    Financial Audit: IRS's Fiscal Years 2005 and 2004 Financial
    Statements (10-NOV-05, GAO-06-137).

    Because of the significance of Internal Revenue Service (IRS)
    collections to federal receipts and, in turn, to the consolidated
    financial statements of the U.S. government, which GAO is
    required to audit, and Congress's interest in financial
    management at IRS, GAO audits IRS's financial statements annually
    to determine whether (1) the financial statements IRS prepares
    are reliable and (2) IRS management maintained effective internal
    controls. We also test IRS's compliance with selected provisions
    of significant laws and regulations and its financial management
    systems' compliance with the Federal Financial Management
    Improvement Act of 1996 (FFMIA).
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-137
        ACCNO:   A41318
      TITLE:     Financial Audit: IRS's Fiscal Years 2005 and 2004
    Financial Statements
         DATE:   11/10/2005
      SUBJECT:   Accountability
    	     Financial management
    	     Financial management systems
    	     Financial statement audits
    	     Information security
    	     Internal controls
    	     Noncompliance
    	     Reporting requirements

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    GAO-06-137

         * Report to the Secretary of the Treasury
              * November 2005
         * FINANCIAL AUDIT
              * IRS's Fiscal Years 2005 and 2004 Financial Statements
         * Contents
              * Opinion on IRS's Financial Statements
              * Opinion on Internal Controls
              * Compliance with Laws and Regulations and FFMIA Requirements
              * Consistency of Other Information
              * Objectives, Scope, and Methodology
              * Agency Comments and Our Evaluation
         * Management Discussion and Analysis
         * Financial Statements
         * Supplemental Information
         * Material Weaknesses, Reportable Conditions, and Compliance Issues
              * Material Weaknesses
                   * Financial Reporting
                   * Unpaid Tax Assessments
                   * Tax Revenue and Refunds
                   * Information Security
              * Reportable Conditions
                   * Hard-Copy Tax Receipts and Taxpayer Information
                   * Property and Equipment
              * Compliance Issues
                   * Release of Federal Tax Liens
                   * Financial Management Systems' Noncompliance with FFMIA
         * Details on Audit Methodology
         * Comments from the Internal Revenue Service

                     United States Government Accountability Office

                                     November 2005

    FINANCIAL AUDIT

                 IRS's Fiscal Years 2005 and 2004 Financial Statements

                                           a

    FINANCIAL AUDIT

    IRS's Fiscal Years 2005 and 2004 Financial Statements

      What GAO Found

    In GAO's opinion, IRS's fiscal years 2005 and 2004 financial statements
    were fairly presented in all material respects. Because of serious
    internal control and financial management systems deficiencies, however,
    IRS again had to rely extensively on resource-intensive compensating
    processes to prepare its financial statements. Due to these serious
    internal control and financial management deficiencies, IRS did not, in
    GAO's opinion, maintain effective internal controls over financial
    reporting (including safeguarding of assets) or compliance with laws and
    regulations, and thus did not provide reasonable assurance that losses,
    misstatements, and noncompliance with laws material in relation to the
    financial statements would be prevented or detected on a timely basis.

    IRS has continued to make great strides in addressing its financial
    management challenges and has substantially mitigated several material
    weaknesses in its internal controls. In fiscal year 2005, IRS successfully
    implemented the first phase, or release, of its new Integrated Financial
    System (IFS), which is intended to replace the outdated financial
    management systems IRS used in recent years to process and report
    administrative (nontax) transactions. This first phase of IFS provides for
    improved audit trails and more timely information for such activities and
    transactions as travel, purchases of goods and services, and budgetary
    activities. In addition, IRS continued to make progress in its efforts to
    address its weaknesses in controls over hard-copy taxpayer receipts and
    data and over property and equipment. However, GAO continues to consider
    issues related to IRS's controls over financial reporting, management of
    unpaid assessments, collection of revenue and issuance of tax refunds, and
    information security to be material weaknesses. In addition, IRS was not
    always in compliance with a law concerning the timely release of tax
    liens.

    IRS's most serious financial management weaknesses are rooted in its
    continued reliance on outdated automated systems. The lack of a sound
    financial management system that can produce timely, accurate, and useful
    information needed for day-to-day decisions continues to present a serious
    challenge to IRS management. While implementation of the first phase of
    IFS during fiscal year 2005 was noteworthy, it is still several years away
    from achieving its full potential, which is contingent on future system
    releases and development of a means to integrate the new system with the
    systems IRS uses to support its tax administration activities. IRS's
    present financial management systems, which do not substantially comply
    with FFMIA, inhibit IRS's ability to address the financial management and
    operational issues that affect its ability to fulfill its responsibilities
    as the nation's tax collector. Further, the continued and serious
    weaknesses in information security have significant implications for the
    reliability of information produced by the new financial management system
    being implemented. Solving IRS's financial management problems depends
    largely on the ultimate success of IRS's ongoing systems modernization
    effort.

                     United States Government Accountability Office

    Contents

    Letter

    Auditor's Report 5
    Opinion on IRS's Financial Statements 9
    Opinion on Internal Controls 10
    Compliance with Laws and Regulations and FFMIA Requirements 12
    Consistency of Other Information 13
    Objectives, Scope, and Methodology 13
    Agency Comments and Our Evaluation 14
    Balance Sheets 91
    Statements of Net Cost 92
    Statements of Changes in Net Position 93
    Statements of Budgetary Resources 94
    Statements of Financing 95
    Statements of Custodial Activity 96
    Notes to the Financial Statements 97
    :Details on Audit Methodology 146 148
    :Comments from the Internal Revenue Service
    :Material Weaknesses, Reportable Conditions, and Compliance Issues 125
    Material Weaknesses 125
    Reportable Conditions 138
    Compliance Issues 142

    Management Discussion and Analysis

    91

    Financial Statements

    Supplemental Information

    Appendixes

    Contents

                                     Abbreviations

    CADE            Customer Account Data Engine
    CAP             Custodial Accounting Project
    CFO Act         Chief Financial Officers Act of 1990
    EITC            earned income tax credit
    FFMIA           Federal Financial Management Improvement Act of 1996
    FFMSR           Federal Financial Management System Requirements
    FIA             Federal Managers' Financial Integrity Act of 1982
    FISMA           Federal Information Security Management Act of 2002
    FMS             Financial Management Service
    IFS             Integrated Financial System
    IRS             Internal Revenue Service
    JFMIP           Joint Financial Management Improvement Program
    OMB             Office of Management and Budget
    P&E             property and equipment

    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.

    United States Government Accountability Office Washington, D.C. 20548

    November 10, 2005

    The Honorable John W. Snow The Secretary of the Treasury

    Dear Mr. Secretary:

    The accompanying report presents the results of our audits of the
    financial statements of the Internal Revenue Service (IRS) as of, and for
    the fiscal years ending, September 30, 2005 and 2004. We performed our
    audits in accordance with the Chief Financial Officers (CFO) Act of 1990,
    as expanded by the Government Management Reform Act of 1994. This report
    contains our (1) unqualified opinions on IRS's financial statements,

    (2) opinion that IRS's internal controls were not effective as of
    September 30, 2005, and (3) conclusion that IRS was not in compliance with
    one provision of the laws and regulations we tested and that IRS's
    financial management systems were not in substantial compliance with the
    requirements of the Federal Financial Management Improvement Act of 1996.

    Our unqualified opinions on IRS's fiscal years 2005 and 2004 financial
    statements were made possible by the continued extraordinary efforts of
    IRS senior management and staff to compensate for serious internal control
    and financial management systems deficiencies. IRS is currently in the
    midst of a major business systems modernization effort that is ultimately
    intended to resolve its most serious financial systems challenges.
    However, this effort is not scheduled to be completed for several years.
    Until the modernization is accomplished, preparing reliable financial
    statements will continue to be a difficult challenge for IRS, requiring
    continued use of extraordinary compensating measures. To date, these
    measures have proved successful: for the sixth consecutive year, IRS has
    received an unqualified opinion on its financial statements and, for the
    fourth consecutive year, the audit was completed and the report issued by
    November 15.

    Over the last several years, IRS has made great strides in addressing its
    financial management challenges and has resolved or substantially
    mitigated several material weaknesses in its internal controls. However,
    IRS's most serious financial management weaknesses are rooted in its
    continued reliance on outdated automated systems, whose numerous
    limitations render IRS unable to develop cost-based performance or other
    information to support informed decision making throughout the year.

    Solving these problems depends largely on the ultimate success of IRS's
    ongoing systems modernization effort. In 1995, we designated financial
    management and systems modernization at IRS as high-risk areas.1 However,
    because resolution of IRS's most serious and intractable financial
    management issues largely depends on the success of IRS's business systems
    modernization efforts, in 2005 we combined these two previous high-risk
    areas into one Business Systems Modernization high-risk area.2

    During fiscal year 2005, IRS successfully implemented the first phase, or
    release, of its new Integrated Financial System (IFS), which is intended
    to replace the outdated financial management system that IRS used in
    recent years to process and report administrative transactions. This first
    phase of IFS provides for improved audit trails and more timely
    information for such activities and transactions as travel, purchases of
    goods and services, and budgetary activities. However, full operational
    capability of IFS is several years away, and is contingent on the
    successful implementation of future system releases. Additionally, IRS
    will need to address how IFS will ultimately be integrated with those
    systems that support financial management of its tax administration
    functions to fully resolve many of its long-standing financial management
    challenges.

    Among the most serious financial management issues still remaining to be
    addressed are the continued significant weaknesses in IRS's information
    security. Consequently, as IRS continues its efforts to modernize its
    financial and operational systems, it is critical that IRS take actions to
    establish and maintain more effective information security controls on a
    continuing basis, through an ongoing cycle of risk management activities,
    to protect the processing, storage, and transmission of financial and
    sensitive data. Until IRS successfully manages its information security
    risks, management will not have assurance over the integrity and
    reliability of the information generated from the new financial management
    system, and IRS's opportunities for further improvements in financial
    management will be limited.

    We commend IRS for the improvements it has continued to make in its
    financial processes and operations. Nonetheless, IRS management and staff
    will continue to be challenged to sustain the level of effort needed to

    1GAO, High-Risk Series: An Overview, GAO/HR-95-1 (Washington, D.C.:
    February 1995). 2GAO, High-Risk Series: An Update, GAO-05-207 (Washington,
    D.C.: January 2005).

    Page 2 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

    produce reliable financial statements until the agency is able to fully
    address the underlying systems and internal control issues that have made
    this process so time consuming and resource intensive. As we previously
    reported, IRS continues to lack accurate, useful, and timely financial
    information and sound controls with which to make fully informed decisions
    and to ensure ongoing accountability, which is a primary objective of the
    CFO Act. IRS has made significant progress in addressing its serious
    control and systems deficiencies and improving financial management during
    the past 9 years. It is important that these financial management
    initiatives continue in order to achieve comprehensive and lasting
    financial management reform.

    The agency also continues to face a significant challenge in strengthening
    its enforcement of the nation's tax laws, another challenge at IRS that we
    have designated as high risk.3 In recent years, the resources IRS has been
    able to dedicate to enforcing the tax laws have not kept pace with the
    increases it has seen in its enforcement workload. At the same time, IRS
    faces significant compliance-related issues, including combating abusive
    tax shelters and tax schemes, on which it is placing a high priority.
    Critical to IRS's efforts in improving enforcement and, ultimately,
    taxpayer compliance, is the need to have current information on the rate
    of compliance, both overall and by type of taxpayer. IRS recently
    completed a study of the rate of compliance with the nation's tax laws by
    individuals and some small business taxpayers, and is exploring approaches
    to developing compliance estimates for other groups of taxpayers. It is
    critical that such efforts be continued as, without current information on
    noncompliance, the challenge of targeting IRS enforcement resources to
    areas where they would prove most effective is problematic.

    The accompanying report also discusses other significant issues that we
    considered in performing our audit and in forming our conclusions, which
    we believe should be brought to the attention of IRS management and users
    of IRS's financial statements.

    We are sending copies of this report to the Chairmen and Ranking Minority
    Members of the Senate Committee on Appropriations; Senate Committee on
    Finance; Senate Committee on Homeland Security and Governmental Affairs;
    Senate Committee on the Budget; Subcommittee on Transportation, Treasury,
    the Judiciary, Housing and Urban Development

    3 GAO-05-207.

    and Related Agencies, Senate Committee on Appropriations; Subcommittee on
    Taxation and IRS Oversight, Senate Committee on Finance; Subcommittee on
    Oversight of Government Management, the Federal Workforce, and the
    District of Columbia, Senate Committee on Homeland Security and
    Governmental Affairs; House Committee on Appropriations; House Committee
    on Ways and Means; House Committee on Government Reform; House Committee
    on the Budget; Subcommittee on Transportation, Treasury, and Housing and
    Urban Development, the Judiciary, and the District of Columbia, House
    Committee on Appropriations; Subcommittee on Government Management,
    Finance, and Accountability, House Committee on Government Reform; and
    Subcommittee on Oversight, House Committee on Ways and Means. We are also
    sending copies of this report to the Chairman and Vice Chairman of the
    Joint Committee on Taxation, the Commissioner of Internal Revenue, the
    Director of the Office of Management and Budget, the Chairman of the IRS
    Oversight Board, and other interested parties. Copies will be made
    available to others upon request. In addition, the report is available at
    no charge on GAO's Web site at h ttp://www.gao.gov.

    This report was prepared under the direction of Steven J. Sebastian,
    Director, Financial Management and Assurance, who can be reached at (202)
    512-3406 or sebastians@gao.gov. If I can be of further assistance, please
    call me at (202) 512-5500. Contact points for our Offices of Congressional
    Relations and Public Affairs may be found on the last page of this report.

    Sincerely yours,

    David M. Walker Comptroller General of the United States

    United States Government Accountability Office Washington, D.C. 20548

    To the Commissioner of Internal Revenue

    In accordance with the Chief Financial Officers (CFO) Act of 1990, as
    expanded by the Government Management Reform Act of 1994,4 this report
    presents the results of our audits of the financial statements of the
    Internal Revenue Service (IRS) for fiscal years 2005 and 2004. The
    financial statements report the assets, liabilities, net position, net
    costs, changes in net position, budgetary resources, reconciliation of net
    costs to budgetary obligations, and custodial activity related to IRS's
    administration of its responsibilities for implementing federal tax
    legislation. The financial statements do not include an estimate of the
    amount of taxes that are owed the federal government but have not been
    reported by taxpayers or identified by IRS, often referred to as the tax
    gap,5 nor do they include information on tax expenditures.6

    In its role as the nation's tax collector, IRS has a demanding
    responsibility in collecting taxes, processing tax returns, and enforcing
    the nation's tax laws. IRS is a large and complex organization, adding
    unique operational challenges for management. IRS employs tens of
    thousands of people in 10 service center campuses, three computing
    centers, and numerous other field offices throughout the United States. In
    each of fiscal years 2005 and 2004, IRS collected about $2.3 trillion and
    $2.0 trillion, respectively, in tax payments, processed hundreds of
    millions of tax and information returns, and paid about $267 billion and
    $278 billion, respectively, in refunds to taxpayers.

    4CFO Act of 1990, Pub. L. No. 101-576, 104 Stat. 2838 (Nov. 15, 1990);
    Government Management Reform Act of 1994, Pub. L. No. 103-356, 108 Stat.
    3410 (Oct. 13, 1994).

    5IRS includes an estimate of the tax gap in the tax gap disclosures
    contained in the other accompanying information to the financial
    statements. This estimate is based on a recently completed study by IRS on
    the rate of compliance with the tax laws by individuals and some small
    business taxpayers. IRS is exploring approaches to developing compliance
    estimates for other groups of taxpayers.

    6Tax expenditures are revenue losses-the amount of revenue that the
    government forgoes-resulting from federal tax provisions that grant
    special tax relief for certain kinds of behavior by taxpayers or for
    taxpayers in special circumstances. Under U.S. generally accepted
    accounting principles, tax expenditure amounts are not required to be
    disclosed as part of federal agencies' financial statements, but certain
    information on tax expenditures can be included as other accompanying
    information to the financial statements.

    One of the largest obstacles continuing to face IRS management is the
    agency's lack of an integrated financial management system capable of
    producing the accurate, useful, and timely information IRS managers need
    to assist in making day-to-day decisions. While progress is being made to
    modernize its financial management capabilities, IRS nonetheless continued
    to confront many of the pervasive internal control weaknesses that we have
    reported each year since we began auditing its financial statements in
    fiscal year 1992,7 though it continued to make strides in addressing its
    financial management challenges. In fiscal year 2005, for the sixth
    consecutive year, IRS was able to produce financial statements covering
    its tax custodial and administrative activities that are fairly stated in
    all material respects. Moreover, for the fourth consecutive year, IRS was
    able to issue its final audited financial statements only a month and a
    half after the end of the fiscal year.

    IRS's continued success in meeting this reporting date is a major
    accomplishment and, for fiscal year 2005, was all the more notable because
    IRS met this date while implementing the first phase of its new financial
    management system, which is ultimately expected to resolve its most
    serious financial management challenges. Nevertheless, many of IRS's
    long-standing systems and internal control weaknesses continued to exist,
    necessitating continued reliance on costly compensating processes,
    statistical estimates, external contractors, substantial adjustments, and
    monumental human efforts to prepare a set of reliable financial
    statements. These costly efforts would not be necessary if IRS's systems
    and controls operated effectively.

    7GAO, Financial Audit: Examination of IRS' Fiscal Year 1992 Financial
    Statements, GAO/AIMD-93-2 (Washington, D.C.: June 30, 1993).

    Page 6 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

    During fiscal year 2005, IRS continued to make progress in its efforts to
    address its weaknesses in controls over financial reporting, property and
    equipment (P&E), and hard-copy taxpayer receipts and data. For example, as
    a result of its implementation of the first phase of its new financial
    management system, IRS improved the timeliness and accuracy of its
    recording of P&E acquisitions. Additionally, IRS implemented several
    initiatives to improve the safeguarding of, and accountability for,
    hardcopy taxpayer receipts and data at lockbox banks and taxpayer
    assistance centers. However, control deficiencies in P&E and physical
    security over taxpayer receipts and data continued to represent reportable
    conditions,8 requiring further attention by IRS management. Additionally,
    we continue to consider issues related to controls over financial
    reporting, management of unpaid assessments, and collection of revenue and
    issuance of tax refunds to be material weaknesses.9 These weaknesses are
    caused primarily by IRS's continued reliance on outdated automated systems
    to provide the financial information that management relies on to make
    decisions. In addition, we continue to consider issues related to
    information security to be a material weakness. The persistent, serious
    deficiencies in information security increase the risk that confidential
    IRS and taxpayer information will be compromised and have serious
    implications related to the reliability of financial management
    information produced by IRS's systems.

    IRS has made progress in improving its financial management, and the
    process changes IRS has instituted in the last several years represent
    good financial management practices. However, IRS's most serious remaining
    problems are caused by its inadequate automated systems, and these
    problems will continue to exist until its systems are replaced. In the
    interim, opportunities for further improvement will be limited. Until its
    systems are replaced, IRS will continue to be challenged to sustain the
    level of effort needed to produce reliable financial statements timely.
    Perhaps more important, IRS will continue to rely on processes that cannot
    produce the accurate, useful, and timely financial and performance
    information IRS

    8Reportable conditions are matters coming to our attention that, in our
    judgment, should be communicated because they represent significant
    deficiencies in the design or operation of internal controls that could
    adversely affect IRS's ability to meet the objectives described in this
    report.

    9A material weakness is a reportable condition that precludes the entity's
    internal controls from providing reasonable assurance that material
    misstatements in the financial statements would be prevented or detected
    on a timely basis.

    needs for decision making on an ongoing basis, which is a primary
    objective of the CFO Act. These processes also cannot fully address the
    underlying financial management and operational issues that adversely
    affect IRS's ability to effectively fulfill its responsibilities as the
    nation's tax collector.

    IRS is currently installing a new financial management system intended to
    resolve many of the issues discussed in this report. During fiscal year
    2005, IRS implemented a major component of this system-the first release
    of the Integrated Financial System (IFS). IFS is intended to replace the
    outdated financial management system IRS has used in recent years to
    process and report administrative transactions such as procurement and
    utilization of budgetary resources, and to provide IRS with a general
    ledger system that complies with the U.S. Government Standard General
    Ledger. During the fiscal year, IRS converted financial data from its
    previous financial system to IFS, verified that the information was
    converted properly, and closely monitored the conversion in an effort to
    ensure a successful transition to this first release of IFS. Replacing a
    financial system of this magnitude is an inherently difficult and complex
    effort that entails significant risks. IRS recognized this, and devoted
    significant resources to mitigate those risks. This, and earlier decisions
    to delay implementation to address issues that arose during the design of
    the system, enabled IRS to successfully implement the first phase of IFS
    with minimal disruptions to its financial activities.

    While IRS's progress with respect to the implementation of this first
    phase of IFS is noteworthy, it is important to recognize that substantial
    work remains to be done to complete the modernizing of IRS's financial
    management systems so as to achieve sound financial management. Presently,
    IFS serves as IRS's core financial management system for its
    administrative activities, and includes such functionality as accounts
    payable, accounts receivable, budget formulation and execution, and the
    general ledger. While IFS contains cost accounting capability, it will be
    several years before such capabilities can be fully and successfully
    utilized. Additionally, IRS's effort to bring the system online
    experienced significant problems and delays in the past, and this, coupled
    with funding constraints, led to a decision to indefinitely defer future
    releases of IFS, including those related to property management,
    procurement, and performance management functions.

      Opinion on IRS's Financial Statements

    IRS also will have to address how IFS will ultimately be integrated with
    those systems that support financial management of IRS's tax
    administration functions, including its collection of tax revenue
    receipts, disbursement of tax refunds, and identification, management, and
    collection of outstanding federal taxes. During fiscal year 2005, IRS
    expanded processing of the less complex individual tax returns through the
    first phase, or release, of the Customer Account Data Engine (CADE), which
    is the system being designed to replace IRS's master files.10 CADE was to
    eventually provide tax information to IFS for reporting purposes through
    the Custodial Accounting Project (CAP), a system which was to support
    management needs for information related to tax operations for purposes of
    day-to-day decision making, performance management, and reporting.
    However, significant delays and problems, as well as budget constraints,
    resulted in first the deferral, and later the cancellation, of CAP. At
    this time, IRS is exploring options to implement alternative systems that
    would perform the functions that CAP had been intended to perform, but it
    remains unclear when IRS's new financial management systems will be fully
    implemented. Additionally, continuing and newly identified weaknesses in
    IRS's information security raise serious concerns about the integrity of
    information that will be generated from these modernized systems, as well
    as about future modernization efforts that support the preparation of
    IRS's financial statements.

    IRS's financial statements, including the accompanying notes, present
    fairly, in all material respects, in conformity with U.S. generally
    accepted accounting principles, IRS's assets, liabilities, net position,
    net costs, changes in net position, budgetary resources, reconciliation of
    net costs to budgetary activity, and custodial activity as of, and for the
    fiscal years ended, September 30, 2005, and September 30, 2004.

    However, misstatements may nevertheless occur in other financial
    information reported by IRS as a result of the internal control weaknesses
    described in this report.

    IRS's financial statements include tax revenues collected during the
    fiscal year as well as the total unpaid taxes for which IRS, the taxpayer,
    or courts agree on the amounts owed. Cumulative unpaid tax assessments for
    which

    10IRS's master files contain detailed records of taxpayer accounts.

      Opinion on Internal Controls

    there is no future collection potential or for which there is no agreement
    on the amounts owed are not reported in the financial statements. Rather,
    they are reported as write-offs and compliance assessments, respectively,
    in supplemental information to IRS's financial statements. Also, in
    conformity with U.S. generally accepted accounting principles, to the
    extent that taxes owed in accordance with the nation's tax laws are not
    reported by taxpayers and are not identified through IRS's various
    enforcement programs, they are not reported in the financial statements
    nor in supplemental information to the financial statements. Additionally,
    in conformity with U.S. generally accepted accounting principles, tax
    expenditures, which represent the amount of revenue the government forgoes
    resulting from federal tax provisions that grant special tax relief for
    certain kinds of behavior by taxpayers or for taxpayers in special
    circumstances, are not reported in the financial statements.

    Because of the material weaknesses in internal controls discussed below,
    IRS did not maintain effective internal controls over financial reporting
    (including safeguarding of assets) or compliance with laws and
    regulations, and thus did not provide reasonable assurance that losses,
    misstatements, and noncompliance with laws material in relation to the
    financial statements would be prevented or detected on a timely basis. Our
    opinion is based on criteria established under 31 U.S.C. S: 3512 (c), (d),
    commonly referred to as the Federal Managers' Financial Integrity Act of
    1982 (FIA), and Office of Management and Budget (OMB) Circular No. A-123,
    Management Accountability and Control (revised June 21, 1995).11

    Despite its material weaknesses in internal controls and its systems
    deficiencies, IRS was able to prepare financial statements that were
    fairly stated in all material respects for fiscal years 2005 and 2004.
    Nonetheless, IRS continues to face the following key issues that represent
    material weaknesses in internal controls:

    11A reexamination of internal control requirements for financial reporting
    by federal agencies was initiated in light of the new internal control
    requirements for publicly traded companies contained in the Sarbanes-Oxley
    Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002). On
    December 21, 2004, OMB issued a revision of Circular No. A-123,
    Management's Responsibility for Internal Control, which will become
    effective in fiscal year 2006. In the interim, OMB has instructed federal
    agencies to continue to follow the 1995 revision.

         o weaknesses in controls over the financial reporting process, resulting
           in IRS not (1) being able to prepare reliable financial statements
           without extensive compensating procedures and (2) having current and
           reliable ongoing information to support management decision making and
           to prepare cost-based performance measures;
         o weaknesses in controls over unpaid tax assessments, resulting in IRS's
           inability to properly manage unpaid assessments and leading to
           increased taxpayer burden;
         o weaknesses in controls over the identification and collection of tax
           revenues due the federal government and over the issuance of tax
           refunds, resulting in lost revenue to the federal government and
           potentially billions of dollars in improper payments; and
         o weaknesses in information security controls, resulting in increased
           risk of unauthorized individuals being allowed to access, alter, or
           abuse proprietary IRS programs and electronic data and taxpayer
           information.

    The material weaknesses in internal controls noted above may adversely
    affect any decision by IRS's management that is based, in whole or in
    part, on information that is inaccurate because of these weaknesses. In
    addition, unaudited financial information reported by IRS, including
    performance information, may also contain misstatements resulting from
    these weaknesses.

    In addition to the material weaknesses discussed above, we identified two
    reportable conditions, which, although not material weaknesses, represent
    significant deficiencies in the design or operation of internal controls
    that could adversely affect IRS's ability to meet the internal control
    objectives described in this report. These conditions concern deficiencies
    in (1) controls over hard-copy tax receipts and taxpayer data, which
    increase the government's and taxpayers' risk of loss or inappropriate
    disclosure of taxpayer data, and (2) controls over P&E, which preclude IRS
    from readily reconciling its property records to its financial records.

