IRS Audits: Weaknesses in Selecting and Conducting Correspondence Audits
Published: 1999-03-31T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO reviewed the Internal Revenue Service's (IRS) program to audit income tax returns through correspondence, focusing on: (1) the number, results, and duration of correspondence audits as well as the characteristics of the audited returns; and (2) processes and requirements that IRS has had for years to govern correspondence audits.
section_title: What GAO Found
paragraphs: GAO noted that: (1) several weaknesses were found in IRS' correspondence audit processes; (2) these weaknesses, individually or in combination, can erode the integrity of the correspondence audit processes, which are designed to help ensure that taxpayers pay the correct tax amounts and are treated properly; (3) during fiscal years 1992-1997, the annual number and results of correspondence audits conducted by IRS varied considerably; (4) the number ranged annually from just over 200,000 to about 1.1 million audits; (5) the rate at which IRS auditors closed audits without recommending additional taxes ranged from 13 percent to 46 percent; (6) when they did recommend additional taxes, the average amounts ranged from $1,300 to $2,800; (7) the rate at which taxpayers did not respond to these recommended additional taxes after being requested to do so by IRS ranged from 29 percent to 63 percent; (8) these variations resulted, in part, from an increase in the number of correspondence audits of returns claiming an earned income credit (EIC); (9) for the traditional correspondence audits closed in fiscal year 1996, the time between the filing of a return and the start of the correspondence audit averaged 10 months; (10) it then took 11 more months before IRS assessed any taxes that were recommended during the audits; (11) as for the characteristics of these 1996 returns, an estimated 75 percent had reported adjusted gross incomes of less than $15,000; (12) in part, this percentage reflects the correspondence audit's focus on simple tax issues and EIC; (13) IRS had weaknesses in implementing the correspondence audit requirements for four processes; (14) not all of the traditional correspondence audits closed in 1996 were manually reviewed (or classified) to identify all issues for audit, as required by IRS; (15) support for recommended audit findings was not adequately documented in the audit workpaper files, as required, for about one-third of the audits; (16) the taxpayer documentation that was required to justify EIC claims varied from service center to service center; (17) GAO found weaknesses in the reviews that IRS did on a sample of closed audits to measure their quality; and (18) in addition to the weaknesses in implementing the requirements, IRS allowed service centers to exclude certain types of audits that did not have all required documentation from being measured against the audit standard on workpaper documentation.

section_title: Letter
paragraphs: This report responds to your request that we review the Internal Revenue Service’s (IRS) program to audit income tax returns through correspondence. We provide information on the number, results, and duration of correspondence audits as well as the characteristics of the audited returns and examine the processes and requirements that IRS has put in place to govern correspondence audits. This report also includes our recommendations on improving the correspondence audit program.
We are sending copies of this report to Representative William J. Coyne, Ranking Minority Member, Subcommittee on Oversight, House Committee on Ways and Means; Senator William V. Roth, Jr., Chairman, and Senator Daniel Patrick Moynihan, Ranking Minority Member, Senate Committee on Finance; various other congressional committees; The Honorable Robert E. Rubin, Secretary of the Treasury; The Honorable Charles O. Rossotti, Commissioner of Internal Revenue; The Honorable Jacob Lew, Director, Office of Management and Budget; and other interested parties. Copies will also be made available to others upon request.
This report was prepared under the direction of Thomas D. Short, Assistant Director. Other major contributors are listed in appendix VI. If you have any questions about this report, please call me or Mr. Short on (202) 512-9110.
subsections: section_title: Introduction
paragraphs: Using a variety of tools, IRS checks all individual income tax returns filed each year for compliance with the tax laws. These compliance checks include reviews of some required information, such as signatures and social security numbers, at the time a return is filed; computerized corrections of what IRS labels “math errors;” computerized matching of information, such as income, with the corresponding information reported to IRS by third parties; and audits.
IRS audits individual income tax returns to help ensure that taxpayers pay their proper tax liability. Audits are one of the enforcement tools used by IRS in its efforts to close the tax gap—the amount of taxes owed but not voluntarily paid. IRS’ most recent estimate put the individual tax gap at over $125 billion for 1992. IRS also estimates that it eventually collects about one-quarter of the gross tax gap through its enforcement efforts.
The audits account for a small share of the returns filed annually—about 1 or 2 percent. Between 1992 and 1997, IRS audited between 1 million and 2 million individual income tax returns per year. In 1996, when about 119 million individual income tax returns were filed, IRS audited 1.9 million returns—1.1 million at its 10 service centers and about 760,000 at its 33 district offices. In selecting returns to audit, IRS attempts to identify those that are most likely to have errors—or audit potential—owing to questionable tax issues such as income, deductions, exemptions, and credits. IRS’ process for selecting returns with the highest audit potential is important because audits can be costly for both taxpayers and IRS.
In recent years, Congress has been concerned about IRS’ use of its enforcement tools, particularly about whether the tools are used fairly and in a manner that does not impose excessive burdens on taxpayers. Concerns such as these led, in part, to the passage of the IRS Restructuring and Reform Act of 1998. The act included provisions affecting audits.
subsections: section_title: Screening and Classification of Tax Returns
paragraphs: IRS uses both computer technology and manual review to select returns for audit. This selection process results in a determination of whether a return has audit potential. If the return does, the process helps identify specific tax issues to be audited (audit issues) and the audit technique to be used—correspondence sent to taxpayers from IRS’ service centers or meetings with taxpayers or their representatives through IRS’ district offices.
