Partnerships group two or more individuals or entities—such as corporations or other partnerships—to carry on a business. Individuals, corporations, trusts, estates, tax-exempt entities, and other partnerships may all be partners. S corporations may have between 1 and 100 shareholders. Individuals, certain trusts, estates, and certain tax-exempt entities may be S corporation shareholders. Partnerships and S corporations must file tax returns (IRS Forms 1065 and 1120-S, respectively). Partnerships and S corporations differ from C corporations—which are covered by subchapter C of the Internal Revenue Code and include nearly all publicly traded corporations—in that C corporations pay corporate income tax on their profits. Partnerships and S corporations do not directly pay taxes on the net income reported on Forms 1065 or 1120- S. Instead, they pass profits to partners and shareholders, respectively, who pay any applicable taxes. In recent decades, partnership and S corporation activity has represented a growing share of business activity, while the share of C corporation activity has declined, as measured by gross business receipts, the revenue that a business receives from its trade or operations before subtracting expenses and deductions. As a result, a larger share of business activity is now subject to taxation at the individual, rather than the corporate level, than in the past. According to IRS statistics compiled for tax year 1980 through tax year 2008, the percentage of business receipts taken in by partnerships and S corporations grew from about 7 percent to about 34 percent, as shown in figure 1. There were about 4 million S corporations and 3 million partnerships in the United States in tax year 2008. However, the bulk of flow-through business activity was concentrated in a smaller number of entities. In the case of partnerships, 95 percent of business receipts in tax year 2008 went to the 260,000 partnerships with receipts of $1 million or more (see figure 2). Partnerships and S corporations are required to send each of their partners and shareholders a Schedule K-1 that reports how much income or loss they allocated to that partner or shareholder in the past year, and to send a copy to IRS. Individuals and business entities to which partnerships and S corporations allocated income are required to report that income on their income tax returns. IRS has multiple compliance assurance processes. Two important ones for detecting misreporting of partnership and S corporation income are examinations (commonly known as audits) and K-1 matching. Examinations are IRS reviews of an entity’s or individual’s books and records conducted to verify what is reported on a tax return. They can be labor intensive and time consuming for IRS, but can detect complicated forms of noncompliance. IRS may examine a flow-through entity, the partners or shareholders (such as individuals) who are allocated income from the flow-through, or—if the entity is part of tiered structure of related entities—IRS may examine the entire tiered network. The examination process generally occurs in three steps. Typically, it starts with return selection—a largely automated process that selects tax returns for further review if they appear to be at risk for noncompliance. In the next step—classification—trained staff look at the selected tax returns and determine whether they warrant an examination, what issues should be examined, and how the examination should be conducted. In the final step—examination—a more detailed review of the return and other relevant information IRS possesses, such as information returns (for example, K-1s), is conducted. The examination generally includes contact with the taxpayer and a review of the taxpayer’s books and records. It ends with a decision about whether to recommend no change, a refund, or additional tax assessment. K-1 matching is a function of IRS’s Automated Underreporter (AUR) program (see figure 3 for a description of the AUR process). AUR matches the information returns that IRS receives about a taxpayer with income reported on that taxpayer’s Form 1040. Information returns are documents, such as W-2s (used to report wages) and K-1s, that third parties provide to taxpayers and IRS about taxpayers’ income. K-1 matching aims to detect mismatches between each taxpayer’s Form 1040 and K-1s, allowing IRS to detect taxpayers who misreport income from partnerships and S corporations. Because taxpayers know that IRS receives a copy of each K-1, matching encourages voluntary compliance K-1 matching of individual returns is not designed at the taxpayer level.to detect misreporting about business operations at the flow-through entity level. Additionally, it does not match partnership and S corporation returns with the K-1s they receive from other flow-through entities. There is substantial uncertainty surrounding the extent of income misreporting by partnerships and S corporations themselves, and by the individual taxpayers to whom the income is allocated. IRS has estimated misreporting by S corporations but not by partnerships. In IRS’s most recent study of S corporation misreporting— covering tax years 2003 and 2004—IRS conducted detailed examinations of a sample of S corporation tax returns. However, such a study inevitably cannot detect all misreporting. IRS analysis of the study did not include an adjustment for income that examiners were unable to detect, so the true amount of misreporting by S corporations may have been significantly larger than IRS reported, according to a preliminary report by an official from IRS’s Office of Research, Analysis, and Statistics. For those two years, using a weighted average, IRS estimated that S corporations misreported about $55 billion per year in net income. Because IRS has not conducted a similar study of partnerships since 1988, and does not have plans to conduct one, it does not have a similar estimate for partnerships. Moreover, estimating total partnership income or loss and the misreported amounts of income and loss is complicated by the fact that substantial portions of those amounts get double counted as they pass from one partnership to another. 2011, partnerships reported a total of $1,468 billion of income and $507 billion in losses. About 31 percent of this income and 36 percent of the losses were allocated to other partnerships before ultimately being passed on to another party, resulting in double counting of this income and losses. Partnerships may also allocate income to others, including S corporations, estates, and trusts, which would complicate correcting for double counting. About 31 percent of partnerships were part of multitiered networks in tax year 2011, as shown in figure 4. See appendix II for more information on tiering of flow-through networks. Throughout this report, we use the term double counted to refer to items that are counted two or more times (not necessarily exactly two times). A simple network is a network that includes a flow-through entity that does not receive allocations from another flow-through entity nor allocate income to another flow-through entity. A multitiered network includes at least one flow-through entity that allocates income to another flow-through entity. Because the database containing the data this figure is based on has incomplete data, the extent of tiering presented in this figure represents a minimum amount, and counts are approximate. Numbers do not sum to total, and dividing entity counts by totals do not match up with percentages, due to rounding. Without a strategy for better estimating the extent and nature of partnership misreporting, IRS cannot make fully informed decisions on how to allocate resources across enforcement programs and across different types of business entities and taxpayers. IRS’s strategic plan for 2009-2013 calls for IRS to develop improved research-driven methods and tools to detect and combat noncompliance and improve resource allocation. As we discussed in a 2012 report, optimizing resource allocation has the potential to bring in substantially more enforcement revenue. IRS’s compliance research studies have produced data on flow-through income misreporting by individual taxpayers. Using this information, and considering various caveats and uncertainties, we estimated a rough order of magnitude of the misreporting to be $91 billion per year for tax years 2006 through 2009. This estimate does not cover all flow-through income. Only some types of income—ordinary business income, rental income, and guaranteed payments—can be included in an estimate of income