Internal Revenue Service: Challenges Remain in Combating Abusive Tax Shelters
Published: 2003-10-21T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Recent scandals involving corporations, company executives, and accounting, law, and investment banking firms heightened awareness of abusive tax shelters and highlighted the importance of the Department of the Treasury and the Internal Revenue Service (IRS) addressing them. During 1999, Treasury issued a report indicating that abusive shelters were a large and growing problem, involving billions of dollars of tax reductions. Treasury was concerned that abusive shelters could ultimately undermine the integrity of the voluntary compliance tax system. GAO's statement today is based on work done at the request of the Chairman and the Ranking Minority Member of the Senate Committee on Finance to examine IRS's strategy for dealing with abusive tax shelters. In reporting on abusive shelters, GAO is describing (1) their nature and scope; (2) IRS's strategy and enforcement mechanisms to combat them and the performance goals and measures IRS uses to track its major effort in that area; and (3) the decision-making process IRS used and the plans it has to devote more resources to addressing abusive shelters.
section_title: What GAO Found
paragraphs: By their nature, abusive tax shelters are varied, complex, and difficult to detect and measure. Abusive shelters manipulate many parts of the tax code or regulations and may involve steps to hide the transaction within a tax return. In recent years, IRS has been accumulating information about them and, although it does not have a reliable measure of the size of the abusive shelter problem, has come to believe that abusive shelters deserve substantially increased attention. IRS continues to gather more information to better define the scope of the problem and has data sources, all with their own limitations, that suggest abusive tax shelters total tens of billions of dollars of potential tax losses over about a decade. IRS's broad-based strategy for addressing abusive shelters included: (1) targeting promoters to head off the proliferation of shelters; (2) making efforts to deter, detect, and resolve abuse; (3) offering inducements to individuals and businesses to disclose their use of questionable tax practices; and (4) using performance indicators to measure outputs and some outcomes and intending to go down the path it has started and develop long-term performance goals and measures linked to those goals. Without these latter elements, Congress would find gauging IRS's progress difficult. In allocating resources to shelters, IRS used a systematic decision-making process that relied on admittedly limited information. It planned to shift significant resources in fiscal years 2003 and 2004 to address abusive shelters but faces challenges, especially in the near term, in addressing abusive shelters due to a growing workload and limited information on how long it takes to examine shelter cases. IRS's understanding of how many staff will be needed to address the problem over what period will continue to evolve as it gains a better understanding of the problem's scope.

section_title: Letter
paragraphs: I appreciate the opportunity to testify on the Internal Revenue Service’s  (IRS) efforts to deal with abusive tax shelters.  I am using the term “abusive  shelters” to describe very complicated transactions promoted to  corporations and wealthy individuals to exploit tax loopholes and provide  large, unintended tax benefits.  Recent scandals involving corporations,  company executives, and accounting, law, and investment banking firms  heightened awareness of abusive shelters and highlighted the importance  of the Department of the Treasury and IRS addressing the problem.  During  1999, Treasury issued a report indicating that abusive shelters were a large  and growing problem, involving billions of dollars of tax reductions.Treasury was concerned that abusive shelters could ultimately undermine  voluntary compliance by eroding the integrity of the tax system.  In  response to information pointing to the rapid growth of abusive shelters,  IRS formalized a strategic initiative in fiscal year 2000 to strengthen its  capacity to deal with abusive corporate shelters.  One element of IRS’s  initiative involved creating a central office within the Large and Mid-Size  Business (LMSB) Division to coordinate and guide efforts to curb the  growth of abusive shelters.
My statement today is based on work we have done at the request of the  Chairman and the Ranking Minority Member.  In examining abusive  shelters, we focused on (1) their nature and scope, (2) IRS’s strategy and  enforcement mechanisms to combat them and the performance goals and  measures IRS uses to track its major effort in that area, and (3) the  decision-making process IRS used to allocate resources to abusive shelters  and the plans it has to devote more resources to addressing abusive  shelters.  We were also asked to provide information on IRS’s Schedule K-1  document matching program, which we are including in appendix I.
To do our work, we analyzed IRS’s and other shelter reports, publications, data, and other  documentation providing insight into the characteristics, complexity,  size, and type of the problem; reviewed IRS’s planning documents with information on its strategies,  measures, and resources; compared the contents of IRS’s planning documents to Government  Performance and Results Act of 1993 (GPRA)criteria for what elements  strategic planning should include; and  interviewed agency officials about their views on, among other things,  the problem’s nature and scope and IRS’s strategy.
We did our work from September 2002 through August 2003 in accordance  with generally accepted government auditing standards.  As agreed, we are  also discussing the related problem of abusive tax schemes in a report to be  released in the near future.  Abusive tax schemes are used more by  individuals than by large businesses and encompass such distortions of the  tax system as falsely describing the law (saying, for example, that the  income tax is unconstitutional), misrepresenting facts (for instance,  promoting the deduction of personal expenses as business expenses), and  using trusts or offshore bank accounts to hide income.  The boundary  between what we are calling an abusive tax shelter and an abusive scheme  is not always clear.  Organizationally, although IRS’s LMSB Division has  lead responsibility for combating abusive shelters, abusive shelters are  pursued by IRS’s Small Business/Self-Employed Division when they are  used by businesses with assets of less than $10 million or by high-wealth  individuals with complicated tax returns.
