Report to the Honorable William J.

Coyne, Ranking Minority Member,

Subcommittee on Oversight,

Committee on Ways and Means,

House of Representatives

United States General Accounting Office

GAO

May 2002 INTERNAL REVENUE

SERVICE

Efforts to Identify and

Combat Abusive Tax

Schemes Have

Increased, but

Challenges Remain

GAO-02-733
Page i GAO-02-733 Combating Abusive Tax Schemes

Letter 1

Results in Brief 1

Background 3

Scope and Methodology 4

Four Categories of Abusive Tax Schemes 5

Evidence of Rapid Tax Scheme Growth 6

Expanded IRS Efforts to Identify and Control Tax Schemes 9

IRS’s Coordination with Other Relevant Federal Agencies 20

Conclusions 21

Agency Comments and Our Evaluation 22

Appendix Comments from the Internal Revenue Service 24

Table

Table 1: Summary of Domestic and Foreign Trust Cases from

Fiscal Years 1999 through 2001 17

Abbreviations

CI Criminal Investigation

DOJ Department of Justice

FBI Federal Bureau of Investigation

FinCEN Financial Crimes Enforcement Network

FTC Federal Trade Commission

IRS Internal Revenue Service

QRDT Questionable Refund Detection Teams

QRP Questionable Refund Program

PIO public information officers

SEC Securities and Exchange Commission

SB/SE Small Business and Self-Employed

USAO United States Attorneys Offices

TIGTA Treasury Inspector General for Tax Administration

W&I Wage and Investment

Contents
Page 1 GAO-02-733 Combating Abusive Tax Schemes

May 22, 2002

The Honorable William J. Coyne

Ranking Minority Member

Subcommittee on Oversight

Committee on Ways and Means

House of Representatives

Dear Mr. Coyne:

In early 2001, several congressional hearings and related press reports

raised the issue of increased promotion and use of various forms of

organized tax evasion such as abusive tax schemes. More recently, in April

2002, the Commissioner of Internal Revenue (IRS) testified that identifying

and combating actively promoted tax schemes are IRS’s highest

compliance priorities.1

 These abusive tax schemes represent a significant

loss of tax revenue to the Treasury. Furthermore, tax schemes give the

appearance that the tax system is unfair, which in turn can undermine

taxpayer confidence in the tax system.

In recognizing the apparent proliferation of abusive tax schemes, you

asked us to determine (1) the types of activities IRS considers to be

organized tax evasion, (2) the extent of such activities, (3) the actions IRS

takes to identify and deal with such tax evasion, and (4) how IRS

coordinates its actions with other relevant federal agencies.

To respond to your request, we interviewed IRS and other appropriate

agencies’ officials and obtained documents related to the extent of abusive

schemes and IRS’s efforts to combat them. Our review focused primarily

on abusive tax schemes that are used by individuals rather than those used

by corporations. Our scope and methodology is discussed in more detail in

a separate section of this report.

IRS characterizes an abusive tax scheme as any plan or arrangement

created and used to obtain tax benefits not allowable by law. As such,

 1

 See testimony by the Commissioner of Internal Revenue before the Senate Committee on

Finance, April 11, 2002.

United States General Accounting Office

Washington, DC 20548

Results in Brief
Page 2 GAO-02-733 Combating Abusive Tax Schemes

schemes can be based on improper use of domestic and foreign trusts,

inflated business expenses and deductions, falsely claimed tax credits and

refunds, and various anti-tax arguments. According to IRS, abusive tax

schemes fall into four categories: frivolous returns, frivolous refunds,

abusive domestic trusts, and offshore schemes.

IRS estimates the potential revenue loss from abusive tax schemes to be in

the tens of billions of dollars annually. According to an IRS official,

developing accurate estimates in this noncompliance area is difficult. For

example, taxpayers using domestic trusts and offshore schemes may file

tax returns, but those returns alone seldom provide enough information

for IRS to determine whether an abusive tax scheme was used. IRS often

bases its estimates in this area on limited numbers of cases that have been

examined or investigated, on intelligence obtained in the course of normal

tax administration and criminal investigation activities, and on IRS

officials’ professional judgments. Although abusive tax schemes are used

in a small portion of the approximately 130 million individual income tax

returns that yield about a trillion dollars in revenue, the estimated extent

of tax schemes is nevertheless significant. In February 2002, IRS estimated

that about 740,000 taxpayers used abusive tax schemes in tax-year 2000.

IRS detected approximately $5 billion in improper tax avoidance or tax

credit and refunds claims, and it estimated that another $20 billion to $40

billion in taxes had not been identified and addressed related to offshore

schemes. Subsequent to these estimates, IRS increased the number of

taxpayers believed to be involved in abusive offshore activities, which

potentially could increase the amount of revenue lost. IRS is increasing its

estimates primarily because the numbers of taxpayers with offshore

accounts is greater than earlier believed. In contrast to abusive domestic

trusts and offshore activities, frivolous return and frivolous refund

estimates are based in large part on returns and refund claims that IRS

identified while processing tax returns. IRS addressed these tax schemes

by pulling the associated returns and notifying the taxpayers that their

returns contain a frivolous position and requesting that a corrected return

be submitted.

According to IRS’s Commissioner, identifying and combating abusive tax

schemes are the highest compliance priorities within IRS. IRS identifies

and examines abusive tax scheme promoters and participants primarily

through efforts by its Small Business and Self-Employed (SB/SE) division

and Criminal Investigation (CI). In fiscal year 2000, IRS created a program

that focuses on false and frivolous schemes. IRS has also created new

offices that focus exclusively on abusive tax schemes that use legal

structures like domestic and offshore trusts and partnerships. Recent data
Page 3 GAO-02-733 Combating Abusive Tax Schemes

suggest that IRS’s efforts have contributed to increases in convictions of

persons who engage in promoting schemes as well as those who

participate in them. IRS also is educating the public about abusive tax

schemes and publicizing the results of its enforcement activities related to

abusive tax schemes. In the process of improving its compliance and

enforcement efforts, IRS has also recognized that its resources are

stretched and these multiple efforts require organizational coordination.

