    Internal Revenue Service: Challenges Remain in Combating Abusive
    Tax Shelters (21-OCT-03, GAO-04-104T).

    Recent scandals involving corporations, company executives, and
    accounting, law, and investment banking firms heightened
    awareness of abusive tax shelters and highlighted the importance
    of the Department of the Treasury and the Internal Revenue
    Service (IRS) addressing them. During 1999, Treasury issued a
    report indicating that abusive shelters were a large and growing
    problem, involving billions of dollars of tax reductions.
    Treasury was concerned that abusive shelters could ultimately
    undermine the integrity of the voluntary compliance tax system.
    GAO's statement today is based on work done at the request of the
    Chairman and the Ranking Minority Member of the Senate Committee
    on Finance to examine IRS's strategy for dealing with abusive tax
    shelters. In reporting on abusive shelters, GAO is describing (1)
    their nature and scope; (2) IRS's strategy and enforcement
    mechanisms to combat them and the performance goals and measures
    IRS uses to track its major effort in that area; and (3) the
    decision-making process IRS used and the plans it has to devote
    more resources to addressing abusive shelters.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-04-104T
        ACCNO:   A08744
      TITLE:     Internal Revenue Service: Challenges Remain in Combating
    Abusive Tax Shelters
         DATE:   10/21/2003
      SUBJECT:   Data collection
    	     Decision making
    	     Performance measures
    	     Strategic planning
    	     Tax administration
    	     Tax evasion
    	     Tax shelters
    	     IRS Coordinated Industry Case Program

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    GAO-04-104T

                        United States General Accounting Office

                                     GAO Testimony

    Before the Committee on Finance, U.S. Senate

    For Release on Delivery Expected at 10:00 a.m. EDT Tuesday, October 21,
    2003

    INTERNAL REVENUE SERVICE

                  Challenges Remain in Combating Abusive Tax Shelters

    Statement of Michael Brostek Director, Tax Issues

                                           a

    GAO-04-104T

    Highlights of GAO-04-104T, a testimony to the Committee on Finance, U.S.
    Senate

    Recent scandals involving corporations, company executives, and
    accounting, law, and investment banking firms heightened awareness of
    abusive tax shelters and highlighted the importance of the Department of
    the Treasury and the Internal Revenue Service (IRS) addressing them.
    During 1999, Treasury issued a report indicating that abusive shelters
    were a large and growing problem, involving billions of dollars of tax
    reductions. Treasury was concerned that abusive shelters could ultimately
    undermine the integrity of the voluntary compliance tax system.

    GAO's statement today is based on work done at the request of the Chairman
    and the Ranking Minority Member of the Senate Committee on Finance to
    examine IRS's strategy for dealing with abusive tax shelters. In reporting
    on abusive shelters, GAO is describing

    o  their nature and scope,

    o  	IRS's strategy and enforcement mechanisms to combat them and the
    performance goals and measures IRS uses to track its

    October 21, 2003

    INTERNAL REVENUE SERVICE

    Challenges Remain in Combating Abusive Tax Shelters

    By their nature, abusive tax shelters are varied, complex, and difficult
    to detect and measure. Abusive shelters manipulate many parts of the tax
    code or regulations and may involve steps to hide the transaction within a
    tax return. In recent years, IRS has been accumulating information about
    them and, although it does not have a reliable measure of the size of the
    abusive shelter problem, has come to believe that abusive shelters deserve
    substantially increased attention. IRS continues to gather more
    information to better define the scope of the problem and has data
    sources, all with their own limitations, that suggest abusive tax shelters
    total tens of billions of dollars of potential tax losses over about a
    decade.

    IRS's broad-based strategy for addressing abusive shelters included:

    o  targeting promoters to head off the proliferation of shelters;

    o  making efforts to deter, detect, and resolve abuse;

    o  	offering inducements to individuals and businesses to disclose their
    use of questionable tax practices; and

    o  	using performance indicators to measure outputs and some outcomes and
    intending to go down the path it has started and develop long-term
    performance goals and measures linked to those goals. Without these latter
    elements, Congress would find gauging IRS's progress difficult.

    In allocating resources to shelters, IRS used a systematic decision-making
    process that relied on admittedly limited information. It planned to shift
    significant resources in fiscal years 2003 and 2004 to address abusive
    shelters but faces challenges, especially in the near term, in addressing
    abusive shelters due to a growing workload and limited information on how
    long it takes to examine shelter cases. IRS's understanding of how many
    staff will be needed to address the problem over what period will continue
    to evolve as it gains a better understanding of the problem's scope.

                             major effort in that area, and

    o  	the decision-making process IRS used and the plans it has to devote
    more resources to addressing abusive shelters.

    www.gao.gov/cgi-bin/getrpt?GAO-04-104T.

    To view the full product, including the scope and methodology, click on
    the link above. For more information, contact Michael Brostek at (202)
    512-9110 or brostekm@gao.gov.

    Shift in Examination Resources Allocated to Abusive Tax Shelters

    Note: Fiscal year 2002 full-time equivalents include actual time spent on
    the entire returns containing shelters, not on the shelter issues alone.
    Fiscal year 2003 and 2004 full-time equivalents are planned amounts that
    are focused more on the shelter issues themselves.

    Mr. Chairman and Members of the Committee:

    I appreciate the opportunity to testify on the Internal Revenue Service's
    (IRS) efforts to deal with abusive tax shelters. I am using the term
    "abusive shelters" to describe very complicated transactions promoted to
    corporations and wealthy individuals to exploit tax loopholes and provide
    large, unintended tax benefits. Recent scandals involving corporations,
    company executives, and accounting, law, and investment banking firms
    heightened awareness of abusive shelters and highlighted the importance of
    the Department of the Treasury and IRS addressing the problem. During
    1999, Treasury issued a report indicating that abusive shelters were a
    large and growing problem, involving billions of dollars of tax
    reductions.1 Treasury was concerned that abusive shelters could ultimately
    undermine voluntary compliance by eroding the integrity of the tax system.
    In response to information pointing to the rapid growth of abusive
    shelters, IRS formalized a strategic initiative in fiscal year 2000 to
    strengthen its capacity to deal with abusive corporate shelters. One
    element of IRS's initiative involved creating a central office within the
    Large and Mid-Size Business (LMSB) Division to coordinate and guide
    efforts to curb the growth of abusive shelters.

    My statement today is based on work we have done at the request of the
    Chairman and the Ranking Minority Member. In examining abusive shelters,
    we focused on (1) their nature and scope, (2) IRS's strategy and
    enforcement mechanisms to combat them and the performance goals and
    measures IRS uses to track its major effort in that area, and (3) the
    decision-making process IRS used to allocate resources to abusive shelters
    and the plans it has to devote more resources to addressing abusive
    shelters. We were also asked to provide information on IRS's Schedule K-1
    document matching program, which we are including in appendix I.

    To do our work, we

    1Department of the Treasury, The Problem of Corporate Tax Shelters
    (Washington, D.C.: July 1999).

    o 	analyzed IRS's and other shelter reports, publications, data, and other
    documentation providing insight into the characteristics, complexity,
    size, and type of the problem;2

    o 	reviewed IRS's planning documents with information on its strategies,
    measures, and resources;

    o 	compared the contents of IRS's planning documents to Government
    Performance and Results Act of 1993 (GPRA)3 criteria for what elements
    strategic planning should include; and

    o 	interviewed agency officials about their views on, among other things,
    the problem's nature and scope and IRS's strategy.

