Employment Taxes: Timely Use of National Research Program Results Would Help IRS Improve Compliance and Tax Gap Estimates
Released: 2017-05-18T00:00:00

Letter

Background

Employment Taxes

For federal tax purposes, employers generally are required to withhold and remit two types of taxes from their employees’ salaries: 1. Federal income tax withholding. Income tax is withheld from the pay of most employees. Pay includes regular pay, bonuses, commissions, and vacation allowances as well as reimbursements and other expense allowances paid. The amount of income tax that employers withhold depends on the amount earned and the information on the employee’s Form W-4. 2. Federal Insurance Contribution Act (FICA) taxes. These taxes include Old-Age, Survivors and Disability Insurance (Social Security) and hospital insurance (Medicare) taxes. In 2016, the FICA taxes to be withheld consisted of 6.2 percent of an employee’s taxable earnings up to $118,500 for Social Security taxes and an additional 1.45 percent of the taxable earnings for Medicare not subject to a wage cap. Employers are required to match the amounts withheld from an employee’s salary for Social Security and Medicare taxes.

Employers must also pay a federal unemployment insurance (FUTA) payroll tax. This tax is equal to 6 percent of the total wages of (up to $7,000) each employee. This tax is not withheld and remitted from an employee’s wages. Taken all together, federal income tax withholding, FICA, and FUTA comprise employment taxes.

In general, employers who withhold federal income tax and Social Security and Medicare taxes report to IRS either quarterly on Form 941 (Employer’s Quarterly Federal Tax Return) or annually on Form 944 (Employer’s Annual Federal Tax Return). Form 941 includes the tax liabilities of the employers (the employer share of FICA) as well as the tax liabilities of employees (withheld income tax and the employee share of FICA) that are required to be withheld by the employer and paid to the government on the employee’s behalf. Employers report their annual FUTA tax to IRS on Form 940, (Employer’s Annual Federal Unemployment Tax Return). In fiscal year 2016, almost 30.5 million employment tax returns were filed.

Taxes withheld by employers are a significant portion of federal revenue. In fiscal year 2016, of revenue remitted by employers, almost $1.27 trillion came from income taxes, $1 trillion came from FICA employment taxes, and $8 billion from FUTA taxes.

Operational Employment Tax Examinations

IRS’s SB/SE and TE/GE divisions both have responsibility for ensuring that employers comply with employment taxes. While some differences exist for how operational employment tax examinations take place in SB/SE and TE/GE, they generally follow the steps in figure 1.

These represent the key steps in the IRS employment tax examination process, but differences exist in the process between the TE/GE-Exempt Organizations (EO), TE/GE-Federal, State, and Local Governments (FSLG), and SB/SE business units. For example, TE/GE-EO focuses its examinations on the Form 990 (Return of Organization Exempt From Income Tax) and does not select returns exclusively for employment tax examinations. Returns are inspected and a separate employment tax examination may be necessary if the inspection does not reveal compliance. By contrast, TE/GE-FSLG examinations of government entities focus only on employment tax issues and SB/SE has a specialty group that focuses exclusively on employment tax issues.

Other differences exist between the latter two business units. The key difference tends to be the extent to which SB/SE and TE/GE-FSLG “build the case file” for examiners before the examination starts. TE/GE-FSLG tends to include more information upfront whereas SB/SE offers the information on request, noting that examiners are able to determine if they need additional information for specific identified issues.

National Research Program Studies and Examinations

IRS carries out detailed research studies of different types of taxpayer compliance through NRP. For example, IRS completes an annual NRP study of individual income tax returns, which we have previously evaluated. Data for the NRP studies come from detailed examinations that strive to verify information reported on filed returns in addition to taxes that may have been under- or over-reported. According to the IRM, IRS seeks to use NRP data to increase public confidence in the fairness of the tax system by helping identify compliance problems and direct resources to efficiently address them. The IRM also states that IRS is supposed to use NRP data to better estimate the tax gap, update methods for selecting returns for examination, and improve strategic planning, among other benefits.

IRS’s NRP study of employment taxes for tax years 2008, 2009, and 2010 was its first on employment taxes since a study for tax year 1984. IRS started the NRP study in February 2010 and IRS officials said that they completed most of the examinations by May 2016. IRS selected a random sample of about 7,200 taxpayers that filed Form 941 employment tax returns from tax years 2008 to 2010. The NRP data are therefore a representative sample of only certain types of employer entities, which includes exempt organizations, government entities, and businesses (appendix I lists types of entities not included in the sample). NRP estimates can be analyzed to learn about the level of taxpayer compliance on filed returns, such as the difference between the correct amount of employment taxes and the amount reported on employment tax returns.

IRS’s Office of Research, Applied Analytics, and Statistics (RAAS) is responsible for the NRP, which includes designing the studies, collecting and housing the data, and analyzing the results of the studies. The two business units that administered the NRP employment tax examinations, TE/GE and SB/SE, also have internal research functions that could analyze the NRP results.

RAAS houses various types of compliance data, including the results from its NRP studies, in the Compliance Data Warehouse (CDW). Data in CDW are made available to staff across IRS and the Department of the Treasury for research and analysis purposes. RAAS is responsible for ensuring that the final NRP dataset provided to CDW is consistent and accurate, and represents the examination results. According to IRS officials, ensuring that the data meet these outcomes is an iterative process, meaning data from an NRP study might be initially posted to CDW, but could continue to change as staff working with the data identify inconsistencies and errors. RAAS began this iterative process for the NRP employment tax study in the spring of 2016.

