DEPARTMENT OF THE TREASURY

INTERNAL REVENUE SERVICE

ANNUAL REPORT 

FISCAL YEAR 1998

PUTTING SERVICE FIRST 
During a White House ceremony

on July 22, 1998, President Clinton

signs the IRS Restructuring and

Reform Act of 1998.
Provide America’s taxpayers

top quality service by helping

them understand and meet

their tax responsibilities and

by applying the tax law with

integrity and fairness to all.

IRS MISSION
2

CONTENTS

Message from the Commissioner 4

Message from the Chief Financial Officer 6

Management Discussion and Analysis 9

Financial Statements and Notes 37

Supplemental Information 52

Other Accompanying Information 58

Appendix: Auditor’s Report on Financial Statements and Management’s Responses 61

EXHIBITS

Exhibit 1 Organization Chart 10

Exhibit 2 Modernization Concept 11

Exhibit 3 Balanced Measurement System 13

Exhibit 4 Key Performance Indicators 13

Exhibit 5 Disaster Relief Activities 21

Exhibit 6 Year 2000 Conversion Phases 29

Exhibit 7 Year 2000 Key Risks 32

Exhibit 8 Components of Unpaid Assessments 34

Exhibit 9 Unpaid Taxes and Interest Penalty Components of Unpaid Assessments 35

Exhibit 10 FMFIA Internal Controls 55

Exhibit 11 FMFIA Financial Management Systems 55

Exhibit 12 Prompt Pay Act Compliance 56

Exhibit 13 User Fees 57

Exhibit 14 Digital Daily inside back cover

Exhibit 15 TAXi inside back cover
DEPARTMENT OF THE TREASURY

INTERNAL REVENUE SERVICE

ANNUAL REPORT FISCAL YEAR 1998
4

With a renewed focus on meeting taxpayer needs, the Internal Revenue Service (IRS) made significant

strides in the past year to improve service to America’s taxpayers while still processing more than 200

million returns and collecting approximately $1.7 trillion.

During the 1998 filing season, taxpayers experienced more convenient and reliable phone service than

ever before. As of April 18, 1998, the IRS answered over 37 million taxpayer phone calls. The phone

help lines are now open 16 hours a day/6 days a week, and in January 1999, taxpayers will be able to

call-in 24 hours a day/7 days a week. New technology will reduce even further hold time and allow

callers to get specific information and help on, for example, the sale of a house, retirement or job

changes.

We also offered expanded walk-in office hours and offered Saturday service at over 170 sites for six

Saturdays from March through April 15, 1998. We will expand this option beginning in January 1999

with walk-in service on 13 Saturdays at 250 different sites across the nation.

The IRS continues to hold the very successful “Problem Solving Days”. Every month throughout the

year, taxpayers can sit down and meet face-to-face with an IRS representative to help resolve a particular problem. Since the inception of Problem Solving Days in November 1997, approximately 27,000

taxpayers have taken advantage of this innovative program with even more taxpayers expected to participate in 1999.

Problem Solving Days are also scheduled at times and locations convenient for taxpayers often from

the lunch hour to evening on weekdays, and on Saturdays, too. The Problem Solving Day schedule can

be found on the IRS Home Page at www.irs.ustreas.gov and the events are publicized in local newspapers and on radio and television.

In addition, more community-based locations, such as banks, libraries and shopping malls, will have

tax forms and publications. Of course, more taxpayers are discovering that they can get these forms

without leaving home. There are more than 5,000 tax products, including forms, on the IRS Home

Page that can be downloaded to the taxpayer’s personal computer. Use of the IRS web site skyrocketed in recent years. There were 27 million downloads in the 1998 filing season alone.

Paperless filing is the wave of the future. The IRS is greatly expanding and promoting the use of electronic filing through the e-file program. Last year, 24.6 million taxpayers chose an e-file option, up 28

percent over the previous year. Over the past filing season, six million taxpayers filed their tax returns

by phone through the award winning TeleFile program.

MESSAGE FROM THE COMMISSIONER
PUTTING SERVICE FIRST 5

It is not just individual filers who are using electronic filing. Nearly two million businesses are currently enrolled in the Electronic Federal Tax Payment System (EFTPS), making more than $20 billion

in Federal tax deposits in a typical week. That is nothing less than a spectacular achievement for the

IRS and all of our private sector partners who are promoting the use of electronic filing and payments.

Approximately 70 cents out of every tax dollar collected is coming into the Treasury through EFTPS,

and another three percent is delivered through other electronic means. Earlier this year, we surpassed

the one trillion dollar mark for funds deposited through EFTPS.

The biggest milestone for the IRS occurred, however, on July 22, 1998, when President Clinton signed

into law bipartisan legislation to restructure the IRS. In addition to the many important taxpayer protections, the Restructuring and Reform Act (RRA98) requires the IRS to fundamentally change the way

it conducts its business and to become more business-like in the way it interacts with taxpayers.

The RRA98 goes hand-in-hand with the IRS modernization plan that I presented to Congress in

January 1998. The legislative and report language moves the IRS away from its present organizational

structure to one with operating units serving particular groups of taxpayers with specific needs exactly as we proposed. The RRA98 gives us some important tools we need to bring positive and meaningful changes to the Service.

The IRS and our partners in the National Treasury Employees Union have begun to implement the

practical changes needed to move the IRS in the direction of seeing our operations and their impact

from the taxpayers point of view. Nowhere is this reflected more than in our new Mission Statement:

“Provide America’s taxpayers top quality service by helping them understand and meet their tax

responsibilities and by applying the tax law with integrity and fairness to all”.

We must focus on understanding,solving, and preventing taxpayer problems not just reacting after the

fact. For example, in the case of small business, and especially start-up businesses, we want to work

with the owner throughout the life of the business right from the moment of inception so they do not

get behind, or become non-compliant. We are now in the process of putting together teams to develop the blueprints for the four operating divisions and other units. We hope to have this phase finished

by April 1999.

Modernizing the IRS will be a long process requiring patience, diligence and a commitment to seeing

the process through to its conclusion. However, the RRA98 and the modernization plan provide us

with a once-in-a-lifetime opportunity to bring meaningful, positive change to the IRS both to our taxpayers and to the dedicated men and women at the IRS who serve them. With the support of the

Administration, Congress, and the many people who genuinely want the IRS to serve the public 

better, I believe we can succeed.

Sincerely,
MESSAGE FROM THE CHIEF FINANCIAL OFFICER

6

I am pleased to present the Internal Revenue Service (IRS) Annual Report for Fiscal Year 1998 as required

by the Government Management Reform Act of 1994. The Annual Report is a consolidated report in

support of the Department of the Treasury’s participation in a pilot program to streamline reporting.

This report includes a discussion of the IRS organization, mission, objectives, goals, performance indicators, operational highlights, significant issues, financial statements, and auditors opinions.

The following accomplishments would not have been possible without the dedication, commitment,

and professionalism exhibited by the employees of the IRS organization during FY 1998. It is with

great satisfaction that we share the following achievements:

■ For the second consecutive year, the IRS received an “unqualified” (clean) audit opinion from the

General Accounting Office (GAO) on the IRS Statement of Custodial Activity (as of September 30,

1998). By receiving this opinion, GAO could attest to the reliability of approximately $1.8 trillion in

revenue collected and $151 billion of tax refunds paid.

■ A landmark study entitled “FY 1996 Cost of Submission Processing in Service Centers” was completed which provided, for the first time, the fully-burdened cost of processing by filing method (paper

vs. electronic) and by return type. This study provides one of the key underpinnings of the electronic tax administration study and serves as a prototype for future cost accounting efforts in the IRS. This

project was recognized as a “best practice” by the Association of Government Accountants during its

annual conference and was also instrumental in identifying over $28 million in budgetary savings.

■ The IRS successfully completed the design, testing, and implementation phases of its Year 2000

(Y2K) enhancement to our administrative financial management system (Automated Financial

System-AFS) as well as all other ancillary administrative financial management systems including

the Travel Reimbursement and Accounting System (TRAS), and the Program for

Relocation Information and Moving Expenses (PRIME). This was a major undertaking and accomplishment, assuring Y2K compliance for the Service’ administrative financial management systems

and their products.

By sustaining previous successes and redoubling our efforts in areas where improvements are needed,

the Chief Financial Officer’s resources will be better positioned to support the IRS new mission statement and modernization concept. We are pleased and excited to participate in this process.
MANAGEMENT DISCUSSION 

AND ANAL YSIS

FOR THE FISCAL YEAR ENDED 

SEPTEMBER 30, 1998
8

(Upper Right) The Tingle Table, designed by an IRS

employee in 1961, is used at Service Centers to sort

paper tax returns. (Lower Right) The Multifunctional

Document Handling System is used in Service Centers

to mail outgoing taxpayers notices. This automated

equipment is capable of handling 5,000 pieces of mail

per hour. (Lower Left) Filing a federal tax return electronically through an authorized provider (e-file), over

the telephone (TeleFile), or On-line can result in a faster

refund, electronic confirmation of receipt and the use

of credit or debt cards to pay off balances due.
PUTTING SERVICE FIRST 9

ORGANIZATION

To facilitate the administration of the tax program, the IRS has a decentralized organizational structure with a Headquarters, Regional and District Offices and Service Centers. A detailed organization

chart showing the Service’s structure can be seen on Exhibit 1.

HEADQUARTERS

The National Office, located in Washington, DC, develops nationwide policies and programs for the

administration of the Internal Revenue laws and directs, guides, coordinates and controls the operations of the IRS. Also assigned to Headquarters are the Martinsburg Computing Center in

Martinsburg, West Virginia; Detroit Computing Center in Detroit, Michigan; Beckley Administrative

Services Center in Beckley, West Virginia and 10 Service Centers located throughout the U.S.

REGIONAL OFFICES

There are four Regional Offices, each headed by a Regional Commissioner, which executes nationwide

plans and policies and coordinates, directs, and reviews the activities of the District Offices.

DISTRICT OFFICES

There are 33 Internal Revenue Districts, each administered by a District Director. Districts may

encompass several states, an entire state, or a certain number of counties within a State, depending on

population. Districts may have local offices, the number and location of which are determined by taxpayer and agency needs. District programs include Taxpayer Service, Examination, Collection,

Criminal Investigation and, in some Districts, Employee Plans and Exempt Organizations. Functions

performed are assistance and service to taxpayers, determination of tax liability by examination of tax

returns, determination of pension plan qualification or tax exempt status, collection of delinquent

returns and taxes, and investigation of criminal and civil violations of internal revenue laws (except

those relating to alcohol, tobacco, firearms and explosives).

SERVICE CENTERS

The Executive Officer for Service Center Operations maintains jurisdictional responsibility for 10

service centers. Each service center processes tax returns and related documents and maintains

accountability records for taxes collected. Programs include the processing, verification, and accounting control of tax returns; the assessment of taxes; certification of refunds and administration of

assigned examination, criminal investigation, and collection functions.

MANAGEMENT DISCUSSION AND ANAL YSIS

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
1 0

IRS ORGANIZA TION

NATIONAL DIRECTOR, TAXPAYER TREATMENT & SERVICE IMPROVEMENTS

NATIONAL DIRECTOR OF QUALITY

NATIONAL DIRECTOR, EEO & DIVERSITY

MODERNIZATION TEAMS

Commissioner

Assistant

Commissioner

(Customer Service)

Assistant

Commissioner

(Examination)

Assistant

Commissioner

(Collection)

Assistant

Commissioner

(Criminal Investigation)

Assistant

Commissioner

(EP/EO) 2

CHIEF OPERATIONS

OFFICER

Chief Financial Officer

Assistant

Commissioner

(Procurement)

Assistant

Commissioner

(Support Services)

Assistant

Commissioner

(Program Analysis)

National Director

Strategic Planning

Division

National Director

Analysis & Studies

Division

CHIEF

MANAGEMENT &

FINANCE

Regional Directors 

of Appeals (4)

Director of Practice

Regional 

Commissioners (4)

NATIONAL DIRECTOR

OF APPEALS CHIEF COUNSEL1

Deputy

Commissioner

Operations

Deputy

Commissioner

Modernization

Assistant Commissioner

(International)

Assistant Commissioner

(Electronic Tax

Administration)

Assistant Commissioner 

(Research & Statistics 

of Income)

Assistant Commissioner

(Forms & Submission

Processing)

Executive Officer for

Service Center

Operations

Chief, Headquarters

Operations

CHIEF 

COMMUNICATION 

& LIASON

NATIONAL TAXPAYER

ADVOCATE

CHIEF INFORMATION

OFFICER

Deputy CIO, Operations

Deputy CIO, Information

Resources Management

Deputy CIO, Systems

Development

Director, 

Government Program

Management Office

Director, 

Systems Standards &

Evaluation Office

1. Chief Counsel reports directly to the Commissioner except in circumstances

specified by The IRS Restructuring and Reform Act of 1998.

2. Abbreviation for Employee Plans and Exempt Organizations

E xhib it 1
PUTTING SERVICE FIRST 1 1

MISSION, OBJECTIVES, GOALS

In September 1997, the Internal Revenue Service (Service) completed its “Strategic Plan Through

2002”. This plan encompassed FY 1998 and included the Mission, Objectives and Goals shown in

Exhibit 4. The driving force behind Mission accomplishment was “funding the government”.

Consequently, the Service’s initiatives were heavily focused on collecting taxes with less emphasis

placed on helping taxpayers comply with tax laws.

In January 1998, the Commissioner announced a Concept for Modernizing the IRS. The Modernizing

Concept calls for serving taxpayers better through service to each taxpayer, service to all taxpayers, and

productivity through a quality work environment. Major portions of the Concept were mandated in

the IRS Restructuring and Reform Act of 1998 (RRA 98). The RRA 98 requires that the Service place

a stronger emphasis on customer service including restating our Mission to emphasize serving the

public and meeting taxpayer needs; creating an oversight board to review and approve major activities; and expanding taxpayer rights in several areas. Effective in January 1998, the Service began operating under the Commissioner’s new Modernization Concept as shown in Exhibit 2.

In September 1998, the Service announced its revised Mission Statement reflecting a new emphasis on

serving taxpayers. The Service’s new mission is to: “Provide America’s taxpayers top quality service by

helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all”. As the new concept is fully developed, the Service’s strategic plan and key performance indicators will undergo a complete revision as well. The Service anticipates completing a

new strategic plan during 1999. Until then, the Service’s FY 2000 OMB Budget Submission of September

14, 1998 (pages one through 12) will serve as an interim update of the FY 2002 Strategic Plan.

MODERNIZING THE IRS

A New Mission based on helping people comply with tax laws and ensuring fairness of compliance.

E xhib it 2

Goals

■ Service to each taxpayer

■ Service to all taxpayers

■ Productivity through a quality 

work environment

Guiding Principles

■ Understand and solve problems

from taxpayer’s point of view 

■ Expect managers to be 

accountable

■ Use balanced measures of 

performance

■ Foster open, honest 

communication

■ Insist on total integrity 

5 Critical Areas of Change

■ Revamped business practices

■ Organizing into four operating 

divisions

■ Developing management roles

with clear responsibility

■ Adopting a balanced 

measurement of performance

■ Implementing new technology
KEY PERFORMANCE INDICATORS

Background

The Internal Revenue Service (Service) is a large and complex organization that, consistent with established management principles and the Government Performance and Results Act, uses a sophisticated

measurement system to gauge its performance and that of its employees. Historically, the Service has

faced a dilemma in devising its indicators. For the most part, the Service has measured its success by

things that could be counted (outputs) such as the number of returns processed, refunds issued, calls

answered, and dollars collected through enforcement. These quantitative indicators were productivity

driven, overvalued enforcement, focused on isolated steps, not outcomes, and may have

inadvertently encouraged unfair treatment of taxpayers.

During the 1960s and 1970s,the Service banned all enforcement related statistics as a measure of performance. In September 1997, the Senate Finance Committee held three days of

oversight hearings on the Service. Following these hearings, a number of independently

conducted reviews documented considerable historical pressure on the IRS to improve

productivity,resulting in a strong emphasis on productivity results throughout the organization. Congressional scrutiny, General Accounting Office (GAO) reports, the

Government Performance and Results Act, and various Administration initiatives required

the Service to generate more revenue with fewer resources. In response, the Service measured and reported progress against dollar productivity goals. The reports found that the

IRS environment emphasized revenue production without always providing a corresponding emphasis on

quality or the fair treatment of taxpayers. In October 1997, the Service suspended use of dollar goals and

quotas in measuring revenue from collections and audits; and the inclusion of penalties as part of examrecommended assessments.

New Performance Indicators - Balanced Measures, Balanced Performance

The IRS is changing the way it uses measures to focus attention on priorities, assess organizational performance, and identify improvement opportunities. A measures task force has worked for many months

to develop a plan for addressing existing weaknesses and to set up a new method for measuring organizational performance. Under the new approach, the framework for measuring performance will balance the

Service’s focus across three major areas: business results, customer satisfaction and employee satisfaction,

with business results being comprised on measures of quality and quantity (See Exhibit 3). Unlike previous measurement efforts, the redesigned measures will ensure that customer and employee satisfaction

share equal importance with business results in driving the agency’s actions and programs. While recognizing that it will take several years to fully develop and refine the right set of measurements, initial steps

have begun and fiscal year 1999 will be a transition year to introduce the balanced set of measures, educate and train managers and employees, gather and analyze data, and fine-tune the measurement system.

1 2
WHA T THE BALANCED SYSTEM WILL MEASURE

E xhib it 3

Current Performance Indicators

For Fiscal Year 1998, the Service is reporting its performance against the indicators shown in Exhibit 4.

These indicators are part of the Service’s “Strategic Plan Through FY 2002”, published September 30, 1997.

The Service is in the process of developing a balanced set of indicators and intends to issue new interim

indicators, based on the frameworks previously discussed by fiscal year end. Consequently, the indicators

shown in Exhibit 4 will most likely be replaced as more relevant ones are developed. Also, not all systems

generating the indicator data have been reviewed by the GAO to determine if they produce reliable information.As such,the reader should use prudence in making assessments or drawing conclusions from them.

IRS KEY PERFORMANCE INDICA TORS

MISSION AND OBJECTIVES

PERFORMANCE MEASURES: FY 98 PLAN FY 98 ACTUAL FY 97 ACTUAL

MISSION: COLLECT THE PROPER AMOUNT OF T AX REVENUE A T THE LEAST COST

1. Mission Effectiveness Indicator (MEI):

Total Net Revenue - (Budget + Burden)

Total True Tax Liability 79.5% 79.7% 79.3%

OBJECTIVE: IMPROVE CUSTOMER SERVICE

2. Taxpayer Burden Cost (in Dollars) for 

IRS to Collect $100 $8.53 $8.35 $8.66

3. Initial Contact Resolution Rate 73.0% 65.8% 70.7%

4. Toll-Free Telephone Level of Access 70.0% 89.96% 64.93%

5. Tax Law Accuracy Rate for Taxpayer

Inquiries (On-Line) 96.0% 93.8% 95.1%

OBJECTIVE: INCREASE COMPLIANCE

6. Total Collection Percentage (TCP) 87.4% 87.4% 87.3%

7. Total Net Revenue Collected $1.575T $1.616T $1.480T

OBJECTIVE: INCREASE PRODUCTIVITY

8. Budget Cost (in Dollars) for 

IRS to Collect $100 $0.47 $0.46 $0.48

E xhib it 4

PUTTING SERVICE FIRST 1 3
1 4

Key Performance Indicators—Analysis

M ISSION E FFECTIVENESS I NDICA TOR (MEI)

The MEI grew modestly (0.5%) between FY 1997 and FY 1998. This increase was influenced primarily by a stronger than expected growth in Total Net Revenue Collected. While Treasury projected revenue gains of 2.6% between FY 1997 and FY 1998, revenue collections instead increased to 9.1% ($136

billion). The booming economy, with low inflation (1.5%) and moderate growth in personal income

(2.7%), contributed to this growth. Given the magnitude of the MEI indicator, the budget and burden

figures have little impact. The marginal increase in the Total Collection Percentage (causing an increase

in the Total True Tax Liability) would independently cause a reduction in the MEI, but this was more

than offset by the gains in net revenue.

T AXP A YER B URDEN C OST ( I N D OLLARS ) FOR IRS T O C OLLECT $100

Taxpayer burden cost declined from $8.66 in FY 1997 to $8.35 in FY 1998 (a decline of 3.5%). Gains in

net revenue collections (9.1%) were the primary factor influencing this growth; these revenue gains outpaced the gains in taxpayer burden costs (5.3%),the cost of taxpayers to fulfill their tax obligations.Burden

cost, as measured in dollars, increased as total burden hours and the wage rate increased (2.2% and 3.0%,

respectively). Increases in burden hours were influenced by the following: statutory changes (e.g., the Tax

Reform Act of 1997 and the Small Business Job Protection Act of 1997); a growing economy; and changing demographics (e.g., a growing population with more tax filers).

I NITIAL C ONT ACT R ESOLUTION (ICR)

The ICR rate for FY 98 marginally declined from target and prior year due to a shift in

program emphasis to Level of Access. As anticipated, this change required the redeployment of a large number of non-toll-free employees to telephone staffing who in

some instances, referred questions to subject matter experts for resolution in a subsequent callback.

T OLL - F REE T ELEPHONE L EVEL O F A CCESS

The Toll-Free Telephone Level of Access for FY 98 significantly surpassed target and prior year. This

dramatic change primarily resulted from Customer Service initiatives designed to respond to Senate

Finance Committee hearings on taxpayer rights as well as the IRS Restructuring and Reform Act of

1998. Customer Service was asked to provide a greater Level of Access than in prior years.

Consequently, a large population of employees were trained in a very short timeframe resulting in

more taxpayers answered on the first call.