    We did our work from September 2002 through August 2003 in accordance with
    generally accepted government auditing standards. As agreed, we are also
    discussing the related problem of abusive tax schemes in a report to be
    released in the near future. Abusive tax schemes are used more by
    individuals than by large businesses and encompass such distortions of the
    tax system as falsely describing the law (saying, for example, that the
    income tax is unconstitutional), misrepresenting facts (for instance,
    promoting the deduction of personal expenses as business expenses), and
    using trusts or offshore bank accounts to hide income. The boundary
    between what we are calling an abusive tax shelter and an abusive scheme
    is not always clear. Organizationally, although IRS's LMSB Division has
    lead responsibility for combating abusive shelters, abusive shelters are
    pursued by IRS's Small Business/Self-Employed Division when they are used
    by businesses with assets of less than $10 million or by high-wealth
    individuals with complicated tax returns.

    My statement today will make the following points:

    2As part of this work, we tested the tax shelter database maintained by
    the Office of Tax Shelter Analysis (OTSA) by reviewing related
    documentation, interviewing knowledgeable agency officials, and doing
    electronic testing, finding that the required data elements were
    sufficiently reliable for the purposes of our work. This finding does not
    mean, however, that the database contains all the information that would
    be needed to estimate the full size of the abusive shelter problem.

    3Pub. L. No.103-62.

    o 	By their nature, abusive shelters are varied, complex, and difficult to
    detect and measure. Abusive shelters manipulate many parts of the tax code
    or regulations and may involve steps to hide the transaction within a tax
    return. In recent years, IRS has been accumulating information about
    abusive shelters and the extent that they were promoted, and it has come
    to believe that abusive shelters deserve substantially increased
    attention. Suffice it to say, although they do not have a reliable measure
    of the size of the abusive shelter problem, Treasury and IRS believe that
    tens of billions of dollars of taxes are being improperly avoided and the
    potential for the proliferation of abusive shelters is strong. IRS
    continues to gather more information to better define the scope of the
    problem and has several data sources, each with certain limitations, that
    point to billions in tax losses. As of September 30, 2003, a database on
    shelter transactions that IRS has publicly declared to be tax avoidance
    transactions suggested the potential tax loss to be about $33 billion, the
    majority of which was concentrated from tax year 1993 through the present.
    This database included only transactions disclosed to or discovered by
    IRS. In addition, an IRS contractor estimating annual tax gaps resulting
    from abusive shelters estimated that the annual average of foregone taxes
    between 1993 and 1999 could have been as small as about $11.6 billion or
    as large as about $15.1 billion. However, Treasury, IRS, the contractor,
    and we all have concerns about the reliability of the contractor's
    estimates because of methodological and data constraints that the
    contractor faced.

    o 	The broad-based strategy reflected in IRS planning documents included
    various features as well as elements of strategic planning:

    o  targeting promoters to head off the proliferation of shelters;

    o  making efforts to deter, detect, and resolve abuse;

    o  coordinating efforts throughout IRS;

    o 	offering inducements to individuals and businesses to disclose their
    use of questionable tax practices; and

    o 	using performance indicators to measure outputs and some outcomes and
    intending to continue down the path it has started and develop long-term
    performance goals and measures linked to those goals. Without these latter
    elements, Congress would find gauging IRS's progress difficult.

    o 	In developing this strategy, IRS has had to make decisions about
    staffing allocations and what can be accomplished on the basis of
    admittedly limited information. After using a systematic process to
    determine staffing priorities, IRS planned a significant shift in
    resources to address abusive shelters in fiscal years 2003 and 2004.
    However, it faces challenges, especially in the near term, in addressing
    abusive shelters due to a growing workload and limited information on how
    long it takes to examine shelter cases. IRS's understanding of how many
    staff will be needed to address the problem over what period will continue
    to evolve as IRS gains a better understanding of the problem's scope.

    Background	Although IRS has no single, authoritative definition of abusive
    shelters, IRS generally characterizes abusive shelters as very complicated
    transactions that sophisticated tax professionals promote to corporations
    and wealthy individuals, exploiting tax loopholes and reaping large and
    unintended tax benefits. As the Joint Committee on Taxation has said,
    "taxpayers and tax administrators have struggled in determining the line
    between legitimate `tax planning' and unacceptable `tax shelters.'" Even
    though, it continued, "there is no uniform standard as to what constitutes
    a tax shelter ... there are statutory provisions, judicial doctrines, and
    administrative guidance that attempt to limit or identify transactions in
    which a significant purpose is the avoidance or evasion of income tax."4

    Abusive shelters have been promoted by some accounting firms, law firms,
    and investment banks. Investors in these abusive shelters range from large
    and small corporations to wealthy individuals. IRS approaches the tax
    shelter enforcement problem from both the promoter and investor
    perspectives. IRS promoter investigations are designed to learn (1) what
    abusive shelters have been promoted, if the shelters are registered,5 and
    possibly how much they cost investors, (2) who purchased the shelters and
    what tax savings the investors expect, and (3) whether promoters should
    pay penalties for their activities. IRS examines investor and other tax

    4Joint Committee on Taxation, Background and Present Law Relating to Tax
    Shelters, JCX-19-02 (Washington, D.C.: Mar. 19, 2002).

    5A promoter or other tax shelter organizer must register a tax shelter
    with the Secretary of the Treasury by describing it and its tax benefits.
    The Secretary assigns the shelter an identification number.

    returns to see if income, expenses, taxes, and credits are accurately
    reported.

    In a June 2002 letter, Treasury responded to congressional questions about
    whether Treasury had a comprehensive strategy for combating tax avoidance.
    In his letter to the then Ranking Member of the Committee on Finance, then
    Secretary of the Treasury O'Neill addressed the actions being taken to
    combat abusive shelters, referring to Treasury's March 20, 2002,
    enforcement proposals on the topic. The proposals said that IRS had made
    significant organizational improvements to coordinate its response to
    ongoing abusive tax shelters. Treasury, all of IRS's operating divisions,
    and IRS's Office of Chief Counsel are involved in combating abusive
    shelter activity.

    Within IRS, LMSB has primary responsibility for combating abusive tax
    shelter activity. LMSB's OTSA was created in February 2000 to centralize
    and coordinate the IRS response nationwide. As shown in figure 1, OTSA is
    the focal point for IRS shelter activities, overseeing promoter tax
    shelter registrations; taxpayer disclosures of tax shelters; hotline tip
    analysis and referral; and issue coordination and interface between the
    Office of Chief Counsel, Treasury, the Tax Shelter Committee, the 6700
    Committee (referring to section 6700 of the Internal Revenue Code), and
    external stakeholders.6 The Tax Shelter Committee oversees LMSB's tax
    shelter program. The committee is composed of the Commissioner and Deputy
    Commissioner of LMSB, the Director of Pre-Filing and Technical Guidance,
    LMSB Division Counsel, five Industry Directors, the Director of
    International, and the Directors of Field Specialists and Research and
    Program Planning. The 6700 Committee serves under the Tax Shelter
    Committee and approves all LMSB tax shelter promoter activities. The
    financial services' industry director chairs this committee. IRS's appeals
    function receives and evaluates taxpayer objections to IRS examination
    determinations and may agree with those determinations or reduce or
    eliminate changes to tax returns resulting from them. The Office of Chief
    Counsel plays an integral role in combating shelters through summons
    enforcement and targeted litigation. By litigating, IRS establishes case
    law supporting IRS enforcement programs and aims to diminish the
    incentives taxpayers find for investing in tax avoidance transactions by
    increasing the risks and costs of IRS discovery.