My statement today will make the following points:
By their nature, abusive shelters are varied, complex, and difficult to  detect and measure.  Abusive shelters manipulate many parts of the tax  code or regulations and may involve steps to hide the transaction within  a tax return.  In recent years, IRS has been accumulating information  about abusive shelters and the extent that they were promoted, and it  has come to believe that abusive shelters deserve substantially  increased attention.  Suffice it to say, although they do not have a  reliable measure of the size of the abusive shelter problem, Treasury and  IRS believe that tens of billions of dollars of taxes are being improperly  avoided and the potential for the proliferation of abusive shelters is  strong.  IRS continues to gather more information to better define the  scope of the problem and has several data sources, each with certain  limitations, that point to billions in tax losses.  As of September 30, 2003,  a database on shelter transactions that IRS has publicly declared to be  tax avoidance transactions suggested the potential tax loss to be about  $33 billion, the majority of which was concentrated from tax year 1993  through the present.  This database included only transactions disclosed  to or discovered by IRS.  In addition, an IRS contractor estimating  annual tax gaps resulting from abusive shelters estimated that the  annual average of foregone taxes between 1993 and 1999 could have  been as small as about $11.6 billion or as large as about $15.1 billion.  However, Treasury, IRS, the contractor, and we all have concerns about  the reliability of the contractor’s estimates because of methodological  and data constraints that the contractor faced.
The broad-based strategy reflected in IRS planning documents included  various features as well as elements of strategic planning: targeting promoters to head off the proliferation of shelters; making efforts to deter, detect, and resolve abuse; coordinating efforts throughout IRS; offering inducements to individuals and businesses to disclose their  use of questionable tax practices; and using performance indicators to measure outputs and some  outcomes and intending to continue down the path it has started and  develop long-term performance goals and measures linked to those  goals.  Without these latter elements, Congress would find gauging  IRS’s progress difficult.
In developing this strategy, IRS has had to make decisions about staffing  allocations and what can be accomplished on the basis of admittedly  limited information.  After using a systematic process to determine  staffing priorities, IRS planned a significant shift in resources to address  abusive shelters in fiscal years 2003 and 2004.  However, it faces  challenges, especially in the near term, in addressing abusive shelters  due to a growing workload and limited information on how long it takes  to examine shelter cases.  IRS’s understanding of how many staff will be  needed to address the problem over what period will continue to evolve  as IRS gains a better understanding of the problem’s scope.
subsections: section_title: Background
paragraphs: Although IRS has no single, authoritative definition of abusive shelters, IRS  generally characterizes abusive shelters as very complicated transactions  that sophisticated tax professionals promote to corporations and wealthy  individuals, exploiting tax loopholes and reaping large and unintended tax  benefits.  As the Joint Committee on Taxation has said, “taxpayers and tax  administrators have struggled in determining the line between legitimate  ‘tax planning’ and unacceptable ‘tax shelters.’”  Even though, it continued,  “there is no uniform standard as to what constitutes a tax shelter … there  are statutory provisions, judicial doctrines, and administrative guidance  that attempt to limit or identify transactions in which a significant purpose  is the avoidance or evasion of income tax.”
Abusive shelters have been promoted by some accounting firms, law firms,  and investment banks.  Investors in these abusive shelters range from large  and small corporations to wealthy individuals.  IRS approaches the tax  shelter enforcement problem from both the promoter and investor  perspectives.  IRS promoter investigations are designed to learn (1) what  abusive shelters have been promoted, if the shelters are registered, and  possibly how much they cost investors, (2) who purchased the shelters and  what tax savings the investors expect, and (3) whether promoters should  pay penalties for their activities.  IRS examines investor and other tax  returns to see if income, expenses, taxes, and credits are accurately  reported.
In a June 2002 letter, Treasury responded to congressional questions about  whether Treasury had a comprehensive strategy for combating tax  avoidance.  In his letter to the then Ranking Member of the Committee on  Finance, then Secretary of the Treasury O’Neill addressed the actions being  taken to combat abusive shelters, referring to Treasury’s March 20, 2002,  enforcement proposals on the topic.  The proposals said that IRS had made  significant organizational improvements to coordinate its response to  ongoing abusive tax shelters.  Treasury, all of IRS’s operating divisions, and  IRS’s Office of Chief Counsel are involved in combating abusive shelter  activity.
Within IRS, LMSB has primary responsibility for combating abusive tax  shelter activity.  LMSB’s OTSA was created in February 2000 to centralize  and coordinate the IRS response nationwide.  As shown in figure 1, OTSA is  the focal point for IRS shelter activities, overseeing promoter tax shelter  registrations; taxpayer disclosures of tax shelters; hotline tip analysis and  referral; and issue coordination and interface between the Office of Chief  Counsel, Treasury, the Tax Shelter Committee, the 6700 Committee  (referring to section 6700 of the Internal Revenue Code), and external  stakeholders. The Tax Shelter Committee oversees LMSB’s tax shelter  program.  The committee is composed of the Commissioner and Deputy  Commissioner of LMSB, the Director of Pre-Filing and Technical Guidance,  LMSB Division Counsel, five Industry Directors, the Director of  International, and the Directors of Field Specialists and Research and  Program Planning.  The 6700 Committee serves under the Tax Shelter  Committee and approves all LMSB tax shelter promoter activities.  The  financial services’ industry director chairs this committee.  IRS’s appeals  function receives and evaluates taxpayer objections to IRS examination  determinations and may agree with those determinations or reduce or  eliminate changes to tax returns resulting from them.  The Office of Chief  Counsel plays an integral role in combating shelters through summons  enforcement and targeted litigation.  By litigating, IRS establishes case law  supporting IRS enforcement programs and aims to diminish the incentives  taxpayers find for investing in tax avoidance transactions by increasing the  risks and costs of IRS discovery.
section_title: Nature of Abusive Shelters Is Varied and Complex
paragraphs: Abusive shelters are complex transactions that manipulate many parts of  the tax code or regulations and are typically buried among “legitimate”  transactions reported on tax returns.  Because these transactions are often  composed of many pieces located in several parts of a complex tax return,  they are essentially hidden from plain sight, which contributes to the  difficulty of determining the scope of the abusive shelter problem.  Often  lacking economic substance or a business purpose other than generating  tax benefits, abusive shelters are promoted by some tax professionals,  often in confidence, for significant fees, sometimes with the participation  of tax-indifferent parties, such as foreign or tax-exempt entities.  They may  involve unnecessary steps and flow-through entities, such as partnerships,  which make detection of these transactions more difficult.
