Tax Administration: Audit Trends and Taxes Assessed on Large Corporations
Published: 1995-10-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO reviewed the results of the Internal Revenue Service's (IRS) efforts to audit the tax returns of about 45,000 large corporations, focusing on: (1) audit trends for fiscal years 1988 through 1994; (2) the portion of taxes recommended by agents that were eventually assessed; and (3) the profiles of audited large corporations compared with those of nonaudited corporations.
section_title: What GAO Found
paragraphs: GAO found that: (1) for every dollar invested in large corporation audits, IRS ultimately assessed $15 in additional taxes for the years 1988 through 1994; (2) IRS invested more hours in directly auditing large corporations but recommended less additional tax per hour invested in 1994 compared to 1988; (3) in 1994, large corporations appealed 66 percent of the additional taxes that IRS recommended in its audits; (4) between 1988 and 1994, IRS assessed 27 percent of the recommended additional taxes either after agreement or resolution in appeals; (5) IRS believed that the assessment rate was not an accurate measure of audit effectiveness, since various factors outside the audit could lower the rate; (6) the assessment rates ranged from 20 to 38 percent for four asset classes and from 0 to 103 percent by IRS district, but the reasons for the disparities were unclear; (7) the rates for audits closing without any adjustments has rapidly increased, raising questions about how IRS selects returns for audits; and (8) audited corporations tended to report higher average incomes, tax liabilities, and other tax amounts than nonaudited corporations.

section_title: Letter
paragraphs: This report focuses on the results of the Internal Revenue Service’s (IRS) program to audit the tax returns of about 45,000 large corporations. IRS audits of returns filed by these 45,000 corporations plus the 1,700 largest corporations in IRS’ Coordinated Examination Program (CEP) have generated about two-thirds of the additional taxes recommended from all income tax audits. Although we have reported on CEP, under which IRS audits the largest corporations, we have not previously studied audits of other large corporations, particularly trends on what IRS invests in and produces from these audits. Until recently, IRS had not analyzed these trends either.
We used IRS data to (1) analyze audit trends for fiscal years 1988 through 1994, (2) compute the assessment rate—the portion of taxes recommended by revenue agents that were eventually assessed, and (3) develop and compare profiles of audited large corporations with those not audited. The second phase of our work, now under way, will analyze factors that affect the assessment rate and review IRS’ methodology for estimating it.
subsections: section_title: Background
paragraphs: For audit purposes, IRS’ Examination Division defines a corporation as large or small depending on the amount of assets reported on its income tax return. Small corporations (about 2.4 million) are defined as those that report total assets of less than $10 million.
Corporations reporting higher assets are considered to be large, and IRS audits large corporations in two groups. IRS annually selects about 1,700 of the largest and most complex corporations for CEP. The remaining large corporations (about 45,000) may be audited under a separate IRS program—the subject of this report.
IRS has different ways to select corporations for audits. For small corporations, IRS uses a formula that measures the likelihood of changes to tax liability. This formula helps IRS objectively select returns for audits that are considered to be most likely to produce tax changes. IRS developed the formula by analyzing results of line-by-line audits of a random sample of tax returns. Once selected, a small corporation return is usually audited by an IRS revenue agent. In fiscal year 1994, IRS audited about 44,000 (1.8 percent) of 2.4 million income tax returns filed by small corporations.
For CEP, IRS selects corporations on the basis of criteria for size, complexity, and the like. After considering its audit resources and manually reviewing the audit potential of every CEP return, IRS selects returns for audit. IRS audits CEP returns with teams of revenue agents and specialists, such as economists and engineers. Our 1992 report on CEP noted that IRS audited about 77 percent of the CEP returns for fiscal year 1991.
The remaining large corporations (hereafter referred to as large corporations) are usually selected for audit on the basis of IRS agents’ judgment, rather than through a scoring formula or specific criteria. In some cases, revenue agents at a service center select returns and send them to a district office to be audited; in other cases, all relevant returns are sent to the district office, where revenue agents choose those they will audit. Unlike with CEP returns, IRS usually uses a revenue agent (hereafter referred to as auditor) rather than a team to audit the returns from this segment of the large corporation universe. According to IRS Examination officials, these individual auditors recently have been using IRS specialists more than they have in the past.
To give perspective on the sizes of these large corporations compared to other types of businesses, we analyzed average assets reported for 1992 (the most recent year of available data at IRS’ Statistics of Income Division). Reported assets ranged from an average of about $0.4 million by small corporations to about $6.8 billion by CEP corporations. Within this wide range, the remaining large corporations reported an average of $130.7 million in assets as compared with partnerships, which reported an average of $1.3 million in assets.
In recording the audit results for large corporations not part of CEP, IRS has created four classes according to asset size, ranging from $10 million to over $250 million. To facilitate our reporting of trends, we collapsed the four classes into two, (1) lower asset ($10 million to less than $100 million) and (2) higher asset ($100 million and over). Narrative in this letter and appendix II focuses on the differences in the trends for the two combined classes but also discusses the four classes, particularly their assessment rates.
section_title: Objectives, Scope, and Methodology
paragraphs: Our objectives were to (1) analyze audit trends in fiscal years 1988 through 1994 for large corporations, (2) compute their assessment rate, and (3) develop and compare profiles of audited large corporations with those not audited. To identify large corporations, we used IRS data on those reporting assets of $10 million and more. We used IRS data to eliminate CEP corporations.
