March 26, 2001
The Honorable Charles E. Grassley
Chairman, Committee on Finance
United States Senate
Washington, D.C. 20510
Dear Mr. Chairman:
Thank you for your letter concerning how the IRS reports on audits and other forms of verification of tax returns. I believe this is an important question and I will do my best to clarify the issues you raise as well as provide the specific data you request.
While the audit rate alone is not an adequate indicator of IRS's compliance activities, audits remain extremely important for ensuring the fairness of the tax system to the average taxpayer. Our budget proposal was carefully designed to meet this minimum goal.
I understand that the basic thrust of your letter is to question whether the "audit rate" as publicly reported by the IRS understates the ability of the IRS to verify the accuracy of individual tax returns. My view is that your question is well founded. Simply focusing on the audit rate does substantially understate the IRS's capacity to find errors in returns, especially in certain kinds of returns. In my many press interviews in the past few years in which this topic has come up, I have consistently made this point, often citing our computer matching program as an example of a technique that the IRS uses in addition to traditional audits. Recently I gave an interview to the New York Times on this subject, which resulted in a "quote of the day" (Friday, February 16, 2001) as follows:
With the use of document matching as well as other return verification techniques that will eventually be enabled by new technology, it is my view that there is no need to return to the levels of individual audit coverage that existed even five years ago, which was three times the FY 2000 level. The IRS strategic plan and budget proposals as presented to the IRS Oversight Board do not call for this approach. However, our strategic plan sets forth an approach in the short run to stabilize our level of traditional compliance activities, such as individual audits, at or slightly above current levels and to focus them on the areas where they are most required. In the long run, we will rely on our business systems modernization program to increase the effectiveness and efficiency of these activities.
As noted in your letter, the IRS has for many years relied on a range of techniques to verify certain items on tax returns. Each of these techniques is appropriate for particular returns or types of potential errors. Enclosure 1 provides a list of techniques used by the IRS for verifying tax returns and the type of return/issue for which they are most useful. As you requested, we have also shown historical data on the use of each such technique (Enclosure 2).
With respect to Information Returns Processing, or document matching as it has often been called, this technique is very effective for verifying certain income items reported on individual returns against that reported by third parties, including wages, interest, dividends and miscellaneous payments. It can also be used to verify gross sales of assets, such as securities, but cannot be used to verify the gain or loss on such sales since we have no third-party reporting on the cost basis of assets. It is also of limited value in verifying some deductions, such as mortgage interest.
Document matching is not useful for verifying business income, gain or loss on asset sales, or most itemized deductions. We estimate that the total personal income that cannot be verified by document matching represented about $1.2 trillion in FY 1998, or 19.7% of total reported personal income. An important role of audits is to verify these major categories of income and deductions.
The significance of verifying income and deduction items through audits is illustrated by the fact that the average in-person audit of an individual return results in an assessment of approximately $9,540, while the average assessment from a document matching case is $1,506. In FY 2000, the IRS closed 247,212 in-person audits of individual returns and assessed $2.4 billion from this program; in the document matching program in FY 2000, the IRS closed 1,353,545 cases and assessed $2.1 billion.
One of my real concerns about the decline in audits is fairness to the majority of taxpayers whose income is reported and can be readily verified. It is relatively easy for the IRS to verify the returns and reported income of taxpayers whose income results from wages, interest and dividends and who take the standard deduction, who comprise the majority of taxpayers. It is harder, and often requires audits, to verify the income of taxpayers with other forms of income and deductions or more complex returns, who are often higher income taxpayers. The proportion of income that cannot be verified through document matching is 10% for taxpayers with income under $100,000, as compared with 35% for taxpayers over $100,000. Also, 91% of returns reporting income over $100,000 itemize deductions, compared to 26% of those below $100,000, and most itemized deductions cannot be verified through document matching. To the extent that the IRS uses more and more document matching and less and less auditing, the effect may be perceived as, and will in fact be unfair because higher income taxpayers will not have their returns verified to the same degree as middle income taxpayers.
Another concern with respect to both tax revenues and fairness is the income reported by corporations and partnerships. While the IRS continues to audit the 1,100 largest corporations every year, the audit rate for all other corporations has declined from 3.0% in 1992 to 1.1% today. A particular source of concern is the growing number of entities, such as partnerships, trusts and S-corporations, which pay no income tax at the business level but pass their net income on to their shareholders or partners. As shown in Enclosure 3, in 2000, these "passthrough" entities filed 7.4 million returns, reported $5.0 trillion of gross revenues and $680 billion of income. However, the IRS audited only 29,057 of these entities, or only 1 of every 256 returns - .39% (Enclosure 4). We do plan to begin a program to match income reported on K-1 forms from these entities to individual tax returns. However, this technique will not provide any verification of the income reported by the business entity itself, which requires an audit.
