United States General Accounting Office 

GAO Testimony 

Before the Committee on Finance, U.S. Senate 

For Release on Delivery 

Expected at 10:00 a.m. EDT 

Tuesday, October 21, 2003 

INTERNAL REVENUE 

SERVICE 

Challenges Remain in 

Combating Abusive Tax 

Shelters 

Statement of Michael Brostek 

Director, Tax Issues 

GAO-04-104T


a
Highlights of GAO-04-104T, a testimony to 

the Committee on Finance, U.S. Senate 

Recent scandals involving 

corporations, company executives, 

and accounting, law, and 

investment banking firms 

heightened awareness of abusive 

tax shelters and highlighted the 

importance of the Department of 

the Treasury and the Internal 

Revenue Service (IRS) addressing 

them. During 1999, Treasury 

issued a report indicating that 

abusive shelters were a large and 

growing problem, involving billions 

of dollars of tax reductions. 

Treasury was concerned that 

abusive shelters could ultimately 

undermine the integrity of the 

voluntary compliance tax system. 

GAO’s statement today is based on 

work done at the request of the 

Chairman and the Ranking Minority 

Member of the Senate Committee 

on Finance to examine IRS’s 

strategy for dealing with abusive 

tax shelters. In reporting on 

abusive shelters, GAO is describing 

• their nature and scope, 

• 	 IRS’s strategy and enforcement 

mechanisms to combat them 

and the performance goals and 

measures IRS uses to track its 

October 21, 2003 

INTERNAL REVENUE SERVICE 

Challenges Remain in Combating 

Abusive Tax Shelters 

By their nature, abusive tax shelters are varied, complex, and difficult to 

detect and measure. Abusive shelters manipulate many parts of the tax code 

or regulations and may involve steps to hide the transaction within a tax 

return. In recent years, IRS has been accumulating information about them 

and, although it does not have a reliable measure of the size of the abusive 

shelter problem, has come to believe that abusive shelters deserve 

substantially increased attention. IRS continues to gather more information 

to better define the scope of the problem and has data sources, all with their 

own limitations, that suggest abusive tax shelters total tens of billions of 

dollars of potential tax losses over about a decade. 

IRS’s broad-based strategy for addressing abusive shelters included: 

• targeting promoters to head off the proliferation of shelters; 

• making efforts to deter, detect, and resolve abuse; 

• 	 offering inducements to individuals and businesses to disclose their use 

of questionable tax practices; and 

• 	 using performance indicators to measure outputs and some outcomes 

and intending to go down the path it has started and develop long-term 

performance goals and measures linked to those goals. Without these 

latter elements, Congress would find gauging IRS’s progress difficult. 

In allocating resources to shelters, IRS used a systematic decision-making 

process that relied on admittedly limited information. It planned to shift 

significant resources in fiscal years 2003 and 2004 to address abusive 

shelters but faces challenges, especially in the near term, in addressing 

abusive shelters due to a growing workload and limited information on how 

long it takes to examine shelter cases. IRS’s understanding of how many 

staff will be needed to address the problem over what period will continue to 

evolve as it gains a better understanding of the problem’s scope. 

major effort in that area, and 

• 	 the decision-making process 

IRS used and the plans it has 

to devote more resources to 

addressing abusive shelters. 

www.gao.gov/cgi-bin/getrpt?GAO-04-104T. 

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Michael 

Brostek at (202) 512-9110 or 

brostekm@gao.gov. 

Shift in Examination Resources Allocated to Abusive Tax Shelters 

Note: Fiscal year 2002 full-time equivalents include actual time spent on the entire returns 

containing shelters, not on the shelter issues alone. Fiscal year 2003 and 2004 full-time equivalents 

are planned amounts that are focused more on the shelter issues themselves. 
Mr. Chairman and Members of the Committee: 

I appreciate the opportunity to testify on the Internal Revenue Service’s 

(IRS) efforts to deal with abusive tax shelters. I am using the term “abusive 

shelters” to describe very complicated transactions promoted to 

corporations and wealthy individuals to exploit tax loopholes and provide 

large, unintended tax benefits. Recent scandals involving corporations, 

company executives, and accounting, law, and investment banking firms 

heightened awareness of abusive shelters and highlighted the importance 

of the Department of the Treasury and IRS addressing the problem. During 

1999, Treasury issued a report indicating that abusive shelters were a large 

and growing problem, involving billions of dollars of tax reductions.1 

Treasury was concerned that abusive shelters could ultimately undermine 

voluntary compliance by eroding the integrity of the tax system. In 

response to information pointing to the rapid growth of abusive shelters, 

IRS formalized a strategic initiative in fiscal year 2000 to strengthen its 

capacity to deal with abusive corporate shelters. One element of IRS’s 

initiative involved creating a central office within the Large and Mid-Size 

Business (LMSB) Division to coordinate and guide efforts to curb the 

growth of abusive shelters. 

My statement today is based on work we have done at the request of the 

Chairman and the Ranking Minority Member. In examining abusive 

shelters, we focused on (1) their nature and scope, (2) IRS’s strategy and 

enforcement mechanisms to combat them and the performance goals and 

measures IRS uses to track its major effort in that area, and (3) the 

decision-making process IRS used to allocate resources to abusive shelters 

and the plans it has to devote more resources to addressing abusive 

shelters. We were also asked to provide information on IRS’s Schedule K-1 

document matching program, which we are including in appendix I. 

To do our work, we 

1

Department of the Treasury, The Problem of Corporate Tax Shelters (Washington, D.C.: July 

1999). 

Page 1 GAO-04-104T 
•	 analyzed IRS’s and other shelter reports, publications, data, and other 

documentation providing insight into the characteristics, complexity, 

size, and type of the problem;2 

•	 reviewed IRS’s planning documents with information on its strategies, 

measures, and resources; 

•	 compared the contents of IRS’s planning documents to Government 

Performance and Results Act of 1993 (GPRA)3 criteria for what elements 

strategic planning should include; and 

•	 interviewed agency officials about their views on, among other things, 

the problem’s nature and scope and IRS’s strategy. 

We did our work from September 2002 through August 2003 in accordance 

with generally accepted government auditing standards. As agreed, we are 

also discussing the related problem of abusive tax schemes in a report to be 

released in the near future. Abusive tax schemes are used more by 

individuals than by large businesses and encompass such distortions of the 

tax system as falsely describing the law (saying, for example, that the 

income tax is unconstitutional), misrepresenting facts (for instance, 

promoting the deduction of personal expenses as business expenses), and 

using trusts or offshore bank accounts to hide income. The boundary 

between what we are calling an abusive tax shelter and an abusive scheme 

is not always clear. Organizationally, although IRS’s LMSB Division has 

lead responsibility for combating abusive shelters, abusive shelters are 

pursued by IRS’s Small Business/Self-Employed Division when they are 

used by businesses with assets of less than $10 million or by high-wealth 

individuals with complicated tax returns. 

My statement today will make the following points: 

2

As part of this work, we tested the tax shelter database maintained by the Office of Tax 

Shelter Analysis (OTSA) by reviewing related documentation, interviewing knowledgeable 

agency officials, and doing electronic testing, finding that the required data elements were 

sufficiently reliable for the purposes of our work. This finding does not mean, however, that 

the database contains all the information that would be needed to estimate the full size of 

the abusive shelter problem. 

3

Pub. L. No.103-62. 