    6Section 6700 covers penalties for promoters of abusive shelters.

    Figure 1: OTSA's Role in Coordinating IRS Work on Abusive Shelters

    Abusive shelters are complex transactions that manipulate many parts of
    the tax code or regulations and are typically buried among "legitimate"
    transactions reported on tax returns. Because these transactions are often
    composed of many pieces located in several parts of a complex tax return,
    they are essentially hidden from plain sight, which contributes to the
    difficulty of determining the scope of the abusive shelter problem. Often
    lacking economic substance or a business purpose other than generating tax
    benefits, abusive shelters are promoted by some tax professionals, often
    in confidence, for significant fees, sometimes with the participation of
    tax-indifferent parties, such as foreign or tax-exempt entities. They may
    involve unnecessary steps and flow-through entities, such as partnerships,
    which make detection of these transactions more difficult.

    When a transaction has certain abusive characteristics defined by section
    6111 of the Internal Revenue Code, the promoter or other tax shelter

      Nature of Abusive Shelters Is Varied and Complex

    organizer is required to register it, describing the transaction and its
    tax benefits to the Secretary of the Treasury. This registration
    requirement enables Treasury and IRS to identify and evaluate questionable
    transactions. Under recently issued Treasury regulations,7 effective
    February 28, 2003, there are six categories of transactions for which
    promoters must maintain lists of investors who have entered into the
    transactions, and investors must disclose the transactions into which they
    have entered. The rules are designed to allow IRS to use information from
    investors to identify promoters who do not register transactions and to
    use promoter registrations and investor lists to identify investors who
    fail to disclose transactions. The six categories are

    o  transactions offered under conditions of confidentiality,

    o  transactions including contractual protections to the investor,

    o  transactions resulting in specific amounts of tax losses,

    o 	transactions generating a tax benefit when the underlying asset is held
    only briefly,

    o 	transactions generating differences between financial accounts and tax
    accounts greater than $10 million, and

    o  "listed transactions."

    A "listed transaction" is a transaction that is the same as or similar to
    one of the types of transactions IRS has determined to be a tax avoidance
    transaction. For a transaction to be a listed transaction, IRS must issue
    a notice, regulation, or other form of published guidance informing
    taxpayers of the details of the transaction. As of mid-August 2003, IRS
    had listed 27 kinds of abusive tax shelter transactions, a number that, as
    figure 2 shows, has grown more quickly in recent years than it had grown
    earlier.

    7Treas. Reg. Sec. 301.6112-1 and Treas. Reg. Sec. 1.6011-4.

    Figure 2: Cumulative Number of Listed Transactions over Time,
    1990-mid-August 2003, and Transaction Descriptions

    Source: Compiled by GAO from IRS information.

    Disputes between IRS and taxpayers about the abusive nature of a
    transaction may be litigated. In some, but not all, cases, the courts have
    upheld the government position. The following cases illustrate features of
    abusive shelters:

    o 	In 1993, a corporation began a company-owned life insurance (COLI)
    program in which the company purchased whole-life insurance on 36,000
    employees for which the company was the sole beneficiary. The company then
    borrowed money against the policies at interest rates that averaged 11
    percent and deducted the interest expense and administrative fees from
    income on its tax returns. Over 60 years, the interest costs and
    administrative fees would have exceeded the cash surrender value of the
    policies and benefits paid by several billion dollars. IRS disallowed the
    deductions and the case was litigated. Despite the fact that the money the
    company made on this arrangement may have been used to fund the company's
    benefits program, or for other business purposes, the court found that the
    function of the program itself was only to generate tax deductions. As a
    result, the Tax Court sustained the IRS disallowance of deductions and
    concluded that the COLI program was a sham.8 The Eleventh Circuit Court of
    Appeals affirmed the Tax Court's decision.

    o 	A company had a sizable gain from the sale of a subsidiary and wanted
    to avoid or minimize paying tax on the gain. An investment bank proposed
    forming an offshore partnership with a foreign corporation (a
    tax-indifferent party) for the express purpose of sheltering the capital
    gains of its corporate client. The partnership purchased and quickly
    resold notes in a contingent installment sale transaction. The partnership
    earned a large capital gain, most of which it allocated to the foreign
    corporate partner. Later, related losses were allocated to the U.S.
    corporation, generating an approximate $100 million capital loss for the
    investment bank's client. The corporation used this capital loss to
    shelter its U.S.-based capital gains. Both the Tax Court and the Third
    Circuit Court of Appeals ruled that the transaction lacked economic
    substance.9 The Third Circuit, in addition to requiring economic
    substance, held that a transaction must have a subjective nontax business
    motive to be respected for tax purposes.10 For this transaction, the
    investment bank was to earn a fee of $2 million. This was one of 11

    8Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999), aff'd, 254
    F. 3d 1313 (11th Cir. 2001).

    9ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), aff'g, 73
    T.C.M. 2189 (1997), cert. denied, 526 U.S. 1017 (1999).

    10Id. at 248.

    such partnerships formed over a 1-year period from 1989 to 1990 by the
    investment bank.

      Several Sources Indicate That the Scope of Abusive Shelters Is in the Tens of
      Billions of Dollars, Though All Are Based on Limited Data

    IRS has information that suggests the scope of abusive shelters totaled
    tens of billions of dollars over about a decade,11 but those estimates are
    based on limited data. This information comes from an OTSA database,
    examinations of large corporations, and a contractor study. Information
    contained in the OTSA database includes transactions disclosed to or
    discovered by IRS and estimates of potential tax losses. The tax loss
    estimates vary from being IRS officials' recommended taxes based on
    examining some transactions to taxpayer judgments regarding potential
    losses in cases where examinations have not been done. In addition to
    being based on judgments, the database does not include any reductions
    resulting from examination, appeal, litigation, or other sources.
    Information from examinations of the largest corporations, which may
    overlap information in the OTSA database, shows proposed income
    adjustments in the tens of billions of dollars before reductions, but data
    were not available from IRS on the results of examinations of smaller
    corporations, partnerships, trusts, S corporations, or individuals.
    Information from IRS's contractor study estimates an annual tax gap due to
    abusive shelters but has data and methodological limitations.

    OTSA Database 	As shown in table 1, as of September 30, 2003, an OTSA
    database included estimated potential tax losses of about $33 billion from
    investments in listed transactions, before considering any reductions
    resulting from examination, appeal, litigation, or other sources and
    another $52 billion in potential tax losses from nonlisted transactions
    with some characteristics of abusive shelters. This database contains
    information on promoters and investors and the amount of potential tax
    savings resulting from listed and nonlisted transactions. Nonlisted
    transactions are transactions that needed to be registered because they
    have some characteristics of abusive shelters but were not, at least yet,
    determined to be abusive. According to an IRS official, IRS was studying
    nonlisted transactions with about $12 billion in potential tax losses for
    possible listing. The database only

    11For the decade from 1993 through 2002, corporations paid almost $2
    trillion in income taxes.

    includes information on abusive or possibly abusive transactions that had
    been disclosed to or discovered by IRS.

