Partnerships and S Corporations: IRS Needs to Improve Information to Address Tax Noncompliance
Published: 2014-05-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since 1980, partnerships' and S corporations' share of business receipts increased greatly. These entities generally do not pay income taxes. Instead, income or losses (hundreds of billions of dollars annually) flow through to partners and shareholders to include on their income tax returns. GAO has previously reported that the misreporting of income by partners and shareholders poses a tax compliance risk.
GAO was asked to assess IRS's efforts to ensure compliance by partnerships and S corporations. This report (1) describes what is known about misreporting of flow-through income, (2) assesses how much misreporting IRS identifies, and (3) analyzes possible improvements in IRS's use of data to better identify partnerships and S corporations to consider examining. Comparing partnership, S corporation, and other entities' examination results, GAO analyzed 2003-2012 IRS data and evaluated possible improvement ideas stemming, in part, from prior GAO work, for how IRS identifies examination workload.
section_title: What GAO Found
paragraphs: The full extent of partnership and S corporation income misreporting is unknown. The Internal Revenue Service's (IRS) last study of S corporations, using 2003-2004 data, estimated that these entities annually misreported about 15 percent (an average of $55 billion for 2003 and 2004) of their income. IRS does not have a similar study for partnerships. Using IRS data and the study results, GAO derived a rough-order-of-magnitude estimate of $91 billion per year of partnership and S corporation income being misreported by individuals for 2006 through 2009.
IRS examinations and automated document matching have not been effective at finding most of the estimated misreported income. For example, IRS reported that examinations identified about $16 billion per year of misreporting in 2011 and 2012, the bulk of which related to partnerships. However, such information about compliance results is not reliable. IRS estimated that 3 to 22 percent of the misreporting by partnerships was double counted due to some partnership income being allocated to other partnerships or related parties. Further, IRS does not know how income misreporting by partnerships affects taxes paid by partners. IRS does not have a strategy to improve the information. As a result, IRS does not have reliable information about its compliance results to fully inform decisions about allocating examination resources across different types of businesses.
IRS's processes for selecting returns to examine could be improved. Not all partnership and S corporation line items from paper returns are digitized, and IRS officials said that having more return information available electronically might improve examination selection. In 2011, about 65 percent of partnerships and S corporations electronically filed (e-filed). Certain large partnerships and S corporations are required by statute to e-file. Expanding the mandate would increase digitized data available for examination selection. Further, in 1995 GAO found that IRS's computer scoring system for selecting partnership returns to examine used outdated information. IRS does not have a strategy to update and use this information to select partnerships for examination. Relatively few partnerships are examined compared to other business entities, and many examinations result in no change in taxes owed. Improved examination selection based on more current information could generate more revenue and reduce IRS examinations of compliant taxpayers.
section_title: What GAO Recommends
paragraphs: GAO suggests that Congress consider requiring more partnerships and corporations to e-file their tax returns. GAO recommends, among other things, that IRS (1) develop a strategy to improve its information on the extent and nature of partnership misreporting, and (2) use the information to potentially improve how it selects partnership returns to examine. IRS stated it would consider all the recommendations and identify appropriate actions.

section_title: Letter
paragraphs: Over the past few decades, partnerships and S corporations have  accounted for an increasing share of business activity in the United  States. For example, from tax year 1980 to tax year 2008, these two  types of business entities’ share of all business receipts increased from  about 7 percent to about 34 percent.
Partnerships and S corporations are flow-through entities, which are  entities that generally do not pay taxes themselves on income, but  instead, pass income or losses to their partners and shareholders, who  must include that income or loss on their income tax returns.  Each year,  partnerships and S corporations allocate hundreds of billions of dollars of  income to their partners and shareholders. Individuals, corporations, tax- exempt organizations, and other flow-through entities can be partners or  shareholders and can receive allocations of flow-through income.
Partnership and S corporation income may be misreported to the Internal  Revenue Service (IRS) by both the partnerships and S corporations  themselves, and the taxpayers to whom they allocate income. For  instance, in 2007, GAO reported that the tax gap—the difference between  taxes owed and taxes paid on time—for income reported by individuals  from partnerships, S corporations, estates, and trusts was $22 billion for  2001. Income from partnerships and S corporations was the primary  driver for noncompliance for this area.to examine for possible misreporting depend on data from both of these  groups’ returns. Resource limitations and interest in minimizing taxpayer  burden prevent IRS from examining anything but a small fraction of the  total number of tax returns—including from partnerships and S  corporations—filed for a given tax year.
IRS’s efforts to identify tax returns  One challenge that IRS faces in ensuring that flow-through entities  comply with tax reporting requirements is that these entities can be linked  together in multitiered networks. For example, a partnership could be a  partner in another partnership. In multitiered networks, flow-through  entities receive allocations from other flow-through entities, and may pass  the allocations through to still other flow-through entities on their way to  taxpayers. While there are legitimate reasons for businesses to set up  networks, such as isolating one part of a business from liability for the  losses of another part, networks can also be used to evade taxes and  make misreporting difficult for IRS to identify.
You asked us to assess IRS’s efforts to ensure compliance in reporting of  partnership and S corporation income by individual taxpayers and by the  entities themselves. The objectives of this report are to (1) describe what  is known about the extent of income misreporting by partnerships and S  corporations, and by the individuals to whom these entities allocate that  income; (2) assess how much misreported partnership and S corporation  income IRS identifies and assesses taxes on; and (3) analyze how IRS  could improve its use of data to better identify partnerships and S  corporations to consider for examination.
For the first two objectives, we collected and analyzed the latest available  data from various IRS databases, which ranged from 2003 to 2012. Using  these data, we reviewed IRS estimates of entity-level misreporting,  estimated individuals’ misreporting of income allocated by partnerships  and S corporations, analyzed IRS’s examination findings related to that  income, and reviewed the amount of additional taxes that were assessed  as a result of IRS’s matching of individuals’ tax returns against Schedule  K-1 information reporting related to those returns, the only returns against  which IRS routinely matched K-1s. We also analyzed data that IRS  provided on the extent and nature of tiering of partnerships and S  corporations.
For the third objective, we reviewed various IRS documents and  interviewed IRS officials to determine how IRS identifies partnership and  S corporation returns for later classification and examination. In addition,  we identified different approaches for improving how IRS identifies  potentially noncompliant returns for eventual examination based on our  audit findings as well as our past recommendations and  recommendations made by the Treasury Inspector General for Tax  Administration (TIGTA), and evaluated the approaches’ costs and  benefits. more noncompliance, make examinations more efficient, reduce taxpayer  burden, or meet other IRS needs. For specific approaches, we evaluated  whether they might reduce how often IRS examinations resulted in no  changes to tax returns or how electronic filing (e-filing) rates for  partnerships and S corporations compared to other e-filing rates.
GAO, Tax Administration: IRS’ Partnership Compliance Activities Could Be Improved,  GAO/GGD-95-151 (Washington, D.C.: June 16, 1995); TIGTA, Despite Some Favorable  Partnership Audit Trends, the Number of No-Change Audits Is a Concern, 2012-30-60  (Washington, D.C.: June 20, 2012); The Recommended Adjustments from S Corporation  Audits Are Substantial, but the Number of No-Change Audits Is a Concern, 2012-30-62  (Washington, D.C.: June 21, 2012). consistency with published IRS data, and interviews with IRS officials. We  found the IRS databases we used to be reliable for the purposes of this  report. All percentage estimates derived from samples used in this report  have 95-percent confidence intervals that are within plus or minus 10  percentage points of the estimates themselves, unless otherwise  specified. All other estimates in this report have 95-percent confidence  intervals that are within plus or minus 10 percent of the estimates  themselves, unless otherwise specified. Appendix I contains additional  details about our scope and methodology.
