[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]




 
 2004 TAX RETURN FILING SEASON AND THE IRS BUDGET FOR FISCAL YEAR 2005

=======================================================================

                                HEARING

                               before the

                       SUBCOMMITTEE ON OVERSIGHT

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

                             MARCH 30, 2004

                               __________

                           Serial No. 108-70

                               __________

         Printed for the use of the Committee on Ways and Means



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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
E. CLAY SHAW, JR., Florida           FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut        ROBERT T. MATSUI, California
AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
JIM MCCRERY, Louisiana               JIM MCDERMOTT, Washington
DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. MCNULTY, New York
JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio                    XAVIER BECERRA, California
PHIL ENGLISH, Pennsylvania           LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona               EARL POMEROY, North Dakota
JERRY WELLER, Illinois               MAX SANDLIN, Texas
KENNY C. HULSHOF, Missouri           STEPHANIE TUBBS JONES, Ohio
SCOTT MCINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
ERIC CANTOR, Virginia

                    Allison H. Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel

                                 ______

                       SUBCOMMITTEE ON OVERSIGHT

                    AMO HOUGHTON, New York, Chairman

ROB PORTMAN, Ohio                    EARL POMEROY, North Dakota
JERRY WELLER, Illinois               GERALD D. KLECZKA, Wisconsin
SCOTT MCINNIS, Colorado              MICHAEL R. MCNULTY, New York
MARK FOLEY, Florida                  JOHN S. TANNER, Tennessee
SAM JOHNSON, Texas                   MAX SANDLIN, Texas
PAUL RYAN, Wisconsin
ERIC CANTOR, Virginia

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.


                            C O N T E N T S

                               __________
                                                                   Page

Advisory of March 23, 2004, announcing the hearing...............     2

                               WITNESSES

Internal Revenue Service, Hon. Mark W. Everson, Commissioner.....     5
U.S. General Accounting Office, James R. White, Director of Tax 
  Issues.........................................................    33
Internal Revenue Service Oversight Board, Nancy Killefer, Chair..    55

                                 ______

LFS Professional IRSs, Inc., Allen I. Orwick.....................    73
American Bar Association, Tax section, Richard Shaw..............    76
American Institue of Certified Public Accountants, Tax Executive 
  Committee, Robert Zarzar.......................................    80
National Association of Enrolled Agents, James D. Leimbach.......    86
Tax Executives Institute, Inc, Timothy J. McCormally.............    99

                       SUBMISSION FOR THE RECORD

Scorse, Gerald E., New York, NY, statement.......................   115


 2004 TAX RETURN FILING SEASON AND THE IRS BUDGET FOR FISCAL YEAR 2005

                              ----------                              


                        TUESDAY, MARCH 30, 2004

             U.S. House of Representatives,
                       Committee on Ways and Means,
                                 Subcommittee on Oversight,
                                                    Washington, DC.

    The Subcommittee met, pursuant to notice, at 3:04 p.m., in 
room 1100, Longworth House Office Building, Hon. Amo Houghton 
(Chairman of the Subcommittee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS

                       SUBCOMMITTEE ON OVERSIGHT

                                                CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
March 23, 2004
OV-12

                     Houghton Announces Hearing on

                 2004 Tax Return Filing Season and the

                    IRS Budget for Fiscal Year 2005

    Congressman Amo Houghton (R-NY), Chairman, Subcommittee on 
Oversight of the Committee on Ways and Means, today announced that the 
Subcommittee will hold a hearing on the 2004 tax return filing season 
and the Internal Revenue Service (IRS) budget for fiscal year 2005. The 
hearing will take place on Tuesday, March 30, 2004, in the main 
Committee hearing room, 1100 Longworth House Office Building, beginning 
at 3:00 p.m.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. 
Witnesses will include IRS Commissioner Everson, and representatives of 
the U.S. General Accounting Office (GAO), the IRS Oversight Board, the 
tax section of the American Bar Association (ABA), the American 
Institute of Certified Public Accountants (AICPA), Tax Executives 
Institute, Inc. (TEI), and the National Association of Enrolled Agents 
(NAEA).
      

BACKGROUND:

      
    The 2004 tax return filing season refers to the period from January 
1st to April 15th when U.S. taxpayers will file more than 130 million 
tax returns, including more than 50 million e-filed returns. During 
this period the IRS is expected to issue more than 105.7 million tax 
refunds, answer nearly 36.8million telephone calls from taxpayers 
asking for assistance, and its homepage is projected to receive more 
than 4.8 billion hits.
      
    The Administration's budget requests $10.67 billion to fund the IRS 
for fiscal year 2005. This level of funding will support approximately 
101,272 employees who will collect an estimated $1.716 trillion in 
taxes (net of refunds), according to Administration estimates. Beyond 
supporting the traditional activities of the filing season, the fiscal 
year 2005 budget request addresses the Administration's key strategic 
goals for the IRS.
      
    In announcing the hearing, Chairman Houghton stated, ``During the 
next 3 weeks, tens of millions of Americans will perform a key duty of 
citizenship. They will file their federal income tax return. Also, 
millions of aspiring citizens and residents will file faithfully.''
      
    ``This is a great country for many reasons, not the least being our 
sense of honesty and decency. For most, rather than gaming the system 
on April 15th, they try to uphold it. Maybe this is one of the sacred 
strengths of our country. I applaud the efforts of IRS Commissioner 
Everson and the Bush Administration in upholding our standards.''
      

FOCUS OF THE HEARING:

      
    The hearing will focus on the 2004 tax return filing season and the 
IRS budget for fiscal year 2005.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Please Note: Any person or organization wishing to submit written 
comments for the record must send it electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, by close of business Tuesday, April 13, 2004. In the 
immediate future, the Committee website will allow for electronic 
submissions to be included in the printed record. Before submitting 
your comments, check to see if this function is available. Finally,due 
to the change in House mail policy, the U.S. Capitol Police will refuse 
sealed-packaged deliveries to all House Office Buildings.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, in WordPerfect or MS Word format and MUST NOT exceed a 
total of 10 pages including attachments. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. All statements must include a list of all clients, persons, or 
organizations on whose behalf the witness appears. A supplemental sheet 
must accompany each statement listing the name, company, address, 
telephone and fax numbers of each witness.
      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov.

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.

                                 

    Chairman HOUGHTON. Good afternoon, ladies and gentlemen. We 
are delighted to have you here. I am going to make an opening 
statement, and then I will ask the Democratic leader of this 
Committee, Mr. Pomeroy, to make his statement. Nice to see you 
here, Mr. Portman.
    Mr. PORTMAN. Good morning, Mr. Chairman.
    Chairman HOUGHTON. Nice to see you here. Commissioner, we 
are obviously honored that you are going to be here expressing 
your views and giving us your wisdom. During the next 3 weeks, 
as most people know, tens of millions of Americans will perform 
a key duty of citizenship. They are going to be filing their 
Federal income tax returns. Millions of aspiring citizens and 
residents will also file. As we all know, this is a great 
country for a variety of reasons, not the least of which is our 
sense of honesty and decency. For most, rather than gaming the 
system on April 15th, they will try to uphold it. I don't think 
there is another Nation in the world that does this as well. It 
is for the benefit of the vast majority of law-abiding 
taxpayers that we are holding this hearing today. We owe it to 
these honest and decent taxpayers to see that we are served by 
a Federal tax agency that treats all taxpayers with dignity and 
respect and one that is both efficient and strong enough to 
deter cheating and bring the others to justice.
    Appearing before us today, is Internal Revenue Service 
(IRS) Commissioner Mark Everson, who has made it one of his key 
priorities to reverse the decline in voluntary compliance 
consistent with taxpayer rights. On the next panel, we are 
going to have representatives from the IRS Oversight Board and 
the U.S. General Accounting Office (GAO). Finally, we have a 
distinguished panel of practitioners who represent some of the 
organizations that have helped the IRS and Congress to shape 
tax policy and tax administration in the past. I welcome you 
all and look forward to your testimony, all of the witnesses, 
and I am now pleased to yield to our Ranking Democrat, Mr. 
Pomeroy.
    Mr. POMEROY. I thank the Chairman. I thank him for his 
leadership of this Committee, for convening this meeting and 
for being my friend. An important function of the Subcommittee 
on Oversight is to keep an evaluation of how the tax-filing 
season is proceeding. We are aware that there will be 130 
million tax returns filed during this filing season which ends 
in about 2 weeks. During this time, we will have received over 
50 million e-filed returns, issued over 100 million tax refunds 
and answered nearly 40 million telephone calls from taxpayers 
seeking assistance. The reports indicate that the 2003 tax 
return filing season is progressing smoothly, and we certainly 
look forward to your further testimony on that. I must say that 
I am concerned about the Washington Post story. I will just 
read you the lead paragraph:
    ``President Bush's 2005 budget request for the IRS would 
seriously shortchange the Agency's tax-collection activities, 
leaving half a million tax accounts uncollected, 15 million 
service calls unanswered and nearly 46,000 audits unscheduled, 
according to the President's own IRS Oversight Board.'' So, as 
we look at the performance of the IRS relative to this tax-
filing season, I would also like to have one eye down the road 
where we will be in 1 year, if we cannot adequately fund these 
essential collection activities the statutes direct the IRS to 
perform. I would cite this article that is in today's paper to 
everyone to really look at the daunting issues before the IRS 
relative to performing activities.
    Congress has to understand--I think Congress may have a 
tendency to note problems in the field, haul in the 
Commissioner or other representatives of the IRS, rail 
indignantly about the administrative failings relative to the 
tax season and never accept any responsibility for the fact 
that we have never given you the resources you need to do the 
job. I hope if nothing else could come from this hearing, Mr. 
Chairman, it would represent a bit of Congress owning up to its 
own responsibilities to giving you the resources so that the 
job can done in the first place. There is a specific item of 
concern that I have asked to be addressed in the course of this 
hearing, and I am very pleased that among the practitioner 
panel, Allen Orwick, a constituent of mine from North Dakota, 
will be on the panel.
    He will be presenting testimony concerning the recent e-
file program and also talk about a recent ruling by the IRS 
regarding the Conservation Reserve Program CRP), a recent Chief 
Counsel's letter ruling that now appears to change what has 
been longstanding practice relative to the treatment of CRP 
rent to retired farmers as active income from the farm 
requiring the self-employment tax to be administered. This is 
different than it has been in the past, has caused a lot of 
concern in farm country, can be clarified in ways that I will 
suggest in the course of this hearing. Thank you for, even 
while we talk about the macro issues, allowing the discussion 
of this particular issue, so important not just to North 
Dakota, but all of farm country. Mr. Chairman, thank you, and I 
look forward to this hearing.
    Chairman HOUGHTON. Thank you very much. We are going to try 
to move this thing along pretty fast. Unless anybody has an 
opening statement, we are going to go right to Mr. Everson. 
There are going to be votes. I do not know when they are going 
to be. They may be at 3:30 p.m. We are going to do the best we 
can, and we will roll this thing as fast as we can, and then we 
will have to just stop until we have the votes, and then we 
will be coming back. I would like to introduce, once again, the 
Honorable Mark Everson, Commissioner of the IRS. Thanks for 
being here.

   STATEMENT OF THE HONORABLE MARK W. EVERSON, COMMISSIONER, 
                    INTERNAL REVENUE SERVICE

    Mr. EVERSON. Thank you, Mr. Chairman, Ranking Member 
Pomeroy, and Members of the Subcommittee. I appreciate the 
opportunity to testify this afternoon on the President's 2005 
budget request for the IRS and the 2004 tax filing season. At 
the onset, let me indicate how much I appreciate the 
Subcommittee's ongoing support for the IRS. In particular, I am 
very thankful for your efforts to secure adequate budgetary 
resources for the IRS.
    Mr. Chairman, Ranking Member Pomeroy, and Congressman 
Portman, in your March 24th letter to Chairman Istook and 
Ranking Member Olver of the Appropriations Subcommittee, with 
jurisdiction over the IRS, you wrote: ``we hope you will fully 
fund the President's budget, and in particular the 10.7-percent 
increase in enforcement funding.'' You went on to write that 
the ``new moneys for enforcement will allow the IRS to make up 
ground in compliance that was lost while the IRS conducted the 
IRS restructuring.'' Thank you.
    As you know, my working equation for the IRS is service 
``plus'' enforcement equals compliance not service ``or'' 
enforcement. The IRS must do both. We must run a balanced 
system of tax administration based on a foundation of taxpayer 
rights. Earlier this month, we released our enforcement 
statistics for fiscal year 2003. They demonstrate that we have 
arrested the enforcement decline which began in the nineties 
and worsened with the implementation of Restructuring and 
Reform Act 1998 (RRA 98). Audits, criminal investigations and 
moneys collected were all up. In particular--and you can see 
the chart over on the easel--when compared with the fiscal year 
which started October 1, 2000, audits of taxpayers with incomes 
over $100,000 were up by over 50 percent.
    [The charts are being retained in the Committee files.]
    The President's 2005 budget request for the IRS will 
continue to rebuild our enforcement activities. I would note 
that two-thirds of the new moneys will be devoted to enhancing 
our compliance efforts in the high-income and corporate arenas, 
as well as increasing our criminal investigations. These 
incremental resources will help us address the tax gap--the 
difference between what is owed and what is paid, due to 
nonfiling, underreporting, and underpayment--and secure 
billions of extra dollars for the Department of the Treasury.
    Furthermore, over a 4-year period, we have seen an increase 
in the percentage of Americans who think it is okay to cheat on 
their taxes from 11 percent to 17 percent. I find this 
alarming, as do you. I believe, however, that enhanced 
enforcement efforts will improve attitudes concerning 
compliance by reassuring the average American, who pays his or 
her taxes, that when he or she pays, neighbors and competitors 
will do the same. I am convinced we can augment our enforcement 
activities without diminishing our commitment to service. Our 
filing season results thus far in 2004 show that we can. 
Through last Friday, returns filed have increased almost 2 
percent, but our electronically filed returns are up 12 percent 
from last year. Electronic filing is more reliable, both for 
the taxpayer and the IRS, and it is faster, allowing the IRS to 
issue refunds in half the time.
    Also, noteworthy is that the Free File Initiative, which 
helps low--and middle-income taxpayers, has grown in volume by 
over 24 percent from last year. Our other IRS indicators, for 
the most part, also show improvement. We have handled increased 
call volumes with stable resources and bettered our level of 
service, and there is increased usage of automated services 
both on the phone and the Internet. While we made some changes 
to improve tax law accuracy and had some startup problems 
earlier in the season, in recent weeks, our tax law accuracy 
results have recovered. While we have 2 weeks yet to go, I 
expect good results through the remainder of the filing season. 
Thank you.
    [The prepared statement of Mr. Everson follows:]

    House Committee on Ways and Means

Statement of The Honorable Mark Everson, Commissioner, Internal Revenue 
                                Service
INTRODUCTION
    Chairman Houghton, Ranking Member Pomeroy, and Members of the 
Subcommittee, thank you for the opportunity to testify today on the 
2004 tax filing season, our FY 2005 budget request and the progress 
that the Internal Revenue Service is making in the fair and efficient 
administration of taxes.
    Our working equation at the IRS is service plus enforcement equals 
compliance. The better we serve the taxpayer, and the better we enforce 
the law, the more likely the taxpayer will pay the taxes he or she 
owes.
    This is not an issue of service OR enforcement, but service AND 
enforcement. As you know, IRS service lagged in the 1990s. In response, 
we took important and necessary steps to upgrade service--we 
significantly improved the answering of taxpayer telephone inquiries 
and electronic filing to name just a couple areas.
    Unfortunately, improvement in service coincided with a drop in 
enforcement of the tax law. Since 1996, the number of IRS revenue 
agents, officers, and criminal investigators has dropped by over 25 
percent.
    We currently have a serious tax gap--the difference between what 
taxpayers are supposed to pay and what is actually paid--in this 
country. By our best estimates, we lose a quarter trillion dollars each 
year due to non-filing, under-reporting, and underpayment. (This is a 
rough estimate based largely upon data from our old Taxpayer Compliance 
Measurement Program, most of which was collected in the 1980s. Our 
estimates have been updated to reflect changes in the economy during 
the intervening years, but a key assumption is that compliance behavior 
has remained largely unchanged. If taxpayer compliance has changed in 
the last 15 years, the tax gap could well be much different than our 
estimate suggests.)
    In addition, over the last four years, the number of Americans 
saying it is OK to cheat on taxes rose from 11 to 17 percent. Sixty 
percent of Americans believe that people are more likely to cheat on 
taxes and take a chance on being audited. (See Roper ASW, 2003 IRS 
Oversight Board Annual Survey on Taxpayer Attitudes, September 2003.)
    We must restore the balance between service and enforcement, but 
that will not come at the expense of continued improvements to taxpayer 
service. In recent years, we have begun to attack these declines by 
revitalizing our investigations, audits and prosecutions against those 
who do not pay their taxes. The President's FY 2005 budget--if approved 
by Congress--will help with our efforts to boost enforcement while 
maintaining our levels of service. The submission requests an 
additional $300 million for enforcement activities over the FY 2004 
consolidated appropriations level.
    In a moment, I will talk much more about service and enforcement 
and the President's budget request. But first, let me give you an 
update on the 2004 filing season and what we are doing to make the tax 
season easier and more convenient for the American taxpayer.

2004 FILING SEASON
    Mr. Chairman, I have been on the job for not quite a year so I am 
still going through my first filing season. Each year at the IRS, we 
process billions of tax-related documents. We process well over one 
hundred million taxpayer returns. We send out about one hundred million 
refunds. And we do a lot of other things as well.
    It all peaks, of course, on April 15, a little more than two weeks 
away.
    Here are some highlights as of March 19th (unless otherwise 
indicated):

Return Receipts
    The IRS has received 68 million total individual returns. 25 
million returns (36.86%) are paper and 43 million (63.14%) are e-file. 
Total returns have increased 1.2 million from last year, a 1.81% 
growth.

      The number of online returns is at 9.88 million, a 22.9% 
increase from last year.
      Through March 17h, 2.46 million Free File returns have 
been accepted, an increase of 24% from last year (1.98 million).

Funds
    Refund measures continue to show an increase over 2003. Total 
refunds are up from 2003 by 4.6%. Total dollars paid are 9.77% higher 
than last year, with an average refund of $2,128 paid.

Telephone Measures
    Assistor level of service, at 84%, is up 1.9% compared to last 
year. Assistors have answered approximately 731,000 more calls than 
they did during the same period in 2003.
    Automated calls completed are 304,000 more than the same period in 
2003. A major contributor to this increase is Advanced Child Tax Credit 
(ACTC) related calls.
    We created automated ACTC applications for use in providing 
taxpayers the correct amount of ACTC to report on their 2003 tax 
return. These applications are available through telephone automation 
and interactive web applications.

Telephone Quality Rates
    We measure telephone quality two ways, 1) customer account accuracy 
and 2) tax law accuracy. While our customer account accuracy estimates 
are 89.75%, up slightly over the previous two years, our tax law 
accuracy has declined from 84% in 2002 to 75.79% thus far in 2004.
    FY 2004 Quality Review results indicate that two of our most 
frequent tax law defects are: Incomplete Research and Applying Tax Law 
Incorrectly.
    We are undertaking the following efforts to improve performance:

      Identifying root cause of performance deficiencies and 
implementing corrective initiatives through analysis;
      Establishing Quality Review Improvement Teams to 
determine the drivers of Customer Accuracy rates and to establish 
resolution priorities as needed; and
      Strengthening accountability to the frontline managerial 
level to facilitate improvement in services provided.

Taxpayer Assistance Sites (TACS)
    The number of taxpayers walking into a TAC for assistance has 
decreased as a result of streamlined services in the TACs and 
initiatives to educate taxpayers on alternate methods of obtaining 
services generally requiring a face-to-face contact. The advent of 
technological advances in irs.gov services such as ``Free File'' and 
``Where's My Refund'', and the accessibility of forms online have all 
contributed to the decline in the number of customers walking into a 
TAC.

IMPROVING SERVICE
    As this snapshot of the filing season makes clear, we are improving 
service to the taxpayer. Let me give a broader picture of service and 
compliance, and how the President's budget will lead to more effective 
and fair collection of taxes.
    It was not long ago that IRS service was not all that it should 
be--some would even say it was poor. In many areas the service level we 
provided, or more accurately stated, failed to provide, frustrated 
taxpayers in their effort to understand and comply with the tax law.
    Regardless of the merits of some of the allegations directed 
against the IRS in the mid-1990s, there was a significant gap between 
the quality of service that the IRS was providing taxpayers and the 
quality of service that the public had a right to expect. This 
shortfall in services clearly warranted the fundamental improvements 
and reorganization established under the Internal Revenue Service 
Restructuring and Reform Act of 1998 (RRA 98).
    The reorganization of the IRS along customer lines of business and 
the other changes brought about by RRA 98 were, taken as a whole, sound 
reforms. The twin themes of the legislation were improvement of service 
and protection of taxpayer rights.
    Through an almost single-minded focus on RRA 98 implementation, the 
IRS has demonstrated unmistakable progress in improving customer 
service and increasing its recognition of, and respect for, taxpayer 
rights. While we still aim to reach a higher level of customer service, 
our improvement and commitment with respect to these core goals is 
measurable.
    Last year 53 million individuals filed their returns 
electronically. Thus far this year, nearly 2 weeks away from ``tax 
day'', electronic filing is up again, by about 11 percent. Electronic 
filing is more reliable, both for the taxpayer and the IRS. And it is 
faster. Over three-quarters of Americans get refunds, and we issue the 
refund in about half the time when a taxpayer files electronically.
    Another challenge in the 1990s was getting through to the IRS at 
all. We now have a world-class telephone call routing system. A call is 
directed to the right person, someone who knows something about 
charitable contributions or IRAs--whatever the subject may be--and the 
system balances workforce planning against predictable workload 
patterns to reduce waiting time. Busy signals--the crudest indication 
of service failure--decreased from 400 million in 1995 to 600 thousand 
in 2003.
    All told, we have reduced taxpayer call-waiting time in half, 
reduced the number of abandoned calls by 50%, and doubled the number of 
refund inquiries from our Spanish-speaking taxpayers.
    Meanwhile, we have delivered other applications that provide 
tangible benefits to taxpayers and improve the efficiency and 
effectiveness of our tax administration system. They include:

      Where's My Refund?/Where's My Advance Child Tax Credit?, 
which gives taxpayers instant updates on the status of their tax 
refunds and advance child tax credits. These applications have received 
over 40 million requests since the beginning of the year. By shifting a 
significant volume of customer demand to the Internet, we have seen a 
measurable improvement in service to taxpayers who still choose to 
call.
      e-Services, which includes preparer tax identification 
number (TIN) applications with instant delivery, individual TIN 
matching for 3rd party payers, on-line registration for electronic e-
Services, and on-line initiation of the electronic originator 
application (currently released to a controlled segment of external 
users). I am pleased to announce that we recently made the first part 
of e-Services available on our public web site. The remaining parts 
will come out over the next several months.
      Internet EIN, which permits small businesses to apply 
for, and receive, an Employer Identification Number on-line.
      HR Connect, which allows IRS users to perform many 
personnel actions on-line. This technological advance will enable the 
Service to redirect hundreds of positions to enforcement activities by 
the time it is fully deployed, which we have planned for October 2005.
    Are we where we need to be on service? Not yet. As you know, I have 
been emphasizing enforcement, but I do not want this subcommittee or 
anyone to think the IRS will walk away from service. We still continue 
to maintain and improve service.
    Our objectives for improved taxpayer service are three-fold:
      First, to improve and increase service options for the 
tax-paying public;
      Second, to facilitate participation in the tax system by 
all sectors of the public; and
      Third, to simplify the tax process.

    These are service objectives that recognize the dynamics of a 
rapidly changing world, one in which the Internet will be the dominant 
communications tool. Yet we realize there will remain a wide range of 
computer and technological literacy among individual taxpayers, and we 
must not fail to provide the same level of service to all taxpayers 
regardless of their technological sophistication. Our objectives also 
recognize an America with an increasingly diverse population, and that 
diversity will create challenges for us as tax administrators. 
Nevertheless, we are confident that we can and will serve all American 
effectively.
    Continued changes in traditional media will make it harder to cover 
the waterfront as we seek to educate taxpayers. Moreover, the 
complexity of our tax laws, along with the frequency of changes to 
these laws, is not only a challenge to taxpayers trying to comply with 
the tax laws, but a basis of cynicism about complying with the tax 
laws. The Administration is committed to addressing this complexity. 
While it remains, we have an obligation to help taxpayers navigate 
these laws and make it as easy as possible for them to comply.
    In a world increasingly impatient for prompt and reliable 
information and transaction processing, all of these factors pose 
significant challenges to the IRS as it strives to improve the level of 
service provided to the American taxpayer.
    A good example of the challenges we will face is reconciling our 
desire to standardize our processes through electronic filing with the 
reality that some groups, such as immigrants and the elderly, will need 
different, targeted services. Electronic filing is important to the IRS 
and to taxpayers, but we cannot overemphasize it to the detriment of 
services to taxpayer groups who will not utilize it. Addressing 
competing priorities on the service side of the IRS will not be easy, 
but we will work diligently to provide a balanced, effective program.

EFFECTIVE ENFORCEMENT
    Our focus on the strong mandate of RRA 98 to improve IRS services 
to the taxpaying public made it difficult for us to balance both the 
service and enforcement elements that are so necessary to the success 
of our tax system. Improved taxpayer service enhances compliance and 
respect for our laws among the vast majority of Americans who do their 
best to pay their fair share. Improved taxpayer service also may help 
discourage those who might not otherwise do what is necessary to comply 
with our tax laws. Taxpayer service, however, does not address those 
who actively seek to avoid paying their fair share. I believe most 
people would agree that we achieved improvement of IRS taxpayer 
services in large part at the expense of needed enforcement activities.
    Over a five-year period beginning in 1997, the IRS refocused its 
enforcement resources significantly. The number of revenue agents 
(those who conduct audits), the number of revenue officers (those who 
collect monies due), and the number of criminal investigators (those 
who prepare cases for possible prosecution by the Justice Department) 
each declined by over a quarter.
    In essence, we did not observe the wise admonition of President 
John F. Kennedy that ``Large continued avoidance of tax on the part of 
some has a steadily demoralizing effect on the compliance of others.''
    We are correcting our course and re-centering the agency. We are 
strengthening the IRS enforcement of the tax laws in a balanced, 
responsible fashion. And we will do so without compromising taxpayer 
rights. As the IRS enhances enforcement, we have four priorities:
    First, we are working to discourage and deter non-compliance, with 
emphasis on corrosive activity by corporations and high-income 
individuals. Attacking abusive tax shelters is the centerpiece of this 
effort. What is at stake is greater than many billions of dollars of 
lost tax revenues. Our surveys indicate that 80 percent of Americans 
believe it is very important for the IRS to enforce the law as applied 
to corporations and high-income individuals. Enforcing compliance in 
these sectors is critical to maintaining Americans' faith that our 
system is fair. The abuses of recent years have to a very real degree 
strained the credibility of our tax administration system.
    The IRS is moving aggressively to attack these transactions. 
Working with our partners in the Treasury Department, we have 
accelerated the issuance of guidance identifying abusive and 
potentially abusive transactions and improved disclosure requirements 
to provide greater transparency--sorely needed in today's complex 
world. And we have over 100 promoter audits underway, not to mention 
thousands of audits of high-income individuals and corporations who 
have entered into potentially abusive transactions. Where necessary, 
the Treasury Department, on behalf of the Administration, has proposed 
legislation that would stop abusive transactions that we may not be 
able to fully or quickly address under existing law.
    But we need to do better. We need to do more, and we particularly 
need to do it faster. The length of time it takes us to complete the 
audit of a large, complex corporation is five years from the date the 
return is filed, which in most cases is already eight and one-half 
months after year end. And these figures don't include the appeals 
process, which runs another two years before the matter is settled or 
goes to court. That means that half of our current inventory of large 
cases is from the mid 1990s or the early 1990s. In today's rapidly 
changing world, we might as well be looking at transactions from the 
Civil War.
    Simply stated, the IRS did not detect and deter the abusive 
transactions that spread during the 1990s on an adequate or timely 
basis because we did not have an informed view of current taxpayer 
behavior, only an historical understanding of events long past. And the 
challenge is becoming greater every day, as promoters of abusive tax 
transactions operate globally, without regard to national boundaries.
    The lessons we have learned make it imperative to get current in 
our audits, to identify transactions and shorten the feedback loop so 
that abusive transactions can be shut down promptly. I am convinced we 
can do it. Technology will help. Right now it takes two years on 
average before complicated corporate returns find their way into the 
hands of the assigned examiner. We are addressing this issue. 
Electronic filing by corporations will facilitate our analysis of data 
and help us calibrate risk. Through speedier audits we will provide 
better service to the compliant taxpayer by resolving ambiguity 
earlier, and hold accountable those who seek to game the system. And we 
are creating a web of disclosure, registration and maintenance of 
investor lists that will provide information about abusive 
transactions.
    Second, we are working to ensure that attorneys, accountants and 
other tax practitioners adhere to professional standards and follow the 
law. In recent decades, with an accelerated slide in the nineties, the 
model for accountants and attorneys changed. The focus shifted from 
independent audit and tax functions, premised on keeping the client out 
of trouble, to value creation and risk management. The tax shelter 
industry had a corrupting influence. It got so bad that in some 
instances blue-chip professionals actually treated compliance with the 
law--in this case IRS registration and list maintenance requirements--
as a business decision. They weighed potential fees for promoting 
shelters but not following the law against the risk of IRS detection 
and the size of our penalties.
    Our system of tax administration depends upon the integrity of 
practitioners. The vast majority of practitioners are honest and 
scrupulous, but even they suffered from the erosion of ethics by being 
subjected to untoward competitive pressures. The IRS is acting. We have 
augmented our Office of Professional Responsibility by doubling its 
size and appointing as its director a tough, no nonsense, former 
prosecutor; we are tightening the regulatory scheme; and we are 
receiving excellent support from the Justice Department in our promoter 
and associated investigations. But we need the Congress to enact the 
tougher penalties proposed by the Administration for those promoters 
who have not yet gotten the message.
    Third, we must detect and deter domestic and offshore-based 
criminal tax activity, our traditional area of emphasis, and financial 
criminal activity. Our Criminal Investigation Division is a storied and 
proud law enforcement agency. Their expertise comprises not just 
criminal tax matters but other financial crimes. Our investigators are 
the best in law enforcement at tracking and documenting the flow of 
funds. In addition to our tax investigations, the IRS has over one 
hundred agents assigned on an ongoing basis to support the President's 
Corporate Fraud Task Force. We will continue and intensify these 
important efforts.
    Two factors account in significant part for America's great 
economic vigor and success. They are our pervasive culture of 
entrepreneurship, on the one hand, and the stability and transparency 
of our markets on the other. The reputation and attractiveness of our 
markets have been compromised by the scandals of recent years. The 
President's Corporate Fraud Task Force and the President and Congress 
with Sarbanes-Oxley have taken important steps to restore confidence. 
Through these three enforcement initiatives, the IRS will do its part 
so that sound tax administration contributes to public confidence in 
our economic system.
    We have one more enforcement priority. The stakes for America in 
this area are also important. We will discourage and deter non-
compliance within tax exempt and government entities, and the misuse of 
such entities by third parties for tax avoidance or other unintended 
purposes. Non-compliance involving tax-exempt entities is especially 
disturbing because it involves organizations that are supposed to be 
carrying out some special or beneficial public purpose. Enforcement in 
this area has suffered as IRS staffing in the exempt organizations area 
fell from 1996 through 2003. Enactment of the President's budget would 
allow us to gradually build up staffing in this important area and step 
up enforcement.
    If we do not act to guarantee the integrity of our charities, there 
is a risk that Americans will lose faith in and reduce their support 
more broadly for charitable organizations, damaging a unique and vital 
part of our nation's social fabric.
    A case in point is credit-counseling agencies. These organizations 
have been granted tax-exempt status because they are supposed to be 
educating and assisting people who are experiencing credit or cash flow 
problems. Based on the information we have reviewed, we believe that a 
troubling number of these organizations, however, instead are operating 
for the benefit of insiders or in league with profit-making companies, 
such as loan companies, to generate income from lending to these 
distressed individuals and families. We are taking a close look at 
these organizations to ensure that they are operating within the bounds 
of the law.
    It is, of course, imperative as we reinvigorate the enforcement 
program that IRS employees maintain their respect for and diligence to 
all taxpayer due process rights and protections.
    We are making progress in our effort to reduce the annual tax gap. 
Our enforcement statistics for Fiscal 2003, released in early March, 
demonstrate that we have arrested the enforcement decline that began in 
the 1990s and worsened with the implementation of RRA 98. Audits, 
criminal investigations and monies collected were all up. In 
particular, the number of high-income taxpayer audits again increased 
by 24 percent. Moreover, audits of taxpayers with income over $100,000 
were up over 50 percent from two years ago. Overall audits of all 
taxpayers increased to 849,296, an increase of 14 percent from 2002.

BUSINESS SYSTEMS MODERNIZATION AT THE IRS
    While not as publicly visible as service or enforcement, 
modernization of IRS information technology is also a high priority. 
This effort is often referred to as Business Systems Modernization or 
BSM. Most of our tax administration systems are very old and difficult 
to keep current with today's fast paced environment--they must be 
modernized.
    We are committed to resizing our modernization efforts to allow 
greater management capacity and to focus on the most critical projects 
and initiatives. Last summer, we used comprehensive studies to help us 
identify opportunities to improve management, re-engineer business 
processes and implement some new systems and technology.
    As I have noted, the IRS has made progress on applications such as 
improved telephone service, electronic filing, and a suite of e-
services to tax practitioners. But we have failed thus far to deliver 
several important projects with which taxpayers are not directly 
involved.
    The projects include replacing our master file system, implementing 
the on-line security features, and building the modernized 
technological infrastructure on which all of our future modernization 
applications will depend.
    Four studies completed last year consistently identified the 
following problems in delivering the large information technology 
efforts:

      Insufficient participation in the technology program by 
IRS business units;
      An overly ambitious portfolio;
      Inadequate performance by the contractor.
    The IRS is responding by to this challenge by:
      Increasing business unit ownership of projects;
      Resizing the project portfolio and reducing the 
modernization program from $388 million this year to $285 million in 
the President's FY 2005 request;
      And revising our relationships with the contractor and 
ensuring joint accountability.

    While we have much work to do on modernization, I can assure you 
that it is one of my top priorities as Commissioner. We need to put in 
place the foundation upon which the tax system will build and rely for 
decades to come.

PRESIDENT'S FY 2005 BUDGET SEEKS INCREASE IN ENFORCEMENT
    The President has asked for an IRS fiscal year 2005 budget of 
$10.674 billion, a 4.8 percent increase over the fiscal year 2004 
consolidated appropriations level for the IRS.
    This budget includes the goals of customer service, infrastructure/
modernization and enforcement. After a period of declining enforcement 
resources, the IRS has stabilized and increased the amount of resources 
dedicated to enforcement.
    This budget has an increase of $300 million for a more vigorous 
enforcement of the tax laws. This strong commitment to tax 
administration will provide a significant augmentation of our 
enforcement resources.
    The additional $300 million will increase enforcement in several 
key ways:

      Discourage and deter non-compliance, with emphasis on 
corrosive activity by corporations, high-income individual taxpayers 
and other contributors to the tax gap;
      Assure that attorneys, accountants and other tax 
practitioners adhere to professional standards and follow the law;
      Detect and deter domestic and off-shored based tax and 
financial criminal activity;
      Discourage and deter non-compliance within tax-exempt and 
government entities and misuse of such entities by third parties for 
tax avoidance or other unintended purposes.

    Let me now provide more details on the broad categories of the 
budget request for the IRS.

PROCESSING, ASSISTANCE, AND MANAGEMENT
    We are seeking $4,148,403,000 for processing, assistance and 
management. This includes necessary expenses for prefiling taxpayer 
assistance and education, filing and account services, shared services 
support, and general management and administration. Up to $4.1 million 
of the $4.1 billion total will be for the Tax Counseling for the 
Elderly Program and $7.5 million of the total will be available for 
low-income taxpayer clinic grants.
    The Processing, Assistance, and Management (PAM) appropriation 
handles all functions related to processing tax returns, including both 
manual and electronic submissions, and provides assistance and 
education to taxpayers to enable them to file accurate returns. The PAM 
appropriation issues refunds, maintains taxpayer accounts, and provides 
tax law assistance that includes tax law interpretation and rulings and 
agreements related to tax law issues. This appropriation is responsible 
for IRS personnel, facilities, and procurement services.
    The IRS will continue to focus on pre-filing services and is 
requesting funding for taxpayer communication and education to help all 
taxpayers comply with tax laws and assume their fair share of the tax 
burden. Funding is being requested for resources to warn taxpayers of 
abusive tax schemes and improve compliance by preventing fraud and 
abuse. The IRS is redirecting funding to enhance customer service by 
reengineering processes to complement new technology and to develop an 
outreach strategy for the Child Tax Credit.
    The IRS is reinvesting resources for filing and account services by 
providing funding for field assistance to reduce filing season details 
of compliance staff, funding the Business Master File workload 
increase, improving the level of telephone service to taxpayers, and 
updating processes to complement technology.
    As part of the shared services program, the IRS will reinvest 
resources in new training and training delivery methods to develop and 
to improve expert consultative skills. This effort will significantly 
improve administrative and resource management decisions that will 
enhance delivery of compliance initiatives. Additional resource 
reinvestments will be used to defer rent annualization costs (based on 
partial year costs extrapolated annually for approved FY 2003 space 
expansion projects) to fulfill the IRS' operational mission objectives. 
Shared services will implement HR Connect, the integrated Human 
Resources Management System over the next two years. This system will 
seamlessly link multiple Human Resource applications that should result 
in significant program efficiencies.
    The OMB Program Assessment Rating Tool (PART) review of Submissions 
Processing recommends that IRS successfully implement the Modernized E-
File IT projects. IRS is enabling e-file growth by increasing the 
numbers of returns eligible to be electronically filed. In FY 2005, the 
IRS plans to complete the architecture and engineering analysis 
required to develop and deploy functionality, allowing taxpayers to 
electronically file Forms 1065, 990T, and 1041.

TAX LAW ENFORCEMENT
    For enforcement, we are requesting $4,564,350,000. This 
appropriation ensures IRS' ability to: provide equitable and 
appropriate enforcement of the tax laws, identify possible non-filers 
for examination, investigate violations of criminal statutes, support 
the Statistics of Income program, conduct research to identify 
compliance issues and support the national effort to combat domestic 
and international terrorism.
    The resources in the Tax Law Enforcement (TLE) Appropriation 
provide service to taxpayers after a return is filed and support 
activities such as research to identify compliance and tax 
administration problems, as well as tabulation and publication of 
statistics related to tax filing. In FY 2001, Tax Law Enforcement was 
realigned and redefined as mandated by RRA 98 to better serve the needs 
of taxpayers. The modernized IRS structure is similar to those widely 
used in the private sector: organized around customers' needs, in this 
case taxpayers. The IRS has set up four operating divisions to service 
the four major categories of taxpayers; Wage and Investment Income 
(W&I), Small Business and Self-Employed (SBSE), Tax Exempt and 
Government Entities (TEGE) and Large and Mid-Sized Business (LMSB). 
Each of these business units has substantial operations within the Tax 
Law Enforcement appropriation. The Criminal Investigation (CI) business 
unit investigates criminal violations of the Internal Revenue Code and 
also supports the National effort to combat terrorist financing by 
integrating CI special agents into the Joint Terrorism Task Forces and 
other anti-terrorism task forces. CI has the largest part of its 
operation within the Tax Law Enforcement appropriation.
    The TLE appropriation is the primary source of funding for the 
compliance functions of the IRS, including: (1) automated, in-person 
and correspondence collection of delinquent taxpayer liabilities, (2) 
the matching of reporting documents with taxpayer returns, to insure 
reporting compliance, (3) face-to-face examination to determine 
taxpayers' correct income levels and corresponding tax liabilities, (4) 
service center support of the field examination function and 
correspondence with taxpayers regarding tax issues, (5) investigation 
of criminal violations of the tax laws, (6) processing of currency 
transaction reports over $10,000, (7) tax litigation, (8) acting as an 
advocate to provide prompt resolution of taxpayer problems and (9) a 
general counsel function to offer legal advice and guidance to all 
components of the IRS.
    The functions in TLE are essential to accomplishing the primary 
goals of the FY 2005 Budget Request. To accomplish this goal, the IRS 
must restore the strength of the compliance function. Staffing devoted 
to compliance and enforcement operations has declined in recent years. 
Annual growth in return filings and additional work related to RRA 98 
have contributed to a steady decline in enforcement presence, audit 
coverage and case closures in front-line compliance programs.
    The FY 2004 Appropriations Act merged the Earned Income Tax Credit 
(EITC) Appropriation with the TLE Appropriation. The merge of EITC into 
the TLE appropriation will provide for customer service and public 
outreach programs, strengthened enforcement activities and enhanced 
research efforts to reduce over claims and erroneous filings associated 
with the Earned Income Tax Credit (EITC) compliance initiative.
    Customer service for the EITC initiative includes dedicated toll-
free telephone assistance, community-based tax preparation sites and a 
coordinated marketing and educational effort (including paid 
advertising and direct mailings) to assist low--income taxpayers in 
determining their eligibility for EITC. Improved compliance activities 
include increased staff and systemic improvements in submission 
processing, examination, and criminal investigation programs. Increased 
examination coverage, prior to issuance of refunds, reduces 
overpayments and encourages compliance in subsequent filing periods; in 
addition, post-refund correspondence audits by service center staff aid 
in the recovery of erroneous refunds. Criminal investigation activities 
target individuals and practitioners involved in fraudulent refund 
schemes and generate referrals of suspicious returns for follow-up 
examination. Examination staff assigned to district offices audit 
return preparers and may apply penalties for non-compliance with ``due 
diligence requirements.''
    OMB Program Assessment Rating Tool (PART) observations concluded 
that the IRS does not work enough collection cases with its current 
resources, work processes and technology to ensure fair tax 
enforcement. Each year IRS fails to work billions of dollars worth of 
collection cases. Consequently, the Budget includes a legislative 
proposal to allow IRS to hire private collection contractors to assist 
the IRS in addressing a significant number of cases. In addition to the 
increased resources requested, the IRS is making internal process 
improvements, including: developing models to better identify high 
priority work, better use of the predictive dialer, realigning the 
workforce to core hours and creating a performance support tool to 
provide employees with technical guidance while handling calls. The 
PART review also determined that IRS financial management systems 
remain weak. In response, the IRS plans to modernize its' collection 
technology to improve effectiveness. New technology tools will be 
developed to collection employees, (e.g., eACS, contact recording, and 
desktop integration), which will improve program efficiency.

HEALTH INSURANCE TAX CREDIT ADMINISTRATION
    We are requesting $34,841,000for expenses necessary to implement 
the health insurance tax credit included in the Trade Act of 2002. This 
appropriation provides operating funding to administer the advance 
payment feature of the Trade Adjustment Assistance health insurance tax 
credit program to assist dislocated workers with their health insurance 
premiums. The Trade Act of 2002 created the tax credit program and it 
became effective in August of 2003.

INFORMATION SYSTEMS
    We are requesting $1,641,768,000 for information systems. This 
appropriation is for necessary expenses of the Internal Revenue Service 
for information systems and telecommunications support, including 
developmental information systems and operational information systems.
    It provides for IRS information systems operations and maintenance, 
investments to enhance or develop business applications for the IRS 
Business Units and staff support for the Service's Modernization 
program.
    The appropriation includes staffing, telecommunications, hardware 
and software (including commercial-off-the-shelf), and contractual 
services. It also provides for Servicewide Information Systems (IS) 
operations, IRS staff costs for support and management of the Business 
Systems Modernization effort, and investments to support the 
information systems requirements of the IRS business units. It includes 
staffing, telecommunications, hardware and software (including 
commercial-off-the-shelf software), and contractual services.
    Staffing in this activity develops and maintains the millions of 
lines of programming code supporting all aspects of the tax-processing 
pipeline as well as operating and administering the Service's hardware 
infrastructure mainframes, minicomputers, personal computers, networks, 
and a variety of management information systems.
    In addition, the Information Systems ``Tier B'' modernization 
initiatives fund projects that modify or enhance existing IRS systems 
or processes, provide changes in systemic functionality, and establish 
bridges between current production systems and the new modernization 
architecture being developed as part of the Servicewide Business 
Systems Modernization efforts. Investment activities also include 
improvements or enhancements to business applications that support 
requirements unique to one of the IRS business units. These Tier B 
projects yield increased efficiency and allow the Service to 
progressively improve the quality of its interactions with the 
taxpaying public and its many other internal and external customers.

BUSINESS SYSTEMS MODERNIZATION
    We are seeking $285,000,000, for our Business Systems Modernization 
(BSM) efforts. This request is based upon the resizing efforts we began 
following the various internal and external reviews of BSM.
    This appropriation provides for the planning and capital asset 
acquisition of information technology systems, including related 
contractual costs of such acquisition and contractual costs associated 
with operations authorized by 5 U.S.C. 3109, to modernize IRS' 
antiquated business systems.
    The IRS collects $1.7 trillion in revenues annually through an 
assortment of computer systems developed over a 40-year period. The IRS 
developed the most important systems that maintain all taxpayer records 
in the 1960s and 1970s. These outdated systems do not allow the IRS to 
meet today's taxpayer and business needs. Failure to modernize IRS's 
tax administration business systems will result in a significant 
increase in resources required to maintain legacy systems--systems that 
no longer efficiently or effectively serve America's taxpayers.
    The BSM Appropriation provides for revamping business practices and 
acquiring new technology. The IRS is using a formal methodology to 
prioritize, approve, fund and evaluate its portfolio of BSM investments 
across the IRS Business Units and Modernization and Information 
Technology Services (MITS). This methodology enforces a documented, 
repeatable and measurable process for managing investments throughout 
their life cycle. The MITS Enterprise Governance (MEG) Committee, which 
includes the Chief Information Officer and other senior MITS 
executives, the Chief Financial Officer, and the heads of the Business 
Operating Divisions, approves investment decisions. This executive-
level oversight ensures that products and projects delivered under the 
Business Systems Modernization program are fully integrated into IRS 
Business Units. The Department of the Treasury Investment Review Board 
also reviews the BSM expenditure Plan once the IRS executive-level 
oversight board approves the investment decisions. The plan is then 
cleared through OMB and submitted through the Appropriations 
Committees.
    The IRS has undergone an intensive servicewide portfolio 
prioritization effort, leading to a long-term modernization plan 
identifying selected modernization projects, a release sequence for 
each project, and estimated costs for each project. The effort is based 
on vision and strategy initiatives that created an enterprise-wide 
view, which unified the needs of the IRS Business Units. FY 2005 
resources will fund the infrastructure, program management, and 
releases of business applications to support the successful delivery of 
a modernized tax administration system. More complete details are 
provided in the BSM Expenditure Plan.
    A partial FY 2004 BSM Expenditure Plan was submitted by the 
Department of Treasury for Congressional approval in January 2004, and 
the full-year revision incorporating current project information should 
be completed by this spring.

PROGRAM PERFORMANCE
    The IRS expects to achieve the following levels of performance 
after attaining full performance of the requested FY 2005 initiatives:

      Examine an additional 30,000 investor returns in the 
Small Business and Self-Employed(SB/SE) business unit and increase 
coverage of high-income taxpayers, generating an additional $170 
million in FY 2006. SB/SE also anticipates closing an additional 50,000 
taxpayer delinquent accounts, resulting in an estimated $215 million in 
additional revenue.
      Hire and train over 2,000 new staff in the Examination, 
Collection and Document Matching programs. These increases will 
generate some $2.8 billion in direct enforcement revenue through FY 
2007. Additional audits of investor returns and high-income taxpayers, 
together with 55,000 correspondence examinations, will yield more than 
$1.0 billion during that same period and help to maintain an overall 
audit coverage rate of 0.57%. Collection closures will increase by 
240,000 and taxpayer contacts through the Automated Underreporter 
Program by some 300,000 through FY 2007--generating an additional $1.8 
billion.
      Increase the overall audit coverage rate in the Large and 
Mid-Sized (LMSB) business unit from 5.1% in FY 2004 to 9.6% in FY 2007 
and increase projected return closures by 63% from 16,067 returns in FY 
2004 to 26,193 returns in FY 2007. Enforcement revenue recommended for 
the three years FY 2005 through FY 2007 should increase by over $3 
billion.
      Complete 229 significant Corporate Fraud investigations 
through FY 2007. Tax-related completed investigations will increase by 
approximately 20 percent over the FY 2003 level by FY 2007. In 
addition, CI is striving to reduce elapsed time on completed 
investigations by 30 percent from FY 2002 levels.