Page 2 GAO-04-104T 
•	 By their nature, abusive shelters are varied, complex, and difficult to 

detect and measure. Abusive shelters manipulate many parts of the tax 

code or regulations and may involve steps to hide the transaction within 

a tax return. In recent years, IRS has been accumulating information 

about abusive shelters and the extent that they were promoted, and it 

has come to believe that abusive shelters deserve substantially 

increased attention. Suffice it to say, although they do not have a 

reliable measure of the size of the abusive shelter problem, Treasury and 

IRS believe that tens of billions of dollars of taxes are being improperly 

avoided and the potential for the proliferation of abusive shelters is 

strong. IRS continues to gather more information to better define the 

scope of the problem and has several data sources, each with certain 

limitations, that point to billions in tax losses. As of September 30, 2003, 

a database on shelter transactions that IRS has publicly declared to be 

tax avoidance transactions suggested the potential tax loss to be about 

$33 billion, the majority of which was concentrated from tax year 1993 

through the present. This database included only transactions disclosed 

to or discovered by IRS. In addition, an IRS contractor estimating 

annual tax gaps resulting from abusive shelters estimated that the 

annual average of foregone taxes between 1993 and 1999 could have 

been as small as about $11.6 billion or as large as about $15.1 billion. 

However, Treasury, IRS, the contractor, and we all have concerns about 

the reliability of the contractor’s estimates because of methodological 

and data constraints that the contractor faced. 

•	 The broad-based strategy reflected in IRS planning documents included 

various features as well as elements of strategic planning: 

• targeting promoters to head off the proliferation of shelters; 

• making efforts to deter, detect, and resolve abuse; 

• coordinating efforts throughout IRS; 

•	 offering inducements to individuals and businesses to disclose their 

use of questionable tax practices; and 

•	 using performance indicators to measure outputs and some 

outcomes and intending to continue down the path it has started and 

develop long-term performance goals and measures linked to those 

goals. Without these latter elements, Congress would find gauging 

IRS’s progress difficult. 

Page 3 GAO-04-104T 
•	 In developing this strategy, IRS has had to make decisions about staffing 

allocations and what can be accomplished on the basis of admittedly 

limited information. After using a systematic process to determine 

staffing priorities, IRS planned a significant shift in resources to address 

abusive shelters in fiscal years 2003 and 2004. However, it faces 

challenges, especially in the near term, in addressing abusive shelters 

due to a growing workload and limited information on how long it takes 

to examine shelter cases. IRS’s understanding of how many staff will be 

needed to address the problem over what period will continue to evolve 

as IRS gains a better understanding of the problem’s scope. 

Background	 Although IRS has no single, authoritative definition of abusive shelters, IRS 

generally characterizes abusive shelters as very complicated transactions 

that sophisticated tax professionals promote to corporations and wealthy 

individuals, exploiting tax loopholes and reaping large and unintended tax 

benefits. As the Joint Committee on Taxation has said, “taxpayers and tax 

administrators have struggled in determining the line between legitimate 

‘tax planning’ and unacceptable ‘tax shelters.’” Even though, it continued, 

“there is no uniform standard as to what constitutes a tax shelter ... there 

are statutory provisions, judicial doctrines, and administrative guidance 

that attempt to limit or identify transactions in which a significant purpose 

is the avoidance or evasion of income tax.”4 

Abusive shelters have been promoted by some accounting firms, law firms, 

and investment banks. Investors in these abusive shelters range from large 

and small corporations to wealthy individuals. IRS approaches the tax 

shelter enforcement problem from both the promoter and investor 

perspectives. IRS promoter investigations are designed to learn (1) what 

abusive shelters have been promoted, if the shelters are registered,

5

 and 

possibly how much they cost investors, (2) who purchased the shelters and 

what tax savings the investors expect, and (3) whether promoters should 

pay penalties for their activities. IRS examines investor and other tax 

4

Joint Committee on Taxation, Background and Present Law Relating to Tax Shelters, JCX19-02 (Washington, D.C.: Mar. 19, 2002). 

5

A promoter or other tax shelter organizer must register a tax shelter with the Secretary of 

the Treasury by describing it and its tax benefits. The Secretary assigns the shelter an 

identification number. 

Page 4 GAO-04-104T 
returns to see if income, expenses, taxes, and credits are accurately 

reported. 

In a June 2002 letter, Treasury responded to congressional questions about 

whether Treasury had a comprehensive strategy for combating tax 

avoidance. In his letter to the then Ranking Member of the Committee on 

Finance, then Secretary of the Treasury O’Neill addressed the actions being 

taken to combat abusive shelters, referring to Treasury’s March 20, 2002, 

enforcement proposals on the topic. The proposals said that IRS had made 

significant organizational improvements to coordinate its response to 

ongoing abusive tax shelters. Treasury, all of IRS’s operating divisions, and 

IRS’s Office of Chief Counsel are involved in combating abusive shelter 

activity. 

Within IRS, LMSB has primary responsibility for combating abusive tax 

shelter activity. LMSB’s OTSA was created in February 2000 to centralize 

and coordinate the IRS response nationwide. As shown in figure 1, OTSA is 

the focal point for IRS shelter activities, overseeing promoter tax shelter 

registrations; taxpayer disclosures of tax shelters; hotline tip analysis and 

referral; and issue coordination and interface between the Office of Chief 

Counsel, Treasury, the Tax Shelter Committee, the 6700 Committee 

(referring to section 6700 of the Internal Revenue Code), and external 

stakeholders.6 The Tax Shelter Committee oversees LMSB’s tax shelter 

program. The committee is composed of the Commissioner and Deputy 

Commissioner of LMSB, the Director of Pre-Filing and Technical Guidance, 

LMSB Division Counsel, five Industry Directors, the Director of 

International, and the Directors of Field Specialists and Research and 

Program Planning. The 6700 Committee serves under the Tax Shelter 

Committee and approves all LMSB tax shelter promoter activities. The 

financial services’ industry director chairs this committee. IRS’s appeals 

function receives and evaluates taxpayer objections to IRS examination 

determinations and may agree with those determinations or reduce or 

eliminate changes to tax returns resulting from them. The Office of Chief 

Counsel plays an integral role in combating shelters through summons 

enforcement and targeted litigation. By litigating, IRS establishes case law 

supporting IRS enforcement programs and aims to diminish the incentives 

taxpayers find for investing in tax avoidance transactions by increasing the 

risks and costs of IRS discovery. 

6

Section 6700 covers penalties for promoters of abusive shelters. 

Page 5 GAO-04-104T 
Figure 1: OTSA’s Role in Coordinating IRS Work on Abusive Shelters 

OTSA 

is the focal point for 

IRS shelter activities 

Source: Compiled by GAO from IRS information 

Tax Shelter 

Committee 

oversees LMSB’s tax shelter 

program, and its affiliated 

6700 Committee approves 

LMSB promoter 

activities 

Counsel 

works on guidance, 

helps develop issues, 

and litigates 

IRS field offices 

conduct shelter 

examinations 

Other internal 

stakeholders 

for instance, IRS 

operating divisions, such as 

SB/SE, provide feedback 

and guidance 

External stakeholders 

such as Treasury, tax 

practitioners, and the press, 

provide guidance and 

receive information 

Appeals 

handles shelter 

appeals 

Abusive shelters are complex transactions that manipulate many parts of 

the tax code or regulations and are typically buried among “legitimate” 

transactions reported on tax returns. Because these transactions are often 

composed of many pieces located in several parts of a complex tax return, 

they are essentially hidden from plain sight, which contributes to the 

difficulty of determining the scope of the abusive shelter problem. Often 

lacking economic substance or a business purpose other than generating 

tax benefits, abusive shelters are promoted by some tax professionals, 

often in confidence, for significant fees, sometimes with the participation 

of tax-indifferent parties, such as foreign or tax-exempt entities. They may 

involve unnecessary steps and flow-through entities, such as partnerships, 

which make detection of these transactions more difficult. 