IRS uses computer programs to screen tax returns filed each year by individual taxpayers for audit potential. One program utilizes a computerized series of discriminant function (DIF) formulas to compute a score for each return. The higher the score, generally speaking, the greater the likelihood that the return’s reported tax would be changed if audited. Districts have used DIF scores as a primary source to select most of the returns they audited. Service centers rarely use DIF scores because centers usually focus on one audit issue, whereas DIF focuses on returns with multiple, more complex issues.
Service centers have their own computer programs to identify returns with issues to be audited through correspondence. The types of issues to be audited vary from year to year as Congress, IRS, and the local district offices and service centers focus on particular aspects of the tax law. For example, in recent years, earned income credit (EIC) claims and individual retirement account penalties have been highlighted by the service centers.
Once the screening programs have identified tax returns with audit potential, the returns are to be reviewed (or “classified”) by qualified staff for each district office and service center. IRS requires the returns to be classified to determine which can be accepted as filed and, if not accepted, to identify all potential audit issues. IRS allows tax returns to be classified by different types of auditors, depending on the complexity of the returns and the issues. Returns with more complex audit issues that require personal contacts with the taxpayers are to be reviewed by revenue agents or tax auditors. Returns with less complex issues that can be audited through correspondence are to be sent to service centers to be reviewed by tax examiners. (See app. I for detailed explanations of screening and classification.) Once returns are classified and selected for audit, any identified audit issue is to be documented in the audit workpaper file.
The IRS staff who do the classification have varying degrees of training and audit experience. Revenue agents are the highest graded auditors and are required to have at least 24 hours of college-level accounting courses to audit the most complex tax returns from corporations, other businesses, and higher income individuals. Tax auditors, who usually have some accounting education, audit less complex issues by meeting with taxpayers at the district offices. Service centers use tax examiners to audit the simpler individual issues. Tax examiners, who are not required to have any accounting education, audit simple issues through correspondence and are not trained to audit complex issues on business and investment schedules attached to tax returns.
section_title: The Correspondence Audit Process
paragraphs: According to IRS, tax returns assigned to the service centers are to involve only one or two simple tax issues, such as EIC claims, that can be audited through correspondence. Correspondence audits are to exclude complicated tax issues, such as those on business and investment schedules, and are designed to quickly review a taxpayer’s support for the tax issues.
The time needed to audit returns and establish the appropriate tax liability depends, in large part, on the number of letters IRS sends to taxpayers and the sufficiency of the taxpayers’ responses. IRS typically sends two letters—one asking for information or documentation and at least one reporting any changes to the tax liability reported on the tax return as a result of the audit. (See fig. 1.1.)
IRS service centers send an initial letter to notify taxpayers of the issues on the return to be audited and to request information on those issues within 30 days. If the taxpayer provides the information requested, a tax examiner is to determine whether it supports the audit issues. If it does provide the support, the tax return can be accepted as filed and the audit closed with no change in the reported tax liability. If the information does not support the issues, the tax examiner can request further clarification or documentation. After reviewing all the submitted information, the tax examiner determines whether additional taxes are warranted. Should the taxpayer not provide information to support the audit issues, the tax examiner is to treat the issues as unsubstantiated and recommend additional taxes.
Whether or not the taxpayer responds to IRS’ initial letter, IRS is to notify the taxpayer in writing of the results of the audit, such as whether the tax examiner is recommending any changes to the reported tax liability and, if so, the amount of change. This IRS letter also gives taxpayers a 30-day period to agree or disagree with the recommended results. If the taxpayer agrees, any recommended tax changes are to be assessed as taxes owed. If the taxpayer disagrees, IRS is required to inform the taxpayer of the right to file a protest with IRS’ Appeals Office to determine whether the recommended taxes should be assessed.
Taxpayers who do not respond to these 30-day letters are to be sent another notice giving them an additional 90 days to respond before the recommended taxes are formally assessed. If the taxpayer does not respond to this 90-day letter, the recommended taxes are to be assessed, and the matter is to be referred to IRS’ Collection Division.
In addition to the formal appeals process, IRS allows taxpayers who disagreed with the audit results or who did not respond to IRS’ audit letters to ask for a reconsideration of any additional taxes that were assessed as a result of an audit. IRS extends this option to taxpayers who provide new information about these assessed taxes, including those who bypassed opportunities to resolve their disputes in IRS’ Appeals Office or the Tax Court.
section_title: Audit Quality Reviews
paragraphs: IRS has two quality review functions to see whether correspondence audits comply with its requirements and standards. The audit standards include such requirements as adequate consideration of all significant audit issues and workpaper support for all audit findings. (See app. II, which describes each standard.)
The first review is to be carried out by supervisors who are to periodically review the tax examiners’ work during the audits. The results of these reviews are to be used in the tax examiners’ performance evaluations, but IRS does not require supervisors to document the results in the audit workpaper files.