CONCLUSION
    The IRS has lagged behind, for reasons that are understandable, in 
tax enforcement. But that is changing. We will continue to improve 
service and respect taxpayer rights. But we will also enforce the law. 
We won't relax until taxpayers who are unwilling to pay their fair 
share see that that is not a worthwhile course to follow.
    Mr. Chairman, the great majority of Americans honestly and 
accurately pay their taxes. Average Americans deserve to feel confident 
that, when they pay their taxes, their neighbors and competitors are 
doing the same.
    The President's budget request will help us enforce the tax law 
more fairly and efficiently. I am most grateful for your support of 
increased enforcement, and I look forward to working with you on this 
important budget request.
    Thank you very much. I'd be happy to take your questions.

                                 

    Chairman HOUGHTON. Thank you very much. I would just like 
to ask one question to kick this off, and then I am sure that 
others would like to ask some questions. What is the 
relationship between the number of audits and the increase in 
revenues?
    Mr. EVERSON. There are two components, I would say, Mr. 
Chairman. When you address audits or any of our enforcement 
activities, there is a direct relationship to revenues, which 
is to say that through an audit or through a criminal 
investigation or any enforcement action, you secure the 
incremental dollars for the Treasury, and then there is what 
some call a spillover effect, which is to say changes in 
behavior more broadly. If you are sitting at the country club 
and down in the locker 5 yards away you hear somebody saying, 
``Geez, I never should have gotten into that abusive shelter. I 
was audited by the IRS, and now I have got to pay the moneys 
due, interest and penalties,'' well, not only have we recovered 
money from that audit, but we have had a change in behaviors 
that we believe takes place when that fellow who overheard that 
conversation is a little more conservative and reluctant to 
engage in a pattern or practice of abuse.
    Chairman HOUGHTON. When you take a look at the audits of 
$100,000-taxpayers on the rise, does it give you the feeling 
that we are regaining the sense of trust that we so desperately 
have held onto for so many years?
    Mr. EVERSON. I think that one component of this erosion in 
the attitudes toward compliance was a feeling on the part of 
many that others were getting away with something they should 
not be getting away with. So, clearly, we needed to augment the 
audits. I cannot tell you a magic number as to where those 
ought to be, frankly, Mr. Chairman. I think we need to do more, 
particularly in the high income. We need to do audits 
responsibly, though, in a way that treats people fairly and 
does not, in any way, intimidate folks as we go through the 
process.
    Chairman HOUGHTON. Mr. Pomeroy?
    Mr. POMEROY. I think that that chart is interesting and 
alarming. It shows to me how quickly things can come apart in 
terms of a national mores that you better pay what you owe. I 
believe that we have got a period of about 6 years there of 
declining audits, and ultimately a substantially fewer set of 
audits at the bottom of the trough than at the beginning of the 
decline. You indicate national statistics showing that those 
who believe you can cheat on your taxes has gone from 11 
percent to 17 percent. I suspect, just from anecdotally, it 
might even be higher. After all, who is going to respond to a 
pollster, ``do you think it is okay to cheat on your taxes or 
not?'' I believe there will be people that will never fess up 
to such a thing, but would do it in a heartbeat if they had the 
chance.
    That is why I believe that Congress, in administering, as 
the ultimate authority on our Nation's revenue collection 
system, has to be very careful. We cannot go off on some kind 
of ideological lark/funding on compliance because we are mad at 
taxes and basically try to make ideological statements about 
the role and function of government based upon whether you can 
do the job that you are statutorily required to do. We can 
fight tax rates, tax levels, we can fight role of government. 
Those are stand-alone questions that need their own fighting, 
but we can't fight them by proxy by trying to hurt and cripple 
the IRS from doing the job it is supposed to do.
    I will read to you a statement from the Chair of your 
Oversight Board, which was presented in testimony yesterday, 
and ask whether you agree or disagree with the statement. 
Admittedly, this is from Nancy Killefer, the Chair, not your 
words, but the statement, ``the IRS is doing a better job of 
identifying egregious noncompliance. Now, it needs the 
resources to fight back. In the past 2 years, IRS has sharpened 
its compliance focus to identify and pursue promoters and 
participants of abusive tax shelters and tax evasion schemes. 
For example, the agency is now targeting its resources on 
promoters of illegal tax schemes that are often marketed to 
high-income individuals, but are also finding their way to 
middle-market businesses. Despite this focus, enforcement 
activities are still at an unacceptable level simply because 
the IRS does not have the resources needed to accomplish its 
mission. It continues to be outmanned and outgunned. In fiscal 
year 2003, the agency was able to pursue only 18 percent of 
known cases of abusive devices designed to hide income, leaving 
an estimated $447 million uncollected, and that is from known 
cases. We knew $447 million was out there. We knew it was 
illegally withheld from tax payment, but we didn't have the 
resources to go and get it.'' Do you ascribe to the statements 
made by the Chair? Let me put it differently. Do those 
statements made by the IRS Oversight Board Chairman accurately 
reflect the situation?
    Mr. EVERSON. I agree that the IRS needs more resources to 
combat compliance issues. I believe that the President has made 
a very strong commitment to improved tax administration, 
through the 5 percent budget increase. The increase is over 10 
percent, as you know, in the enforcement funding for the IRS. I 
think that coupled with our own emphasis on improving our 
business processes on the enforcement side, much as the IRS has 
done on the service side over the last several years, we will 
further improve our compliance and enforcement efforts, and 
bring in more moneys, bring up the audits and increase the 
investigations and the criminal prosecutions. There will be 
more to do, undoubtedly. I will continue to look at the funding 
levels on an ongoing basis and discuss, within the Treasury 
Department and with Office of Management and Budget (OMB), what 
I believe is necessary to run a balanced program.
    What I want to emphasize at this point is my principal goal 
to make sure that we do secure 100 percent of the President's 
request. That is the real key for me, if you will, because, as 
you have indicated, in the past, on average, over the last 10 
years, there has been a 3-percent shortfall between what 
President Clinton or President Bush has requested and what 
ultimately the Congress has provided. So, I would like to first 
secure the full funding of the President's request this year, 
which would be a departure from the past. If we need more from 
there, I will take that up in the 2006 budget process within 
the Administration.
    Mr. POMEROY. Mr. Chairman, if I might have a couple of more 
minutes' leave. I will pursue quickly. When we have some of the 
major accounting firms in this country marketing these shady or 
illegal tax-dodge schemes, I think it goes to show you the 
impunity with which noncompliance has become socially 
acceptable. Are the major accounting firms out of that 
business?
    Mr. EVERSON. I think we are seeing changes in what I would 
call the larger accounting firms and the larger blue-chip 
corporations. Our concern has been, though, that as we clamp 
down in one area, we continue to see issues in mid-size 
businesses or also on a continued basis with wealthy 
individuals. We have a great partnership with the Department of 
Justice on this issue. They are supporting us in litigation 
with the accounting firms and the law firms. As you know, first 
time ever where we have litigated against law firms, in terms 
of those who are acting as promoters, so that they are handled 
as promoters.
    There are matters before the Justice Department now that 
include criminal investigations that will send a real signal 
through the professions, and I do expect that this will 
continue to receive a lot of attention on an ongoing basis. I 
was at the President's Corporate Fraud Task Force meeting just 
a week ago, and this was emphasized to all, not just by myself, 
but by the leader of the task force, the Deputy Attorney 
General, that combatting abusive tax shelters are part of the 
effort to clean up corporate governance and should receive top 
priority.
    Mr. POMEROY. Thank you.
    Chairman HOUGHTON. Mr. Portman?
    Mr. PORTMAN. I thank you, Mr. Chairman. Commissioner, thank 
you for being here today. It is timely to talk about the filing 
season, but also to go over some of these budget issues with 
regard to 2005. I will say that, as I read this, your budget 
request this year is a 4.8-percent increase over the enacted 
amount from 2004.
    Mr. EVERSON. Correct.
    Mr. PORTMAN. This is a substantial increase. I just did the 
math, which may be wrong, but it seems to me that from 2002 to 
now we have a 13.5-percent increase during this Administration. 
I sometimes fight for more than that, as do my two colleagues 
on the left. They happen to be to my left right now.
    [Laughter.]
    We have had substantial increases at a time when, frankly, 
we are looking at practically a freeze in your budget for the 
non-defense and non-homeland security domestic discretionary 
spending, and so I am pleased that we had the 4.8 percent. I 
appreciate your comment that a lot of this is about allocation. 
In fact, when I look--and I know Ms. Killefer is going to 
testify later, and I look forward to her testimony, although I 
need to run out to another meeting, and I will try to come 
back--but Congress has funded, since 1998, all but about 1 
percent of what the IRS has requested, and we have increased 
funding every year. Again, I would like to see more sometimes. 
There is a sense out there somehow that Congress has cut 
funding. We have not.
    There have been allocation of those resources, as you say, 
during the restructuring more toward customer service and less 
toward enforcement, and I think that is now being corrected, 
and I think appropriately so. I couldn't agree with you more 
that they are not inconsistent with one another. I will also 
say that we were 2.6-percent below the request from the 
Oversight Board in the past 3 years.
    This year, it looks like we will be more below, but I think 
that request is about 5 percent above yours. So, these are not 
big numbers as compared to the overall budget, and although I 
would like to see more funding into enforcement, I think it 
would be wrong to leave the impression that somehow Congress 
has been reducing this funding. We fight for it for every year, 
and we will fight for it again this year, to be sure that the 
IRS gets additional funding which is needed. Three other quick 
questions if I could. One on simplification. You have indicated 
in your statement and elsewhere that simplification would help 
you, particularly the Sub S filings have increased. Do you have 
any advice for us, as Congress, as to how we could help you to 
enforce this Tax Code?
    Mr. EVERSON. I think simplification is critical because 
there really are two components to compliance: One is the 
service side, and by service we mean helping taxpayers 
understand their filing obligation and facilitating their 
participation. Clearly, there is a very real drag on 
understanding obligations and on facilitating participation in 
the system that occurs from the increasing complexity of the 
Tax Code. Some people just throw up their hands, increasing 
errors that are made. So, anything that we can do on 
simplification in terms of the Tax Code is important.
    The other point I would make is that, as you and I have 
discussed, as you add more missions to the IRS, you also put 
further stresses on the tax administration system. When you get 
a new responsibility to embed a benefits program, say, in the 
IRS, you have to devote adequate management, and technical, and 
human resource talents to achieving that new program. It makes 
it more complicated to administer the Tax Code and diverts our 
attention from other normal activities.
    Mr. PORTMAN. Those are key points I hope we will always 
keep in mind. That is really where the Commission ended up was, 
yes, we need a change at the IRS, but ultimately the Tax Code 
itself was one of the major problems, and this Subcommittee has 
been focused on the simplification issue, but it is as to 
compliance, as you say, but also as to cost----
    Mr. EVERSON. Yes.
    Mr. PORTMAN. What your costs are increase. This goes to the 
next question I have, which is training. Are you putting 
adequate resources against training, and could we put more 
resources against training, which would then lead to having 
better audits, more targeted audits and perhaps less resources 
over time in enforcement?
    Mr. EVERSON. I think we are carefully looking at our 
training, particularly in what we will need to do as we augment 
the enforcement resources, because we are not going to just 
hire several thousand more Revenue agents, Revenue officers and 
criminal investigators. We also have a very seasoned work 
force, and we are going to have a lot of turnover, particularly 
in our people who do the corporate returns or in appeals. It is 
critical, therefore, that as we add new people and as we ask 
others to step up to greater responsibility, that we do our 
training. We are trying to benchmark now against the 
corporations as to how they train their work force, but I think 
this is an area where we are going to have to devote a lot of 
attention. I do not think our plans are yet fully crystallized, 
but they need to be.
    Mr. PORTMAN. We would like to work with you on that 
training. Final question, quickly. You talked about increased 
audits of those making over $100,000 a year. How about your 
audits of corporations, where are they, and does it concern you 
that audits are off on corporations, if I understand that to be 
the case?
    Mr. EVERSON. I think that we will see, when we look at 
corporate audits for 2004 versus 2003, that we have arrested 
what was a decline that was much like the decline in individual 
audits. Part of the most recent decrease was really related to 
the fact that as we have worked on these abusive shelters, and 
as we have devoted more resources to promoters, we did draw 
down a bit some of the numbers of the audits we were doing. So, 
I think that this was, in fact, at least in fiscal year 2003, a 
wise decision, and it was one that was based on a risk 
assessment as to where the real problems were. I would note 
that part of the President's budget request, for instance, it 
will double audit rates for corporations between $10--and $250 
million of assets. Right now, the audit rate is about 5 percent 
or so. It will double it to 10 percent. That is an important 
step, and it is why we need the money.
    Mr. PORTMAN. Thank you, Commissioner. Thanks for your good 
work.
    Mr. EVERSON. Thank you.
    Chairman HOUGHTON. Mr. Ryan?
    Mr. RYAN. Thank you, Mr. Chairman. Thank you, Mr. Everson, 
for being here. I have two very specific questions. My first 
question is in regard to child tax credit overpayments as a 
result of the child tax credit advance payments that were sent 
out last year. I can go through the whole scenario, but the 
sense basically where you have divorced couples, you have this 
anomaly where they take every other year, they claim their 
children as a dependent. So, what you had in this last year, 
with an advance payment on the child tax credit, was in 2002 
spouse, ex-spouse claimed the dependent, and in 2003 they got 
the advance payment. Whereas, the other spouse takes the credit 
of the child as a dependent in 2003, and according to your 
rules, it is my understanding, they will get the full tax 
credit. What is the estimate of the difference? It is also my 
understanding that you will not claw back or require a 
repayment from the other spouse who doesn't legitimately claim 
the dependent in 2003. What is the measurement of those 
overpayments of child tax credits?
    Mr. EVERSON. I am going to have to supply----
    Mr. RYAN. Could you look into that for me.
    Mr. EVERSON. Supply that for you for the record. I will say 
this, that----
    Mr. RYAN. I just wanted to make sure I was clear on how I--
--
    Mr. EVERSON. I think that is a question I cannot answer 
directly. I will say this, that the most common problem we have 
seen so far in the filing season is accounting correctly for 
the child credit. It accounts for about two-thirds of the 
errors that we are seeing. We automatically correct for the 
calculation, but I am not sure that our corrections would run 
to the matching that you are talking about in this instance.
    Mr. RYAN. Let me just make sure I can clarify your policy, 
which is you will not require a repayment by a spouse who gets 
the advance credit from having their child as a dependent on 
2002, even though, in 2003, they will not have that person as a 
dependent, and you will give that 2003 parent who claims them 
that year as a dependent the full tax credit; is that correct?
    Mr. EVERSON. I want to make sure that I have a correct 
understanding of that. We will give you a complete answer to 
that.
    Mr. RYAN. If you could, and I would like to just see an 
estimate if I could.
    Mr. EVERSON. Certainly.
    Mr. RYAN. My second question is with the The Federal Tax 
Refund Offset Program (TOPS) program. It allows government 
agencies to submit to the IRS claims for delinquent debts up to 
10 years old. The State of Wisconsin is currently participating 
in this, and it is for the purpose of recovering State-owed 
debts. Right now, local municipalities are not permitted to 
participate in the TOPS program to include debts owed to local 
and municipal agencies. Do you believe that the current system 
could accommodate local municipalities to participate in TOPS? 
If not, what would your position be on allowing them to do so?
    Mr. EVERSON. I am going to want to take a look at this 
because we are working very actively with the States in a whole 
variety of ways. You may know recently we signed an agreement, 
and we are implementing it, cooperating with 46 different 
States on the abusive tax shelter transactions.
    Mr. RYAN. Right.
    Mr. EVERSON. We are working everywhere we can to help the 
States. As to whether there is additional capacity in this 
question, I will come back to you on that.
    Mr. RYAN. Could you get back to me in writing. 
Specifically, you will find, as you look into this, that a lot 
of States already have agreements with the State government, 
where their local municipalities and counties can work together 
to reclaim debts. Does the current statute allow you to give 
that same participation that you are giving right now to States 
to municipalities and county governments or does it not, and 
what is your position if it does?
    Mr. EVERSON. I will take a look at that and make sure we 
come back to you.
    Mr. RYAN. That would be great. Thank you.
    Mr. EVERSON. Thank you, sir.
    Chairman HOUGHTON. Thanks, Mr. Ryan. Mr. Johnson?
    Mr. JOHNSON. Thank you, Mr. Chairman. Good evening.
    Mr. EVERSON. Good afternoon.
    Mr. JOHNSON. Glad to see you. Let me ask you a technical 
question, if I might. Is there ever a time when you would have 
tax people walk up to somebody's door unannounced?
    Mr. EVERSON. Unannounced, in the sense of just launching an 
audit or a criminal investigation?
    Mr. JOHNSON. I am a guy in a house, and I am sort of, I 
have got a case in mind, and I will talk to you about it 
privately, but where the wife is at home, in a residential 
area, good housing, and two people walk up to the door and say, 
``You did not file your tax returns.''
    Mr. EVERSON. I do not think that is our normal procedure. 
What we would tend to do is contact someone, initially by a 
letter, indicating that we would like to--we are initiating an 
audit. We do audits that are either correspondence audits, 
which is a big block of the work, or else field audits, where 
we would visit a taxpayer.
    Mr. JOHNSON. Yes, but not without notice.
    Mr. EVERSON. I would imagine that this was an exceptional 
circumstance. I would like to understand what the circumstances 
were.
    Mr. JOHNSON. Well, you are not denying that it never 
happens, then.
    Mr. EVERSON. I do not know that it has happened, but you 
seem to know more than I do about a specific case, so----
    Mr. JOHNSON. No, I am trying to solve the problem, if I 
could.
    Mr. EVERSON. Right.
    Mr. JOHNSON. If you do not have enough people, and you need 
more money, blah, blah, blah, and yet you have got people 
running out there being accusatory without first warning the 
people that they are going to, I do not think that is right.
    Mr. EVERSON. We have, and we do follow very specifically, 
procedures that were put into place about notices on 
collections, and there were changes in the new law, as you 
know, from 1998. If our people are violating those procedures, 
they are held accountable. So, if you could tell me about the 
case, I would be happy to take a look at it, and if there has 
been some irregularity that is improper, I will make sure that 
we deal with it.
    Mr. JOHNSON. Well, and I know that you have people in there 
that you can talk to, too, about those sorts of things, but I 
have never encountered you being heavy-handed like that before, 
and I will talk to you separately about it. One of the 
proposals in this year's budget would make changes in 1203, 
called, ``The 10 Deadly Sins'' provision. Can you explain why 
those changes are necessary and important?
    Mr. EVERSON. I think that if you go back to the hearings 
that took place in the mid and late nineties, clearly, I agree 
with the substance of the reforms, taken as a whole, that came 
out of RRA 98. There was a big gap between the service level 
that Americans had every right to expect of the IRS and what we 
were actually delivering or failing to deliver.
    At the same time, I think there was a climate that was a 
difficult climate. Some charges were made against IRS employees 
which, as you would remember, were subsequently found to be 
unproven or slightly exaggerated. The folks who have worked in 
the Agency inform me that all of this had a real overhang, in 
terms of for a while a reluctance to pursue the enforcement 
activities. To some degree, that clearly contributed to the 
decline in actions. In terms of these ``deadly sins,'' I think 
that what we are trying to get at there is simply to allow more 
discretion to the Commissioner to mitigate some of these areas 
of problems if, on a balanced basis, that seems warranted. It 
doesn't make it in any way automatic. It just says that there 
should be more discretion in some cases if it is warranted.
    Mr. JOHNSON. Thank you very much. Thank you, Mr. Chairman.
    Chairman HOUGHTON. Thank you. Mr. Pomeroy.
    Mr. POMEROY. Thank you, Mr. Chairman. I have been looking 
with great interest at a couple of these charts that you 
brought along. I'm wondering if you could put up the 
enforcement chart, just to show you the pattern that we have 
followed. It tracks very closely this audit history. Then, 
after that, Commissioner, if you don't mind, if you would pull 
up the exempt organizations and just give us as brief read on 
that one.
    Mr. EVERSON. This simply says that over a period of years 
we have kept the resources stable in terms of manpower on the 
service side, the infrastructure side of the IRS. We brought 
down year after year the enforcement personnel. That red line 
is the number of revenue agents, revenue officers and criminal 
investigators. Those are the people who develop cases for 
potential prosecution by Justice. We brought that back up, and 
it will go up further with the President's 2005 request, if we 
get the funding. So, we're bringing it back up.
    I would say it's not only about money, but it's also about 
bettering our procedures and also about prioritization, because 
it comes back to the Chairman's question on what is the effect 
of the audits. You don't only have a direct effect; you have 
the indirect effect, too. So, it's not only about augmenting 
resources. Just to zoom in on something that this Committee has 
had an interest in, which is credit counseling and sureties, 
you had a hearing when I was here last November looking at 
credit counseling organizations. The challenge, as you know, 
one of our enforcement priorities is to discourage, deter 
abuses within tax-exempt entities.
    Mr. POMEROY. Just to refresh the audience's memory on this 
one, if I recall, now we see omnipresent debt counseling ads 
everywhere you turn. Some of the main entities involved in 
that, as we looked in the course of this hearing, basically 
operating under the guise of being nonprofits, had extremely 
highly paid founders or Presidents. It was in the millions in 
terms of wages, something that would certainly raise all kinds 
of questions about whether they are actually operating 
appropriately in a tax-exempt structure, and whether the value 
of what they offer to the consumer comports with what they say 
it does.
    Mr. EVERSON. That's correct. In fact, I indicated last week 
that I expected, as a result of ongoing audits that we have 
underway, we will be lifting tax-exemption status for some of 
these entities and may, in fact, also end up making criminal 
referrals. So, this is a very serious area of focus for us. All 
this does is it zooms into that tax-exempt area and says that, 
over time, you had a real increase in total assets, you've had 
an increase in the returns filed, and now, after years of the 
staffing going down, we're bringing the staffing back up.
    To show you just what has to be done here, we are also 
harnessing technology, again improving procedures. So, I would 
hasten to add that I don't expect that you need to take these 
lines up as high as the increases in the activity, but clearly, 
you can't continue on this trajectory that we've been on. We 
have arrested it and we're bringing it back up. I think you see 
from the budget request that we've got new moneys and new 
personnel coming into this tax-exempt area. This is not just 
credit counseling; this is the whole tax-exempt sector.
    Mr. POMEROY. I would just note that I had hoped our hearing 
might have some positive effect in terms of diminishing that 
blatant and what I find to be offensive practice of their 
solicitations. It seems as though they have redoubled their 
efforts. So, I'm looking forward to this getting out of the 
private matter of internal IRS auditing and into the much more 
publicized criminal arena, because I believe many of their 
activities are criminal. If we hang one or two from the 
yardarm, maybe it will have some positive effect in terms of 
their activities in the future.
    Mr. EVERSON. That may very well happen. What I suggested, 
Congressman, last week on the Senate side--they had a hearing 
on this, the Levin/Coleman permanent Subcommittee. As we went 
through this, I was shocked, because I found that the schemes 
of the interlocking relationships between the charity and the 
related profit-making entities, they rivaled the complexity of 
the interlocking network of reinforcing relationships that you 
see in the tax shelter area. That is all the more disturbing 
because these aren't people out there just trying to make 
money; these are folks who are supposedly serving the public 
good. Yet they have become equally sophisticated in some 
instances and equally, I would say, hardened toward their true 
mission.
    Mr. POMEROY. I totally agree with that. A final question. 
The CRP payments to retired farmers has since the 1988 letter 
ruling largely been viewed as not subject to self-employment 
tax. A letter ruling issued in May of 2003 was written broadly 
enough so that it appears to apply now to retired farmers with 
CRP income. This would be very much unlike other rental income 
they would be receiving.
    We learned in a meeting with IRS staff in North Dakota last 
Friday that that letter ruling was not drafted with 
contemplation of the circumstance of retired farmers. The 
result of it has been to put a big question mark on the 
shoulders of taxpayers and retired farmers alike about what to 
do with this income. Needless to say, it represents a very 
substantial new tax obligation to people living on fixed 
incomes, especially when they all had available the option of 
renting the land in the first place, which would carry no self-
employment tax.
    I will hand you a copy and put into the record a treatise 
by Dr. Neil Harl, who is a tax expert operating out of Iowa, on 
the question of the tax status of this income for retired 
farmers. He recommends withdrawal of the letter ruling of 2003, 
sorting this out in a more comprehensive way and dealing with 
it going forward, based on a more comprehensive resolution but 
lifting the cloud that affects this tax filing season.
    [The information follows:]

  Self-employment Tax Aspects of the Conservation Reserve Program* by 
                             Neil E. Harl**

    I. The Food Security Act 1985 instituted a 10-year conservation 
reserve program (CRP) under which the Secretary of Agriculture entered 
into contracts with owners and operators of highly erodible cropland to 
take such cropland out of crop production and place it in conservation 
and soil and water improving use in exchange for payments of cash and 
commodities. 16 U.S.C.  3831, added by Pub. L. No. 99-198, Sec. 1231, 
99 Stat. 1508 (1985). Final regulations were issued in 1987 
implementing the program. 7 C.F.R. Pt. 704, 52 Fed. Reg. 4,269 (1987).
---------------------------------------------------------------------------
    * Presented at a conference, Washington, D.C., sponsored by Cong. 
Earl Pomeroy, June 8, 2004.
    **Charles F. Curtis Distinguished Professor in Agriculture and 
Emeritus Professor of Economics, Iowa State University, Ames, Iowa; 
Member of the Iowa Bar.
---------------------------------------------------------------------------
    II. The self-employment tax treatment of CRP payments

    A. Initially, tax practitioners relied on prior authority drawn 
from other settings. E.g., Rev. Rul. 60-32, 1960-1 C.B. 23 (payments 
under soil bank program includible as self-employment income of owner-
operator).
    B. The Associate Chief Counsel, Technical, of IRS, stated in 1987, 
that where the farm operator or owner is materially participating in 
the farm operation, CRP payments constitute receipts from farm 
operations includible in net earnings from self-employment. Letter from 
Peter K. Scott, Associate Chief Counsel, Technical, March 10, 1987. The 
Commissioner of Social Security agreed.
    C. In 1988, the Internal Revenue Service, in a letter ruling, 
indicated that, for a retired taxpayer who is not materially 
participating, payments received under the federal Conservation Reserve 
Program would not be considered net income from self-employment. Ltr. 
Rul. 8822064, March 7, 1988 (no tenant involved; landowner's activities 
under CRP did not constitute material participation).
    D. In a 1996 Tax Court case, Ray v. Commissioner, T.C. Memo. 1996-
436, the Tax Court held that, for taxpayers who materially participate 
in the operation, CRP payments are to be reported as self-employment 
income if the CRP land had a ``direct nexus'' with the farming 
business. The Tax Court found that a direct nexus in that case existed 
where the CRP land was in the same general vicinity as the farming 
operation, the CRP seeding was maintained with equipment used in the 
farming operation and the farmer admitted that, at the termination of 
the CRP contract, the land involved would be used in the farm business.
    E. A 1996 letter ruling involving a husband and wife as directors 
and officers of a family ranch corporation held that they had 
materially participated in the overall operation. Ltr. Rul. 9637004, 
May 1, 1996.
    F. In 1998, the Tax Court held that CRP payments were ``rents'' 
and, therefore, not subject to self-employment tax by virtue of I.R.C. 
 1402(a)(1). Wuebker v. Commissioner, 110 T.C. 431 (1998). The Tax 
Court said the primary purpose of the CRP contract was to achieve 
specified environmental benefits by converting highly erodible cropland 
to soil conserving use. Thus, the contract payments represented 
compensation from the use restrictions on the land rather than 
remuneration for the taxpayer's labor. However, that case was reversed 
on appeal in 2000 by the Sixth Circuit Court of Appeal. Commissioner v. 
Wuebker, 205 F.3d 897 (6th Cir. 2000).
    G. Legislation was first introduced in April of 2000 to treat CRP 
payments as rent for self-employment tax purposes and reintroduced in 
2001 and 2003. S. 2422, S. 2344, H.R. 4212, 106th Cong., 2d Sess. 
(2000); S. 315, 107th Cong., 1st Sess. (2001); S. 665, S. 1316, 108th 
Cong., 1st Sess. (2003).
    H. In a Chief Counsel's Letter Ruling dated May 29, 2003, IRS took 
the position that a landowner's activities under a CRP contract 
amounted to material participation and the payments should be reported 
on Schedule F, not Schedule E or Form 4835. CCA Ltr. Rul. 200325002, 
May 29, 2003I. The letter ruling did not except retired landowners 
(taxpayer B is an individual not engaged in the trade or business of 
farming) and so the 2003 CCA Letter Ruling was counter to Ltr. Rul. 
8822064, March 7, 1988.
    The text of the CCA Letter Ruling, CCA Ltr. Rul. 200325002, May 29, 
2003, is included in full in Appendix A hereto.

    III. In summary, before the issuance of CCA Ltr. Rul. 200325002, 
May 29, 2003, landowners could be separated into four categories with 
respect to liability for SE tax on CRP payments.
    A. Landowners who were retired when the land was bid into CRP and 
were not materially participating in retirement were not liable for SE 
tax on the CRP payments. Ltr. Rul. 8822064, March 7, 1988.
    B. For landowners who were not carrying on the trade or business of 
farming and there was no direct nexus between the CRP land and a 
farming business (or landowners who were carrying on the trade or 
business of farming but there was no direct nexus between the CRP land 
and the farming business), the landowner was not liable for SE tax on 
the CRP payments. See Ray v. Commissioner, T.C. Memo. 1996-436.
    C. For landowners who were carrying on the trade or business of 
farming and there was a direct nexus between the CRP land and a farming 
business, the individual or individuals were liable for SE tax on the 
CRP payments.
    D. For landowners who retired after the land was bid into the CRP 
program, and who were liable for SE tax on CRP payments before 
retirement, there were conflicting authorities>
    1. Some authorities have focused on the taxpayer's status at the 
time the agreement was entered into and that status prevailed for the 
duration of the contract. Notice 87-26, 1987-1 C.B. 470 (dairy 
termination payments); Rev. Rul. 60-32, 1960-1 C.B. 23 (soil bank 
payments).
    2. Other authorities suggested that it is the taxpayer's status at 
the time payment is received that determines liability for SE tax. Soc. 
Sec. Rul. 67-42 (cropland adjustment income; dictum).
    IV. Recommendations
    A. Withdrawal of CCA Ltr. Rul. 200325002, May 29, 2003, or 
reissuance with a narrowing of the ruling to harmonize with Ltr. Rul. 
8822064, March 7, 1988, would remove much of the current confusion.
    B. The CCA Ltr. Rul. seems to apply to all Federal conservation 
programs also. It would be helpful to know whether that was intended.
    C. Guidance on the matter of SE tax liability for those who retire 
during the term of the CRP contract would be helpful.

                               APPENDIX A

    CCA Ltr. Rul. 200325002, May 29, 2003.
    TO: Virginia E. Cochran, Deputy Area Counsel (Great Lakes & Gulf 
Coast Area), Office of Division Counsel/Associate Chief Counsel (Tax 
Exempt & Government Entities), CC:TEGE:GLGC:DAL
    FROM: Michael A. Swim, Senior Technician Reviewer, Employment Tax 
Branch 1, Office of Division Counsel/Associate Chief Counsel (Tax 
Exempt & Government Entities), CC:TEGE:EOEG:ET1
    SUBJECT: Conservation Reserve Program & SECA
    This Chief Counsel Advice responds to your request for advice 
regarding the Conservation Reserve Program (CRP) of the United States 
Department of Agriculture (USDA) and Self-Employment Contributions Act 
(SECA) tax. In accordance with section 6110(k)(3) of the Internal 
Revenue Code, this Chief Counsel Advice should not be cited as 
precedent.

ISSUES
    1. Whether annual ``rental'' payments received by Taxpayer A, who 
is an individual, for land enrolled in the CRP constitute self-
employment income to Taxpayer A that is subject to SECA tax where 
Taxpayer A was engaged in the trade or business of farming prior to 
enrolling the land in the CRP and Taxpayer A personally fulfilled her 
CRP contractual obligations.
    2. Whether annual ``rental'' payments received by Taxpayer B, who 
is an individual, for newly acquired land, that had been enrolled in 
the CRP by the land's previous owner and the enrollment is continued by 
the Taxpayer B, constitute self-employment income to Taxpayer B subject 
to SECA tax where Taxpayer B was not engaged in the trade or business 
of farming prior to acquiring the land but Taxpayer B personally 
fulfilled his CRP contractual obligations.
    3. Whether the annual ``rental'' payments respectively received by 
Taxpayer A and Taxpayer B under the CRP should be reported (i) on 
Schedule F (Form 1040), Profit or Loss from Farming, as farming income 
from a trade or business, (ii) on a Schedule E (Form 1040), 
Supplemental Income and Loss, as rental income from real estate, or 
(iii) on a Form 4835, Farm Rental Income and Expenses, as rental income 
from crop or livestock production.

CONCLUSIONS
    1. The annual ``rental'' payments received by Taxpayer A for land 
enrolled in the CRP constitute self-employment income to Taxpayer A 
that is subject to SECA tax where Taxpayer A was engaged in the trade 
or business of farming prior to enrolling the land in the CRP and 
Taxpayer A personally fulfilled her CRP contractual obligations.
    2. The annual ``rental'' payments received by Taxpayer B for newly 
acquired land, that had been enrolled in the CRP by the land's previous 
owner and the enrollment is continued by Taxpayer B, constitute self-
employment income to Taxpayer B subject to SECA tax where Taxpayer B 
was not engaged in the trade or business of farming prior to acquiring 
the land but Taxpayer B personally fulfilled his CRP contractual 
obligations.
    3. The annual ``rental'' payments respectively received by Taxpayer 
A and Taxpayer B under the CRP constitute self-employment income to the 
recipient taxpayer that is subject to SECA tax and is not rental income 
that is excludible under the rentals-for-real-estate exclusion. The 
respective payments received by each recipient taxpayer must be 
reported on a Schedule F and Schedule SE (Form 1040), Self-Employment 
Tax, filed by that taxpayer with that taxpayer's Form 1040, U.S. 
Individual Income Tax Return. The use of Schedule E or Form 4835 is not 
allowed.

FACTS
    The CRP, 16 U.S.C.  3801, 3831-36, is a USDA voluntary 
conservation reserve program under which land is enrolled through the 
use of contracts. The program generally assists owners and operators of 
land to conserve and improve the soil, water, and wildlife resources of 
such land. The CRP offers, among other things, annual ``rental'' 
payments to owners and operators for converting highly erodible 
cropland normally devoted to the production of an agricultural 
commodity to less intensive use. In general, the durations of contracts 
are from 10 to 15 years. The Farm Security and Rural Investment Act of 
2002, Pub. L. No. 107-171, provides that up to 39.2 million acres can 
be enrolled in CRP at any one time during the 2002 through 2007 
calendar years.
    No specific taxpayer or detailed factual situation was provided in 
regards to the requested advice. Accordingly, we address two 
hypothetical situations.
    Taxpayer A was a farmer who owned highly erodible cropland. After 
planting crops on the land for 6 years, Taxpayer A decided to enroll 
Taxpayer A's cropland into the CRP and entered into a CRP contract with 
the USDA.
    Under the CRP contract, Taxpayer A agreed to certain terms and 
conditions as to the cropland under contract. Among the terms and 
conditions, Taxpayer A Agreed to: (1) implement a conservation plan for 
converting the land normally devoted to the production of an 
agricultural commodity on the farm to a less intensive use, such as 
pasture, permanent grass, legumes, shrubs, or trees; (2) not to use the 
land for agricultural purposes except as permitted by the USDA; (3) 
establish approved vegetative cover or maintain existing cover on the 
land; and (4) not engage in or allow grazing, harvesting, or other 
commercial use of the land, except with USDA's permission (e.g., 
harvesting and grazing in response to a drought or other emergency).
    Taxpayer B purchased highly erodible cropland that had been 
enrolled in the CRP by its previous owner. As the new owner, Taxpayer B 
executed an agreement to continue and assume all obligations of the CRP 
contract under the same terms and conditions as the original owner. 
These terms and conditions were identical to those in Taxpayer A's CRP 
contract. Taxpayer B was not engaged in the trade or business of 
farming prior to acquiring the cropland that was and continues to be 
subject to a CRP contract.
    Taxpayer A and Taxpayer B each personally fulfilled their duties 
under their respective CRP contracts and received annual ``rental'' 
payments. Neither Taxpayer A nor Taxpayer B disputed the taxability of 
the CRP payments as includible in gross income under section 61. 
However, both taxpayers reported the payments as rental income not 
subject to SECA tax. Taxpayer A reported the amounts received as rental 
income from real estate on Schedule E. Taxpayer B reported the amounts 
as rental income from farm production and crop shares on Form 4835.

LAW AND ANALYSIS
    Section 1401 imposes SECA tax on the self-employment income of 
every individual. SECA tax consists of the Old-Age, Survivors and 
Disability Insurance tax (OASDI tax which is commonly referred to as 
Social Security tax) and the Hospital Insurance tax (HI tax which is 
commonly referred to as Medicare tax).
    Section 1402(b), in pertinent part, defines ``self-employment 
income'' as the net earnings from self-employment derived by an 
individual (other than a nonresident alien individual, except as 
provided by an agreement under section 233 of the Social Security Act) 
during any taxable year; except that such term shall not include:
    (1) in the case of the OASDI tax imposed by section 1401(a), that 
part of the net earnings from self-employment which is in excess of (i) 
an amount equal to the contribution and benefit base (as determined 
under section 230 of the Social Security Act) which is effective for 
the calendar year in which such taxable year begins, minus (ii) the 
amount of the wages paid to such individual during such taxable years; 
or
    (2) the net earnings from self-employment, if such net earnings for 
the taxable year are less than $400.
    Section 1402(a) defines the term ``net earnings from self-
employment'' as the gross income derived by an individual from any 
trade or business carried on by such individual, less the deductions 
allowed by subtitle A which are attributable to such trade or business, 
plus the individual's distributive share (whether or not distributed) 
of income or loss described in section 702(a)(8) from any trade or 
business carried on by a partnership of which the individual is a 
member, with certain enumerated exceptions.
    Section 1402(a)(1) generally excludes from the computation of ``net 
earnings from self-employment'' rentals from real estate and from 
personal property leased with the real estate (including such rentals 
paid in crop shares) together with the deductions attributable thereto, 
unless such rentals are received in the course of a trade or business 
as a real estate dealer, with an exception. Under this exception, any 
income derived by the owner or tenant of land must be included in the 
computation of ``net earnings from self-employment'' if:
    (A) such income is derived under an arrangement, between the owner 
or tenant and another individual, which provides that such other 
individual shall produce agricultural or horticultural commodities 
(including livestock, bees, poultry, and fur-bearing animals and 
wildlife) on such land, and that there shall be material participation 
by the owner or tenant (as determined without regard to any activities 
of an agent of such owner or tenant) in the production or the 
management of the production of such agricultural or horticultural 
commodities, and
    (B) there is material participation by the owner or tenant (as 
determined without regard to any activities of an agent of such owner 
or tenant) with respect to any such agricultural or horticultural 
commodity.
    See also, Income Tax Reg.  1.1402(a)-4.
    Section 1402(c) provides that the term ``trade or business'' when 
used with reference to self-employment income or net earnings from 
self-employment shall have the same meaning as when used in section 162 
(relating to trade or business expenses), with certain enumerated 
exceptions. In order for an individual to have net earnings from self-
employment, the individual must carry on a trade or business, either as 
an individual or as a member of a partnership. Whether or not the 
individual is engaged in carrying on a trade or business will be 
dependent upon all of the facts and circumstances in the particular 
case. See also, Income Tax Reg.  1.1402(c)-1.
    In considering whether an individual is engaged in a trade or 
business, the U.S. Supreme Court has stated that ``to be engaged in a 
trade or business, the taxpayer must be involved in the activity with 
continuity and regularity and that the taxpayer's primary purpose for 
engaging in the activity must be for income or profit. A sporadic 
activity--does not qualify.'' Commissioner v. Groetzinger, 480 U.S. 23, 
35 (1987) [87-1 USTC  9191]. The question of whether a taxpayer is 
engaged in a trade or business requires an examination of the relevant 
facts in each case. Id. at 36.
    In order for income received by an individual to be taxable as 
self-employment income, not only must the income in question derive 
from a trade or business carried on by the individual, but there must 
be a nexus between the income and the trade or business. Newberry v. 
Commissioner, 76 T.C. 441, 444 (1981) [CCH Dec. 37,756]. The income 
``must arise from some actual (whether present, past, or future) 
income-producing activity of the taxpayer.'' Id. at 446.
    In determining what income is includible in self-employment income, 
sections 1401 and 1402 are to be broadly construed to favor coverage 
for Social Security purposes. Braddock v. Commissioner, 95 T.C. 639, 
644 (1990) [CCH Dec. 47,046]. In order to achieve this end, the rental 
exclusion under section 1402(a)(1) is ``narrowly construed.'' Johnson 
v. Commissioner, 60 T.C. 829, 833 (1973) [CCH Dec. 32,117], see also 
Delno v. Celebrezze, 347 F.2d 159, 165 (9th Cir. 1965) (noting that a 
parallel provision of the Social Security Act relates Congress' 
specific intent for the ``rental exclusion to be narrowly restricted to 
payments for occupancy only'').
    In Wuebker v. Commissioner, 205 F.3d 897 (6th Cir. 2000) [2000-1 
USTC  50,254], the Sixth Circuit reversed a Tax Court decision that 
CRP payments received by Frederick and Ruth Wuebker (taxpayers) were 
excludible from their self-employment income as rentals from real 
estate. The Sixth Circuit held that CRP payments received by a farmer 
in exchange for the farmer's implementation of a conservation plan were 
includible in self-employment income from the trade or business of 
farming that were subject to SECA tax pursuant to section 1401.
    In Wuebker, the taxpayers had been farming for approximately twenty 
years when they enrolled a portion of their farmland into the CRP. The 
Sixth Circuit held that because the taxpayers were ``engaged in the 
business of farming prior to and during the term of their CRP 
contract'' and their ``agreement . . . required them to perform several 
ongoing tasks with respect to the land enrolled in the CRP, the very 
land they already owned and had previously farmed,'' the CRP payments 
``were `in connection with' and had a `direct nexus to' their ongoing 
trade or business.'' Id. at 902. The Sixth Circuit noted that the 
taxpayers were required under the CRP contract to perform tasks that 
are intrinsic to the farming trade or business (e.g., tilling, seeding, 
fertilizing, and weed control) that required the use of their farming 
equipment. Id. at 903.
    The Sixth Circuit found that the taxpayers' contention that their 
involvement with the CRP land was insufficient to constitute ``material 
participation'' within the meaning of section 1402(a)(1) had no bearing 
on whether the CRP payments constituted rentals from real estate. The 
issue of material participation arises only when there is an 
arrangement between an owner or tenant and another individual whereby 
the other individual is to produce agricultural or horticultural 
commodities on the land. No such arrangement was present in Wuebker.
    In addition, because of the narrow construction required of the 
exclusion for rentals from real estate, the Sixth Circuit held that the 
CRP payments were not true rental payments for the use or occupancy of 
property. The essence of the CRP program is to prevent participants 
from farming of the property and to require the participants to perform 
various activities in connection with the land continuously throughout 
the life of the contract with the government's access limited to 
inspection. Id. at 904. Furthermore, the Sixth Circuit looked to the 
``substance, rather than the form, of the transaction'' \1\ in 
determining that the income derived from the CRP contract is includible 
in self-employment income earned in lieu of farm income, for which SECA 
tax was due.
---------------------------------------------------------------------------
    \1\ Although the CRP contract referred to the payments as annual 
``rental'' payments, such reference does not compel the conclusion that 
they should fall within the rentals-from-real estate conclusion. 
Wuebker 904; citing Cline v. Commissioner, 617 F.2d 192, 195 (6th Cir. 
1980) [80-1 USTC  9315] (``Courts must look to the substance, rather 
than the form, of the transactions--'').
---------------------------------------------------------------------------
    The CRP payments are not excludible per se as rentals from real 
estate. Rent is defined as ``consideration paid--for the use or 
occupancy of property (esp. real property).'' Id. at 904 citing Black's 
Law Dictionary 1299 (7th ed. 1999). Under a CRP contract, the USDA does 
not obtain the right to ``occupy'' the land enrolled in the CRP. The 
government's access is limited to inspecting the property and 
determining whether the recipients of the CRP payments are in 
compliance with the CRP contract. See id. at 904.
    In Hasbrouck v. Commissioner, T.C. Memo. 1998-249 [CCH Dec. 
52,783(M)], taxpayers purchased land that had already been enrolled in 
the CRP. The taxpayers, who fulfilled their obligations under the terms 
and conditions of the CRP contract, considered themselves engaged in 
the trade or business of farming and reported their CRP income and 
expenses on Schedule F. Prior to the purchase, the taxpayers were not 
engaged in the trade or business of farming. The Service initially 
reclassified the income and expenses as rentals from real estate on the 
basis that the taxpayers were not engaged in the trade or business of 
farming when they acquired the land. The Service, however, following 
the decision in Ray v. Commissioner, T.C. Memo 1996-436 [CCH Dec. 
51,573(M)], reconsidered its position, and conceded the case.
    In Ray, the Tax Court found that payments received under a CRP 
contract were includible in self-employment income. In this case, the 
taxpayers were engaged in the business of farming and cattle grazing 
and had acquired additional land that had been previously enrolled in 
the CRP. The Tax Court held that there was a sufficient nexus between 
the CRP payments received and the taxpayer's trade or business of 
farming to support the finding that the payments were includible in 
self-employment income subject to SECA tax.
    In Rev. Rul. 60-32, 1960-1 C.B. 23, the Service held that annual 
payments received under the Soil Bank Act \2\, an earlier acreage 
reserve program of the USDA, were includible in determining the 
recipient's net earnings from self-employment, if the recipient 
operated his farm personally or through agents or employees. The 
Service reasoned that the payments were in the nature of receipts from 
farm operations in that they replaced income which producers could have 
expected to realize from the normal use of the land devoted to the 
program. This was also true if the recipient's farm was operated by 
others and he participated materially in the production of commodities, 
or management of such production, within the meaning of section 
1402(a)(1). However, if the recipient did not so operate or materially 
participate, payments received were not to be included in determining 
net earnings from self-employment.
---------------------------------------------------------------------------
    \2\ Soil Bank Act, Title I of the Agricultural Act 1956, 7 U.S.C. 
1801-37 (repealed 1965). Under  103(a) of the Act, the Secretary of 
Agriculture is authorized and directed to carry out an acreage reserve 
program from the crops of specified commodities. Producers 
participating in the program are compensated for reducing their acreage 
of a commodity below their farm acreage allotments or their farm base 
acreage, whichever may be applicable. Producers must enter into a 
contract where they agree to perform various activities in connection 
with the land.
---------------------------------------------------------------------------
    In Rev. Rul. 65-149, 1965-1 C.B. 434, the Service addressed whether 
grain storage fees paid to a farm operator under the price support loan 
program of the Commodity Credit Corporation are to be regarded as 
attributable to the operator's trade or business of farming and 
considered in computing the operator's self-employment income. The 
Service argued that income derived from the operation of a farm, 
regardless of the form of the income (cash sales, Commodity Credit 
Corporation loans, government subsidies, including soil bank payments, 
conservation reserve payments, and so forth.), should be treated in a 
manner consistent with the position set forth in Rev. Rul. 60-32. That 
is to say, if this income is received by a farm operator, or a landlord 
who materially participates, it should be treated as self-employment 
income. If it is received by a landlord who does not materially 
participate, it should be treated as rental income and excluded from 
net earnings from self-employment.
    More recently, in Announcement 83-43, 1983-10 I.R.B. 29, the 
Service concluded that if a farmer participates in the Payment-in-Kind 
(PIK), or any other land diversion program sponsored by the USDA, and 
receives cash or a payment in kind from the USDA with respect to the 
diverted acres, the farmer is liable for SECA tax on the cash or 
payment in kind received. The announcement further provided that, for 
estate tax purposes (sections 2032A and 6166), land diverted from the 
production of an agricultural commodity under a USDA land diversion 
program will be treated as being used as a farm for farming purposes 
and in the active conduct of a farming business.
    Furthermore, participation in a USDA land diversion program and in 
the devotion of such land to conservation purposes under such programs 
will be treated as material participation in the operation of a farm 
with respect to the diverted acres.
    As to reporting requirements, section 6017 provides that every 
individual (other than a nonresident alien) having net earnings from 
self-employment of $400 or more for the taxable year shall make a 
return with respect to SECA tax. Income Tax Reg.  1.6017-1(a)(2) 
provides that the return required by section 6017 for SECA tax shall be 
Form 1040.
    Schedule SE is the form used to report net earning from self-
employment and SECA tax. See 2002 Instructions for Schedule SE, Self-
Employment Tax.
    Schedule F is the form used to report farm income and expenses. See 
2002 Instructions for Schedule F, Profit or Loss From Farming.
    Schedule E is the form used to report income and expenses for 
rentals of real estate (including personal property leased with real 
estate) and royalty income and expenses. See 2002 Instructions for 
Schedule E, Supplemental Income and Loss.
    Form 4835 is the form used by landlords or sub-lessors to report 
farm rental income and expenses based on the crops or livestock 
produced by the tenant where the landlord or sub-lessor did not 
materially participate (for SECA tax purposes) in the operation or 
management of the farm. The use of Form 4835 only applies to those 
circumstances where there is an arrangement between an owner or tenant 
and another individual whereby the other individual is to produce 
agricultural or horticultural commodities on the land. See General 
Instructions for Form 4835.
    In each case, the annual ``rental'' payments that Taxpayer A and 
Taxpayer B individually receive for land enrolled in the CRP are in the 
nature of receipts from farm operations earned in lieu of income that 
each taxpayer could have expected to realize from the normal use of 
their respective cropland, if they had not enrolled the cropland in the 
CRP. See Rev. Rul. 60-32.
    Pursuant to the terms of the CRP contract, each taxpayer is 
required to engage in soil conservation practices, to establish or 
maintain approved vegetative cover on the cropland, to not use the land 
for agricultural purposes except as permitted by USDA, and to not 
conduct any harvesting or grazing on the cropland. The income is 
derived from the income-producing activity of the taxpayers in 
performing under the CRP contract. The CRP contracts require Taxpayer A 
and Taxpayer B to perform tasks that are intrinsic to the farming trade 
or business. The fact that Taxpayer A was previously engaged in the 
trade or business of farming prior to enrolling Taxpayer A's land in 
the CRP is an additional fact that helps establish that Taxpayer A is 
continuing to be engaged in the trade or business of farming. However, 
Taxpayer B, who was not engaged in farming prior to the purchase of 
land subject to a CRP contract, becomes engaged in trade or business of 
farming in personally fulfilling Taxpayer B's obligations under the 
terms and conditions of the CRP contract. See Hasbrouck. As long as 
Taxpayer A and Taxpayer B are actively fulfilling their respective 
obligations under their respective CRP contracts, they will both 
individually be considered to be engaged in the trade or business of 
farming.
    The CRP payments are in connection with and have a direct nexus to 
the taxpayer's ongoing business of farming. See Wuebker; see also Ray.
    Although the payments are labeled as ``rental'' payments for 
purposes of the CRP, the narrow-construction placed on the section 
1402(a)(1) exclusion for rentals from real estate eliminates these 
payments from its provisions. See Wuebker. Further, under our facts, 
neither Taxpayer A nor Taxpayer B leased the land to a third party, 
such as another individual, on a rental basis. Thus, the test regarding 
material participation by the owner of rented land to a third party is 
irrelevant.\3\
---------------------------------------------------------------------------
    \3\ Under the rentals-from-real estate exception, the owner of a 
farm operated on a rental basis must include the rental income in 
determining net earnings if (1) such income is derived under an 
arrangement between the owner and another individual which provides 
that there be material participation by the owner in the production or 
the management of the production of such commodities, and (2) there is 
material participation by the owner with respect to such commodity.
---------------------------------------------------------------------------
    The income derived from the CRP contract is includible in self-
employment income subject to SECA tax. Taxpayer A must report the CRP 
payments as self-employment income from farming subject to SECA tax. 
Similarly, Taxpayer B must report the CRP payments as self-employment 
income from farming subject to SECA tax.
    After having concluded that CRP payments are includible in self-
employment income from farming, such CRP payments should be reported on 
Schedule F, filed with Form 1040. See Pub 225, Farmer's Tax Guide; and 
Instructions for Schedule F; Cf. Hasbrouck. Any profit or loss from 
farming should then be reported on a Schedule SE for SECA tax purposes 
pursuant to form instructions. See 2002 Instructions for Schedule F, 
Profit or Loss From Farming.
    CRP payments are not considered rental income from real estate nor 
are they rental income from farm production or crop shares.\4\ 
Accordingly, the use of Schedule E or Form 4835, under our facts, is 
not allowed.
---------------------------------------------------------------------------
    \4\ An arrangement for the production of agriculture or 
horticulture commodities is not present under the CRP contract for 
either Taxpayer A or Taxpayer B.
---------------------------------------------------------------------------
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
    This memorandum does not address cost-share assistance.
    This writing may contain privileged information. Any unauthorized 
disclosure of this writing may have an adverse effect on privileges, 
such as the attorney client privilege. If disclosure becomes necessary, 
please contact this office for our views.
    Please call if you have any further questions.