When a transaction has certain abusive characteristics defined by section  6111 of the Internal Revenue Code, the promoter or other tax shelter  organizer is required to register it, describing the transaction and its tax  benefits to the Secretary of the Treasury.  This registration requirement  enables Treasury and IRS to identify and evaluate questionable  transactions.  Under recently issued Treasury regulations, effective  February 28, 2003, there are six categories of transactions for which  promoters must maintain lists of investors who have entered into the  transactions, and investors must disclose the transactions into which they  have entered.  The rules are designed to allow IRS to use information from  investors to identify promoters who do not register transactions and to use  promoter registrations and investor lists to identify investors who fail to  disclose transactions.  The six categories are transactions offered under conditions of confidentiality, transactions including contractual protections to the investor, transactions resulting in specific amounts of tax losses, transactions generating a tax benefit when the underlying asset is held transactions generating differences between financial accounts and tax  accounts greater than $10 million, and “listed transactions.”
A “listed transaction” is a transaction that is the same as or similar to one of  the types of transactions IRS has determined to be a tax avoidance  transaction.  For a transaction to be a listed transaction, IRS must issue a  notice, regulation, or other form of published guidance informing taxpayers  of the details of the transaction.  As of mid-August 2003, IRS had listed 27  kinds of abusive tax shelter transactions, a number that, as figure 2 shows,  has grown more quickly in recent years than it had grown earlier.
Disputes between IRS and taxpayers about the abusive nature of a  transaction may be litigated.  In some, but not all, cases, the courts have  upheld the government position.  The following cases illustrate features of  abusive shelters:
In 1993, a corporation began a company-owned life insurance (COLI)  program in which the company purchased whole-life insurance on  36,000 employees for which the company was the sole beneficiary.  The  company then borrowed money against the policies at interest rates that  averaged 11 percent and deducted the interest expense and  administrative fees from income on its tax returns.  Over 60 years, the  interest costs and administrative fees would have exceeded the cash  surrender value of the policies and benefits paid by several billion  dollars.  IRS disallowed the deductions and the case was litigated.  Despite the fact that the money the company made on this arrangement  may have been used to fund the company’s benefits program, or for  other business purposes, the court found that the function of the  program itself was only to generate tax deductions.  As a result, the Tax  Court sustained the IRS disallowance of deductions and concluded that  the COLI program was a sham.The Eleventh Circuit Court of Appeals  affirmed the Tax Court’s decision.
A company had a sizable gain from the sale of a subsidiary and wanted  to avoid or minimize paying tax on the gain.  An investment bank  proposed forming an offshore partnership with a foreign corporation (a  tax-indifferent party) for the express purpose of sheltering the capital  gains of its corporate client.  The partnership purchased and quickly  resold notes in a contingent installment sale transaction.  The  partnership earned a large capital gain, most of which it allocated to the  foreign corporate partner.  Later, related losses were allocated to the  U.S. corporation, generating an approximate $100 million capital loss for  the investment bank’s client.  The corporation used this capital loss to  shelter its U.S.-based capital gains.  Both the Tax Court and the Third  Circuit Court of Appeals ruled that the transaction lacked economic  substance. The Third Circuit, in addition to requiring economic  substance, held that a transaction must have a subjective nontax  business motive to be respected for tax purposes. For this transaction,  the investment bank was to earn a fee of $2 million.  This was one of 11  such partnerships formed over a 1-year period from 1989 to 1990 by the  investment bank.
section_title: Several Sources Indicate That the Scope of Abusive Shelters Is in the Tens of Billions of Dollars, Though All Are Based on Limited Data
paragraphs: IRS has information that suggests the scope of abusive shelters totaled tens  of billions of dollars over about a decade, but those estimates are based  on limited data.  This information comes from an OTSA database,  examinations of large corporations, and a contractor study.  Information  contained in the OTSA database includes transactions disclosed to or  discovered by IRS and estimates of potential tax losses.  The tax loss  estimates vary from being IRS officials’ recommended taxes based on  examining some transactions to taxpayer judgments regarding potential  losses in cases where examinations have not been done.  In addition to  being based on judgments, the database does not include any reductions  resulting from examination, appeal, litigation, or other sources.  Information from examinations of the largest corporations, which may  overlap information in the OTSA database, shows proposed income  adjustments in the tens of billions of dollars before reductions, but data  were not available from IRS on the results of examinations of smaller  corporations, partnerships, trusts, S corporations, or individuals.  Information from IRS’s contractor study estimates an annual tax gap due to  abusive shelters but has data and methodological limitations.
subsections: section_title: OTSA Database
paragraphs: As shown in table 1, as of September 30, 2003, an OTSA database included  estimated potential tax losses of about $33 billion from investments in  listed transactions, before considering any reductions resulting from  examination, appeal, litigation, or other sources and another $52 billion in  potential tax losses from nonlisted transactions with some characteristics  of abusive shelters.  This database contains information on promoters and  investors and the amount of potential tax savings resulting from listed and  nonlisted transactions.  Nonlisted transactions are transactions that  needed to be registered because they have some characteristics of abusive  shelters but were not, at least yet, determined to be abusive.  According to  an IRS official, IRS was studying nonlisted transactions with about  $12 billion in potential tax losses for possible listing.  The database only  includes information on abusive or possibly abusive transactions that had  been disclosed to or discovered by IRS.