The NRP employment tax examination process generally follows the same process as operational employment tax examinations, discussed in figure 1 above. Given the purpose of NRP and its data-driven nature, NRP examinations differ from operational examinations by examining a wider breadth of issues, documenting all adjustments and using the data differently as shown in table 1.

IRS Has Not Finished Analyzing the NRP Data or Used the Results to Improve Employment Tax Compliance Efforts

Neither RAAS nor the business units (TE/GE and SB/SE) that completed the NRP examinations have finished analyzing the results from the study, according to IRS officials. They also do not have specific documented plans to analyze the NRP employment tax study data or use the results to improve employment tax compliance programs. Instead, IRS officials described high-level concepts of what they would like to do with the NRP results in 2017 or beyond. For example, RAAS officials said that they intend to complete and release the next tax gap estimates by 2019, and conduct other research on employment tax compliance that responds to recommendations from our prior report.

Similarly, TE/GE and SB/SE officials said they plan to partner to explore and summarize the NRP data and are developing analysis plans for this work, but had no timeline for when the plans would be ready. According to officials, TE/GE has a statistician on detail who will be devoted almost exclusively to summarizing and analyzing study results. TE/GE officials said they are updating the programming code developed after year 1 of the study to analyze all 3 years of the NRP results. SB/SE officials said that after an NRP study, their normal process has been to identify emerging compliance issues, update return selection criteria and processes, explore ways to refine classification, and evaluate the need for research projects as well as for reallocation of examination resources. SB/SE officials also said they intend to use the NRP data to enhance examiner training, edit audit technique guides, and clarify or reinforce examiner procedures as necessary.

However, for the efforts and plans described above, IRS did not have documentation outlining the detailed objectives and the specific NRP data to be analyzed and used. IRS officials described these efforts and plans to us in meetings and then provided a list of them in writing with little additional detail. RAAS officials said they have not developed specific plans to analyze the data due to competing priorities and limited resources. TE/GE officials cited similar reasons for not developing such plans, but TE/GE and SB/SE officials added they are waiting for the final NRP data to be made available before they develop detailed analysis plans. RAAS officials noted that the data initially were available as of fall 2016, and that as of February 2017 the data were still being evaluated and corrected for inconsistencies, such as duplicate numbers, missing information, and other errors, which according to IRS has delayed its ability to analyze the results. According to RAAS officials, updated study data are expected to be delivered in 2017. RAAS officials said they likely will continue to evaluate and correct the data as staff in RAAS, SB/SE, and TE/GE begin to work with the data.

Analyzing and using the NRP study results is important for various reasons. The NRP’s primary benefit, according to the IRM, is to improve workload selection systems, such as how IRS selects returns to examine. The IRM notes that the NRP program seeks to increase public confidence in the fairness of our tax system by helping IRS identify where compliance problems occur so that IRS can efficiently use its resources to address those problems. IRS also uses the NRP data to help update its estimate of the tax gap. IRS’s most recent employment tax gap for FICA and FUTA are projections based on compliance data from 1984. In addition, analyzing the NRP employment tax study results would align with IRS’s strategic plan, which includes an objective to identify trends, detect high- risk areas of noncompliance and prioritize enforcement approaches by applying research and advanced analytics.

By not developing detailed plans to analyze and use the results of NRP, IRS is missing an opportunity to identify compliance problems on employment tax returns as well as identify solutions to address these problems. Implementing those detailed plans can guide IRS efforts to identify and correct data inconsistencies. For example, IRS found a number of errors within the data as a result of our attempts to analyze the NRP data. Moreover, by not analyzing these data, IRS will not have current tax gap estimates, continuing to rely on outdated information.

Noncompliance Varied across Employment Tax Issues and Employer Size

Given that IRS has not completed its own analysis, we reviewed the NRP employment tax results for tax years 2008 through 2010 to identify areas—known as issues—of noncompliance in terms of the examination proposing adjustments to the amount of taxable wages. We reviewed 1) issues that were most frequently adjusted, 2) the amounts by which wages were adjusted for these issues, and 3) employer groups that were more noncompliant.

Worker Classification and Fringe Benefits Were Among the Most Frequent Issues of Noncompliance and Led to Highest Percentage of Wage Adjustments

By reviewing the results from the NRP employment tax examinations for tax years 2008 through 2010, we identified issues where employers were noncompliant in reporting taxable wages. We analyzed the frequently examined issues through NRP, which are described in table 2.

Our review of such issues focused on employer noncompliance in reporting the correct amount of taxable wages and proposed adjustments to the reported taxable wage amount for employees. These wage adjustments, in turn, affect the amount of taxes withheld and paid by employers and employees. Overall, the NRP study examined an estimated 15.7 million employment tax issues, of which an estimated 6.7 million issues resulted in wage adjustments.

Based on our review of the NRP examination results for tax years 2009 through 2010, figure 2 shows the employment tax issues that were the most frequently examined and adjusted. For example, fringe benefits, payment recharacterization, and worker classification issues were the most frequently examined issues (see table 6), representing 38 percent, 24 percent, and 20 percent of all issues that were examined. These issues were also among those most frequently requiring adjustments (see table 8)—representing an estimated 33 percent, 20 percent, and 19 percent of issues that required adjustments, respectively. The issue most likely to result in an adjustment when examined was backup withholding, where an estimated 1.4 million (74 percent) of the 1.9 million backup withholding issues required adjustments (see table 10).

