Partnerships, S-corporations, trusts, and estates are collectively known as "flow-through entities," because they have the legal capacity to pass net income or loss through to their partners, shareholders, and beneficiaries untaxed. As shown in figure 1, these flow-through entities file tax returns with IRS that report the entities' income and expenses with schedules showing all partners', shareholders', or beneficiaries' shares of net income or loss. Flow-through entities also are required to provide each partner, shareholder, or beneficiary with a Schedule K-1 stating the individual share of net income or loss to be reported. These partners, shareholders, or beneficiaries are then responsible for reporting this income or loss on their individual income tax returns and paying any tax. According to IRS in tax year 2001, over 9 million flow-through entities reported passing through $998 billion to approximately 24 million partners, shareholders, or beneficiaries. For reporting purposes flow-through income is broken into several categories. These include income or loss from trade and business activities, rental real estate, other rental activities, interest, dividends, royalties and capital gains. The purpose of the Schedule K-1 matching program is to compare the information provided by flow-through entities to that reported by individuals on their tax returns in order to ensure compliance. The Schedule K-1 matching program is part of IRS's general matching program, the underreporter program. As shown in figure 2, the underreporter program identifies potentially noncompliant taxpayers using information from two primary data sources: income reported to IRS by taxpayers on their individual tax returns and income reported to IRS from third parties, such as employers, banks and other financial institutions, partnerships, S- corporations, estates, and trusts on forms such as the W-2, 1099, and Schedule K-1. In order to describe IRS's implementation of its Schedule K-1 matching program, reasons for suspending the issuance of notices, impact/burden on taxpayers, and results of the program, we: reviewed and analyzed IRS management plans, risk assessments, and other discussions of how the matching program would operate, including work group meeting minutes; interviewed IRS officials regarding the efforts required to plan and implement the program, including preliminary program testing, early plans for the program, changes made in program plans, problems with stakeholder communication, and the suspension of notices related to Schedule K-1 income; reviewed documents issued by external parties regarding concerns with the Schedule K-1 matching program; interviewed stakeholders from outside IRS, including enrolled agents and members of professional organizations, IRS advisory committees; and reviewed data and statistics resulting from the Schedule K-1 matching program, including number of taxpayers sent notices and tax revenue assessed. We assessed IRS's management of the Schedule K-1 matching program by reviewing the plans and risk assessment developed by IRS and then comparing IRS's implementation of the program to these plans. To describe the steps IRS is taking to reduce burden and improve the matching program, we: interviewed IRS officials regarding the changes being implemented for continuation of the Schedule K-1 matching program, including changes to reduce taxpayer burden; reviewed external stakeholder documents that offered suggestions for the future of the Schedule K-1 matching program; interviewed stakeholders from outside IRS regarding their suggestions for the Schedule K-1 matching program; observed a public meeting of the Information Reporting Program Advisory Committee (IRPAC); and observed a working group session of IRS and external program stakeholders. The underreporter data presented in this report was produced by IRS, and we did not independently verify its accuracy. However, we have used underreporter program data in past reports and have found underreporter summary statistics of the type used in this report to be reasonably accurate. We performed our work from June 2002 through May 2003 in accordance with generally accepted government auditing standards. In its original plan for the Schedule K-1 matching program, IRS intended to focus on two categories of income: interest and dividends. IRS officials believed that such a focus would enable IRS to minimize the number of notices sent to compliant taxpayers. However, information system limitations, along with a desire to direct resources towards K-1 underreporter cases, caused IRS to expand this focus and include more categories of income in the program. This change was not clearly communicated to taxpayers or preparers and led to more compliant taxpayers receiving underreporter notices. In the face of complaints about the burden imposed on compliant taxpayers, IRS stopped sending K-1 underreporter notices. Originally, IRS planned the Schedule K-1 matching program to focus on two categories of flow-through income: interest and dividends. The plan called for identifying underreporter cases with discrepancies between interest and dividend income reported on a K-1 and what was reported on an individual's tax return. Notices would then be sent to the taxpayers asking them to explain the discrepancies or pay the additional tax. IRS chose to focus the Schedule K-1 matching program on interest and dividend income to minimize the chances of compliant taxpayers receiving notices about K-1 discrepancies. IRS based its decision on a risk matrix that summarized the risk of sending a notice to a compliant taxpayer for the various categories of flow-through income. Interest and dividend income were identified as low risk because they are easily identified on individuals' tax returns. Short and long-term capital gains and royalties were considered a moderate risk because the K-1 information was less