                               APPENDIX B

Ltr. Rul. 8822064, March 7, 1988.
                                 ______
                                 
    Under the Food Security Act 1985, the Secretary of Agriculture 
instituted a 10-year conservation acreage reserve program under which 
the Secretary enters into contracts with owners and operators of highly 
erodible cropland to take the cropland out of production of intertilled 
crops and place the land in conservation and soil and water conserving 
uses. Those bidding their lands into a CRP program are compensated on a 
pre-acre basis in cash or, occasionally, commodities. Not more than 25 
percent of the acreage in a county may be placed in the reserve, unless 
the Secretary of Agriculture determines that additional acres in the 
program in that county will not affect adversely the local economy.
    Approximately 34 million acres are presently enrolled in the CRP 
program. Periodically, the Secretary of Agriculture announces that, for 
a designated time, owners wanting to enroll land in the Conservation 
Reserve Program can make an offer in bid form to idle the land in 
exchange for the bid price per acre. In accepting bids, the Secretary 
of Agriculture is to take into consideration the extent of erosion on 
and the productivity of the land involved; accept offers that provide 
for permanently vegetated stream borders and filter strips; establish 
criteria for different regions of the country; and give priority to 
owners and operators under the greatest economic stress.
    The amount of rental payments made to a ``person'' may not exceed 
$50,000 per year, which is in addition to payments that can be received 
under any other agricultural commodity program.
    Under a CRP contract, the owner or operator must agree to:

     1.  implement a plan approved by the local conservation district 
to convert highly erodible crop land to less intensive use, including 
pasture, grass, legumes, forbs, shrubs or trees;
     2.  place the highly erodible land specified in the contract in 
reserve so as not to be used for agricultural purposes except as 
permitted by the Secretary of Agriculture;
     3.  establish vegetative cover on the land;
     4.  forfeit all rights to rental and cost sharing payments and 
refund any rental and cost sharing payments received under the 
contract, with interest, upon termination of the contract resulting 
from a violation of the terms of the contract;
     5.  refund to the Secretary of Agriculture or accept adjustments 
to the rental and cost sharing payments provided to the owner for 
violation of the terms of the contract which does not cause termination 
of the contract;
     6.  forfeit all rights to rental and cost sharing payments under 
the contract upon transfer of the land, unless the transferee of the 
land agrees to assume all obligations of the contract;
     7.  refund rental and cost sharing payments or accept adjustments 
in the rental and cost sharing payments, unless the transferee of the 
land agrees to assume all obligations of the contract;
     8.  not make any commercial use, such as harvesting or grazing, of 
the forage on the contract land, unless permitted by the Secretary of 
Agriculture in case of drought or other emergency;
     9.  not plant trees on the contract land unless permitted by the 
contract, except that customary forestry practices may be allowed on 
land converted to forestry use;
    10.  not adopt any practice specified in the contract which may 
defeat the purposes of the program; and
    11.  comply with any additional contract provisions.

    Charles F. Curtiss Distinguished Professor in Agriculture and 
Emeritus Professor of Economics, Iowa State University, Ames, Iowa. 
Member of the Iowa Bar.

                                 

    Mr. POMEROY. I don't expect necessarily that you can speak 
to what might be under contemplation at the IRS, but I would 
like your attention to those recommendations, and as quickly as 
possible, because people literally have dozens, if not 
hundreds, of tax filings and a questioned status in their 
offices, not knowing how to treat this new development.
    Mr. EVERSON. I had a discussion on this before the hearing 
today with some of my folks who were familiar with the meeting 
that I think you held last week on this.
    Mr. POMEROY. Yes.
    Mr. EVERSON. As we indicated in the early conversation, 
this is a discussion that has broad ramifications, particularly 
as the country moves to a model where there are more 
individuals who are self-employed or running small businesses. 
We need to tread very carefully as we look at this. I give you 
my commitment that we will look at this very carefully.
    Mr. POMEROY. Mr. Commissioner, can we expect to have any 
guidance from the IRS prior to the filing date for this tax 
season?
    Mr. EVERSON. I don't know the answer to that. I would 
imagine that would be quite expedited, since we're only a 
couple of weeks away from April 15th. I will ask that specific 
question. It is not one that we discussed or had an expectation 
of something that rapid in the conversation I had, in fact, 
earlier today on this subject. I will check.
    Mr. POMEROY. To sharpen the point to you, by 
acknowledgement of the IRS, the letter ruling--which is private 
and nonbinding, but nonetheless stands with some authority 
about what the tax treatment might be in this area--was 
prepared without contemplation of retired farmers but the 
wording of it is broad enough to sweep them in. It leaves 
people in a very difficult position on whether to ignore it, as 
has been the treatment of this matter since 1988, or whether 
you change based on the IRS wording that was put out not in 
contemplation of this specific issue. So, some clarification I 
believe in this instance would be appropriate. Again, we're not 
asking the IRS not to--what we want them to do is lift the 
confusion by basically lifting the letter ruling as it applies 
to retired farmers, and then come forward with a more 
definitive statement with the contemplation of this particular 
set of circumstances, going forward for future guidance. I 
thank the Commissioner.
    Chairman HOUGHTON. Thanks very much, Mr. Pomeroy. Well, 
thank you, Mr. Commissioner. We appreciate your testimony.
    Mr. EVERSON. Thank you, sir.
    Chairman HOUGHTON. Now we've got a time problem. I'm going 
to ask Mr. White, who is Director of Tax Issues for the GAO, 
and also Nancy Killefer, Chairman of the IRS Oversight Board, 
if you be willing to maybe squeeze in your testimony in maybe 3 
minutes apiece in order that we can get through your testimony. 
Then when we come back from these three votes, we can get right 
into the questions. Is that all right with you, Ms. Killefer?
    Ms. KILLEFER. Absolutely.
    Chairman HOUGHTON. Good. Thanks very much. Okay, Mr. White.

STATEMENT OF JAMES R. WHITE, DIRECTOR, TAX ISSUES, U.S. GENERAL 
                       ACCOUNTING OFFICE

    Mr. WHITE. Mr. Chairman and Members of the Committee, we 
are pleased to be here. For several years, we have reported on 
the opposing trends in taxpayer service and enforcement that 
we've heard discussed already. IRS' 2005 budget addresses both 
enforcement and systems modernization.
    One point I want to make about the budget request for 2005 
is that this is not IRS' first request for additional 
enforcement staff. It follows similar requests in IRS' past 
five budgets. You can see what actually has happened in figure 
1 on page 8 of my statement. Staffing in three key enforcement 
occupations--revenue agents, revenue officers and special 
agents--declined by over 21 percent between 1998 and 2003. 
These declines occurred, even though IRS' budget requests were 
almost fully funded and IRS did realize some savings. IRS 
funded other priorities, such as unbudgeted cost and 
improvements to taxpayer services.
    Switching quickly to systems modernization, as you are 
aware, some projects have been completed but many of the 
projects that have not been completed are over cost and behind 
schedule. The point I want to make here is that this impacts 
taxpayers. The customer account data engine, for example, is 
intended to facilitate faster refund processing and better 
answers to taxpayer questions. IRS, in response to these 
problems, has reduced its modernization budget request to focus 
on fewer projects and is implementing action plans to correct 
deficiencies.
    Turning to the 2004 filing season, IRS is continuing to 
improve most but not all taxpayer services, and we see this as 
a payoff from the completed modernization projects. I have some 
examples in my statement but I will skip most of those. Another 
point to make related to customer service and IRS' budget both 
has to do with elec-

tronic filing. Electronic filing is continuing to grow, but it 
is not growing at the rate that would meet either IRS' 80 
percent goal but, in fact, is growing at a slower rate each 
year. This continues a trend that we have seen over time.
    Electronic filing is important because it's a way to gain 
efficiencies. It's much cheaper to process electronically filed 
returns than to process paper filed returns, which is a very 
labor-intensive process. An example of the consequence of the 
growth of electronic filing that we've seen is that IRS has 
been able to reduce processing staff. In 2003, for example, 
about 1,000 full time equivalents in the processing area of IRS 
was the size of the decline there. So, it's a significant 
saving in that area.
    Mr. Chairman, my three themes--declines in enforcement 
staff, systems modernization, and improved service--are 
related. Recent history causes us to question whether IRS will 
be able to increase enforcement staffing as much as proposed in 
the 2005 budget. IRS already expects some unbudgeted costs. If 
all IRS's planned savings are not realized, then funds for 
enforcement could be further reduced. One near term option for 
increasing enforcement staff is to reconsider the level and 
types of services IRS provides. For example, the improvements 
in phone and Internet service raise a question about whether 
IRS needs to operate as many walk-in sites. Longer term systems 
modernization, if successful, could generate efficiencies and 
increase e-filing which would allow IRS to do more with less.
    I want to make a final point on enforcement staffing. As 
noted, many fear that declines could be reducing taxpayers' 
incentives to voluntarily comply. However, IRS currently does 
not have a measure of voluntary compliance. IRS is working to 
develop a measure, but won't have results until 2005. Those 
results could impact future IRS budgets. If compliance is 
stable or has improved, the pressure to increase IRS' 
enforcement staff might diminish in the future. If, however, 
compliance is down, the pressure on IRS' budget will likely 
increase in the future. Thank you, Mr. Chairman.
    [The prepared statement of Mr. White follows:]

   Statement of James R. White, Director of Tax Issues, U.S. General 
                           Accounting Office

    Mr. Chairman and Members of the Subcommittee:
    We are pleased to participate in the Subcommittee's hearing on the 
Internal Revenue Service's (IRS) fiscal year 2005 budget request and 
its performance to date during the 2004 tax filing season.
    Effective tax administration requires a combination of quality 
taxpayer service to help those who want to comply, and effective 
enforcement measures against those who do not. Although tax 
administrators continually debate the proper balance between taxpayer 
service and enforcement, the ultimate goal is to assure a high level of 
voluntary compliance. Currently, about 98 percent of the money IRS 
collects is received voluntarily--without any IRS enforcement action.
    For the last few years, we have been reporting on trends in 
taxpayer service and enforcement. During this period, IRS has 
noticeably improved the quality of service to taxpayers. At the same 
time, there have been declines in many of IRS's enforcement programs 
and in the numbers of the most skilled enforcement staff. Many inside 
and outside IRS have become concerned that the declines in enforcement 
efforts have reduced taxpayers' incentive to voluntarily comply with 
the tax laws. While the actual impact on voluntary compliance is 
unknown, because IRS does not have a reliable current estimate of the 
overall compliance rate, the fear is that taxpayers could lose 
confidence in IRS's ability to ensure that all taxpayers pay what they 
should. If taxpayers ever lose confidence that their friends, 
neighbors, and business competitors are paying their fair share of 
taxes, then they could become less willing to pay themselves.
    One key to improving taxpayer service and enforcement is IRS's 
Business Systems Modernization (BSM) effort, now in its 6th year. If 
successful, BSM is expected to allow IRS to better serve taxpayers and 
enforce the tax laws without a major increase in staffing and other 
resources. However, we continue to report that modernization is a high-
risk area, the scope and complexity of BSM is growing, and BSM projects 
are experiencing additional costs and delays.
    As you requested, our statement discusses both IRS's 2005 budget 
request and its 2004 filing season performance to date. With respect to 
the budget, we assessed the likelihood that (1) IRS will be able to 
allocate more resources to enforcement, and (2) BSM and other 
technology efforts will deliver cost savings and efficiencies in the 
immediate future. With respect to the filing season, we assessed IRS's 
performance in processing returns and providing assistance to 
taxpayers.
    Our assessment of the budget request and BSM is based on a 
comparative analysis of IRS's fiscal year 2002 through 2005 budget 
requests, funding, and expenditures, supporting documentation, and 
interviews with IRS officials. Our assessment of the filing season is 
based on a comparison of IRS's performance this year to the previous 
two filing seasons, site visits to an IRS processing center and walk-in 
sites, monitoring processing status meetings, interviews with IRS and 
Treasury Inspector General for Tax Administration (TIGTA) officials and 
other external stakeholders, reviews of TIGTA and other external 
reports, and reviews of IRS's Web site. We used historical budget and 
performance data including filing season performance data from reports 
and budget requests used by the IRS, Department of Treasury, and Office 
of Management and Budget (OMB). Although we have not verified the 
accuracy of the most recent data, in past reports we have assessed 
IRS's budget and performance data.\1\ As a result, we considered the 
data to be sufficiently reliable for purposes of this testimony. The 
budget and performance projections for fiscal years 2004 and 2005 are 
subject to change. Also, we did not independently validate planned BSM 
projects' cost estimates or confirm, through system and project 
management documentation, the validity of IRS-provided information on 
the projects' content and progress. We performed our work in 
Washington, D.C. and Atlanta, Ga. from December 2003 through March 
2004, in accordance with generally accepted government auditing 
standards.
---------------------------------------------------------------------------
    \1\ U.S. General Accounting Office, Tax Administration: IRS Needs 
to Further Refine Its Tax Filing Season Performance Measures, GAO-03-
143 (Washington, D.C.: Nov. 22, 2002) and U.S. General Accounting 
Office, Financial Audit: IRS's Fiscal Years 2003 and 2002 Financial 
Statements, GAO-04-126 (Washington, D.C.: Nov. 13, 2003)
---------------------------------------------------------------------------
    In summary, our assessment of IRS's 2005 budget request shows that:

      IRS is requesting $10.7 billion, an increase of $489.8 
million over fiscal year 2004. The 2005 budget proposes $377.3 million 
to fund new initiatives, primarily increases in enforcement staff, and 
$373 million to cover the increased costs, such as salary increases, of 
maintaining current programs. IRS plans to fund the additional spending 
from three sources--the budget increase, program reductions ($149.7 
million) and internal savings ($110.8 million). IRS has made increasing 
enforcement staff a priority in its last five budget requests. However, 
despite getting its requests almost fully funded and despite realizing 
some savings--although not all that were projected--IRS did not achieve 
increases in enforcement staff. Staffing in three key enforcement 
occupations--revenue agents, revenue officers, and special agents--
declined by over 21 percent between 1998 and 2003. IRS funded other 
priorities such as unbudgeted expenses and improvements to taxpayer 
service. This raises several questions and concerns. One is whether IRS 
will be able to increase enforcement staff as planned in 2005. Another 
is whether the declines in enforcement staff, and the resulting 
declines in statistics related to IRS's enforcement programs, are 
eroding taxpayers' incentive to voluntarily comply with the tax laws.
      Included in IRS's budget request is about $1.93 billion 
(including 7,385 staff years) in information technology resources. This 
includes (1) $285 million for the agency's multiyear capital account 
that funds contractor costs for the BSM program and (2) about $1.64 
billion for information systems, of which $1.55 billion is for 
operations and maintenance. The BSM request has been developed 
consistent with federal guidance on budget preparation. While BSM 
management controls have improved, some weaknesses, such as cost and 
schedule estimating, still remain. Most BSM projects have experienced 
cost overruns and schedule delays that have postponed the delivery of 
benefits to taxpayers and IRS operations. In an effort to better ensure 
that projects are delivered within budget and on schedule, IRS has 
reduced its BSM budget request to focus on a smaller modernization 
project portfolio and is implementing action plans to respond to 
deficiencies noted in several recent assessments of the BSM program. In 
addition, with respect to its information systems budget request, IRS 
has made progress in implementing investment management best practices 
for developing and supporting it. However, until IRS fully implements 
planned process improvements, its ability to develop supportable 
information systems operations and maintenance budget requests will 
remain limited.

    Our assessment of the 2004 filing season to date shows that:

      IRS's performance during the 2004 filing season has 
improved in most areas compared to this time last year and the year 
before, based on the data we reviewed on key filing season activities--
paper and electronic processing, telephone assistance, IRS's Web site 
and walk-in assistance. In particular, access to IRS's telephone 
assistors has improved and Web site usage has increased. However, the 
accuracy of responses to tax law questions provided by telephone 
assistors declined the last two years. Additionally, the number of 
taxpayers seeking assistance at IRS's walk-in sites continued to 
decline and IRS is shifting work from its walk-in sites to alternative 
means of providing assistance, such as its volunteer organizations and 
its Web site. Although it cannot be quantified, the improvements 
overall in the 2004 filing season performance appear to represent a 
payoff from IRS's modernization and increased emphasis on service since 
1998.

Enhancing Enforcement Is A Key Priority But Devoting More Resources To 
        Enforcement May Be Difficult
    The fiscal year 2005 budget is the fifth consecutive budget request 
where IRS is proposing increased staffing for enforcement and the third 
where it has identified internally-generated savings to help fund the 
increase. The 2005 budget proposes that, of the $377.3 million for new 
initiatives to be paid for either through new funding and reinvested 
savings, $315.2 million or 84 percent go to enforcement. In the past, 
IRS has not been able to realize all the projected savings intended to 
help fund enforcement staffing increases. In addition, other 
priorities, including unbudgeted expenses and taxpayer service, have 
consumed budget increases and internally-generated savings. This raises 
the question about IRS's ability to increase enforcement staffing as 
planned in 2005.

IRS is Asking For Significantly More For Enforcement in 2005
    IRS's fiscal year 2005 budget request is $10.7 billion, up $489.8 
million or 4.8 percent from the amount appropriated for fiscal year 
2004. IRS's request identifies a total of $750.3 million of new 
proposed spending--$377.3 million for new initiatives, primarily 
enforcement, and $373 million to maintain current operations (such as 
salary increases included in the budget). IRS plans to fund the 
additional spending from three sources--budget increases, program 
reductions, and internal savings. IRS is proposing to receive $489.8 
million in budget increases, gain $149.7 million from program 
reductions, primarily from reducing the amount for BSM, and save $110.8 
million from process improvements. For context about IRS's staff 
resources, we provide information about how IRS allocated those 
resources in fiscal year 2003 to various functions including returns 
processing, taxpayers service and enforcement in appendix I.
    In its 2005 budget request, IRS makes increasing enforcement 
staffing its priority. IRS identified its priority enforcement areas 
as:

      promoters of tax schemes,
      misuses of offshore transactions,
      uses of corporate tax avoidance transactions,
      underreporting of income by higher income taxpayers, and
      failures to file and pay large amounts of employment 
taxes.

    IRS is proposing to spend $377.3 million on new initiatives; $315.2 
million, or 84 percent is slated for enforcement initiatives. The rest 
is for infrastructure projects to, for example, consolidate paper 
processing operations. The major enforcement initiatives include:

      $90.2 million and 874 Full Time Equivalents (FTEs) to 
target noncompliance by small business and self-employed taxpayers by 
hiring field examination and collection, automated collection and 
service center-based compliance staff;
      $65 million and 260 FTEs for additional criminal 
investigation resources to combat corporate fraud, increase tax 
enforcement, and enhance criminal investigation capabilities by hiring 
additional criminal investigators and special agents to focus on 
corporate financial fraud, general tax enforcement, improve forensic 
electronic evidence capabilities and increase special agent support 
staff;
      $36 million and 207 FTEs to combat corporate abusive tax 
shelters by devoting more resources to reviewing offshore transactions;
      $15.5 million and 175 FTEs to increase individual 
taxpayer compliance by focusing on the full spectrum of individual 
taxpayer noncompliance, including nonfilers, nonpayers of tax owed, and 
more tax assessments on underreported income; and
      $15.1 million and 144 FTEs to combat diversions of 
charitable assets and stop abusive transactions in the tax-exempt area 
by focusing on terrorism funding and civil fraud by charities, and 
targeting tax avoidance strategies by charities.

    IRS is proposing to spend $373 million to maintain current 
operations, which would cover increased costs of continuing current 
operations. The increased costs include $133 million for salary 
increases assumed in IRS's budget. IRS's 2005 budget assumes a federal 
salary increase of 1.5 percent. If the actual federal salary increase 
is higher than 1.5 percent, IRS will have to cover the unbudgeted 
portion of the increase.
    For 2005, IRS has identified $110.8 million in savings to be 
generated from process and system improvements. Key savings initiatives 
include:

      $34.0 million and 408 FTEs from a reorganization of the 
information systems function that will consolidate three parallel 
organizations, and reduce staff, to improve operations and support to 
IRS customers;
      $15.7 million and 220 FTEs from consolidating insolvency 
and exam/collection field support from over 80 to 5 or fewer locations;
      $14.9 million and 167 FTEs from the termination of 
transition employees who could not be placed when offices closed and 
jobs shifted when IRS's reorganization into business units; and
      $5.1 million and 130 FTEs due to more electronic filing.

    In addition to the savings, IRS has identified $149.7 million in 
program reductions to help fund its 2005 spending priorities. The 
reductions include $102.7 million due to reductions in the scope of 
certain BSM projects (discussed later in more detail) and $18 million 
in overhead reductions.

Recent History Suggests Increasing Enforcement Staffing May Be 
        Difficult
    In its last five budget requests, IRS has asked for more 
enforcement staff, to be funded partly by budget increases and partly 
through internal savings. Despite budget requests that were almost 
fully funded and despite achieving some savings, the number of skilled 
enforcement staff actually declined. The budget increases and savings 
were consumed by other priorities including unbudgeted expenses.

IRS's Recent Budget Requests Were Almost Fully Funded, and Some Savings 
        Were Achieved
    Table 1 shows that IRS has received almost 98 percent or more of 
its budget requests since fiscal year 2002.

          Table 1: IRS's requested and approved budget for fiscal years 2002 through 2005 (in millions)
----------------------------------------------------------------------------------------------------------------
                                                                                                   Fiscal Year
                                                Fiscal Year      Fiscal Year      Fiscal Year          2005
                                               2002  (Actual)   2003  (Actual)    2004  (est.)     (Requested)
----------------------------------------------------------------------------------------------------------------
Requested budget                                      $9,422           $9,916          $10,437          $10,674
----------------------------------------------------------------------------------------------------------------
Budget approved                                        9,437            9,835           10,185
----------------------------------------------------------------------------------------------------------------
Source: IRS data.

    Table 2 shows that in 2003 IRS realized about 34 percent of its 
anticipated budget savings and about 41 percent of its anticipated 
staff savings. In 2004, IRS officials believe they did a better job in 
both estimating and tracking the savings and estimate they will be able 
to reinvest 77 percent of the anticipated budget savings and 53 percent 
of the anticipated staff savings.\2\
---------------------------------------------------------------------------
    \2\ Although IRS officials were able to produce more complete 
supporting documentation on cost estimates and savings justifications 
than for fiscal year 2004, we were unable to verify actual IRS claims 
on savings and reinvestments. IRS's budget office generally accepts the 
savings and reinvestment data claimed by various IRS operating 
divisions, and reduces the budget allocation of the unit that 
identified the savings. If expected savings do not materialize, the 
operating division must either find a way to make up the savings 
elsewhere with new efficiencies, reduce expected expenditures, or 
petition for additional resources from other parts of the organization.

    Table 2: IRS's reported actual and estimated savings and reinvestments for fiscal year 2003 and 2004 (In
                                                    millions)
----------------------------------------------------------------------------------------------------------------
                                             Fiscal Year 2003        Fiscal Year 2004     Fiscal Year 2005 (est)
                                         -----------------------------------------------------------------------
                                                         Staff                   Staff                   Staff
                                            Dollars     Levels      Dollars     Levels      Dollars     Levels
----------------------------------------------------------------------------------------------------------------
Savingsa
----------------------------------------------------------------------------------------------------------------
Budgeted                                      157.8       2,287       166.5       2,145       110.8       1,442
----------------------------------------------------------------------------------------------------------------
Actual                                         53.4         944       113.0       1,120
----------------------------------------------------------------------------------------------------------------
Percentage of actualb                           34%         41%         68%         53%
----------------------------------------------------------------------------------------------------------------
Reinvestmentsa
----------------------------------------------------------------------------------------------------------------
Projected                                     157.8       1,830       166.5         649       110.8         712
----------------------------------------------------------------------------------------------------------------
Actual                                         47.4        2 39        99.5         259
----------------------------------------------------------------------------------------------------------------
Percentage of actualb                           30%         13%         77%         53%
----------------------------------------------------------------------------------------------------------------
Source: GAO analysis of IRS data.
a IRS considers savings to be gained through process or systems improvements and reinvestments to be those
  savings that were realized and available for other purposes.
b IRS reported actuals for 2003 and end of year projections for 2004.

    IRS should be commended for identifying saving and reinvestment 
opportunities in its budget request. While IRS has been unable to 
achieve its savings targets, we recognize that budget preparation 
begins about 18 months before the beginning of the fiscal year, making 
it difficult to accurately predict future savings. IRS officials 
believe they are doing a better job both estimating and tracking 
savings. Nevertheless, IRS's history raises questions about its ability 
to achieve the 2005 savings targets.

IRS Has Been Unable to Achieve Increases In Enforcement Staffing in 
        Recent Years
    Despite budget requests that were almost fully funded, and despite 
realizing some savings, IRS has been unable to achieve the enforcement 
staffing increases projected in its recent budgets.
    As shown in figure 1, the number of revenue agents (those who audit 
complex returns), revenue officers, (those who do field collection 
work), and special agents (those who performed criminal investigations) 
has decreased over 21 percent between 1998 and 2003.

Figure 1: Revenue agents, revenue officers, and special agents, fiscal 
                            years 1998-2003

[GRAPHIC] [TIFF OMITTED] T3828A.001

    The Large--and Mid-size Business (LMSB) operating division, 
responsible for combating abusive corporate tax shelters and assuring 
that large businesses are in compliance with the tax laws, is an 
example of these staffing trends. According to LMSB officials, at the 
beginning of fiscal year 2002, they had 5,047 revenue agents on board. 
This was reduced to 4,431 at the beginning of fiscal year 2004--a 12 
percent reduction--due to attrition and the inability to hire.
    The declines in enforcement staff have been associated with 
declines in enforcement efforts. For example, audit rates are below the 
levels of the mid-1990s, even after accounting for recent increases. 
Figure 2 shows the trend in total audits of individual taxpayers since 
1993. Total audits includes both face-to-face audits and less complex 
correspondence audits. IRS and GAO have reported \3\ that IRS has 
experienced steep declines in audit rates since 1996, although the 
audit rate has slowly increased since 2000.
---------------------------------------------------------------------------
    \3\ U.S. General Accounting Office, Tax Administration: IRS Should 
Continue to Expand Reporting on Its Enforcement Efforts, GAO-03-378, 
(Washington, D.C.: Jan. 31, 2003).
---------------------------------------------------------------------------

 Figure 2: Audit rate individual income tax returns, fiscal year 1993-
                                  2003

[GRAPHIC] [TIFF OMITTED] T3828A.002

    The link between the decline in enforcement staff and the decline 
in enforcement actions, such as audit rates, is complicated by other 
factors, such as changes over time in the mix of complex and simple 
enforcement actions. However, IRS officials have stated that the 
decline in enforcement staff has restricted their enforcement efforts. 
For example, LMSB officials stated that they hired about 200 fewer 
revenue agents than planned in fiscal year 2003 and expect to hire 
about 95 fewer in fiscal year 2004 because of budget constraints. They 
estimated that had this hiring occurred as planned, LMSB could have 
examined an additional 505 returns and 1,877 returns in fiscal years 
2003 and 2004 respectively. In addition, the 2005 budget request 
attributes the decline in enforcement actions to the decline in 
enforcement staff.
    The impact of the recent declines in enforcement staffing and 
enforcement actions on taxpayers' rate of voluntary compliance is not 
known. This leaves open the question of whether these declines are 
eroding taxpayers' incentives to voluntarily comply. As we have 
reported,\4\ the IRS's National Research Program (NRP), which is 
developing new estimates of taxpayer compliance, is underway. These 
estimates will be the first based on data more recent than 1988, when 
IRS last measured voluntary compliance. According to IRS officials the 
new estimates should be available in 2005. Until the NRP estimates are 
available, IRS lacks current data on compliance including changes in 
taxpayers' compliance rate.
---------------------------------------------------------------------------
    \4\ U.S. General Accounting Office, Tax Administration: IRS is 
Implementing the National Research Program as Planned, GAO-03-614, 
(Washington, D.C.: June 16, 2003).
---------------------------------------------------------------------------
    NRP is important for several reasons beyond measuring compliance. 
It is intended to help IRS better target its enforcement actions, such 
as audits, on non-compliant taxpayers, and minimize audits of compliant 
taxpayers. It could also help IRS better understand the impact of 
taxpayer service on compliance.

Other IRS Priorities Have Consumed Recent Budget Increases and Savings
    Priorities other than enforcement, including unbudgeted expenses 
and taxpayer service, have consumed IRS's budget increases and savings 
over the last few years. Unbudgeted expenses include unfunded portions 
of the annual pay increases, that can be substantial given IRS's large 
workforce, and other costs, such as postage increases and higher-than-
budgeted rent increases. According to IRS officials, these unbudgeted 
expenses accounted for

      $154 million of IRS's budget in 2002;
      $311 million of IRS's budget in 2003; and
      $169 million of IRS's budget in 2004.

    IRS officials also told us that they anticipate having to cover 
unbudgeted expenses in 2005. As of March 2004, they were projecting 
unbudgeted salary increases for fiscal year 2005 of at least $100 
million. This projection could change since the actual federal salary 
increase for 2005 has not been finalized.
    Another reason for the reduction in enforcement staff has been 
IRS's emphasis on improving service to taxpayers. According to IRS 
officials, much of this improvement has been at the expense of 
additional resources for enforcement and has resulted in less hiring of 
new staff for enforcement activities.

IRS's Information Technology Budget Includes Funding For BSM and 
        Information Systems
    IRS is requesting about $1.93 billion (including 7,385 staff years) 
in information technology (IT) resources for fiscal year 2005. This 
includes (1) $285 million for the agency's multiyear capital account 
that funds contractor costs for the Business Systems Modernization 
(BSM) program and (2) about $1.64 billion for information systems, of 
which $1.55 billion (including 7,137 staff years) are for operations 
and maintenance. BSM is important for IRS's future because it has the 
potential for long-term efficiency gains without major increases in 
staffing or other resources.

Fiscal Year 2005 BSM Request Developed Consistent with Federal Guidance
    Consistent with the Clinger-Cohen Act of 1996 \5\ and the 
Government Performance and Results Act of 1993,\6\ OMB guidance on 
budget preparation and submission \7\ require that, before requesting 
multiyear funding for capital asset acquisitions, agencies develop 
sufficient justification for these investments. The guidance requires 
that agencies implement key IT management practices, including an 
integrated IT architecture and a process for managing information 
systems projects as investments. In addition, agencies are to prepare 
business cases that reasonably demonstrate how proposed investments 
support agency missions and operations, and provide positive business 
value in terms of expected costs, benefits, and risks.
---------------------------------------------------------------------------
    \5\ This fiscal year 1997 Omnibus Consolidated Appropriations Act, 
Pub. L. 104-208, renamed both Division D (the Federal Acquisition 
Reform Act) and E (the Information Technology Management Reform Act) of 
the 1996 Department of Defense Authorization Act, Pub. L. 104-106, as 
the Clinger Cohen Act of 1996.
    \6\ P.L. 103-62.
    \7\ See, for example, Office of Management and Budget, Preparing, 
Submitting, and Executing the Budget, Circular No. A-11 (Washington, 
D.C.: July 25, 2003).
---------------------------------------------------------------------------
    Beginning in 1995, when IRS was involved in an earlier attempt to 
modernize its tax processing systems, and continuing since then, we 
have made recommendations \8\ that IRS implement fundamental 
modernization management capabilities before acquiring new systems. We 
recommended, among other things, that IRS (1) put in place an 
enterprise architecture \9\ (modernization blueprint) to guide and 
constrain its business system investments, and (2) implement 
disciplined processes for investment decision management and system 
development management.
---------------------------------------------------------------------------
    \8\ See U.S. General Accounting Office, Tax Systems Modernization: 
Management and Technical Weaknesses Must Be Corrected If Modernization 
Is to Succeed, GAO/AIMD-95-156 (Washington, D.C.: July 26, 1995); Tax 
Administration: IRS' Fiscal Year 1997 Spending, 1997 Filing Season, and 
Fiscal 1998 Budget Request, GAO/T-GGD/AIMD-97-66 (Washington, D.C.: 
March 18, 1997); Tax Systems Modernization: Blueprint is a Good Start 
But Not Yet Sufficiently Complete to Build or Acquire Systems, GAO/
AIMD/GGD-98-54 (Washington, D.C.: February 24, 1998); and Tax 
Administration: IRS' 2000 Tax Filing Season and Fiscal Year 2001 Budget 
Request, GAO/T-GGD/AIMD-00-133 (Washington, D.C.: March 28, 2000).
    \9\ An enterprise architecture provides an institutional 
``blueprint'' for defining how an organization operates today (baseline 
environment) in both business and technological terms, and how it wants 
to operate in the future (target environment). It also includes a 
sequencing plan that provides a road map for transitioning between 
these environments.
---------------------------------------------------------------------------
    In response to our recommendations, IRS developed and is using an 
enterprise architecture, which describes IRS's current and target 
business and technology environments, and the associated high-level 
transition strategy that identifies and conceptually justifies needed 
investments to guide the agency's transition over many years from its 
current to its target architectural state. In addition, IRS also 
implemented a capital planning and investment control process for 
developing business cases and managing BSM projects as part of an 
investment portfolio, as well as a systems life cycle management 
methodology, which IRS refers to as the enterprise life cycle.
    IRS's $285 million request for the BSM account for fiscal year 2005 
is based on its enterprise architecture as well as its related 
investment management process and life cycle management methodology. 
IRS's BSM budget request constitutes a reduction of greater than 25 
percent from the planned fiscal year 2004 spending level of $388 
million, and reflects the agency's decision, in light of ongoing 
project delays, to focus on a smaller modernization project portfolio 
in an effort to better ensure cost targets are maintained, project 
schedules are met, and the promised projects are delivered.

BSM Management Controls Improved, But Weaknesses Remain
    Pursuant to statute,\10\ funds from the BSM account are not 
available for obligation until IRS submits to the congressional 
appropriations committees for approval an expenditure plan that meets 
certain conditions.\11\ In January 2004, IRS submitted an expenditure 
plan seeking approval to obligate funds from the BSM account for its 
planned fiscal year 2004 projects and program-level initiatives. IRS's 
fiscal year 2004 plan reported the deployment of modernization projects 
during fiscal year 2003 that have benefited taxpayers and the agency, 
including an application that provides refund status for the advanced 
child tax credit and the first release of a new human resources system, 
HR Connect, which has now been delivered to 73,000 IRS employees.
---------------------------------------------------------------------------
    \10\ P.L. 108-199, Div. F, Title II, Jan. 23, 2004.
    \11\ IRS's BSM expenditure plans are required to (1) meet the 
capital planning and investment control review requirements established 
by OMB, (2) comply with IRS's enterprise architecture, (3) conform with 
IRS's enterprise life cycle methodology, (4) be approved by IRS, 
Treasury, and OMB, (5) be reviewed by GAO, and (6) comply with federal 
acquisition rules, requirements, guidelines, and systems acquisition 
management practices.
---------------------------------------------------------------------------
    In our briefing to the staff of the relevant appropriations 
subcommittees on the results of our review of the fiscal year 2004 
expenditure plan, we reported that IRS has made progress in 
implementing our prior recommendations to improve its modernization 
management controls and capabilities. However, certain of these 
controls and capabilities related to configuration management, human 
capital management, cost and schedule estimating, and contract 
management have not yet been fully implemented or institutionalized. 
Our analysis has shown that weaknesses in these controls and 
capabilities have contributed, at least in part, to cost and schedule 
shortfalls experienced by most BSM projects. In the absence of 
appropriate management controls, systems modernization projects will 
likely be hampered by additional costs and schedule shortfalls. The 
reasons are twofold: the tasks associated with those projects that are 
moving beyond design and into development are, by their nature, more 
complex and risky. Also, the fiscal year 2004 expenditure plan supports 
progress toward the later, more complex phases of key projects as well 
as continued development of other projects.

BSM Projects Continue to Incur Cost Increases and Schedule Delays
    Based on IRS's expenditure plans, BSM projects have consistently 
cost more and taken longer to complete than originally estimated. In 
its fiscal year 2004 plan, IRS disclosed that key BSM projects have 
continued to experience cost and schedule shortfalls against prior 
commitments. Table 4 shows the life cycle variance in cost and schedule 
estimates for completed and ongoing BSM projects. These variances are 
based on a comparison of IRS's initial and revised cost and schedule 
estimates to complete initial operation \12\ or full deployment \13\ of 
the projects. We did not independently validate planned projects' cost 
estimates or confirm, through system and project management 
documentation, the validity of IRS-provided information on the 
projects' content and progress.
---------------------------------------------------------------------------
    \12\ Initial operation refers to the point at which a project is 
authorized to begin enterprisewide deployment.
    \13\ Full deployment refers to the point at which enterprisewide 
deployment has been completed and a project is transitioned to 
operations and support.

   Table 4: IRS BSM project life cycle cost/schedule variance and benefits summary for completed and on-going
                                                    projects
----------------------------------------------------------------------------------------------------------------
                                                    Reported/
                                          Cost       revised    Schedule     Reported/
               Project                  variance    estimated   variance      revised      Reported IRS/taxpayer
                                           (in      cost (in      (in        estimated            benefits
                                       thousands)  thousands)   months)   completion date
----------------------------------------------------------------------------------------------------------------
Completed Projects
----------------------------------------------------------------------------------------------------------------
Security and Technology                   +$7,553     $41,287         +5         1/31/02               Provides
 Infrastructure Release 1............                                           (initial     infrastructure for
                                                                              operation)   secure telephony and
                                                                                                     electronic
                                                                                           interaction among IRS
                                                                                                 employees, tax
                                                                                             practitioners, and
                                                                                                     taxpayers.
----------------------------------------------------------------------------------------------------------------
Customer Communications 2001.........      +5,310      46,420         +9   2/26/02 (full               Improves
                                                                             deployment)     telecommunications
                                                                                                infrastructure,
                                                                                            including telephone
                                                                                           call management, call
                                                                                           routing, and customer
                                                                                                   self-service
                                                                                                  applications.
----------------------------------------------------------------------------------------------------------------
Customer Relationship Management Exam      -1,938       7,375         +3   9/30/02 (full   Provides commercial-
                                                                             deployment)          off-the-shelf
                                                                                                software to IRS
                                                                                              revenue agents to
                                                                                                  allow them to
                                                                                             accurately compute
                                                                                              complex corporate
                                                                                                  transactions.
----------------------------------------------------------------------------------------------------------------
Human Resources ConnectRelease 1.....        +200      10,200          0        12/31/02   Allows IRS employees
                                                                                (initial   to access and manage
                                                                              operation)   their human resources
                                                                                            information online.
----------------------------------------------------------------------------------------------------------------
Internet Refund/ Fact of Filing......     +12,923      26,432        +14   9/26/03 (full       Provides instant
                                                                             deployment)          refund status
                                                                                                information and
                                                                                               instructions for
                                                                                               resolving refund
                                                                                           problems to taxpayers
                                                                                           with Internet access.
----------------------------------------------------------------------------------------------------------------
Ongoing Projectsa
----------------------------------------------------------------------------------------------------------------
Modernizede-File Release 1...........     +17,057      46,303       +4.5        3/31/04b      Provides a single
                                                                                (initial    standard for filing
                                                                              operation)         electronic tax
                                                                                                       returns.
----------------------------------------------------------------------------------------------------------------
e-Services                                +86,236     130,281        +18   4/30/05 (full   Provides a Web portal
                                                                             deployment)   and other e-Services
                                                                                            to promote the goal
                                                                                             of conducting most
                                                                                           IRS transactions with
                                                                                              taxpayers and tax
                                                                                                  practitioners
                                                                                                electronically.
----------------------------------------------------------------------------------------------------------------
Customer Account Data Engine--            +36,760      97,905       +30c  6/30/05c (full           Provides the
 Individual Master File Release 1....                                        deployment)    modernized database
                                                                                                  foundation to
                                                                                             eventually replace
                                                                                                   the existing
                                                                                              individual master
                                                                                                file processing
                                                                                           systems. Facilitates
                                                                                                  faster refund
                                                                                            processing and more
                                                                                             timely response to
                                                                                             taxpayer inquiries
                                                                                                for Form 1040EZ
                                                                                                        filers.
----------------------------------------------------------------------------------------------------------------
Integrated Financial System Release 1     +53,916     153,786       TBDc      TBDc (full      Provides a single
                                                                             deployment)     general ledger for
                                                                                                  custodial and
                                                                                           financial data and a
                                                                                           platform to integrate
                                                                                            core financial data
                                                                                                   with budget,
                                                                                           performance, and cost
                                                                                               accounting data.
----------------------------------------------------------------------------------------------------------------
Custodial Accounting Project Release      +72,058     119,219       TBDc      TBDc (full    Provides integrated
 1...................................                                        deployment)     tax operations and
                                                                                            internal management
                                                                                                 information to
                                                                                               support evolving
                                                                                            decision analytics,
                                                                                                    performance
                                                                                               measurement, and
                                                                                                     management
                                                                                             information needs.
----------------------------------------------------------------------------------------------------------------
Source: GAO analysis of data contained in IRS's BSM expenditure plans. a Projects ongoing as of 9/30/03. b IRS
  subsequently reported that Modernized e-File began initial operation on 2/23/04. c Project schedules for the
  Customer Account Data Engine, the Integrated Financial System, and the Custodial Accounting Project are
  currently under review.

    As the table indicates, the cost and schedule estimates for full 
deployment of the e-Services project have increased by just over $86 
million and 18 months, respectively, which included a significant 
expansion from the initial project scope. In addition, the estimated 
cost for the full deployment of Customer Account Data Engine (CADE) 
Release 1 has increased by almost $37 million, and project completion 
has been delayed by 30 months. In addition to the modernization 
management control shortcomings discussed above, our work has shown 
that the increases and delays were caused, in part, by

      inadequate definitions of systems requirements. As a 
result, additional requirements have been incorporated into ongoing 
projects.
      increases in project scope. For example, the e-Services 
project has changed significantly since the original design. The scope 
was broadened by IRS to provide additional benefits to internal and 
external customers.
      underestimating project complexity. This factor has 
contributed directly to the significant delays in the CADE release 1 
schedule.
      competing demands of projects for test facilities. 
Testing infrastructure capacity is insufficient to accommodate multiple 
projects when testing schedules overlap.
      project interdependencies. Delays with one project have 
had a cascading effect and have caused delays in related projects.

    These cost overruns and schedule delays impair IRS's ability to 
make appropriate decisions about investing in new projects, delay 
delivery of benefits to taxpayers, and postpone resolution of material 
weaknesses affecting other program areas.
    Producing reliable estimates of expected costs and schedules is 
essential to determining a project's cost-effectiveness. In addition, 
it is critical for budgeting, management, and oversight. Without this 
information, the likelihood of poor investment decisions is increased.
    Schedule slippages delay the provision of modernized systems' 
direct benefits to the public. For example, as table 4 shows, slippages 
in CADE will delay IRS's ability to provide faster refunds and respond 
to taxpayer inquiries on a timely basis.
    Delays in the delivery of modernized systems also affect the 
remediation of material internal management weaknesses. For example, 
the Custodial Accounting Project is intended to address a material 
weakness in IRS's financial reporting process and provide a mechanism 
for tracking and summarizing individual taxpayer transactions. This 
release has yet to be implemented, and a revised schedule has not yet 
been determined. In addition, the Integrated Financial System is 
intended to address financial management reporting weaknesses. When IRS 
submitted its fiscal year 2003 BSM expenditure plan, Release 1 of the 
Integrated Financial System was scheduled for delivery on October 1, 
2003. However, it has yet to be implemented, and additional cost 
increases are expected.
IRS Is Acting to Resolve Issues Identified in Recent BSM Assessments
    Given the continued cost overruns and schedule delays experienced 
by these BSM projects, IRS and the prime systems integration support 
(PRIME) contractor, Computer Sciences Corporation (CSC), initiated and 
recently completed several in-depth and more comprehensive assessments 
of BSM. These assessments revealed several significant weaknesses that 
have driven project cost overruns and schedule delays and also provided 
a number of recommendations for IRS and CSC to address the identified 
weaknesses and reduce the risk to BSM. The deficiencies identified are 
consistent with our prior findings. IRS developed a BSM action plan to 
address the findings and recommendations resulting from these 
assessments. IRS expects to complete implementation of its actions by 
the end of the calendar year. Because of the significant risks 
associated with the findings of these various assessments, continued 
monitoring by IRS and validation of the effectiveness of corrective 
actions is critical to reducing the likelihood of additional cost 
overruns and schedule delays.
    It will be important for IRS to continue its efforts to balance the 
scope and pace of the program with the agency's capacity to handle the 
workload, and to institutionalize the management processes and controls 
necessary to resolve the deficiencies identified by our reviews and the 
recent program assessments. Meeting these challenges and improving 
performance are essential if IRS and the PRIME contractor are to 
successfully deliver the BSM program.