IRS recently reorganized its compliance organization in an attempt to

combat abusive tax schemes more effectively.

IRS coordinates with federal agencies to identify, monitor, and prosecute

promoters and participants in abusive tax schemes. These activities range

from sharing information and detection techniques with agencies such as

the Securities and Exchange Commission (SEC) and the Federal Trade

Commission (FTC) to assisting in the prosecution of fraud related cases

with the Department of Justice (DOJ). IRS participates in work groups that

share information, skills, and procedures. These work groups discuss

procedures for combating fraud on the Internet and the use of civil

injunctions against promoters of abusive tax schemes.

In a May 16, 2002 letter, the IRS Commissioner agreed with the

conclusions in this report. (See agency comments and our evaluation

section and the appendix.)

According to IRS, during the mid- to late-1990s, abusive tax schemes

reemerged across the country after last peaking in the 1980s. As previously

mentioned, during hearings held in 2001, several witnesses testified about

the increased promotion and use of such tax schemes. Marketing of these

schemes by promoters through the use of the Internet was mentioned as

giving them a thriving new life by making them available to millions of

taxpayers easily and inexpensively.

Schemes run from simple to very complex, from clearly illegal to those

carefully constructed to disguise the illegality of the scheme. Furthermore,

users of schemes can range from those believing their position is correct

to those who knowingly and willfully file incorrect tax returns. Some

schemes are created by tax professionals such as accountants, lawyers,

and paid tax preparers, and by groups and individuals. Tax schemes are

offered to taxpayers using various means, including conferences or

seminars, publications, advertisements, and the Internet. Others are

promoted by word-of-mouth.

Background
Page 4 GAO-02-733 Combating Abusive Tax Schemes

To determine the types of activities IRS considers to be abusive tax

schemes, we interviewed cognizant IRS officials from SB/SE, who have

specialized expertise in abusive tax schemes issues. In addition, we

obtained pertinent IRS documents related to abusive tax scheme activities,

including information from IRS’s CI Internet site and the Small Business

and Self-Employed Strategic Assessment Report.

To determine the extent or magnitude of the abusive tax scheme issue, we

obtained and reviewed estimates from IRS’s SB/SE division for the

identified abusive tax scheme categories—Frivolous Returns, Frivolous

Refunds, Abusive Domestic Trusts, and Offshore Schemes. The estimates

include the number of taxpayers involved in each scheme category; in

conjunction, the estimates report the amount of tax revenue protected by

the identification of frivolous returns and refunds and the amount of

potential revenue lost in abusive trusts and offshore schemes.

To determine the actions IRS takes to identify and deal with abusive tax

scheme activities, we interviewed officials from IRS’s SB/SE division and

CI. Additionally, we obtained and reviewed relevant documents related to

the organizations and programs involved in addressing IRS’s abusive tax

scheme activities.

To determine how IRS coordinates its actions with other federal agencies,

we interviewed cognizant officials within CI and at several federal

agencies. The federal officials we interviewed were from the FTC, the

SEC, the Financial Crimes Enforcement Network (FinCEN), DOJ, the

Federal Bureau of Investigation (FBI), and the Executive Office for United

States Attorneys. You also expressed interest in IRS’s coordination efforts

with state agencies. We are not reporting on this topic because many of

the states contacted did not consider abusive tax schemes to be a major

issue for them. Due to their limited resources, states focused on

noncompliance issues that were more directly related to the types of taxes

they collect such as sales and employment taxes.

This review primarily focuses on abusive tax schemes that are used by

individuals rather than those that are used by corporations. Although some

overlap may exist between the schemes used by individuals and

corporations, our focus was on schemes that are generally used by

individuals to inappropriately reduce the taxes they owe or to generate

refunds to which they are not properly entitled.

We performed this work from July 2001 through April 2002 in accordance

with generally accepted government auditing standards.

Scope and

Methodology
Page 5 GAO-02-733 Combating Abusive Tax Schemes

Abusive tax schemes, which are generally used by individuals, fall into

four major categories. For the first two, frivolous returns and frivolous

refunds, taxpayers submit a tax return that either states an argument that

IRS can readily identify as frivolous or a tax return with characteristics

IRS has identified as reflecting a frivolous argument. For the other two,

abusive domestic trusts and offshore schemes, taxpayers’ returns are less

likely to reveal the use of a clearly abusive tax scheme.

These schemes generally use any number of anti-tax arguments to

incorrectly claim that income is exempt from taxation or that IRS

otherwise lacks authority needed to tax income. These arguments have

been well litigated in the courts and consistently ruled to be without merit.

Examples include the following:

• Form 2555 Scheme: In this scheme, individuals file an IRS Form 2555,

Foreign Earned Income, and claim that their income was not earned

within the United States. This is also known as the “not a citizen”

argument in which taxpayers file returns stating they are citizens of the

“Republic of [any state]” and not citizens of the United States, and thus,

their income is not taxable.

• Section 861: Individuals using this scheme claim that under Internal

Revenue Code Section 861 income tax must only be paid on foreign

income and, therefore, their income is not subject to tax or

withholding. In these cases, taxpayers file a tax return and show a zero

amount for wages. According to IRS, this argument has spread to some

employers who are using it to avoid withholding and paying payrolltype taxes on their employees.

According to IRS, credit and refund abusive tax schemes are designed to

substantially reduce taxes or create a refund for the taxpayer, generally by

claiming eligibility for a credit that does not exist or to which the taxpayer

is not properly entitled. One such scheme that has received much attention

is the Slavery Reparation Refund scheme. According to IRS, promoters

circulate or publish information claiming African Americans are eligible

for slavery reparations. Taxpayers claiming this credit generally enter a

significant amount on their tax return as a credit that results in a taxpayer

realizing a refund if not detected by IRS.