We used three IRS databases to meet our objectives. To analyze audit trends, we used Audit Information Management System (AIMS) data on large corporate audits closed in fiscal years 1988 through 1994. To compute the assessment rate, we computer-matched the AIMS data on recommended tax assessments to actual tax assessments on the Business Master File (BMF), which contains information about business tax returns. We tracked the BMF data through December 1994. To develop a profile of the large corporations, we obtained the 1992 Statistics of Income (SOI) file for corporations—the most recent at the time we did our work. We matched the SOI and AIMS data to divide our population into audited and not audited groups.
We asked IRS Examination officials at the National Office to review our analyses of the audit trends and assessment rates and to provide any explanations. We performed our work in Washington, D.C., and Mission, KS, between May 1994 and May 1995 in accordance with generally accepted government auditing standards. Appendix I has more information on our objectives, scope, and methodology.
section_title: Audit Trends
paragraphs: Figure 1 summarizes trends in large corporate audits for fiscal years 1988 through 1994.
More details on these trends follow. 1. Number of audits: The total number of audited returns increased about 3 percent (from 10,062 in 1988 to 10,392 in 1994), after peaking in 1991 at 11,962. This increase largely involved corporations with less than $50 million in assets. The number of audited returns for higher asset corporations fluctuated but decreased 16 percent between 1988 and 1994, particularly in 1989 and 1990. (Refer to table II.1.) 2. Audit coverage: Audit coverage rose from 23 percent in 1988 to 24 percent in 1994, after peaking at 28 percent in 1991. Coverage varied by asset class. It decreased (especially from 1991 to 1992) from 43 percent to 31 percent for higher asset corporations, and it increased from 18 percent to 22 percent for those with lower assets after peaking in 1991 at 25 percent. (Refer to table II.2.) 3. Direct audit hours: A comparison of 1988 and 1994 shows that IRS invested 25 percent more hours in auditing large corporations, particularly those with lower assets. Audit hours decreased for higher asset corporations, particularly 1988 through 1990. (Refer to table II.3.) 4. Direct audit hours per return: This ratio increased 21 percent from 1988 to 1994, driven by audits of lower asset corporations. Their ratio increased 43 percent compared to 14 percent for higher asset corporations. On average, IRS spent twice as long auditing a return with higher assets compared to those with lower assets—184 hours versus 89 hours, respectively. (Refer to table II.4.) 5. Additional recommended taxes: This amount increased 16 percent from about $1.6 billion in 1988 to $1.9 billion in 1994. It also increased for both types of corporations. The amount peaked in 1992 for lower asset corporations and fluctuated year to year for higher asset corporations while peaking in 1993. IRS Examination officials explained that a few large audits produced the peaks in 1991 and 1993. In 1994 constant dollars, however, recommended taxes decreased 4 percent between 1988 and 1994. (Refer to table II.5 for current dollar data on additional taxes recommended and table V.1 for 1994 constant dollars.) 6. Additional recommended taxes per return: As with recommended taxes, this ratio increased overall and for both categories of corporations. It rose 12 percent from about $160,000 in 1988 to $180,000 in 1994 (after reaching $242,000 in 1993). Higher asset corporations drove this increase as its ratio increased 38 percent after declining in 1992 and 1994. Although IRS audited fewer of their returns, IRS recommended a relatively higher amount of taxes. In 1994 constant dollars, recommended taxes per return decreased 7 percent between 1988 and 1994. (Refer to table II.6 and table V.3 for details.) 7. Additional recommended taxes per audit hour: The overall ratio decreased 7 percent from $1,409 in 1988 to $1,313 per hour in 1994. Although the ratio rose for corporations with higher assets, this rise was more than offset by a declining ratio for those with lower assets. In 1994 constant dollars, the overall ratio decreased 23 percent from 1988 to 1994. (Refer to tables II.7 and V.4.)
IRS Examination officials offered reasons for the increase in direct audit hours outpacing increases in audit coverage and recommended taxes after 1988. IRS has been auditing more complex returns and using more IRS specialists. Both steps took more time and reduced coverage. Also, many auditors have needed more time as they gradually shifted from auditing corporate tax shelters to auditing the whole large corporation return. On the other hand, recommended amounts can be reduced by economic downturns. They also cited 1986 tax law changes that took away audit issues (e.g., investment tax credit) with relatively high yield for a small time investment and that lowered corporate tax rates, affecting additional recommended taxes in later years.
We also analyzed trends in audit closures. The large corporations agreed with higher portions of recommended tax amounts from 1988 to 1994 (34 percent by 1994), but they continued to appeal most amounts (66 percent by 1994). Although they had similar trends over the 7 years, higher asset corporations agreed, on average, with 21 percent of all recommended amounts while lower asset corporations agreed with 33 percent (see table II.9). Even so, large corporations increasingly agreed with most audits (52 percent for 1994) that recommended taxes (see table II.8). In sum, they tended to agree with small tax amounts recommended in many audits but appeal larger amounts recommended in fewer audits.
Audits that end with no change to taxes owed could have adjustments (e.g., reduced a reported net operating loss but not enough to produce a tax liability) or no adjustments. IRS views the former as productive and the latter as unproductive. The no-change trends differed. Those with adjustments dropped from 28 percent to 16 percent; those without adjustments increased from 8 to 16 percent. The without adjustments rate had reached 18 percent for lower asset corporations and 10 percent for those with higher assets by 1994.
