TIGTA Again Critical of IRS Correspondence Audit Process

The Treasury Department’s Inspector General for Tax Administration (TIGTA) has issued another audit report critical of the IRS correspondence audit process.  (See prior post here.)  In its latest audit report, entitled “Actions Are Needed to Strengthen the National Quality Review System for Correspondence Audits,” TIGTA found that problems with correspondence audits are not always recognized and reported, resulting in missed opportunities for the IRS to reduce noncompliance that contributes to the Tax Gap and promote tax system fairness among taxpayers. 

In contrast to the more detailed and lengthy face-to-face audit at an IRS office or in the field at a taxpayer’s place of business, the correspondence audit process is conducted by mail and is less intrusive, more automated, and conducted by examiners who are trained to deal with less complex tax issues.  Because of its automated features and less complex tax issues, the correspondence audit process enables the IRS to reach more taxpayers at a lower cost.  The IRS currently conducts correspondence audits in approximately 37 program areas.

By FY2008 and FY2012, the IRS conducted almost 5.7 million correspondence audits and recommended approximately $40.4 billion in additional taxes.  This represents about 77 percent of all audits the IRS conducted of individual income tax returns and about 56 percent of the estimated $72.4 billion in recommended additional taxes resulting from those audits.  The responsibility for conducting correspondence audits rests largely with the IRS’s Small Business/Self-Employed (SB/SE) Division, which handles complex individual tax returns, and its Wage and Investment Division, which handles simple tax returns filed by individuals reporting wages, interest, dividends, and other investment income.

The correspondence audit process typically begins with the IRS mailing a computer-generated letter from one of its campuses to a taxpayer. The letter outlines the examination process, identifies one or more items on the tax return being questioned, and requests supporting information to resolve the questionable items. Once the requested information is returned, examiners review it to determine whether it resolves the questions.  If the questions can be sufficiently answered by the information provided, the audit is generally closed without any changes to the tax; if not, the taxpayer is sent a letter requesting more information or indicating a recommended change to the tax.  The taxpayer can thereafter:

  • Agree with the examiner;
  • Provide the examiner with clarifying information; or
  • Appeal the decision to the IRS’s Office of Appeals.

In instances where the taxpayer does not respond to IRS letters, the examiner’s recommended tax changes are assessed by default and the taxpayer will generally have to file a petition in the U.S. Tax Court to contest the assessment.

To ensure that correspondence audits are conducted in a quality manner, the IRS uses a comprehensive quality review system.  The system includes a statistical sampling of correspondence audits.  The IRS has established seven auditing quality standards.  Each standard has key elements that elaborate on and further define the overall standard.  For example, one of the key elements for Adequate Consideration of Significant Issues instructs examiners to consider and/or pursue audits of the prior and/or subsequent year returns when they contain the same issues as in the year examined.  (A recent TIGTA audit report criticized the IRS for failing to pursue correspondence audits of prior and/or subsequent years.)  Another quality standard examines whether applicable penalties were considered and applied correctly.

The quality review system is conducted at the management level, where “first line managers” review the documentation for a sample of audit case files to identify and correct quality problems in conjunction with evaluating the performance of the examiners they supervise.  In addition, each of the five IRS campus sites that conduct correspondence audits also perform quality review audits as part of the IRS-wide National Quality Review System (NQRS).

TIGTA’s audit discovered that the National Quality Review System should be strengthened because numerous errors were found during the audit process.  TIGTA found numerous errors in tests of the accuracy-related penalty determination category that were not detected and reported by NQRS quality reviewers.  For example, TIGTA found that in cases where examiners disallowed itemized deductions in excess of $20,000 due to lack of documentation, no negligence penalty was asserted.  Similarly, TIGTA found that in cases were taxpayers understated their tax liabilities, penalties were not considered.  TIGTA also found “inconsistency and confusion” over when, and if, the scope of single-year audit should be expanded to include prior and/or subsequent years. 

In management’s response to the TIGTA audit, IRS largely agreed with the findings and recommendations.  As a result, we expect to see a greater focus from examiners and their managers on the assertion of penalties, where appropriate, during the correspondence audit process.  We also expect to see more prior and/or subsequent year audits in this area.

TIGTA Audit Report: Budget Cuts Devastate IRS Enforcement Activities

The Treasury Department’s Inspector General for Tax Administration (TIGTA) has issued a report entitled “Trends in Compliance Activities Through Fiscal Year 2012” which confirms that cuts to the Internal Revenue Service budget have taken a severe toll on the agency’s ability to carry out its enforcement mission.  The report studies the IRS’s collection and examination functions during FY2011 and FY2012.