The estimated tax losses contained in the OTSA database cover a wide  range of years from at least as far back as tax year 1989 and extending even  to future tax years since, for instance, improperly claimed deductions may  be used in some cases to reduce future taxes.  For the $29 billion in  estimated tax losses associated with listed transactions contained in the  January 14, 2003, database, about 82 percent of the potential tax losses  were concentrated in the period from 1993 through 2002.
According to data IRS provided in mid-October 2003, OTSA had  information on almost 300 firms that had possibly promoted abusive  shelters as well as other tax planning products that contain at least some  features of abusive transactions.  It was also aware of about 6,400  investors, including individuals and corporations that bought abusive  shelters and other aggressive tax planning products.
section_title: Examinations of Large Corporations
paragraphs: IRS has proposed shelter-related adjustments to large corporations’ income  in examinations it has closed and in examinations still open as of early May  2003.  In cases closed between October 1, 2001, and May 6, 2003, IRS  proposed about $10.6 billion in abusive shelter-related adjustments to the  income of 42 large corporations for tax years 1992-2000.  These proposed  adjustments would result in about $3.5 billion in tax revenue if the  adjustments were not reduced.  The corporations were in what is known as  the Coordinated Industry Case (CIC) program, which includes the nation’s  largest corporations.They agreed with about $1.2 billion of the $10.6  billion in proposed adjustments to income.As of early August 2003,  Appeals research showed that few of the issues comprising the $9.4 billion  unagreed amount had been resolved yet by Appeals or through a settlement  initiative, although the database did not track all of them. For the 141  large corporations with cases still open in early May 2003, the amount of  proposed shelter-related income adjustments was $47.6 billion, translating  to about $16 billion in tax if not reduced.  IRS did not have similar  information for smaller corporations.  Also, since one of the sources of  information in the OTSA database is shelter-related adjustments proposed  in examinations, the proposed adjustments in the CIC program may  overlap the information in the OTSA database.
section_title: Contractor Study
paragraphs: In July 2003, an IRS contractor estimated the tax gap resulting from abusive  shelters for different years.  For 1993 through 1999, based on the  contractor’s estimates, the average annual tax gap could have been as small  as about $11.6 billion or as large as about $15.1 billion of forgone tax.  However, the reliability of the contractor’s estimates is questionable  because of methodological and data constraints the contractor faced when  developing them.
The estimates followed a September 2001 recommendation by the Treasury  Inspector General for Tax Administration (TIGTA) that LMSB obtain a  more precise estimate of the shelter problem to lay a better foundation for  its strategy for addressing abusive shelters. In response, IRS contracted  for models to predict the likelihood of finding abusive shelters within  certain tax returns and to estimate the annual “tax gap” due to abusive  shelters.  Both IRS and contractor officials believe the contract results are  more useful to predict returns with abusive shelters than they are to value  the size of the abusive shelter problem.
Nevertheless, as table 2 shows, the contractor produced estimates of the  size of the problem for each year from 1993 through 1999.  Yearly low-end  estimates ranged from $9.0 billion of foregone tax in 1993 to $14.5 billion in  1999.  On the other hand, the high-end estimates ranged from $12.1 billion  in 1993 to $18.4 billion in 1999.Averaging the estimates over time results  in the $11.6 billion to $15.1 billion range cited earlier.
The tax gap model used three different kinds of data:  (1) IRS’s Statistics of  Income data for the largest U.S. companies, those with assets over  $250 million falling within the CIC program, (2) Standard and Poor’s  Compustat financial data, and (3) surveys of IRS field offices.  IRS  conducted surveys from 1999 through 2001 that asked field managers to  identify abusive tax shelters in their open inventory of examinations-- relying on each manager’s understanding of what an abusive tax shelter is.  Since survey data are included in the OTSA database, some of the same  information used by the contractor appears in the OTSA information cited  earlier.
Treasury, IRS, the contractor, and we have concerns about the contractor  estimates.  First, it is difficult to determine whether these estimates might  be overstating or understating the true extent of the tax gap because of the  uncertainties in the underlying data and the elusive nature of the problem.  In identifying abusive shelters in the IRS surveys, field managers might  have anticipated that some abusive shelters existed where there were none  or where the assertion of abuse might not be sustained.  On the other hand,  they might not have identified all the abusive shelters in their open  inventory of examinations because their definitions of abusive shelters  might have differed from each other.  Finally, the data might not be  representative of all transactions, especially those that closed, because  survey responses were only to include open cases.
Second, the Statistics of Income data only included U.S. corporations with  assets of over $250 million falling within the CIC program.  Many shelters  may be reflected in tax returns of smaller corporations, partnerships,  Subchapter S corporations, and wealthy individuals and were not included  in this study.  Since these transactions were not included in the contractor’s  estimate, the resulting tax gap estimate is incomplete.
Third, the estimates are based on known shelters.  They were developed  using 1990s’ ideas of what constituted abusive shelters.  Since then, more  shelters have been disclosed or identified by IRS and still others are under  consideration for listing.  Since the definition of an abusive shelter can  change over time, and the data cannot reflect unknown or unidentified  shelters, the operational definition of abusive shelters was a conservative  one.
