TIGTA Releases Annual Report on IRS Compliance Trends

The Treasury Inspector General for Tax Administration (TIGTA) released its annual report on IRS compliance trends yesterday.  The key takeaway from the report is TIGTA’s finding that the total amount of revenue received and collected by the IRS increased for the third year running, despite the fact that the IRS had fewer employees and decreased funding levels.  However, the IRS conducted fewer examinations, and its Collection function continued to receive more delinquent accounts than it closed, the report concluded.

“Budget reductions contributed to a decrease in the number of examinations and an increase in the number of delinquent taxes being assigned to an inactive status at the Internal Revenue Service last year,” said J. Russell George, Treasury Inspector General for Tax Administration.  “However, overall enforcement revenue increased in 2013, due, in part, to several large appeal case settlements.”

Here are the key findings of TIGTA’s report:

  • The Internal Revenue Service’s appropriated budget decreased 7.4 percent between FY2010 and FY2013, from $12.1 billion to $11.2 billion after sequestration.  The budget cuts resulted in reductions in the number of employees available to provide services to taxpayers and enforce the tax laws.  Specifically, the number of full-time equivalents dropped by nearly 9 percent, from 94,618 at the end of FY2010 to 86,310 at the end of FY2013, including a 4 percent reduction between FY2012 and FY2013.  The number of enforcement personnel decreased by more than 1,000 employees during FY2013.
  • Despite these challenges, total dollars received and collected (gross collections) increased for the third straight year to $2.9 trillion (a 13 percent increase) in FY2013.  Enforcement revenue collected also increased from $50.2 billion in FY2012 to $53.3 billion in FY2013, due, in part, to several large Appeals case settlements.  Tax return filings continued to increase as did gross accounts receivable, which increased to $400 billion.
  • TIGTA found that the FY2013 Collection function activities showed mixed results. The amount collected on delinquent accounts by both the Automated Collection System and Field Collection decreased.  The Collection function continued to receive more delinquent accounts than it closed, although the number of delinquent accounts in the Collection queue decreased, due in part to the shelving of millions of accounts that were not resolved.  Fewer Notices of Federal Tax Lien were filed, fewer levies were issued, and fewer seizures were made.  Meanwhile, taxpayers’ use of payment options such as offers in compromise increased.

TIGTA’s report found that IRS Examination function conducted 6 percent fewer examinations in FY2013 than in FY2012.  The decline in examinations occurred across all tax return types, including individual, corporation, S corporation, and partnership. In particular:

  • Individual Income Tax Return Examinations – The number of individual income tax return examinations decreased for the third straight year.  The IRS examined 1,404,931 (one of every 104) tax returns in FY2013.  This is approximately 11 percent fewer examinations than the 1,581,394 reported in FY2010 (one of every 90). During FY2013, 81 percent of the examinations of individuals were performed by correspondence.  One of every 541 individual income tax returns filed received a face-to-face examination, which is a 4 percent decrease compared with FY 2012, when one of every 522 individual returns received a face-to-face examination.
  • Corporate Income Tax Return Examinations – Fewer corporate tax returns were examined during FY2013 than any of the past five years.  The number of examinations decreased in FY2013 to a five-year low of 27,480 (one of every 70 returns filed). Also in FY2013, there were fewer corporate tax filings than in any of the last five years (1,912,105).  Over the past five years, the number of corporate tax returns examined with assets of less than $10 million decreased 4 percent, from 18,298 in FY2009 to 17,604 in FY2013.  These examinations decreased by 17 percent in the past year alone, from the five-year high in FY2012 of 21,164. As examinations of these returns have reached lows, filings have also dropped over the past five years.  Corporate tax return filings with assets of less than $10 million have decreased nearly 14 percent since FY2009, with a 2 percent decrease since FY2012.
  • S Corporation Tax Return Examinations – The number of S corporation examinations decreased 14 percent from the 21,658 examinations conducted in FY2012.  However, the number of S corporation examinations in FY2013 (18,670) was nearly 7 percent more than the number examined in FY2009 (17,455).  In FY2012, one of every 206 S corporation returns filed were examined, compared with one of every 240 filed in FY 2013. S corporation return filings increased for the fifth straight year, reaching 4.5 million in FY2013.
  • Partnership Return Examinations – The number of partnership returns examined decreased 11 percent to 14,870 in FY2013 after increasing to 16,691 in FY2012.  One of every 211 returns filed in FY2012 were examined.  This decreased to one of every 239 in FY2013. Partnership return filings increased to 3.6 million in FY2013.
  • Other Tax Type Examinations (fiduciary, employment, excise, estate, and gift taxes) – The overall number of examinations in these five classes was 87,836 for FY2013.  This is a 13 percent decrease in examinations from FY2012, when the number of examinations was more than 101,000.  Each of the five other tax type returns experienced decreases in the number of examinations between FY2012 and FY2013.  Excise return examinations decreased by 25 percent and estate return examinations decreased by 14 percent.  During FY2012, only one of the five other tax types (estate) experienced decreases in the number of examinations.  The return filings increased for all five of these other tax type returns in FY2013.  Estate return filings and excise return filings increased 123 percent and 52 percent, respectively.

