IRS Return Selection: Certain Internal Controls for Audits in the Small Business and Self-Employed Division Should Be Strengthened
Released: 2016-01-13T00:00:00

Letter

Background

IRS’s operating divisions develop annual plans to guide audit decisions in terms of the number of returns to be audited. SB/SE audit plans strive to balance the number of audits in any fiscal year across all types of tax returns (e.g., individual income tax returns) and taxpayers (e.g., individual wage earners, small businesses, corporations) given the available number and location of IRS auditors, and knowledge about types of noncompliance to pursue through audits.

SB/SE conducts audits through field offices located in seven regional areas. These audits generally are conducted by meeting with the taxpayer and/or his or her representatives. The field auditors include revenue agents who tend to audit the most complex returns and tax compliance officers who tend to audit simpler returns. SB/SE also does audits through its four campus locations; these audits tend to be the simplest and are generally done by tax examiners through correspondence with the taxpayers. Figure 1 shows an organizational chart of IRS’s operating divisions and SB/SE’s audit offices.

In fiscal year 2014, SB/SE closed 823,904 audits, representing more than half of nearly 1.4 million closed audits across IRS in fiscal year 2014. SB/SE audits resulted in over $12 billion of the $33 billion in total recommended additional taxes across all IRS audits. For details on results of SB/SE audits, see appendix II.

In addition to audits, IRS conducts nonaudit compliance checks, which may lead to an audit. These checks include the Math Error, Automated Underreporter (AUR), and Automated Substitute for Return (ASFR) programs. The Math Error program electronically reviews tax returns as they are filed for basic computational errors or missing forms/schedules. Several months after returns have been filed, AUR electronically matches information reported by third parties, such as banks or employers, against the information that taxpayers report on their tax returns. This matching helps identify potentially underreported income or unwarranted deductions or tax credits. ASFR also uses information return data to identify persons who did not file returns; constructs substitute tax returns for certain nonfilers; and assesses tax, interest, and penalties based on those substitute returns. Although these and other compliance checks may identify potentially noncompliant tax returns that are subsequently audited, these programs are not the subject of this report.

In March 2014, IRS’s Chief Risk Officer, who oversees its agency-wide program to identify and assess risks, completed a high-level, risk-based review of the IRS audit selection process. The review focused on the potential for bias based on the judgment of the Risk Officer and not on analysis against objective standards, such as comparing steps in the process to the internal control standards. Even so, the Risk Officer concluded that IRS maintained sound internal controls in its audit programs and that the risk of partiality in IRS’s audit selection was very low. The risk of partiality appeared lowest in the automated selection programs. It appeared to be slightly higher for manual selection and referral programs because greater employee judgment was involved.

SB/SE Uses a Multiphase Process and Many Methods to Identify and Review Returns for Potential Audit; Most Returns Are Not Selected

SB/SE Uses a Multiphase Process to Select Tax Returns for Audit

SB/SE selects potentially noncompliant tax returns for audit using a multiphase process intended to enable IRS to narrow the large pool of available returns to those that most merit investment of audit resources. As shown in figure 2, in broad terms, this process generally includes (1) identifying an initial inventory of tax returns that have audit potential (e.g., reporting noncompliance), (2) reviewing that audit potential to reduce the number of returns that merit selection for audit (termed “classification”), (3) selecting returns by assigning them to auditors based on a field manager’s review of audit potential given available resources and needs, and (4) auditing selected returns.

SB/SE Uses More Than 30 Methods to Identify and Review Returns for Potential Audit

SB/SE uses 33 methods, called workstreams, to identify and review tax returns that may merit an audit. These workstreams can be categorized into seven groups based on how the return was initially identified (see appendix IV for a table of workstreams by group). We have listed these groups in general order of how much discretion is involved in identifying, reviewing, and selecting returns, starting with those that involve more discretion. This ordering does not correspond to the number of audits conducted. For example, although referrals generally involve more discretion in selecting returns for audit, they do not make up the largest percentage of SB/SE field audits (see figure 3).

Referrals. IRS employees and units, as well as external sources, such as other agencies and citizens, can refer potentially noncompliant taxpayers to SB/SE. SB/SE may start an audit if the referral indicates significant potential for noncompliance. Referrals can involve, among others, those promoting shelters created to avoid taxation, whistleblowers, and those not filing required tax returns.

Related pickups. After opening an audit, SB/SE may identify the taxpayer’s prior or subsequent year returns or returns of related taxpayers to audit.

User-developed criteria. These criteria use filters or rules embedded in computer software to identify returns with specific characteristics, often for projects. These characteristics generally involve a specific tax issue known or suspected to have high noncompliance in a particular geographic area, industry, or population. For example, the criteria may be used for projects that explore or test ways to uncover noncompliance or improve compliance.

Computer programs. Computer programs use rules or formulas to identify potential noncompliance across a type of tax return, rather than for a specific tax issue. For example, IRS uses a computer algorithm, the discriminant function (DIF), to determine the probability of noncompliance somewhere on the tax return. When a return receives a high enough score, SB/SE may review the return for audit potential.

Data matching. When information on a tax return—such as wages, interest, and dividends—does not match information provided to IRS by states, employers, or other third parties, these discrepancies may prompt SB/SE to review returns for audit potential. An example of a workstream that uses data matching is the payment card income pilot, which uses information from credit card transactions to identify income that may be underreported.

Taxpayer-initiated. When taxpayers contact IRS to request an adjustment to their respective tax returns, tax refunds, or tax credits, or request to have a previous audit reconsidered, SB/SE may initiate an audit after reviewing these requests.

