a

GAO

United States General Accounting Office

Report to the Chair, Committee on Small 

Business and Entrepreneurship, 

U.S. Senate

May 2003 TAX 

ADMINISTRATION

Changes to IRS’s 

Schedule K-1 

Document Matching 

Program Burdened 

Compliant Taxpayers

GAO-03-667
IRS stopped issuing Schedule K-1 notices after complaints about the burden 

the program imposed on compliant taxpayers. Originally, IRS intended to 

focus the program on two categories of income--interest and dividends--

wherein matching was straightforward, and therefore the number of notices 

sent to compliant taxpayers could be minimized. However IRS changed the 

matching program to cover additional categories of flow-through income 

without clearly informing taxpayers and tax preparers. Matching these 

additional categories of income was less straightforward. As a result, IRS 

sent notices about suspected noncompliance to more compliant taxpayers 

than it intended. In fact, about two-thirds of the notices were sent to 

taxpayers later determined to be compliant. After taxpayers complained, and 

after sending out about 70 percent of the planned notices, IRS responded by 

stopping the notices. IRS has assessed about $41.4 million in additional tax 

from the notices that were sent and approximately $26.9 million was directly 

attributable to Schedule K-1 underreporting. 

IRS did not timely implement two parts of the plans for managing the 

Schedule K-1 matching program. First, IRS did not test the feasibility of 

focusing the program on interest and dividend income until after 

recommending such a focus and communicating the recommendation to 

taxpayers, preparers, and other stakeholders. Second, after changing the 

plan, IRS did not clearly communicate the changes. 

IRS is taking steps to improve communications and reduce the burden on 

compliant taxpayers. However, neither IRS nor GAO knows whether these 

changes will improve communications and reduce burden while maintaining 

the effectiveness of the Schedule K-1 matching program as a compliance 

tool. 

Illustration of the Taxation of Income That Flows Through Partnerships, S-corporation, 

Estates and Trusts 

About $1 trillion in income was 

distributed in 2001 by flow-through 

entities such as partnerships and 

trusts. As shown below, these 

entities do not pay taxes on flowthrough income. They report it to IRS

on a Schedule K-1 and their partners 

or beneficiaries pay any tax. 

Concerned about underreporting, 

IRS began matching the flowthrough income reported on 

Schedule K-1s with that reported 

on individuals’ returns. In 2002, IRS 

began sending notices to taxpayers 

about suspected noncompliance. 

After complaints that many notices 

were going to compliant taxpayers, 

IRS stopped sending notices. 

Concerned about the burden, the 

committee asked GAO to, among 

other things, (1) describe the 

burden caused by the notices and 

IRS’s rationale for stopping them, 

(2) assess IRS’s management of the 

program, and (3) describe the steps 

IRS will take to address any 

problems. 

GAO is not making any 

recommendations, but the 

uncertainty about the effectiveness 

of the steps IRS is taking to 

improve the program highlight the 

importance of IRS continuing to 

monitor the impact of the program 

on compliant taxpayers. In ongoing 

work, requested by the Senate 

Committee on Finance, GAO is 

assessing the effectiveness of the 

program. 

www.gao.gov/cgi-bin/getrpt?GAO-03-667.

To view the full report, including the scope 

and methodology, click on the link above. 

For more information, contact James R. White 

at (202) 512-9110 or whitej@gao.gov. 

Highlights of GAO-03-667, a report to the 

Committee on Business and 

Entrepreneurship, United States Senate 

May 2003

INTERNAL REVENUE SERVICE 

Changes to IRS’s Schedule K-1 

Document Matching Program Burdened 

Compliant Taxpayers 
Page i GAO-03-667 IRS’s Schedule K-1 Matching Program 

Letter 1

Results In Brief 2

Background 3

Scope and Methodology 6

IRS Stopped Issuing Schedule K-1 Notices after Complaints about 

Burden Imposed by Program Changes 8

IRS Did Not Timely Test Its Plans or Communicate Plan Changes 

to Stakeholders 11

IRS Is Taking Steps Intended to Improve the Schedule K-1 

Matching Program in 2003 14

Conclusion 17

Agency Comments 18

Appendix I GAO Contact and Staff Acknowledgments 19 

Figures 

Figure 1: Illustration of the Taxation of Income That Flows through 

Partnerships, S-corporations, Estates and Trusts 4

Figure 2: General Underreporter Matching Process 5

Figure 3: The Number of Schedule K-1 Underreporter Notices Sent 

to Taxpayers 10

Figure 4: Chronology of Key Events in IRS Implementation of the 

Schedule K-1 Matching Program 13

Contents 

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Page 1 GAO-03-667 IRS’s Schedule K-1 Matching Program 

May 30, 2003 

The Honorable Olympia J. Snowe 

Chair 

Committee on Small Business and Entrepreneurship 

United States Senate 

Dear Madame Chair: 

Approximately $1 trillion in income was distributed for tax year 2001, 

according to Internal Revenue Service (IRS), by flow-through entities such 

as partnerships, S-corporations, estates, and trusts. These entities, many of 

which are small businesses, do not pay taxes on income they pass through, 

whether or not the income is actually distributed to their partners, 

shareholders, or beneficiaries. The partners, shareholders, or beneficiaries 

report the income or losses received on their individual tax returns and 

pay any applicable tax. 