Continued Efforts Needed to Strengthen Information Systems Budget 
        Request Development Process
    The Paperwork Reduction Act (PRA) \14\ requires federal agencies to 
be accountable for their IT investments and responsible for maximizing 
the value and managing the risks of their major information systems 
initiatives. The Clinger-Cohen Act of 1996 \15\ establishes a more 
definitive framework for implementing the PRA's requirements for IT 
investment management. It requires federal agencies to focus more on 
the results they have achieved and introduces more rigor and structure 
into how agencies are to select and manage IT projects.
---------------------------------------------------------------------------
    \14\ 44 U.S.C.  3506(h).
    \15\ P.L. 104-106.
---------------------------------------------------------------------------
    Leading private--and public-sector organizations have taken a 
project--or system-centric approach to managing not only new 
investments but also operations and maintenance of existing systems. As 
such, these organizations

      identify operations and maintenance projects and systems 
for inclusion in budget requests;
      assess these projects or systems on the basis of expected 
costs, benefits and risks to the organization;
      analyze these projects as a portfolio of competing 
funding options; and
      use this information to develop and support budget 
requests.

    This focus on projects, their outcomes, and risks as the basic 
elements of analysis and decision-making is incorporated in the IT 
investment management approach that is recommended by OMB and GAO.\16\ 
By using these proven investment management approaches for budget 
formulation, agencies have a systematic method, on the basis of risk 
and return on investment, to justify what are typically very 
substantial information systems operations and maintenance budget 
requests.
---------------------------------------------------------------------------
    \16\ See, for example, U.S. General Accounting Office, Information 
Technology Investment Management: A Framework for Assessing and 
Improving Process Maturity, GAO-04-394G (Washington, D.C.: March 2004, 
Version 1.1).
---------------------------------------------------------------------------
    In our assessment of IRS's fiscal year 2003 budget request, we 
reported that the agency did not develop its information systems 
operations and maintenance request in accordance with the investment 
management approach used by leading organizations. We recommended that 
IRS prepare its future budget requests in accordance with these best 
practices.\17\ To address our recommendation, IRS agreed to take the 
following actions:
---------------------------------------------------------------------------
    \17\ U.S. General Accounting Office, Internal Revenue Service: 
Assessment of Budget Request for Fiscal Year 2003 and Interim Results 
of 2002 Tax Filing Season, GAO-02-580T (Washington, D.C.: Apr. 9, 2002) 
and Internal Revenue Service: Improving Adequacy of Information Systems 
Budget Justification, GAO-02-704 (Washington, D.C.: June 28, 2002).

      develop an activity-based cost model to plan, project, 
and report costs for business tasks/activities funded by the 
information systems budget;
      develop a capital planning guide to implement processes 
for capital planning and investment control, budget formulation and 
execution, business case development, and project prioritization; and
      implement a process for managing all information systems 
investments as a portfolio, patterned after the BSM program.

    IRS has made progress in implementing investment management best 
practices in developing and supporting its information systems budget 
request. IRS officials reported that the agency is managing all 
information systems funding requirements as a portfolio within 
Treasury's IT investment portfolio system, and preparing business cases 
for many of its operational program activities, as required by OMB. 
According to IRS, these business cases are updated on a periodic basis 
and are evaluated within the context of the agency's overall IT funding 
portfolio. IRS plans to align this portfolio management process with 
the capital planning and investment control system now being 
implemented to provide a uniform process to select, manage, and control 
all IT investments, including modernization, enhancements, and 
sustaining operations.
    Although progress has been made, IRS has not yet completed all of 
its planned actions to implement our prior recommendation. Completion 
of IRS's capital planning and investment control guide has been delayed 
due to changing roles and responsibilities within the Modernization and 
Information Technology Services organization, and thus was not used in 
preparing the fiscal year 2005 information systems budget request. 
According to IRS, the capital planning guidance will not be completed 
until September 2004. In addition, as of March 2004, IRS has not yet 
developed an activity-based cost accounting system to enable it to 
account for the full cost of operations and maintenance projects and 
determine how effectively IRS projects are achieving program goals and 
mission needs. This cost model, which is being developed in conjunction 
with the Integrated Financial System modernization project, has been 
delayed, and due to Integrated Financial System schedule delays, will 
not be available until the fiscal year 2008 budget formulation cycle. 
Until IRS implements the capital planning and investment control 
guidance and the activity-based cost model and incorporates them into 
the preparation of its information systems budget request, the agency 
will not be able to ensure that the information systems operations and 
maintenance request is adequately supported.

Interim Results Of IRS's 2004 Filing Season Show Improvement Except In 
        Telephone Accuracy
    IRS's filing season performance through mid-March has improved in 
most areas compared to recent years, based on data we reviewed on five 
key filing season activities--paper and electronic processing, 
telephone assistance, IRS's Web site, and walk-in assistance. However, 
the accuracy of tax law answers provided by IRS telephone staff 
declined. Although we cannot quantify the connection between these 
improvements and IRS's actions, they appear to represent a payoff from 
IRS's modernization and an increased emphasis on service since the IRS 
Restructuring and Reform Act of 1998.\18\
---------------------------------------------------------------------------
    \18\ P.L. 105-206.
---------------------------------------------------------------------------
    Table 5 summarizes IRS's filing season performance so far this year 
compared to recent years. The following sections will address IRS's 
specific performance in key areas.

  Table 5: IRS performance in the first weeks of the 2002 through 2004
                             filing seasons
------------------------------------------------------------------------
      Volume in thousands           2002          2003          2004
------------------------------------------------------------------------
Actual returns processeda
------------------------------------------------------------------------
Paper                                 24,491        22,117        20,232
------------------------------------------------------------------------
Electronic                            35,067        38,627        42,988
------------------------------------------------------------------------
Telephone assistance
------------------------------------------------------------------------
Total callsb                          34,489        27,905        29,058
------------------------------------------------------------------------
Answered by assistors                  9,208         9,434        10,116
------------------------------------------------------------------------
Answered by automation                25,281        18,471        18,942
------------------------------------------------------------------------
Customer service                         62%           82%           84%
 representative level of
 service
------------------------------------------------------------------------
Accounts customer accuracy        88% +/- 1%    88% +/- 1%    89% +/- 1%
 rate estimatesc
------------------------------------------------------------------------
Tax law customer accuracy rate    84% +/- 1%    81% +/- 1%    76% +/- 1%
 estimatesc
------------------------------------------------------------------------
Internet assistance
------------------------------------------------------------------------
Forms and publications               158,000       195,000       205,000
 downloadedd
------------------------------------------------------------------------
Refund status inquiriese                 N/A         9,300        14,300
------------------------------------------------------------------------
Child Tax Credit inquiriesf              N/A           N/A         8,500
------------------------------------------------------------------------
Walk-in assistance
------------------------------------------------------------------------
Total Walk-in Contactsg                  N/A         2,740         2,433
------------------------------------------------------------------------
Returns prepared at IRS walk-            436           291           186
 in sitesh
------------------------------------------------------------------------
Returns prepared at volunteer            466           594           737
 sitesj
------------------------------------------------------------------------
Source: IRS Data.
a From January 1 to March 22, 2002, January 1 to March 21, 2003, and
  January 1 to March 19, 2004.
b Total calls, calls answered by assistors and automation, and CSR level
  of service are based on actual counts from January 1 to March 16,
  2002, January 1 to March 15, 2003, and January 1 to March 13, 2004.
  2002 totals include increased call demand as a result of the Economic
  Growth and Tax Relief and Reconciliation Act of 2001 (P.L.107-16).
  Employer Identification Number data has been added to 2002 and 2003 to
  ensure valid data comparisons can be made to 2004 which includes
  Employer Identification Numbers.
c Based on a representative sample estimated at the 90 percent
  confidence level from January to February 2002, 2003 and 2004.
d From January 1 to February 28, 2002, January 1 to February 28, 2003,
  and January 1 to February 29, 2004.
e From January 1 to March 20, 2003, and January 1 to March 20, 2004.
f From January 1 to March 21, 2004.
g From January 1 to March 15, 2003, and January 1 to March 13, 2004.
h From January 1 to March 16, 2002, January 1 to March 15, 2003, and
  January 1 to March 13, 2004.
i From January 1 to March 9, 2002, January 1 to March 8, 2003, and
  January 1 to March 6, 2004.

IRS's Processing Operations Have Gone Smoothly, and Electronic Filing 
        Continues to Grow, But Not at Rate to Meet 2007 Goal
    According to IRS officials, tax industry representatives and data 
reviewed, the 2004 filing season is progressing smoothly (meaning 
without disruptions in IRS computer systems used in processing that 
would have a negative impact on taxpayers) and IRS is either meeting or 
exceeding its goals for the number of days to process an individual 
income tax returns, depending on the type of return. As table 5 shows, 
through March 19, 2004, IRS has processed about 63 million individual 
tax returns--of which 43 million were received electronically, which is 
about 4.4 million more electronically filed returns than this time last 
year. IRS officials have attributed this year's performance, in part, 
to having planned appropriately for issues such as correcting errors 
related to the advanced child tax credit. Through March 12, 2004, IRS 
had identified about 2.7 million individual tax returns with errors, 
with approximately 1.6 million related to the advanced child tax 
credit.\19\
---------------------------------------------------------------------------
    \19\ In 2003, the IRS, through Financial Management Service, issued 
advanced child tax credit payments to more than 25 million taxpayers in 
a manner similar to the 86 million advance refund checks issued in 
2001. See U.S. General Accounting Office, Tax Administration: IRS 
Issued Advance Child Tax Credit Payments on Time, but Should Study 
Lessons Learned, GAO-04-372 (Washington, D.C.: Feb. 17, 2004).
---------------------------------------------------------------------------
    Electronic filing has grown from the same time last year. It has 
also grown by about 250 percent overall--from about 15 million returns 
in 1996 to about 53 million in 2003. Although electronic filing 
continues to grow, IRS is not on track to reach the long-term 
electronic filing goal of 80 percent by 2007 set by Congress in the IRS 
Restructuring and Reform Act of 1998.\20\ IRS officials recognizes that 
they will not achieve the goal of having 80 percent of all individual 
income tax returns filed electronically by 2007. However, IRS officials 
told us they will continue to strive to achieve that goal in the 
future. Moreover, as we reported last year,\21\ the growth rate from 
1996 through 2003 has been generally decreasing, with the 13 percent 
growth rate in 2003 representing the smallest percentage increase in 
the number of individual tax returns filed electronically since 
1996.\22\ Although the current growth rate is about 11 percent, 
according to IRS officials, the number of electronic filings is ahead 
of their estimates at this time. Consequently, IRS officials believe 
IRS will meet and might exceed the annual growth rate goal of 12 
percent by the year's end.
---------------------------------------------------------------------------
    \20\ P.L. 105-206.
    \21\ U.S. General Accounting Office, Internal Revenue Service: 
Assessment of Fiscal Year 2004 Budget Request and 2003 Filing Season 
Performance to Date, GAO-03-641T (Washington, D.C.: Apr. 8, 2003).
    \22\ Some slowing of the growth rate might be expected because, for 
example, taxpayers most easily attracted to electronic filing have 
already been converted.
---------------------------------------------------------------------------

 Figure 3: Growth rate in the number of individual income tax returns 
                    filed electronically 1996--2004

[GRAPHIC] [TIFF OMITTED] T3828A.003

    Note: For 2004, the growth rate compares to the number of returns 
filed electronically as of March 12, 2004 to the same period in 2003.

    Growth in electronic filing remains a key part of IRS's 
modernization strategy. Electronic filing has allowed IRS to reduce 
resources devoted to processing (discussed in appendix I) and begin 
consolidating paper processing centers. It also reduces errors because 
IRS would not have to transcribe tax returns information and some up-
front checks are built into electronic filing. Finally, taxpayers get 
refunds quicker with electronic filing--IRS's goal for refunds for 
electronically filed returns is about half the 40 days that IRS allows 
for refunds for returns filed on paper.
    IRS has implemented numerous initiatives over the years intended to 
increase electronic filing usage. IRS's new major electronic filing 
initiatives this year are related to business not individual income tax 
returns. They are modernized E-File, which allows the electronic filing 
of corporate income tax form 1120 and E-Services, which is a suite of 
Internet services offered to tax practitioners such as electronic 
account resolution and transcript delivery. IRS officials do not expect 
these initiatives to dramatically increase electronic filing of 
individual tax returns this year, because taxpayers and practitioners 
will need to adjust their behavior and take advantage of the new 
services. However, these initiatives are important, because they should 
increase the willingness of tax practitioners to file both corporate 
and individual tax returns electronically in future filing seasons, 
which can currently be done only on a limited basis for corporate 
returns.
    IRS made some changes to improve the Free File Alliance \23\ 
program, which began last year to promote electronic filing of 
individual income tax returns. As of March 7, 2004, IRS had received 
almost 2.5 million free file tax returns compared to 2.0 million for 
the same time last year--an increase of 24 percent. One issue with the 
Free File program is that IRS cannot determine how many of the Free 
File users are new electronic filers. We plan to follow up on this 
issue as part of our annual filing season report.
---------------------------------------------------------------------------
    \23\ In 2003 IRS entered into a 3-year-agreement with the Free File 
Alliance, a consortium of tax preparation companies, to provide free 
electronic filing to taxpayers that access any of the companies via a 
link from the IRS Web site. IRS is in the second year of its initiative 
with the Free File Alliance, and there are currently 17 companies that 
are offering free filing via IRS's Web site.
---------------------------------------------------------------------------
Telephone Access Improved Over Last Two Years, While Tax Law Accuracy 
        Declined
    Access to IRS's toll-free telephone lines has improved over the 
last two years, although account accuracy (the accuracy of answers to 
questions from taxpayers about the status of their accounts) has 
stabilized and tax law accuracy declined. As table 5 shows, as of March 
13, 2004, IRS had received 29 million telephone calls. The percentage 
of taxpayers that attempted to reach an assistor and actually got 
through and received service--referred to as the Customer Service 
Representative (CSR) level of service--increased to 84 percent, which 
is 2 percentage points over the same period last year and 22 percentage 
points over the same period in 2002. According to IRS officials, the 
gains in CSR level of service are largely due to continued improvements 
resulting from increased specialization, improved technology, and 
continued focus on maintaining telephone staffing.
    IRS estimates that accounts accuracy is essentially the same this 
year as for the last two years at this time. As shown in table 5, 
taxpayers who called about their accounts received correct information 
an estimated 89 percent of the time in 2004. IRS officials said that 
accounts accuracy rates remained stable, because the accounts workload 
has remained relatively stable.
    At the same time, table 5 shows that IRS estimates that tax law 
accuracy declined from 84 percent in 2002 and 81 percent last year to 
76 percent so this year. IRS officials said that tax law accuracy rates 
declined because formatting changes made in 2003 to the guide CSRs use 
to help them answer questions have not enhanced the usability as IRS 
anticipated. According to IRS, although training was provided to the 
staff for the changes to their assigned subjects, IRS underestimated 
the impact these changes would have on overall quality. Also, IRS 
officials said they have begun redesigning the CSRs' guide and are 
continuing to conduct detailed analysis of quality data to identify 
immediate opportunities to improve the accuracy of service.

Web Site Usage is Increasing, But Concerns About Usability Still Exist
    IRS's Web site use has increased over the last 2 years as shown in 
table 6. Also, an independent Web site rater reported that, for 7 of 
out 10 weeks of the filing season, IRS's Web Site has ranked in the top 
10 out of 40 in a government Web site index for time it took to 
download information.
    Over the last 2 years, IRS has added two features to assist 
taxpayers, which likely contributed to the increased usage of IRS Web 
site. In fiscal year 2003, IRS added the ``Where's My Refund?'' and in 
2004 added ``Remember Your Advanced Child Tax Credit'' features. The 
``Where's My Refund?'' feature enables taxpayers to access IRS's Web 
site to determine if IRS received their tax return, whether their 
refund was processed, and if processed, when approximately to expect 
the refund. Table 5 shows that as of March 20, 2004, the use of this 
feature was up by 53 percent from last year, from about 9.3 million 
attempts to about 14.3 million. The ``Remember Your Advanced Child Tax 
Credit'' enables a person to access IRS's Web site to determine the 
amount of the advanced child tax credit they received. As of March 21, 
2004, about 8.5 million accesses have been made to the ``Remember Your 
Child Tax Credit'' feature.
    Overall we found that IRS's Web site continues to improve when it 
comes to providing services to taxpayers. However, we continue to have 
concerns about the forms and publication search function. We found that 
the forms and publication search function still does not always make 
the most pertinent information readily available. For example, when we 
typed, ``earned income tax credit'' into the forms and publication 
search function, Publication 596--the primary publication on the earned 
income tax credit--was the 79th item on the list and we had to scroll 
through eight pages to find it.
Use of IRS's Walk-in Assistance Sites Continues to Decline
    The number of taxpayers receiving assistance at IRS walk-in sites 
continued to decline. At any one of IRS's over 400 walk-in sites, 
taxpayers get various types of assistance, including answers to tax law 
questions, assistance with their accounts, and return preparation 
assistance (generally for low income taxpayers).
    The number of people who received assistance at an IRS walk-in site 
declined by 11 percent compared to the same period last year. IRS 
continues to restrict free tax preparation services to, for example, 
taxpayers with an annual gross income level of $35,000 or less, because 
of the labor intensive nature of that work and to enable staff to 
concentrate on other services that only IRS can provide such as account 
assistance. IRS reduced the number of staff available for return 
preparation by 20 percent from 2003. As the data in table 5 indicate, 
the number of returns being prepared has decreased by about 36 percent 
over this time last year. These trends are consistent with ones we have 
previously reported for recent filing seasons.\24\
---------------------------------------------------------------------------
    \24\ GAO-04-84.
---------------------------------------------------------------------------
    Figure 4 shows a downward trend in the overall assistance provided 
and in the return preparation at the walk-in sites.

Figure 4: Assistance provided by IRS walk-in and volunteer sites,       
                     2000-2003 filing seasons        

[GRAPHIC] [TIFF OMITTED] T3828A.004

    Notes: Total walk-in figures shows all IRS face-to-face assistance, 
including return preparation, account services, and tax law assistance. 
It does not include the number of taxpayers assisted by walk-in 
employees via telephone or correspondence, which ranged from about 
96,000 in 2000 to over 150,000 in 2003. Total figures do not include 
returns prepared at volunteer sites. The number of returns prepared at 
volunteer sites was not available for the 2000 filing season. The time 
periods covered by this figure each began on January 1 and ended on 
April 22, 2000; April 21, 2001; April 20, 2002; and April 19, 2003.
    Sites staffed by volunteers certified by IRS do not provide the 
range of services IRS provides, such as account assistance, and operate 
primarily during the filing season. IRS is promoting these as 
alternatives to its walk-in assistance sites for certain types of 
service. IRS works to ensure that walk-in sites have a listing of 
services, hours, and locations of the volunteer sites in their area. As 
of March 2004, there are approximate 11,600 volunteer sites. IRS also 
promotes its telephone operations and Web site at its walk-in sites as 
well.
    The quality of tax law assistance \25\ provided at IRS's walk-in 
sites in 2004 was comparable to the same period last year. This 
conclusion is based on TIGTA reviews \26\ through February 2004.
---------------------------------------------------------------------------
    \25\ IRS determines the quality of account assistance after the 
filing season. Only tax law assistance is evaluated during the filing 
season.
    \26\ TIGTA determines tax law accuracy by measuring the percentage 
of correct answers to questions asked during anonymous visits to a 
sample of walk-in sites. Questions were designed by TIGTA to cover a 
range of tax law topics and assess whether taxpayers were receiving 
correct answers to questions that a taxpayer might ask when visiting a 
walk-in site. The TIGTA are statistically valid only for the times and 
the locations within which respondents were surveyed.
---------------------------------------------------------------------------
Concluding Observations
    Congress has been supportive of IRS's efforts to improve service to 
taxpayers and increase enforcement staff and IRS has succeeded at the 
former. However, despite budgets that were almost fully funded and 
realizing savings through efficiency gains, IRS has not been able to 
increase enforcement staff. In fact, staffing of key enforcement 
occupations has declined. The declines in IRS's enforcement staff and 
the related declines in its enforcement efforts raise concerns that 
taxpayers' incentives to voluntarily comply with their tax obligations 
could be eroding.
    Strengthening enforcement programs by increasing staffing while 
providing a high level of taxpayer service will continue to be a 
challenge for IRS. Unbudgeted costs are expected to compete for the 
funds IRS has allocated in its 2005 budget request for new spending 
including the enforcement initiatives. If, as has been the case in 
recent years, IRS fails to realize all expected savings then the funds 
available for new spending would be further reduced.
    One option for increasing enforcement staff in the near-term is to 
reconsider the level and types of service IRS provides to taxpayers. 
Taxpayer services are much improved raising a question about the 
appropriate balance to strike between investing in further service 
improvements and enforcement. At the same time, the use of IRS's walk-
in assistance sites is declining. The improvements in telephone 
service, increased Web site use, and the availability of volunteer 
sites raise a question about whether IRS should continue to operate as 
many walk-in sites. Reconsidering the level and types of service is an 
option--but not a recommendation--to be considered by IRS management 
and the Congress.
    The challenge of increasing IRS's enforcement staff highlights the 
importance of succeeding with NRP and BSM. NRP should, if completed 
successfully, provide the first new data to estimate the voluntary 
compliance rate since IRS last estimated the compliance rate using 1988 
data. The new estimates could have implications for future IRS budgets. 
If compliance rates are comparable to those estimated using 1988 data, 
the pressure to increase IRS' s enforcement staff would likely 
diminish. If, however, compliance rates are down, the pressure to 
increase enforcement staff and the pressure on IRS's budget could 
increase.
    BSM and related initiatives such as electronic filing hold the 
long-term promise of efficiency gains that could allow IRS to improve 
both taxpayer service and enforcement without budget increases. 
However, cost overruns and schedule delays associated with on-going BSM 
projects, along with planned reductions in the BSM project portfolio 
mean, that many of these benefits will not be realized in the short 
term. As we have recommended, various management controls and 
capabilities need to be fully implemented and institutionalized. 
Otherwise the projects will likely encounter additional cost and 
schedule shortfalls.

Appendix I: How IRS Aoolcated Expenditures and Staff Resources in 
        Fiscal Year 2003
    In our review of IRS's 2004 budget request, we provided figures 
showing IRS's expenditures and staff allocations in fiscal year 
2002.\27\ Figures 5 and 6 illustrate how the Internal Revenue Service 
(IRS) allocated expenditures and staff in fiscal year 2003.
---------------------------------------------------------------------------
    \27\ GAO-03-641T.
---------------------------------------------------------------------------
    Figure 5 shows that total expenditures increased from $10.4 billion 
in 2002 to $11.8 billion in 2003. While the division of expenditures 
across categories has generally remained the same as 2002 allocations, 
equipment increased from 4 to 6 percent of total expenditures from 2002 
to 2003.

            Figure 5: IRS's expenditures in fiscal year 2003

[GRAPHIC] [TIFF OMITTED] T3828A.005

    Figure 6 shows IRS's total staff resources have decreased slightly 
from 99,180 in 2002 to 98,381 in 2003. IRS's allocation of staffing 
resources remained largely similar, but with a 1 percentage point 
decrease in the percent of staff years processing tax returns. The 
boundaries between the categories presented in these figures may not be 
well defined. For example, staff categorized under providing management 
and other services could also be considered under taxpayer service, 
processing, or compliance. Therefore, the figures are meant to provide 
a summary of how IRS uses its resources and should be interpreted with 
caution. However, the 1 percentage point decrease in staff years 
devoted to processing tax returns is important because it represents a 
cumulative payoff from electronic filing and shows the potential for 
shifting IRS resources from one area to another.

   Figure 6: How IRS spent its 98,381 staff years in fiscal year 2003

[GRAPHIC] [TIFF OMITTED] T3828A.006

                                 

    Chairman HOUGHTON. Thank you very much. We're just going to 
have to stop now. Miss Killefer, I'm sorry about this. We will 
just suspend the hearing until we come back from the votes. 
We'll be back as fast as we can. Thank you very much.
    [Recess.]
    Could we re-commence the hearing, please? Ms. Killefer, 
thanks very much.

 STATEMENT OF NANCY KILLEFER, CHAIR, INTERNAL REVENUE SERVICE 
                        OVERSIGHT BOARD

    Ms. KILLEFER. Mr. Chairman, thank you for inviting us here 
to testify. The Board believes that the IRS Budget is more than 
dollars or cents. It is really about the choices we as a nation 
make about the future of our tax administration system, and how 
we help over 100 million American taxpayers deal with, 
unfortunately, an increasingly complex Tax Code and ensure that 
every American citizen pays his or her fair share of their 
taxes. We strongly believe that this is a critical time in our 
tax system's history, and it is a time to strengthen it, not 
merely to maintain it. As we all know, billions of dollars in 
uncollected taxes are left on the table because the IRS simply 
does not have the resources to do the job, and with each 
passing year, as the Board has done in its own research with 
the Roper Survey, we know that more Americans believe that it 
is more acceptable to cheat. This is particularly true of young 
Americans, and that is a very disturbing trend.
    In crafting our budget to present to Congress, the Board 
addressed the concerns head on by reinvesting in the IRS to 
produce tangible increases in enforcement while maintaining the 
high level of customer service that we have achieved through 
the implementation of RRA 98. The Board is calling for a 10 
percent increase in funding which should result in an increase 
of over 3,000 enforcement personnel, which would allow the IRS 
to improve its enforcement while maintaining customer service, 
and we also call for an increase in the budget for 
modernization versus the administration.
    While we applaud the Administration, and particularly 
Secretary Snow, for requesting a funding increase for the IRS, 
we feel there is a fatal flaw in the budget and it comes 
because left uncorrected are the lack of funding for what we 
believe will be pay parity between the civilian and military 
budgets, an issue that you are grappling with here on the Hill, 
as well as unfunded costs in areas such as rent, postage, that 
have gone on for the 3 years preceding this. What this problem 
ends up with is the IRS has never been able to hire the FTEs 
that it projects. Each year for the past 4 years, and perhaps 
before, those increases have been eaten up by pay parity that 
was unfunded in the President's budget, as well as other 
unfunded liabilities. In an organization like the IRS that it 
80 percent people, there is no choice but to hold back on 
hiring.
    Our concern with the Administration's budget is that if you 
believe that pay parity will happen yet again, and that many of 
the increases that we know will already be there from GSA in 
terms of rent increases, and so forth, you will not be able to 
hire any of the additional people that the Administration 
recommends. We feel, as private sector members of the Board, 
that we cannot let this trend go on. It simply will lead to 
once again with increasing tax load from both more taxpayers 
filing as well as more schemes out there, that their 
enforcement will become hollow, and we think that is a terribly 
disturbing trend.
    What we are recommending therefore is a 10-percent increase 
which would assume the funding of, if you will, a parity pay 
increase as well as full funding of rent increases that are 
already on the table from GSA, and other increases we 
anticipate, and then allow for the hiring of over 3,000 
additional enforcement personnel, which we feel are badly 
needed, and which I think in fact the Commissioner and GAO 
absolutely support. One last point I would like to make from 
the Board's perspective is RRA 98 gave us, in fact demanded, 
that we submit a budget to you directly that represented our 
best judgment about the requirements of the IRS to fulfill its 
strategic mission.
    From our collective expertise and familiarity with the 
private sector and best practices on the IRS' problems, we 
believe that these investments in enforcement pay for 
themselves many times over, not only in the revenue dollars 
that are directly collected through these enforcement 
activities, but by also reinforcing our voluntary tax system 
through the belief that every person is paying his or her fair 
share, and that is the fundamental strength of our tax system. 
Thank you.
    [The prepared statement of Ms. Killefer follows:]

        Statement of Nancy Killefer, Chair, IRS Oversight Board

Introduction
    Mr. Chairman, thank you for the opportunity to testify before the 
House Ways and Means Subcommittee on Oversight. The Internal Revenue 
Service (IRS) Oversight Board is required by 26 U.S.C. Section 7802(d) 
to review and approve the budget request prepared by the IRS, submit a 
request to Treasury, and ensure that the approved budget supports the 
annual and long-range strategic plans of the IRS.
    This year, the IRS drafted a special report presenting its 
recommended FY2005 IRS budget, comparing it to the Administration's 
request, and explaining why the Board believes its recommended budget 
is needed to support the annual and long-term needs of the IRS. My 
testimony today will discuss that report. The complete version is 
available on the Board's web site at www.irsoversightboard.treas.gov.

The IRS Oversight Board Budget Recommendation
    Mr. Chairman, the IRS budget is more than dollars and cents. It 
represents the choices that we as a nation make about the future of our 
tax administration system and how we help over 100 million American 
taxpayers deal with an increasingly complex tax code while ensuring 
that everyone pays his or her fair share of taxes.
    The IRS Oversight Board acknowledges that the IRS's budget has 
increased in each year of President Bush's Administration, and that the 
Administration's request for FY2005 is significant against other non-
defense, non-homeland security discretionary funding. That commitment 
is commendable, and the Board recognizes and thanks Secretary Snow for 
his efforts, especially at a time when the nation must balance many 
important and competing priorities.
    However, the Board believes that now is a critical time for our tax 
system to be strengthened, not merely maintained at current levels. 
Enforcement activities are still at unacceptable levels. Our nation's 
tax gap is estimated at $311 billion,\1\ leaving billions of dollars on 
the table simply because the IRS does not have the resources to do its 
job.\2\
---------------------------------------------------------------------------
    \1\ Nina Olson, National Taxpayer Advocate's 2003 Annual Report to 
Congress, (Washington, DC: December 31, 2003) p. 20-21. This is based 
on a July 2001 IRS Office of Research report.
    \2\ Charles O. Rossotti, Report to the IRS Oversight Board: 
Assessment of the IRS and the Tax System (Washington, DC: September 
2002), p. 16.
---------------------------------------------------------------------------
    The Board's own research shows that each year, more Americans 
believe it is acceptable to cheat on their taxes. At the same time, our 
already complex tax code continues to be a changing, tangled mystery to 
most honest taxpayers--and an asset to those intent on skirting the 
law. Every effort must be made to provide quality service to honest 
taxpayers who want to comply with the law.
    In crafting its FY2005 budget for the IRS, the Board addressed 
these concerns head on by reinvesting in the IRS to produce tangible 
benefits and results for America's taxpayers and our nation. It is a 
sensible and pragmatic budget that reflects the real world in which the 
IRS must operate and be funded.
    The Board recommends a 10 percent increase in funding from FY2004 
to $11.204 billion, with a significant increase of 3,315 full-time 
equivalents (FTEs) to boost enforcement efforts. If enacted, the 
Board's budget would increase our nation's revenue by approximately $5 
billion each year once the IRS has hired and trained additional 
enforcement personnel.\3\
---------------------------------------------------------------------------
    \3\ These estimates are based upon the projected revenue 
anticipated by hiring and training full-time employees who would audit 
or collect owed taxes in known cases of taxpayers who did not file or 
pay, or who substantially underreported their taxes, as described in 
former IRS Commissioner Charles O. Rossotti's Report to the IRS 
Oversight Board: Assessment of the IRS and the Tax System, p. 16.
---------------------------------------------------------------------------
    Under the Board's budget, the IRS would have the additional 
resources to:

      Close over an additional 1,000 cases involving high risk/
high-income taxpayers and promoters who avoid paying income taxes by 
using offshore credit cards and abusive trusts and shelters.
      Boost audit rates by 42 percent from FY2004 to examine 
companies that use aggressive tax avoidance tactics, such as offshore 
transactions and flow-through entities.
      Contact an additional 200,000 taxpayers who fail to file 
or pay taxes due; a 40 percent boost from FY2004 and a 27 percent 
increase from the Administration's request. This alone will allow the 
IRS to collect $84 million more in revenue owed than the 
Administration's request would allow.
      Sustain the one-on-one assistance that millions of 
Americans rely on at tax time. The Board's budget will ensure that the 
IRS will be able to maintain its improved service to taxpayers by 
answering eight out of ten phone calls.

IRS Must Stay the Course on Customer Service
    Mr. Chairman, the vast majority of Americans want to file their 
returns and pay their fair share, yet our nation's tax code continues 
to become more complex. Resources must be available so the IRS can 
answer taxpayers' questions and promptly and accurately, whether it is 
over the phone, through the IRS web site, by mail, or at walk-in 
center.
    Under the board's proposed budget, customer service funding will 
remain at about the same level as FY2004; however, service should 
improve due to the deployment of self-service technology.
    For taxpayers, that means eight out of ten phone calls will be 
answered. For tax practitioners calling the IRS toll-free hotline to 
resolve problems regarding clients' accounts, hold-time will remain at 
current levels.
    The IRS call-routing systems as well as web-site applications that 
allow taxpayers to check the status of their tax refunds have already 
shown dramatic benefits in speeding service to taxpayers. New systems, 
such as e-Services, will soon be available, providing additional 
automated services to tax practitioners.
    Clearly, service to taxpayers has improved in the past five years. 
Such improvements make it all the more imperative that we sustain them 
and not allow this positive trend to languish, or worse, decline. The 
agency must stay the course.

Days of ``Outmanned and Outgunned'' IRS Must End
    The IRS is doing a better job of identifying egregious 
noncompliance--now it needs the resources to fight back. In the past 
two years, the IRS sharpened its compliance focus to identify and 
pursue promoters and participants of abusive tax shelters and tax 
evasion schemes. For example, the agency is now targeting its resources 
on promoters of illegal tax schemes that are often marketed to high-
income individuals, but are also finding their way to middle-market 
businesses.
    Despite this focus, enforcement activities are still at an 
unacceptable level simply because the IRS does not have the resources 
needed to accomplish its mission. It continues to be outmanned and 
outgunned. In FY2003, the agency was able to pursue only 18 percent of 
known cases of abusive devices designed to hide income, leaving an 
estimated $447 million uncollected.\4\
---------------------------------------------------------------------------
    \4\ Rossotti, p. 16.
---------------------------------------------------------------------------
Tax Cheating: Alarming Trends

[GRAPHIC] [TIFF OMITTED] T3828A.007

    Public attitudes towards tax cheating show some alarming trends, 
particularly among young Americans. The Board's 2003 Survey on Taxpayer 
Attitudes found that support for total tax compliance diminished by 
four points over the previous year to 81 percent. In other words, 
nearly one out of five Americans now believe that it is acceptable to 
cheat at least a little on their taxes. Almost one-third (30%) of young 
adults age 18-24 age are among those most likely to feel that any 
amount of cheating is acceptable, an increase of six points since last 
year. Yet ironically, ``fear of being audited'' has the greatest impact 
on these non-compliers at a time when actually being audited is near 
historic lows.\5\
---------------------------------------------------------------------------
    \5\ Roper ASW, 2003 IRS Oversight Board Annual Survey on Taxpayer 
Attitudes, September 2003, p.17.
---------------------------------------------------------------------------
    The IRS must prove to the public that it can and will identify and 
pursue those who show contempt for the tax code. The Board's proposed 
budget allows the IRS to begin to reverse this disturbing trend.
    The Board's recommendation would increase our nation's revenue by 
almost $5 billion each year once the IRS has hired and trained 
additional enforcement personnel. The Board believes the additional 
revenue achieved makes a strong business case for the recommended 
additional enforcement resources. While this is a modest boost in 
closing our compliance gap, it will also send a message to those 
contemplating tax avoidance: the IRS' hands are no longer tied.

Modernization Critical to Tax Administration
    In December 2003, the Oversight Board released an independent 
analysis of the IRS Business Systems Modernization (BSM) program. The 
Board called for nine specific recommendations for turning around the 
critical but troubled program that has experienced significant and 
unacceptable delays and cost overruns.
    However, the Board still believes that the overall Modernization 
plan is sound and well-designed. Moreover, it is critical to the future 
of tax administration. As a nation, we must remain committed to the 
IRS' computer modernization program. The Board testified before the 
House Ways & Means Subcommittee on Oversight on Feb 12, 2004:
    The IRS Oversight Board firmly believes that the IRS Modernization 
program cannot be allowed to fail. The IRS cannot continue to operate 
with the outmoded and inefficient systems and processes it uses today. 
Over time, the existing systems will become impossible to maintain and 
at that point, the ability to administer our country's tax system will 
be in grave danger. Such a risk to our nation is unacceptable. We 
remain convinced that the overall Modernization plan is sound and well-
designed. The challenge is executing that plan. The IRS and the Prime 
must get it right this time.\6\
---------------------------------------------------------------------------
    \6\ Larry R. Levitan, IRS Oversight Board Testimony before House 
Ways and Means Oversight Subcommittee Hearing on IRS BSM Program, 
February 10, 2004.
---------------------------------------------------------------------------
    The Board's proposed budget provides the stable resources needed to 
focus and stabilize the steady stream of funding for the IRS' computer 
modernization initiative. Special controls are in place to ensure that 
no funding in this account is spent until the IRS has the capability to 
spend it effectively. If the IRS does not correct the weaknesses in the 
BSM program by FY2005, the Board advocates that the funds earmarked for 
modernization should not be spent. However, the Board does not believe 
the IRS should plan for failure. The agency must be poised to move 
forward with BSM once it has demonstrated that it has corrected the 
program's weaknesses. The funding level recommended by the Board sets 
the foundation for genuine progress for the program in FY2005.
    The Board expects that the Customer Account Data Engine (CADE) 
Release 1 will occur in 2004. Over the next year, the IRS will test and 
build upon that system. The IRS should continue to strengthen its 
ability to manage the program and the Prime to deliver projects on 
budget and on time. By the end of FY2005 and early FY2006, the IRS 
should be able to proceed with the remaining releases of CADE as 
quickly as possible. This will minimize future risk and the long-term 
cost of modernization while providing a basis to deliver tangible 
results for taxpayers.
    If the IRS' FY2005 BSM funding is reduced to $285 million, as it is 
in the Administration's budget, future funding likely will be adversely 
affected. If that happens, the projects will drag on, risk will 
increase, and ultimately, the program will cost taxpayers much more.
    For that reason, the Board believes FY2005 BSM funding should be 
set at $400 million, with only $285 million put into the FY2005 spend 
plan. This will allow the IRS' Business Systems Modernization fund to 
operate like a multi-year fund, as originally envisioned by Congress 
and as the Board has recommended each year since its inception.
    Further, as its archaic, tape-based computers begin to give way to 
modern business systems, the IRS must plan for a smooth transition. The 
Board's budget recognizes that need. As new systems are incorporated, 
the IRS must plan to operate both the old and new systems in parallel 
for some time. The IRS must also retain employees with critical skills 
while training existing and new employees to use new systems. This will 
allow the IRS to reduce the risk of a catastrophic disruption to the 
system.
    In addition, the Board believes that the transition to 
modernization is a real cost that must be incurred. There are no short 
cuts to successful modernization--the IRS' budget must reflect the real 
cost of maintaining legacy systems while simultaneously supporting 
modernized systems. Accordingly, the Board recommends an additional $25 
million to cover these costs. The Administration's budget fails to 
acknowledge them.

The Administration's FY2005 Budget Request
    By comparison, the Board believes the Administration's FY2005 
budget cannot achieve its stated goal to add almost 2,000 personnel to 
bolster the IRS' enforcement efforts, and will threaten hard-earned 
improvements in customer service. This year's request will lead to a 
$230 million shortfall in the IRS budget because it fails to budget 
adequately for the anticipated $130 million of congressionally-mandated 
civilian pay raises, rent increases, and at least $100 million of 
unfunded expenses.
    In its FY2005 budget recommendation, the Board anticipates a 3.5 
percent pay raise for civilian employees, which achieves parity with 
the Administration's call for a 3.5 percent military pay raise. The 
Administration, but contrast, calls for a 1.5 percent civilian pay 
raise. While discussions are now underway in Congress regarding parity, 
the Board believes that the 1.5 percent civilian pay increase fails to 
recognize recent history.
    In fact, FY2005 is the fourth year in a row in which the 
Administration has called for IRS staff increases, while not covering 
pay raises or required expenses.
    As a result, the Administration's proposed increase in the IRS' 
FY2005 budget will erode before new employees can be hired, more 
taxpayer phone calls can be answered, or new audits of possible tax 
cheats can be conducted.
Impact of $230 Million Budget Shortfall on Three Major IRS Functions

[GRAPHIC] [TIFF OMITTED] T3828A.008

Board Cites Complexity as Fundamental Flaw
    The IRS Oversight Board is precluded by law from addressing tax 
policy issues, but it would be remiss not to address the cost of our 
nation's complex tax system; a cost ultimately borne by taxpayers and 
the IRS. The Administration's legislative proposals contained in its 
budget request only begin to address the problems caused by complexity. 
The approach so far to tax simplification fails to address a 
fundamental flaw in our tax system: its costly, confusing, and 
debilitating complexity. The Administration has, however, requested 
that Congress provide some relief in FY2005 on the Alternative Minimum 
Tax, but has not yet identified a long-term solution.\7\ In her annual 
report, IRS National Taxpayer Advocate Nina Olson recommended repeal of 
the AMT, saying:
---------------------------------------------------------------------------
    \8\ Recent public remarks by Treasury Secretary Bodman noted that 
the President's budget extends through 2005 the temporary increase in 
the AMT exemption and the provision that allows certain personal 
credits to offset the AMT. These temporary provisions will keep the 
number of taxpayers affected by the AMT from rising significantly in 
the near-term. More importantly, they will allow the Treasury 
Department the time necessary to develop a comprehensive set of 
proposals to deal with the AMT in the long-term. Treasury Press Release 
JS-1250 contains the full statement of his remarks.
---------------------------------------------------------------------------
    The AMT is extremely and unnecessarily complex and results in 
inconsistent and unintended impact on taxpayers. . . . [T]he AMT is bad 
policy, and its repeal would simplify the Internal Revenue Code, 
provide more uniform treatment for all taxpayers, and eliminate the 
oddity of dual tax systems. AMT repeal would also allow the IRS to 
realign compliance resources to facilitate more efficient overall 
administration of the tax code.\8\
---------------------------------------------------------------------------
    \8\ Olson, p. 16.
---------------------------------------------------------------------------
    The Board fully concurs with her assessment, and urges the 
Administration and Congress to consider accepting this recommendation 
in future legislation.