Random identification. The National Research Program (NRP) studies tax compliance through audits of a randomly-identified sample of tax returns. Specifically, NRP measures voluntary compliance in reporting income, deductions, and credits, among other categories, and generalizes those measures to the population being studied.

SB/SE Selection Methods Have Similarities but Also Vary

All of SB/SE’s selection methods or workstreams follow the general multiphase selection process to identify and review potentially noncompliant returns before selecting and actually auditing them. Workstreams also share some common characteristics. For example, multiple staff are involved in the various phases so that one person cannot control the entire process. About one-third of the workstreams use some form of automation to identify the returns that should enter the workstream. Most workstreams involve some form of manual review to determine which returns have audit potential. For example, IRS auditors review (i.e., classify) tax returns identified as having audit potential to determine which returns have the highest potential and which parts of the return should be audited. Finally, all workstreams screen out returns as part of the review process. This winnowing means that the large pool of returns initially identified as having audit potential becomes a much smaller pool of returns that are selected for audit.

However, variations exist among the workstreams, particularly between the field and campus. For example, the field process generally uses more review steps and manual involvement (e.g., classification) than for campus. The latter generally focuses on a single compliance issue and relies more on automated filters and rules to identify returns. Among field workstreams, the extent of review varies. For example, a few workstreams use a committee to review proposals and authorize new projects or investigations before returns can enter the workstream. Also, for field audits, group managers generally decide whether to assign, hold, or screen out returns for audit, whereas returns selected for campus audits are generally assigned through automated processes after campus analysts review the returns to ensure that they adhere to the selection rules embedded in the automated processes. Some workstreams, such as taxpayer claims and some referrals, involve more manual processes to identify and review returns; other workstreams involve both manual and automated processes or are almost entirely automated. Finally, the procedures for screening out returns vary across workstreams.

SB/SE Relied on Different Methods in Its Field and Campus Locations to Select Most Returns for Audit

In fiscal year 2014, related pickups from various identification methods or workstreams accounted for about 50 percent of SB/SE closed field audits. Most of these pickups were related to various ways in which taxpayers attempt to shelter income from taxation and DIF-sourced returns. The DIF workstream alone (part of the computer program identification group) accounted for over 22 percent of SB/SE closed field audits, and various referral workstreams accounted for nearly 7 percent, as shown in figure 3. For details on the workstreams included in the categories shown in figure 3, see appendix VI.

For campus audits closed in fiscal year 2014, available IRS data showed that 31 percent focused on the Earned Income Tax Credit (EITC). SB/SE relies on a computer program known as the Dependent Database (DDb) to identify most of the returns to be audited for EITC issues. DDb is a rules-based system that identifies potential noncompliance related to tax benefits based on the dependency and residency of children. According to IRS, DDb rules are reviewed yearly for changes, and no additional filtering or review is needed on the cases that are selected for audit. In fiscal year 2014, DDb identified more than 77 percent of the closed EITC audits. The other approximate 23 percent of closed EITC audits were identified using various other methods, such as referrals from within IRS and pickups related to audits of other tax returns.

Most Returns SB/SE Identified for Potential Audit Were Not Selected

SB/SE does not have complete data on the number of returns that are initially identified as having audit potential, reviewed, and selected for audit for all 33 workstreams. Using data that are available, table 1 illustrates differences in the extent to which returns are winnowed from identification through selection for two workstreams. For example, about half of the DIF-sourced returns reviewed were selected for audit, and almost all returns reviewed for NRP were selected for audit.

Some SB/SE Procedures for Selecting Returns for Audit Met Internal Control Standards, but Objectives Were Unclear and Documentation and Monitoring Procedures Were Inconsistent

An effective internal control system can help federal agencies achieve their missions and objectives and improve accountability. As set forth in Standards for Internal Control in the Federal Government, also known as the Green Book, internal controls comprise the plans, methods, and procedures used to meet an entity’s mission, goals, and objectives, which support performance-based management. Internal controls help agency program managers achieve desired results. They also provide reasonable assurance that program objectives are being achieved through, among other things, effective and efficient use of resources. Internal control is not one event, but rather a series of actions and activities that occur throughout an entity’s operations and on an ongoing basis. Two examples of internal control standards are the establishment of clearly defined objectives and a commitment to documenting significant events.

SB/SE has some procedures in place that are consistent with internal control standards. However, we identified some internal control weaknesses that leave SB/SE vulnerable to inconsistent return selection for audit or the perception of it.

Some SB/SE Procedures Met Internal Control Standards

Our review of IRS and SB/SE procedures on selecting returns for audit found several procedures that adhered to internal control standards which provided some assurance of fairness and integrity in the selection process. For our review, we relied on documentation demonstrating that the standards were employed and did not independently test whether the standards were systemically applied.

Ethics. SB/SE demonstrated a commitment to promoting ethical behavior among staff, which provides some high-level assurance that it may be able to meet its goal of integrity and fair treatment of taxpayers in general. For example, IRS’s ethics training and annual certification process provide some assurance that IRS staff should be aware of the need to act ethically and impartially.

Awareness of internal controls by managers. SB/SE has demonstrated a commitment to employ internal control activities to ensure accountability in achieving its mission. All managers are required to do an annual self-assessment of internal control procedures. To the extent that SB/SE managers report deficiencies and SB/SE uses the results, the annual self-assessment can provide assurance that the importance of internal control is understood in SB/SE. Our work was not designed to test how effectively IRS used the self-assessments to identify and address deficiencies.