IRS Examination officials said they would like to see the no-change rate without adjustments fall below 10 percent. They believed that this rate will start falling as IRS closes ongoing audits that they viewed as more productive. For example, they believed that their investment in audits of more complex returns will start shifting more no-change audits to audits that recommend taxes. Also, more auditors have now learned how to audit large corporations, not just tax shelters. Even so, these officials still want better systems for selecting and classifying (i.e., finding issues that need to be audited) returns. In recognizing this need, they convened task forces during 1994 to overcome such problems with large corporation audits. These task forces are slated to last through 1996.
See appendix II for detailed information about these trends and IRS’ explanations and appendix V for trends for recommended tax amounts in constant dollars.
section_title: Assessment Rate
paragraphs: In tracking taxes recommended for large corporations from 1988 through 1994, we found that the final assessment had been recorded for $8.6 billion of $12 billion in net recommended taxes. Our computer match, involving about 56,000 audited returns, showed that IRS assessed $2.3 billion of the $8.6 billion (27 percent) through December 1994. In computing this rate, we subtracted the tax refunds recommended from the additional taxes recommended for these audited returns.
The assessment rate was similar for higher and lower asset corporations—26 percent and 28 percent, respectively. The rate, however, differed widely by the four asset classes, ranging from 20 percent to 38 percent. By IRS district, the assessment rate ranged from over 100 percent to less than 1 percent.
The reasons for these wide variations were not apparent in the IRS databases we used to compute the assessment rates. Our work has shown that various factors can cause the rate to exceed 100 percent, such as IRS Appeals assessing more taxes than recommended by the auditors. Also, the rates can drop whenever corporate claims for refunds or net operating losses from other tax years reduce or offset taxes that were recommended in the audit.
Nor did IRS Examination officials know the reasons for the wide variation in the rates. They noted that the lowest rates occurred in two regions and they are starting to pinpoint the reasons. We also plan to explore these reasons during a follow-on review.
Our discussions with IRS Examination officials disclosed possible reasons for low rates. These officials pointed to nonaudit factors that can lower the assessment rate, even if auditors supported the taxes recommended. They cited retroactive tax law changes, court decisions that affect the recommended taxes, and other tax abatements. In addition, they said IRS Appeals can concede recommended taxes to avoid the hazards of litigation or because the corporation provides new information that swayed Appeals’ decision; this information could have dissuaded the auditors from recommending the taxes. These officials did not know the extent to which these factors lowered the assessment rate, given limitations in IRS’ databases. For this reason, our 1994 report on CEP recommended corrections to IRS’ databases.
In sum, IRS Examination officials cautioned against misinterpreting the assessment rates. Because of these nonaudit factors, they believed that the rates reflect more about the tax system and economic fluctuations than the effectiveness of the audits. Appendix III provides details on assessment rates and IRS’ explanations.
We also computed the assessment rate for just the additional taxes recommended (i.e., excluding audits recommending refunds). That rate equalled 38 percent. IRS had estimated a similar assessment rate on just the additional taxes recommended for audits closed in fiscal years 1992 through 1994—36 percent.
Regardless of which type of assessment rate is considered, we did not attempt to track how much of the assessed taxes were ultimately collected. IRS Finance officials provided data indicating that IRS collected 23 percent of the taxes recommended and 68 percent of the taxes assessed as of July 1995 for the audits closed in fiscal years 1992 through 1994. IRS based these results on data being tracked in a new system. We plan to analyze the data and methodology being used in this system during the second phase of our work.
Whenever audits recommend additional taxes that go unassessed, IRS can miss opportunities to invest audit resources more productively, and large corporations can incur more costs to challenge those recommendations. Data on many of these costs were not available. Using only the direct audit costs, we calculated that IRS recommended $56 and assessed $15 in taxes for each dollar directly spent on auditing large corporations from 1988 through 1994. These calculations exclude indirect audit costs (e.g., overhead), IRS costs outside of audits (e.g., appeals and litigation processes to settle on assessed tax amounts), and corporations’ costs. It is important to recognize that these ratios provide just one indicator of IRS’ audit activities. The ratios do not account for the costs and taxes associated with what IRS calls revenue protection. For example, IRS may audit various corporate claims for tax refunds to determine whether the claims are proper. In doing so, IRS protects the government’s revenue. Auditors disallowed $202 million in claims by large corporations during 1994 in addition to the $1.9 billion they recommended in taxes. In 1991—the first year for which IRS tracked protected tax revenue—IRS auditors denied $212 million of these claims.
To provide perspective, we computed a similar ratio for all IRS audits. Although not readily available for assessed taxes, data were available in IRS’ 1996 budget to compute the ratio of recommended taxes to the costs of all IRS audits. Our computations showed that the ratio has been about $16 in recommended taxes to $1 in audit costs (including indirect costs) for recent years.
section_title: Profiles of Large Corporations
paragraphs: According to 1992 income tax returns, over 60 percent of the large corporations were engaged in manufacturing or in the finance/insurance industry. This profile was similar for both the audited and nonaudited large corporations. Audited large corporations, however, tended to report higher amounts, on average, of total income, taxable income, and income tax liability.
Whether audited or not, large corporations tended to claim the possessions tax credit more frequently than other tax credits; 57 percent of $6.4 billion in tax credits claimed was for the possessions tax credit. Appendix IV provides more details on the profile of large corporations for 1992.
section_title: IRS Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from the IRS Commissioner, and we received comments from her representatives at a meeting on August 9, 1995. These IRS officials included the Assistant Commissioner for Examination and his staff that oversee audits of large corporations as well as staff from IRS’ Office of Legislative Affairs. While generally agreeing with the trends we analyzed, these officials had comments on our draft. In addition to technical comments that we have incorporated where appropriate, they offered comments on three major issues.
