TAX

ADMINISTRATION

IRS’ Return Selection

Process

United States General Accounting Office

GAO Report to the Chairman, Committee on

Ways and Means; and the Chairman,

Subcommittee on Oversight, Committee

on Ways and Means, House of

Representatives

February 1999

GAO/GGD-99-30

United States

General Accounting Office

Washington, D.C. 20548

General Government Division

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Page 1 GAO/GGD-99-30 IRS’ Return Selection Process

GAO

February 22, 1999

The Honorable Bill Archer

Chairman, Committee on Ways and Means

House of Representatives

The Honorable Amo Houghton

Chairman, Subcommittee on Oversight

Committee on Ways and Means

House of Representatives

For 1992, according to the most recent estimate of the Internal Revenue

Service (IRS), individual taxpayers, at the time they submitted their tax

returns, did not pay about $100 billion in income tax liabilities. An audit is

one of the enforcement tools IRS uses to try to reduce this figure.

Recently, Congress has voiced concerns about the methods IRS uses to

select returns for audit and the techniques used to conduct audits. These

concerns contributed to the passage of the IRS Restructuring and Reform

Act of 1998 (Public Law 105-206, July 22, 1998). Among other things, this

act limits IRS’ ability to use certain audit techniques and requires that IRS

include in information it sends to taxpayers an explanation of the reasons

why it selects returns for audit.

IRS has many sources from which to select tax returns for audit. IRS’

intent is to select returns with audit potential—returns for which an audit

is most likely to find errors and recommend changes to the reported tax.

One source is the discrimnant function (DIF), an automated system for

scoring individual tax returns according to their audit potential. IRS’ policy

also allows returns to be selected through non-DIF sources (e.g., referrals

from other federal and state government agencies) if these returns can be

shown to have a greater audit potential than a DIF-selected return.

In an April 1996 letter, the committee asked that, among other things, we

explore how effectively IRS selects individual income tax returns for

audit.1

 However, IRS does not have information on all aspects of audit

effectiveness. Consequently, we agreed, on the basis of discussions with

your office, to focus on audits in which auditors in IRS district offices hold

 

1

This is the third in a series of reports you requested on IRS’ audit process. The other two were: Tax

Administration: More Criteria Needed on IRS’ Use of Financial Status Audit Techniques, (GAO/GGD98-38, December 30, 1997); and IRS Audits: Workpapers Lack Documentation of Supervisory Review,

(GAO/GGD-98-98, April 15, 1998).
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Page 2 GAO/GGD-99-30 IRS’ Return Selection Process

face-to-face meetings with individual taxpayers to review their books and

records. 2 For these books and records audits, we agreed to (1) determine

the extent to which IRS district offices have used various sources to select

these individual returns for audit; and (2) compare the results of audits

selected using these sources in terms of the rate at which audits

recommended no-change to the tax reported (no-change audits), amount

of additional taxes recommended per return audited, and rates at which

IRS assessed and collected such recommended taxes after the audit.3

 For

our analyses, we examined books and records audits of returns received

by IRS in 1992, 1993, and 1994 that were closed within a 4-year period.4

Of the 1.1 million closed books and records audits of returns received in

1992, 1993, and 1994, our analysis showed that IRS selected 59 percent of

the returns using its DIF source. The other 41 percent were selected using

non-DIF sources.

When we compared the results from DIF and non-DIF audits of returns

received in 1992, 1993, and 1994, the non-DIF audits generally resulted in

lower no-change rates and higher recommended additional taxes than DIF

audits. These results are consistent with IRS’ policy to use non-DIF

sources if the audit potential appears to be higher than it would be from a

DIF audit.

In contrast, we estimated that IRS collected a greater proportion of the

additional taxes recommended in DIF audits than for non-DIF audits,

based on a sample of returns received in 1992. An estimated 57 percent of

the recommended additional taxes were collected for DIF audits versus 35

percent for non-DIF. Several IRS operations affect collections and we were

unable to determine from IRS’ data which of these caused the non-DIF

collection rate to be lower.

Caution is needed if one uses the three results we analyzed to compare the

effectiveness of DIF and non-DIF sources. The no-change rate, the

recommended additional tax amounts, and the collection rate on these

recommended amounts do not present a complete picture of audit

 

2

As discussed in the Scope and Methodology section and appendix I of this report, we excluded some

audits because they are not typical books and records audits.

3

In this report, when we refer to the recommended additional tax, this includes refunds and penalty

amounts, if applicable. IRS combines tax and penalties into one figure reported as “audit results.” This

figure cannot be separated in IRS’ data files.

4

Between 2 and 5 percent of the returns selected for audit remained open at the end of our study

period. See the scope and methodology section for a discussion of these open audits.

Results in Brief
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Page 3 GAO/GGD-99-30 IRS’ Return Selection Process

effectiveness. For example, data are not readily available on how audits

affect voluntary compliance and taxpayer burden. Nor are data readily

available on how other factors, such as the quality of the audits, affected

the results across the selection sources.

IRS conducts various compliance checks to determine whether taxpayers

reported the correct tax liability on their returns. Initially, taxpayers may

be contacted as IRS processes their filed returns if IRS identifies a math

error or missing information on the return. IRS also uses computers to

match information on the tax return with information obtained from third

parties, such as employers and financial institutions, that report payments

such as salaries and interest paid to individuals. During fiscal year 1996,

IRS used computer matching to identify about 3.2 million taxpayers who

may have underreported income on returns or not filed required returns.

Additionally, IRS audited about 2.1 million tax returns to determine

whether taxpayers reported the correct tax liability.

Audits are performed at IRS’ 10 service centers and 33 district offices.

Service centers and district offices perform different types of audits on the

basis of complexity of the audit, training and pay grade of auditors, and

audit techniques used. Service centers conduct correspondence audits,

generally of a single issue such as earned income credit claims. These

audits rely on correspondence to ask taxpayers to provide information

about an item on the tax return. Face-to-face audits with taxpayers to

review their books and records occur in IRS’ 33 district offices. District

office audits are more complex, with multiple issues and often more than 1

tax year being audited.

IRS has developed many sources, or reasons, for selecting returns for

audit, which can be segregated into those using DIF sources and those

using non-DIF sources.5

 DIF scores are automatically calculated for all

filed individual tax returns. This DIF calculation is based on a series of

formulas developed by IRS that are designed to indicate the returns that

have the highest probability of a tax change if audited. The higher the DIF

score the greater this probability.