A trust is a legitimate form of ownership that completely separates asset

responsibility and control from the benefits of ownership. As such, trusts

Four Categories of

Abusive Tax Schemes

Frivolous Returns

Frivolous Refunds

Abusive Domestic Trusts
Page 6 GAO-02-733 Combating Abusive Tax Schemes

are commonly used in matters such as estate planning. An abusive

domestic trust scheme usually involves a taxpayer creating a trust that

does not meet the Internal Revenue Code requirements that the assets and

income of the trust not be subject to the control of the taxpayer. Once

such an improper trust is established and the taxpayer has transferred

business or personal assets to it, the scheme may involve further abuses,

such as offsetting income of the trust by overstating its business expenses

or including the taxpayer’s personal expenses—like a home mortgage—as

an expense of the trust. The taxpayer will often use multiple entities such

as partnerships, limited liability companies, or secondary level trusts that

can be tiered or layered to mask the taxpayer’s continued ownership or

control of the trust’s income or assets.

Abuses that involve foreign locations can take a wide array of forms and

attempt to use a number of techniques to improperly avoid paying taxes.

One common technique is simply to use foreign locations to add another

level of complexity in obscuring the true ownership of assets or income

and thus obfuscating whether taxes are owed and by whom. Use of foreign

locations, for instance, can be combined with use of trusts to make

unraveling the true ownership of assets and income more difficult for IRS.

According to IRS, criminals long have used offshore schemes to disguise

the true nature of their enterprise and the resulting income. Promoters of

abusive tax schemes have, according to IRS, increasingly devised schemes

that in some fashion involve transferring income or title to assets to

foreign locations. Often, foreign locations are selected because they are

tax havens with little or no taxation on income in their jurisdiction, have

privacy rules that help schemers hide what they are doing, or have other

characteristics favorable to carrying out the schemes. According to IRS,

once such transfers are established, income is often repatriated back to

the U.S. owners through loans, credit cards, or debit cards. By using

complex transactions and multiple entities, the individuals using these

schemes attempt to hide their income and avoid potential tax liabilities.

Of the approximately 130 million individual income tax returns filed

annually yielding about a trillion dollars in revenue, approximately 740,000

taxpayers used abusive tax schemes in tax-year 2000 according to IRS

estimates. According to IRS’s fiscal year 2003-2004 Small Business and

Offshore Schemes

Evidence of Rapid

Tax Scheme Growth
Page 7 GAO-02-733 Combating Abusive Tax Schemes

Self-Employed (SB/SE) Division Strategic Assessment Report,2 abusive tax

schemes represent a rapidly growing risk to the tax base. IRS estimates

the potential revenue loss from these schemes to be in the tens of billions

of dollars annually. According to an IRS official, to make accurate

estimates in this area of noncompliance is difficult. Despite the difficulties

in accurately estimating the significance of abusive tax schemes, IRS

provided us with estimates in four major scheme areas— Frivolous

Returns, Frivolous Refunds, Abusive Domestic Trusts, and Offshore

Schemes. According to IRS, its estimates were made in February 2002 and

were derived from information gathered during tax return processing and

examination activities and from the work of IRS’s Criminal Investigation

(CI), the law enforcement arm of IRS. According to an IRS official, these

estimates were derived from tax-year 2000 information, the last full year

for which data were available. IRS’s estimates are as follows:

• Frivolous returns: about 62,000 taxpayers with associated tax amounts

approximating $1.8 billion.

• Frivolous refunds: about 105,000 taxpayers with associated tax amounts

approximating $3.1 billion.

• Abusive domestic trusts: about 65,000 taxpayers with tax losses

approximating $2.9 billion.

• Offshore schemes: about 505,000 taxpayers with tax losses ranging from

$20 billion to $40 billion.

IRS’s estimates for the numbers of taxpayers and taxes in connection with

frivolous returns and frivolous refunds, although not precise, likely have

less uncertainty than its estimates of the numbers of taxpayers and taxes

at risk in connection with abusive domestic trusts and offshore schemes.

IRS’s estimates for frivolous returns and frivolous refunds are based in

large part on returns and refund claims that IRS has identified while

processing tax returns and has addressed by pulling the associated returns

and notifying the taxpayers that their returns contained a frivolous

position that needed to be corrected by submitting a revised return. Thus,

in these cases, IRS has a fairly direct basis for counting the number of

taxpayers involved and the amount of tax involved. Furthermore, because

 2

 The FY 2003-2004 SB/SE Strategic Assessment Report (Mar. 1, 2002) provides IRS

assessment of critical trends, issues, and problems facing the SB/SE taxpayer customer

segment.
Page 8 GAO-02-733 Combating Abusive Tax Schemes

IRS has pulled these returns from processing, in general, improper refund

claims have not been paid out, and IRS is pursuing collection of the proper

amount of tax when taxpayers have failed to pay the full amount owed.3

In contrast, although taxpayers using domestic trusts and offshore

schemes may file tax returns, those returns alone seldom provide enough

information for IRS to determine whether an abusive scheme was used.

Therefore, IRS’s estimates of the numbers of taxpayers and the taxes at

risk for the domestic trust and offshore scheme categories generally rely

on limited numbers of cases that have been examined or investigated, on

intelligence obtained in the course of normal tax administration and CI

activities, and on IRS officials’ professional judgments.

Recognizing that offshore transactions are a significant factor in offshore

schemes, IRS has been taking steps concerning the use of credit/debit

cards issued by offshore banks to U.S. taxpayers. Although having an

offshore credit card is not illegal, IRS believes that some U.S. taxpayers

are using such cards to evade U.S. taxes. In October 2000, a federal judge

authorized IRS to serve “John Doe” summonses on American Express and

MasterCard to obtain limited information on U.S. taxpayers holding credit

cards issued by banks in several tax-haven countries.

On the basis of information received from MasterCard, IRS identified

about 235,000 accounts issued through 28 banks located in 3 countries.

