Small Businesses: IRS Considers Taxpayer Burden in Tax Administration, but Needs a Plan to Evaluate the Use of Payment Card Information for Compliance Efforts
Released: 2015-07-22T00:00:00

Letter

Background

Identifying the Small Business Population

A consensus does not exist on a definition of small business, including which specific attributes or thresholds distinguish small businesses from other firms. Estimates of the small business population are driven by the purpose, concepts, and data that are used to produce the estimates. As we have previously reported, various thresholds such as number of employees, gross receipts, and number of shareholders may be used when determining which provisions of the tax code apply to a small business.

In this report, we rely on studies that use taxpayer data for individuals and entities that generate business income. Businesses (including small businesses) file specific tax forms based on certain attributes of the business, such as the ownership structure and how the business income is taxed. Below are different types of businesses and the required forms and schedules.

Nonfarm sole proprietorships (Form 1040, Schedule C) are unincorporated and owned by a single individual. Net business income or loss is included in the owner’s individual adjusted gross income.

Landlords (Form 1040, Schedule E-Part I) are individuals who report rental real estate activity on Part I of Schedule E.

Farmers (Form 1040, Schedule F or Form 4835) are individuals who report farm income or landowners who report farm rental income.

C corporations (Form 1120) are owned by shareholders. Corporate income is taxed at the corporate level on taxable income and at the shareholder level on distributed profits.

S corporations (Form 1120-S) cannot have more than 100 shareholders, among other requirements. Gross income is distributed to shareholders and taxed at the shareholder level.

Partnerships (Form 1065) are unincorporated businesses that have two or more owners. Profits and losses are distributed to owners who are taxed at the partner level.

IRS has separate operating divisions that focus on different types of taxpayers—individuals, small businesses and self-employed, large businesses, and tax exempt organizations. The Small Business and Self- Employed division oversees taxpayers filing tax returns as individuals with business income and as businesses with less than $10 million in total assets. However, not all of these tax returns are for business entities. This is because the principal purpose of some entities that file tax returns reporting business income may not be to generate revenue or to engage in substantive business activity. For example, some C corporations can serve as investment vehicles that engage in little or no business activity. Further, partnerships may be created to redistribute profits generated by Filers of another partnership and may not generate income themselves.Form 1040, Schedule C, may be independent contractors who may more closely resemble employees rather than small businesses. Additionally, rental income for some individuals may be incidental and not represent business activities.

Small Business Tax Compliance Burden

We define tax compliance burden as the time and money spent by the taxpayer to meet tax obligations. This would include federal, state, and local obligations. This does not include tax liability. For the purposes of this report, we are only examining compliance burden as a result of federal tax obligations. Time spent on tax activities can include working with a paid professional, tax planning, keeping records, completing forms, submitting forms, learning tax laws, and working with IRS on tax issues. Monetary burden can include expenses for hiring a paid professional to file taxes, investing in a tax software system, paying for payroll services, and legal fees. When measuring tax compliance burden, researchers may separate burden into both time and money, or they may place a value on the time spent by taxpayers and add it to monetary burden to create a single measure of tax compliance burden. A key concept in tax administration is minimizing burden, including eliminating unnecessary burden.

Most Small Businesses are Individuals, but Most Small Business Income is Earned by Partnerships and Corporations

As shown in figure 1, using data from researchers at Treasury’s Office of Tax Analysis (OTA), most small businesses (approximately 69 percent or 16 million) are individual taxpayers who report business income on their Form 1040, using Schedule C (sole proprietor), Schedule E-Part I (landlords), or Schedule F (farmers). The remaining 31 percent of small businesses (or roughly 7.3 million) are partnerships, S corporations, or C corporations. OTA researchers also provide a total income measure, generally defined as the sum of all business income reported on tax returns, including gross receipts, rents, dividends, capital gains, royalties, and interest. Individual small businesses generated only 23 percent (or $1.4 trillion) of the total income of all small businesses, whereas small business partnerships, S corporations, and C corporations accounted for the majority—77 percent (or about $4.5 trillion)—of total small business income.

When looking at the average total income for small businesses (total income divided by number of filers), partnerships, S corporations, and C corporations each generated more than $450,000 on average, while sole proprietors, farmers, and landlords reported income of about $100,000 or less on average. Figure 2 shows the estimated average total income by small business type.

About 99 Percent of Businesses Report Total Income and Deductions of Less Than $10 Million

Small businesses (as defined as reporting total income and deductions of less than $10 million) make up 99 percent of the taxpayers identified as For being engaged in substantial and substantive business activity.each type of filer, small businesses account for at least 95 percent of businesses. Among individual filers reporting business income, small businesses account for most of the reported income. However, among S corporations, C corporations, and partnerships, larger businesses account for most of the reported income, even though they are far outnumbered by small businesses, as shown in figure 3. The estimated average total income across all types of small businesses is $250,000, while the average total income for larger businesses is estimated to be $121 million.

Most Small Business Income Is Generated by Employers, but Most Small Businesses Are Not Employers

Small businesses with at least one employee (which we will refer to as employers) generated most of the reported total income for small businesses (or about 71 percent). Employers account for about 86 percent of total income for small business C corporations and S corporations combined and about 55 percent for small business sole proprietors, farmers, and partnerships.

Employers make up about 20 percent of all small businesses. Employers make up 16 percent of the combined group of small business Schedule C sole proprietors, Schedule F farmers, and partnerships and 51 percent of the combined group of small business C corporations and S corporations. Figure 4 shows the estimated number of small business filers and total income separated by employers and non-employers.

As shown in figure 5, employer small businesses, on average, generate more income than non-employer small businesses.

Tax Compliance Burdens Vary Depending on a Small Business’s Size, Number of Employees, Entity Type, Industry, and Other Characteristics

Small businesses undertake a number of tax compliance-related activities that create burden. These activities can be grouped into general categories: employer-related tax activities, and third-party information reporting and industry-specific tax activities.

The tax compliance burden associated with these activities varies by characteristics of the small business. Some of these characteristics include the business’s asset size, filing entity type, number of employees, and industry type.

Tax compliance activities are not limited to the annual filing of a tax return, but rather occur throughout the year. For example, sole proprietors are generally required to file income tax returns every April. Some small businesses need to pay estimated income taxes four times a year. Moreover, small businesses with employees are required to deposit employment taxes either monthly or semiweekly, and to report summary information of these activities on a quarterly basis. Additionally, depending on specific business operations, other tax compliance activities such as reporting excise tax, tax planning, and recordkeeping happen throughout the tax year. Figure 6 provides an overview of some of these tax compliance activities for sole proprietors and when they occur.

Appendix III, table 8 provides a more detailed description of tax activities.

Income Tax Activities, Such as Filing Income Tax Forms and Schedules, Vary by Small Business Type

Every year, small businesses need to file income tax returns and may pay estimated income taxes quarterly. The type of small business dictates the type of income tax returns and related schedules that need to be filed. Some of the returns include a set of schedules embedded in the form— found within the income tax return—while some small businesses and individuals with business income must attach a mandatory schedule to their return. For example, the primary corporate income tax return, Form 1120, U.S. Corporation Income Tax Return, contains eight embedded schedules, while sole proprietorships file Form 1040, U.S. Individual Income Tax Return, and attach Form Schedule C, Profit or Loss from Business.