First, they pointed to various efforts undertaken to correct problems with large corporation audits. The major effort entails studying ways to improve the selection of returns for audit. Our letter now refers to these efforts.
Second, they suggested explanations for some trends. For example, they offered various reasons for the increases in audit coverage and additional recommended taxes lagging behind the increase in direct audit time. They noted that IRS has been investing time in auditing more complex issues and in using IRS specialists. They viewed this investment as necessary and as likely to pay off soon. They also cited tax law changes in 1986 and the transition in the early 1990s from auditing corporate tax shelters to all large corporate tax issues. Both factors had dampening effects on recommended tax amounts after 1988, according to these officials. They suggested that these factors, in combination with auditing more complex returns, also contributed to IRS closing more audits with neither changes to taxes owed nor adjustments to taxable income. While we did not validate IRS’ suggested explanations, we have added them to the letter and related appendixes.
Third, they asked for clarification on the 27 percent assessment rate. Although our draft report had not labelled this rate as a measure of audit effectiveness, they wanted cautions noted. They said the rate should not be used as such a measure because of nonaudit factors (e.g., net operating losses from other tax years that offset audit yield). They did not know the extent to which these factors affected the rate but they believed that the rate was just as likely to be the product of the tax and economic systems, which they have little control over, rather than of the audits. We have added their comments about the potential effects of these nonaudit factors on the rates.
We are sending copies of this report to the Senate Committee on Finance, the House Committee on Ways and Means, and other interested parties. Major contributors to this report are listed in appendix VI. If you or your staff have any questions concerning this report, please contact me at (202) 512-5407.
section_title: Objectives, Scope, and Methodology
paragraphs: Our objectives were to (1) analyze audit trends for large corporations not in the Coordinated Examination Program (CEP) for fiscal years 1988 through 1994, (2) compute the portion of taxes recommended in audits that were actually assessed, and (3) develop and compare profiles of audited large corporations with those not audited.
The Internal Revenue Service (IRS) defines large corporations as those reporting assets of $10 million or more on their income tax returns. IRS divides large corporations into four asset classes as follows: (1)assets of $10 million to less than $50 million, (2)assets of $50 million to less than $100 million, (3)assets of $100 million to less than $250 million, and (4)assets of $250 million and over.
For these corporations, our analyses focused on data from Forms 1120 (U.S. Corporation Income Tax Return) and other related corporate returns, except for nontaxable returns such as the Form 1120-S. These related income tax returns included the following: (1)1120-L (U.S. Life Insurance Company Income Tax Return), (2)1120-PC (U.S. Property and Casualty Insurance Company Income Tax Return), (3)1120 Consolidated income tax return, (4)1120L Section 594/1504c income tax return for U.S. life insurance companies, (5)1120-PC Section 1504c income tax return for U.S. property and casualty insurance companies, (6)1120 Section 594/1504c income tax return for U.S. corporations.
Our analyses of audit trends, assessment rates, and the profiles excluded large corporations in CEP. We excluded CEP corporations from the profile information using IRS data on CEP.
We asked IRS Examination officials at the National Office to review our analysis of the audit trends and assessment rates and to provide any explanations. We have summarized their comments throughout this report.
subsections: section_title: Analyzing Audit Trends
paragraphs: To analyze audit trends, we used IRS’ Audit Information Management System (AIMS) data. This database includes records from all audits closed during a given fiscal year. We reconciled totals from this database to totals in IRS’ annual report.
For audits closed from fiscal years 1988 through 1994, we obtained AIMS data on additional tax recommended, tax decreases recommended, returns audited, and direct audit hours spent on returns. We then calculated such measures as tax recommended per return, tax recommended per hour, and audit hours per return. Appendix II reports these trends, using current dollars for the recommended tax amounts. Appendix V reports those trends in constant dollars.
To calculate audit coverage, we used IRS’ method of dividing the number of audits completed in a given fiscal year by the number of returns filed the previous year. We also computed IRS’ direct costs for auditing these returns. For audited corporations by asset class, we applied the average cost IRS calculated for fiscal years 1991 and 1992 for each staff year that IRS directly spent on these audits. We adjusted the costs to current dollars for the specific fiscal year of the audit to obtain the average cost for each of the 7 years we analyzed.
We also analyzed the ways in which IRS closed audits of the tax returns. If IRS recommended additional taxes, large corporations could agree to pay or appeal these taxes. If IRS did not recommend such taxes, we analyzed how often IRS closed these no-change audits without any audit adjustments or with adjustments.
section_title: Computing the Assessment Rate
paragraphs: To compute the assessment rate—the percentage of recommended taxes ultimately assessed after audits—we did a computer data match of corporate income tax returns between two IRS databases. For all closed audits in our populations, we matched the recommended tax assessments recorded on AIMS to the actual tax assessments recorded on the Business Master File (BMF). In addition to the assessed tax liabilities, the BMF contains information on taxable income, taxes not yet paid, penalties, interest, payments, refunds, and audit actions for business tax returns. In both systems, each record contains the taxpayer identification number (TIN), tax year, and return type.
To use BMF data, we eliminated all BMF records of tax returns that had no audit adjustment code. We also eliminated all records with audit transactions that were posted before fiscal year 1988. Because our AIMS data covered fiscal years 1988 through 1994, none of these audit adjustments could have been posted on BMF before fiscal year 1988.
Also, we applied our criterion of a “completed audit.” We defined this term as the period in which IRS made at least one tax adjustment resulting from an audit, followed by an audit release indicator. As the starting point, we used the last day of the previous audit period or, if not present, the date that IRS posted the return. The BMF audit release indicator identified the end of an audit. We added 30 calendar days to the audit release date to identify late posting audit adjustments. IRS also does this adjustment on its new Enforcement Revenue Information System to match tax adjustments to taxes recommended.