Segregation of duties. All of SB/SE’s selection workstreams involve multiple parties so that no individual can control the decision-making process. For example, staff who classify a return cannot later audit the same return. Also, for field audits, IRS coordinators in an area office generally determine which returns will be assigned to the field offices, rather than field offices and auditors generating their own work. SB/SE also has procedures to ensure that managers review about 10 percent of returns classified for the DIF and NRP workstreams. Also, managers must approve auditors’ requests to open audits for prior or subsequent year and related returns. Although not every step in the selection process is reviewed, these procedures provide some assurance that the decision to audit a return is not determined unilaterally.

Safeguarding data/systems. SB/SE demonstrated that safeguards are in place to restrict system access to authorized users. IRS has procedures on system security and uses a multitiered authentication process to control system access, which we observed.

SB/SE Has Not Clearly Defined or Communicated “Fairness” in Its Return Selection Process

The mission statements for both IRS and SB/SE declare the strategic goal of administering the “tax law with integrity and fairness to all.” SB/SE officials stated that integrity and fairness are core values of IRS. However, they did not define these terms or provide evidence that staff know what is to be achieved by this strategic goal. Without a clear definition of fairness that has been communicated to staff, SB/SE has less assurance that its staff consistently treat all taxpayers fairly.

Internal Control Standard: Define objectives Internal control standards call for program objectives to be clearly defined in measurable terms to enable the design of internal control for related risks. Specific terms should be fully defined and clearly set forth so they can be easily understood at all levels of the entity. Consistent information must be reliably communicated throughout the entity if the entity is to achieve its goals. “The purpose of the Internal Revenue Service is to collect the proper amount of tax revenues at the least cost to the public, and in a manner that warrants the highest degree of public confidence in our integrity, efficiency and fairness.” “All must perform their professional responsibilities in a way that supports the IRS Mission. This requires auditors to provide top quality service and to apply the law with integrity and fairness to all.” “The obligation to protect taxpayer privacy and to safeguard the information taxpayers entrust to us is a fundamental part of the Service’s mission to apply the tax law with integrity and fairness to all.” “Requirements governing the accuracy, reliability, completeness, and timeliness of taxpayer information will be such as to ensure fair treatment of all taxpayers.”

These references point to the overall concept of fairness without explaining what it means, particularly when selecting tax returns for audit. Fairness can be difficult to define because everyone may have different concepts of what constitutes fair treatment. We heard different interpretations of fairness and integrity from IRS participants involved in the selection process during the eight focus groups we conducted. Given the different interpretations, not having a clear definition of fairness unintentionally can lead to inconsistent treatment of taxpayers and create doubts as to how fairly IRS administers the tax law. In our focus groups, SB/SE staff stated that they viewed audit selection as fair when they: focus on large, unusual, and questionable items, do not consider taxpayer’s name, location, etc., avoid auditing taxpayers they know or may be in their neighborhood, treat issues consistently across returns, apply same standards, treat all taxpayers the same, account for varying costs across locations (e.g., housing costs), and avoid being influenced by personal preferences.

Each comment represents someone’s concept of fairness. According to SB/SE officials, IRS relies on the judgment of its staff to determine what is fair. Although many concepts sound similar, they can be different, or even incompatible. For example, some participants said that not considering a taxpayer’s name or geographic location was fair treatment. However, other participants said that considering geographic location was necessary to avoid auditing taxpayers they knew or to determine whether expenses were reasonable for that location (e.g., larger expenses may be reasonable for high-cost locations). Also, some audit projects focus on indications of certain types of noncompliance in specific locations, such as an IRS area or a state. SB/SE officials stated that both views of fairness regarding location may be appropriate for classification.

We reviewed training materials used to instruct revenue agents in the decision-making process when selecting returns to audit, as well as the orientation briefing provided to staff assigned to classification details. Our review of the documentation, as well as discussions with focus group participants involved in classification, indicate that the training materials and the briefing have not defined fairness or how to apply it consistently when selecting returns for audit.

Another challenge to treating all taxpayers consistently or under the same standard arises when the group manager in the field has to manage resource constraints. Some group managers talked about not having the right type and grade of auditor in a location to select a particular return that was deemed worth auditing. Others talked about not having enough travel money for auditors to justify selecting some tax returns. Group managers in other locations may be able to select a similar return because they have fewer of these constraints.

In addition, SB/SE officials said that what is fair may vary depending on the role of the IRS staff involved. They said IRS staff members may have different perspectives of what is “fair” depending on their responsibilities and position, such as IRS staff who are analysts or managers in headquarters versus analysts, auditors, and their managers in the field.

SB/SE Has Not Established Objectives for Fair Selection of Returns for Audit, Which Challenges Performance Measurement and Risk Management

SB/SE has not established objectives on the fair selection of returns. Without a definition of fairness, SB/SE cannot be assured that an objective for fair selection clearly indicates what is to be achieved. For example, objectives could be based on definitions of fairness that we heard in our focus groups, such as the extent to which selection occurs because of large, unusual, and questionable items on a return or because SB/SE is applying the same standards to similar tax returns.

Internal Control Standard: Assess risks and performance to objectives Internal control standards call for management to set program objectives that align with an entity’s mission, strategic plan, goals, and applicable laws and regulations. Clearly-defined objectives can enhance the effectiveness and efficiency of a program’s operations and are necessary to assess risks. Objectives should clearly define what is to be achieved, who is to achieve it, and how and when it will be achieved. Documenting objectives promotes consistent understanding.