The second review is to be performed by quality assurance staff within the service centers. The staff are to review a sample of all closed audits for adherence to IRS’ requirements and audit standards. The results of these reviews are to be entered into the Correspondence Examination Quality Management System (CEQMS) database and used to identify procedural and systemic weaknesses and to develop improvements where needed.
section_title: Objectives, Scope, and Methodology
paragraphs: In response to a request from the Chairman, Subcommittee on Oversight, House Committee on Ways and Means, this report (1) provides information on the number, results, and duration of correspondence audits as well as the characteristics of the audited returns and (2) examines the processes and requirements that IRS has had for years to govern correspondence audits.
To provide information on the number, results, and duration of correspondence audits, we gathered data from various IRS sources. We gathered detailed data on audits closed in fiscal years 1992-97 from IRS’ Audit Information Management System (AIMS), including the number of audits, amount of additional taxes recommended, and type of audit closures (e.g., no tax changes). For the duration and other characteristics, we gathered data from a statistically valid sample of traditional correspondence audits closed in fiscal year 1996 by reviewing audit workpaper files and IRS’ individual masterfile data. We did not check the reliability of IRS’ data in AIMS and the masterfile.
In selecting the 1996 sample, we sought traditional correspondence audits, which required us to exclude certain types of workload. According to Customer Service officials, most returns audited in fiscal year 1996 were not the traditional correspondence workload. Rather, they included work on EIC returns that misreported Social Security numbers—which IRS transferred out of the audit program to the math-error adjustment program in 1997. Therefore, with the concurrence of the Customer Service officials, we excluded these and other types of tax returns from our sample to allow us to analyze more traditional correspondence audit work.
This adjusted the fiscal year 1996 total of 1.1 million tax returns audited to 335,050 returns, from which we randomly selected 502 returns. We stratified our sample by whether (1) the taxpayer responded to IRS’ letters and (2) a tax change was recommended. IRS located 446 of the 502 tax returns and related audit workpapers for us to analyze. (See app. III for a detailed description of our sampling methodology.)
To examine IRS’ processes and requirements for correspondence audits, we collected documentation and did interviews at IRS on those processes and requirements. We then used three methodologies. First, we reviewed the 446 tax returns in our sample and related audit workpaper files. For these returns, IRS’ Fresno Service Center also provided masterfile account data on what happened to the additional taxes assessed as of April 1998. Second, we received written comments to a survey from all 10 service center Compliance chiefs on the processes and requirements. And third, we interviewed Examination officials at the National Office, as well as the Directors, Compliance chiefs, Examination chiefs, and selected Examination officials in 4 of IRS’ 10 service centers: Andover, MA; Fresno, CA; Kansas City, MO; and Memphis, TN. (See app. IV for a comparison of workloads at the service centers.)
We requested comments on a draft of our report. IRS provided comments in a meeting on February 23, 1999, and a letter dated March 12, 1999.
We have incorporated these comments as appropriate. We have also summarized the comments at the end of chapter 3 and have reprinted the letter in appendix V.
We performed our audit work between September 1997 and August 1998 in accordance with generally accepted government auditing standards.
section_title: Correspondence Audits From 1992 to 1997
paragraphs: During fiscal years 1992-97, the correspondence audit program experienced distinct shifts. IRS tripled the number of returns audited from 1992 to 1994-95 before reducing its correspondence audit inventory in 1997. A higher percent of the audits closed with no tax changes during fiscal years 1994-96, and the percent of audits that closed with no response from taxpayers more than doubled from 1995 to 1997.
In terms of the characteristics for the traditional correspondence audits closed in 1996, an average of about 11 months elapsed between the start of the audit and the assessment of any taxes recommended during the audit. Many of the audited returns included complicated business and investment schedules that were not audited. Because so many of the correspondence audits in our study population year dealt with EIC claims, the reported income of most of the audited taxpayers was below $15,000.
subsections: section_title: Number of Returns Audited and the Results of the Correspondence Audits
paragraphs: The number of correspondence audits and their results varied considerably between 1992 and 1997, with three distinct periods. As discussed with Customer Service officials and shown in table 2.1, these periods were 1992-94, 1995-96, and 1997.
In the first period (fiscal years 1992-94), the number of tax returns IRS audited through correspondence totaled a few hundred thousand annually. Comparing 1992 to 1994, the amount of taxes recommended overall and per audited return declined. According to Customer Service officials, these 3 fiscal years represented IRS’ traditional practices for doing correspondence audits.
In the second period (fiscal years 1995-96), IRS’ correspondence audit inventory increased to over 1 million returns annually because of an increase in audits of returns that claimed EIC. Almost 800,000 of the audits that closed in 1996 involved EIC returns with missing or invalid Social Security numbers. This increased audit focus on EIC arose from congressional concerns about EIC noncompliance. With the threefold increase in audits, the amount of recommended taxes more than doubled. As a result, the tax amounts recommended per audited return declined by as much as about half (from $2,483 in 1993 to $1,298 in 1995).
In the third period (fiscal year 1997), IRS decreased the correspondence audit inventory to about 758,000. Customer Service officials told us that IRS moved over 700,000 EIC returns with misreported Social Security numbers to its math-error adjustment program. To partially substitute for these transferred audits, the officials said IRS began auditing more individual retirement accounts and potential nonfilers. With this shift in the audit inventory in 1997, the number of audited returns and staff years decreased and the amounts of taxes recommended overall and per audited return increased compared to 1996. With the new types of tax issues being audited, the audits were more likely to recommend tax changes in higher amounts compared to audits of other types of issues such as EIC.