Using the 25,395 taxpayers identified in AIMS data for fiscal years 1988 through 1994, we were able to match 22,679 TINs to BMF. For these TINs, we obtained records for 56,146 returns for various tax years ranging from 1964 to 1993. AIMS has the recommended tax adjustments for each closed audit. We dropped records that showed recommended taxes of $1 because some IRS districts use this amount if, for some reason, they must close the case on AIMS for a second time.
Across the AIMS and BMF data, we sought the same corporate TINs and same audited tax years for audits closed during fiscal years 1988 through 1994. We matched the AIMS data on recommended assessments from these audits to BMF data on actual assessments for these audits up through December 1994. We then analyzed the assessment rate by variables such as the asset size of the corporation and IRS district office that did the audit.
section_title: Profiling Large Corporations
paragraphs: To develop a profile of the large corporations, we obtained the 1992 Statistics of Income (SOI) file for corporations—the most recent file when we did our work. We eliminated CEP corporations as we did for our other analyses. We selected the large corporations by using our criteria for return type and the asset size. We matched these data with AIMS data to divide the large corporation population into audited and nonaudited groups. Table I.1 shows the SOI universe and populations for each of these steps.
Sampling errors associated with our SOI estimates are less than 5 percent at the 95 percent confidence level, except for the following items:
For audited lower asset size corporations claiming the net operating loss deduction, the sampling errors were $1.3 billion + 6.8 percent for the net operating loss deduction claimed and $1 million + 5.9 percent for the average deduction claimed.
For the nonaudited corporations, the average Foreign Tax Credit claimed as shown in table IV.2 had a sampling error of $1.593 million + 5.8 percent.
For the other tax credits reported in table IV.2, the sampling errors exceeded 5 percent for both audited and nonaudited corporations. The sampling errors for the total amount claimed were $13.9 million + 5.7 percent and $11 million + 8.9 percent for audited and nonaudited corporations, respectively. The sampling error for the average amount claimed is as follows: $179 thousand + 16.6 percent and $225 thousand + 21.4 percent for audited and nonaudited corporations, respectively.
section_title: Audit Trends for Large Corporations
paragraphs: This appendix presents our analysis of IRS’ audit results for large corporations, using IRS’ AIMS data. We asked IRS Examination officials to explain any major shifts in the trends. The narrative within this appendix reflects any explanations that these officials provided.
subsections: section_title: Table II.1: Number of Large Corporation Returns Audited, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. $100 mil. < $100 mil. < $250 mil.
From 1988 to 1994, the number of returns audited has increased slightly, particularly from 1988 to 1991, when it peaked at 11,962 returns and then decreased to 10,392 by 1994. IRS Examination officials attributed the decline since 1991 to auditing more complex returns and issues. Doing so takes more time that could have been spent on more returns. Corporations with less than $50 million in assets accounted for the overall increase in audits during the 7 years. All other asset classes had decreases.
Over the 7 years, the number of returns audited averaged 10,674. Of these audited returns, lower asset corporations filed 72 percent (7,704 returns) on average.
section_title: Table II.2: Audit Coverage for Large Corporations, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. $100 mil. < $100 mil.
Audit coverage lower asset size < $250 mil.
Audit coverage higher asset size Averages are computed using actual data points and may not equal the averages of the whole numbers in the columns.
For 1988 through 1994, audit coverage changed as follows: It increased from 18 percent to 22 percent, peaking in 1991, for lower asset corporations. This increase stemmed from IRS doing more audits while the number of returns filed remained fairly constant over the 7 years. In fact, the audit rate increased only for corporations with assets of $10 million to less than $50 million. It decreased from 45 percent to 31 percent for the higher asset classes. Their rate held fairly steady through 1991 but then dropped through 1994. Over all 7 years, their coverage decreased because more returns were filed but fewer were audited. IRS Examination officials said IRS has spent more time on complex audits since 1991. It averaged 25 percent overall. As asset size increased, so did the average coverage rate. Over the four asset classes, the average rate ranged from 20 percent to 44 percent.
section_title: Table II.3: Direct Audit Hours for Large Corporations, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. $100 mil. < $100 mil. < $250 mil.
Time spent directly on the audit is measured in hours. After dropping from 1988 to 1989, the audit hours steadily increased about 40 percent from fiscal years 1989 through 1994. This change represents an increase from about 1 million to 1.4 million staff hours. IRS Examination officials attributed the increase to investing in audits of more complex tax returns and issues.
The increased hours primarily arose from doing more audits of lower asset corporations over the 7 years (see fig. II.1). The audit time for these corporations increased from 487,162 hours in 1988 to 793,115 hours in 1994 (63 percent) after peaking in 1991 and then decreasing slightly through 1994. Audit hours for higher asset corporations decreased from 654,974 hours in 1988 to 628,851 hours in 1994 (4 percent); their hours decreased from 1988 to 1990 and then increased steadily through 1994.
section_title: Table II.4: Direct Audit Hours per Return for Large Corporations, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. $100 mil. < $100 mil. < $250 mil. $250 mil. & over Averages are computed using actual data points and may not equal the averages of the whole numbers in the columns.
On average, IRS auditors spent twice as long auditing returns from higher asset corporations compared to those with lower assets—184 hours versus 89 hours per return, respectively.
