbers and vice versa.

According to IRS officials, it would be too costly to do more data 
transcription quality review of paper-filed K-1s, such as reentry of K-
1 data. Instead, IRS is taking other measures to improve K-1 data 
accuracy. For example:

* For tax year 2003, IRS began scanning all K-1s using optical 
character recognition (OCR) equipment. Also, for tax year 2003, IRS is 
accepting K-1s with bar codes that contain all the K-1 data. If the bar 
code is present, the system will pick up the information from the bar 
code, otherwise the system will image the K-1 and read the line entries 
using OCR. Portions of the K-1 or bar code that cannot be read by OCR 
are manually transcribed. Although IRS originally projected 30 percent 
of K-1s would be bar coded in tax year 2003, as of July 2004 only 8 
percent of K-1s submitted were bar coded. For the 92 percent of K-1s 
without bar codes that OCR read, almost 20 percent required no 
transcription, 60 percent required less than half of normal 
transcription, and 20 percent were entirely transcribed. Although bar 
coding and OCR bypass most of the manual data transcription, which 
reduces some data transcription cost and errors, IRS officials still 
prefer e-filing because bar coding is a paper process with accompanying 
processing costs.

* To improve the accuracy of transcription, IRS has implemented new 
software and improved transcription training. At two IRS locations, IRS 
is using a new transcription software intended to increase 
transcription productivity and accuracy, compared to the current 
transcription software. In addition, transcription training for the K-
1 program has evolved. Each year, feedback is funneled to the IRS 
transcription trainers to improve the K-1 transcription process.

* IRS is redesigning the K-1s for both partnerships and S-Corp returns 
so that IRS can scan them into the computer instead of having to 
transcribe the data manually. Although the redesigned partnership and 
S-Corp K-1s are expected to be ready by tax year 2004, the redesigned 
trust K-1 will not roll out until tax year 2005 because trust law makes 
the trust K-1 different from the other two K-1s.

* IRS is conducting educational outreach to increase accurate K-1 
filing and provide updates to changes in K-1 design. In April 2004, IRS 
issued a news release to provide tips for businesses, individuals, and 
tax professionals on accurate K-1 filing. For example, flow-through 
entities are instructed to ensure the correct TINs are used on K-1s. In 
addition, the six IRS Tax Forums in 2004 include a session on reporting 
flow-through items, which addresses the redesign of K-1 forms and K-1 
reporting reminders. IRS has also included updates on the K-1 matching 
program and K-1 redesign in external speeches to stakeholder groups. 
Finally, in late 2004, IRS plans to implement a multifaceted 
communication plan to publicize the release of the redesigned K-1s.

IRS's K-1 Data Contain Incorrect Taxpayer Identification Information:

For IRS to use K-1 data in its document-matching program, the TINs and 
names on K-1s need to be accurate so they can be linked to individuals' 
tax returns and other tax documents. In tax year 2002, about 94 percent 
of 24 million K-1s that IRS processed contained valid TINs. The 
remaining 6 percent, or approximately 1.5 million K-1s, had invalid 
TINs because either IRS made transcription errors or the flow-through 
entities submitted invalid data. The 1.5 million K-1s with invalid TINs 
had combined income gains of $57.3 billion and combined income losses 
of $84.1 billion. IRS was able to correct the invalid TINS on about 
750,000 of the K-1s, with income gains totaling $20.6 billion and 
incomes losses totaling $6.8 billion, so that they could be used in 
IRS's document-matching program or for other compliance and research 
purposes. However, the remaining 740,000 K-1s with invalid TINs, with 
income gains of $36.6 billion and incomes losses of $77.2 billion, 
could not be perfected and thus were unmatchable. IRS did not have data 
on the number of K-1s that had either corrected or unmatchable TINs in 
the IRMF that resulted from transcription errors.

IRS Does Not Notify Flow-Through Entities of Invalid TINs That It Was 
Unable to Correct:

After IRS checks the validity of TINs provided on K-1s, it does not 
notify either paper-filing or e-filing flow-through entities of the 
invalid TINs it finds so the entities can take steps to correct the 
TINs, due to concerns about the potential burden on the entities and 
resource constraints. Because e-filed returns do not go through time-
consuming paper processing steps, including transcription, if IRS were 
to notify the originating entities of invalid TINs, they should have 
time to correct invalid K-1s before IRS performs its document matching 
in the fall following a tax filing year. For paper-filed K-1s, many 
entities likely could not respond before the document matching occurs.

Because e-filed K-1s are not subject to transcription errors, none of 
the keypunching errors associated with paper returns are in e-filed 
data. However, as table 1 shows, in tax year 2002 the overall 
percentage of invalid K-1 TINs IRS found with its TIN validation 
program was comparable for e-filed (about 7 percent) and paper (6 
percent).

Table 1: Percentage of Invalid Schedule K-1 TINs That Were Not 
Corrected and Corrected by IRS for Tax Year 2002 by Type of Entity 
Return:

Type of entity return: Partnership; 
E-filed K-1s: Percentage of TINs found invalid by IRS's validation 
program: 8.7%; 
E-filed K-1s: Percentage of invalid TINs IRS was unable to correct: 
62.1%; 
E-filed K- 1s: Percentage of invalid TINs IRS corrected: 36.8%; 
Paper K- 1s: Percentage of TINs found invalid by IRS's validation 
program: 6.5%; 
Paper K-1s: Percentage of invalid TINs IRS was unable to correct: 
50.8%; 
Paper K-1s: Percentage of invalid TINs IRS corrected: 49.2%. 

Type of entity return: Trust; 
E-filed K-1s: Percentage of TINs found invalid by IRS's validation 
program: 3.7%; 
E-filed K-1s: Percentage of invalid TINs IRS was unable to correct: 
24.3%; 
E-filed K-1s: Percentage of invalid TINs IRS corrected: 75.7%; 
Paper K-1s: Percentage of TINs found invalid by IRS's validation 
program: 7.1%; 
Paper K-1s: Percentage of invalid TINs IRS was unable to correct: 
56.3%; 
Paper K-1s: Percentage of invalid TINs IRS corrected: 43.7%. 