     Table 1: IRS's Compilation of Tax Shelter Amounts as of January 14, 2003, and
                                   September 30, 2003

    Category of Number of transactions as Potential tax loss (billions)a as of
    transaction            of
                            January 14, 2003 January 14, 2003b September 30, 2003
                          September 30, 2003
         Listed                  3,423 5,185                          $29.3 $33.0
        Nonlisted                1,334 1,582                            44.7 52.0
          Total                  4,757 6,767                          $73.9 $85.0

    Source: IRS OTSA database.

    aThe potential tax loss covers a multiyear period and does not consider
    reductions that may result from examination, appeal, litigation, or other
    sources.

    bThe numbers do not add to the total due to rounding.

    The estimated tax losses contained in the OTSA database cover a wide range
    of years from at least as far back as tax year 1989 and extending even to
    future tax years since, for instance, improperly claimed deductions may be
    used in some cases to reduce future taxes. For the $29 billion in
    estimated tax losses associated with listed transactions contained in the
    January 14, 2003, database, about 82 percent of the potential tax losses
    were concentrated in the period from 1993 through 2002.

    According to data IRS provided in mid-October 2003, OTSA had information
    on almost 300 firms that had possibly promoted abusive shelters as well as
    other tax planning products that contain at least some features of abusive
    transactions. It was also aware of about 6,400 investors, including
    individuals and corporations that bought abusive shelters and other
    aggressive tax planning products.

    Examinations of Large Corporations

    IRS has proposed shelter-related adjustments to large corporations' income
    in examinations it has closed and in examinations still open as of early
    May 2003. In cases closed between October 1, 2001, and May 6, 2003, IRS
    proposed about $10.6 billion in abusive shelter-related adjustments to the
    income of 42 large corporations for tax years 1992-2000. These proposed
    adjustments would result in about $3.5 billion in tax revenue if the
    adjustments were not reduced. The corporations were in what is known as
    the Coordinated Industry Case (CIC) program, which includes the nation's

    largest corporations.12 They agreed with about $1.2 billion of the $10.6
    billion in proposed adjustments to income.13 As of early August 2003,
    Appeals research showed that few of the issues comprising the $9.4 billion
    unagreed amount had been resolved yet by Appeals or through a settlement
    initiative, although the database did not track all of them.14 For the 141
    large corporations with cases still open in early May 2003, the amount of
    proposed shelter-related income adjustments was $47.6 billion, translating
    to about $16 billion in tax if not reduced. IRS did not have similar
    information for smaller corporations. Also, since one of the sources of
    information in the OTSA database is shelter-related adjustments proposed
    in examinations, the proposed adjustments in the CIC program may overlap
    the information in the OTSA database.

    Contractor Study 	In July 2003, an IRS contractor estimated the tax gap
    resulting from abusive shelters for different years. For 1993 through
    1999, based on the contractor's estimates, the average annual tax gap
    could have been as small as about $11.6 billion or as large as about $15.1
    billion of forgone tax. However, the reliability of the contractor's
    estimates is questionable because of methodological and data constraints
    the contractor faced when developing them.

    The estimates followed a September 2001 recommendation by the Treasury
    Inspector General for Tax Administration (TIGTA) that LMSB obtain a more
    precise estimate of the shelter problem to lay a better foundation for its
    strategy for addressing abusive shelters.15 In response, IRS contracted
    for models to predict the likelihood of finding abusive shelters within

    12Under the CIC program, IRS continually audits about 1,100 of the
    nation's largest corporations, all of which have assets of more than $250
    million.

    13IRS did not track the additional tax payments these corporations
    actually made related just to the shelter-related adjustment. However,
    according to data provided by IRS, they paid about an additional $552
    million in taxes related to all issues raised by IRS, including the
    abusive shelter issues.

    14In mid-August 2003, IRS gave us information showing that for the 14
    abusive shelter transactions Appeals had closed in fiscal year 2003 for
    CIC and other cases, Appeals sustained about 71 percent of the dollar
    amounts proposed as adjustments to income. Similar information was not
    available for earlier years.

    15TIGTA, Management Advisory Report: The Strategy for Curbing Abusive
    Corporate Tax Shelter Growth Shows Promise but Could Be Enhanced by
    Performance Measures, Report Number 2001-30-159 (Washington, D.C.: Sept.
    13, 2001).

    certain tax returns and to estimate the annual "tax gap" due to abusive
    shelters. Both IRS and contractor officials believe the contract results
    are more useful to predict returns with abusive shelters than they are to
    value the size of the abusive shelter problem.

    Nevertheless, as table 2 shows, the contractor produced estimates of the
    size of the problem for each year from 1993 through 1999. Yearly low-end
    estimates ranged from $9.0 billion of foregone tax in 1993 to $14.5
    billion in 1999. On the other hand, the high-end estimates ranged from
    $12.1 billion in 1993 to $18.4 billion in 1999.16 Averaging the estimates
    over time results in the $11.6 billion to $15.1 billion range cited
    earlier.

    Table 2: Contractor Estimates of the Size of the Abusive Shelter Problem
    (Dollars in Billions)

                                   Year     Lower bound               Upper bound
                                   1993        $ 9.0                        $12.1
                                   1994         9.5                          12.7
                                   1995         10,3                         13.6
                                   1996         11.4                         14.9
                                   1997         12.7                         16.4
                                   1998         13.6                         17.3
                                   1999         14.5                         18.4
                      1993-1999 average         11.6                         15.1

    Source: Report provided by IRS.

    Note: As computed by the contractor, the lower and upper bounds are the
    boundaries of 90 percent confidence intervals associated with the
    estimates.

    The tax gap model used three different kinds of data: (1) IRS's Statistics
    of Income data for the largest U.S. companies, those with assets over $250
    million falling within the CIC program, (2) Standard and Poor's Compustat
    financial data, and (3) surveys of IRS field offices. IRS conducted
    surveys from 1999 through 2001 that asked field managers to identify
    abusive tax shelters in their open inventory of examinations--

    16Because the contractor found that estimating the problem's size was
    difficult and problematic, it applied a statistical technique to the
    estimates and produced other estimates for each year. However, because it
    did not believe the statistical technique improved the original estimates,
    we are not including the second set of estimates here.

    relying on each manager's understanding of what an abusive tax shelter is.
    Since survey data are included in the OTSA database, some of the same
    information used by the contractor appears in the OTSA information cited
    earlier.

    Treasury, IRS, the contractor, and we have concerns about the contractor
    estimates. First, it is difficult to determine whether these estimates
    might be overstating or understating the true extent of the tax gap
    because of the uncertainties in the underlying data and the elusive nature
    of the problem. In identifying abusive shelters in the IRS surveys, field
    managers might have anticipated that some abusive shelters existed where
    there were none or where the assertion of abuse might not be sustained. On
    the other hand, they might not have identified all the abusive shelters in
    their open inventory of examinations because their definitions of abusive
    shelters might have differed from each other. Finally, the data might not
    be representative of all transactions, especially those that closed,
    because survey responses were only to include open cases.

    Second, the Statistics of Income data only included U.S. corporations with
    assets of over $250 million falling within the CIC program. Many shelters
    may be reflected in tax returns of smaller corporations, partnerships,
    Subchapter S corporations, and wealthy individuals and were not included
    in this study. Since these transactions were not included in the
    contractor's estimate, the resulting tax gap estimate is incomplete.

    Third, the estimates are based on known shelters. They were developed
    using 1990s' ideas of what constituted abusive shelters. Since then, more
    shelters have been disclosed or identified by IRS and still others are
    under consideration for listing. Since the definition of an abusive
    shelter can change over time, and the data cannot reflect unknown or
    unidentified shelters, the operational definition of abusive shelters was
    a conservative one.