IRS’s ongoing analysis of these data leads it to estimate that between

60,000 and 130,000 U.S. customers are associated with these 235,000

accounts. In part because MasterCard is estimated to have about 30

percent of this market, IRS estimates that there could be 1 to 2 million U.S.

citizens with credit/debit cards issued by offshore banks. However, this is

a very preliminary estimate. IRS officials believe this estimate may be

reduced because, among other things, a portion of these accounts may not

be associated with abusive tax schemes. By comparison, only about

117,000 individual taxpayers indicated that they had offshore bank

accounts in tax-year 1999. On March 25, 2002, IRS petitioned for

permission to serve a summons on VISA International, seeking records on

transactions using cards issued by banks in over 30 tax-haven countries.

 3

 IRS is not able to detect and stop every frivolous refund scheme. For example, the

Treasury Inspector General for Tax Administration (TIGTA) estimated that about $31

million in refunds was sent to taxpayers who claimed reparations credits in tax-year 1999

and in tax-year 2000 returns that were processed from mid-February to mid-April of 2001.

IRS has subsequently taken action to recover the funds.
Page 9 GAO-02-733 Combating Abusive Tax Schemes

According to an IRS official, a judge granted the summons on March 27,

2002. In May 2002, IRS is scheduled to meet with Visa International to

discuss delivery of the information requested in the summons.

In addition, on April 24, 2002, the Treasury Department’s FinCEN

published an interim final rule to define and provide guidance to operators

of credit card systems concerning a provision in the Bank Secrecy Act that

requires them to establish anti-money laundering programs. Part of the

justification for the rule was the potential for utilizing a credit card system

to access in the United States funds located in foreign financial

institutions. The successful “John Doe” summonses filed against

MasterCard and American Express by IRS were cited by FinCEN as

support for publishing the interim rule.

The Treasury Department is concerned that foreign financial institutions

located in tax-haven countries are being used to violate and/or evade

domestic tax requirements, among other things. Recognizing that, the

Secretary of the Treasury submitted a report to Congress on April 26, 2002,

proposing several actions to improve compliance regarding foreign bank

and financial accounts. These actions are geared to improving reporting,

compliance, and enforcement efforts related to U.S. citizens and residents

transacting business with foreign financial institutions.

The estimates of the number of individuals and dollar consequences

associated with offshore credit/debit card schemes are very uncertain at

this time. Nevertheless, IRS’s February 2002 estimate of $20 billion to $40

billion in tax dollars at risk from offshore schemes may grow as IRS learns

more about the extent of the problem.

No one individual or office could provide an agencywide perspective on

IRS’s strategy, goals, objectives, performance measures, or program

results, for its efforts to address abusive tax schemes. Consequently, a

clear and consistent picture of IRS’s efforts was difficult to obtain.

Available information indicates that IRS began increasing its efforts to

combat abusive schemes over the past 2 or 3 years, continued to do so in

2001, and plans further future efforts. Limited data also suggest that these

enhanced efforts have helped IRS convict more promoters and users of

abusive schemes over the past 3 years. IRS has also increased its

education and publicity as a way to deter and control the use of abusive

tax schemes.

Expanded IRS Efforts

to Identify and

Control Tax Schemes
Page 10 GAO-02-733 Combating Abusive Tax Schemes

Organizationally, IRS identifies and deals with schemes in two primary

ways—during its processing and examination of tax returns (compliance

and enforcement) and through the work of CI. Therefore, most of IRS’s

programs to address abusive schemes are the responsibility of IRS’s SB/SE

division and CI.

IRS has taken a number of steps to enhance its compliance and

enforcement efforts—its audit and other civil enforcement activities—that

focus on abusive tax schemes. In the past year, for example, IRS has

increased staff years devoted to examining abusive tax scheme promoters,

decided to assign and train about 50 more agents to promoter

examinations, and laid plans for assigning 200 or more additional staff to

reviewing abusive tax schemes and offshore compliance schemes.

Furthermore, IRS has created an organization that initially will focus on

developing leads and cases related to abusive scheme promoters and that

will monitor abusive promoter web sites. IRS has also recognized that its

resources are stretched to improve compliance and enforcement efforts

and these multiple efforts require organizational coordination. IRS

identifies many abusive tax schemes during its normal tax return

processing and examination activities. For example, when tax returns

initially are processed either manually or by computers, processes are in

place to detect apparent frivolous returns or returns reflecting improper

refunds. In these cases, the returns are pulled from processing to be

forwarded to a unit that specializes in addressing these types of returns.

Both the Wage and Investment (W&I) and SB/SE divisions in IRS process

taxpayers’ tax returns and both have responsibilities for identifying tax

returns that may involve abusive tax schemes.

Three principal SB/SE division efforts focusing on or related to abusive tax

schemes are

• the Frivolous Return Program,

• the Office of Flow-Through Entities and Abusive Tax Schemes, and

• the National Fraud Program.

The Frivolous Return Program identifies the tax returns of individuals who

assert unfounded legal or constitutional arguments and refuse to pay their

taxes or to file a proper tax return. The program also identifies returns

claiming frivolous refunds, such as those involving slavery reparations.

Generally, IRS provides guidance to those who process tax returns to

Compliance and

Enforcement Efforts

Frivolous Return Program
Page 11 GAO-02-733 Combating Abusive Tax Schemes

identify the characteristics of returns claiming such frivolous arguments or

refunds. IRS also has programmed its computers to do so. The Treasury

Inspector General for Tax Administration (TIGTA) helped IRS develop

software programs to identify slavery reparation schemes. Since both W&I

and SB/SE staff process tax returns, both divisions are involved in

identifying such returns.

Once identified, the returns are pulled out of the tax return processing

stream and forwarded to the Frivolous Return Program unit where they

are to be resolved with the taxpayer. The program was consolidated in

January 2001, at the Ogden, Utah, Compliance Services Center. The

compliance center staff enters information about each case into a

database and assigns 1 of 31 different codes identifying the frivolous

argument or refund being claimed by the taxpayer. Then, a notice

requesting taxpayers to file a proper tax return is to be sent advising them

that IRS has judged their tax return to include an argument that is without

legal merit or a credit or tax refund to which they are not entitled.

