Tax Administration: Taxpayer Rights and Burdens During Audits of Their Tax Returns
Published: 1997-09-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO discussed the rights of taxpayers and their treatment during audits of their tax returns by the Internal Revenue Service (IRS).
section_title: What GAO Found
paragraphs: GAO noted that: (1) IRS has limited data on both the treatment of taxpayers and the burdens imposed on them during audits; (2) IRS recently created a system to track taxpayers' complaints about improper treatment but IRS does not solicit input on all improper treatment; (3) similarly, IRS has no comprehensive definition of, and little data on, the burden its audits impose on taxpayers; (4) IRS has recently developed a survey that will ask individual taxpayers about their satisfaction with various parts of the audit process but results will not be available until 1998; (5) IRS has various indicators and standards on audit performance; (6) one measure of audit performance is how much additional tax is recommended; (7) IRS does not have a corresponding measure on how much of the recommended tax is ultimately collected after taxpayer appeals; (8) without an indicator to balance taxes recommended against those collected, IRS auditors could have an incentive to recommend taxes that would be unlikely to withstand a taxpayer challenge; (9) IRS has nine audit standards; (10) GAO's work on one set of IRS audit techniques--those used in analyzing taxpayers' financial status to identify unreported income--showed that IRS used these techniques in less than a quarter of the audits completed in the time periods covered by GAO's review; (11) in about one-quarter of the audits in which financial status techniques were used, IRS did not have to contact the taxpayer to obtain information on the taxpayer's financial status beyond what was reported on the tax return; (12) GAO also found that IRS' use of financial status techniques has not increased in recent years; (13) regarding revenue impact, GAO found that in about 16 percent of the cases where they were used, these techniques did help to identify significant amounts of unreported income--$10,000 or more; (14) IRS is concerned that its ability to target the potentially most noncompliant taxpayers for audits is deteriorating; (15) IRS' concern arises because it has not been able to rely on its past approach for developing statistically valid research data that allowed IRS to create and periodically update formulas to target the returns with the most potential for noncompliance; (16) IRS last collected these data through audits of a random sample of taxpayers for tax year 1988; and (17) IRS subsequently abandoned that approach due to concerns about its costs and to concerns from the public and Congress about the taxpayer burden involved with those audits.

section_title: Letter
paragraphs: Taxpayers and Congress have expressed concerns with how the Internal Revenue Service (IRS) treats taxpayers in audits and whether audits are too burdensome. Based on its ongoing and previous work, GAO makes the following points on these issues: IRS has limited data on both the treatment of taxpayers and the burdens imposed on them during audits. IRS recently created a system to track taxpayers’ complaints about improper treatment but IRS does not solicit input on all improper treatment. Similarly, IRS has no comprehensive definition of, and little data on, the burden its audits impose on taxpayers. IRS has recently developed a survey that will ask individual taxpayers about their satisfaction with various parts of the audit process but results will not be available until 1998. IRS has various indicators and standards on audit performance. One measure of audit performance is how much additional tax is recommended. IRS does not have a corresponding measure on how much of the recommended tax is ultimately collected after taxpayer appeals. Without an indicator to balance taxes recommended against those collected, IRS auditors could have an incentive to recommend taxes that would be unlikely to withstand a taxpayer challenge. IRS has nine audit standards. The standards focus on the efficient use of auditors’ time and not on when they should use particular audit techniques. To ensure adherence to the standards, IRS relies on oversight by the auditors’ managers. However, their workload limits their time for doing oversight. • GAO’s work on one set of IRS audit techniques—those used in analyzing taxpayers’ financial status to identify unreported income—showed that IRS used these techniques in less than a quarter of the audits completed in the time periods covered by GAO’s review. In about one-quarter of the audits in which financial status techniques were used, IRS did not have to contact the taxpayer to obtain information on the taxpayer’s financial status beyond what was reported on the tax return. GAO also found that IRS’ use of financial status techniques has not increased in recent years. Regarding revenue impact, GAO found that in about 16 percent of the cases where they were used, these techniques did help to identify significant amounts of unreported income—$10,000 or more. However, in over three-quarters of the total audits in which these techniques were used, no changes resulting from the use of these techniques were made to the income reported. Most of the audits did result in some tax change for other reasons. Data are not available to permit GAO or IRS to determine the additional burden imposed on taxpayers from the use of the techniques in audits.