To facilitate compliance, the tax law requires flow-through entities to 

report the income passed through on Schedule K-1 and to send one copy 

of the schedule to IRS and another to partners, shareholders, or 

beneficiaries. While the law requires such reporting of flow-through 

income, IRS estimates that between 6 and 15 percent of such income is not 

reported on individuals’ returns. 

Because of the significant amount of income being distributed and the 

estimated noncompliance, IRS began in 2001 to match the tax year 2000 

Schedule K-1 information provided by flow-through entities against the 

flow-through income reported on individuals’ tax returns. IRS began 

notifying taxpayers of potential discrepancies between income reported 

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

complaints that notices were being sent to compliant taxpayers, IRS 

stopped sending notices in August 2002. 

Because of concerns about the burden the Schedule K-1 matching program 

was imposing on compliant taxpayers, including the time and expense of 

responding to the notices, you asked us to review IRS’s implementation of 

the program and determine what happened and why. Specifically, as 

agreed with your office, our objectives were to (1) describe the 

implementation of the Schedule K-1 matching program, the extent of the 

burden caused by the notices, IRS’s rationale for stopping the notices, and 

United States General Accounting Office

Washington, DC 20548 
Page 2 GAO-03-667 IRS’s Schedule K-1 Matching Program 

any results the program achieved, (2) assess IRS’s management of the 

Schedule K-1 matching program, and (3) describe the steps IRS is planning 

to take to address any identified problems and improve Schedule K-1 

reporting and matching. 

To describe IRS’s Schedule K-1 matching program implementation, the 

burden caused by the notices, IRS’s rationale for suspending the program, 

and any results, we interviewed IRS officials and analyzed IRS data. To 

assess IRS’s management of the program, we compared IRS’s management 

plan to what was implemented. Finally, to describe the steps IRS plans to 

take to improve the program, we reviewed IRS’s plans for continuing the 

program in 2003 and reducing the burden on compliant taxpayers. 

IRS stopped issuing Schedule K-1 notices after complaints about the 

burden imposed by program changes on compliant taxpayers. Originally, 

IRS intended the Schedule K-1 matching program to focus on two 

categories of income—interest and dividends—that are easily identified on 

tax returns and would minimize the number of notices sent to compliant 

taxpayers. However, IRS learned during testing that it could not separate 

underreported K-1 interest and dividend income from the other 

underreported interest and dividend income such as that paid by banks. 

After the test, IRS expanded the Schedule K-1 matching program to cover 

additional categories of income, including flow-through income from trade 

or business activities. This created a burden for compliant taxpayers. 

About two-thirds of the 69,097 notices sent to taxpayers under the 

program were sent to taxpayers whom IRS later determined to be 

compliant. Compounding the problem, the expansion of the program was 

not clearly communicated to taxpayers or tax preparers. After complaints 

from taxpayers and after sending out about 70 percent of the notices 

intended, IRS stopped sending notices. IRS followed up on notices that 

were sent and has resolved about 92 percent of those cases. About 62 

percent of the cases were resolved with no change to the taxpayer’s 

liability. In the other 38 percent of the cases, an additional $41.4 million in 

taxes was assessed, of which $26.9 million was directly attributable to K-1 

underreporting. 

While detailed plans for managing the Schedule K-1 matching program 

were developed, IRS did not timely implement two parts of the plans. 

First, IRS did not test the feasibility of focusing the program on interest 

and dividend income until after recommending such a focus and 

communicating the recommendation to taxpayers, tax preparers, and 

Results In Brief 
Page 3 GAO-03-667 IRS’s Schedule K-1 Matching Program 

other stakeholders. Second, after changing the plan, IRS did not clearly 

communicate with taxpayers, tax preparers, and other stakeholders about 

the changes. 

For 2003, the focus of the program will be on the same categories of 

income as in 2002. IRS is taking several steps intended to improve the K-1 

matching program. IRS has been meeting with tax preparers and 

stakeholder groups in an effort to reestablish communication. Further, IRS 

has identified several program changes intended to reduce taxpayer 

burden by reducing the number of “no-change” notices sent to compliant 

taxpayers. Examples of these changes are more stringent screening 

criteria before notices can be sent and revisions to clarify forms and 

schedules. Neither IRS nor we know whether these changes will reduce 

the burden on compliant taxpayers while maintaining the effectiveness of 

the Schedule K-1 matching program as a compliance tool. We are not 

making recommendations in this report, but for the Senate Committee on 

Finance, we are assessing the program’s ability to detect and prevent 

noncompliance. IRS has a tracking system that should provide it 

information about the effectiveness of the changes before all the notices 

are sent out. 