Another important measure of audit productivity is the percentage of audited tax returns that result in recommended adjustments to the tax return.  The IRS associates a high percentage of audited tax returns that result in recommended adjustments with greater audit productivity, while audits that result in no change are considered unproductive.  The no-change rates for:

  • Revenue agent examinations of individual tax returns reached a five-year low in FY2011 (8 percent).  Since then, the no-change rate gradually increased to 10 percent in FY2013.
  • Tax compliance officer examinations of individual tax returns continued to remain at either 9 or 10 percent between FY2009 and FY2013.
  • Revenue agent examinations of corporate tax returns increased to 29 percent during FY2013.
  • Revenue agent examinations of partnership returns increased during FY 2013 to 47 percent.  The no-change rate increased in FY2010 (44 percent) and FY2011 (48 percent) and decreased in FY2012 to 44 percent.
  • Revenue agent examinations of S corporations continue to decrease from 39 percent in FY2011 to 33 percent in FY2012 and 31 percent in FY2013.

The conclusion to TIGTA’s report is as follows:

The IRS faced many challenges during FY 2013, including implementing provisions related to new tax legislation and operating with fewer resources and employees.  Several indicators showed the negative effect of these challenges, including 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 of tax returns.  While some indicators are positive, including increases in gross collections, enforcement revenue, and dollar yield per hour on examinations of corporations, the negative trends continue to be cause for concern, especially given that diminished enforcement could also affect voluntary compliance over time.

TIGTA Urges IRS to Scrutinize Tax Returns Claiming Foreign Earned Income Exclusion

The Treasury Inspector General for Tax Administration (TIGTA) issued an audit report on December 12, 2013, recommending that the Internal Revenue Service increase its scrutiny of tax returns claiming the Foreign Earned Income Exclusion.  The report, which is entitled “The Referral Process for Examinations of Tax Returns Claiming the Foreign Earned Income Exclusion Needs to Be Improved,” is available here

By way of background, to alleviate double taxation of taxpayers earning foreign income while residing overseas, IRC Section 911(a) provides for the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion/Deduction.  For Tax Year 2012, the FEIE allowed taxpayers to exclude foreign earned income of up to $95,100.   Qualifying taxpayers living and working in a foreign country may also claim a limited exclusion or deduction for the amount of their housing expenses.  These benefits can significantly reduce or eliminate taxpayers’ U.S. income tax liabilities regardless of whether they paid any foreign income taxes.

TIGTA found that of approximately 140 million individual income tax returns filed for tax year 2009, 372,119 (or 0.27 percent) tax returns included a Form 2555/2555-EZ, Foreign Earned Income/Foreign Earned Income Exclusion.  The exclusions, credits, and deductions claimed were as follows:

  • $23.3 billion in the FEIE.
  • $5 billion in foreign tax credits.
  • $2.7 billion in Foreign Housing Exclusions.
  • $102.6 million in Foreign Housing Deductions.