      Compliance with Laws and Regulations and FFMIA Requirements

    We have reported on these material weaknesses and reportable conditions in
    prior audits and have provided IRS recommendations to address these
    issues. Eighty-four of these recommendations were still open as of the
    date of this report.12 IRS continues to make strides in resolving these
    matters. We will follow up in future audits to monitor IRS's progress in
    implementing these recommendations. For more details on these issues, see
    appendix I.

    Our tests of compliance with selected provisions of laws and regulations
    disclosed one area of noncompliance that is reportable under U.S.
    generally accepted government auditing standards and OMB guidance. This
    area relates to IRS not timely releasing federal tax liens against
    taxpayers' property.

    Except as noted above, our tests for compliance with laws and regulations
    disclosed no other instances of noncompliance that would be reportable
    under U.S. generally accepted government auditing standards or OMB audit
    guidance. However, the objective of our audit was not to provide an
    opinion on overall compliance with laws and regulations. Accordingly, we
    do not express such an opinion.

    We also found that IRS's financial management systems did not
    substantially comply with the requirements of the Federal Financial
    Management Improvement Act of 1996 (FFMIA).13

    For more details on these issues, see appendix I.

    12This number does not include open recommendations related to information
    security. These recommendations, because of their sensitive nature, are
    contained in a series of Limited Official Use Only reports that we have
    issued to IRS over the past several years.

    13Pub. L. No. 104-208, div. A, S: 101(f), title VIII, 110 Stat. 3009,
    3009-389 (Sept. 30, 1996).

    Page 12 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

      Consistency of Other Information

    IRS's Management Discussion and Analysis and required supplemental
    information contain a wide range of data, some of which are not directly
    related to the financial statements. We did not audit and do not express
    an opinion on this information. However, we compared this information for
    consistency with the financial statements and discussed the methods of
    measurement and presentation with IRS officials. Based on this limited
    work, we found no material inconsistencies with the financial statements
    or nonconformance with OMB guidance. Under OMB guidance for the financial
    statements of federal agencies, agencies are asked to strive to develop
    and report objective measures that to the extent possible, provide
    information about the cost-effectiveness of their programs. We found,
    however, that because of the noted internal control and systems
    limitations, IRS cannot report reliable cost-based performance measures
    relating to its various programs consistent with the Government
    Performance and Results Act of 1993.14

      Objectives, Scope, and Methodology

    Management is responsible for (1) preparing the annual financial
    statements in conformity with U.S. generally accepted accounting
    principles; (2) establishing, maintaining, and assessing internal control
    to provide reasonable assurance that the broad control objectives of 31
    U.S.C. S: 3512 (c), (d) (FIA) are met; (3) ensuring that IRS's financial
    management systems substantially comply with the requirements of FFMIA;
    and (4) complying with applicable laws and regulations.

    We are responsible for obtaining reasonable assurance about whether (1)
    the financial statements are presented fairly, in all material respects,
    in conformity with U.S. generally accepted accounting principles and (2)
    management maintained effective internal controls, the objectives of which
    are the following:

    o  Financial reporting-transactions are properly recorded, processed, and
    summarized to permit the preparation of financial statements in conformity
    with U.S. generally accepted accounting principles and assets are
    safeguarded against loss from unauthorized acquisition, use, and
    disposition.

    14Pub. L. No. 103-62, S: 4(b), 107 Stat. 285, 287 (Aug. 3, 1993) (codified at 31
                                    U.S.C. S: 1115).

        Page 13 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

      Agency Comments and Our Evaluation

    o  Compliance with laws and regulations-transactions are executed in
    accordance with laws governing the use of budget authority and with other
    laws and regulations that could have a direct and material effect on the
    financial statements and any other laws, regulations, and governmentwide
    policies identified by OMB audit guidance.

    We are also responsible for (1) testing whether IRS's financial management
    systems substantially comply with the three FFMIA requirements, (2)
    testing compliance with selected provisions of laws and regulations that
    have a direct and material effect on the financial statements and laws for
    which OMB audit guidance requires testing, and (3) performing limited
    procedures with respect to certain other information appearing in these
    annual financial statements. For more details on our methodology and the
    laws and regulations we tested, see appendix II.

    We did not evaluate all internal controls relevant to operating objectives
    as broadly defined by FIA, such as controls relevant to preparing
    statistical reports and ensuring efficient operations. We limited our
    internal control testing to testing controls over financial reporting and
    compliance with laws and regulations.

    We did not test compliance with all laws and regulations applicable to
    IRS. We limited our tests of compliance to those laws and regulations that
    had a direct and material effect on the financial statements or that were
    required to be tested by OMB audit guidance that we deemed applicable to
    IRS's financial statements for the fiscal years ended September 30, 2005
    and 2004. We caution that noncompliance may occur and not be detected by
    these tests and that such testing may not be sufficient for other
    purposes.

    We performed our work in accordance with U.S. generally accepted
    government auditing standards and OMB audit guidance.

    In responding to this report, IRS agreed that the report fairly presents
    the agency's financial management progress and remaining management and
    systems challenges. IRS noted that the agency's dedication to financial
    management improvement enabled it to achieve, for the sixth consecutive
    year, an unqualified opinion on its financial statements. Additionally,
    IRS cited a number of financial management improvements it had undertaken
    during fiscal year 2005, the most notable of which was its successful
    deployment of the initial release of its Integrated Financial System
    (IFS). In addition to the implementation of IFS, IRS noted other financial
    management improvements, such as (1) implementation of a crosswalk to
    convert the Interim Revenue Accounting Control System trial balance
    accounts into a format compliant with the United States Standard General
    Ledger, (2) centralization of all Small Business/Self-Employed Automated
    Trust Fund Recovery Penalty (TFRP) work to two campuses to improve
    efficiency and reduce TFRP assessment errors by improving the
    cross-referencing and posting of the payment process, and (3) development
    of Security and Internal Control Performance Measures for physical
    security, courier, personal security, and internal controls over receipts
    and receipt processing at lockbox banks.

    In its response, IRS also agreed with our findings and opinions related to
    information security, and indicated that it had developed an action plan
    to address deficiencies in access controls, rules of behavior, contingency
    planning and disaster recovery, audit trails, training, and certification
    and accreditation. IRS also recognized the need to continue to address
    identified problems and remain focused on its modernization efforts. IRS
    noted that the agency had established a deep and continuing commitment to
    improving financial management and its intention to aggressively pursue
    appropriate actions to improve processes and systems.

    David M. Walker Comptroller General of the United States

    October 31, 2005

                           Management Discussion and Analysis

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    I. Introduction

    The Internal Revenue Service (IRS) administers America's tax laws and
    collects the revenues that fund most government operations and public
    services. To do so, the IRS helps taxpayers comply with the tax system and
    ensures that those who are unwilling to comply pay their fair share. In a
    constantly evolving economy, this mission requires not only a sharp focus
    on service and enforcement, but also an increasingly flexible agency, one
    capable of smooth adjustment to 21st century change.

    The IRS' five-year Strategic Plan provides the blueprint to meet this
    challenge. This plan focuses on three key goals: improving taxpayer
    service, enhancing enforcement of the tax law and modernizing the IRS
    through its people, processes and technology. Fiscal Year (FY) 2005
    witnessed the IRS making significant progress toward each of these goals.

    The way taxpayers pay their taxes and access IRS information is changing.
    This year, for the first time, more than half of all taxpayers filed
    electronically and more than five million of these taxpayers filed for
    free though the Free File Alliance. Additionally, tens of millions of
    taxpayers visited the IRS website to obtain forms, publications and
    answers to their many tax questions. In FY 2005, as in prior years, IRS
    employees made millions of contacts with American taxpayers and
    businesses, improving service to them by reducing response times to
    taxpayer inquiries, improving communications with taxpayers, providing
    taxpayers and their paid prepares with needed resources and reducing the
    paperwork burden.

    The IRS has also increased enforcement with the aim of improving taxpayer
    compliance. The FY 2005 performance results confirm that the IRS is
    striking the right balance between service and enforcement. For FY 2005,
    the IRS met or exceeded the targets in 17 of its 211 measures (81%
    compared to 67% in FY 2004). Of particular note are the IRS' efforts to
    enhance criminal enforcement, use of civil injunctions to stop abusive tax
    schemes and investigate promoters and users of tax shelters. Two major
    settlement initiatives involving the use of abusive tax shelters generated
    over $4.7 billion in revenue. IRS enforcement actions also contribute to
    national security and homeland defense; the IRS has a unique role in
    combating the use of charitable organizations to raise funds for terrorist
    organizations.

    Business systems modernization remains a high priority for the IRS. A
    robust, secure and up-to-date infrastructure will improve services-both to
    taxpayers and to other government agencies-and will strengthen enforcement
    by giving IRS employees better tools. In FY 2005, the IRS implemented its
    new Integrated Financial System (IFS), designed to provide the IRS with
    more accurate and timely financial information and improved compliance
    with legislative and regulatory requirements. The major components of IFS
    are accounts payable, accounts receivable, budget formulation, budget
    execution, general ledger, financial statements and cost accounting. Today
    there are thousands of procurement commitments, obligations and
    receipt/acceptance documents being processed through the new IFS system.
    Another success includes the Customer Account Data Engine (CADE),

    1

    Data for the Earned Income Tax Credit measure will not be available until
    the close of Calendar Year 2005 and two information systems measures were
    discontinued this year.

                                           1

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    the IRS' modernized database; CADE posted over 1.4 million returns for
    filing season 2005 and generated over $427 million in refunds.

    During FY 2006, the IRS will continue to seek efficiencies in delivering
    taxpayer service, bolster its enforcement efforts to improve compliance
    with the tax laws and modernize its infrastructure. The IRS will continue
    to research and evaluate information regarding taxpayer service needs,
    priorities, and preferences in order to improve delivery services. In the
    area of enforcement, the IRS will expand enforcement by targeting its case
    work and enforcement activities to more effectively deliver results and
    drive down the tax gap. Finally, the IRS will continue its modernization
    with the further development of CADE; Modernized e-File (MeF); and the
    Filing and Payment Compliance system, a system that analyzes tax
    collection cases to determine uncontested cases that no longer require IRS
    involvement and can be turned over to private collection agencies.

    Mission and Goals

    Provide America's taxpaye rs top-quality se rvice by helping them understand and
    meet their tax responsibili ties and by applying the tax law with integrity and
                                   fai rness to all.

    This mission statement reflects the IRS' priorities of supporting
    taxpayers in fulfilling their tax obligations, providing high quality
    services and information and applying and enforcing the tax laws with the
    highest standards of fairness and integrity.

    In fulfilling its mission, the IRS focuses on achieving three overarching
    strategic goals:

    Improve Ta xp a yer Se rvice Enhance Enforcement o f the Tax La w Moderni
    ze the IRS through Its People , Processes and Technology

    Each strategic goal is supported by operational objectives and annual
    performance measures. The operational objectives reflect IRS' business
    priorities; the performance measures reflect the IRS' plans to evaluate
    its ongoing success in meeting its stated objectives.

    Organization

    The IRS continues to transform its programs and activities to keep pace
    with the changing environment, taxpayer demands and new mandates. The IRS'
    primary operations are supported by four business units centered on unique
    groups of taxpayers: individual taxpayers, small business owners,
    corporations and tax-exempt and government entities. The IRS Commissioner
    and two Deputy Commissioners have oversight for all agency operations, as
    described on the following pages.

    Direct Reports to the Commissioner

    A number of business units and functions report directly to the IRS
    Commissioner. They set policies, provide leadership and direction for the
    Internal Revenue Service and provide

    2

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    support for strategic decision-making activities needed to fulfill the
    IRS' mission in administering the nation's tax laws.

    x The Office of Appeals resolves tax controversies between taxpayers and
    the IRS without litigation on a basis that is fair and impartial to both
    the Government and the taxpayer. Appeals provides an independent channel
    for taxpayers who wish to dispute a recommended enforcement action.

    x Taxpayer Advocate Service (TAS) helps taxpayers resolve problems that
    have not been resolved through regular IRS channels. TAS is an independent
    function headed by the National Taxpayer Advocate. Each state and IRS
    Service Center has at least one local Taxpayer Advocate who operates
    independently and reports directly to the National Taxpayer Advocate.
    Local Taxpayer Advocates work directly with operating divisions to
    identify and recommend solutions to systemic problems.

    x Communication and Liaison (C&L) oversees and manages the IRS' external
    communications activities with the news media, members of Congress and
    their staffs, tax professionals and practitioners as well as internal
    communications with employees. C&L also coordinates marketing and
    advertising activities on behalf of the IRS and establishes policies and
    guidelines governing communications throughout the IRS.

    x The Office of Chief Counsel provides correct and impartial
    interpretation of the Internal Revenue laws and the highest quality legal
    advice and representation for the Internal Revenue Service. The Chief
    Counsel's principal customers are the IRS Commissioner, the operating
    divisions, the functional units and the Department of the Treasury and the
    Department of Justice. Litigation and legal advice are the largest
    programs provided by Chief Counsel field office attorneys and support
    staff. Published guidance, advance case resolution and legal advice are
    the largest programs provided by attorneys and support staff in the
    National Office.

    x Research, Analysis, and Statistics (RAS) supports IRS senior management,
    operating divisions, functional units, and various research organizations,
    the Department of the Treasury and the general public by producing
    studies, program evaluations and statistical analyses of taxpayer trends
    and data and by providing research and reference tools for front line IRS
    employees.

    x Equal Employment Opportunity and Diversity (EEO&D) educates IRS
    employees about diversity and helps them understand their EEO rights and
    responsibilities, ensuring that the IRS applies civil rights laws with
    integrity and fairness to all.

    Deputy Commissioner for Services and Enforcement

    IRS tax operations are aligned into four Operating Divisions, Criminal
    Investigations and the Office of Professional Responsibility, each
    focusing on specific taxpayer constituencies and business issues. They
    report to the Deputy Commissioner for Services and Enforcement.

    3

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Wage and Investment Division (W&I) manages tax processing and customer
    service for all individual and business taxpayers and provides compliance
    services to individual taxpayers. Employees at nine campuses perform tax
    processing services. Twenty five sites provide account management
    services. Employees at five campuses perform compliance services, which
    tend to focus on dependent exemptions, credits, filing status and personal
    deductions. W&I's field operations provide information, support and
    assistance to taxpayers in fulfilling their tax obligations.

    In FY 2005, the IRS consolidated its Customer Account Services (CAS)
    units, making better use of resources and streamlining and enhancing
    communications. Consolidating the top level management structure allowed
    the IRS to continue the successes of high levels of service, decreased
    inventory and cycle times and deployment of successful web applications
    for customers while eliminating redundancies and duplication.

    x Small Business and Self Employed Division (SB/SE) serves partially or
    fully self-employed individuals with income from rents, royalties,
    pensions, annuities, partnerships, estates and trusts; small businesses,
    including corporations and partnerships, with assets up to $10 million;
    and others who file employment, excise, estate, gift, fiduciary and
    international tax returns. SB/SE has the largest compliance and
    enforcement presence in the Service, allocating 93% of its resources to
    compliance activities. SB/SE is aligned along functional lines of
    Examination, Collection, Specialty Tax Programs, Compliance
    Services/Campus Operations and Fraud/Bank Secrecy Act to provide a more
    focused approach to program delivery by making the best use of existing
    knowledge and experience, ensuring end-to-end accountability and
    leveraging the specialized expertise of the workforce.

    x Large and Mid-Size Business Division (LMSB) is the branch of the IRS
    charged with administering taxes for the largest corporations and
    partnership entities in the United States - multinational businesses with
    assets of over $10 million. LMSB serves about 54,600 corporate taxpayers
    and related entities with a combined annual tax liability approaching $200
    billion. Its workforce is structured around five "industry" groupings that
    include Communications; Technology and Media; Financial Services; Heavy
    Manufacturing and Transportation; Natural Resources and Construction; and
    Retailers, Food, Pharmaceuticals and Healthcare. Operating within this
    structure, LMSB is able to provide taxpayers with specialized, focused
    support on specific tax issues. LMSB's six thousand person workforce
    consists largely of field-based employees, including revenue agents,
    international examiners, field specialists, technical experts and various
    support personnel. Collectively, they deal with tax issues ranking among
    the most complex addressed by any division in the Internal Revenue
    Service.

    x Tax-Exempt and Government Entities Division (TE/GE) serves a wide range
    of customers including small local community organizations,
    municipalities, major universities, pension funds, state governments,
    Indian tribal governments and tax exempt bond issuers. TE/GE administers
    and enforces a variety of complex laws governing tax-exempt organizations
    and entities. TE/GE employees ensure that these tax-exempt entities
    properly adhere to applicable statutes.

    4

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Criminal Investigation (CI) enforces the criminal provisions of Internal
    Revenue Code and related statutes. Tax investigations encompass a wide
    variety of sophisticated schemes including abusive tax schemes, employment
    tax fraud, refund crimes and the failure to file required returns
    (non-filers). Further, CI's unique statutory jurisdiction and expertise
    enable it to investigate diverse crimes including money laundering,
    corporate fraud, narcotics related crimes and terrorist financing.
    Criminal Investigation is organized in 31 field offices grouped in five
    areas. Each field office is headed by a Special Agent in Charge (SAC) who
    reports to a Director of Field Operations (DFO) responsible to the
    National Headquarters. Successful prosecutions are important to the
    success of the Service's overall compliance strategies.

    x Office of Professional Responsibility (OPR) fosters excellence in tax
    professional services to taxpayers by setting, communicating and enforcing
    standards of competence, integrity and conduct.

    Deputy Commissioner for Operations Support

    IRS support functions are aligned into five support units. Each provides
    specific services, systems and processes that support tax operations.
    Support units also help facilitate efficiency improvements and
    implementation of best practices throughout the IRS. The support units
    report to the Deputy Commissioner for Operations Support.

    x Chief Information Officer (CIO) leads the Modernization and Information
    Technology Services (MITS) organization, which delivers information
    technology solutions that anticipate and meet enterprise-wide needs by
    empowering employees to deliver customer-centered, systems, products,
    services and support. The CIO advises the Deputy Commissioner for
    Operations Support on strategic technology planning, data administration,
    technology standards and privacy assurance and telecommunications issues.

    x Agency-Wide Shared Services (AWSS) delivers shared services throughout
    the IRS, including space acquisition and management, acquisition planning
    and the Employee Resource Center.

    x Human Capital Officer (HCO) supports all IRS Divisions and Functions in
    attracting, motivating and retaining quality employees to meet the needs
    of America's taxpayers and the tax administration system. HCO also
    oversees labor relations programs and various human resources functions,
    including the employee pre-complaint processing and prevention, and
    alternative dispute resolution services.

    x Chief Financial Officer (CFO) oversees the IRS' financial management,
    financial systems, strategic planning, performance measurement and
    internal controls. The CFO accounts for over $2 trillion in taxpayer
    receipts and the IRS' $10 billion annual operating budget.

    5

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Mission Assurance (MA) is responsible for the protection of taxpayer
    data and information systems and the continuing security of IRS personnel
    and facilities.

                                           6

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    II. Performance Goals and Results

    The IRS uses performance measures to determine its effectiveness in
    meeting its three strategic goals. The FY 2005 performance information
    that follows is organized by the IRS' strategic goals, highlighting
    successes and challenges.

    Strategic Goal 1: Improve Taxpayer Service

    Objectives:  f Improve service options for the tax-paying public  f
    Facilitate participation in the tax system by all sectors of the public  f
    Simplify the tax process

    Major Results, Accomplishments, and Challenges

    Taxpayer Service and Burden Reduction

    Assisting the public to understand their tax reporting and payment
    obligations is the cornerstone of taxpayer compliance. For FY 2005, the
    IRS met or exceeded performance for all (8 of 8) of its performance
    targets related to taxpayer service. The following highlights the IRS'
    performance in FY 2005:

    x Processed more than 130 million individual returns and issued more than
         99 million refunds
         totaling over $210 billion during the 2005 filing season (Tax Year
         2004).
    x Achieved an 82.6% level of service on answering toll-free calls from
         taxpayers, above the
         target of 82%.
    x Answered 33.4 million assistor telephone calls and completed nearly 25.7
         million automated
         calls.
    x Correctly responded to 89% of tax law questions and 91.5% of account
         questions received
         via the telephone.

    For FY 2005, the IRS set a record for the number of returns filed
    electronically. For the first time, more than half (68 million) of all
    individual taxpayers filed electronically, representing an 11% increase
    over FY 2004. The IRS also received a higher satisfaction rating from
    e-filers. The 2004 NOP World rating was 52%, an increase from 49% in 2003
    and a substantial increase over its lowest point of 32% in 1998. For FY
    2005, the IRS exceeded all of its performance targets related to
    electronic filing including:

    x Home computer usage to prepare and e-file tax returns increased 17.3% to
    more than 17.1 million returns. x Tax preparation professional use of
    e-file increased 11%, with 47.6 million filing electronically.

    x In its third year, the Free File Alliance, the public private
    partnership between the IRS and a consortium of tax software companies,
    saw 5 million taxpayers use the free service, a 43% increase from last
    year.

    The IRS now requires many businesses and tax-exempt organizations to file
    their returns electronically. The IRS introduced new forms for filing
    extensions for corporations and information returns for private
    foundations to the suite of electronic forms offered. The IRS

    8

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    electronically received more than 143,000 business returns from nearly
    6,000 participating providers, twice the number participating in FY 2004.

    The IRS remains committed to making it easier for all taxpayers to
    understand their filing requirements. The IRS simplified tax forms and
    instructions to allow taxpayers to fulfill their reporting obligations
    more quickly and with less frustration. As an example, Schedule C-EZ was
    designed to allow taxpayers with a small home business to report business
    expenses at a higher threshold and in a simplified format. By giving
    taxpayers an alternative to the more complex Schedule C, more than 500,000
    small business owners were able to save time and money in meeting
    reporting requirements. Similar design and procedural changes were made in
    partnership returns, unemployment tax deposits and quarterly withholding
    tax reporting requirements. The simplified forms and procedures also
    assist taxpayers by decreasing pre-filing preparation errors and reducing
    the need for post-filing error notices.

    Internet access to online forms and publications makes it easier for
    taxpayers to secure forms and find instructions. More than 4.8 billion
    "hits" registered in FY 2005 on the award-winning website, IRS.gov, a 20%
    increase over FY 2004. This increase was largely due to improved website
    functionality and an expanded selection of electronically-provided
    services. Internet tools such as the "IRS Withholding Calculator" give the
    taxpayer self-service access to information previously reported in a
    lengthy publication. More than 22 million taxpayers used the popular
    "Where's my Refund?" application to check on the status of their refunds
    this past filing season, 49% more than last year. A new feature of the
    refund inquiry application allowed taxpayers to generate replacement
    checks if the first one was lost or undeliverable due to an out-of-date
    address. The IRS also expanded electronic tax products for businesses
    through increased marketing and business e-file programs. In addition, the
    IRS expanded the suite of products and services geared toward Spanish
    speaking taxpayers including new marketing flyers, tax forms, and
    publications; toll free assistance; and accessibility through web links.

    The IRS is striving to make the Earned Income Tax Credit (EITC) easier to
    claim by eligible taxpayers. In FY 2005, the IRS deployed the EITC
    Assistant on IRS.gov. EITC Assistant is a web-based application to help
    taxpayers determine eligibility, filing status and estimated EITC amount.
    The EITC Assistant is available in English and Spanish and reflects the
    EITC tax law changes, including new income limits for EITC eligibility as
    well as the option to include nontaxable combat pay in earned income for
    the earned income credit. The IRS also deployed telephone and web
    self-service applications on IRS.gov to help taxpayers determine their
    certification status and explain determinations made during the
    certification process. IRS enhanced the EITC Online Toolkit for tax
    professionals and launched EITC messages on Housing and Urban Development
    (HUD) kiosks in over 100 locations nationwide.

    Modernizing the IRS' antiquated business systems and identifying new
    opportunities to provide taxpayers with e-Government functionality are key
    components of taxpayer service. A robust and secure infrastructure will
    improve services - both to taxpayers and other government agencies and
    will give the IRS the speed, security, and functionality to keep pace with
    a modern and increasingly electronic economy.

    The IRS continues to provide alternative services to assist taxpayers that
    do not have Internet access or are not in close proximity to established
    walk-in Taxpayer Assistance Centers. The IRS, through its partners,
    operates 38 self-help kiosks in 20 states and increases service

    9

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    options during the filing season by offering service in alternate
    locations such as shopping malls, libraries and other government offices.
    The Volunteer Income Tax Assistance (VITA) and Tax Counseling for the
    Elderly (TCE) partner programs provide Internet access to participants as
    part of their services. In FY 2005, the VITA/TCE partnerships experienced
    a 10% (71% to 78%) increase over FY 2004 in e-file usage with almost 86%
    of VITA returns and nearly 70% of TCE returns filed electronically.

    During FY 2006, the IRS will continue to seek alternative, less costly
    ways to address the challenge of improving taxpayer service. The following
    discussion addresses two of the most significant challenges for the IRS.

    Delivering cost effective and efficient services needed to meet the
    demands of diverse taxpayer segments remains a challenge for the IRS,
    particularly in today's constrained budget environment. The IRS will
    employ highly integrated and targeted service, balancing accessibility and
    ease of use to reduce taxpayers' burden in complying with the tax laws
    through continued research and evaluation of taxpayer service needs,
    priorities, and preferences for obtaining information or services. The IRS
    will seek opportunities to invest in technology, process improvement and
    training to achieve consistent quality of service with reduced unit
    delivery costs.

    Achieving the goal of having taxpayers submit 80% of all filings,
    information, and returns, electronically by FY 2007 remains a significant
    challenge. While the e-filing rate continues to increase, it is only this
    past year in FY 2005, that more than half of all individual tax returns
    were filed electronically. The IRS is considering mandating e-filing for
    certain groups, by regulation or legislation, to ensure increased
    e-filing. Also, the Administration's proposal to extend the April filing
    date for electronically-filed tax returns to April 30, if enacted, may
    also increase electronic filing. But without a legislative change to
    mandate electronic filing, the challenge remains one of identifying
    options to encourage more of the taxpaying public to e-file. For example,
    many taxpayers use tax preparation software to prepare their returns, but
    then print out and mail in the return. The IRS must develop additional
    strategies to induce more of these taxpayers and preparers to take the
    next step and file electronically.

    Hurricane Katrina Support

    IRS assisted taxpayers following the wake of Hurricane Katrina by granting
    tax filing and payment relief to all affected taxpayers. Over 4,100 IRS
    employees helped FEMA register hurricane victims by opening a dedicated
    toll-free disaster phone line and providing a special information section
    on the IRS web site. As of September 30, 2005, IRS employees have answered
    more than 706,246 registration calls for FEMA, more than 30,000 calls on
    the special IRS toll-free line and provided over 163,864 disaster relief
    kits.

    Following are key indicators the Service uses to measure success in
    improving taxpayer service from the IRS Strategic Plan for 2005 through
    2009.