Before implementing DIF, IRS had no systematic way to evaluate which

among all filed returns had the greatest potential for changes to the

reported tax if audited. Instead, IRS relied on its auditors across the

 5

The exact number of source codes used varies by year because IRS periodically combines some and

develops new ones. See appendix I for list of all source codes used by IRS during the years covered in

this review.

Background
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country to identify which returns to audit by using their experience and

judgment in reviewing returns. This process was time consuming and

required large amounts of resources.

Starting in 1969, IRS began using DIF as part of a multistage process to

narrow down the number of returns to be reviewed by the auditors. This

process change was intended not only to improve the effectiveness of

return selection, but also to reduce the amount of judgment involved in

selecting returns for audit. Calculating the DIF score for all filed returns is

the first stage of this process. Then, returns with DIF scores above a

national cutoff are to be placed in the DIF inventory, from which they may

be selected for audit by a district office.

In the next stage, the district offices are to indicate how many DIF-scored

returns will be needed by their various suboffices. Returns with the highest

DIF scores are to be pulled from the DIF inventory and reviewed by

experienced auditors to determine whether the return will be accepted as

filed or sent to the district for audit. In this process, known as

classification, reviewers also are to indicate which portions of the return

should be audited. Once in the district, returns are generally reviewed at

multiple levels before being sent to an audit group for distribution to the

auditors.

Districts also use numerous non-DIF sources for identifying specific

returns for audit. As with DIF returns, these non-DIF returns are to be

reviewed in the district office at multiple levels and either accepted as filed

or forwarded to audit groups. Unlike audits selected using DIF, these

returns need not be selected by DIF score or solely from the DIF

inventory. For the non-DIF sources we include in our review, we grouped

these into five categories.6

• IRS projects, which include audits that focus on specific types of issues,

such as unreported income, or types of taxpayers, such as those operating

cash businesses, whose returns have specific characteristics that indicate

potential noncompliance;

• referrals of potentially noncompliant returns that come from both inside

and outside IRS; for example, returns are referred by IRS’ Collection

Division and by state tax agencies;

 

6

In this report we use the term “non-DIF sources” when referring to the five categories. IRS has many

other non-DIF sources for audit selection at the district office. Because this review focused on the

sources associated with the selection process for audits of taxpayers’ books and records, we did not

analyze these other non-DIF sources. A complete list of source codes and the reasons for excluding

them can be found in appendix I.
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Page 5 GAO/GGD-99-30 IRS’ Return Selection Process

• individuals whose returns were completed by a preparer that IRS has

identified as questionable;

• regular classification that is a catchall group for various kinds of audits

that had to be manually selected, such as those involving bankruptcy; and

• all other reasons for selecting a return for books and records audits, such

as those involving income from illegal narcotics, tax fraud, or abusive tax

shelters.

The DIF formulas, together with the multiple levels of review in the

selection process, are designed to ensure that returns having the greatest

potential for a change to the reported tax are most likely to be audited. If

this audit potential can be justified, IRS districts can use non-DIF sources

to select returns for audit. Specifically, the districts should show that using

a non-DIF source would generally offer more potential for changing the

reported tax than continuing to audit returns identified by DIF. 7 The steps

for selecting DIF and non-DIF returns for audit are shown graphically in

appendix II.

To determine the extent to which IRS district offices have used various

sources to select returns for audit, we first reviewed return selection

procedures and sources as outlined in the Internal Revenue Manual (IRM)

and in attachments to the instructions for IRS’ Audit Information

Management System (AIMS). We collected data on these sources from IRS’

closed case data files. We talked to IRS’ Examination and Research

Division staffs in the National Office as well as Examination staff in the

Northern California District and Western Regional offices to understand

the information about the procedures and sources. Finally, we collected

data from the AIMS data files on closed audits on the extent to which IRS

used each source in accordance with the criteria outlined below.

To compare the no-change rate and additional tax recommended per

audited return for the various audit selection sources, we used data from

AIMS files on closed audits. Our primary interest was books and records

audits of individual returns. We focused on such audits at district offices

because service center audits were being evaluated in another assignment.

We eliminated audits such as those coded as claims for refund, nonfilers,

research and reference, and taxpayer requests because these are generally

not books and records audits. In addition, we eliminated audits of related

 

7

Certain types of returns, such as those claiming large refunds, are considered mandatory and may or

may not be selected for audit solely because of the potential for a tax change.

Scope and

Methodology
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Page 6 GAO/GGD-99-30 IRS’ Return Selection Process

and multiyear returns because of the difficulty of associating these audits

to 1 of the 3 years we analyzed.8

We analyzed returns received by IRS in 1992, 1993, and 1994. Because the

criteria for selecting returns may change from year to year, we wanted to

organize our data in a manner that would reflect the selection source. We

discussed this with IRS officials and concluded that our analysis would be

based on the year IRS received the return (filing year) rather than on the

year the audit was closed (as presented in the AIMS files). Using the closed

case data files for fiscal years 1992 through 1997, we collected data for

audits of returns

• received in 1992 with audits closed during 1992 through 1995,

• received in 1993 with audits closed during 1993 through 1996, and

• received in 1994 with audits closed during 1994 through 1997.

We used these years because they were the most recent filing years for

which IRS had 4 years of audit closures. Tracking 4 years allowed us to

account for almost all of the returns selected for audit. Even so, some

audits of returns received in 1992, 1993, and 1994 remained opened at the

end of our 4 year test period. Using the AIMS files, we determined that

• 4 percent of the audits for 1992 returns were open at the end of fiscal year

1995,

• 5 percent of the audits for 1993 returns were open at the end of fiscal year

1996, and

• 2 percent of the audits for 1994 returns were open at the end of fiscal year

1997.

To compare how much of the additional tax recommended was assessed

and collected for DIF and non-DIF audits, we selected a sample of audits

from the 1992 study population. We selected 1992 instead of 1993 or 1994

to allow as much time as possible for collection activities. This sample was

divided into 4 strata: (1) audits selected using the DIF scores and closed

with the taxpayer agreeing to the additional tax recommended (agreed

audits), (2) audits selected using the DIF scores and closed without the

taxpayer agreeing to all of the additional tax recommended (unagreed

audits), (3) agreed audits selected using non-DIF sources, and (4)

unagreed audits selected using non-DIF sources. We used transcripts from

IRS’ master file to compare the amount actually collected with the

 

8

See appendix I for a more complete description of the source codes eliminated and those used in the

study population.
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amounts recommended. A more complete explanation of our sample

selection strategy and sampling errors can be found in appendix III.