Employer-Related Tax Activities, Such as Withholding Employment Taxes, Depend on a Business’s Number of Employees

Small businesses with employees are responsible for reporting, withholding, and depositing employment and unemployment taxes. While these requirements may impose a cost on employers, withholding is widely believed to improve compliance and may reduce compliance burdens for employees. The number of employment tax reports and deposits depends on the number of employees and the resulting employment tax liability owed at a particular time (see table 1). In general, businesses with an employment tax liability greater than $50,000 need to make deposits more frequently than businesses with a lower liability. Additionally, each year, the employer must furnish a copy of Form W-2, Wage and Tax Statement, to each employee. Since the characteristics of employers vary, responsibilities for withholding, depositing, and reporting employment taxes can differ. For example, consider a small business restaurant owner who has 20 employees and has an employment tax liability of less than $50,000. She files a Form 941 quarterly which details the income tax withholdings for each of her 20 employees. Since her liability is less than $50,000, she deposits these withholdings monthly. At the end of the year, she must complete 20 Forms W-2 to report wages, tips, and other compensation paid to each employee.

Small businesses also report health care and retirement information. The information reported for these areas depends on a business’s number of employees. The entity type also plays a role in the information reported about health care. Under the Patient Protection and Affordable Care Act, employers report the cost of coverage under an employer-sponsored group health plan on Form W-2. Beginning in January 2016, employers with 50 or more full-time employees will need to provide employees with a Form 1095-C, Employer-Provided Health Insurance Offer and Coverage. Some employers decide to offer pension plans and are responsible for reporting this information. While businesses must maintain records about these plans, most pension plans do not have any separate filing or reporting requirements with IRS. However, certain retirement plans offer small employers and self-employed individuals a deduction for contributions, and allows them to defer tax on income paid into the plan. To receive deductions, the small businesses must report this information to IRS using certain forms.

Third-Party Reporting Varies Depending on Business Size and Entity Type; Excise Tax Burden Is Industry Specific

Many businesses, including small businesses, are required to report on certain transactions they enter into with other entities. This is a form of third-party reporting. IRS uses this information to verify compliance by comparing the income or expenses reported by third parties to the income or expenses reported by small businesses on tax returns. Using Form 1099-MISC, small businesses report items such as rent payments and payments to nonemployees for services of at least $600, subject to certain exceptions. The burden created by this requirement grows with the size of the business because larger businesses would need to file more 1099-MISC forms. However, while a larger business may have more transactions, it may also have an accounting system designed to identify transactions of more than $600 that a smaller business might not have.

Another characteristic that affects third-party reporting requirements is entity type. For example, partnership entities are required to report the distributive shares of their partners on Schedule K-1. However, other entity types such as sole proprietorships do not have similar requirements.

Additionally, a small business may have many industry-specific requirements related to excise taxes. IRS administers several broad categories of excise taxes, including environmental taxes, communications taxes, fuel taxes, retail sale of heavy trucks and trailers, luxury taxes on passenger cars, and manufacturers’ taxes on a variety of different products. For example, a small business in the trucking industry that makes deliveries over public highways is required to file Form 2290, Heavy Highway Vehicle Use Tax Return.

IRS’s Compliance Burden Models’ Estimates Provide Valuable Insights

IRS has developed several models to provide information for assessing the impact of the tax code and IRS programs on taxpayers. These models also help IRS assess the role of compliance burden and comply with requirements by the Office of Management and Budget for information on burden under the Paperwork Reduction Act. In the past 15 years, IRS has developed a number of burden models for individual and business taxpayers—both small and large.

Estimated Recordkeeping and Filing Burdens Vary with Characteristics of Businesses and Complexity of Returns

Estimates of business compliance burdens that IRS’s models have produced over the years indicate that burdens increase with the size of businesses, whether measured in terms of assets, receipts, or employment; however burden per dollar of assets or receipts or per employee decline with size due to economies of scale. For example, a small business owner who does his own taxes may create a spreadsheet to compute the business’s taxes and keep track of the employment taxes he owes for each employee. The effort the small business owner makes to build that spreadsheet is a fixed cost—a cost that does not change with an increase or decrease in the amount of goods or services that are produced. As the small business owner’s sales grow and as he hires more employees, he doesn’t have to repeat that effort; he just has the small additional cost of adding new data on income and employees to the spreadsheet. As this business grows, its total compliance costs decline both as a proportion of sales and on a per-employee basis. For these reasons, the costs per dollar of receipts or per employee are larger for small businesses than for larger ones.

IRS measured money and time burden as a portion of total business receipts, total assets, and burden per employee. Across all three measures, IRS results are consistent with the assumption that small businesses face significant fixed compliance costs combined with decreasing marginal costs as the business grows (see appendix III, tables 9 through 11).businesses, estimated total monetized business compliance costs by business entity type varied depending on the type of entity and the entity’s gross receipts. This variation is one reason why compliance burden on small businesses is a concern (see appendix III, table 12).

When looking at total receipts and asset size across all Figure 7 shows IRS’s estimates of compliance costs per employee for S corporations, C corporations, and partnerships. According to the estimates, costs for corporations and partnerships with 1 to 5 employees range from $4,308 to $4,746, compared to $182 to $191 per employee for businesses with 50 or more employees. IRS conducted this research using 2002 taxpayer data. Estimates using more recent data have not been produced. A number of factors would likely affect these estimates if they were produced using current data, including inflation, accounting software improvements, and tax law changes.

Estimates from IRS’s compliance burden models also show that burdens vary by industry. According to IRS, the retail trade industry incurs the largest pre-filing and filing time burden—businesses in this industry spent an average of between 325 and 331 hours per year on such activities. Manufacturing incurred the largest pre-filing and filing monetary burden, with businesses spending an average of $2,740 to $2,813 per year on these activities. Agriculture, forestry, and fisheries incurred the smallest average time spent on tax compliance activities (180 to 184 hours) and second smallest average compliance costs ($1,489 to $1,590). Some industries have higher time and monetary compliance costs because the nature of those businesses may affect the complexity of tax activities. For additional information on industry burden, see table 13 in appendix III.

IRS and Treasury researchers have used both the business and individual taxpayer burden models to estimate the influence of specific business characteristics on compliance burdens. Their estimates suggest that recordkeeping and filing burdens increase as the volume of complex compliance activities undertaken by businesses increases, regardless of the size or other characteristics of those businesses. The results for the full population of individual taxpayers were similar. categorized into varying levels of complexity based on an overall complexity of extracting information from the entity’s financial books, items that may require a separate recordkeeping system or a process with potentially separate rules for each item, and tracking records across years.

These results are presented in Rosemary Marcuss, et.al., “Income Taxes and Compliance Costs: How Are they Related?”, National Tax Journal, December 2013, 66 (4), pp. 833-854 and George Contos, et.al., “Taxpayer Compliance Costs for Small Businesses: Evidence from Corporations, Partnerships, and Sole Proprietorships,” (2009) Proceedings of the One Hundred Second Annual Conference on Taxation pp. 50-59, National Tax Association, Washington, D.C. forms to about $2 per form for 100 forms, with one of them charging about $.80 per form for 100,000 forms.

Audits and Other Compliance Contacts Can Be a Significant Source of Burden for Taxpayers, but Research Is Limited

IRS has not conducted research to estimate the compliance costs of audits and other post-filing compliance contacts for small businesses. However, IRS conducted preliminary research on compliance costs for individual filers that can provide some insights into the sources of burden that would affect some small businesses that report business income on individual tax returns. From the taxpayer perspective, post-filing begins when the taxpayer receives notice of an issue with an already filed tax return and concludes when the issue has been resolved. Post-filing compliance costs include any time spent on resolving an issue or money spent on things ranging from postage to paying a tax professional. IRS’s preliminary data on individual post-filing compliance costs provide information on the time and money spent on post-filing activities such as an audit—a review of accounts and financial information to ensure information is being reported correctly—or collections—receiving a bill for not paying taxes in full when a tax return was filed.