    Customer Satisfaction Data

    The IRS determines its customers' overall level of satisfaction of its
    programs and services primarily through telephone and mail surveys. Data
    are also captured for the IRS by the University of Michigan Business
    School's National Quality Research Center for the American

    10

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Customer Satisfaction Index and by NOP World, formerly Roper Starch
    Worldwide, a public opinion polling firm.

    On the 2004 American Customer Satisfaction Index Survey (ACSI), the IRS
    received an overall score of 64 out of a possible 100 for All Individual
    Tax Filers, a 25% increase over the 1999 score of 51. This survey reports
    satisfaction with IRS variables, such as timeliness, accessibility,
    courtesy and professionalism. Individual taxpayers are significantly more
    satisfied with the e-file return process than with paper filing. The 2004
    annual rating for IRS in the NOP World favorability survey (the percentage
    of the public that has a favorable opinion of the IRS as compared with
    most federal agencies) was 52%, up from 49% in 2003 and a substantial
    increase over its lowest point of 32% in 1998.

    Rate of Accuracy

    Customer Accuracy measures how often customers received the correct answer
    to their inquiry and/or had their case resolved correctly based upon all
    available information and Internal Revenue Manual (IRM) required actions.

    The IRS exceeded its performance targets for both Toll Free Tax Law and
    Toll Free Account accuracy measures in FY 2005, with Tax Law measuring 89%
    and Accounts measuring 91.5%. Improvements in the scores are attributed to
    numerous process changes implemented in FY 2005 such as an improved Probe
    and Response Guide, the roll-out of Contact Recording (recording of calls
    for manager/employee feedback) and training assistors on the full scope of
    accounts-related inquiries.

    Level of Service

    The IRS measures Level of Service as the relative success rate of
    taxpayers that call for toll-free services seeking assistance from a
    Customer Service Representative (CSR). Improved efforts in training and
    modernizing raised the level of service for those taxpayers who want to
    speak to an assistor to 82.6%. The IRS will continue to staff toll free
    call sites to achieve the CSR Level of Service target of 82% based on the
    number of calls it expects to answer.

    Rate of Electronic Interaction

    The IRS measures the rate of interaction for both individual and business
    returns. For the first time, over half of individual returns were filed
    electronically, an 11% increase from the previous year. FY 2005
    performance for business returns achieved a 17.8% participation rate and
    is expected to grow further as more filing choices are developed for
    business tax return filers.

    Timeliness of Responding to Customer Inquiries

    The IRS measures the time taxpayers wait on the telephone when calling the
    IRS about their accounts, inquiring about tax laws when preparing tax
    returns, as well as the time from account creation to disposition for
    taxpayers needing account resolution assistance. Additional measures
    calculate the response time for those taxpayers who communicate
    electronically with the IRS.

    In FY 2005, the IRS customer assistance call centers received over 59
    million calls. Improvement efforts such as replacing paper processes with
    electronic ones reduced calls and lessened the need for contacting the
    IRS. This, plus quality control revisions, raised the level of service for
    the taxpayers who speak to an assistor to an unusually high 87% in FY
    2004. For FY 2005, the IRS achieved the target of 82%, a reasonable target
    that is more in line with

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    previous performance while continuing to reflect gradual improvement.
    Although the average time callers spent waiting for telephone assistance
    has dropped steadily over the last few years, the IRS experienced an
    increase in call waiting times based on increased demand and its plan to
    stabilize resources dedicated to telephone services.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Percent Individual Returns Processed Electronically

          FY 2002        FY 2003        FY 2004                FY 2005
           Actual         Actual         Actual           Plan          Actual
           36.0%          40.0%          47.0%           51.0%          51.1%

    FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005
    target.

    Future Plans: E-file participation rates are expected to increase to over
    55% in 2006, based on current experience, historical growth, increased
    advertising, marketing and expanded e-file programs, including free
    Internet filing through the Free File Alliance.

    9. Percent Business Returns Processed Electronically

    Description: The percentage of total number of business returns accepted
    electronically (posted to Business Master File) divided by the total
    returns received through all sources at IRS sites.

    Percent Business Returns Processed Electronically

    FY 2002

    FY 2003

                                        FY 2004

    FY 2005 Actual

    Actual

                                         Actual

    Plan

    Actual 17.4%

    17.0%

    17.8%

    FY 2005 Performance: Target Achieved. The IRS met/exceeded the FY 2005
    target.

    Future Plans: The IRS expects the percent of business filers to increase
    in the future due to increased marketing; expanded business e-file
    programs, including the acceptance of new forms and schedules attached to
    employer, estates and trusts, and partnership tax returns; acceptance of
    amended returns; and acceptance of the new annualized employment tax
    return.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Strategic Goal 2: Enhance Enforcement of the Tax Law

    Objectives:

    f   Discourage and deter non-compliance with emphasis on corrosive
           activity by corporations,
           high-income individual taxpayers and other contributors to the Tax Gap
           Ensure that attorneys, accountants and other tax practitioners adhere
    f   to professional
           standards and follow the law
    f f Detect and deter domestic and offshore-based tax and financial
           criminal activity Deter abuse within Tax-Exempt and Governmental
           Entities and misuse of such entities by
           third parties for tax-avoidance or other unintended purposes

    Major Results, Accomplishments, and Challenges

    Tax Revenue Collected

    The majority of the revenue the IRS collects is paid voluntarily. In FY
    2005, the IRS collected more than two trillion dollars in revenue with a
    record $47.3 billion collected through enforcement activities, a 9.7%
    increase from FY 2004. The $47.3 billion in enforcement revenue was
    collected through concerted efforts by the IRS to detect and deter
    non-compliance with the tax code.

    Reducing the tax gap (the difference between what taxpayers should pay and
    what they actually pay) is at the heart of the IRS' renewed emphasis on
    enforcement and serves as a means to reducing our nation's deficit. The
    tax gap measures the extent to which taxpayers do not pay their correct
    tax liability on time, either because they do not file a required tax
    return on time, do not pay on time the amount of tax that they report on
    their timely return, or most importantly, fail to accurately report their
    correct tax liability on their timely return.

    Underreporting of income taxes, employment taxes and other taxes
    represents about 80% of the tax gap as noted in the March 2005 release of
    the IRS' preliminary tax gap estimates for Tax Year 2001. The single
    largest sub-component of underreporting involves the individual income
    tax, with individuals understating their incomes, taking improper
    deductions, overstating business expenses or erroneously claiming credits.
    The National Research Program (NRP) study further confirmed that the
    majority of understated income comes from business activities, not wage or
    investment income. By the end of December 2005, the IRS expects to provide
    detailed estimates of individual income tax non-compliance based largely
    on an analysis of the NRP data.

    The IRS is primarily focusing its attention on corrosive activities
    conducted by corporations, high income taxpayers and other major
    contributors to the tax gap. The IRS will use data collected from the NRP
    study on individual taxpayers to ensure its audits of individuals are
    focused on the most noncompliant returns. Targeting high-risk taxpayers
    should improve IRS efficiency and reduce the burden on compliant
    taxpayers. It will also increase and focus the IRS' enforcement presence
    where it is most needed.

    Reducing the tax gap is the IRS' most significant challenge. In FY 2006,
    the IRS will continue to target its case work and enforcement activities
    to more effectively deliver results and drive down the tax gap. The IRS
    will focus its analysis of tax information and data from compliance

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    research studies to better define and quantify the tax gap. The IRS will
    use the results of these efforts to better understand and counter the
    methods and means of those taxpayers who fail to report or pay what they
    owe.

    Enforcement Activities

    The IRS met or achieved 69% (9 of 13) of its enforcement-related
    performance targets in FY 2005. These results were achieved through
    streamlining and centralizing work processes, improving workload selection
    techniques and increasing managerial involvement in casework. The IRS
    emphasized efficiency and implemented initiatives to reduce cycle time,
    such as refining case selection criteria. Closely monitoring resources and
    inventories, a focus on case quality and the use of embedded quality
    reports and data to drive improvement efforts also contributed to this
    success. As a result, the IRS completed over 215,000 high-income audits
    (taxpayers earning $100,000 or more) in FY 2005, 10% more than the
    previous year and more than twice as many than in FY 2001. Total audits of
    all taxpayers exceeded 1 million in 2005 for the second consecutive year,
    a 20% increase from FY 2004.

    The IRS audited 81% more small business and 15% more corporations in FY
    2005, a significant achievement given the size (more than $10 million) and
    complexity of these corporate entities. The IRS also expanded examination
    coverage by increasing its focus on identification of limited
    non-compliant corporate returns and the development of strategies to
    address issues at the entity level instead of the return level. A
    reinforced focus on case quality helped the IRS deliver improved business
    results for the second consecutive year.

    Prominent settlement initiatives (offered to taxpayers before the IRS
    initiated an audit) generated more than $4.7 billion in additional revenue
    in FY 2005. One significant tax shelter case worth noting was the Son of
    Boss, in which more than 1,200 qualified taxpayers elected to participate
    in a settlement offer. The taxes, interest and penalties collected from
    the Son of Boss settlement offer have exceeded $3.7 billion. A second
    settlement initiative is underway, in cooperation with the Securities and
    Exchange Commission. This abusive tax transaction involves the transfer of
    executive stock options or restricted family stock to family-controlled
    entities for the personal benefit of executives. At least 42 companies and
    700 executives participated in this abusive practice, resulting in the
    collection of $1 billion through September 2005.

    The IRS increased audit coverage of those responsible for the promotion
    and use of abusive tax schemes and avoidance transactions. During the past
    five years, the IRS identified more than 200,000 questionable returns
    prepared by practitioners on behalf of their clients. These returns
    claimed over $700 million in refunds. Since August 2002, the IRS completed
    more than 98,000 audits and assessed more than $200 million in additional
    tax as a result of the on-going return preparer investigations.

    The IRS Criminal Investigation Division (CID) leveraged its
    Counterterrorism Program effectively to achieve its core mission, while
    simultaneously supporting the war on terrorism. The IRS participated in
    interagency counter-terrorism efforts, providing technical assistance in
    terrorism-related investigations, examining foreign grants, and matching
    third party information. The IRS also undertook a study of tax-exempt
    organizations with foreign grants and operations to determine how well
    internationally-oriented U.S. charities are protecting their assets from
    diversion and compliance with tax laws. In FY 2005, CID recommended 86
    cases for

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    prosecution, of which 67 resulted in indictments or other forms of action.
    Approximately 50% of CID's inventory of terrorism related cases has a tax
    related violation under investigation.

    In FY 2005, the IRS also improved its collection performance by improving
    workload selection techniques, reengineering outdated processes to account
    for improved case selection tools, deploying centralized processing to
    reduce overhead in the internal support functions and increased managerial
    presence in review of case decisions. Improved case selection tools
    including risk-based modeling are a critical component for ensuring timely
    processing of appropriate cases of the Collection Program's inventory. For
    example, employment taxes (also known as trust fund or payroll) are at
    high risk for non-compliance and one of IRS' collection priorities due to
    rapid pyramiding of quarterly employment tax liabilities. Risk based
    modeling reveals the best opportunity for bringing an employer with
    multiple delinquent quarters (pyramiding) back into full compliance is
    early intervention. Collection's inventory delivery system factored
    pyramiding into case assignment rules, ensuring earlier assignment of
    cases meeting these criteria and to stem growth in the overall collection
    inventory. The IRS also reduced its inventory growth through timely and
    appropriate filing of Notices of Federal Tax Lien. Educating taxpayers
    about lien subordination, discharge, posting bonds or other collateral
    where appropriate has aided taxpayers in satisfying their outstanding
    liabilities, increasing compliance. As a result of these efforts, the IRS
    collected 14% more revenue and closed 12% more cases compared to FY 2004.

    Moving forward in FY 2006 and beyond, the IRS will continue to identify
    effective enforcement strategies necessary to target growing and
    increasingly complex corrosive tax schemes.

    An enforcement priority for the IRS is to deter and prevent abusive tax
    avoidance transactions or tax motivated transactions that are corrosive to
    the equity and the fairness of the tax law for all taxpayers. Vigorous
    enforcement of the criminal provisions of the Internal Revenue Code,
    coupled with appropriate civil sanctions, materially contributes to
    maintaining voluntary compliance and public confidence in the fairness of
    the tax system. Tax shelter promoters continue to modify schemes, making
    it difficult to detect patterns and identify participants on a timely
    basis. Because these types of transactions present unacceptable tax
    avoidance behavior, the IRS needs to continue efforts to identify them
    timely and to make the public aware of the IRS' concerns.

    Recent trends indicate that the tax shelter population will continue to
    expand to small to midsize corporations where the issues will be more
    difficult to identify and examine. Large corporate taxpayers are
    increasingly engaging in structured transactions designed individually for
    them, thereby avoiding some of the provisions allowing early
    identification. These structured transactions involve highly complex fact
    patterns and large dollar issues. Promoters of tax shelters are migrating
    from the large accounting firms to firms and businesses that specialize in
    tax shelters. These promoters are less compliant for registration and less
    stable in their business operations, making it more difficult to pursue
    them for information and for penalties.

    The number of fraudulent refund claims continues to escalate. For the 2005
    processing year, the IRS identified approximately $451 million of
    fraudulent refund claims for individuals. Return preparer fraud continues
    to be one of the IRS' key investigative priorities as well. The current
    inventory of return preparer investigations represents a five-year high.
    As of August 2005, subject criminal investigation initiations increased
    approximately 22% over the same time period in 2004. For tax return
    processing year 2005, IRS fraud detection centers identified more than

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    33,000 questionable client returns associated with unscrupulous tax return
    preparers, claiming approximately $103 million in refunds. Key to
    effective detection and deterrence of these fraudulent claims is the need
    to invest in new technology.

    Following are the key indicators the Service uses to measure success in
    enhancing enforcement of the tax law from the IRS Strategic Plan for 2005
    through 2009.

    Percent of Priority Guidance List Items Published

    The 2004-2005 Guidance Priority List (GPL) included 283 projects, focusing
    resources on guidance items most important to taxpayers and tax
    administration. Sixty-six additional items were added during the course of
    the plan year (July 1, 2004 - June 30, 2005). The IRS' 2005 goal was to
    publish 76% of the Guidance Priority List; final performance shows 211
    items were published, 75% of the original and 60% of the final GPL.

    The IRS did not meet its goal in part due to a shift in priorities
    necessitated by enactment (October 2004) of the American Jobs Creation Act
    of 2004 (AJCA) which required immediate implementation. The AJCA made
    sweeping changes in corporate and international taxation and 97% of the
    provisions were effective before, on, or within six months of the date of
    enactment. One hundred seventy eight new provisions required IRS to issue
    guidance to help taxpayers understand key concepts of the act.

    The Office of Chief Counsel will continue to monitor and prepare for
    legislation resulting from the President's tax reform initiative.
    Fundamental reform would affect all aspects of the economy and all
    taxpayers. The IRS and Counsel will support the Treasury Department in its
    efforts to craft and evaluate different reform options by assessing
    administrative and technical issues.

    Percent of Americans Who Think it is OK to Cheat on Taxes

    The IRS Oversight Board conducts an annual NOP World survey to assess the
    public's perceptions about tax compliance. The survey was initially
    conducted in 1999 and has been repeated each year since 2001. Results from
    the 2005 survey are expected in January 2006. In 2004, 86% of taxpayers
    (up five points from 2003), continued to believe that it is "not at all"
    acceptable to cheat on income taxes. More taxpayers (73%, up 4 points from
    2003 and down 8 points from the 1999 high point) completely agreed that it
    is everyone's civic duty to pay their fair share of taxes and that
    everyone who cheats should be held accountable (62%, up 2 points from
    2003).

    Average Cycle Time

    A measure of the length of time from receipt of a case for audit or
    collection until the audit or collection activity is completed; average
    cycle time is computed on audits of individuals, small and large business
    entities and tax-exempt entities.

    The IRS' principal strategy is reducing the Months-In-Group cycle time;
    i.e., the portion of the overall cycle time when the return is actually
    under examination within a field group. Over the past two years, the IRS
    has realized an 18% improvement in Industry Months-In-Group cycle time and
    a 15% improvement in Coordinated Industry Months-In-Group cycle time.
    Several new initiatives, such as the Appeals/LMSB Joint Cycle Time
    Measure, increased Fast Track Appeals, more limited scope examinations and
    electronic filing, are underway or in place to reduce overall cycle time.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    The mix of examination inventory is complex, with growing numbers of tax
    shelter, partnership and joint committee returns, which have longer cycle
    times than less risky return categories. The IRS uses several strategies,
    such as Modernized e-Filing, better return risk assessment and
    Months-in-Group cycle time to counteract the negative influence of these
    long cycle time, high-risk return categories on overall cycle times.

    The IRS' Field Collection organization has made great strides in reducing
    cycle time in FY 2005. For non-payment cases, the cycle time was reduced
    from 42 weeks to 36 weeks, a 16% reduction.

    Rate of Reporting Compliance

    The Rate of Reporting Compliance or the Voluntary Reporting Rate (VRR) is
    defined as the amount of individual income tax that is reported on
    timely-filed returns for a given tax year, expressed as a percentage of
    the amount of tax liability that should have been reported on those
    returns. The IRS has made preliminary estimates of the Tax Year 2001 VRR
    based on the recently completed National Research Program study of
    individual income tax reporting compliance. Preliminary estimates range
    from 82% to 85%, roughly consistent with estimates from similar studies
    for earlier years. Final estimates are due at the end of 2005. Estimates
    of the amount of Tax Year 2001 individual income tax that was
    underreported range from $150 billion to $187 billion.

    Rate of Filing Compliance

    The timely filing rate is the percentage of required returns that are
    filed timely for a given tax year. This rate for individual taxpayers is
    computed by dividing the estimated number of required returns filed on
    time for a given tax year by the estimated number of all individual
    returns required to be filed for that year. The IRS' latest estimate of
    the timely filing rate was 88.9% for Tax Year 2001.

    Rate of Payment Compliance

    The voluntary payment compliance rate is the percentage of the total tax
    liability reported on timely filed returns that is paid in a timely
    manner. The voluntary payment compliance rate is

    98.9 percent for Tax Year 2003, which is a slight improvement over Tax
    Year 2002.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Strategic Goal 3: Modernize the IRS through its people, processes and
    technology

    Objectives:

    f   Increase organizational capacity to enable full engagement and maximum
           productivity of
           employees Modernize information systems to improve service and
           enforcement Ensure the safety and security of people, facilities and
    f f information Modernize business processes and align the infrastructure
    f   support to maximize resources
           devoted to front-line operations

    Major Results, Accomplishments and Challenges

    Ensuring Organizational Effectiveness

    The IRS faces high expectations for the level of service and enforcement
    required for the fair and uniform application of tax laws. Each year, IRS
    employees contact millions of taxpayers. In each of these contacts, the
    IRS strives to maintain a level of professionalism and integrity that will
    assure taxpayers of competent, efficient and respectful treatment. The IRS
    is improving accuracy of responses to taxpayer inquiries, increasing the
    clarity of communications and providing taxpayers and their paid preparers
    with requested resources on a timely basis.

    Workforce planning is a significant challenge. With a diverse population
    of more than 100,000 employees and more than 700 duty stations across the
    country, the IRS works continuously to ensure that its employees are in
    the right place at the right time and have the skills and competencies
    needed to accomplish the IRS mission. The expansion of pay-for-performance
    provides a higher degree of accountability in the workforce and numerous
    training and leadership programs improve the overall level of
    professionalism. The IRS established a trained core recruitment group that
    is responsible for attracting excellence in potential employees. This
    cadre works to maintain partnerships with many colleges and universities
    and attends campus and commercial events around the country to promote the
    benefits of becoming an IRS employee.

    The IRS continued its workforce restructuring to achieve both the optimum
    mix of skills within the IRS and the optimum number of employees that
    directly support tax processing, administration and compliance functions.
    The IRS continues to ensure an adequate talent pool to administer the tax
    law as a primary component in maintaining the integrity and excellence of
    the workforce. In FY 2005, the IRS achieved efficiencies in filing
    technology and in overhead functions. More importantly, the percentage of
    the IRS workforce engaged in compliance-related work increased from 48% to
    50% of the workforce in FY 2005. This shift was possible because of cost
    reductions provided by increased electronic filing and through the
    restructuring of administrative areas. While the number of IRS employees
    has decreased overall, the IRS has been able to maintain or increase
    employment in the key compliance occupations of revenue agents, revenue
    officers, and special agents.

    The IRS recognizes that its workforce is maturing and that significant
    numbers of employees will soon be eligible to retire. Analysis of
    workforce data shows that the most problematic area is the projected
    attrition of senior leadership. To ensure continuity of leadership, the
    IRS launched a comprehensive leadership succession planning initiative.
    The first phase of the initiative

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
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    included an assessment of 103 executives to measure and benchmark
    competency strengths and weaknesses. Additional efforts to address the
    aging workforce challenge include hiring initiatives to ensure that the
    IRS maintains the appropriate level of employees in mission-critical
    occupations necessary to achieve its mission.

    Modernization

    The IRS successfully deployed the new Integrated Financial System (IFS) at
    the start of FY 2005. The IFS serves as the "core" administrative
    financial management system. The major components of IFS are accounts
    payable, accounts receivable, budget formulation, budget execution,
    general ledger, financial statements and cost accounting. The IFS is a
    fully integrated, customized commercial off-the-shelf (COTS) software
    package designed to provide IRS with more accurate and timely financial
    and cost information and improved compliance with legislative and
    regulatory requirements. Today there are thousands of procurement
    commitments, obligations and receipt/acceptance documents being processed
    through the new IFS system. The IRS successfully maintained its record of
    submitting the monthly SF-224 and the monthly Treasury Information
    Executive Repository (TIER) files to Treasury on time since going live.

    The IRS Business Systems Modernization (BSM) program improved its success
    in delivering projects, attaining cost and schedule targets, realizing
    benefits to taxpayers and improving BSM program management capabilities.
    After re-baselining in late 2004, the BSM program delivered most projects
    and releases in FY 2005 on time, on budget and met or exceeded the scope
    of expectations.

    In FY 2005, the IRS modernization efforts focused on three key tax
    administration systems that provided additional benefits to taxpayers and
    IRS employees, specifically: the Customer Account Data Engine (CADE)
    project; Modernized e-File; and Filing and Payment Compliance (F&PC).

    CADE replaces the IRS' antiquated system called the Master File, which is
    the repository of taxpayer information. CADE allows faster refunds (CADE
    processes refunds on a daily basis), improved taxpayer service, faster
    issue detection, more timely account settlement, and a robust foundation
    for integrated and flexible modernized systems. More than 1.4 million
    returns were posted with more than $427 million in refunds generated. Next
    year, CADE should be able to process over twice as many returns. It will
    be the single authoritative repository for account and return data.

    Modernized e-File (MeF) deployed Form 7004 (filing extension for
    corporations) as well as Form 990PF (information return for private
    foundations). This allowed the IRS to establish regulations requiring
    large corporations and tax-exempt organizations to electronically file
    their income tax or annual information returns. Through September 2005,
    MeF is processing 1120 and 990 returns at higher-than-expected volumes
    while still achieving performance goals - a significant reduction in
    burden and time for corporate and tax-exempt taxpayers.

    The IRS completed architecture engineering analysis and development of a
    limited functionality release for Filing & Payment Compliance (F&PC)
    Release 1.1 designed to separate complex cases requiring direct IRS
    involvement from those that can be handled by private collection

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    agencies (PCAs). This release will provide initial capabilities for
    competitive outsourcing of collection activities in FY 2006.

    In 2004, Congress passed the American Jobs Creation Act, a provision of
    which allows the IRS to use Private Collection Agencies (PCAs). The
    current volume of delinquent taxpayers exceeds the IRS' capacity and
    results in a serious backlog of collection cases that cannot be adequately
    addressed with current resources. This backlog represents lost revenue
    opportunities and undermines the fairness of the tax system. The
    legislation authorized the IRS to augment its collection efforts by using
    PCAs to pursue undisputed, uncollectible tax liabilities. PCAs will not
    have enforcement authority and will only contact delinquent taxpayers to
    arrange voluntary, full-payment installment agreements.

    In FY 2005, the IRS implemented new network management software, an
    off-the-shelf product called "CiscoWorks." Results of the new network
    management tools include:

    x Improved service and network performance to all customers through
    reduced configuration

    errors, enhanced security and network management capabilities; x
    Streamlined access to troubleshooting reports that a year ago would
    usually have required

    multiple logons and hours of time; x Reduced cost of audits; x Increased
    efficiency through improved configuration controls; and x Assurance of
    stable and predictable network performance for all business units.

    To address its modernization challenges, the IRS updated a strategic
    vision for the BSM's future beyond 2007 and setting goals for the year
    2010 that align with and support the IRS Strategic Plan. The FY 2006 BSM
    portfolio will focus on delivery of three major tax administration
    projects (highlighted below), along with infrastructure initiatives and
    continued improvement to program management operations. Each Tax
    Administration project will address a core IRS strategic priority. Program
    operations will continue to focus on improving program performance;
    improving and streamlining management process disciplines; and ensuring
    delivery of projects on time, on budget, and on scope by taking a greater
    ownership and leadership role in managing the BSM program.

     prepare
           for the expanding taxpayer base served through combined Federal and
           State processing of tax returns. BSM also continues working on access
           capabilities for disabled taxpayers through e-Services upgrade of the
           PeopleSoft Commercial Off-the-Shelf application.
    , are managed well and are productive. Data
    used to determine this result is taken from the IRS' annual employee
    satisfaction survey.

    In 2005, more than 57,000 employees participated in the annual Employee
    Engagement Survey. The scores improved on all questions. The IRS uses the
    response to the following question, "Considering everything, how satisfied
    are you with your job?" as a broad indicator of employee satisfaction. In
    2005, over 64% of employees were very satisfied or extremely satisfied
    with their job compared to 60% in 2004.

    The IRS continued its strong improvement on survey items especially the
    categories of receiving recognition and feedback on progress. The IRS will
    provide results of "SURVEY2005" to employees for discussions in
    workgroups, with subsequent action plans developed to ensure continued
    improved working conditions. Responses to questions about training and
    development also continued to improve.

    For the second year in a row, over 65% of employees who took the survey
    reported that they participated in team feedback and action planning
    sessions. Team feedback and action planning sessions are a crucial part of
    the employee satisfaction process. Employees who participated in these
    meetings also reported much higher levels of satisfaction than employees
    who did not. Each IRS business unit is encouraged to identify one or two
    specific areas of the survey that will be the focus of concentrated
    improvement actions. In prior years, this approach proved to be very
    beneficial for a number of business units.

    The addition to the employee scholarship program targeted at key staffing
    needs reinforces the IRS' commitment to employee development. The Human
    Resources Investment Fund (HRIF), established in response to earlier
    employee feedback about training needs, also continues as a complement to
    the scholarship program.

    Index of Employee Perceptions of Performance Management System

    This is an index based on how employees responded to specific questions on
    the Federal Human Capital Survey (FHCS) conducted annually by the Office
    of Personnel Management. The questions relate to employee perceptions
    regarding how well the organization rewards good performance and addresses
    poor performance. The IRS has developed target levels for this index and a
    2005 goal from which to assess its current performance. The IRS has not
    received the results of the latest survey as of the date of this report.