We conducted this performance audit from January 2013 through May  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Partnerships group two or more individuals or entities—such as  corporations or other partnerships—to carry on a business. Individuals,  corporations, trusts, estates, tax-exempt entities, and other partnerships  may all be partners. S corporations may have between 1 and 100  shareholders. Individuals, certain trusts, estates, and certain tax-exempt  entities may be S corporation shareholders. Partnerships and S  corporations must file tax returns (IRS Forms 1065 and 1120-S,  respectively).
Partnerships and S corporations differ from C corporations—which are  covered by subchapter C of the Internal Revenue Code and include  nearly all publicly traded corporations—in that C corporations pay  corporate income tax on their profits. Partnerships and S corporations do  not directly pay taxes on the net income reported on Forms 1065 or 1120- S. Instead, they pass profits to partners and shareholders, respectively,  who pay any applicable taxes.
In recent decades, partnership and S corporation activity has represented  a growing share of business activity, while the share of C corporation  activity has declined, as measured by gross business receipts, the  revenue that a business receives from its trade or operations before  subtracting expenses and deductions. As a result, a larger share of  business activity is now subject to taxation at the individual, rather than  the corporate level, than in the past. According to IRS statistics compiled  for tax year 1980 through tax year 2008, the percentage of business  receipts taken in by partnerships and S corporations grew from about 7  percent to about 34 percent, as shown in figure 1.
There were about 4 million S corporations and 3 million partnerships in  the United States in tax year 2008. However, the bulk of flow-through  business activity was concentrated in a smaller number of entities. In the  case of partnerships, 95 percent of business receipts in tax year 2008  went to the 260,000 partnerships with receipts of $1 million or more (see  figure 2).
Partnerships and S corporations are required to send each of their  partners and shareholders a Schedule K-1 that reports how much income  or loss they allocated to that partner or shareholder in the past year, and  to send a copy to IRS. Individuals and business entities to which  partnerships and S corporations allocated income are required to report  that income on their income tax returns.
IRS has multiple compliance assurance processes. Two important ones  for detecting misreporting of partnership and S corporation income are  examinations (commonly known as audits) and K-1 matching.
subsections: section_title: Overview of Examinations and Examination Workload Identification
paragraphs: Examinations are IRS reviews of an entity’s or individual’s books and  records conducted to verify what is reported on a tax return. They can be  labor intensive and time consuming for IRS, but can detect complicated  forms of noncompliance.
IRS may examine a flow-through entity, the partners or shareholders  (such as individuals) who are allocated income from the flow-through,  or—if the entity is part of tiered structure of related entities—IRS may  examine the entire tiered network.
The examination process generally occurs in three steps. Typically, it  starts with return selection—a largely automated process that selects tax  returns for further review if they appear to be at risk for noncompliance. In  the next step—classification—trained staff look at the selected tax returns  and determine whether they warrant an examination, what issues should  be examined, and how the examination should be conducted. In the final  step—examination—a more detailed review of the return and other  relevant information IRS possesses, such as information returns (for  example, K-1s), is conducted. The examination generally includes contact  with the taxpayer and a review of the taxpayer’s books and records. It  ends with a decision about whether to recommend no change, a refund,  or additional tax assessment.
section_title: Overview of K-1 Matching
paragraphs: K-1 matching is a function of IRS’s Automated Underreporter (AUR)  program (see figure 3 for a description of the AUR process). AUR  matches the information returns that IRS receives about a taxpayer with  income reported on that taxpayer’s Form 1040. Information returns are  documents, such as W-2s (used to report wages) and K-1s, that third  parties provide to taxpayers and IRS about taxpayers’ income. K-1  matching aims to detect mismatches between each taxpayer’s Form 1040  and K-1s, allowing IRS to detect taxpayers who misreport income from  partnerships and S corporations. Because taxpayers know that IRS  receives a copy of each K-1, matching encourages voluntary compliance   K-1 matching of individual returns is not designed  at the taxpayer level.to detect misreporting about business operations at the flow-through  entity level. Additionally, it does not match partnership and S corporation  returns with the K-1s they receive from other flow-through entities.
section_title: Due to Undetected Misreporting, Incomplete Compliance Data, and Double Counting of Income within Networks, the Full Extent of Partnership and S Corporation Income Misreporting Is Unknown
paragraphs: There is substantial uncertainty surrounding the extent of income  misreporting by partnerships and S corporations themselves, and by the  individual taxpayers to whom the income is allocated.
subsections: section_title: Partnerships and S Corporations
paragraphs: IRS has estimated misreporting by S corporations but not by  partnerships. In IRS’s most recent study of S corporation misreporting— covering tax years 2003 and 2004—IRS conducted detailed examinations  of a sample of S corporation tax returns. However, such a study  inevitably cannot detect all misreporting. IRS analysis of the study did not  include an adjustment for income that examiners were unable to detect,  so the true amount of misreporting by S corporations may have been  significantly larger than IRS reported, according to a preliminary report by  an official from IRS’s Office of Research, Analysis, and Statistics.
For  those two years, using a weighted average, IRS estimated that S  corporations misreported about $55 billion per year in net income.
Because IRS has not conducted a similar study of partnerships since  1988, and does not have plans to conduct one, it does not have a similar  estimate for partnerships. Moreover, estimating total partnership income  or loss and the misreported amounts of income and loss is complicated  by the fact that substantial portions of those amounts get double counted  as they pass from one partnership to another. 2011, partnerships reported a total of $1,468 billion of income and $507  billion in losses. About 31 percent of this income and 36 percent of the  losses were allocated to other partnerships before ultimately being  passed on to another party, resulting in double counting of this income  and losses. Partnerships may also allocate income to others, including S  corporations, estates, and trusts, which would complicate correcting for  double counting. About 31 percent of partnerships were part of multitiered  networks in tax year 2011, as shown in figure 4. See appendix II for  more information on tiering of flow-through networks.
Throughout this report, we use the term double counted to refer to items that are  counted two or more times (not necessarily exactly two times).
A simple network is a network that includes a flow-through entity that does not receive allocations  from another flow-through entity nor allocate income to another flow-through entity. A multitiered  network includes at least one flow-through entity that allocates income to another flow-through entity.
Because the database containing the data this figure is based on has incomplete data, the extent of  tiering presented in this figure represents a minimum amount, and counts are approximate.
Numbers do not sum to total, and dividing entity counts by totals do not match up with percentages,  due to rounding.
Without a strategy for better estimating the extent and nature of  partnership misreporting, IRS cannot make fully informed decisions on  how to allocate resources across enforcement programs and across  different types of business entities and taxpayers. IRS’s strategic plan for  2009-2013 calls for IRS to develop improved research-driven methods  and tools to detect and combat noncompliance and improve resource  allocation. As we discussed in a 2012 report, optimizing resource  allocation has the potential to bring in substantially more enforcement  revenue.
section_title: Individual Taxpayers
paragraphs: IRS’s compliance research studies have produced data on flow-through  income misreporting by individual taxpayers. Using this information, and  considering various caveats and uncertainties, we estimated a rough  order of magnitude of the misreporting to be $91 billion per year for tax  years 2006 through 2009.
This estimate does not cover all flow-through income. Only some types of  income—ordinary business income, rental income, and guaranteed  payments—can be included in an estimate of income that individuals  misreported from partnerships and S corporations.  These items are  reported on a section of the individual tax return specific to income from  partnerships and S corporations. Some other types of income individuals  receive via partnerships and S corporations, including interest, dividends,  and royalties, cannot be estimated based on available data because they  are combined with the same types of income from nonflow-through  sources on another part of the individual tax return.