When a transaction has certain abusive characteristics defined by section 

6111 of the Internal Revenue Code, the promoter or other tax shelter 

Nature of Abusive 

Shelters Is Varied and 

Complex 

Page 6 GAO-04-104T 
organizer is required to register it, describing the transaction and its tax 

benefits to the Secretary of the Treasury. This registration requirement 

enables Treasury and IRS to identify and evaluate questionable 

transactions. Under recently issued Treasury regulations,7

 effective 

February 28, 2003, there are six categories of transactions for which 

promoters must maintain lists of investors who have entered into the 

transactions, and investors must disclose the transactions into which they 

have entered. The rules are designed to allow IRS to use information from 

investors to identify promoters who do not register transactions and to use 

promoter registrations and investor lists to identify investors who fail to 

disclose transactions. The six categories are 

• transactions offered under conditions of confidentiality, 

• transactions including contractual protections to the investor, 

• transactions resulting in specific amounts of tax losses, 

•	 transactions generating a tax benefit when the underlying asset is held 

only briefly, 

•	 transactions generating differences between financial accounts and tax 

accounts greater than $10 million, and 

• “listed transactions.” 

A “listed transaction” is a transaction that is the same as or similar to one of 

the types of transactions IRS has determined to be a tax avoidance 

transaction. For a transaction to be a listed transaction, IRS must issue a 

notice, regulation, or other form of published guidance informing taxpayers 

of the details of the transaction. As of mid-August 2003, IRS had listed 27 

kinds of abusive tax shelter transactions, a number that, as figure 2 shows, 

has grown more quickly in recent years than it had grown earlier. 

7

Treas. Reg. Sec. 301.6112-1 and Treas. Reg. Sec. 1.6011-4. 

Page 7 GAO-04-104T 
Figure 2: Cumulative Number of Listed Transactions over Time, 1990–mid-August 2003, and Transaction Descriptions 

Year 

Number 

1990 

Revenue Ruling 90-105: Certain 

accelerated deductions 

1995 

Notice 95-34: Certain employer 

welfare fund trusts 

Notice 95-53: Lease strips; 

superseded by Notice 2003-55 

1998 

Notice 98-5, part II: Foreign tax 

credit transactions 

Contingent installment sale 

transactions 

1999 

Treasury Regulation Section 

1.643(a)-8: Certain distributions 

from charitable remainder trusts 

Revenue Ruling 99-14: Leasein/lease-out or LILO transactions 

Notice 99-59: Bond and option 

sales strategy (BOSS) transactions 

Treasury Regulation Section 

1.7701(l)-3: Fast pay or step-down 

preferred transactions 

2000 

Revenue Ruling 2000-12: Debt 

straddles 

Notice 2000-44: Inflated 

partnership basis transactions 

(son of BOSS) 

Notice 2000-60: Stock 

compensation transactions 

Notice 2000-61: Guam trust 

2001 

Notice 2001-16: Intermediary 

transactions 

Notice 2001-17: Section 351 

contingent liability 

Notice 2001-45: Section 302 

basis-shifting transactions 

2002 

Notice 2002-21: Inflated basis 

custom adjusted rate debt 

transactions 

Notice 2002-35 and Revenue 

Ruling 2002-30: Notional 

principal contracts 

Revenue Ruling 2002-46 and 

Revenue Ruling 2002-73: 

Section 401k accelerators 

Notice 2002-50: Partnership 

straddle tax shelter 

Notice 2002-65: Pass-through 

entity straddle tax shelter 

Notice 2002-70: Certain 

reinsurance arrangements 

2003 

Revenue Ruling 2003-6: 

Abuses associated with S 

corporation employee stock 

option plans 

Notice 2003-22: Offshore 

deferred compensation 

arrangements 

Notice 2003-24: Certain 

welfare benefit fund trusts 

Notice 2003-47: 

Compensatory stock options 

Notice 2003-54: Common 

trust fund straddle 

0 

5 

10 

15 

20 

25 

30 

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: Compiled by GAO from IRS information. 

Disputes between IRS and taxpayers about the abusive nature of a 

transaction may be litigated. In some, but not all, cases, the courts have 

upheld the government position. The following cases illustrate features of 

abusive shelters: 

Page 8 GAO-04-104T 
•	 In 1993, a corporation began a company-owned life insurance (COLI) 

program in which the company purchased whole-life insurance on 

36,000 employees for which the company was the sole beneficiary. The 

company then borrowed money against the policies at interest rates that 

averaged 11 percent and deducted the interest expense and 

administrative fees from income on its tax returns. Over 60 years, the 

interest costs and administrative fees would have exceeded the cash 

surrender value of the policies and benefits paid by several billion 

dollars. IRS disallowed the deductions and the case was litigated. 

Despite the fact that the money the company made on this arrangement 

may have been used to fund the company’s benefits program, or for 

other business purposes, the court found that the function of the 

program itself was only to generate tax deductions. As a result, the Tax 

Court sustained the IRS disallowance of deductions and concluded that 

the COLI program was a sham.8 The Eleventh Circuit Court of Appeals 

affirmed the Tax Court’s decision. 

•	 A company had a sizable gain from the sale of a subsidiary and wanted 

to avoid or minimize paying tax on the gain. An investment bank 

proposed forming an offshore partnership with a foreign corporation (a 

tax-indifferent party) for the express purpose of sheltering the capital 

gains of its corporate client. The partnership purchased and quickly 

resold notes in a contingent installment sale transaction. The 

partnership earned a large capital gain, most of which it allocated to the 

foreign corporate partner. Later, related losses were allocated to the 

U.S. corporation, generating an approximate $100 million capital loss for 

the investment bank’s client. The corporation used this capital loss to 

shelter its U.S.-based capital gains. Both the Tax Court and the Third 

Circuit Court of Appeals ruled that the transaction lacked economic 

substance.9 The Third Circuit, in addition to requiring economic 

substance, held that a transaction must have a subjective nontax 

business motive to be respected for tax purposes.10 For this transaction, 

the investment bank was to earn a fee of $2 million. This was one of 11 

8

Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999), aff’d, 254 F. 3d 1313 (11th 

Cir. 2001). 

9

ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), aff’g, 73 T.C.M. 2189 

(1997), cert. denied, 526 U.S. 1017 (1999). 

10Id. at 248. 

Page 9 GAO-04-104T 
such partnerships formed over a 1-year period from 1989 to 1990 by the 

investment bank. 

Several Sources 

Indicate That the 

Scope of Abusive 

Shelters Is in the Tens 

of Billions of Dollars, 

Though All Are Based 

on Limited Data 

IRS has information that suggests the scope of abusive shelters totaled tens 

of billions of dollars over about a decade,11 but those estimates are based 

on limited data. This information comes from an OTSA database, 

examinations of large corporations, and a contractor study. Information 

contained in the OTSA database includes transactions disclosed to or 

discovered by IRS and estimates of potential tax losses. The tax loss 

estimates vary from being IRS officials’ recommended taxes based on 

examining some transactions to taxpayer judgments regarding potential 

losses in cases where examinations have not been done. In addition to 

being based on judgments, the database does not include any reductions 

resulting from examination, appeal, litigation, or other sources. 

Information from examinations of the largest corporations, which may 

overlap information in the OTSA database, shows proposed income 

adjustments in the tens of billions of dollars before reductions, but data 

were not available from IRS on the results of examinations of smaller 

corporations, partnerships, trusts, S corporations, or individuals. 

Information from IRS’s contractor study estimates an annual tax gap due to 

abusive shelters but has data and methodological limitations. 