For individual filers, IRS research indicates that the level of compliance costs are highly dependent on the approach IRS takes in how it contacts the taxpayer to address potential underreporting or underpayment of tax obligations. IRS’s preliminary estimates, based on survey data from 2011, indicate that the average post-filing compliance costs were the highest for a field exam—an audit conducted at an individual’s home or place of business—at $4,800, followed by office exam—an audit conducted at an IRS office—at $2,165. A notice informing the taxpayer that they did not report all of their earnings had the lowest estimated average post-filing compliance costs at $230. IRS’s research on the magnitude of audit costs for individual filers likely includes individual filers who are small business owners. Those businesses are likely to have more complicated returns and, as a consequence, their burden is likely to be at least as great as the averages show for individual filers. For more details concerning post-filing compliance costs, see figure 13 in appendix III.

According to IRS, the audit rate for small business taxpayers is higher than the rate across all individual taxpayers because small businesses historically have higher noncompliance than other taxpayers. Table 2 provides detailed information on the audit rates across small business types.

While we did not examine post-filing costs, in a past report on correspondence audits, we found a number of issues which contribute to taxpayer compliance burden. These issues included IRS backlogs in responding to taxpayers who provide documentation in response to IRS’s audit notices and unrealistic audit time frames set by IRS.

IRS’s Decision- Making Framework Includes Consideration of Small Business Compliance Burden

IRS’s Strategic Goals and Internal Revenue Manual Describe the Agency-wide Approach to Taxpayer Burden Reduction

One of IRS’s goals in its strategic plan is to deliver high quality and timely service to reduce taxpayer burden and encourage voluntary compliance. Under this goal, IRS has identified seven objectives that further define how it intends to achieve the goal. One objective is to reduce taxpayer burden and increase return accuracy at filing through timely and efficient tax administration processing. IRS outlined performance measures for each strategic goal and objective in a supplement to its financial statement for fiscal years 2013 and 2014.this supplement, IRS describes some of the initiatives launched or continued and progress made in achieving performance goals. IRS also includes a discussion of goals missed. Several of these goals, if achieved, could have a positive impact on reducing small business compliance burden. For example, responding more quickly to telephone calls, correspondence, and requests for in-person service, as well as enhancing the online experience for customers, could benefit small businesses by requiring them to expend less time and fewer resources for IRS outreach.

In addition to the goals and objectives that focus on burden reduction in the strategic plan, IRS listed general guiding principles for reducing burden in the Internal Revenue Manual 22.24.1 - IRS Servicewide Burden Reduction Activities. The guiding principles are intended to support the consideration of compliance burden as part of tax administration. According to the manual, IRS carries out its mission to achieve significant reduction in unnecessary burden by considering taxpayer burden when implementing and reviewing policies and procedures. See table 3 for a list of the guiding principles.

According to the Internal Revenue Manual, the mission to reduce taxpayer burden and improve service is embedded in the IRS culture and a responsibility of all divisions. Though staffed to the Small Business and Self-Employed division, a senior advisor serves as the single point of contact for taxpayer burden reduction initiatives across all divisions. The manual states that this arrangement is intended to provide a link across the agency to ensure burden reduction is incorporated within decision- making frameworks. The advisor also acts as a liaison with external stakeholders.

IRS Has Worked with Internal and External Stakeholders to Identify and Reduce Small Business Tax Compliance Burden

IRS officials provided examples of efforts made to engage with internal and external stakeholders to reduce small business tax compliance burden. To engage internal stakeholders, employees can suggest ways to reduce burden by using Form 13285, Taxpayer Burden Reduction Referral. This form allows employees to note an issue causing taxpayer burden, describe the affected population, and propose a solution. Employees can also explain who needs to be involved in making the change, the resources needed, taxpayer benefits, compliance risks, and suggestions for how to measure burden reduction savings (e.g., reduced costs to the taxpayer or reduced costs to IRS). One notable example of a burden reduction initiative at IRS was developing a simplified method for determining the Office in the Home tax deduction.

Simplified Office in the Home Deduction Illustrates How IRS Considers Burden When Implementing Initiatives IRS officials offered an example of how the agency considered compliance burden principles when implementing new or changed tax laws or administrative procedures with the introduction of a simplified method for small businesses to calculate their Office in the Home Deduction. This method was introduced in 2013 and generally allows filers to receive a deduction of $5 per square foot of office space, up to a maximum area of 300 square feet. The alternative method involves a more complex calculation of property depreciation.

Although the Department of the Treasury (Treasury) and IRS officials reported considering this proposal as early as 2006, in July 2012, Treasury and IRS redoubled their efforts in response to an Office of Management and Budget request to identify initiatives that would eliminate at least 2 million hours in annual burden. To meet this request, IRS reached out to employees and Senior Executive staff, and also reviewed prior submissions, form burden statistics, and other suggestions that had been considered in the past. The group reviewed the proposals and made a final determination that this initiative should be implemented. IRS officials told us that they considered burden and compliance risk within this decision-making process and discussed tradeoffs of their decisions. IRS received external stakeholder input from representatives of the small business community, such as the U.S. Chamber of Commerce and the National Federation of Independent Business, who have recognized this as a positive development. IRS said the process of working collaboratively across the organization, with external parties, and with Treasury allowed them to consider the interests and concerns of all parties. This helped IRS weigh tradeoffs of decisions that could affect both compliance and compliance burden.

Other internal activities include providing employees with an online burden risk estimator tool designed to aid employees in determining whether certain decisions about the design of tax forms for individuals (Form 1040 and associated schedules and forms) could impose significant burdens on taxpayers. This tool is an Excel spreadsheet that uses some of the data used in the more elaborate burden estimation models discussed previously in this report. The tool provides staff with an estimate of the number of taxpayers who would be affected by a specific potential tax form change, as well as a rough indication of whether the effect on compliance burden would be significant. Divisions can use this tool to identify decisions that merit more in-depth evaluations, potentially involving the full burden estimation model.

IRS undertakes a number of activities to engage external stakeholders such as providing information on its website and holding forums with small business representatives. IRS has a website page that defines taxpayer burden, provides links to submit ideas for burden reduction, and outlines how IRS selects burden reduction initiatives. Another example of IRS outreach to the small business community is the quarterly Small Business Forum. IRS officials told us that they use the information from these forums to inform their decision-making process for practices and policies that affect small businesses. For example, IRS used feedback from forum participants to refine the language used in burden surveys it administers to the business community, and used what was learned to inform its current burden models. Similar to internal stakeholders, external stakeholders can make burden reduction suggestions using Form 13285- A, Reducing Tax Burden on America’s Taxpayers (Referral Form for Use by the Public), which allows them to describe the issue causing taxpayer burden, the affected population, and the proposed solution.

Small Business Representatives We Spoke with Identified Areas That Contribute to Compliance Burden

We also interviewed small business representatives (external stakeholders) who acknowledged IRS’s external stakeholder outreach efforts and how they have been effective in identifying opportunities to reduce compliance burden. However, they also described a number of areas where small business compliance burden could be further reduced. These areas include issues related to IRS customer service, filing requirements, lack of or delayed official guidance, and compliance contacts. According to these representatives, when they call IRS, they can have long wait times, be disconnected, or be directed to IRS staff who are unable to provide the needed assistance. We have recently reported on these issues as well.

Further, several representatives shared the perspective that complex filing requirements contribute to compliance burden. While small businesses sometimes anticipate significant tax relief through tax credits and deductions such as the small employer health care credit and mileage and vehicle deductions, some small businesses may not be claiming these credits due to the time, cost, and complexity associated with claiming them. One concern we heard from small business representatives was that after a tax practitioner expends resources to compile the necessary documentation and calculate the credit, their client (the small business) is ineligible to claim the credit. This could result in additional taxpayer burden if tax preparers bill their clients for calculating the credit when it is not claimed.

In addition to facing burdens due to new and complex tax provisions, representatives we spoke with also expressed concern over the compliance burden associated with delayed or missing official guidance, particularly for the Patient Protection and Affordable Care Act employer Representatives also noted that deadlines for responding to mandate.certain IRS notices can be difficult for small businesses when the requested information is not readily available. We recognize that IRS is aware of many of these concerns and, through various initiatives, has made efforts to address these issues. However, continued attention to these areas will be key to effectively reducing burden.