    Ratio of Mission-Critical Occupations (MCO) Employees to Non-MCO Employees

    This is the proportion of staff employed in mission critical areas, those
    that support tax processing, administration and compliance, compared to
    non-mission critical areas. This indicator will help the IRS determine if
    its staffing and employee development initiatives result in the
    appropriate level of talent assigned to MCOs in support of the IRS'
    mission and goals. The IRS has developed target levels for this indicator
    which it uses to assess its actual performance.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
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    The target MCO/non-MCO ratio for FY 2005 is 64%. The ratio reported at the
    end of FY 2005 was 62.9%.

    Benchmark IT Services and Development to Private Industry Standards for
    Cost, Scheduling, and Functionality

    MITS has developed performance measures that will be monitored from the
    CIO level down to the operational levels. These measures will provide
    comprehensive management information to executives to monitor success at
    meeting performance targets keyed to industry best practices. This
    measures development effort has been far more comprehensive than any ever
    conducted in MITS and includes over 250 measures and metrics at various
    organizational levels. In addition, MITS established a comprehensive time
    reporting system/work planning and control system and has undertaken the
    development of a comprehensive cost accounting system. Presently, the IRS
    is halfway through the decomposition phase on this effort and will
    ultimately quantify the relationship between all MITS products and
    services and their related costs.

                                           33

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    New Measures

    The following measures are reported for the first time in the FY 2005
    MD&A:

    Timeliness of Critical Other Tax Products to the Public Percent Business
    Returns Processed Electronically Examination Coverage - Individual
    Examination Coverage - Business Examination Efficiency - Individual
    Collection Coverage - Units Collection Efficiency - Units Field Collection
    Quality of Cases Handled in Person

    Discontinued Measures

    In the first quarter of FY 2005, the Department of the Treasury launched a
    process to streamline its current set of performance measures. Its purpose
    was to increase the value of the information provided to stakeholders,
    respond to congressional requests, focus priorities and reduce
    administrative burden. Results of the process indicated a 60-70% reduction
    in the number of performance measures overall at the Treasury level. At
    the bureau level, measures that are no longer included in the budget
    submission are classified as "discontinued," and are indicated as such.
    These measures are only discontinued for external reporting purposes; the
    IRS will continue to internally collect and monitor these measures.

    Customer Accuracy - Customer Accounts Resolved (Adjustments) Percent
    Tickets Resolved on Time Field Assistance Accuracy of Tax Law Contacts
    Percent Resolution at First Contact Toll Free Customer Satisfaction Field
    Assistance Customer Satisfaction Field TDA Closures Field TDI Closures
    Field Collection Customer Satisfaction Compliance Services Collection
    Operation Accuracy ACS (TDA and TDI Closures) ACS Customer Satisfaction
    Automated Underreporter Case Accuracy Automated Underreporter - Cases
    Closed Correspondence Examination non EITC Returns Examined Correspondence
    Exam - Customer Satisfaction Correspondence Exam Accuracy Business Returns
    Examined Individual Returns Examined (> $100,000 and < $100,000)
    Examination Customer Satisfaction (SBSE) Examination Customer Satisfaction
    (LMSB) EP/EO Examination Case Quality EP/EO Customer Satisfaction Number
    of TEGE Compliance Contacts Appeals Closure to Receipt Ratio Taxpayer
    Advocate Closure to Receipt Ratio Contracted Program Cost & Schedule
    Variance (* not reported internally or externally) Contracted Requirements
    Stability & Contracted Requirements Delivered (*)

    35

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    III. System Controls and Legal Compliance

    Federal Managers' Financial Integrity Act (FMFIA)

    During FY 2005, the Internal Revenue Service (IRS) complied with the
    control requirements of the Federal Managers' Financial Integrity Act
    (FMFIA) and the Reports Consolidation Act of 2000. The IRS also complied
    with the review requirements of the Federal Financial Management
    Improvement Act (FFMIA). The systems of management controls for the IRS
    organizations are designed to ensure that:

    3/4 Programs achieve their intended results  3/4 Resources are used
    consistent with the overall mission  3/4 Programs and resources are free
    from waste, fraud, and mismanagement  3/4 Laws and regulations are
    followed  3/4 Controls are sufficient to minimize improper and erroneous
    payments  3/4 Performance information is reliable  3/4 System security is
    in substantial compliance with all relevant requirements  3/4 Continuity
    of operations planning in critical areas is sufficient to reduce risk to
    reasonable

    levels

    The number of open material weaknesses for IRS is five. Because the IRS
    has remaining material weaknesses and the IRS' financial management
    systems do not substantially comply with FFMIA, the IRS provides qualified
    assurance that the above listed systems of management control objectives
    were achieved by the IRS during FY 2005. This assurance is provided
    relative to Sections 2 and 4 of FMFIA.

    The material weaknesses are:

    3/4 Collection of Unpaid Taxes  3/4 Improve Modernization Management
    Controls and Processes  3/4 Financial Accounting of Revenue-Custodial  3/4
    Earned Income Tax Credit Non-Compliance  3/4 Computer Security

    Federal Financial Management Improvement Act (FFMIA)

    As of September 30, 2005, the Service's financial management systems did
    not substantially comply with the FFMIA. Remediation Plans for Custodial
    and Administrative Financial Systems are in place to resolve this
    condition. The IRS has improved its financial management systems'
    compliance with FFMIA. In FY 2005, the IRS implemented the Integrated
    Financial System which corrected many administrative accounting
    deficiencies. The IRS developed a plan to improve custodial accounting
    through the Custodial Detail Data Base project.

                                           36

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Laws and Regulations

    As of September 30, 2005, the IRS did not always comply with section 6325
    of the Internal Revenue Code regarding the release of federal tax liens.
    An action plan to address the non compliance issue is being monitored by
    the Financial and Management Controls Executive Steering Committee.

    Reports Consolidation Act of 2000

    In accordance with the Reports Consolidation Act of 2000, the IRS provides
    assurance that the critical performance measures are reliable. Internal
    Revenue Manual 1.5, "Managing Statistics in a Balanced Measurement System
    Handbook," provides a detailed measures template that documents each
    measure's definition, formula, reliability, and reporting frequency. These
    controls ensure the data are consistently and accurately collected over
    time.

    Continuity of Operations

    During FY 2005, the IRS took action to enhance the compliance of IRS
    computer systems with the Federal Information Security Management Act
    (FISMA). The IRS established FISMA project offices in each business unit
    and focused attention on resolution of the computer security material
    weakness and other system security weaknesses. Substantial progress was
    made in this area, as over 90 percent of IRS general support systems
    completed full certification and accreditation by September 1, 2005. In
    addition, the IRS initiated a major effort to update the security
    documentation and complete rigorous security testing on all Service
    systems. This effort will continue through FY 2006.

    Limitations of the Financial Statements

    The principal financial statements have been prepared to report the
    financial position and results of operations of the entity, pursuant to
    the requirements of 31 U.S.C. 3515(b). While the statements have been
    prepared from the books and records of the entity in accordance with
    generally accepted accounting principles (GAAP) for Federal entities and
    the format prescribed by the Office of Management and Budget, the
    statements are in addition to the financial reports used to monitor and
    control budgetary resources, which are prepared from the same books and
    records. The statements should be read with the realization that they are
    for a component of the U.S. Government, a sovereign entity.

                                           37

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    IV. Future Challenges

    As the IRS begins FY 2006, it is faced with challenges, both from within
    and outside of its organization. The following discussion identifies some
    of the most significant challenges.

    Abusive Tax Shelters

    Abusive Tax Avoidance Transactions (ATAT) remain a challenge and a high
    enforcement priority for the IRS. These tax motivated transactions are
    corrosive to the equity and the fairness of the tax law for all taxpayers.
    Specifically, the prevalence and proliferation of ATAT impacts the
    achievement of the IRS' mission, goals, objectives, and the success of its
    major strategies by impeding the IRS' ability to make gains in compliance
    and interfering with allocation of workforce resources. Vigorous
    enforcement of the criminal provisions of the Internal Revenue Code,
    coupled with appropriate civil sanctions, materially contributes to
    maintaining voluntary compliance and public confidence in the fairness of
    the tax system.

    Tax shelter promoters continue to modify schemes, making it difficult to
    detect patterns and identify participants on a timely basis. Because these
    types of transactions present unacceptable tax avoidance behavior, the IRS
    needs to continue efforts to identify them timely and to make the public
    aware of the IRS' concerns.

    Recent trends indicate that the tax shelter population will continue to
    expand to small to midsize corporations where the issues will be more
    difficult to identify and examine. Large corporate taxpayers are
    increasingly engaging in structured transactions designed for them
    individually thereby avoiding some of the provisions allowing early
    identification. These structured transactions involve highly complex fact
    patterns and large dollar issues. Promoters of tax shelters are migrating
    from the large accounting firms to firms and businesses that specialize in
    tax shelters. These promoters (boutique promoters) are less compliant for
    registration and less stable in their business operations, making it more
    difficult to pursue them for information and for penalties.

    Taxpayer Service Challenges

    Delivering cost effectively and efficiently valued and effective
    information and services to taxpayers while meeting demands to reduce the
    complexity of tax law, be responsive to large and diverse taxpayer
    segments, and provide preferred means of delivery within budget
    limitations remains a challenge for the IRS. A successful approach will
    employ highly integrated and targeted service avenues, balancing
    accessibility, ease of use, content complexity, and delivery cost. The IRS
    will continue to research and evaluate information regarding taxpayer
    service needs, priorities, and preferences in order to improve delivery
    services that support taxpayer preferable approaches for obtaining
    information or services. The IRS will seek opportunities to invest in
    technology, process improvement, and training to achieve consistent
    repeatable quality service with reduced unit delivery costs. The IRS'
    long-term service measures will include the impact on taxpayer qualitative
    experience and behavior.

    Technology Modernization Projects

    From FY 2002 to FY 2005, the IRS has taken steps to balance the scope and
    pace of its technology modernization program with the management capacity
    of the IRS and the modernization contractor consortium. Since then, the
    IRS improved both its cost and scheduling performance including those
    projects that were not re-baselined. While these improvements do not
    completely eliminate all risk, they mitigate a major risk and demonstrate

    38

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    that the steps the IRS took in 2004 to improve program performance are
    having a positive impact. As a result, FY 2004 and FY 2005 marked a
    reverse in trend of cost overruns that plagued the IRS in previous years.

    In FY 2005, Business Systems Modernization (BSM) continues to build and
    improve upon its 2004 success by delivering projects, attaining cost and
    schedule targets, realizing benefits to taxpayers, and improving BSM
    program management capabilities. With the exception of the Integrated
    Financial System, BSM delivered the majority of projects and releases
    planned on time, within budget, and met or exceeded scope expectations.

    Customer Account Data Engine continues to develop the expansion of the
    number of tax returns processed and taxpayers served, targeting 33 million
    returns to be processed during 2007. Modernized e-File (MeF) continues
    engineering development in preparation for expansion of the taxpayer base
    served through combined Federal and State processing of tax returns. BSM
    also continues working on access capabilities for disabled taxpayers
    through e-Services upgrade of the PeopleSoft Commercial Off-the-Shelf
    application from Version 8.1 to 8.8. BSM will develop the first release of
    the Filing and Payment Compliance system to analyze tax collection cases
    to determine uncontested cases that no longer require direct IRS
    involvement and can be turned over to private collection agencies.

    The FY 2006 BSM portfolio will focus on delivery of three major tax
    administration projects (CADE, MeF and F&PC), along with infrastructure
    initiatives and continued improvement to program management operations.
    Each Tax Administration project will address a core IRS strategic
    priority. Program operations will continue to focus on improving program
    performance, improving and streamlining management process disciplines,
    and ensuring delivery of projects on time, on budget, and on scope by
    taking a greater ownership and leadership role in managing the BSM
    program.

    In addition, the IRS is developing a vision for BSM's future beyond 2007
    and setting goals for the year 2010 that align with and support the IRS
    Strategic Plan. The IRS established a team of IT and business specialists
    to develop an IT modernization roadmap showing how the IRS can effectively
    meet IT modernization goals in an incremental approach that provides
    near-term value.

    Achieving 80 Percent e-Filing

    Achieving the goal of having taxpayers submit 80% of all filings,
    information, and returns, electronically by FY 2007 continues to be a
    significant challenge. While the e-filing rate continues to increase, it
    is only this past year in FY 2005, that more than half of all individual
    tax returns were filed electronically. The IRS is considering mandating
    e-filing for certain groups, by regulation or legislation, to ensure
    increased e-filing. Also, the Administration's proposal to extend the
    April filing date for electronically-filed tax returns to April 30, if
    enacted, may also increase electronic filing. But without a legislative
    change to mandate electronic filing, the challenge remains one of
    identifying options to encourage more of the taxpaying public to e-file.
    For example, many taxpayers use tax preparation software to prepare their
    returns, but then print out and mail in the return. The IRS needs to
    induce more of these taxpayers and preparers to take the next step and
    file electronically.

    39

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    The Tax Gap

    Reducing the tax gap is at the heart of the IRS' renewed emphasis on
    enforcement. The IRS will continue to expand enforcement by targeting its
    case work and enforcement activities to more effectively deliver results
    and drive down the tax gap. The IRS will continue to analyze tax
    information and data from compliance research studies to better define and
    quantify the tax gap. The IRS will use the results of these efforts to
    better understand and counter the methods and means of those taxpayers who
    fail to report or pay what they owe. The IRS is focusing on discouraging
    and deterring non-compliance with the emphasis on corrosive activity by
    corporations, high-income individual taxpayers, and other contributors to
    the tax gap.

    The Complexity of the Tax Code

    The December 2004 Report to Congress required by the Internal Revenue
    Service Restructuring and Reform Act of 1998 identifies the complexity of
    the Internal Revenue Code as the most serious problem facing taxpayers and
    the IRS alike. The Code contains well over a million words, bedeviling
    individual taxpayers with provisions such as the alternative minimum tax
    and the earned income tax credit. Business taxpayers must grapple with a
    patchwork of rules that cover the depreciation of equipment; numerous and
    overlapping filing requirements for employment taxes; and vague factors
    that govern the classification of workers as either employees or
    independent contractors. The IRS must explain the Code in a way that
    taxpayers can understand.

    Tax Reform

    In January 2005, President Bush established an Advisory Panel on Federal
    Tax Reform to devise options to reform the tax code and make it simpler,
    fairer, and more pro-growth to benefit all Americans. The Advisory Panel
    will submit to the Secretary of the Treasury a report containing revenue
    neutral policy options for reforming the Federal Internal Revenue Code.
    These options will:

    x Simplify the tax laws to reduce the costs of compliance and to make it
         easier for taxpayers
         to plan for the future and manage their affairs;
         Share the burdens and benefits of the tax system in an appropriately
    x fair and progressive
         manner while recognizing the importance of homeownership and charity in
         American
         society; and
         Promote long-run economic growth, higher wages and job creation by
    x encouraging work
         effort and increased saving and investment to strengthen the
         competitiveness of the United
         States in the global marketplace.

                                           40

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

      Major Management Challenges and High-Risk Areas

    Over the last several years the Government Accountability Office (GAO),
    the Treasury Inspector General for Tax Administration (TIGTA) and the
    Office of the Inspector General (OIG) for Treasury have identified several
    Management Challenges and High-Risk Areas facing the IRS. The IRS has
    identified specific steps and actions to address these issues through its
    existing program activities. Measures of these program activities serve to
    show progress in addressing the management challenges and high-risk areas.
    A crosswalk showing the relationship between management challenges and the
    IRS Operating Divisions is shown below.

    Management                                                                                              Business Operating Divisions
    Challenge or  Agency-Wide         Chief   Chief     Communications&                       Human         EqualEmploymentOpportunity Large &          MissionAssurance Modernization                  Office of      Research,  SmallBusiness/Self-Employed Tax Exempt &       Taxpayer
    High Risk     Shared      Appeals Counsel Financial Liaison         CriminalInvestigation CapitalOffice &Diversity                 Mid-SizeBusiness and Security     &InformationTechnologyServices Professional   Analysis &                             GovernmentEntities Advocate Wage &
    Area          Services                    Officer                                                                                                   Services                                        Responsibility Statistics                                                Service  Investment
    IRS Business
    Systems                                       X                                                                                                                                    X                                                       X                      X                       X
    Modernization
    Tax
    Compliance                                                                    X                                                           X                                        X                      X            X                   X                      X                       X
    Initiatives
    Strengthen
    Information
    Security;                                                                                                                                                  X                       X
    Security of
    the IRS
    Establish
    Measures
    Comparable
    Over Time and
    Collect
    Sufficient         X         X       X        X            X                  X                 X                   X                     X                X                       X                      X            X                   X                      X             X         X
    Performance
    Data;
    Integrating
    Performance
    and Financial
    Management
    Complexity of                X       X                                                                                                    X                                                               X            X                   X                      X             X         X
    the Tax Law
    Providing
    Quality
    Customer           X         X                             X                                                                              X                                        X                      X                                X                      X             X         X
    Service
    Operations
    Processing
    Returns &
    Implementing
    Tax Law                      X       X                     X                                                                              X                                        X                                                       X                      X             X         X
    Changes
    During Filing
    Season
    Taxpayer
    Protection                   X       X                                        X                 X                   X                     X                                                               X            X                   X                      X             X         X
    and Rights
    Human Capital                                                                                   X                   X
    Enforcement                  X       X                     X                  X                                                           X                                                               X                                X                      X                       X
    of Tax Laws
    Bring
    Treasury's
    Financial
    Management
    Systems into
    compliance                                    X
    with Federal
    Financial
    Management
    Improvement
    Act (FFMIA)
    of 1996

    41

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    The following pages summarize each Management Challenge and High-Risk issue, FY
    2005 accomplishments, and actions identified for completion in FY 2006 and
                                         beyond

    IRS Business Systems Modernization

    Issue: Bring the IRS' business systems and financial systems to a level
    that provides management current and reliable information to support
    informed decision making. GAO in its FY 2005 High Risk series has
    consolidated IRS Business Systems Modernization and IRS Financial
    Management into one Business Systems Modernization high-risk area.

    Actions Taken

    x Customer Account Data Engine (CADE) (implemented in 2004) expanded its
         capacity,
         processing more than 1.4 million of the basic 1040 EZ tax returns during
         the 2005 filing
            season. Further expanded functionality will accept returns received
                    with an address
         change, allowing more returns to be processed through CADE.
         Completed architecture engineering analysis and development of a limited
    x functionality
         release for Filing & Payment Compliance (F&PC) Release 1.1 designed to
         separate
         complex cases requiring direct IRS involvement from those that can be
         handled by private
         collection agencies (PCAs). This release will provide initial
         capabilities for competitive
         outsourcing of collection activities in FY 2006.
         Implemented the Integrated Financial System (IFS) as the IRS internal
    x accounting system of
         record. IFS replaced the IRS' core legacy financial systems. Version
         4.6C deployed
         expenditure controls, some of IRS' accounts payable, accounts
         receivable, general ledger,
         budget formulation, purchasing controls, 3-year rolling forecast, and
         statements of net cost.
         Deployed Modernized e-File (MeF) Release 3.1 which processed 7004
    x (corporations),
         990PF (tax-exempt organizations) and tax law changes for filing season
         2004. In FY 2005,
         MeF processed 1120 and 990 returns at higher than expected volumes while
         still achieving
         performance goals. The MeF platform speeds turnaround time for tax
         return submissions
         and uses the latest, secure Internet technology. This project is key to
         achieving the 80% e-
         filing goal mandated by Congress and is an integral part of the
         Administration's move
         towards an all-electronic government.
         Completed Modernized e-File re-sequencing plan to support Disaster
    x Recovery
         requirements.
         Developed and published e-Strategy for Growth: Expanding e-Government
    x for Taxpayers
         and Their Representatives. This product serves as a strategy providing
         IRS' plans for
         electronic tax administration and will be used as a communication tool
         for both internal and
         external customers.

    Actions Planned or Underway

    Modernized e-File (MeF) will become the primary interface for all business
    filings. During FY 2006, MeF will deliver electronic filing capabilities
    for 1065 forms (Partnership Income),

    42

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    enabling nearly 2.7 million small business and self-employed taxpayers to
    be served. MeF will remedy Legacy electronic filing limitations (e-File)
    which do not allow partnerships to comply with the Taxpayer Relief Act of
    1997 without having to seek waivers to avoid financial penalties.

    x The Filing & Payment Compliance (F&PC) project is a key element of the
    Enforcement strategy, which will develop systems to analyze tax collection
    cases and separate cases requiring direct IRS involvement from those that
    can be handled by private collection agencies (PCAs). In FY 2006, the F&PC
    will stand up initial capabilities for competitive outsourcing of
    collection activities.

    x The Customer Account Data Engine (CADE) will continue to move the IRS
    towards realizing its Technology Modernization strategy by establishing
    phased replacement of components that can no longer sustain today's tax
    laws, policy and taxpayer needs. In FY 2006, CADE will expand the type and
    number of 1040 family of returns processed on modernized systems beyond
    the current base of 1040EZ forms. This will provide key taxpayer benefits
    such as processing refunds faster, submitting daily postings of
    transactions and updating accounts, which will significantly improve
    customer service.

    x Continue process improvement and development of metrics for software
    development.

    x Modernize infrastructure components per Enterprise Architecture.

    x Maintain the successful track record on on-schedule, on-budget release
    upgrades for the major modernization application to include CADE, IFS, MeF
    and e-Services.

    x Accelerate modernization to maximize modernization potential and promote
    operational efficiencies and strengthen transition of Business Systems
    Modernization (BSM) systems into the operating environment.

    Tax Compliance Initiatives

    Issue: Administer programs to deal with tax gap issues especially those
    resulting from corporate and high-income individual taxpayers as well as
    domestic and off-shore tax and financial criminal activity.

    Actions Taken

    x Addressed key areas of noncompliance with enhanced enforcement of tax
    laws through:

    inars and professional responsibility (Circular 230) presentations;
           and
    d September 30, 2005

    x Deployed new Automated Underreporter (AUR) EITC selection methodology
    including business rules for selecting and excluding EITC cases in AUR and
    including Schedule C cases.

    x Strengthened Field Assistance enforcement programs to increase voluntary
    compliance and reduce the risk of noncompliance. During the third quarter
    of FY 2005, an additional 245 Tax Resolution Representatives (TRR) and
    their managers were trained for Collection case work.

    x Developed new models for Individual Master File (IMF) to assist in
    selecting the most productive work. This effort eliminates duplicate
    selection codes, facilitates the identification of the "Next Best Case"
    for case creation, and simplifies programming.

    x Continued to identify flow-through entities used to disguise
    questionable structured transactions by high-income taxpayers. Identified
    those engaging in abusive tax practices through enforcement, full
    implementation of K-1 matching, education and research.

    x Continued the enhancements of risk-based compliance approaches by:

    eet legal requirements, are
           compatible with technological capabilities, and have the greatest
           potential to deter non-compliance. (Ongoing)

    x Released updated tax gap estimates for Individual Income Tax Reporting
    Compliance. Preliminary findings indicate that the gross tax gap was
    between $312 billion and $353 billion in Tax Year (TY) 2001.
    Underreporting noncompliance is the largest component of the tax gap and
    accounts for more than 80% of the total, with non-filing and underpayment
    at about 10% each. Individual income tax is the single largest source of
    the tax gap, accounting for about two-thirds of the total. For individual
    underreporting, more than 80% stems from understated income, not
    overstated deductions.

    x Delivered final TY 2003 Voluntary Payment Compliance Rates (VPCR) by
    type of tax, tax year and operating division. The VPCR, which is the
    percentage of the total tax liability reported on timely-filed returns
    that is paid in a timely manner, provides a valid assessment of the
    overall level of payment compliance and facilitates the proper allocation
    of resources for enforcement activities.

    x Provided an estimate of the overall improper payment level (overclaim
    estimates) for EITC based on National Research Program individual
    reporting compliance data. Data will be used to help refine and evaluate
    EITC initiatives to reduce inappropriate claims and improve the program's
    effectiveness.

    x Established the Office of Fraud/Bank Secrecy Act (BSA) which has
    end-to-end accountability for BSA policy formation, operations and data
    management, recognizing the

    44

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    importance of the IRS' role in the fight against terrorism and money
    laundering. Over 300
    examiners and managers are trained and dedicated full-time to the BSA
    program.
         Completed a model Federal and State Memorandum of Understanding (MOU),
    x which
         provides both the IRS and the participating state the opportunity to
         leverage resources for
         BSA examinations, outreach and training.
         Expanded examinations of self-employment income by earners in U.S.
    x Possessions (Puerto
         Rico, Guam, etc...), closing over 10,000 Form 1040s in FY 2005.
         Made efficiency gains in the Offer-In-Compromise (OIC) program.
    x Declining receipts and
         improvements in timely closures of OIC permitted reassignment of
         approximately a quarter
         of field offer specialists back to the general collection program.
         Focused criminal enforcement resources on key areas of noncompliance,
    x including the
         promotion of abusive schemes such as offshore accounts to hide or
         improperly reduce
         income, the use of abusive corporate tax avoidance transactions and
         high-income
         individuals underreporting of income and/or failure to file returns.

    Actions Planned or Underway

    x Upgrade the Bank Secrecy Act (BSA) workload database to provide a more
    complete record of these institutions and to better predict which entities
    have a greater probability of noncompliance.

    x Continue the enhancements of risk-based compliance approaches by
    implementing major programming changes to inventory and incorporating
    cost-benefit of Dependent Database selection process. (01/2006)

    x Finalize plans for Tax Year 2006 Earned Income Tax Credit (EITC)
    compliance study to assess changes in taxpayer EITC filing volume and
    track EITC return math error accuracy.

    x Charter EITC research efforts to identify ways to reduce EITC erroneous
    payments, as well as identify trends in the diverse EITC taxpayer
    population. Use the results of these studies for strategic planning of the
    EITC program. (Ongoing)

    x Develop enhancements to the multifunctional non-filer strategy that will
    target outreach and compliance efforts; develop alternative treatments to
    influence non-filing taxpayer behavior and promote compliance. (09/2006)

    x Continue the Federal Employee/Retiree Delinquency Initiative (FERDI) to
    reduce noncompliance of federal employees and retirees. (Ongoing through
    09/2006)

    x Utilize Individual Master File (IMF) data to track production, return
    characteristics and error information on volunteer-prepared returns.
    (Ongoing through 09/2006)

    x Perform a study to establish the compliance characteristics of
    volunteer-prepared returns. (09/2006)

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Initiate a Qualitative Assessment Study that analyzes the effects on
         taxpayer attitudes
         towards EITC participation and compliance. (09/2006)
         Initiate an 1120-S full reporting compliance study to analyze the
    x accuracy of S-corporation
         tax returns and estimate the voluntary reporting compliance of
         subchapter S-corporations.
         (Ongoing)
         Enhance data exchange opportunities and implement national initiatives
    x with state taxing
         organizations to leverage limited government resources.
         Focus on securing State Income Tax Levy program (SITLP) agreements with
    x remaining
         non-participating income tax states.
         Enter into tip reporting agreements with more than 90% of gaming
    x casinos. (12/2005)

    Strengthen Information Security; Security of the IRS

    Issue: Strengthening the security infrastructure and the applications that
    guard sensitive data.