The large number of audited EIC returns also affected audit closures. From 1992 to 1994, less than 25 percent of the audits closed with no changes to tax liability. Further, the default rate—that is, the rate at which audits closed when taxpayers did not respond to tax assessment notices— remained relatively constant at around 40 percent. With the inclusion of EIC returns in 1995, the no-change rate doubled to 46 percent, and the default rate initially dropped to 29 percent. After the EIC returns were transferred to the math-error adjustment program in 1997, the no-change rate decreased to the 1992 level, but the default rate more than doubled compared to 1995, reaching 63 percent. Table 2.2 shows these shifts in audit closures over the three time periods.
section_title: Time Taken to Conduct Correspondence Audits
paragraphs: In the correspondence audit process, many audits are started soon after the returns are filed, while others are started a year or more later. For returns involving EIC claims, beginning the audit soon after the return is filed increases the likelihood that the issues can be examined before any tax refunds are released. For other returns filed in the spring, the audits often do not begin until the following winter. Audits of taxpayers who do not file tax returns may take a year or more to begin.
For traditional correspondence audits closed in 1996, we found that the time between the filing of the return and the start of the audit averaged 10 months, and the time between the start of the audit and the assessment of any additional taxes took, on average, over 11 more months. The length of the audit varied, depending on whether taxpayers responded and how it was closed. On the one hand, audits took about 7 months when taxpayers responded to IRS’ notice of audit and the audits closed without recommending additional taxes. On the other hand, when taxpayers did not respond to IRS’ 90-day letters notifying them of any additional tax assessments and the audits closed with the taxpayer defaulting, audits took much longer. For example, an average of about 13 months elapsed between the start of the audit and the assessment of any additional taxes.
Seven months of this time were spent simply waiting for the taxpayers to respond to one or more of IRS’ letters.
For these audits, the average time that elapsed from the filing of the return to the additional tax assessment was 21 months. This elapsed time is significant in two respects. First, IRS collects 27 percent of taxes assessed through correspondence audits before the assessment becomes final and another 49 percent within 15 weeks of the final assessment. Second, Congress’ 1998 legislation to restructure IRS contains provisions that suspend the accrual of interest and some penalties if IRS fails to notify the taxpayer of additional tax liabilities within 18 months after a return is filed. After 2003, suspension will begin 12 months after the tax return is filed. Delays in completing the audit, therefore, could reduce revenue from penalty and interest assessments.
Aside from these considerations, the time to assess any recommended taxes in these audits may be extended if taxpayers choose to exercise their right to appeal these audit recommendations. For audits being appealed or otherwise disputed by the taxpayer, a long amount of time can elapse before a determination on the tax assessment can be reached.
section_title: Profile of Tax Issues Audited Through Correspondence
paragraphs: The traditional correspondence audits closed in 1996 dealt with a few types of simpler tax issues rather than the more complex business and investment tax issues on individual returns. The types of tax issues audited through correspondence primarily included EIC claims and self- employment tax. On average, each traditional correspondence audit dealt with two tax issues. As figure 2.1 shows, EIC and related issues, such as the taxpayer’s filing status and dependent exemptions, accounted for over half of these audited tax issues.
section_title: Profile of Tax Returns Audited Through Correspondence
paragraphs: Although IRS’ traditional correspondence audits closed in 1996 usually addressed simpler tax issues, an estimated 65 percent of the audited returns had at least one schedule attached. Many of these schedules (such as C, D, E, and F) reported more complex business and investment tax issues that were not audited. For the audited returns with schedules, an estimated
61 percent had schedules supporting their EIC claims;
26 percent had a schedule A or B to report itemized deductions or interest
22 percent had a schedule C to report business income from self-
10 percent had a schedule D to report capital gains or losses;
8 percent had a schedule E to report gains or losses from rental property, partnerships, and other entities; and
3 percent had a schedule F to report income from farming.
In addition, the individual taxpayers subjected to traditional correspondence audits that closed in 1996 usually reported annual incomes of less than $15,000 on their audited returns. In fact, as table 2.3 shows, an estimated 76 percent of the audited returns reported taxable incomes of less than $15,000. However, 44 percent of all income tax returns filed by individuals in 1996 reported taxable incomes of less than $15,000. The returns audited through correspondence tend to report income below $15,000 because they also report simpler tax issues and EIC claims, both of which can be associated with lower amounts of income.
It is important to recognize that table 2.3 does not compare all taxpayers with audited returns to all taxpayers who filed returns. Taxpayers with higher annual incomes and more complex tax issues are typically audited through IRS district offices using other types of audit methods than correspondence audits.
section_title: Weaknesses in Processes and Requirements for Selecting and Conducting Correspondence Audits
paragraphs: The correspondence audit process is one of the tools IRS uses to help ensure that taxpayers pay their proper tax liability. It is designed to audit, through the mail, all questionable issues identified on less complicated tax returns. However, our work pointed to a number of weaknesses in the processes for implementing requirements for selecting returns to audit and for auditing those returns.
subsections: section_title: Most Tax Returns Audited Through Correspondence Were Not Classified
paragraphs: We found that service centers did not follow IRS’ requirements for classifying returns and referring returns with complex business or investment schedules to district offices. IRS manuals state that after being identified for audit, tax returns should be classified to ensure that all issues worth auditing are identified. Returns with complex issues and schedules are to be classified by revenue agents or tax auditors who have the training and experience with complex tax issues. Returns with less complicated issues can be classified by tax examiners. However, service centers used tax examiners to classify most returns, some of which involved complex schedules, and rarely referred returns with complex schedules to an IRS district office.