We routinely issue reports on aspects of IRS’s enforcement and administrative operations, some of which may impact small business tax compliance burden. In many cases we have made recommendations that, if implemented, could help to reduce these burdens. Selected recommendations that have yet to be implemented are listed in appendix IV.

IRS’s Overall Evaluation of Its Payment Card Pilot Has Several Strengths, but Does Not Fully Address All Elements Necessary to Effectively Assess Results

New Payment Card Data Provide Opportunities to Improve Voluntary Compliance and Have Potential to Help IRS Better Identify Noncompliant Small Business Taxpayers

Beginning in tax year 2011, payment settlement entities were required to send IRS Forms 1099-K to report gross merchant payments in which a payment card or a third-party payment network was used as the form of payment. Payment settlement entities report the gross amount of all reportable transactions a merchant made through them, for the calendar year, without regard to adjustments for credits, cash equivalents, discounts, fees, refunds, or other deductions.

A copy of the 1099-K is also sent to the taxpayer. The reporting of this information to both IRS and the taxpayer can encourage voluntary compliance by small businesses in at least two ways. First, since taxpayers know IRS is also receiving this income information, they are more likely to include it on their tax return. Second, taxpayers have another source of information they can use to help calculate or verify business income.

Payment card reporting also provides IRS with an information source it can use to compare against the income reported by small business taxpayers on their tax returns. As such, it can serve as a tool for identifying noncompliant taxpayers, including those who failed to file a tax return at all and those who underreported their income. This type of comparison is a common IRS enforcement technique. For example, IRS can directly compare information it receives on a taxpayer’s Form W-2, Wage and Tax Statement, against a tax return to determine if the taxpayer reported earnings and withheld taxes correctly.

However, matching is more complicated for Forms 1099-K than Forms W- 2 because IRS cannot directly match the line items on 1099-Ks to line items on tax returns. The Form 1099-K reports the gross amount of payment card and third party network transactions made through a payment settlement entity. This does not match the gross receipts line on tax returns because Form 1099-K transactions may include items like sales tax, gratuities, and cash back, all of which are not income. Furthermore, tax return gross receipts can include cash and check revenue, which is not captured on Form 1099-K. To leverage Form 1099- K data, IRS researched and tested ways in which the new data can be used to most effectively and efficiently improve voluntary compliance, detect noncompliance, and identify those who did not file returns.

The Payment Card Pilot includes six activities to test three methodologies for selecting cases, as described in table 4.

In all of the pilot activities, IRS uses taxpayer identification numbers to first match Forms 1099-K with the correct tax returns. IRS then compares Form 1099-K information with business income reported on individual and business tax returns. This process is detailed in figure 8. In the two underreporter pilot activities, IRS compares line by line the gross dollar amount of payments listed on Form 1099-K to gross receipts reported on the tax return to identify potential underreporting of payment card and third-party network revenue.

The payment mix methodology aims to identify potential underreporting of gross receipts from both card and cash sources. For this methodology, IRS first calculates a payment mix—the relative ratio of cash and card revenues of similar businesses. IRS determines this ratio by dividing the gross payment amount on Form 1099-K by gross receipts on the tax return. IRS then computes the amount of potential underreporting by comparing this payment mix to that of similar businesses based on variables including industry type and size, population density, per capita income, and average transaction sizes. As part of the test and learn process, IRS has expanded the number of variables to refine identification of possible underreporting taxpayers. One example of this is illustrated in figure 9.

If implemented successfully and properly evaluated, the payment card pilot could allow IRS to determine which, if any, pilot activities are effective enough to justify broader expansion, including integration with or replacement of other compliance enforcement efforts.

IRS’s Evaluation Plan Enabled It to Rapidly Test, Learn from, and Adapt Pilot Activities, but Does Not Include Key Elements for Assessing Overall Pilot Performance

To assess IRS’s plan for evaluating the payment card pilot we used our previously developed guidance to identify key elements for designing quality evaluations. Addressing each element at the overall pilot and pilot activity levels can provide program managers with objective information to iteratively assess program performance. The five key elements we identified for quality evaluation design are described in table 5.

IRS’s evaluation plan for pilot activities integrated many characteristics of a well-designed evaluation. As a result, IRS was able to make rapid, ongoing assessments of pilot activities and continually incorporate changes based on what was learned. This approach allowed IRS to test many hypotheses simultaneously while limiting the number of small business taxpayers affected by the pilot.

However, the overall evaluation plan for the pilot lacked characteristics of each element that are necessary to ensure a quality evaluation. If IRS does not address these gaps, it risks not having the evidence needed to effectively decide whether, how, and when to integrate pilot activities into broader small business compliance improvement efforts.

Clarify Understanding of the Pilot’s Goals and Strategy

IRS clearly defined the overall pilot goal, which is to use Form 1099-K data to identify and reduce underreported and unreported income. IRS outlined and detailed the specific program activities it tested and documented pilot planning and results in a strategic planning document and several other executive-level updates. These documents detailed various actions, including internal meetings, assessments, outreach, training, and information technology activities, during the early stages of the pilot. IRS’s strategic planning document also provided a conceptual representation of the different stages of the pilot and the growth of compliance case volume at each stage, as seen in figure 10.

IRS has generally documented the expected short-, medium- and long- term impacts of the pilot. One important short-term impact included learning about the small business population to improve identification of noncompliant taxpayers. For example, IRS realized an issue was arising because some small businesses—such as high-end restaurants—have lower cash revenue than other similar businesses. To address this issue, IRS added a line to Form 1099-K to collect data about the number of payment transactions (see figure 11). IRS uses this information to determine the average payment card transaction amount. In the medium term, IRS sees the potential for improved taxpayer voluntary compliance. After the first year of the pilot, IRS tested compliance levels of taxpayers before and after the introduction of the pilot and found that almost half of taxpayers increased their reported gross receipts, and about 60 percent of those contacted reported their income more accurately the following year. In the long term, IRS sees these activities helping to reduce the tax gap.

While IRS has defined high-level pilot goals, such as improving voluntary compliance and reducing the tax gap, it did not establish performance measures for these goals and has not decided on a time frame for developing them. IRS has defined broad stages for pilot implementation, but has not clearly identified measures or indicators to determine when the pilot has moved or will move from one stage to the next.

IRS identified pilot staffing needs. In June 2012, IRS estimated the number of full-time equivalents (FTE) it would need to conduct field exams. IRS officials also said they track resources for some of the pilot activities, including the implementation of the payment mix methodology pilots. However, IRS’s evaluation plan has not fully identified and tracked resource needs or use, including the actual numbers of FTEs hired or management resources to design and monitor test and learn pilots.

IRS identified external factors that could affect the progress or effectiveness of the overall pilot. It identified potential hurdles, including possible litigation and access to necessary technology solutions. However, IRS has not articulated how these factors affect the future of the pilot and what decisions it will make to address them under different scenarios.

Develop Relevant and Useful Evaluation Questions and an Analysis Plan

IRS evaluated pilot activity results, but there is no clear documentation of its evaluation questions or analysis plan. However, these can be inferred based on the evaluation results. According to IRS officials, one of the evaluation goals was to learn why some compliant taxpayers were identified as potential underreporters of income. IRS examined the results of closed cases to learn how to better identify compliant and noncompliant taxpayers. An example of this analysis and resulting change is described in more detail in the text box.

IRS Test and Learn Approach to Improve Identification of Noncompliant Taxpayers One IRS pilot learning goal is to test a new case selection methodology called the payment mix methodology. IRS is learning how to improve this methodology to better identify noncompliant taxpayers.