IRS officials state that the number of staff assigned to the Frivolous Return

Program unit in Ogden grew from 18 employees in September 2000 to 45

employees in September 2001. Some of this increase may not reflect a net

IRS-wide increase in full-time equivalents (FTE) for frivolous returns since

the increase has, in part, been due to centralizing efforts in Ogden from

other IRS locations. IRS officials expect to assign more employees to this

program in fiscal year 2003.

The Office of Flow-Through Entities and Abusive Tax Schemes became

operational in January 2000.4

 Flow-through entities include domestic trusts

and offshore trusts and partnerships. These are flow-through entities

because their income “flows through” to their partners or other

beneficiaries, where it is subject to taxation. The office was created to

organize IRS’s efforts in addressing abusive tax schemes, particularly

trusts, and to identify their promoters and sellers. The unit’s goals are (1)

to catalog and profile schemes and trends, (2) direct compliance resources

to examine schemes and promoters or refer tax scheme promoters and

participants for criminal prosecution, (3) increase employee knowledge

 4

 As part of reorganization within SB/SE, the responsibilities of the Flow-Through Entities

and Abusive Tax Schemes office were undergoing change in April 2002. We discuss these

changes later in the report.

Office of Flow-Through Entities

and Abusive Tax Schemes
Page 12 GAO-02-733 Combating Abusive Tax Schemes

and skills related to abusive tax scheme issues, and (4) enhance

coordination within IRS on issues related to abusive tax schemes.

IRS expects to assign and train about 50 revenue agents this fiscal year to

focus mainly on promoters of abusive tax schemes. The agents are to

undergo training during the summer of 2002 and to begin examining cases

by the fall of 2002. According to IRS, the number of abusive promoter

leads increased from 25 in March 2001 to 155 in February 2002. In addition,

the number of abusive promoter cases approved for further examinations

has increased from 17 cases to 94 cases during the same period. The time

spent on these cases is also increasing. IRS also reports that time spent on

promoter examinations for fiscal year 2002 is expected to be 12.1 staff

years, which is up from 4.4 and 1.2 staff years in fiscal year 2001 and fiscal

year 2000, respectively.

Furthermore, IRS plans additional expansion of its abusive tax scheme

compliance efforts. For example, IRS expects to develop units that will

include 8 to 10 agents in each of 15 locations. These units will address

abusive tax schemes and flow-through entities. In addition, given the

growing significance of the offshore credit/debit card schemes, IRS plans

to create four special enforcement groups. Each group will be staffed by

approximately 8 agents and will concentrate on these offshore schemes.

This growth in staffing reflects IRS’s increased priority for these schemes.

IRS officials expect that the agents assigned to these units will be

redirected largely from other compliance areas.

Schedule K-1 Transcription and Matching. In the spring of 2001, the

transcription of Schedule K-1 information became a major responsibility of

the Office of Flow-Through Entities and Abusive Tax Schemes.5

 According

to IRS, information provided on Schedule K-1s is important for

determining whether recipients of flow-through income have properly

reported that income on their tax returns. IRS can use transcribed data for

information matching to determine whether proper reporting of income

occurred.

IRS believes that flow-through entities such as trusts and partnerships are

increasingly being used in abusive tax schemes. IRS can also use these K-1

 5

 The schedule K-1 is an information return that flow-through entities send to partners and

beneficiaries with a copy also being provided to IRS. The schedule K-1 provides

information on income distributed to partners and beneficiaries. Transcription is the

process of taking paper K-1’s and inputting them into an electronic format.
Page 13 GAO-02-733 Combating Abusive Tax Schemes

data in its return examination and tax collection activities to help identify

abusive tax schemes.

Tax-year 1995 marked the last year that Schedule K-1 information was

transcribed by IRS. From 1990 through 1995, IRS transcribed

approximately 5 percent to 12 percent of the Schedule K-1s received. After

1995, IRS did not transcribe Schedule K-1 information submitted with

paper returns nor did it match the income information contained on the

schedules with the information presented on individual beneficiaries’ or

partners’ tax returns. IRS again started to transcribe tax-year 2000 K-1

information during the spring of 2001 and completed the process in

December 2001. IRS officials told us that the matching of the K-1

information against individual tax returns was to begin in March 2002.

IRS cites several reasons for reinstating its transcription and matching of

Schedule K-1s. First, IRS has observed a significant increase in flowthrough entities. The number of tax returns filed by trusts, partnerships,

and S-corporations has increased by 12 percent, 33 percent, and 35

percent, respectively, over the 6-year period from fiscal years 1995 through

2000. IRS also estimates an overall increase of nearly 2 million such

returns by 2009. Second, based on a small study, in January 2002, IRS

estimated that between 6 percent and 15 percent of total flow-through

income would not be reported on tax-year 2001 returns. IRS estimates that

income of about $1 trillion was distributed to taxpayers from flow-through

entities for tax-year 2000. Third, IRS expects its Schedule K-1 matching

program not only to identify underreporting or nonreporting of income but

also to improve taxpayer compliance. Transcription and matching of

Schedule K-1 data are expected to increase accurate reporting of trust

income on future tax returns just as matching of wage, interest, and other

types of income has increased the accuracy of taxpayers’ tax returns. As a

result, the Schedule K-1 program places taxpayers who receive flowthrough income on a more equal footing with taxpayers who are wage

earners.

Lead Development Center. IRS has adopted a strategy of identifying

promoters of tax schemes as a key to halting their promotion and

identifying those who have taken advantage of the scheme and thus likely

owe taxes. The SB/SE division is currently developing plans and strategies

for a Lead Development Center. The center’s primary functions will be to

develop case leads and assemble case information for distribution to

compliance field offices for further investigation. Initially, the center will

focus on abusive tax scheme promoters, and over time, it will expand to

perform similar functions for fraud and anti-money laundering cases. The
Page 14 GAO-02-733 Combating Abusive Tax Schemes

center will also operate a computer laboratory that, among other things, is

expected to monitor possible abusive promoter sites on the Internet.