    Actions Taken

    x Updated and strengthened security plans for tax payment lockbox sites
    for tax payment processing at the IRS campuses.

    x Completed certifications and accreditations of IRS redefined General
    Support Systems (GSS); took steps to thoroughly review the security
    controls of its networks and other critical information technology assets
    and to correct any weaknesses that exist.

    x Improved Federal Information Security Management Act of 2002 reporting
    process to fully and actively engage business management in meeting and
    reporting on security requirements for the systems within their purview.

    x Participated with the Department of the Treasury in disaster simulations
    designed to test continuity of operations plans.

    x Provided executives, managers and staff (including personnel with
    essential security roles) with relevant security-related training.

    x Implemented program-level security controls disseminated by Mission
    Assurance & Security Services.

    x Established a multi-agency working group including representatives from
    the Department of the Treasury, the Federal Trade Commission (FTC), the
    Social Security Administration (SSA) and the Department of Homeland
    Security (DHS) to better enable Federal agencies to provide consistent
    information and services to assist victims of identity theft:

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    ) usage;
    x Expanded the IRS' ability to respond to emergencies through more
    frequent exercise of Continuity of Operations Plan (COOP) and other
    emergency response actions.

    x Completed business resumption plans in response to changes in threat
    conditions.

    x Fully supported government-wide and Departmental emergency response
    initiatives.

    Actions Planned or Underway

    x Complete mitigation of General Support Services (GSS) weaknesses
    identified during certification and other review activities sufficient to
    upgrade GSS with Interim Authority to Operate status to Full Authority to
    Operate. (09/2006)

    x Conduct certification and accreditation update activities to meet
    government-wide guidelines for percentage of information systems
    certified. (09/2006)

    x Define an enterprise-wide strategy for IT systems disaster recovery,
    including implementation of strategic testing of disaster recovery plans.
    (09/2006)

    x Develop a back-up for the IRS incident response capability to reduce
    geographic vulnerability. (09/2006)

    x Continue to improve Federal Information Security Management Act (FISMA)
    compliance by further increasing business owner participation in all areas
    including monitoring, review, mitigation and reporting activities.
    (Ongoing)

    47

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Develop a physical security technology "roadmap" for the IRS to improve
         uniformity and cost
         effectiveness of security technologies at IRS sites. (05/2006)
         Support Homeland Security Presidential Directive 12 (HSPD-12), which
    x mandates a uniform
         approach to employee authentication and access government-wide. HSPD-12
         requirements
         contain a timeline for all agencies to follow and requirements for
         meeting the objectives of
         the Directive. (Multi-year)
         Continue to refine both the IRS' Continuity of Operations Plan (COOP)
    x activities and the
         IRS' contribution to Department/government-wide COOP activities.
         (09/2006)

    Establish Measures Comparable Over Time and Collect Sufficient Performance
    Data; Integrating Performance and Financial Management

    Issue: Establish long-term goals and integrate performance into
    decision-making and resource allocation processes to completely achieve an
    integrated performance budget.

    Actions Taken

    x The IRS budget submission for FY 2007 includes programmatic long-term
    goals (LTG) that combined with the program-related efficiency and outcome
    measures will be used as indicators of the program's long-term objectives.
    In FY 2005, the IRS aligned its budget programs with the objectives
    outlined in the IRS Strategic Plan 2005 through 2009.

    x Draft long-term goals, indicating optimal performance and targets
    through FY 2009, were developed for each Taxpayer Service program and for
    a majority of the Enforcement programs.

    x The IRS' Integrated Financial System (IFS) was deployed in FY 2005 to
    provide timely access to accurate and consistent financial data including
    cost data that is used to develop cost-based performance measures. The IRS
    cost module has captured data for 10 months of FY 2005 enabling the IRS to
    view direct expense data (labor, supplies, travel, etc), FTE and on-rolls
    data captured at the lowest cost center (group or work unit) level. In
    addition, the IRS developed and implemented allocation methodology to
    distribute support costs to the operational business units.

    x The IRS completed three Program Assessment Rating Tool (PART)
    evaluations for the FY 2007 budget cycle: examination, criminal
    investigation and submission processing. All three programs received
    "moderately effective" ratings from OMB.

    x The Chief Financial Officer and Modernization & Information Technology
    Services have proposed and developed a concept of enhancing the current
    Financial Management Information System (FMIS) to substantially comply
    with the requirements of FFMIA.

                                           48

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

                              Actions Planned or Underway

    x The IRS will continue to analyze the cost data obtained through the
         Integrated Financial
         System to further develop robust cost-based performance measures for its
         major programs.
         In FY 2006 the IRS will introduce a suite of enterprise-wide goals which
    x link directly to
         the IRS Strategic Plan goals of Improve Taxpayer Service, Enhance
         Enforcement of the Tax
         Laws, and Modernize the IRS Through People, Processes and Technology.
         The enterprise-
         wide goals will be consistent with the measures represented in the IRS
         budget. The new
         goals are intended to provide focus and rigor to measuring the outcome
         of the nation's self-
         assessment tax system: Improve Voluntary Compliance in all areas.
         For the FY 2008 budget cycle, the IRS will submit its non-revenue
    x generating programs to
         OMB for a PART assessment. Based on the performance improvements the IRS
         has
         shown for the collection program, the IRS plans to request reassessment
         and removal of the
         prior PART rating of "Results Not Demonstrated."
         Financial Management Information System (FMIS) enhancements are planned
    x through four
         releases beginning in 2006. FMIS is currently working on Release 1,
         which is the
         development of the Unpaid Assessment and Trust Fund Recovery Penalty
         (TFRP) data
         base.

    Complexity of the Tax Law

    Issue: Simplifying the tax process by developing legislative
    recommendations to clarify tax instructions or forms and computer
    modernization.

    Actions Taken

    x Provided Congress with legislative recommendations in the upcoming
    National Taxpayer Advocate 2004 Annual Report to Congress (December 31,
    2004), including elimination of the Alternative Minimum Tax;
    simplification of provisions to encourage education; and simplification of
    provisions to encourage retirement savings.

    x Finalized the Taxpayer Rights Impact Statement, which is an assessment
    of an IRS program or policy by the National Taxpayer Advocate with respect
    to its impact on taxpayer rights.

    x Participated in research initiatives such as "Abusive Tax Schemes: The
    'Tipping Point' Study;" The Impact of Representation on the Outcome of
    Earned Income Tax Credit (EITC) Audits, Federal Case Registry Study; EITC
    Certification Test; EITC Pre-certification Test; EITC Recertification;
    Downstream Effects of Compliance Initiatives.

    Actions Planned or Underway

    x Continue to work with the Treasury Department on revisions to the
    regulations under Internal Revenue Code 7216, relating to the use and
    disclosure of tax return information by tax returns preparers. (Ongoing)

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Examine the possibility of a Unified Family Credit that will combine the
    provisions of the EITC, Child Tax Credit, and Dependency Exemption,
    thereby further reducing taxpayer compliance burdens associated with
    claiming these provisions. (Ongoing)

    x Legislative proposal to issue regulations specifying returns that must
    be filed electronically. Expanding the scope of returns that are required
    to be filed electronically would help the IRS meet its 80% goal set by
    Congress.

    x Legislation is being proposed to issue regulations that would extend the
    due date to file and pay individual taxes by April 30th, provided the
    taxpayer files the return electronically and pays the entire balance due
    electronically by the due date.

    x Legislation is being proposed to expand authority of the IRS to require
    businesses (including corporations, partnerships and other business
    entities) and exempt organizations to file their returns electronically.

    Providing Quality Customer Service Operations

    Issue: Providing top quality service to every taxpayer in every
    transaction is an integral part of the IRS' strategic and modernization
    plans.

    Actions Taken

    x Established new Queuing Management (Q-Matic) codes to enhance the data
    captured at the walk-in sites to provide additional feedback on outreach
    efforts involved in the EITC Qualifying Child Certification Test. This
    will enable the IRS to learn about taxpayer problems with certification as
    well as the potential burden a certification requirement could impose on
    IRS field assistance sites.

    x Completed Phase 1 of Q-Matic to facilitate customer traffic and workload
    planning.

    x Developed the electronic installment agreement initiative to enable
    taxpayers meeting certain criteria to request and set-up their own
    installment agreements over the Internet on IRS.gov.

    x Completed a successful pilot of Contact Recording initiative to enable
    synchronized voice/data recordings to monitor face-to-face interactions in
    Taxpayer Assistance Centers (TACs) to assess quality as well as trends.

    x Completed 108 Taxpayer Assistance Center Model projects, thus far, to
    retrofit TACs to provide adequate space to accommodate customer traffic,
    provide modernized workstations, integrate technology enhancements,
    improve privacy and enhance security.

    x Deployed new Automated UnderReporter (AUR) EITC selection methodology to
    more precisely select cases that have a high probability of misreported
    income.

    x Revised the e-Services incentive products minimum returns filed
    threshold to five (down from 100) for all return types supported by e-File
    or Modernized e-File (MeF) to allow more

    50

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Electronic Return Originators (EROs) to use electronic incentive products
    such as
    Disclosure Authorization, Transcript Delivery System and Electronic
    Account Resolution.
          Improved and enhanced the availability of online services such as
    x  Internet Employer
          Identification Number (EIN), Centralized Authorization File (CAF), and
          Practitioner Priority
          Services (PPS).
    x  Continued work with private industry providers to expand Free File.
          Enhanced research to maximize the best use of resources for the
    x  Volunteer Income Tax
          Assistance (VITA) site identification, partnership development and
          return preparation.
          Expanded Internet Refund-Fact of Filing to include Refund Trace and
    x  Change of Address
          capabilities for lost and/or stolen refunds.

    Actions Planned or Underway

    x Expand the web-based learning program (Link and Learn Taxes) that
    provides online training in tax return preparation. (Ongoing through
    09/2006)

    x Refine "Life Cycle Products" line of publications designed to educate
    taxpayers about the tax impact of significant life events. (Ongoing
    through 09/2006)

    x Incorporate multi-year Volunteer Return Preparation Program
    (VRPP)-Quality Improvement Process (QIP) plan to promote quality assurance
    for the VITA program. (Ongoing through 09/2006)

    x Utilizing pilot models developed in FY 2005 to implement a national
    rural strategy that provides outreach, free tax return preparation and/or
    financial literacy education to rural America. (09/2006)

    x Continue expansion of Internet Refund Fact of Filing (IRFOF) application
    to reduce toll-free demand and offer customers alternative methods of
    service. (09/2006)

    x Develop a TeleFile and Internet electronic funds withdrawal (Direct
    Debit) application for notice payments. (09/2006)

    x Develop an electronic funds withdrawal (Direct Debit) application for
    installment agreements. (09/2006)

    x Complete Phase II rollout of Queuing Management (Q-Matic) which will
    automate the process of tracking employee activity and contribute to
    improve customer traffic and workload planning. (09/2006)

    x Continue to educate EITC taxpayers through partnerships with key
    stakeholders and a public service campaign. (Ongoing)

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Assess the overall EITC marketing/awareness campaigns that target the
         eligible EITC non-
         claimant population and refine/refocus as necessary to improve
         compliance and increase
         overall participation. (Ongoing)
         Continue to improve the quality and clarity of computer-generated
    x notices issued to
         taxpayers to reduce the number of telephone contacts and make it easier
         for taxpayers to
         understand and comply with their tax requirements. (Ongoing)
         Establish the Virtual Translation Office to develop new and revised
    x Spanish-language tax
         products. (09/2006)
         Continue conducting surveys and focus groups to obtain feedback from
    x taxpayers and tax
         practitioners about ways to improve tax forms, instructions and
         publications. (Ongoing)
    x Complete an additional 25 TAC Model projects. (09/2006)
         Roll-out Contact Recording in the TACs piloted in 2005 to an additional
    x 100 locations in FY
         2006 and continuing through FY 2008 until all TACs are equipped with
         contact recording.

    Processing Returns and Implementing Tax Law Changes During the Filing
    Season Issue: Tax law changes from prior years that have not been
    correctly implemented. Actions Taken

    x Developed secure access for taxpayers who file electronically to enable
    them to review their account electronically.

    x Deployed the Transcript Delivery System (TDS) to improve efficiency by
    implementing a "One-click process" for servicing transcript requests. From
    May to September 2005, 610,000 transcripts were mailed to taxpayers.

    x Completed the ramp-down of the Memphis Submission Processing Center
    (MSPC).

    x Ensured the Corporate Filing Season Readiness Process is operational for
    filing seasons 2005 and 2006 and covers all aspects of the filing season,
    including the Annual Readiness Certification. Filing Season 2005 was
    timely certified and the Filing Season Readiness committee is in place for
    filing season 2006.

    x Set a record for electronic filing, reaching 68 returns, an increase of
    approximately 11% from 2004.

    Actions Planned or Underway

    x Automate the financial statement of net cost in IFS.

    x Pilot an automated adjustment document to make a change or correction to
    a taxpayer account, reducing adjustment time and increasing the quality of
    required adjustments.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Pilot Embedded Quality Review System (EQRS), establishing common
         attributes and review
         tools for evaluating organizational performance and individual
         performance.
         Begin development of strategies to smoothly transition and consolidate
    x the Philadelphia
         Submission Processing Center. (Multi-year initiative)
         Complete deployment of Transcript Delivery System (TDS) by December
    x 2005.

    Taxpayer Protection and Rights

    Issue: The IRS has made significant progress in complying with RRA `98 and
    most provisions have been implemented. Significant management attention is
    still required to ensure that all issues situations have been addressed.

    Actions Taken

    x Reduced procedural barriers by making refinements to both third party
    notification and collection due process procedures.

    x Administered an EITC survey as part of the EITC Qualifying Child
    Certification Test, consisting of questions regarding the time and cost
    associated with the certification and making an EITC claim. The survey was
    conducted to gather information to better understand claimants' experience
    with the certification process and to determine the impact of EITC
    certification on taxpayer participation in the EITC program.

    x Implemented several EITC notice redesign efforts (CP-75 notice series,
    initial audit contact letters, Publication 3498-A, The Examination
    Process: Examinations by Mail). The redesign of the notices will enable
    taxpayers to better understand their responsibilities and entitlements
    under a very complicated section of tax law.

    x Improved the CP 09 (Earned Income Credit - You May Be Entitled to EIC)
    and 027 (EIC Potential for Taxpayer Without Qualifying Children), which
    notifies taxpayers who have not claimed EITC that they may be eligible.
    Simplified the CP 09 and 027 language to improve understanding and
    improved the determination checklist to make the notices more user
    friendly.

    x Improved the EITC recertification and two- and ten-year ban notices,
    making them easier to understand and clearly explaining the consequences
    of the two- and ten-year bans, including the tax years to which the bans
    apply.

    x Implemented a solution for encrypting electronic return data during the
    transmission process from electronic return transmitters.

    x Developed a new workload methodology that will focus on those areas of
    the filing population constituting the greatest increase in compliance
    risk with a high probability of unreported income. This strategy will
    promote fairness of our tax system by identifying potential noncompliance
    from taxpayers who would not otherwise be subject to matching document
    reviews.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Rolled out the Taxpayer Assistance Center (TAC) model, as it is critical
    to maintaining taxpayers' privacy and confidentiality, particularly as the
    IRS becomes more involved in compliance activities.

    x Reviewed IRS training to ensure that employees, particularly in
    compliance functions, are properly and regularly trained on the protection
    of taxpayer rights.

    x Pursued abuses in the consumer credit counseling industry, targeting for
    audit 60 firms representing 50% of revenue in this industry.

    Actions Planned or Underway

    x Focus on taxpayer groups that are at higher risk of noncompliance to
    maintain confidence in the integrity of the tax administration program.
    (Ongoing)

    x Continue to educate EITC taxpayers through partnerships with key
    stakeholders and a public service campaign. As of June 2005, the public
    education campaign, through the media and grassroots community
    partnerships, generated almost one billion potential contacts. (Ongoing)

    x Continue efforts to enhance EITC systemically generated notices.

    x Ensure protection of taxpayer information entered at return preparation
    sites and local offices. (Ongoing)

    x Refine procedures to certify compliance with requirements of Title VI of
    the Civil Rights Act of 1964 to provide equal access and
    non-discriminatory services to all eligible taxpayers. (Ongoing)

    x Work under auspices of the Electronic Tax Administration Policy Council
    (ETAPC) to establish security policy and address issues. Complete
    additional reviews requested by ETAPC of the authentication methods.
    Continue to implement new website functionality requested by the Business
    Operating Divisions. (Ongoing)

    x Continue systems modernization efforts to enhance the IRS' security
    program. (Ongoing)

    x Develop and implement the Taxpayer Rights Impact Statement to help the
    IRS incorporate awareness and consideration of taxpayer rights into its
    program planning and implementation. (Ongoing)

    x Work with preparers to design a program that enables the majority of
    taxpayers to feel confident that their preparers are competent to prepare
    their taxes and that the IRS will take appropriate enforcement action on
    preparers when they perform negligently or recklessly. (Ongoing)

    x Advocate enforcement of existing penalties for paid preparers as well as
    the strengthening and enhancement of penalties by Congress. (Ongoing)

    54

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Human Capital

    Issue: The IRS' ability to meet program requirements and the expectations
    of both external and internal customers.

    Actions Taken

    x Streamlining operations resulted in moving personnel from
    non-enforcement to enforcement positions during FY 2005 and cost savings
    from centralizing case processing will be directed to enforcement hires
    for FY 2006.

    x Submitted to the IRS Oversight Board the final draft of the 2005-2009
    Human Capital Strategic Plan, the primary guidance vehicle for strategic
    management of human capital in the IRS.

    x Implemented an IRS-wide human capital governance structure, including
    representatives from the IRS business units, support functions and
    specialized units, that provides a forum for all IRS entities to jointly
    address and propose solutions to human capital issues and challenges
    resulting from the implementation of large-scale human capital programs,
    policies and initiatives and ensures consistent and fair treatment of
    employees impacted by workforce change initiatives.

    x Continued work on Mission Critical Occupations (MCOs):

    d development.

    x Negotiated a new recruitment marketing contract because previous
    contract, including option years, had expired. Maintained an active print
    and internet media campaign, produced new multi-media job previews and
    updated the IRS Careers website. A recruiter cadre continued to foster
    partnering relationships with over 200 colleges and universities across
    the country as part of the IRS' ongoing effort to improve recruiting
    performance, particularly the recruitment of applicants to fill Mission
    Critical Occupations.

    55

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x To support workforce restructuring initiatives and to mitigate impact on
         employees involved
         in restructuring, the IRS used all available tools, including VERA
         (early outs) and VSIP
         (buyouts) and relocation bonuses throughout the year to support
         workforce restructuring
         initiatives and to mitigate impact on employees involved in
         restructuring.
         Developed a Human Capital Office (HCO) Concept of Operations that
    x articulates HCO's
         vision, mission, values and role in the IRS human capital community as
         well as HCO's
         various Lines of Business, i.e., major categories of human capital work
         within the IRS.
         Executed Service Level Agreements with customers which describe the
    x services HCO has
         agreed to provide, HCO and customer commitments relating to delivery of
         HCO services
         and how HCO's performance will be measured.
         Evaluated each new human capital initiative for workforce impact to
    x determine effective and
         appropriate mitigation strategies to address the results.
         Implemented a multi-year recruitment and marketing strategy that
    x includes the expansion of
         the Internet employment website, a complete print media advertising
         campaign, market
         research and an extensive Internet media advertising campaign.
         Used competency models and occupational studies to identify and target
    x competencies
         necessary for successful performance in all frontline occupations;
         targeted competencies in
         the recruitment and hiring process and the individual and employee
         training process to
         address skill gaps.
         Developed a Career-Pathing process that focuses on training,
    x application, assessment and
         feedback to provide opportunities to develop technical expertise needed
         for senior
         professional positions.
         Expanded QuickHire, an Internet-based tool that automates the hiring
    x process, to include
         additional occupations.

    Actions Planned or Underway

    x Deploy the Learning Content Management System (LCMS) to permit more
    efficient development of training materials and ensure more consistency in
    training across the Service. (09/2006)

    x Complete the conversion of all its Mission Critical Occupation (MCO)
    application processes to the CareerConnector system and begin the
    conversion of the non-MCO occupations. (09/2006)

    x Complete development of the Human Capital Strategic Implementation Plan
    (HCSIP) to:

    o Identify specific human capital programs and initiatives for the next
    two years needed to execute the strategies and achieve the goals outlined
    in the Human Capital Strategic Plan;

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    s-on
    experience to realize the "stepping stone" approach. (Ongoing)

    x Continue the selective use of Voluntary Employee Retirement Authority
    (early-outs) and Voluntary Separation Incentive Payments (buyouts) to
    support organizational restructuring and workforce reshaping initiatives.
    (Ongoing)

    x Extend partnerships with key colleges and universities. (Ongoing)

    x Improve recruiting performance through expansion of category ratings and
    the increased use of simulations in assessing job applicants-particularly
    in front- line occupations. (Ongoing)

    Enforcement of Tax Laws

    Issue: Address the evolving challenge of unpaid taxes and continuing
    Earned Income Credit noncompliance.

    Actions Taken

    x Improved collection processes resulted in increases in productivity,
    dollars collected, enforcement activity and customer satisfaction along
    with decreases of time between return filing and assignment and decrease
    of time between assignment and case closure. Adoption of clear guiding
    principles including revisions to key Internal Revenue Manual sections on
    enforcement activity, coupled with improved electronic research and
    guidance tools and enhancement of managerial consultations contributed to
    overall improvements.

    x Implemented key recommendations identified by the Federal Tax Compliance
    Task Force (FCTC) to improve the levy process for Department of Defense
    (DoD) Contractors thru the Federal Payment Levy Program. Actions include:

     notices; and

    57

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    o Added additional DoD payment systems to the Treasury Offset Program
    (TOP). To date, 18 of the 20 Defense Finance and Accounting Service (DFAS)
    Commercial Pay Systems have been implemented, which represents 99.7% of
    the total annual disbursements.

    x Improved Automated Collection System (ACS) levy process by identifying
    new sources from Electronic Filed Returns, State Employment Commissions
    and through Information Return Master File and the Remittance Processing
    System.

    x Partnered with 27 states to levy individual state refunds for
    outstanding federal income tax liabilities through the State Income Tax
    Levy Program (SITLP). An encryption software purchase for states will
    allow transmission of levy payment into the Electronic Federal Tax Payment
    System (EFTPS).

    x Developed a multi-year strategy through the Federal Employee Retiree
    Delinquency Program (FERDI) to provide outreach and education to assist
    military retirees with understanding their obligations and improving
    compliance.

    x Other than the Earned Income Tax Credit (EITC) Program, the IRS has no
    high-risk programs that require baseline and annual error rate measures or
    the development of a reduction plan with annual targets. Therefore, the
    IRS' focus on eliminating improper payments is placed on the Earned Income
    Tax Credit Program. EITC is a refundable federal income tax credit for
    low-income working individuals and families. In FY 2004, nearly 22 million
    people received almost $38 billion from the credit, making the EITC the
    nation's largest anti-poverty program.

    x To better administer EITC, the IRS developed a detailed, long-term EITC
    business plan in the form of a Concept of Operations with a focus on a
    balanced EITC Program - one that reduces erroneous payments while
    increasing participation by eligible taxpayers. In keeping with the goals
    of the EITC program throughout FY 2005 and into FY 2006, the IRS will
    implement new, technology-enabled business process improvements as well as
    continue to test and evaluate new approaches to reduce improper payments.
    The IRS will use these tests to make data driven decisions about
    improvements to each segment of the program including customer service,
    outreach and compliance.

    x The EITC business plan is consistent with the IRS Commissioner's
    five-point initiative announced in June of 2003 to reduce burden on
    taxpayers, improve the IRS audit processes, increase outreach efforts,
    address unreported income and test new approaches to reducing EITC error.
    The IRS' continued efforts to improve EITC compliance activities have
    enabled it to decrease the amount of time it takes to complete an EITC
    examination by 6.4%, or 12 days and to reduce the volume of aged EITC
    cases in inventory by 38% during last year.

    x As part of the Commissioner's initiative, in FY 2005, the IRS continued
    several tests to evaluate new ways of reducing erroneous EITC payments
    while maintaining participation by eligible taxpayers:

    o Qualifying Child Test: Requires certain EITC claimants to certify that
    they meet the qualifying child residency requirement before paying out the
    refund. Initial testing results

    58

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    showed that a certification requirement had a significant effect on
    improper EITC claims;

    nt to head of household). The first test indicated that the
           IRS needed to modify its selection methodology to ensure a better
           focus on non-compliant taxpayers; and
    election methodologies and showed successes in a
           lower no change rate and changes to the credit.

    x Based on the results of the Misreporting Income (Automated
    Underreporter) test, in early FY 2005 the IRS implemented the improved
    selection methodologies for Automated Underreporter cases. During 2006,
    the IRS will complete the last part of the Qualifying Child test and
    evaluate the effects of the Filing Status and Qualifying Child tests on
    reducing erroneous EITC payments and maintaining participation by eligible
    taxpayers before making decisions to implement either on a broader scale.

    x Other FY 2005/FY 2006 activities include a program to focus education
    and compliance efforts, as appropriate, on EITC paid preparers. As a part
    of the EITC Return Preparer Strategy, the IRS completed over 400 due
    diligence compliance visits to paid tax preparers with a
    probability/record of preparing erroneous EITC returns. The IRS has also
    implemented the selection of amended EITC returns for examination using
    the Dependent Database.

    x The IRS is also striving to make the EITC easier to claim by eligible
    taxpayers. To reduce taxpayer burden, the IRS is improving communications
    to taxpayers, making the credit clearer and easier to understand and
    providing potential claimants and their paid preparers with resources to
    help them determine whether they are eligible. During FY 2005, the IRS
    launched the EITC Assistant, a web-based eligibility calculator on
    irs.gov; implemented enhancements to the EITC Online Toolkit for tax
    professionals for FY 2005 and FY 2006; delivered EITC messages on Housing
    and Urban Development kiosks in 106 locations nationwide; and distributed
    EITC educational materials to 3,300 Western Union agent locations in New
    York, Los Angeles, Atlanta, and San Antonio. Also in FY 2005, IRS
    partnerships and coalitions prepared nearly two million tax returns for
    low-income families, in addition to making countless taxpayer contacts
    through an array of EITC educational products and messages.

    Actions Planned or Underway

    x Launch final portion of the qualifying child certification test.

    x Complete compliance analysis of TY 2001 returns claiming EITC (National
    Research Program).

    x Develop and distribute materials to educate taxpayers and practitioners
    on EITC eligibility rules and compliance issues.