T A X L A W A CCURACY R A T E FOR T AXP A YER I NQUIRIES ( O N - LINE )

The modest FY 98 decline in Tax Law Accuracy from Target and prior year resulted from a shift in programmatic emphasis to Level of Access.Although many newly trained employees were used to support

this service, the rate experienced only marginal change.

T O T A L C OLLECTION P ERCENT AGE (TCP)

The Total Collection Percentage represents the rate at which the IRS is successful in collecting all revenue due by all taxpayers (Total Net Revenue Collected divided by Total True Tax Liability). The TCP

is based on an intensive audit program, last conducted in 1988. Compliance Research developed this

measure, and is now working on alternate means to measure the tax gap (Total True Tax Liability

minus Total Net Revenue Collected).
PUTTING SERVICE FIRST 1 5

T O T A L N E T R EVENUE C OLLECTED

Net revenue collections surged 9.1% from FY 1997 to FY 1998. The flourishing economy, (a 1.5%

increase in inflation and a 2.7% growth in real income), contributed to this significant growth.

B UDGET C OST ( I N D OLLARS ) FOR IRS T O C OLLECT $100

The budget cost to collect $100 was $0.48 in FY 1997 and improved to $0.46 in FY 1998. This indicator measures the cost to the IRS of executing its revenue collection activities. The measure improved

as the revenue surge (9.1%) was only slightly offset by a budget increase (3.7%). A change in the budget

cost by just two cents reflects a 5.0% improvement.
1 6

(Upper Left) Modernization Team members consisting of

executives, managers and employees meet regularly to

design, analyze and validate processes intended to create the framework for a “modernized IRS”. (Lower

Center) The Integrated Submissions and Remittance

Processing System allows for taxpayer data to be input

with improved accuracy and speed while enhancing the

way that payments are credited to taxpayer accounts.
PUTTING SERVICE FIRST 1 7

PROGRAMMATIC HIGHLIGHTS: OPERATIONS

Submission Processing

The IRS is responsible for receiving and processing electronic and paper tax returns and payments. The

IRS collects more than one trillion dollars annually, processing more than 200 million returns and 80

million individual refunds. In 1998, Submission Processing delivered another successful filing season

and processed over 2 million additional individual returns from the prior year.

Part of this success was due to the Service’s efforts to make it easier for taxpayers to file their tax returns. These efforts include providing easier tax forms,

alternative means of filing such as by computer or phone and by electronic

access to authoritative guidance from the IRS’ award winning Internet website.

The IRS Internet site “The Digital Daily” (see exhibit 14) has also been extremely popular. During the January through April 1998 filing season, the site

received over 300 million “hits” (information accesses) compared to 117 million

for the same period the previous year. The number of downloaded files quadrupled from 6 million in the January through April 1997 period, to over 28 million in the same period in 1998. The following applications were either developed or upgraded during FY 98.

Tax Professional Corner—The Tax Professional’s Corner provides a quick listing of the information

resources most needed by Tax Professionals. It provides news items, early release of items to be issued

in the Internal Revenue Bulletins, drafts of revised forms, e-file resources and links to the most technical items on our website.

Tax Interactive—TAXi, the online learning lab (see exhibit 15) - The IRS in partnership with the

American Bar Association’s Section of Taxation developed an on-line learning lab for first-time taxpayers, students aged 13-18, who learn about taxes in school. It covers the reasons we pay taxes and

how they can meet their tax obligations. Particularly important is the availability of electronic filing

options and teaching electronic filing. First time taxpayers will learn electronic filing methods rather

than paper based filing and learn to interact electronically with the IRS.

IRS Local News Net—IRS Local News Net is a List Server which supplements the Digital Dispatch

(there are over 40,000 Digital Dispatch subscribers) by providing localized, targeted and immediate

information for tax professionals. It is a system capable of reliable and efficient delivery of information to the tax professional community across the nation.
1 8

The system is structured to support the localized nature of information based upon the tax professional’s specific needs. Any District Office, Service Center or Computing Center that needs to communicate with the public or with tax professionals on a regular basis can request a list server. Local–

News Net Servers are being developed primarily to reduce the print and postage costs incurred with

the Director newsletter.

Corporate Partnership Program—The “IRS Corporate Partnership Program” builds working relationships with large employers to help the employer, their employees and the IRS. The program is designed

to increase availability of tax material, reduce the cost of distribution of materials, and increase awareness of self-help IRS electronic services. Program participants receive the IRS Federal Tax Products

CD-ROM, Publication 1796. The CD-ROM, which is free to partners, contains more than 700 current

year tax forms, instructions, publications as well as prior year products.

Expanded MailMan Application—MailMan enables customers to submit tax questions on the web site

and receive responses via e-mail. MailMan expanded from one site to four in 1998 with about 100

trained Customer Service Representatives.

Future FY 99 applications include:

Small Business CD-ROM—The CD-ROM for new small businesses, provides a start-up

kit to ensure a comprehensive orientation. It will provide a basic tax primer which

highlights the tax information of most importance during the first two years of operation. In addition, it will provide web links to resources available on other government

and non-profit websites.

Reducing Unnecessary Filing—Taxpayers will be able to answer a series of questions and

determine if their income is below the filing requirements. If their income is below the

filing requirements, we provide them with the capability to download a W-4 or W-4P

to adjust their withholding for subsequent years.

E-File Provider Database —Taxpayers can search for the nearest authorized e-file provider. There will

also be an option to download files for reuse in database software packages.

Message Boards—Message Boards will allow IRS to host discussion forums on topics of interest both

to taxpayers and the IRS. One of the first events the Digital Daily will host is a request for comments

on the redesign of IRS notices. The message board capability will be utilized for topics of interest to

the public or to gain some sense of public opinion about IRS policy or proposal.

The Electronic Tax Administration mission is to revolutionize how taxpayers transact and communicate with the IRS. There are several methods used by the IRS to receive tax returns electronically: (1)

individual taxpayers through TeleFile, (2) taxpayers filing through an Electronic Return Originator

including both Federal and State tax returns,(3) taxpayers using computer software and filing through

a third party, (4) business taxpayers filing quarterly 941s electronically, (5) business taxpayers also

using TeleFile for certain returns, and (6) the current pilot for On-Line filing for Forms 941 and 1999

pilot of Federal/State TeleFile for individual taxpayers. In 1998, over 24.5 million returns were filed

electronically, an increase of over 20% from FY 1997.
PUTTING SERVICE FIRST 1 9

Customer Service

Customer Services provided a greater level of telephone access (customers receiving fewer busy signals)

than in prior years. The Toll-Free Level of Access was significantly raised from our FY 1998 goal of 70% to

almost 90%. Large numbers of employees were trained, in a short period of time, and answered more customers on the first call. In addition, telephone service was expanded to 16 hours a day and 6 days a week.

As expected, newly trained employees have a reduced rate of initial contact resolution and need to refer

some customers to more experienced employees or prepare a call-back. While the initial contact resolution rate decreased, there was only a minimal drop in Tax Law and Account Accuracy rates. In addition to

expanded telephone service, walk-in service was added on six Saturdays during the filing season at 178

sites nationwide.Customer Service provided representatives for Problem Solving and Problem Prevention

Days. During the past year, approximately 35,000 taxpayers nationwide have participated in problem solving days.A July survey of taxpayers that participated in Problem Solving Days showed 89 percent gave the

program’s overall service the highest grades possible. All walk-in offices provided return preparation for

disabled, low income, and elderly taxpayers who were unable to use the Volunteer Income Tax Assistance

(VITA) or the Tax Counseling for the Elderly (TCE) programs. VITA and TCE increased e-file service by

24% from FY 1997. Walk-In and Taxpayer Education emphasized the Earned

Income Tax Credit (EITC) program through EITC Awareness Days and direct

assistance at special sites.Customer Service continued to help increase compliance

through the Automated Underreporter and the Automated Substitute for Return

programs which are primarily intended to identify and follow-up on income

reporting discrepancies. These programs exceeded expectations and allowed many

customers to return to full compliance in a positive manner.

Taxpayers will encounter improvements in telephone and Walk-In assistance for

the FY 1999 filing season. The most noteworthy changes include: 24 hours per

day, 7 days a week telephone service. Intelligent Call Routing (ICR) technology

will forward taxpayer calls to skilled assistors, regardless of the caller’s or assistor’s location. In addition, our office hours for Walk-In service will be standardized and convenient so that taxpayers will know the time our offices will be open for assistance. In a few sites, an

automated system will track how long it takes to serve our Walk-In customers, so that more adequate

plans can be developed and sites staffed to provide quality service. Also, current Customer Satisfaction

Surveys will be analyzed to determine if customers are satisfied and that information will be used to

improve customer service. Finally, a Notice Redesign project is underway to implement notice clarification changes to reduce taxpayer contact, and an Internet/E-mail project will give taxpayers who access

the IRS website the option of directing their tax law question to a Customer Service site for response.

The prestigious Hammer Award was given to IRS employees from North Dakota and Minnesota

District Offices who were involved in the Red River Disaster Relief Team. Their efforts minimized the

chance that local residents would be exploited by “fly-by-night” construction contractors and established a broad-based, ongoing campaign to educate individual taxpayers about reporting casualty

gains and losses and utilizing extended filing and payment due dates.

IRS disaster relief was also provided for Hurricane Georges, Tropical Storm Frances, Typhoon Keith

and Typhoon Paka. All IRS disaster relief activities are shown in Exhibit 5. Although the number of

major disasters increased by 11% over FY 1997, taxpayers assisted decreased for the same period primarily due to diminished storm damage in FY 1998.
2 0

(Upper Left) IRS Federal Tax Products (Publication 1796) on

CD-ROM, contains more than 26,000 pages of tax information including: current and prior year tax forms, instructions

and publications; IRS Bulletins; and, taxpayer information

publications. (Upper Right) The Service Center Automated

Mail Processing System provides intelligent mail handling

by reading bar coded envelopes; detecting checks and

routing all items departmentally.
PUTTING SERVICE FIRST 2 1

DISASTER RELIEF ACTIVITIES

FY 1998 FY 1997

Major Disasters 65 56

States and Territories 39 36

Counties 906 782

Taxpayers Assisted 33,264 53,000

Disaster Related Requests for Tax Return Transcripts 151,004 170,069

Processed for Small Business Administration

IRS Initiated Penalty and Interest Abatement Relief 70,459 Not Implemented

E xhib it 5

Examination

As of July 1998, Examination audits resulted in recommendations of over $19.5 billion. In addition to

traditional audits, new approaches stress early resolution of issues which save time and money for taxpayers and the Federal Government. With programs like Accelerated Issues Resolution (AIR), the IRS

resolves taxpayers’ issues quickly and completely, while improving the collection of taxes owed.

In response to the Service’s shift in program emphasis to customer service, Examination doubled its

support of Customer Service programs from the previous year. Its staff assisted on the phones during

peak demand times and answered approximately 700,000 taxpayer questions.

In partnerships with private industry, IRS developed two initiatives that benefit both employers and

employees — the Tip Rate Determination Agreement (TRDA) and the Tip Reporting Alternative

Commitment (TRAC). Employers benefit from not having significant unplanned tax liabilities

assessed against them. Employees benefit from increased Social Security, unemployment, worker’s

compensation benefits and retirement plan contributions. To date, IRS has received nearly 1,100

TRDA’s representing more than 2,400 establishments and more than 8,000 TRAC agreements representing more than 25,000 concerns.

The Service is responding to the increased sophistication of transactions in the financial world and

specialization in the business community. The IRS cooperatively developed Market Segment

Specialization Program guidelines, focusing on the practical problems of examining a market segment,

such as an industry like construction or a profession such as real estate agents, and identifying particular issues of interest to the IRS. By sharing this information with professional groups and industry

specific associates, employers and employees in these industries gain greater insight into IRS concerns.

Through September 1998, the Service issued 45 Market Segment guidelines. All 45 Market Segment

Specialization Program Guidelines are available through the Government Printing Office and 32 of

them are also available on the IRS website.

Employee Plans & Exempt Organizations

The EP/EO function was involved in several initiatives to enhance customer service during FY 1998.

Among the initiatives were: planning for first quarter FY 1999 implementation of a centralized, tollfree customer service call site for handling EP/EO inquiries in the Ohio Key District; completion of the

centralization of the front-end processing of all determination work into the Cincinnati Service

Center; centralized EO return processing (including imaging select returns) in the Ogden Service

Center; expanded educational outreach efforts to the EP and EO communities; establishment of a 
2 2

voluntary self-correction program to permit colleges and universities to address noncompliance with

the withholding requirements for payments to nonresident aliens; and, issuance of publications that

provide guidance on gaming activities and IRA investments.

Rapid changes in the health care industry triggered a host of issues for FY 1998 which were of concern

to both the Exempt Organizations and Examination functions. To confront challenging issues such as

joint ventures between for-profit (taxable) entities and non-profit (tax-exempt) health care organizations, EP/EO and Examination Divisions in District Offices coordinated efforts to initiate joint examination of health care companies. Greater emphasis was also placed on new approaches to increasing

compliance as measured in the staff days devoted to work in the Market Segment Compliance

Programs (MSCP) areas. The MSCP was expanded to include new projects such as: Fraternal

Organizations, Travel Tours, Low Income Housing, 401(k) plans, and multi-employer plans.

During FY 1998, the Service issued the Employee Plans Compliance Resolution System (Revenue

Procedure 98-22). This revenue procedure provides a comprehensive system of self-correction programs

for sponsors of retirement plans, that are intended to satisfy various Internal Revenue Code requirements

for plans that have not met these requirements for some time. The system permits plan sponsors to correct qualification shortfalls and thereby continue to provide their employees with retirement benefits on

a tax-favored basis. Seven U.S. Senators expressed their gratitude for this accomplishment.

International 

International administers U.S. international tax laws, encourages the highest degree of

voluntary compliance involving international tax matters and is responsible for all of

IRS’ various international tax activities. During FY 1998, International completed

return profiles of the top 25 countries to assist in focusing International programs.

Through its customer service efforts, International assisted approximately 383,000 taxpayers worldwide, 34,000 more than in FY 1997. International also oversees tax treaties

and tax information exchange agreements on behalf of the U.S. government through

the competent authority process. Tax administration advisory assistance to countries is facilitated

through project teams, training, and international visitors program.

Specifically, during FY 1998, International hosted 424 foreign visitors to IRS, and continued providing

in-country project assistance to the Republic of Georgia, Greece, Turkey, Saudi Arabia and Puerto Rico.

Collection

While Collection activities resulted in $5.3 billion in annual receipts, Collection continued its commitment to providing the Customer Service organization with the support necessary to ensure taxpayers receive the level of access required by walk-in taxpayers as well as those attempting to contact

us via telephone. Refocusing of resources was demonstrated in Collection’s nationwide support of

Problem Solving Days and enhanced walk-in service. With the passage of the IRS Restructuring and

Reform Act of 1998 (RRA 98), Collection implemented several procedural changes, such as modifications to the supervisory approval process for certain collection actions, the review of jeopardy and termination levy actions by IRS Counsel and the increase in levy exemption amounts. In addition,

Collection is expected to continue its efforts implementing the RRA 98 including procedural changes

related to Offers in Compromise and Innocent Spouse processing.
PUTTING SERVICE FIRST 2 3

(Upper Left) Walk-in tax assistance is available at more

than 400 IRS offices nationwide. This includes forms,

publications and answers to specific taxpayer questions.

Expanded hours and Saturday service was offered at

over 170 sites during the 1998 filing season. 

(Lower Left) IRS Customer Service Representatives can

help taxpayers resolve account questions as well as

those dealing with technical tax law matters. Recent

innovations include giving the representatives immediate

access to the callers account, anywhere in the country,

and the ability to make certain on-line account adjustments. Unresolved taxpayer problems can be pursued

through the IRS Problem Resolution Program, which is

administered by local IRS Taxpayer advocates. (Right)

The IRS toll-free telephone operations feature Intelligent

Call Routing. Operating as a single call-center with

employees at multiple locations around the country, this

technology routes each incoming call to the next available representative, regardless of the caller or representatives geographic location. Calls are also routed to representatives using language and skill based determinants to ensure that the unique needs of each taxpayer

are efficiently met.
2 4

Criminal Investigation

Criminal Investigation (CI) is actively identifying and investigating new and emerging areas of financial fraud that affect the economy and exploit honest citizens. These areas include pension fraud,

domestic and foreign trust fraud, subsidy and entitlement fraud.

National Taxpayer Advocate (NTA)

The IRS Restructuring and Reform Act of 1998 (RRA 98), established the position of NTA. Generally,

the NTA assumed the prior duties of the Taxpayer Advocate as head of the Problem Resolution

Program (PRP), but with significant new authority and independence. The NTA is now appointed by

the Secretary of the Treasury and reports directly to the Commissioner of the IRS. In addition, RRA

98 mandates that there be at least one local Taxpayer Advocate in each state and that those local

Advocates report directly to the NTA. Prior to this change, the local Taxpayer Advocates reported to

the IRS Regional, District, or Service Center Director. RRA 98 also expands the authority to issue a

Taxpayer Assistance Order (TAO), which can provide relief to taxpayers in hardship situations. The

new authority in addition to the added powers provided by the Taxpayer Bill of Rights 2 (TBOR2),

have significantly expanded the ability of the NTA to assist taxpayers. During 1998, the NTA Office

remedied staffing deficiencies in addition to improving the level of automation support to field offices.

Despite the high level of effort necessary to affect this organizational realignment, the Office of the

NTA was still able to achieve the following significant accomplishments for the year:

■ Through the IRS Problem Resolution Program, resolved more than 272,000 cases and

received requests for assistance on over 32,000 potential hardships cases.

■ Of the over 32,000 applications for a TAO, taxpayers were granted relief or

otherwise provided appropriate assistance in 73.8% of these cases. For the

remaining cases (26.2%), assistance could not be provided due to inappropriate requests

(66.4%), law(s) preventing relief (17.2%), or requests not meeting hardship criteria

(16.4%).

■ Identified the 20 most serious problems facing taxpayers as reported by taxpayer focus

groups, tax practitioners and IRS staff. There is a general consensus that the

underlying root cause of these problems stems from the overall complexity of tax

administration. The NTA’s Office also identifies and reports on actions, either inprocess or planned, to address these problems.

■ Identified the 10 most litigated issues for 4 classifications of taxpayer: individual, corporate,

small business and other. Determined that many of the most litigated issues are also reported within the 20 most serious problems facing taxpayers. Several of the issues identified

have been addressed by provisions of recent tax legislation (RRA 98) and may be less problematic in future years.

■ Identified three primary areas of taxpayers compliance burden and developed, in

conjunction with internal and external stakeholders, associated legislative proposals (38)

intended to provide relief.
PUTTING SERVICE FIRST 2 5

■ Coordinated IRS Problem Solving Days (PSD) which provide taxpayers with the

opportunity to have face-to-face contact with an IRS employee who could assist them in

resolving problems with the IRS. Approximately 35,000 taxpayers attended PSD’s

during fiscal year 1998.

■ Coordinated the formation of and provided direction to a Citizens Advocacy Panel

(CAP) which is intended to enhance IRS customer service through citizen participation in

identifying problems and making recommendations for improvement of local IRS systems

and procedures. The first CAP was implemented during fiscal year 1998 in the South

Florida district. Three more are planned for fiscal year 1999.

■ Established an NTA toll-free telephone number for PRP cases. This service is provided

during both “normal business hours” as well as “after hours”. Assistors in the PRP toll-free

sites will provide one-stop, same-day service, when possible, to ensure that the case is

resolved the first time and does not have to be re-opened. If the case cannot be resolved in

this manner, necessary action will be taken to resolve the case without an additional contact by the taxpayer.

■ Started the Taxpayer Equity Task Force, composed of 16 IRS executives

whose charter is to “recommend to the Taxpayer Advocate measures to

further the interests of fairness in tax administration, balancing the need

for equity in relation to taxpayers as a whole” Administrative recommendations endorsed by the NTA are sponsored by the affected function(s) for implementation as soon as possible. Legislative change recommendations are forwarded directly to Congress through the NTA.
2 6

(Center) The Automatic Cartridge Loader is a component

of a laser printing system which provides faster and more

cost efficient printing of taxpayer communications. (Upper

Right) Computer tape reels are used for storing the output

from taxpayer return processing. This form of media storage is being replaced by cartridge tapes and automated

tape libraries as part of the IRS modernization strategy.
PUTTING SERVICE FIRST 2 7

SIGNIFICANT ISSUES REQUIRING MANAGEMENT ATTENTION

IRS Restructuring and Reform Act 1998 (RRA 98)

The IRS Restructuring and Reform Act of 1998 (RRA 98) was signed into law on July 22, 1998. The

RRA 98 directs IRS to reorganize from its current geographic structure of a National Office, four (4)

Regions, 33 Districts, ten (10) Service Centers and two (2) Computing Centers into a structure that

services groups of taxpayers with similar needs. Four taxpayer groups have been

identified. They are individuals, small businesses, large corporations, and tax

exempt organizations.

Reorganizing the IRS reflects the shift from revenue collection and enforcement

to a taxpayer-service oriented organization. The IRS’ new mission statement

reflects all taxpayer’s needs. “The mission of the IRS is to provide America’s taxpayers top quality service by helping them understand and meet their tax

responsibilities and by applying the tax law with integrity and fairness to all”.

The RRA 98 contains five major provisions which affect the Commissioner.