Additionally, there is uncertainty surrounding any estimate of how much  income individual taxpayers misreported due to presumed misreporting  that IRS research examiners are inevitably unable to detect. IRS  assumes that such misreporting exists and adjusts its estimates to  account for it when it does its compliance studies on individual taxpayers.  For individual taxpayers, an estimate of the rate of partnerships’ and S  corporations’ misreporting of their own income can be incorporated into  the adjustment, since errors at the entity level would generally be passed  through to individual taxpayers. The individual misreporting rate would be  expected to be at least as high as the misreporting rate for the entities  that are allocating income to them. However, as mentioned above, IRS’s  most recent estimate of S corporation misreporting is itself uncertain, and  IRS does not have a similar estimate for partnerships.
With these caveats in mind, we estimated, based on IRS research  examination data, that in tax years 2006 through 2009, the annual  average income that individual taxpayers were allocated from  partnerships and S corporations was $517 billion, and annual average  losses were $94 billion, for a net of $423 billion. Of this $423 billion, we  estimated that individual taxpayers misreported about $91 billion per year  (this amount includes understated income plus overstated losses, less  overstated income and understated losses). These taxpayers paid their  taxes based on the misreported amounts, and we estimated that the $91  billion corresponded to about $19 billion per year in lost tax revenue. This  $91 billion likely includes some of the $55 billion of misreporting by S  corporations, but IRS is unable to calculate how much. Given all of the  uncertainty involved, these estimates should both be considered rough  orders of magnitude. See appendix III for details on our estimation  methodology and more information on factors contributing to uncertainty,  as well as a comparison of individual taxpayers’ misreporting of income  from partnerships and S corporations with misreporting of other types of  income.
section_title: IRS Identified a Relatively Small Percentage of Estimated Misreported Income through Examinations and K-1 Matching and Lacks Reliable Information on Examination Results
subsections: section_title: Examinations
paragraphs: IRS examinations have not been effective at finding most of the  misreported income discussed above. According to information that IRS  collected for revenue agent examinations closed in fiscal years 2011 and  2012, IRS proposed increasing the total income reported by partnerships  and S corporations by an annual average of about $16.3 billion.
Additionally, for just partnerships, which accounted for the bulk of  proposed partnership and S corporation adjustments, IRS estimated that  from 3 percent to 22 percent of the proposed adjustments were double  counted in the $16.3 billion total. An unknown amount of IRS’s proposed  adjustments to entity-level income included adjustments flowing through  multiple tiers of flow-through entities or showing up in related returns,  resulting in double counting. Thus, the true amount of unique adjustments  might be smaller than IRS’s records seem to show.
Adjustments at the entity level can generally only result in increased taxes  to the extent that adjustments and assessments are subsequently made  at the partner or shareholder level. IRS officials said that because of  computer systems limitations, they did not have an estimate of the extent  to which proposed adjustments to income at the entity level increased  actual taxes collected at the partner or shareholder level. Because IRS  does not know how much of what it proposes in adjustments for  partnerships relates to non-duplicate income, nor to what extent those  adjustments result in increased taxes collected, it cannot know its return  on investment for partnership examinations. IRS’s examination rate for  partnerships is much lower than the rate for C corporations and for sole  proprietorships. Without a strategy for estimating the effectiveness of  partnership examinations, IRS cannot know whether the differences in  examination rates across different types of business entities are justified,  i.e., whether it is optimally allocating its enforcement resources across its  enforcement programs. As mentioned above, IRS’s strategic plan calls for  IRS to develop improved research-driven methods and tools to detect and  combat noncompliance and improve resource allocation, and optimizing  resource allocation has the potential to bring in substantially more  enforcement revenue. However, identifying the taxes collected that result  from proposed adjustments at the partnership level would require IRS to  upgrade its computer systems, which would require funding.
As the data in table 1 indicate, partnerships differ significantly in terms of  the types of income that they earn through their own activities or receive  from other partnerships, estates, or trusts. These differing characteristics  may indicate that separate enforcement approaches, focusing on different  compliance issues, are appropriate for each subpopulation. One  significant distinction among partnerships is whether they generate  ordinary business income of their own. More than 40 percent of  partnerships have no ordinary business income or loss, and about 20  percent of the ordinary business income and losses that partnerships  report is simply passed on from other partnerships. A large portion of  partnership income other than ordinary business income is portfolio  income. Partnerships can receive interest, dividend, or royalty payments  directly from the original issuers of these payments, or they can receive  them as pass-through amounts from other partnerships. Rental income  (primarily from real estate) is another important type of income.
IRS examination program monitoring tabulations currently do not track  examination rates, no-change rates, or enforcement revenue to cost  ratios for partnership subpopulations, defined in terms of the types of  income they earn. Consequently, we do not know whether these  measures differ significantly across the various groups. Without a strategy  for better estimating the extent and nature of misreporting by different  subpopulations of partnerships, and the effectiveness of partnership  examinations in detecting misreporting by different subpopulations of  partnerships, IRS cannot enhance its case selection processes to focus  its enforcement tools on activities that pose the highest risk of  noncompliance, as is called for in its strategic plan.
For IRS to make informed decisions in expanding its flow-through income  compliance initiatives, it would have to resolve what it considers to be  high-priority problems with the accuracy, completeness, and timeliness of  K-1 data. In July 2013, an IRS data issues team found that these issues  included K-1s that were at times missing, unable to be matched to  partnership returns or validated, unavailable for months, subject to  misreporting by recipients, and only partially allocating partnership  income. The IRS team believed the problems hurt IRS’s ability to identify  partner, partnership, and network compliance issues and use risk  assessment tools to evaluate them.
To resolve these K-1 data issues, IRS staff presented to IRS  management 15 short- and long-term potential solutions, most of which  IRS is waiting to address because of funding considerations. The  solutions included what IRS considered to be critical fixes needed in 2 to  3 years, but IRS needed more analysis to identify and address  partnership return data issues. Without approving other solutions,  management approved costing out three 1-to-2-year fixes, including  testing K-1 data programming errors and checking that the data were  correctly processed. Once the costing out was completed, management  expected to decide whether to fund these three fixes, although it did not  provide us a date for making that decision. It had approved nothing else.
For individual taxpayers, in examinations closed in fiscal years 2011 and  2012, IRS proposed adjusting the total income allocated to the individuals  from partnerships and S corporations by an annual average of about $2.9  billion. We calculated this amount based on data from IRS’s  Examination Operational Automation Database on examinations of  taxpayers’ returns. Only some types of income from partnerships and S  corporations—such as ordinary business income and rental income— could be included in this amount. Other types, including interest,  dividends, and royalties, could not be included because as noted earlier,  they are combined with the same types of income from nonflow-through  sources on individual taxpayers’ returns. Based on an estimated tax rate  range of 15 percent to 35 percent, the adjustments to income would have  corresponded to between $450 million and $1 billion in taxes assessed.
Some of these $2.9 billion in adjustments potentially would have been  made due to the $16 billion in adjustments at the partnership and S  corporation level, but as mentioned above, IRS officials told us that they  could not quantify the extent to which this would have been the case.
section_title: K-1 Matching
paragraphs: As previously noted, IRS matches K-1s to individual tax returns, but IRS  does not routinely match K-1s or other information returns to partnership  and S corporation tax returns. Matching K-1s to partnership and S  corporation tax returns might provide another tool for detecting  noncompliance by these types of entities. IRS’s strategic plan calls for  IRS to develop improved research-driven methods and tools to detect and  combat noncompliance and improve resource allocation, improve  compliance by leveraging third-party reporting information, and streamline  processes to increase the timeliness of enforcement. Rather than waiting  until costing of data fixes is completed for further management  involvement, management could begin planning now for how to use the  improved data. Specifically, IRS could develop a plan for testing, or  otherwise analyzing the data, to, for instance, determine whether  matching at the entity level of some combination of K-1s and other  information returns, could assist in verifying compliance. Matching might  assist directly, by detecting misreported income, or indirectly by helping  identify returns with examination potential. Without such a plan, when the  costing of the data fixes is completed IRS will know the costs but perhaps  not all of the benefits of moving to implement the data fixes.