The NRP examination adjustments to taxable wages for employment tax obligations represent billions of dollars. For our review, we focused on the wage adjustments because the NRP tax adjustments include various tax relief provisions available to employers and, therefore, underestimate the level of employment tax noncompliance. For example, the safe harbor provision through Section 530 of the Revenue Act of 1978 prevents IRS from examining protected employers for worker classification issues.

The NRP data only provides compliance information on worker classification issues when Section 530 safe harbor protection does not apply. Two other examples of employment tax relief include the worker classification settlement program (CSP) and income tax withholding relief.

Our review of wage adjustments by issue is shown in figure 3. The highest wage adjustment amounts involved worker classification, fringe benefit, and payment recharacterization issues (see table 11).

The estimated average wage adjustment for all adjusted issues (see table 12) is $32,747. The two issues with the highest average wage adjustments were worker classification and tip income. Worker classification issues included reclassifications involving corporate officers, statutory employees such as drivers who distributed certain food items and the factors that may be used to determine whether the worker was an independent contractor or employee based on, among other things, whether the employer controlled how the worker was to provide the service, such as through written contracts and training. The tip income issue included employers in industries that reported tip income, such as restaurants and gaming activities.

NRP Study Results for SB/SE Employers Suggest Noncompliance May Be Higher for Smaller Employers than for Larger Employers

Our review of these study results suggests that smaller SB/SE employers are more noncompliant than larger ones using a couple of different size measures. We focused on results of NRP examinations involving SB/SE employers because, as we have previously reported, small businesses tend to have more compliance problems than other taxpayers. In addition, tax compliance burdens can be greater for small businesses due to economies of scale. To the extent that these burdens affect tax compliance of taxpayers, smaller businesses likely would be more noncompliant than larger ones.

We estimate using the NRP data that 2.9 million of the 6.4 million examined issues (46 percent) for SB/SE employers with three or less employees resulted in adjustments, compared to 3.3 million of the 7.9 million examined issues (42 percent) for employers with four or more employees. We also estimate that SB/SE employers with three or less employees represent 44 percent of SB/SE wage adjustments, but only employ 6 percent of SB/SE employees. Conversely, larger SB/SE employers (four or more employees) account for 56 percent of the SB/SE wage adjustments and employ 94 percent of SB/SE employees. This comparison suggests greater noncompliance for smaller SB/SE employers than for larger employers on a per employee basis.

Similarly, our review indicates that smaller SB/SE employers are more noncompliant than larger employers on a basis of total compensation. For example, we estimate using the NRP data that 2.6 million of the 5.6 million examined issues (47 percent) for SB/SE employers paying total compensation of $78,500 or less resulted in adjustments, compared to 3.6 million of the 8.7 million examined issues (41 percent) for SB/SE employers that pay more than $78,500 in total compensation. In addition, SB/SE employers paying total compensation of $78,500 or less represent about 37 percent of the SB/SE wage adjustments, but only pay 4 percent of SB/SE total compensation. Conversely, larger SB/SE employers (pay more than $78,500 in total compensation) account for 63 percent of the SB/SE wage adjustments and pay 96 percent of SB/SE total compensation. The disproportionate level of wage adjustments suggests greater noncompliance for smaller SB/SE employers than for larger employers on a basis of total compensation.

IRS Business Units Applied Aspects of NRP Examination Practices to Operational Employment Tax Examinations

NRP Examinations Led to Changes in Planning, Documenting, and Reporting of Operational Employment Tax Examinations

Certain practices that were used for NRP examinations were carried over and are now used for operational employment tax examinations by the three business units that participated in the NRP study. These practices fell into three categories: planning, documentation, and reporting.

Planning: IRS carried over NRP practices that help examiners plan the issues to examine.

Information Return Analysis System (IRAS): A program that analyzes electronic versions of information returns, such as Form W-2s and Form 1099s, to test if income was treated as nontaxable, and if certain employees were incorrectly treated as exempt from employment taxes or received both a Form W-2 and Form 1099, among other tests. The results from these tests can help IRS examiners identify potential examination issues. According to IRS officials and examiners, IRAS allows examiners to analyze a substantial number of information returns quickly.

Notice CP2100: A notice taxpayers receive that provides information on improperly filed Form 1099s with an invalid Taxpayer Identification Number (TIN), no TIN, or mismatched TIN. It indicates if the employer may be subject to backup withholding, which requires income tax withholding of 28 percent from certain payments if the employee fails to furnish the correct TIN. According to IRS examiners, this tool allowed them to identify these issues early in NRP examinations.

Data Collection Instrument (DCI)-1: A workbook that contains data about the taxpayer, an issue summary, and issue specific lead sheets that IRS examiners used in the NRP study. The workbook is used to plan the examination steps. For operational examinations, the Employment Tax Lead Sheet (ETLS) is now used, which is based on the DCI-1.

Related Entity Return Information. According to IRS examiners, having the related income tax return, the Exempt Organization return, or specific lines of information from those returns help to identify issues to examine.

Documentation: The DCI-1 was also used in the NRP examinations to allow examiners to document their findings on examined issues. In our group discussions with examiners, a number of them mentioned that the DCI-1 provided a roadmap for documenting the examination steps, such as the questions posed to the taxpayer, the information requested, and the support for the examination findings. For operational examinations, ETLS is now used, which is based on the DCI-1.