Type of entity return: S-Corp; 
E-filed K-1s: Percentage of TINs found invalid by IRS's validation 
program: n/a[A]; 
E-filed K-1s: Percentage of invalid TINs IRS was unable to correct: 
n/a[A]; 
E-filed K-1s: Percentage of invalid TINs IRS corrected: n/a[A]; 
Paper K-1s: Percentage of TINs found invalid by IRS's validation 
program: 5.0%; 
Paper K-1s: Percentage of invalid TINs IRS was unable to correct: 
36.0%; 
Paper K-1s: Percentage of invalid TINs IRS corrected: 64.0%. 

Type of entity return: Total all K-1s; 
E-filed K-1s: Percentage of TINs found invalid by IRS's validation 
program: 7.0%; 
Paper K-1s: Percentage of TINs found invalid by IRS's validation 
program: 6.1%. 

Source: GAO analysis of IRS information.

Note: Numbers may not add up to 100 percent because of rounding.

[A] Not applicable because e-file was not available for S-Corp returns 
until tax year 2003.

[End of table]

Factors that may be contributing to e-filed K-1s having TIN errors 
comparable to those of paper K-1s include (1) large partnerships, which 
are mandated to file K-1s electronically, submitting such large volumes 
of K-1s that many may unknowingly submit one or more K-1s with invalid 
TINs[Footnote 18] and (2) IRS not applying one of its up-front checks 
for e-filed partnership K-1s.

According to our analysis of IRS's K-1 database, partnerships that 
submit a higher volume of K-1s are more likely to submit a K-1 with an 
invalid TIN compared to partnerships that submit only a few K-1s. In 
tax year 2002, e-filed partnerships' K-1s had the highest rate of 
invalid TINs (8.7 percent). That same year, 97 percent of the 
partnerships with more than 100 partners, which are required to e-file, 
submitted at least one K-1 with an invalid TIN. In contrast, 18 percent 
of partnerships with 100 or fewer partners submitted at least one K-1 
with an invalid TIN.

To encourage electronic filing of partnership returns, IRS is not 
applying its up-front check that would reject an e-filed partnership's 
return if it has even one TIN on a K-1 that falls outside the range of 
numbers associated with SSNs and EINs. If IRS applied this validation 
criterion in tax year 2002, 12 percent of the e-filed partnership K-1s 
with unmatchable TINs would have been rejected and the originating 
entities would have been asked to take steps to correct the TINs. 
However, some partnerships have hundreds or thousands of partners, 
making it more challenging for them to ensure that all partners' TINs 
are correct. IRS officials have determined that accepting an e-filed 
return when the vast majority of the K-1 TINs fall within the range of 
numbers associated with SSNs and EINs, rather than rejecting the entire 
entity return due to one or a few TINs that fall outside that range, 
promotes e-filing.

In addition, IRS does not notify either e-filing or paper-filing flow-
through entities if submitted TINs are found to be invalid during the 
TIN validation checks it performs subsequent to accepting entities' 
returns. In tax year 2002, more than half of the K-1s submitted by 2 
percent of the flow-through entities contained invalid TINs. The total 
number of unmatchable K-1s submitted by these entities represented 
about 29 percent of the total number of K-1s with unmatchable TINs. IRS 
officials said that requiring flow-through entities to correct invalid 
TINs could be a burden because the entities rely on information 
supplied by individual taxpayers and the correct TINs may not be 
readily available, particularly for those entities submitting a large 
number of K-1s. In contrast, IRS does notify filers of missing or 
invalid TINs submitted on other types of information returns, which 
then may require the filers to contact third parties for corrected 
information. For example, for tax years 2000 and 2001 combined, IRS 
proposed just over $204 million in penalties against nonfederal payers 
for information returns with invalid TINs. IRS officials acknowledged 
that flow-through entities may have made mistakes themselves that 
resulted in invalid TINs or may have the correct information on hand. 
They also stated that sending such notices would entail some additional 
cost to IRS and that they currently face resource constraints. However, 
IRS officials do not have estimates of either the potential benefits, 
such as increased revenue obtained from document matching utilizing 
accurate TINs, or the cost to IRS of obtaining valid TINs from flow-
through entities.

If IRS were to notify flow-through entities of invalid TINs and ask 
that they take steps to correct the TINs, it likely would be able to 
receive many corrected TINs, particularly from e-filers, in time for 
its annual document-matching program. IRS does its document matching 
generally from November of the calendar year through January of the 
following year. The time when document matching occurs changes somewhat 
from year to year. IRS corrects TINs, including K-1 TINs, four times a 
year: at the end of June, early September, mid-November, and late 
November. Based on the IRS's 2001 Statistics of Income samples, at 
least 97 percent of partnerships and S-Corps filed calendar year 
returns.[Footnote 19] Consequently, all of these returns were due to be 
filed prior to IRS's first TIN validation check in June.[Footnote 20] 
Since IRS accepts e-filed returns within 2 days of their submission, 
all e-filed returns for which filers have not requested extensions 
should be available for IRS's June TIN validation program. In this 
case, IRS would be able to notify the flow-through entities of the 
invalid TINs and the entities would have several months to correct the 
TINs and get them back to IRS before IRS posts the corrected K-1s to 
the IRMF in time for use in the document-matching program. Even if a 
flow-through entity did not submit the corrected TIN in time, the 
entity would be aware of the error and could correct the TIN for the 
following year.

For paper-filing flow-through entities, fewer entities likely would be 
able to correct invalid TINs in time for inclusion in the document-
matching program. Transcription of paper-filed entity returns, 
including K-1s, begins in May. Because transcription can take up to 6 
months, a significant portion of paper-filed entity returns and 
associated K-1 TINs likely would not be available for the June TIN 
validation. For those not available until the early September TIN 
validation, the entities would have much less time to correct TINs and 
get back to IRS in time for IRS to include the corrected TINs in the 
document-matching program. Because IRS's new return scanning and bar-
coding efforts should make paper-filed return data available more 
quickly, IRS may be able to include more of them in the June TIN 
validation and thus provide entities sufficient time to provide 
corrected TINs if it sends notices of invalid TINs to flow-through 
entities.