SB/SE develops audit objectives in its annual work plan. For fiscal year 2014, audit objectives included (1) review workload identification and selection models, collaborate with other IRS units to revise processes/guidelines, and develop guidance and monitoring tools to ensure consistent application; and (2) use more research data to develop alternative workload identification streams and delivery. These objectives address the process of selecting returns but not whether returns are selected fairly. For example, applying selection models and processes consistently does not ensure that the models and processes were designed to achieve fairness. Further, IRS has not identified a level of consistency that would indicate that fairness has been achieved.

Without clearly-defined objectives aligned to its mission and a clear understanding across SB/SE of how fairness is defined, SB/SE has less assurance that it is measuring progress toward or achieving its strategic goal of treating taxpayers fairly.

IRS Has Established Performance Measures, but None Directly Assessing Fair Selection of Returns for Audit

Given that SB/SE does not have clearly-defined objectives on fair selection, it also does not have performance measures aligned with these objectives and explicitly tied to integrity or fairness. For example, if IRS defined fairness as focusing on large, unusual, and questionable items and developed an objective based on this definition, performance measures could assess the quality and extent to which auditors focused on these items. SB/SE officials pointed to a variety of existing performance measures that they believe assess whether selection processes were impartial and consistent. Examples of these performance measures include: IRS’s Customer Satisfaction survey asks taxpayers to rate their satisfaction with the auditor’s explanation for how the return was selected for audit. However, SB/SE did not show how answers were used to assess whether the selection process was fair or modify the process to make it fair. Further, taxpayer dissatisfaction is subjective, and taxpayers would not have context to know why their returns were selected compared to others.

SB/SE conducts business reviews to assess how well its selection process is performing. However, concerns raised in these reviews focused on selection process steps, such as ordering returns and conducting research projects, instead of the underlying fairness of selecting a return.

All employees are to be evaluated on how well they provide fair and equitable treatment to taxpayers as required by the Internal Revenue Service Restructuring and Reform Act of 1998; the IRM provides examples of behaviors that would meet this requirement. These behaviors may be consistent with IRS’s mission, but they focus on how taxpayers were treated after the audit started rather than how auditors reviewed returns for potential audit selection.

Without performance measures that align with objectives to achieve fair selection, SB/SE lacks assurance that it can measure progress toward fair return selection.

IRS Has Taken Steps to Identify Risks, but Linkage to Audit Selection Objectives Is Needed

IRS’s efforts to identify risks and assess whether and how to manage them operate under two complementary approaches.

Internal controls framework. The procedures in IRM 1.4.2 govern IRS’s processes for monitoring and improving internal controls, which include the identification and mitigation of risks. Managers are expected to understand the risks associated with their operations and ensure that controls are in place and operating properly to mitigate those risks.

Enterprise Risk Management (ERM). ERM is broader in scope than internal controls, focusing on agency-wide risks. ERM is intended to help organizations in setting strategy to consider risk and how much risk the organization is willing to accept. IRS implemented ERM in February 2014 to increase awareness by IRS management of IRS- wide risks and to serve as an early-warning system to identify emerging challenges and address them before they affect operations.

Both approaches to risk management require clear, defined objectives in measurable terms to identify and analyze risks that could challenge achieving desired outcomes. Risks toward achieving those objectives can be identified and analyzed, and risk tolerances can be determined.

Understanding the significance of the risks to achieving objectives provides the basis for responding to the risks.

Without clear audit selection objectives on fairness, SB/SE lacks assurance that it can identify and assess risks to the fair selection of returns to audit. Absent risk identification and assessments linked to program objectives, vulnerabilities may go unaddressed, which could lead to unfair return selection.

SB/SE Has Not Consistently Documented Audit Selection Procedures and Decisions

We found many instances where SB/SE documented the review and selection of returns for audit. However, we also found several instances where SB/SE did not document various aspects of its return selection process nor locate documentation in time for our review.

Internal Control Standard: Document transactions Internal control and all transactions and other significant events need to be clearly documented, and the documentation should be readily available for review.

Audit plan changes. Changes to the field audit plan are documented during the annual planning process, but SB/SE did not document its process for modifying the field audit plan during the year. According to SB/SE officials, they modify the plan during the year as additional budget and staffing information from IRS’s finance unit becomes available. Officials stated that changes to this audit plan are documented by the budget information received and by the recalculated plan. However, SB/SE did not document how it translated the budget and staffing information into changes in the inventory targets or staffing nor why some targets were changed but not others.

Selection decisions and rationale. SB/SE did not consistently document decisions for selecting certain tax returns over others for audit and the rationale behind the decisions. SB/SE does not require all of these decisions and rationales to be documented. Returns that are stored electronically and are deemed to be excess inventory can be screened out without documentation such as a form, stamp, or signature. For discriminant function (DIF)-sourced returns, SB/SE’s primary workstream for field audits, and some referrals, only a group manager stamp is required to screen out the returns, rather than also documenting the rationale for screening them out. Documentation requirements also vary within a workstream. For example, for returns involving a tax shelter fostered by a promoter, audit screen-out rationales are required to be documented at the group level in the field but not at the area office level. Officials said that, aside from the Form 1900 for certain returns, they generally do not document why a return was not selected. To illustrate, we found nine files without documentation of the screen-out decision or rationale in our file review of 30 screened-out returns. Regardless of whether a form is required, the screen-out decision should be documented.