There are some limitations on our data analysis. We did not validate AIMS

data files on the closed audits. During our analysis of the master file

transcripts for a selected sample, however, we noted some data

inconsistencies between the master file and the AIMS files. We found

source codes on the AIMS files that differed from those on the master file.

According to IRS, the source code recorded on the AIMS files is correct,

and there is no mechanism to make these changes on the master file

accounts. We also found substitute for return (SFR) audits even though we

had removed SFR source codes from our analysis.9

 IRS officials indicated

that it was not possible to identify all SFRs by source code. We excluded

only those SFRs that could be identified using the AIMS coding. Moreover,

we did not adjust the dollar amounts for inflation, thus the dollars reported

may be conservative.

We performed our audit at IRS headquarters offices in Washington, D.C.;

the Western Region; the Northern California District Office; and IRS’

Fresno Service Center. Our work was done between January 1998 and

September 1998 in accordance with generally accepted government

auditing standards.

DIF-selected returns accounted for 59 percent of the books and records

audits conducted at IRS’ district offices of returns received in 1992, 1993,

and 1994.10 The remaining 41 percent of the audits were selected from the 5

non-DIF sources. Table 1 shows the number of books and records audits

conducted for each of the six sources for returns received by IRS between

1992 and 1994.

 

9

IRS files a substitute return for certain individuals who do not appear to have filed required tax

returns. These returns are prepared from information documents provided by third parties, such as

banks and employers. According to IRS officials, these SFRs may have been selected for other audit

purposes and thus were not coded as SFRs.

10Audits of taxpayer books and records averaged less than one-half of 1 percent of the returns received

in 1992, 1993, and 1994. During this same period, staffing and other workload limited all district office

audits to only about 1 percent of returns received.

Sources of IRS Audits
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Categorya1992 1993 1994 Total

DIF 178,419 142,142 310,557 631,118

Non-DIF-selected sources 135,564 128,993 174,490 439,047

Projects 41,173 40,804 50,797 132,774

Referrals 40,353 31,173 32,102 103,628

Preparers 26,578 25,799 37,561 89,938

Regular classification 16,563 20,008 24,795 61,366

Other sources 10,897 11,209 29,235 51,341

Total 313,983 271,135 485,047 1,070,165

a

See appendix I for a summary of the specific source codes included in each of the categories.

Source: Summarized from IRS’ closed case data files for fiscal years 1992 through 1997.

Most returns are selected for audit using DIF because, according to IRS

officials, it is IRS’ primary indicator of noncompliance and enables them to

select returns that have the greatest probability of error on a nationwide

basis. In addition, IRS officials also told us that districts might be unable to

identify any additional returns with a higher audit potential through nonDIF sources than through those selected by DIF. Moreover, it may be

easier to obtain large numbers of returns with potential noncompliance

through DIF than through non-DIF sources. For DIF, districts simply

request that service centers send them a certain number of returns. The

service center selects the highest DIF-scored returns meeting the district’s

geographic requirements. For non-DIF, selection is more complex. District

office officials must identify specific returns that appear to have a greater

potential for tax change than DIF-selected returns. These returns must

then be ordered individually by taxpayer name and Social Security

number.

As part of our analysis of IRS’ audit selection sources, we separated the

audits into returns filed by nonbusiness individuals with income under

$50,000; nonbusiness individuals with income of $50,000 and above; and

individual taxpayers whose primary source of income was from selfemployment (labeled as business).11 To look at how IRS distributed audits

by sources and these types of individual taxpayers, we combined the 3

years covered in this review.

Figure 1 shows that IRS conducted a larger percentage of audits of

nonbusiness individuals with income under $50,000 than of individuals

with higher incomes or business income, regardless of the selection

 

11Individuals report business income on the Schedule C of Form 1040. Business income cannot be

broken out the same way nonbusiness income is because IRS does not organize the income data in the

same manner. For example, business income is grouped in three categories as below $25,000, $25,000

but less than $100,000, and over $100,000. Nonbusiness income is grouped into five categories that are

not comparable.

Table 1: Number of Books and Records

Audits Conducted for Returns Received

Between 1992 and 1994
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Page 9 GAO/GGD-99-30 IRS’ Return Selection Process

source. For example, over half the audits with DIF as the source were of

individuals with income under $50,000; 30 percent were of higher income

individuals; and less than 20 percent were of individuals with business

income. It is important to recognize, however, that over 75 percent of the

returns received by IRS during 1992, 1993, and 1994 reported income under

$50,000. Although a higher absolute number of audits are done on

individuals with nonbusiness income under $50,000, IRS audits a greater

percentage of individuals with business income and individuals with

nonbusiness income over $50,000.

Source: GAO analysis of IRS data for 1992, 1993, and 1994.

Figure 1: Percent of Audits by Type of

Taxpayer and Source of Audit
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For audits of returns that were received in 1992, 1993, and 1994, the nochange rates were generally lower and recommended tax amounts were

generally higher for the five non-DIF sources compared to the results from

DIF sources. This is consistent with IRS’ policy to use non-DIF sources if

the audit potential appears to be higher than for DIF sources. However, on

the basis of a sample of audits of returns received in 1992, we found that

IRS collected a greater proportion of the recommended tax amount from

audits selected using DIF than from those using non-DIF sources.

The no-change rate varied depending on the selection source and the type

of taxpayer being audited. Overall, for the 3 years of audits covered in our

analysis, the no-change rate was 22 percent.12 For the six sources we

identified as being books and records audits, the overall no-change rate

varied from about 15 percent for audits selected due to a questionable

preparer to about 28 percent for audits selected using regular

classification. Returns selected using DIF were closed with no change in

about 26 percent of the audits. Detailed information on the no-change rate

by source and year can be found in appendix IV. Table 2 shows the nochange rate by year and audit selection source.

Percent of audits closed with no change to tax

Selection source 1992 1993 1994 All years

DIF 27 27 25 26

Projects 19 19 20 19

Referrals 14 17 17 16

Preparers 15 17 14 15

Regular classification 24 28 30 28

Other sources 22 19 12 16

Source: GAO analysis of IRS data for 1992, 1993, and 1994.