IRS is concerned that its ability to target the potentially most noncompliant taxpayers for audits is deteriorating. IRS’ concern arises because it has not been able to rely on its past approach for developing statistically valid research data that allowed IRS to create and periodically update formulas to target the returns with the most potential for noncompliance. IRS last collected these data through audits of a random sample of taxpayers for tax year 1988. IRS subsequently abandoned that approach due to concerns about its costs and to concerns from the public and Congress about the taxpayer burden involved with those audits.
subsections: section_title: Tax Administration: Taxpayer Rights and Burdens During Audits of Their Tax Returns
paragraphs: Madam Chairman and Members of the Subcommittee: We are pleased to be here today to assist the Subcommittee in its inquiry into the rights of taxpayers and their treatment during audits of their tax returns by the Internal Revenue Service (IRS). Recently, taxpayers, tax professionals, and Congress have expressed concerns about how IRS treats taxpayers during audits and whether audits are overly burdensome. You asked us to discuss IRS’ data on taxpayer complaints and the burden imposed on taxpayers as well as IRS’ indicators for measuring audit performance. You also asked us to discuss our ongoing work for the Chairman of the House Committee on Ways and Means on IRS’ use of a particular audit technique—reviews of taxpayers’ financial status (i.e., their flow of income and expenses)—and IRS’ methodology for selecting tax returns for audit.
Today, I would like to make four points taken from this ongoing work as well as from previous reports and testimonies. • First, IRS has limited data on both the treatment of taxpayers and the burdens imposed on them during audits. IRS recently created a system to track taxpayers’ complaints about improper treatment but IRS does not solicit input on all improper treatment. Similarly, IRS has no comprehensive definition of, and little data on, the burden its audits impose on taxpayers. IRS has recently developed a survey that will ask individual taxpayers about their satisfaction with various parts of the audit process but results will not be available until 1998. While recognizing the difficulties in collecting data from taxpayers about treatment and burden, we believe that this survey may have the potential to provide better information than presently exists. • Second, IRS’ Examination Division has various indicators and standards on audit performance. One measure IRS uses for audit performance is how much additional tax is recommended. IRS does not have a corresponding measure on how much of the recommended tax is ultimately collected after taxpayer appeals. Without an indicator to balance taxes recommended against those collected, IRS auditors could have an incentive to recommend taxes that would be unlikely to withstand a taxpayer challenge. IRS has nine audit standards. The standards focus on the efficient use of auditors’ time and not on when they should use particular audit techniques. To ensure adherence to the standards, IRS relies on oversight by the auditors’ managers. However, their workload limits their time for doing oversight.
• Third, our work on one set of audit techniques—those used in analyzing taxpayers’ financial status to identify any unreported income—provided several interesting statistics. We estimated that IRS auditors used these techniques in less than a quarter of the audits completed in the time periods covered by our review. When used, financial status techniques were always part of an audit that included other techniques or methodologies. In about one-quarter of the audits in which financial status techniques were used, IRS did not have to contact the taxpayer to obtain information on the taxpayer’s financial status beyond what was reported on the tax return. We also found that the use of financial status techniques has not increased in recent years. Regarding revenue impact, we found that in about 16 percent of the cases where they were used, these techniques did help to identify significant amounts of unreported income—$10,000 or more. However, of the total audits in which these techniques were used, in over three-quarters no changes resulting from the use of these techniques were made to the income reported, although most of the audits resulted in some tax change for other reasons. Data are not available to permit either us or IRS to determine the additional burden imposed on taxpayers from the use of financial status techniques in audits. • Fourth, IRS is concerned that its ability to target the potentially most noncompliant taxpayers for audits is deteriorating. IRS’ concern arises because it has not been able to rely on its past approach for developing statistically valid research data that allowed IRS to create and periodically update formulas to target the returns with the most potential for noncompliance. IRS last collected these data through audits of a random sample of taxpayers for tax year 1988. IRS subsequently abandoned that approach due to concerns about its costs and to concerns from the public and Congress about the taxpayer burden involved with those audits. For context, we note that from the 1960s, when IRS first created its research-based audit formulas until it stopped gathering that research data after 1988, it had reduced the rate to which its audits made no recommended tax change from more than 40 percent to around 10 to 15 percent, depending on the type of return and the year of the audit.
I would like to discuss each of these points in more detail after providing an overview on why IRS audits tax returns and how IRS is supposed to do the audits.
subsections: section_title: Overview of IRS Audits of Tax Returns
paragraphs: based on self-assessment, IRS also does audits to induce taxpayer compliance and promote public confidence in the tax system.
The income tax gap—the difference between taxes owed and taxes paid voluntarily and on time—is one reason why IRS seeks to provide an audit presence. Under IRS’ most recent estimate, the 1992 income tax gap for individuals exceeds $90 billion, of which about two-thirds can be attributed to individuals not reporting income on their tax returns.
