Reliability of Information on Taxpayers Claiming Many Withholding
Allowances or Exemption from Federal Income Tax Withholding	 
(15-SEP-03, GAO-03-913R).					 
                                                                 
When taxpayers claim more withholding allowances than they are	 
entitled to or improperly claim exemption from withholding,	 
either no tax or too little tax is withheld from their wages. As 
a result, some taxpayers end up owing the Internal Revenue	 
Service (IRS) additional taxes, and if the taxes are not paid on 
time, they become delinquent. This report responds to a 	 
Congressional request for information on these taxpayers.	 
Specifically, we provided information on (1) how many taxpayers  
claimed more than 10 allowances for federal income tax		 
withholding purposes and (2) how many taxpayers claimed exemption
from federal income tax withholding and, of those taxpayers, what
proportion did not file federal income tax returns and had	 
invalid Social Security numbers.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-913R					        
    ACCNO:   A08500						        
  TITLE:     Reliability of Information on Taxpayers Claiming Many    
Withholding Allowances or Exemption from Federal Income Tax	 
Withholding							 
     DATE:   09/15/2003 
  SUBJECT:   Federal taxes					 
	     Income taxes					 
	     Taxpayers						 
	     Tax administration 				 
	     Tax violations					 
	     IRS Questionable Form W-4 Program			 

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GAO-03-913R

GAO- 03- 913R Reliability of IRS*s Form W- 4 Information

United States General Accounting Office Washington, DC 20548

September 15, 2003 The Honorable Elton Gallegly House of Representatives

Subject: Reliability of Information on Taxpayers Claiming Many Withholding
Allowances or Exemption from Federal Income Tax Withholding

Dear Mr. Gallegly: When taxpayers claim more withholding allowances than
they are entitled to or improperly claim exemption from withholding,
either no tax or too little tax is withheld from their wages. As a result,
some taxpayers end up owing the Internal Revenue Service (IRS) additional
taxes, and if the taxes are not paid on time, they become delinquent. This
report responds to your request for information on these taxpayers.

Specifically, you asked that we provide you with information on (1) how
many taxpayers claimed more than 10 allowances for federal income tax
withholding purposes and (2) how many taxpayers claimed exemption from
federal income tax withholding and, of those taxpayers, what proportion
did not file federal income tax returns and had invalid Social Security
numbers. However, because of concerns about the completeness and currency
of the information reported to IRS on taxpayers who claimed more than 10
withholding allowances or taxpayers who claimed exemption from
withholding, we could not use it to respond to your questions. This report
discusses why we could not use IRS*s information to answer your questions
and briefly describes IRS*s proposals to help address this problem. To
perform our work, we analyzed information from IRS*s Questionable Form W-
4 database 1 and interviewed IRS officials responsible for managing the
Questionable Form W- 4 program. Further details on our scope and
methodology are provided later in this report.

Results in Brief

We have two concerns about the information that IRS maintains on taxpayers
who claimed more than 10 withholding allowances or exemption from federal
tax withholding that preclude us from using it to answer your questions.
First, we are concerned about the completeness of the information because
a significant number of employers may not send IRS the required forms.
Second, some of the information may not be current* it may not reflect the
current withholding status of some

1 This refers to IRS*s Questionable Form W- 4 Case Control System.

GAO- 03- 913R Reliability of IRS*s Form W- 4 Information Page 2 taxpayers.
While acknowledging the limits of the information for answering your

questions, IRS officials told us that the information is useful for tax
compliance purposes. Also, the officials said that IRS has efforts under
way intended to influence employers to comply with the reporting
requirement. IRS provided oral comments on a draft of this report stating
that it generally agreed with our findings. IRS*s comments are summarized
later in this report.

Background

Section 3402 of the Internal Revenue Code requires employers to withhold
income tax from wages and other forms of income. It outlines the basis for
claiming withholding allowances or exemption from withholding and
specifies the general content of the IRS Form W- 4* Employee*s Withholding
Allowance Certificate (Form W- 4) that employees submit to employers when
making their withholding allowance claims.

Each employee is required to submit a completed Form W- 4 to his or her
employer. Employees are to use the worksheet attached to the Form W- 4 to
determine the number of withholding allowances they should claim. The
worksheet*s instructions consider, among other things, a taxpayer*s filing
status, number of dependents he or she claims on the tax returns, and
eligibility for the child tax credit. For example, a married taxpayer
filing a joint tax return who has four dependent children and large
itemized deductions may be eligible to claim more than 10 allowances. Some
taxpayers not claiming a specific number of allowances may claim exemption
from federal income tax withholding. Generally, taxpayers can claim
exemption from withholding if they had no tax liability for the previous
year and expect to have none in the current year.