From a statistical sample of 2009 tax returns, TIGTA estimated that U.S. taxpayers living and working in foreign countries who claimed the FEIE reduced their federal income taxes by $562 million.  Taxpayers claiming the Foreign Housing Exclusion/Deduction reduced their federal income taxes by an additional $174 million for 2009.

In addition, during FY2009 through FY2011, 2,851 (or 99 percent) of the 2,876 individual income tax returns examined where a Form 2555/2555-EZ was present were not referred to an international examiner as required by IRS procedures.  TIGTA estimated that improving the audit referral process could result in approximately $2.7 million in additional tax assessments, or $13.5 million over five years.  Moreover, 1,583 examinations that were not required by the IRS to be referred might warrant referral to international examiners.  Referral of these tax returns could potentially result in approximately $1.5 million in additional tax assessments, or $7.5 million over five years.

As a result of its audit findings, TIGTA recommended that the IRS ensure that (1) domestic examiners and their managers are aware of the international referral criteria and (2) the international referral criteria process is evaluated to determine if it should be expanded to include the Wage and Investment Division.  In their response to the report, IRS officials agreed with the recommendations and plan to take corrective actions.

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.

IRS Criticized for Correspondence Audit Process; Expect to See More Prior/Subsequent Year Audits

The Treasury Department’s Inspector General for Tax Administration (TIGTA) has issued an audit report sharply criticizing the IRS correspondence audit process.  The report, entitled “The Correspondence Audit Selection Process Could Be Strengthened,” studied the effectiveness of the correspondence audit process utilized by the IRS.  In contrast to a traditional “field audit” when an IRS revenue agent meets the taxpayer face-to-face, correspondence audits are generally conducted through the mail and are less instrusive, more automated, and conducted by examiners who are trained to deal with less complex tax issues.  During a correspondence audit, agents do not perform “required filing checks” which are used during field audits in order to determine whether the same pattern of non-compliance identified on the audited tax return is present on prior and/or subsequent year tax returns. 

The IRS relies heavily on the correspondence audit process to identify possible underreporting on individual tax returns.  For example, during FY2012, the IRS audited a total of 1.5 million tax returns.  Of that number, 1.1 million, or 73%, were conducted through correspondence audits, and additional taxes of $9.2 billion were recommended from correspondence audits alone.  Correspondence audits are generally more economical to conduct than field audits, with the average cost per correspondence audit of $274 as compared to an average cost per field audit of $2,278.

During its review of the IRS correspondence audit process, TIGTA reviewed a statistical sample of single-year correspondence audits where the taxpayers involved agreed that they had understated thair tax liabilities by at least $4,000.  TIGTA found that similar tax issues existed for the prior and/or subsequent years tax returns for many of the sampled taxpayers, yet the IRS did not audit their prior and/or subsequent year returns, leading to significant lost revenue for the U.S. Treasury.  TIGTA projected that the IRS could generate approximately $69.4 million in additional revenue if the correspondence audit process were strengthened by focusing on prior and/or subsequent tax years.

As of result of these findings, TIGTA recommended that the IRS develop and implement procedures in the Interal Revenue Manual to instruct examiners how current year correspondence audit results are to be used in deciding whether the prior and/or subsequent year returns warrant an audit.  IRS management agreed with TIGTA’s recommendation and plans to develop an IRM section to provide examiners with direction on expanding correspondence audits, where appropriate, to prior and/or subsequent years. 

The correspondence audit process is a key enforcement tool used by the IRS to detect underreporting on individual tax returns.  The correspondence audit process is efficient, economical, and provides significant return to the IRS.  As a result of TIGTA’s findings and criticism of the correspondence audit process, we expect to see IRS revenue agents more frequently expanding current year audits to include prior and/or subsequent years.