Tax Administration: Audit Trends and Results for Individual Taxpayers
Released: 1996-05-22T00:00:00

Letter

Background

IRS believes that taxpayers are more likely to voluntarily comply with the tax laws if they believe that their return may be audited and unpaid taxes identified. In concert with audits, IRS uses other enforcement and nonenforcement methods. For example, IRS uses computers to match information returns filed by banks and other third parties with individual tax returns so it can identify unreported income. In recent years, IRS has also emphasized taxpayer education and assistance to encourage voluntary compliance.

As part of its audit approach, IRS has established 10 audit classes for individual returns based on taxpayer income—5 involving returns without business income, and 5 involving returns with business income from self-employment. IRS tracks audit results by these audit classes and also by various audit sources—programs and techniques used to select potentially noncompliant returns for audit. Audit sources include, among others, suspected tax shelters, IRS and non-IRS referrals, compliance projects, and computer matches of third party information. One of the major audit sources—discriminant function (DIF)— involves returns selected solely because of a computer score designed to predict individual tax returns most likely to result in additional taxes if audited. This scoring provides an objective way to select returns and has helped IRS avoid burdening potentially compliant taxpayers with an audit.

Traditionally, IRS has done two types of face-to-face audits from its district offices to review taxpayers’ books and records in support of a filed return: (1) field audits, in which an IRS revenue agent visits an individual taxpayer who has business income or a very complex return and (2) office audits, in which a tax auditor at an IRS office is visited by an individual taxpayer who has a less complex return. Tax examiners at IRS service centers also review returns and third-party information, and contact taxpayers concerning potential discrepancies on their returns. These discrepancies include such items as unreported income, as well as unallowable credits, such as the Earned Income Credit (EIC).

Starting in fiscal year 1994, IRS decided to include all service center contacts by tax examiners as audits. IRS attributed this change to the fact that such contacts are part of its overall efforts to correct inaccurate returns. Unlike traditional field or office audits, these contacts usually involve a single tax issue on the return and do not involve a face-to-face audit. IRS is also counting other nontraditional types of work as audits, such as recent reviews of nonfilers done by district office auditors.

After reviewing a taxpayer’s support for the return, IRS auditors decide whether to recommend changes to tax liability. If a tax change is recommended, the taxpayer has the right to either agree with the recommended tax change or to appeal it through IRS’ Office of Appeals or the courts. Depending on the outcome of such appeals, additional recommended tax revenue may or may not ultimately be assessed and collected.

Objectives, Scope, and Methodology

Our objectives were to provide information on the overall trend in IRS’ individual audit rates and on the overall results of IRS’ most recent individual audits. We did the audit rate analysis for fiscal years 1988 through 1995 because published data were readily available for this period. We did the audit results analysis for fiscal years 1992 through 1994 because this was the most recent readily available data.

To determine the trend in IRS’ audit rates, we reviewed IRS’ annual reports for fiscal years 1987 through 1994 as well as unpublished data for fiscal year 1995. We collected information on the overall annual audit rates by type of taxpayer. We also collected information on the number of returns filed and the number of returns audited each year by IRS’ regions and by the district offices within those regions. We reviewed this information to identify IRS’ overall published audit rates for fiscal years 1988 through 1995, which included a combination of district office audits and service center contacts. To show what the overall rates would have been based solely on traditional district office audits, we recalculated these rates excluding service center contacts. We also used this information to calculate regional audit rates, both including and excluding service center contacts, as well as audit rates for each district office.

To determine the specific results of IRS’ audit efforts for fiscal years 1992 through 1994, we analyzed IRS Audit Information Management System (AIMS) data. IRS uses AIMS to track its audits of tax returns, including the resources used and any additional taxes recommended. We obtained copies of AIMS tapes for each year from fiscal year 1992 through 1994 and did various analyses to generate overall results for each year by (1) 10 individual audit classes, (2) 15 major audit sources, (3) 3 types of audit staff, and (4) 4 broad categories of audit closures. For each of these analyses, we determined the number and percentage of audited returns as well as the total direct hours and the total additional tax recommended for each year. From this information, we computed the direct hours per return, the taxes recommended per return, and the taxes recommended per direct hour for each year.