While the last two concerns argue that the contractor’s estimates  understate the true level of abusive shelters for recent years, the  contractor’s estimates and other indicators of the problem’s size based on  past data may also be of limited use as guides to current and future activity  for other reasons.  According to Treasury and IRS officials, the legal and  economic environment has changed since the data for this study were  developed.  First, they said, IRS has taken many administrative actions to  address abusive shelters.  For instance, it is their belief that nothing puts  more of a damper on taxpayer participation in a particular type of  transaction than IRS listing it.  Similarly, although corporate-owned life  insurance transactions may heavily influence the contractor’s estimates,  legislation addressed the problem in 1996 and 1997, and therefore current  and future estimates would not reflect that problem—although they could  reflect problems not identified in the period covered by the contractor’s  study.  Second, court cases have largely supported IRS’s assertions about  the need for business purpose requirements and about requirements for  economic substance in transactions.  Third, today’s economy is not as  robust as the economy in the late 1990s, generating less profit to protect.  Finally, the publicity surrounding numerous corporate scandals may create  a chilling effect in the market for aggressive transactions. Countering these  points, however, are other opinions appearing in the press that (1) the  courts could uphold some tax shelters and (2) IRS’s capacity to stem  abusive shelters is limited.
section_title: IRS Strategy to Combat Abusive Shelters Is Broad-Based but Generally Has No Long-Term Performance Goals or Measures Linked to Goals
paragraphs: IRS developed a broad-based strategy for combating abusive shelters that  included various features as well as elements of strategic planning.  Deeming it a strategic initiative, IRS is executing a strategy incorporating  four principal elements:  (1) an emphasis on promoters, (2) efforts to deter,  detect, and resolve abuse, (3) coordination of efforts throughout IRS, and  (4) inducements provided for taxpayers to come forward and expedite case  resolution.  IRS is implementing a variety of initiatives designed to reduce  taxpayer incentives to participate in abusive transactions and discourage  promoters from marketing these transactions.  Although IRS documents  outline an overall strategy for combating abusive shelters, IRS has  generally not yet defined long-term performance goals for the effort and the  measures it would use to track progress in achieving those goals.However, IRS is planning to establish such goals and measures when it has  more information on the abusive shelter activities it is currently tracking.
subsections: section_title: IRS Is Actively Pursuing Promoters
paragraphs: IRS is actively pursuing abusive promoters to ensure (1) that tax strategies  containing characteristics of potentially abusive shelters are registered,  (2) that information about transactions is disclosed to IRS as required by  sections 6111 and 6112 of the Internal Revenue Code, and (3) that,  according to IRS’s OTSA manager, those who generate noncompliance  change their behavior or go out of business.  With 98 abusive shelter  promoters approved for investigation as of June 30, 2003, IRS uses  investigations to gain access to lists of the clients who buy promoters’  products and devise a roadmap to audit shelters included in the tax returns  of the investors.  IRS is also using promoter investigations to enforce the  transaction registration requirements, which, in turn, assist in its efforts to  understand, track, and close abusive shelters.  IRS announced the  completion of three large promoter investigations in 2001 through July  2003.  They resulted in, among other things, three substantial payments and  promoter promises to work with IRS to ensure ongoing compliance with  shelter registration and list maintenance requirements.
section_title: IRS Efforts Are to Deter, Detect, and Resolve
paragraphs: IRS focuses its efforts on deterring future marketing and sales of abusive  tax shelters and on detecting and resolving existing shelters.  TIGTA  described IRS’s abusive shelter approach along the lines of deter, detect,  and resolve in September 2001. IRS considers its efforts to provide  guidance as early as possible to taxpayers and promoters in the form of  recently proliferating IRS and Treasury determinations, notices, and rulings  on abusive transactions and of registration, list maintenance, disclosure,  and other requirements to be a key deterrent.  (See fig. 2.)  Also designed to  deter abusive tax shelters, accuracy-related penalties aim at investors who  use abusive shelters to substantially undervalue true tax liability.  Other  penalties are for promoters who market shelters that aid and abet the  understatement of tax liability or who fail to register shelters.  IRS’s  Examination Returns Control System showed IRS assessing 21 investor  penalties totaling about $73 million between July 1, 2002, and May 1, 2003,  which taxpayers had not necessarily agreed to pay.  During our review,  Treasury included proposed legislation in the Administration’s revenue  proposals to strengthen the penalties that could be used in abusive shelter  situations.
IRS’s ability to detect abusive shelters increased in the last 3 years due to  OTSA’s hotline, through which callers provide tips about transactions or  investors; disclosure, registration, and list maintenance requirements;  increased attention by IRS management; and increased use of IRS  examination resources to look for shelter irregularities.  For instance,  between May 31, 2000, and July 30, 2003, the hotline received 729 shelter- related telephone calls and e-mails, some of them leading IRS to new listed  transactions, promoters, and investors.  As another example, IRS expanded  its disclosure requirements in June 2002 to include noncorporate  taxpayers.  Finally, as evidence of increased management attention, IRS  established a new senior position reporting to the IRS Chief Counsel to  supervise staff and lead task force initiatives to more quickly identify and  deal with abusive shelters.
Cases may be resolved at the examination level if taxpayers agree with IRS  findings.  If taxpayers do not agree, cases are resolved at the appeals level,  through litigation, or by alternative dispute resolution.
In addition to these detection and case resolution efforts, IRS is using  Schedule K-1 data to research better methods of detecting abusive shelters  that involve multiple levels of flow-through entities. These complex  structures of related entities pose challenges in analyzing tax compliance  by creating opportunities for taxpayers to disguise noncompliance.  In the  future, IRS hopes to use advanced data analysis tools such as link analysis  and graph-based data mining to identify potential abusive shelters.  Link  analysis is the process of building networks of related entities, such as  flow-through entities and Schedule K-1 recipients, in order to expose  patterns and trends.  Graph-based data mining, a form of link analysis, is  intended to enable IRS to identify structures of known abusive shelters and  find similar patterns in the population of flow-through networks to  discover previously undisclosed potential abusive shelter transactions.  IRS  has paid a contractor $200,000 so far to assess the feasibility of these  technologies and plans to spend $575,000 over the next 1.5 to 2 years to  develop these concepts into models.
section_title: IRS Emphasizes Internal Coordination
paragraphs: Coordination within IRS and interface with Treasury on abusive shelters is  a core objective in IRS’s plans for addressing those shelters.  OTSA is the  focal point for all shelter-related activity performed in the Tax Shelter  Committee, the 6700 Committee, Counsel, Appeals, and LMSB.  For  example, if a taxpayer discloses an investment in a tax shelter to IRS, OTSA  is to enter the transaction into its database, and OTSA reviews the  transaction in collaboration with IRS technical advisors and counsel.  OTSA may also forward it to LMSB examiners for compliance action.