In examining the administrative files and audit workpapers for the traditional correspondence audits closed in 1996, we found that, excluding nonfilers, an estimated 69 percent did not have any evidence of classification as required. When returns are not classified by trained staff, potential noncompliance may go undetected. Moreover, the lack of classification can lead to IRS’ unnecessarily auditing returns or issues and thus burdening taxpayers.
For the returns that had been classified, we found indications that tax examiners did most of the classification. Having tax examiners classify one or two issues on simpler tax returns is to be expected. However, in 1996, an estimated 20 percent of the tax returns traditionally audited through correspondence included complex business and investment schedules.Specifically, IRS requires returns with more than one business schedule or schedules C or F to be referred to district offices for classification and possible audit. We found referrals of such returns to IRS district offices in less than an estimated 1 percent of the traditional correspondence audits.
We reviewed a judgmental sample of about 30 files with these complex returns and found that one-third could have merited referral to a district.
For example, we found complex business returns that deducted sizable expense amounts compared to the reported business income but no evidence that anyone at IRS looked at the audit potential of these deductions. Without a control such as classification of returns with complex schedules by IRS tax auditors or revenue agents with commensurate training and experience, IRS could not verify whether returns slated for correspondence audits should have been referred to district offices.
We surveyed compliance chiefs at all 10 service centers, who confirmed that not all returns are classified and that tax examiners do most classifications. For example, five chiefs noted that their service centers usually classify less than one-third of the returns they audit. When classification occurs, tax examiners classify 85 percent or more of the returns according to six compliance chiefs; the other four centers use tax examiners but also use tax auditors or revenue agents. Two compliance chiefs added that tax examiners are trained to audit simple issues and are not ideal for classifying returns with complex issues. Also, many chiefs noted that service centers might not have referred returns with complex issues because they believed the returns would not meet district office criteria. They said service centers tend to receive returns because computerized criteria targeted a simpler issue to audit, usually before districts began their classification of returns.
In our follow-up on the classification practices, Customer Service officials told us that not all tax returns needed to be classified to identify all potential audit issues. They said that correspondence audits were designed for quickly auditing one or two issues through the mail and then moving on to other audits with similar types of issues. As a result, these officials said that a fuller classification beyond the one or two issues is unnecessary for simple returns, which most of the audit workload comprises. However, these officials also said that such a fuller classification might be useful for returns with complex issues and schedules.
section_title: Audits Did Not Always Have Adequate Documentation
paragraphs: IRS’ manuals and audit quality standards require that tax examiners adequately support their audit recommendations in the audit workpaper files. Officials at the four service centers we visited told us that documents with information on the case history, audit issue development, and support for recommended taxes are key documents in developing an audit trail on the examiners’ actions as well as in documenting support. Without an audit trail or documented support, neither IRS nor the taxpayer can be assured of the basis for any additional taxes recommended.
Our analysis of these and other documents in the workpaper files for traditional correspondence audits closed in 1996 showed that about one- third of the audits had little or no evidence of documents to explain the audit trail. Furthermore, about one-fourth of the issues audited had little or very little support in the workpaper files for the recommended additional taxes. In making our determination, we looked for these key documents or any evidence to show what the tax examiners did or how they arrived at certain tax recommendations. When any evidence was in the files, we assessed the extent to which it documented the tax examiners’ actions, ranging from none or a very little extent to a very great extent. Kansas City Service Center staff confirmed our determinations for files with none or a very little extent. (See table 3.1.)
In attempting to determine the reasons for this lack of documentation, our analyses showed a direct relationship between the amount of time charged and degree of documented support. That is, the less time charged to an audit, the less the workpapers documented the audit findings. (See app. III for a detailed description of our analyses.) It is possible that some audits may be so brief that documentation to a little extent may be enough. For example, Customer Service officials said that audits of nonfilers or in which taxpayers did not respond might have less documentation. However, these officials could not describe an audit for which no or very little documentation would be acceptable.
At two of the four service centers we visited, we found that management affected how much time tax examiners spent documenting their work. For example, the Andover Service Center management told us they encouraged tax examiners to document their work in the files. We found that Andover examiners spent 1.2 hours per audited return in 1996 and were generally consistent in documenting their work in the files. However, the Fresno Service Center management eased documentation requirements in 1996 because of the increase in EIC work. As such, Fresno tax examiners spent 0.6 hours per audited return and had a larger proportion of audit files with little or no audit trail or documented support for the additional taxes recommended.