Other than reconciling totals from the AIMS database to IRS’ annual reports, we did not verify the accuracy of the AIMS data. Nor did we attempt an in-depth analysis to identify the reasons for the audit rate trends and audit results. Rather, we asked IRS Examination officials at the National Office to review our analysis of the audit rate trends and the audit results and provide explanations. We requested comments on a draft of this report from the Commissioner of Internal Revenue. On March 26, 1996, several IRS Examination Division officials, including the Acting Assistant Commissioner (Examination); Director, Management and Analysis; and, Team Leader, Management and Analysis, as well as a representative from IRS’ Office of Legislative Affairs, provided us with both oral and written comments. Their comments are summarized on page 14 and have been incorporated in this report where appropriate.

We performed our audit work in Washington, D.C., between August 1995 and February 1996 in accordance with generally accepted government auditing standards.

Trends in IRS’ Audit Rates

Between fiscal years 1988 and 1993, IRS’ audit rate for individuals decreased from 1.57 percent to 0.92 percent. IRS Examination Division officials told us that they attributed the decrease to more returns being filed by taxpayers; more time spent auditing complex returns by IRS auditors; and, an overall reduction in examination staffing. During fiscal years 1994 and 1995, the audit rate increased, reaching 1.67 percent by 1995. IRS officials told us they attributed this increase to the involvement of district office auditors in pursuing nonfiler cases and the increasing number of EIC claims reviewed by service center examination staff.

Starting in fiscal year 1994, IRS decided to include all service center contacts by tax examiners in its audit rates. As a result, when the annual statistics for fiscal years 1993 and 1994 were published, IRS also recomputed its audit rates for fiscal years 1988 through 1992 to include all service center contacts. Counting such work as part of the audit rate, coupled with IRS recent nonfiler and EIC emphasis, tended to produce higher audit rates, as most of this work takes less time to do than traditional face-to-face audits. Figure 1 shows the trend in individual audit rates from fiscal years 1988 through 1995, based on rates that both include and exclude service center results.

Major Audit Sources Reflect the Impact of Recent IRS Initiatives

In analyzing the audit results from fiscal year 1992 through 1994, we did an in-depth review of various sources of IRS’ audits. Our analysis of these sources illustrated the shift from traditional audits to other types of work. Over these 3 years, four sources accounted for over half of IRS’ audits. As shown in figure 2, two of these—returns selected because of DIF or potential tax shelters—declined by at least half, while the other two—returns involving potential nonfilers or unallowable items—at least tripled. The first two sources reflect traditional audits and the latter two sources reflect nontraditional work, such as the nonfiler initiative and EIC claims, respectively.

Audit Rates Varied by Geographic Location

IRS’ individual audit rates varied widely by geographic location, regardless of whether service center contacts and other nontraditional audits were included. As figure 3 shows, for fiscal year 1995 the rates tended to be highest in the western regions of the country and lowest in the middle regions. IRS Examination Division officials told us that these trends were consistent with TCMP data, which showed higher taxpayer noncompliance in IRS’ Western and Southwest Regions and lower taxpayer noncompliance in its Central and Midwest Regions. With few exceptions, these regional patterns largely held true from fiscal years 1988 through 1995. (See table I.1 for our analysis of regional audit rates.) Throughout this period, audit rates also varied widely by district office. (See table I.2 for our analysis of district office audit rates.)