For individual taxpayers, because of the way IRS tracks tax assessments  through AUR, only a portion of the net assessments that resulted from K-  Specifically, when there are  1 matching can be definitively determined.mismatches for both K-1 income and other types of income, IRS’s AUR  data systems do not separate out the K-1 amounts. With this caveat in  mind, K-1 matching definitively resulted in net tax assessments of $24  million for tax year 2009, the latest year for which complete data were  available. The actual amount could be higher, but is probably a relatively  small portion of the $19 billion of unpaid taxes we estimated individuals  misreported of partnership and S corporation income. The entire AUR  program assessed $8 billion for more than 50 different categories of  income and expenses.
K-1 matching through AUR, as noted above, is not used to detect  misreporting between entities in a tiered network, nor is it designed to  detect ordinary business income misreported on a K-1. As a  consequence, the information on K-1s may match what is on individuals’  1040s, but both documents may understate the true income amount.  More details about K-1 matching are discussed in appendix IV.
section_title: Options for IRS to Improve Identification of Partnerships and S Corporations to Consider Examining Involve Challenges, Some of Which Could Be Mitigated
paragraphs: There are various means through which IRS could improve how it selects  partnership and S corporation tax returns to examine. As we have  concluded previously, improving examination selection could have two  positive impacts: increasing enforcement revenue by better focusing  examinations on noncompliant taxpayers and reducing burden by  reducing unnecessary audits of compliant taxpayers.
IRS must decide how to allocate its enforcement resources based on  limited information. IRS typically examines about 0.4 percent to 0.5  percent of partnership and S corporation returns per year, compared to  about 1.4 percent to about 1.6 percent of C corporations, and 1.5 to 1.9  percent of nonfarm sole proprietorships that did not claim the earned  income tax credit. Figure 5 shows these rates for fiscal year 2012.
The results of partnership and S corporation examinations are difficult to  interpret. On one hand, IRS’s rate for not recommending adjustments to  income or expense items on partnership and S corporation examinations  is relatively high. In fiscal years 2010 through 2012, no-change rates  ranged between 42 percent and 46 percent for partnerships and 34  percent and 39 percent for S corporations. These rates are computed for  the business entity. They do not reflect adjustments at the entity level that  did not result in adjustments to the ultimate partners’ or shareholders’  individual returns. No-change rates for partnerships and S corporations  exceeded those for nonfarm sole proprietorships and C corporations in all  3 fiscal years from 2010 through 2012.
On the other hand, when IRS revenue agents proposed income  adjustments after partnership and S corporation examinations, the dollars  were significant in absolute size, as shown in table 2. As may be  expected given the size of the entities involved, the average proposed  income adjustments for IRS’s Large Business and International (LB&I)  division returns were higher than for its Small Business/Self-Employed  (SB/SE) division returns. However, as was the case with no-change rates,  the proposed adjustments at the entity level do not necessarily show  whether the ultimate partners or shareholders paid any additional tax at  the individual level.
subsections: section_title: More Tax Return Digitization May Improve Workload Identification, but Digitizing All Partnership and S Corporation Return Items Is Not an Immediate IRS Priority
paragraphs: Not all partnership and S corporation line items are digitized. IRS officials  said that having more return information available electronically might  improve examination selection. For instance, when IRS subject matter  experts with examination experience suggested filters for an SB/SE  research project to use to identify potentially noncompliant preparers of  partnership and S corporation returns, the lack of transcription prevented  SB/SE from using all of the filters.
Enhancing digitization of paper-filed partnership and S corporation returns  would involve costs to IRS. In 2010, the direct labor costs and related  overhead to transcribe all then-nontranscribed lines on partnership and S  corporation returns would have exceeded $6 million for SB/SE and LB&I.  This amount did not include significant direct labor costs for other  processing functions such as input correction or quality review or costs to  reprogram submission processing or post-processing systems, according  to IRS officials. Responding to our recommendation from 2011, IRS  considered studying the benefits of transcribing items from many forms to  match against already-calculated costs. However, according to an  official in IRS’s Return Preparer Office in September 2013, it decided  against the study because of resource needs and budget constraints. By  not transcribing more partnership and S corporation line items, IRS might  be forgoing proposed adjustments to income that could result in  increased tax assessments that might offset the cost of added  transcription. However, according to an IRS official, more transcription  might not be IRS’s highest-priority partnership data problem. A higher- priority problem would be the issues described earlier with the accuracy,  completeness, and timeliness of K-1 data. Within that context, IRS  considered improving transcription a critical fix needed in 2 to 3 years. By  that time, about 5 years would have passed since our 2011  recommendation, which we continue to believe has merit, but resource  issues could still exist.
section_title: Increasing Electronic Filing Would Increase Digitization, and the Added Burden on Taxpayers Could Be Mitigated
paragraphs: Increasing electronic filing (e-filing) of partnership and S corporation tax  returns would increase the amount of tax return data that arrive at IRS  already digitized. Increasing the amount of digitized information arriving at  IRS would reduce IRS processing costs and also reduce the cost of  transcribing information from the remaining paper returns. One way to  increase e-filing is for Congress to mandate it.
Currently, partnerships with more than 100 partners are required by law  to e-file. Corporations, including S corporations, must e-file if they have  assets of $10 million or more and file at least 250 returns during a  calendar year. However, under current law, e-filing cannot be required  for partnerships with 100 partners or less or corporations, including S  corporations, unless the entity is required to file at least 250 returns  during a calendar year.
The percentages of partnerships and S corporations that e-file tax returns  have been growing rapidly in recent years, reaching 64 percent and 66  percent, respectively, in tax year 2011, the latest year for which data are  available. IRS has projected rapid continued growth for the next couple of  years and a leveling off after that, meaning that some paper-filed returns  will always be expected. to transcribe more partnership and S corporation line items off the  remaining paper-filed returns, at least in the short term.
However, as noted before, IRS will not be able  Unless all returns are digitized, IRS will not be able to use all return line  items in its examination selection process. Less than full digitization limits  IRS in selecting the most productive returns to examine and increases the  likelihood of it examining compliant taxpayers. As noted above,  transcribing the remaining paper returns is not a priority. Without a low- cost way to digitize paper returns, digitizing them is at risk of remaining an  unfunded critical fix.
For instance, IRS projected that 80 percent of partnerships would e-file in fiscal year  2015 and 86 percent in fiscal year 2020. According to IRS officials, the projections were  based on processing activity. Processing activity refers to everything related to a particular  return that goes through IRS in a given processing year. For instance, if two, three, or four  iterations of a tax return go through IRS, the return is counted two, three, or four times.  Actual e-filing percentages mentioned here count each return only once. requiring e-filing based on the size of a partnership’s or corporation’s  assets, with different asset requirements than now exist.