From 1988 to 1994, the direct audit hours per return increased 43 percent (74 to 107 hours) for lower asset corporations, 14 percent (187 to 213 hours) for higher asset corporations, and 21 percent (114 to 137 hours) overall. These increases match the increases in direct audit hours (see table II.3) and in audited returns for lower asset corporations and all large corporations (see table II.1).
However, the number of direct audit hours and audited returns decreased for higher asset large corporations. The increase in direct audit hours per return results from a larger decrease in the number of audited returns (see table II.1) compared to the number of audit hours (see table II.3).
IRS Examination officials said they expected the upward trend in audit hours per return to continue as IRS does more complex audits. They also cited other reasons. The lack of training and experience in auditing an entire large corporation return instead of just corporate tax shelters has added time.
section_title: Table II.5: Additional Taxes Recommended for Large Corporations, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. $100 mil. < $100 mil. < $250 mil.
For all large corporations, additional recommended taxes grew 16 percent from about $1.6 billion in 1988 to about $1.9 billion in 1994; except for 1989, these amounts had increased through 1993 and then dropped in 1994. IRS Examination officials did not know the reasons for the 1994 decrease. Both higher and lower asset corporations had similar increases over the 7 years but those with higher assets always accounted for the bulk of the additional tax amounts.
For higher asset corporations, recommended taxes peaked in 1993—about double the amount from 1989—but then decreased 35 percent by 1994. IRS Examination officials attributed the big increases in 1991 and in 1993 to a few large dollar audits. For lower asset corporations, recommended taxes increased 53 percent from 1988 to 1992 but then decreased 24 percent through 1994.
All four asset classes had percentage increases from 1988 to 1994 in taxes recommended; the $100 million to less than $250 million class had the greatest increase (42 percent), while the $250 million and over class had the smallest (5 percent). Each class also had fluctuations over the 7 years and different peak years, ranging from 1990 to 1993.
Table II.5.1: Net Additional Taxes Recommended for Large Corporations, Fiscal Years 1988 Through 1994 $50 mil. $100 mil. < $100 mil. < $250 mil.
IRS’ audit mission is to determine the correct tax liability. This includes determining additional taxes that taxpayers owe or that should be refunded to the taxpayers.
Although IRS collects the data, IRS reports on audit results did not offset recommended taxes by recommended tax refunds. Our analysis of IRS data showed that subtracting refunds from reported additional taxes recommended would reduce additional taxes between 8 to 34 percent over the 7 years.
section_title: Table II.6: Additional Taxes Recommended per Return for Large Corporations, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. < $100 mil. $100 mil. < $250 mil. $250 mil. & over Averages are completed using actual data points and may not equal the averages of the whole numbers in the columns.
Over the 7 years, the additional taxes recommended per audited return averaged about $189,000 for all large corporations. Audits of higher asset corporations drove this average; these audits averaged about $444,000.
A comparison of 1988 to 1994 showed that the ratio of recommended taxes per return increased for lower and higher asset corporations but at different rates and with different fluctuations, as follows:
For lower asset corporations, the ratio increased just 3 percent. This ratio increased about 43 percent between 1990 and 1992 and then decreased through 1994.
For higher asset corporations, the ratio increased 38 percent from 1988 to 1994 after fluctuations. This ratio increased from 1988 to 1990, flattened out for 1990 through 1992, increased in 1993, and then dropped 36 percent in 1994.
As noted after table II.5, a few large cases drove the 1991 and 1993 results according to the IRS officials.
section_title: Table II.7: Additional Taxes Recommended per Direct Audit Hour for Large Corporations, Fiscal Years 1988 Through 1994
paragraphs: $50 mil. $100 mil. < $100 mil. < $250 mil. $250 mil. & over Averages are computed using actual data points and may not equal the averages of the whole numbers in the columns.
A comparison of 1988 to 1994 showed that taxes recommended per audit hour decreased 7 percent. This ratio increased from 1988 to 1990 but then fluctuated through 1994. It increased for higher asset corporations and decreased for lower asset corporations. More specifically, this ratio: increased for higher asset corporations because audits of those with assets of (1) $100 million to less than $250 million recommended more taxes for a proportionately smaller increase in audit hours, and (2) $250 million or more spent fewer audit hours to recommend a slight increase in the amount of taxes; and decreased for lower asset corporations because audits of those with assets of (1) $10 million to less than $50 million required more time to recommend less tax, and (2) $50 million to less than $100 million invested comparatively higher amounts of audit time to recommend higher tax amounts.
IRS Examination officials pointed to a few large audits as major contributors to the 1991 and 1993 results.
Our analysis of how IRS closed audits of large corporations revealed two distinct trends from 1988 through 1994. These trends were similar for lower and higher asset corporations.
First, large corporations appealed a smaller percentage of the returns that recommended additional taxes and agreed with a higher percentage of these returns. A comparison of 1988 to 1994 showed that higher asset corporations reduced their appeal rate from 33 percent to 19 percent of the audited returns; this rate was 28 percent in 1993. Lower asset corporations reduced this rate from 24 percent to 16 percent of the returns.
Second, the two types of no-change rates moved in different directions over the 7 years. The rate with audit adjustments steadily declined and the rate without audit adjustments slowly increased. The rate without adjustments increased for both types of corporations over the 7 years—a 100-percent increase for higher asset corporations and an 80-percent increase for lower asset corporations. Conversely, the rate with adjustments decreased by over 40 percent for both higher and lower asset corporations.
Further, a comparison of 1988 rates to 1994 rates showed that the no-change rate without adjustments for lower asset corporations was about twice the rate for higher asset corporations. Over the 7 years, the overall no-change rate averaged 34 percent for lower asset corporations and 28 percent for higher asset corporations.