We asked IRS to provide comments on our report but did not receive a 

response in time to include it with this report. However, IRS officials 

responsible for the program told us that they agree with the facts 

presented in this report. 

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

“flow-through entities,” because they have the legal capacity to pass net 

income or loss through to their partners, shareholders, and beneficiaries 

untaxed. As shown in figure 1, these flow-through entities file tax returns 

with IRS that report the entities’ income and expenses with schedules 

showing all partners’, shareholders’, or beneficiaries’ shares of net income 

or loss. Flow-through entities also are required to provide each partner, 

shareholder, or beneficiary with a Schedule K-1 stating the individual 

share of net income or loss to be reported. These partners, shareholders, 

or beneficiaries are then responsible for reporting this income or loss on 

their individual income tax returns and paying any tax. According to IRS 

in tax year 2001, over 9 million flow-through entities reported passing 

through $998 billion to approximately 24 million partners, shareholders, or 

beneficiaries. 

Background 
Page 4 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Figure 1: Illustration of the Taxation of Income That Flows through Partnerships, Scorporations, Estates and Trusts 

For reporting purposes flow-through income is broken into several 

categories. These include income or loss from trade and business 

activities, rental real estate, other rental activities, interest, dividends, 

royalties and capital gains. 

The purpose of the Schedule K-1 matching program is to compare the 

information provided by flow-through entities to that reported by 

individuals on their tax returns in order to ensure compliance. The 

Schedule K-1 matching program is part of IRS’s general matching program, 

the underreporter program. As shown in figure 2, the underreporter 

program identifies potentially noncompliant taxpayers using information 

from two primary data sources: 

• income reported to IRS by taxpayers on their individual tax 

returns and 

• income reported to IRS from third parties, such as employers, 

banks and other financial institutions, partnerships, Scorporations, estates, and trusts on forms such as the W-2, 

1099, and Schedule K-1. 
Page 5 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Figure 2: General Underreporter Matching Process 

The third party data is matched with the individual taxpayer’s return data 

to verify that all income is reported. In fiscal year 2002, the matching 

process identified approximately 14 million cases where individual tax 

return information did not match income information reported to IRS from 

third party sources. 

IRS does not follow up on all of these potential underreporter cases. In 

2002, IRS selected 3 million of the 14 million potential underreporter cases 

for further review. After the cases are selected from this inventory, tax 

examiners perform a manual review, called “screening” of tax returns to 

determine if the income or deductions in question can be identified on the 

actual tax return. If so, the case is closed; however, if reasonable doubt 

remains, the taxpayer is sent an underreporter notice.1

 At this point, 

taxpayers can choose to agree with the additional assessment, disagree 

and provide reasons, or ask for an appeal. 

In order for K-1 data to be used in the matching process, IRS had to input 

or transcribe data from K-1 information returns filed on paper into its 

information systems. For tax year 2000, 14.3 million paper K-1s were filed 

with IRS and another 5 million were filed electronically. Until it began 

transcription in 2001, IRS had not transcribed paper K-1 return information 

since 1995. 

 1

 The underreporter notice informs taxpayers of a proposed change to tax liability because 

of income that is not identifiable or apparently not fully reported on the return. 
Page 6 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Because IRS had not transcribed Schedule K-1 information since 1995, the 

agency suspected noncompliance among K-1 taxpayers was significant. 

Based on a small study conducted in July 2000, IRS estimated that 

between 6 and 15 percent of the Schedule K-1 returns attached to flowthrough returns are omitted from individual tax returns. Therefore, to 

identify the taxpayers who were potentially noncompliant and collect 

additional tax, IRS began planning in 2000 to (1) match Schedule K-1 

income information from partnerships, etc., against income information on 

individual tax returns to identify potential discrepancies and (2) send 

underreporter notices to taxpayers suspected of noncompliance. 

In 2000, Congress funded the Staffing Tax Administration for Balance and 

Equity (STABLE) Initiative that provided funding for transcription and 

matching of K-1 information. IRS told us funding provided for K-1 

transcription was 378 full-time equivalent (FTE) staff, but transcription 

rates were higher than planned and 485 FTEs were actually expended. IRS 

pulled funding from other programs to cover the shortfall. The 

approximate cost of the K-1 transcription was about $20 million. STABLE 

also included 69 FTEs and about $3 million for screening of matched K-1 

cases. 

IRS had two primary goals for the K-1 matching program. The first goal 

was to increase voluntary reporting of flow-through income by taxpayers. 

Although the program will bring in some revenue directly from notices 

sent to taxpayers who underreported, IRS believes that the indirect effect 

on voluntary reporting could be more important. IRS believes that the 

knowledge that K-1s are being matched will have a positive impact on selfreporting of flow-through income. 