    While the last two concerns argue that the contractor's estimates
    understate the true level of abusive shelters for recent years, the
    contractor's estimates and other indicators of the problem's size based on
    past data may also be of limited use as guides to current and future
    activity for other reasons. According to Treasury and IRS officials, the
    legal and economic environment has changed since the data for this study
    were developed. First, they said, IRS has taken many administrative
    actions to address abusive shelters. For instance, it is their belief that
    nothing puts more of a damper on taxpayer participation in a particular
    type of

    transaction than IRS listing it. Similarly, although corporate-owned life
    insurance transactions may heavily influence the contractor's estimates,
    legislation addressed the problem in 1996 and 1997, and therefore current
    and future estimates would not reflect that problem-although they could
    reflect problems not identified in the period covered by the contractor's
    study. Second, court cases have largely supported IRS's assertions about
    the need for business purpose requirements and about requirements for
    economic substance in transactions. Third, today's economy is not as
    robust as the economy in the late 1990s, generating less profit to
    protect. Finally, the publicity surrounding numerous corporate scandals
    may create a chilling effect in the market for aggressive transactions.
    Countering these points, however, are other opinions appearing in the
    press that (1) the courts could uphold some tax shelters and (2) IRS's
    capacity to stem abusive shelters is limited.

      IRS Strategy to Combat Abusive Shelters Is Broad-Based but Generally Has No
      Long-Term Performance Goals or Measures Linked to Goals

    IRS developed a broad-based strategy for combating abusive shelters that
    included various features as well as elements of strategic planning.
    Deeming it a strategic initiative, IRS is executing a strategy
    incorporating four principal elements: (1) an emphasis on promoters, (2)
    efforts to deter, detect, and resolve abuse, (3) coordination of efforts
    throughout IRS, and (4) inducements provided for taxpayers to come forward
    and expedite case resolution. IRS is implementing a variety of initiatives
    designed to reduce taxpayer incentives to participate in abusive
    transactions and discourage promoters from marketing these transactions.
    Although IRS documents outline an overall strategy for combating abusive
    shelters, IRS has generally not yet defined long-term performance goals
    for the effort and the measures it would use to track progress in
    achieving those goals.17 However, IRS is planning to establish such goals
    and measures when it has more information on the abusive shelter
    activities it is currently tracking.

    IRS Is Actively Pursuing Promoters

    IRS is actively pursuing abusive promoters to ensure (1) that tax
    strategies containing characteristics of potentially abusive shelters are
    registered, (2) that information about transactions is disclosed to IRS as
    required by

    17Although GPRA is generally applied to agencywide strategic plans, its
    framework is useful to guide any type of planning. GPRA requires long-term
    strategic and annual performance goals and associated measures, preferring
    measures relating to outcomes (results) versus outputs (activities). The
    Office of Management and Budget says that strategic plans set out
    long-term goals, outlining planned accomplishments and their
    implementation schedule.

    sections 6111 and 6112 of the Internal Revenue Code, and (3) that,
    according to IRS's OTSA manager, those who generate noncompliance change
    their behavior or go out of business. With 98 abusive shelter promoters
    approved for investigation as of June 30, 2003, IRS uses investigations to
    gain access to lists of the clients who buy promoters' products and devise
    a roadmap to audit shelters included in the tax returns of the investors.
    IRS is also using promoter investigations to enforce the transaction
    registration requirements, which, in turn, assist in its efforts to
    understand, track, and close abusive shelters. IRS announced the
    completion of three large promoter investigations in 2001 through July
    2003. They resulted in, among other things, three substantial payments and
    promoter promises to work with IRS to ensure ongoing compliance with
    shelter registration and list maintenance requirements.

    IRS Efforts Are to Deter, Detect, and Resolve

    IRS focuses its efforts on deterring future marketing and sales of abusive
    tax shelters and on detecting and resolving existing shelters. TIGTA
    described IRS's abusive shelter approach along the lines of deter, detect,
    and resolve in September 2001.18 IRS considers its efforts to provide
    guidance as early as possible to taxpayers and promoters in the form of
    recently proliferating IRS and Treasury determinations, notices, and
    rulings on abusive transactions and of registration, list maintenance,
    disclosure, and other requirements to be a key deterrent. (See fig. 2.)
    Also designed to deter abusive tax shelters, accuracy-related penalties
    aim at investors who use abusive shelters to substantially undervalue true
    tax liability. Other penalties are for promoters who market shelters that
    aid and abet the understatement of tax liability or who fail to register
    shelters. IRS's Examination Returns Control System showed IRS assessing 21
    investor penalties totaling about $73 million between July 1, 2002, and
    May 1, 2003, which taxpayers had not necessarily agreed to pay. During our
    review, Treasury included proposed legislation in the Administration's
    revenue proposals to strengthen the penalties that could be used in
    abusive shelter situations.

    IRS's ability to detect abusive shelters increased in the last 3 years due
    to OTSA's hotline, through which callers provide tips about transactions
    or investors; disclosure, registration, and list maintenance requirements;
    increased attention by IRS management; and increased use of IRS

    18TIGTA, Report Number 2001-30-159.

    examination resources to look for shelter irregularities. For instance,
    between May 31, 2000, and July 30, 2003, the hotline received 729
    shelter-related telephone calls and e-mails, some of them leading IRS to
    new listed transactions, promoters, and investors. As another example, IRS
    expanded its disclosure requirements in June 2002 to include noncorporate
    taxpayers. Finally, as evidence of increased management attention, IRS
    established a new senior position reporting to the IRS Chief Counsel to
    supervise staff and lead task force initiatives to more quickly identify
    and deal with abusive shelters.

    Cases may be resolved at the examination level if taxpayers agree with IRS
    findings. If taxpayers do not agree, cases are resolved at the appeals
    level, through litigation, or by alternative dispute resolution.

    In addition to these detection and case resolution efforts, IRS is using
    Schedule K-1 data to research better methods of detecting abusive shelters
    that involve multiple levels of flow-through entities.19 These complex
    structures of related entities pose challenges in analyzing tax compliance
    by creating opportunities for taxpayers to disguise noncompliance. In the
    future, IRS hopes to use advanced data analysis tools such as link
    analysis and graph-based data mining to identify potential abusive
    shelters. Link analysis is the process of building networks of related
    entities, such as flow-through entities and Schedule K-1 recipients, in
    order to expose patterns and trends. Graph-based data mining, a form of
    link analysis, is intended to enable IRS to identify structures of known
    abusive shelters and find similar patterns in the population of
    flow-through networks to discover previously undisclosed potential abusive
    shelter transactions. IRS has paid a contractor $200,000 so far to assess
    the feasibility of these technologies and plans to spend $575,000 over the
    next 1.5 to 2 years to develop these concepts into models.

    IRS Emphasizes Internal Coordination

    Coordination within IRS and interface with Treasury on abusive shelters is
    a core objective in IRS's plans for addressing those shelters. OTSA is the
    focal point for all shelter-related activity performed in the Tax Shelter
    Committee, the 6700 Committee, Counsel, Appeals, and LMSB. For example, if
    a taxpayer discloses an investment in a tax shelter to IRS, OTSA is to
    enter the transaction into its database, and OTSA reviews the

    19Appendix I describes the Schedule K-1, flow-through entities, and other
    compliance efforts using Schedule K-1 data.

    transaction in collaboration with IRS technical advisors and counsel. OTSA
    may also forward it to LMSB examiners for compliance action.