When analyzing results of the first year of the pilot program, IRS found that a significant percentage of online-only businesses—which do not accept cash—were falsely identified by the payment mix methodology as potential underreporters of cash income. To decrease the likelihood that compliant online-only businesses were selected in future years, IRS added a line to Form 1099-K that allows the payment settlement entity to specify the aggregate gross amount of all reportable payment transactions during the calendar year where the card was not present at the time of the transaction or the card number was keyed into the terminal. Typically, this relates to online sales, phone sales, or catalogue sales. Because IRS reduces the probability that compliant small business taxpayers are identified as potential underreporters of income, the overall burden for compliant taxpayers is reduced.

IRS evaluated the results of all pilot activities. IRS compared the average time to complete an audit and the average dollars assessed in additional tax for each case against existing compliance and enforcement efforts. IRS could use this information to decide which pilot activities to implement in a full compliance program.

IRS did not have evaluative questions and criteria to assess whether the overall pilot or the pilot activities achieved the intended goals or produced the intended results. Understandably, as IRS tests and adapts different approaches, it has learned and will continue to learn which approaches demonstrate the most promise in efficiently and effectively identifying noncompliant taxpayers. Clearly articulated evaluative questions and related analysis plans would allow IRS to determine whether the overall pilot and pilot activities are achieving results that would signal what next steps should be taken. These may include deciding the pilot can move beyond the learning stage, be expanded, or, ultimately, moved from pilot to full implementation as a compliance program. Conversely, the determination could be that the pilot and pilot activities are not achieving the intended results and should be discontinued or modified.

Assess the Relevance and Quality of Available Data Sources

During the early stages of the pilot, part of IRS’s evaluation of pilot activities involved assessing Form 1099-K data quality. IRS monitored potential errors that payment settlement entities could make when filling out the form, including invalid or missing taxpayer identification numbers. Such data entry errors could negatively affect IRS’s efforts to compare the data with information reported on small business taxpayer returns. When errors were identified IRS contacted the payment settlement entities to make corrections. IRS officials told us that because of this effort, accuracy rates for matching rose from 90.3 percent for tax year 2011 to 95.4 percent for tax year 2013. IRS officials have told us that analysis of Form 1099-K data is ongoing.

Since IRS lacks evaluative questions and an analysis plan for assessing the overall pilot, it does not have complete descriptions of the information or data and sources needed to assess the overall pilot against evaluation criteria, how that information will be gathered, and an assessment of data reliability. Because IRS addressed the relevance and quality of data sources in some of the early evaluations of some pilot activities, this information could feed into the development of the broader evaluation plan.

Address Data, Scope, and Methodology Limitations

IRS documented certain assumptions of its analysis. For example, in the alternative notice pilot, IRS sent assessments to taxpayers who did not respond to the notice and those who admitted to underreporting. IRS referred cases to IRS field work when taxpayers sent insufficient responses or communicated that a review of books and records was necessary.

Furthermore, in the early stages of the pilot, IRS showed evidence that it checked that data were free of errors. In the first year of the pilot, officials took steps to ensure that compliance examiners understood and consistently applied decision rules to determine compliance results.

IRS provided evidence that it estimated timelines and relative resource needs to move from the test and learn phase to a full compliance program. IRS outlined three scenarios to achieve a given level of compliance at program implementation. However, these scenarios were developed without a program level evaluation. Until IRS conducts an evaluation, it will not have the information it needs to determine which approach to take.

Although IRS showed evidence that data, scope, and methodology limitations were considered and addressed for certain pilot activities, these limitations were not fully addressed for the overall pilot. IRS would first need to develop evaluative questions, assessment criteria, and an analysis plan for the overall pilot before it could clearly assess data, scope, and methodology considerations. An assessment of design limitations would include stating any limitations of pilot scope, determining comparisons against which to assess pilot results, and assessing whether the evaluation fits available time and resources. Asking these questions would help clarify the potential impact of any project design limitations when determining whether to move pilot activities toward full program implementation.

Facilitate Use of the Evaluation Results in Program Management Decision Making

IRS provided evidence that leadership from multiple offices across the agency—the Small Business and Self-Employed Division, Office of Compliance Analytics, and the Information Technology Organization— demonstrated commitment to using evaluation data to inform pilot decision making for the beginning of the pilot. Senior officials from each of these offices met weekly during the early stages of the pilot. The leadership actively engaged internal stakeholders and developed strategies to internally communicate information about pilot program activities. These strategies included organizing employee focus groups, training, and leadership updates on pilot progress. For example, in October and November of 2012, IRS provided an update on project communication status to communication directors across all operating divisions.

In addition, IRS leadership engaged with external stakeholders before launching the pilot. In October 2011, IRS addressed small business representatives’ concerns about paperwork burdens by announcing that it would not require taxpayers to reconcile gross receipts and merchant card transactions. IRS also worked to address tax practitioner questions about the use of the payment mix methodology for case selection. As a result of the outreach, for example, IRS developed and tested a tool to help tax practitioners determine if their clients would be at risk for underreporting cash transactions.

Conclusions

IRS’s payment card matching program has the potential to enhance the agency’s ability to identify noncompliant small business taxpayers. Better identification of noncompliance would reduce the burden placed on honest taxpayers because the likelihood they would be selected for costly and time-consuming audits or other compliance contacts could be reduced. Further, more effective identification of noncompliant taxpayers means IRS can more efficiently use limited resources.

IRS’s Payment Card Pilot shows promise in producing these results. However, IRS has a long road ahead to figure out whether and how the pilot, and its many activities, can be fully implemented. IRS has not clearly defined the stages of the pilot or measurable goals that it can use to determine when the pilot has moved from one stage to the next, or if it should. Without defining the stages and establishing related metrics, IRS will not be able to articulate the pilot’s status at critical points in time. Further, it will not be able to justify the investment of additional resources if it cannot demonstrate progress toward those goals. In addition, IRS has not developed a full evaluation plan that will allow for a systematic assessment of the overall pilot against evidence-based criteria. Such a plan is necessary so IRS can ensure that it is making informed decisions about moving forward. Following key elements of evaluation design will help ensure that the results of the evaluation are valid and reliable. Finally, documenting the plan’s limitations will reduce the risk that IRS will draw conclusions that are beyond what can be supported.

Recommendations

To improve the evaluation of the payment card pilot, the Commissioner of Internal Revenue should take the following actions:

Clearly define the stages of the payment card pilot and establish measurable goals for determining when the pilot advances from one stage to the next.

Develop an evaluation plan for the overall pilot and building on pilot activities to inform decisions about whether, how, and when to integrate pilot activities into overall enforcement efforts. This plan should include evaluation questions, evidence-based evaluative criteria, an analysis plan, a complete description of data to be collected, a data reliability assessment, and documentation of evaluation limitations.

Agency Comments

We provided a draft of this report to the Commissioner of Internal Revenue and the Secretary of the Treasury for their review and comment. IRS’s Deputy Commissioner for Services and Enforcement provided written comments, which expressed appreciation to GAO for recognizing IRS’s efforts to consider taxpayer burden when implementing processes and procedures. In its response to the draft, IRS agreed to incorporate an evidence-based assessment of the payment card pilot that includes identifying clearly defined pilot stages and implementing an evaluation plan with measurable goals. IRS stated it will provide a more detailed response to our recommendations after this report has been released. These comments are reprinted in appendix V. IRS also provided us with technical comments, which we incorporated into the report as appropriate. Treasury did not provide comments.

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

If you or your staff have any questions about this report, please contact me at (202) 512-9110 or by email at mctiguej@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 VI.

Appendix I: Objectives, Scope, and Methodology

The objectives of this report are to: (1) describe the characteristics of the small business population; (2) describe how characteristics of a small business affect compliance burden; (3) describe how the Internal Revenue Service (IRS) integrates small business compliance burden considerations in decision making; and (4) assess IRS’s plan for evaluating its payment card pilot.