First, the Act states the duties of the Commissioner. Second, the Commissioner

is appointed to a five year term of office and may be reappointed to it. Part of the intent is to

ensure that the IRS Commissioner is insulated from political influences. Third, the

Commissioner is now required to have a “demonstrated ability in management”. Fourth, the

Commissioner is given the power to appoint and remove personnel from significant management

positions. Fifth, the Commissioner is to consult with the Oversight Board on operational functions of

the IRS and the selection, evaluation and compensation of senior IRS executives.

The RRA 98 allows it to create a nine-person Oversight Board to ensure the IRS is organized and operated in a matter that carrys out its mission. The Board will oversee IRS administration, management,

conduct, direction and supervision of the execution and application of internal revenue laws and tax

treaties. It will ensure taxpayers are treated properly; be involved in strategic planning at the IRS;

review the IRS budget; review performance standards related to mission and objectives; review any

plans for reorganization; review plans for modernizing the tax system, outsourcing, managed competition, training and education; and recommend candidates to fill high-level IRS positions. Six Board

members are from the private sector; the Treasury Secretary, Commissioner and an employee representative are also members. Members must have expertise in one or more of these areas: (1) management of large service corporations, (2) customer service, (3) federal tax laws including tax administration and compliance, (4) information technology, (5) organization development, (6) needs and

concerns of taxpayers, and (7) needs and concerns of small business.
2 8

Under the RRA 98, the Commissioner recommends candidates for the Chief Counsel position and can

also recommend the Chief Counsel’s removal. Generally, the Chief Counsel reports to the

Commissioner except on (1) matters of tax policy where the Chief Counsel reports to the Treasury

General Counsel, and (2) on legal advice and interpretations of tax law not relating solely to tax policy (revenue rulings and revenue procedures, technical advice and memoranda, private letter rulings

and published guidance not described in the law) and with respect to tax litigation when the Chief

Counsel reports to both the Commissioner and the Treasury General Counsel.

The RRA 98 directs the reorganization of the Taxpayer Advocate to ensure its independence. Prior to

the RRA 98, the Taxpayer Advocate was appointed by the Commissioner and local taxpayer advocates

were reviewed by District and Service Center Directors. Under the RRA 98, the National Taxpayer

Advocate is appointed by the Treasury Secretary and must have a background in customer service, tax

law and experience representing taxpayers. The National Taxpayer Advocate will appoint and evaluate

local taxpayer advocates. Local offices must have independent mailing addresses and telephonic and

electronic communications from the IRS. The National Taxpayer Advocate will issue taxpayer assistance guidelines to local and regional problem resolution officers who work for the IRS. Its functions

are to assist taxpayers in resolving issues with the IRS; identify areas in which taxpayers have problems

in dealing with the IRS; propose changes to administrative practices to relieve taxpayer burden, and

identify possible law changes to resolve identified concerns. The RRA 98 requires the

National Taxpayer Advocate to report to Congress semi-annually. The first report

addresses the objectives for the year. The second report responds to 11 activities

included in the RRA 98 which identify the initiatives and problems and the actions

taken on them.

Prior to the RRA 98, IRS had an Office of the Chief Inspector to conduct audits and

inspections. The Treasury Department Inspector General (IG) did not have responsibility for these functions, and the IRS and Treasury Inspector General had agreements

on the respective roles of each in investigating and overseeing the IRS. The RRA 98

eliminates the Office of the Chief Inspector and creates a new, independent office for

oversight and inspection of the IRS in the Office of the Treasury Inspector General for Tax

Administration. The reason for this provision is to ensure structural and actual independence as well

as improved quality and integrity in conducting audits, evaluations and investigations of the IRS. The

Chief Inspector has transferred its functions to the Treasury IG for Tax Administration with the exception of its IRS background program. This program will remain in the IRS as part of the Chief

Management and Finance.

Year 2000 Conversion Program

1. S T A T E O F R EADINESS

a. Conversion Method

The IRS uses a conversion method consisting of fourteen distinct milestones that encompass

assessment, renovation, validation, implementation, 100% independent code analysis, and Endto-End integration testing. The fourteen milestones can be mapped to the five GAO Year 2000

Conversion Model Stages.
PUTTING SERVICE FIRST 2 9

The IRS Year 2000 conversion program is in the implementation stage. All systems will be converted according to a schedule of seven conversion implementation phases. The phases are based on the

semi-annual IRS production cycles. The IRS is committed to convert its mission-critical application systems by 1/31/1999. However, there are some rare exceptions, such as external interfaces

having later completion dates or hardware/software vendors having later delivery dates. In such

cases, components of some systems may not be fully renovated, tested, and implemented by

1/31/1999. Waivers to complete conversion of these components after 1/31/1999 will be considered.

PHASE S T ART DA T E T ARGET COMPLETION DA T E S T A TUS

1 September 1996 January 1997 Completed January 1997

2 January 1997 July 1997 Completed August 1997

3 February 1997 January 1998 Completed January 1998

4 January 1998 July 1998 Completed July 1998

5 February 1998 January 1999 Completed January 1999

6 January 1999 July 1999 On Schedule

7 February 1999 January 2000 On Schedule

Exhibit 6

b. Information Technology (IT)

At the end of FY 1998, the IRS had 167 systems made up of 128 mission-critical application systems, seven mission-critical telecommunications systems and 32 non-mission-critical application systems. As of 9/28/1998, of the 128 mission-critical application systems, 82 had been

implemented (completed the conversion process and put back into production), one system was

scheduled to be retired, and the remaining 52 were scheduled to be converted by 1/31/1999.

During FY 1999, the IRS continued to make progress. As of 1/25/1999, IRS has a total of 133

mission-critical application and telecommunications systems with two systems to be retired. Of

the 131 mission-critical application and telecommunications systems to be made Year 2000

compliant, 126 were renovated, 119 were validated, and 111 were implemented.

c. Non-Information Technology (Non-IT)

During FY 1998, the IRS completed the assessment and inventory of the environment and security systems at its Service Centers, Computing Centers, and National Office. The IRS also completed the personal property inventory and a contractor had begun the assessment phase for

this equipment. Projections estimated completion of IRS Non-IT conversion by March 1999.

Subsequently, during FY 1999, the following was accomplished:

■ The renovation of the IRS Service Centers, Computing Centers, and National Office is 45

percent complete and 99 percent of the Non-IT personal property is compliant or has no

Year 2000 implication. The completion date of IRS Non-IT conversion is now estimated to

be June 1999. The target completion date change from March to June 1999 will have no

negative impact.
3 0

■ As of 1/25/1999, the IRS completed an inventory and assessment of 29 mission-critical IRS

Customer Service and Forms Distribution sites nationwide. The responsibility for the Year

2000 renovation of these sites belongs to the General Services Administration (GSA). The

IRS will negotiate, but not schedule or control, these renovations.

d. Key External Trading Partners

During FY 1998, the IRS initiated an independent risk assessment of its key trading partners. The

IRS identified 13 key trading partners, including the Social Security Administration, the Treasury

Financial Management Service, key providers of electronic payments, returns and third party

documents. An independent contractor conducted site visits and a risk assessment of the trading

partners’ Year 2000 conversion progress. At the end of FY 1998, twelve of the thirteen key trading partners were in “green” status showing little or no risk of a Year 2000 related business failure.

The independent contractor continues to perform risk assessments.

2. C OSTS T O A DDRESS IRS Y EAR 2000 I SSUES

Through the end of FY 1998, the IRS spent $623 million on its Year 2000 Related Stay In Business projects. These costs include the Century Date Change Conversion, the Service Center

Mainframe Consolidation, and the Integrated Submission and Remittance Processing

System. In FY 1999, the IRS obligated $42 million as of 12/31/1998. (All dollar

amounts derived from IRS’ Automated Financial System Obligation/Expenditure

data). As of 1/5/1999, the IRS’s total projected costs for its Year 2000 Related Stay In

Business initiatives equal $1.377 billion for FY 1996 through FY 2001.

3. R ISKS O F Y EAR 2000 I SSUES T O IRS

Each year the IRS collects over $1.7 trillion in tax revenue to support the operations of

the Federal Government. In order to fulfill its mission of service to taxpayers, the IRS

depends on its automated systems to process tax returns, issue refunds, deposit payments, and provide

taxpayers with basic answers to inquiries. Not making our systems Year 2000 compliant could mean

the generation of millions of erroneous tax notices, refunds, bills, and any number of financial reporting errors.

In FY 1998, the IRS retained a contractor to perform a risk analysis of the IRS Year 2000 conversion

efforts. These activities continue during FY 1999. The contractor verifies and validates compliance

progress across the Century Date Change projects. This activity includes cyclical risk assessments and

bi-weekly risk identification meetings. The contractor continues to conduct a risk assessment. All

high-risk items are reported to the Combined Program Management for Century Date Change and

Filing Season Executive Steering Committee, which is chaired by the IRS Commissioner.

Exhibit 7 lists Key Risks as of September 4, 1998 that were reported to the Combined Program

Management for Century Date Change and Filing Season Executive Steering Committee. The righthand column lists the mitigation activities.
PUTTING SERVICE FIRST 3 1

(Right) The Roll-Aid Unwinder is a key piece of pre-processing equipment (paper handling) for an automated

laser printing system which provides high quality taxpayer

documents at minimum cost. (Left) This training screen is

representative of those seen by IRS Tax Examiners who

perform on-line reviews of taxpayer notices prior to mailing. On-line Notice Review minimizes the likelihood of

unnecessary taxpayer communication from the IRS while

reducing related processing costs.
3 2

KEY RISKS AS OF 9/30/98

• FY 1999 Funding

The IRS is at risk of not being able to fund its

Century Date Change Conversion needs

over and above the $140 million requested in

the President’s Budget for FY 1999.

• GSA and IRS Differences in estimation of 

Non-IT Impacts

Because the General Services

Administration’s (GSA) estimate of Non-IT

impacts is substantially less than the IRS’

estimate, the IRS is taking actions and

incurring costs towards assuring that its

critical facilities will be operational in 2000.

• Mail Sorting Systems Not Compliant

Without a compliant mail sorting system 

for the Composite Mail Processing System

(COMPS) or a formal business operations

contingency plan, IRS’ continuity of operations into 2000 at the Service Centers is 

at risk.

• TRW Performance on Treasury

Communications System Compliance

Without adequate contractor project controls, the IRS will not have early warning

that mission critical telecommunications

services may fail in 2000.

• Tier 2 Milestone Schedule

Because there is no written schedule of Tier

2 compliance milestones and actions for

specific product items, organizations

dependent on the compliance platforms

cannot coordinate schedules for related

activities (e.g., application implementations

on compliant servers).

• Filing Season 2000 Requirements

If the filing season 2000 requirements are

not received in a timely manner, the IRS is at

risk of not successfully managing or testing

the magnitude of changes associated with

the Year 2000 and Filing Season 2000.

MITIGA TION ACTIVITIES

• Mitigation activities are ongoing.

• The IRS received $227 million from the FY 1999 Year 2000

Emergency Fund for Century Date Change Conversion

activities ($140 million requested in the President’s budget and $87

million in additional needs). In addition, carryover funds from FY

1998 of $12 million will be added, bringing the total to $239 million.

As of 1/11/99, the IRS has firm plans for all of the $239 million total

availability. The IRS is developing an additional needs estimate and

will work this issue with the Department of the Treasury and the

Office of Management and Budget.

• Mitigated on 12/4/1998.

• The IRS completed an assessment of all of its mission-critical

facilities including leased buildings. The IRS established additional

tracking metrics to monitor assessment and renovation progress

for which GSA is responsible. GSA established a website to provide compliance status of its facilities. 

• Mitigated on 10/9/1998.

• The contract for a replacement for COMPS was awarded in July

1998. Full implementation is scheduled for November 1999. The

COMPS contingency plan is in place to ensure COMPS can remain

operational into the Year 2000. The COMPS Contingency Plan testing was completed on 9/23/1998, and the final report validated the

effectiveness of the contingency plan. 

• Mitigation activities are ongoing.

• The telecommunications data has been added to the IRS corporate

inventory database. Efforts to correct its inaccuracies are scheduled for completion in March 1999. The severity of the risk was

reduced on 12/18/1998. As of 1/25/1999, the Year 2000 compliance

rate for the entire telecommunications inventory is 98 percent.

• Mitigation activities are ongoing.

• Tier 2 Project Offices were established and an integrated Master

Schedule (IMS) is being completed. The IMS captures critical milestone dates of 27 key systems and provides a program view of key

Tier 2 projects throughout target test and deployment efforts. Most

Tier 2 key systems will have the infrastructure of commercial products Year 2000 compliant by 1/31/1999. The balance of Tier 2 infrastructure conversion is scheduled for completion by July 1999 with

the exception of four systems whose infrastructure will be compliant by 9/30/1999.

• Mitigation activities are ongoing.

• The schedule for making changes to IRS systems for the Year 2000

filing season has been accelerated in order to mitigate this risk and

to allow for the final critical end-to-end test, which will run 97 mission-critical tax processing systems in a production simulated environment with all system clocks set to Year 2000. Prioritization of the

changes for the Year 2000 filing season is well underway and plans

are scheduled to be finalized by the end of February.

E xhib it 7
PUTTING SERVICE FIRST 3 3

4. B USINESS C ONTINUITY AND C ONTINGENCY P LANNING

During FY 1998, the IRS developed and implemented a Contingency Management Plan (CMP).At the

end of FY 1998, Version 4.0 was scheduled to be published on 10/1/1998. The IRS business organizations planned to have draft contingency plans for the most critical high priority/high risk business

processes, known as Business Continuity and Contingency Plans (BCCPs) completed in December

1998. CMP Version 4.0 further refines contingency planning guidance for the IRS. It includes guidance

for both Information Technology (IT) and Non-IT contingency planning. It also responds to a May

1998 report by the General Accounting Office by addressing business continuity planning activities for

potential Year-2000 induced system failures. The CMP Version 4.0 details four enterprise-wide core

business processes and includes a mapping of mission critical automated systems to 27 critical business subprocesses subject to potential Year 2000 risk.

The draft Service-level Business Continuity and Contingency Plan (BCCP) Version 1.0, which identifies

significant business process risks and includes a compilation of 179 threat/failure scenario matrices, was

completed on 10/15/1998. These matrices assist in identifying business process impacts, probability of

failure of supporting systems, a methodology for assigning system risk ratings, and ensures that the most

likely worst case scenarios are identified and given the highest priority for contingency plan development.

The final BCCP was released on 11/24/1998. It identified 37 required plans, all of which are in progress.

Of these, contingency plans for 24 of 37 of the most critical high priority/high risk business processes

are scheduled for completion by the business organizations by 3/31/1999. Thirteen additional business

plans will be completed by 5/31/1999.

The End Game Plan to support Year 2000 implementation is under development. An End Game draft

Action Plan is currently being developed and is scheduled to be completed on February 24, 1999. This

draft action plan will include appropriate expansion of normal problem monitoring/handling procedures plus extraordinary processes (i.e., identification and advance planning for policies and procedures to handle potential emergent requirements, identification of and planning for “day zero” activities, and planning and establishment of continuous monitoring/reaction/reporting capability for key

Y2K situation indicators (internal and external).

Most Unpaid Assessments Are Not Receivables and Are Largely Uncollectible

As reflected in the supplemental information to IRS’ fiscal year 1998 Financial Statements, the unpaid

assessments balance was approximately $222 billion as of September 30, 1998. This unpaid assessments

balance represents assessments resulting from taxpayers filing returns without sufficient payment as

well as from the Service’s enforcement programs such as examination, underreporter, substitute for

return, and combined annual wage reporting. A significant portion of this balance is not considered a

receivable. Also, a substantial portion of the amounts considered receivables is largely uncollectible.

Under federal accounting standards, unpaid assessments require taxpayer or court agreement to be

considered federal taxes receivable. Assessments not agreed to by taxpayers or the courts are considered compliance assessments and are not considered federal taxes receivable. Assessments with little or

no future collection potential are called write-offs.

Exhibit 8 depicts the components of the unpaid assessments balance as of September 30, 1998.
3 4

COMPONENTS OF IRS’ $222 BILLION UNP AID ASSESSMENTS (Dollars in Billions)

E xhib it 8

Of the $222 billion balance of unpaid assessments, $119 billion represent write-offs. Write-offs principally consist of amounts owed by deceased, bankrupt or defunct taxpayers, including many failed

financial institutions resolved by the Federal Deposit Insurance Corporation (FDIC) and the former

Resolution Trust Corporation (RTC). As noted above, write-offs have little or no future collection

potential but statutory provisions require that these assessments be maintained until the statute for

collection expires. In addition, $22 billion of the unpaid assessments balance represents amounts that

have not been agreed to by either the taxpayer or a court. Due to the lack of agreement, these compliance assessments are less likely to have future collection potential than those unpaid assessments that

are considered federal taxes receivable.

The remaining $81 billion of unpaid assessments represent federal taxes receivable. About $55 billion

(68 percent) of this balance is estimated to be uncollectible due primarily to the taxpayer’s economic

situation, such as individual taxpayers who are unemployed, or have other financial problems.

However, IRS may continue collection action for 10 years after the assessment or longer under certain

conditions. Thus, these accounts may still ultimately have some collection potential if the taxpayer’s

economic condition improves.About $26 billion, or about 32 percent, of federal taxes receivable is estimated to be collectible. Components of the collectible balance include installment agreements with

estates and individuals, confirmed payment plans through bankruptcy, as well as relatively newer

amounts due from individuals and businesses who have a history of compliance.

It is also important to note that of the unpaid assessments balance, about $140 billion (63 percent)

represents interest and penalties, as depicted in Exhibit 9, which are largely uncollectible.

Taxes

Receivable

Uncollectible

($55)

Write-offs

($119)

Taxes

Receivable

Collectible

($26)

25%

54%

11% 10%

Compliance

Assessments

($22)
PUTTING SERVICE FIRST 3 5

UNP AID T AXES AND INTEREST AND PENAL TY COMPONENTS OF $222 BILLION IN

UNP AID ASSESSMENTS (Dollars in Billions)

E xhib it 9

Interest and penalties are such a high percentage of the balance because IRS continues accruing them

through the 10-year statutory collection date, regardless of whether an account meets the criteria for

financial statement recognition or has any collection potential. For example, interest and penalties

continue to accrue on write-offs, such as FDIC and RTC cases, as well as on exam assessments where

the taxpayers have not agreed to the validity of the assessment. The overall growth in unpaid assessments during fiscal year 1998 was mostly attributable to the accrual of interest and penalties.

Taxes

($82)

Interest and

Penalties

($140) 63%

37%
3 6

SIGNIFICANT CHALLENGES

During fiscal year 1999, the IRS faces significant challenges from implementing the following: the new

IRS Mission Statement and Modernization Concept in compliance with the IRS Restructuring and

Reform Act of 1998 and the Information Systems Modernization program including the Century Date

Change.

LIMITATIONS OF THE FINANCIAL STATEMENTS

The financial statements were prepared to report the financial position and the results

of operations of the Internal Revenue Service, pursuant to the requirements of the

Chief Financial Officer’s Act of 1990.

While the statements were prepared from the books and records of the IRS in general

accordance with the format prescribed by OMB, they are different from the financial

reports used to monitor and control budgetary resources that are prepared from the

same books and records.

The statements should be read with the realization that they are for a component of a

sovereign entity (the United States Government), that unfunded liabilities reported in the financial

statements cannot be liquidated without enactment of an appropriation, and that the payment of all

liabilities other than for contracts can be abrogated by the sovereign entity.
FINANCIAL ST A TEMENTS 

AND NOTES

FISCAL YEAR 1998

PUTTING SERVICE FIRST 3 9

BALANCE SHEET

A S OF SEPTEMBER 30, 1998

ASSETS ( I N M ILLIONS )

Entity Assets:

INTRAGOVERNMENTAL: Fund balance with Treasury and other (Note 2) $ 1,969

Property and equipment, net, and other 202

Total Entity Assets 2,171 

Non-entity Assets:

INTRAGOVERNMENTAL: Due from Treasury 1,159

Federal taxes receivable, net of allowance for doubtful accounts of $ 55,000 (Note 3) 26,000

Other custodial assets 57

Total Non-entity Assets 27,216

Total Assets $ 29,387 

LIABILITIES 

Liabilities Covered by Budgetary or Other Resources

INTRAGOVERNMENTAL: Due to Treasury (Note 3) $26,000

Accounts payable and accrued benefits 125

Federal tax refunds payable 1,159

Other custodial liabilities 57

Accounts payable and other 103

Accrued payroll 216

Total Liabilities Covered by Budgetary or Other Resources 27,660

Liabilities not Covered by Budgetary Resources

INTRAGOVERNMENTAL: Accrued Workers’ Compensation 70

Accrued annual leave 353

Actuarial liability for Workers’ Compensation 356

Contingencies (Note 4) 17

Total Liabilities not Covered by Budgetary Resources 796

Total Liabilities 28,456

NET POSITION (Note 5) 931

Total Liabilities and Net Position $29,387

The accompanying notes are an integral part of these statements.
4 0

COSTS ( I N M ILLIONS )

Programs Costs

Processing Assistance & Management $ 3,083

Tax Law Enforcement 3,459

Information Systems 1,405

Subtotal 7,947

Less: Earned revenues not attributed to programs (198 )

Net Cost of Operations (Note 6) $7,749

The accompanying notes are an integral part of these statements.

