Sole proprietors are to file Form 1040, Individual Income Tax Return, and attach to it Schedule C, Profit or Loss From Business (Sole Proprietorship), or Schedule F, Profit or Loss From Farming. IRS requires most sole proprietors to write their SSN on Form 1040 and to write both their SSN and EIN on Schedules C and F. However, not all sole proprietors are required to have and use EINs. IRS requires only those sole proprietors who also file employment, pension, or excise tax returns to have and use EINs. IRS received about 15 million 1040 returns from sole proprietors for tax year 1991, and about 2.2 million included an EIN on a Schedule C. The Internal Revenue Code requires taxpayers to include taxpayer identification numbers on tax returns and gives IRS the authority to decide what identification system will be used. The Social Security Administration issues SSNs to individuals. IRS issues EINs to businesses, which must apply to IRS to obtain an EIN. IRS has two master files containing the tax accounts of individuals and businesses. Data from Form 1040 returns, including Schedules C and F, are posted to the Individual Master File using the primary SSN as the primary account number. Data from employment and excise tax returns filed by sole proprietors are posted to the Business Master File using the EIN as the primary account number. If a sole proprietor has an account on each file, IRS can connect them by cross-referencing account numbers. The proprietor’s SSN is recorded in the Business Master File account, and the EIN is recorded in the proprietor’s Individual Master File account. IRS records sole proprietor information on a third file, the Cross-Reference Entity File (CREF). IRS created CREF in response to a recommendation we made in 1987. We reported then that IRS could make better use of information returns in determining whether businesses filed returns and fully reported their income. Information returns are the documents that third-party payers, such as employers, corporations, and financial institutions, send to taxpayers and IRS to report such payments as wages, dividends, interest, and other types of income. In addition to listing the taxpayer’s name, information returns identify taxpayers by either SSN or EIN. IRS created CREF so that it could consolidate information returns filed under a sole proprietor’s SSN with those filed under its EIN. By computer matching these consolidated data with income tax return data, IRS can determine whether sole proprietors filed tax returns and reported all income shown on information returns. As agreed with the Joint Committee, our objectives were to determine whether IRS (1) accurately cross-references sole proprietor identification numbers on the Individual Master File, Business Master File, and CREF and (2) needs to take any actions to improve the accuracy of its cross-reference files. To accomplish these objectives, we reviewed IRS’ procedures for (1) issuing EINs, (2) processing sole proprietor tax returns, and (3) entering SSNs and EINs on the two master files. We interviewed various IRS officials who were responsible for (1) updating Individual and Business Master File records, (2) creating and updating CREF, and (3) managing and operating the information-returns-based programs for identifying taxpayers who may have failed to file returns or report all income. In addition, we reviewed samples of sole proprietor accounts to determine the accuracy of SSNs and EINs posted to them. To help us obtain samples, IRS gave us a computer file of the 1.8 million tax year 1991 Schedule Cs filed with the Fresno Service Center in calendar year 1992, the most recent year for which complete data were available when we began our work. We picked the Fresno Service Center because it was a logistically and geographically convenient location in which to do our work. According to IRS officials, we could expect to find similar conditions at all IRS service centers. We analyzed the file to identify Schedule Cs that were filed with an EIN; 243,289 Schedule Cs included a unique EIN and a primary SSN or secondary SSN that was not duplicated. We matched these 243,289 EINs against EINs listed on the tax year 1991 CREF, which we had obtained from IRS. This match showed that 217,279 of these Schedule C EINs were on CREF and 26,010 were not. From the 217,279 EINs that matched, we selected a random sample of 250 accounts to determine whether the identification numbers on CREF, the Individual Master File, and the Business Master File were accurate. For each account, we reviewed the Individual and Business Master File entity and tax year 1991 records. We judged the information on the files to be accurate when the EIN and SSN on CREF matched those on the Individual and Business Master File records. From the 26,010 Schedule C EINs that were not on CREF, we randomly selected 250 to determine whether there were valid reasons for their absence from