K-1 Data Accuracy and Availability Pose Problems in Research and 
Examination Efforts:

In addition to using K-1 data in its document-matching program, IRS is 
using K-1 data in its research programs to better understand flow-
through relationships. When data such as TINs are unavailable or 
inaccurate, researchers are unable to establish a complete 
understanding of the network of related entities and taxpayers. Data 
limitations have also affected IRS's efforts to identify potentially 
noncompliant taxpayers for examination. IRS researchers and examination 
staff indicated that more complete and accurate data would enhance 
their efforts to detect noncompliance.

Inaccurate TINs Affect Research Efforts to Link Related Entities:

IRS researchers are using K-1 data to visualize how taxpayers are 
related to different entities and to evaluate whether compliance issues 
may exist with flow-through entities. However, inaccurate TINs have 
sometimes prevented researchers from establishing all relevant links in 
a network of related entities. As a result, IRS is less able to track 
the flow of income and losses among entities and could be missing 
opportunities to address areas of noncompliance.

Figure 3 illustrates how inaccurate TINs may prevent IRS from tracking 
the flow of income through a chain of financial transactions. In this 
example, an S-Corp distributes losses to an individual shareholder, 
possibly to allow the shareholder to offset other gains, and 
distributes income to another shareholder, a trust. Since trusts are 
flow-through entities and may be nontaxable, the individual shareholder 
may be using the trust to reallocate income (perhaps to someone in a 
lower tax bracket) that would otherwise need to be reported and taxed 
on that individual's return.

Figure 3: How Inaccurate TINs May Prevent IRS from Tracking Flow of 
Income through a Chain of Financial Transactions:

[See PDF for image]

[End of figure]

In our example, the S-Corp transfers income to Trust A, which in turn 
transfers the income to Trust B. In both transactions, the S-Corp and 
Trust A submit K-1s with accurate TINs to IRS, so IRS can track the 
flow of income between the entities. Trust B then transfers the income 
again to Trust C and submits a K-1 with an inaccurate TIN to IRS. 
Because of the inaccurate TIN on the K-1, IRS would likely be unable to 
identify that Trust C is related to the other entities or track the 
flow of income to its final destination and ultimately determine 
whether any income was underreported.

Limited Transcription Lines Do Not Fully Meet the Needs of Examination 
and Research Programs:

IRS transcribes limited line items from K-1s that accompany partnership 
and S-Corp returns. According to IRS staff, at least some of the 
nontranscribed lines would provide useful information. Similarly, IRS 
does not transcribe many of the lines from the flow-through entity's 
return to which the K-1s are attached. Since e-filing of the full 
entity's return is part and parcel of achieving e-filing of K-1s, e-
filing of K-1s would have the additional effect of making the complete 
entity's tax return information available to IRS examiners and 
researchers. Complete entity data also would provide useful information 
for research and examination purposes. For K-1s, IRS identified the 
line items to be transcribed based on the needs of its document-
matching program and not on other potential uses.

Regarding K-1s, IRS transcribes about 14 percent of partnership K-1 
line items and about 17 percent of S-Corp K-1 line items. Research and 
examination staff indicated that the nontranscribed information would 
provide useful information. For example:

* The "Other Income/(Loss)" line is not captured from the K-1 because 
it is not useful for document matching, but it can be helpful to 
researchers in identifying abusive shelters, for example, where the 
gain is allocated to a tax haven country and the loss is allocated to a 
domestic investor.

* Transcribing the shareholder's ownership percentage from the K-1 
would more easily allow classifiers to determine if the taxpayer has a 
controlling interest in the S-Corp and if income/losses are distributed 
evenly.

Regarding the flow-through entity's return, IRS currently transcribes 
about 23 percent and 20 percent of the line items for partnership and 
S-Corp returns, including the K-1, respectively. As discussed below, 
additional data from the full entity return would potentially benefit 
examination and research programs. For example:

* The IRS Examination Guide for Abusive Tax Shelters and Transactions 
lists partnership (Form 1065) and S-Corp (Form 1120S) tax return lines 
that when examined with other information, may indicate tax shelter 
transactions. For partnership returns, about 80 percent of the line 
items listed in the guide as useful to detect tax shelters are not 
captured in IRS's database. For S-Corp returns, about 87 percent of 
line items listed are not captured. When selecting returns to be 
examined, IRS classifiers who focus on tax shelter issues lack 
information that may identify taxpayers most likely to be using tax 
shelters.

* IRS researchers developed a computer model to better identify S-Corp 
returns for examination by helping classifiers separate accurate 
returns from those needing further investigation. The model uses data 
from IRS's database of business returns, including Form 1120S and 
accompanying schedules. From the approximately 23,000 returns that the 
model analyzed, IRS identified about 58 percent of the returns as 
having low potential for noncompliance and therefore eliminated them 
from the universe that might be examined. The remaining 42 percent of 
returns could not be classified because the model did not have enough 
data to evaluate them. As a result, IRS has continued to rely on 
examination staff who focus on S-Corp compliance issues to manually 
review the returns that the model has not been able to classify. To 
help address the lack of 1120S data, IRS will be capturing 10 
additional line items from the 1120S for tax year 2003. One IRS 
researcher estimated that the 10 additional 1120S line items would 
enable the computer model to identify 15 S-Corp compliance issues 
compared to its current capability of identifying 2 compliance issues.

From our file review of closed S-Corp and partnership tax return 
examination cases and discussions with IRS examination and research 
staff, we also found that additional line items from the K-1 and other 
parts of the entity's return may assist IRS in selecting tax returns to 
examine. Based on our sample of closed examination cases,[Footnote 21] 
in at least 40 percentof the examinations, IRS corrected line items 
that are currently not transcribed. IRS examination and research staff 
we interviewed indicated that if IRS captured this information and made 
it available to them, it would help them identify those returns with 
errors or omissions that IRS should examine. Most of the nontranscribed 
line items that were corrected were from Schedule A (Cost of Goods 
Sold) and Schedule K[Footnote 22] (Partners' Shares of Income, Credits, 
Deductions, etc., or Shareholders' Shares of Income, Credit, 
Deductions, etc.) for both partnerships and S-Corps. IRS identified two 
of these line items, both from Schedule K and K-1, as important for 
improving the effectiveness of computer modeling and mentioned other 
nontranscribed lines, such as "Short Term Capital Loss," from the 
entity return that would be useful.