Conclusion
    The Board was established to bring to bear its collective expertise 
and familiarity with private sector best practices on the IRS' 
problems. To the private-life Board members, investments in enforcement 
pay for themselves many times over, not only in revenue dollars but by 
the deterrence value of reinforcing the belief that all taxpayers are 
paying their fair share. A strong business case can be made for 
providing the IRS with several hundred million dollars so it can 
collect billions in revenue. At a time when federal revenue as a 
percentage of the economy has shrunk to 1950s levels and we face a $500 
billion deficit, the Board believes it imperative that we strengthen 
our tax collection system.
    For that reason, the Board recommends that both Congress and the 
Administration reevaluate their methodology by including the revenue 
value to the country when estimating budget requests for the IRS. 
Indeed, considering the positive impact of additional resources 
provides a better framework for making informed decisions and will lead 
to a more effective IRS.
    In conclusion, the Board calls for Congress to stay the course it 
set more than five years ago with the passage of the IRS Restructuring 
and Reform Act. The IRS has made progress in carrying out the spirit 
and letter of the Act; we must now give it the resources to finish the 
job.
                                 ______
                                 

 IRS Oversight Board FY2005 IRS Budget Recommendation and Administration
                  Request: Program  Summary  Comparison
          Administration FY2005 Budget Request Preogram Summary
                          (dollars in millions)
------------------------------------------------------------------------
                                                          Increase
     Appropriation Title        FY2004   FY2005 OB ---------------------
                               Enacted    request   $millions   Percent
------------------------------------------------------------------------
Processing, Administration       $4,009     $4,148       $139       3.5%
 and Management
------------------------------------------------------------------------
Tax Law Enforcement              $4,171     $4,564       $393       9.4%
------------------------------------------------------------------------
Information Systems              $1,582     $1,642        $60       3.8%
------------------------------------------------------------------------
Business Systems                   $388       $285      -$103     -26.5%
 Modernization
------------------------------------------------------------------------
Health Insurance Tax Credit         $35        $35         $0       0.0%
 Administration
------------------------------------------------------------------------
Appropriation                   $10,185    $10,674       $490       4.8%
------------------------------------------------------------------------


        IRS Oversight Board FY2005 Budget Request Program Summary
                          (dollars in millions)
------------------------------------------------------------------------
                                                          Increase
     Appropriation Title        FY2004   FY2005 OB ---------------------
                               Enacted    request   $millions   Percent
------------------------------------------------------------------------
Processing, Administration       $4,009     $4,291       $282       7.0%
 and Management
------------------------------------------------------------------------
Tax Law Enforcement              $4,171     $4,770       $598      14.3%
------------------------------------------------------------------------
Information Systems              $1,582     $1,708       $126       8.0%
------------------------------------------------------------------------
Business Systems                   $388       $400        $12       3.1%
 Modernization
------------------------------------------------------------------------
Health Insurance Tax Credit         $35        $35         $0       0.3%
 Administration
------------------------------------------------------------------------
Appropriation                   $10,185    $11,204     $1,019      10.0%
------------------------------------------------------------------------

                                 ______
                                 

                    Unfunded IRS Costs, FY 2002-2004
                         (in millions, rounded)
------------------------------------------------------------------------
                 Detail                   FY 2002    FY 2003    FY 2004
------------------------------------------------------------------------
Labor Inflation
------------------------------------------------------------------------
Unfunded Pay Raise Increase                  $42.3       $128
 (President's Request to Congressional
 Action)
------------------------------------------------------------------------
                                            $42.30       $128
------------------------------------------------------------------------
Non-Labor Inflation
------------------------------------------------------------------------
Rent Shortfall                                 $32      $54.0
------------------------------------------------------------------------
Postage                                        $16      $53.0
------------------------------------------------------------------------
Corporate & Electronic Contracts                          $23
------------------------------------------------------------------------
Health Service Contract                         $3         $2
------------------------------------------------------------------------
Interpreter's Contract                        $0.5       $0.3
------------------------------------------------------------------------
Child Care Subsidy                              $1
------------------------------------------------------------------------
Increased Department of Labor EFAST             $2
 Contract Processing Costs
------------------------------------------------------------------------
                                               $55    $132.00
------------------------------------------------------------------------
Added Requirements
------------------------------------------------------------------------
Background Investigations                                  $4
------------------------------------------------------------------------
Increase Cash Awards from 1.24% to              $8        $16
 1.42%
------------------------------------------------------------------------
Competitive Sourcing                                       $8
------------------------------------------------------------------------
Campus Security Response                       $15
------------------------------------------------------------------------
Congressional Mandates                          $5
------------------------------------------------------------------------
Guard Services                                 $20        $16
------------------------------------------------------------------------
Public Transportation Subsidy                   $9
------------------------------------------------------------------------
                                               $56        $44
------------------------------------------------------------------------

------------------------------------------------------------------------
Total                                         $153       $304
------------------------------------------------------------------------
Total less pay raise and rent                  $79       $122
------------------------------------------------------------------------

------------------------------------------------------------------------


                             Where the Additional Enforcement Resources Are Applied
                                             (in thousands rounded)
----------------------------------------------------------------------------------------------------------------
                                                   Oversight Board       Administration          Difference
                                                   Recommendation        Recommendation    ---------------------
            Enforcement Initiatives            --------------------------------------------
                                                  Budget      FTE       Budget      FTE       Budget      FTE
----------------------------------------------------------------------------------------------------------------
SBSE-2 Curb Egregious Non-Compliance              159,264      1,408     90,161        874    $69,103        534
----------------------------------------------------------------------------------------------------------------
SBSE-3 Select High-Risk Cases for Examination       5,500          0          0          0     $5,500          0
----------------------------------------------------------------------------------------------------------------
SBSE-7 Savings through Consolidation--Case         16,085        200     14,469        144     $1,616         56
 Processing
----------------------------------------------------------------------------------------------------------------
SBSE-8 Savings through Consolidation--              7,656         69      5,531         65     $2,125          4
 Insolvency Processing
----------------------------------------------------------------------------------------------------------------
WAGE-2 Increase Individual Taxpayer Compliance     46,406        521     15,469        175    $30,937        346
----------------------------------------------------------------------------------------------------------------
WAGE-9 Improve ITIN Application Process            15,484         50          0          0    $15,484         50
----------------------------------------------------------------------------------------------------------------
WAGE-10 Eliminate Erroneous EITC Payments          18,000          0          0          0    $18,000          0
----------------------------------------------------------------------------------------------------------------
LMSB-1 Combat Corporate Abusive Tax Schemes        60,017        394     36,100        207    $23,917        187
----------------------------------------------------------------------------------------------------------------
TEGE-1 Combat Diversion of Charitable Assets        3,914         44      3,914         44         $0          0
----------------------------------------------------------------------------------------------------------------
TEGE-5 Stop Abusive Transactions in the TEGE       11,140        100     11,140        100         $0          0
 Community
----------------------------------------------------------------------------------------------------------------
CI-1 Combat Financial Fraud in the Corporate       25,600         98     25,600         98         $0          0
 Sector
----------------------------------------------------------------------------------------------------------------
CI-2 Dismantle International and Domestic          12,208         80          0          0    $12,208         80
 Terrorist Financing
----------------------------------------------------------------------------------------------------------------
CI-3 Reinforce Core Mission Tax Enforcement        34,086        130     34,086        130         $0          0
 Resources
----------------------------------------------------------------------------------------------------------------
CI-7 Forensic Electronic Evidence Acquisition       3,104          4      3,104          4         $0          0
 and Analysis
----------------------------------------------------------------------------------------------------------------
CI-10 Leverage/Enhance Special Agent                2,500         28      2,500         28         $0          0
 Productivity
----------------------------------------------------------------------------------------------------------------
APPEALS-1 Resolve Appeals                          13,945        112      7,000         56     $6,945         56
----------------------------------------------------------------------------------------------------------------
COUNSEL-1 Combat Abusive Tax Avoidance             10,852         75      5,426         38     $5,426         37
----------------------------------------------------------------------------------------------------------------
NHQ-2 Deliver Strategic Compliance Data             2,712          2          0          0     $2,712          2
----------------------------------------------------------------------------------------------------------------
FY2005 Enforcement Increases                      448,472      3,315    254,500      1,963   $193,972      1,352
----------------------------------------------------------------------------------------------------------------


                                 

    Chairman HOUGHTON. Let me ask Mr. White a question, and 
then we will come back to you, Ms. Killefer. Mr. White, the 
Commissioner showed us a chart showing the audit rates of those 
making over $100,000 and they are increasing. The GAO has done 
previous work on the ways the IRS assures compliance through 
other means, such as document matching. Do you think the IRS 
has taken the right steps to make sure all taxpayers are paying 
what they owe?
    Mr. WHITE. I would make several points, Mr. Chairman. It is 
true that there are substitutes for certain types of audits. 
There may not be substitutes for the more complex face-to-face 
types of audits. Another point I would make though is that 
right now IRS does not know the size of the compliance problem. 
They do not have a current measure of the compliance rate. The 
last time they measured the compliance rate was using 1988 tax 
return data. So, they are in the process of developing a new 
measure, but it is not going to be available for at least 
another year, so we do not know the size of the problem.
    In terms of steps that IRS can take to actually increase 
enforcement, there are several things they can do. One is to 
use their existing enforcement resources more efficiently. 
Their efforts to measure compliance should help them better 
target pockets of noncompliance, and therefore better allocate 
their existing resources. Right now they are sort of flying 
blind when it comes to allocating resources because it has been 
so long since they researched where noncompliance is. Another 
thing they need to do to use the existing enforcement resources 
more efficiently is make sure the business systems 
modernization is successful. They need to bring the new systems 
online. That will help.
    Finally, something else they can do is free up resources 
from other parts of IRS and transfer those resources, 
reallocate those resources into enforcement work. One example 
is e-filing. I said in my statement that e-filing has now 
started to result in decreases in the number of processing 
staff at IRS. In 2003 they reduced the number of processing 
FTEs by about 1,000. They can also reconsider the level and 
types of services that they offer. Now the telephone service is 
so much improved, now that the Internet provides options that 
didn't exist even a couple of years ago, maybe it is time to 
raise the question of whether as many walk-in sites are needed 
at IRS. In fact, taxpayers are already making this decision. 
The number of taxpayers who use walk-in sites has been steadily 
declining at IRS. So, there are some opportunities to free 
resources from other parts of IRS and shift them into 
enforcement.
    Chairman HOUGHTON. It seems almost impossible for me to 
believe that they do not know the size of the problem. Break 
that down a little bit.
    Mr. WHITE. The last time they measured compliance, the rate 
at which taxpayers are paying what they know--this gets back to 
the measure of the tax gap which is the difference between what 
people ought to owe and what they are actually paying. The last 
time they estimated that compliance rate with a statistically 
valid approach was based on 1988 tax return data. Since then we 
have had tremendous changes in the economy. They now have their 
National Research Program to come up with a new measure of the 
compliance rate, but as I said, those results will not be 
available for another year.
    Chairman HOUGHTON. What about the chart that the 
Commissioner used in terms of the enforcement resources that 
have been halted, and the effort remains below what is needed? 
There has got to be some relationship to the resources put in 
and to the people that are not complying or they don't think 
are complying.
    Mr. WHITE. That is the fear that many people have, that 
because of the decline in those enforcement resources and what 
that has meant for their ability to conduct enforcement, that 
people's willingness to voluntarily comply may be going down. 
They have less incentive to comply than they did before, that 
they view IRS as less of a credible enforcement threat. The way 
I often think about this is from the point of view of honest 
taxpayers. Those taxpayers--and I think you raised this issue 
yourself--the system depends on trust. The confidence that 
honest taxpayers have that their friends, neighbors and 
business competitors are paying their fair share of the taxes, 
and if we ever lose that, then the compliance rate will suffer.
    Chairman HOUGHTON. Ms. Killefer, I would like to go back to 
some of your statements. I suppose the law which created the 
Oversight Board gave you the proper authority and the resources 
to do your job. Is that right?
    Ms. KILLEFER. In many ways, yes. I think we have learned 
over the course of the first three plus years of the Oversight 
Board we have a couple of things that were not foreseen. For 
example, as you all know, the nomination process is a lengthy 
one, and we currently have two vacant Board seats. We will have 
a couple more coming up. It is very difficult to conceive of 
the Board operating without a full membership as it was 
conceived. So, there are some things that we are learning as we 
go. Indeed, we were given the authority to submit a budget, but 
we have learned that we have become a footnote in the 
President's budget. Hence, we have started to issue our own 
report and appreciate the opportunity to testify here to be 
clear about what we think are the necessary resources.
    Chairman HOUGHTON. I am sure you are very worried about the 
expense to revenue ratio. Whether this is going to turn around 
overnight or not, I have no idea. Probably not. The nonmilitary 
discretionary account, which is now about one-sixth of the 
overall budget, is getting squeezed all the time. I think it is 
a good idea. We are in a national crisis. We have to support 
our troops abroad. Hopefully it will not be as much in the 
future as it has been the last 2 years, but we have to do our 
bit here. If you look at a budget of an agency that is $10.7 
billion, you have to believe that there is some opportunity for 
maneuvering, and I know it is not what you want, and I know you 
have suggested other resources, and I know there are other 
things as far as compliance that are important. Isn't there an 
opportunity with that size budget to do some of the things, 
particularly since we are in such a cost crunch in the country?
    Ms. KILLEFER. Chairman, what I would say is from a private 
sector point of view it is unfortunate that the Federal budget 
views this as a cost center and fails to be able to recognize 
its revenue potential. If you had a company--and I know you 
have--and had the opportunity to invest in growth and revenue, 
would you do it? I know the answer is yes. That is what we are 
facing here. When you talk about the IRS, and it is 100,000 
people, recognize that the sheer processing of returns, which 
has gone up every year and become more complex every year, and 
the answering of the phone calls, right, the very basic 
processing simply needs to get done. That is what has driven 
down the enforcement resources. It has not been a desire to do 
less enforcement. It has been the problem of with a fixed 
amount of resource--you have seen they have not gone up--the 
number of returns has gone up, the complexity of the returns 
has gone up, so you have an increasing workload with a fixed 
amount of resources, and what you have to do is process basic 
returns, answer the phone calls, put out the tax forms, and the 
discretionary becomes enforcement.
    Chairman HOUGHTON. Yes, but there was a seismic shift in 
the structure of the IRS that took away from some of the 
enforcement capabilities, but now, getting back into balance, I 
would imagine that that would be lightened a bit.
    Ms. KILLEFER. If you call it a seismic shift to take the 
phone service from less than 50 percent to now currently 80 
percent, it was. If you consider that you want to go back to 50 
percent so that you can fund enforcement? I think that is a 
promise that we would disagree with as a Board. We believe 
that----
    Chairman HOUGHTON. That is not my process.
    Ms. KILLEFER. Why did we put----
    Chairman HOUGHTON. My question is this: you have $11.7 
billion. Why can't you work something in terms of the things 
you think are important within that overall figure?
    Ms. KILLEFER. Chairman, there have been productivity 
improvements at the IRS, in fact, completely in line with the 
financial sector of this country. So, they have achieved 
productivity. As Jim pointed out, we have gotten more 
electronic returns. The Brookhaven Center has shut down. We are 
shutting down another center. There will be another coming. 
Productivity improvements have occurred, but what you have here 
is an increasing workload at the same time, and we are off 
base--and I think a false base--of an unacceptable level of 
service, and we don't know whether it was the right level of 
enforcement. So, the premise that we started out with an 
adequate base and therefore can achieve productivity and 
redeploy, I think is a false premise. We were at an 
unacceptable level. I think if you go back and look over 
history, there are times that the IRS was funded at a much 
greater level, in the mid nineties. It is simply, if you just 
run the workload numbers, you cannot do the work that needs to 
get done and support an enhancement of the enforcement efforts.
    Chairman HOUGHTON. Mr. Pomeroy.
    Mr. POMEROY. That was a very interesting exchange and I 
agree with both perspectives that were voiced. I think the 
Chairman raises a good point, that we want to capture all 
efficiencies and the savings flowing from them, and redirect 
them to agency priorities, and that would certainly be 
enforcement. At the same time I think you have been such an 
advocate, Ms. Killefer, I am making certain we understand 
enforcement takes funding. Failure to fund enforcement means 
people don't pay their taxes and you leave revenue uncollected, 
revenue that is owed under the law, revenue that most law-
abiding taxpayers are paying, but some who are breaking the law 
are not paying. It is indeed a revenue center. Do you have any 
ball-park notion of for every dollar spent on enforcement, what 
you might collect in revenues?
    Ms. KILLEFER. As Jim said, there are no recent 
calculations. The old numbers were approximately 10 or $11 per 
dollar spent, but those are very, very old, and I would not 
suggest that those are correct today.
    Mr. POMEROY. When I was in the State legislature we enacted 
a program called Catch the Tax Cheater Program, and for every 
dollar expended we got $10 in revenue. I would believe, in 
fact, when we look at the demise of collections, driven by 
demise of audits, we might even do better than 10 to 1 in this 
environment. Mr. White, do you have any notions in that regard?
    Mr. WHITE. We don't have any independent estimates. IRS has 
done some very crude guesstimates on it which suggest that you 
could bring in more than a dollar that you spend. They don't 
have a very good database for making those estimates, however.
    Mr. POMEROY. I think that in helping Congress understand 
that funding IRS is in part a revenue center, not a cost 
center, some greater quantification of this would be helpful.
    Ms. KILLEFER. Absolutely.
    Mr. POMEROY. I hope we can work toward getting some better 
figure here. Let me turn to the back part of your testimony, 
Ms. Killefer, which talks about specifically enforcement 
activities requested but not collected. We spent an awful lot 
of time talking about abusive corporate tax shelters. I note 
that the funding requested by the Oversight Board was almost 
double what was funded by the Administration. Funding was 
reduced $23 million, 187 positions. Is that correct?
    Ms. KILLEFER. That is correct.
    Mr. POMEROY. Is it your belief that there will therefore be 
abusive corporate tax shelters that will not be caught, and 
there will be tax revenues owed but not paid because of these 
abusive corporate tax shelters and our somewhat limited ability 
to catch and deal with them?
    Ms. KILLEFER. We do have that concern, and history would 
suggest that that is true.
    Mr. POMEROY. There is another line item that is even more 
stark in terms of positions requested by the Oversight Board 
but not funded, and this is dismantling international and 
domestic terrorist financing. You request $12 million, 80 
positions. Nothing was granted, no positions, no dollars to 
this request for dismantling international and domestic 
terrorist financing. Can you give us some background on that?
    Ms. KILLEFER. The IRS I think traditionally over time has 
played an important role beyond sheer tax collection, be it the 
old Al Capone case. We feel that it really has the ability and 
the talent from its financial actuarial skills actually to play 
a great service to the country. So, we felt it was worthy to 
fund. I am not sure what the Administration is thinking. I am 
sure that they share our intent. I just think that that is the 
way the dollars fell out.
    Mr. POMEROY. We have been working for some years to try and 
get at the financial underpinnings of international terrorism. 
Is the IRS without the capability to participate in that 
effort?
    Ms. KILLEFER. I am not sure how they will actually end up 
allocating resources when they finally get their budget.
    Mr. POMEROY. The Oversight Board came to the conclusion 
that we need to play a more robust role in attacking the 
international financing of terrorist, and 80 positions ought to 
be committed in this regard. None were allowed by the 
Administration.
    Ms. KILLEFER. That is correct.
    Mr. POMEROY. Thank you, Mr. Chairman.
    Chairman HOUGHTON. Thanks, Mr. Pomeroy. Mr. Portman.
    Mr. PORTMAN. Thank you, Mr. Chairman. I would like to hear 
the Administration's response to that 80 positions. I would 
imagine that they have allocated resources through some means, 
and I hope we can get that in writing from the Administration.
    Ms. Killefer, I thank you very much for not just being here 
today, but for the work you do on the Board, and as you know, I 
think the Board is critically important, and when we created 
the Board we gave the Board a few very important 
responsibilities that were in the area of approval and not just 
review and oversight, and one was in preparing a budget which 
would go to the Secretary, to the President and then require it 
to be submitted to the Hill. This year your budget, as I read 
it, is about 5 percent greater than the Administration's 
request, last years, about 2.7 percent.
    This is, frankly, what we expected to have happen. You 
indicated that back in the nineties the IRS was funded better. 
I assume you mean that in relative terms because in the mid 
nineties you referred to, we went from 7.4 billion down to 7.3 
billion, down to 7.2 billion by 1997, and in 1998, when we 
issued our Restructuring and Reform Commission Report and then 
legislated, we went back up to 7.8 billion, and since then we 
have gone up. Earlier we said this proposal the Administration 
has before us is for a 4.8 percent budget increase. Remembering 
that there will be, in the congressional, budgeting process, I 
believe, a freeze on all non-security domestic discretionary 
spending, which includes the IRS, the Administration had less 
than a 1-percent increase, so the IRS did relatively well 
compared to other agencies and Departments.
    Given what our deficit is and given where we are as a 
country right now, in fighting the war on terrorism, that is a 
fairly healthy increase. So, I just want to put that in some 
perspective to make sure we are not leaving the impression with 
those who might be listening that somehow we are terribly 
shortchanging the agency. In fact, in the Bush years, we have 
gone up almost 14 percent in spending for the IRS. It is tough. 
Every year this Subcommittee or at least some of its membership 
takes into account what the Oversight Board tells us, and our 
own independent analysis, and we fight with the appropriations 
process to try to be sure that there is adequate funding. The 
IRS is not always the most popular agency to fund. This year I 
think a 4.8-percent increase, again, is generous, and that is 
why we wrote a letter, the three of us, to the appropriators 
asking that that be fully funded. We are not suggesting how 
that is allocated between various enforcement and taxpayer 
service accounts, but we believe that at a minimum we ought to 
have this rather substantial increase in funding, again, 
relative to other agencies and Departments.
    So, having said all that, I very much appreciate your 
budget and I appreciate the fact that you have laid out for us 
what you think the priorities are. I do think it is a little 
dangerous to get into saying, gee, because the Oversight Board 
has said specifically there ought to be 80 positions here, that 
if the budget of the Administration doesn't fund those, that 
that function somehow isn't accommodated--I don't know if it is 
or not--but that wasn't really the purpose of the Board, to get 
into that kind of micro management. It was the purpose to give 
us your unvarnished view of what you think the needs really are 
within a realistic framework, and I think you have done that. 
One quick question for you. The Oversight Board, as you know, 
is currently being reviewed as well, and as a strong supporter 
of the Board and someone who believes that it has met its 
intended purpose to provide oversight, do you think the Board 
itself is being given adequate support and adequate resources 
to do its job?
    Ms. KILLEFER. That was a question that Chairman Houghton 
asked before, and I said we have learned through this first 3 
plus years of the Board that there are some things that were 
not foreseen. As you know, having spent time with us, we 
actually are short two members and the nomination process has 
proved quite lengthy, and that has left us understaffed from a 
member standpoint. We also have some issues about continuity of 
our Board staff that concern us, and so we actually would 
suggest there may be some changes that we all want to make in 
the interest of ensuring the Board actually fulfills its intent 
over time, and having the strength of a full membership at all 
time and continuity in its staff support.
    Mr. PORTMAN. That would be sensible since one of the main 
reasons for the Board was to provide continuity as well as 
expertise and accountability, and I think those are functions 
that have been performed very well. This hearing today is an 
example of that. I would just again say we need to keep it in 
perspective, that the Administration is proposing a substantial 
increase. The Commissioner, as you testified earlier, is 
focusing that increase where it needs to go right now, which is 
on enforcement, at the same time recognizing that we should 
never sacrifice the service gains we have made. We cannot allow 
this pendulum to swing, and that is where the Board provides an 
invaluable break on what might otherwise be the tendency in 
government to swing from one, in this case, enforcement, away 
from taxpayer service. They are consistent with one another I 
believe, and we will have that theory tested I suppose over the 
next couple of years as we try to do both. Thank you, Ms. 
Killefer.
    Chairman HOUGHTON. Thank you, Mr. Portman. Mr. Pomeroy.
    Mr. POMEROY. Ms. Killefer, I would like to come back to 
these positions in the international and domestic terrorist 
budget request. Can you tell us a little bit about the 
activities that you envisioned this corps doing? If you are not 
prepared to speak to it, I will certainly request some follow 
up writing regarding this matter, but it really does jump out 
as a pretty serious difference of opinion between the Oversight 
Board and the Administration. Can you give us information on 
it?
    Ms. KILLEFER. Let me say that I don't know that it is as 
serious a disagreement as it would appear. I think what we 
reviewed as a Board in putting together the budget is where we 
felt there were initiatives that required increased resources. 
That was one of them you see among many in the enforcement 
arena. I am not sure the thinking that went on in the 
Administration as they tried to generate a budget that fit into 
the total budget, but they clearly brought down their request 
that both the IRS and we submitted. In doing that they made 
some choice. I am not sure that they are the ultimate choices 
that they will actually make when they receive a budget level. 
How they allocate resources post getting a budget among 
initiatives, I am not sure what they will do. I would be happy 
to provide you with detail around that initiative to give you 
some sense of why we approved it.
    Mr. POMEROY. I would very much like that information, and I 
believe you have been kind in your characterization. You 
requested 80 positions. They did not give you any positions. 
This isn't just kind of differing at the edges of this 
proposal. It seems as though you believe that within the IRS 
structure and competencies, tracking the international flow of 
money to finance terrorism is something you would have very 
substantial enforcement powers to move out. I believe that most 
Americans think we need all hands on deck on this one, and if 
IRS can play a role along with the major criminal investigatory 
powers of this country, and whatever resources are being 
brought to bear, it would in all likelihood be a very helpful 
addition. So, I am going to want to pursue this and get some 
answers.
    Ms. KILLEFER. We certainly do believe they can play a 
meaningful role in this, given their skills.
    Mr. POMEROY. Then I would certainly like to know where 
specifically you see that and then engage the OMB in some 
discussions as to why they so completely disagreed and 
eliminated you from participating in this area. I thank the 
Chair and look forward to receiving the information from the 
witness. Thank you.
    Chairman HOUGHTON. Mr. Portman.
    Mr. PORTMAN. I should probably stop here, but I just have 
to say to my friend, Mr. Pomeroy, and to my friend, Nancy 
Killefer, I do think the Oversight Board has incredible 
expertise and specifically under law you are supposed to have 
expertise in management, which you do, and information 
technology, as Larry does, and in reorganization of large 
corporations and even small business expertise. We did not 
select you for your expertise on terrorism. So, I would hope 
that those who are listening, again, would not assume that this 
Oversight Board has the ability to decide how our government 
should be drying up resources to terrorists. That is not a 
function we looked for you to perform, and I am frankly 
disappointed that the Oversight Board is making recommendations 
about where they think terrorism ought to be approached within 
the IRS budget. That was not the idea. We do respect your 
budget, and I am again delighted to have it, but I would hope 
that we would understand that this Board--and this was a very 
controversial Board to set up--was put in place with some very 
specific constraints and very specifically looking for 
expertise in the areas where the IRS was most lacking, and that 
was in management, information technology and small business, 
and taxpayer sensitivity, and not, as important as it is, in 
fighting the war against terrorism. Thank you, Mr. Chairman.
    Mr. POMEROY. You know the depth of my regard for my 
colleague, Rob Portman, and there has not been a legislator of 
the 435 of us more committed over the long haul to making sure 
the IRS is focusing on the right priorities and has the 
resources to do it, and he is in the weeds in technical 
competencies and he has worked it over time with great 
conscientiousness, and I admire his work in this area a great 
deal. I want to take a little issue with what he was just 
talking about in this area. Ms Killefer, you, as one Board 
Member, do have some background in international finance; is 
that correct?
    Ms. KILLEFER. Yes, sir, some.
    Mr. POMEROY. You are in fact a senior partner at McKenzie 
and Company, and indeed have a specific expertise within that 
company in international management consulting; is that 
correct?
    Ms. KILLEFER. It is an international management consulting 
company.
    Mr. POMEROY. You have held a variety of positions, public 
and private, relating not just to the flow of finance 
domestically, but internationally; is that correct?
    Ms. KILLEFER. To some extent. I would say what--just to 
clarify for both of you--that what the Board does when it 
construct its budget--is work very closely with the IRS and 
look at a series of initiatives that we don't propose, that 
they propose to us as ones that would meet their mission. It is 
through that process that among other things this was one of 
their initiatives. So, we did not propose it, nor would we 
expect to propose initiatives to them.
    Mr. POMEROY. Many illegal conspiracies have ultimately been 
brought down by investigators following the flow of money. 
Following the flow of money is something the IRS is pretty good 
at, isn't it?
    Ms. KILLEFER. I would think so. There are other elements of 
government that do the same.
    Mr. POMEROY. Undoubtedly, and there have been no 
discussions this afternoon about taking all other investigative 
areas here and stripping it from those agencies and putting it 
in the IRS. That is not what we are talking about at all, but 
we are talking about being able to tap some of the 
extraordinary institutional potential in the agency that 
through history has been in charge of basically following the 
money, finding out what is owed to our government, collecting 
it, including not just taxpayers at the H&R Block Office this 
afternoon, but very sophisticated international enterprises. 
That some of this in-house expertise, if augmented with 
appropriate resources, could have played a very interesting 
additional role perhaps in back-stopping these other agencies. 
So, as the Board, with all of its tremendous sophistication in 
international finance, evaluated this proposal from the IRS, it 
isn't as though you are without expertise, without competence 
to have an informed opinion on this matter, in my belief, and 
that is why I look forward very much to receiving this 
additional information from you. I thank the Chair. I yield 
back.
    Chairman HOUGHTON. I feel like I have been at a tennis 
match here.
    [Laughter.]
    Mr. White, you and I ought to have our own session here. 
Anyway, I thank you very much for your testimony. I appreciate 
the work. You are great citizens. I think we will now move on 
to our next panel. Mr. Orwick, who is the President and Owner 
of the LFS Professional IRSs; Richard Shaw, Chair of the Tax 
section, American Bar Association, Robert Zarzar, who is 
Chairman of the Tax Executive Committee at the American 
Institute of Certified Public Accountants, James Leimbach, 
Enrolled Agent, National Association of Enrolled Agents, and 
Timothy McCormally, Executive Director of the Tax Executives 
Institute. Now, Mr. Pomeroy, would you like to introduce the 
invited witness, Mr. Orwick?
    Mr. POMEROY. I would be delighted. Allen Orwick is 
President and Owner of LFS Professional IRSs, a tax accounting 
and property management company located in Lakota, North 
Dakota, where he prepares income tax returns on more than 500 
filers. He has done this for 23 years.
    We have had some exposure, Mr. Chairman, to some of the 
fanciest firms out there in terms of financial consulting and 
tax preparation. In my view, none exceed the professional 
integrity that Mr. Orwick brings to bear on behalf of his 
clients. He is not trying to stretch the law. He is trying to 
understand it, and he is trying to, therefore, give his advice 
to his taxpayer clients in terms of what they owe and what they 
do not owe. There is a significant issue that has come up 
relative to a major part of his work, and that is servicing 
retired farmers, and so we will hear from him on this question 
in the course of this panel.
    I thank the Chairman, but I most particularly thank Mr. 
Orwick. I would just note as an aside, he is also the Mayor of 
Michigan, North Dakota. So, while he is in the depth of filing 
season, he is out here testifying, and, by the way, Michigan, 
North Dakota, is having significant flooding, which he is also 
dealing with at the same time. So, this is a man of many hats, 
but we are glad he is bringing his tax preparer hat to this 
table this afternoon. Thank you.
    Chairman HOUGHTON. Well, Mr. Orwick, we are going to give 
you a chance to prove that you are as good as Mr. Pomeroy says 
you are.
    [Laughter.]
    So, thank you very much. Would you give your testimony?

    STATEMENT OF ALLEN I. ORWICK, PRESIDENT AND OWNER, LFS 
       PROFESSIONAL SERVICES, INC., LAKOTA, NORTH DAKOTA

    Mr. ORWICK. Thank you, Mr. Chairman and Mr. Pomeroy. I 
appreciate the opportunity to be here today. I am not so sure 
that I can live up to that billing, but I will do my best. Just 
to revisit, I have a tax practice located in Lakota, North 
Dakota. It is the northeastern part of the State, very 
agriculturally involved, also a county that has an aged 
population. So, the various issues that Mr. Pomeroy alluded to 
earlier are big, big issues in our home area. Overall, I would 
say our tax season is going very well. The day-to-day workings 
of the complex tax law, of course, seem to put more and more 
hours on myself and my staff every year. If I were to wish for 
one thing, I guess it would be simplification, like everybody 
else.
    We have had various contacts with State agencies and the 
IRS and feel very fortunate to work with such high-quality 
people, and the courtesy and help that they have given us 
throughout the season are appreciated. Since 1997, we have been 
very involved in the e-file program, and as of last Sunday, 
when I tallied it up, we had utilized the e-file program for 
99.2 percent of the qualified tax returns. Of those that we did 
transmit, 98.4 percent were approved on the first transmission, 
which is something that we are very proud of. We are a big 
believer in the program and recommend use of the program to our 
peers.
    In regard to the situation of the CRP, prior to the letter 
ruling that Mr. Pomeroy referred to earlier that was issued 
last May, it has been our understanding that CRP is to be 
reported as self-employment income for those who are actively 
farming, and rental income for those who are not. With this 
recent ruling, it has really thrown everybody into a frenzy as 
to whether or not that is the correct process or not. I 
participated in a meeting last Friday, put together by 
Congressman Pomeroy in Bismarck, North Dakota, and we had 
members of the IRS, myself, Dr. Harl, and our State Agriculture 
Commissioner there. During that meeting, there were a lot of 
different thoughts brought forward, but what we did notice is 
no resolution.
    It is a huge item to a retired person, and it looks as 
though about 10 percent of my clientele could be adversely 
affected by this ruling if that is the case, with an average 
cost of $1,200 per taxpayer, which out of my firm alone is 
$60,000. This is money that the taxpayers did not count on 
paying when they walked into my office. It was something that I 
had to inform them of possibly being out there. My clients are 
very conservative, and they are law-abiding citizens, and they 
want to do what is right. The problem we have today is that we 
don't know what is right because of the situation with this 
recent ruling.
    I would like to mention Dr. Harl's recommendations at that 
meeting, one of which was the withdrawal of CCA Letter Ruling 
200325002 or reissue it and bring it into harmony with Private 
Letter Ruling 8822064 and giving us some time to go through and 
sort this matter out. I would hope that the IRS would look upon 
these recommendations and adopt them so that we can bring some 
certainty and closure to this matter. I would also like to 
mention that I support legislation that is being offered by 
Congressman Pomeroy and others to completely exempt CRP 
payments from self-employment tax. I want to thank you for the 
opportunity to be here today. I will answer any questions that 
you may have.
    [The prepared statement of Mr. Orwick follows:]

  Statement of Allen I. Orwick, President and Owner, LFS Professional 
                  Services, Inc., Lakota, North Dakota

    I am Allen Orwick, President and owner of LFS Professional 
Services, Inc., a tax accounting and property management company 
located in Lakota, North Dakota. I have been preparing income tax 
returns professionally for twenty-three years, owning my own practice 
since 1984. LFS Professional Services, Inc. specializes in the 
preparation of income tax returns for active and retired farmers in 
northeastern North Dakota, preparing approximately five hundred returns 
annually.
    We have been very active in the Internal Revenue Service e-file 
program, first using the system to e-file 1997 tax returns. In 1999, 
the Internal Revenue Service chose LFS Professional Services, Inc. as 
an Exemplary Electronic Return Originator.
    During the current tax season we have utilized the IRS e-file 
program for 99.2% of qualified returns. As of March 28, 2004, 98.4% of 
our transmitted returns were accepted the first time. We are very proud 
of our accomplishments in the e-file program and promote its use among 
our peers at every opportunity.
    The current filing season has gone quite well. Our contacts with 
both federal and state agencies have been very positive experiences. 
Dealing with the complexity of the tax law is not always an easy task, 
my firm works very hard everyday to provide a high quality, 
professional service to our clients. The main area of concern this tax 
season has been Conservation Reserve Program payments and the manner in 
which they are to be taxed for retired taxpayers.
    Many of our clients have some involvement with the Conservation 
Reserve Program. Prior to this year we have reported CRP payments based 
on previous Internal Revenue Service guidelines and court cases 
indicating that CRP payments received by an active farmer were subject 
to self-employment tax and those received by retired farmers were 
generally considered rental payments and exempt from self-employment 
taxes.
    On June 23, 2003, the Internal Revenue Service released a Chief 
Counsel's letter ruling on the taxability of CRP payments for self-
employment tax purposes. In CCA Ltr. Rul. 200325002 (May 29, 2003), the 
IRS took the position, one which appears to be directly contrary to 
Priv. Ltr. Rul. 8822064 (March 7, 1998), that a landowner's activities 
under a CRP contract amount to material participation and the payments 
should be reported on Schedule F, not Schedule E or Form 4835. In other 
words, even retired farmers must now pay self-employment taxes on CRP 
rental payments.
    The ruling dealt with two fact situations involving CRP payments. 
In the first fact situation the taxpayer was engaged in the trade or 
business of farming and bid land into the Conservation Reserve Program. 
The second situation was of a taxpayer, not involved in the trade or 
business of farming, who acquired land that had already been bid into 
CRP. This ruling stated the CRP payments in both fact situations should 
have been reported on Schedule F and were liable for self-employment 
tax.
    This latest CCA ruling on the second fact situation is at variance 
with prior Private Letter rulings and commentary issued with Tax Court 
decisions. It has created great concern and much confusion on how CRP 
proceeds are to be reported for retired landowners.
    I participated in a panel discussion on this issue in Bismarck, 
North Dakota on March 26, 2004. At this meeting John Schmittdiel, an 
IRS Associate Area Counsel for the SB/SE division of Chief Counsel in 
St. Paul, Minnesota stated that CCA Lrt. Rul. 200325002 and Priv. Ltr. 
Rul. 8822064 were issued in response to single cases and were not meant 
to set a precedent. Another member of the panel, Dr. Neil E. Harl, the 
Charles F. Curtiss Distinguished Professor in Agriculture and Professor 
of Economics at Iowa State University, and one of the country's most 
respected agricultural tax scholars, stated that without clarification 
from Congress or specific rulings from the IRS, tax practitioners had 
to rely on what guidance is available including the two previously 
noted rulings on this matter.
    The 2003 Internal Revenue Service Publication 225 (Farmer's Tax 
Guide) instructs taxpayers that ``Under, the Conservation Reserve 
Program (CRP), if you own or operate highly erodible or other specified 
cropland, you may enter into a long-term contract with the USDA, 
agreeing to convert to a less intensive use of the cropland. You must 
include the annual rental payments and any one-time incentive payment 
you receive under the program on lines 6a and 6b of Schedule F. Cost-
share payments you receive may qualify for the cost-sharing exclusion. 
CRP payments are reported to you on Form CCC-1099-G.''
    It is ironic that the instructions refer to these payments as 
``annual rental payments''. While rental payments a landlord might 
receive are not generally subject to the self-employment tax, rental 
payments under the CRP program are now subject to the self-employment 
tax. The USDA Farm Service Agency also uses the term ``rent'' when 
reporting CRP payments on Form CCC-1099-G. If it is truly ``rental 
income'' it should not be subject to self-employment taxes.
    Legislation to exempt all CRP payments from self-employment tax was 
introduced for consideration in legislative bills of 2000, 2001 and 
2003. Many tax professionals feel legislative action is necessary to 
clearly define the Congress's intent relative to the circumstances 
when, if ever, CRP and other similar land idling program payments will 
be subject to or exempt from self-employment tax.
    My clients are surprised to learn that self-employment taxes may 
apply to their CRP income while they are retired. There has been very 
little publicity on this subject in farm publications and local 
newspapers. Because of the IRS' recent ruling, tax preparers and 
retired landowners participating in the CRP program are unsure of how 
to file their income tax returns for 2003. Tax practitioners range from 
being unaware of the ruling to believing that CCA Ltr. Rul. 200325002 
is the most recent authority and must be followed. Others believe the 
recent ruling will be overturned or that it does not really apply to 
retired farmers based on previous authority. Unfortunately, this ruling 
does not address prior rulings and case law and the IRS has not issued 
any additional guidance.
    It is my firm's opinion that each client must choose between two 
alternatives when filing their 2003 income tax return. The first choice 
is to pay the additional tax and hope for future relief, either from 
the IRS or Congress. The second choice is to prepare the return in the 
same manner as in previous years and disclose to the IRS that they are 
filing contrary to CCA Ltr. Rul. 200325002. If retired farmers are 
required to pay self-employment tax on their CRP income it will make a 
large difference on the total taxes they will be required to pay.
    Based on all of the clients I have met with so far this tax season, 
approximately ten percent will be adversely affected by this recent IRS 
ruling, and all of the retired farmers owning CRP are affected. The 
average additional cost to those taxpayers is about $1,200. This 
equates to an additional $60,000 of self-employment taxes being paid by 
my clients alone. Most of these taxpayers are elderly and living a very 
moderate lifestyle. These are not private landowners who have never 
farmed and are looking at the CRP program as easy money or an 
investment, but instead are people who have generally farmed the same 
land for much of their lives and CRP payments are a significant source 
of their retirement income. This additional tax is a severe financial 
burden for them.
    My clients are all law-abiding citizens and they want to do what is 
right. At this point I can not tell them what is right, because I do 
not know. My clients are conservative and tend to select the option 
that they feel has the least risk. A majority are choosing to pay the 
self-employment tax and hope that additional clarification will allow 
them an opportunity to amended their return and apply for a refund.
    During the aforementioned March 26, 2004 panel discussion, Dr. Harl 
made the following recommendations:

    1.  Withdrawal of CCA Ltr. Rul. 200325002, May 29, 2003, or 
reissuance with a narrowing of the ruling to harmonize with Ltr. Rul. 
8822064, March 7, 1988, this would remove much of the current 
confusion.
    2.  The CCA Ltr. Rul. seems to apply to all federal conservation 
programs payments. It would be helpful to know whether that was 
intended.
    3.  Have the IRS give guidance on the matter of SE tax liability 
for those who retire during the term of the CRP contract bringing 
clarification to this question.

    I agree with Dr. Harl's recommendations. In addition, I believe 
that Congress should pass legislation to clear up once and for all it's 
intent on the tax treatment of Conservation Reserve Payments. It is 
very important to taxpayers and tax professionals that certainty and 
closure be brought to this issue. It is my hope that common sense will 
prevail and that at least those whom are retired, will not be subject 
to the self-employment tax.
    Thank you for your consideration.

                                 

    Chairman HOUGHTON. Well, I thank you very much for that. 
Also, I thank you for coming in under your time limit. That is 
very helpful.
    Mr. Shaw.

STATEMENT OF RICHARD A. SHAW, CHAIR, TAX SECTION, AMERICAN BAR 
                          ASSOCIATION

    Mr. SHAW. Good afternoon, Mr. Chairman and Mr. Pomeroy. 
Thank you. My name is Richard Shaw. I am Chair of the American 
Bar Association (ABA) section of Taxation. This testimony is 
presented on behalf of the 400,000 members of the American Bar 
Association and the 20,000 members of the section of Taxation. 
We appear before you today to specifically talk about one 
primary subject, and that is the subject of simplification. We 
want to emphasize it today. The ABA and the section of Taxation 
have long been advocates of simplification of the Tax Code. 
Last month, the Board of Governors and the House of Delegates 
of the Bar Association adopted a resolution which treats 
simplification as one of 12 of the highest priority legislative 
areas where we believe emphasis needs to be placed. We believe 
that complexity is at the root of many of the significant 
obstacles to efficient and effective administration of the tax 
laws. Let's talk first about complexity creates controversy.
    As the National Tax Advocate and others have well 
documented, the scope and complexity of the tax laws make it 
virtually certain that taxpayers will face procedural, 
technical, and bureaucratic obstacles in trying to meet their 
tax obligations. This not only creates problems on the front 
end, when they are trying to prepare their returns, but when 
errors appear it appears at the back end, where it results in 
complexity and litigation and controversy that should not have 
to take place. Second, let's consider the problem of fairness. 
Complexity has materially reduced the taxpayers' perceptions of 
fairness of the Federal tax system by creating disparate 
treatment of similarly placed and situated taxpayers. It is 
hard to imagine how taxpayers and Congress can see the IRS as 
an efficient, modern service or agency when the taxpayer cannot 
perceive the tax system as even being fair.
    Finally, let's evaluate the manipulation. Tax law 
complexity creates opportunities for technical manipulation of 
the tax laws, often in ways not contemplated by Congress. 
Aggressive exploitation of ambiguities in the laws not only 
further aggravates the perception problem but it forces the 
IRS, the IRS, to divert resources from working with compliant 
taxpayers to having to interpret and aggressively avoid the 
problem of--or the ability to deal with aggressive 
noncompliant. We would prefer that they be able to deal with 
the voluntary taxpayers, but recognize the need for dealing 
with noncompliance as well.
    What we are saying is that legislation on simplification is 
necessary. It results in difficult choices. The political 
realities of seeking a fiscal balance limits the ability to 
seek simplification. We know that. Simplification necessitates 
a willingness to embrace objective standards without dealing 
with passionate and political constituencies. Simplification 
requires that you avoid popular proposals and deal with 
realistic ones that avoid complexity. The code is replete with 
burdens where there are complexity, and these burdens are 
greater than the benefits that are obtained by engaging in 
simplification. Frequently, taxpayers have to engage in 
torturous struggles between a maze of cross-references and 
inconsistent definitions in order to examine an issue and then 
determine finally that it is not even relevant.
    There is a problem of deadwood where we have many statutes 
that were fair and applicable when they were first enacted, but 
because of changes are no longer relevant. I want to draw 
attention to several just quick examples where we believe 
simplification is helpful. It is necessary and appropriate that 
we deal with a phase-out of tax benefits. The Joint Committee 
on Taxation has sought that they be phased out. The child 
definition creates problems. There are at least five different 
definitions. When the taxpayers find that one works, they tend 
to think that it works for all. This results in complexity and 
it interferes with efficiency of the system. We think that 
there is a need for the elimination of the alternative minimum 
tax. It has created complexity that is unnecessary. The capital 
gains provisions apply several definitions and notes. Schedule 
D is almost impossible to complete.
    The foreign tax rules need to be modified. In a true sense, 
we believe that simplification must be dealt with at this time. 
We also touch on the fact that regulatory simplification should 
be dealt with. We recognize that Congress prepares and enacts 
the law. We also think that Congress needs to oversee the IRS 
in a way that will assure that there is more efficient 
administration that will provide guidance for taxpayers so that 
they are able to comply properly with the tax laws and satisfy 
their obligations.
    I have cut my comments very short, but I would like to 
summarize by simply stating that our primary message is the 
need for Congress to devote its energy and its resources to 
promote changes in the tax laws that will result in greater 
simplification. It is difficult to expect taxpayers to have 
confidence in taxes imposed under current laws when even 
experienced tax return preparers consistently get different 
results on similar data because of the complexity of the tax 
laws. The integrity, the fairness, and the equity of the tax 
system required and do require a concerned effort to obtain 
simplification now and not 10 years from now.
    [The prepared statement of Mr. Shaw follows:]

Statement of Richard Shaw, Chair, Tax Section, American Bar Association

    Thank you, Mr. Chairman. My name is Richard A. Shaw. I am Chair of 
the American Bar Association Section of Taxation. This testimony is 
presented on behalf of the American Bar Association.
    The American Bar Association appreciates the opportunity to appear 
before the Subcommittee on Oversight (the ``Subcommittee'') today to 
discuss the critical need for simplification of the federal tax laws. 
We know this is an issue the Subcommittee takes seriously, and we 
appreciate the efforts the Chairman and other Members of the 
Subcommittee have taken over the past few years to focus attention on 
the need for simplification.

                        ABA Section of Taxation

    The ABA is comprised of more than 400,000 members and its Section 
of Taxation has approximately 20,000 tax lawyers who work in law firms, 
corporations and other business entities, government, nonprofit 
organizations, academia, accounting firms and other multidisciplinary 
organizations. Accordingly, to make the tax system fairer, simpler and 
easier to administer is one of the Association's legislative 
priorities.
    Our members provide advice on every substantive and procedural area 
of the tax laws, and interact regularly with the Internal Revenue 
Service (the ``Service''), the Treasury Department, and other 
government agencies and offices responsible for administering and 
enforcing the tax laws. Many of our members have served in staff and 
executive-level positions at the Service, the Treasury Department, the 
Tax Division of the Department of Justice, and Congressional tax-
writing committees.

                      The Need for Simplification

    The ABA and its Section of Taxation have long been strong advocates 
for simplification of the Internal Revenue Code. For nearly thirty 
years, the ABA has been on record urging tax law simplicity, a broad 
tax base and lower tax rates.
    We have reiterated this position in testimony before Congressional 
tax-writing committees on numerous occasions. For a number of years, 
the Section of Taxation has worked with our colleagues at the AICPA Tax 
Division and the Tax Executives Institute on this important issue. The 
Tax Section will continue these efforts and we remain optimistic that 
real steps can be taken by Congress to simplify the tax laws.
    We believe that complexity is at the root of many significant 
obstacles to efficient and effective administration of the tax laws.
    First, as the National Taxpayer Advocate and others have well 
documented, the scope and complexity of the tax laws make it virtually 
certain that taxpayers will face procedural, technical and bureaucratic 
obstacles in meeting their tax obligations. This not only creates 
problems on the front end, when taxpayers attempt to prepare and file 
returns, but also at the back end, when errors rooted in complexity 
result in audits and controversy with the Service.
    Second, as the staff of the Joint Committee on Taxation documented 
in their comprehensive 2001 study on tax simplification, complexity has 
materially reduced taxpayers' perceptions of fairness of the federal 
tax system by creating disparate treatment of similarly situated 
taxpayers. Although perceptions--and their impact--are difficult to 
measure, it is hard to imagine how taxpayers or Congress can see the 
Service as an efficient, modern and responsive agency if they do not 
perceive the tax law itself to be fair.
    Third, as we have seen in recent years, tax law complexity creates 
opportunities for technical manipulation of the tax laws--often in ways 
never contemplated by Congress. Aggressive exploitation of ambiguities 
in the laws not only further aggravates the perception problem, but 
also forces the Service to divert resources from working with compliant 
taxpayers in resolving legitimate issues of interpretation to pursuing 
the aggressively noncompliant instead.

                       Legislative Simplification

    Of course, we recognize that simplifying the tax law requires 
Congress to make difficult choices. This is particularly true when, as 
now, the political realities of the fiscal balance limit the ability to 
simplify in a manner that reduces revenue. Simplification necessitates 
a willingness to embrace objective proposals that are often dull and 
without passionate political constituencies. Simplification also 
requires that politically popular proposals be avoided if they would 
add significant new complexity. Simplification--and preventing greater 
complexity--may not garner political capital or headlines, but it is 
crucial to a tax system that is fair and can be efficiently 
administered.
    The Code is replete with tax provisions where the burden of 
complexity is much greater than the perceived abuse to which the 
provision was aimed, or the benefit that was deemed gained by its 
addition.
    Frequently, taxpayers, or more likely their tax representatives, 
must engage in a torturous struggle through a maze of cross-references 
and inconsistent definitions to ascertain that a set of complex 
provisions are not relevant to a transaction or tax obligation.
    The Code contains many provisions that at the time of enactment may 
have been desirable, but with the passage of time, or the enactment of 
other changes, have truly become ``deadwood.'' Despite the absence of 
any practical utility in such provisions (whether in a relative or 
absolute sense), analysis of the effect of such provisions will 
generally be required, either in the preparation of the tax return or 
in the consummation of a proposed transaction. The elimination of such 
provisions would greatly simplify the law.
    In the past, working with our colleagues in the AICPA and TEI, 
examples of provisions have been offered that, when analyzed, do not 
justify their continuation in the law. We are grateful that the 
Congress has acted to address some of these problems. We encourage you 
to continue these efforts, as every step taken to simplify the tax laws 
is an important part of providing tax relief to the American taxpayers.
    Today I want to draw your attention to a few areas in particular: 
the complexity wrought by the numerous provisions of the tax code that 
phase-out tax benefits based on income levels, and the complexity 
caused by the multiple definitions of a ``child'' under the tax code.
    As you know, the tax code is often used to distribute benefits 
under a variety of social policy programs among selected groups of 
taxpayers. To accomplish these diverse goals, many code sections phase-
out available deductions and credits over various income ranges based 
on differing measures of taxpayer income. Currently, these phase-out 
ranges are not consistent either in defining income, the applicable 
levels of income, the range of income over which the phase-out applies, 
or the method of applying the phase-outs. The phase-out ranges even 
differ depending on the filing status of the taxpayer, and these 
differences are also internally inconsistent. As a result, phase-outs 
cause inordinate complexity--particularly for taxpayers attempting to 
prepare their own returns without the assistance of tax preparation 
software.
    The staff of the Joint Committee on Taxation recommended three 
years ago that most phase-outs be eliminated and in 2002, the ABA 
adopted a formal policy to support that position. Congress has already 
taken an initial step in this effort by providing that, beginning in 
2006, two of these troubling phase-out provisions, dealing with 
personal exemptions and the overall limitation on itemized deductions, 
will begin to be eliminated. We applaud this legislative action, and 
encourage the Subcommittee to seek out ways of building on that 
experience to address further the problem of unduly complex phase-outs.
    As the Subcommittee is undoubtedly aware, the use of different 
definitions to determine who is a qualifying child for purposes of:

    (1) the dependency exemption;
    (2) the earned income tax credit (``EITC'');
    (3) the child credit;
    (4) the dependent care credit;
    (5) and head of household filing status,

has led to widespread confusion and inadvertent errors. Taxpayers 
mistakenly believe that if they have a ``child'' who qualifies for one 
of the benefits, they are entitled to all of them. These errors 
inevitably lead to controversies with the Service that are very 
difficult for taxpayers and particularly, lower-income families to 
handle.
    To the extent that the Service is required to devote its limited 
resources to sorting through the controversies caused by five (5) 
different definitions of ``child,'' the end result is that the Service 
is not able to focus attention on other taxpayers in need of assistance 
or in pursuing enforcement against tax evasion.
    The problems wrought by these confusing definitions of a child are 
well-documented, and similar approaches to simplifying this part of the 
tax laws have been endorsed by both the Treasury Department and the 
staff of the Joint Committee on Taxation, as well as several Members of 
this Subcommittee. We encourage the Subcommittee to take whatever steps 
it can to further these efforts this year. We note that the 2005 budget 
proposals contain nine (9) specific tax simplification items. We 
strongly recommend consideration of the many recommendations made in 
the 2001 Joint Committee on Taxation Staff Report.