that individuals misreported from partnerships and S corporations. These items are reported on a section of the individual tax return specific to income from partnerships and S corporations. Some other types of income individuals receive via partnerships and S corporations, including interest, dividends, and royalties, cannot be estimated based on available data because they are combined with the same types of income from nonflow-through sources on another part of the individual tax return. Additionally, there is uncertainty surrounding any estimate of how much income individual taxpayers misreported due to presumed misreporting that IRS research examiners are inevitably unable to detect. IRS assumes that such misreporting exists and adjusts its estimates to account for it when it does its compliance studies on individual taxpayers. For individual taxpayers, an estimate of the rate of partnerships’ and S corporations’ misreporting of their own income can be incorporated into the adjustment, since errors at the entity level would generally be passed through to individual taxpayers. The individual misreporting rate would be expected to be at least as high as the misreporting rate for the entities that are allocating income to them. However, as mentioned above, IRS’s most recent estimate of S corporation misreporting is itself uncertain, and IRS does not have a similar estimate for partnerships. With these caveats in mind, we estimated, based on IRS research examination data, that in tax years 2006 through 2009, the annual average income that individual taxpayers were allocated from partnerships and S corporations was $517 billion, and annual average losses were $94 billion, for a net of $423 billion. Of this $423 billion, we estimated that individual taxpayers misreported about $91 billion per year (this amount includes understated income plus overstated losses, less overstated income and understated losses). These taxpayers paid their taxes based on the misreported amounts, and we estimated that the $91 billion corresponded to about $19 billion per year in lost tax revenue. This $91 billion likely includes some of the $55 billion of misreporting by S corporations, but IRS is unable to calculate how much. Given all of the uncertainty involved, these estimates should both be considered rough orders of magnitude. See appendix III for details on our estimation methodology and more information on factors contributing to uncertainty, as well as a comparison of individual taxpayers’ misreporting of income from partnerships and S corporations with misreporting of other types of income. IRS examinations have not been effective at finding most of the misreported income discussed above. According to information that IRS collected for revenue agent examinations closed in fiscal years 2011 and 2012, IRS proposed increasing the total income reported by partnerships and S corporations by an annual average of about $16.3 billion. Additionally, for just partnerships, which accounted for the bulk of proposed partnership and S corporation adjustments, IRS estimated that from 3 percent to 22 percent of the proposed adjustments were double counted in the $16.3 billion total. An unknown amount of IRS’s proposed adjustments to entity-level income included adjustments flowing through multiple tiers of flow-through entities or showing up in related returns, resulting in double counting. Thus, the true amount of unique adjustments might be smaller than IRS’s records seem to show. Adjustments at the entity level can generally only result in increased taxes to the extent that adjustments and assessments are subsequently made at the partner or shareholder level. IRS officials said that because of computer systems limitations, they did not have an estimate of the extent to which proposed adjustments to income at the entity level increased actual taxes collected at the partner or shareholder level. Because IRS does not know how much of what it proposes in adjustments for partnerships relates to non-duplicate income, nor to what extent those adjustments result in increased taxes collected, it cannot know its return on investment for partnership examinations. IRS’s examination rate for partnerships is much lower than the rate for C corporations and for sole proprietorships. Without a strategy for estimating the effectiveness of partnership examinations, IRS cannot know whether the differences in examination rates across different types of business entities are justified, i.e., whether it is optimally allocating its enforcement resources across its enforcement programs. As mentioned above, IRS’s strategic plan calls for IRS to develop improved research-driven methods and tools to detect and combat noncompliance and improve resource allocation, and optimizing resource allocation has the potential to bring in substantially more enforcement revenue. However, identifying the taxes collected that result from proposed adjustments at the partnership level would require IRS to upgrade its computer systems, which would require funding. As the data in table 1 indicate, partnerships differ significantly in terms of the types of income that they earn through their own activities or receive from other partnerships, estates, or trusts. These differing characteristics may indicate that separate enforcement approaches, focusing on different compliance issues, are appropriate for each subpopulation. One significant distinction among partnerships is whether they generate ordinary business income of their own. More than 40 percent of partnerships have no ordinary business income or loss, and about 20 percent of the ordinary business income and losses that partnerships report is simply passed on from other partnerships. A large portion of partnership income other than ordinary business income is portfolio income. Partnerships can receive interest, dividend, or royalty payments directly from the original issuers of these payments, or they can receive them as pass-through amounts from other partnerships. Rental income (primarily from real estate) is another important type of income. IRS examination program monitoring tabulations currently do not track examination rates, no-change rates, or enforcement revenue to cost ratios for partnership subpopulations, defined in terms of the types of income they earn. Consequently, we do not know whether these measures differ significantly across the various groups. Without a strategy for better estimating the extent and nature of misreporting by different subpopulations of partnerships, and the effectiveness of partnership examinations in detecting misreporting by different subpopulations of partnerships, IRS cannot enhance its case selection processes to focus its enforcement tools on activities that pose the highest risk of noncompliance, as is called for in its strategic plan. For IRS to make informed decisions in expanding its flow-through income compliance initiatives, it would have to resolve what it considers to be high-priority problems with the accuracy, completeness, and timeliness of K-1 data. In July 2013, an IRS data issues team found that these issues included K-1s that were at times missing, unable to be matched to partnership returns or validated, unavailable for months, subject to misreporting by recipients, and only partially allocating partnership income. The IRS team believed the problems hurt IRS’s ability to identify partner, partnership, and network compliance issues and use risk assessment tools to evaluate them. To resolve these K-1 data issues, IRS staff presented to IRS management 15 short- and long-term potential solutions, most of which IRS is waiting to address because of funding considerations. The solutions included what IRS considered to be critical fixes needed in 2 to 3 years, but IRS needed more analysis to identify and address partnership return data issues. Without approving other solutions, management approved costing out three 1-to-2-year fixes, including testing K-1 data programming errors and checking that the data were correctly processed. Once the costing out was completed, management expected to decide whether to fund these three fixes, although it did not provide us a date for making that decision. It had approved nothing else. For individual taxpayers, in examinations closed in fiscal years 2011 and 2012, IRS proposed adjusting the total income allocated to the individuals from partnerships and S corporations by an annual average of about $2.9 billion. We calculated this amount based on data from IRS’s Examination Operational Automation Database on examinations