Treasury regulations 2 require that employers send IRS *questionable Form
W- 4s.* 3 According to IRS, a questionable Form W- 4 is any Form W- 4 on
which a taxpayer claims more than 10 withholding allowances or claims
exemption from withholding with over $200 per week in wages. The
information that IRS receives from employers on questionable Form W- 4s is
maintained in the Questionable Form W- 4 database.

IRS uses information in the database to identify potential noncompliance
with its withholding guidelines. IRS*s tax examiners at the Fresno
Computing Center review selected questionable Form W- 4 cases to determine
if the withholding is appropriate based on the taxpayer*s filing history
and may contact the taxpayer if additional information is needed to
substantiate the withholding allowances claimed. If the tax examiners
determine that the withholding allowances claimed are incorrect or if
taxpayers do not respond to IRS contacts, the tax examiners mail *lock-
in* letters to the taxpayers* employers directing them to disregard the
taxpayers* Form W- 4s as filed and to withhold at the rate for a single
person with zero allowances or at some other rate determined by the tax
examiners.

2 Treasury Regulation S:31. 3402( f)( 2)- 1( g)( 1)-( 2). 3 If a new
employee does not give the employer a completed Form W- 4, the employer is
to withhold tax as if the employee is single, with no withholding
allowances.

GAO- 03- 913R Reliability of IRS*s Form W- 4 Information Page 3

Findings

Because of concerns about the completeness and currency of the information
in IRS*s Questionable Form W- 4 database, we cannot respond to your
questions. According to our guidance for assessing the reliability of
computer- processed data, 4 we cannot use data that are significantly
incomplete, inaccurate, and not up to date and subsequently could lead to
an unintentional or incorrect message.

We are concerned about whether the information in IRS*s Questionable Form
W- 4 database is sufficiently complete because some employers likely do
not send IRS withholding information on employees who claim more than 10
allowances or claim exemption from federal income tax withholding, as
required. IRS program officials told us that they do not know the extent
to which employers might not be sending in questionable Form W- 4s. 5
However, IRS*s analysis of large employers with 1,000 or more employees
that sent in questionable Form W- 4s provides some evidence that a
significant number of large employers may not be reporting Form W- 4
information to IRS. This analysis showed that 25 percent of the employers
with 1,000 or more employees in its Large and Medium- Size Business (LMSB)
and Small Business/ SelfEmployed (SB/ SE) divisions that filed employment
tax returns in tax year 2001 sent in questionable Form W- 4s to IRS (1,933
of 7,713 employers). Similarly, 16 percent of the employers with 1,000 or
more employees in IRS*s Tax Exempt/ Government Entities Division had
submitted questionable Form W- 4s (610 of 3,888 employers). Although the
number of questionable Form W- 4s IRS might receive from individual
employers can vary, we question whether 75 percent of large employers with
1,000 or more employees in IRS*s LMSB and SB/ SE divisions could have no
employees who submitted questionable Form W- 4s. Information from IRS
showed that IRS received about 800,000 questionable Form W- 4s from 33,000
employers in calendar year 2002 or, on average, about 25 forms from each
employer who submitted. This average includes many employers with fewer
than 1,000 employees.

Under current law, IRS does not have statutory authority to impose a
penalty to enforce employer compliance with the reporting requirement. The
reporting requirement was promulgated in Treasury regulations.

In addition, IRS*s questionable Form W- 4 database may not accurately
reflect the current withholding status of some taxpayers. In particular,
if an employee who previously claimed more than 10 allowances or claimed
exemption from federal income tax withholding submitted a new Form W- 4
claiming 10 or fewer allowances or not claiming exemption from
withholding, the database would continue to show the earlier information.
This is because employers are only required to send

4 U. S. General Accounting Office, Applied Research and Methods: Assessing
the Reliability of Computer- Processed Data (External Version 1), GAO- 03-
273G (Washington, D. C.: October 2002). 5 IRS conducted questionable Form
W- 4 compliance checks in the 1980s based on a representative sample of
3,331 employers. Less than 50 percent of the questionable Form W- 4s
received by employers were reported to IRS.

GAO- 03- 913R Reliability of IRS*s Form W- 4 Information Page 4
questionable Form W- 4s to IRS. 6 There is no requirement for employers to
forward to

IRS new Form W- 4s that do not meet the questionable Form W- 4 criteria.
IRS officials acknowledged the limitations of IRS*s Questionable Form W- 4
database for answering your questions. However, the officials said that
the database provides IRS with useful leads in determining possible
underwithholding issues that may lead to noncompliance. They told us that
they use the database for identifying taxpayers who may be
underwithholding taxes since those taxpayers also may not file tax
returns. IRS*s tax examiners review certain questionable Form W- 4s to
substantiate taxpayers* withholding claims. 7 When the taxpayers* claims
cannot be substantiated, the tax examiners issue *lock- in* letters to
both the taxpayers* employers and the taxpayers stating that the
taxpayers* withholdings are to be adjusted based on IRS*s investigation.