Files not located. IRS could not locate 18 of the 233 files we requested in time for our review. For example, for non-DIF pickup returns, 5 out of 24 files requested were not located in time. For all types of referrals we reviewed, we were unable to review 8 out of 56 files requested because they were not located in time. According to officials, IRS could not locate these files because files for one audit may be stored with files for any number of related audits, files for open or recently closed audits may not yet be available, and files may have been stored in the wrong location.

In addition to internal control standards, the IRM requires all records to be efficiently managed until final disposition.

Having procedures to ensure that selection decisions and rationale are clearly and consistently documented helps provide assurance that management directives are consistently followed and return selection decisions are made fairly. Further, being able to find files efficiently can aid congressional and other oversight, and prevent unnecessary taxpayer burden if IRS later needs to contact the taxpayer regarding material that would have been in the file.

SB/SE Has Not Regularly Monitored Decisions Made and Coding Used for Audit Selection

As discussed earlier in this report, SB/SE has procedures that, if implemented, help provide some assurance that its return selection process is generally monitored. However, we found that SB/SE did not have requirements to monitor certain steps in the selection process.

Internal Control Standard: Monitor controls Program managers should have a strategy and procedures to continually monitor and assure the effectiveness of its control activities. Key duties and responsibilities should be divided among different people to reduce the risk of error and to achieve organizational goals. Program managers need operational data to determine whether they are meeting their strategic and annual performance plans and their goals for effective and efficient use of resources.

Dollar threshold for campus audits. We found that the dollar threshold for selecting some returns for campus audits has remained constant or has been adjusted informally based on inventory needs. SB/SE has not evaluated whether the threshold should change or be changed more formally. According to officials, the dollar threshold is the break-even point for collecting enough tax to justify the audit. However, the threshold is only a guide; sometimes the threshold can be higher depending on how many returns need to be audited to meet the audit plan. According to one official, the threshold amount has been in place at least 4 years and possibly as long as 10 years.

Classification review. We also found that classification decisions are not always required to be reviewed. For DIF and NRP returns, about 10 percent of classified returns are required to be reviewed for accuracy and adherence to classification guidelines. However, other field audit selection methods, including some referrals, do not include a formal classification quality review. Likewise, campus audit selections by analysts are not formally reviewed.

Review of group manager decisions. SB/SE does not always require that group manager return selection decisions (i.e., screen- out) be reviewed. Even though multiple people are involved, in some cases, the group manager can independently make the final selection or screen-out decision. For state and agency referrals, and others to varying degrees, screen-out decisions by group managers are not reviewed. For example, in our file review of 30 screened-out returns, 8 were screened out by group managers. We did not see documentation of the approval for screening out these returns because such documentation was not required. According to SB/SE officials, group managers are the most knowledgeable about the resources available to meet audit goals. The managers also consult with territory and area managers to determine which returns should be screened out. For campus audits, approvals are not required to screen out returns from audit. Officials said that workload selection analysts communicate about the status of current and upcoming work to determine which returns are excess inventory and not needed to meet the annual audit plan or unable to be worked because of resource limitations.

Source codes. We found that some codes for identifying the return to be audited, called source codes, were mislabeled, not used, or not well defined, even though the IRM states that all data elements in IRS databases should be defined and documented. In our review of 215 files, six returns were coded as non-Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) related pickups. SB/SE officials later explained that these returns were mislabeled and should be moved to the source code used for TEFRA-related work. We also found two files that were coded as information referrals that should have been coded as related pickup audits, one file that was coded as a DIF-sourced return that should have been coded as a claim by a taxpayer to adjust a return he or she had filed, and three files that were coded as compliance initiative projects that should have been coded as returns selected to train auditors. For campus audits, source codes are assigned to each return audited but are not used to identify, select, or monitor campus inventory and do not serve any other purpose in campus audits. As a result, a source code may not represent the actual source of the inventory. Further, we found two source codes that were not well defined. One source code associated with about 35 percent of campus audits completed in fiscal year 2014 included references to DIF that were generally not applicable, since these returns were not related to or identified using DIF scoring. Another source code associated with about 18 percent of campus audits completed in fiscal year 2014 was labelled as two different items and did not accurately describe many of the returns using this code.

Spreading responsibility for reviewing selection and screen-out decisions can reduce the potential for error and unfairness. In addition, adequate controls can help ensure that audits are appropriately coded so that IRS has accurate information to better ensure the efficient and effective use of resources. For example, having better controls on how returns are coded decreases the risk that data elements are misleading, which can hinder the decision-making process, such as prioritizing returns to select for audit and analyzing whether goals are met.

Conclusions

SB/SE relies on a variety of sources and processes to select returns for audit. This complexity underscores the importance of having a robust internal control system to support the selection process and achieve SB/SE’s mission of administering the “tax law with integrity and fairness to all.” SB/SE has some procedures in place that are consistent with internal control standards. However, we identified some internal control weaknesses that leave its audit program vulnerable to inconsistent return selection or the perception of it. Without effective internal controls, including defining fairness in selecting returns, SB/SE cannot know if it is achieving its mission and whether its return selection policies and procedures are aligned with its mission. Further, IRS will not be able to manage risk or monitor performance as well as it otherwise could. Finally, IRS risks the appearance that its return selection process is unfair to taxpayers because it is unable to communicate key pieces of information, such as its definition of fairness, to the public.

Recommendations for Executive Action

To help ensure SB/SE’s audit selection program meets its mission and selects returns fairly, we recommend that the Commissioner of Internal Revenue take the following actions:

Clearly define and document the key term “fairness” for return selection activities.