Any option for an e-filing mandate would impose some burden on tax  return filers. However, the extent of the burden may be small, since about  90 percent of partnerships and S corporations already use a paid  preparer. Additionally, any burden could be mitigated. Waivers allowing  paper filing in hardship and other special cases could eliminate burden for  some tax return filers, and thresholds limiting the requirement to entities  of a certain size (based on number of partners or some other measure)  would eliminate the burden for entities below that size. Also, phase-in  periods could allow time for entities to adjust. When IRS implemented the  preparer e-file mandate for individuals, it found that the number of  hardship waivers was fewer than anticipated, about 2,250 versus the  6,000 that had been expected.
section_title: IRS’s Computer Scoring System for Identifying Partnership Returns to Examine Uses Outdated Formulas, but Upgrading Faces Challenges
paragraphs: SB/SE’s partnership discriminant function (DIF) model to identify entities  to examine was built on data that are now outdated, and does not capture  partnership compliance issues related to tiering. We pointed out in 1995  that because the formulas the model relied on were developed using data  from the 1980s and tax laws and taxpayer behaviors had changed, the  model unreliably indicated partnership compliance. At the time, IRS said  that it was planning to develop new formulas in 1998. However, SB/SE is  still using the same DIF formulas.
Despite the model’s formulas being outdated, indications are mixed on  whether the partnership DIF model needs upgrading or is adequately  identifying a productive workload of potentially noncompliant returns  compared to other workload identification methods. In two 2012 reports,  TIGTA found that no-change rates for partnership and S corporation  returns selected by the DIF model and examined by nontrainee SB/SE  revenue agents greatly exceeded those for other SB/SE partnership and  S corporation returns examined by nontrainees. On the other hand,  when training examinations are included, LB&I, which did not use the DIF  model, often had a higher no-change rate for revenue agent examinations  for partnerships and S corporations than SB/SE, which used the DIF  model. LB&I pointed out that its blend of returns to be examined may  differ from SB/SE’s, skewing the comparison.
According to IRS officials, updating the partnership DIF model could be  complicated, expensive, and time consuming, taking resources from  possibly productive examinations and having an unknown outcome.  However, without determining whether an improved partnership DIF  model should be developed after IRS has better information on  noncompliance and program effectiveness, IRS cannot know whether it is  missing an opportunity to select partnership returns for examination more  effectively. IRS’s strategic plan calls for IRS to develop improved  research-driven methods and tools to improve resource allocation and to  enhance its case-selection processes in order to focus its enforcement  tools on activities that pose the highest risk of noncompliance. IRS  officials told us they have started to look into ways to develop a new  partnership DIF model, but there is no strategy, time frame, or plan for  completing this effort.
section_title: IRS Is Beginning to Follow Up Its Work on Filters to Be Used in Examination
paragraphs: In 1995 we identified filters, that is, flags that detect certain characteristics  of partnerships whose examinations were the most productive for IRS to  examine. In 2012, TIGTA did the same thing for both partnerships and S  corporations.returns related to them, TIGTA found the examinations of real estate or  construction partnerships with two partners and a reported loss were  highly productive in terms of the size of recommended adjustments.  Similar to what we had suggested more than a decade earlier, TIGTA  recommended that, as resources become available, SB/SE analyze  partnership and S corporation data files looking for ways to better identify  productive returns for audit.
For instance, for returns selected by the DIF model and for  In response, in 2013, SB/SE researchers expanded an earlier study of  partnership and S corporation returns to test the efficacy for examination  selection of some new automated filters. They tested the filters on  completed examinations to determine if using the filters could have  resulted in a lower no-change rate. Three of the filters that were tested  showed some promise in terms of reduced no-change rates. The  researchers recommended that the SB/SE examination function use the  promising filters to screen returns that the DIF model selected for  examination and validate that the filters reduce the no-change rate below  historical averages and are operationally feasible. According to SB/SE  officials, they have begun that process.
section_title: Conclusions
paragraphs: Partnerships and S corporations account for billions of dollars of unpaid  taxes and their share of business activity is growing. This underscores the  importance of understanding the effectiveness of IRS’s partnership and S  corporation tax law enforcement efforts.
Currently, IRS examines a small fraction of partnership and S corporation  tax returns. Other forms of businesses, such as C corporations and sole  proprietorships, are examined at rates that are several times higher. IRS  cannot make fully informed decisions about whether this allocation of  enforcement resources is justified because it has limited information  about the extent and nature of income misreporting by partnerships and S  corporations as well as about the effectiveness of its examinations at  detecting such misreporting. This also leaves IRS unable to make a fully  informed, data-based decision about whether or not to update one of its  major partnership examination selection tools, the DIF formula.
We identified two additional opportunities to better use data to improve  compliance by flow-through entities. First, enabling greater digitization of  tax return information would help IRS identify which partnership and S  corporation tax returns would be most productive to examine. In the  absence of funding for transcription, one way to increase digitization is a  statutory mandate requiring increased e-filing of partnership and S  corporation tax returns. Improving IRS’s selection of partnership and S  corporation returns to examine would also benefit compliant taxpayers  whose returns may otherwise be selected for examination. Further,  expanded e-filing would reduce IRS’s tax return processing costs.
Second, IRS may be able to take advantage of its ongoing efforts to  improve the quality of K-1 data to test whether compliance processes  could be improved. Issues with the accuracy and timely availability of K-1  data have been a concern to IRS. Planning now for how to use the  improved data would leave IRS well positioned to analyze options for  improving its partnership and S corporation compliance programs.
section_title: Matter for Congressional Consideration
paragraphs: Congress should consider expanding the mandate for partnerships and  corporations to electronically file their tax returns to cover a greater share  of filed returns.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Commissioner of Internal Revenue take the  following steps:
Develop and implement a strategy to better estimate   (1)  the extent and nature of partnership misreporting, and   (2)  the effectiveness of partnership examinations in detecting this  misreporting.
Use the better information on noncompliance and program  (1)  whether the differences in examination rates across different types  of business entities are justified, and  (2)  whether an improved tool for selecting partnerships for  examination, such as an updated partnership DIF, should be  developed.
While IRS works to improve the quality of its Schedule K-1 data,  develop a plan for conducting testing or other analysis to determine  whether the improved Schedule K-1 data, perhaps combined with  other IRS information about businesses and taxpayers, could be used  more effectively to ensure compliance with the reporting of flow- through income.
section_title: Agency Comments and Our Evaluation
paragraphs: We sent a draft of this report to the Commissioner of Internal Revenue for  comment. We received written comments from IRS’s Deputy  Commissioner for Services and Enforcement on May 6, 2014 (for the full  text of the comments, see appendix V). We also received technical  comments from IRS, which we incorporated into the final report where  appropriate.
In its written comments, IRS said that it had not yet fully evaluated GAO’s  recommendations but expressed concerns regarding actions requiring a  significant expenditure of resources. However, it said it would consider all  of GAO’s recommendations and identify appropriate IRS actions while  keeping resource limitations in mind. It is these very resource  limitations—which we recognize in this report—that underscore the  importance of our recommendations to develop better information for  making decisions on how to allocate existing resources.
As agreed with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from its  issue date. At that time, we will send copies to the Secretary of the  Treasury, the Commissioner of Internal Revenue, and other interested  parties. The report will also be available at no charge on GAO’s website  at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or at whitej@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs are on the last page  of this report. Key contributors to this report are listed in appendix VI.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report are to (1) describe what is known about the  extent of income misreporting by partnerships and S corporations, and by  the individuals to whom these entities allocate that income; (2) assess  how much misreported partnership and S corporation income IRS  identifies and assesses taxes on; and (3) analyze how IRS could improve  its use of data to better identify partnerships and S corporations to  consider for examination.
To describe what is known about the extent of income misreporting by  partnerships and S corporations, we reviewed what IRS’s National  Research Program (NRP) had done at the entity level. For NRP, IRS  selects a random sample of tax returns to examine and strives to verify  information taxpayers and others reported or should have reported. We  reviewed NRP documents and information on the 2003-04 entity-level  study of S corporations, which was IRS’s most recent study of S  corporations. We also interviewed NRP officials about that study and  what information was available about partnerships.