Reporting: The DCI-2 is a workbook used in the NRP examinations to complete the employment tax report. The DCI-2 calculates the tax adjustments as a result of examination findings and presents them in closing reports to the taxpayer. In addition, IRS officials said that the DCI-2 helped examiners to automatically make complex calculations to determine additional taxes and penalties due, instead of making them by hand. For operational examinations, the workbook is known as the Employment Tax Examiner’s Report, which is based on the DCI-2.

Table 3 shows the specific practices that SB/SE, TE/GE-EO, and TE/GE- FSLG each carried over from NRP examinations to operational employment tax examinations, and whether those practices are provided upfront as part of the case file or on request.

As seen in table 3, the only NRP practice carried over to all business units was IRAS. However, only FSLG offers IRAS data upfront in the case file, as done for NRP examinations. FSLG also offers the CP2100 upfront. In contrast, the NRP practices carried over by SB/SE and TE/GE-EO were made available to examiners on request. Other practices, such as the taxpayer’s examination history, were in place in all three business units before IRS started the NRP study.

In general, the business units decided which NRP practices to carry over to operational employment tax examinations based on annual feedback sessions held with their staff involved in the study as well as informal discussions among those staff. The annual feedback sessions were organized by the RAAS division, which designed the NRP employment tax study. The feedback sessions were mainly held to improve the operations of the study. However, during the feedback sessions, examiners identified NRP practices, such as IRAS, that they found helpful, but they did not have access to or access to in the same manner on operational examinations.

Beyond this feedback, officials in SB/SE and TE/GE said that they carried over NRP practices to operational employment tax examinations based on the resources each unit had available. They also said they considered those “best practices” that were helpful and made sense on the operational side. IRS officials said that they did not analyze the benefits of NRP practices carried over to operational examinations. IRS officials said that the purpose of the NRP employment tax study was not to improve the operational examination process, but to improve tax gap estimates and identify noncompliance areas. They also said they had no baseline data before the NRP study to compare changes made to operational examinations after the NRP study. Therefore, IRS was unable to analyze the effects of making these changes.

TE/GE-FSLG did not carry over some NRP practices because they were not applicable to its examinations. For example, TE/GE-FSLG government entities do not have a related return, which is why that practice was not carried over to operational examinations, according to officials.

IRS Examiners See Benefits to NRP Practices for Operational Employment Tax Examinations, but Half Were Unaware They Could Request Access to Certain Practices

Examiners Would Like Access to NRP Practices at the Start of Operational Examinations but IRS Officials Raised Concerns

IRS examiners who have worked on both NRP employment tax examinations and operational employment tax examinations identified NRP practices that they would like to have access to when operational employment tax examinations start. Their responses to our survey, which asked about a number of the NRP practices, indicated that the majority of them would like to have access to all of the practices used in NRP examinations as well as electronic case files upfront when the operational examination starts. See figure 4.

The NRP practice that most IRS examiners said they wanted upfront in the case file and also found to be most helpful were the data used in IRAS and IRAS itself. Specifically, 181 of 200 (90.5 percent) respondents wanted access to IRAS and the IRAS data upfront, and 98 of 105 respondents stated that having IRAS and the IRAS data prior to starting an examination was very or extremely helpful. See figure 5.

As noted earlier, only TE/GE-FSLG includes the IRAS data in the case file sent to the examiner at the start of the examination. TE/GE FSLG officials noted that establishing a case on its systems and requesting the IRAS data as well as other data such as from the CP2100 and taxpayer’s examination history can take their one case preparer 60 to 90 minutes, and that receiving the requested IRAS data takes 1 to 2 weeks depending on the day of the week the request is made.

As for the other two units, TE/GE-EO does not include the IRAS data in a case file since the examination focuses on the Form 990, and employment tax issues are examined only to the extent the examiners uncover potential noncompliance when checking those issues. SB/SE provides the IRAS data if requested by the examiner. In our survey, 87 of 100 SB/SE examiners said they were aware that they could request IRAS data for operational examinations. However, 91 of the 100 SB/SE examiners in our survey preferred to have IRAS data in the case file when an examination starts rather than on request. In addition, of the SB/SE examiners who have used IRAS on operational examinations since the NRP examinations, 46 of 50 survey respondents found it very or extremely helpful.

For a May 2013 report on a different NRP study, we developed a set of criteria for evaluating whether NRP practices should be applied to operational examinations. These criteria include:

Would the change be likely to help examiners correctly identify more noncompliance?

Is it likely to make the examination more efficient—(i.e., reduce the cost of conducting an examination, increase benefits for the same cost, or increase benefits commensurate with justifiable or no increase in costs)?

Is it likely to reduce taxpayer burden?

Would the change meet any other IRS need?

For this review, we planned to apply these criteria to determine if the NRP employment tax practices that IRS examiners wanted the most and found most helpful would be applicable to operational examinations, such as providing IRAS and the data used in it upfront. However, SB/SE had limited data and information that aligned with the criteria. Therefore, we relied on our survey of examiners and interviews with IRS officials as discussed below.

In the survey, examiners said that having IRAS data upfront is helpful because it allows them to better plan the examination and identify issues sooner. IRAS does so by allowing them to electronically match and analyze a large number of W-2s and information returns. The identification of examination issues, in turn, facilitates their initial interview and contact with the taxpayer. It can also reduce taxpayer burden and make the examination more efficient, according to IRS examiners. These benefits align with IRS’s strategic plan to deliver high-quality and timely service to reduce taxpayer burden and encourage voluntary compliance.