Clearly communicate examples of fair selections to staff to better assure consistent understanding.

Develop, document, and implement program-level objective(s) to evaluate whether the return selection process is meeting its mission of applying the tax law with integrity and fairness to all.

To help ensure that SB/SE’s audit selection objective(s) on fairness are used and met, we recommend that the Commissioner of Internal Revenue take the following actions:

Develop, document, and implement related performance measures that would allow SB/SE to determine how well the selection of returns for audit meets the new objective(s).

Incorporate the new objective(s) for fair return selection into the SB/SE risk management system to help identify and analyze potential risks to fair selections.

In addition, we recommend that the Commissioner of Internal Revenue take the following actions:

Develop and implement consistent documentation requirements to clarify the reasons for selecting a return for audit and who reviewed and approved the selection decision.

Develop, document, and implement monitoring procedures to ensure that decisions made and coding used to select returns for audit are appropriate.

Agency Comments and Our Evaluation

We provided a draft of this report to the Commissioner of Internal Revenue for review and comment. The Deputy Commissioner for Services and Enforcement provided written comments on November 23, 2015, which are reprinted in appendix VII. IRS stated that it agrees with the importance of sound internal controls and is committed to their improvement, especially in the areas we recommended. IRS stated that it agreed with our seven recommendations. Accordingly, the enclosure to the letter listed specific IRS actions planned to implement the recommendations. IRS also provided technical comments, which we incorporated where appropriate.

As IRS’s letter mentioned, its audit program includes various features that are intended to promote fair return selection, such as documents that convey the importance of “fairness,” existing objectives and measures, and types of monitoring. However, as our report discusses, these features do not clarify what fair selection of returns for audit entails and how IRS would know whether fair selections are occurring, except for when someone such as a taxpayer questions the fairness of return selection.

For our recommendations on defining and documenting “fairness” for return selection activities and communicating examples of fair selections to staff, IRS stated that the concept of fairness has both collective and individual attributes. IRS noted that fairness for return selection encompasses three components—pursuing those who fail to comply, objectively selecting noncompliant returns across all areas of noncompliance, and respecting and adhering to taxpayers’ rights. As such, IRS has taken the first step to implement our recommendation. However, to fully implement our recommendation, IRS will need to clarify how each component relates to return selection. For example, the first and third components also cover what happens after return selection, such as pursuing noncompliance and interacting with taxpayers during the audit.

In regard to our recommendations on developing one or more program objectives and related measures on return selection related to fairness, as our report discusses, IRS’s current program objectives and measures do not address fair selection of returns. We believe that IRS should develop at least one objective and related measure that tie to its definition of fairness. Doing so would allow IRS to more conclusively demonstrate and assess whether its selection decisions were fair.

We also recommended that IRS improve the documentation and monitoring of selection decisions. Our report acknowledges that documentation and monitoring does occur in many areas but provides examples of the need for more in other areas. As such, IRS needs additional documentation and monitoring as opposed to merely a plan to evaluate the need to take these actions.

We note three other clarifications based on statements in IRS’s letter.

First, IRS’s letter correctly stated that our report did not identify any instances where the selection was considered inappropriate or unfair. We did not design our study to look for inappropriate and unfair selections, but rather to assess the internal controls that help ensure a fair selection process. Further, even if we did design our study to look for unfair selections, our design would be hampered by the lack of a definition for fairness and related objective(s) and measures(s) to evaluate whether selections were fair.

Second, IRS’s letter stated that the seven groupings in our report do not reflect how IRS views its workstreams for identifying returns for potential audit selection. As discussed in the report, our groupings are based on how a return was initially identified rather than on IRS’s workstreams. For example, related pickups, including DIF-related pickups, are identified by auditors, whereas DIF-selected returns are identified by a computer algorithm. Therefore, we separately grouped DIF-related pickups from DIF- selected returns. Furthermore, IRS could not provide complete data on the number of returns audited from each of its workstreams but could provide data on audits selected from other sources, such as related pickups. While some of these sources could be associated with a workstream, it was not possible for all. As a result, we used the available IRS data to show how all SB/SE audits were distributed by these audit identification workstreams and sources (shown in the report as figure 3).

Third, DIF return selections do not involve the least amount of discretion, as IRS’s letter stated. As discussed in our report, many returns that were initially identified through DIF automation as having audit potential were not audited. The actual audit selections do not occur until multiple IRS staff review those returns, requiring some human discretion. Our report discusses other groupings with less staff discretion than DIF, such as when taxpayers request that IRS review their returns or when IRS randomly selects returns for a research program.

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 Secretary of the Treasury, Commissioner of Internal Revenue, and other interested parties. In addition, this report is available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions or wish to discuss the material in this report further, please contact me at (202) 512-9110 or mctiguej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix VIII.

Appendix I: Objectives, Scope, and Methodology

This report (1) describes the processes for selecting Small Business/Self- Employed (SB/SE) returns for audit, and (2) assesses how well the processes and controls for selecting those returns support SB/SE’s mission of “applying the tax law with integrity and fairness to all.”

For the first objective, we reviewed Internal Revenue Service (IRS) documents that describe the processes and criteria for selecting SB/SE returns for audit. These documents included sections of the Internal Revenue Manual (IRM), procedures documents, process flowcharts, and summaries of selection processes prepared by SB/SE officials. We also interviewed IRS officials responsible for overseeing audit selection. To provide information on closed IRS and SB/SE audits, we analyzed data for 2011 through 2014 from the Compliance Data Warehouse Audit Information Management System (AIMS) closed table. We compared the results of our analyses of data in AIMS to the IRS data book to assess consistency of results. We determined that these data were sufficiently reliable for the purposes for which they were used in this engagement.