Audit Rates Varied Among Income Groups

Our analysis of the audit rates and audit results also identified patterns related to income reported by taxpayers. Our analysis focused on individuals who reported significant amounts of business income and individuals who did not report such income, (i.e., nonbusiness), particularly those that were in the lowest- and highest-income groups. Figure 4 shows that the IRS reported audit rates from fiscal years 1988 to 1995 (1) increased in the last 2 fiscal years among those in the lowest-income group (less than $25,000), particularly for business individuals, for whom the rate more than doubled, and (2) decreased among those in the highest-income group ($100,000 or more), particularly for nonbusiness individuals, for whom the fiscal year 1995 rate dropped to about one-fourth of what it had been in fiscal year 1988. IRS Examination Division officials said they attributed the increase in audit rates for the lowest-income groups, which generally occurred in fiscal years 1994 and 1995, to the nonfiler initiative and the recent emphasis on EIC. They said the decrease in audit rates for the highest-income nonbusiness individuals was due to an overall reduction in examination staffing coupled with an increase in the number of returns filed for this income group. (See table I.4 for our analysis of the audit rate trends for all income groups.)

Audit Productivity Also Varied Among Income Groups

Concerning audit productivity measured by income groups, differing patterns emerged. In general, audits of the highest-income groups resulted in as much as 4 to 5 times more additional tax recommended per return—for both nonbusiness and business individuals—than did audits of the lowest-income groups. As figure 5 shows, from fiscal year 1992 to fiscal year 1994, additional taxes recommended per return (1) decreased among business individuals for the lowest-income group and increased for the highest-income group and (2) increased among nonbusiness individuals for the lowest-income group and decreased for the highest-income group. IRS Examination officials said the increases or decreases in additional taxes recommended from fiscal years 1992 to 1994 for both the highest-income business and nonbusiness individuals were affected by the small number of individual tax returns that IRS audited as part of its Coordinated Examination Program. This program is designed to audit the largest corporations; individual taxpayers audited under this program are usually corporate officers or shareholders.

Another measure of audit productivity is the amount of additional taxes recommended for each direct audit hour used to complete the audit. Whereas from fiscal years 1992 to 1994, the amount of additional taxes recommended per direct hour was similar to the amount of additional taxes recommended per return for nonbusiness individuals; however, these amounts differed for business individuals. As figure 6 shows, from fiscal years 1992 to 1994, taxes recommended per direct hour (1) among business individuals increased for both the lowest- and highest-income groups and (2) increased among nonbusiness individuals for the lowest-income group and decreased for the highest-income group. (See tables II.1 through II.3 for an overall analysis of the results of audits by income classes.)

We provide more detailed information from our analyses of various other elements of both the audit rates and the audit results in appendixes I and II. Such elements include audit rates by IRS district offices (tables I.2 and I.3), audit results on whether or not the IRS auditor recommended additional taxes, and if so, whether the taxpayer appealed the additional taxes recommended (tables II.10 through II.12), and the no-change rate for selected audit sources (table II.13).

Agency Comments and Our Evaluation

We requested comments on a draft of this report from the Commissioner of Internal Revenue or her designated representative. Responsible IRS Examination Division officials, including the Acting Assistant Commissioner (Examination); Director, Management and Analysis; and, Team Leader, Management and Analysis, as well as a representative from IRS’ Office of Legislative Affairs provided IRS’ comments in a March 26, 1996, meeting. They basically agreed with the information presented in the report and provided additional explanations for some of the audit trends and results, such as (1) the downward trend in overall audit rates, as well as the rate for the highest-income nonbusiness individuals, from fiscal years 1988 to 1993; (2) the increases or decreases in additional taxes recommended for the highest-income business and nonbusiness individuals from fiscal years 1992 to 1994; (3) the decrease in additional taxes recommended for the lowest-income business individuals from fiscal years 1992 to 1994; and (4) the amount of additional tax recommended per direct hour for the highest-income individuals compared to that for the lowest-income individuals. In response to their comments, we have incorporated the additional explanations in the report where appropriate.

As agreed with you, unless you announce the contents of this report earlier, we plan no further distribution of this report until 30 days from the date of this letter. At that time, we will send copies of this report to various congressional committees, the Commissioner of Internal Revenue, and other interested parties. We also will make copies available to others upon request.

The major contributors to this report are listed in Appendix III. If you have any questions concerning this report, please contact me at (202) 512-9044.