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    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Test and report the results of the National Directory of New Hires
    database match.

    x Plan for a FY 2007 compliance study.

    x Continue to leverage partnership opportunities with states that offer
    tax credits comparable to EITC.

    x Implement new Automated Case Selection and Assignment and Decision
    Support Tools. (01/2006)

    x Implement new Amended Returns process. (03/2006)

    x Launch additional Risk-Based Scoring Strategy and inventory management
    capability to improve selection and assignment of EITC returns for
    examination. (03/2006)

    x Enhance methodology to improve the selection of EITC amended returns for
    examination.

    x Expand the Questionable Refund Program to include prisoner returns. The
    IRS will continue to coordinate with prison officials to acquire complete
    and accurate information on the prison population to maximize the
    effectiveness of its automated systems in promptly identifying
    questionable returns filed by inmates. Furthermore, the IRS will ensure
    all Fraud Detection Centers have procedures in place to coordinate fraud
    prevention efforts with the prisons in the states they serve.

    x Enhance IRS' Electronic Fraud Detection System to improve its efficiency
    in detecting fraudulent refund schemes involving individual as well as
    business returns.

    x Integrate the Decision Support Tool into the Reporting Compliance Case
    Resolution workflow. (06/2006)

    x Develop joint W&I and SB/SE Reporting Compliance Concept of Operations
    and system concept for coordinated workload management and resolution
    system to manage and move case inventory (this replaced EITC's Corporate
    Inventory Management Routing & Integration project). (12/2005)

    x Identify new ways to administer EITC by partnering with states (New
    York, Massachusetts, and New Jersey) through the use of proactive research
    initiatives. (12/2005)

    x Use data-driven scoring and selection methods to select cases for
    examination and apply the right compliance treatments to address
    taxpayers. (01/2006)

    x Test new selection tools to determine more effective compliance
    treatments for return preparers. (03/2006)

    x Initiate research to assess changes in taxpayer EITC filing volume and
    track EITC return math error accuracy through outreach campaigns and
    volunteer tax return preparation. (Ongoing)

    60

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    x Develop multi-year return preparer strategy that addresses paid preparer
         non-compliance
         and gather data on the effects of these efforts on paid preparers as
         well as taxpayers.
         (Ongoing)
         Test the use of a National Directory of New Hires (NDNH) database match
    x in the IRS'
         Criminal Investigation EITC Fraud Detection Centers. (12/2006)

    Bring Treasury's Financial Management Systems into compliance with Federal
    Financial Management Improvement Act (FFMIA) of 1996

    Issue: The IRS' financial management systems remain a challenge, despite
    producing combined financial statements covering tax custodial and
    administrative activities for the seventh consecutive year. Also, the IRS
    has achieved an unqualified audit opinion from the Government
    Accountability Office (GAO) on all financial statements since FY 2000.
    IRS' current financial systems alone cannot produce reliable information
    necessary to prepare financial statements in accordance with federal
    accounting standards. The data produced from the current financial system
    has to be reconciled with other subsidiary systems to produce reliable
    financial statements. The IRS lacks the timely, accurate, and useful
    information needed to make informed management decisions on an ongoing
    basis.

    Actions Taken

    x Custodial Accounting Project (CAP) was shutdown due to funding
    shortfalls.

    x Implemented the Integrated Financial System (IFS) as the IRS' internal
    accounting system of record.

    x The IRS developed a strategy concept to enhance the current Financial
    Management Information System (FMIS) to be compliant with FFMIA
    requirements.

    x FMIS enhancement concept was accepted by the Financial and Management
    Controls Executive Steering Committee and has been presented to Treasury
    CFO, OMB, and GAO.

    x The IRS developed a less costly alternative strategy to down grade
    custodial reporting weakness via implementation of new custodial database
    project.

    Actions Planned or Underway

    x FMIS enhancements are planned to be accomplished through four releases
    beginning in 2006 through 2008.

    x MITS is currently developing on Release 1 which is the Unpaid Assessment
    and Trust Fund Recovery Penalty (TFRP) database and sub-ledger functions.

    x Full funding requirements for the FMIS enhancements have been included
    in the FY 2007 E-300 submission.

    61

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Success is measured by a set of key milestones for each project identified
    in the detailed project plans developed for all Tier A projects. Success
    is also measured by the Office of Management and Budget through the
    President's Management Agenda. The IRS receives scores for both Plan and
    Status on a quarterly basis.

                                           62

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    V. Financial Highlights

    Stewardship Information Analysis

    a. Overview of Revenue and Administrative Accounts

    The IRS' financial statements and footnotes received an unqualified audit
    opinion for the sixth consecutive year for administrative accounts and the
    ninth consecutive year for revenue accounts. Administrative accounts
    reflect resources used and expenses incurred in administering the tax
    laws. Revenue accounts reflect net taxes receivable and net taxes
    collected to support the federal government.

    The Balance Sheet reflects total assets of $27 billion. Of these assets,
    77.8% are Federal Taxes Receivable. These receivables are the amounts
    expected to be collected from past due accounts. The increase in assets of
    $1.4 billion is primarily attributable to increases in the amounts due
    from Treasury for tax refunds due taxpayers, taxpayer deposits for unpaid
    assessments and federal taxes receivable. The majority of the liabilities,
    83.7%, consist of amounts due to Treasury related to Federal Taxes
    Receivable.

    The Statement of Custodial Activity shows that IRS programs resulted in
    $2.267 trillion in Federal receipts. IRS collections constitute 96% of the
    Federal Government receipts, as shown in the chart below.

                           Total Federal Receipts - (Percent)

                                           63

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    b. Financing Sources

    The IRS receives the majority of its funding through annual and multi-year
    appropriations which are available for use within certain specified
    statutory limits. There are three major and two minor operating
    appropriations. The Processing, Assistance and Management appropriation
    funds the processing of tax returns and related documents, assistance for
    taxpayers in the filing of their returns and paying taxes due, matching
    information with returns, conducting internal audit reviews and security
    investigations and managing financial resources. The Tax Law Enforcement
    appropriation provides funds for the examination of tax returns and the
    administrative and judicial settlement of taxpayer appeals of examination
    findings, as well as providing resources for expanded customer service and
    education, strengthened enforcement and enhanced research to reduce valid
    claims and erroneous filings associated with the Earned Income Tax Credit
    (EITC) program. The Information Services appropriation funds costs for
    data processing and information and telecommunications support for the
    Service's activities. The Business Systems Modernization Account is the
    most significant of the minor operating appropriations and funds capital
    asset acquisitions of information technology systems. The Health Coverage
    Tax Credit appropriation (HCTC) funds necessary expenses to implement the
    program.

    Besides appropriations, the Service utilizes other financing sources.
    These include net transfers from other federal agencies, User Fees for
    direct services provided to customers (for example, installment fees,
    photocopy fees, and letter rulings and determinations fees) and imputed
    financing (subsidies from other federal funds that cover specific expenses
    such as retirement benefits).

    c. Use of Resources

    The Statement of Net Cost reflects the use of resources in carrying out
    the agency's major programs.

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    The major programs are Pre-filing, Filing and Account Services, Compliance
    and Administration of Tax Credit Programs (EITC and HCTC). Pre-filing
    activities include taxpayer education and outreach, pre-filing agreements
    and tax publication issuance and distribution. Filing and Account Services
    activities include the filing of tax returns, current account status and
    processing of taxpayer information. Compliance activities include document
    matching, audits, and criminal investigation activities. Administration of
    the Tax Credit programs includes EITC pre-filing, filing and account
    services, and compliance activities and HCTC health insurance tax credit
    program activities.

    Revenue and Refund Trend Information

    Federal tax revenues are collected through six major classifications:
    individual income, corporate income, excise taxes, estate and gift taxes,
    railroad retirement, and Federal unemployment taxes. Overall revenue
    receipts ($2.267 trillion) for FY 2005 increased by approximately 12% from
    FY2004 to FY2005. Individual income taxes, which include both FICA and
    SECA taxes, increased by 10%. Corporate income taxes increased by 33%.
    Collections from all other tax sources increased 3% from FY2004 to FY2005.

    Gross combined individual income tax and employment tax withholding
    increased as wages and salaries grew. Gross combined individual
    non-withheld and SECA receipts increased due to the increase in final
    payments on calendar year 2004 liabilities. Contributing factors include
    the higher 2004 incomes, lower 2004 deductions and a higher effective tax
    rate on 2004 taxable income reported in Fiscal Year 2005. Net corporate
    receipts increased due to the growth in gross corporate tax receipts and
    the decrease in refunds. Net IRS excise tax receipts increased in line
    with the expansion of the economy.

    Federal tax refund activity, which includes tax, interest, payments for
    Earned Income Tax Credit and Child Care Tax Credit in excess of the tax
    liability was $267 billion. In fiscal year 2005, the Service issued $62
    million in advance payments of the Earned Income Tax Credit. Overall
    refund disbursements decreased by 4% from FY2004 to FY2005.

     Analysis of Unpaid Assessments Most Unpaid Assessments Are Not Receivables and
                               Are Largely Uncollectible

    This unpaid assessment balance represents assessments resulting from
    taxpayers filing returns without sufficient payment; as well as from the
    Service's enforcement programs such as Examination, Underreporter,
    Substitute for Return and Combined Annual Wage Reporting. As reflected in
    the supplemental information to the IRS' fiscal year 2005 Financial
    Statements, the unpaid assessment balance was about $230 billion as of
    September 30, 2005.

    Under federal accounting standards, unpaid assessments require taxpayer or
    court

    agreement to be considered federal taxes receivable. Assessments not
    agreed to by

    taxpayers or the courts are considered compliance assessments and are not
    considered

    federal taxes receivable. Assessments considered to have no future
    collection potential are

    called write-offs.

    65

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    Components of the IRS' $230 Billion of Unpaid Assessments

                                    Compliance ($44)

    Write-offs

    Of the $230 billion balance of unpaid assessments, $98 billion represents
    write-offs. Write-offs include amounts owed by defunct corporations with
    no assets and include many failed financial institutions assisted by the
    Resolution Trust Corporation (RTC) and the Federal Deposit Insurance
    Corporation (FDIC). The remaining amounts are owed by taxpayers with
    extreme economic and/or financial hardships, deceased taxpayers, and
    taxpayers who are insolvent due to bankruptcy. Write-offs at September 30,
    2005 ($98 billion) decreased about 15% from September 30, 2004 ($115
    billion) due primarily to the expiration of the statute for collections on
    amounts owed by defunct corporations and failed financial institutions. In
    FY2005, statutes expired for $21 billion of failed financial institution
    unpaid assessment accounts assisted by the RTC and the FDIC.

                                           66

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

                    Components of the IRS' $98 Billion of Write-offs

    The $44 billion of the unpaid assessments representing compliance
    assessment are amounts that have not been agreed to by either the taxpayer
    or a court. These assessments result primarily from various Service
    enforcement programs promoting voluntary compliance. Due to the lack of
    agreement, they have less potential for future collection than the unpaid
    assessments considered federal taxes receivable.

    The remaining $88 billion of unpaid assessments represent federal taxes
    receivable. About $67 billion (76%) of this balance is estimated to be
    uncollectible due primarily to the taxpayer's economic situation,
    including individual taxpayers who are unemployed, are currently in
    bankruptcy or have other financial problems. However, under certain
    conditions, the IRS may continue collection actions for 10 years after the
    assessment. Thus, these accounts may still ultimately have some collection
    potential if the taxpayer's economic condition improves.

    About $21 billion (24%) of federal taxes receivable is estimated to be
    collectible. Components of the collectible balance include installment
    agreements with estates and individuals, confirmed payment plans through
    bankruptcy and some newer amounts due from individuals and businesses with
    a history of compliance. The taxes receivable amount from September 30,
    2004 ($89 billion) to September 30, 2005 ($88 billion) decreased by $1
    billion. The percent estimated to be collectible at September 30, 2005
    (24%), increased from September 30, 2004 (22%).

    67

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

                 Components of the IRS' $88 Billion of Taxes Receivable

                           Taxes Receivable Collectible ($21)

                         Taxes Receivable - Uncollectible ($67)

    It is important to note that the unpaid assessment balance contains unpaid
    assessed tax, penalty, and interest and accrued penalty and interest
    computed through September 30, 2005.

                                           68

    INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
    Year Ended September 30, 2005

    About $136 billion (59%) of the unpaid assessment balance as of September
    30, 2005, consists of interest and penalties and is largely uncollectible.

    Unpaid Taxes and Interest and Penalty Components of $230 Billion in Unpaid
    Assessments

    Interest and penalties are such a high percentage of the balance of unpaid
    assessments because the IRS must continue to accrue them through the
    10-year statutory collection date, regardless of whether an account meets
    the criteria for financial statement recognition or has any collection
    potential. For example, interest and penalties continue to accrue on
    write-offs, such as FDIC and RTC cases, and on exam assessments where
    taxpayers have not agreed to the amount assessed. The overall decrease in
    unpaid assessments during fiscal year 2005 was mostly attributable to
    expiration of the statute for collections on amounts owed by failed
    financial institutions assisted by the RTC and the FDIC.

                                           69

                       FY 2005 Management Discussion and Analysis

      ADDENDUM: President's Management Agenda Scorecard

    The IRS made steady progress on the President's Management Agenda (PMA)
    this year, earning "Green" in progress and status on Competitive Sourcing,
    and "Green" in progress on Human Capital and Budget and Performance
    Integration. The IRS adjusted its "getting to green plans" to reflect the
    new "proud to be" criteria to achieve these goals during 2005. In FY 2005,
    Eliminating Improper Payments became a separate initiative in the
    President's Management Agenda. Eliminating Improper Payments is geared
    toward reducing erroneous payments in the Earned Income Tax Credit (EITC)
    program. EITC is a refundable Federal income tax credit for low-income
    working individuals and families and is the IRS' only program impacted by
    the Improper Payments and Information Act of 2002 (IPIA).

    IPIA requires agencies to annually review programs and activities to
    identify those susceptible to significant erroneous payments. Under
    implementing OMB guidance, "Significant" means the estimated error rate
    and dollar amount exceed the threshold of 2.5% of program payments and $10
    million. Once agencies identify high-risk programs, a method for
    systematically reviewing them is developed using statistically valid
    sampling to determine error rates. If those rates, when applied to total
    program funding, result in a level of improper payments greater than or
    equal to $10 million, then an action plan is developed for resolving
    identified problems and reducing errors.

    The table below summarizes OMB's scorecard for Treasury for FY 2005.

           Initiative                        1st       2nd       3rd       4th
          Competitive                      Quarter   Quarter   Quarter   Quarter
         Sourcing Human                     Green     Green     Green     Green
    Capital Budget and                  Yellow     Green     Green     Green
          Performance                      Yellow    Yellow    Yellow    Yellow
    Integration E- Gov                   Green     Green     Green     Green
          Eliminating                      Yellow    Yellow    Yellow    Yellow
    Improper Payments  Status Progress Green Red Green Red Green Red Green Red
           Financial      Status Progress Green NR  Green Red  Yellow   Green Red
          Performance     Status Progress  NR Red   Green Red    Red     Yellow
                          Status Progress  Yellow      Red     Yellow      Red
                          StatusProgress                         Red     Yellow
                          Status Progress                      Yellow

    Green = Meets OMB Scorecard criteria Yellow = Partially meets scorecard
    criteria

    Red = Does not meet criteria
    NR  = Not Rated
           70
                    Page 85 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial
                                                                       Statements

                       FY 2005 Management Discussion and Analysis
         Deploy a Learning Content Management System that will permit more
    x efficient development
         of training materials and ensure more consistency in training across the
         IRS.
    x Complete the conversion of all MCO application processes to the
         CareerConnector system
         and begin the conversion of the non-MCO occupations.

    Competitive Sourcing

        Accomplished

    x Received the 2004 President's Quality Award for Innovation in
    Competitive Sourcing (CS).

    x Recognized in March 2005 with the 2004 NISH organization's Government
    Award for Services for Service-wide Mail and Toll Free Forms Taxpayer
    virtual call center contracts issued under the Javits-Wagner-O'Day Act
    providing work opportunities for disabled individuals including first time
    home-based employment for people with disabilities.

    x Implemented National Distribution Center (NDC) competitive sourcing
    initiative enabling the IRS to cancel leases releasing approximately
    395,000 square feet and reducing rent by $4.1 million.

    x Launched Competitive Sourcing Internet knowledge sharing content at
    www.irs.gov and Share A-76.

    x Developed "Managing an Effective Competitive Sourcing Program" DVD
    training sponsored by the Federal Acquisition Institute.

    x Completed 2005 FAIR Act Inventory for all of Treasury on schedule.

    x Implemented Microsoft Project Server enhancing project management
    discipline across all support functions-HR, Procurement, Business
    Divisions, etc.

    x Implemented virtual team rooms using SharePoint software improving team
    knowledge sharing through secure shared document creation and version
    control.

    x Participated in the HR Connect System walkthrough activity leading to
    the use of HR Connect for FY 2006 FAIR Act inventory.

    x Awarded Campus Files competition to IRS employees who were deemed Most
    Efficient Organization (MEO).

    x Awarded Building Designation contract to private contractor.

        Planned

    x Conduct Preliminary Planning on Seat Management and Fuel Compliance.

    x Continue Business Case Analysis (BCA): Real Estate and Facilities
    Management.

    x Announce Solicitation: Logistics.

    x Develop Learning and Education Business Process Re-engineering design.

    x Implement approved Shared Services recommendations.

    x Lead the development of the second Competitive Sourcing Training DVD.

    x Brief the Strategy and Resource Council on proposed potential CS
    projects to begin BCA planning schedules.

    x Capture baseline costing in COMPARE and verify projected economic
    savings.

    x Continue Expert Contractor Delivery of Competitive Sourcing Training
    (all phases) to IRS employees and managers.

    Budget & Performance Integration

                                           72

    FY 2005 Management Discussion and Analysis

    Accomplished

    x Improved Program Assessment Rating Tool (PART) rating to "Moderately
         Effective" for
         Submission Processing Program.
    x Received PART rating of "Moderately Effective" for Criminal
         Investigation and Examination
         Programs.
    x Used IFS cost module capabilities to capture cost data for FY 2005,
         enabling the IRS to
         analyze direct expense data (labor, supplies, travel, etc), FTEs and
         on-rolls data from the
         lowest cost center.
    x Completed allocation to distribute support costs to the operational
         business units.
    x Improved performance and efficiency for over half of IRS programs.
    x Included programmatic long-term goals in FY 2007 budget submission.
    x Developed draft set of strategic long-term goals.

        Planned

    x Reach agreement with the Administration and the Appropriators on the
    structure of the FY 2007 budget request.

    x Link resource needs with expected performance and long term goals in the
    FY 2007 Congressional Justification.

    x Continue to assess and use the cost data obtained through IFS to further
    develop robust cost-based performance measures for major programs.

    x Continue efforts to identify long-term goals for Regulatory Compliance
    and Research.

    x Introduce enterprise-wide goals linking directly to the IRS Strategic
    Plan.

    x Expand the pay for performance system to frontline managers linking
    performance results with salary increases.

    x Develop FY 2008 congressional request linking resource needs with
    expected performance and long term goals.

    x Submit remaining programs to OMB for an initial PART assessment.

    E-Government

        Accomplished

    x Processed over five million Free File returns in 2005, representing a
    43% increase over the prior year.

    x Expanded support of electronic filing of business forms by completing
    agreements with New York and Georgia to link state registration
    applications to the federal Internet Employer Identification Number (EIN)
    application for a one-stop experience.

    x Expanded electronic filing of additional business forms: 1120, 990, and
    94X series.

    x Actively supported other e-gov initiatives, such as Business Gateway,
    grants.gov, and GovBenefits.gov.

    x Implemented an eCatalog (eCat) pilot program to begin an Integrated
    Acquisition Environment which will use Contract Optimization and Strategic
    Contracts as tools to incur savings.

    x Identified IFS alternative from Line of Business Initiative to implement
    as the IFS Go Forward Strategy.

    x Completed the security certification and accreditation of its network
    infrastructure general support systems making substantial progress in
    improving the Federal Information System Management Act (FISMA) compliance
    status of all IRS information systems.

    x Developed General Support Systems (GSS) and Major Applications' Plans of
    Actions and Milestones (PoAMs) to manage, monitor and track corrective
    actions.

                                           73

                       FY 2005 Management Discussion and Analysis
    x Completed FY 2004 qualifying child certification and Filing Status test.
    x Finalized new participant selection methodology for FY 2005 qualifying
         child certification
         test.
    x Completed final report to Congress on results of FY 2004 qualifying
         child certification and
         filing status tests.
    x Evaluated research initiatives and assessed prior year studies to
         improve EITC outreach,
         compliance initiatives, program delivery and measurement strategies.

        Planned

    x Launch the final phase of the qualifying child certification test-focus
    on improved selection methodology.

    x Complete compliance analysis of TY 2001 returns claiming EITC (National
    Research Program).

    x Continue to develop and distribute materials to educate taxpayers and
    practitioners on EITC eligibility rules and compliance issues.

    x Report results of the National Directory of New Hires database match
    test.

    x Plan for TY 2006 compliance study.

    x Launch integrated decision support tool for EITC examiners.

    x Launch new risk-based scoring strategy and inventory management
    capability to improve

    selection and assignment of EITC returns for examination.

    x Complete evaluation of FY 2004 certification, filing status and income
    misreporting tests.

    x Test new selection tools to determine more effective compliance
    treatments for return preparers.

    x Complete evaluation of FY 2005 certification and filing status tests.

    x Launch significantly enhanced methodology to improve the selection of
    EITC amended returns for examination.

    x Update EITC Strategy and Program plan and identify EITC education and
    outreach targets based on results from FY 2004, FY 2005 and FY 2006 tests.

                                           75

    Financial Statements

      Balance Sheets

        Internal Revenue Service Balance Sheet As of September 30, 2005 and 2004

                                     (In Millions)
    Assets                                                2005         2004
    Intragovernmental:
    Fund balance with Treasury (Note 2)                 $    1,990  $    1,725
    Due from Treasury (Note 13)                              1,946       1,801
    Other assets (Note 4)                                      150         149
    Total Intragovernmental                                  4,086       3,675
    With the Public:
    Cash and other monetary assets (Notes 3, 13)               466          86
    Federal Taxes receivable, net of
    allowance for doubtful accounts (Notes 5, 13)          21,000       20,000
    Other assets (Note 4)                                       12          21
    Total with the Public                                  21,478       20,107
    Property and equipment, Net (Note 6)                     1,422       1,775
    Total Assets                                        $  26,986   $   25,557
    Liabilities
    Intragovernmental:
    Due to Treasury (Notes 5, 13)                       $  21,000   $   20,000
    Other liabilities (Note 7)                                 174         165
    Total Intragovernmental                                21,174       20,165
    Federal tax refunds payable (Note 13)                    1,946       1,801
    Other liabilities (Notes 7 to 10)                        1,973       1,524
    Total Liabilities                                   $  25,093   $   23,490
    Net position
    Unexpended Appropriations                           $    1,538  $    1,255
    Cumulative Results of Operations                           355         812
    Total Net Position                                  $    1,893  $    2,067
    Total Liabilities and Net Position                  $  26,986   $   25,557

            The accompanying notes are an integral part of these statements.

    1

                                  Financial Statements

      Statements of Net Cost

    Internal Revenue Service Statement of Net Cost For the Years Ended September 30,
                                     2005 and 2004

                                     (In Millions)
                                                               2005      2004
    Program
    Pre-Filing Taxpayer Assistance and Education
    Full cost                                        $       627  $        673
    Exchange revenue                                        (46)          (59)
    Net cost of program                                      581           614
    Filing and Account Services
    Full cost                                            3,970           3,452
    Exchange revenue                                        (43)          (69)
    Net cost of program                                  3,927           3,383
    Compliance Services
    Full cost                                            6,859           6,280
    Exchange revenue                                       (183)         (159)
    Net cost of program                                  6,676           6,121
    Administration of Tax Credit Programs
    Full cost                                                279           280
    Exchange revenue                                           -             -
    Net cost of program                                      279           280
    Net Cost of Operations (Note 17)                 $  11,463    $     10,398

            The accompanying notes are an integral part of these statements.

    2

                                  Financial Statements

      Statements of Changes in Net Position

      Internal Revenue Service Statement of Changes in Net Position For the Years
                           Ended September 30, 2005 and 2004

                                     (In Millions)
                                                   2005           2004
                                             Cumulative Cumulative
                              Results of   Unexpended   Results of   Unexpended
                              Operations Appropriations Operations Appropriations
    Beginning Balances                   812$ 1,255$ 647$ 1,139$
    Budgetary Financing Sources:
    Appropriations received                   10,318                    10,245
    Canceled appropriations and
    rescissions
    and other                       (129)          3                     (138)
    Appropriations used            10,038  (10,038)      9,991         (9,991)
    Other Financing Sources:
    Imputed financing from costs     1,121                   611
    absorbed by others
    Transfers in/out without               15                15
    reimbursement
    Transfers to General Fund            (39)               (54)
    Total Financing Sources         11,006     283         10,563          116
    Net Cost of Operations         (11,463)               (10,398)
    Net Change                          (457)  283           165           116
    Ending Balances                      355$ 1,538$ 812$ 1,255$

            The accompanying notes are an integral part of these statements.

    3

                                  Financial Statements

      Statements of Budgetary Resources

     Internal Revenue Service Statement of Budgetary Resources For the Years Ended
                              September 30, 2005 and 2004

                                     (In Millions)
                                                                 2005   2004
    Budgetary Resources:
    Budget authority: Budgetary appropriations       $             $
    received (Note 11) Unobligated balance,
    beginning of period Spending authority from         10,408 570      10,329
    offsetting collections (Note 19) Recoveries of          161 59     473 173
    prior year obligations Permanently not available         (126)   154 (138)
    Total Budgetary Resources                        $   11,072    $    10,991
    Status of Budgetary Resources:
    Obligations incurred (Note 18)                   $   10,584    $    10,421
    Unobligated balance - available (Note 2)                   252         178
    Unobligated balance - not available (Note 2)               236         392
    Total Status of Budgetary Resources              $   11,072    $    10,991
    Relationship of Obligations to Outlays:
    Obligated balance, net, beginning of period      $ 1,161       $ 1,266
    Obligated balance, net, end of period (Note 12)    (1,511)       (1,161)
    Outlays: Disbursements Less: collections Less:                      10,372
    offsetting receipts                              $      10,179 $     (173)
                                                           (164) (91)        (89)
    Net Outlays                                      $    9,924    $    10,110

            The accompanying notes are an integral part of these statements.