For all sources, audits of nonbusiness individuals with income of over

$50,000 had the highest no-change rate.13 Figure 2 summarizes these results

for each source and type of taxpayer.

 

12IRS reported no-change rates of 15 percent, 12 percent, and 8 percent for all district office audits of

individual returns closed in fiscal years 1992, 1993, and 1994, respectively. IRS’ no-change rates are

lower than ours because our calculation includes only audits of taxpayer books and records. IRS’ rates

include other kinds of audits, such as claims and nonfilers, that often have very low no-change rates.

13Regardless of source, the lowest no-change rate occurred in the group of taxpayers with the lowest

income and the highest no-change rate occurred in audits of taxpayers with the highest income.

Appendix IV describes these results in more detail.

Comparison of DIF

and Non-DIF Audits

Table 1: No-change Rate by Filing Year

and Selection Source
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Page 11 GAO/GGD-99-30 IRS’ Return Selection Process

Source: GAO analysis of IRS data for 1992, 1993, and 1994.

The average amount of additional tax recommended per audit covered in

our analysis declined from over $4,000 for closed audits of returns

received in 1992 to about $3,300 for closed audits of returns received in

1994 (a decrease of about 18 percent). By audit selection source, our

analysis of 1992 compared to 1994 showed that the recommended

additional tax increased only in audits of returns selected using DIF and

preparer sources. The average additional tax recommended in DIF audits

increased from about $2,500 in 1992 to almost $3,100 in 1994 (an increase

of about 24 percent). The average additional tax recommended in audits

selected due to a questionable preparer increased from about $1,950 in

1992 to almost $2,100 in 1994 (an increase of about 7 percent).

Our analysis by selection source also showed that the average amount of

additional taxes recommended per audit over the 3 years varied. The

Figure 2: No-change Rate by Type of

Taxpayer and Source of Audit
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average amounts ranged from less than $2,000 for returns selected because

of questionable tax preparers to over $10,000 for referrals. However, the

average recommended additional tax for referrals was always at least

double the averages for other selection sources. Table 3 shows the average

additional tax recommended by selection source for each of the years in

our analysis.

Average additional recommended tax

Selection source 1992 1993 1994 Overall

DIF $2,487 $2,945 $3,082 $2,883

Projects 4,286 3,771 3,357 3,772

Referrals 12,542 8,804 8,329 10,091

Preparers 1,949 1,912 2,094 1,999

Regular classification 3,358 2,507 2,969 2,924

Other sources 3,974 3,373 2,218 2,843

Source: GAO analysis of IRS data for 1992, 1993, and 1994.

As figure 3 shows, the average amount of additional tax recommended per

audit varied by type of taxpayer and source.14 It shows lower average tax

amounts in audits of nonbusiness individuals with income under $50,000

compared to the remaining two groups for all sources. It also shows higher

average amounts in audits of business individuals compared to audits of

nonbusiness individuals—except for referrals and other sources.

 

14Regardless of the source, the averages ranged from $2,100 for lower income taxpayers to almost

$7,100 for individuals with business returns.

Table 2: Average Additional

Recommended Tax by Filing Year and

Selection Source
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Source: GAO analysis of IRS data for 1992, 1993, and 1994.

IRS does not have a system that allows it to readily track taxes assessed

and collected from audits by the source of the audit. IRS can track

collections through its Enforcement Revenue Information System (ERIS).

However, IRS has not analyzed the information in ERIS to determine the

collection rate by audit source. Although an analysis by source is possible

using information from ERIS, it would be difficult.

To obtain information on the amount of recommended additional tax that

is assessed and collected, we selected a sample of audits of returns

received in 1992 that were included in our earlier analyses. Using

information from these sampled audits and IRS’ master file, we estimated

assessments and collections for audited returns in this population.

Figure 3: Average Additional Tax

Recommended by Taxpayer Type and

Source of Audit
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We found no statistically significant difference in the proportion of

recommended tax assessed between audits selected using DIF and audits

selected using non-DIF sources. However, we found a statistically

significant difference in the proportion collected. We estimated that IRS

collected about 57 percent of the recommended tax for DIF returns and

about 35 percent for non-DIF returns as of April 1998.15 It was not clear

from the data we had why collections were greater for DIF-selected

returns.

Our estimated 57 percent collection rate for DIF sources is high compared

to the collection rate for all individual taxpayer audits conducted at district

offices. In a June 1998 report to the House Ways and Means Committee, we

found that for all types of district office audits closed in 1992, IRS had

collected about 31 percent of the amounts recommended.16

Caution is needed if one uses the three results we analyzed to compare the

effectiveness of DIF and non-DIF sources. The no-change rate, the

recommended additional tax amounts, and the collection rate on these

recommended amounts do not present a complete picture of audit

effectiveness. Nor is it easy to control for other factors that may influence

the three types of results we analyzed.

To evaluate the overall effectiveness of selection sources, these audit

results are not the only ones that could be used. As noted in our June 1998

report, the impacts of audits on voluntary compliance and taxpayer burden

are other results that could help IRS develop a more balanced picture of

audit effectiveness, but IRS does not collect such data.17 That report

recognized that gathering such data was difficult because of limitations in

data sources and research methods. Beyond these possible results, we

concluded that IRS could do more to collect data on its direct and indirect

costs to do audits and then assess or collect any additional taxes. We

recommended that IRS begin to collect such data, and IRS agreed to do so.

In addition, IRS does not have data available that would allow it to control

for other factors that may affect the three audit results we analyzed. For

example, data on whether the results across the selection sources vary by

 

15Because of the sample size and variability of the data, we were unable to make statistically valid

estimates of the assessments or collections for specific selection sources. Point estimates and

sampling errors can be found in appendix III.

16Tax Administration: IRS Measures Could Provide a More Balanced Picture of Audit Results and Costs

(GAO/GGD 98-128, June 23, 1998).

17GAO/GGD 98-128, June 23, 1998.

Caution Is Needed

When Comparing the

Results of DIF and

Non-DIF Audits
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the type of tax issue being audited are not available. Nor does IRS have

data on how the quality of the audit affects the results across the selection

sources.