S T A TEMENT OF NET COST

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
PUTTING SERVICE FIRST 4 1

( I N M ILLIONS )

Net Cost of Operations $7,749

Financing Sources (other than exchange revenues)

Appropriations used 7,413

Imputed financing 426

Total Financing Sources 7,839

Net Results of Operations 90

Increase in Unexpended Appropriations 376

Change in Net Positions 466

Net Position—Beginning of Period 465

Net Position—End of Period $931

The accompanying notes are an integral part of these statements.

S T A TEMENT OF CHANGES IN NET POSITION

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
4 2

( I N M ILLIONS )

Budgetary Resources

Budget authority $7,903

Unobligated balances—beginning of period 293

Spending authority from offsetting collections 132

Adjustments 93

Total Budgetary Resources $8,421

Status of Budgetary Resources

Obligations incurred $7,987

Unobligated balances—available 364

Unobligated balances—not available 700

Total Status of Budgetary Resources $8,421

Outlays

Obligations incurred $7,987

Less: spending authority from offsetting collections and adjustments ( 271 )

Obligated balance, net—beginning of period 1,163

Less: obligated balances, net—end of period ( 1,542 )

Total Outlays $7,337

S T A TEMENT OF BUDGET A R Y RESOURCES

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998

The accompanying notes are an integral part of these statements.
PUTTING SERVICE FIRST 4 3

( I N M ILLIONS )

Obligations and Nonbudgetary Resources

Obligations incurred $7,987

Less: spending authority from offsetting collections and adjustments ( 271 )

Financing source—imputed financing 426

Exchange revenue not in the budget ( 92 )

Total Obligations, as Adjusted, and Nonbudgetary Resources 8,050

Resources That Do Not Fund the Net Cost of Operations

Change in amount of goods, services, and benefits ordered but not yet received or provided ( 325 )

Costs capitalized on the balance sheet ( 65 )

Financing sources that fund costs of prior periods ( 36 )

Total Resources That Do Not Fund the Net Cost of Operations ( 426 )

Costs That Do Not Require Resources

Depreciation and amortization 100

Total Costs That Do Not Require Resources 100

Financing Sources Yet to be Provided 25

Net Cost of Operations $7,749

S T A TEMENT OF FINANCING

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998

The accompanying notes are an integral part of these statements.
4 4

( I N B ILLIONS )

REVENUE ACTIVITY

Collections of Federal Tax Revenue (Note 7)

Individual income, FICA/SECA, and other $1,472

Corporate income 213

Excise 46

Estate and gift 25

Railroad retirement 5

Federal unemployment 6

Total Collections of Federal Tax Revenue 1,767

Decrease in federal taxes receivable, net ( 2 )

TOTAL FEDERAL TAX REVENUES 1,765

Distribution of Federal Revenue to Treasury (1,767 )

Decrease in Amount to Treasury 2

NET FEDERAL REVENUE ACTIVITY $ 0

FEDERAL TAX REFUND ACTIVITY (NOTE 8) 

Total Refunds of Federal Taxes $ 151

Appropriations Used for Refund of Federal Taxes (151 )

NET FEDERAL TAX REFUND ACTIVITY $ 0

S T A TEMENT OF CUSTODIAL ACTIVITY

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998

The accompanying notes are an integral part of these statements.
PUTTING SERVICE FIRST 4 5

The Internal Revenue Service’s (the Service’s) financial statements have been prepared as mandated by

the Chief Financial Officers Act of 1990 and the Government Management Reform Act of 1994, 31

U.S.C. 3515 (b). In preparing the statements, the Service used the Office of Management and Budget’s

(OMB’s) Bulletin Number 97-01, Form and Content of Agency Financial Statements. This OMB bulletin provides format and disclosure information for preparing financial statements for federal entities. This bulletin also incorporates those standards promulgated by the Federal Accounting Standards

Advisory Board (FASAB). The Service prepared these financial statements from the books and records

of the Service in accordance with the formats prescribed by OMB.

NOTE 1 SUMMAR Y OF SIGNIFICANT ACCOUNTING POLICIES

A . R EPORTING E NTITY

The Service is a bureau of the U.S. Department of the Treasury (Treasury). The Service originated in

1862, when the Congress established the Office of the Commissioner of the Internal Revenue. In 1952

the Bureau was reorganized by the Congress and in 1953 became the Internal Revenue Service.

The mission of the Service is to provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.

These financial statements report on both the administrative and custodial activities which were presented separately in prior years. On the balance sheet, assets relating to administrative and custodial

activities are presented, respectively, in separate "Entity" and "Non-entity" sections, in accordance with

applicable OMB guidance. Non-entity assets and corresponding liabilities are administered by the

Service on behalf of the Treasury. In accordance with applicable law, these assets and liabilities are

unavailable for use in Service operations.

B . B ASIS O F A CCOUNTING AND P RESENT A TION

B ALANCE S HEET , S T A TEMENT O F N E T C OST , S T A TEMENT O F C HANGES I N N E T P OSITION

These statements are presented on the accrual basis of accounting. Under the accrual method,revenues

are recognized when earned and expenses are recognized when a liability is incurred, without regard

to receipt or payment of cash.

S T A TEMENT O F B UDGET ARY R ESOURCES

The statement of budgetary resources is presented using the budgetary basis of accounting. Budgetary

accounting facilitates compliance with legal constraints and controls over the use of federal funds.

NOTES TO FINANCIAL ST A TEMENTS

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
4 6

This financial statement is in addition to the reports prepared by the Service throughout the year pursuant to OMB directives for purposes of monitoring and controlling the Service's obligation and

expenditure of budgetary resources.

S T A TEMENT O F F INANCING

The statement of financing is presented using both an accrual and a budgetary basis of accounting as

a means to facilitate understanding of the differences between the two accounting bases.

S T A TEMENT O F C USTODIAL A CTIVITY

The statement of custodial activity is presented primarily on the modified cash basis of accounting.

Specifically, total federal revenue is recognized when received and is reported net of the change in federal taxes receivable. The related distribution of all such collections to the U.S. Treasury, however, is

reported on the cash basis. Refunds of taxes and interest, as well as Earned Income Tax Credit (EITC)

payments, are also reported on the modified cash basis. Specifically, refunds, and EITC payments, are

recognized when disbursed and are reported net of the change in the federal tax refunds payable.

C . F UND B ALANCE WITH T REASUR Y

Fund balance with Treasury represents the aggregate amount in the Service’s accounts with which the

Service is authorized to make expenditures and pay liabilities. This amount includes clearing account

balances. The Service also receives reimbursement from federal agencies, state and local governments,

and the public for services rendered.

To the extent that the Service maintains fund balances in deposit, suspense, and clearing accounts that

are not available to finance its activities, those balances are reported as non-entity assets.

D . P ROPERTY AND E QUIPMENT , N E T , AND O THER

Property and equipment purchased individually that cost $50,000 or more is capitalized. Leasehold

improvements in excess of $50,000 are also capitalized. Depreciation is calculated on a straight-line

basis over the useful life of the asset. Other entity assets, included on the balance sheet, consist of

imprest funds, accounts receivable, advances, inventory and related property.

IRS has cancelable agreements with the General Services Administration for office space for a quarterly/monthly rental fee.

E . P ERMANENT AND I NDEFINITE A PPROPRIA TION

The Service uses a special class of appropriation, designated as "permanent and indefinite," to disburse

tax refund principal and related interest. This permanent and indefinite appropriation is not subject

to budgetary ceilings set by the Congress during the annual appropriation process. Because the

refunds, from a budgetary standpoint, are permanently funded by the Congress, refunds payable at

year-end are fully funded. The asset "Due from Treasury" designates this approved funding to pay yearend tax refund liabilities, which are reflected in the appropriations used for refund of federal taxes on

the statement of custodial activity along with tax refund payments for the year.
PUTTING SERVICE FIRST 4 7

Although funded through appropriations, refund activity is reported as a custodial activity of the Service.

This presentation is appropriate because refunds are, in substance, a custodial revenue-related activity in

that they are a direct result of taxpayer overpayments of their tax liabilities. Federal tax revenue received

from taxpayers is not available for use in the operation of the Service and is not reported on the statement

of net cost. Likewise, the resultant refunds of overpayments are not available for use by the Service in

operations.Consequently,to present refunds as an expense of the Service on the statement of net cost with

related appropriations used would be inconsistent with the reporting of the related federal tax revenue

and would materially distort the costs incurred by the Service in meeting its strategic objectives.

F . T A X A SSESSMENTS AND A B A TEMENTS

Under the Internal Revenue Code Section 6201, the Commissioner of the IRS, as delegated by the

Secretary of Treasury, is authorized and required to make inquiries, determinations, and assessments of

all taxes which have been imposed and accruing under any internal revenue law but which have not been

duly paid (including interest, additions to the tax, and assessable penalties). Unpaid assessments result

from taxpayers filing returns without sufficient payment; as well as from the Service’s enforcement programs, such as examination, underreporter, substitute for return, and combined annual wage reporting.

The Commissioner of the IRS also has authority to abate the paid or unpaid portion of an assessed tax,

interest, and penalty. Abatements occur for a number of reasons and are a normal part of the tax

administration process (e.g., correcting an assessment from an enforcement program, taxes discharged

in bankruptcy, accepted offers in compromise for less than the full amount of taxes owed, amended tax

returns, and penalty abatements for reasonable cause). The abatement process is also used by taxpayers

to contest assessments made due to mathematical or clerical errors, and for contesting an assessment

once the liability has been satisfied. Another form of abatement occurs when a qualifying corporation

claims a net operating loss that creates a credit that can be carried back to reduce a prior year’s tax liability. Abatements may result in claims for refunds or a reduction of the unpaid assessed amount.

G . F EDERAL T AXES R ECEIV ABLE

Federal taxes receivable and the corresponding liability, "Due to Treasury," are not accrued until related tax returns are filed, or assessments made, and prepayments netted against liabilities. Accruals are

made to reflect penalties and interest on taxes receivable through the balance sheet date.

The Statement of Federal Financial Accounting Standards (SFFAS) No. 7 is effective for fiscal year 1998,

although the Service implemented significant provisions related to federal taxes receivable during fiscal

year 1997. This standard distinguishes between amounts of unpaid assessments that should be reported as receivables on the financial statements (taxes receivable) and the compliance assessments and

write-offs that IRS discloses as supplemental information. A summary of each category follows.

Taxes receivable consist of unpaid assessments (taxes and associated penalties and interest), due from

taxpayers, for which the Service can support the existence of a receivable through taxpayer agreement,

such as filing of a tax return without sufficient payment, or a court ruling in favor of the IRS. Taxes

receivable are shown on the balance sheet net of an allowance for doubtful accounts. The allowance for

doubtful accounts reflects an estimate of the portion of total taxes receivable deemed to be uncollectible.
4 8

Compliance assessments are unpaid assessments in which neither the taxpayer nor a court has

affirmed that the taxpayer owes amounts to the Federal Government. Examples include assessments

resulting from an IRS audit or examination in which the taxpayer does not agree with the results of

the audit or examination.

Write-offs consist of unpaid assessments for which the Service does not expect further collections due

to factors such as taxpayers’ bankruptcy, insolvency, or death. These amounts are not reported on the

balance sheet; however,statutory provisions require that these accounts be maintained until the statute

for collection expires.

H . A CCRUED W ORKERS ’ C OMPENSA TION

The Federal Employees Compensation Act (FECA) program is administered by the U.S. Department of

Labor and provides income and medical cost protection to covered federal civilian employees who have

been injured on the job or have incurred a work-related occupational disease. The Service recognizes estimated incurred FECA costs for claims of IRS employees as a liability not covered by budgetary resources.

I . A CCRUED A NNUAL L E A V E

Accrued annual leave consists of accrued payroll and benefits that the Service’s employees have earned

but are unpaid at September 30, 1998. At the end of the year, the balance is adjusted to reflect current

wage rates and the net change in the amount of accrued leave earned and taken during the year.

Accrued annual leave is classified as a liability not covered by budgetary resources as the Service

expects to pay this accrued unfunded liability from future years’ appropriations.

J . A CTUARIAL L IABILITY FOR W ORKERS ’ C OMPENSA TION

The actuarial liability estimates for FECA benefits represent the expected liability for death, disability,

medical, and miscellaneous costs for approved compensation cases. In 1998, the liability was determined using the paid losses extrapolation method calculated over the next 37-year period. This

method uses historical benefit payment patterns related to a specific incurred period to predict ultimate payments related to that period.

K . F INANCING S OURCES AND E XCHANGE R EVENUE

The Service receives the majority of its funding through annual, multi-year, no-year, and trust fund

appropriations that are available for use within statutory limits for operating and capital expenditures.

Appropriations are recognized as financing sources when the related expenses are incurred. The

Service enters into reimbursable agreements with Treasury, bureaus of Treasury, and other federal entities to accomplish program objectives. Under these arrangements, IRS provides, or receives, goods or

services at an agreed-upon price that usually covers all applicable costs. Revenue from reimbursable

agreements is recognized when the services are provided. A liability is recognized when services are

rendered by the providing entity. The Service also receives revenue from user fees.

In addition, the IRS incurs certain costs that are paid in total or in part by other federal entities, such

as pension costs. These constitute subsidized costs and are recognized by IRS on its statement of changes

in net position as an imputed financing source equal to the cost paid by the other federal entity.
PUTTING SERVICE FIRST 4 9

NOTE 2 FUND BALANCE WITH TREASUR Y AND OTHER ( I N M ILLIONS )

Fund balance with Treasury and other consisted of the following as of September 30, 1998:

Appropriate and other funds $1,832 

Other Intragovernmental Entity Assets:

Accounts receivable, net 35

Advances to other government agencies 102

Subtotal: Other 137

Fund Balance with Treasury and Other $1,969

NOTE 3 FEDERAL T AXES RECEIV ABLE, NET

Federal taxes receivable (gross) was $81 billion as of September 30, 1998, and consisted of tax assessments, penalties, and interest which were not paid or abated, and which were agreed to by either the

taxpayer and the Service, or the courts.

Federal taxes receivable, net, equaled $26 billion as of September 30, 1998, and is the portion of federal taxes receivable (gross) estimated to be collectible. It is based on projections of collectibility from a

statistical sample of taxes receivable. An allowance for doubtful accounts of $55 billion was established

for the difference between the gross federal taxes receivable and the portion estimated to be collectible.

Due to Treasury is the offsetting liability to federal taxes receivable, representing amounts to be transferred to Treasury when collected.

NOTE 4 CONTINGENCIES

As of September 30, 1998, the Service identified and accrued liabilities of $17 million for pending and

threatened legal matters which, in the opinion of the Chief Counsel, are probable losses associated

with pending and threatened legal matters. These liabilities could change depending on the ultimate

outcome of cases. Further, additional losses from pending and threatened legal matters, considered

reasonably possible by the Chief Counsel, are estimated to be $8 million. The Service is also involved

in various legal actions for which amounts will be payable from the Judgment Fund in accordance

with 31 U.S.C. 1304. Of the $17 million accrued by the Service, $15 million will be payable from the

Judgment Fund for judgments and settlements relating to Service litigation and claims. Of the $8 million in reasonably possible losses, approximately $1 million will be payable from the Judgment Fund.

NOTE 5 NET POSITION ( I N M ILLIONS )

Net position as of September 30, 1998 was as follows:

Unexpected Appropriations:

Unobligated balances

Unrestricted $364

Restricted 70

Undelivered orders 963

Total Unexpended Appropriations 1,397

Change in Net Position (466 )

Net Position $931
5 0

Unexpended appropriations represent the amount of spending authorized as of year-end that is unliquidated or unobligated and had not lapsed, been rescinded, or withdrawn. No-year appropriations

remain available for obligation until expended. Annual appropriations remain available for upward or

downward adjustment of obligations until cancelled.

NOTE 6 NET COST OF OPERA TIONS ( I N M ILLIONS )

The schedule below details the net cost of operations by budget functional classifications:

EXPENSE CA TEGOR Y GENERAL GOVERNMENT

Personnel Compensation and Benefits $5,811

Rent 859

Equipment 339

Printing and Reproduction 70

Travel and Transportation 160

Other Services 647

Other 61

Subtotal 7,947

Less: Earned Revenues not Attributed to Programs ( 198 )

Net Cost of Operations $7,749

Personnel compensation and benefits includes $209 million in compensation and benefits for FICA

and Medicare which is also included as revenue on the statement of custodial activity.

NOTE 7 COLLECTIONS OF FEDERAL T AX REVENUE

Total tax collections are transferred by the Service to the U.S. Treasury. Collection activity, by financial statement line item and tax year, was as follows for the fiscal year ended September 30, 1998 (in

billions):

COLLECTIONS TAX YEAR

RECEIVED PRIOR

FY 1998 1998 1997 1996 YEARS

Individual income, FICA/SECA, and other $1,472 $ 948 $ 502 $11 $11

Corporate income 213 * 139 64 2 8

Excise 46 31 15 0 0

Estate and gift 25 0 22 1 2

Railroad retirement 5 4 1 0 0

Federal unemployment 6 5 1 0 0

Total $1,767 $1,127 $605 $14 $21

100 % 64 % 34 % 1% 1%

* Includes tax year 1999 corporate income tax receipts of $7 billion

Individual income, FICA/SECA, and other includes $44 billion in payroll taxes collected from other

federal agencies. Of this amount, $9 billion represents the portion paid by the employers.
PUTTING SERVICE FIRST 5 1

NOTE 8 FEDERAL T AX REFUND ACTIVITY

Refund activity, broken out similarly to collection activity by tax year, was as follows for the fiscal year

ended September 30, 1998 (in billions):

REFUNDS TAX YEAR

DISBURSED PRIOR

FY 1998 1998 1997 1996 YEARS

Individual income, FICA/SECA, and other $123 $1 $113 $6 $ 3

Corporate income 26 1 12 3 10

Excise 1 1 0 0 0

Estate and gift 1 0 1 0 0

Railroad retirement 0 0 0 0 0

Federal unemployment 0 0 0 0 0

Total $151 $3 $126 $9 $13

100 % 2 % 83 % 6% 9%

Individual income, FICA/SECA, and other refunds amount includes EITC refunds. The EITC was

originally authorized by the Tax Reduction Act of 1975 (Public Law 94-12) and made permanent by

the Revenue Adjustment Act of 1978 (Public Law 95-600). The EITC is a special credit for taxpayers

who work and whose earnings fall below the established allowance ceiling. Qualified taxpayers can

receive partial credit in advance in each paycheck.

In FY 98, IRS issued $23.2 billion in EITC refunds, of which $108 million was applied to advance EITC.

An additional $6.6 billion of the EITC credits were applied to reduce taxpayer liability.
5 2

SUPPLEMENT AL INFORMA TION

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998

Other Claims for Refunds

Management has estimated amounts that may be paid out as other claims for tax refunds. This estimate represents an amount (principal and interest) that may be paid for claims pending judicial review

by the Federal courts or, internally, by Appeals. The total estimated payout (including principal and

interest) for claims pending judicial review by the Federal courts is $9.8 billion and by Appeals is $14.9

billion. Although these refund claims have been deemed to be probable, they do not meet the criteria

in SFFAS No. 5 for reporting the amounts in the balance sheet or for disclosure in the notes to the

financial statements. However, they meet the criteria in SFFAS No. 7 for inclusion as supplemental

information.

Federal Taxes Receivable, Net (In Billions)

In accordance with SFFAS No. 7, some unpaid assessments do not meet the criteria for financial statement recognition as discussed in Note 1 to the financial statements.Although compliance assessments

and write-offs are not considered receivables under federal accounting standards, they represent legally enforceable claims of the IRS - acting on behalf of the federal government. There is, however, a 

significant difference in the collection potential of these categories.

The components of the total unpaid assessments and derivation of net federal taxes receivable at

September 30, 1998, were as follows:

Total unpaid assessments $222

Less: Compliance assessments ( 22 )

Write-offs ( 119 )

Gross Federal Taxes Receivable 81

Less: Allowance for doubtful accounts ( 55 )

Federal Taxes Receivable, net $ 26

The Service cannot reasonably estimate the amount of allowance for doubtful accounts pertaining to

its compliance assessments, and thus cannot determine their net realizable value nor the value of the

pre-assessment work-in-process.
PUTTING SERVICE FIRST 5 3

To eliminate double-counting, the compliance assessments reported above exclude trust fund recovery penalties, totaling $15 billion, assessed against officers and directors of businesses who were

involved in the nonremittance of federal taxes withheld from their employees. The related unpaid

assessments of those businesses are reported as taxes receivable or write-offs, but the Service may also

recover portions of those businesses’ unpaid assessments from any and all individual officers and

directors against whom a trust fund recovery penalty is assessed.

Schedule of Budgetary Resources by Major Budget Accounts (IN MILLIONS)

PROCESSING

ASSISTANCE & TAX LAW INFORMATION

MANAGEMENT ENFORCEMENT SYSTEMS OTHER TOTA L

BUDGET A R Y RESOURCES

Budget authority $2,965 $3,106 $1,369 $463 $7,903

Unobligated balances—

beginning of period 18 42 222 11 293

Spending authority from 

offsetting collections 34 70 6 22 132

Adjustments ( 83 ) 12 192 ( 28 ) 93

Total Budgetary Resources $2,934 $3,230 $1,789 $468 $8,421

S T A TUS OF BUDGET A R Y 

RESOURCES

Obligations incurred $2,907 $3,199 $1,731 $150 $7,987

Unobligated balances—

available 8 4 34 318 364

Unobligated balances—

not available 19 27 24 — 70

Total Status of Budgetary Resources $2,934 $3,230 $1,789 $468 $8,421

OUTLA Y S

Obligations incurred $2,907 $3,199 $1,731 $150 $7,987

Less: spending authority from offsetting

collections and adjustments 50 ( 102 ) ( 200 ) ( 19 ) ( 271 )

Obligated balance, net—

beginning of period 267 353 545 ( 2 ) 1,163

Less: obligated balances, net—

end of period ( 533 ) ( 295 ) ( 706 ) ( 8 ) ( 1,542 )

Total Outlays $2,691 $3,155 $1,370 $121 $7,337
5 4

Federal Managers’ Financial Integrity Act (FMFIA)

In accordance with the requirements of the Federal Managers’ Financial Integrity Act, the Service 

evaluated its systems of internal controls for the fiscal year ending September 30, 1998.