OTSA Database 	 As shown in table 1, as of September 30, 2003, an OTSA database included 

estimated potential tax losses of about $33 billion from investments in 

listed transactions, before considering any reductions resulting from 

examination, appeal, litigation, or other sources and another $52 billion in 

potential tax losses from nonlisted transactions with some characteristics 

of abusive shelters. This database contains information on promoters and 

investors and the amount of potential tax savings resulting from listed and 

nonlisted transactions. Nonlisted transactions are transactions that 

needed to be registered because they have some characteristics of abusive 

shelters but were not, at least yet, determined to be abusive. According to 

an IRS official, IRS was studying nonlisted transactions with about 

$12 billion in potential tax losses for possible listing. The database only 

11For the decade from 1993 through 2002, corporations paid almost $2 trillion in income 

taxes. 

Page 10 GAO-04-104T 
includes information on abusive or possibly abusive transactions that had 

been disclosed to or discovered by IRS. 

Table 1: IRS’s Compilation of Tax Shelter Amounts as of January 14, 2003, and September 30, 2003 

Category of transaction Number of transactions as of Potential tax loss (billions)a

 as of 

January 14, 2003 September 30, 2003 January 14, 2003b September 30, 2003 

Listed 3,423 5,185 $29.3 $33.0 

Nonlisted 1,334 1,582 44.7 52.0 

Total 4,757 6,767 $73.9 $85.0 

Source: IRS OTSA database. 

a

The potential tax loss covers a multiyear period and does not consider reductions that may result from 

examination, appeal, litigation, or other sources. 

b

The numbers do not add to the total due to rounding. 

The estimated tax losses contained in the OTSA database cover a wide 

range of years from at least as far back as tax year 1989 and extending even 

to future tax years since, for instance, improperly claimed deductions may 

be used in some cases to reduce future taxes. For the $29 billion in 

estimated tax losses associated with listed transactions contained in the 

January 14, 2003, database, about 82 percent of the potential tax losses 

were concentrated in the period from 1993 through 2002. 

According to data IRS provided in mid-October 2003, OTSA had 

information on almost 300 firms that had possibly promoted abusive 

shelters as well as other tax planning products that contain at least some 

features of abusive transactions. It was also aware of about 6,400 

investors, including individuals and corporations that bought abusive 

shelters and other aggressive tax planning products. 

Examinations of Large 

Corporations 

IRS has proposed shelter-related adjustments to large corporations’ income 

in examinations it has closed and in examinations still open as of early May 

2003. In cases closed between October 1, 2001, and May 6, 2003, IRS 

proposed about $10.6 billion in abusive shelter-related adjustments to the 

income of 42 large corporations for tax years 1992-2000. These proposed 

adjustments would result in about $3.5 billion in tax revenue if the 

adjustments were not reduced. The corporations were in what is known as 

the Coordinated Industry Case (CIC) program, which includes the nation’s 

Page 11 GAO-04-104T 
largest corporations.12 They agreed with about $1.2 billion of the $10.6 

billion in proposed adjustments to income.13 As of early August 2003, 

Appeals research showed that few of the issues comprising the $9.4 billion 

unagreed amount had been resolved yet by Appeals or through a settlement 

initiative, although the database did not track all of them.14 For the 141 

large corporations with cases still open in early May 2003, the amount of 

proposed shelter-related income adjustments was $47.6 billion, translating 

to about $16 billion in tax if not reduced. IRS did not have similar 

information for smaller corporations. Also, since one of the sources of 

information in the OTSA database is shelter-related adjustments proposed 

in examinations, the proposed adjustments in the CIC program may 

overlap the information in the OTSA database. 

Contractor Study 	 In July 2003, an IRS contractor estimated the tax gap resulting from abusive 

shelters for different years. For 1993 through 1999, based on the 

contractor’s estimates, the average annual tax gap could have been as small 

as about $11.6 billion or as large as about $15.1 billion of forgone tax. 

However, the reliability of the contractor’s estimates is questionable 

because of methodological and data constraints the contractor faced when 

developing them. 

The estimates followed a September 2001 recommendation by the Treasury 

Inspector General for Tax Administration (TIGTA) that LMSB obtain a 

more precise estimate of the shelter problem to lay a better foundation for 

its strategy for addressing abusive shelters.15 In response, IRS contracted 

for models to predict the likelihood of finding abusive shelters within 

12Under the CIC program, IRS continually audits about 1,100 of the nation’s largest 

corporations, all of which have assets of more than $250 million. 

13IRS did not track the additional tax payments these corporations actually made related just 

to the shelter-related adjustment. However, according to data provided by IRS, they paid 

about an additional $552 million in taxes related to all issues raised by IRS, including the 

abusive shelter issues. 

14In mid-August 2003, IRS gave us information showing that for the 14 abusive shelter 

transactions Appeals had closed in fiscal year 2003 for CIC and other cases, Appeals 

sustained about 71 percent of the dollar amounts proposed as adjustments to income. 

Similar information was not available for earlier years. 

15TIGTA, Management Advisory Report: The Strategy for Curbing Abusive Corporate Tax 

Shelter Growth Shows Promise but Could Be Enhanced by Performance Measures, Report 

Number 2001-30-159 (Washington, D.C.: Sept. 13, 2001). 

Page 12 GAO-04-104T 
certain tax returns and to estimate the annual “tax gap” due to abusive 

shelters. Both IRS and contractor officials believe the contract results are 

more useful to predict returns with abusive shelters than they are to value 

the size of the abusive shelter problem. 

Nevertheless, as table 2 shows, the contractor produced estimates of the 

size of the problem for each year from 1993 through 1999. Yearly low-end 

estimates ranged from $9.0 billion of foregone tax in 1993 to $14.5 billion in 

1999. On the other hand, the high-end estimates ranged from $12.1 billion 

in 1993 to $18.4 billion in 1999.

16 Averaging the estimates over time results 

in the $11.6 billion to $15.1 billion range cited earlier. 

Table 2: Contractor Estimates of the Size of the Abusive Shelter Problem (Dollars in 

Billions) 

Year Lower bound Upper bound 

1993 $ 9.0 $12.1 

1994 9.5 12.7 

1995 10,3 13.6 

1996 11.4 14.9 

1997 12.7 16.4 

1998 13.6 17.3 

1999 14.5 18.4 

1993-1999 average 11.6 15.1 

Source: Report provided by IRS. 

Note: As computed by the contractor, the lower and upper bounds are the boundaries of 90 percent 

confidence intervals associated with the estimates. 

The tax gap model used three different kinds of data: (1) IRS’s Statistics of 

Income data for the largest U.S. companies, those with assets over 

$250 million falling within the CIC program, (2) Standard and Poor’s 

Compustat financial data, and (3) surveys of IRS field offices. IRS 

conducted surveys from 1999 through 2001 that asked field managers to 

identify abusive tax shelters in their open inventory of examinations--

16Because the contractor found that estimating the problem’s size was difficult and 

problematic, it applied a statistical technique to the estimates and produced other estimates 

for each year. However, because it did not believe the statistical technique improved the 

original estimates, we are not including the second set of estimates here. 

Page 13 GAO-04-104T 
relying on each manager’s understanding of what an abusive tax shelter is. 

Since survey data are included in the OTSA database, some of the same 

information used by the contractor appears in the OTSA information cited 

earlier. 

Treasury, IRS, the contractor, and we have concerns about the contractor 

estimates. First, it is difficult to determine whether these estimates might 

be overstating or understating the true extent of the tax gap because of the 

uncertainties in the underlying data and the elusive nature of the problem. 

In identifying abusive shelters in the IRS surveys, field managers might 

have anticipated that some abusive shelters existed where there were none 

or where the assertion of abuse might not be sustained. On the other hand, 

they might not have identified all the abusive shelters in their open 

inventory of examinations because their definitions of abusive shelters 

might have differed from each other. Finally, the data might not be 

representative of all transactions, especially those that closed, because 

survey responses were only to include open cases. 