Even with these cautions, comparing DIF and non-DIF audit sources by

the audit results we analyzed can be useful. For example, the comparisons

we did by source and selection year could provide a baseline that would

allow IRS to gauge some of the impacts of changes to the audit selection

process over time.

We requested comments on a draft of this report from the Commissioner

of Internal Revenue. Officials representing the Assistant Commissioners

for the Examination and Research Divisions, as well as a representative

from the Commissioner’s Office of Legislative Affairs, provided IRS’

comments in a January 13, 1999, meeting. IRS also provided written

comments in a January 20, 1999, letter, which is reprinted in appendix V.

IRS was in overall agreement with the draft report and said it fairly

describes IRS’ return selection program. IRS also provided some additional

information to elaborate on issues we raised and technical comments;

where appropriate, we made changes to this report on the basis of these

technical comments.

We are sending copies of this report to the Committee’s Ranking Minority

Member, the Chairman and Ranking Minority Member of the Senate

Committee on Finance, various other congressional committees, the

Director of the Office of Management and Budget, the Secretary of the

Treasury, the Commissioner of Internal Revenue, and other interested

parties.

The major contributors to this report are listed in appendix VI. If you or

your staffs have any questions concerning this report, please contact me or

Thomas D. Short, Assistant Director, on (202) 512-9110.

James R. White

Director, Tax Policy and

 Administration Issues

Agency Comments
Page 16 GAO/GGD-99-30 IRS’ Return Selection Process

Contents

1 Letter

Appendix I 20

Definition of Source

Codes for IRS Audits

Appendix II 23

Flow Chart of IRS'

Audit Selection

Process

24

Study Population 24

Sample Selection and Weighting 24

Sampling Errors and Confidence Intervals of Estimates 25

Controlling for Nonsampling Errors 25

Appendix III

Statistical

Methodology for

Analyzing Assessments

and Collections of

Recommended Tax

Appendix IV 26

Tables of Audit Results

for Filing Years 1992,

1993, and 1994

Appendix V 31

Comments From the

Internal Revenue

Service

Appendix VI 34

Major Contributors to

This Report
Contents

Page 17 GAO/GGD-99-30 IRS’ Return Selection Process

Table 1: Number of Books and Records Audits

Conducted for Returns Received Between 1992 and

1994

8

Table 1: No-change Rate by Filing Year and Selection

Source

10

Table 2: Average Additional Recommended Tax by Filing

Year and Selection Source

12

Table I.1: Number of Audits by Year the Return Was

Received

20

Table I.2: Source Code Table—Inclusions and Exclusions 21

Table III.1: Distribution of Audits in the AIMS Database

by Sample Strata

24

Table III.2: Confidence Interval for Estimate of difference

in Assessments and Collections for DIF-Selected and

Non-DIF-Selected Audits

25

Table IV.1: Number of Returns by Activity Code and

Source Group--Returns Received in 1992

26

Table IV.2: Number of Returns by Activity Code and

Source Group—Returns Received in 1993

27

Table IV.3: Number of Returns by Activity Code and

Source Group--Returns Received in 1994

27

Table IV.4: No-change Rate by Source of Audit and

Activity Code--Returns Received in 1992

28

Table IV.5 No-change Rate by Source of Audit and

Activity Code--Returns Received in 1993

28

Table IV.6: No-change Rate by Source of Audit and

Activity Code--Returns Received in 1994

29

Table IV.7 Average Audit Results by Source of Audit and

Activity Code--Returns Received in 1992

29

Table IV.8: Average Audit Results by Source of Audit and

Activity Code--Returns Received in 1993

30

Table IV.9: Average Audit Results by Source of Audit and

Activity Code--Returns Received in 1994

30

Tables

Figure 1: Percent of Audits by Type of Taxpayer and

Source of Audit

9

Figure 2: No-change Rate by Type of Taxpayer and

Source of Audit

11

Figure 3: Average Additional Tax Recommended by

Taxpayer Type and Source of Audit

13

Figures

Figure II.1: Summary of IRS’ process for selecting

returns to audit.

23
Contents

Page 18 GAO/GGD-99-30 IRS’ Return Selection Process

Abbreviations

AIMS Audit Information Management System

DCI data collection instrument

DIF discriminant function

IRM Internal Revenue Manual

IRS Internal Revenue Service

SFR substitute for return
Page 19 GAO/GGD-99-30 IRS’ Return Selection Process
Appendix I

Definition of Source Codes for IRS Audits

Page 20 GAO/GGD-99-30 IRS’ Return Selection Process

This appendix shows the types of audits included in our study population.

We included sources that appeared to be for audits of taxpayer books and

records conducted at one of the Internal Revenue Service’s (IRS) district

offices.

We excluded audits for two reasons:

• Reason 1: We excluded audits that did not deal with the taxpayers’ books

and records or that were not conducted at an IRS’ district office. These

audits included claims for refund, nonfilers, substitute for return, service

center correspondence audits, and research studies.

• Reason 2: We excluded related and multiyear audits because we were

unable to relate them to specific returns in one of our target years. Also,

some of these returns were selected on the basis of audits of partnership

or corporation returns

Table I.1 shows the total number of audits closed by IRS for the 3-year

period of our analysis and the number included in the analysis. Table I.2

shows the individual source codes and indicates which are included in the

study population and which are not. This table also provides the reason a

source was excluded or the source code group for those included.

Description Year return was received by IRSa

Type of audit 1992 1993 1994

Total recorded audits 806,344 1,129,956 1,593,912

Less (excluded audits)

Service center auditsb 246,602 305,711 688,441

Nonfilers 115,108 434,238 296,527

Multiple returns 70,826 61,467 60,144

Related returns 47,046 41,148 50,600

Claims 10,309 11,529 10,175

Other excluded returns 2,470 4,728 2,978

Total audits excluded from analysis 492,361 858,821 1,108,865

Returns included in the analysis

DIF-selected returns 178,419 142,142 310,557

IRS projects 41,173 40,804 50,797

Referrals 40,353 31,173 32,102

Preparers 26,578 25,799 37,561

Regular classification 16,563 20,008 24,795

All other selection reasons 10,897 11,209 29,235

Total audits included in analysis 313,983 271,135 485,047

a

Each of the years contains audit information from 4 years of IRS’ Audit Information Management

System (AIMS) closed case database.

b

Service center audits are those with an organization code of 5000 or above on the AIMS database.