TE/GE-FSLG officials said that providing IRAS and the IRAS data upfront has improved efficiency by helping examiners plan the examination and reduce the need to ask taxpayers to provide information. They added that they do not have data to document their views. In addition, TE/GE- FSLG’s examinations only focus on employment tax liabilities, which covered 2,003 returns in fiscal year 2015.

When we shared our survey results with SB/SE officials, they were concerned about providing IRAS data upfront for all operational examinations as was done for NRP examinations. Specifically, SB/SE’s employment tax examination caseload is much higher as SB/SE examined 41,554 Form 941 returns in fiscal year 2015. Given this caseload, SB/SE officials raised concerns about providing the data upfront through case building. One concern they raised is that returns sent to an IRS campus for case building or assigned for examination from the campus may not be examined. As a result, having the campus pull IRAS data for all returns will risk that the data may not be used for some. Similarly, SB/SE officials added that many of their large examinations could involve many corporate subsidiaries of which only a handful are examined. Thus, requiring SB/SE to include the IRAS data for all subsidiaries would be burdensome. Beyond these large examinations, these officials noted that many SB/SE examinations involve employers with 10 or fewer information returns, which are too few to merit using IRAS. IRS did not have data on examinations by the numbers of subsidiaries or information returns.

SB/SE officials also said that providing IRAS data in all case files upfront would move the cost burden from the examiner to an administrative office at IRS’s Cincinnati campus, which helps prepare the cases. According to IRS officials, the support staff at the Cincinnati campus is shared between SB/SE’s specialty groups for employment tax and excise tax. In fiscal year 2015, less than one full-time equivalent employee was devoted to building employment tax cases for SB/SE at the campus. The administrative staff who prepare the cases are generally on the General Schedule (GS)-7 pay scale, whereas the examiners tend to have more technical experience and a higher GS grade, and can determine whether the IRAS information would be helpful. The SB/SE examiners who participated in our survey were GS-11 or higher. IRS officials added that many support organizations in IRS are operating with smaller staffs due to budget constraints, and their desire is to maximize the use of resources for meeting face-to-face with taxpayers.

While we recognize that resource constraints can be an important consideration, none of the business units who have offered IRAS on request or upfront in case files had evaluated whether providing the IRAS data upfront made sense in line with the criteria we identified in May 2013 for making such decisions. Nor did SB/SE have data on the type of examinations, such as just those with large numbers of information returns, in which IRAS would be more or less applicable. Without having these necessary data, IRS is limited in determining whether and when to provide IRAS data upfront in line with criteria we have identified in our prior work on evaluating the applicability of practices used in an NRP study.

IRS examiners we surveyed also found it helpful to have electronic case files and related return information upfront. For example, 108 of 133 survey respondents found electronic case files extremely or very helpful while 84 of 94 found related return information similarly helpful. They cited a number of benefits for both.

According to IRS examiners, electronic case files enhance efficiency by making it easier to do tasks, such as recording, updating, organizing, and transmitting the examination information. However, IRS officials added that in some instances, such as if a case is appealed by the taxpayer, paper case files have to be completed in addition to electronic case files. TE/GE FSLG and TE/GE-EO already have fully electronic case files while SB/SE uses partially electronic case files. SB/SE officials noted that they are considering moving to fully electronic case files by the middle of 2017 or later. SB/SE officials noted that it would take that long given the complexity of aligning various IRS information systems and limited IRS resources for information technology.

Similarly, for related return information, examiners noted that having the information upfront helps plan the work and identify issues. SB/SE does not provide the related return when the examination starts, but SB/SE examiners are able to access an electronically filed related entity return shortly after an employment examination starts.

In contrast, for the CP2100 and cash transaction data, a much smaller number of IRS examiners used them on operational employment tax examinations since completing the NRP employment tax study. According to IRS officials, the low use could be due to examinations where the CP2100 or cash transaction data were not necessary. For example, 28 of 209 survey respondents had used the CP2100 and 11 of 181 survey respondents had used the cash transaction data on operational examinations since completing examinations for NRP employment tax study. This may be because the data on the CP2100 and cash transactions infrequently apply to related employment tax issues.

When the CP2100 and cash transaction data did apply, survey respondents who used both types of data on operational employment tax examinations since completing the NRP study generally found them helpful. According to IRS examiners, the CP2100 can help narrow the scope and better plan the examination, and the cash transaction data can help understand the operations of the business under examination.

Half of IRS Examiners Were Unaware They Could Request Certain NRP Practices For Operational Employment Tax Examinations

Over half of IRS examiners in our survey asked if they were aware how to request two NRP practices for operational examinations—the CP2100 and cash transaction data—answered no. See figure 6.

All NRP practices in our survey are available for request (SB/SE and TE/GE-EO) or provided upfront (TE/GE-FSLG). However, examiners are not always aware of how to access each NRP practice. This is inconsistent with IRS’s strategic plan to empower employees with the tools and training to further develop skill proficiency and improve business performance.

IRS officials said examiners may be unaware of how to request CP2100 and cash transaction data because the related employment tax issues are infrequently examined. Our survey results showed that a small portion of our survey respondents had used either NRP practice on operational employment tax examinations since completing the NRP examinations. Even so, examiners found these two types of data to be helpful when they did apply to the examination.