Specifically, the laboratory will support examiners in their casedevelopment needs, including adequately capturing and documenting

information from web sites in a manner suitable for introduction into

evidence in a court proceeding. The center also will serve as a

coordinating link among various IRS groups that deal with abusive tax

scheme issues and with outside stakeholders such as DOJ, FTC, and

others.

The National Fraud Program, which operates at IRS’s campuses and field

offices, coordinates efforts and provides oversight to IRS’s compliance

efforts to identify potential tax fraud. In addition, the program helps

identify trends and disseminates the information within IRS and acts as a

liaison on fraud cases involving bankruptcy and employment and excise

taxes among other types of tax fraud. A National Fraud Program manager

sets overall policy and program direction. Fraud managers are located in

five area offices, and they oversee the activities of about 65 fraud referral

specialists. These specialists assist other IRS revenue compliance staff in

identifying cases with fraud potential, determining when indications of

fraud are present, and developing potential cases. They also review fraud

cases for technical accuracy and adequacy of supporting documentation to

ensure appropriate and consistent application of fraud program guidelines

and requirements. Cases where criminal activity is involved are referred to

CI.

According to the Commissioner of Internal Revenue, illegal tax schemes

place a major demand on IRS resources. A complex illegal offshore trust

case could require several times as many hours as a typical exam, and

thousands of these cases are emerging. IRS is now beginning to gather

data that will better enable it to estimate the magnitude and nature of the

offshore credit and debit card schemes. Improved data will help IRS

identify how many and what types of resources it may need to address the

schemes. However, the evasive nature of these schemes may necessitate

face-to-face audits in a significant portion of cases to determine whether

taxes are owed and the amount owed. Even if the number of individuals

involved in these schemes is a fraction of the reported estimate of 1 to 2

million, IRS’s staff may be challenged to audit them and maintain its

current audit coverage as well. IRS’s face-to-face audits have been

declining, decreasing from nearly 400,000 in fiscal year 1999 to nearly

200,000 in fiscal year 2001.

National Fraud Program

Recent and Continuing Efforts

to Deal with the Challenges of

Abusive Schemes
Page 15 GAO-02-733 Combating Abusive Tax Schemes

Accordingly, IRS has begun considering whether other techniques than

audits could be used to resolve these cases. For example, IRS is

considering options such as disclosure initiatives, settlement initiatives,

and self-correction programs. These techniques will need to be tested and

refined to determine which, if any, are effective.

The increased scope of abusive tax schemes has also led IRS to

• develop an improved process for selecting the best cases to pursue among

the many that it identifies,

• develop a new policy to govern simultaneous criminal and civil

enforcement investigations of taxpayers,

• consider how to ensure that increased volumes of scheme-related tax

assessments are followed up by IRS’s collection function when taxpayers

are unable to pay in full, and

• use its internal research group and a contractor to develop better models

for identifying indicators that taxpayers may be participating in abusive

tax schemes.

In addition, a significant organizational change has just been implemented

in the SB/SE division that is intended to increase program oversight and

coordinate programs and units dealing with abusive tax schemes and

related tax fraud activities. To that end, in the past few weeks, the SB/SE

division has divided its Office of Flow-Through Entities and Abusive Tax

Schemes. Now, its efforts to ensure accurate reporting of income

connected to flow-through entities will fall under a director for reporting

compliance. IRS separated the flow-through entity effort from other

abusive tax scheme efforts because it judged that the flow-through effort

is more related to its traditional information-matching and examination

programs than to its abusive scheme efforts. The flow-through effort will,

however, also provide useful information for IRS to use elsewhere in

investigations of abusive schemes.

The rest of IRS’s SB/SE division’s major programs and efforts that are

more directly focused on abusive tax schemes—the National Fraud

Program, the Abusive Tax Schemes Program, the Lead Development

Center, and the Anti-Money Laundering Program—have been placed under

a single executive for reporting enforcement. Monitoring the Internet and

other media outlets where abusive tax schemes often are advertised will

also be part of this centralized effort.
Page 16 GAO-02-733 Combating Abusive Tax Schemes

IRS’s Criminal Investigation (CI) investigates and pursues promoters and

sellers of abusive schemes and the individuals using such schemes. CI’s

role is the enforcement of the tax laws for individuals who willfully fail to

comply with their obligation to file and pay taxes and who ignore IRS’s

collection and compliance efforts. The most flagrant cases are

recommended for criminal prosecution.

CI also administers the Questionable Refund Program that focuses on

stopping the payment of various false tax refunds and, if warranted, on

prosecuting the taxpayers involved. Furthermore, CI develops education

and publicity activities warning taxpayers about abusive tax schemes and

placed public information officers (PIO) in the field to specifically

generate publicity regarding IRS’s law enforcement efforts.

CI’s enforcement strategy as it relates to fraudulent tax schemes is to

focus primarily on the promoters of these schemes and on taxpayers who

willfully use these schemes to evade taxes. For example, during a tax

scheme investigation, CI generally attempts to gain access to a fraudulent

promoter’s list of clients to whom the promoter sold the scheme. In

addition to pursuing the promoter, CI can then use the list of clients to

determine who may have used the abusive scheme. CI determines which

users of the abusive scheme merit investigation for possible prosecution

and which users merit referral to IRS operating divisions for possible

compliance and civil enforcement action.

Although CI has data on enforcement activity related to several types of

tax scams (e.g., related to employment tax, refunds, return preparers,

nonfilers, and domestic and foreign trusts), CI only separately tracked its

promoter efforts for domestic and foreign trusts. (See table 1.) CI officials

said that the number of full-time equivalent staff working on domestic and

foreign trusts increased from 55 in fiscal year 1999 to 69 in fiscal year 2001.