The Trend in IRS Individual Audit Rates for Fiscal Years 1988 Through 1995

This appendix presents our analysis of the trend in IRS’ individual audit rates from fiscal year 1988 through fiscal year 1995. The audit rate is the percentage of individual tax returns that IRS has audited of the total number of individual tax returns filed. The appendix includes a comparison of IRS’ published annual audit rates, which include both district office and service center results, with recomputed audit rates that we derived by excluding service center results. It also presents trends in individual audit rates by geographic location as well as by various income groups.

Audit rate by fiscal year (continued)

The Results of IRS Individual Audits for Fiscal Years 1992 to 1994

This appendix presents our analysis of the results of IRS’ individual audits from fiscal year 1992 through fiscal year 1994. It includes information on the number of individual returns audited; the amount of direct hours and additional taxes recommended resulting from these audits; and a computation of the direct hours per return, as well as the additional taxes recommended per return and per direct hour, for the following four categories: (1) taxpayer income groups, (2) audit sources, (3) types of audit staff, and (4) types of audit closures.

Table II.2: Direct Audit Hours and Additional Recommended Tax by Audit Class, FYs 1992 Through 1994

Table II.3: Audit Productivity by Audit Class, FYs 1992 Through 1994

Table II.4: Number of Individual Returns Audited by Examination Position, FYs 1992 Through 1994

Table II.7: Number of Individual Returns Audited by Audit Sources, FYs 1992 Through 1994 Note 1: See glossary for definition of terms used in this table.

Note 2: Percentages are the percent of total audits for the year and have been rounded to the nearest whole percent.

Table II.8: Direct Audit Hours and Additional Recommended Tax by Audit Source, FYs 1992 Through 1994

Note 1: See glossary for definition of terms used in this table.

Note 2: Dollars rounded to the nearest whole dollar.

Table II.10: Number of Returns Audited by Type of Closure, FYs 1992 Through 1994

Table II.13: Number of Audits Resulting in No Change Without Adjustment, FYs 1992 Through 1994 Note 1: See glossary for definition of terms.

Note 2: Percentages are the percent of individual audits resulting in No Change Without Adjustments by the specific audit source for the year, rounded to the nearest whole percent.

Major Contributors to This Report

General Government Division, Washington, D.C.

Glossary

Claims for Refund

Returns involving an audit of an amended return in which the taxpayer has claimed a refund.

Compliance Projects

Returns identified through IRS’ information gathering projects.

Returns selected on the basis of a computer generated score (the scoring is based on an analysis technique known as discriminate function).

DIF Multiyear

Related returns from prior or subsequent years for the same taxpayer identified during the audit of a DIF-source return.

DIF Related

Related returns identified during an audit of a DIF-source return, other than returns from prior or subsequent years.

Non-DIF Multiyear

Related returns from prior or subsequent years for the same taxpayer, when the initial source was other than a DIF-source return.

Nonfilers

Audits initiated against known taxpayers who did not file a return with IRS.

Other Sources

Over 25 other audit sources, such as referrals from other IRS Divisions, which were not one of the 10 largest sources during the period of our review.

Regular Classification

Manually selected returns for audit that do not result from other specified audit sources.

Return Preparers

Returns identified for audit due to questionable tax practitioners.

Self-Employment Tax

Returns involving self-employment tax issues initiated by IRS service center examination staff.

Service Center Studies and Tests

Returns identified through service center projects initiated by the IRS National Office.

State Information

Returns identified from various state sources, generally under exchange agreements between the IRS and the states.

Tax Shelter Related

Related returns of partners, grantors, beneficiaries, and shareholders identified during audits of either partnerships, fiduciaries, or Subchapter S corporations involving potential tax shelter issues.

Total Personal Income

Total income, such as wages and interest, reported on a tax return prior to any deductions or adjustments.

Unallowable Items

Returns involving refundable credits and dependency exemptions, such as the Earned Income Credit, initiated by service center examination staff.

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