At the IRS-wide level, an executive steering committee provides a forum  for coordinating work on both abusive shelters and abusive schemes.  It  meets monthly and includes participants from LMSB, the Small  Business/Self Employed Division, Appeals, Counsel, and other  organizations.  It operates under the auspices of IRS’s Enforcement  Committee, which was chartered in July 2003.  Chaired by the Deputy  Commissioner for Services and Enforcement, a new position created in  May 2003, the Enforcement Committee is to guide IRS-wide enforcement  strategies, focusing on high-visibility issues involving many divisions or  potentially having significant compliance impact.
Although we did not systematically measure whether coordination is  facilitated by these mechanisms, we did review minutes of selected  executive steering committee meetings.  In doing so, we saw such evidence  of coordination as the discussion of an LMSB and SB/SE working group on  who would work a corporate officer case when LMSB works on a  corporation.
section_title: IRS Offers Inducements for Taxpayers to Disclose Shelters and Expedite Case Resolution
paragraphs: LMSB attempts to leverage its limited resources by using inducements to  achieve compliance.  These tools include penalty relief, “fast track” issue  resolution, and various structured settlement programs that allow  participating taxpayers to keep a percentage of a shelter’s benefits in  exchange for conceding most benefits and expediting case resolution.  For  example, under a disclosure initiative that expired on April 23, 2002,  taxpayers who revealed shelters and their respective promoters avoided  accuracy-related penalties.  IRS’s aim was to more readily identify  promoters who had not registered shelters and, through the promoters,  find taxpayers who had not disclosed their shelter participation.  As a  result of this initiative, IRS received 1,664 disclosures from 1,206 taxpayers,  disclosing tens of billions of dollars of losses and deductions.
IRS offered taxpayers various alternative dispute resolution mechanisms as  inducements to settle abusive shelter issues with IRS, mitigating the  hazards of litigation for both sides and moving more cases through the  administrative system quickly.  For example, from October 2001 through  April 7, 2003, 17 taxpayers agreed with IRS on their respective shelter  issues in the Fast Track Issue Resolution program, resolving about  $1.6 billion in proposed adjustments to income (potentially about  $540 million in tax).  In another example, IRS announced initiatives in  October 2002 to resolve disputes related to three shelters:  COLI, basis- shifting shelters, and contingent liability shelters. In these initiatives, if  taxpayers agreed to settle their cases with IRS by a certain date, with the  last initiative closing March 5, 2003, they would pay a large percentage of  the full amount IRS disallowed.  A summary as of early May 2003 of the  number of investors involved in the three settlement initiatives and the  potential tax dollars conceded or to be conceded appears in table 3.
section_title: Generally IRS Does Not Have Long-Term Performance Goals or Measures Linked to Goals
paragraphs: Although IRS has outlined and begun to implement a multipart strategy for  combating tax shelters, it has not yet generally defined performance goals  for the effort and established the measures it would use to track progress in  achieving those goals.  Performance goals define what an organization is  trying to achieve over time, preferably focusing on the outcome desired  rather than activities or outputs.  To date, according to IRS officials, their  shelter-related goals cover the number of staff years to be devoted to  shelter examinations and the number of shelter examinations to be closed.  Also, LMSB planning documents have a few short-term goals.  For example,  LMSB had a short-term goal to begin compliance actions on all voluntary  shelter disclosures by June 30, 2003, a goal IRS officials told us was met.  IRS management officials recognize that developing other performance  goals and associated measures to track progress is desirable but point to  challenges they face in assessing the scope of the abusive shelter problem.  Nonetheless, IRS intends to establish such goals in the future when it has  more information on activities it is currently tracking.
IRS has already started down this road by developing several measures  that, while not tied to longer-term performance goals, are to be used in  tracking its progress in combating abusive tax shelters.  It devised these  measures for fiscal year 2003 responding to a September 2001 TIGTA  recommendation to develop performance measures so managers could  better target problem areas, highlight successes, evaluate alternatives, and  track whether OTSA is achieving desired outcomes.  IRS is mostly tracking  outputs related to case management, such as the number of tax shelter  examinations closed and tax shelter return cycle time, and is using output  measures of IRS program activities, such as published guidance issued and  hotline contacts.  IRS is also using some measures that track tax  enforcement outcomes, namely adjustments proposed to tax returns from  disallowing abusive shelters and tax shelter penalties proposed. Since  fiscal year 2003 was the first year IRS used these measures, it had no  baseline data with which to evaluate its performance measures.  However,  LMSB plans to evaluate its measures over time to assess their usefulness.
section_title: Resource Shifts Are Significant but IRS Faces Challenges in Addressing Abusive Shelter Workload
paragraphs: Using admittedly limited information, IRS used a systematic decision- making process in deciding to shift a large portion of LMSB examination  staff resources toward addressing abusive shelters.  From fiscal year 2002  through fiscal year 2004, LMSB expected to increase the portion of its  examination resources devoted to combating abusive shelters from 3  percent in 2002 to 20 percent in 2004.  In doing so, it will have shifted  resources out of examining the category of cases including such areas as  net operating losses and claims for refunds.  Even so, IRS faces challenges,  especially in the near term, in addressing expected increases in its shelter  workload because of the growing number of shelter cases and limited  information it has on how long it takes to conduct shelter examinations.  As  will be described, GAO has previously raised questions about IRS’s ability  to shift compliance resources as planned.