CREF. We made this determination by searching IRS master file and tax return records for EINs in our random sample and analyzing the records when a match occurred. We also reviewed and evaluated IRS’ procedures for excluding records from CREF. Our sampling methodology, which is described in more detail in appendix I, allowed us to project the results of our samples to 217,279 of the 243,289 tax year 1991 Schedule Cs that contained EINs and were filed with the Fresno Service Center. We also reviewed the legislative history of the Code provision that authorizes the use of taxpayer identification numbers on tax returns. In addition, we discussed the need for both numbers with IRS and Social Security Administration officials. We did our work from January 1994 to March 1995 at IRS’ National Office in Washington, D.C., and its Fresno Service Center in accordance with generally accepted government auditing standards. We requested comments on a draft of this report from the Commissioner of Internal Revenue. On June 13, 1995, IRS officials provided us IRS’ comments. IRS representatives at that meeting included the National Director of Submission Processing and representatives of the Assistant Commissioners for Taxpayer Services and Collections. Their comments are summarized on pages 14-17 and incorporated in this report where appropriate. Sole proprietors are the only type of business entity that has one identification number for income tax purposes and another for business tax purposes. Other business taxpayers, such as corporations, use their EINs for all tax purposes. Sole proprietors report tax information that other individual taxpayers report, such as filing status, number of exemptions claimed, alimony paid, medical and dental expenses, interest paid on home mortgages, and taxable income. They also report tax information about their businesses, such as the accounting method used to keep the business’ books, business expenses (e.g., advertising, utilities, employee wages), and cost of goods sold. They report the business information on Schedule C or F and carry to Form 1040 the net profit or loss from the sole proprietorship. IRS records the tax information sole proprietors report on two different master files. It records the individual tax information, including Schedule C and F data, on the Individual Master File and the business tax information, such as data from employment and excise tax returns, on the Business Master File. As their names suggest, the Individual Master File holds the tax information of persons who file individual income tax returns, and the Business Master File holds the tax information submitted by sole proprietors, corporations, partnerships, and other businesses. IRS requires sole proprietors to use two different identification numbers because each master file will accept only one type of identification number as the primary account number. The Individual Master File will accept only SSNs as the primary number for Form 1040. The Business Master File will only accept EINs as the primary account number for Form 941 employment tax returns and other business returns. Therefore, in order to record tax information about them on the two files, IRS requires sole proprietors to file Form 1040 with an SSN and employment and excise tax returns with an EIN. IRS cross-references the SSN and EIN that a sole proprietor reports. However, we found that the cross-references were not always correct. Better validation of sole proprietor SSNs and EINs by IRS when processing returns could mitigate the problem but would not eliminate it. As previously mentioned, we sampled 250 of the 217,279 tax year 1991 Schedule Cs filed at the Fresno Service Center in 1992 and listed on CREF and 250 of the 26,010 returns that were not on CREF. We reviewed these cases to determine whether EINs on the Schedule Cs belonged to the taxpayers who entered them. On the basis of our sample results, we estimate that 48,608, or 20 percent, of the 243,289 EINs posted to Individual Master File tax year 1991 records as cross-references to the Business Master File were erroneous. That is, the EIN would not serve as a bridge to the sole proprietor’s account on the Business Master File. Before posting, IRS did not screen EINs to detect those incorrectly reported on Schedule C. As table 1 shows, in filing Schedule Cs, sole proprietors used EINs that either belonged to another business, did not exist on the Business Master File, or were the same as the sole proprietor’s SSN. Cases involving an EIN belonging to another taxpayer included those where sole proprietors received an information return for services provided to another business and then used the EIN of that business as shown on the information return. Cases involving an EIN not on the Business Master File included those in which sole proprietors transposed digits of their EINs or otherwise entered numbers that did not reflect valid EINs.