IRS’s other primary goal was to target K-1 related underreporter notices on 

noncompliant taxpayers to the extent possible. Responding to notices is 

burdensome for compliant taxpayers. Taxpayers and preparers are 

required to collect, organize, and submit information to IRS either by 

telephone or in writing to explain any discrepancy cited in the notice. 

Resolving notices sent to compliant taxpayers also forces IRS to divert 

scarce enforcement staff away from noncompliant taxpayers. 

In order to describe IRS’s implementation of its Schedule K-1 matching 

program, reasons for suspending the issuance of notices, impact/burden 

on taxpayers, and results of the program, we: 

Scope and 

Methodology 
Page 7 GAO-03-667 IRS’s Schedule K-1 Matching Program 

• reviewed and analyzed IRS management plans, risk 

assessments, and other discussions of how the matching 

program would operate, including work group meeting minutes; 

• interviewed IRS officials regarding the efforts required to plan 

and implement the program, including preliminary program 

testing, early plans for the program, changes made in program 

plans, problems with stakeholder communication, and the 

suspension of notices related to Schedule K-1 income; 

• reviewed documents issued by external parties regarding 

concerns with the Schedule K-1 matching program; 

• interviewed stakeholders from outside IRS, including enrolled 

agents and members of professional organizations, IRS advisory 

committees; and 

• reviewed data and statistics resulting from the Schedule K-1 

matching program, including number of taxpayers sent notices 

and tax revenue assessed. 

We assessed IRS’s management of the Schedule K-1 matching program by 

reviewing the plans and risk assessment developed by IRS and then 

comparing IRS’s implementation of the program to these plans. 

To describe the steps IRS is taking to reduce burden and improve the 

matching program, we: 

• interviewed IRS officials regarding the changes being 

implemented for continuation of the Schedule K-1 matching 

program, including changes to reduce taxpayer burden; 

• reviewed external stakeholder documents that offered 

suggestions for the future of the Schedule K-1 matching 

program; 

• interviewed stakeholders from outside IRS regarding their 

suggestions for the Schedule K-1 matching program; 

• observed a public meeting of the Information Reporting 

Program Advisory Committee (IRPAC); and 

• observed a working group session of IRS and external program 

stakeholders. 

The underreporter data presented in this report was produced by IRS, and 

we did not independently verify its accuracy. However, we have used 

underreporter program data in past reports and have found underreporter 

summary statistics of the type used in this report to be reasonably 

accurate. We performed our work from June 2002 through May 2003 in 

accordance with generally accepted government auditing standards. 
Page 8 GAO-03-667 IRS’s Schedule K-1 Matching Program 

In its original plan for the Schedule K-1 matching program, IRS intended to 

focus on two categories of income: interest and dividends. IRS officials 

believed that such a focus would enable IRS to minimize the number of 

notices sent to compliant taxpayers. However, information system 

limitations, along with a desire to direct resources towards K-1 

underreporter cases, caused IRS to expand this focus and include more 

categories of income in the program. This change was not clearly 

communicated to taxpayers or preparers and led to more compliant 

taxpayers receiving underreporter notices. In the face of complaints about 

the burden imposed on compliant taxpayers, IRS stopped sending K-1 

underreporter notices. 

Originally, IRS planned the Schedule K-1 matching program to focus on 

two categories of flow-through income: interest and dividends. The plan 

called for identifying underreporter cases with discrepancies between 

interest and dividend income reported on a K-1 and what was reported on 

an individual’s tax return.2

 Notices would then be sent to the taxpayers 

asking them to explain the discrepancies or pay the additional tax. 

IRS chose to focus the Schedule K-1 matching program on interest and 

dividend income to minimize the chances of compliant taxpayers receiving 

notices about K-1 discrepancies. IRS based its decision on a risk matrix 

that summarized the risk of sending a notice to a compliant taxpayer for 

the various categories of flow-through income. Interest and dividend 

income were identified as low risk because they are easily identified on 

individuals’ tax returns. Short and long-term capital gains and royalties 

were considered a moderate risk because the K-1 information was less 

likely to be accurate or the income could be harder to locate on 

individuals’ returns. Income from trade or business activities, rental real 

estate, other rental activities, and guaranteed payments was considered 

high risk because it could be much harder to isolate on individuals’ 

returns. For example, some taxpayers would reduce or net their flowthrough income in these four categories by subtracting carryover losses or 

expenses. Although IRS’s tax form instructions caution against such 

 2

 While the K-1 matching program was designed to select the underreporter cases with 

discrepancies in interest and dividend income reported on the K-1s, a small sample of cases 

with other types of K-1 income was also to be included. 

IRS Stopped Issuing 

Schedule K-1 Notices 

after Complaints 

about Burden 

Imposed by Program 

Changes 

The Types of Income 

Covered by the Schedule 

K-1 Matching Program 

Changed from IRS’s 

Original Plan 
Page 9 GAO-03-667 IRS’s Schedule K-1 Matching Program 

netting, some taxpayers still do so, which can make flow-through income 

appear to be underreported. 