This summer, IRS managers conducted a thorough self-assessment of the management controls for

their operations and reported any deficiencies identified. This fall, the Service’s Senior Council for

Management Controls reviewed those reports and considered the audit findings reported this year to

determine whether new weaknesses needed to be reported. The Senior Council also reviewed existing

weaknesses to determine which weaknesses could be closed.

S ECTION 2

The Service is closing Computing Center Security, Deterrence and Detection of Return Filing Fraud,

Low Income Housing Credit, Non-resident Alien Withholding, Local Oversight of Locator Services

(Credit Bureau Security), and Quantifying and Accurately Reporting IRS’ Tax Assessments Needs

Improvement. The Service is reporting Use of Enforcement Statistics as a new material weakness.

S ECTION 4

The Service is closing the Excise Tax Certification Fiscal Non-conformance.

Annual Assurance Statement Fiscal Year 1998

Federal Managers’ Financial Integrity Act (FMFIA)

The Service provides qualified assurance that Section 2 and Section 4 objectives are being achieved. As

such, qualified assurance is provided that, overall, IRS internal control systems are adequate and effective in achieving the objectives of the Integrity Act.

Federal Financial Management Improvement Act (FFMIA)

As of September 30, 1998, the Service’s financial management systems did not substantially comply

with the FFMIA. Remediation plans are in place to resolve the material weaknesses causing this condition. Where appropriate, these plans and associated initiatives are contained in the IRS

Modernization blueprint.

Commissioner of Internal Revenue
PUTTING SERVICE FIRST 5 5

The Service is reviewing the following issues identified by GAO as part of its FY 1998 Financial

Statement Audit, and will develop corrective actions plans as appropriate:

• lack of subsidiary ledger and adequate documentation for unpaid assessments;

• weaknesses in controls related to excise tax certification, taxpayer receipts and data, and installment agreements;

• weaknesses in administrative activities, including subsidiary ledgers for accounts payable and

undelivered orders, reconciliation of fund balances with Treasury, and adequacy of support for

non-payroll related expenses; and

• weaknesses in refund controls related to (1) delays in matching tax returns to W-2’s and 1099’s,

and (2) the EITC program.

SECTION A: ST A TISTICAL SUMMAR Y OF PERFORMANCE

SECTION 2, INTERNAL CONTROL

NUMBER OF MA TERIAL WEAKNESSES

NUMBER REPORTED FOR THE YEAR, NUMBER THAT FOR THAT YEAR, NUMBER

FOR THE FIRST TIME IN HAVE BEEN CORRECTED STILL PENDING

Prior Years 52 47 5

1996 Report 2 1 1

1997 Report 5 1 4

1998 Report 1 0 1

Total 60 49 11

Of the total number corrected, how many were corrected in 1998? 6

E xhib it 10

SECTION 4, FINANCIAL MANAGEMENT SYSTEMS

NUMBER OF MA TERIAL NON-CONFORMANCES

NUMBER REPORTED FOR THE YEAR, NUMBER THAT FOR THAT YEAR, NUMBER

FOR THE FIRST TIME IN HAVE BEEN CORRECTED STILL PENDING

Prior Years 176 172 4

1996 Report 0 0 0

1997 Report 0 0 0

1998 Report 0 0 0

Total 176 172 4

Of the total number corrected, how many were corrected in 1998? 1

E xhib it 11
5 6

Prompt Payment Act

To ensure that Federal agencies pay private sector vendors in a prompt fashion, Congress passed the

Prompt Payment Act and the Office of Management and Budget (OMB) issued Circular A-125.

Generally, the Act requires payment within thirty days from the later of either the receipt of a proper

invoice or acceptance of the goods/services. If this is not met, an interest penalty must be paid to the

vendor. Within the Department of the Treasury, the standard for the late payment is that no more than

2% of the invoices subject to the prompt payment will be paid late (at least 98% paid within 30 days).

The Service’s prompt payment performance for the past two years is presented below. To ensure the

integrity of payment data, the Service does quarterly quality control reviews. To date, the reviews have

not revealed any significant errors that would have a material impact on the prompt payment data reported.

DESCRIPTION 1998 1997

1. All Invoices Paid Subject to Circular A-125 $798,326,041 $607,464,133

2. Number of Invoices Paid Subject to the Circular A-125 120,297 135,248

3. Dollar Value of Invoices Paid Late $46,147,743 $23,656,128

4. Interest Penalties Paid $86,609 $82,862

5. Number of Invoices Paid Late 3,761 3,308

6. Relative Frequency of Late payment Based on the 3.10% 2.45%

Total Number of Invoices Subject to the Circular 5/2

E xhib it 12

The slight decline in prompt pay performance from the prior fiscal year was primarily due to the

implementation of electronic receipt and acceptance. Receipt and acceptance is entered into

Procurement’s Request Tracking System (RTS) by users who request goods and/or services. The receipt

and acceptance information is subsequently interfaced for payment by the accounting payment offices.

The inherent inefficiencies associated with a manual to automated conversion were heightened by a

shift in resources necessary to develop user training for over 500 employees, including authoritative,

uniform guidance in the form of a CFO Standard Announcement, Processing Procedures and a Quick

Reference Guide. Once fully implemented, it is anticipated that this program will enhance future

prompt pay performance.

User Fees

Three authorities exist for the collection of user fees by the Service. Under 31 U.S.C. Section 9701, the

Service collects fees for Installment Agreements, Enrolled Agent Applications and Renewals, and

Advanced Art Determinations. Under Section 10511 of the Revenue Act of 1987, as amended, the

Service charges fees for requests for ruling letters, opinion letters, and determination letters and for

similar requests. Under I.R.C. Section 6103(p), the Service charges a fee for the reproduction of returns

and disclosure of return information.

The Service deposits receipts to the Treasury General Fund as required by 31 U.S.C. Section 3302(b) as miscellaneous receipts. Under the Treasury, Postal Service and General Government Appropriations Act of

1995, the Service may retain up to $119 million per fiscal year of new or increased user fee receipts providing the fees are based on the cost of providing the service. Under I.R.C. Section 7809(c)(1), fees collected under I.R.C. Section 6103(p) reimburse the appropriations that bore the costs of providing the services.
PUTTING SERVICE FIRST 5 7

As required, the Service conducts a review of the costing of user fees on a biannual basis for each fee.

During Fiscal Year 1998, the Service conducted reviews of all material fees for requests for ruling letters, opinion letters, and determination letters. During Fiscal Year 1997, we conducted reviews on these

fees as well as fees for installment agreements and fees for the reproduction of returns and disclosure

of return information. The fees charged to the public are set to recover full cost of the related programs

except where a lower fee was appropriate to promote tax compliance. The fees for Installment

Agreements are the only material fees set below full cost.

DESCRIPTION GENERAL FUND RET AINED

1998 1997 1998 1997

Installment Agreements N/A N/A $93.1 $85.7

Rulings, Opinion Letters, and Determinations $41.7 $45.1 2.5 4.4

Enrolled Agents .6 .2 .3 .2

Art Determinations N/A N/A .0 .1

Section 6103(p) N/A N/A 4.3 3.5

N/A: not applicable

E xhib it 13
5 8

Tax Burden

The Internal Revenue Code provides for progressive rates of tax, whereby higher incomes are generally subject to higher rates of tax. The chart below illustrates the latest available information on the taxable

income and related income tax for individuals by income level and for corporations by size of assets.

T AX BURDEN T ABLE

INDIVIDUAL INCOME T AX RETURNS ( T A X Y EAR 1996 D A T A )

Size of Adjusted Gross Income ( I N T HOUSANDS )

< $15 $15 to $30 $30 to $50 $50 to $100 $100 to $200 > $200

Total returns 42,673,765 29,547,114 22,116,289 20,160,813 4,612,244 1,524,048

Taxable income

(in thousands) $60,751,843 $322,967,109 $558,587,366 $976,861,175 $468,615,932 $712,936,340

Total tax liability

(in thousands) $10,726,679 $ 48,648,432 $93,949,993 $186,713,424 $115,008,844 $234,221,163

Tax burden % of

taxable income 17.66% 15.06% 16.82% 19.11% 24.54% 32.85%

Average Tax per Return $251.36 $1,646.47 $4,248.00 $9,261.21 $24,935.55 $153,683.59

CORPORA TE INCOME T AX RETURNS (T AX YEAR 1995 DA T A )

Size of T otal Assets ( I N M ILLIONS )

< $1 $1 to $10 $10 to $50 $50 to $100 $100 to $250 > $250

Total returns 4,053,016 356,591 41,448 8,359 7,216 7,537

Taxable income

(in thousands) $23,776,302 $24,489,972 $24,045,087 $14,844,318 $28,007,712 $449,569,626

Total tax liability

(in thousands) $5,734,339 $7,528,148 $7,788,947 $4,777,066 $8,767,868 $121,796,421

Tax burden % of

taxable income 24.12% 30.74% 32.39% 32.18% 31.31% 27.09%

Average Tax per Return $1,414.83 $21,111.44 $187,920.94 $571,487.74 $1,215,059.31 $16,159,801.11

Tax Expenditures (In Thousands)

Tax expenditures are the foregone federal revenue resulting from deductions and credits provided in

the Internal Revenue Code. Since tax expenditures directly affect funds available for government operations, decisions to forego federal revenue are as important as decisions to spend federal revenue.

The tax expenditures figure for deductions is calculated using the average tax burden percentage of taxable

income applied to the total deductions. Total credits against tax liability result directly in tax expenditure.

OTHER ACCOMP ANYING INFORMA TION

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
PUTTING SERVICE FIRST 5 9

A summary of certain categories of tax expenditures follows. Please note that the chart below presents the

latest available tax return data.

T AX EXPENDITURES T ABLE ( I N M ILLIONS )

INDIVIDUAL INCOME T AX RETURNS ( T A X Y EAR 1996 D A T A )

Deductions on Taxable Income Deductions & Credits Resulting Tax Expenditures

Basic std deduction $415,113,986 —

Additional std deduction 13,462,417 —

Itemized in excess of limitation 18,901,571 —

Medical & dental expense 26,787,262 —

Interest paid 227,625,566 —

Taxes paid 202,508,276 —

Charitable contribution 84,264,918 —

Total Deductions $988,663,996 $219,780,006

Average tax burden % 22.3%

Credits Against Tax Liability

Child care credit $2,530,689 —

Credit for the elderly or disabled 32,060 —

Foreign tax credit 3,147,731 —

General business credit 648,634 —

Minimum tax credit 636,343 —

Earned Income Tax credit, offset tax liability 5,763,150 —

Total Credits $12,758,607 $12,758,607

Total Expenditures—Individual Tax Returns $232,538,613

CORPORA TION INCOME T AX RETURNS (T AX YEAR 1995 DA T A )

Deductions

Net operating loss $57,135,546 —

Dividends received 23,365,442 —

Public utility dividends paid 71,598 —

Total Deductions $80,572,586 $22,310,549

Average tax burden % 27.69%

Credits

Foreign tax credit $30,420,276 —

U.S. possessions tax credit 3,056,017 —

Non conventional source fuel credit 732,031 —

General business credit 3,388,423 —

Total Credits $37,596,747 $37,596,747

Total Expenditures—Corporation Income Tax Returns $59,907,296
PUTTING SERVICE FIRST

FINANCIAL AUDIT

IRS’ FISCAL YEAR 1998

FINANCIAL STATEMENTS

UNITED STATES GENERAL ACCOUNTING

OFFICE REPORT TO THE SECRETARY OF

THE TREASURY
FINANCIAL AUDIT

IRS’ FISCAL YEAR 1998 FINANCIAL STATEMENTS

United States General Accounting Office

GAO Report to the Secretary of the Treasury

March 1999 FINANCIAL AUDIT

IRS' Fiscal Year 1998

Financial Statements

GAO/AIMD-99-75

6 2
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GAO United States

General Accounting Office

Washington, D.C. 20548

Comptroller General

of the United States

B-281967 

March 1, 1999

The Honorable Robert E. Rubin

The Secretary of the Treasury

Dear Mr. Secretary:

This report presents the results of our audit of the principal financial

statements of the Internal Revenue Service (IRS) for the fiscal year ending

September 30, 1998, which we performed in accordance with the Chief

Financial Officer’s Act of 1990, as expanded by the Government

Management Reform Act of 1994. It contains our (1) opinions on IRS’

balance sheet and statement of custodial activity, (2) disclaimers of

opinion on IRS’ statement of net cost, statement of changes in net position,

statement of budgetary resources, and statement of financing, (3) opinion

on IRS management’s assertion about the effectiveness of its internal

controls, and (4) conclusions on IRS’ compliance with significant

provisions of laws and regulations we tested and on whether its financial

management systems comply with the requirements of the Federal

Financial Management Improvement Act of 1996.

This report also discusses significant matters that we considered in

performing our audit and in forming our conclusions, including identified

weaknesses in IRS’ internal controls, noncompliance with laws and

regulations and the requirements of the Federal Financial Management

Improvement Act of 1996, and other matters that should be brought to the

attention of IRS management and users of IRS’ principal financial

statements and other reported IRS financial information. We will be

separately reporting in more detail and recommending corrective actions

to address the weaknesses in IRS’ internal controls and compliance with

laws and regulations issues discussed in this report.

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

Minority Members of the Senate Committee on Appropriations; Senate

Committee on Finance; Senate Committee on Governmental Affairs;

Senate Committee on the Budget; Subcommittee on Treasury, General

Government, and Civil Service, Senate Committee on Appropriations;

Subcommittee on Taxation and IRS Oversight, Senate Committee on

Finance; Subcommittee on Oversight of Government Management,

Restructuring, and the District of Columbia, Senate Committee on

Governmental Affairs; House Committee on Appropriations; House

Committee on Ways and Means; House Committee on Government

Page 1 GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements

6 3
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IRS’ FISCAL YEAR 1998 FINANCIAL STATEMENTS

B-281967 

Reform; House Committee on the Budget; Subcommittee on Government

Management, Information, and Technology, House Committee on

Government Reform; Subcommittee on Oversight, House Committee on

Ways and Means; and Subcommittee on Treasury, Postal Service, and

General Government, House Committee on Appropriations. We are also

sending copies of this report to the Chairmen and Vice Chairmen of the

Special Committee on the Year 2000 Technology Problem and Joint

Committee on Taxation, the Commissioner of the Internal Revenue

Service, the Director of the Office of Management and Budget, and other

interested parties. Copies will be made available to others upon request.

If I can be of further assistance, please call me at (202) 512-5500. This

report was prepared under the direction of Gregory D. Kutz, Associate

Director, Governmentwide Accounting and Financial Management Issues,

Accounting and Information Management Division, who can be reached at

(202) 512-3406.

Sincerely yours,

David M. Walker

Comptroller General

of the United States

Page 2 GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements

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Contents

Letter 1

Opinion Letter 6

Principal Financial

Statements

38

Balance Sheet 38

Statement of Net Cost 39

Statement of Changes in Net Position 40

Statement of Budgetary Resources 41

Statement of Financing 42

Statement of Custodial Activity 43

Notes to Financial Statements 44

Supplemental and

Other Accompanying

Information

51

Supplemental Financial Information - Unaudited 51

Other Accompanying Information - Unaudited 53

Management

Discussion and

Analysis

55

Appendix I 

Provisions of Internal

Revenue Code Tested

for the Fiscal Year

1998 Audit

83

Appendix II 

Comments From the

Internal Revenue

Service

84

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IRS’ FISCAL YEAR 1998 FINANCIAL STATEMENTS

Contents

Abbreviations

BPD Bureau of the Public Debt

CFO Chief Financial Officer

EITC Earned Income Tax Credit

FASAB Federal Accounting Standards Advisory Board

FFMIA Federal Financial Management Improvement Act of 1996

FFMSR Federal Financial Management Systems Requirements

FIA Financial Integrity Act

FMS Financial Management Service

GPRA Government Performance and Results Act

HI Hospital Insurance Trust Fund

IRS Internal Revenue Service

JFMIP Joint Financial Management Improvement Program

MD&A management discussion and analysis

OMB Office of Management and Budget

OTA Office of Tax Analysis

P&E property and equipment

SFFAS Statement of Federal Financial Accounting Standards

SGL U.S. Government Standard General Ledger

SMI Supplemental Medical Insurance Trust Fund

SSA Social Security Administration

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GAO United States

General Accounting Office

Washington, D.C. 20548

Comptroller General

of the United States

B-281967 

To the Commissioner of Internal Revenue

In accordance with the Chief Financial Officers’ Act of 1990, as expanded

by the Government Management Reform Act of 1994, this report presents

the results of our audit of the principal financial statements of the Internal

Revenue Service (IRS) for fiscal year 1998. The principal financial

statements report the assets, liabilities, net position, net costs, changes in

net position, budgetary resources, reconciliation of net costs to budgetary

obligations, and custodial activity related to IRS’ administration of its

responsibilities for implementing federal tax legislation, which include

collecting federal tax revenues, refunding overpayments of taxes, and

pursuing collection of amounts owed.

During fiscal year 1998, IRS combined the financial reporting of its

administrative1

 and custodial activities, which had previously been

reported and audited separately, into a single set of principal financial

statements.2

 This required IRS to include both administrative and custodial

activities on its balance sheet. Also, IRS has presented four principal

financial statements which were required for the first time for fiscal year

1998: the (1) statement of net cost, (2) statement of changes in net

position, (3) statement of budgetary resources, and (4) statement of

financing. As a result of these changes, comparison of IRS’ fiscal year 1998

principal financial statements with the fiscal year 1997 financial

statements would not be meaningful. Accordingly, these financial

statements reflect financial information as of and for the fiscal year ended

September 30, 1998, only.

IRS continues to face significant financial and other management

challenges and risks. Although focusing primarily on financial

management and federal taxes receivable and other unpaid assessments,

this report alerts readers to other significant issues facing IRS including tax

systems modernization, filing fraud, information systems security, and the

Year 2000 computer problem.3

 We reported on these issues in

1

IRS’ administrative activities include managing costs funded by appropriations and reimbursements

from other federal agencies, state and local governments, and the public.

2

The fiscal year 1997 results of IRS’ administrative activities were audited by the Department of the

Treasury Office of Inspector General. See Internal Revenue Service Accountability Report, Fiscal Year

1997, Department of the Treasury (March 1998).

3

The Year 2000 problem is rooted in the way dates are recorded and computed in automated

information systems. For the past several decades, systems have used two digits to represent the year,

such as “99” representing 1999, to conserve on electronic data storage and reduce costs. With this two

digit format, however, the Year 2000 is indistinguishable from 1900, or 2001, from 1901, etc. As a result,

system or application programs that use dates to perform calculations, comparisons, or sorting may

generate incorrect results or, worse, not function at all.

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January 1999 in our high-risk series update and a report on major

management challenges and program risks facing the Department of the

Treasury.4

 We realize that IRS’ ability to successfully meet the financial

management challenges it faces must be balanced with the competing

demands placed on its resources by its customer service and tax law

compliance responsibilities. However, it is critical that IRS rise to the

challenges posed by these financial management issues, because IRS’

success in achieving all aspects of its strategic objectives depends in part

upon reliable financial management information and effective internal

controls. It is also important to recognize that several of the financial

management issues raised in this report directly or indirectly affect IRS’

ability to meet its customer service and tax law responsibilities.

In summary, pervasive weaknesses in the design and operation of IRS’

financial management systems, accounting procedures, documentation,

recordkeeping, and internal controls, including computer security

controls, prevented IRS from reliably reporting on the results of its

administrative activities. IRS was able to reliably report on the results of its

custodial activities for fiscal year 1998, including tax revenue received, tax

refunds disbursed, and taxes receivable due from the public. However, this

achievement required extensive, costly, and time-consuming ad hoc

procedures to overcome pervasive and long-standing internal control and

systems weaknesses. IRS’ major accounting, reporting, and internal control

deficiencies include:

• an inadequate financial reporting process that resulted in IRS’ inability to

reliably prepare several of the required principal financial statements,

• the lack of a subsidiary ledger to properly manage unpaid assessments,

which has resulted in both taxpayer burden and lost revenue to the

government,

• deficiencies in preventive controls over tax refunds that have permitted

the disbursement of millions of dollars of fraudulent refunds,

• a failure to reconcile its fund balance to Treasury records during fiscal

year 1998,

• the inability to properly safeguard or reliably report its property and

equipment,

• vulnerabilities in computer security that may allow unauthorized

individuals to access, alter, or abuse proprietary IRS programs and data,

and taxpayer information,

4

See High-Risk Series: An Update (GAO/HR-99-1, January 1999) and Major Management Challenges and

Program Risks: Department of the Treasury (GAO/OCG-99-14, January 1999).

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• vulnerabilities in controls over tax receipts and taxpayer data that

increase the government’s and the taxpayers’ risk of loss or inappropriate

disclosure of sensitive taxpayer data, and

• an inability to provide assurance that its budgetary resources are being

properly accounted for, reported, and controlled.