To describe general characteristics of the small business population such as the number of small businesses and total income, we reviewed taxpayer data from IRS Statistics of Income (SOI) and studies with access to taxpayer data. We reviewed SOI documents about data reliability and sampling methodology, and interviewed officials in SOI. We reviewed reports from researchers at the U.S. Department of Treasury, Office of Tax Analysis (OTA). We interviewed two of the OTA authors about their methodology for identifying the small business population. We performed data reliability tests by comparing OTA estimates for all filers against SOI estimates and by comparing OTA estimates for tax year 2007 and 2010. We found the estimates from researchers at OTA were sufficiently reliable for our purposes of describing general characteristics of the small business population. See appendix II for a more detailed discussion of OTA researchers’ methodology and assumptions.

To describe how characteristics of a small business affect compliance burden, we conducted a literature review where we reviewed IRS research papers and conference presentations, academic studies, and our prior work on taxpayer compliance burden. We searched relevant databases such as ProQuest, Accounting & Tax, EconLit, ABI/Inform, Nexis.com, and Tax Notes. We identified and reviewed selected IRS studies on tax compliance burden conducted over the last 11 years. We also asked IRS officials from the Research, Analysis, and Statistics (RAS) division to identify any additional IRS research assessing small business tax compliance burden and post-filing burden. To obtain information related to federal small business tax requirements, we reviewed IRS taxpayer guidance found on the IRS website including the 2015 tax calendar. We interviewed relevant IRS officials to clarify our understanding of the research and models, and to verify our analysis.

To describe how IRS integrates small business compliance burden considerations in decision making, we examined IRS’s strategic plan and relevant goals and objectives related to taxpayer burden. We also reviewed IRS’s Internal Revenue Manual, which outlines, among other things, guiding principles for considering burden reduction. We interviewed IRS officials in the Small Business and Self-Employed division (SB/SE), RAS, and the Office of Taxpayer Burden Reduction about other activities IRS conducts related to taxpayer burden reduction, tools it uses to manage burden reduction efforts, and initiatives it implemented. In addition, we interviewed tax practitioners, associations, and other liaisons to the small business community to identify areas of burden associated with interactions between IRS and the small business community, and discuss what might alleviate burden. We conducted unstructured interviews with a non-generalizable sample of 12 organizations based on their knowledge of small business tax policy resulting from historical involvement and relationships with the small business community and IRS. We reviewed supporting documentation, where available. We selected these organizations to represent a variety of perspectives and groups within the small business community.

To assess IRS’s plan for evaluating the payment card pilot, we reviewed and summarized documentation that included IRS’s Information Reporting and Document Matching Strategic Roadmap; Communication, Outreach, and Education Strategic Plan; and IRS internal presentations to the IRS Commissioner. We interviewed IRS officials from SB/SE and Office of Compliance Analytics divisions on the pilot to link IRS’s test and learn approach to defining strategic goals, evaluation questions, an analysis plan, and the ability to track benefits of the pilot efforts. We compared these efforts to our guidance on program evaluation design and applied criteria adapted from the guidance to both the overall pilot and pilot activities.

We conducted this performance audit from July 2014 to June 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: Description of Methodology and Reliability of Data Used to Produce Small Business Population Estimates

For our analysis, we use estimates from researchers at the U.S. Department of the Treasury, Office of Tax Analysis (OTA), to describe the characteristics of the small business population, such as the number of small businesses and total income. There are no universally accepted criteria for defining the small business population. OTA estimates address some of the limitations of describing the small business population using estimates based solely on the type of tax return that is filed by excluding certain tax returns that may not be actual businesses. Not all tax returns that report business income represent business entities with the principal purpose to generate revenue or to engage in substantive business activity. For example, some C corporations can serve as investment vehicles that engage in little or no business activity. Further, partnerships may be created to redistribute profits generated by another partnership and may not generate income themselves. Filers of Form 1040, Schedule C, may be independent contractors who may more closely resemble employees than small businesses. Additionally, rental income for some individuals may be incidental and not represent business activities. Uncertainty within OTA estimates can come from: (1) assumptions that were made to distinguish small businesses engaged in substantial and substantive business activities from other entities that file the same tax return; and (2) that the estimates are based on sampled taxpayer data and subject to sampling error. Consequently, results that are slightly higher or lower than those reported in this particular analysis may be equally valid for describing the numbers of businesses in each subgroup and the size of their incomes. We found the estimates from the researchers at OTA were sufficiently reliable for our purposes of describing general characteristics of the small business population.

Throughout this report, we refer to the estimated number of small business filers as the number of small businesses. Using these estimates may understate the number of small businesses where individual taxpayers can own multiple small businesses. For example, individual taxpayers can file multiple schedules to report business activity (profit, loss, and supplemental income and loss from rental real estate activity) from different lines of business. The number of schedules filed is greater than the number of Form 1040 tax returns to which these schedules are attached due to some returns having multiple schedules. The total income estimates are the sum of all business income reported on tax returns, including gross receipts, rents, dividends, capital gains, royalties, and interest. Total income for Schedule E filers is limited to rental real estate activity from Part I of that schedule to avoid attributing income from pass-through entities or from royalties to these businesses.

The OTA analysis had access to taxpayer data made available by IRS Statistics of Income (SOI). Available data from SOI samples indicate that the sampling errors for the total number of filers and total business receipts for each type of taxpayer is less than +/- 6 percent at the 95 percent confidence level. Sampling errors of subpopulations may be higher where tax returns have been sampled at lower rates. Data were not available to determine sampling errors for the OTA total income measure; however, business receipts make up such a substantial portion of the OTA total income that we would not expect the sampling error to be significantly greater for the OTA total income estimates than it is for the SOI estimates for business receipts. For C corporations, S corporations, partnerships, and sole proprietorships in 2010, the OTA number of filers is within +/- 2 percent of SOI estimates of the number of filers. OTA total income estimates are higher (within + 20 percent) of SOI total receipts estimates for these filers because OTA’s total income measure includes types of income other than business receipts.

The estimates used in this report are based on thousands of returns from the 2010 SOI Individual, Corporate, and Partnership Studies. Although we do not know the exact number of records used for each estimate, the Individual sample has 50,464 Form 1040 returns with a Schedule C with a sample selection amount of less than $10 million and 5,804 Form 1040 returns with Schedule F but without a Schedule C. The sample selection amount is the greater of indexed negative income and indexed positive income. The Corporate sample has 20,085 Form 1120 returns with total assets less than $10 million and size of proceeds less than $2.5 million where proceeds is defined as the larger of the absolute value of net income (deficit) or absolute value of cash flow (which includes net income, depreciation, and depletion). The Corporate sample also has 15,741 Form 1120S returns that have total assets less than $10 million and size of proceeds less than $2.5 million. The Partnership sample has 35,744 returns with total assets or current activity measure less than $10 million. Current activity measure is the maximum of the absolute value of receipts and income/loss. In this situation, receipts is the sum of the net receipts, rental income, gross income, portfolio interest income, dividend interest income, royalty income, and net long-term capital gain/loss. Income/loss is the sum of ordinary income, net income, net income from the balance sheet, portfolio interest income, royalty income, and net long- term capital gain/loss.

Table 6 shows SOI estimates for the total number of filers and total income by type of tax return for tax year 2010 (as reported by Prisinzano et al.). The OTA analysis and Prisinzano et al. apply two tests to exclude tax returns filed that do not represent filers that generate substantial income or engage in substantive business activity. The first test is a de minimis activity test that requires taxpayers to report total income or total deductions greater than $10,000, or that their sum be greater than $15,000. The second test requires total deductions be greater than $5,000, which indicates substantive business activity based on expenses related to employees, inventories, and investment, among other things. The application of these two tests results in the exclusion of 46.7 percent of the 44.6 million total tax returns, but only 0.6 percent of the total $33.3 trillion in total income represented by these tax returns.