Starting in 2001, IRS began briefing representatives from stakeholder 

groups on its plan for the Schedule K-1 matching program. IRS met with 

two of its advisory committees, composed primarily of tax practitioners, 

the Internal Revenue Service Advisory Committee (IRSAC) and the 

Information Reporting Program Advisory Committee (IRPAC), and other 

practitioner groups. During these discussions with stakeholders, IRS 

informed them that underreported K-1 interest and dividend income would 

be the focus of the K-1 matching program. 

In October of 2001, IRS discovered during testing that the underreporter 

computer system could not distinguish underreported K-1 interest and 

dividend income from other interest and dividend income reported on 

information returns such as Form 1099s. Because of a desire to direct the 

69 FTEs allocated for screening K-1 underreporter cases to K-1 cases, IRS 

decided to expand the focus of the K-1 matching program. IRS officials 

told us they had wanted to direct the resources to K-1 cases exclusively in 

order to be able to determine the results achieved with those resources. 

The revised program included flow-through income from trade or business 

activities, rental real estate, other rental activities, and guaranteed 

payments. These four categories contained K-1 reported income 

exclusively. As will be discussed in more detail later, IRS did not clearly 

communicate the change to taxpayers, tax preparers, and other 

stakeholders. 

Under the revised matching program, IRS selected for screening by the 69 

dedicated FTEs a total of 141,000 underreporter cases that appeared to 

have only underreported K-1 income from the four categories as shown in 

figure 3. In addition IRS selected another 237,000 cases that appeared to 

have both underreported K-1 income and underreported income from 

other sources. After manual screening, IRS determined that 97,200 cases 

raised sufficient questions about the accuracy of the amount reported on 

the individual tax returns to merit sending a notice of the potential 

discrepancy to the taxpayers. IRS began sending notices about the 

discrepancies to taxpayers in April 2002. 
Page 10 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Because of the change in focus of the program, more compliant taxpayers 

received underreporter notices than IRS had originally intended. As shown 

in figure 3, of the over 63,000 cases closed through March 2003, about 62 

percent or 39,153 were closed with no change to the tax liability. The 

compliant taxpayers or their preparers who responded to the notices were 

required to submit information to IRS in writing or via telephone that 

explained how they reported the flow-through income on their tax return. 

Figure 3: The Number of Schedule K-1 Underreporter Notices Sent to Taxpayers 

Some of these compliant taxpayers were burdened because they 

improperly reported net amounts on their returns. As discussed 

previously, IRS instructions tell taxpayers to list K-1 income without 

netting. Nevertheless, according to IRS, many taxpayers reported net 

amounts, making it appear that they had underreported. After the 

discrepancies were explained to IRS, about 62 percent of the notices 

resulted in no change in the tax liability. 

The Revised Schedule K-1 

Matching Program 

Burdened More Compliant 

Taxpayers Than Originally 

Intended 
Page 11 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Taxpayers, tax preparers, and various external stakeholder groups 

complained about the notices for two reasons. First, as discussed 

previously, the notices imposed a burden on compliant taxpayers. Though 

some of these taxpayers may have improperly reported net amounts on 

their returns, the taxpayers argued that they had been filling out their 

returns this way for years without incident. Second, they were not 

expecting underreporter notices related to flow-through income about 

trade or business activities, rental real estate, other rental activities, and 

guaranteed payments. 

IRS responded by stopping the K-1 matching program notices as of August 

1, 2002. As shown in figure 3, IRS sent 69,097 notices to taxpayers before 

that date. 

As of March 2003, IRS data shows that nearly 92 percent or 63,084 of the 

Schedule K-1 notices issued were closed, or resolved to IRS’s satisfaction, 

as shown in figure 3. In nearly 38 percent or 23,931 of the closed cases, 

taxpayers agreed that the notices were correct, that the Schedule K-1 

income was misreported, and that they owed more taxes. These cases 

resulted in about $41.4 million of additional taxes assessed of which 

$26.9 million related exclusively to Schedule K-1 income. IRS estimates 

that about 90 percent of the assessed tax will be collected. 

In addition to the revenue resulting directly from the notices, IRS expects 

that K-1 matching will have a psychological impact on taxpayers, 

encouraging voluntary compliance. IRS did not have data at the time the 

program was being planned to allow it to estimate the likely impact on 

voluntary compliance. Nor does IRS have any data on the actual impact on 

voluntary compliance. IRS did project that a one percent improvement in 

K-1 reporting levels would result in approximately $1.7 billion in additional 

tax reported. 

IRS developed a plan for the Schedule K-1 matching program that, 

according to IRS, relied on established project management principles. 

However, IRS did not timely implement two parts of the plan. First, IRS 

did not test the feasibility of focusing the program on interest and dividend 

income until after recommending such a focus and communicating the 

recommendation to taxpayers, tax preparers, and other stakeholders. 