To describe what is known about the extent of income misreporting by  individuals with income from partnerships and S corporations, we  obtained data from NRP for tax years 2006 through 2009, the most recent  years for which data were available. At the individual level, IRS conducts  NRP studies annually. IRS uses the NRP data to estimate the tax gap  and update return selection formulas used in planning examinations.  Using these data, we estimated the amount of individual taxpayers’  misreporting of income and losses from partnerships and S corporations  on their Forms 1040, U.S. Individual Income Tax Return. We adjusted our  raw result based on an IRS estimate of net misreporting percentage. See  appendix III for a discussion of our and IRS’s estimation techniques. For  this analysis, we looked only at partnership and S corporation income that  was separately reported on Schedule E (Form 1040), Supplemental  Income and Loss. Some income from partnerships and S corporations  may also be included within, and reported under, other line items on Form  1040, such as capital gains.
To calculate the amount of taxes that corresponded to our misreporting  estimate, we used NRP data to calculate the income and misreporting  that related to individuals with different effective tax rates (defined as total  tax divided by adjusted gross income). Looking at taxpayers with effective  tax rates between 15 percent and 35 percent, we calculated lower and  upper bounds for the amount of tax that would have been owed on their  misreported income from partnerships and S corporations.
To assess how much misreported partnership and S corporation income  IRS identifies and assesses taxes on, we obtained data from IRS’s Audit  Information Management System (AIMS), Examination Operational  Automation Database (EOAD), and Automated Underreporter (AUR)  program on K-1 matching. From AIMS, we obtained data on IRS  proposed adjustments to partnership and S corporation tax returns for  fiscal years 2011 and 2012, the latest years for which information was  available when we obtained it.
From EOAD, we obtained data on IRS proposed adjustments to individual  tax returns for fiscal years 2011 and 2012, the most recent years for  which complete data were available. With these data, we calculated  proposed adjustments to income and losses from partnerships and S  corporations, to income and losses from estates and trusts, and to short-  and long-term gains and losses from partnerships, S corporations,  estates, and trusts. Based on the proposed adjustments and estimated  tax brackets, we estimated the amount of taxes assessed based on these  examinations.
Using AUR data for tax year 2009, the most recent year for which  complete data were available, we reviewed the minimum amount of taxes  assessed through matching K-1s against individual tax returns, the only  returns against which IRS routinely matched K-1s. The minimum amount  was based on returns for which K-1 discrepancies were the only matching  discrepancies. We also determined the total amount of assessments that  were not attributed to specific types of income, an unknown portion of  which might be due to K-1 matching.
We interviewed officials from IRS’s examination and AUR programs to  determine the reliability of the data and to discuss examination and AUR  operations. For contextual purposes, we analyzed IRS Statistics of  Income (SOI) partnership data for 2011. Specifically, we determined  income, losses, and percentages of income received from other  partnerships, estates, or trusts for partnerships earning different kinds of  income.
To analyze how IRS could improve its use of data to better identify  partnerships and S corporations to consider for examination, we analyzed  examination statistics derived from AIMS. For example, to see whether  IRS’s identification of potential examinations differed across different  kinds of entities, we compared the percentage of partnership and S  corporation returns that IRS examined to the percentage of C corporation  and sole proprietorship returns that it examined. We also compared the  rate at which IRS examinations recommended no adjustments to items  reported on partnership and S corporation returns to no-change rates for  examinations of C corporations and sole proprietorships.
We reviewed IRS guidance and interviewed IRS officials to learn how IRS  identifies partnership and S corporation returns for later classification and  examination and to understand to what extent the process is automated.  From various documents, including GAO and Treasury Inspector General  for Tax Administration (TIGTA) reports and recommendations, and  interviews with IRS and Treasury officials, we evaluated the costs and  benefits of various approaches we encountered that could improve IRS’s  use of data to better identify partnerships and S corporations to consider  for examination and reduce the no-change rate for partnership and S  corporation examinations. We assessed whether the approaches  included steps that IRS was taking or possibly could take to identify more  noncompliance, make examinations more efficient, reduce taxpayer  burden, or meet other IRS needs. More specifically, the approaches  covered the following:  Increasing K-1 and partnership and S corporation return  transcription and other digitization. While considering this  approach, we determined—from IRS transcription guidance and from  interviews with IRS officials—how much of the data filed on paper K- 1s and partnership and S corporation returns are not digitized into IRS  databases. We also determined any resulting ramifications for  workload identification. From IRS documentation and officials, we  determined the details of how IRS plans to fix problems with the  timeliness, completeness, and accuracy of K-1s to better use the  information for workload identification.
Increasing partnership and S corporation return electronic filing.  We reviewed documents and interviewed IRS and Department of the  Treasury officials about e-filing. More specifically, we explored the  status of 2003 TIGTA ideas and subsequent legislative proposals on  mandating more e-filing of partnership returns. As part of this effort,  we reviewed past and projected e-filing rates prepared by IRS’s Office  of Research, Analysis, and Statistics (RAS), including SOI, and  determined how many partnerships and S corporations would be  affected by various enhancements to the e-filing mandate. We also  compared e-filing rates for partnerships and S corporations to other e- filing rates.
Upgrading the computer scoring system for identifying  partnership returns to eventually examine. From various IRS and  other documents and officials, we reviewed the history of IRS’s  computer scoring system, known as the discriminant function, or DIF,  and the challenges to changing the system. We also reviewed TIGTA  reports relating to the system.
Analyzing partnership and S corporation data files to identify  workload. In accordance with 2012 TIGTA and 1995 GAO ideas on  using IRS databases, we obtained documentation regarding IRS  efforts to use partnership and S corporation databases to develop  examination leads and to select returns to examine.
In addition to our main objectives, we also provided the following  information in the appendixes. For appendix II, to describe the extent and  nature of multitiered networks of partnerships and S corporations, we  obtained data from RAS on the tiering characteristics of partnerships and  S corporations. The data related to a particular entity include information  for all owners of at least 0.1 percent of that entity. Using data for tax year  2011, the most recent year for which complete and reliable data were  available in the K-1 database that RAS used, we developed charts  describing the relevant information. We interviewed RAS officials to  determine the reliability of the data.
For appendix III, to compare individual taxpayers’ misreporting of income  from partnerships and S corporations with other income types, we  calculated: net misreporting amounts; the percentage of taxpayers who misreported;  the median amount of misreporting; and  the net misreporting percentage for the following categories of  income: (1) income from partnerships and S corporations, (2) other  business income subcategories reported on Schedule E of Form  1040, and business income categories on Form 1040 itself, with  estimated reported incomes with absolute values greater than $10  billion, and (3) the six nonbusiness income categories with estimated  reported incomes of more than $150 billion reported on Form 1040.
We determined confidence intervals for all our estimates. Although we  adjusted our estimate of misreporting of income from partnerships and S  corporations based on an IRS estimate of net misreporting percentage,  as mentioned above, we presented both the adjusted and unadjusted  estimates in appendix III since we did not make comparable adjustments  for the other income categories. We also compared the results for each  income category with reported IRS determinations of whether the  category was subject to little or no third-party information reporting, some  information reporting, or substantial information reporting that IRS could  match against Form 1040 reporting. We interviewed officials from RAS to  determine the reliability of the NRP data and to discuss the adjustments  that IRS makes to the data to calculate its reported net misreporting  percentage and tax gap estimates.
For appendix IV, we calculated and compared the no-change rates in the  AUR workload for K-1 matching and for all matching. We also attended  and asked questions at a joint Information Reporting Program Advisory  Committee and Internal Revenue Service Advisory Council meeting to  obtain views on K-1 matching from paid tax return preparers and other  relevant stakeholders.