likely to be accurate or the income could be harder to locate on individuals' returns. Income from trade or business activities, rental real estate, other rental activities, and guaranteed payments was considered high risk because it could be much harder to isolate on individuals' returns. For example, some taxpayers would reduce or net their flow- through income in these four categories by subtracting carryover losses or expenses. Although IRS's tax form instructions caution against such netting, some taxpayers still do so, which can make flow-through income appear to be underreported. Starting in 2001, IRS began briefing representatives from stakeholder groups on its plan for the Schedule K-1 matching program. IRS met with two of its advisory committees, composed primarily of tax practitioners, the Internal Revenue Service Advisory Committee (IRSAC) and the Information Reporting Program Advisory Committee (IRPAC), and other practitioner groups. During these discussions with stakeholders, IRS informed them that underreported K-1 interest and dividend income would be the focus of the K-1 matching program. In October of 2001, IRS discovered during testing that the underreporter computer system could not distinguish underreported K-1 interest and dividend income from other interest and dividend income reported on information returns such as Form 1099s. Because of a desire to direct the 69 FTEs allocated for screening K-1 underreporter cases to K-1 cases, IRS decided to expand the focus of the K-1 matching program. IRS officials told us they had wanted to direct the resources to K-1 cases exclusively in order to be able to determine the results achieved with those resources. The revised program included flow-through income from trade or business activities, rental real estate, other rental activities, and guaranteed payments. These four categories contained K-1 reported income exclusively. As will be discussed in more detail later, IRS did not clearly communicate the change to taxpayers, tax preparers, and other stakeholders. Under the revised matching program, IRS selected for screening by the 69 dedicated FTEs a total of 141,000 underreporter cases that appeared to have only underreported K-1 income from the four categories as shown in figure 3. In addition IRS selected another 237,000 cases that appeared to have both underreported K-1 income and underreported income from other sources. After manual screening, IRS determined that 97,200 cases raised sufficient questions about the accuracy of the amount reported on the individual tax returns to merit sending a notice of the potential discrepancy to the taxpayers. IRS began sending notices about the discrepancies to taxpayers in April 2002. Because of the change in focus of the program, more compliant taxpayers received underreporter notices than IRS had originally intended. As shown in figure 3, of the over 63,000 cases closed through March 2003, about 62 percent or 39,153 were closed with no change to the tax liability. The compliant taxpayers or their preparers who responded to the notices were required to submit information to IRS in writing or via telephone that explained how they reported the flow-through income on their tax return. Some of these compliant taxpayers were burdened because they improperly reported net amounts on their returns. As discussed previously, IRS instructions tell taxpayers to list K-1 income without netting. Nevertheless, according to IRS, many taxpayers reported net amounts, making it appear that they had underreported. After the discrepancies were explained to IRS, about 62 percent of the notices resulted in no change in the tax liability. Taxpayers, tax preparers, and various external stakeholder groups complained about the notices for two reasons. First, as discussed previously, the notices imposed a burden on compliant taxpayers. Though some of these taxpayers may have improperly reported net amounts on their returns, the taxpayers argued that they had been filling out their returns this way for years without incident. Second, they were not expecting underreporter notices related to flow-through income about trade or business activities, rental real estate, other rental activities, and guaranteed payments. IRS responded by stopping the K-1 matching program notices as of August 1, 2002. As shown in figure 3, IRS sent 69,097 notices to taxpayers before that date. As of March 2003, IRS data shows that nearly 92 percent or 63,084 of the Schedule K-1 notices issued were closed, or resolved to IRS's satisfaction, as shown in figure 3. In nearly 38 percent or 23,931 of the closed cases, taxpayers agreed that the notices were correct, that the Schedule K-1 income was misreported, and that they owed more taxes. These cases resulted in about $41.4 million of additional taxes assessed of which $26.9 million related exclusively to Schedule K-1 income. IRS estimates that about 90 percent of the assessed tax will be collected. In addition to the revenue resulting directly from the notices, IRS expects that K-1 matching will have a psychological impact on taxpayers, encouraging voluntary compliance. IRS did not have data at the time the program was being planned to allow it to estimate the likely impact on voluntary compliance. Nor does IRS have any data on the actual impact on voluntary compliance. IRS did project that a one percent improvement in K-1 reporting levels would result in approximately $1.7 billion in additional tax reported. IRS developed a plan for the Schedule K-1 matching program that, according to IRS, relied on established project management principles. However, IRS did not timely implement two parts of the plan. First, IRS did not test the feasibility of focusing the program on interest and dividend income until after recommending such a focus and communicating the recommendation to taxpayers, tax preparers, and other stakeholders. Second, after