These weaknesses, as they relate to IRS’ administrative activities,

prevented us from rendering an unqualified opinion on five of IRS’ six

principal financial statements. With respect to IRS’ custodial activities, we

were able, through extensive audit procedures, to verify that the reported

balances were reliable. However, the substantial deficiencies we identified

in our audit represent serious agencywide financial and other management

challenges that will require a substantial commitment of resources, time,

effort, and expertise to correct. IRS has acknowledged these weaknesses

and has plans in place or under development to address these challenges.

We will follow up in future audits to assess the effectiveness of these plans

in resolving these issues.

Opinions on Principal

Financial Statements

Our opinion on the statement of custodial activity is unqualified. The

statement of custodial activity and accompanying notes present fairly, in

all material respects, in conformity with federal accounting standards as

described in note 1, IRS’ fiscal year 1998 custodial activities. The basis of

accounting described in note 1 is a comprehensive basis of accounting

other than generally accepted accounting principles.

Our opinion on the balance sheet is qualified. Except for (1) the limitations

on the scope of our work resulting from insufficient evidence about the

reliability of the fund balance with Treasury and accounts payable, and the

resulting effect on net position, and (2) evidence that leads us to conclude

that property and equipment is likely to be materially understated, the

balance sheet and accompanying notes present fairly, in all material

respects, in conformity with federal accounting standards as described in

note 1, IRS’ assets and liabilities as of September 30, 1998.

We are unable to render an opinion on the statement of net cost, statement

of changes in net position, statement of budgetary resources, or statement

of financing because of limitations on the scope of our work resulting

from the balance sheet issues described in the previous paragraph, and

insufficient evidence about nonpayroll expenses and budgetary balances.

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Opinion on

Management’s

Assertion About the

Effectiveness of

Internal Controls

We evaluated IRS management’s assertion about the effectiveness of its

internal controls designed to provide reasonable assurance that the

following objectives are met:

• Reliability of financial reporting - transactions are properly recorded,

processed, and summarized to permit the preparation of principal

financial statements in accordance with federal accounting standards and

safeguarding of assets against loss from unauthorized acquisition, use, and

disposition.

• Compliance with applicable laws and regulations - transactions are

executed in accordance with laws governing the use of budget authority

and with other laws and regulations that could have a direct and material

effect on the principal financial statements and any other applicable laws,

regulations, and governmentwide policies identified by the Office of

Management and Budget (OMB) in Bulletin 98-08,5

 Appendix C, as

applicable.

IRS management asserted that, due to the material weaknesses in internal

controls presented in the agency’s fiscal year 1998 Federal Managers’

Financial Integrity Act (FIA) annual assurance statements to Treasury on

compliance with relevant internal control and accounting standards,

internal controls provided qualified assurance that misstatements, losses,

or noncompliance material in relation to the principal financial statements

would be prevented or detected on a timely basis.

Management made this assertion based on criteria under FIA and the OMB

Circular A-123, Management Accountability and Control. Our internal

control work would not necessarily disclose material weaknesses not

reported by IRS. However, due to material weaknesses in its financial

accounting, reporting, and safeguarding controls, which were also cited by

IRS in its fiscal year 1998 FIA assurance statements to Treasury, IRS cannot

provide reasonable assurance that (1) government assets, taxpayer funds,

and confidential taxpayer information are appropriately safeguarded,

(2) laws and regulations material to the principal financial statements are

complied with, and (3) financial or budgetary information reported by IRS

is accurate, timely, and meaningful to users. Consequently, we found that

IRS’ internal controls were not effective in satisfying the above objectives.

5

Audit Requirements for Federal Financial Statements, August 24, 1998.

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Compliance With

Laws and Regulations

and the Requirements

of FFMIA

Our tests of compliance with selected provisions of laws and regulations

disclosed one instance of noncompliance with laws and regulations which

we consider to be reportable under generally accepted government

auditing standards and OMB Bulletin 98-08. This concerns IRS’

noncompliance with a provision of the Internal Revenue Code concerning

the use of installment agreements to collect delinquent taxes. Also, due to

the limitations on the scope of our work discussed above, we were unable

to test compliance with the Anti-Deficiency Act, as amended.6

 We also

concluded that IRS’ financial management systems do not substantially

comply with the following requirements of the Federal Financial

Management Improvement Act of 1996 (FFMIA), which is reportable under

OMB Bulletin 98-08:

• Federal Financial Management Systems Requirements;

• applicable federal accounting standards; and

• the U.S. Government Standard General Ledger at the transaction level.

In its fiscal year 1998 FIA assurance statement to the Treasury, IRS also

concluded that its financial management systems do not comply with

FFMIA. The objective of our audit was not to provide an opinion on overall

compliance with laws, regulations, and requirements tested. Accordingly,

we do not express such an opinion.

Material Weaknesses During our audit of IRS’ fiscal year 1998 principal financial statements, we

identified six material weaknesses7

 in internal controls that may adversely

affect any decision by IRS’ management which is based, in whole or in part,

on information that is inaccurate because of these deficiencies. We were

unable to obtain, through substantive audit procedures, reasonable

assurance that IRS’ fund balance with Treasury, accounts payable, net

position, nonpayroll expenses and budgetary balances were reliable. In

addition, we found evidence that leads us to conclude that property and

6

The Anti-Deficiency Act, as amended (31 U.S.C. § 1341), prohibits officers and employees of the

Federal government from (1) making or authorizing an expenditure or obligation exceeding an amount

in an appropriation or fund for the expenditure or obligation, or (2) involving the Federal government

in a contract or obligation for the payment of money before an appropriation is made unless

authorized by law.

7

A material weakness is a reportable condition in which the design or operation of the internal control

elements does not reduce to a relatively low level the risk that errors, fraud, or noncompliance in

amounts that would be material in relation to the principal financial statements being audited may

occur and not be detected within a timely period by employees in the normal course of performing

their assigned functions. Reportable conditions are matters coming to our attention that, in our

judgment, should be communicated because they represent significant deficiencies in the design or

operation of internal control that could adversely affect IRS’ ability to meet the objectives described in

this report.

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equipment is likely materially understated. Unaudited financial

information reported by IRS, including budget and performance

information, may also contain misstatements resulting from these

deficiencies. In addition, some of these material weaknesses have allowed

inappropriate refund payments and errors in taxpayer accounts, resulting

in increased taxpayer burden. These material weaknesses relate to IRS’

• financial reporting process,

• supporting subsidiary ledger and documentation for unpaid assessments,

• controls over refunds,

• controls over fund balance with Treasury,

• controls over property and equipment, and

• computer security.

In our report on IRS’ fiscal year 1997 custodial financial statements,8

 we

reported a material weakness in IRS’ revenue accounting and reporting

because of its inability to (1) separately report Social Security, Hospital

Insurance,9

 and individual income taxes collected on its statement of

custodial activity for fiscal year 1997 as required by OMB’s form and

content of governmentwide financial statements,10 and (2) determine the

amount of excise tax revenue it collected for the relevant trust funds. We

also noted that effective for fiscal year 1998, federal accounting standards

would require IRS to separately report Social Security, Hospital Insurance,

and individual income taxes. However, during fiscal year 1998, the Federal

Accounting Standards Advisory Board (FASAB)11 provided clarification on

the federal accounting standards requirement and OMB provided

clarification noting that agencies are allowed flexibility in the

classification of tax revenues on the statement of custodial activity. IRS’

presentation of federal tax revenues on its fiscal year 1998 statement of

custodial activity is consistent with federal accounting standards and OMB

reporting requirements. Accordingly, we no longer consider this issue to

be a material weakness since it does not materially affect IRS’ principal

8

See Financial Audit: Examination of IRS’ Fiscal Year 1997 Custodial Financial Statements

(GAO/AIMD-98-77, February 26, 1998).

9

The Hospital Insurance Trust Fund (HI) is one of two trust funds comprising the accumulated funds

of the Medicare program. The other Medicare trust fund is the Supplemental Medical Insurance Trust

Fund (SMI). Of these trust funds, only HI receives distributions from the Treasury’s general revenue

fund.

10OMB’s Formats and Instructions for the Form and Content of the Financial Statements of the U.S.

Government (September 2, 1997).

11FASAB considers and recommends accounting standards and principles for the Federal government

considering the financial and budgetary information needs of congressional oversight groups,

executive agencies, and the needs of other users of federal financial information.

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financial statements. However, we still consider this limitation to be a

reportable condition as discussed later in this report.

IRS’ Financial Reporting

Controls Are Inadequate

IRS does not have internal controls over its financial reporting process

adequate to provide reasonable assurance that its principal financial

statements are fairly presented. As a result, IRS (1) was unable to prepare

reliable statements of net cost, changes in net position, budgetary

resources, and financing, and (2) could not support material amounts

reported on its balance sheet, including fund balance with Treasury,

accounts payable, and net position. In addition, we found evidence that

leads us to conclude that property and equipment is likely materially

understated. These weaknesses also left IRS reliant on extensive and labor

intensive compensating ad hoc procedures to enable it to report reliable

revenue and refund balances on its statement of custodial activities, and

reliable tax refunds payable, taxes receivable and the corresponding

liability to Treasury amounts on its balance sheet. We found that

• the custodial and administrative general ledger systems which support the

principal financial statements are not in conformance with the U.S.

Government Standard General Ledger (SGL)12 at the transaction level and

do not provide a complete audit trail for recorded transactions,

• material balances reported on IRS’ principal financial statements are not

supported by detailed subsidiary records, and

• IRS’ principal financial statements are not subject to management oversight

adequate to provide reasonable assurance that significant errors and

omissions are identified and corrected before they are issued.

During our audit of IRS’ fiscal year 1997 custodial financial statements,13 we

reported that IRS’ general ledger system for its custodial activities was not

able to routinely generate the information on custodial assets and

liabilities needed to prepare principal financial statements, and did not use

the standard federal accounting classification structure or provide a

complete audit trail. During fiscal year 1998, these problems continued. IRS

was again unable to rely on its custodial general ledger to support related

amounts on the principal financial statements.

We also found problems that affected IRS’ administrative general ledger.

IRS’ general ledger for its administrative activities does utilize the SGL

12The SGL establishes the general ledger account structure for federal agencies as well as the rules for

agencies to follow in recording financial events.

13See GAO/AIMD-98-77, February 26, 1998.

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account structure. However, it does not conform to the SGL at the

transaction level since it does not provide an adequate audit trail for

significant administrative activities including property and equipment,

accounts payable, nonpayroll expenses, and undelivered orders. For

example, IRS’ property and equipment system does not interface with its

general ledger system. Also, IRS initially records property and equipment

purchases in its operating expense account, and at year-end posts entries

to record the purchases in the property and equipment general ledger

account. Our testing of nonpayroll operating expenses revealed that

property and equipment purchases were inappropriately included as

operating expenses.

Implementation of the SGL is required by the Core Financial System

Requirements of the Joint Financial Management Improvement Program,14

and OMB Circular A-127. FFMIA also requires financial systems that

implement the SGL at the transaction level. Because of the problems

discussed above, IRS’ general ledgers do not comply with these

requirements. In addition, IRS does not consistently capture costs to permit

it to routinely prepare reliable cost-based performance measures for

inclusion in its management discussion and analysis which accompanies

its principal financial statements, or to prepare the information to be

included in its annual performance plan as required by the Government

Performance and Results Act (GPRA) of 1993.

Also, IRS does not have a detailed subsidiary ledger for undelivered orders,

taxes receivable or accounts payable. For example, IRS relies upon a

detailed transaction history to support its balance for accounts payable.

However, this transaction history includes all transactions which have

been recorded in accounts payable, including amounts that have since

been paid and are therefore no longer payables. As a result, IRS cannot

readily determine the basis for the reported total nor determine the basis

for the total amount owed to each of its creditors. In addition, the detailed

history for nonpayroll expenses included transactions which were not

valid current year expenses, such as property and equipment and prior

year expenses. As a result, we were unable to verify that total nonpayroll

expenses were reliable.

In an effort to overcome these pervasive deficiencies, IRS employs a costly,

labor intensive and time-consuming process involving extensive and

14The Joint Financial Management Improvement Program (JFMIP) is a cooperative undertaking of the

Office of Management and Budget, the Department of the Treasury, the Office of Personnel

Management, and GAO, working in cooperation with each other and with operating agencies to

improve financial management practices.

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complex analysis and ad hoc procedures to assist in preparing its principal

financial statements. IRS continues to utilize specialized computer

programs to extract information from data bases underlying the

administrative and custodial general ledgers to derive and/or support

amounts to be reported in the principal financial statements. For example,

IRS must use this process to identify the portion of its unpaid assessments

that represent taxes receivable for financial reporting purposes. However,

similar to fiscal year 1997, the amounts produced by this approach needed

material audit adjustments to produce reliable financial statement

balances. With respect to IRS’ administrative activities, this approach was

unsuccessful in producing reliable balances.

In addition, IRS’ basic approach was designed specifically for the narrowly

defined purpose of preparing auditable balances at year end only. This

mechanism is not capable of producing reliable agencywide principal

financial statements or financial performance information to measure

results throughout the year as a management tool, which is standard

practice in private industry and some federal entities. Also, for custodial

activities, even the successful application of this approach at year-end

requires extensive technical knowledge of IRS’ master files—its data base

of taxpayer information—which is possessed by only a limited number of

key individuals. Should these individuals become unavailable for any

reason, this approach could cease to be a viable option, and IRS will be

forced to rely on a financial reporting process which, in the absence of

such specialized expertise, cannot generate reliable custodial balances.

Also, IRS’ previously separate financial reporting processes for its custodial

and administrative activities, respectively, have not been integrated under

unified supervision at the operational level. This unnecessarily

complicates IRS’ year-end financial reporting process and hampers efforts

to provide interim IRS-wide financial information as a management tool.

IRS’ complex and often manual financial reporting process requires

extensive technical computer and accounting expertise, and is highly

vulnerable to human error. It is therefore critical that this process be

adequately staffed and supervised, and be subject to adequate

management oversight at each stage as balances and disclosures are

developed. Similarly, the final financial statements should be carefully

reviewed by senior IRS management prior to public issuance to ensure they

are in accordance with all applicable standards and meet the objectives of

management.

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However, we found that IRS’ financial reporting process often lacked these

basic controls. For example, during fiscal year 1998, key personnel with

responsibilities for financial systems and reporting on IRS’ administrative

activities left IRS and had not been replaced by year-end. Consequently, IRS

was compelled to attempt to prepare its financial statements without the

necessary staff. These problems were compounded by the implementation

of new federal accounting and reporting requirements which required IRS

to prepare four new financial statements. In addition, throughout the

process, we found numerous errors and omissions in financial reporting

documentation as well as draft financial statements themselves, which

likely would have been caught and corrected had these records been

appropriately reviewed by management.

IRS Continues to Lack a

Subsidiary Ledger and

Adequate Supporting

Documentation for Unpaid

Assessments

As we have previously reported,15 IRS does not have a detailed listing, or

subsidiary ledger, which tracks and accumulates unpaid assessments and

their status16 on an ongoing basis. This condition adversely affects IRS’

ability to effectively manage and accurately report unpaid assessments. As

a result, IRS is unable to readily identify and focus collection efforts on

those accounts most likely to prove collectible,17 and cannot readily

prevent or detect and correct errors in taxpayer accounts. This condition

has resulted in instances of unnecessary taxpayer burden. In addition, IRS

continues to experience difficulty locating and providing adequate

supporting documentation for individual unpaid assessment balances.

To compensate for the lack of a subsidiary ledger, IRS runs computer

programs against its master files to identify, extract, and classify the

universe of unpaid assessments for financial reporting purposes. However,

this approach is only designed for the limited purpose of allowing IRS to

report auditable financial statement totals at year-end, and is not an

adequate substitute for a reliable subsidiary ledger which provides an

15See GAO/AIMD-98-77, February 26, 1998.

16Unpaid assessments consist of (1) taxes due from taxpayers for which IRS can support the existence

of a receivable through taxpayer agreement or a favorable court ruling (federal taxes receivable),

(2) compliance assessments where neither the taxpayer nor the court has affirmed that the amounts

are owed, and (3) write-offs, which represent unpaid assessments for which IRS does not expect

further collections due to factors such as the taxpayer’s death, bankruptcy, or insolvency. Of these

three classifications of unpaid assessments, only federal taxes receivable are reported on the principal

financial statements. As of September 30, 1998, IRS reported $26 billion (net of an allowance for

doubtful accounts of $55 billion), $22 billion, and $119 billion in these three categories, respectively.

17It should be noted that, despite the fact that certain taxpayer accounts have little likelihood of

collection, IRS would generally continue some efforts to collect, to reinforce continued compliance by

those taxpayers who appropriately report and pay their tax obligations and to increase compliance by

taxpayers who are not compliant with respect to reporting and paying their tax obligations.

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accurate outstanding balance for each taxpayer on an ongoing basis.

Without this information, IRS cannot ensure that payments and

assessments are promptly posted to the appropriate taxpayer accounts.

We found in our sample of fiscal year 1998 unpaid assessments that this

problem resulted in inaccurate taxpayer account balances, and led to IRS

pursuing collection efforts against taxpayers that had already paid their

taxes in full. In addition, in our sample we found that IRS inappropriately

issued refunds to taxpayers with outstanding tax assessment balances.

For example, when a company does not pay IRS the taxes that have been

withheld from employee’s wages, such as Social Security or individual

income tax withholdings, IRS has the authority to assess the responsible

officers individually for the amount withheld from employees. Thus, IRS

may record assessments against several individuals (officers) each for the

employee withholding component of the payroll tax liability in an effort to

collect the total tax liability of the business. While these

assessments—known as trust fund recovery penalties—are a necessary

enforcement tool, IRS’ current systems cannot automatically link each of

the multiple assessments made to one tax liability. This is due to the fact

that the corporation’s tax liability is maintained in IRS’ business master

files, while the trust fund recovery penalties assessed against the

corporation’s officers are maintained in the individual master files. These

are two separate databases, each of which is independent of the other. In

fact, in numerous unpaid payroll tax cases we reviewed involving multiple

assessments, we found that payments were not accurately recorded to

reflect each responsible party’s reduction in tax liability. Also, we found

that IRS’ failure to quickly identify and assess responsible officers resulted

in refunds being sent to those officers that could have been offset by IRS

against amounts due.

We previously reported that IRS had significant problems locating

supporting documentation for unpaid assessment transactions. To address

this issue, we worked closely with IRS and identified various forms of

documentation to support these items, and we requested these documents

in performing our fiscal year 1998 testing. We did note some improvement

in the documentation. For example, estate case files we reviewed

generally contained an independent appraisal of the estate’s assets.

However, we continued to find that IRS experienced difficulties in

providing other supporting documentation. For example, bankruptcy case

files frequently did not include the information necessary to verify the IRS’

creditor status. In addition, nonestate installment agreement cases rarely

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contained documentation sufficient to validate all of the installment

agreements.

The lack of adequate supporting documentation may make it difficult for

IRS to readily identify and focus collection efforts. The lack of

documentation also made it difficult to assess the classification and

collectibility of unpaid assessments reported in the principal financial

statements as federal tax receivables. Through our audit procedures, we

were able to verify the existence and proper classification of unpaid

assessments and obtain reasonable assurance that reported balances were

reliable. However, this required tens of billions of dollars of audit

adjustments to IRS’ principal financial statements to correct misstated and

duplicate unpaid assessment balances identified by our testing.

Continued Weaknesses in

Controls Over Refunds

We previously reported18 that IRS did not have sufficient preventive

controls over refunds to reduce to an acceptable level the risk that

inappropriate payments for tax refunds will be disbursed. We found that in

fiscal year 1998, inappropriate refund payments continued to be issued

due to (1) IRS comparing the information on tax returns and third party

data such as W-2s (Wage and Tax Statement) too late to identify and

correct discrepancies between these documents, (2) significant levels of

invalid Earned Income Tax Credit (EITC) claims, and (3) deficiencies in

controls that allowed duplicate refunds to be issued. We also found

instances of erroneous refunds being issued as a result of errors or delays

in posting assessments to taxpayer accounts. Although IRS has detective

(post-refund) controls in place, the lack of sufficient preventative controls

exposes the government to potentially significant losses due to

inappropriate disbursements for refunds. According to IRS’ records, IRS’

investigators identified over $17 million in alleged fraudulent refunds that

had been disbursed during the first 9 months of calendar year 1998 and

prevented the disbursement of an additional $65 million in alleged

fraudulent refund claims. During calendar year 1997, IRS’ records indicate

that intervention by IRS investigators prevented the disbursement of

additional alleged fraudulent refund claims totaling over $1.5 billion.

However, the full magnitude of invalid refunds disbursed by IRS is

unknown.

As we have previously reported, IRS does not compare tax returns to

accompanying W-2s until months after the tax return has been processed.

As a result, we found differences between these documents that were not

18See GAO/AIMD-98-77, February 26, 1998.

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detected by IRS. These differences could indicate an invalid refund claim

filing that is not being detected in time to prevent the disbursement of

incorrect refund amounts. We also found instances where inappropriate

refunds were issued as a result of errors or delays in posting tax

assessments to taxpayers accounts. For example, we identified a case

where a taxpayer who owed taxes was erroneously issued a refund

because the tax assessment had not yet been posted to the taxpayer’s

account. Errors and posting delays such as these also impair IRS’ ability to

effectively offset refunds due taxpayers against amounts owed by the

same taxpayers on another account. For example, IRS does not always

properly offset refunds against other amounts owed by individuals. Most

frequently, we noted this was a problem where multiple payees were

responsible for the same unpaid assessment. In some cases we reviewed

involving unpaid payroll taxes, individuals received a refund even though

amounts were owed by their businesses.