Increasing E-Filing of K-1s Would Provide Benefits and Challenges for 
IRS and Taxpayers:

Increasing e-filing of K-1s provides benefits and challenges for IRS 
and taxpayers. The benefits for IRS are faster and more comprehensive 
information as well as cost reductions. The benefits to taxpayers are 
the receipt of acknowledgment notices, faster rejection notices that 
allow taxpayers to resolve problems faster, and more accurate 
information. Currently IRS's main challenge is the lack of complete e-
filing capacity, but IRS is scheduled to have this capacity by 2007. 
The main challenge for taxpayers is the cost of converting from paper 
to e-filing. However, limited data indicate that most K-1s are computer 
generated, which is a prerequisite for e-filing. Also, all of the 
software companies that offer e-filing that disclosed their fees (about 
half of those we contacted) do so for less than a dollar per K-1 or for 
no additional charge. Congress has mandated that IRS increase e-filing 
to at least 80 percent of all tax and information returns by 2007. 
Currently, both IRS and Congress are considering increasing mandatory 
e-filing of flow-through entity returns.

Increasing E-Filing of K-1s Would Provide Better Information and Cost 
Reductions for IRS:

Currently, IRS electronically receives about a quarter of the K-1s 
filed, although only partnerships with more than 100 partners are 
mandated to e-file. Increasing e-filing of K-1s would benefit IRS 
because of the following:

E-filing K-1s provides IRS with faster and more complete information 
for use in compliance and research programs. A recent Treasury 
Inspector General for Tax Administration (TIGTA) report stated that the 
savings in processing time resulting from e-filing would significantly 
affect IRS's attempt to reduce its lengthy corporate examination 
process. In addition, the TIGTA report stated that comprehensive 
electronic information would minimize the number of no change audits by 
enabling IRS to better target resources to issues that have the 
greatest compliance risk.[Footnote 23]

* E-filing K-1s would save IRS millions of dollars a year because it 
would eliminate the processing and transcription costs of paper K-1s. 
According to IRS, the cost to process e-filed K-1s is minimal once the 
systems are in place, while processing and transcribing paper K-1s cost 
IRS $14.6 million in fiscal year 2001 and $13.1 million in fiscal year 
2002. If IRS was able to re-allocate these cost savings, IRS could, for 
example, pay the salaries of 284 additional field collection revenue 
officers. While, as noted earlier, some of the processing and 
transcribing costs will be reduced because of bar coding and scanning, 
IRS regards bar coding as a lesser alternative to e-filing. In 
addition, bar coding results in incomplete information because only the 
transcribed lines are scanned into the computer systems, and the K-1s 
are the only part of the entity return that is bar coded. Also, there 
is limited availability of software that has bar-coding capacity; only 
four software companies provide bar-coding capability compared to 19 
software companies that provide e-filing.

The primary benefits for taxpayers of increasing e-filing are as 
follows:

* Taxpayers that e-file will receive electronic acceptance or rejection 
notices within 2 days of submitting tax returns. The tax form is 
electronically transmitted to the software company and then the 
software company transmits the tax return to IRS. IRS sends the 
software company an electronic acceptance or rejection notice within 2 
days, and the software company then sends the notice to the taxpayers. 
Taxpayers that file paper returns do not receive acceptance notices and 
thus do not have proof that the returns were filed on time in case the 
tax returns are lost. E-filing taxpayers also receive rapid rejection 
notices and are thus informed of problems much faster than paper-filing 
taxpayers, who may wait for 6 months for IRS to process tax returns.

* The information on an e-filed tax return should be more accurate 
because of the lack of IRS transcription errors. More accurate 
information would reduce the potential for burdensome taxpayer notices 
resulting from transcription errors. To respond to IRS notices, 
taxpayers and preparers are required to collect, organize, and submit 
information to IRS to explain any discrepancies cited in the notices, 
which requires an investment of both the taxpayers' time and money. In 
recent reports, TIGTA noted that e-filing would eliminate transcription 
errors that result in erroneous and burdensome taxpayer 
notices.[Footnote 24]

Increasing Electronic Filing of K-1s Requires Complete IRS E-Filing 
Capacity and Taxpayers' Conversion from Paper Filing to E-Filing:

The primary challenge for IRS of mandating increased e-filing is to 
implement computer systems that can electronically process the complete 
set of tax documents that flow-through entities may file with K-1s. 
Although IRS currently has the capacity to electronically process K-1s 
that accompany flow-through entity returns, IRS is unable to 
electronically process all the forms that accompany those of trusts and 
partnerships. This impedes e-filing of the flow-through returns with 
accompanying K-1s because taxpayers that submit partnership and trust 
returns (that include three-fourths of K-1s) have to submit both paper 
and electronic documents--a disincentive for e-filing. For example, 
signature forms have to be sent in on paper. In contrast, IRS currently 
has complete e-filing capacity for the entire S-Corp return, so no 
forms have to be filed on paper. IRS is scheduled to have complete e-
filing capacity for partnerships and trusts, but has pushed the 
completion date for this effort from 2006 to 2007 due to limited 
resources.