changing the plan, IRS did not clearly communicate with taxpayers, tax preparers or other stakeholders about the changes. Failure to timely implement these two parts of the plan led to compliant taxpayers being surprised and burdened by the notices they received and ultimately resulted in IRS halting the Schedule K-1 notification process before all 97,200 notices were sent to taxpayers. In planning the Schedule K-1 matching program, IRS officials said they relied on established principles from its Enterprise Life Cycle (ELC) project management approach, the same strategy IRS has used for planning and implementing its ongoing information systems modernization efforts. IRS developed a series of K-1 matching program management plans including those covering transcription and compliance management, risk management, and internal and external stakeholder communications. The K-1 compliance management plan called for performing two tests before selecting cases for the K-1 matching program. The first test was of underreporter program procedures and was intended to determine needs such as computer system and training updates in order to accommodate Schedule K-1 data. The second test was a review of underreporter program processes more generally. The K-1 communication plan called for communicating with internal and external stakeholders about the project status in order to address questions and concerns and manage expectations. IRS did not test whether its original case selection process, focused on interest and dividend income, was feasible before recommending it. As shown in figure 4, IRS began planning the Schedule K-1 matching program in January 2001. As previously discussed, in July 2001, IRS recommended selecting for review by tax examiners all underreporter cases with K-1 interest and dividend income. An IRS official told us that internal discussions led IRS to believe that this was possible--that the underreporter computer system could distinguish cases with interest and dividend income reported on K-1s from that reported on other information returns. Consequently, the feasibility of focusing the K-1 program on interest and dividend income was not tested before the recommendation was made. The second test in IRS's plan was conducted in October 2001 and revealed that system limitations would prevent IRS from focusing the K-1 program on interest and dividend income. IRS discovered that the underreporter computer system could not distinguish K-1 interest and dividend income from interest and dividend income reported on other information returns such as Form 1099s. As a result, the focus of the Schedule K-1 matching program was changed. As discussed earlier, the revised program covered underreported trade or business, rental real estate, other rental activity, and guaranteed payment flow-through income. Although the program communication plan called for communicating with internal and external stakeholders, IRS failed to inform taxpayers, tax preparers, and other stakeholders of the changes it made to the matching program and the potential for the changes to increase burden on compliant taxpayers. An IRS official responsible for the K-1 program stated that a communication breakdown resulted in mixed messages being shared with stakeholders about the type of cases that would be selected for the K-1 matching program. IRS officials were unable to show us any documentation in which they communicated the changes to the plan. An IRSAC member told us they only became aware of the change to the program after taxpayers began receiving notices. Tax preparers and stakeholders were critical of the fact that IRS failed to inform them of the changes made in the Schedule K-1 matching program and the effect those changes would have on compliant taxpayers. They believed compliant taxpayers were unfairly burdened by having to respond to K-1 notices since, according to an IRSAC member, preparers had not been required to submit any explanatory documents with their tax returns in the past. As was the case with the revised Schedule K-1 matching program in 2002, for 2003, interest and dividend income reported on K-1s will be included in the underreporter program; however, the 69 FTEs devoted to K-1 matching will again focus on the four flow-through income categories including income from trade or business activities, rental real estate, other rental activities, and guaranteed payments. As of April 2003, IRS has started issuing notices related to discrepancies in tax year 2001. Also this year, IRS is taking steps intended to reestablish communication with external stakeholders and reducing the burden on compliant taxpayers. At this time, the effectiveness of these steps is unknown. For 2003, the Schedule K-1 matching program will have the same focus as the revised program in 2002. Therefore, during the 2003 Schedule K-1 matching effort, it is no longer necessary for IRS to test this case selection approach in the underreporter system. IRS is working to reestablish clear communications with external stakeholders. Since notices were stopped in August 2002, IRS has kept external stakeholders informed of program developments and held meetings with these stakeholders to consider a number of suggestions for improving the Schedule K-1 matching program. For example, in the 2 months following the notice stoppage, IRS briefed both IRSAC and its own Oversight Board on reasons for notice suspension, data collected, and plans for continuing the program with external stakeholder input. IRS also held public meetings with IRSAC in October 2002 and IRPAC in November 2002 during which it obtained the committees' comments and suggestions for the Schedule K-1 matching program. In addition, IRS held a meeting in December 2002 with representatives of various practitioner and other stakeholder groups to discuss various aspects of the program. In this meeting, IRS presented results of the case