As we previously reported, EITC have historically been vulnerable to high

rates of invalid claims.19 During fiscal year 1998, IRS reported that it

processed EITC claims totaling over $29 billion, including over $23 billion

(79 percent) in refunds.20 In an effort to minimize losses due to invalid EITC

claims, IRS electronically screens tax returns claiming EITC to identify those

exhibiting characteristics considered indicative of potentially questionable

claims based on past experience, and then selects those claims considered

most likely to be invalid for detailed examination. During fiscal year 1998,

IRS examiners reviewed over 290,000 tax returns claiming $662 million in

EITC, of which $448 million (68 percent) was found to be invalid. These

examinations are an important control mechanism for detecting

questionable claims and providing a deterrent to future invalid claims.

However, because examinations are often performed after any related

refunds are disbursed, they cannot substitute for effective preventative

controls designed to identify invalid claims before refund disbursement. In

fiscal year 1998, IRS began implementing a 5-year EITC compliance initiative

intended to expand customer service to increase taxpayer awareness of

their rights and responsibilities related to EITC, strengthen enforcement of

EITC requirements, and enhance research into the sources of EITC

noncompliance. However, most of IRS’ efforts under that initiative had not

progressed far enough at the time we completed our audit work for us to

make any judgment about their effectiveness.

19High Risk Series: An Update (GAO/HR-99-1, January 1999), and Major Management Challenges and

Program Risks: Department of the Treasury (GAO/OCG-99-14, January 1999).

20EITC claims do not always result in refunds. They may also reduce tax assessments.

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As we have previously reported, IRS is also vulnerable to issuance of

duplicate refunds allowed by gaps in its internal controls. IRS’ manual and

automated systems are not properly coordinated to prevent identical

refunds from being processed through both systems. For example, we

identified three refunds which were paid twice. In each case, IRS processed

one manually, and the other through automated procedures. Since IRS

systems were not coordinated to compare the two, both were paid. IRS

reported this condition as a material weakness in its fiscal year 1998 FIA

assurance statement to Treasury. While we were able to substantiate the

amounts of refunds disbursed as reported on IRS’ fiscal year 1998 principal

financial statements, IRS nevertheless lacks effective preventive controls to

minimize its vulnerability to payment of inappropriate refunds. Once an

inappropriate refund has been disbursed, IRS is compelled to expend both

the time and expense to attempt to recover it, with dubious prospect of

success.

IRS Did Not Reconcile Its

Fund Balance With

Treasury

During fiscal year 1998, IRS did not reconcile its administrative fund

balance with Treasury accounts, in accordance with federal accounting

standards.21 Treasury policy and prudent financial management practices

require an agency to routinely reconcile its fund balance with Treasury

accounts to Treasury’s records. Reconciling these accounts involves

identifying differences between IRS and Treasury records, determining the

reason for the differences, and correcting them. Differences arise when

either IRS or Treasury erroneously records or delays recording of deposits

and disbursements to IRS cash accounts. Correcting such differences

should result in adjustments to either Treasury’s or IRS’ records, or both.

This process is similar to a company or individuals reconciling their

checkbook to the monthly bank statement.

In January 1999, IRS’ contractor provided what it considered to be

reconciliations of IRS’ Treasury fund balance for the 12 months of fiscal

year 1998. However, we found that these efforts were inadequate in

several respects. For example, material amounts on the reconciliations for

Treasury and IRS balances did not agree with Treasury and IRS records, and

reconciling items listed on the reconciliations were not investigated and

resolved. Similarly, IRS has not been investigating and resolving amounts in

its administrative suspense accounts. As of September 30, 1998, IRS had

items totaling a net credit balance of over $100 million in its fund balance

21Statement of Federal Financial Accounting Standards No. 1 Accounting for Selected Assets and

Liabilities.

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with Treasury suspense account, including some items dating back to 1989

appropriations.

Lack of timely, thorough reconciliations makes it difficult if not impossible

for IRS to determine if operating funds have been properly spent, or if

reported amounts for operating expenses, assets, and liabilities are

reliable. Without performing such reconciliations, IRS has no assurance

that its fund balance with Treasury is accurate. Lack of reconciliations

also impact IRS’ ability to ensure that it complies with the law governing

the use of its budget authority. Because this fundamental internal control

was not followed, we were unable to conclude whether IRS’ fund balance

with Treasury account was reliable at September 30, 1998. This

contributed to our qualification on IRS’ fiscal year 1998 balance sheet. For

the future, it will be important for IRS to prepare these reconciliations

monthly, and timely resolve any differences. Absent timely, appropriate

reconciliations of fund balance with Treasury, this historically problematic

area for IRS will continue to affect its ability to produce reliable financial

information.

Weaknesses in Controls

Over Property and

Equipment Records

As previously reported,22 IRS’ controls over its property and equipment

(P&E) records are not adequate to ensure that these records provide a

complete and reliable record of P&E assets. IRS cannot ensure the

completeness of its reported P&E balance because it does not have policies

and procedures in place to ensure that all P&E purchases are identified and

capitalized at the appropriate cost in accordance with federal accounting

standards.23 Consequently, P&E balances are likely materially understated.

IRS also does not record individual property transactions in its general

ledger P&E account throughout the year. Instead, IRS records adjustments

at year-end for all property activity during the year. Consequently, the

general ledger does not contain the transaction detail information

necessary to allow IRS to reconcile it to the P&E detailed records.

Weaknesses in IRS’ controls over P&E on hand increase its vulnerability to

loss. IRS reported P&E controls as a material weakness in its fiscal year 1998

FIA assurance statement to Treasury. This issue was also reported as a

material weakness by the Department of the Treasury’s Office of Inspector

General in its report on IRS’ fiscal year 1997 administrative financial

22Financial Audit: Examination of IRS’ Fiscal Year 1996 Administrative Financial Statements

(GAO/AIMD-97-89, August 29, 1997).

23Statement of Federal Financial Accounting Standards (SFFAS) No. 6 Accounting for Property, Plant,

and Equipment (effective beginning with fiscal year 1998).

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statements. The effects of these weaknesses, taken together resulted in

our concluding that P&E is likely to be materially understated.

The Comptroller General’s Standards for Internal Controls in the Federal

Government require that documentation of transactions or other

significant events be complete and accurate. Property and equipment

subsidiary records need to be promptly updated to reflect changes due to

purchases and dispositions. In addition, all transactions should be

accurately recorded, and balances should be periodically reconciled to the

general ledger and to the results of physical inventories of P&E on hand.

Without current and accurate records, IRS cannot ensure that the P&E items

it owns are not lost or stolen, that new purchases of equipment are

appropriately capitalized in its accounting records, or that related

principal financial statements balances are reliable.

We found evidence in our audit work that IRS does not have policies and

procedures in place to ensure that material P&E are recorded in IRS’

financial statements. For example, IRS’ computer systems information

shows substantial funding available and used for computer systems, such

as mainframe consolidation and a new receipts processing system. IRS’

computer systems information also shows evidence of contractor services

related to design, plans, and specifications for computer hardware and

software projects—costs required to be capitalized under federal

accounting standards. Also, IRS’ financial records show equipment-related

expenses of $339 million in fiscal year 1998.

Although this significant P&E activity occurred, only about $30 million was

recognized as P&E additions in fiscal year 1998. We also saw evidence of

substantial unrecorded capital expenditures in fiscal year 1997. These

problems are compounded by IRS’ use of a $50,000 minimum financial

statement cost capitalization threshold as permitted by Treasury policy.

This amount far exceeds the cost of most of the P&E items IRS purchases

and results in a material distortion of IRS’ reported P&E in its financial

statements. We found, based on assets included in IRS’ property systems,

that $1.2 billion or 69 percent of IRS’ gross P&E was not included in property

and equipment in the financial statements because of the use of this

threshold to capitalize P&E assets. Although IRS uses the $50,000 minimum

for financial reporting purposes, it uses a much lower threshold for

recording and tracking P&E in its subsidiary systems.

In addition to the P&E completeness problem, IRS’ policies and procedures

for recording P&E transactions impede its ability to reconcile the general

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ledger to related P&E subsidiary records. IRS’ field offices record individual

property acquisitions and dispositions on site throughout the year.

However, IRS’ accounting system expenses property purchases during the

year, then records adjustments at year end to reflect P&E dispositions, and

to move property purchases from expenses to P&E based on subsidiary

records maintained in the field offices. As a result, IRS has no assurance

that the amounts it records in its general ledger and underlying P&E

subsidiary systems, respectively, are complete and agree with each other.

IRS is compelled to manually adjust the general ledger at year end to force

it to agree with its P&E subsidiary records. In making this adjustment, IRS

attempts to eliminate from its nonpayroll operating expenses the P&E

additions for the fiscal year. However, IRS has no assurance that the

amount it removes from nonpayroll operating expenses for specific P&E

additions reflects the actual amount paid.

Because IRS ultimately relies on its subsidiary P&E records to support the

reported P&E balance, we tested the reliability of those records by

attempting to physically verify the existence of selected property items.

However, we found that IRS was unable to locate 10 (7 percent) of the 153

items we selected for review from IRS detailed records of P&E, including

items such as a Chevrolet Blazer motor vehicle, a laptop computer, and a

laser printer costing over $300,000. Additionally, we found that 10

(7 percent) of 141 items we selected from the floor of IRS’ field offices were

not included in IRS’ detailed property records, including items such as a

television, a facsimile machine, and a video cassette recorder. We also

found instances where different IRS field offices had recorded substantially

identical items at significantly different costs. For example, the cost IRS

assigned to substantially identical machines used to sort and open mail

ranged from $300,000 to $1,000,000 at different field offices.

We observed IRS staff conducting physical inventories of P&E at two field

offices. At one office, of 130 computer equipment assets each costing over

$50,000 identified from IRS P&E records, IRS staff were unable to locate 19

(15 percent). In addition, 20 (5 percent) of 443 items identified from the

floor were not included in IRS’ P&E records. At a different office, we found

that 11 of 12 (91 percent) items over $50,000 that had been disposed of had

not been removed from the P&E records. We also found problems with IRS’

internal controls over physical inventories of P&E. An April 1998 IRS

internal audit report on the Northeast Region noted that P&E inventory

procedures for computer equipment and software were not effective for

maintaining an accurate inventory or consistently followed by all districts

in the region. Also, IRS reported that district management did not ensure

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that the computer property records were always updated to reflect an

accurate inventory. These discrepancies and reported problems reflect

weaknesses in IRS property management controls that impair its ability to

ensure that P&E are used only in accordance with IRS policy and that

related records are accurate.

Controls Over Computer

Security Are Inadequate

As we have previously reported,24 IRS has significant and long-standing

weaknesses in controls over its computer information systems. IRS places

extensive reliance on these computer information systems to perform its

basic functions such as processing tax returns, maintaining sensitive

taxpayer data, calculating interest and penalties, and generating refunds.

Consequently, such weaknesses could render IRS unable to perform these

vital functions, or result in the unauthorized disclosure, modification, or

destruction of taxpayer data. In December 1998, we reported that as of

July 1998, IRS was significantly progressing in improving its computer

security.25 For example, IRS has centralized responsibility for IRS’ security

and privacy issues in its Office of Systems Standards and Evaluation. The

office is implementing a servicewide security program to manage risk and

has led IRS’ efforts in mitigating about 75 percent of the weaknesses

identified in our April 1997 report.26

We found, however, serious weaknesses continued to exist in the

following six functional areas: (1) security program management,

(2) access control, (3) application software development and change

controls, (4) system software, (5) segregation of duties, and (6) service

continuity. Continued weaknesses in these areas can allow unauthorized

individuals access to critical hardware and software where they may

intentionally or inadvertently add, alter, or delete sensitive data or

programs. Such individuals can also obtain personal taxpayer information

and use it to commit financial crimes in the taxpayers’ name (identity

fraud), such as fraudulently establishing credit, running up debts, and

taking over and depleting banks accounts. IRS has agreed with our

recommendations to address these problems and stated that our

conclusions and recommendations were consistent with its ongoing

actions to improve system security and mitigate the remaining

24See IRS Systems Security: Tax Processing Operations and Data Still at Risk Due to Serious

Weaknesses (GAO/AIMD-97-49, April 8, 1997) and GAO/AIMD-98-77, February 26, 1998.

25IRS Systems Security: Although Significant Improvements Made, Tax Processing Operations and

Data Still at Serious Risk (GAO/AIMD-99-38, December 14, 1998).

26See GAO/AIMD-97-49, April 8, 1997.

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weaknesses. We will follow up during future audits to assess the

effectiveness of IRS’ efforts to resolve these problems.

Reportable Conditions In addition to the material weaknesses discussed above, we identified two

reportable conditions which, although not material to the principal

financial statements, represent significant deficiencies in the design or

operation of internal controls which could adversely affect IRS’ ability to

meet the internal control objectives described in this report. These

conditions concern weaknesses in IRS’ internal controls over (1) manually

processed tax receipts and taxpayer information and (2) revenue reporting

and distribution to trust funds.

Inadequate Physical

Security Over Manual Tax

Receipts and Taxpayer

Information

As we have previously reported,27 IRS’ controls over cash, checks, and

related hardcopy taxpayer data it manually receives from taxpayers are

not adequate to reduce to an acceptably low level the risk that these

payments will not be properly credited to taxpayer accounts and

deposited in the Treasury, or that proprietary taxpayer information will

not be properly safeguarded. We found weaknesses in IRS’ physical

security over tax receipts and taxpayer data on hand at IRS field offices and

in transit to depository institutions. In addition, we found that delays in

background and fingerprint checks resulted in new employees being hired

and entrusted with taxpayer receipts and data before the results of these

checks were known. We found that similar weaknesses exist at

commercial lockbox banks under contract to IRS.

28 Although we do not

consider this weakness to be material to IRS’ principal financial statements,

it involves issues central to IRS’ customer service goals. It is therefore

critical that IRS resolve these issues promptly and effectively.

The Comptroller General’s Standards for Internal Controls in the Federal

Government require that access to resources and records be limited to

authorized individuals. Such physical security is critical to ensure that

receipts are not lost or stolen nor sensitive taxpayer data compromised.

However, we found that (1) unattended checks and tax returns were often

stored in open and easily accessible areas, (2) hundreds of millions of

dollars of receipts in the form of checks, and in one case cash, were

27See Internal Revenue Service: Physical Security Over Taxpayer Receipts and Data Needs

Improvement (GAO/AIMD-99-15, November 30, 1998); Internal Revenue Service: Immediate and

Long-Term Actions Needed to Improve Financial Management (GAO/AIMD-99-16, October 30, 1998);

and GAO/AIMD-98-77, February 26, 1998.

28IRS contracts with 10 lockbox banks nationwide to process receipts—one for each service center.

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transported from IRS field offices to financial institutions by unarmed

couriers who often used unmarked civilian vehicles including, in one

instance, a bicycle, and (3) individuals were hired and entrusted with

access to cash, checks, and sensitive taxpayer data before completion of

background or fingerprint checks. This problem is particularly acute

during peak filing season when IRS typically hires thousands of temporary

employees. We found similar weaknesses exist at commercial lockbox

banks IRS contracts with to process tax receipts, including the use of

unarmed couriers and the hiring of temporary employees before

background checks are completed.

In fiscal years 1997 and 1998, IRS identified 56 actual or alleged employee

thefts of receipts at IRS field offices and lockbox banks totaling about

$1 million. However, based on IRS’ inspections’ database, an additional 100

cases were opened during the period in which the amount potentially

stolen was not quantified. Further, the magnitude of thefts not identified

by IRS is unknown. The weaknesses discussed above also expose

taxpayers to increased risk of losses due to financial crimes committed by

individuals who inappropriately gain access to confidential information

entrusted to IRS. For example, this information, which includes names,

addresses, social security and bank account numbers, and details of

financial holdings, may be used to commit identity fraud. Although

receipts and taxpayer information will always be vulnerable to theft, IRS

has a responsibility to protect the government and taxpayers from such

losses. IRS substantially agreed with the recommendations we provided to

address these issues and indicated that it plans to address the control

deficiencies we identified related to tax receipts and taxpayer data. We

will follow up in future audits to assess the effectiveness of IRS’ corrective

actions.

Weaknesses in IRS’

Revenue Reporting and

Distribution Process

IRS is unable to currently determine the specific amount of revenue it

actually collects for Social Security, Hospital Insurance, Highway, or other

relevant trust funds. As we previously reported,29 this is primarily because

the accounting information needed to validate the taxpayer’s liability and

record the payment to the proper trust fund is provided on the tax return,

which is received months after the payment is submitted. Further, the

information on the return only pertains to the amount of the tax liability,

not the distribution of the amount previously collected. As a result, IRS

cannot report the specific amount of revenue it actually collected for three

29See Excise Taxes: Internal Control Weaknesses Affect Accuracy of Distributions to the Trust Funds

(GAO/AIMD-99-17, November 9, 1998); GAO/AIMD-98-77, February 26, 1998; and GAO/AIMD-99-16,

October 30, 1998.

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of the federal government’s four largest revenue sources, including Social

Security, Hospital Insurance, and individual income taxes. In response to

our previous reports, IRS conducted a study to consider whether it should

require taxpayers to provide this additional information when they remit

their taxes. The results of this study were not available for our review at

the completion of our audit.

This condition presents other operational issues for IRS and Treasury in the

distribution of excise tax receipts to the trust funds. Because data is not

available to allocate excise taxes to the appropriate trust funds when

deposits are made, Treasury uses a process to estimate the initial

distribution of excise taxes. This process involves the use of economic

models prepared by the Office of Tax Analysis (OTA) to estimate the initial

distribution of tax receipts. Treasury’s Financial Management Service

(FMS) uses these estimates to prepare entries for the initial distribution to

the trust funds, which are then recorded by the Bureau of Public Debt

(BPD) in the books and records of the trust funds maintained by the

Treasury. Subsequent to the initial distribution, IRS certifies quarterly the

amounts that should have been distributed to the excise tax related trust

funds using its records of payments received and the subsequently

provided tax returns. FMS uses these certifications to prepare adjustments

to the initial trust fund distributions, which are then recorded by BPD.

Typically, there is a 6-month lag between the quarter end and the excise

tax certification by IRS.

As we have reported,30 this process is complex, cumbersome and prone to

error. During our fiscal year 1997 audit, we found that weaknesses in

fundamental internal controls, such as supervisory review, allowed errors

in the certification process to occur and not be detected. These included

taxpayer errors in preparing excise tax returns — errors that IRS did not

identify; errors by IRS when inputting excise tax information to its master

files; and IRS errors in using this information in preparing the certification.

We found similar problems during our fiscal year 1998 audit. As long as IRS

lacks the data to identify the specific amount of revenue received for each

tax type at the time of receipt, IRS, Treasury, and excise tax related trust

funds such as the Highway and Airport and Airways trust funds, will

continue to depend on a complex estimation process for determining

revenue distributions which continues to be vulnerable to errors.

30See GAO/AIMD-99-17, November 9, 1998.

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Noncompliance With

Laws and Regulations

and FFMIA

Requirements

As discussed above, limitations on the scope of our work prevented us

from testing compliance with the Anti-Deficiency Act. Otherwise, our tests

of compliance with selected provisions of laws and regulations disclosed

one instance of noncompliance which is reportable under generally

accepted government auditing standards and OMB Bulletin 98-08, Audit

Requirements for Federal Financial Statements. This concerns IRS’

noncompliance with a provision of the Internal Revenue Code concerning

the use of installment agreements to collect delinquent taxes. We also

found that IRS’ financial management systems do not substantially comply

with the requirements of FFMIA.

IRS’ Use of Installment

Agreements Did Not

Comply With the Internal

Revenue Code

Section 6159 of the Internal Revenue Code authorizes IRS to enter into

installment agreements with taxpayers to satisfy the taxpayer’s liability.

During our fiscal year 1998 audit, we identified numerous instances in

which IRS has entered into installment agreements under whose terms the

payments will not be sufficient to satisfy the taxpayers’ outstanding tax

liability prior to the expiration of the statutory collection period for these

tax liabilities.31 Specifically, in 48 of the 93 unpaid assessment cases we

reviewed (52 percent) where active individual installment agreements

were in place between the taxpayer and IRS, we found that the payments to

be received under the installment agreement would not be sufficient to

fully satisfy the outstanding liability. For example, in one case, an

installment agreement required the taxpayer to make payments of $25

each month toward an outstanding tax liability due of over $16 million.

Based on the number of months remaining in the statutory collection

period, we determined that under the terms of the agreement, IRS would

only collect a maximum of $1,625, assuming the taxpayer does not default

on the installment agreement.

Because these agreements will not result in full satisfaction of the

outstanding tax liability, the 48 cases are not in compliance with Section

6159 of the Internal Revenue Code. IRS’ Collection Division recognized this

problem. In March, 1998, the Deputy Commissioner issued a memorandum

stating clearly that under any new installment agreement, the taxpayer

must fully satisfy his/her tax liability. This memorandum was followed in

August 1998 by a memorandum from the Chief Operations Officer issuing

guidelines on installment agreements pending updates to the Internal

Revenue Manual.

31The statutory collection period is generally 10 years from the date of the assessment. However, this

period can be extended by agreement with the taxpayer when an installment agreement is entered

into.