Second, the Statistics of Income data only included U.S. corporations with 

assets of over $250 million falling within the CIC program. Many shelters 

may be reflected in tax returns of smaller corporations, partnerships, 

Subchapter S corporations, and wealthy individuals and were not included 

in this study. Since these transactions were not included in the contractor’s 

estimate, the resulting tax gap estimate is incomplete. 

Third, the estimates are based on known shelters. They were developed 

using 1990s’ ideas of what constituted abusive shelters. Since then, more 

shelters have been disclosed or identified by IRS and still others are under 

consideration for listing. Since the definition of an abusive shelter can 

change over time, and the data cannot reflect unknown or unidentified 

shelters, the operational definition of abusive shelters was a conservative 

one. 

While the last two concerns argue that the contractor’s estimates 

understate the true level of abusive shelters for recent years, the 

contractor’s estimates and other indicators of the problem’s size based on 

past data may also be of limited use as guides to current and future activity 

for other reasons. According to Treasury and IRS officials, the legal and 

economic environment has changed since the data for this study were 

developed. First, they said, IRS has taken many administrative actions to 

address abusive shelters. For instance, it is their belief that nothing puts 

more of a damper on taxpayer participation in a particular type of 

Page 14 GAO-04-104T 
transaction than IRS listing it. Similarly, although corporate-owned life 

insurance transactions may heavily influence the contractor’s estimates, 

legislation addressed the problem in 1996 and 1997, and therefore current 

and future estimates would not reflect that problem—although they could 

reflect problems not identified in the period covered by the contractor’s 

study. Second, court cases have largely supported IRS’s assertions about 

the need for business purpose requirements and about requirements for 

economic substance in transactions. Third, today’s economy is not as 

robust as the economy in the late 1990s, generating less profit to protect. 

Finally, the publicity surrounding numerous corporate scandals may create 

a chilling effect in the market for aggressive transactions. Countering these 

points, however, are other opinions appearing in the press that (1) the 

courts could uphold some tax shelters and (2) IRS’s capacity to stem 

abusive shelters is limited. 

IRS Strategy to Combat 

Abusive Shelters Is 

Broad-Based but 

Generally Has No 

Long-Term 

Performance Goals or 

Measures Linked to 

Goals 

IRS developed a broad-based strategy for combating abusive shelters that 

included various features as well as elements of strategic planning. 

Deeming it a strategic initiative, IRS is executing a strategy incorporating 

four principal elements: (1) an emphasis on promoters, (2) efforts to deter, 

detect, and resolve abuse, (3) coordination of efforts throughout IRS, and 

(4) inducements provided for taxpayers to come forward and expedite case 

resolution. IRS is implementing a variety of initiatives designed to reduce 

taxpayer incentives to participate in abusive transactions and discourage 

promoters from marketing these transactions. Although IRS documents 

outline an overall strategy for combating abusive shelters, IRS has 

generally not yet defined long-term performance goals for the effort and the 

measures it would use to track progress in achieving those goals.17 

However, IRS is planning to establish such goals and measures when it has 

more information on the abusive shelter activities it is currently tracking. 

IRS Is Actively Pursuing 

Promoters 

IRS is actively pursuing abusive promoters to ensure (1) that tax strategies 

containing characteristics of potentially abusive shelters are registered, 

(2) that information about transactions is disclosed to IRS as required by 

17Although GPRA is generally applied to agencywide strategic plans, its framework is useful 

to guide any type of planning. GPRA requires long-term strategic and annual performance 

goals and associated measures, preferring measures relating to outcomes (results) versus 

outputs (activities). The Office of Management and Budget says that strategic plans set out 

long-term goals, outlining planned accomplishments and their implementation schedule. 

Page 15 GAO-04-104T 
sections 6111 and 6112 of the Internal Revenue Code, and (3) that, 

according to IRS’s OTSA manager, those who generate noncompliance 

change their behavior or go out of business. With 98 abusive shelter 

promoters approved for investigation as of June 30, 2003, IRS uses 

investigations to gain access to lists of the clients who buy promoters’ 

products and devise a roadmap to audit shelters included in the tax returns 

of the investors. IRS is also using promoter investigations to enforce the 

transaction registration requirements, which, in turn, assist in its efforts to 

understand, track, and close abusive shelters. IRS announced the 

completion of three large promoter investigations in 2001 through July 

2003. They resulted in, among other things, three substantial payments and 

promoter promises to work with IRS to ensure ongoing compliance with 

shelter registration and list maintenance requirements. 

IRS Efforts Are to Deter, 

Detect, and Resolve 

IRS focuses its efforts on deterring future marketing and sales of abusive 

tax shelters and on detecting and resolving existing shelters. TIGTA 

described IRS’s abusive shelter approach along the lines of deter, detect, 

and resolve in September 2001.18 IRS considers its efforts to provide 

guidance as early as possible to taxpayers and promoters in the form of 

recently proliferating IRS and Treasury determinations, notices, and rulings 

on abusive transactions and of registration, list maintenance, disclosure, 

and other requirements to be a key deterrent. (See fig. 2.) Also designed to 

deter abusive tax shelters, accuracy-related penalties aim at investors who 

use abusive shelters to substantially undervalue true tax liability. Other 

penalties are for promoters who market shelters that aid and abet the 

understatement of tax liability or who fail to register shelters. IRS’s 

Examination Returns Control System showed IRS assessing 21 investor 

penalties totaling about $73 million between July 1, 2002, and May 1, 2003, 

which taxpayers had not necessarily agreed to pay. During our review, 

Treasury included proposed legislation in the Administration’s revenue 

proposals to strengthen the penalties that could be used in abusive shelter 

situations. 

IRS’s ability to detect abusive shelters increased in the last 3 years due to 

OTSA’s hotline, through which callers provide tips about transactions or 

investors; disclosure, registration, and list maintenance requirements; 

increased attention by IRS management; and increased use of IRS 

18TIGTA, Report Number 2001-30-159. 

Page 16 GAO-04-104T 
examination resources to look for shelter irregularities. For instance, 

between May 31, 2000, and July 30, 2003, the hotline received 729 shelterrelated telephone calls and e-mails, some of them leading IRS to new listed 

transactions, promoters, and investors. As another example, IRS expanded 

its disclosure requirements in June 2002 to include noncorporate 

taxpayers. Finally, as evidence of increased management attention, IRS 

established a new senior position reporting to the IRS Chief Counsel to 

supervise staff and lead task force initiatives to more quickly identify and 

deal with abusive shelters. 

Cases may be resolved at the examination level if taxpayers agree with IRS 

findings. If taxpayers do not agree, cases are resolved at the appeals level, 

through litigation, or by alternative dispute resolution. 

In addition to these detection and case resolution efforts, IRS is using 

Schedule K-1 data to research better methods of detecting abusive shelters 

that involve multiple levels of flow-through entities.19 These complex 

structures of related entities pose challenges in analyzing tax compliance 

by creating opportunities for taxpayers to disguise noncompliance. In the 

future, IRS hopes to use advanced data analysis tools such as link analysis 

and graph-based data mining to identify potential abusive shelters. Link 

analysis is the process of building networks of related entities, such as 

flow-through entities and Schedule K-1 recipients, in order to expose 

patterns and trends. Graph-based data mining, a form of link analysis, is 

intended to enable IRS to identify structures of known abusive shelters and 

find similar patterns in the population of flow-through networks to 

discover previously undisclosed potential abusive shelter transactions. IRS 

has paid a contractor $200,000 so far to assess the feasibility of these 

technologies and plans to spend $575,000 over the next 1.5 to 2 years to 

develop these concepts into models. 