Compliance chiefs in the four service centers we visited told us that the significant increase in the number of audits during 1995 and 1996 added pressure on tax examiners to respond to taxpayers within prescribed time frames and to close the audits as quickly as possible. They said service centers with the greatest increase in workload had even more pressure to quickly audit the returns. As a result, they said the tax examiners had difficulty documenting their audit work when they were expected to quickly audit so many returns.
In addition to the increased workload, the four chiefs also indicated that service center management diverts tax examiners from their audit work to assist in nonaudit duties, such as answering telephone calls during the filing season. According to various service center officials, the filing season is a critical time for tax examiners because most of the EIC workload is done then. Thus, they said these diversions placed additional pressure on the tax examiners to work quickly.
section_title: Some Service Centers Accepted Differing Levels of Justification for EIC Claims
paragraphs: Because the traditional correspondence audits that closed in 1996 contained a large number of returns claiming EIC, we determined whether the service centers adhered to IRS’ seven-point eligibility test, including third-party verification to support the EIC claims. For example, taxpayers claiming EIC are required to provide information on the children being served by EIC, such as their birth dates, Social Security numbers, and school records. IRS sends taxpayers a questionnaire with the initial letter to solicit documentation, including information from third parties, that justifies their EIC claims.
We found that the 10 service centers accepted differing levels of documentation to justify EIC claims. For the traditional correspondence audits that closed in 1996, at least three service centers allowed EIC claims based on assurances from the taxpayers but without documentation or third-party verification. Officials at one of the three service centers stated that the documentation requirements were eased because the center’s tax examiner work force was inexperienced and unable to otherwise audit the large volume of returns within the prescribed time frames. As taxpayers responded to IRS’ letters, service center management pushed the tax examiners to provide timely responses. To do this as quickly as possible, the service center eased the documentation requirements. We did not ask IRS to check these EIC claims to determine whether any of these taxpayers received an EIC to which they were not entitled or were denied a claim to which they were entitled.
The other seven service centers required varying degrees of taxpayer and third-party justification. Of these seven service centers, at least three required taxpayers to submit documentation, such as birth certificates and Social Security cards or third-party residency verification from schools or day care providers.
section_title: Limited Supervisory Reviews and Audit Quality Reviews
paragraphs: IRS has two levels of review to check whether correspondence audits adhered to established requirements and audit standards. The first review is to be performed by the tax examiners’ supervisors while the audits are being conducted. A second review is to be conducted on a sample of closed audits by each service center’s audit quality staff to measure adherence to the audit quality standards.
We found evidence of supervisory review in an estimated 6 percent of the workpaper files for the traditional correspondence audits. In searching these files, we counted any supervisory comment that pertained to the quality of the audits and the support for the auditor’s recommendation. We also found that the requirement for supervisory review varied by service center. For example, one center required supervisors to review all the “no- change” audits plus the audit workload of each tax examiner monthly. Another center required supervisors to review eight audits per tax examiner per quarter. A third center required reviews of six audits per examiner for an entire year.
Customer Service and service center officials told us that supervisors could not have reviewed all of the 1.1 million audits that were closed in 1996. They explained that the number of audits that can be reviewed depends on the supervisor’s workload, which typically includes overseeing between 10 and 15 tax examiners, with each examiner having roughly 50 audits ongoing at any given time. The officials said they believed that the supervisors reviewed more than 6 percent of the closed audits. It may be possible that some supervisors did reviews but just did not document them. IRS does not require supervisors to document their reviews against the audit quality standards in the audit workpapers. Even so, after we shared the results of our analyses of the 1996 audits, Andover Service Center officials said they would implement a control to ensure that supervisory reviews were documented in the workpapers.
As for the reviews to measure audit quality, IRS requires each service center to review a sample of all its correspondence audits closed annually, regardless of how they closed, for adherence to IRS’ audit standards. For this sample, service centers are required to rate adherence to audit standards, such as the existence of documentation in the workpapers on the audit steps, and support for audit recommendations, such as additional taxes. The results of these reviews are to be entered into the Correspondence Examination Quality Management System (CEQMS) and analyzed to measure the extent of adherence to each quality standard and to identify problem areas.
Further, we found some disparities between the CEQMS data and our results. For example, the CEQMS data for the correspondence audits closed in 1996 showed that almost 100 percent of the audits had been appropriately classified and that 96 percent of the audits met IRS’ standards for workpaper documentation. However, as stated earlier, our review of the workpapers for traditional correspondence audits closed in 1996 found that, excluding nonfilers, an estimated 69 percent had no evidence of classification, and an estimated 34 percent had little or no evidence of documents to explain the audit trail. We asked IRS officials about these disparities. Customer Service officials had no opinions about the reasons for the disparities. Officials at 6 of IRS’ 10 service centers attributed the disparities to unreliable CEQMS data because service centers are excluding certain types of audits from the review sample and from being measured against the audit standard on workpaper documentation.
In following up with service center officials about CEQMS data reliability, we found that not all service centers were following IRS’ requirements for drawing the review samples. For example, according to these officials, some centers’ samples excluded closed audits in which the taxpayers did not respond to IRS’ letters because there were few workpapers to review. Even when taxpayers do not respond, the audit recommendations still need to be supported. Similarly, some service centers also excluded audits that recommended no tax changes. Even when recommending no tax changes, examiners are still required to follow IRS’ audit quality standards and document adherence to those standards.