We tested the reliability of NRP, AUR, EOAD, AIMS, and SOI data for  previous GAO engagements, and we supplemented our knowledge  through interviews with IRS officials and through documentation review,  and, where applicable, electronic checks. We also tested these data for  internal consistency, and for consistency with other IRS data when  available. For example, for AIMS data we analyzed, we tested numbers  against information published in TIGTA reports and IRS’s Data Book,  which annually provides information on returns filed, taxes collected,  enforcement, taxpayer assistance, the IRS budget and workforce, and  other selected activities. We also checked that the data extracts we used  from different parts of RAS, including SOI, were consistent with each  other and with information from the IRS Oversight Board. All percentage  estimates derived from samples used in this report have 95-percent  confidence intervals that are within plus or minus 10 percentage points of  the estimates themselves, unless otherwise specified. All other estimates  in this report have 95-percent confidence intervals that are within plus or  minus 10 percent of the estimates themselves, unless otherwise  specified.
We tested the K-1 data that IRS provided for internal consistency and  consistency with published IRS data, verified the programming IRS used  to create tables summarizing the K-1 data, and interviewed the IRS  official who created the tables. Based on IRS documents and interviews  with IRS officials, data in the K-1 database may be incomplete. Some K- 1s may be missing from the database because of problems such as  partnerships and S corporations failing to file K-1s, IRS errors, and timing  problems. However, given IRS’s estimates of the level of incompleteness,  we believe that any inaccuracies would not change percentage results  enough to change the overall conclusions presented in this report. In  general, the amounts of tiering shown represent minimums and entity  counts are approximate because the missing data would add more  entities and linkages to the tables and charts we present.
We found the IRS databases we used to be reliable for the purposes of  this report.
We conducted this performance audit from January 2013 through May  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Multitiered Networks of Partnerships and S Corporations
paragraphs: Many flow-through entities are connected to each other in tiered  networks. As we have reported before, networks of related entities are a  feature of modern business organizations. Many legitimate reasons  explain why business owners may choose to use a network of related  entities to conduct operations. For example, networks can be used to  isolate one line of business from the potential liabilities or risk of business  loss of another, to manage a business’s financing arrangements, or to  separate ventures based in different states and countries. However,  networks can also be used in complex tax evasion schemes that are  difficult for IRS to identify. More complex networks also make businesses  more difficult for IRS to examine. IRS officials said that some businesses  may believe that if their networks are sufficiently complex, they will be  difficult for IRS to examine. Therefore, it is helpful to understand the  extent to which partnerships and S corporations are involved in  multitiered networks, as well as the complexity of such networks. See the  text box for tiering terminology.
Flow-through Entity: An entity for which income is allocated by the  business to its owners, with taxes on that income paid only by the  owners. Taxes generally are not paid by the flow-through entities  themselves. Flow-through entities include partnerships, S  corporations, trusts, and estates.
Ultimate Owner: A final recipient of flow-through income allocations.  Ultimate owners include nonflow-through businesses (e.g., tax-exempt  entities and C corporations) and individuals.
Simple Network: A network that includes a flow-through entity that  does not receive allocations from another flow-through entity or  allocate income to another flow-through entity. It allocates income to  ultimate owners.
Multitiered Network: A network that includes at least one flow- through entity that allocates income to another flow-through entity.
Enterprise: A network of flow-through entities and their owners  whose economic activity is under the control (defined as 50 percent or  more direct or indirect ownership) of a single taxpayer or married  couple.
Top-tier Entity: A flow-through entity that allocates income to another  flow-through entity (and possibly also to ultimate owners) but does not  receive allocations from another flow-through entity.
Middle-tier Entity: A flow-through entity that both receives allocations  from another flow-through entity and allocates income to another flow- through entity (and possibly also to ultimate owners).
Bottom-tier Entity: A flow-through entity that receives allocations  from another flow-through entity, but does not allocate income to  another flow-through entity. It allocates income to ultimate owners.
Many of the above concepts are illustrated in figure 6, which shows an  example of a simple network and a multitiered network with a top, middle,  and bottom tier.
subsections: section_title: S Corporations Have Shallow Tiering Depths, while Some Partnerships Have Greater Depths
paragraphs: In tax year 2011, only about 1 percent of S corporations had 2 or more  tiers below them (see table 3). More partnerships, on the other hand, had  greater tiering depths. About 23 percent of partnerships had 2 or more  tiers below them, and some partnerships had 11 or more tiers below  them. See figure 6 above for examples of how tiers below flow-through  entities are counted.
section_title: Most Ultimate Owners Are Individuals
paragraphs: Most ultimate owners of partnerships and S corporations are individuals.  This ownership structure is the most simple. Structures with ultimate  owners that are businesses are more complex because the businesses,  in turn, are controlled by other entities. For example, C corporations are  controlled by their boards and shareholders.
Most partnerships and S corporations were owned exclusively by  individuals in tax year 2011. S corporations’ ownership was simplest, with  97 percent of all S corporations owned exclusively by individuals.  Partnerships showed greater complexity, with 77 percent of all  partnerships owned exclusively by individuals and 22 percent owned by  mixed types of owners.corporations in tax year 2011 are shown in table 4.
section_title: Most Partnerships and S Corporations Have 1 to 2 Ultimate Owners, but Many Have 11 or More
paragraphs: Another factor in the complexity of a flow-through entity is the number of  ultimate owners (see the text box above for a definition of ultimate  owners). As shown in figure 7, most S corporations are closely held, i.e.,  owned by a small number of ultimate owners. In tax year 2011, 62  percent had only one ultimate owner, and an additional 28 percent had  only two ultimate owners. Partnerships tend to have more ultimate  owners. In tax year 2011, 51 percent had 2 ultimate owners, 38 percent  had 3 to 10 ultimate owners, and 9 percent had 11 or more ultimate  owners.
section_title: Most Enterprises Are Simple, but Some Are Multitiered with Many Component Entities
paragraphs: Most enterprises (see text box above for definition) are simple and have  few component entities, but some are multitiered and have large numbers  of component entities (see figure 8). Enterprises are of particular interest  to IRS because controlling owners have the ability to influence activity  throughout the network. In tax year 2011, about 62 percent of enterprises  had two tiers—i.e., they were simple networks—and were composed of  about four entities on average (counting both flow-through entities and  ultimate owners). About 35 percent of enterprises had three tiers and  were composed of about five entities on average. In comparison, the  seven enterprises that were nine or more tiers deep were composed of  about 735 entities on average.
section_title: Appendix III: Additional Information about Misreporting
subsections: section_title: Methodology for Estimating Individuals’ Total Misreporting of Income from Partnerships and S Corporations
paragraphs: The Internal Revenue Service (IRS) estimated that individual taxpayers  misreported, in net terms, 15 percent of the total income from  partnerships and S corporations that they should have reported on their  tax returns. This percentage is known as the net misreporting  percentage (see figure 9).
We calculated the total income that should have been reported—$606  billion—from the IRS’s National Research Program (NRP) data on  individual taxpayer compliance as the sum of the absolute values of the  income amounts that individual taxpayers should have reported. Absolute  values are used in calculating the amount of income that should have  been reported to prevent negative income amounts from canceling out  positive income amounts. Based on these figures, we estimated that in  tax years 2006 through 2009, individual taxpayers reported about $91  billion less per year in net income from partnerships and S corporations  than they actually were allocated. To arrive at the $91 billion estimate, we  adjusted upward based on IRS’s 15 percent misreporting percentage  estimate from a raw estimate of $27 billion.