    At the IRS-wide level, an executive steering committee provides a forum
    for coordinating work on both abusive shelters and abusive schemes. It
    meets monthly and includes participants from LMSB, the Small Business/Self
    Employed Division, Appeals, Counsel, and other organizations. It operates
    under the auspices of IRS's Enforcement Committee, which was chartered in
    July 2003. Chaired by the Deputy Commissioner for Services and
    Enforcement, a new position created in May 2003, the Enforcement Committee
    is to guide IRS-wide enforcement strategies, focusing on high-visibility
    issues involving many divisions or potentially having significant
    compliance impact.

    Although we did not systematically measure whether coordination is
    facilitated by these mechanisms, we did review minutes of selected
    executive steering committee meetings. In doing so, we saw such evidence
    of coordination as the discussion of an LMSB and SB/SE working group on
    who would work a corporate officer case when LMSB works on a corporation.

    IRS Offers Inducements for Taxpayers to Disclose Shelters and Expedite
    Case Resolution

    LMSB attempts to leverage its limited resources by using inducements to
    achieve compliance. These tools include penalty relief, "fast track" issue
    resolution, and various structured settlement programs that allow
    participating taxpayers to keep a percentage of a shelter's benefits in
    exchange for conceding most benefits and expediting case resolution. For
    example, under a disclosure initiative that expired on April 23, 2002,
    taxpayers who revealed shelters and their respective promoters avoided
    accuracy-related penalties. IRS's aim was to more readily identify
    promoters who had not registered shelters and, through the promoters, find
    taxpayers who had not disclosed their shelter participation. As a result
    of this initiative, IRS received 1,664 disclosures from 1,206 taxpayers,
    disclosing tens of billions of dollars of losses and deductions.

    IRS offered taxpayers various alternative dispute resolution mechanisms as
    inducements to settle abusive shelter issues with IRS, mitigating the
    hazards of litigation for both sides and moving more cases through the
    administrative system quickly. For example, from October 2001 through
    April 7, 2003, 17 taxpayers agreed with IRS on their respective shelter
    issues in the Fast Track Issue Resolution program, resolving about $1.6
    billion in proposed adjustments to income (potentially about

    $540 million in tax). In another example, IRS announced initiatives in
    October 2002 to resolve disputes related to three shelters: COLI,
    basis-shifting shelters, and contingent liability shelters.20 In these
    initiatives, if taxpayers agreed to settle their cases with IRS by a
    certain date, with the last initiative closing March 5, 2003, they would
    pay a large percentage of the full amount IRS disallowed. A summary as of
    early May 2003 of the number of investors involved in the three settlement
    initiatives and the potential tax dollars conceded or to be conceded
    appears in table 3.21

    Table 3: Investors Accepting Abusive Shelter Settlement Initiative Offers
    and Potential Tax Dollars Conceded or to Be Conceded as of Early May 2003

                                  Number of
                                  taxpayers Number of taxpayers
                                  accepting    for whom IRS had
                                        IRS information on          Potential tax
                                            taxes                         dollars
                                 settlement   conceded or to be conceded or to be
                      Settlement      offer            conceded          conceded
                      initiative                                       (billions)
                            COLI         24                  14              $0.2
                  Basis shifting        267                  33
            Contingent liability         62                  62              2.8a
                           Total       353b                109b              $3.6

    Source: Compiled by GAO from IRS data.
    aGAO estimated this number using an average of certain capital loss
    percentages to be conceded.
    bWe do not know if a particular taxpayer was involved in more than one
    type of settlement initiative.

    Generally IRS Does Not Although IRS has outlined and begun to implement a
    multipart strategy for Have Long-Term combating tax shelters, it has not
    yet generally defined performance goals Performance Goals or for the
    effort and established the measures it would use to track progress in
    Measures Linked to Goals achieving those goals. Performance goals define
    what an organization is

    20IRS Notice 2001-51 identifies certain listed transactions. It describes
    basis-shifting transactions as "certain redemptions of stock in
    transactions not subject to U.S. tax in which the basis of the redeemed
    stock is purported to shift to a U.S. taxpayer." It describes contingent
    liability transactions as "transactions involving a loss on the sale of
    stock acquired in a purported [Internal Revenue Code section] 351 transfer
    of a high basis asset to a corporation and the corporation's assumption of
    a liability that the transferor has not yet taken into account for federal
    income tax purposes."

    21Some of these investors are also included in the fast track program just
    described.

    trying to achieve over time, preferably focusing on the outcome desired
    rather than activities or outputs. To date, according to IRS officials,
    their shelter-related goals cover the number of staff years to be devoted
    to shelter examinations and the number of shelter examinations to be
    closed. Also, LMSB planning documents have a few short-term goals. For
    example, LMSB had a short-term goal to begin compliance actions on all
    voluntary shelter disclosures by June 30, 2003, a goal IRS officials told
    us was met. IRS management officials recognize that developing other
    performance goals and associated measures to track progress is desirable
    but point to challenges they face in assessing the scope of the abusive
    shelter problem. Nonetheless, IRS intends to establish such goals in the
    future when it has more information on activities it is currently
    tracking.

    IRS has already started down this road by developing several measures
    that, while not tied to longer-term performance goals, are to be used in
    tracking its progress in combating abusive tax shelters. It devised these
    measures for fiscal year 2003 responding to a September 2001 TIGTA
    recommendation to develop performance measures so managers could better
    target problem areas, highlight successes, evaluate alternatives, and
    track whether OTSA is achieving desired outcomes. IRS is mostly tracking
    outputs related to case management, such as the number of tax shelter
    examinations closed and tax shelter return cycle time, and is using output
    measures of IRS program activities, such as published guidance issued and
    hotline contacts. IRS is also using some measures that track tax
    enforcement outcomes, namely adjustments proposed to tax returns from
    disallowing abusive shelters and tax shelter penalties proposed.22 Since
    fiscal year 2003 was the first year IRS used these measures, it had no
    baseline data with which to evaluate its performance measures. However,
    LMSB plans to evaluate its measures over time to assess their usefulness.

    22LMSB called the tracking of adjustments a "record of tax enforcement
    results." IRS does not use performance measures for outcome measures like
    these because the IRS Restructuring and Reform Act of 1998 prohibited it
    from using tax enforcement results to evaluate any employee or to impose
    or suggest production quotas or goals.

      Resource Shifts Are Significant but IRS Faces Challenges in Addressing Abusive
      Shelter Workload

    Using admittedly limited information, IRS used a systematic
    decision-making process in deciding to shift a large portion of LMSB
    examination staff resources toward addressing abusive shelters. From
    fiscal year 2002 through fiscal year 2004, LMSB expected to increase the
    portion of its examination resources devoted to combating abusive shelters
    from 3 percent in 2002 to 20 percent in 2004. In doing so, it will have
    shifted resources out of examining the category of cases including such
    areas as net operating losses and claims for refunds. Even so, IRS faces
    challenges, especially in the near term, in addressing expected increases
    in its shelter workload because of the growing number of shelter cases and
    limited information it has on how long it takes to conduct shelter
    examinations. As will be described, GAO has previously raised questions
    about IRS's ability to shift compliance resources as planned.