    4

                                  Financial Statements

      Statements of Financing

     Internal Revenue Service Statement of Financing For the Years Ended September
                                   30, 2005 and 2004

                                     (In Millions)
                                                                    2005   2004
    Resources Used to Finance Activities:
    Budgetary Resources Obligated:
    Obligations incurred (Note 18)                           $ 10,584 $ 10,421
    Less: spending authority from offsetting collections and    (220)    (327)
    recoveries
    Less: offsetting receipts                                    (91)     (89)
    Net obligations                                            10,273   10,005
    Imputed financing from costs absorbed by others            1,121       611
    Transfers in/out without reimbursement                         15       15
    Other resources used to finance activities, net                91     (48)
    Total Resources Used to Finance Activities               $ 11,500 $ 10,583
    Resources Used to Finance Items Not Part of the Net Cost
    of Operations:
    Change in budgetary resources obligated for goods,
    services, and benefits
    ordered but not yet provided                             $  (340) $   (40)
    Resources that finance the acquisition of assets            (286)    (572)
    Total Resources Used to Finance Items Not Part of the       (626)    (612)
    Net Cost of Operations
    Total Resources Used to Finance the Net Cost of          $ 10,874 $  9,971
    Operations
    Components of the Net Cost of Operations That Will Not
    Require or Generate
    Resources in the Current Period:
    Components Requiring or Generating Resources in Future
    Periods:
    Increase in annual leave liability                       $      6 $     22
    Other                                                        (28)       15
    Components Not Requiring or Generating Resources in
    Future Periods
    Depreciation and amortization                                 464      390
    Revaluation of assets or liabilities                          147        -
    Total Components of Net Cost of Operations That Will Not
    Require or
    Generate Resources in the Current Period                 $    589 $    427
    Net Cost of Operations                                   $ 11,463 $ 10,398

            The accompanying notes are an integral part of these statements.

    5

                                  Financial Statements

      Statements of Custodial Activity

      Internal Revenue Service Statement of Custodial Activity For the Years Ended
                              September 30, 2005 and 2004

                                     (In Billions)
                                                                   2005    2004
    REVENUE ACTIVITY
    Collections of Federal Tax Revenue (Note 15)
    Individual income, FICA/SECA, and other                $  1,865  $   1,696
    Corporate income                                             307       230
    Excise                                                        58        55
    Estate and gift                                               26        26
    Railroad retirement                                            4         4
    Federal unemployment                                           7         7
    Total Collections of Federal Tax Revenue                  2,267      2,018
    Increase/(Decrease) in federal taxes receivable, net           1         -
    Total Federal Tax Revenue                                 2,268      2,018
    Distribution of Federal Tax Revenue to Treasury           2,267      2,018
    Increase/(Decrease) in amount due to Treasury                  1         -
    Total Disposition of Federal Tax Revenue                  2,268      2,018
    NET FEDERAL REVENUE ACTIVITY                           $       - $       -
    FEDERAL TAX REFUND ACTIVITY (Note 16)
    Total Refunds of Federal Taxes                         $     267 $     278
    Appropriations Used for Refund of Federal Taxes            (267)     (278)
    NET FEDERAL TAX REFUND ACTIVITY                        $       - $       -

            The accompanying notes are an integral part of these statements.

    6

                                  Financial Statements

                           Notes to the Financial Statements

                                INTERNAL REVENUE SERVICE

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    Note 1. Summary of Significant Accounting Policies

    A. Reporting Entity

    The Internal Revenue Service (the Service) is a bureau of the U.S.
    Department of the Treasury (Treasury). The Service originated in 1862,
    when Congress established the Office of the Commissioner of the Internal
    Revenue. In 1952, the Bureau was reorganized by Congress and became the
    Internal Revenue Service (IRS) in 1953.

    Currently, the organization consists of:

    x Four operating divisions - Wage and Investment (WAGE) addresses the
    needs of taxpayers with wage and investment income only. Small Business
    and Self-Employed (SBSE) serves self-employed individuals and small
    businesses. Tax-Exempt and Government Entities (TEGE) supports employee
    plans, tax exempt organizations, and government entities. Large and
    Mid-Size Business (LMSB) serves corporations, sub-chapter S corporations,
    and partnerships with assets greater than $5 million.

    x Functional support - Appeals, Criminal Investigation, Taxpayer Advocate
    and Chief Counsel are independent of the operating divisions and other
    units of the Service. Taxpayer Advocate reports directly to Congress and
    Chief Counsel reports to the Secretary of the Treasury.

    x National Headquarters fills the role of setting broad policy, providing
    executive oversight, reviewing plans and goals of the operating units, and
    developing major improvement initiatives.

    x Two cross-servicing organizations - Modernization and Information
    Technology Services (MITS) and Agency Wide Shared Services (AWSS) provide
    central support to all areas of the Service.

    The mission of the Service is to provide America's taxpayers with
    top-quality service by helping them understand and meet their tax
    responsibilities and by applying the tax law with integrity and fairness
    to all.

    B. Basis of Accounting and Presentation

    The financial statements have been prepared from the accounting records of
    the Service in conformity with accounting principles generally accepted in
    the United States (GAAP) and the Office of Management and Budget (OMB)
    Circular A-136, Financial Reporting Requirements. Accounting principles
    generally accepted for federal entities are the standards prescribed by
    the Federal Accounting Standards Advisory Board (FASAB). FASAB is
    recognized by the American Institute of Certified Public Accountants as
    the official accounting standards-setting body of the Federal Government.

    These financial statements are provided to meet the requirements of the
    Government Management Reform Act of 1994. They consist of the Balance
    Sheet, the Statement of Net Cost, the Statement of Changes in Net
    Position, the Statement of Budgetary Resources, the Statement of
    Financing, and the Statement of Custodial Activity. The statements and the
    related notes are prepared in a comparative form to present both FY 2005
    and FY 2004 information.

                                           7

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    Balance Sheet, Statement of Changes in Net Position

    These statements are presented on the accrual basis of accounting. Under
    the accrual method, revenues are recognized when earned, and expenses are
    recognized when costs are incurred or goods or services are received,
    without regard to receipt or payment of cash.

    Statement of Net Cost

    This statement is presented on the accrual basis of accounting. The
    Statement of Net Cost presents the costs incurred by the Service in
    performing its mission, net of related exchange revenues. These costs
    include direct costs, indirect costs assigned in a manner that reflects
    direct consumption of resources, and a proportionate share of other
    indirect costs.

    Program costs are aggregated across divisional lines into broad-based cost
    centers - pre-filing, filing, compliance and administration of tax credit
    programs described below.

    Pre-Filing Taxpayer Assistance and Education

    Provides services to taxpayers before returns are filed to assist
    taxpayers in preparing correct returns. Primary activities include
    interpretations, preparing and disseminating tax publications and
    information, taxpayer education programs, researching customer needs,
    pre-filing agreements and determinations, and initiatives to promote
    electronic tax filing. Exchange revenues include user fees from the
    pre-filing agreements and determinations, letter rulings, and enrolled
    agent fees.

    Filing and Account Services

    Performs accounts maintenance functions of processing tax returns,
    recording tax payments, issuing refunds, and maintaining taxpayer
    accounts. The scope extends to all tax returns and taxpayer accounts
    regardless of type and method of filing. Program activities also include
    providing field assistance in preparing tax returns and supplying tax
    forms to the public. Exchange revenues include user fees from photocopy
    services. Exchange revenues also include reimbursable revenues from
    services provided to other federal agencies.

    Compliance Services

    Administers compliance activities after a return is filed in order to
    identify and correct possible errors or underpayments. This program
    includes field collection activities, document matching, examination of
    returns, criminal investigation, and tax litigation. Exchange revenues
    include installment agreement fees and offers in compromise. Exchange
    revenues also include reimbursable revenues from services provided to
    other federal agencies.

    Administration of Tax Credit Programs

    Administers the Earned Income Tax Credit (EITC) and Health Coverage Tax
    Credit (HCTC) programs. EITC includes expanded customer service, public
    outreach, enforcement, and research efforts to reduce claims and erroneous
    filings associated with the program. EITC comprises pre-filing, filing and
    account services, and compliance activities. EITC payments actually
    refunded to individuals or credited against

    8

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    other tax liabilities are not included in program costs. HCTC includes
    activities focused on implementing the health insurance tax credit program
    set out in the Trade Act of 2002.

    Statement of Budgetary Resources

    The Statement of Budgetary Resources is presented using the budgetary
    basis of accounting. Budgetary accounting facilitates compliance with
    legal constraints and controls over the use of federal funds. This
    financial statement is in addition to the reports prepared by the Service
    throughout the year pursuant to OMB directives for purposes of monitoring
    and controlling the Service's obligation and expenditure of budgetary
    resources.

    Statement of Financing

    The Statement of Financing is presented using both an accrual and a
    budgetary basis of accounting as a means to facilitate understanding of
    the differences between the two accounting bases.

    Statement of Custodial Activity

    The Statement of Custodial Activity is presented on the modified cash
    basis of accounting. This method initially reports revenue in the
    financial statements on the cash basis, which is then adjusted by the
    change in net federal taxes receivable --net of the change in refunds
    payable -- during the current fiscal year. This adjustment effectively
    converts the cash basis revenue and refunds to a full accrual amount. The
    related distribution of all such collections to the Treasury is similarly
    reported on the cash basis. It is then adjusted to the accrual basis by
    the net change during the fiscal year in uncollected amounts due to
    Treasury.

    Refunds of taxes and interest are reported on the cash basis. Refunds
    include payments of earned income tax credits (EITC), health coverage tax
    credits (HCTC), and child care credits, as well as overpayments of taxes.

    C. Financing Sources and Exchange Revenue

    The Service receives the majority of its funding through annual,
    multi-year, and no-year appropriations that are available for use within
    statutory limits for operating and capital expenditures. Appropriations
    are recognized as financing sources when the related expenses are
    incurred. The following are the different types of operating
    appropriations:

    Processing, Assistance, and Management

    This appropriation provides funds for processing tax returns and related
    documents, assisting taxpayers in the filing of their returns and in
    paying taxes that are due, strategic planning and oversight, finance,
    human resources, and agency-wide shared services.

    Tax Law Enforcement

    The purpose of this appropriation is to provide funds for the enforcement
    of Internal Revenue Laws, examination of tax returns, administration of
    taxpayer appeals, collection of unpaid accounts, and securing unfiled tax
    returns and payments. It also provides for issuing technical rulings,
    monitoring employee pension plans, qualifying exempt organizations,
    examining exempt tax returns, and compiling statistics of income and
    compliance research.

                                           9

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    Information Systems

    This appropriation funds costs for data processing and information and
    telecommunication support for the Service's activities, including
    developmental information systems and operational information systems. The
    operational systems are located in a variety of sites including the
    Martinsburg Computing Center, the Detroit Computing Center, the Tennessee
    Computing Center, and in field offices and service centers.

    Other

    These budgetary accounts consist of an aggregate of smaller
    multi-functional funds that support the Service's mission to collect the
    proper amount of tax and provide improved customer service to the
    taxpayer. The Business Systems Modernization (BSM) appropriation is the
    largest of these funds and may be obligated as Congress approves
    expenditure plans. The Health Insurance Tax Credit Administration
    appropriation funds necessary expenses to implement the health insurance
    tax credit and was included in the Trade Act of 2002.

    In addition, the Service incurs certain costs that are paid in total or in
    part by other federal entities, such as pension costs administered by the
    Office of Personnel Management and legal judgments paid by the Treasury
    Judgment Fund. These constitute subsidized costs and are recognized by the
    Service on its Statement of Changes in Net Position and Statement of
    Financing as imputed financing sources equal to the cost paid by other
    federal entities. Pursuant to FASAB Interpretation Number 6 of the
    Statement of Federal Financial Standards Number 4, in fiscal year 2005,
    the Service began recording additional imputed financing sources for costs
    that are paid in total or in part by other entities within the Department
    of Treasury, notably Financial Management Services for electronic funds
    transfers.

    D. Fund Balance with Treasury

    The fund balance with Treasury is the aggregate amount of funds in the
    Service's accounts, including appropriated funds, from which the Service
    is authorized to make expenditures and pay liabilities, as well as funds
    in deposit, suspense, and clearing accounts.

    E. Other Assets - Accounts Receivable and Advances

    Intragovernmental accounts receivable consist of amounts due from federal
    agencies. Accounts receivable are recorded, and reimbursable revenues are
    recognized, as the services are performed and costs are incurred. Accounts
    receivable are also recorded, and transfers-in are recognized, when
    notices are received from official representatives of the Treasury
    Forfeiture Fund (TFF) advising IRS of the amount and availability of
    planned discretionary nonreciprocal distributions of TFF assets to IRS.
    The allowance for uncollectible accounts is based on an annual review of
    groups of accounts by age and includes accounts receivable balances older
    than one year.

    Advances to government agencies primarily represent funds paid to the
    Treasury Working Capital Fund (WCF). Amounts in the fund are available for
    expenses of operating and maintaining common administrative services of
    Treasury that can be performed more economically as a centralized service.
    Centralized services funded through the WCF for the Service consist
    primarily of telecommunications services, payroll processing, and
    depreciation of property and equipment owned by the WCF.

    10

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    The majority of advances to the public are for investigations and employee
    travel advances, which are expensed upon receipt of employees' expense
    reports.

    F. Property and Equipment

    The net book values of Property and Equipment as of September 30, 2005 and
    2004 consist of the following components:

    Property and Equipment Acquisitions

    Property and equipment is recorded at historical cost. The Service
    acquires property and equipment through direct purchase, construction,
    development of software and systems, and through capital lease agreements.
    Property and equipment consists of tangible assets and software that are
    intended for use by the Service and have an estimated life of two years or
    greater. Other than limited exceptions noted below, property and equipment
    is capitalized regardless of acquisition cost. The Service depreciates
    property and equipment on a straight line basis with a half year
    depreciated in the first and final years. Disposals are recorded when
    deemed material.

    The Service classifies property and equipment into the following classes:
    ADP equipment, non-ADP equipment, furniture, investigative equipment,
    vehicles, major systems, internal use software, and leasehold
    improvements.

    ADP Equipment

    ADP Equipment consists of five types of equipment: 1) mainframe computers
    and related equipment, 2) minicomputers and related equipment, 3) local
    area network (LAN) servers and related equipment, 4) desktop and laptop
    computers and related equipment, and 5) telecommunications equipment. ADP
    equipment includes all related software, including commercial
    off-the-shelf software, except as separately stated under Internal Use
    Software discussed below. Mainframe computers and related equipment,
    minicomputers and related equipment, and telecommunications equipment have
    an estimated useful life of seven years. LAN servers and equipment have an
    estimated useful life of four years. Desktop and laptop computers and
    related equipment have an estimated useful life of three years.

    Office Equipment and Furniture, Investigative Equipment, and Vehicles

    The Service capitalizes office equipment and furniture, investigative
    equipment, and vehicles, with an individual-asset acquisition cost of
    $5,000 or more. The estimated useful life of office equipment and
    investigative equipment is ten years. Furniture has an estimated useful
    life of eight years, and vehicles have an estimated useful life of five
    years.

    Major Systems

    Prior to FY 2001, the Service capitalized certain costs of large-scale
    computer software systems as major systems. Subsequently, such costs are
    included in internal use software. Only projects exceeding $20 million
    were considered major systems. Major systems capitalized prior to
    September 30, 2000, had an estimated useful life of seven years, and
    continue to be depreciated over their remaining useful lives.

    11

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    Internal Use Software

    In accordance with Statement of Federal Financial Accounting Standards No.
    10 (SFFAS No. 10), Accounting for Internal Use Software, beginning in FY
    2001, the Service capitalizes all internal use software projects
    recognized and authorized by management as major development projects.
    Only projects with useful lives of two years or more and recognized as
    major development projects by the Modernization and Information Technology
    Services Executive Governance Council are capitalized.

    The Service capitalizes direct and indirect costs of internal use software
    incurred in the development phase of a project as defined in the SFFAS No.
    10. Direct costs include direct salaries and benefits of IRS employees
    assigned to the projects, consultant fees, and contracting costs. Related
    infrastructure and project management costs are allocated to the projects.
    Direct costs exclude maintenance contracts in effect at any time during
    development or thereafter.

    The Service applies indirect overhead to internal use software projects
    using a three-year average rate of overhead costs. The overhead rate is
    applied only to salaries and benefits of IRS employees directly assigned
    to the internal use software projects.

    In accordance with SFFAS No. 10, costs incurred for the development phase
    of a project are capitalized, while costs incurred for design (prior to
    the development phase) and operations (after the development phase) are
    expensed. The design phase, defined by Standard No. 10, includes
    conceptual formulation of alternatives, determination and testing of
    alternatives, determination of existence of needed technology, and final
    selection of alternatives. The development phase includes developing the
    software configuration and interfaces, coding, installation of hardware
    and software, and testing. The operational phase begins upon successful
    completion of testing.

    Internal use software's capitalized costs are accumulated in work in
    process until final acceptance and testing are successfully completed.
    Once completed, the costs are transferred to depreciable property.
    Internal use software has an estimated useful life of seven years with no
    residual value, and is depreciated using the straight-line method with a
    half-year convention in the first and final years.

    In accordance with SFFAS No. 10, disposals are recognized when software is
    determined to be obsolete or nonfunctional. The IRS treats terminated
    projects and/or subprojects as 100% obsolete. Obsolete projects are
    adjusted to reduce both the asset and accumulated depreciation accounts,
    and record any losses as a result of the disposal.

    Leasehold Improvements

    All leasehold improvement projects are capitalized regardless of cost.
    Leasehold improvements have an estimated useful life of ten years.

    G. Capital Lease Liability

    Capital lease liability includes amounts for non-ADP equipment and
    computer software leased under software licensing agreements. The
    liability reported represents the lesser of the net present value of
    future lease payments or the fair market value of the asset acquired. The
    liability for non-ADP equipment acquired under a capital lease is included
    in funded liabilities. The liability for software licenses is generally
    included in Liabilities Not Covered by Budgetary Resources.

    12

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    H. Permanent and Indefinite Funds

    The Service uses a special class of funds, designated as "permanent and
    indefinite", to disburse tax refund principal and related interest. These
    permanent and indefinite funds are not subject to budgetary ceilings set
    by Congress during the annual appropriation process. Because Congress
    permanently funds tax refunds from a budgetary standpoint, tax refunds
    payable at year-end are fully funded. The asset "Due from Treasury"
    designates this approved funding to pay year-end tax refund liabilities,
    which are reflected in the funds used for refund of federal taxes on the
    Statement of Custodial Activity along with tax refund payments for the
    year.

    Although funded through the appropriation process, refund activity is
    reported as a custodial activity of the Service. This presentation is
    appropriate because refunds are, in substance, a custodial revenue-related
    activity. Federal tax revenue received from taxpayers is not available for
    use in the operation of the Service and is not reported on the Statement
    of Net Cost. Likewise, the resultant refunds of overpayments are not
    available for use by the Service in operations. Consequently, to present
    refunds as an expense of the Service on the Statement of Net Cost with
    related appropriations used would be inconsistent with the reporting of
    the related federal tax revenue and would materially distort the costs
    incurred by the Service in meeting its strategic objectives.

    I. Tax Assessments and Abatements

    Under the Internal Revenue Code 26 USC Section 6201, the Secretary of the
    Treasury is authorized and required to make inquiries, determinations, and
    assessments of all taxes that have been imposed and accruing under any
    internal revenue law but have not been duly paid (including interest,
    additions to the tax, and assessable penalties). The Secretary has
    delegated this authority to the Commissioner of the IRS. Unpaid
    assessments result from taxpayers filing returns without sufficient
    payments, as well as from the Service's enforcement programs, such as
    examination, under-reporter, substitute for return, and combined annual
    wage reporting.

    The Commissioner of the IRS also has authority to abate the paid or unpaid
    portion of an assessed tax, interest, and penalty. Abatements occur for a
    number of reasons and are a normal part of the tax administration process
    (abatements may be allowed for a qualifying corporation that claimed a net
    operating loss which created a credit that can be carried back to reduce a
    prior year's tax liability, amend tax returns, and to correct an
    assessment from an enforcement program, taxes discharged in bankruptcy,
    accepted offers in compromise, penalty abatements for reasonable cause,
    contested assessments made due to mathematical or clerical errors, and
    assessments contested after the liability has been satisfied). Abatements
    may result in claims for refunds or a reduction of the unpaid assessed
    amount.

    J. Federal Taxes Receivable

    Federal taxes receivable and the corresponding liability, "Due to
    Treasury", are not accrued until related tax returns are filed or
    assessments made by IRS and agreed to by either the taxpayer or the court
    and prepayments netted against liabilities. Accruals are made to reflect
    penalties and interest on taxes receivable through the balance sheet date.

    Taxes receivable consist of unpaid assessments (taxes and associated
    penalties and interest) due from taxpayers for which the Service can
    support the existence of a receivable through taxpayer agreement, such as
    filing of a tax return without sufficient payment, or a court ruling in
    favor of the Service. Taxes

                                           13

                                  Financial Statements

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    receivable are shown on the balance sheet net of an allowance for doubtful
    accounts. The allowance for doubtful accounts reflects an estimate of the
    portion of total taxes receivable deemed to be uncollectible.

    Compliance assessments are unpaid assessments for which neither the
    taxpayer nor a court has affirmed that the taxpayer owes amounts to the
    Federal Government. Examples include assessments resulting from an IRS
    audit or examination in which the taxpayer does not agree with the
    results. These amounts are not reported on the balance sheet; however,
    statutory provisions require that these accounts be maintained until the
    statute for collection expires.

    Write-offs consist of unpaid assessments for which the Service does not
    expect further collections due to factors such as taxpayers' bankruptcy,
    insolvency, or death. These amounts are also not reported on the balance
    sheet; however, statutory provisions require that these accounts be
    maintained until the statute for collection expires.

    Note 2. Fund Balance with Treasury (In Millions)

    Fund balance with Treasury as of September 30, 2005 and 2004, consist of
    the following:

        Fund Balance 2005 2004

    Appropriated funds and other $ 1,990 $ 1,725

    Fund Balance with Treasury $ 1,990 $ 1,725

        Status of Fund Balance with Treasury 2005 2004

    Unobligated balances:

    Available

    Unavailable Obligated balances not yet disbursed

    Other funds

                                                  $ 252 $ 178 236 392 1,508 1,161

    (6) (6)

        Fund Balance with Treasury $ 1,990 $ 1,725

    The Business Systems Modernization (BSM) fund represents $297 million and
    $340 million of the appropriated fund balance as of September 30, 2005 and
    2004, respectively. BSM funds can only be obligated pursuant to an
    expenditure plan approved by Congress. Other funds primarily consist of
    suspense, deposit, and clearing funds.

                                           14

                                  Financial Statements

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    Note 3. Cash and Other Monetary Assets (In Millions)

    Cash and other monetary assets with the public as of September 30, 2005
    and 2004, consist of the following:

    2005 2004

    Imprest fund $ 4 $ 3 Other custodial assets 462 83

          Total Cash and Other Monetary Assets $ 466 $ 86

    Imprest funds are maintained by Headquarters and field offices in
    commercial bank accounts.

    Other custodial assets primarily represent voluntary deposits received
    from taxpayers, pending application of the funds to unpaid tax
    assessments. This category also includes seized monies of less than $1
    million as of September 30, 2005 and $1 million as of September 30, 2004,
    which are held pending the results of criminal investigations. As
    described in Note 13, other custodial assets are classified as "Nonentity
    Assets" and are offset by an equal liability in other custodial
    liabilities.

    Note 4. Other Assets (In Millions)

    Other assets as of September 30, 2005 and 2004, consist of the following:

    2005 Intra-With the Governmental Public

    2004 Intra-With the Governmental Public

    Advances $

    Accounts receivable, net

    Federal tax lien revolving fund

    Suspense

                                           130$ 8$ 129$ 12 16 719 7 -2 -1 4(5)1 1

          Total Other Assets $ 150 $ 12 $ 149 $ 21

    Note 5. Federal Taxes Receivable, Net

    Federal taxes receivable (gross) were $88 billion and $89 billion as of
    September 30, 2005 and 2004, respectively, and consisted of tax
    assessments, penalties, and interest that were not paid or abated, and
    which were agreed to by the taxpayer and the Service, or upheld by the
    courts.

    Federal taxes receivable (net) equaled $21 billion and $20 billion as of
    September 30, 2005 and 2004, respectively, and are the portion of federal
    taxes receivable (gross) estimated to be collectible. It is based on
    projections of collectibility from a statistical sample of taxes
    receivable. An allowance for doubtful accounts of $67 billion and $69
    billion was established in FY 2005 and FY 2004, respectively, for the
    difference between the gross federal taxes receivable and the portion
    estimated to be collectible. Due to

                                           15

    Financial Statements

                                INTERNAL REVENUE SERVICE

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    Treasury is the offsetting liability to federal taxes receivable,
    representing amounts to be transferred to Treasury when collected.

    Note 6. Property and Equipment (In Millions)

    Property and Equipment as of September 30, 2005 and 2004, is shown in the
    schedule below. The Cost column primarily represents the actual cost of
    property and equipment, net of disposals. The cost basis for FY 2005 and
    FY 2004 is $3,502 million and $3,422 million, respectively. Accumulated
    depreciation for FY 2005 and FY 2004 is $2,080 million and $1,647 million,
    respectively.

    Useful Category Life Cost

    2005 2004 Accumulated Net Book Net Book Depreciation Value Value

    ADP assets 3 to 7 Years Furniture and non-ADP

    equipment 8 to 10 Years Investigative equipment 10 Years Vehicles 5 Years
    Major systems 7 Years Internal use software 7 Years Internal use software
    - work in

    process Leasehold improvements 10 Years Assets Under Capital Lease 4 to 10
    Years

    $ 1,730 $ (1,228) $ 502 $ 534

          59 (39) 20 24 12(9)3 3 86 (60) 26 25 422 (333) 89 150 653 (145) 508 104

                                        35 -35635 423 (221) 202 225 82 (45) 37 75

            Total Property and Equipment $ 3,502 $ (2,080) $ 1,422 $ 1,775

    Prior to FY 2001, the Service captured the costs of major systems
    consulting and contractual services in the category "Major Systems". The
    Service has ten systems it considers major systems as of September 30,
    2005 and 2004. As of September 30, 2005, major systems consisted largely
    of costs associated with re-engineering the Martinsburg and Tennessee
    Computing Centers, known as the Mainframe Consolidation project, and a
    system to convert paper tax documents and remittances into electronic
    records, known as the Integrated Submission and Remittance Processing
    System.

    Major systems consist of the following:

    2005 2004 Accumulated Net Book Net Book Category Cost Depreciation Value
    Value

    Mainframe consolidation $ Integrated Submission and Remittance Processing
    System Other

    201 $ (158)$ 43 $ 72

    97 (76) 21 35 124 (99) 25 43

    Totals $ 422 $ (333) $ 89 $ 150

                                           16

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements

    For the Years Ended September 30, 2005 and 2004

    After FY 2000, the Service captured development of major systems as
    Internal Use Software. As of September 30, 2005 and 2004, the Service has
    15 internal use software projects, including deployed and work in process.
    Several projects are being deployed in phases (releases) as those releases
    become functional and are placed into service. Deployed projects include
    Customer Account Data Engine (Release 1), E-Services, Modernized E-File
    (Releases 1, 2, and 3.1), Security and Technology Infrastructure Release
    (STIR), Integrated Financial System (IFS), Internet Refund Fact of Filing,
    Enterprise Systems Management (ESM), and Customer Communications. CADE is
    a project to replace the Service's master file for taxpayer accounts.
    E-Services is a project to develop web-based products and services to
    communicate with the public and expand electronic filing of returns and
    requests. Modernized E-File is an electronic filing system for corporate
    tax returns. STIR is a project to modernize and standardize the
    information technology security infrastructure throughout the Service. IFS
    is an administrative financial system that was deployed at the start of
    fiscal year 2005. Internet Refund Fact of Filing is a project to allow
    taxpayers to review the status of their refund. ESM is a project that
    created a new information technology infrastructure, and Customer
    Communications is a customer service telephone system.