The main challenge to expanded use of e-filing for taxpayers is the 
cost of converting from paper filing to e-filing. In separate reviews 
of flow-through entity returns by IRS and GAO, the majority of the tax 
returns were found to be computer generated, prepared by a paid 
preparer, or both, which might make the conversion to e-filing easier. 
Based on our sample of Audit Information Management System agreed 
closed case examinations of partnerships and S-Corps with tax years 
ending in 2000 or 2001, paid preparers prepared at least 84 percent of 
the returns, and at least 90 percent of the returns were computer 
generated.[Footnote 25] Of the nonprojectable sample of 200 partnership 
and trust returns that IRS reviewed, a paid preparer prepared 169 
returns, and 173 were computer generated.[Footnote 26]

Since the above-mentioned reviews of flow-through entity returns 
indicate that a paid preparer prepares the majority of returns that 
accompany K-1s by computer, the cost to convert to e-filing may be 
marginal or nonexistent. If a paid preparer is using software that has 
e-filing capacity, then taxpayers can simply choose to use this option, 
which can entail a marginal cost increase. According to our survey of 
the software companies that offer e-filing of partnership, trust, and 
S-Corp returns, all of the software companies that disclosed their fees 
(about half of those we contacted) either charge from $0.30 to $0.90 
per e-filed K-1 or include the option to e-file in the price of the 
software. In order to e-file, flow-through entities have to buy the 
software and e-file the entire flow-through entity return, at costs 
that vary from $3.50 per return to over $15,000 for comprehensive 
support for partnership returns, corporate income tax returns, and 
affiliated forms. For partnerships, if the paid preparer does not use 
software with e-filing capacity and the data are formatted according to 
IRS's specifications, paid preparers can send the partnership return 
electronically to a software company that will then electronically 
transmit the partnership return. One software company stated that it 
would generally charge $0.40 per K-1.

IRS and Congress Are Considering Increasing E-Filing:

According to IRS officials, IRS is considering mandating increased e-
filing of information and tax returns, including those of flow-through 
entities. In recent reports, TIGTA has recommended that IRS should work 
with the Department of the Treasury to mandate increased e-filing of 
flow-through entity returns, either through current regulatory 
provisions or through legislative action.[Footnote 27] As a result, IRS 
is currently studying the possibility of increasing mandated e-filing 
of flow-through entities' returns with accompanying K-1s under Internal 
Revenue Code (I.R.C.) Section 6011 as part of an agencywide initiative 
to increase e-filing to meet a congressionally mandated goal of having 
at least 80 percent of all tax and information returns filed 
electronically by 2007.[Footnote 28] IRS's study includes the cost for 
taxpayers to convert from paper filing to e-filing, the cost for IRS to 
initiate and administer increased mandated e-filing, the perspective of 
the paid tax preparer and business communities, and how to implement 
increased mandated e-filing. In addition, according to IRS officials, 
IRS is also considering mandating e-filing for those returns for which 
IRS has complete e-filing capacity.

In addition, Congress is currently considering the Tax Administration 
Good Government Act of 2004,[Footnote 29] which would permit IRS to 
mandate increasing e-filing of flow-through entity returns and 
accompanying forms, such as K-1s, in two new ways. First, the law would 
remove the present restrictions in I.R.C. Section 6011 that prevent IRS 
from mandating individuals, estates, and trusts to e-file. Since the 
law would remove the restriction on mandating e-filing of individuals, 
IRS would then be able to mandate e-filing by paid preparers that 
prepare individual tax returns. Second, the law would lower the 
threshold at which IRS could mandate e-filing of information and tax 
returns for any taxpayer to 5 returns. Currently, the threshold is 250 
returns. Thus, IRS could mandate e-filing by paid preparers who file 5 
or more flow-through entity returns or individual tax returns.

Conclusions:

Although there are some costs to taxpayers to e-file and to IRS in 
processing e-filed flow-through entity returns and related K-1s, in 
general e-filed K-1s offer substantial advantages for both IRS and 
taxpayers. We are not making a recommendation for further action to 
expand e-filing of flow through-entities' returns, including K-1s, 
because IRS agreed to take steps to do so pursuant to a TIGTA 
recommendation and is currently studying the costs of increasing e-
filing to IRS and taxpayers. One step, upgrading its overall capability 
to accommodate an increase in e-filed flow-through entity returns, 
including K-1s, is under way. However, we are concerned that IRS's 
estimated date for having this capacity has been pushed back to 2007 
due to limited resources. The sooner this can be accomplished, the 
sooner IRS can reap the potential benefits of an increase in e-filed 
Schedule K-1s while moving closer to achieving the congressionally 
mandated goal of having 80 percent of all federal tax returns and 
information returns filed electronically by 2007.

Regardless of whether e-filing is expanded, IRS is missing an 
opportunity to improve the accuracy of TINs associated with K-1s and 
thereby is undermining the benefits that can be realized from its 
document-matching program, efficient targeting of examination 
resources, and new research to identify noncompliance. Although IRS 
officials expressed concern about the possible burden on flow-through 
entities of dealing with TIN error notices and about IRS's ability to 
deal with the costs of sending such notices given its resource 
constraints, IRS does not have information on the likely benefits and 
costs of sending TIN error notices to flow-through entities. Given the 
high concentration of TIN errors among a small portion of flow-through 
entities, even if costs are high compared to the benefits of sending 
notices to some flow-through entities, the situation may be much 
different for error-prone flow-through entities.

Recommendation for Executive Action:

To improve the availability and usefulness of Schedule K-1 data to IRS 
for detecting noncompliance, we recommend that IRS conduct a pilot 
study to determine the benefits and costs of requiring flow-through 
entities to correct invalid TINs on K-1s as soon as it has been 
determined that the TINs cannot be "perfected" via IRS's TIN validation 
program.

Agency Comments and Our Evaluation:

We received written comments on a draft of this report from the 
Commissioner of Internal Revenue, which are reprinted in appendix II. 
The Commissioner agreed with our assessment of Schedule K-1 TIN 
accuracy and that a pilot project would be useful in identifying ways 
to improve TIN accuracy. He said that IRS plans to study a number of 
options to ensure that TINs included on Schedule K-1s are accurate, 
including our recommendation that IRS conduct a pilot study to 
determine the benefits and costs of obtaining corrected TINs from flow-
through entities. The Commissioner said that IRS's Flow-Through 
Compliance Committee recently initiated a project to study invalid TINs 
on Schedule K-1s to determine their potential compliance impact. In 
addition, he also mentioned other initiatives, such as form redesign, 
outreach efforts, and scanning Schedule K-1s, to improve the overall 
effectiveness of flow-through compliance efforts.

As agreed with your offices, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
after its date. At that time, we will send copies to the Chairman and 
Ranking Minority Member, House Committee on Ways and Means, and the 
Chairman and Ranking Minority Member, Subcommittee on Oversight, House 
Committee on Ways and Means. We will also send copies to the Secretary 
of the Treasury, the Commissioner of Internal Revenue, and other 
interested parties. The report will also be available at no charge on 
GAO's Web site at [Hyperlink, http://www.gao.gov].