Source: IRS’ AIMS database.

Table I.1: Number of Audits by Year the

Return Was Received
Appendix I

Definition of Source Codes for IRS Audits

Page 21 GAO/GGD-99-30 IRS’ Return Selection Process

Source

code Definition Status

Reason

excluded/group

01 Tax shelters and automatics Included Other

02 DIF source returns Included DIF

03 Unallowable items Included Other

04 Multiple filers Included Other

05 DIF-related pickup Excluded Reason 2

06 Correspondence examination Included Other

07a Claim—medium examination potential Excluded Reason 1

08 Self-employment examination Included Other

09a All other claims for refund Excluded Reason 1

10 DIF multiyear Excluded Reason 2

11 Studies, tests, and research programs Excluded Reason 1

12 DIF related delinquent return Excluded Reason 2

13a Married taxpayers filing separately Included Other

14 Information Return Program—high underreporter Included Other

15a Math/clerical error abatement Excluded Reason 1

16a Returns with an illegal narcotics issue Included Other

17 Tax shelter program Included Other

20 Regular classification Included Reg. Class.

23 IRA recovery Included Other

24 Nonfiler/refusal to file Tax Delinquency

Investigation

Excluded Reason 1

25b Substitute for return Excluded Reason 1

26 Alternative minimum tax program Included Other

30 Claims for refund Excluded Reason 1

31b Paid claims for refund Excluded Reason 1

32 Carry-back refund Excluded Reason 1

35b Administrative adjustment request (claim) Excluded Reason 1

37a Stockholder returns Included Other

39 Tax shelter—related pickup Excluded Reason 2

40 Multiyear examination—non-DIF-related Excluded Reason 2

44 Delinquent return—non-DIF-related Excluded Reason 1

45 Reference and research Excluded Reason 1

46 IRS employee returns Included preparer

48 Service center—unallowable related Excluded Reason 2

49 Return preparer program Included Preparer

50 Related pickup—non-DIF Excluded Reason 2

60 Information reports Included Referral

62 Compliance projects—national office Included IRS projects

63a Referrals from appeals Included Referral

64 Pickup related to form 1065 (partnership), 1041

(estate), or 1120S (S-Corp).

Excluded Reason 2

65 Collection referral Included Referral

66a Referrals from criminal investigation Included Referral

67a Compliance projects—regional office Included IRS projects

68a Underreported income program—DIF Included DIF

70 Referrals Included Referrals

71a Referrals from Social Security Included Referral

73 Taxpayer request and reconsideration Excluded Reason 2

75a Referrals from Justice Included Referral

76a Referrals from other U.S. agencies Included Referral

77 Referrals from state tax agencies Included Referral

Table I.2: Source Code Table—

Inclusions and Exclusions
Appendix I

Definition of Source Codes for IRS Audits

Page 22 GAO/GGD-99-30 IRS’ Return Selection Process

Source

code Definition Status

Reason

excluded/group

80 Taxpayer Compliance Measurement Program Included Other

85 Information return program match Included Referral

86a All other information return program methods Included Referral

88 Special enforcement Included Referral

90 Fraud Included Referral

91 TCMP related returns Excluded Reason 2

95a IRS racketeer Included Referral

96a Strike force Included Referral

97 a Wagering Included Referral

98 a Illegal income Included Referral a

These codes used for returns received in 1992 and 1993 only.

b

These source codes effective for posting years 1994 and after only.

Source: IRS’ AIMS closed case data files and AIMS Coding Manual.
Appendix II

Flow Chart of IRS' Audit Selection Process

Page 23 GAO/GGD-99-30 IRS’ Return Selection Process

Source: Review of IRS’ written procedures and discussions with IRS officials.

Figure II.1: Summary of IRS’ process for selecting returns to audit.
Appendix III

Statistical Methodology for Analyzing

Assessments and Collections of

Recommended Tax

Page 24 GAO/GGD-99-30 IRS’ Return Selection Process

This appendix describes the methodology we used to determine how much

of the recommended additional tax the IRS actually assesses and collects.

We used information from IRS’ master file and a sample of audits of

returns received in 1992 that were audited during the period 1992 through

1995. We used this sample to compare the amount of assessment and

collection for audits selected using the DIF score and those where the DIF

score was not the primary reason the return was selected for audit.

IRS does not maintain information on the source for selecting a return for

audit, the additional tax recommended, and the amount assessed and

collected in the same database. To determine what proportion of

additional tax was assessed and collected, we looked at information on

IRS’ individual master file for amount assessed and collected and the AIMS

closed audit database for the selection source and the amount of

additional tax recommended in the audit.

As noted in our report, we limited our study population to audits of books

and records done at IRS’ district offices. To compare how much of the

additional tax recommended was assessed and collected for DIF and nonDIF audits, we selected a sample of audits from our 1992 study population.

We selected 1992 instead of 1993 or 1994 to allow as much time as possible

for collection activities. We also eliminated audits where the AIMS

database indicated that a refund had been made or no additional tax had

been recommended during the audit. This sample population contained

records of 229,550 audits.

To obtain the sample of books and records audits, we selected a stratified

probability sample of 1,083 audits of taxpayer books and records. The

sample was stratified by whether or not the taxpayer agreed or disagreed

with the adjustments to tax that IRS recommended and whether or not the

audit was selected because of its DIF score or for some non-DIF reason.

The number of audits sampled in each stratum was based on the number

of returns in the population and the total additional taxes recommended in

the audits. The division of the population and sample of audits between

different strata is shown in table III.1.

Strata

Audits in

population

Results of

examination Audits in sample

Agreed DIF-selected 112,512 $330,957,253 332

Agreed non-DIF-selected 100,254 586,909,138 250

Unagreed DIF-selected 9,583 128,733,806 251

Unagreed non-DIF-selected 7,201 258,077,075 250

Total 229,550 $1,304,677,272 1,083

Source: IRS AIMS database and GAO sampling data.

Study Population

Sample Selection and

Weighting

Table III.1: Distribution of Audits in the

AIMS Database by Sample Strata
Appendix III

Statistical Methodology for Analyzing Assessments

and Collections of Recommended Tax

Page 25 GAO/GGD-99-30 IRS’ Return Selection Process

We obtained copies of the master file transcript for 1,082 of the audits we

selected. IRS could find no record for one of the taxpayers. For each of the

sample audits, we obtained information on the amount of additional tax

recommended (from the AIMS database) and the amount assessed and the

amount collected (from the master file transcript).

