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.