The report opens by noting that while the “Tax Gap” — the difference between what is owed in taxes each year and what is paid voluntarily — is steadily growing, both the IRS’s budget and enforcement revenue are decreasing.  (In a separate audit report, TIGTA has criticized the IRS calculation of the Tax Gap as well.  That report is available here.)  For tax year 2001, the IRS estimated the Tax Gap at $345 billion.  For tax year 2006 (the most recent estimate available), the IRS estimates the Tax Gap to be $450 billion, an increase of 30 percent.  Meanwhile, the IRS budget has decreased from FY2010 to FY2012, with a further reduction of $600 million in FY2013 due to the sequester.  These budget cuts have caused a reduction of approximately 8,000 full-time IRS positions since FY2010, including 5,000 from what TIGTA describes as “front-line enforcement personnel.”  In addition, the report notes that over 30 percent of executives, and 20 percent of non-executive managers, are currently eligible for retirement. 

The audit report notes that enforcement revenue has declined for two straight years, and is currently 13 percent less than the FY2010 level.  TIGTA concluded that this decline correlates directly with the 14 percent reduction in the number of IRS enforcement personnel.  At the same time, the number of tax returns being filed has steadily increased.

On the collection front, the TIGTA report notes that revenue collection decreased by 7 percent from FY2011 to FY2012.  In addition, the overall use of key collection mechanisms — liens, levies,and seizures — has decreased.  Between FY2011 and FY2012, the use of tax liens dropped a whopping 32 percent, but that decline is likely attributable to the new Fresh Start Initiative which limited the IRS’s ability to impose liens in certain circumstances in order to help individuals and small businesses meet their tax obligations without adding unnecessary burdens. 

On the audit front, the IRS has experienced a 13 percent reduction in the number of personnel who conduct examinations of tax returns.  In FY2012, the IRS conducted 4 percent fewer audits, and 70 percent of those examinations were conducted by correspondence.  In FY2012, the number of individual tax returns that were examined decreased for the second straight year, while the number of corporate tax returns that were selected for audit increased to a five-year high.  Gift tax examinations have increased every years since FY2009, and have nearly tripled since FY2008. 

The TIGTA report concludes as follows:

The IRS faced many challenges during Fiscal Years 2011 and 2012, including implementing provisions related to new tax legislation and operating with fewer resources and employees.  Several indicators showed the effect of these challenges, including a decrease in enforcement revenue, a continued increase in accounts receivable, an increase in the number of cases that might never be worked, and a decrease in the overall number of examinations.  Nevertheless, many indicators increased, including gross collections and the examinations of certain tax returns.  Some of these trends are cause for concern, especially given that diminished enforcement could also affect voluntary compliance over time.

IRS Releases Key Statistics on Audit Rates and Enforcement Activity

The Internal Revenue Service has released its annual data book, which it describes as a “snapshot of agency activities for the fiscal year.”  The time period covered in the FY 2012 Data Book is October 1, 2011, through September 30, 2012. 

Among the data presented in the FY 2012 Data Book are audit rates for the past year.  The overall audit rate for individual tax returns was 1.03 percent, which is generally consistent with prior years.  The audit rates for wealth taxpayers, however, saw a slight decrease.  The following chart nonetheless illustrates that the audit risk dramatically increases for taxpayers reporting large amounts of adjusted gross income:

IRS Audit Rates FY 2010 FY 2011 FY 2012
All returns 1.11% 1.11% 1.03%
No AGI 3.19% 3.42% 2.67%
AGI $1 to $25,000 1.18% 1.22% 1.05%
AGI $200,000 to $500,000 1.92% 2.66% 1.96%
AGI $500,000 to $1 million 3.37% 5.38% 3.57%
AGI $1 million to $5 million 6.67% 11.80% 8.90%
AGI $5 million to $10 million 11.55% 20.75% 17.94%
AGI over $10 million 18.38% 29.93% 27.37%

The overall audit rate for estate tax returns is nearly 30 percent, with 12,582 estate tax returns filed during calendar year 2011.  The audit rate for estate tax returns where the size of the gross estate is between $5 million and $10 million is 58.6 percent.

On the enforcement front, the IRS assessed nearly $26.9 billion in civil penalties during FY 2012, and initiated 5,125 new criminal tax investigations.  2,466 taxpayers were convicted of a tax crime during FY 2012, and 2,009 of those individuals (or 81.5 percent) received a sentence of incarceration.  The number of IRS Special Agents (who are responsible for conducting criminal investigations) employed by the agency is down, from 2,730 in FY 2011 to 2,657 in FY 2012.

On the international enforcement front, Acting Commissioner Steven T. Miller offers the following assessment:

The IRS in 2012 made significant progress on international enforcement, specifically in our efforts against the practice of illegally hiding assets and income in offshore accounts.  We have continued our two-pronged approach: offering a voluntary disclosure program for those who want to come in and get right with the government, while at the same time pursuing tax evaders and the promoters and banks assisting them.

Although not discussed in the FY 2012 Data Book, the IRS Offshore Voluntary Disclosure Program remains open and provides a mechanism for taxpayers with undisclosed foreign bank accounts and unreported income from such accounts to obtain amnesty from criminal prosecution through the payment of back taxes, interest, and penalties.  To date, more than 35,000 individuals have enrolled in the OVDP since 2009 and more than $5 billion in additional revenue for the U.S. Treasury has been generated.  Details on how to enroll in the OVDP are available here.