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IRS’ Financial Management

Systems Are Not in

Compliance With FFMIA

In our previous audit,32 we reported that IRS’ custodial financial

management systems did not substantially comply with the Federal

Financial Management Systems Requirements (FFMSR),33 federal

accounting standards, and the SGL at the transaction level. During fiscal

year 1998, we found that this condition continued, and that IRS’

administrative financial management systems also had significant

problems. We found that IRS (1) cannot reliably prepare four of the six

principal financial statements required by OMB 97-01, as amended, (2) does

not have a general ledger(s) that conforms to the SGL, (3) lacks a

subsidiary ledger for its unpaid assessments, accounts payable, and

undelivered orders, and (4) lacks an effective audit trail from its general

ledgers back to subsidiary detailed records and transaction source

documents. In its FIA assurance statement to Treasury, IRS also reported

that its financial management systems did not substantially comply with

FFMIA in fiscal year 1998.

In addition, IRS does not consistently capture cost information in

accordance with federal accounting standards.34 For example, in our

sample of IRS payroll transactions we tested, we found that most

employees did not charge their time to individual job codes for specific

services and activities. As a result, actual cost information for specific

services and activities is not available. Consequently, IRS is unable to

reliably report cost-based performance measures in its management

discussion and analysis (MD&A) that accompanies the principal financial

statements, or otherwise report cost-based information for its

performance plan in accordance with the Government Performance and

Results Act of 1993. This deficiency also renders IRS unable to include

reliable cost-based performance information in its budget submission to

Congress.

These are all requirements under FFMSR. The other four material

weaknesses we discussed above—controls over refunds, property and

equipment, fund balance with Treasury, and computer security—also are

conditions indicating that IRS’ systems do not comply with FFMSR. These

material weaknesses indicate that IRS cannot routinely produce auditable

principal financial statements and related disclosures in conformance with

federal accounting standards. Since IRS’ systems do not comply with FFMSR,

32See GAO/AIMD-98-77, February 26, 1998.

33FFMSR are a series of requirements produced by the JFMIP to improve federal financial management

through uniform requirements for financial information, financial systems, and financial organization.

34Statement of Federal Financial Accounting Standards No. 4, Managerial Cost Accounting Standards.

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federal accounting standards, and the SGL, they also do not comply with

OMB Circular A-127, Financial Management Systems.

In May 1997, IRS provided Congress a systems modernization plan intended

to bring IRS’ custodial financial systems into conformance with FFMIA.

Planned improvements include (1) an SGL compliant code and

classification structure which is traceable to detail in the master files,

(2) automated preparation of financial statement balances from the

general ledger, (3) improved unpaid assessment documentation retention

requirements, and (4) extracts of summary unpaid assessment information

by taxpayer, tax module, account status, age, and installment information.

However, in re-evaluating the modernization plan in light of the material

weaknesses we reported in our previous audit, IRS concluded that the

current modernization strategy cannot achieve compliance within the

3-year time frame required by FFMIA. In IRS’ FFMIA noncompliance

remediation plan for its custodial financial management systems, IRS cited

plans to develop an alternative approach employing modifications to

existing systems and additional manual procedures in lieu of building

some modernized subsystems. Some of the planned financial reporting

improvements are embodied in IRS’ Financial Reporting Release which is

currently scheduled to be installed by April 2000. IRS plans to completely

address its computer security weaknesses by December 2000.

Implementation of the full plan as originally envisioned is not expected for

a decade or more.

In October 1998, IRS prepared a remediation plan designed to address the

material weaknesses cited by the Treasury OIG in its audit of IRS’ fiscal

year 1997 administrative financial statements, which reported material

weaknesses in IRS’ property and equipment and accounting for liabilities

and accrued expenses. However, the corrective actions detailed in this

plan focus primarily on measures such as enhancements to policies and

procedures relevant to these processes and training staff to follow them.

This plan does not address the accounting issues and systemic problems

affecting P&E and accounts payable detailed above, such as the lack of an

accounts payable subsidiary ledger and the inability to account for P&E in

accordance with SFFAS No. 6. In addition, the plan does not address the

additional weaknesses discussed above, such as an administrative general

ledger that does not comply with the SGL, financial reporting weaknesses

that rendered IRS unable to reliably prepare four required principal

financial statements (all of which report only administrative accounts), or

the lack of effective management oversight of the financial reporting

process.

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Status of Prior Year

Compliance Issue

In our audit of IRS’ fiscal year 1997 Custodial Financial Statements, we

reported that IRS certified distributions of excise taxes to the recipient

trust funds based on amounts assessed taxpayers, rather than certifying

them based on actual collections, as required by the Internal Revenue

Code. We first reported this problem in our audit of IRS’ fiscal year 1992

financial statements.35 We also reported this issue in our fiscal year 1993

audit and recommended that IRS develop a means of capturing information

on the specific taxes collected for trust funds so that the amounts

collected by trust funds are readily determinable and excise tax receipts

can be distributed as required by law.36

During fiscal year 1998, IRS certified distributions of excise tax revenue

collected in the last half of fiscal year 1997 based on amounts assessed

taxpayers. IRS developed a method to allocate total excise tax collections

to specific excise tax related trust funds based on the related taxpayer

returns and implemented this method beginning with the June 1998

certification of first quarter fiscal year 1998 excise tax revenue. This new

approach is consistent with our recommendation and brings IRS into

compliance with the requirements of the Code. However, as discussed

above, weaknesses in the internal controls over this process persist.

In addition to the weaknesses and FFMIA noncompliance discussed above,

we noted other, less significant matters involving IRS’ system of accounting

controls and its operations which we will be reporting separately in a

management letter to IRS.

Other Significant

Matters

In addition to the material weaknesses and other reportable conditions

and noncompliance with laws and regulations discussed above, we

identified two other significant matters which we believe should be

brought to the attention of users of IRS’ principal financial statements and

other financial reports. These concern (1) the importance of IRS

successfully preparing its automated systems for the year 2000 and

(2) supplementing of the Social Security and Hospital Insurance Trust

funds by general fund tax revenues.

35Financial Audit: Examination of IRS’ Fiscal Year 1992 Financial Statements (GAO/AIMD-93-2,

June 30, 1993).

36See Examination of IRS’ Fiscal Year 1993 Financial Statements (GAO/AIMD-94-120, June 15, 1994).

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Year 2000 Problem

Presents a Significant

Challenge for IRS

IRS is highly dependent on information technology to carry out its mission.

However, most of IRS’ information systems were not designed to read dates

beyond December 31, 1999. As a result, IRS is in the midst of a massive

effort to make its information systems Year 2000 compliant in order to

avoid significant disruptions in its operations. IRS’ program represents one

of the largest civilian Year 2000 efforts, with an estimated cost of about

$1.4 billion. These cost estimates include work needed for its

mission-critical information systems, telecommunications networks, and

buildings. At the outset, IRS faced significant challenges in making its

systems Year 2000 compliant. In addition to the size of its effort, IRS lacked

a comprehensive inventory of information system assets, particularly of its

information systems infrastructure (i.e., systems software, hardware, and

telecommunications networks), and IRS’ Chief Information Officer did not

control all mission-critical assets.

In a June 1998 report,37 we provided a status of IRS’ Year 2000 efforts. We

reported that IRS had made more progress in fixing its applications than its

infrastructure, and that two major Year 2000 system replacement efforts

were experiencing schedule slippages. In addition, we identified two risk

areas for IRS’ Year 2000 effort—that is, the absence of an integrated master

schedule showing the interdependencies among the many Year 2000

efforts and a limited approach to contingency planning. If IRS is unable to

make its mission-critical systems Year 2000 compliant, IRS could be

rendered unable to properly and promptly process tax returns, issue

refunds, correctly calculate interest and penalties, effectively collect taxes,

or prepare accurate principal financial statements and other financial

reports.

IRS has been acting to address our concerns about a master schedule. The

Commissioner is also taking steps to broaden the contingency planning

effort to help ensure that IRS had adequately assessed the vulnerabilities of

its core business processes to potential Year 2000 system failures.

Specifically, we recommended that the Commissioner (1) solicit input

from the business functional areas to identify core business processes and

identify those processes that must continue in the event of a Year 2000

failure, (2) map IRS’ mission-critical systems to those core business

processes, (3) determine the impact of information system failures on

each core business process, (4) assess existing contingency plans for their

applicability to potential Year 2000 failures, and (5) develop and test

37IRS’ Year 2000 Efforts: Business Continuity Planning Needed for Potential Year 2000 System Failures

(GAO/GGD-98-138, June 15, 1998).

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contingency plans for core business processes if existing plans are not

appropriate.

Since we issued our report, IRS has been taking actions to address our

recommendations. IRS had originally planned to have its first set of

contingency plans by December 15, 1998; however, according to its

officials, IRS did not meet that milestone. We plan to continue monitoring

IRS’ progress in developing contingency plans.

Social Security and

Hospital Insurance Are

Supplemented by General

Fund Revenues

Taxes collected on behalf of the federal government are deposited in the

general revenue fund of the Department of the Treasury, from which they

are subsequently distributed to the appropriate trust funds. Amounts

representing Social Security and Hospital Insurance taxes are distributed

to their respective trust funds based on employee wage information

certified by the Commissioner of the Social Security Administration (SSA).

Consistent with the statutory verification process, the Commissioner

bases this certification on a consideration of both wage information

maintained by SSA and wage information provided by IRS.

Because the distribution of the Social Security taxes IRS collects from

employers is based on this certification rather than actual collections, the

federal government’s general fund revenues supplement the Social

Security and Hospital Insurance trust funds. This supplement occurs

primarily because a significant number of employers that file tax returns

for Social Security and Hospital Insurance taxes never actually pay the

assessed amounts. Many of these businesses ultimately go bankrupt or

otherwise go out of business. Also, a significant number of self-employed

individuals do not pay the assessed amounts. As of September 30, 1998,

the estimated amount of unpaid taxes and interest in IRS’ unpaid

assessments balance was approximately $38 billion for Social Security and

Hospital Insurance.38 While these totals do not include amounts no longer

in the unpaid assessments balance due to the expiration of the statutory

collection period,39 they nevertheless give an indication of the cumulative

amount of the supplement provided from the general fund.

38We included interest accrued in these amounts because assessments distributed to the trust funds

earn interest at Treasury-based interest rates, similar to IRS’ interest accruals.

39As noted earlier, the statutory collection period for collecting taxes is generally 10 years from the

date of the tax assessment. However, this period can be extended under a variety of circumstances,

such as agreements by the taxpayer to extend the collection period, bankruptcy litigation, and court

appeals. Consequently, some tax assessments can and do remain on IRS’ records for decades.

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Consistency of Other

Information

IRS’ management discussion and analysis, supplemental information, and

other accompanying information contain various data, some of which are

not directly related to the principal financial statements. We did not audit

and do not express an overall opinion on this information. However, we

compared this information for consistency with the principal financial

statements and discussed the methods of measurement and presentation

with IRS officials. Based on our limited work, we found no material

inconsistencies with the principal financial statements or OMB guidance.

However, given the severity of the issues raised earlier with respect to

accounting, reporting, and internal controls over IRS’ administrative

activities, such comparisons may not be meaningful.

In performing our review of IRS’ key performance indicators, we found that

the measure related to toll-free telephone level of access40 is potentially

misleading. IRS reports that for fiscal year 1998, the toll-free telephone

level of access is 89.96 percent. Based on this, readers of IRS’ MD&A will

likely conclude that over 89 percent of callers successfully contacted an

IRS representative. However, IRS defines “access” as including all callers

who reach IRS’ telephone system, including those who subsequently hang

up before an IRS representative comes on the line. We found that based

upon another measure IRS refers to as “toll-free telephone level of service,”

approximately 70 percent of callers to IRS actually succeed in having their

calls answered by IRS. We believe this measure, which is not included in its

MD&A, more accurately represents the percentage of callers that

successfully contact IRS.

Objectives, Scope,

and Methodology

Management is responsible for

• preparing the annual principal financial statements in conformity with the

basis of accounting described in note 1 to the principal financial

statements;

• establishing, maintaining, and assessing internal controls to provide

reasonable assurance that the broad control objectives of FIA are met; and

• complying with applicable laws and regulations and FFMIA requirements.

We are responsible for obtaining reasonable assurance about whether

40Toll-free telephone level of access is defined as the sum of the number of calls answered and the

number of calls that are abandoned by the caller before getting assistance divided by total call

attempts (which consist of calls answered, calls that are abandoned, and calls that receive a busy

signal).

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• the principal financial statements are reliable (free of material

misstatements and presented fairly, in all material respects, in conformity

with the basis of accounting described in note 1), and

• management’s assertion about the effectiveness of internal controls is

fairly stated, in all material respects, based upon criteria established under

the Federal Managers’ Financial Integrity Act of 1982 and OMB Circular

A-123, Management Accountability and Control.

We are also responsible for testing compliance with selected provisions of

laws and regulations41 and FFMIA requirements, and for performing limited

procedures with respect to certain other information appearing in these

annual principal financial statements.

Except as discussed above, in order to fulfill these responsibilities, we

• examined, on a test basis, evidence supporting the amounts and

disclosures in the principal financial statements;

• assessed the accounting principles used and significant estimates made by

management;

• evaluated the overall presentation of the principal financial statements;

• obtained an understanding of internal controls related to financial

reporting, including safeguarding assets, and compliance with laws and

regulations, including execution of transactions in accordance with budget

authority;

• tested relevant internal controls over financial reporting, including

safeguarding assets and compliance, and evaluated management’s

assertion about the effectiveness of internal controls;

• considered compliance with the process required by the Federal

Managers’ Financial Integrity Act for evaluating and reporting on internal

control and financial management systems;

• tested compliance with selected provisions of the following laws and

regulations (referenced to the United States Code)

• Internal Revenue Code (appendix I),

• Government Management Reform Act of 1994 {31 U.S.C. §§ 3515, 3521

(f)},

• Civil Service Reform Act of 1978 {5 U.S.C. § 5332},

• Fair Labor Standard Act of 1938, as amended {29 U.S.C. § 206},

• Civil Service Retirement Act of 1930, as amended {5 U.S.C. § 8334},

• Federal Employees’ Retirement System Act of 1986, as amended {5

U.S.C. § 8423},

41These are laws and regulations that, we believe, have a direct and material effect on the principal

financial statements.

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• Social Security Act, as amended {26 U.S.C. §§ 3101, 3121, and 42 U.S.C.

§ 430},

• Federal Employees Benefits Act of 1959, as amended {5 U.S.C. §§ 8905,

8906, 8909}, and

• Federal Employees’ Group Life Insurance Act of 1980 {5 U.S.C. § 8701},

and

• tested whether IRS’ financial management systems comply with FFMIA

requirements: (1) Federal Financial Management Systems Requirements,

(2) applicable federal accounting standards, and (3) the U.S. Standard

General Ledger at the transaction level.

We did not evaluate all internal controls relevant to operating objectives as

broadly defined by FIA, such as those controls relevant to preparing

statistical reports and ensuring efficient operations. We limited our

internal control testing to those controls necessary to achieve the

objectives outlined in our opinion on management’s assertion about the

effectiveness of internal controls. Because of inherent limitations in any

internal control system, losses, noncompliance, or misstatements may

nevertheless occur and not be detected.

As the auditor of IRS’ principal financial statements, we are reporting under

FFMIA on whether IRS’ financial management systems substantially comply

with the Federal Financial Management Systems Requirements, applicable

federal accounting standards, and the U.S. Standard General Ledger at the

transaction level. In making this report, we considered the implementation

guidance for FFMIA issued by OMB in Bulletin 98-08 Audit Requirements for

Federal Financial Statements.

We did not test compliance with all laws and regulations applicable to IRS.

We limited our tests of compliance to those required by OMB under Bulletin

98-08 and which we deemed applicable to the principal financial

statements of IRS. We caution that noncompliance other than that

discussed in this report may occur and not be detected by these tests and

that such testing may not be sufficient for other purposes.

Except for the limitations on the scope of our work on the principal

financial statements described above, we performed our work in

accordance with generally accepted government auditing standards and

OMB Bulletin 98-08.

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Agency Comments

and Our Evaluation

In commenting on a draft of this report, IRS stated that it generally agreed

with the findings and conclusions in the report. IRS acknowledged the

issues, concerns, and internal control weaknesses we cited, and

emphasized its commitment to address these matters. IRS stated that it has

assembled a corrective action team under the direction of the Chief

Financial Officer (CFO) to formulate a detailed plan for addressing each of

the issues raised in the report. IRS stated that it anticipates completing the

plan by March 31, 1999. IRS also stated that it would be bringing in outside

experts to assist its staff in resolving known deficiencies and problems

with respect to the agency’s administrative operations. IRS stated that,

while its financial management systems were not designed to meet current

systems and financial reporting standards, the agency is in the process of

planning and implementing interim solutions until such time as enhanced

systems are available over the next several years. The Chief Information

Officer is working in conjunction with the CFO to identify priorities and

resources needed to complete the necessary systems solutions. We will

continue to work closely with IRS and evaluate the effectiveness of its

corrective actions as part of our audit of IRS’ fiscal year 1999 financial

statements.

Additionally, IRS stated that it had a number of initiatives underway to

address several of the issues raised in this report and in our prior audits.

First, with respect to its unpaid assessments, these initiatives include (1) a

review of multiple assessments—trust fund recovery penalties—and

alternatives to ensure that taxpayer accounts are appropriately credited

for payments and adjustments made to related accounts, and (2) a task

force established to address documentation standards and record

retention policies and practices. We will review the results of these

initiatives as they are completed. With respect to revenue reporting and

distribution, IRS also stated that it had recently completed its study on

whether to require taxpayers to provide information on how payments

should be applied to specific types of taxes at the time the taxpayer

submits the payments, and has concluded that at this time IRS would not

pursue such reporting requirements. We will review the results of this

study as part of our audit of IRS’ fiscal year 1999 financial statements. We

remain concerned, however, that the existing process results in IRS’

inability to separately report on the specific amount of revenue it actually

collects for three of the federal government’s four largest revenue sources,

and necessitates the need for a multi-stage, complex, and error-prone

process to distribute excise taxes to the recipient trust funds.

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We agree with IRS’ comment that the issue of capitalization thresholds for

P&E is a governmentwide issue. We have initiated discussions with the OMB

on the development of governmentwide guidance on P&E capitalization

thresholds. However, as it relates to IRS, we do not believe that

capitalization thresholds used by other agencies are relevant. It is our

position that each federal agency, because of its size and diversity of asset

base, needs a capitalization threshold that is appropriate for its own

unique circumstances. As our report notes, IRS’ use of a $50,000 threshold,

established by the Treasury Department CFO Council, resulted in $1.2

billion (69 percent) of its gross P&E being excluded from the September 30,

1998, financial statements. In addition, IRS’ financial statements show

$339 million of expenses for P&E purchased during fiscal year 1998, while

only about $30 million (9 percent) was actually capitalized. We continue to

believe that the $50,000 capitalization threshold is inappropriate and

significantly contributed to the likely material understatement of IRS’

September 30, 1998, P&E balance.

IRS stated that it continues to report the toll-free telephone level of access

because it is one of seven high impact agency goals identified and tracked

by the National Partnership for Reinventing Government. IRS further stated

that in the future this measure will be replaced with the “toll-free

telephone level of service.” However, reporting of the toll-free telephone

level of access as it is presented in IRS’ MD&A for fiscal year 1998 is

potentially misleading. Readers of IRS’ MD&A will likely inappropriately

conclude that 89.96 percent of taxpayers calling IRS actually speak to an IRS

representative. The use of IRS’ toll-free telephone level of service measure,

which does not recognize an abandoned taxpayer call as a success, is a

more appropriate measure. We support IRS’ use of the toll-free telephone

level of service measure in future years.

David M. Walker

Comptroller General

of the United States

February 12, 1999

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Appendix I 

Provisions of Internal Revenue Code Tested

for the Fiscal Year 1998 Audit

26 U.S.C. § 6159 Agreements for Payment of Tax Liability in Installments

26 U.S.C. § 6402 Authority to Make Credits or Refunds

26 U.S.C. § 6402 Authority to Make Refund Offsets

26 U.S.C. § 6511 Limitations on Credits or Refunds

26 U.S.C. § 6601 Interest on Underpayment, Nonpayment, or Extension of 

 Time for Payment of Tax

26 U.S.C. § 6611 Interest on Overpayments

26 U.S.C. § 6621 Determination of Rate of Interest

26 U.S.C. § 6651 Failure to File Tax Return or to Pay Tax

26 U.S.C. § 6654 Penalty for Failure by Individual to Pay Estimated 

 Income Tax

26 U.S.C. § 6655 Penalty for Failure by Corporations to Pay Estimated 

 Income Tax

26 U.S.C. §§ 9501-9511 

 Trust Funds

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Appendix II 

Comments From the Internal Revenue

Service

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Appendix II 

Comments From the Internal Revenue

Service

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Appendix II 

Comments From the Internal Revenue

Service

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Appendix II 

Comments From the Internal Revenue

Service

(919205) Page 87 GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements

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The IRS Digital Daily (www .irs.gov)

provides a variety of electronic

information services 24 hours a day .

T axpayers can access the website to

obtain self-help tools to assist them

in meeting their tax obligations.

Some of the services offered include

downloading tax forms, instructions,

and publications, fill-in forms online, tax statistics, Electronic Filing

information, employment opportuni -

ties, and important individual busi -

ness, and excise tax dates.

The T A X i Interactive site

(www .irs.gov/taxi/index.html) is

designed to teach middle to high

school students

between the

ages of 13 and

18 about taxes.

The site covers

reasons why we

pay taxes and

how they can

meet their tax

obligation.

E xhib its 14, 1 5

PRINTED ON RECYCLED P APER
Publication 3385 (4-1999)

Catalog Number 27467P

INTERNAL REVENUE SERVICE

1111 CONSTITUTION A VENUE, NW

W ASHINGTON, DC 20224

(202) 622-5000