If you have any questions concerning this report, please contact me at 
(202) 512-9110 or [Hyperlink, brostekm@gao.gov] or Jonda Van Pelt at 
(415) 904-2186 or [Hyperlink, vanpeltj@gao.gov]. Key contributors to 
this report were Ralph Block, Maya Chakko, Keira Dembowski, Elizabeth 
Fan, Robert McKay, and Samuel Scrutchins.

Signed by: 

Michael Brostek: 
Director, Tax Issues:

[End of section]

Appendixes:

Appendix I: Objectives, Scope, and Methodology:

Our objectives were to (1) evaluate the accuracy of K-1 data used by 
the Internal Revenue Service (IRS), specifically transcription errors 
and invalid taxpayer identification numbers (TIN); (2) determine 
whether any limitations in the availability or accuracy of K-1 data 
have affected IRS's ability to identify noncompliance; and (3) describe 
the benefits and challenges of increasing electronic filing of K-1s.

To evaluate the accuracy of K-1 data used by IRS, we requested, 
obtained, and analyzed data from IRS's K-1 database for tax year 
2002.[Footnote 30] We examined two versions of the database, both of 
which had been modified from the original K-1 database by IRS research 
analysts. One, called the K-1 "cleaned database," has original K-1s 
removed when possible where duplicate or amended K-1s for the same 
taxpayer were subsequently submitted by the parent flow-through entity. 
The second, called the "money-cleaned database," also has all amounts 
that were obvious transcription errors removed. Generally, these were 
amounts in excess of $900 million and that exceeded the total amount 
reported on the parent flow-through entity's Schedule K for the 
particular line item. We used the "cleaned database" to identify one 
such transcription error.

We analyzed the "money-cleaned" database to identify the number of K-1s 
that were filed with inaccurate TINs by type of flow-through entity 
(partnership, subchapter S corporation (S-Corp), or trust) and by type 
of submission (e-filed versus paper filed). We subsequently analyzed 
this subset of K-1s to determine the number and total income of K-1s 
with invalid TINs that IRS (1) was able to perfect via its TIN 
Perfection Program and (2) could not perfect and thus remained invalid 
and, in effect, unusable for compliance or research purposes. Because 
specific data were unavailable from the K-1 database concerning 
transcription errors, we conferred with IRS analysts to identify the 
type of transcription errors found during K-1 product reviews they 
conducted from July through November 2003.

To identify whether any limitations in the availability or accuracy of 
K-1 data have affected IRS's ability to identify noncompliance, we 
obtained from IRS the line items the agency transcribes from the K-1 
and related flow-through entity returns. When we calculated the 
percentage of line items transcribed from the entity return, we 
included the K-1 as part of the return. To count line items, we 
included all labeled lines and sub lines, but excluded certain fields, 
including calendar or tax year, name and address, supplemental 
information/attachments, signature and date, preparer's signature and 
date, preparer's self-employment, and preparer's firm name and address.

We also interviewed IRS examination and research staff, as well as 
outside research consultants from the MITRE Corporation, with whom IRS 
contracted to analyze flow-through entities. Specifically, we discussed 
how IRS currently uses K-1 data to select flow-through entity returns 
for examination, how IRS research staff and research consultants are 
using K-1 data to develop analytical tools to aid IRS in better 
targeting returns for examination, and how data limitations affect 
their ability to effectively use K-1 information.

To determine the compliance issues IRS identified and the related line 
items that were adjusted, we reviewed a stratified probability sample 
of partnership and S-Corp tax returns. We selected these returns from 
the population of 253 partnership and 1,121 S-Corp agreed closed 
examination cases listed in the IRS Audit Information Management System 
2002 Closed Case database with tax years ending in 2000 or 2001. We 
reviewed a sample of 107 returns of which 91 returns, consisting of 52 
of the partnership and 39 of the S-Corp returns, could be analyzed. The 
remaining 16 returns could not be analyzed, generally because the 
examination workpapers were not available or the case adjustments were 
based on unusual circumstances, such as amended return submissions from 
taxpayers. We used this sample of 91 returns to estimate several 
characteristics[Footnote 31] of this population of all 1,374 agreed 
partnership and S-Corp cases.

Because these estimates are based on a probability sample, our sample 
is only one of a large number of samples that we might have drawn. 
Since each sample could have provided different estimates, we express 
our confidence in the precision of our particular sample's results as a 
one-sided 95 percent confidence interval. For example, paid preparers 
prepared an estimated 93 percent of the returns, and a one-sided 95 
percent confidence interval for this estimate has a lower bound of 84 
percent. Since the actual population value would be contained in this 
interval for 95 percent of the samples we could have drawn, we are 95 
percent confident that the proportion of paid preparer returns in the 
study population exceeds 84 percent. Similarly, for the adjusted lines 
found in the file review, we are 95 percent confident that adjustments 
made to nontranscribed line items occur in at least 40 percent of the 
examinations.

We subsequently discussed our file review findings with IRS research 
and examination staff to obtain their views regarding whether having 
additional K-1 data available, such as line items not currently 
transcribed, would increase their ability to identify returns with 
compliance issues.

To describe the benefits and challenges of increasing e-filing of K-1s, 
we discussed this issue with IRS officials and officials from seven 
organizations that represent the taxpayer community. We selected the 
organizations based on prior GAO knowledge and referrals from some of 
the organizations that we contacted. From IRS officials, we obtained 
estimates of the cost to transcribe K-1 information, to help identify 
the potential cost savings if K-1s were e-filed. We also discussed 
IRS's current requirements for mandating e-filing K-1s and IRS's 
experience in enforcing these requirements, and obtained data on 
penalties levied for failure to e-file required K-1s. Finally, we 
discussed IRS's current and future ability to electronically process an 
increase in the number of e-filed flow-through entity returns, 
including K-1s. We also contacted all 19 of the software companies that 
offer e-filing for flow-through entities and received e-mail responses 
from just over half of the companies. From officials with the software 
companies, we obtained their current fees for preparing and e-filing 
flow-through entity returns and K-1s.