IRS Emphasizes Internal 

Coordination 

Coordination within IRS and interface with Treasury on abusive shelters is 

a core objective in IRS’s plans for addressing those shelters. OTSA is the 

focal point for all shelter-related activity performed in the Tax Shelter 

Committee, the 6700 Committee, Counsel, Appeals, and LMSB. For 

example, if a taxpayer discloses an investment in a tax shelter to IRS, OTSA 

is to enter the transaction into its database, and OTSA reviews the 

19Appendix I describes the Schedule K-1, flow-through entities, and other compliance efforts 

using Schedule K-1 data. 

Page 17 GAO-04-104T 
transaction in collaboration with IRS technical advisors and counsel. 

OTSA may also forward it to LMSB examiners for compliance action. 

At the IRS-wide level, an executive steering committee provides a forum 

for coordinating work on both abusive shelters and abusive schemes. It 

meets monthly and includes participants from LMSB, the Small 

Business/Self Employed Division, Appeals, Counsel, and other 

organizations. It operates under the auspices of IRS’s Enforcement 

Committee, which was chartered in July 2003. Chaired by the Deputy 

Commissioner for Services and Enforcement, a new position created in 

May 2003, the Enforcement Committee is to guide IRS-wide enforcement 

strategies, focusing on high-visibility issues involving many divisions or 

potentially having significant compliance impact. 

Although we did not systematically measure whether coordination is 

facilitated by these mechanisms, we did review minutes of selected 

executive steering committee meetings. In doing so, we saw such evidence 

of coordination as the discussion of an LMSB and SB/SE working group on 

who would work a corporate officer case when LMSB works on a 

corporation. 

IRS Offers Inducements for 

Taxpayers to Disclose 

Shelters and Expedite Case 

Resolution 

LMSB attempts to leverage its limited resources by using inducements to 

achieve compliance. These tools include penalty relief, “fast track” issue 

resolution, and various structured settlement programs that allow 

participating taxpayers to keep a percentage of a shelter’s benefits in 

exchange for conceding most benefits and expediting case resolution. For 

example, under a disclosure initiative that expired on April 23, 2002, 

taxpayers who revealed shelters and their respective promoters avoided 

accuracy-related penalties. IRS’s aim was to more readily identify 

promoters who had not registered shelters and, through the promoters, 

find taxpayers who had not disclosed their shelter participation. As a 

result of this initiative, IRS received 1,664 disclosures from 1,206 taxpayers, 

disclosing tens of billions of dollars of losses and deductions. 

IRS offered taxpayers various alternative dispute resolution mechanisms as 

inducements to settle abusive shelter issues with IRS, mitigating the 

hazards of litigation for both sides and moving more cases through the 

administrative system quickly. For example, from October 2001 through 

April 7, 2003, 17 taxpayers agreed with IRS on their respective shelter 

issues in the Fast Track Issue Resolution program, resolving about 

$1.6 billion in proposed adjustments to income (potentially about 

Page 18 GAO-04-104T 
$540 million in tax). In another example, IRS announced initiatives in 

October 2002 to resolve disputes related to three shelters: COLI, basisshifting shelters, and contingent liability shelters.20 In these initiatives, if 

taxpayers agreed to settle their cases with IRS by a certain date, with the 

last initiative closing March 5, 2003, they would pay a large percentage of 

the full amount IRS disallowed. A summary as of early May 2003 of the 

number of investors involved in the three settlement initiatives and the 

potential tax dollars conceded or to be conceded appears in table 3.21 

Table 3: Investors Accepting Abusive Shelter Settlement Initiative Offers and 

Potential Tax Dollars Conceded or to Be Conceded as of Early May 2003 

Number of 

taxpayers Number of taxpayers 

accepting for whom IRS had 

IRS information on taxes Potential tax dollars 

settlement conceded or to be conceded or to be 

Settlement initiative offer conceded conceded (billions) 

COLI 24 14 $0.2 

Basis shifting 267 33 

Contingent liability 62 62 2.8a 

Total 353b 109b $3.6 

Source: Compiled by GAO from IRS data.


a

GAO estimated this number using an average of certain capital loss percentages to be conceded.


b

We do not know if a particular taxpayer was involved in more than one type of settlement initiative.


Generally IRS Does Not Although IRS has outlined and begun to implement a multipart strategy for 

Have Long-Term combating tax shelters, it has not yet generally defined performance goals 

Performance Goals or for the effort and established the measures it would use to track progress in 

Measures Linked to Goals achieving those goals. Performance goals define what an organization is 

20IRS Notice 2001-51 identifies certain listed transactions. It describes basis-shifting 

transactions as “certain redemptions of stock in transactions not subject to U.S. tax in 

which the basis of the redeemed stock is purported to shift to a U.S. taxpayer.” It describes 

contingent liability transactions as “transactions involving a loss on the sale of stock 

acquired in a purported [Internal Revenue Code section] 351 transfer of a high basis asset to 

a corporation and the corporation’s assumption of a liability that the transferor has not yet 

taken into account for federal income tax purposes.” 

21Some of these investors are also included in the fast track program just described. 

Page 19 GAO-04-104T 

0.6 
trying to achieve over time, preferably focusing on the outcome desired 

rather than activities or outputs. To date, according to IRS officials, their 

shelter-related goals cover the number of staff years to be devoted to 

shelter examinations and the number of shelter examinations to be closed. 

Also, LMSB planning documents have a few short-term goals. For example, 

LMSB had a short-term goal to begin compliance actions on all voluntary 

shelter disclosures by June 30, 2003, a goal IRS officials told us was met. 

IRS management officials recognize that developing other performance 

goals and associated measures to track progress is desirable but point to 

challenges they face in assessing the scope of the abusive shelter problem. 

Nonetheless, IRS intends to establish such goals in the future when it has 

more information on activities it is currently tracking. 

IRS has already started down this road by developing several measures 

that, while not tied to longer-term performance goals, are to be used in 

tracking its progress in combating abusive tax shelters. It devised these 

measures for fiscal year 2003 responding to a September 2001 TIGTA 

recommendation to develop performance measures so managers could 

better target problem areas, highlight successes, evaluate alternatives, and 

track whether OTSA is achieving desired outcomes. IRS is mostly tracking 

outputs related to case management, such as the number of tax shelter 

examinations closed and tax shelter return cycle time, and is using output 

measures of IRS program activities, such as published guidance issued and 

hotline contacts. IRS is also using some measures that track tax 

enforcement outcomes, namely adjustments proposed to tax returns from 

disallowing abusive shelters and tax shelter penalties proposed.22 Since 

fiscal year 2003 was the first year IRS used these measures, it had no 

baseline data with which to evaluate its performance measures. However, 

LMSB plans to evaluate its measures over time to assess their usefulness. 

22LMSB called the tracking of adjustments a “record of tax enforcement results.” IRS does 

not use performance measures for outcome measures like these because the IRS 

Restructuring and Reform Act of 1998 prohibited it from using tax enforcement results to 

evaluate any employee or to impose or suggest production quotas or goals. 

Page 20 GAO-04-104T 
Resource Shifts Are 

Significant but IRS 

Faces Challenges in 

Addressing Abusive 

Shelter Workload 

Using admittedly limited information, IRS used a systematic decisionmaking process in deciding to shift a large portion of LMSB examination 

staff resources toward addressing abusive shelters. From fiscal year 2002 

through fiscal year 2004, LMSB expected to increase the portion of its 

examination resources devoted to combating abusive shelters from 3 

percent in 2002 to 20 percent in 2004. In doing so, it will have shifted 

resources out of examining the category of cases including such areas as 

net operating losses and claims for refunds. Even so, IRS faces challenges, 

especially in the near term, in addressing expected increases in its shelter 

workload because of the growing number of shelter cases and limited 

information it has on how long it takes to conduct shelter examinations. As 

will be described, GAO has previously raised questions about IRS’s ability 

to shift compliance resources as planned. 