IRS Examination officials noted these increases in the no-change rate without adjustments. For all large corporations, this rate was 16 percent in 1994; this rate had been at or above 10 percent for lower asset corporations and had reached 10 percent for higher asset corporations by 1994. These officials said a more satisfactory rate would be less than 10 percent within all IRS regions. They recognized the need to be more selective in placing returns into the audit stream. They noted that this will only be accomplished by universally using a process that better selects returns for audit and that then identifies issues on those returns that need to be audited. They pointed to a task force that IRS convened in 1994 to develop the universal process across IRS.
As with the trends in closing audited returns, a comparison of 1988 to 1994 showed that the large corporations appealed less and agreed with more of the recommended tax amounts. Unlike with the return trends, the large corporations appealed the majority of these amounts (about two-thirds by 1994).
Further, the larger the asset size, the more likely that the large corporation would appeal the recommended taxes rather than agree to pay them. On average, higher asset corporations appealed 79 percent of the recommended tax amounts compared to 67 percent for those with lower assets over the 7 years.
section_title: Assessment Rates for Large Corporations
paragraphs: Table III.1 shows our computation of the assessment rate on net tax recommendations—recommended additional taxes less recommended tax decreases. IRS assessed $2.33 billion (27 percent) of the $8.64 billion in taxes recommended. IRS made the assessments through December 1994 for audits closed in fiscal years 1988 through 1994. $10 mil. < $50 mil. $50 mil. < $100 mil.
The higher and lower asset corporations had similar assessment rates—26 percent and 28 percent, respectively. By asset class, the rates ranged from 20 percent to 38 percent. The 38 percent rate was driven by audits in the Manhattan District Office. Manhattan accounted for $467.9 million (23 percent) of taxes recommended and $372.7 million (48 percent) of taxes assessed in that asset class.
IRS Examination officials itemized factors outside of the audits that depressed the assessment rate. For this reason, they cautioned against using the rate to measure audit effectiveness. They pointed to net operating losses that large corporations carried over to offset taxes recommended as well as offsets or reductions by claims for refunds, abatements, and retroactive tax law changes and court decisions. They also said recommended taxes can be lost in Appeals due to hazards of litigation and to large corporations withholding tax data until then. If IRS auditors had had these data, they would have been less likely to recommend taxes. These officials did not know the extent to which these nonaudit factors affected the assessment rate.
IRS reports audit results by the gross recommended additional taxes. Table III.2 shows the assessment rate when recommended tax increases and tax decreases are not netted. $10 mil. < $50 mil. $50 mil. < $100 mil.
Our analysis of just the gross additional taxes recommended showed a higher assessment rate overall (38 percent) and by asset class (32 percent to 45 percent) compared to the net rate. IRS has estimated similar gross assessment rates using data from fiscal years 1992 through 1994 versus our 7-year period. IRS’ rate was 36 percent and ranged from 24 percent to 54 percent by asset class.
Table III.3 provides the net assessment rate for the districts that recommended at least $100 million in additional taxes.
Across IRS’ 64 districts, 20 recommended net additional taxes of $100 million or more between fiscal years 1988 and 1994. Three of the 20 districts—San Francisco, Manhattan, and Los Angeles—each recommended about $500 million or more and together accounted for $1.6 billion of the $8.6 billion recommended by all districts.
As table III.3 shows, the assessment rates varied widely across the districts. The rates reached as high as about 103 percent to less than 1 percent. By including all but two IRS districts doing large corporate audits, the lowest rate was negative 20 percent.
Assessment rates that exceed 100 percent indicate that appeals officers assessed more taxes than recommended by revenue agents. This can occur when further adjustments increase tax liability while the case is under Appeals’ jurisdiction. For example, liability increases can occur when an adjustment on another tax year decreases a net operating loss carryback deduction on the tax years being appealed, a math error is found, or a taxpayer files an amended return increasing tax liability.
Negative assessment rates occur when the appeals officer not only concedes all taxes recommended but also approves a tax refund because the taxpayer filed a claim for refund or the appeals process reduced the reported tax liability. For example, the appeals officer can decrease tax liability because of an error in the taxes recommended or an increase in a loss carryback deduction from another tax year to the tax year in Appeals.
IRS Examination officials did not know the specific reasons for the lowest rates. They noted that two regions tended to account for these lowest rates. They planned to follow up with the regions to uncover the reasons and see whether actions need to be taken.
Using gross additional taxes recommended, the assessment rate and ranking of the 20 districts changed slightly. The rate ranges from 90 percent to 3 percent. (See table III.4.)
section_title: Profile of Large Corporations
paragraphs: To develop a profile of large corporations, we used SOI data on large corporations that filed income tax returns for 1992. We split our profile into large corporations that were audited and not audited, using AIMS data. Within that framework, the elements we profiled included the type of industry, asset size, reported income and tax, and types of tax credits claimed.
subsections: section_title: Figure IV.2: Nonaudited Large Corporations by Type of Industry, 1992
paragraphs: The majority of audited large corporations were engaged in finance, insurance and real estate (34 percent); manufacturing (28 percent); and wholesale trade (13 percent).
The industry profile differs for the large corporations that were not audited. A higher percentage of them were involved in finance/insurance and real estate (52 percent), and a lower percentage were in manufacturing (17 percent) and wholesale trade (8 percent). The third-ranking industry involved services (9 percent).
