Each year, the federal government, through the Internal Revenue Service, collects tax revenue to fund government operations. The federal government relies on IRS to collect the proper amount of tax revenue at the least cost to the public. In fiscal year 1997, IRS collected over $1.6 trillion used to finance various government programs and activities. These receipts represent payments by individuals, businesses, corporations, estates, and other types of taxpayers primarily for amounts owed as a result of wages, income, employment, sales, and consumption. To a large extent, the annual receipts collected by IRS represent the amounts taxpayers owe for the given period. However, not all taxpayers pay the amounts they owe the federal government. Some simply do not provide payments on their tax liability when they file their tax returns. Others underreport, either mistakenly or deliberately, the amounts they owe the government. Still others do not report the amounts they owe. While some taxpayers eventually pay some or all of the amounts due, others do not. Also, those that do pay may pay over an extended period. This has resulted in a significant build-up in the amount of unpaid taxes due the federal government because, in addition to taxes owed, taxpayers also become liable for penalty and interest charges that continue to accrue over time until the tax, plus accrued penalty and interest charges, have either been paid in full or the statutory period of collection has expired. As of September 30, 1997, information accompanying IRS’ fiscal year 1997 financial statements reflected a total balance of $214 billion in unpaid taxes, penalties, and interest. These amounts are referred to as unpaid assessments. IRS identifies unpaid assessments through a number of means. Most are identified through the filing of tax returns by the taxpayer. In cases where the taxpayer files a return that reflects an amount or tax liability owed the federal government but does not provide payment or provides only partial payment, the unpaid assessment represents the difference between the tax liability as reflected on the return and the amount actually paid by the taxpayer. IRS refers to these as self-assessments because the amount of the delinquent tax is identified solely through information provided by the taxpayer. IRS also identifies unpaid assessments through its enforcement programs. Such programs include IRS’ underreporter program, where information such as wages, interest, and dividends contained on the tax return is compared to other third party-supplied information, such as wage and earnings statements and annual interest statements. Any differences identified through this process can result in the identification of additional tax liabilities or assessments owed by the taxpayer. Also, IRS tax examinations and audits can identify additional taxes owed the government. IRS’ substitute for return program, where IRS constructs tax returns through the use of third party information and prior taxpayer history for taxpayers who have filed returns in the past but have not filed for the given period, is another tool used by IRS to attempt to identify amounts that are owed the government. Through these various enforcement programs, IRS attempts to close what is referred to as the tax gap, which is the difference between taxes actually collected and the amount that is legally due under the Internal Revenue Code. The tax gap can be further subdivided into the “compliance gap” and the “collection gap.” The compliance gap, which is outside the scope of this report, represents the difference between taxes that should actually be due and those that have been identified by IRS, either through self-assessments or through assessments resulting from IRS enforcement programs. It is this compliance gap that IRS’ enforcement programs attempt to close, although considerable amounts of taxes due on legal and illegal income remain unassessed or underassessed each year. The collection gap represents the difference between the amounts that have been identified as being due through assessments and the amounts that will ultimately be collected on these assessments. This collection gap, which is the subject of this report, represents the amount of IRS’ unpaid assessments that is not collectible. Like a commercial lender’s loan portfolio, IRS’ ability to collect amounts owed is constrained to a great extent by the financial condition of the taxpayer. However, unlike a commercial lender, who can review the financial condition and viability of a prospective borrower prior to extending a loan, IRS does not choose who owes the government taxes. Taxpayers who owe delinquent taxes generally do not have good credit, reliable incomes, or significant assets and in many instances are corporations that have gone out of business. Consequently, IRS cannot manage risk in a manner similar to commercial lenders. This makes closing the collection gap significantly more problematic for IRS than for a commercial lender. The balance of unpaid assessments as of September 30, 1997, consists of the types of taxes that IRS collects, the majority of which result from individual income taxes, Social Security and Hospital Insurance taxes, and corporate income taxes. Payments for these taxes may be made on a periodic basis, or for individuals by their employers via withholdings from their wages. The major types of taxes in IRS’ unpaid assessments balance are: individual income taxes and self-employment taxes, payroll taxes, and corporate income taxes, which are generally taxes on business profits. Other types of taxes in IRS’ balance of unpaid