of taxpayers’ returns. Only some types of income from partnerships and S corporations—such as ordinary business income and rental income— could be included in this amount. Other types, including interest, dividends, and royalties, could not be included because as noted earlier, they are combined with the same types of income from nonflow-through sources on individual taxpayers’ returns. Based on an estimated tax rate range of 15 percent to 35 percent, the adjustments to income would have corresponded to between $450 million and $1 billion in taxes assessed. Some of these $2.9 billion in adjustments potentially would have been made due to the $16 billion in adjustments at the partnership and S corporation level, but as mentioned above, IRS officials told us that they could not quantify the extent to which this would have been the case. As previously noted, IRS matches K-1s to individual tax returns, but IRS does not routinely match K-1s or other information returns to partnership and S corporation tax returns. Matching K-1s to partnership and S corporation tax returns might provide another tool for detecting noncompliance by these types of entities. IRS’s strategic plan calls for IRS to develop improved research-driven methods and tools to detect and combat noncompliance and improve resource allocation, improve compliance by leveraging third-party reporting information, and streamline processes to increase the timeliness of enforcement. Rather than waiting until costing of data fixes is completed for further management involvement, management could begin planning now for how to use the improved data. Specifically, IRS could develop a plan for testing, or otherwise analyzing the data, to, for instance, determine whether matching at the entity level of some combination of K-1s and other information returns, could assist in verifying compliance. Matching might assist directly, by detecting misreported income, or indirectly by helping identify returns with examination potential. Without such a plan, when the costing of the data fixes is completed IRS will know the costs but perhaps not all of the benefits of moving to implement the data fixes. For individual taxpayers, because of the way IRS tracks tax assessments through AUR, only a portion of the net assessments that resulted from K- Specifically, when there are 1 matching can be definitively determined.mismatches for both K-1 income and other types of income, IRS’s AUR data systems do not separate out the K-1 amounts. With this caveat in mind, K-1 matching definitively resulted in net tax assessments of $24 million for tax year 2009, the latest year for which complete data were available. The actual amount could be higher, but is probably a relatively small portion of the $19 billion of unpaid taxes we estimated individuals misreported of partnership and S corporation income. The entire AUR program assessed $8 billion for more than 50 different categories of income and expenses. K-1 matching through AUR, as noted above, is not used to detect misreporting between entities in a tiered network, nor is it designed to detect ordinary business income misreported on a K-1. As a consequence, the information on K-1s may match what is on individuals’ 1040s, but both documents may understate the true income amount. More details about K-1 matching are discussed in appendix IV. There are various means through which IRS could improve how it selects partnership and S corporation tax returns to examine. As we have concluded previously, improving examination selection could have two positive impacts: increasing enforcement revenue by better focusing examinations on noncompliant taxpayers and reducing burden by reducing unnecessary audits of compliant taxpayers. IRS must decide how to allocate its enforcement resources based on limited information. IRS typically examines about 0.4 percent to 0.5 percent of partnership and S corporation returns per year, compared to about 1.4 percent to about 1.6 percent of C corporations, and 1.5 to 1.9 percent of nonfarm sole proprietorships that did not claim the earned income tax credit. Figure 5 shows these rates for fiscal year 2012. The results of partnership and S corporation examinations are difficult to interpret. On one hand, IRS’s rate for not recommending adjustments to income or expense items on partnership and S corporation examinations is relatively high. In fiscal years 2010 through 2012, no-change rates ranged between 42 percent and 46 percent for partnerships and 34 percent and 39 percent for S corporations. These rates are computed for the business entity. They do not reflect adjustments at the entity level that did not result in adjustments to the ultimate partners’ or shareholders’ individual returns. No-change rates for partnerships and S corporations exceeded those for nonfarm sole proprietorships and C corporations in all 3 fiscal years from 2010 through 2012. On the other hand, when IRS revenue agents proposed income adjustments after partnership and S corporation examinations, the dollars were significant in absolute size, as shown in table 2. As may be expected given the size of the entities involved, the average proposed income adjustments for IRS’s Large Business and International (LB&I) division returns were higher than for its Small Business/Self-Employed (SB/SE) division returns. However, as was the case with no-change rates, the proposed adjustments at the entity level do not necessarily show whether the ultimate partners or shareholders paid any additional tax at the individual level. Not all partnership and S corporation line items are digitized. IRS officials said that having more return information available electronically might improve examination selection. For instance, when IRS subject matter experts with examination experience suggested filters for an SB/SE research project to use to identify potentially noncompliant preparers of partnership and S corporation returns, the lack of transcription prevented SB/SE from using all of the filters. Enhancing digitization of paper-filed partnership and S corporation returns would involve costs to IRS. In 2010, the direct labor costs and related overhead to transcribe all then-nontranscribed lines on partnership and S corporation returns would have exceeded $6 million for SB/SE and LB&I. This amount did not include significant direct labor costs for other processing functions such as input correction or quality review or costs to reprogram submission processing or post-processing systems, according to IRS officials. Responding to our recommendation from 2011, IRS considered studying the benefits of transcribing items from many forms to match against already-calculated costs. However, according to an official in IRS’s Return Preparer Office in September 2013, it decided against the study because of resource needs and budget constraints. By not transcribing more partnership and S corporation line items, IRS might be forgoing proposed adjustments to income that could result in increased tax assessments that might offset the cost of added transcription. However, according to an IRS official, more transcription might not be IRS’s highest-priority partnership data problem. A higher- priority problem would be the issues described earlier with the accuracy, completeness, and timeliness of K-1 data. Within that context, IRS considered improving transcription a critical fix needed in 2 to 3 years. By that time, about 5 years would have passed since our 2011 recommendation, which we continue to believe has merit, but resource issues could still exist. Increasing electronic filing (e-filing) of partnership and S corporation tax returns would increase the amount of tax return data that arrive at IRS already digitized. Increasing the amount of digitized information arriving at IRS would reduce IRS processing costs and also reduce the cost of transcribing information from the remaining paper returns. One way to increase e-filing is for Congress to mandate it. Currently, partnerships with more than 100 partners are required by law to e-file. Corporations, including S corporations, must e-file if they have assets of $10 million or more and file at least 250 returns during a calendar year. However, under current law, e-filing cannot be required for partnerships with 100 partners or less or corporations, including S corporations, unless the entity is required to file at least 250 returns during a calendar year. The percentages of partnerships and S corporations that e-file tax returns have been growing rapidly in recent years, reaching 64 percent and 66 