Using this threshold of $10 million or less in both total income and total deductions, small businesses represent 99 percent of tax returns generating substantial income and engaged in substantive business activities (and more than 95 percent of tax returns for each type of tax return). Small businesses account for 17.8 percent of the total income for these tax returns (and more than 91 percent of total income for each type of individual filer and between 5 and 40 percent of total income for each type of corporation and partnership).

Table 7 shows the OTA small business estimates are consistent across the years 2007 and 2010, and are similar to corresponding estimates for all filers. In addition to the measurement errors discussed above, OTA estimates for these tax years are affected by other factors, including changing economic conditions. In spite of these factors, small business estimates for 2010 are within +/- 11 percent of 2007 values for number of filers and within +/- 18 percent of 2007 values for total income. For each type of filer, the percent change from 2007 to 2010 for small businesses is similar to the percent change for all filers (the difference in percent change is within +/- 10 percentage points). We found similar relationships for other subpopulations reported within this report. While we do not have sampling errors for these estimates, we consider estimates of percentages that differ by more than 30 percentage points or totals that differ by more that 100 percent to be different.

Appendix III: Additional Information on Small Business Compliance Burden

The figures and tables in this appendix supplement those in the second objective providing additional information on small business tax-related activities, IRS burden model methodology, and results from IRS burden models.

Table 8 provides a detailed description of tax-related activities that may create burden for small businesses. These activities are grouped by income taxes, employer-related taxes, and third-party information reporting and industry-specific tax activities.

Figure 12 illustrates a simplified depiction of IRS pre-filing and filing burden models. Essentially, IRS uses the data from its compliance burden surveys, combined with data that IRS obtains from the tax returns of survey respondents in econometric models. These models estimate the relationship between taxpayer characteristics and reported burden; the models can then be used to estimate total compliance burden.

IRS then uses estimates of these relationships in simulation models to predict how potential IRS administrative decisions, such as those relating to tax form design and recordkeeping requirements, may affect taxpayer burden. Although such simulation results may provide useful insights, it is difficult to assess the reliability of those results; consequently they should be used with caution. We found IRS research estimates were reliable for our purposes of obtaining an overview of small business tax compliance costs. One difficulty is that to be able to simulate the effect of burden, IRS needed to develop a complicated methodology for apportioning aggregate burden across all of the different types of pre-filing and filing activities. There are no formal statistical tests to estimate the margins of error around the ultimate simulation results.

The following tables and figure are results from IRS burden models. The data were taken from IRS studies concerning how small business characteristics such as size and industry affect small business compliance costs.

Tables 9 through 11 examine the estimated pre-filing and filing monetized burden per employee, as a percentage of total receipts, and as a percentage of total assets.

Table 12 provides information on total monetized business compliance costs by business entity type and total gross receipts across all businesses.

Table 13 shows the estimated average pre-filing and filing time and money burden by industry.

Figure 13 provides the estimated post-filing compliance costs for individual filers.

Appendix IV: Selected Open GAO Recommendations to IRS That May Affect Small Business Taxpayer Burden

Appendix IV: Selected Open GAO Recommendations to IRS That May Affect Small Business Taxpayer Burden Open recommendations The Commissioner of the Internal Revenue should direct the appropriate officials to take the following three actions: (1) Systematically and periodically compare its telephone service to the best in business to identify gaps between actual and desired performance. (2) Include specific countermeasures or options in risk management plans that could guide a response when an adverse event occurs. (3) Develop outcomes that are measurable and plans to analyze service changes that allow valid conclusions to be drawn so that information can be conveyed to Congress, IRS management, and others about the effectiveness of IRS’s service changes and impact on taxpayers.

Status (1) IRS disagreed with this recommendation, noting in February 2015 that it is difficult to identify comparable organizations with a size or scope similar to that of the IRS to identify performance gaps, and that such efforts would not yield improved results over the benchmarking process currently used by IRS. We disagree that IRS’s telephone operations cannot be compared to others. We believe this recommendation remains valid and should be implemented.

Report: Tax Filing Season: 2014 Performance Highlights the Need to Better Manage Taxpayer Service and Future Risks, GAO-15-163 (Washington, D.C.: Dec.16, 2014). (2) IRS agreed with this recommendation and, in February 2015, reported it has already included specific countermeasures or options in risk management plans for those risks ranked highest in likelihood and impact. IRS also reported it considers such efforts to be ongoing as it develops new risk management plans over time. (3) IRS agreed with this recommendation and, in February 2015, reported it is developing outcome measures and plans for analysis to identify and report on the effect of service changes during the 2015 filing season. IRS also reported it anticipates completing this analysis by the end of fiscal year 2015.

To reduce the need for taxpayer calls, ensure that IRS is providing taxpayers with more realistic time frames on when IRS will respond, and more efficiently use IRS resources, the Commissioner of the Internal Revenue Service should: (1) Collect data to analyze whether IRS is responding within the time frames cited in the revised audit notices. (2) If IRS delays are continuing, further revise the notices to provide more realistic response times based on the data and take other appropriate actions to ensure efficient use of IRS tax examiner resources.

According to IRS officials: (1) Correspondence audit program officials analyzed fiscal years 2012-2015 data to provide a monthly breakdown of the volumes of taxpayer correspondence worked in less or more than 75 days. Supporting documentation from IRS is pending.

Open recommendations goals on ensuring compliance in a cost-effective way while minimizing taxpayer burden.

To better inform decisions being made about the correspondence audit program, the Commissioner of the Internal Revenue Service should: (6) Document how the decisions are to be made about the correspondence audit program using performance information. (7) Track and use other program data that have not been used to provide more complete performance information, such as taxpayer burden and experience.

Status their respective inventory levels at the time notices are sent. The notices are expected to be available and implemented in January 2016 after necessary program updates. Supporting documentation from IRS is pending.

To better ensure an effective investment of resources in the Correspondence Assessment Program (CEAP) efforts, the Commissioner of the Internal Revenue Service should: (8) Clearly document the intended benefits of ongoing efforts to address identified problems, and the process for measuring and tracking actual benefits. (9) Develop a plan and timeline for implementing the CEAP contractor’s recommendations on possible ways to improve the (a) selection of correspondence audit workload and (b) allocation of resources between providing telephone assistance and reviewing taxpayer correspondence. (3) through (5) IRS will review current documentation and ensure there is a clear link establishing the correspondence audit program objectives and measures with the overall IRS goals and objectives. Officials also said they will update official guidance as warranted. Actions on these three recommendations are due by March 2016. Supporting documentation on timeframes for specific actions related to these recommendations is pending. (6) IRS will thoroughly document the original plan development process. Action on this recommendation is due by March 2016. Supporting documentation on timeframes for specific actions related to these recommendations is pending.

Report: IRS Correspondence Audits: Better Management Could Improve Tax Compliance and Reduce Taxpayer Burden, GAO-14-479 (Washington, D.C.: June 5, 2014).

Open recommendations agreement data into accounts.

Report: 2013 Tax Filing Season: IRS Needs to Do More to Address the Growing Imbalance between the Demand for Services and Resources, GAO-14-133 (Washington, D.C.: Dec. 18, 2013).

Status since the agency changed its installment agreement program, it has decided to evaluate those changes before exploring whether adopting our recommendation will yield increased efficiencies and lower costs without adversely impacting tax administration. IRS officials stated they will provide a status update in October 2015.

To increase the effectiveness of IRS’s examinations of individual tax returns, the Commissioner of the Internal Revenue Service should: (1) Transcribe data from paper-filed Form 1040 Schedules C and E that are not currently transcribed and make those data available to Small Business and Self- Employed division (SB/SE) examiners for classification. If IRS has evidence that the costs related to transcribing all such data on Schedules C and E are prohibitive, IRS could do one or both of the following actions: (a) transcribe less data by transcribing only the missing data for selected line items, such as certain, large expense line items; or (b) develop a budget proposal to fund an initiative for transcribing Schedule C and E.