                       Regulatory Simplification

    We also want to touch on the need to encourage regulatory 
simplification within the Treasury Department and the Service.
    We appreciate that the Treasury Department and the Service have 
stepped up their efforts in recent years to work towards simplification 
through the regulatory process. The ABA and the Section of Taxation are 
committed to work with Treasury and the Service to continue such 
efforts. We also commend the Service for steps taken since 1998 to 
streamline the administrative system and improve the way the Service 
interfaces with taxpayers. We applaud efforts underway to redesign the 
examination and appeals processes to make them work more efficiently 
for both taxpayers and the Service. However, more can be done in the 
regulatory and administrative areas. As we recently advised the IRS 
Oversight Board, a cornerstone of the IRS strategic plan for the next 
five years must be a meaningful effort to simplify the tax law itself 
and the Service's procedures for interacting with taxpayers.
    The Service's efforts to refine its modernization program should 
consistently consider the necessity for quality and efficiency in 
dealing with taxpayers. The lack of efficiency is evidenced by the 
inability of the system to satisfy adequately the statutory and 
regulatory objectives of the Offers-in-Compromise program. Taxpayers 
should not be stranded in compliance limbo while offers take more than 
three years to be processed through Appeals.
    Prompt issuance of guidance advances the goal of simplification by 
reducing ambiguity and uncertainty. This can take the form of formal 
Revenue Rulings and Revenue Procedures that provide clarity and 
simplify the administration of complex and ambiguous laws and 
regulations. Prompt public releases are essential to provide guidance 
on new tax legislation. There have been at least twenty (20) new tax 
acts within the past five years affecting more than 300 sections of the 
Code. In addition, a strong program to modernize forms and instructions 
that make them more readily understandable and manageable to the 
average taxpayer can advance procedural simplification.
    There are success stories. Much litigation was eliminated when the 
Treasury adopted a ``check-the-box'' system for unincorporated 
associations to elect to be treated as either corporations or 
partnerships. Likewise, the Service adopted practical procedural 
guidelines for remedying defecting Selections without requiring 
taxpayers to file expensive requests for revenue ruling approval.
    Additional training is essential so that auditors and appeals 
officers are better able to explain and apply complex tax laws in a 
fair, consistent and just manner. Taxpayers and the system are not 
served well by Service Center communicators who are correct on complex 
tax laws only about 70% of the time.
    We have encouraged the Service to actively work with this 
Subcommittee and the other tax-writing committees to ensure that you 
are fully educated on how much complexity adversely impacts the ability 
of the Service to achieve its mission.
    In summary, our primary message today is the need for Congress to 
devote its energy and resources to promote changes in the tax laws that 
will lead to greater simplification. It is difficult to expect 
taxpayers to have any confidence that taxes imposed under current laws 
are collected accurately, when even experienced tax return preparers 
consistently get different tax results on similar data because of the 
complexity of the tax laws. The integrity, fairness and equity of the 
tax system require a concerted effort to obtain simplification.

                                * * * *

    The ABA Section of Taxation hopes that the foregoing observations 
and suggestions are helpful to the Subcommittee. The Tax Section would 
be pleased to meet with you to further discuss these views or any other 
matters. Thank you.

                                 

    Chairman HOUGHTON. All right. Thank you very much, Mr. 
Shaw. I don't think anybody disagrees. We will get into this a 
little later. Could I ask the rest of you if you could stay 
within the 5 minutes? I sure would appreciate that. Mr. Zarzar.

STATEMENT OF ROBERT A. ZARZAR, CHAIR, TAX EXECUTIVE COMMITTEE, 
       AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

    Mr. ZARZAR. Thank you, Chairman Houghton and Ranking Member 
Pomeroy, for this opportunity to appear here today. The 
American Institute of Certified Public Accountants (AICPA) is 
the national, professional organization of certified public 
accountants comprised of more than 330,000 members. We believe 
that the 2004 filing season is progressing largely without any 
significant problems, and American taxpayers and practitioners 
generally are pleased with the IRS' performance. I would first 
like to commend Chairman Houghton for his sponsorship and 
active support of H.R. 22, the Individual and Small Business 
Tax Simplification Act of 2003. As Mr. Shaw has said, we firmly 
believe that the enactment of tax simplification measures is 
integral to the success of future filing seasons, and we 
encourage Congress to continue to make tax simplification a 
major legislative priority. As for the IRS budget and the 
Business Systems Modernization program, we urge Congress to 
support full funding of the IRS' fiscal year 2005 budget.
    We note and appreciate the Administration's fiscal year 
2005 request to increase the IRS' funding. We have long 
advocated funding levels that would allow the IRS to 
efficiently and effectively administer the tax laws and collect 
taxes. Giving the IRS the resources necessary to properly 
enforce the tax laws is vital to maintaining our voluntary 
compliance tax system. Last month, before this Subcommittee, 
Commissioner Everson reported on the difficulties the IRS has 
faced with implementation of its Business Systems Modernization 
program--testimony that was generally consistent with the 
conclusions found in the Oversight Board's December report. 
Despite these problems, we strongly urge Congress to stay the 
course in terms of support for appropriate funding for this 
modernization effort. This is an issue that must remain a 
central feature of the IRS' strategic plan for the next 5 
years.
    As for the IRS' e-filing goals, we support their long-range 
goals for electronic tax administration. We applaud the IRS' 
current success with e-filing for the 2004 season, following on 
its successes of last year. We also commend the IRS' efforts to 
phase in the electronic filing of business returns and its 
rollout of the ``Electronic IRSs'' section on the IRS website. 
During the last year, the IRS has taken positive steps to 
listen to the practitioner community about the myriad problems 
tax professionals still face when contemplating conversion of 
their firms to practices offer e-file services to their 
clients. We appreciate this effort on the IRS' part, and to 
this end, we look forward to serving as a positive e-file 
partner with the IRS.
    Now, I do regret to inform you that there have been some 
information return problems this year along the whole line of 
complication rather than simplification. The 2003 Tax Act (P.L. 
108-27) cut the rate to 15 percent for qualified dividends 
received by individuals. Unfortunately, compliance with the new 
15-percent dividend tax rate has proved to be the biggest 
challenge for taxpayers and practitioners during the current 
filing season. Brokerage firms and mutual funds are having 
major difficulties determining when dividends are qualified 
dividends, which has resulted in large numbers of erroneous 
Forms 1099-DIV being mailed to taxpayers. This situation has 
caused havoc for many taxpayers and practitioners.
    Many taxpayers filed their Forms 1040, only to receive an 
amended Form 1099-DIV after the fact from a financial 
institution. The taxpayer and preparer thus are faced with a 
dilemma as to whether an amended return should then be filed, 
including State amended returns, or whether an earlier filed 
return remains the realistic snapshot of the taxpayer's 
position for 2003 and wait for the IRS' matching program to 
satisfy the ultimate obligation of tax. The AICPA stands ready 
to work with Congress and the IRS to develop procedures to 
minimize the processing burdens placed on taxpayers and 
practitioners from such changes.
    Finally, with respect to tax practitioners and their 
professional responsibility, the AICPA commends the IRS and 
Treasury for its efforts to address the professional 
responsibility standards of tax professionals generally, and 
particularly with respect to the eradication of abusive tax 
transactions. These are actions that we support. We have a 
longstanding track record of establishing professional 
standards for our CPA members. The AICPA has adopted and has in 
place a Code of Professional Conduct, as well as enforceable 
``Statements on Standards for Tax IRSs.''
    On the issue of return outsourcing, the AICPA's 
Professional Ethics Executive Committee appointed a task force 
in January 2004 to consider what changes, if any, should be 
made to our Code of Professional Conduct in connection with 
third-party-provider information. We are currently awaiting the 
task force's recommendations on this matter. Regardless of what 
decision a tax professional may make in this area, 
nevertheless, the public should understand that the 
practitioner remains fully responsible for the accuracy of a 
return and for ensuring confidentiality of client information. 
Mr. Chairman, I have completed my remarks and would be pleased 
to answer any questions you may have.
    [The prepared statement of Mr. Zarzar follows:]

 Statement of Robert Zarzar, Chair, Tax Executive Committee, American 
                Institue of Certified Public Accountants

    Mr. Chairman and members of the House Ways and Means Subcommittee 
on Oversight, the American Institute of Certified Public Accountants 
thanks you for the opportunity to appear before you today. I am Robert 
A. Zarzar, Chair of the AICPA's Tax Executive Committee. The AICPA is 
the national, professional organization of certified public accountants 
comprised of more than 330,000 members. Our members advise clients on 
federal, state, and international matters, and prepare income and other 
tax returns for millions of Americans. They provide services to 
individuals, not-for-profit organizations, small and medium-sized 
businesses, as well as America's largest businesses. It is from this 
broad base of experience that we offer our comments today on the IRS 
budget and the 2004 tax filing season.
    The AICPA is happy to report that the 2004 filing season is 
progressing largely without any significant problems and American 
taxpayers and practitioners generally are pleased with the Service's 
performance. We note that enactment of tax simplification measures is 
integral to the success of future filing seasons. Mr. Chairman, the 
AICPA is particularly encouraged by your sponsorship and active support 
of H.R. 22, the Individual and Small Business Tax Simplification Act of 
2003.
    Our comments herein focus on the IRS budget for fiscal year 2005 
and a number of programs of critical importance to the Service. 
Specifically, we are pleased to address: (1) the IRS budget, (2) 
Business Systems Modernization, (3) achieving E-filing goals, (4) 
information return problems, (5) tax practitioners and professional 
responsibility, and (6) tax simplification.

1. The IRS Budget
    The AICPA urges Congress to support full funding of the Internal 
Revenue Service's fiscal year 2005 budget. The AICPA has long advocated 
funding levels which would allow the IRS to efficiently and effectively 
administer the tax laws and collect taxes. Giving the Service the 
resources necessary to properly enforce the tax laws is vital to 
maintaining our voluntary compliance tax system. Obviously, we expect 
the Service to identify responsible ways to allocate any additional 
resources it receives over prior year funding and Congress will through 
its oversight responsibilities ensure that those resources are properly 
utilized.
    We note and appreciate the Administration's fiscal year 2005 budget 
request to increase the Service's funding to $10.674 billion, 
representing an approximate increase of $490 million in funding and 
2,200 staff positions over fiscal year 2004. The AICPA supports the 
objectives of the Administration's budget proposal, which principally 
focuses on increasing staffing and resources in the enforcement area. 
Commissioner Mark Everson recognizes that any increase in enforcement 
funding must be balanced with positive responses to the taxpaying 
public as customers. We encourage this type of balanced approach and 
stand ready to work with the Service to ensure that the needs of 
American taxpayers are fulfilled.
    Many AICPA members are tax practitioners. As such, we have seen 
first-hand the problems caused by an IRS that is not responsive to the 
taxpaying public as customers. We have also witnessed the improvements 
initiated by former Commissioner Charles Rossotti and Commissioner 
Everson, initiatives involving the reorganization mandated by Congress 
in the IRS Restructuring and Reform Act of 1998. Any lack of attention 
to the IRS's funding needs will likely only serve to undercut the tax 
administration improvements Congress expects and we believe the 
nation's taxpayers will suffer as a direct result.

2. Business Systems Modernization
    In testimony before the House Ways and Means Subcommittee on 
Oversight on February 12, 2004, Commissioner Everson reported on the 
difficulties the IRS has faced with implementation of the agency's 
Business Systems Modernization (BSM) program; testimony that was 
generally consistent with the conclusions on BSM found in the December 
2003 report by the IRS Oversight Board. While touching on a number of 
BSM projects, Everson testified about the Service's continuing problems 
with implementation of the customer account data engine (CADE), the 
system designed to replace the agency's master file of taxpayer 
records.
    Despite the problems the IRS has experienced with Business Systems 
Modernization, we strongly urge Congress to stay the course in terms of 
their support for appropriate funding for the modernization effort. 
This is an issue that must remain a central feature of the Service's 
strategic plan for the next five years.
    The BSM goals are critical to the future successes of the Service. 
The program is designed to change the entire way the IRS conducts 
business with taxpayers and stakeholders, by (1) implementing systems 
to improve the IRS's effectiveness in receiving, routing, and 
responding to millions of taxpayer telephone calls; (2) supplying 
Revenue Agents with software capable of accurately assessing a 
taxpayer's liability when faced with a complex tax matter or 
calculation; (3) establishing a modern, reliable data base; and (4) 
implementing a nationwide e-mail and voice-mail messaging system for 
Service employees.

3. Achieving E-Filing Goals
    The AICPA supports the IRS's long-range goals for electronic tax 
administration in general, and electronic filing (ELF) in particular. 
We applaud the Service's current successes with e-filing for the 2004 
filing season, as well as the successes of last year. As of March 17, 
2004, taxpayers have submitted 43 million e-filed returns, or an 11.4 
percent increase over the same period last year. Approximately 53 
million Americans utilized e-file options in 2003.
    We also applaud the Service's efforts to phase-in the electronic 
filing of business returns; and its rollout of the ``Electronic 
Services'' section on the IRS website, which includes a suite of web-
based products for practitioners to do business with the IRS 
electronically. With respect to the Form 1040 e-file program, the IRS 
has implemented a number of improvements to the program in recent years 
that should prove positive for practitioners who file returns 
electronically. We especially appreciate that (1) nearly all Form 1040 
forms and schedules have been made available to electronic filers; (2) 
electronic filers are no longer required to use a paper signature 
document; and (3) the electronic payment options have been expanded.
    One drawback with electronic filing is that it is not an option for 
many low income taxpayers who don't own a computer. These taxpayers 
routinely find that they must rely on commercial preparers who often 
charge disproportionately large fees. Also, blinded by the appeal of 
immediate cash, these taxpayers have high-interest refund anticipation 
loans (RALs) foisted on them by some commercial preparers. As an 
alternative to the regrettable RAL situation, taxpayers can go to a 
low-income taxpayer clinic or get assistance through programs like the 
Volunteer Income Tax Assistance (VITA) Program.
    Unfortunately, funding for low-income taxpayer clinics was 
curtailed last year due to an IRS Chief Counsel interpretation that IRS 
``matching'' funds should only be available to controversy clinics that 
don't prepare returns. National Taxpayer Advocate Nina Olson has 
recommended that the IRS support separate funding for low-income return 
preparation clinics, a recommendation that should encourage e-filing 
and improve compliance by low-income taxpayers generally. Senator Jeff 
Bingaman has introduced legislation that includes a provision 
supporting funding for low-income return preparation clinics. We 
support these recommendations and initiatives.
    The IRS has taken some positive steps during the last year to 
listen to the practitioner community about the myriad problems tax 
professionals still face when contemplating offering e-file services to 
their clients. For a long time the AICPA had been frustrated by the 
Service's response to our attempts both to partner with the IRS in 
promoting ELF to our membership and in explaining the effects of the 
current e-file programs' limitations on our constituency. As the IRS 
shifts its electronic filing focus from individual returns to business 
returns, the importance of involving, listening to, and responding to 
the various stakeholder groups will become all the more critical.
    We recognize the many hurdles on the road to achieving the goals 
established for the electronic filing program by Congress, but look 
forward to a positive partnership in traveling the ELF road.

4. Information Return Problems
    The Jobs and Growth Tax Relief Reconciliation Act of 2003 cut the 
tax rate to 15 percent for ``qualified dividends'' received by 
individuals for tax years 2003 through 2008, the same rate that applies 
to a net capital gain. The 15 percent rate is not available for 
individuals who (1) do not meet certain securities holding period 
requirements and (2) are obligated to make related payments on 
positions in substantially similar or related property.
    Compliance with the new 15 percent dividends tax rate has proved to 
be the biggest challenge for taxpayers and practitioners during the 
current filing season. Brokerage firms and mutual funds are having 
major difficulties determining which dividends that a taxpayer receives 
qualify as a ``qualified dividend'' and the new 15 percent tax rate, 
resulting in large numbers of erroneous Forms 1099-DIV being mailed by 
financial institutions to taxpayers. This situation is causing havoc 
for many taxpayers and practitioners.
    Many taxpayers filed their Form 1040, only to receive an amended 
Form 1099-DIV from a financial institution after the fact from a 
financial institution. The taxpayer and preparer are faced with the 
dilemma as to whether an amended return should be filed; or whether the 
earlier filed return remains a realistic and reasonable ``snapshot'' of 
the taxpayer's tax position for 2003 and therefore, obviating the need 
to file an amended return. Unfortunately, there is nothing to say that 
the same taxpayer will not receive a third generation of corrected 
Forms 1099-DIV.
    We have also received reports that ``eligible education 
institutions'' also are having difficulty providing ``correct'' Forms 
1098-T (Tuition Statement) to students. This form reports the amount of 
qualified tuition and related expenses that a student is required to 
pay when enrolled at an eligible education institution. A number of 
AICPA members have informed us that education institutions are making a 
number of mistakes on the Form 1098-T, including (1) incorrectly 
including income on the information return and (2) reporting inaccurate 
education tax credit information. Practitioners suggest that the 
instructions and tax regulations for the Form 1098-T are not fully 
developed, and that the eligible education institutions are not 
generally experienced in tax compliance.
    The AICPA stands ready to work with Congress and the IRS to develop 
procedures to minimize processing burdens placed on taxpayers and 
practitioners to ensure proper compliance with the new dividend law, as 
well as the filing and processing of Form 1098-T.

5. Tax Practitioners and Professional Responsibility
    The AICPA commends the IRS and Treasury for its efforts to address 
the professional responsibility standards of tax professionals in 
general, and particularly with respect to the eradication of abusive 
tax transactions. We are encouraged by Commissioner Everson's 
commitment to upgrade the Office of Professional Responsibility; and we 
are pleased to have had the opportunity to testify at the February 19, 
2004 IRS hearing on the proposed amendments to Circular 230 involving 
tax opinion standards.
    We have a longstanding track record of establishing professional 
standards for our CPA members. The AICPA has adopted and has in place a 
Code of Professional Conduct, as well as enforceable Statements on 
Standards for Tax Services (SSTSs). Both the Code of Professional 
Conduct and the SSTSs provide meaningful guidance to CPA members in the 
performance of their professional responsibilities. We believe 
compliance with professional standards also confirms the public 
awareness of the professionalism that is associated with CPAs as well 
as the AICPA.
    The AICPA has a clear position on abusive tax transactions--they 
should be eradicated. We have consistently supported the protection of 
the public interest and prohibitions on the misuse of our tax system. 
Our enforceable SSTSs are a clear example of this. We continue to be 
actively engaged in proposing and evaluating various legislative and 
regulatory measures that are designed to identify and prevent taxpayers 
from undertaking, and tax advisers from rendering advice on, 
transactions having no purpose other than the reduction of federal 
income taxes in an abusive manner.
    Through our Tax Executive Committee, over the last several years, 
we have shared with Congress and relevant regulatory bodies our 
recommendations to help them deal with misuse of the tax code through 
inappropriate tax avoidance transactions. The conceptual framework of 
our solution is built on our belief that the most effective way to 
combat abusive tax shelters, without interfering with a taxpayer's 
right to legally minimize taxes, is through disclosure.
    We support the objectives of the (final) tax shelter/reportable 
transaction regulations issued by the Treasury Department on February 
28, 2003, regulations that have existed in various forms (Proposed, 
Temporary) for several years. In specific, these regulations strive to 
(1) identify and shut down abusive tax avoidance transactions and (2) 
provide greater clarity; which, if met, will trigger enhanced taxpayer 
and promoter responsibilities and obligations--accomplished principally 
through disclosure.
    In addition to any governmental sanctions under the February 2003 
reportable transaction regulations, our own disciplinary process will 
be (and has been) invoked where our rules of professional conduct, 
including the enforceable Statements on Standards for Tax Services, are 
violated. Tax practice by AICPA members has always been subject to the 
Institute's Code of Professional Conduct. Most recently, the AICPA 
adopted an Interpretation to SSTS No. 1, which discusses a member's 
ethical obligations and responsibilities in connection with tax 
planning. The Interpretation clarifies how the standards would apply 
across the tax practice spectrum, including situations involving tax 
shelters (regardless of how that term is defined).
    On the issue of tax return outsourcing, the AICPA's Professional 
Ethics Executive Committee appointed a task force in January 2004 to 
consider what changes, if any, should be made to our Code of 
Professional Conduct in connection with the use of third party 
providers; and we are currently awaiting the task force's 
recommendations on the matter. Also, in the March 2004 Journal of 
Accountancy, we have published an article entitled, ``Legal and Ethical 
Considerations Regarding Outsourcing,'' authored by Alan W. Anderson, 
AICPA Senior Vice President--Member and Public Interests, and Richard 
I. Miller, AICPA General Counsel and Secretary.\1\
---------------------------------------------------------------------------
    \1\ Journal of Accountancy, Vol. 197, No. 3 (March 2004); http://
www.aicpa.org/pubs/jofa/mar2004/miller.htm.
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    The Journal of Accountancy article provides our CPA members with 
guidance regarding the current state of the ethical and legal climate 
surrounding the outsourcing issue. Concerned CPAs have inquired about 
their professional responsibilities regarding the use of third party 
providers in the performance of professional services. This AICPA 
article responds to their questions.
    The AICPA first addressed the use of third-party service providers 
in 1973, in response to the then-new practice of computerizing tax 
return preparation. (See Ethics Ruling No. 1, AICPA Code of 
Professional Conduct Rule 301.) Then, as now, to satisfy their 
professional responsibilities, our members should investigate and be 
satisfied with a third-party provider's competence, quality controls, 
security controls, and confidentiality controls. But, regardless of who 
the CPA teams with to provide the service, the CPA always remains fully 
responsible for the accuracy and completeness of the services, the 
confidentiality of client information, and to assure the services are 
performed with due professional care. The article also reviews the 
privacy notification regulations under the Gramm-Leach-Bliley Act, and 
the Internal Revenue Code prohibition on inappropriate disclosures of 
tax-related information (section 7216) and client confidentiality 
requirements (section 7525).

6. Tax Simplification
    The AICPA believes that one of the best ways of ensuring a positive 
tax filing season for taxpayers, practitioners, and the IRS is through 
the passage of major simplification of the tax laws. We encourage the 
Administration and the Congress to continue to make tax simplification 
a major legislative priority.
    Mr. Chairman, the AICPA supports your tax simplification bill (H.R. 
22), the Individual and Small Business Tax Simplification Act of 2003. 
While the AICPA supports outright repeal of the alternative minimum 
tax, we believe the AMT simplification provisions of your legislation 
should provide taxpayers with meaningful burden reduction and relief 
from tax law complexity. Also, we support the provisions of H.R. 22 
that (1) accelerate the repeal of the phase-outs for personal 
exemptions and the limitation on itemized deductions and (2) simplify 
and harmonize the definition of ``child.''
    We have worked closely with the American Bar Association and the 
Tax Executives Institute to jointly identify specific proposals for 
simplification. Tax simplification should result in fewer errors on tax 
returns. Also, we believe tax simplification should mitigate many 
taxpayers' reliance on vague, contorted interpretations of the law that 
have resulted in the marketing of abusive transactions.
    The AICPA is similarly encouraged by the Administration's inclusion 
of simplification proposals in its fiscal year 2005 revenue proposals. 
The Administration's proposals should result in meaningful 
simplification of the tax laws for families by (1) providing for a 
uniform definition of a child, (2) eliminating the income related 
phase-outs for the adoption credit and exclusion, and (3) abolishing 
the household maintenance test for ``head-of-household'' filing status.
    Thank you for the opportunity to share these views with you.

                                 

    Chairman HOUGHTON. Thank you very much, Mr. Zarzar. Mr. 
Leimbach.

   STATEMENT OF JAMES D. LEIMBACH, ENROLLED AGENT, NATIONAL 
      ASSOCIATION OF ENROLLED AGENTS, PANAMA CITY, FLORIDA

    Mr. LEIMBACH. Mr. Chairman, I am deeply honored today to 
present this statement on behalf of the 10,000 members of the 
National Association of Enrolled Agents (NAEA), the 
professional society of Enrolled Agents. I am James Leimbach, 
and I became an Enrolled Agent in 1997 while on active duty in 
the United States Air Force. My wife, Kelly, and I jointly 
operate a private practice in Panama City, Florida, where we 
work with both individual and small business taxpayers in the 
preparation and electronic filing of their returns. I also 
represent taxpayers before the IRS.
    With regards to filing season readiness, overall, filing 
season has run very smoothly. At the beginning of the season, 
however, we did experience processing problems in e-filing. 
Practitioners received a number of erroneous reject notices 
from overwhelmed e-filing centers. During this period, the IRS' 
Quick Alert e-mail system provided practitioners immediate 
notification of these problems, and it was invaluable. This 
information allowed us to plan around the problems as we were 
notified of them. Many practitioners also rely on an IRS CD-ROM 
or Volume 2 of Package X to get their updated forms and 
publications. It is particularly important for practitioners 
who live in areas where they do not have access to high-speed 
Internet service. Unfortunately, the products didn't arrive 
until as late as February 20th.
    NAEA has long supported full funding of the IRS. We believe 
that a properly resources IRS can efficiently process tax 
returns, collect taxes, and resolve taxpayer problems. For far 
too long, IRS has been hamstrung by its legacy computer system. 
NAEA realizes that billions of dollars have been poured into 
the modernization effort. I am here today to tell you that it 
has not been in vain, as I am one of 14 NAEA members testing 
the new suite of e-services products allowing us to represent 
taxpayers electronically. In January of this year, the IRS 
reached a major milestone in the development of new electronic 
capabilities that will revolutionize the way we as tax 
practitioners will conduct future business with the IRS.
    This new electronic capability, which I prefer to call ``e-
representation,'' will enable tax practitioners to quickly 
resolve their clients' IRS individual or business account 
problems via the Internet in a secure environment. It has taken 
the IRS 7 years to reach the point we are at today, and based 
on my experience in computer technology, I do not find that 
unusual in the least. The difficulty in integrating a sixties-
era mainframe with the Internet and doing so in an environment 
using highly complex encryption is enormous, costly, and worth 
every effort and every dime spent. This new e-services 
capability is truly going to revolutionize the way we conduct 
business with the IRS in resolving taxpayer problems.
    Under the new suite of e-services products called 
Disclosure Authorization, Transcript Delivery System, and 
Electronic Account Resolution, I have the ability 24 hours a 
day, 7 days a week, to submit processing requests to the IRS' 
computer system. This access provides me instant processing of 
my power of attorney submittals and instant processing of my 
requests for crucial transcripts. It also allows me to submit 
proposals for problem resolution at any time I choose. When you 
combine the capabilities of Disclosure Authorization, 
Transcript Delivery System, and the Electronic Account 
Resolution, the end result is phenomenal e-representation 
capability. This will truly revolutionize the way we do 
business with the IRS.
    Even though these products are undergoing testing and are 
not yet ready for nationwide deployment, NAEA has concerns 
about the future of this new capability. Our concerns are 
regarding Enrolled Agents that will be denied access due to the 
100 e-file requirement established by the IRS; limitation on 
the types of issues that can be addressed electronically; 
granting full access of e-services to unenrolled tax preparers; 
potential results from premature nationwide deployment. Aside 
from these concerns, NAEA understands, respects, and supporting 
the need for more e-filing of tax returns. We also believe in 
leading by example. Therefore, we respectfully would like to 
make the following suggestion: The IRS needs to lead by example 
when promoting e-filing to the tax practitioner community. They 
can do so easily by requiring all IRS employees to e-file their 
personal and individual returns.
    With regards to regulation of commercial preparers, I have 
included NAEA's recent statement before the IRS Oversight Board 
on the proposed regulation of commercial tax preparers. This is 
not my area of expertise, but NAEA would be pleased to provide 
a written response to any questions in this area. Mr. Chairman, 
it truly is a pleasure and an honor to be able to have shared 
with you our members' views, and if I may be able to answer any 
of your questions, I would be very delighted. Thank you.
    [The prepared statement of Mr. Leimbach follows:]

Statement of James D. Leimbach, Enrolled Agent, National Association of 
                 Enrolled Agents, Panama City, Florida

    Mr. Chairman and members of the Oversight Subcommittee, I am deeply 
honored today to present this statement on behalf of the National 
Association of Enrolled Agents (NAEA), the professional society of 
Enrolled Agents.
    I am James Leimbach, and I became an Enrolled Agent in 1997 while 
on active duty in the United States Air Force. My wife, Kelly, and I 
jointly operate our private practice in Panama City, FL where we work 
with both individual and small business taxpayers in the preparation 
and electronic filing of their returns. I also represent taxpayers 
before the IRS for problem resolution. I believe you already have a 
copy of my biography in your notebook.
    Today, I am representing NAEA whose 10,000 members are tax 
professionals licensed by the U.S. Department of Treasury to represent 
taxpayers before all administrative levels of the Internal Revenue 
Service (IRS).
    Enrolled Agents were created in 1884 to ensure ethical and 
professional representation of claims brought to the Treasury 
Department. Members of NAEA ascribe to a Code of Ethics and Rules of 
Professional Conduct and adhere to annual Continuing Professional 
Education standards that exceed IRS requirements.
    Like attorneys and CPAs, we are governed by Treasury Circular 230 
in our practice before the IRS. We are the only tax professionals who 
are tested by the IRS on our knowledge of tax law.
    Each year, we collectively work with millions of individual and 
small business taxpayers by providing tax preparation, tax planning, 
representation, and other financial services. Consequently, Enrolled 
Agents are uniquely positioned to observe and comment on the average 
American taxpayer's experience within our system of tax administration.
Filing Season Readiness
    Overall, filing season has run very smoothly. NAEA members did 
experience some processing problems in e-filing during the opening of 
filing season. Practitioners received a number of erroneous reject 
notices from overwhelmed filing centers. Most software companies were 
able to quickly recover. I would have to praise IRS for its Quick Alert 
system by which practitioners can receive e-mailed notices of problems. 
Information is the key. If we have it, we can plan around it.
    A greater problem occurred with late delivery of the IRS 2003 CD-
ROM. Many practitioners rely on this to get their updated forms and 
publications. It's particularly important for practitioners who live in 
areas where they don't have access to high speed Internet service. 
Unfortunately, some practitioners reported that they didn't receive 
their CDs until as late as February 20, long after the start of filing 
season.
    Another problem involved distribution of Volume 2 of Package X, a 
paper bound volume which contains essential tax forms and instructions. 
Some NAEA members reported that their copy did not arrive until mid 
February which is far later than normal.
    In both cases, these glitches are unfortunate because these are 
tools practitioners have come to rely upon to get their tax returns 
prepared accurately. We hope that this lateness will not be repeated.

IRS Budget and Modernization: E-Services: Electronic IRS Representation
    NAEA has long supported full funding of the IRS. We believe that a 
properly resourced IRS can efficiently process tax returns, collect 
taxes, and resolve taxpayer problems. For far too long, IRS has been 
hamstrung by its legacy computer system. NAEA realizes that billions of 
dollars have been poured into the modernization effort. I am here today 
to tell you that it has not been in vain as I am one of 14 NAEA members 
who is testing the new Electronic Account Resolution Service (EAR). I 
have attached two EA Journal articles which explain the EAR program.
    In January of this year, the IRS reached a major milestone in the 
development of new electronic capabilities that will revolutionize the 
way we, as tax practitioners, will conduct future business with the 
IRS. This major milestone involved using real taxpayers in the final 
testing of the suite of new capabilities that will be available through 
the IRS' e-services secure Web site this year. I was very pleased and 
honored to have been chosen by the IRS to be the first tax professional 
to use this new e-services capability. The new suite of e-services 
products, which will allow tax practitioners to represent their clients 
electronically and in a highly secure environment, has left me utterly 
speechless. I can assure you that I do not make that statement lightly.
    This new electronic capability which I prefer to call ``E-
Representation,'' will enable tax practitioners to quickly resolve 
their client's IRS individual or business account problems via the 
Internet in a secure environment. The goal of the IRS is to provide a 
response to the tax practitioner within three business days versus the 
weeks and months we currently experience.
    It is important to note that the effort to provide this capability 
has been ongoing since November 26, 1997, when the Electronic Tax 
Administration (ETA) released a Request for Agreement to which NAEA 
responded. NAEA submitted a proposal that members be provided the 
capability to resolve exam and collection issues with the IRS via 
secure email.
    In response, the IRS established a working group in July 1998 that 
determined it would be expedient to provide the capability to address 
electronically the types of account and notice issues normally resolved 
by the IRS' Customer Service sites.
    From that 1997 NAEA initiative, the IRS in February of 2000 
launched a prototype secure Web site that would be used to develop and 
test the concept of electronic representation and was the forerunner of 
the final secure Web site that will be implemented nationwide this 
year. The prototype was called the Practitioner Secure Messaging System 
(PSMS) and it provided NAEA members with the ability to securely 
resolve account and IRS notice related issues.
    After two years of extensive testing by approximately 450 NAEA 
members, Terence Lutes, Director of ETA, deemed the PSMS prototype a 
success. Mr. Lutes stated in his email to the PSMS participants that, 
``For the first time in the history of the Service, we demonstrated the 
capability to interact securely with our practitioners over the 
Internet to resolve account-related inquiries.''
    The PSMS prototype was unfortunately discontinued in May of 2002 
due to budgetary constraints, but that did not hamper the IRS' effort 
with the development of the final secure Web site. Usability Testing of 
the IRS' final secure Web site was conducted on April 22--23, 2003, by 
a small group of tax practitioners, myself included.
    In January 2004, the IRS reached a major milestone when live 
taxpayers were represented electronically through the IRS' e-services 
secure Web site. It has taken the IRS seven years to reach the point we 
are at today and I do not find that unusual in the least. The 
difficulty in integrating a 1960s era mainframe with the Internet and 
doing so in an environment using highly complex encryption is enormous, 
costly, and worth every effort and every dime spent. This new 
capability is truly going to revolutionize the way we conduct future 
business with the IRS. The ultimate beneficiary is your constituent, 
the American taxpayer. I am truly amazed and thrilled beyond 
description at this new way of doing business with the IRS and I would 
like for you to understand why I feel as I do.
    Representing taxpayers before the IRS is very challenging due to 
the complexity of our tax code. It is also very frustrating due to the 
difficulty we encounter in trying to obtain the necessary information 
we need in order to resolve the taxpayer's problem and receiving a 
timely response from the IRS. There are three crucial steps. The first 
is to establish with the IRS the taxpayer's authority to represent 
them, which is done via a Power of Attorney. The next step is to obtain 
the information the IRS has on the taxpayer for the year or years in 
question. The final step is in receiving the response from the IRS on 
our proposed resolution for the taxpayer.
    In our current way of doing business with the IRS, the first step 
of establishing the authority to represent the taxpayer is done by 
either faxing or mailing in the IRS' Form 2848, Power of Attorney and 
Declaration of Representative or acceptable substitute. An IRS employee 
then manually enters the POA into the IRS' computer system. The normal 
turnaround for this to occur is two to three days via fax, and slightly 
over a week for those that are mailed in to the IRS.
    Today, I have the ability, 24 hours a day, seven days a week, to 
submit directly into the IRS' computer system the POA for instant 
processing. This electronic version of the POA is called the Disclosure 
Authorization.
    Through Disclosure Authorization, I can also view and modify those 
POAs that were previously faxed or mailed into the IRS. This is an 
enormous step forward and one that is certainly going to result in a 
cost savings to the IRS by reducing the manpower needed to manually 
input those POAs into the IRS' computer system.
    The next step is to request transcripts, which are printouts of the 
taxpayer's account reflecting pertinent actions that have been recorded 
by the IRS. For example, these actions would include the date a tax 
return was received by the IRS and tax assessed, the detailed 
information on the return, penalties and interest assessed, other 
crucial dates and the like.
    When I first began representing clients before the IRS, the 
quickest I could ever obtain that information from the IRS was to drive 
20 minutes to the local IRS office, stand in line for another 20 
minutes, obtain the necessary transcripts, and then drive 20 minutes 
back to my office. I was fortunate in that the IRS office was only 20 
minutes away. Others are not as fortunate as I am and they end up 
having to use either mail or fax services which can take days to weeks, 
sometimes months, to receive those crucial transcripts.
    With very rare exceptions, I simply cannot represent a client 
before the IRS without transcripts.
    Today, I have the ability, 24 hours a day, seven days a week, to 
submit directly into the IRS' computer system a request for that 
crucial transcript. This capability within the IRS' e-services Web site 
is known as the Transcript Delivery System.
    The process of preparing the Transcript Delivery System submittal 
takes about one minute. Once I submit the request, the transcript is 
delivered immediately. I now find it takes me longer to print the 
transcript than it does to receive it from the IRS. This remarkable 
capability leaves me speechless.
    The cost savings to the IRS because of TDS will be significant. The 
tax practitioner is going to be thrilled beyond words, and the taxpayer 
will be the ultimate beneficiary in that his or her representative can 
begin addressing their IRS issues more quickly than ever before.
    The final step in resolving the taxpayer's IRS problem is receiving 
a timely response from the IRS to our proposed solution. This is the 
most frustrating aspect for the taxpayer when he or she is told to 
expect an IRS reply in several weeks if we are lucky; but more than 
likely it will take months before we have an IRS reply.
    These taxpayers are very anxious for their problem to be resolved 
and I am unable to adequately describe the anguish I have witnessed 
that some of these people go through waiting for their IRS problem to 
finally come to an end.
    Today, I have the ability at any time of the day or week to submit 
directly to the IRS's Customer Service Representative our proposed 
resolution. This capability within the IRS' e-services Web site is 
known as Electronic Account Resolution.
    The IRS' goal is to provide a response to our Electronic Account 
Resolution submittal within three business days. That has been 
achieved.
    When you combine the capabilities of Disclosure Authorization, 
Transcript Delivery System, and Electronic Account Resolution, the end 
result is phenomenal e-representation capability. This is going to 
revolutionize the way we do business with the IRS; it will result in 
cost savings in the days to come; and it will have a significant 
positive impact on taxpayers dealing with perhaps the most stressful 
and agonizing experience of their lives, running afoul of the IRS.
    All of this testimony is not to imply that the system is working 
flawlessly, it is not. The system is undergoing the final stages of 
testing for security, disclosure, and privacy issues. Users are 
encountering some processing problems and this is the normal result for 
such a complex project as Disclosure Authorization, Transcript Delivery 
System, and Electronic Account Resolution. Those processing problems 
are being identified and resolved which is the whole intent of this 
final testing stage. I witnessed the same while in the U.S. Air Force 
with the new technology they brought into operation.
    Much like a child who is learning to take his first few steps, this 
new capability will encounter some stumbling and an occasional bruising 
of the knees. So long as the tax professional community is allowed and 
encouraged to help nurture and guide the maturing of this new 
capability, I foresee e-representation becoming the standard way of 
practice when resolving taxpayer problems.
    Like any parent with a newborn child, concerns for the future will 
arise and the tax professional community has already recognized 
concerns about the future of this new capability.

Concerns of NAEA Members:
    The ability to electronically represent taxpayers through the e-
services Web site is limited by the IRS to only those tax practitioners 
who e-file more than 100 individual returns in a season. The intent of 
the IRS is to offer this extraordinary capability as an incentive to 
tax practitioners who continue to prepare returns and file them in 
paper format to start incorporating e-filing into their practices. It 
is working. I have seen tax practitioners who were adamantly opposed to 
e-filing incorporate e-filing into their practice solely upon hearing 
about this new capability.

Enrolled Agents Denied Access:
    The unfortunate aspect of the IRS' decision to restrict this 
capability to only those tax practitioners who meet the e-file 
requirement is that many of our most experienced and knowledgeable tax 
professionals will be denied this access because they do not prepare 
returns. Their sole focus is on IRS representation. Another type of tax 
professional is one who prepares far fewer than 100 individual returns 
and will never meet the e-file requirement.
    This will be a huge travesty that will adversely affect thousands 
of tax professionals and millions of taxpayers if left unresolved.

Limitation of Problem Resolution Issues:
    Another concern we have is the level of issues that can be 
addressed electronically through the Electronic Account Resolution 
element of e-services. Issues that are currently being handled by the 
collections and under reporter entities within IRS cannot be addressed 
through Electronic Account Resolution. This represents a large segment 
of our workload that will continue to be handled in a less efficient 
manner and it does not need to happen. A possible remedy would be 
either expanding the level of authority and responsibility of the 
Customer Service Representative responding to the Electronic Account 
Resolution submittals or integrating both collections and under 
reporter entities within e-services. Either of which need to be done 
soon since not being able to address collection and under reporter 
issues will undermine to some degree the intent of this new way of 
doing business; namely, the timely resolution of taxpayer problems and 
encouragement of tax practitioners to e-file.

Access Granted to Unenrolled Tax Preparers:
    Allowing unenrolled tax preparers who have no training, experience, 
or knowledge in IRS representation full access to the e-services 
capabilities while at the same time denying access to highly-trained, 
experienced, and knowledgeable tax professionals is nothing more than a 
disaster just waiting to happen. Aside from the huge uproar you can 
expect to hear from the tax professional community about this inequity, 
unenrolled tax preparers pose a significant problem. In all states 
except California and Oregon, all it takes to declare yourself a tax 
preparer is to hang out a shingle. There are no CPE requirements, no 
code of ethics, no disciplinary action by IRS, except loss of ERO 
status if the individual is an e-filer. The end result is they can 
potentially bog the Electronic Account Resolution capability with 
frivolous and wasteful submissions thereby denying the tax professional 
the attention of the Customer Service Representative in a problem 
resolution submission that is based on sound knowledge of tax law and 
regulations.
    NAEA would strongly urge you and the IRS to at the very least limit 
the Electronic Account Resolution portion of e-services to just 
Circular 230 tax practitioners--Enrolled Agents, CPAs, and attorneys.

Lead by Example:
    The IRS needs to lead by example when promoting e-filing to the tax 
practitioner community. They can do so easily by requiring all IRS 
employees to e-file their personal individual returns. If this 
suggestion were to be adopted, then it would need to be promulgated to 
the tax practitioner community and NAEA believes it would have a 
positive impact on the tax practitioners' perception of the importance 
of e-filing.

Premature Nationwide Deployment:
    NAEA is concerned that disastrous results may occur due to a 
premature deployment of this new capability. It is imperative that the 
actual deployment of this new capability only occur after all involved 
in its development have had an opportunity to voice--in an environment 
free from coercion--any and all problem areas they feel could undermine 
the success of this long and expensive effort. Much like Mission 
Control at the Kennedy Space Center prior to a launch, everyone has an 
opportunity to give a ``go'' or ``no go'' from their respective areas. 
Without such input from all involved in the development, we could be 
setting ourselves up for disastrous consequences.