    IRS Used Systematic Planning and Budgeting Process to Determine Staffing
    Priorities

    At an agencywide level, IRS decided staffing resource levels to be devoted
    to addressing abusive shelters through a systematic planning and budgeting
    process based on experience and professional judgment because IRS did not
    and does not have a reliable measure of the abusive shelter problem. Early
    in calendar year 2002, IRS's divisions completed strategic assessments in
    which they studied trends, issues, and priorities affecting their
    operations. In April 2002, IRS's senior management team, including the
    Commissioner, Deputy Commissioner, division heads, and others used two
    rounds of considering IRS's programs to rank the needs for new or
    redirected funding for fiscal year 2004. Of 33 programs considered, the
    program including tax shelters received the third most votes. According to
    an IRS official, this process also informed how funds already requested
    for fiscal year 2003 would actually be spent. After the senior management
    team reached consensus, the Commissioner issued overall planning guidance
    for fiscal years 2003 and 2004 to reflect the jointly set strategic
    direction, and the divisions wrote fiscal year 2003 and 2004 "strategy and
    program plans" outlining staffing resources needed.

    IRS Shifts Significant Levels In 2002, LMSB put forward plans to increase
    its work on abusive shelters of Examination Resources from 3 percent of
    its examination resources to 20 percent between fiscal to Shelters years
    2002 and 2004, assuming congressional funding. To support this shift

    in examination resources, LMSB needed to allocate examination resources

    away from other areas. One area to receive less audit coverage was

    industry audits.23 As shown in table 4, from fiscal year 2003 to fiscal
    year 2004, IRS planned to move resources away from specific types of
    mandatory examinations and from some high-risk nonmandatory returns.24
    IRS's strategy is to mitigate the impact of resource reallocations away
    from nonshelter areas by using such issue management strategies as
    fast-track resolution and prefiling agreements, thereby requiring less
    staff time to close cases and freeing staff to be used in other areas.

    Table 4: Percentage of LMSB Examination Resources in Different Examination
    Areas

                                                                    FY   FY    FY
                                                Examination area 2002a 2003  2004
                                                        Shelters    3%  15%   20%
             Other mandatory examinations (including coordinated   N/A  55%  54%c
                   industry, b claims for refunds, net operating
                                                         losses,
                compliance initiative projects, and flow-through
                                                        entities
                                 related to wealthy individuals)
                                                 Related returns   N/A   5%   4%c
                                 High-risk, nonmandatory returns   N/A  15%   13%
                                Nonreturn examination activities   N/A  10%   10%
                                                           Total    -- 100% 100%d

    Source: LMSB September 20, 2002, presentation to the IRS Oversight Board,
    as amended after the presentation.

    aInformation for most of the rows in this column was not available, as the
    presentation to the Oversight Board did not include it.

    bCoordinated industry cases are examinations of the nation's largest
    corporations, those under continual IRS audit.

    cAt the time of the September 20, 2002, presentation to the Oversight
    Board, the 54 and 4 percent were 52 and 5 percent, respectively.

    dThe column does not add to 100 percent because of rounding.

    23IRS defines an "industry" case return as the return of an organization
    with assets of more than $10 million but without being part of the largest
    corporations that are under continual IRS audit.

    24According to LMSB officials, mandatory examinations are those LMSB knows
    it will do, such as those for abusive shelters and promoters. Nonmandatory
    examinations are what remain after mandatory work is accommodated.
    High-risk nonmandatory examinations are those in the nonmandatory category
    that have the highest probability that a taxpayer needs compliance
    activity.

    In addition to LMSB examination staff, IRS has managers, attorneys, and
    others who work on abusive shelters. For instance, in February 2003, OTSA
    and its parent body, the Office of Pre-Filing and Technical Guidance, had
    39 full-time and 34 part-time technical experts, program analysts, and
    managers. Also at that time, a contact list for listed transactions
    included 17 attorneys. These numbers did not include many of the IRS legal
    resources involved with abusive shelters. In addition, as of September 30,
    2003, LMSB had assigned about 1,900 abusive and potentially abusive
    shelter transactions involving non-LMSB taxpayers to IRS's Small
    Business/Self-Employed Division, which supplies examination staff
    resources of its own.

    IRS Faces Challenges in Addressing Increasing Shelter Workload

    Although IRS appeared to be on track to shift planned resources to shelter
    work in fiscal year 2003, it faces challenges in addressing the abusive
    shelter workload, especially in the near term. This is because of (1) the
    growing numbers of transactions and promoters to be examined and (2)
    limited information on how long it takes to conduct shelter examinations.

    From fiscal year 2002 through fiscal year 2004, LMSB planned to use 1,879
    full-time equivalents (FTE) to address abusive shelters. During fiscal
    year 2002, LMSB used 239 FTEs to address tax returns that included abusive
    shelters.25 According to IRS's fiscal year 2004 congressional budget
    justification, LMSB planned to allocate 691 and 949 FTEs in fiscal years
    2003 and 2004, respectively. In a draft strategy and program plan dated
    September 2003, LMSB projected it would actually use 615 FTEs for shelter
    work in fiscal year 2003, or 88 percent of the planned amount and an
    increase of 157 percent over the fiscal year 2002 FTE level including this
    work.

    Because (1) the known abusive shelter workload has increased, (2) IRS has
    limited experience to judge how many resources will be needed to work the
    cases for how long a period, and (3) the workload may continue to
    increase, it remains uncertain whether the substantial shift of resources
    to shelter work will enable IRS to examine in a timely manner the growing
    workload associated with shelters. For instance, the number of potential

    25According to LMSB officials, the fiscal year 2002 FTEs include time
    spent on the entire returns containing shelters, not on the shelter issues
    alone. The estimates for fiscal years 2003 and 2004 are focused more on
    the shelter issues.

    examinations of listed transactions disclosed has grown since the
    inception of OTSA, adding significantly to IRS resources required to
    address the problem. Table 5 shows the number of listed transactions
    disclosed by taxpayers grew from 51 to 2,182 between December 31, 2000,
    and September 30, 2003, and other transactions disclosed to IRS grew from
    none to 663. The total of all listed and nonlisted LMSB-related
    transactions in the OTSA database, not only those disclosed by taxpayers,
    as of September 30, 2003, was 4,897.

    Table 5: Taxpayer Disclosures of Listed and Other Reportable Transactions
    between 2000 and September 30, 2003

    Section 6011 disclosures Calendar year (CY) 2000 CY 2001 CY 2002 CY 2003 through
                                   September 30 Total

                  Listed transactions disclosed 51 63 1,251 817 2,182

               Other reportable transactions disclosed 0 214 308 141 663

    Source: IRS.

    IRS workload from promoter investigations has also grown since May 2002.
    At that time, IRS planned that 7 promoter investigations would be ongoing
    in fiscal year 2003. As of June 30, 2003, IRS had 98 promoter
    investigations approved. Based on early promoter investigations, an IRS
    official stated that promoter investigations can take thousands of hours
    to develop, and several have been litigated, each requiring a large
    expenditure of resources.

    LMSB has limited information on the amount of time required to examine
    abusive shelter cases. LMSB developed estimates of the amount of
    examination time required for such cases based on its experience examining
    various types of shelters but acknowledged that examiners can spend
    hundreds or thousands of hours depending on the type of shelter examined
    and the facts and circumstances of the case. For example, according to an
    LMSB official, based on personal experience, OTSA estimated that it would
    take about 800 hours to examine a potentially abusive transaction
    reflected in the return of a CIC corporation although LMSB had little data
    to support the estimate. During fiscal year 2003, IRS began collecting
    data on examination time that it plans to use for estimating the resources
    needed to address its abusive shelter workload.