Our strategic plan attempts to reconcile all these factors with the objective of increasing the IRS' s ability to achieve our second strategic goal, which is service to all taxpayers through fair and uniform application of the tax law. If our modernization program is successful, we believe we can do this while continuing to shrink the size of the IRS in relation to the economy.
With respect to the question of why document matching cases are not considered audits, the technical reason is that Section 7605(b) of the tax code generally limits the ability of the IRS to require a taxpayer to submit books and records for inspection by the IRS more than once per return. Since document matching cases do not require the taxpayer to submit books and records to the IRS, a document matching case does not preclude a subsequent audit. Revenue Procedure 94-68 specifically defines IRS taxpayer contacts, including document matching, which are not considered audits for the purpose of Section 7605(c). More generally, it is my understanding that some years ago the IRS proposed to change the definition of an audit to permit inclusion of the document matching cases in the overall reported number of audits, and this proposal was criticized in some parts of Congress as an attempt to inflate IRS's statistics.
Notwithstanding these previous issues, all of these IRS statistics, including the number of document matching cases, are publicly reported and it is our goal to make these reports as informative and meaningful as possible. I would be pleased to discuss with you how we could improve this reporting.
Enclosure 5 provides data in answer to your specific questions.
Sincerely,
Charles O. Rossotti
Enclosures
March 28, 2001
Mr. Charles Rossotti
Commissioner
Internal Revenue Service
Washington, D.C. 20224
Dear Mr. Commissioner:
I am writing in response to your letter of March 26, 2001, regarding audit rates and overall enforcement efforts at the Internal Revenue Service (IRS). I believe our exchange of letters has been extremely useful in highlighting for the Committee, and more importantly, the American taxpayer, that the IRS is quite effective at reviewing and verifying most information on the vast majority of tax returns.
The General Accounting Office (GAO) confirmed for the Committee today that almost all individual tax returns are subject to IRS computer review for third party information under the information reporting program (IRP) as well as checked for math errors. The size and scope of this computer review are reflected in your Enclosure 5, which shows that over 14 million tax returns in 1998 (the most recent data available) were flagged for potential discrepant income or deductions. There were approximately 120 million returns filed in the previous year, thus well over 10% of taxpayer returns were identified by IRS computers for possible further review.
As we approach the end of filing season, it is critical that the American taxpayer hears from the IRS that both they and their neighbors' tax returns will be subject to these vigorous reviews.
Thus, I appreciate your statement in your March 26th letter that focusing solely on the face-to-face audit rate "does substantially understate the IRS's capacity to find errors in returns, especially in certain kinds of returns" and encourage your office to widely publicize the effectiveness of the computer matching program.
That the IRS is on the job is an important message the public must hear, particularly given the explosive growth we have recently seen in Internet tax schemes, scams and cons ? the main topic of the April 5th Finance Committee hearing at which you will be testifying. Many web sites promoting these tax scams cite the low audit rate as an inducement to buy their schemes.
Your letter is also extremely useful in beginning the discussion of where we need to be in terms of compliance efforts. I appreciate your recognition that:
With the use of document matching as well as other return verification techniquesthat will eventually be enabled by new technology, it is my view that there is noneed to return to the levels of individual audit coverage that existed even five years ago, which was three times the FY 2000 level.
This statement is very useful and begins to bring the discussion of audit coverage into better focus and, as important, dismisses histrionic claims that we must return to earlier high levels of face-to-face audit levels. Further, this will allow a more objective and rational review of the IRS' budget proposal.
The focus of my letter was on individual tax returns not pass-through entities. However, I welcome your discussing this important aspect of enforcement. I wish to work with you to ensure that, at a minimum, greater resources within the IRS are made available to address these enforcement issues. I would encourage you to make a priority of having a computer program in place to match income reported on K-1 forms. It is my understanding that the State of California already has a computer program in place that provides this very useful function. Would it be possible for the IRS to gain from California's experience in this area? We are seeing an extensive use of partnerships and other pass-through entities in the area of tax schemes that will be discussed at the April hearing and it is important that would technology be brought to bear on this matter.
In addition, it is important that the IRS have updated data on taxpayer compliance so that it can better target the audits it does perform. More effective and targeted auditing can go far in limiting the number of audits that need to be performed. I believe it is possible to obtain such taxpayer compliance information without subjecting individual taxpayers to an accountant's version of root canal. The IRS has stated for years that it is developing an alternative program to measure taxpayer compliance. I would ask that in your testimony on April 5th, you state when we can anticipate seeing results in this area.
I particularly urge you to proceed in obtaining taxpayer compliance data in the areas of trusts and partnerships. The data in the field of trusts and partnerships, I understand, is very old and given tax schemes like "pure trusts," it is particularly imperative that obtaining new taxpayer compliance data in these fields be a priority.
As the Committee prepares for the April 5th hearing, I will have additional comments about your March 26th letter. For now I want to thank you for your candor in responding to my letter and again encourage the IRS to widely broadcast the news that tax cheats should not rest easy ? the IRS is on the job.
Cordially yours,
Charles E. Grassley
Chairman