For both audited and nonaudited returns of the corporations involved in finance, insurance and real estate, the majority involved banks and credit agencies.
In the manufacturing industry for audited returns, the corporations primarily manufactured electronic equipment, fabricated metals (such as metal cans and shipping containers), food, and chemicals. For returns not audited, the manufacturing corporations had a similar industry profile to those that were audited. They were largely involved in the same industries.
In 1992, 79 percent of the large corporations reported assets of $10 million to $100 million (lower asset size), and 21 percent reported $100 million or more (higher asset size). Over 60 percent reported less than $50 million in assets.
For all corporations, the average asset size was $131 million. The average asset size was $32 million for lower asset corporations and $510 million for higher asset corporations.
Comparing those audited versus not audited, the results were similar. For example, 75 percent of the audited corporations and 81 percent of the nonaudited corporations were in the lower asset group; the rest were higher asset corporations. On average, the audited corporations reported $136 million in assets while those not audited reported $128 million in assets.
In dollar amounts, the nonaudited large corporations reported more total income, taxable income, and income tax than the audited corporations. However, the audited large corporations reported higher average amounts in these categories. These higher average amounts varied by asset group. For example:
Higher asset corporations that were audited reported higher average amounts in these categories than those not audited.
Lower asset corporations that were audited reported much higher average amounts in these categories than those not audited. The reported average amounts by the audited group usually doubled or almost doubled these amounts for the nonaudited group, except for total income. For total income, the audited group reported about 59 percent more on average.
Further analysis uncovered other results for 1992, as follows.
Among all large corporations, the approximate $31.5 billion in reported net tax was about 30 percent of the approximate $106.8 billion in reported taxable income.
The percentage of returns reporting zero taxable income and zero tax was lower for audited returns compared to nonaudited returns. For example, 22 percent of audited returns reported zero net tax compared to 36 percent for nonaudited returns.
We also analyzed the net operating loss deduction that large corporations claimed to reduce their 1992 taxable income. Audited higher asset corporations claimed about $2.5 billion (average of about $4.9 million), and those not audited claimed about $6.6 billion (average of about $7.8 million). Among lower asset corporations, those audited claimed about $1.3 billion (average of about $1 million), and those not audited claimed about $3.9 billion (average of about $0.9 million).
Less than 1 percent.
For corporations audited, the possessions tax credit accounted for 47 percent of the total credits; the foreign tax credit represented another 30 percent. Both credits were claimed primarily by higher asset corporations. Among corporations not audited, the possessions tax credit accounted for 62 percent, and the foreign tax credit accounted for 26 percent of the total credits claimed.
Because the possessions tax credit was claimed so much, we looked more closely at which types of audited and nonaudited large corporations claimed this credit. The differences were minor, as illustrated below.
Among audited corporations, manufacturers claimed 98 percent; manufacturers of chemicals/drugs and food claimed 79 percent of the total. The majority of the corporations claiming this credit were in the higher asset group (90 percent).
Among nonaudited corporations, manufacturers claimed 96 percent; manufacturers of chemicals/drugs and instruments and related products claimed 80 percent of the total. Further, 84 percent of the nonaudited corporations claiming the credit fell into the higher asset group.
section_title: Additional Taxes Recommended Presented in Constant Dollars
paragraphs: Table V.1: Additional Taxes Recommended Presented in Constant Dollars for Large Corporations, Fiscal Years 1988 Through 1994 $50 mil. $100 mil. < $100 mil. < $250 mil.
In a comparison of 1988 to 1994, additional taxes recommended decreased 4 percent overall and for lower asset corporations in 1994 constant dollars. For higher asset corporations, the recommended taxes decreased 5 percent from $1,245 million in 1988 to $1,186 million in 1994. The greatest decrease of 14 percent occurred for corporations with assets of $250 million and over ($877 million in 1988 to $758 million in 1994).
Table V.2: Net Additional Taxes Recommended Presented in Constant Dollars for Large Corporations, Fiscal Years 1988 Through 1994 $50 mil. $100 mil. < $100 mil. < $250 mil.
In 1994 constant dollars, net additional taxes recommended slightly decreased 3 to 4 percent overall and for higher and lower asset corporations in a comparison of 1988 to 1994 results. Of the four asset classes, only the audits of corporations with assets of $100 million to less than $250 million generated more net recommended taxes—about 15 percent (from $323 million in 1988 to $372 million in 1994).
Table V.3: Additional Taxes Recommended per Return, Presented in Constant Dollars for Large Corporations, Fiscal Years 1988 Through 1994 $50 mil. < $100 mil. $100 mil. < $250 mil.
In 1994 constant dollars, a comparison of 1988 to 1994 showed that the amount of additional taxes recommended per return has decreased overall and for lower asset size corporations. For higher asset size corporations, this ratio increased 13 percent (about $355,000 in 1988 to $402,000 in 1994). However, corporations with assets of $10 million to less than $50 million drove the overall change with a decrease of 21 percent of recommended taxes per return (from about $105,000 in 1988 to about $82,000 in 1994).
Table V.4: Additional Taxes Recommended per Direct Audit Hour, Presented in Constant Dollars for Large Corporations, Fiscal years 1988 Through 1994 $50 mil. < $100 mil.
Taxes recommended per audit hour $100 mil. < $250 mil.
A decrease occurred overall and for each asset class except for corporations with assets of $250 million and over. The overall decrease from $1,710 in 1988 to $1,313 in 1994 was 23 percent. However, corporations with assets of $10 million to less than $50 million experienced the greatest decrease of 43 percent ($1,455 in 1988 to $858 in 1994).
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