    The future abusive shelter workload also could increase, at least in the
    short term. For example, as IRS learns more about the use of shelters, it
    may identify and list new kinds of transactions as being abusive. As IRS

    conducts the 98 promoter investigations approved as of June 2003, more
    investors are likely to be identified, and investor cases could lead to
    identifying more promoters. In addition, IRS expanded the types of
    taxpayers subject to disclosure requirements to include taxpayers like
    individuals, partnerships, and S corporations. According to IRS officials,
    disclosures from these types of taxpayers are first due to IRS for filing
    year 2003 and generally do not yet appear in the OTSA database.

    In the longer term, what happens to the abusive shelter workload is less
    certain. To the extent that IRS actions and other factors reduce the size
    of the abusive shelter problem, IRS might not need to continue devoting as
    large a percentage of its examination resources to abusive shelters. How
    much and how soon such a drop may occur in abusive shelter cases is
    uncertain.

    We have previously raised questions about IRS's ability to shift
    compliance resources as planned. We recently testified that many parties
    have expressed concern about declining IRS compliance-especially audit-and
    collection trends for their potential to undermine taxpayers' motivation
    to fulfill their tax obligations.26 Concerned about these trends, IRS has
    sought more resources, including increased staffing for compliance and
    collections since fiscal year 2001. Despite receiving requested budget
    increases, staffing levels in key occupations were lower in 2002 than in
    2000. These declines occurred for reasons such as unbudgeted expenses
    consuming budget increases and other operational workload increases. Based
    on past experience and uncertainty regarding some expected internal
    savings, fiscal year 2004 anticipated staff increases might not fully
    materialize. Thus, if IRS carries through with its intentions to increase
    resources devoted to abusive shelters, it may not have the desired level
    of resources in other areas of compliance.

    Concluding 	Abusive tax shelters represent a potentially significant,
    although imprecisely understood, loss in tax revenues. IRS developed and
    is

    Observations	following a broad-based, multifaceted strategy to combat
    abusive shelters even though it had limited data on the full scope of the
    problem. IRS's strategy generally does not contain long-term performance
    goals and

    26U.S. General Accounting Office, Compliance and Collection: Challenges
    for IRS in Reversing Trends and Implementing New Initiatives, GAO-03-732T
    (Washington, D.C.: May 7, 2003).

    associated measures that can help Congress evaluate IRS's progress.
    Although establishing performance goals and measures is inherently
    difficult since the scope and nature of abusive shelters is elusive, the
    need for such goals and measures is heightened because IRS is shifting
    large amounts of examination staff resources to support combating abusive
    shelters. IRS's initial decisions on shifting resources might need to be
    reevaluated as IRS develops better information on the size of the abusive
    shelter problem and the amount of time it takes to examine abusive shelter
    cases. We encourage IRS to continue its efforts to obtain a better
    analytic basis for determining the resources needed to address schemes and
    shelters-while providing sufficient attention to other tax compliance
    areas-and to develop goals and measures that it and Congress can use to
    gauge IRS's progress.

    Mr. Chairman, this concludes my prepared statement. I would be happy to
    respond to any questions you or other Members of the Committee may have at
    this time.

    Contact and 	For further information on this testimony, please contact
    Michael Brostek at (202) 512-9110 or brostekm@gao.gov. Individuals making
    key

    Acknowledgements	contributions to this testimony include Ralph Block,
    Elizabeth Fan, Amy Friedheim, Lawrence Korb, Signora May, and James
    Ungvarsky.

    Appendix I

    IRS Compliance and Research Programs Using the Schedule K-1

    Schedule K-1s are information returns that link flow-through entities with
    their income recipients and therefore can be used for various compliance
    and research purposes, such as the automated underreporter (AUR) program1
    and profiling potential nonfilers.

    Partnerships, S corporations, trusts, and estates are collectively known
    as flow-through entities because they can legally pass net income or loss
    through to their partners, shareholders, and beneficiaries. Flow-through
    entities are required to provide IRS and each partner, shareholder, or
    beneficiary with a Schedule K-1 stating the individual share of net income
    or loss to be reported. These individuals are then responsible for
    reporting this income or loss on their individual income tax returns and
    paying any applicable tax. According to IRS in tax year 2001, over 9
    million flow-through entities reported passing through almost $1 trillion
    to approximately 24 million partners, shareholders, or beneficiaries. IRS
    research efforts suggest that 6 to 15 percent of the K-1s attached to
    flow-through returns are currently being omitted from beneficiary,
    partner, and shareholder returns. To better detect such noncompliance, IRS
    began transcribing nonelectronically submitted Schedule K-1s for tax year
    2000 at a cost of about $20 million.

    In 2001, IRS added Schedule K-1 document matching to its AUR program. It
    began matching Schedule K-1 data to individual tax returns to identify
    taxpayers who had underreported flow-through income and had consequently
    underpaid their taxes. IRS estimated that K-1 matching program costs would
    be about $23.5 million total for both K-1 transcription and AUR program
    operations and that program yield would be $36 million in direct tax
    assessed. IRS also estimated that if voluntary compliance improved one
    percent due to the matching program, approximately $1.23 billion of
    additional tax would be generated annually. In the first year of the
    program, IRS issued about 69,000 notices to taxpayers and assessed about
    $29 million in additional taxes directly attributable to Schedule K-1
    underreporting.2 GAO estimates that when program assessments are compared
    to the costs of the program's AUR operations, the return per

    1The AUR program matches information return data, such as Forms W-2 and
    1099 and Schedule K-1, with individual tax return data to verify that all
    income is reported.

    2IRS began notifying taxpayers of potential discrepancies between income
    reported on the K-1 and individual tax returns in April 2002. However,
    after receiving complaints that notices were being sent to compliant
    taxpayers, IRS stopped issuing notices in August 2002. IRS data on number
    of notices sent and tax assessed were provided in August 2003.

    Appendix I
    IRS Compliance and Research Programs
    Using the Schedule K-1

    dollar of the K-1 matching program was about $9.31. If the cost of
    transcribing the K-1 data is included, the return per dollar decreases to
    about $1.25.3 Both of these assessment-to-cost ratios are substantially
    lower than that for the AUR program as a whole.4 The AUR program returned
    about $25 for every dollar spent in tax year 2000.5

    IRS has also used Schedule K-1 data to determine characteristics of
    potentially noncompliant taxpayer populations. Its preliminary profiling
    efforts identified over 227,000 business entities with almost $64 billion
    in Schedule K-1 income for tax year 2000 that potentially did not file tax
    returns. As of September 2003, IRS had begun to discuss ways of analyzing
    these cases to determine whether these businesses were required, but
    failed, to file returns, or whether inaccuracies in Schedule K-1 data
    produced false nonfiler leads. In addition, in response to a Treasury
    Inspector General for Tax Administration report issued in September 2002,6
    the agency has begun to research the effectiveness of using information
    returns, such as the K-1, to identify business nonfilers.

    3To increase efficiency and improve the accuracy of K-1 data, IRS is
    exploring two-dimensional bar coding of Schedule K-1s. Instead of
    transcribing K-1 data, IRS would scan a bar code on the K-1 and
    electronically upload the information.

    4Because the Schedule K-1 document matching program is new, its return on
    investment may be low compared to mature AUR programs.

    5Information about the AUR program is based on IRS data from December 28,
    2002.

    6Treasury Inspector General for Tax Administration, The Internal Revenue
    Service Should Evaluate the Feasibility of Using Available Documents to
    Verify Information Reported on Business Tax Returns, Report Number
    2002-30-185 (Washington, D.C.: Sept. 18, 2002).

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