The results of how much of recommended taxes was assessed and

collected shown in this report are estimates because they are based on the

sample of audits drawn from the total population of all eligible audits of

returns received in 1992. The accuracy of these estimates is quantified by

their sampling errors, expressed as 95 percent confidence intervals. In

table III.2 for example, we estimate that the difference between DIF and

non-DIF collections is 22 percent. This estimate is surrounded by a

confidence interval of + 13 percentage points, indicating that we are 95-

percent confident that the actual percentage difference in the population

of all audits of returns received in 1992 lies between 8 percent and 36

percent.

Description

Percent of audit

results assessed

Percent of audit

results collected

Point estimate DIF-selected returns 76% 57%

Confidence interval DIF-selected returns + 8% + 9%

Point estimate non-DIF-selected returns 83% 35%

Confidence interval non-DIF-selected returns + 7% + 9%

Percentage difference 7% 22%

Confidence interval at the 95 percent

confidence level for the percentage difference

+ 11% + 13%

Source: GAO analysis of sampled data for 1992.

In addition to the reported sampling errors, various obstacles can occur

when conducting this type of review and may cause other types of errors,

commonly referred to as nonsampling errors. For example, differences in

how questions are interpreted and errors in entering data could affect the

results. We included steps in both the data collection and data analysis

stages for the purpose of minimizing such nonsampling errors. These steps

involved the 100-percent review of completed data collection instruments

(DCI) and data entry of those DCIs. We also had a second analyst check all

computer analyses and programming.

Sampling Errors and

Confidence Intervals of

Estimates

Table III.2: Confidence Interval for

Estimate of difference in Assessments

and Collections for DIF-Selected and

Non-DIF-Selected Audits

Controlling for

Nonsampling Errors
Appendix IV

Tables of Audit Results for Filing Years 1992,

1993, and 1994

Page 26 GAO/GGD-99-30 IRS’ Return Selection Process

We grouped the audit results of our analyses by IRS’ activity codes. These

are codes IRS uses to categorize individual tax returns relative to the

various tax forms filed and the taxpayer’s income level. The following are

definitions of the activity codes:

• 530 - Form 1040A with total positive income less than $25,000;

• 531 - Non-1040A with total positive income less than $25,000;

• 532 - Total positive income of $25,000 or more but less than $50,000;

• 533 - Total positive income of $50,000 or more but less than $100,000;

• 534 - Total positive income of $100,000 or more;

• 535 - Form 1040C with total gross receipts under $25,000;

• 536 - Form 1040C with total gross receipts of $25,000 or more but less than

$100,000;

• 537 - Form 1040C with total gross receipts of $100,000 or more;

• 538 - Form 1040F with total gross receipts under $100,000; and

• 539 - Form 1040F with total gross receipts of $100,000 or more.

For the grouping of IRS audits included in our analyses, the following sets

of tables present the results of these audits by source of audit and activity

codes for each of the 3 years reviewed—1992, 1993, and 1994. The first set

of tables shows the total number of audits, the second set shows the nochange rate, and the third set shows the average audit results. Each of the

tables summarizes information from IRS’ AIMS closed case data files for

fiscal years 1992 through 1997. Also, a description of the source codes

included in each of the source categories we used can be found in table I.2.

Number of Audits by Sourcea

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other Total

530 27,712 6,413 10,950 16,191 11,955 482 73,703

531 23,800 1,151 3,940 6,196 5,584 1,629 42,300

532 37,987 2,067 5,456 6,094 6,459 2,294 60,357

533 36,298 1,921 2,470 3,380 3,171 2,385 49,625

534 20,557 1,441 290 1,694 2,652 1,592 28,226

535 8,414 502 1,078 1,972 3,349 506 15,821

536 9,845 1,394 1,656 2,880 3,614 1,177 20,566

537 10,757 1,388 644 2,347 3,124 715 18,975

538 2,177 101 59 161 249 77 2,824

539 872 185 35 258 196 40 1,586

Total 178,419 16,563 26,578 41,173 40,353 10,897 313,983

Table IV.1: Number of Returns by Activity Code and Source Group—Returns Received in 1992
Appendix IV

Tables of Audit Results for Filing Years 1992, 1993,

and 1994

Page 27 GAO/GGD-99-30 IRS’ Return Selection Process

Number of audits by sourcea

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other Total

530 20,871 6,789 11,523 18,143 12,292 2,658 72,276

531 18,107 1,273 3,425 5,195 3,287 1,228 32,515

532 38,913 3,224 5,200 5,370 4,315 1,542 58,564

533 25,533 2,780 2,418 3,125 2,184 1,860 37,900

534 13,643 1,894 274 2,002 2,062 1,083 20,958

535 6,610 445 1,340 1,294 1,638 770 12,097

536 8,501 1,362 1,106 2,138 2,380 1,248 16,735

537 7,752 1,775 434 2,847 2,492 645 15,945

538 1,548 111 59 209 208 94 2,229

539 664 355 20 481 315 81 1,916

Total 142,142 20,008 25,799 40,804 31,173 11,209 271,135

Number of audits by sourcea

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other Total

530 39,557 7,688 16,136 19,928 12,061 2,077 97,447

531 37,258 1,758 4,981 5,100 3,298 9,817 62,212

532 84,521 3,453 8,167 6,027 4,689 4,857 111,714

533 62,866 3,686 4,290 5,000 2,733 2,822 81,397

534 30,526 2,967 413 3,755 2,078 1,346 41,085

535 14,264 714 1,578 1,571 1,682 3,383 23,192

536 19,358 1,812 1,329 3,390 2,208 3,095 31,192

537 19,488 2,467 538 4,694 2,950 1,311 31,448

538 1,497 94 97 363 179 443 2,673

539 1,222 156 32 969 224 84 2,687

Total 310,557 24,795 37,561 50,797 32,102 29,235 485,047

Table IV.2: Number of Returns by Activity Code and Source Group—Returns Received in 1993

Table IV.3: Number of Returns by Activity Code and Source Group—Returns Received in 1994
Appendix IV