For the second objective, we reviewed SB/SE’s procedures for selecting returns for audit and related internal controls intended to help SB/SE achieve its stated mission of “enforcing the tax law with integrity and fairness to all.” We then assessed whether these procedures followed standards from Standards for Internal Control in the Federal Government that were relevant to return selection. To determine which standards were most relevant, we used our Internal Control Management and Evaluation Tool, in conjunction with observations from our preliminary audit work. We selected the most relevant internal control standards as criteria in consultation with SB/SE officials and our financial management and assurance and information technology teams.

We also conducted eight focus groups with selected SB/SE staff who are responsible for reviewing or selecting SB/SE returns for audit. We held two groups with field office staff who review returns for audit potential, two groups with area office staff who coordinate the review process, two groups with field office group managers who select returns for audit, one group with campus staff who review and select returns for audit, and one group with specialty tax group managers who select returns for audit. Within these five populations, we randomly selected participants who met our criteria of having more than 2 years of IRS work experience, working in different IRS offices nationwide, and covering a range of compliance issue areas. In total, our groups involved 58 participants with an average of about 9 years of IRS experience, with a range from 3 to 32 years of experience. The focus groups were held by telephone. We asked questions on internal control related topics, such as the clarity of SB/SE procedures and the adequacy of guidance to apply these procedures.

To assess the extent to which SB/SE implemented its procedures, we conducted a file review. We used IRM sections and SB/SE procedures documents as criteria. We obtained the population of SB/SE audits opened from March 2014 to February 2015 as shown in the open AIMS database and selected a nonprobability sample of 173 returns to review. Although the results of our file review cannot be projected to the population of SB/SE audits, they represent a variety of types of returns, sources, and selection processes. We focused on processes that required more manual review or affected a large number of taxpayers. As reflected in table 2, we reviewed more files for referrals and compliance initiative projects because they involve more human discretion in deciding whether to include the return in the selection inventory and in reviewing the returns for audit potential than for some other categories. We also reviewed more files for discriminant function (DIF) returns compared to some other categories because DIF returns are the largest portion of SB/SE’s field audit workload by selection method or workstream. We reviewed the files to determine if decisions were documented and if staff followed procedures, such as documenting the rationale and approval for selecting or screening out returns. In sum, table 2 reflects the different types of returns we sampled, the type of files we reviewed, and the population and sample size of the files.

As shown in the last two rows of table 2, we also reviewed nongeneralizable, random samples of 30 returns that had been surveyed (i.e., screened out) and 30 classification quality review records for the same general time period as the audit files we reviewed. We created a separate sample of screened-out returns because audits were not opened on these returns. The database we used to create the audit file sample only contained returns that had been audited. We obtained the population of screened-out returns from SB/SE officials and randomly selected our sample from this population. We created a separate sample for classification quality review records because SB/SE reviews classification decisions per auditor rather than per return. We obtained the population of auditors that were reviewed during the same general time period as the files for the other samples. We identified subpopulations by region and selected a stratified random sample of these subpopulations.

Finally, we interviewed SB/SE officials about the procedures and discussed deficiencies we identified. We designed uniform data collection instruments for our file review to consistently capture information on the completeness of required documentation and approvals related to return selection. IRS reviewed the instruments and the data we captured. To ensure accuracy, two of our analysts reviewed each file we assessed and reconciled any differences in responses. We then analyzed the results of these data collection efforts to identify main themes and develop summary findings.

We conducted this performance audit from September 2014 to December 2015 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: Summary of Small Business/Self-Employed (SB/SE) Audit Results, Fiscal Year 2014

Appendix III: Description of Small Business/Self-Employed (SB/SE) Selection Methods or Workstreams

