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		 

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO Product.                                                 **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
******************************************************************
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 [email protected].

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 [email protected]. 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).

This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
work may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this material
separately.

GAO's Mission	The General Accounting Office, the audit, evaluation and
investigative arm of Congress, exists to support Congress in meeting its
constitutional responsibilities and to help improve the performance and
accountability of the federal government for the American people. GAO
examines the use of public funds; evaluates federal programs and policies;
and provides analyses, recommendations, and other assistance to help
Congress make informed oversight, policy, and funding decisions. GAO's
commitment to good government is reflected in its core values of
accountability, integrity, and reliability.

Obtaining Copies of GAO Reports and Testimony

The fastest and easiest way to obtain copies of GAO documents at no cost
is through the Internet. GAO's Web site (www.gao.gov) contains abstracts
and full-text files of current reports and testimony and an expanding
archive of older products. The Web site features a search engine to help
you locate documents using key words and phrases. You can print these
documents in their entirety, including charts and other graphics.

Each day, GAO issues a list of newly released reports, testimony, and
correspondence. GAO posts this list, known as "Today's Reports," on its
Web site daily. The list contains links to the full-text document files.
To have GAO e-mail this list to you every afternoon, go to www.gao.gov and
select "Subscribe to e-mail alerts" under the "Order GAO Products"
heading.

Order by Mail or Phone	The first copy of each printed report is free.
Additional copies are $2 each. A check or money order should be made out
to the Superintendent of Documents. GAO also accepts VISA and Mastercard.
Orders for 100 or more copies mailed to a single address are discounted 25
percent. Orders should be sent to:

U.S. General Accounting Office 441 G Street NW, Room LM Washington, D.C.
20548

To order by Phone: 	Voice: (202) 512-6000 TDD: (202) 512-2537 Fax: (202)
512-6061

To Report Fraud, 	Contact: Web site: www.gao.gov/fraudnet/fraudnet.htm

Waste, and Abuse in E-mail: [email protected]

Federal Programs Automated answering system: (800) 424-5454 or (202)
512-7470

Public Affairs	Jeff Nelligan, Managing Director, [email protected] (202)
512-4800 U.S. General Accounting Office, 441 G Street NW, Room 7149
Washington, D.C. 20548

                               Presorted Standard
                              Postage & Fees Paid
                                      GAO
                                Permit No. GI00

United States
General Accounting Office
Washington, D.C. 20548-0001

Official Business
Penalty for Private Use $300

Address Service Requested
*** End of document. ***