percent, respectively, in tax year 2011, the latest year for which data are available. IRS has projected rapid continued growth for the next couple of years and a leveling off after that, meaning that some paper-filed returns will always be expected. to transcribe more partnership and S corporation line items off the remaining paper-filed returns, at least in the short term. However, as noted before, IRS will not be able Unless all returns are digitized, IRS will not be able to use all return line items in its examination selection process. Less than full digitization limits IRS in selecting the most productive returns to examine and increases the likelihood of it examining compliant taxpayers. As noted above, transcribing the remaining paper returns is not a priority. Without a low- cost way to digitize paper returns, digitizing them is at risk of remaining an unfunded critical fix. For instance, IRS projected that 80 percent of partnerships would e-file in fiscal year 2015 and 86 percent in fiscal year 2020. According to IRS officials, the projections were based on processing activity. Processing activity refers to everything related to a particular return that goes through IRS in a given processing year. For instance, if two, three, or four iterations of a tax return go through IRS, the return is counted two, three, or four times. Actual e-filing percentages mentioned here count each return only once. requiring e-filing based on the size of a partnership’s or corporation’s assets, with different asset requirements than now exist. Any option for an e-filing mandate would impose some burden on tax return filers. However, the extent of the burden may be small, since about 90 percent of partnerships and S corporations already use a paid preparer. Additionally, any burden could be mitigated. Waivers allowing paper filing in hardship and other special cases could eliminate burden for some tax return filers, and thresholds limiting the requirement to entities of a certain size (based on number of partners or some other measure) would eliminate the burden for entities below that size. Also, phase-in periods could allow time for entities to adjust. When IRS implemented the preparer e-file mandate for individuals, it found that the number of hardship waivers was fewer than anticipated, about 2,250 versus the 6,000 that had been expected. SB/SE’s partnership discriminant function (DIF) model to identify entities to examine was built on data that are now outdated, and does not capture partnership compliance issues related to tiering. We pointed out in 1995 that because the formulas the model relied on were developed using data from the 1980s and tax laws and taxpayer behaviors had changed, the model unreliably indicated partnership compliance. At the time, IRS said that it was planning to develop new formulas in 1998. However, SB/SE is still using the same DIF formulas. Despite the model’s formulas being outdated, indications are mixed on whether the partnership DIF model needs upgrading or is adequately identifying a productive workload of potentially noncompliant returns compared to other workload identification methods. In two 2012 reports, TIGTA found that no-change rates for partnership and S corporation returns selected by the DIF model and examined by nontrainee SB/SE revenue agents greatly exceeded those for other SB/SE partnership and S corporation returns examined by nontrainees. On the other hand, when training examinations are included, LB&I, which did not use the DIF model, often had a higher no-change rate for revenue agent examinations for partnerships and S corporations than SB/SE, which used the DIF model. LB&I pointed out that its blend of returns to be examined may differ from SB/SE’s, skewing the comparison. According to IRS officials, updating the partnership DIF model could be complicated, expensive, and time consuming, taking resources from possibly productive examinations and having an unknown outcome. However, without determining whether an improved partnership DIF model should be developed after IRS has better information on noncompliance and program effectiveness, IRS cannot know whether it is missing an opportunity to select partnership returns for examination more effectively. IRS’s strategic plan calls for IRS to develop improved research-driven methods and tools to improve resource allocation and to enhance its case-selection processes in order to focus its enforcement tools on activities that pose the highest risk of noncompliance. IRS officials told us they have started to look into ways to develop a new partnership DIF model, but there is no strategy, time frame, or plan for completing this effort. In 1995 we identified filters, that is, flags that detect certain characteristics of partnerships whose examinations were the most productive for IRS to examine. In 2012, TIGTA did the same thing for both partnerships and S corporations.returns related to them, TIGTA found the examinations of real estate or construction partnerships with two partners and a reported loss were highly productive in terms of the size of recommended adjustments. Similar to what we had suggested more than a decade earlier, TIGTA recommended that, as resources become available, SB/SE analyze partnership and S corporation data files looking for ways to better identify productive returns for audit. For instance, for returns selected by the DIF model and for In response, in 2013, SB/SE researchers expanded an earlier study of partnership and S corporation returns to test the efficacy for examination selection of some new automated filters. They tested the filters on completed examinations to determine if using the filters could have resulted in a lower no-change rate. Three of the filters that were tested showed some promise in terms of reduced no-change rates. The researchers recommended that the SB/SE examination function use the promising filters to screen returns that the DIF model selected for examination and validate that the filters reduce the no-change rate below historical averages and are operationally feasible. According to SB/SE officials, they have begun that process. Partnerships and S corporations account for billions of dollars of unpaid taxes and their share of business activity is growing. This underscores the importance of understanding the effectiveness of IRS’s partnership and S corporation tax law enforcement efforts. Currently, IRS examines a small fraction of partnership and S corporation tax returns. Other forms of businesses, such as C corporations and sole proprietorships, are examined at rates that are several times higher. IRS cannot make fully informed decisions about whether this allocation of enforcement resources is justified because it has limited information about the extent and nature of income misreporting by partnerships and S corporations as well as about the effectiveness of its examinations at detecting such misreporting. This also leaves IRS unable to make a fully informed, data-based decision about whether or not to update one of its major partnership examination selection tools, the DIF formula. We identified two additional opportunities to better use data to improve compliance by flow-through entities. First, enabling greater digitization of tax return information would help IRS identify which partnership and S corporation tax returns would be most productive to examine. In the absence of funding for transcription, one way to increase digitization is a statutory mandate requiring increased e-filing of partnership and S corporation tax returns. Improving IRS’s selection of partnership and S corporation returns to examine would also benefit compliant taxpayers whose returns may otherwise be selected for examination. Further, expanded e-filing would reduce IRS’s tax return processing costs. Second, IRS may be able to take advantage of its ongoing efforts to improve the quality of K-1 data to test whether compliance processes could be improved. Issues with the accuracy and timely availability of K-1 data have been a concern to IRS. Planning now for how to use the improved data would leave IRS well positioned to analyze options for improving its partnership and S corporation compliance programs. Congress should consider expanding the mandate for partnerships and corporations to electronically file their tax returns to cover a greater share of filed returns. We recommend that the Commissioner of Internal Revenue take the following steps: Develop and implement a strategy to better estimate (1) the extent and nature of partnership misreporting, and (2) the effectiveness