In recent years, IRS has been auditing about one to two percent of the 100-million plus income tax returns filed annually by individual taxpayers. IRS’ policies and procedures are generally directed at selecting returns that appear to be most noncompliant. After selecting the returns, IRS audits them either (1) through 1 of its 33 district offices by meeting with taxpayers or their representatives or (2) through 1 of its 10 service centers by corresponding with the taxpayers. Since fiscal year 1992, these audits have been recommending between $5 billion to $8 billion in additional taxes each year. Appendix I of my statement summarizes selected audit statistics since fiscal year 1992.
IRS auditors are instructed to not only verify the eligibility and amounts for various types of tax deductions, credits, and exemptions, but to also look for any indications of unreported income. If auditors find such indications, they are to exercise their judgment in deciding whether to do further probes in an effort to determine whether the taxpayer underreported income.
To guide auditors, IRS manuals and publications have identified the rights of taxpayers during audits and the manner in which auditors should treat taxpayers. For example, IRS documents say that taxpayers have the right, among others, to know why IRS is asking for information about the tax return and to authorize another person to represent them during the audit. Through its documents and training programs, IRS instructs its audit staff to explain these rights to the audited taxpayer and to protect those rights. In addition, audit staff are instructed to protect taxpayers’ privacy as well as treat them with professionalism and courtesy.
section_title: IRS Data on Audit Burden and Taxpayer Complaints About Treatment
paragraphs: Recently, taxpayers, tax professionals, and Congress have criticized IRS for treating taxpayers improperly and imposing unnecessary burdens during audits. At a general level, these criticisms have asserted that auditors lacked sufficient experience, training, motivation, or competence. Specific criticisms have focused on a range of asserted IRS behaviors, including: • subjecting compliant taxpayers to unnecessary audits, resulting in no change to the tax liability reported on the tax returns; • wasting taxpayers’ time during the audit by asking for irrelevant documentation or by delving into issues that are minor or personal; and treating taxpayers unprofessionally or abusively, regardless of whether they underpaid their taxes, by lying, making threats, applying pressure, and the like.
IRS has limited data for use in responding to such assertions. With respect to unprofessional or improper treatment, in 1994 and 1996, we reported that IRS lacked comprehensive data on the nature and magnitude of the complaints as well as their resolutions. Nor did IRS have clear definitions that allowed it to determine whether these complaints indicated auditor behaviors that were “abusive” or “unnecessary.”
Since our 1996 report, IRS has developed a definition and tracking system for complaints about improper treatment. IRS defines a complaint as an allegation by taxpayers or their representatives that an IRS employee violated the law, regulation, or IRS rules of conduct or used inappropriate behavior (e.g., rude, overzealous, discriminatory, intimidating) or that an IRS system failed to function properly or within the prescribed time frame.
IRS’ complaint tracking system does not systematically solicit input from taxpayers on their treatment during audits; rather, it records only those complaints initiated by taxpayers. As a result, neither we nor IRS have representative data on the extent to which auditors treat taxpayers improperly across the roughly 2 million audits.
action or through the employee leaving IRS; for the remaining three-quarters of the complaints, IRS concluded that the employee’s behavior was appropriate or that information provided by the taxpayer was not complete enough to take disciplinary action against the employee.
With respect to taxpayer burden, IRS has limited data on the burden—whether necessary or not—imposed by audits. For example, in fiscal year 1996, IRS tax auditors made no changes to 14 percent of the individual tax returns. However, IRS does not know the amount of burden imposed by these or other audits.
Data on burden can be difficult to collect for various reasons. Neither IRS nor its stakeholders have clear definitions or agreement on what constitutes audit burden as well as unnecessary burden. Further, our work has shown that taxpayers do not keep records on the amount of audit burden in terms of time or money.
IRS has recently developed a survey that will ask individual taxpayers about their satisfaction with the audit process. Results will not be available until 1998. Recognizing the difficulties in collecting data about treatment and burden, we believe that this survey may begin to provide better information about taxpayer treatment and burden but its usefulness will need to be evaluated.
section_title: IRS’ Indicators to Measure the Impacts of Audits
paragraphs: IRS has established some indicators for measuring its audit performance. However, existing indicators primarily focus on interim results without also considering final results from the audits. Similarly, IRS has established nine audit standards to guide its auditors. However, the standards do not provide objective criteria on when to use particular audit techniques.
withstand a taxpayer challenge. While we recognize the complexity of the Internal Revenue Code and the difficulties faced by both IRS and the taxpayer in determining the “correct tax,” the fact remains that audit recommendations that do not withstand such a challenge may have imposed an unnecessary burden on the taxpayer. For this reason, in our previous work, we supported the need to measure taxes recommended but advocated balancing that indicator with others such as taxes ultimately collected.
Our work also pointed out that developing an indicator of taxes ultimately collected from audits would be challenging. For example, the time lag between an audit and the ultimate tax collected makes linking the two problematic. IRS is working on developing a way of determining the ultimate taxes collected.