Regulation of Commercial Preparers
    At this point, I would like to include NAEA's recent statement 
before the IRS Oversight board in my testimony. NAEA is aware of S. 
882, the Tax Good Government Act which includes a proposal by National 
Taxpayer Advocate Nina Olson on registration and regulation of 
commercial preparers. The NAEA statement follows:
    ``The members of NAEA are dedicated to the integrity of the tax 
system and the roles professional responsibility and ethics play in 
preserving that integrity. It therefore is disturbing to us that there 
is an increase of taxpayer belief that tax returns will be accepted 
regardless of the facts reported on them. This growth principally 
emanates from the declining rate of audits conducted on returns in 
recent years. It seems that a great number of taxpayers have been 
lulled into concluding that gaming the system and playing the audit 
lottery are acceptable behavior. A recent Gallup survey of taxpayers 
found that there is a marked increase in taxpayers feeling it is all 
right to cheat on their tax returns. An obvious centerpiece concern in 
this respect is that promoters and some tax professionals are selling a 
wide range of tax schemes and devices designed to improperly reduce 
taxes based on the simple premise that they can get away with it. It is 
clear that addressing this concern is needed. However, its resolution 
undoubtedly will not be limited to such schemes and devices.
    ``The IRS has undergone major changes in the last several years. 
Former Commissioner Rossotti's reorganization of the IRS and the 
emphasis he placed on customer service may in part have been a catalyst 
in modifying taxpayer attitude. Most agree that his initiatives were 
good, were consistent with the 1998 IRS Restructuring and Reform Act, 
and have produced a better IRS. However, their implementation resulted 
in resources being shifted away from enforcement activities. Other 
contributing factors include discontinuance of the Taxpayer Compliance 
Measurement Program (TCMP), ineffective technology, and tax law 
complexity.
    ``Commissioner Everson has begun efforts to turn that around. While 
he acknowledges that customer service plus enforcement equal 
compliance, he has announced that effective enforcement of the tax laws 
rather than further improving customer service will be the main focus 
of his administration. In this connection, he implicated the tax 
practitioner community in the diminishment of compliance and challenged 
all practitioners to raise their ethical standards in order to avoid 
actions being taken against them by the government. While much of this 
was done in regard to abusive tax schemes, it seems clear to NAEA (and 
we believe him) that his efforts will not stop there. For example, at a 
November [2003] meeting of the IRS Advisory Council (IRSAC), he was 
asked what IRSAC could do to help his enforcement endeavor. The IRSAC 
members were told in essence to stress the important role practitioners 
play in making our tax system work as it should. He did not limit his 
response to abusive tax schemes. Recent amendments to the regulations 
governing practice before the IRS (Circular 230) bear this out. The 
increased staffing in the Office of Professional Responsibility, the 
office that enforces those regulations, emphasizes his intent. Very 
recent proposed amendments to Circular 230, designed primarily to deal 
with abusive tax schemes, contain a ``best practices'' section that 
appears to address all aspects of tax advice and return preparation, 
which is further evidence of the role ethics play in our tax system. In 
addition, Mark Matthews has joined the IRS as deputy commissioner for 
services and enforcement. Mr. Matthews has a strong enforcement 
background, including having served as director of the IRS Criminal 
Investigation Division. Cono Namorato recently was appointed Director, 
Office of Professional Responsibility, replacing the incumbent who was 
in office for just one year. We surmise that it is Mr. Namorato's 
enforcement experience that resulted in his entry into the Office of 
Professional Responsibility and further evidence of the Commissioner's 
resolve.
    ``Other initiatives, such as the replacement of TCMP by the 
National Research Program, enforcement programs being implemented in 
all four divisions of the IRS, and the recent announcement by the 
Commissioner of reallocation of human resources in order, in part, to 
complement his enforcement mandate, help round out the conclusion that 
cannot be escaped. He means business.
    ``All who provide tax services must be cognizant of the strong 
enforcement component of tax compliance. It has the possibility of 
touching every aspect of tax advice and return preparation. 
Consequently, the topic of this panel at today's meeting is both 
important and timely.
    ``NAEA finds that commercial return preparers are an enigma in 
today's tax practice world. We all seem to know there are problems in 
connection with services performed by paid preparers, but in many 
respects those problems are unknown and the product of anecdotal 
information and conjecture.
    ``The first order of business is to define commercial return 
preparers. We define them as those (1) who prepare federal tax returns 
for a fee and (2) who are not required to possess any knowledge of tax 
law and procedure. At the state level, only California and Oregon 
regulate commercial tax return preparers and it is unlikely that there 
will be a significant increase in states engaged in that type of 
program in the future.
    ``The number of commercial preparers is not known with any 
accuracy, but estimates of upwards of 1 million individuals have been 
bandied about. With 55% of returns having been prepared by someone 
other than the taxpayers in 2001 and perhaps even more in 2002 and 
2003, it seems safe to conclude that the number of returns prepared by 
commercial preparers is considerable and growing. A great number of 
these commercial preparers probably work in a structured environment, 
such as being with a return preparation chain, or those who are 
entrepreneurs in the tax business. Others undoubtedly are seasonal tax 
return preparers who set up shop in January and close them down in 
April--sometimes referred to as ``card table jockeys.'' Still others 
may be somewhere in the middle. Even if we had the numbers, we do not 
know the extent of training, if any, many of the commercial preparers 
have had and the manner in which they keep abreast of the changes in 
tax laws and procedures. Perhaps of greatest concern is the belief the 
public is not aware of the fact that many commercial preparers have no 
credentials. This may in part be the reason taxpayers ``shop'' for 
preparers who will prepare tax returns the way taxpayers wish them to 
be prepared (often unsigned by those preparers), to the detriment of 
responsible return preparers and the integrity of the tax system.
    ``NAEA understands that tax return preparer penalties asserted in 
recent years have been minimal in number as related to the apparent 
potential for such penalties. Those that have been imposed in large 
measure have not been collected. We also know that attempts to 
implement recognition procedures in the electronic filing area, i.e. 
electronic filer originators (EROs), have been the subject of criticism 
due to systemic problems in background checks and the like as 
documented in the Treasury Inspector General for Tax Administration 
(TIGTA) report of June 2002. Further, many of the problems in the 
Earned Income Tax Credit (EITC) program are attributable to paid 
preparer involvement. Again, there does not seem to be a great deal of 
empirical data to support a conclusion as to the number of commercial 
preparers involved in the program and whether or not they do a 
consistently worse job than other preparers, even though there have 
been some informative and well-written white papers on the subject.
    ``Last year the National Taxpayer Advocate recommended in her 
report to Congress that there be a program to register commercial 
return preparers. It was an extremely ambitious program and one that 
would be expensive to establish and run. The IRS disagreed with the 
recommendation citing, among other factors, the expense of the program 
and that the issue is one for states to address rather than the federal 
government. NAEA believes there are problems both with the 
recommendation and the IRS response. We understand that Ms. Olson plans 
to propose more rigorous penalties and liability for commercial EITC 
preparers. While it may be unfair to opine on this year's proposal 
since we have not seen it, a threshold concern is the basis for 
believing that the IRS will be more successful than it has been in the 
past in collecting the penalties, buying into the program, and/or 
putting the troublesome violators out of business.
    ``So what is the solution? There does not seem to be an easy one. 
We don't have hard facts. The available data is said to be 
inconsistent. Attempts to address the issues have not been successful. 
The IRS in fact may not be interested in the subject at this moment in 
time. Attempts by former advisory groups to come to grips with 
commercial preparer issues have met resistance. While there was support 
for a commercial preparer program by the National Commission on IRS 
Restructuring, it was removed from its final report. In addition, 
legislation sponsored by Senator Bingaman of New Mexico appears not to 
have gone anywhere. A recommendation by last year's IRSAC did not 
endorse a course of action for recommendation to the Commissioner, even 
though a subgroup supported a preparer certification program that would 
enhance the competency of individuals or firms that prepare tax returns 
for a fee.
    ``In spite of all the above, NAEA supports Ms. Olson's quest, if 
not her vehicles for achieving it. If left unchecked, the perceived 
problems will continue to grow. In this connection, we believe the 
IRSAC Wage & Investment and Small Business/Self Employed subgroup 
reports warrant favorable consideration. In particular, the SB/SE 
subgroup's belief that the IRS should begin working with outside 
stakeholders to develop a program after examining a number of the 
``unknowns'' would be beneficial.
    ``NAEA subscribes to the belief that ethics are the fabric that 
holds a profession together. In the tax arena, Congress has identified 
those who qualify as federally-authorized tax practitioners (FATPs), 
i.e., Enrolled Agents, Attorneys, and CPAs. All are licensed 
individuals whose professional practice is circumscribed by codes of 
professional conduct and continuing education requirements. NAEA, of 
course, believes that the most meaningful step in overcoming the 
commercial preparer issues is to have all preparers attain Enrolled 
Agent status. Perhaps our Attorney and CPA colleagues have similar 
aspirations.
    ``With the above said, FATPs have dual loyalties. One, of course, 
is to their clients. The other is to the tax system itself. NAEA thinks 
it safe to conclude that all FATPs share the goal of safeguarding the 
integrity of our tax system and would be willing to work to make that 
happen. A possible beginning to assist the IRS in this respect is to 
form a task force comprised of representatives from the Enrolled Agent, 
attorney, and CPA organizations to work with the Service and others to 
help make this happen. NAEA would be pleased to head a practitioner 
organization steering committee to do this. Other organizations, 
individuals, academicians, and the like with similar goals could be 
invited to participate to the extent that the numbers would be 
manageable.
    ``We are eager to move off dead center in our support of overcoming 
the frustrations we all share with respect to the unknown factors 
relative to the issue and doing our part in establishing a program 
evidencing ethics as a vital part of our tax system's integrity.''
Conclusion:
    Mr. Chairman and members of the subcommittee, I am pleased and 
honored to have been able to share with you our members' views. If I 
may answer your questions or provide you with any additional 
information, it would be an honor and my pleasure to do so.
    Thank you.
                                 ______
                                 

                            Lend Me Your Ear

                         By James Leimbach, EA

    For Enrolled Agents, the word ``ear'' will be taking on a whole new 
meaning next spring when the IRS unveils, nationwide, to tax 
professionals the ``Electronic Account Resolution'' program (EAR).
    EAR will, quite simply, enable tax professionals to quickly resolve 
their clients' IRS individual or business account problem(s) via the 
Internet in a secure environment. EAR will be one of several electronic 
services available through the IRS' e-services Web site. The technology 
has been available for quite some time now; implementing it, though, 
was easier said than done.
    Thanks mainly to the more than 250 Enrolled Agents that 
participated in the IRS' prototype named Practioner Secure Messaging 
System (PSMS), that capability is now becoming a reality.
    The PSMS--launched in February of 2000--was the test project 
designed to precede the nationwide implementation of the EAR program. 
PSMS participation was limited to only EAs who met, among other 
criteria, a high level of involvement in the e-file arena. The 
prototype testing involved test-case scenarios as well as live cases 
submitted by EAs. As can be expected with the implementation of any new 
security intensive Internet technology, problems did arise. The intent 
of PSMS was to identify and develop the procedural and software 
corrections for the problems encountered.
    ``For the first time in the history of the service, we demonstrated 
the capability to interact securely with our practitioners over the 
Internet to resolve account-related inquiries'' wrote Terence H. Lutes, 
Director of Electronic Tax Administration (ETA) in his email to the 
PSMS participants. Unfortunately, due to budgetary constraints, the IRS 
was forced to discontinue the PSMS prototype on May 1, 2002. Initially, 
the EAR program was scheduled for nationwide implementation this fall; 
however, due to the demands of project management and testing, the IRS 
found that a more realistic date will be after the 2003 filing season.
    Operating the prototype was invaluable not only for the IRS, but 
also for EAs. The EA profession was the only one selected to 
participate in the prototype testing of what will have a profound 
impact on all tax professionals in future representation before the 
IRS.
    Unlike PSMS, EAR will be much easier to use. The PSMS system 
required users to download and install a Digital ID on their computer. 
The IRS' PSMS web site then used the Digital ID to ensure that the user 
connecting to the site was in fact authorized access. Without the 
Digital ID, nothing could be accessed on the PSMS Web site, not even 
the home page.
    In addition to the Digital IDs required, all users had to install 
Rivest-Shamir-Adleman (RSA) Security Keys on their computers. The RSA 
Security Keys were required in order to decrypt the encrypted email the 
IRS sent in reply to the user's PSMS submission.
    Instead of Digital IDs and RSA Security Keys, the EAR system will 
utilize a transparent version of the Secure Sockets Layer (SSL) 
software--an IRS issued PIN number and password. Users will go to the 
IRS' e-service site and simply log on. The elimination of Digital IDs 
and RSA Security Keys was a major improvement in streamlining access 
for users, particularly for AOL users.
    A significant problem encountered with the PSMS system for AOL 
users was the encrypted email they received. The AOL software was 
unable to handle decrypting the IRS' email due to it being in a Secure/
Multipurpose Internet Mail Extensions, (smime).p7m format. This major 
roadblock required AOL users to set up a separate email account with 
another email service such as Microsoft's Hotmail and use other 
software such as Microsoft Outlook Express in order to access and read 
the encrypted email.
    All of those previous PSMS security problems will be eliminated 
with the use of SSL, IRS issued PINs, and passwords. To be sure, 
security is a paramount issue for the IRS in implementing the EAR 
program. By utilizing SSL encryption, the IRS' security concerns have 
been resolved. Users will log on to the EAR system via a transparent 
security system and retrieve their IRS email response(s) from a secure 
mailbox.
    As with the PSMS system, EAR will require the user to have a Form 
2848, Power of Attorney (POA) or equivalent on file with the 
Centralized Authorization File (CAF) system prior to being granted 
access to a client's account.
    To handle the POA requirement, the PSMS system had a dedicated fax 
machine for its users. After transmitting the POA, users would usually 
have to wait 1--3 days for the POA to be manually input into the CAF 
system before being able to address a client's account electronically.
    With the EAR system, users will access the IRS' Web site, prepare a 
Disclosure Authorization (DA) application which is an electronic 
alternative for submitting a POA. Once the form has been filled out 
completely, the user hits ``Submit'' on the screen, and the DA is 
immediately processed into the CAF system. Practitioners will then be 
able to immediately access their clients' accounts electronically with 
no waiting.
    Another constraint for PSMS users was the inability to 
electronically obtain IRS transcripts such as an IRP, IRMF, etc. The 
Transcript Delivery System (TDS), which is a separate IRS e-service 
from EAR, will resolve that problem by enabling practitioners to obtain 
transcripts from the IRS' secure Internet site.
    The TDS system is planned for implementation at roughly the same 
time that the IRS unveils the EAR Program in 2003. TDS will not be a 
direct part of the EAR system, but instead a separate electronic 
option.
    The ability of a tax professional to resolve a client's IRS account 
problem in a matter of hours via the Internet as opposed to weeks or 
months using the postal system is worthy of every EA's attention.
    With the nationwide implementation of the EAR, DA, and TDS systems, 
tax professionals will be able to have POAs processed immediately into 
the CAF system, obtain transcripts in a matter of minutes, and resolve 
client account problems in a matter of hours.
    As a client with an IRS account problem, which of the following 
would you rather engage:

    1.  A tax professional who estimates 4--8 weeks (or more) for 
resolution of your IRS problem?

      OR

    2.  An EA who estimates a few hours to resolve your problem?

    This is a major change for our profession and it is one that we can 
all participate in and help nurture to become what our clients, the 
IRS, and we need.
    The bottom line is that \2/3\ of the EAR name already has our EA 
credential in it. We, as EAs, need to take advantage of this golden 
opportunity.
About the Author:
    James D. Leimbach, EA (USAF Ret.) is a retired U.S. Air Force 
Senior Master Sergeant who obtained his EA credential while on active 
duty. While in the USAF, he held positions as Superintendent of 
Operations, Chief of Computer Operations, Chief of Systems Control, 
Database Manager and various other computer operations and programming 
positions. His practice provides tax preparation, e-filing, IRS 
representation, with a special focus on military clients. He was the 
36th person selected to participate in PSMS.

                               EA Journal

                                 ______
                                 

     Electronic Account Resolution (EAR) Update Are You Listening?

                          By Jim Leimbach, EA

    A new client came in today. We'll just call him Mr. Joe Smith. He's 
single with no dependents. He came in with a letter from the IRS, 
Letter Number 2566 (SC/CG) a ``Proposed Individual Income Tax 
Assessment.'' Mr. Smith had lost the tax calculation summary that had 
been sent with the letter, so I did not know what the basis was for the 
proposed tax assessment.
    While Mr. Smith was in my office, I informed him that in order for 
me to address his problem with the IRS, I would need his permission to 
represent him. He concurred that was what he wanted and I then accessed 
the IRS' e-services, secure Web site. From there, I selected the 
Disclosure Authorization (DA) product and I then asked him to sign the 
electronic version of the Form 2848, Power of Attorney and Declaration 
of Representative (POA) called a DA.
    He first entered in his AGI, AGI year, and date of birth to 
authenticate who he was, and then entered his electronic signature 
which was done by entering in a self-selected PIN he made up. I also 
electronically signed the DA by entering in my Centralized 
Authorization File (CAF) Number, my password for accessing the IRS' e-
services Web site, and then my self-selected PIN. After hitting the 
``Send'' button, it took about five seconds for me to obtain 
confirmation that the DA had been successfully processed into the CAF 
system.
    I then informed my client that I needed to obtain a transcript 
showing all the income he had received during the year in question in 
order to ascertain the correctness of the proposed tax assessment. 
While he was in my office, I submitted a ``Wage and Income Documents'' 
transcript request from the Transcript Delivery System (TDS) portion of 
the e-services Web site for the year in question.
    There were two choices in how I could receive the transcript: the 
first choice was to have it displayed on my screen and the other choice 
was to retrieve an IRS email response from my secure (encrypted) 
mailbox on the e-services Web site. I chose to have it displayed on my 
screen since I would still be able to print it when displayed. After 
hitting the ``Send'' button, it took approximately one minute to 
receive the transcript.
    I printed all six pages and after reviewing the information, 
concluded the proposed tax assessment was correct. My client owed 
$7,890 but he was not in any position to pay the full amount. I 
discussed the options available and we both agreed that an Installment 
Agreement (IA) was the only alternative available to him.
    I went back to the e-services Web site, and selected the EAR 
product which then allowed me to access the IA feature. I completed our 
proposed IA and I explained to my client that it could take up to three 
business days for a response on the IA submittal but that I expected to 
receive a response later in the afternoon. At the end of the day, six 
hours after having submitted the IA, I received the IRS approval for 
our proposed IA via an email I retrieved from my e-services secure 
(encrypted) mailbox.
    Just before going to lunch, a prior client, we'll just call him Mr. 
Huffy, came in with a CP2000 Notice containing proposed changes to his 
2001 tax return. Again, using the e-services Web site, I submitted the 
DA; obtained transcripts; and after reviewing the transcripts, 
determined that the CP2000 Notice was in error. The proposed change 
involved income that had, in fact, been reported on the client's 2001 
return.
    I logged onto the EAR portion of the e-services Web site and this 
time I accessed the ``Notice'' feature which would allow me to address 
the CP2000 Notice and submit our disagreement with the proposed change. 
The Notice form provided me plenty of room to describe how the income 
had in fact been reported in my client's return. After transmitting our 
``Notice'' submittal, I received my onscreen confirmation number which 
I printed for future reference.
    After returning from lunch, I went back to the e-services Web site 
and retrieved the IRS' response from my e-services secure mailbox 
concurring that an error had been made and that they were updating my 
client's account to reflect no change.
    All this sounds pretty far fetched doesn't it?
    While it did not actually occur, the capability to electronically 
represent our clients via a secure session on the Internet will be 
unveiled nationwide late this year, and you can be sure it will have a 
tremendous impact on the services we provide to our clients.
    The IRS' effort to provide Electronic Account Resolution has been 
on going for several years. It all started back on November 26, 1997 
when the Electronic Tax Administration (ETA) released a Request for 
Agreement (RFA) that NAEA responded to, by submitting a proposal that 
members be provided the capability to resolve exam and collection 
issues with the IRS via secure email.
    From that NAEA initiative, the IRS, in February 2000, launched a 
prototype secure Web site that would be used to develop and test the 
concept of electronic representation and would be the forerunner of the 
final secure Web site that would be implemented nationwide in 2003. The 
prototype was called the Practitioner Secure Messaging System (PSMS) 
and it provided NAEA members the ability to securely resolve account 
related issues.
    After two years of testing by approximately 450 NAEA members, 
Terence H. Lutes, Director of ETA, deemed PSMS a success. Lutes stated 
in his email to the PSMS participants that, ``For the first time in the 
history of the Service, we demonstrated the capability to interact 
securely with our practitioners over the Internet to resolve account-
related inquiries.''
    The PSMS prototype was discontinued in May 2002 due to budgetary 
constraints, but that did not hamper the IRS' effort with the 
development of the final secure Web site. Usability Testing of the IRS' 
final secure Web site was conducted on April 22-23 of this year by a 
group of six practitioners. The following capabilities are those you 
can expect when the IRS unveils nationwide the Electronic Account 
Resolution (EAR) Web site and are based on my firsthand experience from 
participating in the Usability Testing.
    Practitioner Qualifications: Circular 230 practitioners (in good 
standing) must have e-filed 100 or more returns in the latest filing 
season. Exception: The IRS waived the 100 e-file requirement for the 
PSMS participants.
    Practitioner EAR Registration: Practitioners will register over the 
Internet (via secure session) and submit specific personal tax 
information. IRS will validate the information, and the practitioner 
will then obtain a username, password, and PIN. The IRS will send the 
practitioner a confirmation number by mail and the practitioner must 
confirm the registration within 28 days.
EAR Services
    1.  Disclosure Authorization (DA): The DA is essentially an 
electronic version of the Form 2848, POA that is processed directly 
into the CAF system via the IRS' secure (encrypted) Web site. The data 
elements needed for the Web site DA pages are the same as those 
required for the Form 2848 and follow the same flow. The biggest 
difference is how a client and practitioner sign the form.

      For the client to sign, the practitioner will need to ensure the 
client has the following:
        AGI (from any return filed in the last three years)
        AGI Year
        Date of Birth
        PIN (self selected PIN like the e-file)

      For practitioners to be able to sign, they will need:

        CAF number
        Password used for e-services Web site access
        PIN (self-selected)

      DA Pros: 

        Immediate processing into the CAF system
        Immediate access to client's account

      DA Cons:

        Additional representatives must be able to access the 
Web site in order to digitally sign the DA. Not all practitioners will 
be granted access due to the IRS' 100 e-file requirement.
        DA is not available for business clients other than Sch 
C. Form 2848 must be mailed or faxed for manual input into the CAF 
prior to e-service access.

    2.  Tax Information Authorization (Form 8821): An additional option 
to the DA, this form can also be submitted to obtain information 
pertaining to a client. The digital signature requirement is the same.

    3.  Transcript Delivery System (TDS):
       The TDS was hands down, the most impressive portion of the 
Usability Testing. The TDS is actually a separate portal of the e-
services Web site, yet a key component of EAR. After accessing TDS, the 
user is provided a pop-down menu from which to select the type of 
transcript desired. Transcript menu selections are all in plain English 
such as ``Wage and Income Documents'' versus the computer transaction 
ID such as RTVUE or IRPOL, making it very easy for users to determine 
what type of transcript to select.
       Transcripts can only be selected for one year at a time, but 
multiple requests can be submitted together in one session. So if a 
user needed transcripts for the last three years, they would fill out 
the form once and the tax period separate for each of the three years. 
Each tax period/type of return appears in a box at the bottom of the 
request screen. Once all information on the client is entered, you 
submit the transcript request containing all three years. There are 
five types of transcripts to be made available, they are:

          TDS
                                           Similar To:

          1. Account Transcript
                                           MFTRA-X
          2. Return Transcript
                                           RTFTP
          3. Record of Account
                                           MFTRA-X + RTFTP
          4. Verification of Non-filing
                                           IRS Letter
          5. Wage & Income Documents
                                           IRPTR

    The user can choose from two delivery methods as to how they wish 
to receive the transcripts. The first choice is to receive the 
transcript online (directly on the user's screen) and the second is to 
have it sent to the Secure Online Repository (SOR) which is a secure 
(encrypted) mailbox repository that the user will have to register for 
and receive during the e-services registration process. The secure 
mailbox can only be accessed by the authorized userafter logging on to 
the e-services Web site. The user's SOR mailbox will contain all IRS 
responses from EAR and TDS submittals sent by the user. Either 
selection will allow a user to print the transcript.
    The transcripts received will show the typical Transaction Code 
(TC) and also a short literal definition of the TC. This will be 
especially helpful for those practi-

tioners who are not familiar with the multitude of TCs or who are not 
in possession of documentation to decipher the codes.
TDS Pros:
      Ease of navigation. Web pages are kept simple and 
concise.
      Transcripts received in just a few minutes (at most).
      Two selections of transcript delivery: onscreen or SOR 
(either of which can be printed).
TDS Cons:
      No help is available in determining exactly what data is 
provided in a particular transcript.
      TC literal description is much shorter than the full 
description which is not available to the user.
      SOR does not provide any identification in the email 
header that clearly identifies the taxpayer it pertains to, which makes 
it difficult to locate the desired email if several taxpayers are being 
addressed at similar times.
Electronic Account Resolution:
    The EAR portal of the e-services Web site is where practitioners 
will correspond directly with the IRS to resolve a client's tax issue. 
The products to be offered for individuals and businesses are:

      Account Problem
      Notice
      Complex Refunds
      Payment Tracer
      Installment Agreement

    All selections provide a free text or memo area in which to 
elaborate on the details for a client's issue as you normally would in 
a letter. If additional information is requested by the IRS, the 
practitioner will submit a ``Follow-up Inquiry'' that will be linked to 
the previous submission.
    Account Problem: Provides the practitioner the capability to 
address specific account posting issues such as those related to exam, 
collection, record of payments, and resolution of tax form(s) filed for 
a taxpayer, to name just a few. For instance, you would use Account 
Problem if you needed to find out the current balance owed or how 
1040ES payments were posted.
    Individual Notice: Provides the capability to address any IRS-
generated notice that has been sent to the taxpayer. For instance, a 
practitioner would be able to resolve a CP2000 Notice (Notice of 
Proposed Changes) by submitting an agreement or disagreement for the 
CP2000.
    Comples Refunds: Provides the capability to address refunds that 
can involve multiple years and a range of issues involving a taxpayer 
who has not received a refund due to 1040ES posting errors, 1040 
refunds applied to other years, FMS Offsets, undeliverable or destroyed 
refund(s), and erroneous refund(s).

Payment Tracer: Provides the tracing of payments made by a taxpayer to 
        the IRS that have not been posted by the IRS.

Installment Agreement: Provides the capability to submit an IA on 
        behalf of a taxpayer. IAs are limited to just guaranteed and 
        streamlined.
    The Usability Testing of EAR and TDS did uncover shortfalls with 
both, which is to be expected in any development project this complex. 
Most notably was the excessive amount of Web pages required to complete 
for a particular submittal. There were numerous tutorials some of which 
were a bit excessive and others contained hard to read graphics 
imbedded in the tutorial. All-in-all though, the IRS has made a huge 
step forward in providing the tax practitioner community the capability 
to electronically represent clients and resolve their problems in a 
more efficient, timely, and secure manner.
    The lessons learned from the two-year testing of PSMS were 
invaluable to the progress made so far. One significant improvement 
made as a result of PSMS was replacing the use of Digital IDs and RSA 
Security Keys with 128-bit encryption call Secure Socket Layer (SSL). 
The use of SSL provides the highest degree of security available for 
the IRS' e-services Web site while at the same time making it much 
easier for the user to access the Web site.
    EAR and TDS will continue to undergo additional levels of testing 
before being implemented nationwide later this year. Earlier projected 
implementation dates had envisioned late August or early September for 
implementation. However, it appears that it will more than likely occur 
in November. The possibility of additional delays in the final 
implementation is certainly there but the IRS recently solicited the 
PSMS participants for verification of their name and EFIN, which is an 
encouraging step forward.
    I believe that EAR and TDS will grow much like e-file has, in which 
each year; new and improved capabilities are added. Once the general 
public is aware of tax practitioners having the capability to represent 
them electronically before the IRS, you can be sure that those 
utilizing EAR and TDS will be the preference of choice by taxpayers 
when it comes to meeting their representation needs.

About the Author:
    James D. Leimbach, EA (USA Ret.) is a retired U.S. Air Force, 
Senior Master Sergeant who obtained his EA credential while on active 
duty. While in the USAF, he held positions as Superintendent of 
Operations, Chief of Computer Operations, and Chief of Systems Control, 
Database Manager, and various other computer operations and programming 
positions. His practice involves individual and business tax 
preparation, e-filing, and IRS representation, with a special focus on 
military clients.

                               EA Journal

                                 

    Chairman HOUGHTON. Well, thanks very much, Mr. Leimbach. 
Mr. McCormally?

  STATEMENT OF TIMOTHY J. McCORMALLY, EXECUTIVE DIRECTOR, TAX 
                   EXECUTIVES INSTITUTE, INC.

    Mr. MCCORMALLY. Good afternoon, Mr. Chairman. I am Timothy 
McCormally, Executive Director of Tax Executives Institute 
(TEI), whose 5,400 members work for 2,800 of the largest 
companies in North America and Europe. Almost without 
exception, the companies employing TEI's members have been 
assigned to the IRS' Large and Mid-Size Business Division 
(LMSB). The largest 1,600 taxpayers within LMSB are subject to 
heightened scrutiny and ongoing audits as part of LMSB's 
Coordinated Industry Cases program. Our members cannot play the 
audit lottery because, for the most part, they are audited 
every year. From this perspective, TEI has long supported 
adequate funding for the IRS, particularly in respect of 
training and technology, and collaborative efforts between 
taxpayers and the IRS to enhance tax administration, and the 
proper balance between taxpayer service and compliance 
activities.
    At the outset, I wish to echo the testimony of Mr. Shaw and 
the written statement of Mr. Zarzar, as well as the comments of 
the Commissioner and Mrs. Killefer, about how the complexity of 
the tax law strains the limited resources of taxpayers and the 
IRS and impairs the ability of the government to administer a 
fair and efficient tax system. While we are pleased that the 
Bush Administration has included several simplification 
provisions in its 2005 budget, we believe that much broader 
efforts must be undertaken. These include the repeal of both 
the individual and the corporate alternative minimum tax and 
the reform of the international provisions of the Tax Code. 
These changes are necessary to enhance taxpayers' ability to 
comply and the IRS' ability to perform efficient and effective 
audits.
    Effective management of human resources is not a new 
challenge, but it takes on added importance as the government's 
work force ages. Within LMSB, for example, 40 percent of all 
revenue agents will be eligible to retire in fiscal year 2006, 
and that number will rise to more than half just 2 years later. 
This development underscores one of the IRS' greatest 
challenges: the recruitment, retention, and training of 
qualified personnel. Nowhere is that need greater than within 
the LMSB Division, which is responsible for ensuring compliance 
by the country's largest and most complicated enterprises. The 
success of the agency--and LMSB in particular--depends on 
having an effective, efficient, well-trained, and motivated 
staff. Adequate funding is a prerequisite to achieving that 
goal.
    Adequate funding is also required if the IRS is to maintain 
effective compliance strategies. LMSB has developed several 
important programs to streamline the compliance process and 
empower revenue agents and others to resolve issues and settle 
cases more quickly and efficiently. One recent effort deserves 
mention: a project to develop a focused audit planning process, 
which was rolled out to taxpayers and LMSB personnel last fall. 
TEI was pleased to participate not only in the design of the 
program but also in LMSB's training strategy with respect to 
it. A fuller explanation of the program is in our written 
statement.
    Several other innovative procedures--such as the Advance 
Pricing Agreement program, Limited Issue Focused Examinations, 
and Pre-Filing Agreements--have also been used to improve the 
examination process and to promote currency and compliance. 
These initiatives should be encouraged, first, by providing 
ample training resources in connection with them, and then by 
ensuring that the IRS' renewed focus on enforcement does not 
mute their ongoing value. These procedures enable personnel to 
make decisions at a lower level, to resolve disputes fairly and 
more quickly, and thereby to preserve resources. Mr. Chairman, 
TEI commends the Subcommittee for holding this hearing, and we 
look forward to working with you, the staff, and the IRS to 
improve tax administration. I, like the other witnesses, would 
be pleased to respond to your questions.
    [The prepared statement of Mr. McCormally follows:]

Statement of Timothy J. McCormally, Executive Director, Tax Executives 
                            Institute, Inc.

    Good afternoon. I am Executive Director of Tax Executives 
Institute, the preeminent association of business tax professionals. 
The Institute is pleased to participate in today's hearing on the tax 
filing season and the Internal Revenue Service's budget.

Background
    Tax Executives Institute was established in 1944 to serve the 
professional needs of in-house tax practitioners. Today, the Institute 
has 53 chapters in the United States, Canada, and Europe. Our 5,400 
members are accountants, attorneys, and other business professionals 
who work for 2,800 of the leading companies in North America and 
Europe; they are responsible for conducting the tax affairs of their 
companies and ensuring their compliance with the tax laws. Hence, TEI 
represents the business community as a whole, and our members deal with 
the tax code in all its complexity, as well as with the Internal 
Revenue Service, on almost a daily basis. TEI is dedicated to the 
development and effective implementation of sound tax policy, to 
promoting the uniform and equitable enforcement of the tax laws, and to 
reducing the cost and burden of administration and compliance to the 
benefit of taxpayers and government alike.
    The companies that employ TEI's members have almost without 
exception been assigned to the IRS's Large and Mid-Size Business (LMSB) 
Division. The largest 1,600 taxpayers within LMSB are part of the 
Coordinated Industry Cases (CIC) program; this means that they are 
subject to heightened scrutiny and, indeed, continual audit by the IRS. 
As non-participants in the so-called audit lottery, TEI members and the 
companies they represent have a keen interest in ensuring the efficient 
operation of the IRS and the proper balance of the agency's taxpayer 
service, enforcement, and other activities. Specifically, TEI has long 
supported adequate funding for the IRS, particularly in respect of 
training and technology, and collaborative efforts between taxpayers 
and the IRS. We are pleased to offer our views on the IRS's budget for 
fiscal year 2005.

Increased Demand, Decreased Resources
    The Bush Administration has proposed a budget for the IRS for 
fiscal year 2005 of $10.674 billion, a 4.8 percent increase from 2004. 
The proposal would increase funding for the agency's enforcement 
program by $366 million while decreasing funds for business systems 
modernization by $105 million. According to the Administration, the 
reduction in funding for the modernization program flows from 
independent studies concluding that the program should be resized. The 
IRS Oversight Board has also recently recommended that the IRS reduce 
the number of modernization projects to permit better management of the 
program.
    Given current budgetary constraints, TEI agrees that the IRS must 
reexamine its goals and objectives. If the agency is to respond to 
taxpayer needs and to administer the tax code in a fair and efficient 
manner, it must have the resources necessary to fulfill its mission. 
TEI has consistently supported both adequate funding for the Internal 
Revenue Service--including its training and modernization programs--
complemented by oversight by the IRS Oversight Board, the Treasury, and 
Congress. We know the Subcommittee shares our concern and urge you to 
continue to support adequate funding of the IRS to fulfill its 
responsibilities for taxpayer service and enforcement.
    Our testimony today focuses primarily on two areas where adequate 
funding is particularly crucial: (i) the need to attract, train, and 
retain top-notch tax professionals, and (ii) the need to obtain 
currency on audits. But before addressing these issues, we believe that 
it is appropriate to note how the complexity of the tax code strains 
the limited resources of both the IRS and taxpayers and impairs the 
fair and efficient operation of the tax system.

Achieving Simplification
    Complexity and changes in the tax system have important 
ramifications for tax administration and compliance. During the five-
year period ending in 2002, there were 19 enacted tax bills that 
changed 292 tax code sections and required 515 changes to forms and 
instructions. More changes--including the introduction of a new 
Schedule M-3 (which is intended to advance the goal of currency by 
providing the IRS with much more detailed and timely information on the 
differences between financial and tax accounting)--are inevitably on 
the horizon. And each change, no matter how laudable in isolation, will 
require revision of forms and instructions, as well as new training 
efforts that cannot help but detract from the IRS's goals of achieving 
currency on audits.
    More than five years ago, TEI joined with the American Institute of 
Certified Public Accountants and the American Bar Association Section 
of Taxation to recommend changes to simplify the law not only for 
taxpayers--both large and small--but the government as well. We believe 
that even small changes--such as harmonizing the various definitions of 
``child'' as the Administration has proposed--can have a positive 
effect on job performance. Larger changes--such as the repeal of both 
the individual and corporate alternative minimum tax--can have 
significant effect on taxpayers' ability to comply with the law and the 
IRS's ability to perform efficient and effective audits. Enactment of 
simplifying measures can ease pressures and make workers more 
productive. In this regard, we are pleased that the Bush Administration 
has included several simplification provisions in its 2005 budget 
request.
    Incremental simplification is commendable, but steps must also be 
taken to address systemic and structural complexity in the tax law. For 
example, the international tax provisions are among the tax code's most 
complicated and need significant reform and simplification. Several 
pending bills--such as H.R. 2896, the American Jobs Creation Act of 
2003, and S. 1637, the JOBS Act of 2003--contain provisions to address 
this complexity. We urge Congress to move forcefully to make the law 
less complex and therefore more competitive and efficient.

Achieving a Well-Trained Workforce: Management of Human Resources
    Effective management of human resources is not a new challenge, but 
it is one that demands more attention as the government's workforce 
ages. The IRS Oversight Board's 2003 report to Congress observed an 
increased demand for IRS services and a decreased level of resources. 
Specifically, the Board documented a 16-percent increase in the IRS's 
workload between 1992 and 2002 and, during the same period, a 16-
percent decrease in the number of full time equivalent employees (from 
115,205 to 96,714). The Board explained that the result of these trends 
is a huge gap between what taxpayers need and what the IRS can deliver. 
Closing the gap is one of the IRS's greatest challenges, the Board 
concluded.
    During the past few years, the LMSB workforce declined by 600 
employees, 40 percent of LMSB's revenue agents will be eligible to 
retire in FY2006, and that number will rise to more than 50 percent in 
FY2008. Among the division's managers, approximately 40 percent are 
currently eligible to retire.
    These statistics underscore what may be the greatest challenge for 
the IRS over the next five years--its personnel. LMSB is responsible 
for ensuring compliance by approximately 180,000 entities each of whom 
has more than $10 million in assets. These taxpayers are the largest 
enterprises, and correspondingly have the most complex issues and the 
most complex organizational structures. They themselves employ 
qualified tax attorneys and accountants and, in return, they require 
experienced, well-trained agents to understand the complexities and to 
audit those returns. The success of the agency--and the LMSB Division 
and CIC program in particular--depends on an effective, efficient, 
well-trained, and motivated staff. Adequate funding for new hiring is 
an obvious prerequisite to achieve this goal.
    We urge the Subcommittee to ensure that the IRS receives the 
funding it needs to maintain a qualified workforce.

Achieving Currency: Tools for Enforcement
    Adequate funding is required if the IRS is to maintain effective 
enforcement strategies. LMSB has initiated several important 
initiatives to enhance collaboration between taxpayers and IRS 
personnel; to focus on significant (as opposed to immaterial) issues; 
and, more generally, to empower its agents to resolve issues and settle 
cases more quickly and efficiently. Over the years, TEI is pleased to 
have cooperated in numerous efforts to bring greater efficiency to the 
examination process.
    One recent effort deserves mention--a project to develop a focused 
audit planning process, which was rolled out to taxpayers and LMSB 
personnel in October. The goals of the LMSB-TEI Joint Audit Planning 
Process are two-fold: (i) to establish accountability in executing a 
jointly developed audit plan, and (ii) to develop an issue-focused plan 
to, if you will, separate the ``wheat from the chaff'' and thereby 
increase audit efficiency. The resulting report emphasizes that the 
keys to a successful audit are communication, trust, and openness.
    1. Joint Audit Planning--The Benefits of Collaboration. This 
project produced a planning and monitoring tool that lists the steps a 
taxpayer and audit team can take to enhance the quality and timeliness 
of tax examinations. A key to this initiative is the delineation of 
both the individual and the joint responsibilities of all 
participants--the taxpayer, team manager, audit team, specialists, and 
Counsel--thereby focusing time and resources on the most important 
areas.
    The Joint Audit Planning Process brings home the message that, even 
though taxpayers and the IRS sit on opposite sides of the table, they 
share an interest in ensuring that the resources expended in examining 
corporate tax returns are used efficiently and wisely. The initiative 
also underscores the continuing merit of collaborative efforts.
    Several other innovative procedures--such as Limited Issue Focused 
Examination (LIFE), Pre-Filing Agreements, Fast Track Mediation and 
Settlement, Accelerated Issue Resolution, and Early Referral to 
Appeals--have also been introduced in the past few years to improve the 
examination process and promote currency. The Advance Pricing Agreement 
(APA) program--begun more than a decade ago--is also a worthwhile 
process that should be continued and encouraged; the program permits 
the tax system to work more efficiently and effectively without costly 
litigation by resolving fact-intensive pricing issues before tax 
returns are filed. In TEI's view, the APA program is a model 
alternative dispute resolution process that benefits the government and 
taxpayers alike.
    An informal survey of TEI members recently confirmed that LMSB's 
LIFE initiative--which focuses on materiality of issues and risk 
analysis of issues to be audited--is streamlining the examination 
process. We understand that LMSB's interim review of LIFE validates 
this conclusion, and accordingly strongly recommend that future 
initiatives be designed to complement and supplement these programs, 
not replace or supplant them. In addition, we believe that these audit 
techniques could be adapted for other divisions and may resolve some of 
the frustrations felt by personnel concerning their ability to make 
decisions.
    2. Overriding Importance of Training. Training is a critical 
element to the success of these initiatives. Procedures such as LIFE 
and other initiatives empower personnel to make quality decisions at 
the lowest level, to resolve disputes fairly and more quickly, and to 
husband and preserve resources. Training also enhances employee job 
satisfaction and encourages employees to continue pursuing public 
service careers. Many agents are still receiving the training needed to 
implement the initiatives discussed in this testimony. In addition, it 
is our understanding that more significant changes are under 
consideration that will require even more training. While LMSB and the 
IRS generally should remain open to new ideas and programs, the costs 
and consequences of change cannot be ignored. Each new program creates 
new training needs, and a ``flavor-of-the-month'' approach to 
examination techniques has the potential for causing confusion and 
malaise in the field. Steps must be taken to ensure that agents receive 
consistent and timely training.
    TEI recommends that funding be provided to permit continued 
training of revenue agents in alternative dispute resolution 
techniques.
    Tax Executives Institute commends the Oversight Subcommittee for 
holding this public hearing. TEI looks forward to working with the 
Subcommittee and the IRS itself to improve tax administration.

                                 

    Chairman HOUGHTON. Well, I thank you very much. Mr. Pomeroy 
has a question. I have questions, but what I would like to do, 
because of the time here and because we have votes, is to 
submit them in writing to you gentlemen? Would that be all 
right? We just do have a crunch, and I am terribly sorry, but 
there was not anything we could do about it. It is out of our 
hands. Mr. Pomeroy, you probably want to ask a question. I will 
leave. I will leave the whole thing in your hands. Can I trust 
you?
    Mr. POMEROY. You can.
    [Laughter.]
    Chairman HOUGHTON. Well, thank you very much. Gentlemen, I 
really appreciate your participation here today. Thanks very 
much.
    Mr. POMEROY. [Presiding.] Mr. Chairman, let me just advise 
the panel what an odd thing it is, an unusual thing it is for a 
Member of the majority to leave the hearing still in process 
with the minority now to chair it. I assure you I will confine 
my comments only to the CRP issue, and after Mr. Orwick has 
traveled so far, I thank you so much for letting me get some 
information from him into the record. My apologies to the rest 
of the panel. I would like to explore some of these issues with 
you as well, but I believe under the circumstances I should 
best focus on CRP and Mr. Orwick's expertise in that area. If 
you would make one request of the IRS today relative to the 
existing confusion about the taxable status of CRP income for 
retired farmers, what would it be?
    Mr. ORWICK. I think it would be the first of Dr. Harl's 
recommendations, which would be the withdrawal of CCA Letter 
Ruling 200325002 of May 29, 2003, or the reissuance with a 
narrowing of the ruling to harmonize it with Letter Ruling 
8822064, March 7, 1998, that this would remove much of the 
current confusion.
    Mr. POMEROY. There was a 1988 ruling that very clearly 
addressed the question of retired farmers and determined that 
CRP income was not subject to self-employment tax. Is that 
correct?
    Mr. ORWICK. For retired individuals, yes.
    Mr. POMEROY. For retired individuals. So, harmonizing the 
two letter rulings would simply be some clarification to 
indicate, as they orally indicated to us when we met with IRS 
representatives in North Dakota Friday, that this was not--that 
the subsequent letter ruling in 2003 was not written in 
contemplation of the retired farmer and should not have 
application for this tax reporting period to the retired 
farmer. Is that essentially what you would----
    Mr. ORWICK. Yes, that is correct. My understanding of the 
meeting was the IRS' position was that each of these rulings 
were geared specifically to the people in question in each of 
those rulings and not to be used as a precedent, but as Dr. 
Harl indicated, without any other rulings to go by, by default 
we did need to use those to guide us in our decisionmaking 
process.
    Mr. POMEROY. The Commissioner indicated this afternoon--and 
you heard him--that there could be a lot at issue here in light 
of types of income that may or may not involve SE tax, and it 
gets quite involved. I believe that that is a little over 
thinking on this particular question. The fact is, from 1988 
on, the IRS has essentially had one position. People have 
relied upon that position. It was inadvertently placed in 
question by a letter ruling that the IRS now indicates they 
wrote without any contemplation of the retired farmer. So, some 
simple clarification of that letter ruling harmonizing with the 
earlier letter ruling would at least get us through this tax 
season, and we would welcome further clarification from the IRS 
in the area. Is that essentially the state of play?
    Mr. ORWICK. Yes, that is very true. I think that it really 
puts the tax practitioners and taxpayers in an awful position 
the way that it is right now, because we have no idea what is 
our real guidance. Each client is having to step up to the 
plate and make the decision based on their own circumstances, 
and they are not tax professionals and not attorneys well 
versed in this area. We as practitioners can guide them as best 
we can with the facts and circumstances, but they really 
shouldn't be placed in a position to have to make that decision 
and lay awake at night wondering if the IRS is going to be 
knocking on their door with an audit or that there would be 
extra money to pay; or, as most of my clients are choosing to 
do, pay the extra tax because of their conservative nature and 
the fact that they want to be law-abiding citizens.
    Mr. POMEROY. You indicated at the hearing or the meeting 
that we had in North Dakota, you are a conservative 
practitioner, and you have a very conscientious group of 
clients; and if they think they may owe it, they pay it. That 
is why this situation is really particularly unfair to them. It 
will have broad--I believe by far most retired farmers may not 
be aware of this letter ruling, will not be paying the self-
employment tax. In light of the discussion in this area in our 
community, they will be aware of it. Maybe they will pay the 
tax. The thing to do is lift the uncertainty relative to this 
filing season and then deal with it in a more comprehensive and 
involved way with the kind of fact gathering that the IRS would 
appropriately do prior to issuing such further rules in this 
area. Is that right?
    Mr. ORWICK. Yes, that would be a very prudent process.
    Mr. POMEROY. Well, I want to thank all of the panel, and 
especially, again, in absentia, express my appreciation for the 
Chairman. There is only 5 minutes left in the vote, and I 
believe it is his indication that the hearing will end at this 
point in time, so I will do something I have never done before 
and gavel adjournment. Thank you.
    [Whereupon, at 5:35 p.m., the hearing was adjourned.]
    [Questions submitted by Chairman Houghton and 
Representative Ryan to Commissioner Everson, Mr. Orwick, Mr. 
Zarzar, and Mr. Leimbach, and their responses follow:]

            Questions from Chairman Houghton to Mr. Leimbach

    Question: As more and more Americans turn to tax preparers to 
prepare their returns, the role of practitioners in the tax system has 
become more important. According to the National Taxpayer Advocate, as 
many as half of the 1.2 million tax preparers have no formal training 
and are not required to adhere to any professional standards. As you 
may know, the Advocate and others have discussed limited registration 
of paid preparers. What is your view of the proposal?
    Answer: The members of the National Association of Enrolled Agents 
are dedicated to the integrity of the tax system and the roles 
professional responsibility and ethics play in preserving that 
integrity. It therefore is disturbing to us that there is an increase 
in taxpayer belief that tax returns will be accepted regardless of the 
facts reported on them.
    The IRS has undergone major changes in the last several years. 
Former Commissioner Rossotti's reorganization of the IRS and the 
emphasis he placed on customer service may in part have been a catalyst 
in modifying taxpayer attitude. Most agree that his initiatives were 
good, were consistent with the 1998 IRS Restructuring and Reform Act, 
and have produced a better IRS. However, their implementation resulted 
in resources being shifted away from enforcement activities. Other 
contributing factors include discontinuance of the Taxpayer Compliance 
Measurement Program (TCMP), ineffective technology, and tax law 
complexity.
    Commissioner Everson has begun efforts to turn that around. While 
he acknowledges that customer service plus enforcement equal 
compliance, he has announced that effective enforcement of the tax laws 
rather than further improving customer service will be the main focus 
of his administration. In this connection, he implicated the tax 
practitioner community in the diminishment of compliance and challenged 
all practitioners to raise their ethical standards in order to avoid 
actions being taken against them by the government. While much of this 
was done in regard to abusive tax schemes, it seems clear to NAEA and 
we believe to him that his efforts will not stop there.
    All who provide tax services must be cognizant of the strong 
enforcement component of tax compliance. It has the possibility of 
touching every aspect of tax advice and return preparation.
    NAEA finds that commercial return preparers are an enigma in 
today's tax practice world. We all seem to know there are problems in 
connection with services performed by paid preparers, but in many 
respects those problems are unknown and the product of anecdotal 
information and conjecture. We define commercial preparers as those 1) 
who prepare Federal tax returns for a fee, 2) who are not required to 
possess any knowledge of tax law and procedure, and 3) who are subject 
to very limited oversight. At the state level, only California and 
Oregon regulate commercial tax return preparers.
    The number of commercial preparers is not known with any accuracy 
but, as your question suggests, estimates of upward of 1 million 
individuals have been bandied about. With 55% of returns having been 
prepared by someone other than the taxpayers in 2001 and perhaps even 
more in 2002 and 2003, it seems safe to conclude that the number of 
returns prepared by commercial preparers is considerable and growing. 
Even if we had the numbers, we do not know the extent of training, if 
any, many of the commercial preparers have had and the manner in which 
they keep abreast of the changes in tax laws and procedures. Perhaps of 
greatest concern is the belief the public is not aware of the fact that 
many commercial preparers have no credentials. This may in part be the 
reason taxpayers ``shop'' for preparers who will prepare tax returns 
the way taxpayers wish them to be prepared (often unsigned by those 
preparers), to the detriment of responsible return preparers and the 
integrity of the tax system.
    NAEA understands that tax return preparer penalties asserted in 
recent years have been minimal in number as related to the apparent 
potential for such penalties. Those that have been imposed in large 
measure have not been collected. We also know that attempts to 
implement recognition procedures in the electronic filing area, i.e. 
electronic filer originators (EROs), have been the subject of criticism 
due to systemic problems in background checks and the like as 
documented in the Treasury Inspector General for Tax Administration 
(TIGTA) report of June 2002. Further, many of the problems in the 
earned income tax credit (EITC) program are attributable to paid 
preparer involvement. Again, there does not seem to be a great deal of 
empirical data to support a conclusion as to the number of commercial 
preparers involved in the program and whether or not they do a 
consistently worse job than other preparers, even though there have 
been some informative and well-written white papers on the subject.
    As you are aware, the National Taxpayer Advocate's report to 
Congress for the year 2002 recommended that there be a program to 
register commercial return preparers. It would be an extremely 
ambitious program and one that would be expensive to establish and run. 
The IRS disagreed with the recommendation citing, among other factors, 
the expense of the program and that the issue is one for states to 
address rather than the federal government. NAEA believes there are 
problems both with the recommendation and the IRS response. 
Consequently, we were pleased that her request for the year 2003 
compromised the previous recommendation by recommending that there be a 
legislatively mandated task force established to study the situation 
and the many unknowns.
    In spite of the above, NAEA supports Ms. Olson's quest, if not her 
vehicles for achieving it. If left unchecked, the perceived problems 
will continue to grow. In this connection, we believe the IRS Advisory 
Council's Wage & Investment and Small Business/Self Employed subgroup 
reports warrant favorable consideration. In particular, the SB/SE 
subgroup's belief that the IRS should begin working with outside 
stakeholders to develop a program after examining a number of the 
``unknowns'' would be beneficial.
    NAEA subscribes to the belief that ethics are the fabric that holds 
a profession together. In the tax arena, Congress has identified those 
who qualify as Federally authorized tax practitioners (FATPs), i.e. 
Enrolled Agents, Attorneys, and Certified Public Accountants. All are 
licensed individuals whose professional practice is circumscribed by 
codes of professional conduct and continuing education requirements.
    With the above said, FATPs have dual loyalties. One, of course, is 
to their clients. The other is to the tax system itself. NAEA thinks it 
safe to conclude that all FATPs share the goal of safeguarding the 
integrity of our tax system and would be willing to work to make that 
happen. A possible beginning to assist the IRS in this respect is to 
form an independent private sector task force comprised of 
representatives from the Enrolled Agent, attorney, and CPA 
organizations to consider the issue and make recommendations addressing 
them. NAEA would be pleased to head a practitioner organization 
steering Committee to implement this. Other organizations, individuals, 
academicians, and the like with similar goals would be invited to the 
extent that the numbers would be manageable.
    We are eager to move off dead center in our support of overcoming 
the frustrations we all share with respect to the unknown factors 
relative to the issue and doing our part in establishing a program 
evidencing ethics as a vital part of our tax system's integrity. 
However, our eagerness would be meaningful only if there is an intent 
by Congress to pursue the matter through legislation or another 
vehicle.
    Question: In your written statements, all of you have emphasized 
the need to simplify the Tax Code. How did the tax code become so 
complex, and what should Congress do to simplify our tax Code?
    Answer: Our current tax system tries to address every aspect of our 
economy and, to a large degree, social issues as well. The complexity 
resulting therefrom warrants simplification of the tax laws and their 
administration. The National Association of Enrolled Agents believes 
that incremental changes are the most effective means by which to 
accomplish tax simplification. For example, in the recent years, NAEA 
has requested simplification of the Alternative Minimum Tax (AMT), the 
definition of a child, particularly in the context of the earned income 
tax credit, and rationalization of phase-ins and phase-outs.
    Question: Occasionally, we have heard opposition from practitioners 
to a tax simplification proposal that might alter or upset the 
practitioner's chosen specialty of tax. Are your members willing to 
give up a lucrative practice that depends on a wrinkle in the Tax Code? 
How important is tax simplification to your membership and to the tax 
system as a whole?
    Answer: The practice of the members of the National Association of 
Enrolled Agents would not be adversely affected by an incremental 
approach to simplifying the tax system.
    Question: I understand that the IRS is in the process of launching 
a new program that will allow tax preparers to access certain 
information on behalf of the clients and will improve communication 
with the IRS. What is your impression of the new service so far? Are 
there any improvements the IRS should make?
    Answer: The capabilities being referred to are Disclosure 
Authorization, Transcript Delivery System, and Electronic Account 
Resolution within the IRS' e-services, secure Web site. NAEA believes 
that these three (secure) capabilities are, without question, going to 
revolutionize the way tax practitioners conduct business with the IRS.
    The Disclosure Authorization (DA) capability allows tax 
practitioners the ability to submit an electronic Power of Attorney 
(POA) directly into the IRS' Centralized Authorization File (CAF) 
computer system. The process of preparing a DA for a taxpayer takes 
approximately 3-5 minutes. Once the DA is prepared, the submittal and 
processing of the DA into CAF is instantaneous.
    The DA capability will replace the current process of faxing (or 
mailing) a POA into the IRS' IRS Centers for manual input into CAF. The 
normal wait time for the manual input into CAF is usually 2-3 days. The 
cost savings to the IRS will be truly significant when this capability 
becomes available this year once the final testing has been completed. 
The instantaneous processing of the DA into CAF allows tax 
practitioners immediate access to account information on the 
taxpayer(s) being represented via the Transcript Delivery System.
    The Transcript Delivery System (TDS) is the true powerhouse of the 
three capabilities. With TDS, tax practitioners can access the specific 
account related information that is crucial to problem resolution for 
the taxpayer(s). The account information is delivered to tax 
practitioners instantly. It now takes a practitioner longer to print 
the account information transcripts than it does to actually fill out 
the request and receive them. The type of information that can be 
obtained is:

    1.  Account Transcript (Reflects a summary of the return and all 
subsequent information posted to the account.)
    2.  Return Transcript (Contains most of the lines from an original 
return, including the various forms and schedules submitted with the 
return. The transcript contains both the ``per return'' and ``per 
computer'' entries from IRS databases.)
    3.  Record of Account (Merger of both Account Transcript and Return 
Transcript)
    4.  Verification of Non-Filing (This transcript is used in 
circumstances where a taxpayer may need a letter from the IRS 
indicating that he or she did NOT file a tax return. A good example 
would be where a taxpayer has applied for a state-backed mortgage 
subsidy bond.)
    5.  Wage and Income Transcript (W-2, 1099-DIV, 1099-MISC, and so 
forth. Practitioners can also select ``All Documents'' to retrieve 
every wage and income document reported to the IRS)

    Prior to TDS the practitioner either had to drive to the local IRS 
office and obtain transcripts which took a total of 1 hour, or contact 
the IRS' Practitioner Priority IRS and request transcripts to be faxed 
to me. The general turnaround time for receipt of the faxed transcripts 
was anywhere from 1 hour to 1 day.
    TDS is an utterly amazing capability for tax practitioners and will 
have a major impact on the practitioner's ability to better serve their 
clients.
    Once the DA and TDS capabilities have provided the necessary 
service to the tax practitioner, the final step is in the electronic 
(secure) correspondence with the IRS for problem resolution. The secure 
Internet interaction with the IRS is achieved via the Electronic 
Account Resolution (EAR) capability.
    EAR provides practitioners the following:

    1.  Account Problems Inquiry: This type of inquiry will allow users 
to address account related issues (not in ACS or Under Reporter) for 
resolution. A good example would be abatement of penalties due to 
reasonable cause.
    2.  Notice Inquiry: This inquiry will allow users to respond to IRS 
Notices with the exception of those that are outside the scope of EAR 
such as a CP2000, Notice of Underreported Income.
    3.  Complex Refund Inquiry: The Complex Refund inquiry will allow 
users to address refunds that were issued via direct deposit or by 
paper check and have either been destroyed, lost, not received, or 
stolen. It is also possible to inquire about refunds that have been 
offset by the Financial Management System (FMS) or have been applied to 
other tax debt owed to the IRS.
    4.  Payment Inquiry: The Payment Tracer will allow you to inquire 
on behalf of an individual or business, payments made to the IRS but 
not yet posted or to verify the posting of a payment on the account. A 
good example would be 1040-ES payments.
    5.  Installment Agreement Inquiry: The Installment Agreement 
provided in EAR is limited to Guaranteed Installment Agreements (under 
$10,000) and Streamlined Installment Agreements (under $25,000). 
Installment Agreements for amounts over $25,000 cannot be processed 
through EAR at the present time. In addition, the only payment method 
available is through Direct Debit. In addition to submitting a new 
Installment Agreement, you can revise an existing one or reinstate a 
previous Installment Agreement, which are two features that will be 
very useful.
    6.  Follow Up Inquiry: The Follow Up Inquiry will allow users to 
address previously submitted EAR inquiries that require additional 
information for the original submittal (i.e. not enough room in 
comments area), or in responding to a CSR's request for additional 
information.
    7.  Multiple Inquiry: The Multiple Inquiries function allows tax 
practitioners to address simultaneously the first five types of 
inquiries above on behalf of an individual or business.