of partnership examinations in detecting this misreporting. Use the better information on noncompliance and program (1) whether the differences in examination rates across different types of business entities are justified, and (2) whether an improved tool for selecting partnerships for examination, such as an updated partnership DIF, should be developed. While IRS works to improve the quality of its Schedule K-1 data, develop a plan for conducting testing or other analysis to determine whether the improved Schedule K-1 data, perhaps combined with other IRS information about businesses and taxpayers, could be used more effectively to ensure compliance with the reporting of flow- through income. We sent a draft of this report to the Commissioner of Internal Revenue for comment. We received written comments from IRS’s Deputy Commissioner for Services and Enforcement on May 6, 2014 (for the full text of the comments, see appendix V). We also received technical comments from IRS, which we incorporated into the final report where appropriate. In its written comments, IRS said that it had not yet fully evaluated GAO’s recommendations but expressed concerns regarding actions requiring a significant expenditure of resources. However, it said it would consider all of GAO’s recommendations and identify appropriate IRS actions while keeping resource limitations in mind. It is these very resource limitations—which we recognize in this report—that underscore the importance of our recommendations to develop better information for making decisions on how to allocate existing resources. As agreed with your office, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days from its issue date. At that time, we will send copies to the Secretary of the Treasury, the Commissioner of Internal Revenue, and other interested parties. The report will also 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 at whitej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs are on the last page of this report. Key contributors to this report are listed in appendix VI. The objectives of this report are to (1) describe what is known about the extent of income misreporting by partnerships and S corporations, and by the individuals to whom these entities allocate that income; (2) assess how much misreported partnership and S corporation income IRS identifies and assesses taxes on; and (3) analyze how IRS could improve its use of data to better identify partnerships and S corporations to consider for examination. To describe what is known about the extent of income misreporting by partnerships and S corporations, we reviewed what IRS’s National Research Program (NRP) had done at the entity level. For NRP, IRS selects a random sample of tax returns to examine and strives to verify information taxpayers and others reported or should have reported. We reviewed NRP documents and information on the 2003-04 entity-level study of S corporations, which was IRS’s most recent study of S corporations. We also interviewed NRP officials about that study and what information was available about partnerships. To describe what is known about the extent of income misreporting by individuals with income from partnerships and S corporations, we obtained data from NRP for tax years 2006 through 2009, the most recent years for which data were available. At the individual level, IRS conducts NRP studies annually. IRS uses the NRP data to estimate the tax gap and update return selection formulas used in planning examinations. Using these data, we estimated the amount of individual taxpayers’ misreporting of income and losses from partnerships and S corporations on their Forms 1040, U.S. Individual Income Tax Return. We adjusted our raw result based on an IRS estimate of net misreporting percentage. See appendix III for a discussion of our and IRS’s estimation techniques. For this analysis, we looked only at partnership and S corporation income that was separately reported on Schedule E (Form 1040), Supplemental Income and Loss. Some income from partnerships and S corporations may also be included within, and reported under, other line items on Form 1040, such as capital gains. To calculate the amount of taxes that corresponded to our misreporting estimate, we used NRP data to calculate the income and misreporting that related to individuals with different effective tax rates (defined as total tax divided by adjusted gross income). Looking at taxpayers with effective tax rates between 15 percent and 35 percent, we calculated lower and upper bounds for the amount of tax that would have been owed on their misreported income from partnerships and S corporations. To assess how much misreported partnership and S corporation income IRS identifies and assesses taxes on, we obtained data from IRS’s Audit Information Management System (AIMS), Examination Operational Automation Database (EOAD), and Automated Underreporter (AUR) program on K-1 matching. From AIMS, we obtained data on IRS proposed adjustments to partnership and S corporation tax returns for fiscal years 2011 and 2012, the latest years for which information was available when we obtained it. From EOAD, we obtained data on IRS proposed adjustments to individual tax returns for fiscal years 2011 and 2012, the most recent years for which complete data were available. With these data, we calculated proposed adjustments to income and losses from partnerships and S corporations, to income and losses from estates and trusts, and to short- and long-term gains and losses from partnerships, S corporations, estates, and trusts. Based on the proposed adjustments and estimated tax brackets, we estimated the amount of taxes assessed based on these examinations. Using AUR data for tax year 2009, the most recent year for which complete data were available, we reviewed the minimum amount of taxes assessed through matching K-1s against individual tax returns, the only returns against which IRS routinely matched K-1s. The minimum amount was based on returns for which K-1 discrepancies were the only matching discrepancies. We also determined the total amount of assessments that were not attributed to specific types of income, an unknown portion of which might be due to K-1 matching. We interviewed officials from IRS’s examination and AUR programs to determine the reliability of the data and to discuss examination and AUR operations. For contextual purposes, we analyzed IRS Statistics of Income (SOI) partnership data for 2011. Specifically, we determined income, losses, and percentages of income received from other partnerships, estates, or trusts for partnerships earning different kinds of income. To analyze how IRS could improve its use of data to better identify partnerships and S corporations to consider for examination, we analyzed examination statistics derived from AIMS. For example, to see whether IRS’s identification of potential examinations differed across different kinds of entities, we compared the percentage of partnership and S corporation returns that IRS examined to the percentage of C corporation and sole proprietorship returns that it examined. We also compared the rate at which IRS examinations recommended no adjustments to items reported on partnership and S corporation returns to no-change rates for examinations of C corporations and sole proprietorships. We reviewed IRS guidance and interviewed IRS officials to learn how IRS identifies partnership and S corporation returns for later classification and examination and to understand to what extent the process is automated. From various documents, including GAO and Treasury Inspector General for Tax Administration (TIGTA) reports and recommendations, and interviews with IRS and Treasury officials, we evaluated the costs and benefits of various approaches we encountered that could improve IRS’s use of data to better identify partnerships and S corporations to consider for examination and reduce the no-change rate for partnership and S corporation examinations. We assessed whether the approaches included steps that IRS was taking or possibly could take to identify more noncompliance, make examinations more efficient, reduce taxpayer burden, or meet other IRS needs. More specifically, the approaches covered the following: Increasing K-1 and partnership and S corporation return transcription and other digitization. While considering this approach, we determined—from IRS transcription guidance and from interviews with IRS officials—how much of the data filed on paper K- 1s and partnership and S corporation returns are not digitized into IRS