In addition to indicators of audit performance, IRS also has nine audit standards to provide guidance to auditors on minimizing the time spent on an audit, checking large and unusual claims on tax returns, probing for unreported income, and preparing adequate audit workpapers (see app. III for all nine standards). These nine standards do not address the proper treatment of taxpayers. Further, although the standards provide guidance on the proper depth and breadth of audits given the time available, they provide little objective guidance to auditors on when to use particular audit techniques such as those related to an analysis of a taxpayer’s financial status.
To ensure adherence to the standards, IRS relies on managers’ oversight of auditors. However, according to IRS officials, these managers cannot review all audits because their workloads limit the time available for review. As audits close throughout the year, separate groups of IRS staff supplement the managerial review process by reviewing a small sample of audits to measure adherence to the nine standards (see appendix III for measurement results in fiscal years 1992 through 1996).
section_title: IRS’ Use of Financial Status Techniques
paragraphs: and 1995-96, we found that IRS relied primarily on two financial status techniques:1)Cash transaction analysis (or cash-T), in which the auditor uses the tax return and other sources to ensure that adequate income has been reported on the return to cover expenses. In deciding to use this technique, auditors may first do a preliminary cash-T. It differs from the regular cash-T in that the auditor does it before meeting with taxpayers, relying on information reported on tax returns. 2)Bank deposit analysis, in which the auditor verifies that the taxpayer’s bank deposits are consistent with the income reported on the tax return.
To do our work, we randomly sampled from the universe of audits closed in IRS districts in which IRS scheduled meetings with taxpayers to review their records. These samples covered 1992-93 and 1995-96 and were both projectable to universes of about a half million audits.
On the basis of our analysis of these two samples, we estimate that the use of financial status techniques had not increased over the time frames we reviewed—the techniques were used in about one-quarter of the audits in each of our two universes. Financial status techniques were never used alone; they were always part of audits that included other audit techniques to explore issues other than unreported income, such as overstated deductions.
These techniques imposed no or little additional burden on taxpayers in some of the audits where they were used. For example, IRS auditors used just the preliminary cash-T in 23 percent of the 1995-96 audits that used financial status techniques. The preliminary cash-T technique imposes no additional burden on the taxpayer because the auditor relies on the information on the tax return and does not have to contact the taxpayer to obtain additional information or explanations to complete this technique.
techniques, even though IRS did find noncompliance in most of these audits through other techniques.
While neither we nor IRS know the actual burden imposed on taxpayers, our review of IRS’ workpapers illustrated some conditions under which use of certain techniques may impose additional burdens. For example, a bank deposit analysis can be very burdensome if the auditor asks for records on many bank accounts and asks many questions about the deposits in those accounts. A regular cash-T may or may not be very burdensome, depending on the number of contacts with taxpayers to request information and the amount of information requested.
section_title: Barriers to Selecting the Most Noncompliant Tax Returns for Audit
paragraphs: As discussed in previous reports, IRS is concerned about its ability to objectively select tax returns so that it focuses on the most noncompliant taxpayers. IRS’ concerns arise because it has not been able to rely on its past approach for developing statistically valid research data that allowed IRS to create and periodically update formulas to target the returns with the most potential for noncompliance. IRS refers to these as discriminant function (DIF) formulas, which have served as the major method for selecting returns for audit. IRS fears that its DIF formulas have become imprecise because the formulas use outdated statistical data.
In past years, IRS collected the statistically valid research data under its Taxpayer Compliance Measurement Program (TCMP). TCMP involved full-scale audits of a random sample of tax returns—usually for about 50,000 individual taxpayers every 3 years. In 1995, IRS abandoned this approach due to concerns about its costs and to concerns from the public and Congress about the taxpayer burden involved with those audits. As a result, IRS’ last TCMP covered tax year 1988.
its DIF formulas but also to support most of its compliance programs. Accordingly, we recommended that IRS develop a cost-effective, long-term strategy to ensure the continued availability of such compliance data.
Since IRS started to use DIF in the 1960s to better target its audits through fiscal year 1996, IRS has reduced the rate at which its auditors made no tax changes from more than 40 percent of the audited returns to around 10 to 15 percent, depending on the type of return and the year of the audit. IRS is concerned that as time passes, DIF’s precision in identifying noncompliant returns may decrease unless IRS updates the formulas with valid data, and that as a result, more and more compliant taxpayers will be unnecessarily burdened with an audit. We are now designing a study of this issue at the request of the Chairman of the House Committee on Ways and Means.
Madam Chairman, this concludes my testimony. I would be pleased to answer any questions you or other members of the Subcommittee may have.