Criminal Investigation

CI Enforcement Strategy
Page 17 GAO-02-733 Combating Abusive Tax Schemes

Table 1: Summary of Domestic and Foreign Trust Cases from Fiscal Years 1999

through 2001

Cases FY 1999 FY 2000 FY 2001

Active Investigations 131 126 165

 (Promoters) 49 54 66

Prosecutions Recommended 57 44 30

 (Promoters) 18 14 13

Indictments 35 53 32

 (Promoters) 13 14 15

Convictions 24 31 45

 (Promoters) 3 9 23

Note: Statistics in this table refer to individuals, such as indictments brought against 35 individuals in

FY 1999.

Source: IRS’s Criminal Investigation.

Although no consistent pattern exists across all of the categories in table

1, CI has had increases in the number of convictions obtained over the 3-

year period. For purposes of deterring individuals from engaging in

abusive trusts, the increasing numbers of convictions has provided IRS an

opportunity to publicize more cases in which individuals have been found

guilty. Furthermore, the increases in indictments and convictions of

promoters may help deter promoter activity in particular.

Because the investigative and legal processes can span several years, data

like those in table 1 do not show whether the cases investigated lead to

prosecutions, convictions, or indictments in that same year. Furthermore,

the data do not account for differences in the importance of cases, such as

whether major fraudulent efforts are being successfully investigated and

closed. IRS data do show that the average length of sentence for the

abusive domestic and foreign trust program rose substantially from 35

months in 1999 to 64 months in 2001. To the extent that average length of

sentence relates to the severity of the crime, IRS may be making headway

in pursuing key abusive trust cases.

The Questionable Refund Program (QRP), administered by CI, was

established in 1977. The QRP was designed to identify false returns, stop

the payment of false refunds, and prosecute scheme perpetrators. Various

false refund schemes are pursued under this program, including ones

involving the earned income tax credit, the fuel tax credit, social security

refund schemes, and slavery reparations. Questionable Refund Detection

Teams (QRDT), located at IRS compliance service centers, conduct

preliminary pre-refund reviews of questionable returns identified through

Questionable Refund Program
Page 18 GAO-02-733 Combating Abusive Tax Schemes

manual and computerized screening techniques. False return schemes

meeting criminal prosecution criteria are referred to field offices for

possible criminal investigation while returns with questionable civil issues

are referred to the appropriate IRS compliance or collection group.

CI’s efforts also include informing and educating the public about abusive

tax schemes and publicizing the results of its enforcement activities

related to such schemes. CI has been particularly active in trying to

disseminate information to the public to make them aware of IRS’s

activities and accomplishments in combating abusive tax schemes.6

 In

addition, CI has PIOs located across the country who work with local

media to publicize IRS’s efforts and results.

CI Education and Publicity Activities. CI’s education and publicity

activities focus on warning taxpayers about fraudulent tax schemes so that

they will not be tempted to use such schemes. CI hopes that increasing

media coverage of successful tax scheme prosecutions will deter the

public from participating in tax schemes because the perceived risk of

detection, prosecution, and resulting penalties and sanctions will be too

high. In addition, CI officials believe that publicizing the prosecutions of

promoters and users of tax schemes helps assure the public that people

are paying their fair share of taxes.

CI posted its web page (www.ustreas.gov/irs/ci) on the Internet in

September 1997. According to CI officials, over the past 2 years, the

Internet site has evolved into an important tool for educating and alerting

the public about tax schemes and about CI’s efforts to detect and deal with

those who promote and use tax schemes. The Internet site provides

• fraud alerts warning the public of schemes where promoters are

targeting unsuspecting taxpayers;

• information on topics including tax filing responsibilities, nonfilers,

and abusive tax return preparers;

• summaries of cases and successful prosecutions of promoters and

users of fraudulent schemes; and

 6

 Other divisions within IRS also work to publicize IRS’s activities related to abusive tax

schemes. For example, SB/SE devotes part of its Internet site to fraud alerts and press

releases.

CI’s Education and Publicity

Efforts
Page 19 GAO-02-733 Combating Abusive Tax Schemes

• press releases and other IRS publications to generate a wide public

distribution.

Tax practitioners also are targets of CI’s publicity strategy. According to CI

officials, some tax practitioners are using IRS’s materials directly from the

Internet site to inform those clients who may believe that a given tax

scheme is legal. For example, clients may ask the tax practitioner to set up

a fraudulent trust to reduce their taxes, and the tax practitioner can simply

print the brochure about “Too Good to be True? – Trusts” from CI’s

Internet site to discourage the taxpayers from using such a trust.

In conjunction with using the Internet site as an informational tool to

educate and warn the public of frivolous schemes, CI has taken steps to

increase IRS’s visibility and presence on the Internet. According to CI, it

has recently intensified its efforts to improve the ranking of IRS’s web

page through the use of “metatags” or keyword tags. By doing so, IRS

seeks to have Internet users who enter various terms in available Internet

search engines find IRS’s web page listed near the top of displayed search

results. For example, CI is planning to add tags such as “pay no tax,” and

“form 1040” so that entering these terms will result in CI’s Internet site

being listed in the displayed search results.

CI is pursuing other possible strategies to ensure that CI’s site rises to the

top of Internet search responses. For example, CI staff has occasionally

visited known promoter Internet sites to gather information on keywords

used by those sites. IRS plans to incorporate those keyword tags into its

Internet site. As a result, IRS expects to increase the odds that the CI

Internet site would be included alongside Internet sites that promote

questionable tax avoidance strategies. In addition, CI is working to create

a web content manager position with responsibilities that include

designing a strategy to maximize the potential of CI’s Internet site. The

manager would be responsible for helping to integrate CI data into the

pages in IRS’s Internet site that provide information to specific types of

taxpayers.

CI Public Information Officers. In October 2000, CI established PIOs in

each of IRS’s 35 field offices. The PIOs serve as points of contact for all

internal and external CI communications initiatives, including the issuing

of press releases and the coordination of important law enforcement

media events. Although IRS has other media relations specialists located

in its field offices, their duties tend to focus on publicizing tax filing

season information, including the benefits of electronic filing. CI PIOs
Page 20 GAO-02-733 Combating Abusive Tax Schemes

generate publicity specific to IRS’s law enforcement activities, including

the detection and prosecution of abusive tax schemes.