databases. We also determined any resulting ramifications for workload identification. From IRS documentation and officials, we determined the details of how IRS plans to fix problems with the timeliness, completeness, and accuracy of K-1s to better use the information for workload identification. Increasing partnership and S corporation return electronic filing. We reviewed documents and interviewed IRS and Department of the Treasury officials about e-filing. More specifically, we explored the status of 2003 TIGTA ideas and subsequent legislative proposals on mandating more e-filing of partnership returns. As part of this effort, we reviewed past and projected e-filing rates prepared by IRS’s Office of Research, Analysis, and Statistics (RAS), including SOI, and determined how many partnerships and S corporations would be affected by various enhancements to the e-filing mandate. We also compared e-filing rates for partnerships and S corporations to other e- filing rates. Upgrading the computer scoring system for identifying partnership returns to eventually examine. From various IRS and other documents and officials, we reviewed the history of IRS’s computer scoring system, known as the discriminant function, or DIF, and the challenges to changing the system. We also reviewed TIGTA reports relating to the system. Analyzing partnership and S corporation data files to identify workload. In accordance with 2012 TIGTA and 1995 GAO ideas on using IRS databases, we obtained documentation regarding IRS efforts to use partnership and S corporation databases to develop examination leads and to select returns to examine. In addition to our main objectives, we also provided the following information in the appendixes. For appendix II, to describe the extent and nature of multitiered networks of partnerships and S corporations, we obtained data from RAS on the tiering characteristics of partnerships and S corporations. The data related to a particular entity include information for all owners of at least 0.1 percent of that entity. Using data for tax year 2011, the most recent year for which complete and reliable data were available in the K-1 database that RAS used, we developed charts describing the relevant information. We interviewed RAS officials to determine the reliability of the data. For appendix III, to compare individual taxpayers’ misreporting of income from partnerships and S corporations with other income types, we calculated: net misreporting amounts; the percentage of taxpayers who misreported; the median amount of misreporting; and the net misreporting percentage for the following categories of income: (1) income from partnerships and S corporations, (2) other business income subcategories reported on Schedule E of Form 1040, and business income categories on Form 1040 itself, with estimated reported incomes with absolute values greater than $10 billion, and (3) the six nonbusiness income categories with estimated reported incomes of more than $150 billion reported on Form 1040. We determined confidence intervals for all our estimates. Although we adjusted our estimate of misreporting of income from partnerships and S corporations based on an IRS estimate of net misreporting percentage, as mentioned above, we presented both the adjusted and unadjusted estimates in appendix III since we did not make comparable adjustments for the other income categories. We also compared the results for each income category with reported IRS determinations of whether the category was subject to little or no third-party information reporting, some information reporting, or substantial information reporting that IRS could match against Form 1040 reporting. We interviewed officials from RAS to determine the reliability of the NRP data and to discuss the adjustments that IRS makes to the data to calculate its reported net misreporting percentage and tax gap estimates. For appendix IV, we calculated and compared the no-change rates in the AUR workload for K-1 matching and for all matching. We also attended and asked questions at a joint Information Reporting Program Advisory Committee and Internal Revenue Service Advisory Council meeting to obtain views on K-1 matching from paid tax return preparers and other relevant stakeholders. We tested the reliability of NRP, AUR, EOAD, AIMS, and SOI data for previous GAO engagements, and we supplemented our knowledge through interviews with IRS officials and through documentation review, and, where applicable, electronic checks. We also tested these data for internal consistency, and for consistency with other IRS data when available. For example, for AIMS data we analyzed, we tested numbers against information published in TIGTA reports and IRS’s Data Book, which annually provides information on returns filed, taxes collected, enforcement, taxpayer assistance, the IRS budget and workforce, and other selected activities. We also checked that the data extracts we used from different parts of RAS, including SOI, were consistent with each other and with information from the IRS Oversight Board. All percentage estimates derived from samples used in this report have 95-percent confidence intervals that are within plus or minus 10 percentage points of the estimates themselves, unless otherwise specified. All other estimates in this report have 95-percent confidence intervals that are within plus or minus 10 percent of the estimates themselves, unless otherwise specified. We tested the K-1 data that IRS provided for internal consistency and consistency with published IRS data, verified the programming IRS used to create tables summarizing the K-1 data, and interviewed the IRS official who created the tables. Based on IRS documents and interviews with IRS officials, data in the K-1 database may be incomplete. Some K- 1s may be missing from the database because of problems such as partnerships and S corporations failing to file K-1s, IRS errors, and timing problems. However, given IRS’s estimates of the level of incompleteness, we believe that any inaccuracies would not change percentage results enough to change the overall conclusions presented in this report. In general, the amounts of tiering shown represent minimums and entity counts are approximate because the missing data would add more entities and linkages to the tables and charts we present. We found the IRS databases we used to be reliable for the purposes of this report. We conducted this performance audit from January 2013 through May 2014 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. Many flow-through entities are connected to each other in tiered networks. As we have reported before, networks of related entities are a feature of modern business organizations. Many legitimate reasons explain why business owners may choose to use a network of related entities to conduct operations. For example, networks can be used to isolate one line of business from the potential liabilities or risk of business loss of another, to manage a business’s financing arrangements, or to separate ventures based in different states and countries. However, networks can also be used in complex tax evasion schemes that are difficult for IRS to identify. More complex networks also make businesses more difficult for IRS to examine. IRS officials said that some businesses may believe that if their networks are sufficiently complex, they will be difficult for IRS to examine. Therefore, it is helpful to understand the extent to which partnerships and S corporations are involved in multitiered networks, as well as the complexity of such networks. See the text box for tiering terminology. Flow-through Entity: An entity for which income is allocated by the business to its owners, with taxes on that income paid only by the owners. Taxes generally are not paid by the flow-through entities themselves. Flow-through entities include partnerships, S corporations, trusts, and estates. Ultimate Owner: A final recipient of flow-through income allocations. Ultimate owners include nonflow-through businesses (e.g., tax-exempt entities and C corporations) and individuals. Simple Network: A network that includes a flow-through entity that does not receive allocations from another flow-through entity or allocate income to another flow-through entity. It allocates income to ultimate owners. Multitiered Network: A network that includes at least one flow- through entity that allocates income to another flow-through entity. Enterprise: A network of flow-through entities and their owners whose economic activity is under the control (defined as 50 percent or more