Second, after changing the plan, IRS did not clearly communicate with 

taxpayers, tax preparers or other stakeholders about the changes. Failure 

Because of Taxpayer 

Complaints, IRS Stopped 

Sending Schedule K-1 

Underreporter Notices 

IRS Followed Up on 

Schedule K-1 Program 

Notices Sent to Taxpayers 

IRS Did Not Timely 

Test Its Plans or 

Communicate Plan 

Changes to 

Stakeholders 
Page 12 GAO-03-667 IRS’s Schedule K-1 Matching Program 

to timely implement these two parts of the plan led to compliant taxpayers 

being surprised and burdened by the notices they received and ultimately 

resulted in IRS halting the Schedule K-1 notification process before all 

97,200 notices were sent to taxpayers. 

In planning the Schedule K-1 matching program, IRS officials said they 

relied on established principles from its Enterprise Life Cycle (ELC) 

project management approach, the same strategy IRS has used for 

planning and implementing its ongoing information systems modernization 

efforts. IRS developed a series of K-1 matching program management 

plans including those covering transcription and compliance management, 

risk management, and internal and external stakeholder communications. 

The K-1 compliance management plan called for performing two tests 

before selecting cases for the K-1 matching program. The first test was of 

underreporter program procedures and was intended to determine needs 

such as computer system and training updates in order to accommodate 

Schedule K-1 data. The second test was a review of underreporter program 

processes more generally. The K-1 communication plan called for 

communicating with internal and external stakeholders about the project 

status in order to address questions and concerns and manage 

expectations. 

IRS did not test whether its original case selection process, focused on 

interest and dividend income, was feasible before recommending it. As 

shown in figure 4, IRS began planning the Schedule K-1 matching program 

in January 2001. As previously discussed, in July 2001, IRS recommended 

selecting for review by tax examiners all underreporter cases with K-1 

interest and dividend income. An IRS official told us that internal 

discussions led IRS to believe that this was possible--that the 

underreporter computer system could distinguish cases with interest and 

dividend income reported on K-1s from that reported on other information 

returns. Consequently, the feasibility of focusing the K-1 program on 

interest and dividend income was not tested before the recommendation 

was made. 

IRS Developed Plans for 

Testing and 

Communicating about the 

Schedule K-1 Matching 

Program 

IRS Did Not Test the 

Schedule K-1 Case 

Selection Process before 

Recommending It 
Page 13 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Figure 4: Chronology of Key Events in IRS Implementation of the Schedule K-1 

Matching Program 

The second test in IRS’s plan was conducted in October 20013

 and revealed 

that system limitations would prevent IRS from focusing the K-1 program 

on interest and dividend income. IRS discovered that the underreporter 

computer system could not distinguish K-1 interest and dividend income 

from interest and dividend income reported on other information returns 

such as Form 1099s. As a result, the focus of the Schedule K-1 matching 

program was changed. As discussed earlier, the revised program covered 

underreported trade or business, rental real estate, other rental activity, 

and guaranteed payment flow-through income. 

Although the program communication plan called for communicating with 

internal and external stakeholders, IRS failed to inform taxpayers, tax 

preparers, and other stakeholders of the changes it made to the matching 

program and the potential for the changes to increase burden on 

compliant taxpayers. An IRS official responsible for the K-1 program 

stated that a communication breakdown resulted in mixed messages being 

shared with stakeholders about the type of cases that would be selected 

for the K-1 matching program. IRS officials were unable to show us any 

documentation in which they communicated the changes to the plan. An 

 3

 During the Case Preview, information return documents are sampled to test the quality of 

the information and to identify potential problems with the underreporter system. 

IRS Did Not Communicate 

Matching Program 

Changes to Taxpayers and 

External Stakeholders 
Page 14 GAO-03-667 IRS’s Schedule K-1 Matching Program 

IRSAC member told us they only became aware of the change to the 

program after taxpayers began receiving notices. 

Tax preparers and stakeholders were critical of the fact that IRS failed to 

inform them of the changes made in the Schedule K-1 matching program 

and the effect those changes would have on compliant taxpayers. They 

believed compliant taxpayers were unfairly burdened by having to respond 

to K-1 notices since, according to an IRSAC member, preparers had not 

been required to submit any explanatory documents with their tax returns 

in the past. 

As was the case with the revised Schedule K-1 matching program in 2002, 

for 2003, interest and dividend income reported on K-1s will be included in 

the underreporter program; however, the 69 FTEs devoted to K-1 matching 

will again focus on the four flow-through income categories including 

income from trade or business activities, rental real estate, other rental 

activities, and guaranteed payments. As of April 2003, IRS has started 

issuing notices related to discrepancies in tax year 2001. Also this year, 

IRS is taking steps intended to reestablish communication with external 

stakeholders and reducing the burden on compliant taxpayers. At this 

time, the effectiveness of these steps is unknown. 

For 2003, the Schedule K-1 matching program will have the same focus as 

the revised program in 2002. Therefore, during the 2003 Schedule K-1 

matching effort, it is no longer necessary for IRS to test this case selection 

approach in the underreporter system. 