Instructions to examiners for requesting CP2100 and cash transaction data are in the IRM, which can be accessed at the examiner’s discretion. However, IRS does not uniformly remind all examiners how to access them. For example, TE/GE-FSLG made examiners aware of how to access the CP2100 in a quarterly newsletter, which may explain why 22 of 26 survey respondents from FSLG were aware of how to access it, compared to 19 of 79 for TE/GE-EO and 47 of 96 for SB/SE. Prior to the survey, TE/GE-EO had not provided examiners any reminders about how to access the CP2100, but did so afterwards through an informal training, which is also available to examiners through a shared computer drive along with instructions for using CP2100. SB/SE has training on backup withholding that instructs examiners how to request a CP2100.

Without examiners being aware of these practices and able to utilize them when needed, they may be limited in their ability to effectively examine employment tax returns. While survey respondents said CP2100 and cash transaction data were not used frequently, these practices can be helpful when needed. IRS examiners said CP2100 can help an examiner narrow the scope and better plan the examination. Cash transaction data can help the examiner understand the operations of the business under examination.

Conclusions

IRS’s first NRP study on employment tax returns since 1984 provides a valuable opportunity to identify what noncompliance areas are contributing to the $16 billion annual employment tax gap, and better align IRS resources with the most prevalent areas of noncompliance. As our analysis shows, the NRP results present a rich overview of examination issues—like worker classification and fringe benefits—and their estimated prevalence. The study results also provide the opportunity to analyze those issues by various descriptive statistics such as employer size and compensation. However, IRS has no specific plans to study the results and assess issues of noncompliance, or update the current estimate of the employment tax gap, and has not completed any analysis of the results.

In addition, the NRP study provides IRS with an opportunity to improve the operational examination process. Ensuring that examiners are given the opportunity to access certain NRP practices—and are aware of how to do that—once they move from NRP examinations to operational examinations could reduce the burden placed on taxpayers and help examiners identify examination issues. As practices such as the CP2100 and cash transaction data are less frequently used, examiners may need reminders or easily accessible information about how to access them. In some instances, using certain NRP practices when the operational examination starts may help examiners to identify examination issues sooner. If IRS does not pursue these opportunities to maximize its NRP investment, IRS is missing a chance to improve operational examinations.

Recommendations for Executive Action

To help ensure that IRS leverages lessons learned from the NRP examinations and effectively completes operational employment tax examinations, we recommend that the Commissioner of Internal Revenue take the following five actions: 1. Develop and document plans to analyze the results in 2017 of the NRP employment tax study to identify the major issues of noncompliance. 2. Develop and document plans for addressing the noncompliance identified in IRS’s analysis of the NRP employment tax results. 3. Develop and document plans for assessing the results of the NRP employment tax study to estimate the current state of the employment tax gap. 4. Determine whether and when to provide IRAS upfront for SB/SE operational examinations based on criteria such as whether it would help identify more noncompliance, reduce taxpayer burden, and improve audit efficiency by reducing overall IRS costs (examiner versus campus costs). 5. Regularly remind employment tax examiners how they can access and request the CP2100 and cash transaction data for operational employment tax examinations.

Agency Comments

We provided a draft of this report to the Commissioner of Internal Revenue. In its comments, reproduced in appendix IV, IRS generally agreed with all five of our recommendations. We also received technical comments from IRS, which we incorporated where appropriate. IRS also provided additional documentation during its review of our draft report that led us to modify the first recommendation to reflect that IRS has begun preliminary analysis of NRP study results.

We appreciate IRS’s response to our report, which highlighted that addressing the data issues we identified in the NRP data should make the analysis of it more accurate and that IRS is considering additional changes to its examination procedures. We look forward to additional details on the actions and timelines that IRS plans to take in response to our recommendations.

As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies to the Chairmen and Ranking Members of other Senate and House committees and subcommittees that have appropriation, authorization, and oversight responsibilities for IRS. We will also send copies of the report to the Commissioner of Internal Revenue and other interested parties. In addition, this report will be available at no charge on the GAO 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 lucasjudyj@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

Our objectives were to (1) evaluate how the Internal Revenue Service (IRS) plans to analyze the National Research Program (NRP) data, (2) review NRP data available on areas of noncompliance, (3) describe NRP examination practices that IRS applied to operational employment tax examinations, and (4) assess additional NRP examination practices that could be applied to operational employment tax examinations.

To evaluate IRS’s plans to analyze the NRP data and use the NRP results on noncompliance areas, we interviewed IRS research and examination officials about their research and analysis plans and gathered documentation where available. These research and examination officials represented Research, Applied Analytics, and Statistics (RAAS) and Tax-Exempt/Government Entities (TE/GE) and Small Business/Self-Employed (SB/SE). We gathered and reviewed documentation, if available, to confirm any IRS plans to analyze and use the data. We compared this testimonial and documentary evidence to IRS’s strategic plan and the Internal Revenue Manual (IRM).

To review NRP data available on noncompliance areas for employment taxes, we obtained the NRP data set on completed examinations of the employer’s Form 941 - Employer’s Quarterly Federal Tax Return as of July 18, 2016. Each return selected and examined in the study consisted of any of the four quarters filed or required for a tax year. IRS’s final sample sizes for the study were 2,507, 2,387 and 2,318 for tax years 2008, 2009 and 2010, respectively. The sample stratification included 14 strata across the four participating business units (TE/GE-Exempt Organization (EO), TE/GE-Federal, State, and Local Governments (FSLG), SB/SE, and Large Business and International (LB&I)) that served as the primary stratifying variable; other stratifying variables included the employer’s total wages and the mean number of employees. RAAS initially estimated that the NRP employment tax study size should be approximately 20,000 returns. However, according to IRS, this would not be possible based on resources available for the study. The limitations of the sample size were pointed out by the Treasury Inspector General for Tax Administration, which noted that the examination results for the sampled taxpayers may not enable IRS to fully estimate compliance levels for business taxpayers, among other findings.