direct or indirect ownership) of a single taxpayer or married couple. Top-tier Entity: A flow-through entity that allocates income to another flow-through entity (and possibly also to ultimate owners) but does not receive allocations from another flow-through entity. Middle-tier Entity: A flow-through entity that both receives allocations from another flow-through entity and allocates income to another flow- through entity (and possibly also to ultimate owners). Bottom-tier Entity: A flow-through entity that receives allocations from another flow-through entity, but does not allocate income to another flow-through entity. It allocates income to ultimate owners. Many of the above concepts are illustrated in figure 6, which shows an example of a simple network and a multitiered network with a top, middle, and bottom tier. In tax year 2011, only about 1 percent of S corporations had 2 or more tiers below them (see table 3). More partnerships, on the other hand, had greater tiering depths. About 23 percent of partnerships had 2 or more tiers below them, and some partnerships had 11 or more tiers below them. See figure 6 above for examples of how tiers below flow-through entities are counted. Most ultimate owners of partnerships and S corporations are individuals. This ownership structure is the most simple. Structures with ultimate owners that are businesses are more complex because the businesses, in turn, are controlled by other entities. For example, C corporations are controlled by their boards and shareholders. Most partnerships and S corporations were owned exclusively by individuals in tax year 2011. S corporations’ ownership was simplest, with 97 percent of all S corporations owned exclusively by individuals. Partnerships showed greater complexity, with 77 percent of all partnerships owned exclusively by individuals and 22 percent owned by mixed types of owners.corporations in tax year 2011 are shown in table 4. Another factor in the complexity of a flow-through entity is the number of ultimate owners (see the text box above for a definition of ultimate owners). As shown in figure 7, most S corporations are closely held, i.e., owned by a small number of ultimate owners. In tax year 2011, 62 percent had only one ultimate owner, and an additional 28 percent had only two ultimate owners. Partnerships tend to have more ultimate owners. In tax year 2011, 51 percent had 2 ultimate owners, 38 percent had 3 to 10 ultimate owners, and 9 percent had 11 or more ultimate owners. Most enterprises (see text box above for definition) are simple and have few component entities, but some are multitiered and have large numbers of component entities (see figure 8). Enterprises are of particular interest to IRS because controlling owners have the ability to influence activity throughout the network. In tax year 2011, about 62 percent of enterprises had two tiers—i.e., they were simple networks—and were composed of about four entities on average (counting both flow-through entities and ultimate owners). About 35 percent of enterprises had three tiers and were composed of about five entities on average. In comparison, the seven enterprises that were nine or more tiers deep were composed of about 735 entities on average. The Internal Revenue Service (IRS) estimated that individual taxpayers misreported, in net terms, 15 percent of the total income from partnerships and S corporations that they should have reported on their tax returns. This percentage is known as the net misreporting percentage (see figure 9). We calculated the total income that should have been reported—$606 billion—from the IRS’s National Research Program (NRP) data on individual taxpayer compliance as the sum of the absolute values of the income amounts that individual taxpayers should have reported. Absolute values are used in calculating the amount of income that should have been reported to prevent negative income amounts from canceling out positive income amounts. Based on these figures, we estimated that in tax years 2006 through 2009, individual taxpayers reported about $91 billion less per year in net income from partnerships and S corporations than they actually were allocated. To arrive at the $91 billion estimate, we adjusted upward based on IRS’s 15 percent misreporting percentage estimate from a raw estimate of $27 billion. There is some uncertainty with both IRS’s estimated net misreporting percentage and the amount of total income from partnerships and S corporations individual taxpayers should have reported. IRS arrived at an estimate of 15 percent for the net misreporting percentage by adjusting upward the net misreporting percentage based on raw data from its NRP. In NRP, IRS selects a random sample of individual tax returns each year to examine and strives to verify information taxpayers reported or should have reported. The net misreporting percentage based directly on NRP data was 4.5 percent for income allocated to individuals by partnerships and S corporations. According to IRS officials, this was probably an understatement because it did not include misreporting undetected by IRS examiners or possible misreporting at the flow-through entity level carried through to individual taxpayers. Based on an IRS study of S corporation (but not partnership) returns from 2003 and 2004, IRS officials said that the net misreporting percentage for income from both partnerships and S corporations for tax years 2006 through 2009 was probably around 15 percent. IRS used only the S corporation study to arrive at the 15 percent because it has not conducted a similar study of partnerships in recent years. We cannot know whether the estimate might have been higher or lower if partnerships were taken into account. Each of the factors mentioned here—undetected individual misreporting, entity- level misreporting, the age of the data in the S corporation study, and the lack of information on partnerships—creates some uncertainty about the 15 percent estimate. Because of the uncertainty related to IRS’s net misreporting percentage, there is also uncertainty about our estimate for net misreported amount. Additionally, the confidence interval around the raw NRP estimate translates to a larger confidence interval for the adjusted estimate. Likewise, in calculating net misreported income, we considered only partnership and S corporation income that was separately reported on Form 1040’s Schedule E, Supplemental Income and Loss. Some income from partnerships and S corporations may also be included within, and reported under, other line items on Form 1040, such as capital gains. IRS has not issued its own estimate of misreporting of partnership and S corporation income for 2006 or later. Our estimate of lost tax revenue cannot be used to compute a tax gap estimate (defined by IRS as the amount of tax liability faced by taxpayers that is not paid on time), as IRS may perform additional adjustments for its tax gap estimates. To calculate the amount of taxes that corresponded to our misreporting estimate, we used NRP data to calculate the income and misreporting that related to individuals with different effective tax rates (defined as total tax divided by adjusted gross income). From 2006 to 2009, taxpayers with effective tax rates of less than 15 percent had an aggregate annual net loss on income from partnerships and S corporations, while taxpayers with effective tax rates of 15 percent or higher had aggregate net income. The highest tax bracket was 35 percent. Looking at taxpayers with effective tax rates between 15 and 35 percent, and using the minimum and maximum tax rates within each effective tax rate grouping and point estimates for misreporting, we calculated lower and upper bounds for the amount of tax that would have been owed on their misreported income from partnerships and S corporations. With this, we arrived at an estimate of $5 billion to $6 billion. Adjusting our point estimate for taxes based on the same methodology discussed above for our misreporting estimate, we arrived at an estimated $19 billion in taxes owed on the misreported income. There are several ways to compare the extent and nature of misreporting of partnership and S corporation income with individuals’ misreporting of other types of income, which are shown in table 5. To compare net misreporting of income from partnerships and S corporations with other types of income, we needed to use unadjusted data, because IRS had not issued adjusted results for 2006 or later at the level of detail needed for the table. For example, the unadjusted net misreporting amount for