    The current turnaround for an IRS response to a proposed problem 
resolution is generally 1 month, many times much longer. With EAR, the 
IRS' response will be within three business days.
    The combination of DA, TDS, and EAR is just plain phenomenal 
capability in IRS representation. The products will be the first of its 
kind and certainly, enhancements will be needed since many of the 
desired representation aspects will not be included in the initial 
release. Two excellent examples for future inclusion in EAR would be 
the ability to address collection related issues and those handled by 
the under reporter IRS entities.
    The IRS has already solicited the Enrolled Agents and CPAs that 
have been testing the products for their input for future enhancements. 
NAEA's biggest concern for future enhancements is whether or not 
adequate funding will be available. It is crucial that Congress ensure 
that adequate funding for this new capability and the future 
enhancements will be there when needed.
    Question: One of the things that make the tax system complex is 
that the IRS does not always provide a clear answer to the tax 
treatment of a common transaction. Is the IRS doing enough to publish 
clear and concise guidance to taxpayers? Would increasing the resources 
available to the IRS in this area help to make the tax system more 
transparent?
    Answer: The IRS has made progress in its effort to publish clear 
and concise guidance to taxpayers. Part of such progress is making 
information available on the Internet and CDs. The problem in trying to 
publish clear and concise guidance is that the tax issue itself is 
complex and can only be simplified to a point. For example, taxpayers 
with children are faced with numerous different definitions of a child 
for 1) Dependent, 2) Child Tax Credit, 3) Earned Income Credit, 4) 
Credit for Child and Dependent Care Expenses, 5) Adoption Credit. 
Having one definition versus numerous definitions for a child is a 
longstanding problem that has been addressed repeatedly without 
success.
    Increasing the number of IRS personnel working the Customer IRS 
telephone lines and answering questions from the public, especially 
during the tax season would be a sound objective. Bright line guidance 
for IRS employees and the public is agoal worth pursuing. All of this 
would require appropriate training.
    Question: We have discussed the IRS budget with the government 
panelists. What is your view of the budget, as practitioners? Where do 
you believe the IRS should allocate its resources?
    Answer: The National Association of Enrolled Agents always has 
supported full funding for the IRS. In addition to the training 
discussed above, we believe the IRS should focus its resources on 
modernizing antiquated computer systems, expanding the new electronic 
capabilities such as DA, TDS, and EAR, and increasing enforcement, 
especially with respect to non-filers.
    Question: I imagine you have heard about the delays in Business 
Systems Modernization program. Can you explain why it is important to 
you, as practitioners, to complete this important program? What 
benefits do you see, and what services should the IRS provide in the 
future?
    Answer: The Business Systems Modernization effort is crucial for 
the future administration of our tax system. The effective 
administration of our tax system depends, to an enormous degree on 
having computer systems that can process the workload. A 19sixties-era 
mainframe cannot be expected to handle the demands placed upon it fifty 
years later. The volume of taxpayers now and in the future is just 
beyond the computer processing power built in the sixties.
    Question: The IRS has hired a new director of the Office of 
Professional Responsibility, and it is beginning to coordinate the 
efforts of the various working divisions to interact with 
practitioners. What is your initial impression of the IRS's efforts in 
this area, and what should be done in the future?
    Answer: NAEA is very pleased that IRS is finally able to address 
the resource and modernization needs of the Office of Professional 
Responsibility (OPR). As practitioners, we look forward to seeing 
progress in having OPR address longstanding issues involving tax 
professionals. In doing so, we hope that the OPR will be sensitive to 
the independence of this office in fulfilling its quasi-judicial role. 
We believe it is too early to assess the success of its initiatives.
    Question: What is your assessment of the state of the tax system 
today, compared to 6 years ago, when Congress enacted the IRS 
Restructuring and Reform Act?
    Answer: The IRS Restructuring and Reform Act resulted in a 
tremendous cultural shift at IRS. During the process (which is 
ongoing), practitioners found that IRS employees were placed in new 
positions without adequate training. On the front lines, they did not 
know where to send taxpayers for proper resolution or assistance and 
the negative impact it had on the morale of the IRS employees is still 
evident today. The IRS failed in the proper planning and execution of 
the reorganization and it still plagues the IRS today. This is not to 
imply the RRA was wrong. NAEA believes that the same shift in culture 
affecting IRS employees also has affected taxpayers and practitioners.
                                 ______
                                 

             Questions from Chairman Houghton to Mr. Orwick

    Question: As more and more Americans turn to tax prepares to 
prepare their returns, the role of practitioners in the tax system has 
become more important. According to the National Taxpayer Advocate, as 
many as half of the 1.2 million tax prepares have no formal training 
and are not required to adhere to any professional standards. As you 
may know, the Advocate and others have discussed limited registration 
of paid prepares. What is your view of the proposal?
    Answer: I do not oppose limited registration of paid prepares if 
those whom do questionable work are ``weeded'' out of the business of 
preparing tax returns. This registration should have some sort of 
grandfather clause included for qualified prepares.
    Question: In your written statements, all of you have emphasized 
the need to simplify the Tax Code. How did the Tax Code become so 
complex, and what should Congress do to simplify the tax Code?
    Answer: I started preparing tax returns in 1980. Since that time 
every new tax law has added some degree of complication. IRS rulings 
such as Rev. Rul. 2000-4 regarding depreciation and those of which I 
spoke on the taxation of CRP income for retired taxpayers, adds to the 
confusion and frustration of taxpayers and practitioners. The 
alternative minimum tax has also become a burden for many average 
taxpayers; this was not the original intent when it became part the tax 
Code many years ago. When Congress passes tax legislation, it is very 
important that their intent be clear, so the IRS knows how to interpret 
and enforce the law. This alone would ``simplify'' the current tax 
system.
    Question: Occasionally, we have heard opposition from practitioners 
to a tax simplification proposal that might alter or upset the 
practitioner's chosen specialty of tax. Are your members willing to 
give up a lucrative practice that depends on a wrinkle in the Tax Code? 
How important is tax simplification to your membership and to the tax 
system as a whole?
    Answer: Since I do not represent any particular organization I can 
only speak for myself. I believe that simplification is the cornerstone 
to the success of our current tax system. If we as practitioners or the 
taxpayers themselves cannot comply with the law because it is to 
complicated the system no longer works. As to altering or upsetting my 
particular practice with simplification, I feel that we have a broad 
base of clients whom even in a more ``simple'' tax system would 
continue to require the professional services we offer. However, 
simplification would allow my staff and myself to work a normal 
workweek rather than eighteen hours a day, 7 days a week for the tax 
season.
    Question: I understand that the IRS is in the process of launching 
a new program that will allow tax prepares to access certain 
information on behalf of clients and will improve communication with 
the IRS. What is your impression of the new service so far? Are there 
any improvements the IRS should make?
    Answer: I have had limited exposure to the current system and do 
not feel that this exposure has yet given me an opportunity to make an 
educated comment on it's effectiveness. However, I was part of a pilot 
program a few years ago dealing with the same issues and found the 
system a fantastic tool in resolving my clients' account problems with 
the IRS.
    Question: One of the things that makes the tax system complex is 
that the IRS does not always provide a clear answer to the tax 
treatment of a common transaction. Is the IRS doing enough to publish 
clear and concise guidance to taxpayers? Would increasing the resources 
available to the IRS in this area help to make the tax system more 
transparent?
    Answer: Yes, I believe it would. Also the passage of clear and 
concise tax legislation would aid the IRS in reaching their goals.
    Question: We have discussed the IRS budget with the government 
panelists. What is your view of the budget, as practitioners? Where do 
you believe the IRS should allocate its resources?
    Answer: As with anything, the more funds that are available the 
easier it is to do a better job. I feel the IRS is currently doing a 
good job, additional programs designed to build a team effort between 
the IRS, taxpayers and practitioners would be a positive place to apply 
additional funding.
    Question: I imagine you have heard about the delays in the Business 
Systems Modernization program. Can you explain why it is important to 
you, as practitioners, to complete this important program? What 
benefits do you see, and what services should the IRS provide in the 
future.
    Answer: I do not feel that I have enough facts to comment on this 
issue.
    Question: The IRS has hired a new director of the Office of 
Professional Accountability, and it is beginning to coordinate the 
efforts of the various working divisions to interact with 
practitioners. What is your initial impression of the IRS's efforts in 
this area, and what should be done in the future?
    Answer: I believe that all advances in this area are very positive 
steps and I commend them for their efforts. I have not personally been 
exposed to this program, so I do not at this time have an initial 
impression of the IRS's efforts in this area.
    Question: What is your assessments of the state of the tax system 
today, compared to 6 years ago, when Congress enacted the IRS 
Restructuring and Reform Act?
    Answer: I believe that the IRS has become more customer service 
orientated. This along with movement toward electronic filing and other 
advancements of technology have been very positive steps. On the 
downside, I believe the tax legislation passed during this period along 
with the interpretation of it and previous laws by the IRS has made 
working with the current tax system more complicated and cumbersome.
                                 ______
                                 

             Questions from Chairman Houghton to Mr. Zarzar

    Question: As you may know, the Advocate and others have discussed 
limited registration of paid preparers. What is your view of the 
proposal?
    Answer: National Taxpayer Advocate Nina Olson, as part of the 
Advocate's 2003 Annual Report to Congress, calls for the establishment 
of a ``registration, examination, certification, and enforcement 
program for Federal tax return preparers.''
    The legislative intent of the tax return preparer registration 
proposal is to raise the professional standards for unenrolled 
preparers. Providing meaningful guidance to practitioners in the 
performance of their professional responsibilities is an objective we 
strongly support, as reflected by the AICPA's Code of Professional 
Conduct and our Statements on Standards for Tax IRSs. However, we are 
concerned that this registration initiative has not undergone 
sufficient review regarding the level of financial resources required 
for proper administration of the program. No budgetary commitment to 
this program is reflected in the Administration's proposed IRS budget 
for fiscal year 2005.
    In conjunction with any review of the proposal, we also recommend 
that the IRS and Congress study how the current Electronic Return 
Originator (ERO) application process might overlap or duplicate even a 
``limited'' registration process for tax return preparers. Under the 
current ERO application process, IRS conducts a background check of all 
principals and responsible officials affiliated with a tax return 
preparer's firm. This background check includes: (1) an FBI criminal 
background review; (2) a credit history check; and (3) an IRS records 
check with respect to the preparer and the firm's adherence to tax 
return and tax payment compliance requirements, including a review of 
any prior non-compliance under the IRS e-file program.
    Question: In your written statement, all of you have emphasized the 
need to simplify the Tax Code. How did the Tax Code become so complex, 
and what should Congress do to simplify the Tax Code?
    Answer: In our testimony, the AICPA reaffirmed its support of 
efforts to reduce complexity in existing tax law and to curtail 
incremental complexity in the future. While we acknowledge that an 
absolutely simple tax system is not feasible in today's complex 
business and economic environment, we believe it is possible to design 
a simpler tax system.
    We believe that the problem of undue complexity has arisen in part 
because of the dominance of other legislative goals (such as revenue 
enhancement, rate reduction, economic incentives and social policy) 
over the goal of simplification. As a starting point, lawmakers need to 
balance the goal of tax simplification with these competing objectives. 
Incremental additional complexity can be curtailed by following basic 
guiding principles for tax law simplification.\1\ For example, as 
legislation and administrative guidance is drafted, legislators and 
regulators should: (1) seek the simplest approaches; (2) minimize both 
compliance and administrative burdens; (3) avoid inconsistent concepts 
and definitions; and (4) avoid enacting provisions that apply to only a 
few or for only a short period of time.
---------------------------------------------------------------------------
    \1\ See AICPA comments on 2001 Recommendations of the Staff of the 
Joint Committee on Taxation to Simplify the Federal Tax System, 
February 2002.
---------------------------------------------------------------------------
    Congress must then undertake meaningful tax simplification to 
existing law. Considerable consensus has developed in recent years 
identifying desirable proposals that would simplify the law for a large 
number of taxpayers. For example, the AICPA provided lengthy comments 
on the 2001 Recommendations of the Staff of the Joint Committee on 
Taxation to Simplify the Federal Tax System.\2\ In addition, in 
February 2000, the AICPA sent to Congress a package of tax 
simplification recommendations the Institute hammered out in a historic 
joint initiative with the Tax Executives Institute and the American Bar 
Association Section of Taxation.\3\ Among the recommendations were: (1) 
repeal of the alternative minimum tax; (2) harmonization of family 
status definitions; (3) streamlining education tax incentives; and (4) 
eliminating or making uniform the numerous phase-outs contained in the 
Code.
---------------------------------------------------------------------------
    \2\ See AICPA, American Bar Association section of Taxation and Tax 
Executives Institute Tax Simplification Recommendations, February 25, 
2000.
    \3\ Id.
---------------------------------------------------------------------------
    These changes alone would make the Code more consistent, rational, 
fair, and transparent--particularly for low--and middle-income 
taxpayers. While there are revenue costs associated with simplification 
reforms, it is also important to recognize that there are significant 
compliance burdens that will be eliminated by such reforms.
    We note with pleasure Chairman Houghton's introduction of nine 
separate tax simplification bills on April 2, 2004, many of which 
address our top complexity concerns.
    Question: Occasionally, we have heard opposition from practitioners 
to a tax simplification proposal that might alter or upset the 
practitioner's chosen specialty in tax. Are your members willing to 
give up a lucrative practice that depends on a wrinkle in the Tax Code? 
How important is tax simplification to your membership and to the tax 
system as a whole?
    Answer: The AICPA has surveyed its membership on the topic of tax 
law simplification. This has resulted in our firm belief that it is 
essential to simplify the Tax Code in order to preserve our voluntary 
compliance tax system and, as a consequence, preserve a viable tax 
practice for our membership. As a consequence, the AICPA has actively 
supported many Congressional tax simplification efforts and has offered 
Congress many specific recommendations over the years.
    Tax advisers spend considerable time assisting clients with 
compliance problems; time that they believe would be better spent on 
activities such as personal financial or strategic business planning.
    Question: I understand that the IRS is in the process of launching 
a new program that will allow tax preparers to access certain 
information on behalf of clients and will improve communication with 
the IRS. What is your impression of the new service so far? Are there 
any improvements the IRS should make?
    Answer: The IRS has taken a number of positive steps during the 
last year to listen to the practitioner community about the myriad of 
problems tax professionals still face when contemplating offering e-
file services to their clients. This includes the IRS's efforts to 
phase-in the electronic filing of business returns and its rollout of 
the ``Electronic IRSs'' section on the IRS Website, including a suite 
of Web-based products for practitioners to do business with the IRS 
electronically. Electronic IRSs would enable practitioners who e-file 
more than 100 ``accepted'' individual tax returns in a season to (1) 
submit many commonly used IRS contact forms electronically and receive 
an acknowledgement of acceptance from the IRS; (2) make electronic 
inquiries about individual and business tax account problems and 
issues; and (3) request tax return transcripts and account transcripts. 
We support the new e-services, but we encourage the IRS to eliminate 
the 100 return threshold, allowing all practitioners to benefit and 
contribute to the growth of e-filing and account resolution.
    Question: Is the IRS doing enough to publish clear and concise 
guidance to taxpayers? Would increasing the resources available to the 
IRS in this area make the tax system more transparent?
    Answer: All IRS guidance must be effective, clear, timely, and 
designed to promote a uniform understanding and consistent application 
of the tax laws. In this context, we support any initiative designed to 
improve the quality of published IRS guidance. The IRS has made great 
strides in recent years, and we look forward to increased efficiency 
and timeliness in the future. Allocating appropriate resources to 
increase the volume of guidance published will make the tax system more 
transparent.
    Question: What is your view of the IRS budget, as practitioners? 
Where do you believe the IRS should allocate its resources?
    Answer: We applaud Congressional efforts to provide full funding 
for the IRS's fiscal year 2005 budget. The AICPA has long advocated 
funding levels which would allow the IRS to efficiently and effectively 
administer the tax laws and collect taxes. We support the objective of 
the Administration's budget proposal which focuses on increasing 
staffing and providing more resources for enforcement. In addition, we 
believe the budget should strive to provide a positive balance among: 
(1) improving taxpayer service; (2) enhancing enforcement of the tax 
law; and (3) modernizing the IRS through its people, processes, and 
technology.
    Question: Can you explain why it is important to you, as 
practitioners, to complete the Business Systems Modernization program? 
What benefits do you see, and what services should the IRS provide in 
the future?
    Answer: The IRS Oversight Board's December 2003 Business Systems 
Modernization and the IRS have detailed continuing delays in 
implementing the customer account data engine designed to replace the 
IRS Master File of taxpayer records.
    Despite these problems, we urge Congress to stay the course in 
supporting appropriate funding for the modernization effort that must 
remain a central feature of the IRS's strategic plan for the next 5 
years. The Business System Modernization goals are critical to the 
future of the IRS, taxpayers, and the effectiveness of our tax system.
    Question: The IRS has hired a new director of the Office of 
Professional Responsibility and it is beginning to coordinate the 
efforts of various working divisions to interact with practitioners. 
What is your initial impression of the IRS's efforts in this area, and 
what should be done in the future?
    Answer: The AICPA is encouraged by Commissioner Everson's 
commitment to upgrade the Office of Professional Responsibility, and 
his appointment of Cono Namorato as the office's new Director. These 
efforts should greatly enhance the IRS's ability to address 
professional responsibility standards for all tax professionals and 
help eradicate abusive transactions.
    We also commend Treasury and the IRS for their commitment to issue 
final regulations under Circular 230 over the next several months to 
address: (1) ``best practices'' for tax advisors (which we believe 
should be aspirational in nature); and (2) tax shelter opinions. These 
regulations should help to ``raise the bar'' of professionalism for tax 
advisors, as well as the quality of written tax opinions. The final 
regulations should clearly address the need for restoring integrity and 
confidence in the tax system, and we are proud to join with the 
Treasury and the IRS to ensure that tax practitioners have a role in 
that restoration.
    Question: What is your assessment of the state of the tax system 
today, compared to 6 years ago, when Congress enacted the IRS 
Restructuring and Reform Act?
    Answer: The IRS Restructuring and Reform Act has resulted in: (1) 
improved taxpayer service; (2) greater equity in the administration of 
the tax law; and (3) higher productivity of the IRS's workforce. 
Nevertheless, we recognize that further improvements can and should be 
made--improvements that can result in an even higher level of service 
for America's taxpayers. We support Commissioner Everson's push to 
increase staffing in the compliance area and to ensure a proper balance 
between service and enforcement within the context of the IRS budget 
initiatives for fiscal year 2005 and the IRS's strategic plan for the 
next 5 years.
                                 ______
                                 

           Questions from Chairman Houghton to Mr. McCormally

    Question: As more and more Americans turn to tax preparers to 
prepare their returns, the role of practitioners in the tax system has 
become more important. According to the National Taxpayer Advocate, as 
many as half of the 1.2 million tax preparers have no formal training 
and are not required to adhere to any professional standards. As you 
may know, the Advocate and others have discussed limited registration 
of paid preparers. What is your view of the proposal?
    In your written statements, all of you have emphasized the need to 
simplify the Tax Code. How did the Tax Code become so complex, and what 
should Congress do to simplify the tax Code?
    Occasionally, we have heard opposition from practitioners to a tax 
simplification proposal that might alter or upset the practitioner's 
chosen specialty of tax. Are your members willing to give up a 
lucrative practice that depends on a wrinkle in the Tax Code? How 
important is tax simplification to your membership and to the tax 
system as a whole?
    I understand that the IRS is in the process of launching a new 
program that will allow tax preparers to access certain information on 
behalf of clients and will improve communication with the IRS. What is 
your impression of the new service so far? Are there any improvements 
the IRS should make?
    One of the things that makes the tax system complex is that the IRS 
does not always provide a clear answer to the tax treatment of a common 
transaction. Is the IRS doing enough to publish clear and concise 
guidance to taxpayers? Would increasing the resources available to the 
IRS in this area help to make the tax system more transparent?
    We have discussed the IRS budget with the government panelists. 
What is your view of the budget, as practitioners? Where do you believe 
the IRS should allocate its resources?
    I imagine you have heard about the delays in the Business Systems 
Modernization program. Can you explain why it is important to you, as 
practitioners, to complete this important program? What benefits do you 
see, and what services should the IRS provide in the future?
    The IRS has hired a new director of the Office of Professional 
Accountability, and it is beginning to coordinate the efforts of the 
various working divisions to interact with practitioners. What is your 
initial impression of the IRS's efforts in this area, and what should 
be done in the future?
    What is your assessment of the state of the tax system today, 
compared to six years ago, when Congress enacted the IRS Restructuring 
and Reform Act?
    Answer: On behalf of Tax Executives Institute, I am pleased to 
respond to your follow-up questions to the Oversight Subcommittee's 
hearing on the 2004 IRS filing season and IRS budget for FY 2005. TEI 
appreciates the opportunity to express our views.
    In your April 5, 2004, letter, you asked about the effect of the 
complexity of the Internal Revenue Code on tax administration. The IRS 
National Taxpayer Advocate (NTA) has consistently identified the 
complexity of the tax laws as the number one problem facing taxpayers. 
In her 2003 annual report, Nina Olson ranked the alternative minimum 
tax (AMT) for individuals as the number one problem, noting that 
according to IRS estimates, taxpayers spent more than 29 million hours 
in 2000 completing and filing AMT tax forms, or roughly 63 hours per 
taxpayer who actually pays the AMT. ``The AMT is extremely and 
unnecessarily complex,'' the report concludes, ``and results in 
inconsistent and unintended impact on taxpayers.'' Your recent proposal 
(H.R. 4131) to gradually raise the AMT exemption amount and repeal the 
individual AMT after 2013 is a good first step in reducing complexity.
    The corporate AMT, however, suffers from the same policy and 
administrative deficiencies as the individual AMT: It creates enormous 
compliance burdens. TEI strongly believes that taxpayers should not be 
required to compute their taxes twice or to keep two sets of books. In 
addition, the AMT taxes corporations when they can least afford it--
when they are struggling to survive in a down economy. The AMT 
represented poor public policy when it was enacted, and ensnares 
taxpayers who do no more than engage in activities that Congress 
independently determined should be encouraged. The AMT should be 
repealed for all taxpayers, individuals and corporations.
    Everyone--Congress, the U.S. Department of Treasury, the IRS, tax 
professionals, and taxpayers--bears responsibility for the current 
complex state of the law. More than five years ago, TEI joined with the 
AICPA and ABA Tax section to draw attention to the problem and to seek 
solutions. Mr. Chairman, you have been a strong supporter of these 
efforts, and, indeed, during your 17 years in Congress, you have been a 
strong champion for making the tax law simpler. TEI commends you and 
this Subcommittee for highlighting this issue.
    TEI wishes you well on your retirement at the end of this year and 
pledges to continue seeking changes that will make the tax law simpler 
for all of us.
    If you have any questions, please do not hesitate to contact me or 
Fred F. Murray, TEI's General Counsel and Director of Tax Affairs, at 
202.638.5601.
                                 ______
                                 

    Questions from Representative Paul Ryan to Commissioner Everson

    Question: My question is in regards to child tax credit 
overpayments as a result of the child tax credit advance payments that 
were sent out last year.
    A constituent shared with me that they approached the IRS with the 
following scenario: In the case of divorced parents, the individual ex-
spouses may alternate tax years in which they claim the personal 
exemptions and the child tax credit. One parent, for example, may have 
claimed the child tax credit in 2002 and received the child tax credit 
advance payment in 2003. This parent, however, will not claim the child 
tax credit for tax year 2003 because it is the turn of the other parent 
to claim the child tax credit. The constituent asked the IRS if the 
parent who received the child tax credit advanced payment in 2003 would 
have to repay the advance in some way to the IRS? The constituent also 
asked if the parent who will claim the child tax credit for 2003 would 
have to reduce the $1,000 per child credit by the amount of the advance 
payment received by the other parent?
    The IRS indicated to the constituent that if the advance payment 
exceeds the total of the child tax credit and the additional child tax 
credit, the taxpayer does not have to repay the difference. This is 
true even if the taxpayer isn't eligible for the credit in 2003. In 
addition, the IRS told the constituent that a taxpayer takes into 
account only his or her advance payment, not the amount received by 
someone else, even if that person had claimed the qualifying children 
the previous year. Therefore, in the constituent's situation, no 
repayment would need to be made and the other parent would claim the 
full credit allowable without subtracting the advance payment amount.
    My question is, first, is this true? Second, if this is in fact 
true, what does IRS estimate these child tax credit overpayments will 
amount to for tax year 2003?
    Answer: In the scenario described, your constituent was given the 
correct answer. The divorced parent claiming the child for 2003 may 
claim the full credit without regard to the advance child tax credit 
payment received by the other divorced parent. The parent that is not 
claiming the child for 2003 but received the advanced child tax credit 
payment is not required to repay the credit to the IRS.
    IRS does not have a way to calculate the amount of overpaid ACTC to 
parents that have alternating support agreements.
    Question: The Federal tax refund offset program, which is referred 
to as the Treasury Offset Program (TOP), allows government agencies to 
submit to the IRS claims for delinquent debts up to 10 years old. The 
State of Wisconsin is currently participating in this program for the 
purpose of recovering state-owed debts. Local municipalities, however, 
are not permitted to participate in TOP to include debts owed to local 
and municipal agencies. 
    Do you believe that the current system could accommodate local 
municipalities to participate in TOP? If so, what is needed to allow 
local municipalities to participate in TOP? If you do not believe the 
current system could accommodate local municipalities, why?
    Answer: Although the IRS participates in the TOP, the Treasury 
bureau responsible for the operation of TOP is the Financial Management 
IRS (FMS). Therefore, we referred your question to FMS for a response. 
FMS's response is below.
    State debt currently collected through TOP is limited to delinquent 
child support obligations and delinquent state income taxes, which may 
include delinquent local income taxes administered by the chief tax 
administration agency of the state. Legislation would be required to 
expand the program to include debts owed to local and municipal 
agencies.
    FMS receives information about state debt from the U.S. Department 
of Health and Human IRSs for delinquent child support obligations and 
from a single point within each state for state/local income tax debt. 
TOP could not accommodate debt owed to local and municipal agencies 
because to do so would require telecommunications connections with 
hundreds of end-points and extensive systems modifications to 
accommodate hundreds of connections per state. Additionally, we do not 
currently have the resources required to manage and troubleshoot a 
program to collect large volumes of debt owed to local and municipal 
agencies nor to handle debtor inquiries, transfer funds to hundreds of 
end-points, and train thousands of new users.
    To accommodate debt owed to local and municipal agencies, the 
Financial Management IRS would need to forego other priority projects 
and increase development, operational and program staff. Such a project 
would require a significant development effort and modification to debt 
systems with no substantial benefit to the Federal Government. Even if 
these challenges could be met, Treasury might be reluctant to support 
expansion of the program to collect debts that do not have a Federal 
component or a Federal/State partnership interest.
    [Submission for the record follows:]

           Statement of Gerald E. Scorse, New York, New York

    I first want to thank the Committee for the opportunity to make a 
Submission for the Record. Thousands of voices clamor to be heard as 
you go about the nation's business. What claim do I have to be listened 
to? Only this: that the Ways and Means Committee, as the originator of 
all tax legislation, is the proper place to make this petition; that 
the issue I raise is just, as this document will demonstrate; and that 
the issue has a clear and ready solution, if the Committee chooses to 
seek a solution.
    I grew up believing that all income is reported to the Internal 
Revenue Service. Starting with my teen years I received a W-2, which 
reported my wages. In later years I received the 1099 forms on which 
bank interest is reported (and dividends as well, though it would be a 
while before I saw any of those).
    In the 1980s and 1990s, when I began to put money into the stock 
market, I gradually became aware that capital gains income is not 
reported; when it comes to stock transactions, the only information 
reported by a third party to the IRS is the amount of the proceeds and 
the date of the sale. The IRS receives no information on the initial 
purchase of the stock. It does not know the price that was paid; it 
does not know the date of the purchase. I was offended when I found 
this out. It seemed to me then, and seems to me now, profoundly unfair.
    Wages are earned income. People get up early and work late for 
wages. Capital gains are unearned income. (Mine included. I don't work 
for them. I don't sweat for them. They come to me like manna from 
heaven.) Fairness is crucial to our income tax system. When it comes to 
capital gains, the system is unfair. I resolved to find out why, and to 
try to change it. On March 5, 2001, I took my cause to Washington. I 
wrote to Charles Rangel, my Congressman and the ranking Democrat on the 
Ways and Means Committee.

Why Third-Party Reporting is Not Currently Required
    Third party reporting is the foundation of income tax collection in 
the United States. Third parties report income from wages, dividends, 
and interest to the Internal Revenue Service. They report all manner of 
miscellaneous income, e.g., non-employer compensation and gambling 
winnings. Safe to say, our income tax system would collapse without 
third-party reporting.
    Yet this standard reporting requirement does not apply to capital 
gains income. Why so? The answer arrived in a letter dated May 23, 
2002, from Pamela F. Olson, Acting Assistant Secretary (Tax Policy), 
Department of the Treasury, to Representative Rangel, with a carbon to 
myself. Rep. Rangel had relayed my concerns to Treasury Secretary 
O'Neill, who had asked Secretary Olson to reply.
    Secretary Olson restated my position and offered the Treasury's 
opinion: ``. . . Mr. Scorse believes that tax compliance would be 
improved if information reporting for capital gains included the amount 
of capital gains income that a taxpayer is required to show on his or 
her return. We couldn't agree more! Information reporting is the most 
efficient, least intrusive way of helping taxpayers comply with their 
tax obligations to the federal government.''
    So why, when it comes to capital gains from stock transactions, do 
we not help taxpayers comply? In two words, ``specific 
identification''. A brief explanation will suffice. An investor buys 
100 shares of IBM on one date, and 100 additional shares on another 
date. Later, the investor sells 100 shares. As Secretary Olson stated, 
the broker does not know which 100 shares the taxpayer will treat as 
sold. In addition, the purchases might have been handled by different 
brokers.
    Therefore, the Secretary concluded, ``unless taxpayers are denied 
the flexibility of specific identification,'' capital gains income 
cannot be reported by third parties to the IRS. In this view, third-
party brokerage houses and mutual funds simply do not have the 
information. My reply pointed out that there are millions, indeed 
billions of occasions when ``specific identification'' has no 
application. These include 1. When there is a single purchase and a 
single sale of a stock or a mutual fund; 2. When there are many 
purchases of a stock or mutual fund, but a single sale of the entire 
holding. In both instances, third-party holders have exact information 
on taxpayers' capital gains; in neither instance would ``specific 
identification'' stand in the way of third-party reporting.
    I also addressed the issue of shares that move from one financial 
institution to another: ``It should be required . . . that basis prices 
and acquisition dates travel with shares; complete information should 
be part and parcel of any equities transfer.'' (An analogy: do medical 
records vanish when people change doctors?) But ahead of these points, 
I stressed to Secretary Olson and would stress to the Committee, there 
is the larger issue. That issue is the fairness and integrity of the 
tax system.
    The current tax treatment of capital gains income is inherently 
inequitable. It separates taxpayers into first-class and coach. Those 
in first class are allowed to self-report their income, while those in 
coach are required to have their income reported by a third party. It 
hardly needs saying that first-class taxpayers are concentrated among 
the well-to-do and ultra-rich, while those in coach are overwhelmingly 
in the lower income brackets. All so that IRS might provide ``the 
flexibility of specific identification'' to a privileged group of 
taxpayers, myself included.

The Case for Instituting Third-Party Reporting
    The late Senator Everett M. Dirksen is most remembered for a 
statement he likely never made: ``A billion here, a billion there, and 
pretty soon you're talking real money.'' Apropos revenues lost because 
of unreported capital gains income, a paraphrase might well read: ``Ten 
billion here, ten billion there, and pretty soon you're talking real 
money.'' (*The website for the Dirksen Congressional Center says there 
is no record that the fiscally conservative senator ever spoke those 
famous words. The Center is quick to add, however, that he undoubtedly 
would have agreed with the sentiment.)
    Now let's look at several ways by which an interested party, such 
as the Committee, might arrive at that $10 billion figure. It comes as 
no surprise that revenue from capital gains taxes varies sharply from 
year to year, and that it rose by leaps and bounds in recent years. A 
generation ago, in 1980, capital gains taxes netted the Treasury $12.5 
billion. The figure climbed close to 50% by 1983, when it reached $18.5 
billion. In 1992 it was almost double that amount, or $32 billion. That 
number, too, was almost doubled in 1996 when the revenue inflow hit $62 
billion.
    And of course there were the stock market's peak years. Capital 
gains taxes ratcheted up to $84 billion in 1999 and to a record $110 
billion in 1999. All of this, of course, from reported capital gains 
income. What about the revenue shortfall from income that went 
unreported because of the third-party loophole?
    And so we arrive at one of the ways by which the yearly tax 
shortfall, resulting from unreported capital gains income, can be 
estimated at $10 billion or more. That figure could easily be reached 
by an underreporting rate in the neighborhood of 10% to 15%. Is this a 
harsh assessment of the nation's taxpayers? On the contrary, such an 
estimate assumes a remarkable degree of personal honesty; it assumes 
that 85-90 out of 100 people will be completely honest even when 
presented with a golden opportunity to be dishonest, to profit from 
their dishonesty, and to get away clean.
    Here are some less sanguine viewpoints: In a December 2002 op-ed 
piece in The New York Times, Manhattan district attorney Robert M. 
Morgenthau decried what he saw as an escalating disregard for tax laws. 
He cited a survey which found that one in four Americans believe it's 
alright to cheat on their taxes, double the percentage who answered the 
same in a 1999 survey.
    Or consider the valedictory of Charles O. Rossotti, who retired 
after five years as IRS commissioner with the admission that ``the 
agency is steadily losing the war with tax cheats, especially the 
wealthiest and most sophisticated among them.'' Messrs. Rossotti and 
Morgenthau did not single out capital gains tax evasion, but Pulitzer 
journalists Donald L. Barlett and James B. Steele spoke directly to it 
in their book, The Great American Tax Dodge: How Spiraling Fraud and 
Avoidance Are Killing Fairness, Destroying the Income Tax, and Costing 
You. Here is a key sentence: ``Of all the areas where fraud is easy to 
commit and most difficult to identify, capital gains income ranks near 
the top.''
    But all of this is only words. The most compelling rationale for 
third-party reporting of capital gains comes from hard data assembled 
by the IRS itself. We turn now to that information, and to its clear 
implications. Less than a year ago, Kim M. Bloomquist of the IRS 
presented a paper entitled ``Trends as Changes in Variance: The Case of 
Tax Noncompliance '' at the 2003 IRS Research Conference. Early on, the 
paper addressed and reaffirmed the common-sense assumption that tax 
compliance (and non-compliance) correlate directly with third-party 
reporting: ``One of the few generally accepted facts in the literature 
on tax compliance economics is the existence of a positive relationship 
between transaction visibility and reporting compliance. Over the 
years, various Government and academic studies have affirmed this 
relationship (Klepper and Nagin, 1989; Long and Swingden, 1990; 
Andreoni, Erard, and Feinstein, 1998). Random taxpayer audits conducted 
by the Internal Revenue Service (IRS) have consistently shown higher 
compliance rates among income items subject to third-party information 
reporting and withholding (i.e., matchable) versus nonmatchable sources 
of income (Christian, 1994). In the 1988 Taxpayer Compliance 
Measurement Program (TCMP) study, the average weighted net misreporting 
percentage of reported income was 1.8 percent for matchable income and 
22.6 percent for nonmatchable income (Internal Revenue Service, 1996). 
Therefore, ceteris paribus, we would predict a positive correlation 
between the evasion rate and share of nonmatchable income.''
    Unfortunately for the Treasury, and for the nation's honest 
taxpayers, nonmatchable income has been increasing. Not surprisingly, 
one of the major causes has been capital gains income: ``Table 1 shows 
the trend in matchable and nonmatchable sources of income between 1980 
and 2000. In 1980, 91.3 percent of total reported taxpayer income was 
matchable. By 2000, this percentage had fallen nearly 10 percentage 
points to 81.6 percent. The principal factor responsible for this trend 
was the faster than average growth in the nonmatchable income 
components of taxable net capital gains and partnership and small 
business corporation (SBC) net income.'' (*Table not included in this 
submission.)
    Leading, of course, to the predictable tax evasion consequences: 
``Holding constant the 1988 TCMP misreporting rates for matchable and 
nonmatchable income, it is estimated that, between 1980 and 2000, 
overall income underreporting rose from 3.6 percent to 5.6 percent of 
reported income due solely to the increase in the percentage of 
nonmatchable income. This trend of rising noncompliance is not driven 
by a change in taxpayer behavior but is simply the result of improved 
success from existing behavior. Therefore, if tax noncompliance is 
increasing, it is possible that this trend is unrelated to taxpayers' 
higher tax burdens or tax law complexity. Instead, taxpayers simply may 
be enjoying greater success at evasion due to reduced transactions 
visibility.''
    Summing up, the paper reiterated the role played by capital gains 
in driving up the share of unreported income: ``What has caused the 
share of nonmatchable income to increase during the last two decades? 
Clearly, the stock market bubble of the late 1990's contributed 
significantly to the explosive growth in the value of financial assets. 
Between 1995 and 2000, the share of taxpayer reported adjusted gross 
income (AGI) from net capital gains jumped from 4 percent to 9= 
percent.''
    Let me repeat for the Committee, from the IRS paper, the tax 
compliance consequences that flow from reported and unreported income: 
``. . . the average weighted net misreporting percentage of reported 
income was 1.8 percent for matchable income and 22.6 percent for 
nonmatchable income.''
    And then there is the fairness issue. Let me suggest, first of all, 
that there really is no issue. It is inequitable on its face that 
capital gains income should be exempt from the third-party reporting 
requirements that apply to wages and other forms of income.
    I am hardly alone in noting this inequity. On March 26, 2001, IRS 
Commissioner Charles O. Rossotti wrote to Senator Charles Grassley, 
chairman of the Senate Finance Committee. Senator Grassley had seen an 
article in The New York Times quoting from an interview with Mr. 
Rossotti, and had written to him for elaboration. Here is some of what 
Mr. Rossotti said in reply: ``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.''
    So that the original inequity, the non-reporting of capital gains, 
helps spawn a downstream inequity, the disproportionate surveillance by 
the IRS of the tax returns of the middle class. These inequities should 
not and need not stand. Neither should the Treasury have to lose 
upwards of $10 billion a year, year after year, to a tax loophole that 
could easily be closed. (As an aside, realize the difficulty of trying 
to estimate Treasury losses from unreported income. Exactly how is 
anyone to know? The IRS, for instance, has promised the Ways and Means 
Committee an answer by June 1 of this year to the question of whether 
annual tax losses on partnership/K-1 income are in the range of $9 
billion to $64 billion. This is a huge range, and for much the same 
reason; such income is self-reported, and not subject to verification.)
    Shortly before his retirement from the IRS, Rossotti spoke movingly 
of ``the crown jewel, which is the fairness and faith the honest 
taxpayer has in the system.'' The crown jewel needs burnishing. Capital 
gains, like wages and other forms of income, should be subject to 
third-party reporting. There are a number of ways by which this can be 
accomplished. They are both simple and feasible, and I commend them to 
the Committee's attention.

Proposed Methods for Instituting the Reform
    While the methods discussed below are different, and would yield 
different capital gains income figures, they share important 
characteristics. Each has particular qualities, but no special ones. 
None requires any exotic software, any development time, any trial-and-
error experimentation. All are standard, everyday tools, employed by 
mutual funds and brokerage houses to calculate their customers' capital 
gains, and to communicate this information to them. Customers with 
internet access can view the information 24 hours a day, 7 days a week; 
other customers receive written statements monthly or quarterly, or, if 
they desire, can obtain the same information by telephone any business 
day.
    Putting it another way, it would impose no burden on financial 
institutions to require third-party reporting of capital gains income. 
The institutions routinely compile the information, routinely update it 
on a daily basis, and routinely report it to their customers. Come tax 
time, they should be required to report the same information to the 
IRS.
    Any of the methods presented here could be the sole method by which 
third-party reporting is implemented. Alternatively, the methods could 
be offered as a choice to investors. And of course there are methods 
other than these. A small reminder before proceeding. This submission 
is not about which method to use. The only issue at hand is third-party 
reporting of capital gains income, by whatever method the Congress 
elects. Here are three ways that third-party reporting might be 
achieved.

Average Cost Basis
    Average cost basis is probably the most commonly used method, 
particularly by mutual funds, of calculating investors' basis costs. It 
simply totals the number of shares and the prices paid, and determines 
the basis by dividing the total price by the number of shares held. It 
does not consider when any particular shares were purchased, or how 
much was paid for any particular group of shares. It is simple and 
straightforward, and would be a perfectly equitable method of third-
party reporting. However, thanks to computer technology, two other 
methods offer investors superior tax-efficiency.

Highest-In, First-Out (HIFO)
    Current tax rules require that mutual funds distribute essentially 
all of their dividends and realized capital gains each year as taxable 
income. These rules have led to a relatively new breed of so-called 
tax-managed funds. The objective of these funds is to keep the taxable 
gain to shareholders as low as possible; the funds do this by first 
selling their highest-cost shares, which can be a much more tax-
efficient method than FIFO (first-in, first-out). HIFO not only 
minimizes capital gains, it also maximizes capital losses. Losses of 
course can be written off dollar-for-dollar against gains, and an 
additional $3,000 can be used to offset ordinary income; losses greater 
than $3,000 can be carried forward and used to offset future gains. All 
things considered, HIFO would probably be the most attractive method 
for investors of determining basis costs for third-party reporting of 
capital gains. And the higher the tax bracket, the more investors would 
stand to gain from HIFO accounting.

Specific Identification
    ``Specific Share Trading for Mutual Fund Shares Now Available.''
    That was the announcement from Fidelity Investments on October 18, 
2002 to its customers, including myself. The announcement went on: 
``Looking to use the specific share method when selling your mutual 
fund positions online? Look no further. Fidelity now offers customers 
who hold eligible mutual fund positions in non-retirement accounts to 
track and specify shares when selling those positions.''
    Among other things, subject to ``certain exceptions and 
limitations,'' the company said that customers could 1) ``Request 
Fidelity to sort and pre-select the tax lots that best match your tax 
objectives . . .'', 2) ``Sort and review up to 150 open tax lots by 
holding period (short--or long-term) and/or by cost basis per share,'' 
3) ``Get a confirmation of your specific share instructions on either 
your regular trade confirmation or via special correspondence. The gain 
or loss is then reported both online and on your regular Investment 
Report.''
    As Fidelity put it, ``Fidelity customers have always been able to 
use the specific share method for their mutual fund holdings. However, 
they needed to maintain their own cost basis tracking--a complicated 
recordkeeping requirement that deterred many from taking advantage of 
the accounting feature. Now, Fidelity is taking all that recordkeeping 
off of your hands.'' It deserves to be noted that investors have no 
inherent right to specific identification as a means of calculating 
basis costs. While current tax law grants such a privilege, it is 
outweighed by both tax equity and fiscal policy considerations. That 
said, specific identification is in fact another possible means of 
achieving third-party reporting of capital gains income. We have this 
information from an excellent source. We have it from Fidelity 
Investments, which announced the availability of specific 
identification more than a year and a half ago.

Summary
    We have examined and explored the lack of third-party reporting of 
capital gains income. To what conclusions does the evidence lead? There 
is no tax equity defense (nor has the author ever seen one put forth) 
for allowing self-reporting of capital gains income while requiring 
third-party reporting of wages, dividends, interest, and all manner of 
miscellaneous income. Similarly, it makes no fiscal sense for the 
Congress to tolerate the untold billions of dollars lost to the 
Treasury, year after year, due to the lack of third-party capital gains 
reporting. The IRS's own statistics show that tax evasion is 12= times 
more frequent when income is self-reported than when it is reported by 
third parties; this alone should be inducement enough for the Congress 
to require third-party reporting of capital gains.
    In a sense, the Committee is blessed to face this problem. There is 
no complexity here; there is no opaqueness. The problem is simple and 
straightforward, and the solution as well. The problem is the absence 
of third-party reporting of capital gains; the solution is to require 
such reporting, and the systems are essentially already in place to 
perform it. If the Committee will allow, let me repeat the quote from 
Assistant Treasury Secretary Olson's letter of May 23, 2002: ``. . . 
Mr. Scorse believes that tax compliance would be improved if 
information reporting for capital gains included the amount of capital 
gains income that a taxpayer is required to show on his or her return. 
We couldn't agree more! Information reporting is the most efficient, 
least intrusive way of helping taxpayers comply with their tax 
obligations to the federal government.'' I ask the Committee to review 
the facts, and to do the right thing.

                                  
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