We asked IRS officials if they had plans to improve employers* compliance
with the reporting requirement. IRS officials told us that they have
initiated reengineering efforts to improve the existing system and
database, allowing them to, among other things, improve the integration of
other compliance databases to detect noncompliance and expedite the
issuance of lock- in letters. In February 2003, all of IRS operating
divisions and a panel of external stakeholders participated in a Form W- 4
compliance summit. During the summit, the participants identified a number
of suggestions to improve employer and taxpayer compliance with
withholding requirements, including improvements to forms, on- line
information, and services such as W- 4 calculator and development of
frequently asked questions for IRS*s Web site. The officials also said
that IRS*s divisions will continue to work together to identify outreach
and educational strategies to educate employers, stem noncompliance, and
encourage voluntary employer reporting of potential abusive schemes
related to withholding evasion. Because the activities were new or being
implemented, we did not evaluate them to determine their effectiveness in
improving employers* compliance with the reporting requirement.

Concluding Observations

Considering what we learned about the reliability of the data, questions
may be raised about the value of IRS*s efforts to maintain the
Questionable Form W- 4 database. For this reason, we are sending a
separate letter to the Commissioner of Internal Revenue describing what we
learned and recommending that he assess whether IRS*s Questionable Form W-
4 program should continue in its current form.

Agency Comments and Our Evaluation

We asked IRS to provide us oral comments on a draft of this report. On
August 27, 2003, we received comments from the Director of Filing and
Payment Compliance, Wage and Investment Division. The Director generally
agreed with our findings and

6 The database also includes information on employees whose questionable
Form W- 4s were reviewed by IRS tax examiners and were subsequently
adjusted to levels below the criteria for submission to IRS. 7 IRS*s tax
examiners were reviewing cases of taxpayers who have histories of
noncompliance, that is, nonfilers and balance due taxpayers.

GAO- 03- 913R Reliability of IRS*s Form W- 4 Information Page 5
acknowledged the limitations of the Questionable Form W- 4 database in
providing

information we could use to respond to your questions. IRS stated that
although the database did not meet our standards for responding to your
questions, it believes that the database serves its intended purpose of
housing data to facilitate its efforts to address underwithholding at its
source, thereby increasing compliance early and preventing future
delinquencies that can be both costly for IRS to resolve and burdensome to
taxpayers. The comments also stated that reengineering efforts were
recently initiated to improve the Questionable Form W- 4 program as we
mentioned earlier in our report.

Scope and Methodology

To perform our work, we interviewed IRS*s W& I Operating Division staff,
who were responsible for managing the Questionable Form W- 4 program, and
IRS Detroit Computing Center staff, who were responsible for maintaining
the Questionable Form W- 4 database. Based on these contacts, we obtained
an understanding of how the program operates, determined how IRS monitors
employers* compliance with Form W- 4 reporting requirements to help us
assess the reliability of the Questionable Form W- 4 database, and
obtained relevant documentation.

We analyzed IRS*s Questionable Form W- 4 database to determine what
information IRS maintains on taxpayers who claimed more than 10
withholding allowances or claimed exemption from federal income tax
withholding. According to IRS, the database primarily covers a 4- year
period. The database we reviewed primarily covered tax years 1998- 2002.
We assessed the reliability of IRS*s Questionable Form W- 4 database by
performing electronic testing, reviewing existing information about the
data and the system IRS created, and interviewing agency officials
knowledgeable about the data and the system. As stated in the report, we
determined that the data were not sufficiently reliable to answer your
questions.

In addition, we reviewed various IRS documents and publications pertaining
to tax withholding that indicate the responsibilities of taxpayers and
employers. We also reviewed IRS and Treasury Inspector General for Tax
Administration reports related to IRS*s questionable Form W- 4 program. We
conducted our work from October 2002 through June 2003 in accordance with
generally accepted government auditing standards.

- - - - - We are sending copies of this report to the Commissioner of
Internal Revenue and other interested parties. We will make copies
available to others upon request. This report will also be available at no
charge on GAO*s Web site at http:// www. gao. gov.

GAO- 03- 913R Reliability of IRS*s Form W- 4 Information Page 6 If you
have any questions about this report, please contact me at (202) 512- 9110
or by

E- mail at whitej@ gao. gov. Key contributors to this report were Charlie
Daniel and Arthur L. Davis.

Sincerely yours, James R. White Director, Strategic Issues

(440170)
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