To determine how many flow-through entities filed on a calendar year 
basis we used the 2001 Partnership and Corporation Statistics of Income 
(SOI) samples.[Footnote 32] The SOI partnership data we used included 
the entire sample, but the SOI corporation data we used were limited to 
the flow-through S-Corps. Because these are probability samples, the 
SOI estimates are subject to sampling error. We produced estimates from 
these samples using SOI's sampling weights and methods that are 
appropriate for stratified probability samples. In this report we 
present these estimates as intervals, reporting the lower bound on one-
sided 95 percent confidence intervals.[Footnote 33]

We did our work at IRS headquarters in Washington, D.C., as well as at 
the Ogden, Utah, Processing Center and the Oakland, California, Area 
Office from April 2003 through July 2004 in accordance with generally 
accepted government auditing standards.

Data Reliability:

We assessed whether the information contained in the K-1 databases, the 
two SOI databases, and the Audit Information Management System (AIMS) 
database were sufficiently reliable for the purposes of this report. We 
ensured that the copies of all five databases we received from IRS were 
identical to the original databases based on record counts and analyses 
of control totals, comparison to published data, or both. In addition, 
we performed electronic tests on the each database to search for 
missing data and obvious errors.

For the original K-1 database from which the two cleaned versions we 
used originated, we assessed IRS's procedures for processing and 
transcribing Schedule K-1 data. We also assessed other procedures and 
methodologies IRS research analysts used to remove duplicate records 
and obvious errors from transcribed monetary fields. We anticipated the 
K-1 database would have some reliability issues because our engagement 
was designed in part to assess the sufficiency of the data 
transcription effort. While large monetary transcription errors were 
removed from the "money-cleaned" database, additional, undetectable 
transcription errors of amounts within normal ranges may remain.

For the AIMS 2002 Closed Case database, we relied exclusively on 
variables that allowed us to identify agreed closed case partnerships 
and S-Corps, as this was the population of cases from which we drew our 
sample. We interviewed IRS personnel who manage the AIMS databases and 
found that groups in IRS conducting examinations are required to 
validate annually that completed examination cases are actually shown 
as having been closed. In addition, we collected data from original 
returns during our data collection effort and compared those data to 
data contained in the AIMS database. We found no indication that our 
sample contained ineligible cases.

SOI samples are widely used for research purposes. We have documented 
for recent reports[Footnote 34] that IRS performs a number of quality 
control steps to verify the internal consistency and completeness of 
SOI sample data. The agency uses similar quality control procedures for 
all types of SOI samples. For example, the agency performs electronic 
tests to verify the relationships between values on the returns 
selected as part of the SOI samples and manually edits data items to 
correct for problems, such as inaccurate and missing items. Because we 
used the partnership and corporate samples only to determine the 
percentage of partnerships and S-Corps that were calendar year filers, 
we needed no more than four variables from each database to make this 
analysis. We checked these variables for completeness and accuracy and 
found no missing or out of range values.

On the basis of our data reliability reviews of the five IRS databases, 
we believe all five contain data that are sufficiently reliable for the 
purposes of this report.

[End of section]

Appendix II: Comments from the Internal Revenue Service:

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

COMMISSIONER:

September 24, 2004:

Mr. Michael Brostek: 
Director, Tax Issues: 
United States Government Accountability Office: 
Washington, DC 20548:

Dear Mr. Brostek:

I reviewed your draft report titled, Tax Administration-IRS Should Take 
Steps to Improve the Accuracy of Schedule K-1 Data (GAO-04-1040). We 
agree that improving the accuracy of taxpayer identification numbers 
(TI Ns) on Schedules K-1' will help us to better detect taxpayer non-
compliance and that a pilot project would be useful in identifying ways 
to do so.

The complexity of this issue requires that we analyze a number of 
options to ensure we use the best methodology for TIN perfection. In 
fact, the issue of invalid TINs is currently being analyzed by the 
Flow-Through Compliance Committee (FTCC), which is composed of 
representatives from the Large and Mid-Size Business (LMSB) and Small 
Business/Self-Employed (SB/SE) Divisions. The FTCC's mission is to 
identify key risks associated with flow-through entities. It also 
serves as the focal point for the development of new tools and 
techniques for addressing flow-through issues. The committee recently 
initiated a project to explore issues related to invalid TINs on 
Schedules K-1. The project will involve studying a sample of schedules 
with invalid TINs to determine the potential compliance impact. As part 
of this study, we will also study options for perfecting TINs. We will 
weigh the cost of the options against the potential benefits and 
determine if a pilot program is appropriate.

We have already implemented several initiatives to enhance Schedule K-
1 reporting compliance, including the redesign of forms and extensive 
outreach efforts. The form and instructions for the tax year 2003 
Schedule E, Supplemental Income, contained enhancements designed to 
improve Schedule K-1 reporting accuracy. The redesigned Schedules K-1 
for Partnerships and `S' Corporations will be available for tax year 
2004. In addition, a variety of communication efforts have taken place 
during the past two years to educate taxpayers and tax professionals on 
how to reduce errors in reporting income from flow-through entities.

Partner's Share of Income, Credits, Deductions, etc. (Form 1065, 
Schedule K-1); Shareholder's Share of Income, Credits, Deductions, Etc. 
(Form 1120S, Schedule K-1); and Beneficiary's Share of Income, 
Deductions, Credits, etc. (Form 1041, Schedule K-1).

Other actions we have taken include numerous enhancements to our 
matching program and the implementation of 2-D bar coding and Optical 
Character Recognition scanning to reduce transcription errors on paper 
schedules. All of these initiatives have helped to improve the overall 
effectiveness of our flow-through compliance efforts.

We will continue to seek additional ways to enhance the Schedule K-1 
Program. If you have any questions, please contact Robert L. Hunt, 
Acting Deputy Director, Compliance Policy, Small Business/Self-
Employed Division, at (202) 283-2200.