As of March 2015, IRS agreed to study: (1) whether to increase data transcription of additional tax return information as GAO recommended in May 2013. The agency also agreed to study whether to use more data from electronically-filed returns. IRS's study is scheduled to be completed by November 2015, and is expected to weigh the benefits to the agency and the impacts on taxpayers who file returns electronically. (2) expanding the use of electronic data to enhance return classification while weighing the benefits of increased information against the risks of potential impacts to electronic filing. (2) Make all data collected from electronically submitted Form 1040s available to examiners conducting classification.

Report: Tax Administration: IRS Could Improve Examinations by Adopting Certain Research Program Practices, GAO-13-480 (Washington, D.C.: May 24, 2013).

The Commissioner of Internal Revenue should: (1) Outline a strategy that defines appropriate levels of telephone and correspondence service and wait time, and lists specific steps to manage service based on an assessment of time frames, demand, capabilities, and resources. (1) IRS has taken steps to modify services provided to taxpayers, but has not yet developed a strategy outlining IRS’s customer service goals. (2) Tailor appropriate and timely interventions with taxpayers who file balance due returns by pilot testing risk-based approaches that could include (a) implementing the Advanced Consolidated Data Analytics plan, and (b) using more data-driven methods to identify the most appropriate method for contacting a taxpayer.

Report: 2012 Tax Filing: IRS Faces Challenges Providing Service to Taxpayers and Could Collect Balances Due More Effectively, GAO-13-156 (Washington, D.C.: Dec. 18, 2012). (2) IRS agreed with our December 2012 recommendation to pilot more risk-based approaches for contacting taxpayers who have a balance due. However, IRS has reported that because that project was not funded, it used an alternative model to conduct analysis. IRS implemented its updated model in late April 2014. In October 2014, IRS reported that better (more productive) cases will be assigned to select work streams. Further, in January 2015, IRS officials said they will be placing revised models into production in fiscal year 2015.

Open recommendations To help ensure that IRS uses its examination resources efficiently, the Commissioner of the Internal Revenue Service should: (1) Document and analyze the results of examinations involving the Small Employer Health Insurance Tax Credit to identify how much of those results are related to the credit versus other tax issues being examined, what errors are being made in claiming the credit, and when the examinations of the credit are worth the resource investment.

Status (1) As of October 2014, SB/SE analyzed a statistical sample of 2010 examination results for the Small Employer Health Insurance Tax Credit. As a result of the research, SB/SE concluded that the findings do not justify selecting a specific number of returns for examination with the Credit as the primary issue. Instead, they will identify issues as part of the normal classification process, and prepare guidelines for classifiers to reference when selecting returns for examination. (2) Related to the above analysis of examination results on the credit, identify the types of errors with the credit that could be addressed with alternative approaches, such as soft notices.

Report: Small Employer Health Tax Credit: Factors Contributing to Low Use and Complexity, GAO-12-549 (Washington, D.C.: May 14, 2012). (2) As of October 2014, IRS told us that Math Error Authority, fully implemented in January 2014, addresses many of the common errors claiming the Credit. Therefore, there is not an immediate need for alternative approaches, such as soft notices. However, IRS will still consider alternatives.

The Commissioner of the Internal Revenue Service should: (1) Develop a new refund timeliness measure and goal to more appropriately reflect current capabilities. (1) As of October 2014, IRS has yet to develop a new refund timeliness measure. However, IRS has taken steps to identify the number of days it takes to issue a refund in addition to the percentage of refunds received in daily increments from 5 to 60 days. (2) Complete an Internet strategy that (a) provides a justification for the implementation of online self-service tools, and includes an assessment of providing online self-service tools that allow taxpayers to access and update elements of their account online; (b) acknowledges the cost and benefits to taxpayers of new online services; (c) sets the time frame for when the online service would be created and available for taxpayer use; and (d) includes a plan to update the strategy periodically. (2) IRS has made progress in improving its Internet online services strategy. In September 2012, IRS provided us with an updated version of that strategy. However, IRS still needs to take a number of steps to more fully develop its long-term online strategy. As of February 2015, IRS officials reported that it does not have a separate online services strategy.

Report: 2011 Tax Filing: Processing Gains, but Taxpayer Assistance Could Be Enhanced by More Self- Service Tools, GAO-12-176 (Washington, D.C.: Dec. 15, 2011).

Open recommendations questions, upcoming outreach, and description of the letter ruling process.

Status coordination. However, IRS officials said they share with external stakeholders the general timeframes for upcoming guidance.

Report: Information Reporting: IRS Could Improve Cost Basis and Transaction Settlement Reporting Implementation, GAO-11-557 (Washington, D.C.: May 19, 2011).

To gain efficiencies and improve taxpayer service, the Commissioner of Internal Revenue should direct the appropriate officials to: (1) Determine a customer service telephone standard, and the resources required to achieve this standard based on input from Congress and other stakeholders. (2) Assess business units’ needs for holding Contact Analytics calls beyond 45 days and store calls for this period or document that the costs of doing so exceed the benefits. (1) As of August 2014, IRS’s position remained that its measure of telephone service does not need to be revised and the current process for establishing IRS telephone plans is sufficient. However, we continue to believe that a telephone standard would serve as a means of communicating to Congress and others what IRS believes would constitute good service. (3) Establish a performance measure for taxpayer correspondence that includes providing timely service to taxpayers.

Report: 2010 Tax Filing Season: IRS’s Performance Improved in Some Key Areas, but Efficiency Gains Are Possible in Others, GAO-11-111 (Washington, D.C.: Dec. 16, 2010). (2) IRS disagreed with this recommendation. As of August 2014, IRS officials continue to maintain that increasing the recorded call storage beyond 45 days would not be a low cost effort. However, we continue to believe that storing calls for extended periods would allow IRS to better identify trends and taxpayer concerns, thus offsetting the costs. (3) IRS agreed with this recommendation and started using more detailed performance measures that includes an overaged/timeliness measure for its correspondence beginning in fiscal year 2011. However, in April 2014, we reported that overaged correspondence increased from 25 to 47 percent; thus, we continue to believe that elevating this measure to IRS’s suite of balanced measures would help provide more visibility and ultimately better service.

Open recommendations To gauge the extent of 1099-MISC payer noncompliance and its contribution to the tax gap, we recommend that the Commissioner of the Internal Revenue Service, as part of future research studies: (1) Develop an estimate of 1099-MISC payer noncompliance.

Status (1) According to IRS, developing such an estimate requires a multi-pronged approach and a large amount of coordinated effort. As of September 2014, IRS estimates results will be available in December 2015. (2) Determine the nature and characteristics of those payers that do not comply with 1099-MISC reporting requirements so that this information can be factored into an IRS-wide strategy for increasing 1099-MISC payer compliance. (2) IRS researchers are collecting data on 1099-MISC reporting as part of its National Research Program study on employment taxes, a program that involves examinations of a sample of tax returns expected to culminate in 2015. As of September 2014, IRS estimates results will be available in December 2015.

Report: Tax Gap: IRS Could Do More to Promote Compliance by Third Parties with Miscellaneous Income Reporting Requirements, GAO-09-238 (Washington, D.C.: Jan. 28, 2009).

Appendix V: Comments from the Internal Revenue Service

Appendix VI: GAO Contact and Staff Acknowledgments

GAO Contact

Acknowledgments

In addition to the contact named above, Brian James, Assistant Director; Sonya Phillips, Analyst-in-Charge; Courtney Liesener, Robert MacKay, James R. White, and Nell Williams made major contributions to the report. Robert Gebhart, Kirsten Lauber, Donna Miller, Edward Nannenhorn, Karen O’Conor, Andrew Stephens, and James Wozny also provided assistance.