We also found a similar exclusion when taxpayers did not respond with information about the tax issue being audited. IRS allowed service centers to exclude such audits from being measured against the audit standard on workpaper documentation. Customer Service officials told us that service centers might instruct their quality reviewers to record “not applicable” for the documentation standard when required documentation is missing if taxpayers do not respond. Regardless of the issue being audited, less documentation of the audit trail or audit support would be expected when taxpayers do not respond. Even so, the service centers had some reason for contacting the taxpayers about the potential for additional tax liabilities, and they are required to document that reason along with the support for the additional taxes that are to be recommended when taxpayers do not respond.
section_title: Minimal Contact With Nonresponsive Taxpayers
paragraphs: For the traditional correspondence audits closed in 1996, an estimated 57 percent of taxpayers did not respond to IRS’ audit letters. IRS has not identified the reasons why these taxpayers did not respond. We found that tax examiners sometimes tried to contact these nonresponsive taxpayers beyond the minimal requirements for correspondence audits—an initial letter and a final letter to close the audit. Examination officials at the four service centers we visited stated that additional contacts would increase the time spent on such audits, with no guaranteed results, and would prevent tax examiners from auditing more returns.
We asked Customer Service and service center officials why so many taxpayers did not respond. They said they have not studied the reasons but offered three possible explanations. First, some taxpayers might be overwhelmed or intimidated by IRS’ letters and be uncomfortable with responding. Second, some taxpayers might not understand IRS’ letters and not know how to respond. Third, other taxpayers might know that they owe the additional tax but hope that their nonresponsiveness would discourage IRS from trying to collect that tax.
For the traditional correspondence audits closed in 1996, some IRS letters might have been overwhelming or confusing to taxpayers. For example, some letters made blanket, standardized requests for information without specifying the reason for IRS’ concerns; one letter requested up to 14 pieces of information on an alimony issue without stating the specific information needed. Further, we determined that almost half the letters might have been hard to understand because they were written in generic language. An estimated 11 percent of the letters were tailored to a specific audit; in the other audits, either the letters had both generic and tailored language or the workpaper files did not have the letters for us to make a determination.
Customer Service and service center officials acknowledged that their letters were generic and contained legal language that many taxpayers might not be able to understand. The officials also stated that tax examiners tend to rely on this generic language because it is readily accessible in IRS’ computers and expedites the audit. They said that preparing letters tailored to each taxpayer takes more time and thus limits the number of audits that can be processed.
We talked to various Customer Service officials about any plans to gather information from taxpayers on why they do not respond. Although these officials identified some efforts, as of January 1999, these efforts either were not implemented or had not provided any data on why taxpayers did not respond to IRS’ audit letters. Customer Service officials told us that gathering information from these taxpayers could be difficult, but the benefits of the information collected from them would more than likely be cost-effective. Without knowing the reasons for nonresponsiveness, IRS cannot know the extent to which the clarity of its correspondence, or other factors, contributed to taxpayers’ not responding to IRS’ audit letters.
Without taxpayer responses, IRS’ determinations of the correct tax liability are less certain. When taxpayers do not respond, service centers are to assess any additional taxes that they think are owed. Our analyses of correspondence audits closed in 1996 also identified other negative effects when taxpayers did not respond. The audits usually took longer to complete, and additional taxes owed took longer to collect compared to audits where taxpayers responded. Those not responding paid less of their recommended tax assessment than taxpayers who responded. As of April 1998, taxpayers who responded paid an estimated 79 percent of the additional taxes, while those not responding paid an estimated 31 percent.
Further, an estimated 72 percent of those asking IRS to reconsider the recommended taxes had not responded to IRS’ final letter. Occurring months after the audits closed—usually when IRS took action to collect these assessments—audit reconsiderations cause IRS to redo all or part of the audit, adding to the time for IRS and taxpayers to determine the correct tax liability. With the added time, taxpayers also incur additional interest charges on the unpaid assessments that remain after the reconsideration. We found that IRS closed an estimated 72 percent of the reconsiderations without reducing the assessments. These effects might have been minimized if the taxpayers had responded during the audit or had acted on their appeal rights at the close of the audit.
Customer Service officials described their efforts to improve responsiveness. Customer Service officials told us they initiated an effort to revise the correspondence audit letters in August 1998. They also indicated that IRS is contracting with a private firm to improve the clarity of various IRS letters, starting with collection notices. These officials said the correspondence audit letters eventually would be covered under this contract. Finally, they said that IRS plans to test a toll-free phone system in 1999 to encourage taxpayers who receive audit letters to call for clarification if needed. Customer Service officials also shared their plans to measure the effects of each effort on taxpayer responsiveness. However, Customer Service officials did not know whether these efforts would improve taxpayer responsiveness because the efforts were in the initial stages.
section_title: Conclusions
paragraphs: IRS uses audits to help ensure that taxpayers pay their proper tax liability. In reviewing IRS’ correspondence audit processes and requirements, we found weaknesses that undermine its ability to (1) identify and audit all questionable tax issues on tax returns, (2) support its audit recommendations for additional taxes, (3) consistently accept justification for EIC claims, (4) review adherence to audit requirements and quality standards, and (5) solicit taxpayers’ responses about the tax issues being audited.