subsections: section_title: IRS Used Systematic Planning and Budgeting Process to Determine Staffing Priorities
paragraphs: At an agencywide level, IRS decided staffing resource levels to be devoted  to addressing abusive shelters through a systematic planning and budgeting  process based on experience and professional judgment because IRS did  not and does not have a reliable measure of the abusive shelter problem.  Early in calendar year 2002, IRS’s divisions completed strategic  assessments in which they studied trends, issues, and priorities affecting  their operations.  In April 2002, IRS’s senior management team, including  the Commissioner, Deputy Commissioner, division heads, and others used  two rounds of considering IRS’s programs to rank the needs for new or  redirected funding for fiscal year 2004.  Of 33 programs considered, the  program including tax shelters received the third most votes.  According to  an IRS official, this process also informed how funds already requested for  fiscal year 2003 would actually be spent.  After the senior management  team reached consensus, the Commissioner issued overall planning  guidance for fiscal years 2003 and 2004 to reflect the jointly set strategic  direction, and the divisions wrote fiscal year 2003 and 2004 “strategy and  program plans” outlining staffing resources needed.
section_title: IRS Shifts Significant Levels of Examination Resources to Shelters
paragraphs: In 2002, LMSB put forward plans to increase its work on abusive shelters  from 3 percent of its examination resources to 20 percent between fiscal  years 2002 and 2004, assuming congressional funding.  To support this shift  in examination resources, LMSB needed to allocate examination resources  away from other areas.  One area to receive less audit coverage was  industry audits. As shown in table 4, from fiscal year 2003 to fiscal year  2004, IRS planned to move resources away from specific types of  mandatory examinations and from some high-risk nonmandatory returns.IRS’s strategy is to mitigate the impact of resource reallocations away from  nonshelter areas by using such issue management strategies as fast-track  resolution and prefiling agreements, thereby requiring less staff time to  close cases and freeing staff to be used in other areas.
In addition to LMSB examination staff, IRS has managers, attorneys, and  others who work on abusive shelters.  For instance, in February 2003,  OTSA and its parent body, the Office of Pre-Filing and Technical Guidance,  had 39 full-time and 34 part-time technical experts, program analysts, and  managers.  Also at that time, a contact list for listed transactions included  17 attorneys.  These numbers did not include many of the IRS legal  resources involved with abusive shelters.  In addition, as of September 30,  2003, LMSB had assigned about 1,900 abusive and potentially abusive  shelter transactions involving non-LMSB taxpayers to IRS’s Small  Business/Self-Employed Division, which supplies examination staff  resources of its own.
section_title: IRS Faces Challenges in Addressing Increasing Shelter Workload
paragraphs: Although IRS appeared to be on track to shift planned resources to shelter  work in fiscal year 2003, it faces challenges in addressing the abusive  shelter workload, especially in the near term.  This is because of (1) the  growing numbers of transactions and promoters to be examined and  (2) limited information on how long it takes to conduct shelter  examinations.
From fiscal year 2002 through fiscal year 2004, LMSB planned to use 1,879  full-time equivalents (FTE) to address abusive shelters.  During fiscal year  2002, LMSB used 239 FTEs to address tax returns that included abusive  shelters. According to IRS’s fiscal year 2004 congressional budget  justification, LMSB planned to allocate 691 and 949 FTEs in fiscal years  2003 and 2004, respectively.  In a draft strategy and program plan dated  September 2003, LMSB projected it would actually use 615 FTEs for shelter  work in fiscal year 2003, or 88 percent of the planned amount and an  increase of 157 percent over the fiscal year 2002 FTE level including this  work.
Because (1) the known abusive shelter workload has increased, (2) IRS has  limited experience to judge how many resources will be needed to work  the cases for how long a period, and (3) the workload may continue to  increase, it remains uncertain whether the substantial shift of resources to  shelter work will enable IRS to examine in a timely manner the growing  workload associated with shelters.  For instance, the number of potential  examinations of listed transactions disclosed has grown since the inception  of OTSA, adding significantly to IRS resources required to address the  problem. Table 5 shows the number of listed transactions disclosed by  taxpayers grew from 51 to 2,182 between December 31, 2000, and  September 30, 2003, and other transactions disclosed to IRS grew from  none to 663.  The total of all listed and nonlisted LMSB-related transactions  in the OTSA database, not only those disclosed by taxpayers, as of  September 30, 2003, was 4,897.
IRS workload from promoter investigations has also grown since May 2002.  At that time, IRS planned that 7 promoter investigations would be ongoing  in fiscal year 2003.  As of June 30, 2003, IRS had 98 promoter investigations  approved.  Based on early promoter investigations, an IRS official stated  that promoter investigations can take thousands of hours to develop, and  several have been litigated, each requiring a large expenditure of resources.
LMSB has limited information on the amount of time required to examine  abusive shelter cases.  LMSB developed estimates of the amount of  examination time required for such cases based on its experience  examining various types of shelters but acknowledged that examiners can  spend hundreds or thousands of hours depending on the type of shelter  examined and the facts and circumstances of the case.  For example,  according to an LMSB official, based on personal experience, OTSA  estimated that it would take about 800 hours to examine a potentially  abusive transaction reflected in the return of a CIC corporation although  LMSB had little data to support the estimate.  During fiscal year 2003, IRS  began collecting data on examination time that it plans to use for  estimating the resources needed to address its abusive shelter workload.