There is some uncertainty with both IRS’s estimated net misreporting  percentage and the amount of total income from partnerships and S  corporations individual taxpayers should have reported. IRS arrived at an  estimate of 15 percent for the net misreporting percentage by adjusting  upward the net misreporting percentage based on raw data from its NRP.  In NRP, IRS selects a random sample of individual tax returns each year  to examine and strives to verify information taxpayers reported or should  have reported. The net misreporting percentage based directly on NRP  data was 4.5 percent for income allocated to individuals by partnerships  and S corporations. According to IRS officials, this was probably an  understatement because it did not include misreporting undetected by  IRS examiners or possible misreporting at the flow-through entity level  carried through to individual taxpayers. Based on an IRS study of S  corporation (but not partnership) returns from 2003 and 2004, IRS  officials said that the net misreporting percentage for income from both  partnerships and S corporations for tax years 2006 through 2009 was  probably around 15 percent. IRS used only the S corporation study to  arrive at the 15 percent because it has not conducted a similar study of  partnerships in recent years. We cannot know whether the estimate might  have been higher or lower if partnerships were taken into account. Each  of the factors mentioned here—undetected individual misreporting, entity- level misreporting, the age of the data in the S corporation study, and the  lack of information on partnerships—creates some uncertainty about the  15 percent estimate.
Because of the uncertainty related to IRS’s net misreporting percentage,  there is also uncertainty about our estimate for net misreported amount.
Additionally, the confidence interval around the raw NRP estimate  translates to a larger confidence interval for the adjusted estimate.  Likewise, in calculating net misreported income, we considered only  partnership and S corporation income that was separately reported on  Form 1040’s Schedule E, Supplemental Income and Loss. Some income  from partnerships and S corporations may also be included within, and  reported under, other line items on Form 1040, such as capital gains.
IRS has not issued its own estimate of misreporting of partnership and S  corporation income for 2006 or later. Our estimate of lost tax revenue  cannot be used to compute a tax gap estimate (defined by IRS as the  amount of tax liability faced by taxpayers that is not paid on time), as IRS  may perform additional adjustments for its tax gap estimates.
To calculate the amount of taxes that corresponded to our misreporting  estimate, we used NRP data to calculate the income and misreporting  that related to individuals with different effective tax rates (defined as total  tax divided by adjusted gross income). From 2006 to 2009, taxpayers with  effective tax rates of less than 15 percent had an aggregate annual net  loss on income from partnerships and S corporations, while taxpayers  with effective tax rates of 15 percent or higher had aggregate net income.  The highest tax bracket was 35 percent. Looking at taxpayers with  effective tax rates between 15 and 35 percent, and using the minimum  and maximum tax rates within each effective tax rate grouping and point  estimates for misreporting, we calculated lower and upper bounds for the  amount of tax that would have been owed on their misreported income  from partnerships and S corporations. With this, we arrived at an estimate  of $5 billion to $6 billion. Adjusting our point estimate for taxes based on  the same methodology discussed above for our misreporting estimate, we  arrived at an estimated $19 billion in taxes owed on the misreported  income.
section_title: Comparison of Individual Misreporting of Income from S Corporations and Partnerships with Misreporting of Other Income Types
paragraphs: There are several ways to compare the extent and nature of misreporting  of partnership and S corporation income with individuals’ misreporting of  other types of income, which are shown in table 5. To compare net  misreporting of income from partnerships and S corporations with other  types of income, we needed to use unadjusted data, because IRS had  not issued adjusted results for 2006 or later at the level of detail needed  for the table. For example, the unadjusted net misreporting amount for  partnership and S corporation income shown in the table is $27 billion, as  opposed to the adjusted amount of $91 billion.
In general, frequency of misreporting of income from partnerships and S  corporations was lower than for income from sole proprietorships, and  higher than for misreporting of income from nonbusiness sources. There  is a general pattern in misreporting of income. The more third-party  information reporting there is for a type of income (such as W-2s for  wages), the less misreporting there is for that type of income (see table  5). According to IRS, information reporting increases voluntary tax  compliance because taxpayers know that IRS is aware of their income.  For example, employer information on wages and earnings is sent both to  employees and to IRS, and for tax years 2006 through 2009, the net  misreporting percentage for wages was less than 1 percent.
Partnerships and S corporations send partners, shareholders, and IRS  Schedules K-1 that state the amount of income distributed to each partner  or shareholder. In comparison, most other types of business income  earned by individuals are covered by little to no information reporting.  However, according to IRS officials, many partnerships and S  corporations issuing K-1s are closely held, i.e., controlled by the individual  taxpayers receiving the K-1s. In these cases, the information on the K-1  does not truly come from an unrelated third party.
section_title: Appendix IV: Additional Information about K- 1 Matching
subsections: section_title: K-1 Matching Is Complicated for Several Reasons
paragraphs: Schedule K-1 reporting is complex for several reasons:
Some taxpayers with K-1 income have K-1s from multiple  partnerships and S corporations, which adds complexity. For  example, a taxpayer may net the income/loss amounts from different  K-1s, so that the netted amount reported on the 1040 will not match  the individual K-1s, but correct information may turn out to be  contained within the netted numbers, according to IRS officials.
One tax return preparer we interviewed noted that when tiered  networks are involved (e.g., partnerships that have other partnerships  as partners), each tier must wait for the tier above it to send its K-1s in  order to have accurate information, yet they all have the same filing  deadline. If the top-tier entity sends its K-1s close to the deadline, the  lower tiers must estimate the amounts to put on their own K-1s in  order to file on time. This can lead to inaccuracies and mismatches.
When taxpayers respond to notices about mismatches, IRS guidance  directs AUR reviewers to consider the reasonableness of taxpayers’  responses, but reviewers generally do not examine the accuracy of  the information in the responses because they do not have  examination authority.
K-1 matching is only designed to detect noncompliance at the  taxpayer level, not at the entity level. According to an IRS official,  because many partnerships and S corporations issuing K-1s are  controlled by the individual taxpayers receiving the K-1s, the  information on K-1s may match what is on the Forms 1040 but still  understate taxes owed.
Because of issues like these, K-1 matching is only part of IRS’s efforts to  ensure compliance with tax rules about income from partnerships and S  corporations. Examinations, discussed previously, also play a role.
section_title: Individual Tax Returns with Partnership and S Corporation K-1 Mismatches Had Higher Screen-out and No- Change Rates Than All Returns in IRS’s Matching Program
paragraphs: The screen-out rate (percent of returns reviewed without taxpayer  contact) and the no-change rate (percent of taxpayers contacted that did  not result in an assessment) for K-1 matching for tax year 2009, the latest  year for which complete data were available, were higher than for the  Automated Underreporter (AUR) program overall (AUR matches 1040s  with many information documents, including K-1s). As shown in figure 10,  about 61 percent of the returns with partnership and S corporation K-1  mismatches in IRS’s AUR workload were screened out. That is, the AUR  examiner determined that despite the mismatch, the taxpayer was in  compliance with tax law or within a small tolerance threshold (i.e., income  or expenses were misreported by an amount below what IRS considers  productive to address), and the AUR examiner did not contact the  taxpayer. In contrast, about 18 percent of all returns in the total AUR  workload were screened out. Of the partnership and S corporation  mismatch cases where IRS contacted a taxpayer, the no-change rate was  about 58 percent. In contrast, the no-change rate for all of AUR was  about 19 percent.
section_title: Appendix V: Comments from the Internal Revenue Service
section_title: Appendix VI: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Jeff Arkin and David L. Lewis,  Assistant Directors; Sara L. Daleski; Deirdre Duffy; Lois A. Hanshaw;  Lawrence M. Korb; Veronica O. Mayhand; Donna L. Miller; John W.  Mingus, Jr.; Meredith Trauner Moles; Mark F. Ramage; Albert C. Sim;  Andrew J. Stephens; Sonya Vartivarian; James A. Wozny; and John M.  Zombro made key contributions to this report.