Unlike other IRS examinations, NRP examinations can be used to estimate taxpayer reporting compliance, such as for reporting employment tax liabilities. The NRP employment tax study represents employers that filed at least one quarterly Form 941 return for the study year. However, certain types of employers were excluded from the study sample. For example, any nonfilers and other employment tax reporting businesses such as agricultural businesses (Form 943), household employers (Schedule H), or businesses with less than $1,000 in annual employment taxes due (Form 944) were excluded from the sample. Additional exclusions from the sample included federal governments, large corporations with assets of $250 million or more, foreign subsidiaries, Indian Tribal Governments, and maritime employers. Furthermore, the TE/GE-EO division excluded all church cases from the 2008 study year due to an unresolved legal issue; churches were included in the study for tax years 2009 and 2010. Since the study excluded some government entities and large businesses, the NRP results may not reflect the full and accurate level of compliance for government and large business employers.

We analyzed and estimated the issues examined as well as the wage adjustments made as a result of the examination, if any. We were not able to estimate the tax adjustments associated with certain issues being examined because the workpapers used for the NRP examinations spread across two data collection instruments (DCIs). The DCI-1 included the issues (lead sheets) examiners had to examine as part of the NRP employment tax study as well as the wage adjustments to be documented from examining those issues. All wage adjustments were required to be recorded for the study. The DCI-2 included the employment tax reports that were shared with taxpayers as a result of the examination. The DCI-2 calculated the tax adjustments to a taxpayer’s tax liability (based on the wage adjustments in the DCI-1), but did not break out the tax adjustment by issues, similar to the DCI-1. We also analyzed and estimated the SB/SE employers’ wage adjustments by the number of employees and the total compensation.

Our analysis also combined similar issues into higher level groups. For example, we combined examination results on fringe benefits for executives and nonexecutives, meaning that the same employer could be examined for both of these fringe benefit issues. See table 4 for how the employment tax examination issues were combined. IRS reviewed our combining of issues and provided suggestions, which we incorporated.

IRS officials described the quality review and data reliability process they used for data collected from the NRP examinations. In terms of data validations, IRS officials said that they used various consistency and validation checks when the examination was complete to determine if certain fields were blank or not blank, to ensure certain questions were answered based on the response to a prior element, and to check all entries in the DCI-1 against rules they created. This process took place at the end of examination before data were transmitted to the database.

During our analysis of the NRP data, we conducted several reliability tests to ensure the data excerpts were sufficiently complete. For example, we electronically tested the data for obvious errors. Additionally, we shared our results with IRS officials to ensure that the data excerpts we used were complete and accurate for our purposes. We identified a number of inconsistencies that needed to be corrected before we could do our analysis. These included the identification of a number of questionable results for both the total number of employees and the amount of compensation. The inconsistencies included the numbers of employees showing “999999” for some cases, or very large numbers that were the same as the total compensation. Other inconsistencies might show similar numbers of employees for three of the quarters and a substantially different number of employees for the other quarter. In certain instances a fourth quarter value for number of employees or total compensation would be missing. IRS officials said the potential missing fourth quarter data represent the difference in time when the return was filed and when it was selected for the study. In these instances, we replaced the missing values for the number of employees and total compensation with the average value for the three quarters that were not missing.

We shared these inconsistencies and our corrections with IRS officials, who agreed with our changes and said they were working on correcting these inconsistencies as of February 2017. IRS officials said that the NRP employment tax study presented unique challenges in ensuring data reliability, which took significantly longer than previous NRP studies because they were dealing with three business units (SB/SE, TE/GE, and LB&I) that use different systems to track examinations issues.

We reviewed documentation on the NRP data, interviewed IRS officials about the data, and conducted several reliability tests discussed above. We report average annual estimates for 2008 through 2010 where data were available. For example, the variables we used to indicate whether issues were examined during each NRP audit are missing for 2008. However, other examination information, including wage adjustment information, is available by examination issue for all three years of the study. Therefore, we report NRP estimates using data for only 2009–2010 when addressing which issues were examined, while NRP estimates using data for 2008–2010 are used to report wage adjustments amounts by issue and information used to reflect the compliance of SB/SE employers of different sizes. Generally, the precision of estimates increases with more observations. Because a probability procedure based on random selections was used, the sample was only one of a large number of samples that might have been drawn. Since each sample could have provided different estimates, we express our confidence in the precision of our particular sample’s results as a 95 percent confidence interval (e.g., +/- 7 percentage points). This is the interval that would contain the actual population value for 95 percent of the samples that could have been drawn. See appendix II for the specific estimates of this analysis and information about their sampling errors. Based on the steps we undertook, we concluded that the data were sufficiently reliable for the purposes of this report.

To describe NRP examination practices that IRS has applied to operational employment tax examinations, we interviewed RAAS staff who administered the NRP employment tax study on the key differences between NRP and operational examinations. We also interviewed examination staff from the SB/SE division and the TEGE division—who were responsible for NRP examinations during the employment tax study. Within TE/GE, these included examination staff from EO and FSLG groups. Based on those discussions, we gathered documentation, to the extent it was available, to confirm the NRP examination practices carried over to operational employment tax examinations. We also discussed and gathered documentation, if available, on the costs and benefits of carrying over NRP practices to operational employment tax examinations, and discussed the benefits with the SB/SE and TE/GE staffs.