1. Area Office Referral - Area office field personnel refer potential leads with correspondence audit issues to Campus Reporting Compliance (CRC). 2. Audit Information Management Systems (AIMS)/AIMS Computer Information System (A-CIS)/Previously Adjusted Exam Issues on Subsequent-year Filings - Quarterly A-CIS reports are run to identify every campus case closed agreed or default in each of the discretionary audit programs. The subsequent year returns are classified for the same issues that are on the closed audit cases. 3. Audit Reconsideration - Reevaluates the results of a prior audit where additional tax was assessed and remains unpaid, or a tax credit was reversed. IRS also uses the process when the taxpayer contests a Substitute for Return determination by filing an original delinquent return. 4. Campus Reporting Compliance (CRC) Compliance Initiative Project (CIP) Usage - CRC uses CIP Authorization (Form 13498) to document approval for testing potential new inventory in correspondence audits. 5. Category A Claims for Refund - Accounts Management staff refer claims for refunds that meet criteria indicating audit potential directly to Classification and Claim Teams within the campuses. 6. Criminal Investigation Referral - CRC uses IRS’s databases to determine if the issues Criminal Investigation identified exist on the referred returns. 7. Claim - A request for refund or an adjustment of tax paid or credit not previously reported or allowed. 8. Collection Referral - CRC receives two kinds of referrals from collection each year. CRC receives three referrals yearly of potential nonfiler leads from the collection queue. CRC also receives occasional referrals of Form 3949 Information Item referrals. 9. Compliance Data Environment Release 3 - Identifies potential audits through user-defined filters and queries, and forwards those selected to the correct treatment stream. 10. Compliance Data Warehouse/Potential Unreported Heavy Use Tax - Identifies Form 2290 returns (Heavy Highway Vehicle Use Tax Return) with potential unreported heavy use tax. 11. Compliance Initiative Project (CIP) – When IRS identifies potential noncompliance in specific groups of taxpayers, CIPs are used to contact or audit taxpayers or collect taxpayer data within that group when another method to identify such workload is not already in place. 12. Discriminant Function (DIF) - A mathematical technique to estimate or “score” the potential merit of auditing a particular tax return based on its characteristics. 13. Discretionary Exam Business Rules (DEBR) - DEBR rules were developed to identify non-Earned Income Tax Credit returns with the highest audit potential for additional tax assessment for certain return conditions. 14. Employee Audit - Any employee selected for audit under any and all methods of inventory identification (e.g., DIF (see definition above), referrals). It also includes inventory that is specifically identified based on the individual’s position within IRS. Inventory identification is designed to ascertain compliance among IRS employees while maintaining their right to privacy. 15. Employment Tax Referral - Specialty tax personnel refer potential audit leads relating to possible unfiled payroll tax returns to CRC (see definition above). 16. Estate & Gift Tax Form 1041 - Filters identify Form 1041 returns reporting charitable contributions, fiduciary fees, and other miscellaneous deductions. 17. Estate & Gift (E&G) Referrals - E&G tax personnel refer potential audit leads relating to possible unreported executor fees to CRC. 18. Government Liaison and Disclosure (GLD) Referrals - GLD personnel refer information to CRC from sources outside IRS, such as states and the Puerto Rican Tax Authority (see definition below), that are potential audit leads. 19. High Income Nonfiler - Strategy designed to address the filing compliance of taxpayers with known sources of income exceeding $200,000. 20. Information Reports - Reports and referrals that may include information on substantial civil tax potential and significant potential for fraud, or are related to returns for tax years not yet required to be filed. 21. National Research Program (NRP) - A comprehensive effort by IRS to measure compliance for different types of taxes and various sets of taxpayers. It provides a statistically valid representation of the compliance characteristics of taxpayers. 22. Offers-In-Compromise/Doubt as to Liability - An offer in compromise is an agreement between the taxpayer and IRS that settles a tax debt for less than the full amount owed. Doubt as to liability exists where there is a genuine dispute as to the existence or amount of the correct tax debt under the law. 23. Payment Card Income Pilot - Potential underreporters are flagged when Form 1099-K receipts, as a portion of gross receipts, are significantly greater than for similar taxpayers, suggesting cash underreporting. 24. Promoter Investigations and Client Returns - SB/SE auditors, as well as other IRS or external sources, refer potentially abusive transaction promoters/preparers for audit. Client returns are audited to determine whether penalties and/or an injunction are warranted. 25. Puerto Rican Tax Authority Nonfiler - The Puerto Rican Tax Authority provides information to IRS through the Government Liaison Office about residents in Puerto Rico who fail to file their federal tax return. 26. Research Referral - Research personnel refer potential audit leads relating to NRP, possible nonfilers, and problem preparers to CRC. 27. Return Preparer Program Action Cases and Client Returns - Clients of questionable preparers are audited to determine whether preparer penalties and/or injunctive actions are warranted. These are limited to preparer misconduct or incompetence that is pervasive and widespread. 28. Submissions Processing - Submission Processing staff refer potential audit leads relating to the Alternative Minimum Tax program, math error, and unallowables to CRC or campus classifiers. 29. State Audit Referral Program (SARP) - SARP utilizes the audit report information submitted to IRS by various taxing agencies to address areas of noncompliance. 30. State/Other Agency Referral - Federal, state, and local governmental agencies share relationships and data with IRS through the Governmental Liaison staff to increase compliance levels, reduce the tax gap, reduce taxpayer burden, and optimize use of resources. 31. Treasury Inspector General for Tax Administration (TIGTA)

Referral - TIGTA personnel refer potential audit leads relating to TIGTA investigations to CRC. 32. Tip Program Referral - Employees who do not report at or above the tip rate as agreed upon by the employer under various agreements with IRS may be referred for audit. 33. Whistleblower Claim - Allegations of violation of federal tax laws made by a person who requests a reward.

Appendix IV: Small Business/Self Employed (SB/SE) Selection Methods by Broad Identification Source

Table 5 shows the selection methods or workstreams by how the returns were identified.

Appendix V: Examples of Similarities and Variations across Selection Methods

Figures 4 and 5 represent general similarities and variations in the Small Business/Self-Employed (SB/SE) return selection process at its field and campus locations, respectively. They do not include every process that occurs in the various methods or workstreams. In addition, the phases and processes in the figures are not necessarily discrete events but may overlap and involve other processes and staff.

Appendix VI: Small Business/Self-Employed (SB/SE) Field Audit Sources and Audit Information Management System (AIMS) Source Codes

The AIMS source code indicates the initial source of how the return was identified for audit. Table 6 shows the number of field audits closed by source code and by grouping of source codes into categories for fiscal year 2014.

Appendix VII: Comments from the Internal Revenue Service

Appendix VIII: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Tom Short (Assistant Director), Sara Daleski, Hannah Dodd, David Dornisch, Elizabeth Fan, Ted Hu, Ada Nwadugbo, Robert Robinson, Ellen Rominger, Stewart Small, Andrew J. Stephens, and Elwood White contributed to this report.