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.