IRS is working to reestablish clear communications with external 

stakeholders. Since notices were stopped in August 2002, IRS has kept 

external stakeholders informed of program developments and held 

meetings with these stakeholders to consider a number of suggestions for 

improving the Schedule K-1 matching program. For example, in the 2 

months following the notice stoppage, IRS briefed both IRSAC and its own 

Oversight Board on reasons for notice suspension, data collected, and 

plans for continuing the program with external stakeholder input. 

IRS also held public meetings with IRSAC in October 2002 and IRPAC in 

November 2002 during which it obtained the committees’ comments and 

suggestions for the Schedule K-1 matching program. In addition, IRS held a 

meeting in December 2002 with representatives of various practitioner and 

other stakeholder groups to discuss various aspects of the program. In this 

IRS Is Taking Steps 

Intended to Improve 

the Schedule K-1 

Matching Program in 

2003 

IRS Is Working to 

Reestablish 

Communications with 

External Stakeholders 
Page 15 GAO-03-667 IRS’s Schedule K-1 Matching Program 

meeting, IRS presented results of the case studies it conducted after 

suspension of the notices and solicited from the stakeholders ideas for 

improving the program in the areas of forms, matching, education and 

outreach, tax preparation software, and legislative changes. 

At least in part as a result of the stakeholder meetings discussed above, 

IRS has begun implementing steps intended to improve Schedule K-1 

matching and clarify reporting requirements. IRS has adopted a new goal 

of eliminating as many no-change notices as possible and increasing the 

overall effectiveness of the Schedule K-1 matching program. IRS’s strategy 

for reducing no-change notices relies on more rigorous screening of cases 

by examiners before notices are sent. IRS estimates that the program 

changes discussed below should reduce the number of no-change notices 

by about 50 percent from the 2002 levels. At this time, IRS does not have 

an estimate of the number of notices to be sent out or of what it expects 

the no-change rate to be. 

For 2003, IRS has adopted a revised set of standards for screening cases 

for review in its Schedule K-1 matching program, with the intent of 

minimizing taxpayer burden by reducing the number of no-change notices 

sent. In particular, IRS will issue notices to taxpayers if K-1 income 

information is completely missing from a return. Also, if a taxpayer 

received a notice in 2002 for tax year 2000 K-1 items and agreed with the 

changes proposed by that notice, the taxpayer will receive a notice for any 

underreported K-1 income identified this year in the tax year 2001 return. 

If income appears underreported for a taxpayer who received a notice that 

resulted in a no-change last year, that taxpayer will not receive a notice 

this year, with the possible exception of particularly large discrepancies. 

In addition, if a taxpayer received no notice last year or received a notice 

that contained no K-1 items, this taxpayer will be sent a notice if a large 

discrepancy is identified. The revised screening standards will be applied 

to all K-1 flow-through income discrepancies. 

IRS is also trying to educate taxpayers and practitioners about the proper 

way of reporting flow-through income, carryover losses, and deductions in 

order to reduce the need to send notices to compliant taxpayers about 

apparent mismatches. For example, in March 2003, IRS issued a news 

release that provided tips and reminders for K-1 filing. These tips covered 

topics such as proper reporting of Schedule K-1 income on individual 

returns, avoiding netting of income and expenses, reporting losses carried 

forward, and steps for reporting income when the Schedule K-1 has not yet 

been received. 

IRS Is Taking Other Steps 

Intended to Reduce 

Taxpayer Burden 
Page 16 GAO-03-667 IRS’s Schedule K-1 Matching Program 

Also in March 2003, an IRS official participated in a webcast program 

geared to the practitioner community to discuss requirements of Schedule 

K-1 reporting and field questions from practitioners. In addition, the 

agency will present sessions on how to report flow-through items at each 

of its tax forums during the summer of 2003. The agency also seeks to 

further educate taxpayers through outreach programs to be run by the 

Taxpayer Education and Communication unit, a part of IRS’s Small 

Business/Self-Employed operating division. 

Further, IRS is changing certain forms and/or schedules in order to make 

reporting compliance easier for the taxpayer. In a report issued March 

2003, the Treasury Inspector General for Tax Administration (TIGTA) 

stated the lack of detailed information reported by taxpayers and/or 

practitioners may have been a significant reason for the number of K-1-

related notices that were sent. TIGTA then recommended that IRS revise 

Form 1040 Schedule E to classify and report flow-through income in a 

manner that would allow an easier comparison with Schedule K-1. In 

response, an IRS official has stated that, for the 2003 filing season, the 

agency would issue a revised Form 1040 Schedule E that would alert 

practitioners to pay special attention to the written instructions on the 

reporting of certain losses and expenses. The desired effect of this change 

is to make taxpayers less likely to improperly net income and expenses 

being reported on Schedule E. 