Tables of Audit Results for Filing Years 1992, 1993,

and 1994

Page 28 GAO/GGD-99-30 IRS’ Return Selection Process

Percent by source of audita

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other Total

530 17 17 16 15 10 14 15

531 27 30 12 18 12 18 22

532 24 22 12 22 14 22 21

533 31 22 15 26 20 20 28

534 37 32 31 27 23 29 35

535 27 30 14 12 9 15 20

536 20 29 15 14 14 20 18

537 26 32 14 23 20 22 24

538 39 32 23 28 37 32 38

539 38 29 14 27 34 25 34

Total 27 23 15 18 14 21 22

Percent by source of audita

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other Total

530 16 17 20 12 11 26 15

531 27 31 13 20 18 15 23

532 26 33 13 23 17 14 24

533 27 35 17 27 24 11 26

534 43 40 31 29 26 18 38

535 26 25 12 13 14 16 21

536 21 24 13 22 17 18 20

537 31 34 16 27 21 21 28

538 41 36 20 32 38 38 39

539 36 31 25 22 38 25 31

Total 27 28 16 18 16 18 23

Table IV.4: No-change Rate by Source of Audit and Activity Code—Returns Received in 1992

Table IV.5 No-change Rate by Source of Audit and Activity Code—Returns Received in 1993
Appendix IV

Tables of Audit Results for Filing Years 1992, 1993,

and 1994

Page 29 GAO/GGD-99-30 IRS’ Return Selection Process

Activity code Percent by source of audita

DIF

Regular

classification Preparers

Compliance

projects Referrals All other Total

530 16 20 18 12 11 16 15

531 25 34 10 17 20 5 20

532 23 28 10 21 15 13 21

533 25 36 12 27 21 15 25

534 43 42 24 37 28 24 41

535 23 27 14 23 17 9 20

536 16 29 10 22 17 15 17

537 27 32 17 28 19 19 26

538 38 38 15 23 30 37 35

539 35 30 9 18 29 41 28

Total 25 29 14 20 16 12 22

Average audit results by source of audita

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other

Average audit

result—all audits

530 $1,269 $1,976 $1,278 $2,637 $7,409 $5,717 $2,657

531 1,079 2,280 1,504 2,663 8,122 1,719 2,338

532 1,511 2,341 1,878 2,826 8,160 2,116 2,440

533 2,176 2,806 2,444 4,882 11,921 3,298 3,075

534 4,252 8,100 (1,900) 15,839 39,384 7,001 8,537

535 1,705 2,421 2,193 3,599 6,491 2,531 3,037

536 3,300 4,246 4,410 6,382 11,958 3,698 5,429

537 9,823 7,522 9,347 12,180 34,479 8,225 13,929

538 917 6,538 2,226 5,664 6,700 2,094 1,958

539 5,197 1,009 9,282 6,770 14,701 5,214 7,490

Total $2,487 $3,358 $1,949 $4,286 $12,542 $3,974 $4,067

Table IV.6: No-change Rate by Source of Audit and Activity Code—Returns Received in 1994

Table IV.7 Average Audit Results by Source of Audit and Activity Code—Returns Received in 1992
Appendix IV

Tables of Audit Results for Filing Years 1992, 1993,

and 1994

Page 30 GAO/GGD-99-30 IRS’ Return Selection Process

Average audit results by source of audita

Activity

code DIF

Regular

classification Preparers

Compliance

projects Referrals All other

Average audit

results—all

audits

530 $1,430 $2,280 $1,319 $2,157 $5,754 $1,697 $2,420

531 1,143 1,679 1,569 2,755 7,941 1,851 2,181

532 1,515 1,505 1,892 3,008 6,439 2,710 2,079

533 2,236 2,268 2,397 3,287 12,355 4,364 3,023

534 5,773 3,090 4,718 10,011 20,144 6,984 7,398

535 1,757 2,892 2,256 5,528 5,483 1,976 2,776

536 4,235 3,626 4,523 6,817 8,394 3,325 5,058

537 15,269 4,439 8,229 10,628 19,726 7,113 13,410

538 1,116 2,129 2,749 3,363 2,542 4,815 1,709

539 8,297 3,383 2,980 2,596 8,498 5,559 5,817

Total 2,945 2,507 1,912 3,771 8,804 3,373 3,630

Average audit results by source of audita

Activity code DIF

Regular

classification Preparers

Compliance

projects Referrals All other

Average audit

results—all

audits

530 $1,422 $1,810 $1,466 $1,810 $4,343 $2,085 $1,915

531 1,155 1,885 1,615 3,182 6,412 1,189 1,663

532 1,616 1,678 1,938 2,458 5,067 1,346 1,820

533 2,058 2,146 2,840 3,223 8,398 2,612 2,407

534 6,144 5,851 6,509 8,134 23,286 9,236 7,277

535 2,157 3,254 2,108 3,015 5,815 1,271 2,382

536 5,077 3,424 4,840 4,172 9,156 2,546 4,910

537 13,077 6,323 11,375 7,344 21,767 7,458 12,243

538 1,599 2,141 2,477 1,402 7,984 835 1,924

539 14,738 6,406 4,021 3,003 13,851 2,168 9,428

Total 3,082 2,969 2,094 3,357 8,329 2,218 3,324

Table IV.8: Average Audit Results by Source of Audit and Activity Code—Returns Received in 1993

Table IV.9: Average Audit Results by Source of Audit and Activity Code—Returns Received in 1994
Appendix V

Comments From the Internal Revenue Service

Page 31 GAO/GGD-99-30 IRS’ Return Selection Process
Appendix V

Comments From the Internal Revenue Service

Page 32 GAO/GGD-99-30 IRS’ Return Selection Process
Appendix V

Comments From the Internal Revenue Service

Page 33 GAO/GGD-99-30 IRS’ Return Selection Process
Appendix VI

Major Contributors to This Report

Page 34 GAO/GGD-99-30 IRS’ Return Selection Process

Thomas D. Short, Assistant Director, Tax Policy and Administration Issues

Tim Outlaw, Senior Evaluator

Louis G. Roberts, Evaluator-in-Charge

Kathleen E. Seymour, Senior Evaluator

Samuel H. Scrutchins, Senior Data Analyst

Tre M. Forlano, Evaluator

General Government

Division, Washington,

D.C.

San Francisco Field

Office
Page 35 GAO/GGD-99-30 IRS’ Return Selection Process
Page 36 GAO/GGD-99-30 IRS’ Return Selection Process
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