assessments include (1) unemployment taxes, (2) excise taxes, such as fuel, communications, air transportation, sporting goods, alcohol, and environmental taxes, and (3) estate taxes. Not all unpaid assessments are considered accounts or taxes receivable. Federal accounting standards provide criteria for distinguishing which unpaid assessments constitute taxes receivable. IRS has had considerable difficulty properly distinguishing and reporting taxes receivable in its financial statements because its systems were not designed to generate information for use in preparing financial statements in accordance with these standards. Fiscal year 1997 was the first time IRS was able to successfully prepare reliable financial statements covering its tax collection activities. However, this required the use of special programming to extract information from IRS’ master files—its only detailed database of taxpayer information—for use in preparing the financial statements as its systems cannot readily produce this information. Also, this approach still required significant manual intervention and, in the end, adjustments totaling tens of billions of dollars, principally to correct significant misclassifications and duplication of unpaid assessments. As part of our audit of IRS’ fiscal year 1997 Custodial Financial Statements, we reviewed IRS’ unpaid assessments using statistical sampling techniques. Our objectives for the unpaid assessments segment of that audit were to determine (1) whether IRS had properly classified its balance of unpaid assessments between taxes receivable, compliance assessments, and write-offs, (2) whether the balances for taxes receivable, compliance assessments, and write-offs were accurate, and (3) in conjunction with IRS, an estimate of the amount IRS could reasonably expect to collect on its balance of taxes receivable. See appendix I for the scope and methodology used to accomplish these objectives. The objective of this report is to provide detailed information on the composition and collectibility of IRS’ September 30, 1997, balance of unpaid assessments based on the work we performed as part of our audit of IRS’ fiscal year 1997 custodial financial statements. It is important to note that, in performing our work, we did not assess the effectiveness of IRS’ enforcement and collection programs, nor did we attempt to address the compliance gap component of the tax gap. Also, we did not specifically analyze the impact provisions of the IRS Restructuring and Reform Act of 1998 may have on the future composition and collectibility of IRS’ unpaid assessments. We conducted our work from August 1997 through February 1998 in accordance with generally accepted government auditing standards. In commenting on a draft of this report, IRS provided preliminary oral comments, which we have incorporated where appropriate. We requested written comments on a draft of this report from the Commissioner of Internal Revenue. The Deputy Commissioner provided us with written comments, which are discussed in the “Agency Comments” section and are reprinted in appendix II. Taxes receivable are one category of unpaid assessments, and they comprised less than half the balance of IRS’ unpaid assessments as of September 30, 1997. Under federal accounting standards, unpaid assessments fall into three categories: taxes receivable, compliance assessments, and write-offs. Taxes receivable are taxes and associated penalties and interest due for which IRS can support the existence of a receivable through taxpayer agreement, such as the filing of a tax return without sufficient payment, or a court ruling favorable to IRS. The key distinction between taxes receivable and compliance assessments is the acknowledgement by the taxpayer or a court that the taxpayer owes money to the federal government. Compliance assessments are unpaid assessments in which neither the taxpayer nor a court has affirmed that the taxpayer owes money to the federal government. For example, an assessment resulting from an IRS audit or examination in which the taxpayer does not agree with the results of the audit or examination is a compliance assessment but is not considered a receivable under federal accounting standards. Write-offs are unpaid assessments for which IRS does not expect further collections due to factors such as the taxpayer’s bankruptcy, insolvency, or death. Write-offs may at one time have been taxes receivable, but the absence of any future collection potential prevents them from being considered receivables under federal accounting standards. Although compliance assessments and write-offs are not considered receivables under federal accounting standards, they represent legally enforceable claims of IRS—acting on behalf of the federal government—against taxpayers. There is, however, a clear distinction between these categories from the standpoint of assessing what they represent with respect to future cash flow to the federal government. Our review of these categories of unpaid assessments as part of our fiscal year 1997 Custodial Financial Statement audit confirmed that there are significant differences in their collection potential, which clearly supports the usefulness of the distinctions between unpaid assessments required under federal accounting standards. IRS’ fiscal year 1997 Custodial Financial Statements for the first time presented reliable information on the components of IRS’ balance of unpaid assessments. The Statement of Custodial Assets and Liabilities appropriately reflected that portion of IRS’ unpaid assessments that represented taxes receivable that were estimated to be collectible.