Finally, an IRS task force is studying the possibility of simplifying the 

Schedule K-1 and its instructions for different tax situations. The intent 

would be to reduce both pre- and postfiling burden. However, the analysis 

needed for the form redesign will likely not be completed until mid-2003, 

and it would take about 2 years total for the redesign to actually be 

implemented. 

By fiscal year 2005, through the outreach efforts and Form 1040 Schedule 

E revisions discussed in the previous paragraphs, IRS believes that it can 

eliminate the need for the special screening procedures instituted this 

year. In addition to the outreach efforts and form changes mentioned 

above, IRS has also discussed other efforts that could be used to help 

make the program more automated, such as working with software 

vendors to make any necessary changes to electronic tax preparation 

programs. 

While IRS intends that these changes will reduce the number of no-change 

notices regarding flow-through income, at this time the effectiveness of 

the changes is unknown. More specifically, it is not known how ambitious 
Page 17 GAO-03-667 IRS’s Schedule K-1 Matching Program 

IRS’s goal to reduce notices sent to compliant taxpayers by at least 50 

percent is nor is it known whether IRS can reduce notices sent to 

compliant taxpayers while maintaining the ability to act against 

noncompliant taxpayers. 

For the K-1 matching notices being sent in 2003, IRS will be able to track 

the number closed with no-change through tracking reports issued every 2 

weeks. These tracking reports also contain the number of notices with an 

assessment that the taxpayer agreed to, unreported income identified 

through notices, and additional taxes assessed through the notices. The 

reports, which IRS has begun preparing for its tax year 2001 K-1 data 

match, are prepared for IRS management. Officials told us that they would 

also be made available to outside stakeholders. 

The tracking reports should give IRS management information before all 

notices are sent out about the effectiveness of the changes made to the 

program. With respect to the overall effectiveness of the K-1 matching 

program, one IRS official told us that he sees the level of voluntary 

compliance with K-1 reporting requirements as a key measure of the 

program’s effectiveness. This official also told us that IRS plans to 

annually review the number of K-1 returns filed to determine if more K-1 

income is being reported. He said that more reporting of K-1 income could 

be seen as a measure of program effectiveness. Our ongoing work for the 

Senate Committee on Finance will assess IRS’s efforts to detect and 

address noncompliance by taxpayers receiving flow-through income. 

Better targeting the Schedule K-1 matching program notices on 

noncompliant taxpayers matters for two reasons. Sending underreporter 

notices to compliant taxpayers wastes taxpayers’ time and money. 

Similarly, IRS’s scarce enforcement resources are wasted to the extent 

they are used to resolve notices sent to compliant taxpayers. 

While no compliance program can perfectly target noncompliant 

taxpayers, IRS’s goal of reducing the number of Schedule K-1 matching 

program underreporter notices sent to compliant taxpayers is laudable. 

However, at this time, no one--neither IRS nor external stakeholders--

knows how effective IRS’s proposed actions will be. Consequently, IRS’s 

tracking of the no-change rate is very important, both for internal 

management and congressional oversight. Because IRS has begun tracking 

the no-change rate every 2 weeks, we are not making recommendations in 

this report. As noted earlier, we will be looking at opportunities to 

Conclusion 
Page 18 GAO-03-667 IRS’s Schedule K-1 Matching Program 

improve the overall effectiveness of the Schedule K-1 matching program in 

our ongoing work for the Senate Committee on Finance. 

We asked IRS to provide comments on a draft of our report but did not 

receive a response in time to include it with this report. However, IRS 

officials responsible for the program told us that they agree with the facts 

presented in this report. 

As arranged with your office, we will not distribute this report until 30 

days from its issue date unless you publicly announce its contents earlier. 

After that period, we will send copies to the Chairman and Ranking 

Minority Member, House Committee on Ways and Means; Chairman and 

Ranking Minority Member, House Subcommittee on Oversight, House 

Committee on Ways and Means; Chairman and Ranking Minority Member, 

House Committee on Small Business; Chairman and Ranking Minority 

Member, Senate Committee on Finance; and the Ranking Minority 

Member, Senate Committee on Small Business and Entrepreneurship. We 

will also send copies to Secretary of the Treasury, the Commissioner of 

Internal Revenue, and other interested parties. We will make copies 

available to others on request. In addition, the report will be available on 

the GAO web site at http://www.gao.gov. 

If you have any questions, please contact me at (202) 512-9110. Key 

contributors to this report are acknowledged in appendix I. 

Sincerely yours, 

James R. White 

Director, Tax Issues 

Agency Comments 
Appendix I: GAO Contact and Staff 

Acknowledgments 

Page 19 GAO-03-667 IRS’s Schedule K-1 Matching Program 

James R. White, (202) 512-9110 

In addition to the contact above, Marvin McGill, Adam Couvillion, 

Amy Rosewarne, and Joseph Jozefczyk made key contributions to 

this report. 

Appendix I: GAO Contact and Staff 

Acknowledgments 

GAO Contacts 

Staff 

Acknowledgments 

(440154) 
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