studies it conducted after suspension of the notices and solicited from the stakeholders ideas for improving the program in the areas of forms, matching, education and outreach, tax preparation software, and legislative changes. At least in part as a result of the stakeholder meetings discussed above, IRS has begun implementing steps intended to improve Schedule K-1 matching and clarify reporting requirements. IRS has adopted a new goal of eliminating as many no-change notices as possible and increasing the overall effectiveness of the Schedule K-1 matching program. IRS's strategy for reducing no-change notices relies on more rigorous screening of cases by examiners before notices are sent. IRS estimates that the program changes discussed below should reduce the number of no-change notices by about 50 percent from the 2002 levels. At this time, IRS does not have an estimate of the number of notices to be sent out or of what it expects the no-change rate to be. For 2003, IRS has adopted a revised set of standards for screening cases for review in its Schedule K-1 matching program, with the intent of minimizing taxpayer burden by reducing the number of no-change notices sent. In particular, IRS will issue notices to taxpayers if K-1 income information is completely missing from a return. Also, if a taxpayer received a notice in 2002 for tax year 2000 K-1 items and agreed with the changes proposed by that notice, the taxpayer will receive a notice for any underreported K-1 income identified this year in the tax year 2001 return. If income appears underreported for a taxpayer who received a notice that resulted in a no-change last year, that taxpayer will not receive a notice this year, with the possible exception of particularly large discrepancies. In addition, if a taxpayer received no notice last year or received a notice that contained no K-1 items, this taxpayer will be sent a notice if a large discrepancy is identified. The revised screening standards will be applied to all K-1 flow-through income discrepancies. IRS is also trying to educate taxpayers and practitioners about the proper way of reporting flow-through income, carryover losses, and deductions in order to reduce the need to send notices to compliant taxpayers about apparent mismatches. For example, in March 2003, IRS issued a news release that provided tips and reminders for K-1 filing. These tips covered topics such as proper reporting of Schedule K-1 income on individual returns, avoiding netting of income and expenses, reporting losses carried forward, and steps for reporting income when the Schedule K-1 has not yet been received. Also in March 2003, an IRS official participated in a webcast program geared to the practitioner community to discuss requirements of Schedule K-1 reporting and field questions from practitioners. In addition, the agency will present sessions on how to report flow-through items at each of its tax forums during the summer of 2003. The agency also seeks to further educate taxpayers through outreach programs to be run by the Taxpayer Education and Communication unit, a part of IRS's Small Business/Self-Employed operating division. Further, IRS is changing certain forms and/or schedules in order to make reporting compliance easier for the taxpayer. In a report issued March 2003, the Treasury Inspector General for Tax Administration (TIGTA) stated the lack of detailed information reported by taxpayers and/or practitioners may have been a significant reason for the number of K-1- related notices that were sent. TIGTA then recommended that IRS revise Form 1040 Schedule E to classify and report flow-through income in a manner that would allow an easier comparison with Schedule K-1. In response, an IRS official has stated that, for the 2003 filing season, the agency would issue a revised Form 1040 Schedule E that would alert practitioners to pay special attention to the written instructions on the reporting of certain losses and expenses. The desired effect of this change is to make taxpayers less likely to improperly net income and expenses being reported on Schedule E. Finally, an IRS task force is studying the possibility of simplifying the Schedule K-1 and its instructions for different tax situations. The intent would be to reduce both pre- and postfiling burden. However, the analysis needed for the form redesign will likely not be completed until mid-2003, and it would take about 2 years total for the redesign to actually be implemented. By fiscal year 2005, through the outreach efforts and Form 1040 Schedule E revisions discussed in the previous paragraphs, IRS believes that it can eliminate the need for the special screening procedures instituted this year. In addition to the outreach efforts and form changes mentioned above, IRS has also discussed other efforts that could be used to help make the program more automated, such as working with software vendors to make any necessary changes to electronic tax preparation programs. While IRS intends that these changes will reduce the number of no-change notices regarding flow-through income, at this time the effectiveness of the changes is unknown. More specifically, it is not known how ambitious IRS's goal to reduce notices sent to compliant taxpayers by at least 50 percent is nor is it known whether IRS can reduce notices sent to compliant taxpayers while maintaining the ability to act against noncompliant taxpayers. For the K-1 matching notices being sent in 2003, IRS will be able to track the number closed with no-change through tracking reports issued every 2 weeks. These tracking reports also contain the number of notices with an assessment that the taxpayer agreed to, unreported income identified through notices, and additional taxes assessed through the notices. The reports, which IRS has begun preparing for its tax year 2001 K-1 data match, are prepared for IRS management. Officials told