Primary functions of the PIOs include

• establishing contacts with editors, reporters, and news directors to

educate them on tax issues and provide information about IRS and CI

to enable them to write in-depth articles.

• encouraging media to include more stories on the detection and

prosecution of abusive tax schemes.

• getting articles included in trade and professional journals and

magazines that are read frequently by professionals such as doctors,

lawyers, and accountants to make them aware of abusive tax schemes.

• developing a local media strategy. Part of CI’s local strategy involves

generating a “hook” to get the stories focused more on communities. In

addition, CI has employed a strategy of “bundling” news stories. For

example, CI has been working cases on fraud involved in the restaurant

industry. Once several such cases have been put together, CI will

bundle these stories together into a single news story for possible

publication in magazines and journals read by people in the restaurant

industry.

• giving speeches and participating in a wide variety of presentations,

panel discussions, and conferences with professional organizations,

including the American Bar Association, the American Institute of

Certified Public Accountants, and the American Medical Association, to

create public awareness of CI’s activities and to provide information

about fraudulent tax schemes.

IRS works with various federal agencies in its efforts to identify and deal

with fraudulent tax schemes. These include the FTC, the SEC, DOJ, FBI,

and the United States Attorneys Offices (USAO).

In some cases, IRS’s coordination is on an informal basis, as it is with the

FTC and the SEC, and involves the sharing of certain information and

detection techniques. In other cases, the relationship is more formal, as in

the case with DOJ or USAOs, which prosecute fraud and other tax-related

cases with the assistance of IRS staff.

IRS’s Coordination

with Other Relevant

Federal Agencies
Page 21 GAO-02-733 Combating Abusive Tax Schemes

IRS officials participate in various federal agency working groups,

including a multiagency task force to share information, skills, and

procedures for combating fraud on the Internet; an IRS and DOJ working

group created to examine the use of civil injunctions against abusive

promoters currently under criminal investigation; and a money-launderingexperts working group. According to the officials we interviewed, these

working groups are invaluable for developing networking relationships

between agencies, which facilitate information sharing among staff.

IRS staff also attends quarterly meetings with staff from the FTC, SEC, and

DOJ to develop joint initiatives to combat Internet fraud. These meetings

have spawned other activities for IRS staff, including FTC-sponsored

training seminars and periodic visits to FTC’s Internet laboratory to

discuss strategies and share information and techniques to combat

Internet fraud.

IRS also meets regularly with DOJ officials to discuss strategies for

seeking injunctions and shutting down web sites that promote abusive tax

schemes. According to a DOJ official, DOJ has received about 14 case

referrals from IRS for injunctions in the past year or so. These cases have

resulted in two permanent and two preliminary injunctions. The rest of the

cases are in various stages of the judicial process. Furthermore, 10 of

these 14 cases relate to the marketing of various types of abusive tax

schemes and 4 involve shutting down web sites that promote abusive

schemes.

IRS has long-standing programs and related efforts aimed at detecting and

dealing with abusive tax schemes, particularly those related to frivolous

tax returns and fraudulent tax refund claims. Recently, IRS has begun to

take a more assertive and coordinated approach to detecting and dealing

with an ever-changing array of abusive tax schemes, including those

involving the use of domestic and offshore trusts. In the past year, IRS has

added more resources to these efforts, created new programs, and

improved others, and it is reorganizing its operations. Furthermore, based

on the limited data available, IRS appears to be realizing some increased

success in convicting those involved in schemes, publicizing these results,

and uncovering previously hidden major offshore compliance problems.

Nevertheless, it is difficult to get a clear picture of all that is underway in

IRS—how much is new as opposed to reemphasized or reorganized, and

how the pieces combine to form a planned, coordinated effort with

specific, defined outcomes. No central office, group, or executive could

Conclusions
Page 22 GAO-02-733 Combating Abusive Tax Schemes

provide us with an agencywide focus or perspective on IRS’s strategy,

goals, objectives, performance measures, or program results.

Responsibility for the efforts was spread across various functions and

groups within IRS. To some extent, this lack of clarity is not surprising

given the fairly rapid and ongoing change in IRS’s efforts, the expanding

scope of the problem, and the difficulty in determining the difference

between what is legitimate, aggressive tax planning and an abusive tax

scheme.

IRS has recognized that its resources will be stretched to deal with these

often complex schemes and that its multiple, enhanced efforts need to be

better integrated. In an attempt to bring this integration to fruition, IRS’s

SB/SE division is reorganizing to place key efforts to combat abusive

schemes under one executive. A centralized focal point should enhance

IRS’s ability to manage its efforts to reduce the prevalence and magnitude

of abusive tax schemes.

On May 16, 2002, we received written comments on a draft of this report

from the Commissioner of Internal Revenue (see appendix). The

commissioner agreed with the conclusions in the report.

We are sending copies of this report to the Chairmen and Ranking

Minority Members of the Senate Committee on Finance and the House

Committee on Ways and Means and the Chairman of the Subcommittee on

Oversight, House Committee on Ways and Means. We are also sending

copies to the Secretary of the Treasury; the Commissioner of Internal

Revenue; and other interested parties. We will make copies available to

others on request.

If you have any questions or would like additional information, please call

me at (202) 512-9039 or Joseph Jozefczyk at (202) 512-9053. Key

Agency Comments

and Our Evaluation
Page 23 GAO-02-733 Combating Abusive Tax Schemes

contributors to this report are Marvin McGill, Jay Pelkofer, Grace

Coleman, and Kathleen Seymour.

Sincerely yours,

Michael Brostek

Director, Tax Issues
Appendix: Comments from the Internal

Revenue Service

Page 24 GAO-02-733 Combating Abusive Tax Schemes

Appendix: Comments from the Internal

Revenue Service

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