IRS Used Systematic 

Planning and Budgeting 

Process to Determine 

Staffing Priorities 

At an agencywide level, IRS decided staffing resource levels to be devoted 

to addressing abusive shelters through a systematic planning and budgeting 

process based on experience and professional judgment because IRS did 

not and does not have a reliable measure of the abusive shelter problem. 

Early in calendar year 2002, IRS’s divisions completed strategic 

assessments in which they studied trends, issues, and priorities affecting 

their operations. In April 2002, IRS’s senior management team, including 

the Commissioner, Deputy Commissioner, division heads, and others used 

two rounds of considering IRS’s programs to rank the needs for new or 

redirected funding for fiscal year 2004. Of 33 programs considered, the 

program including tax shelters received the third most votes. According to 

an IRS official, this process also informed how funds already requested for 

fiscal year 2003 would actually be spent. After the senior management 

team reached consensus, the Commissioner issued overall planning 

guidance for fiscal years 2003 and 2004 to reflect the jointly set strategic 

direction, and the divisions wrote fiscal year 2003 and 2004 “strategy and 

program plans” outlining staffing resources needed. 

IRS Shifts Significant Levels In 2002, LMSB put forward plans to increase its work on abusive shelters 

of Examination Resources from 3 percent of its examination resources to 20 percent between fiscal 

to Shelters years 2002 and 2004, assuming congressional funding. To support this shift 

in examination resources, LMSB needed to allocate examination resources 

away from other areas. One area to receive less audit coverage was 

Page 21 GAO-04-104T 
industry audits.23 As shown in table 4, from fiscal year 2003 to fiscal year 

2004, IRS planned to move resources away from specific types of 

mandatory examinations and from some high-risk nonmandatory returns.24 

IRS’s strategy is to mitigate the impact of resource reallocations away from 

nonshelter areas by using such issue management strategies as fast-track 

resolution and prefiling agreements, thereby requiring less staff time to 

close cases and freeing staff to be used in other areas. 

Table 4: Percentage of LMSB Examination Resources in Different Examination 

Areas 

FY FY FY 

Examination area 2002a 2003 2004 

Shelters 3% 15% 20% 

Other mandatory examinations (including coordinated N/A 55% 54%c 

industry, 

b

 claims for refunds, net operating losses, 

compliance initiative projects, and flow-through entities 

related to wealthy individuals) 

Related returns N/A 5% 4%c 

High-risk, nonmandatory returns N/A 15% 13% 

Nonreturn examination activities N/A 10% 10% 

Total -- 100% 100%d 

Source: LMSB September 20, 2002, presentation to the IRS Oversight Board, as amended after the presentation. 

a

Information for most of the rows in this column was not available, as the presentation to the Oversight 

Board did not include it. 

b

Coordinated industry cases are examinations of the nation’s largest corporations, those under 

continual IRS audit. 

c

At the time of the September 20, 2002, presentation to the Oversight Board, the 54 and 4 percent 

were 52 and 5 percent, respectively. 

d

The column does not add to 100 percent because of rounding. 

23IRS defines an “industry” case return as the return of an organization with assets of more 

than $10 million but without being part of the largest corporations that are under continual 

IRS audit. 

24According to LMSB officials, mandatory examinations are those LMSB knows it will do, 

such as those for abusive shelters and promoters. Nonmandatory examinations are what 

remain after mandatory work is accommodated. High-risk nonmandatory examinations are 

those in the nonmandatory category that have the highest probability that a taxpayer needs 

compliance activity. 

Page 22 GAO-04-104T 
In addition to LMSB examination staff, IRS has managers, attorneys, and 

others who work on abusive shelters. For instance, in February 2003, 

OTSA and its parent body, the Office of Pre-Filing and Technical Guidance, 

had 39 full-time and 34 part-time technical experts, program analysts, and 

managers. Also at that time, a contact list for listed transactions included 

17 attorneys. These numbers did not include many of the IRS legal 

resources involved with abusive shelters. In addition, as of September 30, 

2003, LMSB had assigned about 1,900 abusive and potentially abusive 

shelter transactions involving non-LMSB taxpayers to IRS’s Small 

Business/Self-Employed Division, which supplies examination staff 

resources of its own. 

IRS Faces Challenges in 

Addressing Increasing 

Shelter Workload 

Although IRS appeared to be on track to shift planned resources to shelter 

work in fiscal year 2003, it faces challenges in addressing the abusive 

shelter workload, especially in the near term. This is because of (1) the 

growing numbers of transactions and promoters to be examined and 

(2) limited information on how long it takes to conduct shelter 

examinations. 

From fiscal year 2002 through fiscal year 2004, LMSB planned to use 1,879 

full-time equivalents (FTE) to address abusive shelters. During fiscal year 

2002, LMSB used 239 FTEs to address tax returns that included abusive 

shelters.

25 According to IRS’s fiscal year 2004 congressional budget 

justification, LMSB planned to allocate 691 and 949 FTEs in fiscal years 

2003 and 2004, respectively. In a draft strategy and program plan dated 

September 2003, LMSB projected it would actually use 615 FTEs for shelter 

work in fiscal year 2003, or 88 percent of the planned amount and an 

increase of 157 percent over the fiscal year 2002 FTE level including this 

work. 

Because (1) the known abusive shelter workload has increased, (2) IRS has 

limited experience to judge how many resources will be needed to work 

the cases for how long a period, and (3) the workload may continue to 

increase, it remains uncertain whether the substantial shift of resources to 

shelter work will enable IRS to examine in a timely manner the growing 

workload associated with shelters. For instance, the number of potential 

25According to LMSB officials, the fiscal year 2002 FTEs include time spent on the entire 

returns containing shelters, not on the shelter issues alone. The estimates for fiscal years 

2003 and 2004 are focused more on the shelter issues. 

Page 23 GAO-04-104T 
examinations of listed transactions disclosed has grown since the inception 

of OTSA, adding significantly to IRS resources required to address the 

problem. Table 5 shows the number of listed transactions disclosed by 

taxpayers grew from 51 to 2,182 between December 31, 2000, and 

September 30, 2003, and other transactions disclosed to IRS grew from 

none to 663. The total of all listed and nonlisted LMSB-related transactions 

in the OTSA database, not only those disclosed by taxpayers, as of 

September 30, 2003, was 4,897. 

Table 5: Taxpayer Disclosures of Listed and Other Reportable Transactions between 2000 and September 30, 2003 

Section 6011 disclosures Calendar year (CY) 2000 CY 2001 CY 2002 CY 2003 through September 30 Total 

Listed transactions disclosed 51 63 1,251 817 2,182 

Other reportable transactions disclosed 0 214 308 141 663 

Source: IRS. 

IRS workload from promoter investigations has also grown since May 2002. 

At that time, IRS planned that 7 promoter investigations would be ongoing 

in fiscal year 2003. As of June 30, 2003, IRS had 98 promoter investigations 

approved. Based on early promoter investigations, an IRS official stated 

that promoter investigations can take thousands of hours to develop, and 

several have been litigated, each requiring a large expenditure of resources. 

LMSB has limited information on the amount of time required to examine 

abusive shelter cases. LMSB developed estimates of the amount of 

examination time required for such cases based on its experience 

examining various types of shelters but acknowledged that examiners can 

spend hundreds or thousands of hours depending on the type of shelter 

examined and the facts and circumstances of the case. For example, 

according to an LMSB official, based on personal experience, OTSA 

estimated that it would take about 800 hours to examine a potentially 

abusive transaction reflected in the return of a CIC corporation although 

LMSB had little data to support the estimate. During fiscal year 2003, IRS 

began collecting data on examination time that it plans to use for 

estimating the resources needed to address its abusive shelter workload. 