partnership and S corporation income shown in the table is $27 billion, as opposed to the adjusted amount of $91 billion. In general, frequency of misreporting of income from partnerships and S corporations was lower than for income from sole proprietorships, and higher than for misreporting of income from nonbusiness sources. There is a general pattern in misreporting of income. The more third-party information reporting there is for a type of income (such as W-2s for wages), the less misreporting there is for that type of income (see table 5). According to IRS, information reporting increases voluntary tax compliance because taxpayers know that IRS is aware of their income. For example, employer information on wages and earnings is sent both to employees and to IRS, and for tax years 2006 through 2009, the net misreporting percentage for wages was less than 1 percent. Partnerships and S corporations send partners, shareholders, and IRS Schedules K-1 that state the amount of income distributed to each partner or shareholder. In comparison, most other types of business income earned by individuals are covered by little to no information reporting. However, according to IRS officials, many partnerships and S corporations issuing K-1s are closely held, i.e., controlled by the individual taxpayers receiving the K-1s. In these cases, the information on the K-1 does not truly come from an unrelated third party. Schedule K-1 reporting is complex for several reasons: Some taxpayers with K-1 income have K-1s from multiple partnerships and S corporations, which adds complexity. For example, a taxpayer may net the income/loss amounts from different K-1s, so that the netted amount reported on the 1040 will not match the individual K-1s, but correct information may turn out to be contained within the netted numbers, according to IRS officials. One tax return preparer we interviewed noted that when tiered networks are involved (e.g., partnerships that have other partnerships as partners), each tier must wait for the tier above it to send its K-1s in order to have accurate information, yet they all have the same filing deadline. If the top-tier entity sends its K-1s close to the deadline, the lower tiers must estimate the amounts to put on their own K-1s in order to file on time. This can lead to inaccuracies and mismatches. When taxpayers respond to notices about mismatches, IRS guidance directs AUR reviewers to consider the reasonableness of taxpayers’ responses, but reviewers generally do not examine the accuracy of the information in the responses because they do not have examination authority. K-1 matching is only designed to detect noncompliance at the taxpayer level, not at the entity level. According to an IRS official, because many partnerships and S corporations issuing K-1s are controlled by the individual taxpayers receiving the K-1s, the information on K-1s may match what is on the Forms 1040 but still understate taxes owed. Because of issues like these, K-1 matching is only part of IRS’s efforts to ensure compliance with tax rules about income from partnerships and S corporations. Examinations, discussed previously, also play a role. The screen-out rate (percent of returns reviewed without taxpayer contact) and the no-change rate (percent of taxpayers contacted that did not result in an assessment) for K-1 matching for tax year 2009, the latest year for which complete data were available, were higher than for the Automated Underreporter (AUR) program overall (AUR matches 1040s with many information documents, including K-1s). As shown in figure 10, about 61 percent of the returns with partnership and S corporation K-1 mismatches in IRS’s AUR workload were screened out. That is, the AUR examiner determined that despite the mismatch, the taxpayer was in compliance with tax law or within a small tolerance threshold (i.e., income or expenses were misreported by an amount below what IRS considers productive to address), and the AUR examiner did not contact the taxpayer. In contrast, about 18 percent of all returns in the total AUR workload were screened out. Of the partnership and S corporation mismatch cases where IRS contacted a taxpayer, the no-change rate was about 58 percent. In contrast, the no-change rate for all of AUR was about 19 percent. In addition to the contact named above, Jeff Arkin and David L. Lewis, Assistant Directors; Sara L. Daleski; Deirdre Duffy; Lois A. Hanshaw; Lawrence M. Korb; Veronica O. Mayhand; Donna L. Miller; John W. Mingus, Jr.; Meredith Trauner Moles; Mark F. Ramage; Albert C. Sim; Andrew J. Stephens; Sonya Vartivarian; James A. Wozny; and John M. Zombro made key contributions to this report.

Summary: Since 1980, partnerships' and S corporations' share of business receipts increased greatly. These entities generally do not pay income taxes. Instead, income or losses (hundreds of billions of dollars annually) flow through to partners and shareholders to include on their income tax returns. GAO has previously reported that the misreporting of income by partners and shareholders poses a tax compliance risk. GAO was asked to assess IRS's efforts to ensure compliance by partnerships and S corporations. This report (1) describes what is known about misreporting of flow-through income, (2) assesses how much misreporting IRS identifies, and (3) analyzes possible improvements in IRS's use of data to better identify partnerships and S corporations to consider examining. Comparing partnership, S corporation, and other entities' examination results, GAO analyzed 2003-2012 IRS data and evaluated possible improvement ideas stemming, in part, from prior GAO work, for how IRS identifies examination workload. The full extent of partnership and S corporation income misreporting is unknown. The Internal Revenue Service's (IRS) last study of S corporations, using 2003-2004 data, estimated that these entities annually misreported about 15 percent (an average of $55 billion for 2003 and 2004) of their income. IRS does not have a similar study for partnerships. Using IRS data and the study results, GAO derived a rough-order-of-magnitude estimate of $91 billion per year of partnership and S corporation income being misreported by individuals for 2006 through 2009. IRS examinations and automated document matching have not been effective at finding most of the estimated misreported income. For example, IRS reported that examinations identified about $16 billion per year of misreporting in 2011 and 2012, the bulk of which related to partnerships. However, such information about compliance results is not reliable. IRS estimated that 3 to 22 percent of the misreporting by partnerships was double counted due to some partnership income being allocated to other partnerships or related parties. Further, IRS does not know how income misreporting by partnerships affects taxes paid by partners. IRS does not have a strategy to improve the information. As a result, IRS does not have reliable information about its compliance results to fully inform decisions about allocating examination resources across different types of businesses. IRS's processes for selecting returns to examine could be improved. Not all partnership and S corporation line items from paper returns are digitized, and IRS officials said that having more return information available electronically might improve examination selection. In 2011, about 65 percent of partnerships and S corporations electronically filed (e-filed). Certain large partnerships and S corporations are required by statute to e-file. Expanding the mandate would increase digitized data available for examination selection. Further, in 1995 GAO found that IRS's computer scoring system for selecting partnership returns to examine used outdated information. IRS does not have a strategy to update and use this information to select partnerships for examination. Relatively few partnerships are examined compared to other business entities, and many examinations result in no change in taxes owed. Improved examination selection based on more current information could generate more revenue and reduce IRS examinations of compliant taxpayers. GAO suggests that Congress consider requiring more partnerships and corporations to e-file their tax returns. GAO recommends, among other things, that IRS (1) develop a strategy to improve its information on the extent and nature of partnership misreporting, and (2) use the information to potentially improve how it selects partnership returns to examine. IRS stated it would consider all the recommendations and identify appropriate actions.