Sincerely,

Signed by: 

Mark W. Everson:

[End of section]

(440139):

FOOTNOTES

[1] An S-Corp is a domestic corporation with no more than 75 
shareholders, all of which are individuals, estates, exempt 
organizations, or certain trusts. A trust is an arrangement by which 
trustees take title to property for the purpose of protecting or 
conserving it for beneficiaries.

[2] Although for simplicity we refer only to individuals' returns, 
corporations, partnerships, and trusts may also be recipients of flow-
through entities' income or losses.

[3] For the remainder of this report, we will refer to Schedule K-1s 
simply as K-1s.

[4] The document-matching program matches information concerning 
selected tax issues reported on tax returns by individual taxpayers and 
reported on information returns by third parties, such as employers, 
banks, flow-through entities, and other payers of income. Transcription 
involves manually keypunching the information for use in IRS's computer 
systems.

[5] GAO, Tax Administration: Changes to IRS's Schedule K-1 Document 
Matching Program Burdened Compliant Taxpayers, GAO-03-667 (Washington, 
D.C.: May 30, 2003).

[6] Because the K-1 is part of the flow-through entity return, 
increased e-filing of the K-1 would require increased e-filing of the 
flow-through entity return.

[7] At the time of our review, this was the most recent year that 
complete K-1 data were available from IRS. 

[8] The TIN is a unique nine-digit number, usually a Social Security 
number (SSN) for an individual, an employer identification number (EIN) 
assigned by IRS for a partnership or corporation, and either an SSN or 
an EIN for a sole proprietor.

[9] We talked with MITRE because IRS has a contract with MITRE to 
conduct flow-through entity data analysis.

[10] The population from which the sample is drawn is agreed 2002 
closed case examinations of partnerships and S-Corps listed in IRS's 
Audit Information Management System with tax years ending in 2000 or 
2001. Agreed cases are cases where the IRS has made adjustments to a 
taxpayer's tax return, and the taxpayer has actively or passively 
accepted the adjustment.

[11] Classification staff, called classifiers, review returns and 
related documentation and select returns to be examined.

[12] Estimates from our sample are subject to sampling error. We are 95 
percent confident that corrected line items not transcribed occur in at 
least 40 percent of the 2002 closed case examinations based on our 
sample evidence. 

[13] For this report we focused upon the K-1 and did not assess the 
accuracy of the dollar amounts reported by the flow-through entity.

[14] As of May 2004, the final results for tax year 2000 were complete, 
while the final results for tax year 2001 were still to be determined.

[15] An IRS examination of a taxpayer's books and records that results 
in no tax change is generally inefficient for IRS because it has spent 
resources to audit an accurate return. No tax change audits also burden 
taxpayers, who are forced to go through the audit process even though 
they are compliant.

[16] Some transcription errors are corrected during processing after 
the point of transcription. IRS did not have data on what percentage of 
transcription errors are later corrected.

[17] Because each partner's distributive share of income is determined 
by the partnership agreement (and this will be respected for tax 
purposes unless the allocations agreed to lack "substantial economic 
effect"), income may not always be distributed evenly. However, this 
example was selected because $85.3 billion appears to be an excessive 
dollar amount for interest income. 

[18] Each partner has a unique TIN.

[19] These figures are based on sample data and subject to sampling 
error. We are 95 percent confident that the percentages exceed the 
value shown for the tax year 2001 partnerships and S-Corps.

[20] In general, for calendar year filers, S-Corp returns are due to be 
filed by March 15 and partnership returns are due by April 15.

[21] See app. I for information regarding the sample population.

[22] Schedule K is a summary schedule of all partners' or shareholders' 
shares of the partnership's or S-Corp's income, credits, deductions, 
and so forth. Schedule K-1 shows each partner's or shareholder's 
separate share. In our file review, we noted adjustments on Schedule K, 
unless the adjustment was specific to Schedule K-1.

[23] Treasury Inspector General for Tax Administration, New Regulations 
Are Needed to Take Full Advantage of the Opportunities Offered by 
Filing Large Corporate Income Tax Returns Electronically, 2003-30-123 
(Washington, D.C.: May 30, 2003).

[24] Treasury Inspector General for Tax Administration, The Internal 
Revenue Service Could Reduce the Number of Unnecessary Notices Sent to 
Taxpayers Regarding Unreported Income From Schedule K-1, 2003-30-071 
(Washington, D.C.: Mar. 14, 2003), and New Regulations Are Needed to 
Take Full Advantage of the Opportunities Offered by Filing Large 
Corporate Income Tax Returns Electronically.

[25] These figures are subject to sampling error. We are 95 percent 
confident that the percentages exceed the values shown.

[26] IRS reviewed a nonprojectable sample of tax year 2000 partnership 
and trust returns from the Austin Service Center.

[27] Treasury Inspector General for Tax Administration, The Internal 
Revenue Service Could Reduce the Number of Unnecessary Notices Sent to 
Taxpayers Regarding Unreported Income From Schedule K-1 and New 
Regulations Are Needed to Take Full Advantage of the Opportunities 
Offered by Filing Large Corporate Income Tax Returns Electronically.

[28] The TIGTA report noted that although there are restrictions under 
current law prohibiting IRS from requiring individuals, estates, or 
trusts to file electronically, there are no restrictions against IRS 
requiring through regulations that corporate and other types of returns 
be filed electronically.

[29] H.R.1528.

[30] At the time of our review, tax year 2002 was the most recent year 
for which complete K-1 data was available from IRS. 

[31] These estimates are the percentage of returns with adjusted line 
items not currently transcribed, percentage of paid preparer prepared 
returns, and percentage of computer-generated returns.

[32] SOI last published information for estate and trust returns for 
tax year 1997.

[33] Additional information regarding the IRS's SOI program and its 
stratified probability samples is available on the Internet at 
www.irs.gov/taxstats/.

[34] GAO, Tax Administration: Comparison of the Reported Tax 
Liabilities of Foreign-and U.S.-Controlled Corporations, 1996-2000, 
GAO-04-358 (Washington, D.C.: Feb. 27, 2004). GAO, International 
Taxation: Tax Haven Companies Were More Likely to Have a Tax Cost 
Advantage in Federal Contracting, GAO-04-856 (Washington, D.C.: June 
30, 2004).

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