Tax returns that are slated for correspondence audits are to be reviewed by knowledgeable staff to identify all questionable issues and to ensure that returns with more complex audit issues have been forwarded to the appropriate auditors. Such a classification is important because IRS generally has one chance to audit a tax return. In reviewing the correspondence audits closed in 1996, we found that an estimated 69 percent had not been classified. When returns were classified, tax examiners usually served as the classifiers. Tax examiners are not trained to identify or audit complex issues, such as investments and business deductions. However, some of the returns we analyzed included complex schedules, and less than 1 percent of these returns had been referred to district offices, where revenue agents and tax auditors are trained to classify and audit the more complex issues. As a result, these complex returns may have had questionable issues that were neither classified nor audited.
We found that the workpaper files for about one-third of the traditional correspondence audits closed in 1996 provided little or no audit trail for the tax examiners’ actions, and about one-fourth of the issues audited had little or very little support in the workpaper files for the recommended additional taxes. Without proper documentation of the workpapers, neither IRS nor taxpayers can be assured that the recommended additional taxes are accurate and supported.
Our analyses indicated that as the time spent by tax examiners on each audit decreased, so did the amount of support in the audit workpaper files. IRS officials said that the large volume of returns that had to be audited pressured the tax examiners to work quickly. Adding to this pressure has been the diversion of tax examiners to nonaudit work during each filing season.
As an outgrowth of this emphasis on working quickly, some service centers eased the documentation requirements for claiming EIC. At least three service centers allowed EIC claims without the third-party verification of the taxpayer’s eligibility. The other service centers required more extensive verification than these three centers. We could not determine from the workpapers whether these audits allowed any taxpayers to claim an EIC to which they were not entitled.
IRS’ two types of quality reviews were unlikely to identify such weaknesses in the correspondence audit process. We found little evidence of supervisory review for the traditional correspondence audits closed in 1996. IRS does not require supervisory reviews to be documented. Although we found weaknesses in classifying and documenting support, IRS’ quality measurement reviews of closed correspondence audits gave these areas high ratings. The discrepancies between our findings and IRS’ measurements can be explained, in part, by some service centers’ not following IRS’ requirement to include all types of audit closures in the review samples. Further, service centers were allowed to exclude audits in which taxpayers did not respond and that lacked required documentation on the audit steps and support for recommended taxes from being measured against the audit standard on workpaper documentation.
Finally, in over half of the traditional correspondence audits closed in 1996, the taxpayers did not respond to IRS’ queries during the audit. IRS officials had not determined the reasons but believed that the language in their letters might be a factor. Audit letters often had generic and legal language that was difficult to understand. Because of pressures to process large audit workloads, tax examiners were not likely to take the time to tailor letters to a specific audit. And when taxpayers did not respond, IRS had to assess the additional taxes under audit without knowing for sure if all these taxes were owed. Further, taxpayers who did not respond paid less of their recommended taxes owed. Without knowing the reasons for taxpayers’ not responding, IRS cannot know the extent to which its letters, or other factors, contributed to their nonresponsiveness.
We did not attempt to measure the specific effects of the weaknesses we found. Nevertheless, each weakness can, individually or in combination, erode the integrity of IRS’ correspondence audit processes, which are designed to help ensure that taxpayers pay the correct tax. Improving controls over the audit processes as well as collecting more information about the weaknesses would help to accomplish these ends.
section_title: Recommendations
paragraphs: GAO recommends that the IRS Commissioner improve controls to better ensure that IRS’ correspondence audit processes adhere to existing audit requirements and standards on classifying filed returns, and in particular, referring returns with complex schedules that may have potential tax changes to staff with sufficient knowledge to classify them; documenting the support for audit findings and recommendations in the ensuring consistency in the treatment of audited EIC claims by collecting and using the information required, including verification from third parties, to justify the claims; and including all types of closed audits across the 10 service centers in the samples for measuring audit quality.
GAO also recommends that the IRS Commissioner require supervisors in the service centers to document their reviews of eliminate the discretion that service centers have to exclude audits that lack documentation on the audit steps and support for audit recommendations from the calculations IRS does to measure adherence to the audit quality standard on workpaper documentation; and determine the reasons, through statistically valid and cost-effective means, for taxpayers’ not responding to IRS’ audit letters, so that IRS can identify ways to encourage more taxpayers to respond.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from the Commissioner of Internal Revenue. Officials representing the Assistant Commissioner for Customer Service and the IRS Commissioner’s Office of Legislative Affairs provided IRS’ comments in a meeting on February 23, 1999. IRS also documented these comments in a letter dated March 12, 1999, which is reprinted in appendix V.
Overall, IRS concurred with all of our recommendations and agreed to take efforts to implement them. IRS officials provided elaboration on our recommendation involving IRS’ requirement to classify returns, particularly returns with complex schedules. Given that the number of returns audited through correspondence that include complex schedules is relatively low, Customer Service officials said that they will work with the Assistant Commissioner (Research and Statistics of Income) on ways to isolate returns with complex schedules so that they are not automatically selected for correspondence audits. This would provide district offices with the opportunity to first look at these returns before they are audited through correspondence.
IRS also provided us with a technical comment on figure 1.1 to clarify at what point recommended taxes become assessed. We have incorporated this comment into the report.