us that they would also be made available to outside stakeholders. The tracking reports should give IRS management information before all notices are sent out about the effectiveness of the changes made to the program. With respect to the overall effectiveness of the K-1 matching program, one IRS official told us that he sees the level of voluntary compliance with K-1 reporting requirements as a key measure of the program's effectiveness. This official also told us that IRS plans to annually review the number of K-1 returns filed to determine if more K-1 income is being reported. He said that more reporting of K-1 income could be seen as a measure of program effectiveness. Our ongoing work for the Senate Committee on Finance will assess IRS's efforts to detect and address noncompliance by taxpayers receiving flow-through income. Better targeting the Schedule K-1 matching program notices on noncompliant taxpayers matters for two reasons. Sending underreporter notices to compliant taxpayers wastes taxpayers' time and money. Similarly, IRS's scarce enforcement resources are wasted to the extent they are used to resolve notices sent to compliant taxpayers. While no compliance program can perfectly target noncompliant taxpayers, IRS's goal of reducing the number of Schedule K-1 matching program underreporter notices sent to compliant taxpayers is laudable. However, at this time, no one--neither IRS nor external stakeholders-- knows how effective IRS's proposed actions will be. Consequently, IRS's tracking of the no-change rate is very important, both for internal management and congressional oversight. Because IRS has begun tracking the no-change rate every 2 weeks, we are not making recommendations in this report. As noted earlier, we will be looking at opportunities to improve the overall effectiveness of the Schedule K-1 matching program in our ongoing work for the Senate Committee on Finance. We asked IRS to provide comments on a draft of our report but did not receive a response in time to include it with this report. However, IRS officials responsible for the program told us that they agree with the facts presented in this report. As arranged with your office, we will not distribute this report until 30 days from its issue date unless you publicly announce its contents earlier. After that period, we will send copies to the Chairman and Ranking Minority Member, House Committee on Ways and Means; Chairman and Ranking Minority Member, House Subcommittee on Oversight, House Committee on Ways and Means; Chairman and Ranking Minority Member, House Committee on Small Business; Chairman and Ranking Minority Member, Senate Committee on Finance; and the Ranking Minority Member, Senate Committee on Small Business and Entrepreneurship. We will also send copies to Secretary of the Treasury, the Commissioner of Internal Revenue, and other interested parties. We will make copies available to others on request. In addition, the report will be available on the GAO web site at http://www.gao.gov. If you have any questions, please contact me at (202) 512-9110. Key contributors to this report are acknowledged in appendix I. In addition to the contact above, Marvin McGill, Adam Couvillion, Amy Rosewarne, and Joseph Jozefczyk made key contributions to this report.

Summary:
About $1 trillion in income was distributed in 2001 by flow-through entities such as partnerships and trusts. These entities do not pay taxes on flow-through income. They report it to the Internal Revenue Service (IRS) on a Schedule K-1 and their partners or beneficiaries pay any tax. Concerned about underreporting, IRS began matching the flow-through income reported on Schedule K-1s with that reported on individuals' returns. In 2002, IRS began sending notices to taxpayers about suspected noncompliance. After complaints that many notices were going to compliant taxpayers, IRS stopped sending notices. Concerned about the burden, Congress asked GAO to, among other things, (1) describe the burden caused by the notices and IRS's rationale for stopping them, (2) assess IRS's management of the program, and (3) describe the steps IRS will take to address any problems. IRS stopped issuing Schedule K-1 notices after complaints about the burden the program imposed on compliant taxpayers. Originally, IRS intended to focus the program on two categories of income--interest and dividends--wherein matching was straightforward, and therefore the number of notices sent to compliant taxpayers could be minimized. However IRS changed the matching program to cover additional categories of flow-through income without clearly informing taxpayers and tax preparers. Matching these additional categories of income was less straightforward. As a result, IRS sent notices about suspected noncompliance to more compliant taxpayers than it intended. In fact, about two-thirds of the notices were sent to taxpayers later determined to be compliant. After taxpayers complained, and after sending out about 70 percent of the planned notices, IRS responded by stopping the notices. IRS has assessed about $41.4 million in additional tax from the notices that were sent and approximately $26.9 million was directly attributable to Schedule K-1 underreporting. IRS did not timely implement two parts of the plans for managing the Schedule K-1 matching program. First, IRS did not test the feasibility of focusing the program on interest and dividend income until after recommending such a focus and communicating the recommendation to taxpayers, preparers, and other stakeholders. Second, after changing the plan, IRS did not clearly communicate the changes. IRS is taking steps to improve communications and reduce the burden on compliant taxpayers. However, neither IRS nor GAO knows whether these changes will improve communications and reduce burden while maintaining the effectiveness of the Schedule K-1 matching program as a compliance tool.