To assess the extent that additional improvements could be made to operational employment tax examinations based on IRS’s NRP experience, we used a three-step process. First, we interviewed IRS officials and examiners who completed NRP and operational examinations to identify potential improvements to operational examinations from using NRP practices. Second, we sent a survey to all IRS examiners who worked on NRP and operational examinations to get their views on additional potential improvements. Third, we discussed the practices that IRS examiners favored with IRS examination staff. We compared those ideas against a set of criteria to the extent data were available to determine whether the ideas warranted further action. We discuss these three steps in more detail below.

We held discussions with RAAS staff as well as SB/SE and TE/GE examination staff who participated in the NRP study to get their views on additional NRP practices that could improve operational employment tax examinations. To get similar views, we held four group discussions (one with FSLG, one with EO, and two with SB/SE) with IRS examiners who had worked both operational examinations and NRP examinations. These examiners were identified by IRS. The practices identified included (1) NRP practices that examiners would like to have, but were not carried over to the operational examinations; or (2) NRP practices that examiners were not aware they had access to on operational examinations, but would like to have that access.

Based on these discussions, we identified a set of NRP practices that (1) could be applied to operational examinations, but have not yet been applied across IRS business units involved in the study; or (2) IRS examiners were not aware they could access. We developed a set of specific, close-ended, and open-ended questions that addressed those topics and had multiple pretests to ensure that the questions were understandable and answerable. We then administered the web-based survey to all IRS examiners in SB/SE and TE/GE who had experience completing operational and NRP employment tax examinations. The survey asked the same set of questions for six NRP practices we identified as well as demographic information about the examiners. These questions included if they would like to have access to these NRP practices on operational examinations, if and why they found them helpful, and if they are aware they had access to those NRP practices on operational employment tax examinations. The survey was sent to the complete list of 269 examiners identified by IRS officials as of July 2016 that were thought to meet the criteria of examiners with NRP and operational examination experience. Of those examiners, 23 were determined to not meet this criteria according to their responses to two screening questions to ensure IRS examiners had applicable experience to fill out the survey. These included: 1. According to IRS records, you have completed both NRP employment tax examinations and non-NRP employment tax examinations. Is this correct? (yes/no) 2. Have you completed a non-NRP employment tax examination since completing an NRP employment tax examination? (yes/no).

If the survey respondents answered no to either question, they were sent to the conclusion section of the survey, and did not provide responses to the remaining demographics questions and questions about the six NRP practices. We received a response rate of 85 percent, with 209 of the 246 examiners who met our criteria completing the survey. We also reviewed the raw data of the survey and made changes to ensure the skip patterns in the survey were adhered to by the respondents. We analyzed the survey data by the IRS business unit, current position, and key case year of NRP returns on which the respondent worked.

For each of the six NRP practices, we also asked an open-ended question about why they thought the NRP practice was helpful. We also asked an open-ended question on whether the respondents had any other views to share at the end of the survey. To analyze the responses to these questions, one of our analysts reviewed the responses and coded them to identify themes for the seven opened-ended responses with a second analyst reviewing those themes and the coded responses; we reconciled any disagreements through discussion.

After analyzing the closed-ended and open-ended data from the survey, we discussed the IRS examiners’ summary responses with IRS examination staff in SB/SE and TE/GE. Specifically, we discussed applying the six NRP examination practices to operational employment tax examinations. To help lead those discussions with IRS examination staff, we used the following criteria, which were used for our prior work evaluating the NRP individual study.

Would the change be likely to help examiners correctly identify more noncompliance?

Is it likely to make the examination more efficient—(i.e., reduce the cost of conducting an examination, increase benefits for the same cost, or increase benefits commensurate with justifiable or no increase in costs)?

Is it likely to reduce taxpayer burden?

Would the change meet any other IRS need?

Where available, we asked for documentation on the criteria above to assess whether to apply those NRP practices to operational examinations. These criteria generally are based on our 2005 report, Understanding the Tax Reform Debate (GAO-05-1009SP), Office of Management and Budget Circular A-94, and the Internal Revenue Manual. IRS officials agreed that these criteria were valid. As noted in our 2005 report, the criteria may conflict with each other, and as a result, trade-offs are to be considered among the criteria when evaluating a particular proposal. In those cases, we used our professional judgment in weighing the relative importance of these criteria in making our recommendations. We discussed these criteria with IRS to get its feedback. To the extent data were available on additional NRP practices that could be used in operational employment tax examinations, we used that data and information to evaluate those NRP practices using the criteria above as well as relevant sections from the IRS strategic plan.

We conducted this performance audit from April 2016 to April 2017 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.

Appendix II: Data on Results of National Research Program Employment Tax Examinations

Small Business/Self-Employed (SB/SE) Observations Only

Other Issues (Increases Only) Other Issues (Decreases Only)

Appendix III: Results from GAO Survey of Internal Revenue Service Examiners

Appendix IV: Comments from the Internal Revenue Service

Appendix V: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Tom Short (Assistant Director), Jehan Chase, Karen O’Conor, Steven Flint, Robert Gebhart, Donna Miller, Robert MacKay, Cynthia Saunders, Albert Sim, Sonya Vartivarian, and Jason Vassilicos made significant contributions to this report.