The future abusive shelter workload also could increase, at least in the  short term.  For example, as IRS learns more about the use of shelters, it  may identify and list new kinds of transactions as being abusive.  As IRS  conducts the 98 promoter investigations approved as of June 2003, more  investors are likely to be identified, and investor cases could lead to  identifying more promoters.  In addition, IRS expanded the types of  taxpayers subject to disclosure requirements to include taxpayers like  individuals, partnerships, and S corporations.  According to IRS officials,  disclosures from these types of taxpayers are first due to IRS for filing year  2003 and generally do not yet appear in the OTSA database.
In the longer term, what happens to the abusive shelter workload is less  certain.  To the extent that IRS actions and other factors reduce the size of  the abusive shelter problem, IRS might not need to continue devoting as  large a percentage of its examination resources to abusive shelters.  How  much and how soon such a drop may occur in abusive shelter cases is  uncertain.
We have previously raised questions about IRS’s ability to shift compliance  resources as planned.  We recently testified that many parties have  expressed concern about declining IRS compliance—especially audit—and  collection trends for their potential to undermine taxpayers’ motivation to  fulfill their tax obligations.Concerned about these trends, IRS has sought  more resources, including increased staffing for compliance and  collections since fiscal year 2001.  Despite receiving requested budget  increases, staffing levels in key occupations were lower in 2002 than in  2000.  These declines occurred for reasons such as unbudgeted expenses  consuming budget increases and other operational workload increases.  Based on past experience and uncertainty regarding some expected  internal savings, fiscal year 2004 anticipated staff increases might not fully  materialize. Thus, if IRS carries through with its intentions to increase  resources devoted to abusive shelters, it may not have the desired level of  resources in other areas of compliance.
section_title: Concluding Observations
paragraphs: Abusive tax shelters represent a potentially significant, although  imprecisely understood, loss in tax revenues.  IRS developed and is following a broad-based, multifaceted strategy to combat abusive shelters  even though it had limited data on the full scope of the problem.  IRS’s  strategy generally does not contain long-term performance goals and  associated measures that can help Congress evaluate IRS’s progress.  Although establishing performance goals and measures is inherently  difficult since the scope and nature of abusive shelters is elusive, the need  for such goals and measures is heightened because IRS is shifting large  amounts of examination staff resources to support combating abusive  shelters.  IRS’s initial decisions on shifting resources might need to be  reevaluated as IRS develops better information on the size of the abusive  shelter problem and the amount of time it takes to examine abusive shelter  cases.  We encourage IRS to continue its efforts to obtain a better analytic  basis for determining the resources needed to address schemes and  shelters–while providing sufficient attention to other tax compliance  areas–and to develop goals and measures that it and Congress can use to  gauge IRS’s progress.
Mr. Chairman, this concludes my prepared statement.  I would be happy to  respond to any questions you or other Members of the Committee may  have at this time.
section_title: Contact and Acknowledgements
paragraphs: For further information on this testimony, please contact Michael Brostek  at (202) 512-9110 or brostekm@gao.gov.  Individuals making key contributions to this testimony include Ralph Block, Elizabeth Fan, Amy  Friedheim, Lawrence Korb, Signora May, and James Ungvarsky.
section_title: IRS Compliance and Research Programs Using the Schedule K-1
paragraphs: Schedule K-1s are information returns that link flow-through entities with  their income recipients and therefore can be used for various compliance  and research purposes, such as the automated underreporter (AUR)  program and profiling potential nonfilers.
Partnerships, S corporations, trusts, and estates are collectively known as  flow-through entities because they can legally pass net income or loss  through to their partners, shareholders, and beneficiaries.  Flow-through  entities are required to provide IRS and each partner, shareholder, or  beneficiary with a Schedule K-1 stating the individual share of net income  or loss to be reported.  These individuals are then responsible for reporting  this income or loss on their individual income tax returns and paying any  applicable tax.  According to IRS in tax year 2001, over 9 million flow- through entities reported passing through almost $1 trillion to  approximately 24 million partners, shareholders, or beneficiaries.  IRS  research efforts suggest that 6 to 15 percent of the K-1s attached to flow- through returns are currently being omitted from beneficiary, partner, and  shareholder returns.  To better detect such noncompliance, IRS began  transcribing nonelectronically submitted Schedule K-1s for tax year 2000 at  a cost of about $20 million.
In 2001, IRS added Schedule K-1 document matching to its AUR program.  It began matching Schedule K-1 data to individual tax returns to identify  taxpayers who had underreported flow-through income and had  consequently underpaid their taxes.  IRS estimated that K-1 matching  program costs would be about $23.5 million total for both K-1 transcription  and AUR program operations and that program yield would be $36 million  in direct tax assessed.  IRS also estimated that if voluntary compliance  improved one percent due to the matching program, approximately  $1.23 billion of additional tax would be generated annually.  In the first year  of the program, IRS issued about 69,000 notices to taxpayers and assessed  about $29 million in additional taxes directly attributable to Schedule K-1  underreporting. GAO estimates that when program assessments are  compared to the costs of the program’s AUR operations, the return per  dollar of the K-1 matching program was about $9.31.  If the cost of  transcribing the K-1 data is included, the return per dollar decreases to  about $1.25. Both of these assessment-to-cost ratios are substantially  lower than that for the AUR program as a whole. The AUR program  returned about $25 for every dollar spent in tax year 2000.
IRS has also used Schedule K-1 data to determine characteristics of  potentially noncompliant taxpayer populations.  Its preliminary profiling  efforts identified over 227,000 business entities with almost $64 billion in  Schedule K-1 income for tax year 2000 that potentially did not file tax  returns.  As of September 2003, IRS had begun to discuss ways of analyzing  these cases to determine whether these businesses were required, but  failed, to file returns, or whether inaccuracies in Schedule K-1 data  produced false nonfiler leads.  In addition, in response to a Treasury  Inspector General for Tax Administration report issued in September 2002,the agency has begun to research the effectiveness of using information  returns, such as the K-1, to identify business nonfilers.
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