The future abusive shelter workload also could increase, at least in the 

short term. For example, as IRS learns more about the use of shelters, it 

may identify and list new kinds of transactions as being abusive. As IRS 

Page 24 GAO-04-104T 
conducts the 98 promoter investigations approved as of June 2003, more 

investors are likely to be identified, and investor cases could lead to 

identifying more promoters. In addition, IRS expanded the types of 

taxpayers subject to disclosure requirements to include taxpayers like 

individuals, partnerships, and S corporations. According to IRS officials, 

disclosures from these types of taxpayers are first due to IRS for filing year 

2003 and generally do not yet appear in the OTSA database. 

In the longer term, what happens to the abusive shelter workload is less 

certain. To the extent that IRS actions and other factors reduce the size of 

the abusive shelter problem, IRS might not need to continue devoting as 

large a percentage of its examination resources to abusive shelters. How 

much and how soon such a drop may occur in abusive shelter cases is 

uncertain. 

We have previously raised questions about IRS’s ability to shift compliance 

resources as planned. We recently testified that many parties have 

expressed concern about declining IRS compliance—especially audit—and 

collection trends for their potential to undermine taxpayers’ motivation to 

fulfill their tax obligations.26 Concerned about these trends, IRS has sought 

more resources, including increased staffing for compliance and 

collections since fiscal year 2001. Despite receiving requested budget 

increases, staffing levels in key occupations were lower in 2002 than in 

2000. These declines occurred for reasons such as unbudgeted expenses 

consuming budget increases and other operational workload increases. 

Based on past experience and uncertainty regarding some expected 

internal savings, fiscal year 2004 anticipated staff increases might not fully 

materialize. Thus, if IRS carries through with its intentions to increase 

resources devoted to abusive shelters, it may not have the desired level of 

resources in other areas of compliance. 

Concluding 	 Abusive tax shelters represent a potentially significant, although 

imprecisely understood, loss in tax revenues. IRS developed and is Observations	 following a broad-based, multifaceted strategy to combat abusive shelters 

even though it had limited data on the full scope of the problem. IRS’s 

strategy generally does not contain long-term performance goals and 

26U.S. General Accounting Office, Compliance and Collection: Challenges for IRS in 

Reversing Trends and Implementing New Initiatives, GAO-03-732T (Washington, D.C.: 

May 7, 2003). 

Page 25 GAO-04-104T 
associated measures that can help Congress evaluate IRS’s progress. 

Although establishing performance goals and measures is inherently 

difficult since the scope and nature of abusive shelters is elusive, the need 

for such goals and measures is heightened because IRS is shifting large 

amounts of examination staff resources to support combating abusive 

shelters. IRS’s initial decisions on shifting resources might need to be 

reevaluated as IRS develops better information on the size of the abusive 

shelter problem and the amount of time it takes to examine abusive shelter 

cases. We encourage IRS to continue its efforts to obtain a better analytic 

basis for determining the resources needed to address schemes and 

shelters–while providing sufficient attention to other tax compliance 

areas–and to develop goals and measures that it and Congress can use to 

gauge IRS’s progress. 

Mr. Chairman, this concludes my prepared statement. I would be happy to 

respond to any questions you or other Members of the Committee may 

have at this time. 

Contact and 	 For further information on this testimony, please contact Michael Brostek 

at (202) 512-9110 or brostekm@gao.gov. Individuals making key Acknowledgements	 contributions to this testimony include Ralph Block, Elizabeth Fan, Amy 

Friedheim, Lawrence Korb, Signora May, and James Ungvarsky. 

Page 26 GAO-04-104T 
Appendix I 

IRS Compliance and Research Programs 

Using the Schedule K-1 

Schedule K-1s are information returns that link flow-through entities with 

their income recipients and therefore can be used for various compliance 

and research purposes, such as the automated underreporter (AUR) 

program1

 and profiling potential nonfilers. 

Partnerships, S corporations, trusts, and estates are collectively known as 

flow-through entities because they can legally pass net income or loss 

through to their partners, shareholders, and beneficiaries. Flow-through 

entities are required to provide IRS and each partner, shareholder, or 

beneficiary with a Schedule K-1 stating the individual share of net income 

or loss to be reported. These individuals are then responsible for reporting 

this income or loss on their individual income tax returns and paying any 

applicable tax. According to IRS in tax year 2001, over 9 million flowthrough entities reported passing through almost $1 trillion to 

approximately 24 million partners, shareholders, or beneficiaries. IRS 

research efforts suggest that 6 to 15 percent of the K-1s attached to flowthrough returns are currently being omitted from beneficiary, partner, and 

shareholder returns. To better detect such noncompliance, IRS began 

transcribing nonelectronically submitted Schedule K-1s for tax year 2000 at 

a cost of about $20 million. 

In 2001, IRS added Schedule K-1 document matching to its AUR program. 

It began matching Schedule K-1 data to individual tax returns to identify 

taxpayers who had underreported flow-through income and had 

consequently underpaid their taxes. IRS estimated that K-1 matching 

program costs would be about $23.5 million total for both K-1 transcription 

and AUR program operations and that program yield would be $36 million 

in direct tax assessed. IRS also estimated that if voluntary compliance 

improved one percent due to the matching program, approximately 

$1.23 billion of additional tax would be generated annually. In the first year 

of the program, IRS issued about 69,000 notices to taxpayers and assessed 

about $29 million in additional taxes directly attributable to Schedule K-1 

underreporting.

2 GAO estimates that when program assessments are 

compared to the costs of the program’s AUR operations, the return per 

1

The AUR program matches information return data, such as Forms W-2 and 1099 and 

Schedule K-1, with individual tax return data to verify that all income is reported. 

2

IRS began notifying taxpayers of potential discrepancies between income reported on the 

K-1 and individual tax returns in April 2002. However, after receiving complaints that 

notices were being sent to compliant taxpayers, IRS stopped issuing notices in August 2002. 

IRS data on number of notices sent and tax assessed were provided in August 2003. 

Page 27 GAO-04-104T 
Appendix I


IRS Compliance and Research Programs 


Using the Schedule K-1


dollar of the K-1 matching program was about $9.31. If the cost of 

transcribing the K-1 data is included, the return per dollar decreases to 

about $1.25.3 Both of these assessment-to-cost ratios are substantially 

lower than that for the AUR program as a whole.4 The AUR program 

returned about $25 for every dollar spent in tax year 2000.5 

IRS has also used Schedule K-1 data to determine characteristics of 

potentially noncompliant taxpayer populations. Its preliminary profiling 

efforts identified over 227,000 business entities with almost $64 billion in 

Schedule K-1 income for tax year 2000 that potentially did not file tax 

returns. As of September 2003, IRS had begun to discuss ways of analyzing 

these cases to determine whether these businesses were required, but 

failed, to file returns, or whether inaccuracies in Schedule K-1 data 

produced false nonfiler leads. In addition, in response to a Treasury 

Inspector General for Tax Administration report issued in September 2002,6 

the agency has begun to research the effectiveness of using information 

returns, such as the K-1, to identify business nonfilers. 

3

To increase efficiency and improve the accuracy of K-1 data, IRS is exploring twodimensional bar coding of Schedule K-1s. Instead of transcribing K-1 data, IRS would scan a 

bar code on the K-1 and electronically upload the information. 

4

Because the Schedule K-1 document matching program is new, its return on investment 

may be low compared to mature AUR programs. 

5

Information about the AUR program is based on IRS data from December 28, 2002. 

6

Treasury Inspector General for Tax Administration, The Internal Revenue Service Should 

Evaluate the Feasibility of Using Available Documents to Verify Information Reported on 

Business Tax Returns, Report Number 2002-30-185 (Washington, D.C.: Sept. 18, 2002). 

(440158) Page 28 GAO-04-104T 
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