For audit purposes, IRS splits large corporations (those reporting $10 million or more in gross assets) into two groups. Of the 46,700 large corporations in 1994, IRS placed about 1,700 corporations, usually exceeding $250 million in assets, into CEP. IRS audits the large corporations not in CEP (hereafter referred to as “large corporations”) under the Examination Division’s general program. The Examination Division audits tax returns to determine whether taxpayers paid the correct amount of tax. As discussed later in detail, IRS audit staff are to take various steps before auditing a return. First, the staff must classify and select a return for audit. IRS classifies returns to highlight tax issues (e.g., income, deductions, credits) that should be audited. Then, an IRS revenue agent is to plan how to audit such issues and collect information from the large corporation, as needed. If the corporation does not provide all requested information in a reasonable period without a valid excuse, IRS may issue a legal summons to compel the taxpayer to comply. The Department of Justice works with IRS to enforce the summons in court. For each audit issue, if the revenue agent views this information as insufficient support for the position taken on the return, the agent is to recommend adjustments to the return and compute a corrected tax liability. On the other hand, if the information supports the return filed by the large corporation, the agent is to recommend no tax change. The revenue agent presents the audit results to the large corporation officials, who may either agree or disagree. If the large corporation agrees, any additional tax that the revenue agent recommended becomes assessed. If the large corporation disagrees, it may file a protest with IRS’ Office of Appeals, which is tasked with settling tax disputes without litigation on the basis of what is fair to the government and the taxpayer. An appeals officer is to evaluate the relative strengths of the government’s and taxpayer’s positions by reviewing the facts, including additional information provided by the taxpayer, pertinent court decisions, and the results of informal conferences with the taxpayer. To settle a tax dispute, an appeals officer can consider the hazards of litigation. The officer is then to negotiate mutual concessions in an attempt to arrive at a settlement. If a case is settled, any additional tax is assessed and the appeals officer is to prepare an Appeals case memorandum, or written summary, of how the case was handled. The summary is to include the issues raised; pertinent facts; applicable regulations, rulings, and court decisions; and the merits and hazards of litigation of each side. If a case is not settled, Appeals is required to issue a notice of deficiency and the taxpayer has 90 days to file a petition with the Tax Court. Even after a case is docketed in court, IRS District Counsel, by itself or by reengaging Appeals, may attempt to settle the case prior to trial. IRS data showed that in fiscal year 1992, Examination sent 2,235 large corporate cases to Appeals. As of late fiscal year 1995, Appeals had settled about 1,800 of those cases. Of those not settled by Appeals, three were settled by District Counsel, two were settled by trial, and the remainder were still open in Appeals. Our objective was to determine what factors affected the results of auditing large corporations as well as the amount of additional taxes recommended in these audits that are ultimately assessed. To accomplish our objective, we used two methodologies. First, we sent questionnaires to IRS revenue agents, IRS appeals officers, and corporate taxpayers associated with a nationally representative sample of audits in which a large corporation agreed with the additional recommended taxes at the end of either the audit or appeals processes during fiscal year 1994. To focus on larger audits, we restricted this questionnaire study to the universe of large corporate audits with $75,000 or more in recommended additional taxes and concentrated about one-third of the sample in a stratum with recommended taxes of $1 million or more. Our sample of 500 included about $2.3 billion of the $2.6 billion in recommended additional taxes and $648 million of the $810 million in taxes assessed from the 1,266 large corporate audits in our universe. Appendix I provides a detailed description of our sample selection methodology. We also sent a more general questionnaire to IRS group managers because, being responsible for many types of audits, they were not as likely as the above respondents to recall information about specific audits of large corporations. We randomly sampled group managers nationwide who had large corporate audits in their inventories as of August 1995. Questionnaire results for revenue agents, group managers, and appeals officers are presented in appendices II through IV, respectively. Because the questionnaires were sent to a sample rather than all members of their respective universes, all of the sample results are subject to sampling error. Unless otherwise noted, all estimates presented in this report have a 95 percent confidence interval of less than plus or minus 10 percent. Questionnaire results for the large corporations are not included because of a low response rate that did not allow us to develop estimates. Second, we obtained input from various IRS staff. We visited IRS’ National Office, its 4 regional offices, and 7 of its 33 district and appeals offices to interview key officials. During the design phase of our review, we visited three additional districts and two additional appeals offices. In the National Office, we contacted officials in the Examination Division, National Appeals Office, and the Strategic Planning Division. In conjunction with our site visits, we interviewed selected Appeals, District Counsel, and Examination officials to obtain their views. Appendix V lists all locations visited and the officials interviewed at each location. In addition, we asked the Examination Chiefs in all 33 IRS district offices nationwide and Appeals Chiefs in all 33 appeals offices nationwide to give us their written comments on certain factors related to these large corporate audits. We received responses from 31 (94 percent) of the Examination Chiefs and 30 (91 percent) of the Appeals Chiefs. Their views are incorporated throughout this report. We obtained oral comments on a draft of our report from IRS and the Tax Executives Institute (TEI). We discuss such comments and our evaluation of them at the end of this letter. Overall, we conducted our work at IRS’ National Office, 4 regional offices, 10 of the 33 district offices, and 9 of the 33 appeals offices. In addition, we used questionnaires received from all of IRS’ 33 district offices. We also asked Examination Chiefs and Appeals Chiefs nationwide to give us their comments on factors related to these large corporate audits. We did our work from May 1995 to November 1996 in accordance with generally accepted government auditing standards. Our 1995 report on large corporate audit trends provided statistics on IRS audits of large corporations between fiscal years 1988 and 1994. These statistics covered the audit results and assessment rate over this 7-year period. Neither we nor IRS knows what the assessment rate should be, but these statistics indicate that IRS has been investing a lot of time and money recommending additional taxes that do not get assessed. For example, in a comparison of data for 1988 and 1994, we found that IRS invested more resources in large corporate audits but recommended less additional tax per hour. IRS spent 25 percent more hours and audited only 3 percent more returns. Even so, the amount of taxes recommended (in constant dollars) dropped 23 percent per audit hour and 7 percent per audited return. In addition, IRS’ no-change rate doubled from 8 percent to 16 percent. Further, for the 7-year period, we computed that IRS assessed, on average, 27 percent of the additional taxes that IRS revenue agents recommended in these audits. The assessment rate includes the amount of recommended taxes that the large corporations agreed to pay at the end of the audit as well as those amounts sustained after any appeal. Over the 7 years, large corporations appealed between 66 and 85 percent of the additional taxes recommended and agreed to pay the rest. Since 1990, corporate taxpayers have been appealing a lower percentage of the recommended taxes and agreeing to a higher percentage. We identified four factors that affected the assessment rate and/or audit results, such as the lower recommended taxes per audit hour in 1994 compared to 1988. Although the exact impact is unknown, each factor can affect both the rate and results. For example, three of the four factors—complex tax laws, conflicting performance measures between Examination and Appeals, and limited coordination between these two IRS functions—can produce a lower assessment rate. As for lower audit results, the three factors can each have a different impact. Complex laws cause IRS’ audits to be very time consuming, which can lower the amount of recommended taxes per hour. Although Examination’s performance measures would encourage higher amounts of recommended tax, Appeals measures would not be as likely to affect the audit results. Limited coordination between Appeals and Examination was unlikely to affect the audit results being disputed by corporations because the audits had already been done. On the other hand, future audit results on similar tax issues were likely to be reduced when revenue agents did not receive feedback on which disputed issues were conceded and why; such knowledge could enhance future audits. The fourth factor entailed a number of aspects of an audit that could reduce the taxes recommended per audit hour or the assessment rate. Because revenue agents generally worked alone without much assistance from counsel or their management, they needed more time to develop enough support to recommend taxes that could be assessed after an appeal. These agents also did not have a sufficient basis for selecting corporate tax returns with potential for significant tax changes. Generally, audits of returns with low potential were more likely to result in recommendations for little or no tax change and were less likely to be appealed. Thus, these audits would generally have little effect on the assessment rate. However, when a revenue agent tried to recommend taxes without sufficient support, such recommended taxes would not likely be sustained in Appeals, and the assessment rate would be lower. The following sections discuss each of these four factors in more detail. IRS and large corporate taxpayers can have legitimate differences over how tax laws should be interpreted.