    Deployed internal use software projects consist of the following:

                                                              2005         2004
                                                Accumulated Net book     Net book
                  Category              Cost   depreciation   value       value
    Integrated Financial System     $  148  (10) $ 138$             $
    Modernized E-File                  113       (22)           91
    E-Services                         142       (30)          112
    CADE                               107       (23)           84
    STIR                                 76      (27)           49          60
    Customer Communications              25      (15)           10          14
    Enterprise Systems Management        16             (6)     10          12
    Internet Refund Fact of Filing       15             (5)     10          12
    Other                                11             (7)      4           6
    Totals                          $  653  (145) $ 508$            $      104

    Until deployed, internal use software projects are carried as work in
    process. Major projects in process include Customer Account Data Engine
    (Release 2) (CADE Release 2) and Modernized E-File Release

    3.2. All development work on Custodial Accounting Project (CAP), a project
    that was in work in process, was stopped in fiscal year 2005 due to
    funding issues. The costs accumulated in work in process for CAP were $143
    million when the project ended. These costs have been recognized as a loss
    on disposal in the current fiscal year.

    17

                                  Financial Statements

                                INTERNAL REVENUE SERVICE

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    The costs of internal use software - work in process consist of the
    following:

          Category 2005 2004

    Customer Account Data Engine $ 18 $ 119 Integrated Financial Systems -140
    Custodial Accounting Project -130 E-Services -147 Modernized E-File 15 96
    Other 2 3

          Totals $ 35 $ 635

    Equipment and software licenses acquired through capital leases are
    included in the categories below. Disclosures concerning associated
    capital lease liabilities are provided in Notes 7 and 8.

    Useful Category Life Cost

    2005 2004 Accumulated Net Book Net Book Depreciation Value Value

    ADP Assets - Software Licenses 7 Years ADP Assets - Equipment 4 Years
    Equipment - Photocopiers 10 Years

    $ 77$ (43)$ 34$ 73 3(1)2 -2(1)1 2

            Totals $ 82 $ (45)$ 37 $ 75

    Note 7. Other Liabilities (In Millions)

    Other liabilities as of September 30, 2005 and 2004, consist of the
    following:

    2005 Intra-With the Governmental Public

    2004 Intra-With the Governmental Public

    Accounts payable $ Accrued expenses Accrued payroll and benefits Workers'
    compensation Accrued annual leave Other custodial liabilities Capital
    leases

         -$ 81$ -$ 30 201 30 188 51 222 42 199 92 520 92 547 -462 -456 -462 -83 1
                                                                           25 151

        Total Other Liabilities $ 174 $ 1,973 $ 165 $ 1,524

    Other custodial liabilities (the offsetting liability to other custodial
    assets) primarily consist of liabilities to taxpayers for deposits pending
    application of the funds to outstanding tax deficiencies and liability for
    seized monies.

                                           18

                                  Financial Statements

                                INTERNAL REVENUE SERVICE

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    Note 8. Leases (In Millions)

    The capital lease liability as of September 30, 2005 and 2004, is $26
    million and $52 million, respectively, for photocopiers and software
    licenses. In FY 2005 and FY 2004, photocopiers were leased under
    Lease-To-Ownership-Plans (LTOPs). The terms of the LTOPs provide for 48 to
    60 monthly payments for photocopiers. Under each LTOP, the equipment is
    owned as of the last monthly payment. Capital lease treatment is accorded
    to computer software leased under software licensing agreements. These
    licensing agreements provide for payments over periods ranging from four
    to six years. During 2005, final payments were made on two leases for
    software licenses. In FY 2005, ADP Equipment was acquired under a 48 month
    capital lease, with payments in the first and second year of the
    agreement. The ADP equipment will be returned to the vendor after the end
    of the 48 months. Interest rates for capital leases range from 6 to 15
    percent.

    Future payments due on capital leases are as follows:

    2010 and Total 2006 2007 2008 2009 beyond

    Photocopiers $ 1 $ Software licenses 24 ADP Equipment 2

    1$ -$ -$ -$ 1311 --

    2----

          Total Lease Obligations $ 27 $ 16 $ 11 $ -$ -$

    Less: interest (1)

    Present Value of Lease Payments $ 26

    Lease Liabilities covered by

    budgetary resources $ 3 Lease Liabilities not covered

    by budgetary resources $ 23

    The Service leases office space, vehicles and equipment under annual
    operating leases. These leases are cancelable or renewable on an annual
    basis at the option of the Service. They do not impose binding commitments
    on the Service for future rental payments on leases with terms longer than
    one year.

    Note 9. Contingencies

    The Service is subject to contingent liabilities involving litigation
    cases whose ultimate disposition is unknown. Based on the information
    currently available, however, it is management's opinion that the expected
    outcome of these matters, either individually or in the aggregate, will
    not have a material effect on the financial statements.

    As of September 30, 2005, the Service does not have contractual
    commitments for payments on obligations related to canceled
    appropriations.

                                           19

    Financial Statements

                                INTERNAL REVENUE SERVICE
                           Notes to the Financial Statements
                    For the Years Ended September 30, 2005 and 2004
    Note
    10.  Liabilities Not Covered by Budgetary Resources (In Millions)
            Liabilities not covered by budgetary resources as of September 30,
            2005 and 2004, consist of the following:
                                                2005             2004
            Intra-Governmental            With the Intra-Governmental With the
                                          Public                      Public
            Workers' compensation           92$ 520 $ 92$ 547 $ -462 -456 -23 -51
            Accrued annual leave
            Capital lease liability
    Note Appropriations Received
    11
            Appropriations received reported in the Statement of Budgetary
            Resources in FY 2005 and FY 2004, include $90 million and $84
            million, respectively, in user fees received from the public for
            services provided and retained by the agency to reduce its net cost
            of operations.
    Note
    12.  Obligated Balances (In Millions)
            Obligated balances as of September 30, 2005 and 2004, in the
            Statement of Budgetary Resources are as follows:
                                                          2005         2004
            Undelivered orders - unpaid              $         (941) $      (718)
            Budgetary accounts payable                         (587)        (462)
            Budgetary accounts                                 17            19
            receivable
            Total Obligated Balances                     $  (1,511)   $   (1,161)

                                           20

                                  Financial Statements

                                INTERNAL REVENUE SERVICE

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    Note 13. Nonentity Assets (In Millions)

    Nonentity assets arise from the Service's custodial duty to collect taxes,
    disburse tax refunds and maintain proper accounting for these activities
    in the books and records of the Service. Nonentity assets as of September
    30, 2005 and 2004, consist of the following:

    2005 Intra-With the Governmental Public

    2004 Intra-With the Governmental Public

    Due from Treasury $ 1,946 $ -$ 1,801 $ Federal taxes receivable, net of

    allowance for doubtful

    accounts -21,000 -20,000 Other custodial assets -462 -83

    Due from Treasury represents tax refunds due to taxpayers but not
    disbursed as of September 30, 2005 and 2004.

    Federal taxes receivable are transferred to Treasury upon receipt. An
    amount equal to federal taxes receivable has been recognized as an
    offsetting intragovernmental liability - Due to Treasury. Federal taxes
    receivable is described in more detail in Note 5.

    Other custodial assets, also discussed in Note 3, primarily relate to
    seized monies and the deposits received from taxpayers, pending
    application of the funds to unpaid tax assessments.

    Note 14. Comparison of Statement of Budgetary Resources and the
    President's Budget (In Millions)

    Statement of Federal Financial Accounting Standards No. 7, Accounting for
    Revenue and Other Financing Sources and Concepts for Reconciling Budgetary
    and Financial Accounting, calls for explanations of material differences
    between budgetary resources available, status of those resources and
    outlays as presented in the Statement of Budgetary Resources (SBR) to the
    related actual balances published in the Budget of the United States
    Government. However, the Budget of the United States Government that will
    include FY 2005 actual budgetary execution information has not yet been
    published. The Budget of the United States Government is scheduled for
    publication in January 2006. Accordingly, information required for such
    disclosure is not available at the time of publication of these financial
    statements.

    Balances reported in the FY 2004 Statement of Budgetary Resources and the
    related President's Budget are shown in the following table for each of
    the major appropriations and the Business Systems Modernization fund. The
    table does not include other minor appropriations.

                                           21

    Financial Statements

    INTERNAL REVENUE SERVICE

    Notes to the Financial Statements For the Years Ended September 30, 2005
    and 2004

    FY 2004

                                                                     Statement of
                                              Budgetary               President's
                                              Resources          Budget
    Processing, Assistance, and Management, Tax Law
    Enforcement, and Information Systems:
    Total budgetary resources                                10,317 $ 10,070 $
    Status of budgetary resources:
    Obligations incurred                                10,041           9,992
    Unobligated balances - available                        74              78
    Unobligated balances - unavailable                     202               -
    Total status of budgetary resources                      10,317 $ 10,070 $
    Outlays                                                    9,764 $ 9,764 $
    Business Systems Modernization Fund:
    Total budgetary resources                                      571 $ 567 $
    Status of budgetary resources:
    Obligations incurred                                           335     334
    Unobligated balances - available                                91     233
    Unobligated balances - unavailable                             145       -
    Total status of budgetary resources                            571 $ 567 $
    Outlays                                                        391 $ 391 $

    There are significant differences between the SBR and the President's
    Budget, which are attributable to differing Treasury and OMB requirements.
    The differences are primarily due to expired and unexpired appropriations:
    the SBR includes both unexpired and expired appropriations, while the
    President's Budget discloses only unexpired budgetary resources that are
    available for new obligations. Outlays are reported the same in both
    statements.

    22

                                  Financial Statements

                                INTERNAL REVENUE SERVICE

      Notes to the Financial Statements For the Years Ended September 30, 2005 and
                                          2004

    Note 15. Collections of Federal Tax Revenue (In Billions)

    The Service transfers total tax collections to the U.S. Treasury.
    Collection activity, by financial statement line item for the fiscal years
    ended September 30, 2005 and 2004, and by tax year for fiscal year ended
    September 30, 2005, is as follows:

    Collections Collections Tax Year Received Received

          2005 2004 2003 Prior Years FY 2005 FY 2004

    Individual income,

    FICA/SECA, and other $ 1,212 * $ Corporate income 210 ** Excise 42 Estate
    and gift Railroad retirement 3 Federal unemployment 5

    621$ 14$ 18$ 1,865$ 1,696 83 1 13307230 15 -15855 17 1 82626 1 --44 2 --77

          Total $ 1,472 $ 739 $ 16 $ 40 $ 2,267 $ 2,018

    65% 32% 1% 2% 100%

    * Includes other collections of $574 million.

    ** Includes tax year 2006 corporate income tax receipts of $9 billion.

    In FY 2005, Individual income, FICA/SECA, and other taxes include $68
    billion in payroll taxes collected from other federal agencies. Of this
    amount, $11 billion represents the portion paid by the employers.

    Note 16. Federal Tax Refund Activity (In Billions)

    Refund activity, broken out similarly to collection activity by financial
    statement line item for the fiscal years ended September 30, 2005 and
    2004, and by tax year for fiscal year ended September 30, 2005, is as
    follows:

    Refunds Refunds Tax Year Disbursed Disbursed

                           2005     2004     2003    Prior Years FY 2005  FY 2004
    Individual income,
    FICA/SECA, and other  $  1  211 $    $     13 6$          231$     231 $
    Corporate income         1        7        6           22       36      47
    Excise                   -        -        -            -        -       -
    Estate and gift          -        -        -            -        -       -
    Railroad retirement      -        -        -            -        -       -
    Federal unemployment     -        -        -            -        -       -

                            Total $ 2$ 218$ 19$ 28$ 267$ 278

    1% 82% 7% 10% 100%

    Individual income, FICA/SECA, and other refund amounts include EITC and
    child tax credit refunds.

    23

                                  Financial Statements

                                INTERNAL REVENUE SERVICE

                           Notes to the Financial Statements

                    For the Years Ended September 30, 2005 and 2004

    Note 17. Net Cost By Budget Functional Classification (In Millions)

    Gross cost and earned revenue for the Service are classified under the
    budget functional classification of General Government under the
    President's Budget. Gross cost and earned revenue are categorized as
    follows:

    Intragovernmental W ith the Public Total 2005 2004 2005 2004 2005 2004

    Gross cost $ 3,856 $ 3,374 $ 7,87 9 $ 7,3 11 $ 11,735 $ 10,685 Earned
    revenue (118) (123) (154) (1 64) (272) (287)

          Net cost $ 3,738 $ 3,251 $ 7,72 5 $ 7,1 47 $ 11,463 $ 10,398

    Note 18. Obligations Incurred

    Each fiscal year, the Office of Management and Budget apportions the
    Service's budgetary resources under apportionment Category B by activities
    and/or projects. In FY 2005, the Service incurred $10,429 million in
    obligations funded by direct appropriations and $155 million funded by
    reimbursable revenue and transfers from the Treasury Asset Forfeiture
    Fund. In FY 2004, the Service incurred $10,256 million in obligations
    funded by direct appropriations and $165 million funded by reimbursable
    revenue and transfers from the Treasury Asset Forfeiture Fund.

    Note 19. Spending Authority from Offsetting Collections (In Millions)

    Spending authority from offsetting collections as of September 30, 2005
    and 2004, in the Statements of Budgetary Resources and Financing is as
    follows:

    2005 2004

    Reimbursable Revenue Receipts for Tax Lien Revolving Fund Refunds from
    Vendors Treasury Asset Forfeiture Fund Transfers

                                                          $ 142 $ 150 56 -2 14 15

    Total Spending Authority From Offsetting Collections $ 161 $ 173

                                           24

                                Supplemental Information

    INTERNAL REVENUE SERVICE

    Supplemental Information - Unaudited For the Years Ended September 30,
    2005 and 2004

    Statement of Net Cost by Responsibility Segment (In Millions):

                                                                         Net Cost
                                                               2005 2004
    Operating divisions:
    WAGE                              2,422 $ $                      2,210
    SBSE                                                   2,734     2,905
    LMSB                                                     771      725
    TEGE                                                     251      231
    Total                                                  6,178     6,071
    Functional support:
    Appeals                                                  210      205
    Chief Counsel                                            308      298
    Criminal Investigation                                   539      472
    Taxpayer Advocate                                        186      180
    Communications                                            24      47
    Total                                                  1,267     1,202
    Operating Net Cost                                     7,445     7,273
    General and Administration                             1,841     1,400
    Information Technology                                 1,566     1,335
    Depreciation/Loss on Disposal                            611      390
    Total Net Cost                    11,463$ $                     10,398
    Other Claims for Refunds

    Management has estimated amounts that may be paid out as other claims for
    tax refunds. This estimate represents an amount (principal and interest)
    that may be paid for claims pending judicial review by the Federal courts
    or, internally, by Appeals. In FY 2005, the total estimated payout
    (including principal and interest) for claims pending judicial review by
    the Federal courts is $11.9 billion and by Appeals is $11.1 billion. In FY
    2004, the total estimated payout (including principal and interest) for
    claims pending judicial review by the Federal courts was $1.7 billion and
    by Appeals was $6.7 billion. Although these refund claims have been deemed
    to be probable, they do not meet the criteria in SFFAS No. 5 for reporting
    the amounts in the balance sheet or for disclosure in the notes to the
    financial statements; however, they meet the criteria in SFFAS No. 7 for
    inclusion as supplemental information. To the extent judgments against the
    government in these cases prompt other similarly situated taxpayers to
    file similar refund claims, these amounts could become significantly
    greater.

    25

                                Supplemental Information

    INTERNAL REVENUE SERVICE

    Supplemental Information - Unaudited

    For the Years Ended September 30, 2005 and 2004

    Federal Taxes Receivable, Net (In Billions)

    In accordance with SFFAS No. 7, some unpaid assessments do not meet the
    criteria for financial statement recognition as discussed in Note 1 to the
    financial statements. Although compliance assessments and write-offs are
    not considered receivables under federal accounting standards, they
    represent legally enforceable claims of the IRS acting on behalf of the
    federal government. There is, however, a significant difference in the
    collection potential of these categories.

    The components of the total unpaid assessments and derivation of net
    federal taxes receivable as of

    September 30, 2005 and 2004, were as follows:
                                                        2005        2004
    Total unpaid assessments                     $        230 $         237
    Less: Compliance assessments                          (44)          (33)
    Write-offs                                            (98)          (115)
    Gross federal taxes receivable                        88            89
    Less: Allowance for doubtful accounts                 (67)          (69)
    Federal taxes receivable, net                $        21 $          20

    The Service cannot reasonably estimate the amount of allowance for
    doubtful accounts pertaining to its compliance assessments, and thus
    cannot determine their net realizable value or the value of the
    pre-assessment work-in-process.

    To eliminate double-counting, the compliance assessments reported above
    exclude trust fund recovery penalties, totaling $13 billion as of both
    September 30, 2005 and 2004, that were assessed against officers and
    directors of businesses who were involved in the non-remittance of federal
    taxes withheld from their employees. The related unpaid assessments of
    those businesses are reported as taxes receivable or write-offs, but the
    Service may also recover portions of those businesses'.unpaid assessments
    from any and all individual officers and directors against whom a trust
    fund recovery penalty is assessed.

    Earned Income Tax Credit

    The EITC is a special credit for employed taxpayers whose earnings fall
    below the established allowance ceiling. In FY 2005, the Service issued
    $35 billion in EITC refunds. In FY 2004, the Service issued $33 billion in
    EITC refunds. An additional $5.3 billion and $5.2 billion of the EITC was
    applied to reduce taxpayer liability for FY 2005 and FY 2004,
    respectively.

                                           26

    Supplemental Information

                                INTERNAL REVENUE SERVICE
                          Supplemental Information - Unaudited
                    For the Years Ended September 30, 2005 and 2004
    Intra-Governmental Assets (In Millions)
                                                                 Fiscal Year 2005
                                                             Accounts Advances to
                             Fund Balance  Due from    Receivable,     Government
             Agency         with Treasury  Treasury        Net         Agencies
    Treasury                                  1,990 $ 1,946 $ 16 $ 105 $
    Dept of Interior                 -             -             -          25
    Other                            -             -             -           -
    Total                                     1,990 $ 1,946 $ 16 $ 130 $
                                                     Fiscal Year 2004
                                                             Accounts Advances to
                             Fund Balance  Due from    Receivable,     Government
             Agency         with Treasury  Treasury        Net           Agencies
    Treasury                                   1,725 $ 1,801 $ 18$ 128 $
    Other                                  -     -               1           1
    Total                                      1,725 $ 1,801 $ 19$ 129 $

                                           27

    Supplemental Information

                                INTERNAL REVENUE SERVICE
                          Supplemental Information - Unaudited
                    For the Years Ended September 30, 2005 and 2004
    Intra-Governmental Liabilities (In Millions)
                                                                 Fiscal Year 2005
                                                                          Accrued
                                  Due to    Accrued   Payroll and     Workers'
                Agency           Treasury   Expenses    Benefits     Compensation
    General Fund of the
    Treasury               $          - -$ 13 $                  $           -
    Treasury                      21,000         1             -             -
    Department of Labor                    -     17            -            92
    Office of Pers. Mgmt                   -     -            38             -
    National Archives                      -     2             -             -
    GSA                                    -     5             -             -
    US Postal Service                      -     3             -             -
    Other                                  -     2             -             -
    Total                                     21,000 $ 30 $ 51 $ 92 $
                                                   Fiscal Year 2004
                                                            Accrued
                                  Due to    Accrued   Payroll and     Workers'
                Agency           Treasury   Expenses    Benefits     Compensation
    General Fund of the
    Treasury                 $        - $          - $         8 $           -
    Treasury                    20,000             1           -             -
    Department of Labor               -           17           -            92
    Office of Pers. Mgmt              -            -          34             -
    National Archives                 -            5           -             -
    GSA                               -            5           -             -
    Other                             -            2           -             -
    Total                                     20,000 $ 30 $ 42 $ 92 $

                                           28

    Supplemental Information

                                INTERNAL REVENUE SERVICE
                          Supplemental Information - Unaudited
                    For the Years Ended September 30, 2005 and 2004
    Schedule of Budgetary Resources by Major Budget Accounts (In Millions)
                                                                 Fiscal Year 2005
                                                                         Business
                           Processing                         Systems
                       Assistance and   Tax Law   Information Modernization
                           Management Enforcement   Systems   and Other   Total
    Budgetary Resources:
    Budget authority:
    Appropriations received            4,082 $ 4,405 $ 1,711 $ 210 $ $  10,408
    Unobligated balance -
    beginning of period
    Spending authority from    117 46 30  79 104 14   79 6   295 5 3   570 161
    offsetting collections       (47)       (54)       12        (2)        59
    Recoveries of prior year                          (23)               (126)
    obligations Permanently
    not available
                Total Budgetary 4,228 $ 4,548 $ 1,785 $ 511 $           $  11,072
                      Resources
    Status of Budgetary Resources:
           Obligations        4,071 $ 4,489 $ 1,679 $ 345 $ 58 8 42 144 $ 10,584
            incurred                                                      252
    Unobligated balance
           - available
    Unobligated balance not
    available                      99          51      64         22       236
    Total Status of Budgetary
           Resources                      4,228 $ 4,548 $ 1,785 $ 511 $ $  11,072
    Relationship of Obligations to
    Outlays:
    Obligated balance,
    net, beginning of
    period                                     432$ 247$ 358 $ 124 $ $   1,161
    Obligated balance,
    net, end of period
    Outlays:                 (476) (311) (533) (191) 3,997 $ 4,415 $   (1,511)
    Disbursements                                      1,492 $ 275 $ $ 10,179
    Less: collections            (46)       (108)       (5)      (5)     (164)
        Less: offsetting receipts    -           -          -      (91)      (91)
         Net Outlays                      3,951 $ 4,307 $ 1,487 $ 179 $ $   9,924

                                           29

    Supplemental Information

                                INTERNAL REVENUE SERVICE
                          Supplemental Information - Unaudited
                    For the Years Ended September 30, 2005 and 2004
                                                                 Fiscal Year 2004
                                                                         Business
    Processing Assistance and                              Systems
                                       Tax Law    Information Modernization
                          Management Enforcement    Systems   and Other   Total
    Budgetary
    Resources: Budget
    authority:
    Appropriations
    received                             4,092$ 4,145 $ 1,646 $ 446$ $  10,329
    Unobligated balance -
    beginning of period
    Spending authority from    88 41 66   71 116 34  109 10    205 6   473 173
    offsetting collections       (45)        (43)    35 (47)  19 (3)     154
    Recoveries of prior year                                            (138)
    obligations Permanently
    not available
             Total Budgetary 4,242 $ 4,323 $ 1,753 $ 673$               $  10,991
                   Resources
    Status of Budgetary
    Resources:
    Obligations incurred                                             $
    Unobligated balance -                                              10,421
    available             4,123 $ 4,244 $ 1,674 $ 380$ 33 26 15 104    178
    Unobligated balance not
    available                      86            53     64       189       392
    Total Status of     4,242 $ 4,323 $ 1,753 $ 673$                 $  10,991
    Budgetary Resources
    Relationship of
    Obligations to
    Outlays: Obligated
    balance, net,                                                    $
    beginning of period
    Obligated balance,  498$ 194 $ 369 $ 205$ (426) (247) (363)        1,266
    net, end of period  (125)                                          (1,161)
    Outlays:                                                            10,372
    Disbursements Less: 4,130$ 4,156 $ 1,644 $ 442$ (41) (116) (9)   $   (173)
    collections Less:   (7) ---(89)                                       (89)
    offsetting receipts
        Net Outlays                        4,089 $ 4,040 $ 1,635 $ 346$ $  10,110

                                           30

                                Supplemental Information

    INTERNAL REVENUE SERVICE

    Supplemental Information - Unaudited

    For the Years Ended September 30, 2005 and 2004

    Child Tax Credit

    The child tax credit was originally authorized by the Taxpayer Relief Act
    of 1997 (Public Law 105-34). The child tax credit is a special credit for
    taxpayers who work, whose earnings fall below the established allowance
    ceiling, and who have a qualifying child. In FY 2005, the Service issued
    $15 billion in child tax credit refunds. An additional $32 billion of
    child tax credits were applied to reduce taxpayer liability. In FY 2004,
    the Service issued $9 billion in child tax credit refunds. An additional
    $23 billion of child tax credits were applied to reduce taxpayer
    liability.

    Tax Gap

    The tax gap is the aggregate amount of tax (i.e., excluding interest and
    penalties) that is imposed by the tax laws for any given tax year but is
    not paid voluntarily and timely. The Service currently projects that the
    annual Federal gross tax gap is somewhere between $312 billion and $353
    billion. This estimate is based on the preliminary results of the National
    Research Program (NRP). The NRPwas a study conducted to measure the
    compliance rate of individual filers based on examination of a statistical
    sample of their filed returns for tax year 2001. The tax gap arises from
    three types of noncompliance: not filing timely tax returns (the nonfiling
    gap), underreporting the correct amount of tax on timely-filed returns
    (the underreporting gap), and not paying on time the full amount reported
    on timely-filed returns (the underpayment gap). Of these three components,
    only the underpayment gap is observed; the nonfiling gap and the
    underreporting gap must be estimated. Each instance of noncompliance by a
    taxpayer contributes to the tax gap, whether or not the IRS detects it,
    and whether or not the taxpayer is even aware of the noncompliance. Some
    of the tax gap arises from intentional (willful) noncompliance, and some
    arises from unintentional mistakes. The tax gap does not include
    underpayments by corporate taxpayers or include taxes that should have
    been paid on income from the illegal sector of the economy.

    Of the three components, underreporting of income tax, employment taxes
    and other taxes represents about 80 percent of the tax gap. The single
    largest sub-component of the underreporting involves individuals
    understating their incomes, taking improper deductions, overstating
    business expenses and erroneously claiming credits. Individual
    underreporting represents about half of the total tax gap. Individual
    income tax also accounts for about half of all tax liabilities.

    The collection gap is the cumulative amount of assessed tax, penalties,
    and interest that the Service expects to remain uncollectible. In essence,
    it represents the difference between the total balance of unpaid
    assessments and the net taxes receivable reported on the Service's balance
    sheet. The tax gap and the collection gap are related and overlapping
    concepts, but they have significant differences. The collection gap is a
    cumulative balance sheet concept for a particular point in time, while the
    tax gap is like an income statement item for a single year. Moreover, the
    tax gap estimates include all noncompliance, while the collection gap
    includes only amounts that have been assessed (a small portion of all
    noncompliance).

                                           31

                                Supplemental Information

    INTERNAL REVENUE SERVICE

    Supplemental Information - Unaudited

    For the Years Ended September 30, 2005 and 2004

    Tax Burden and Tax Expenditures

    The Internal Revenue Code provides for progressive rates of tax, whereby
    higher incomes are generally subject to higher rates of tax. The graphs
    that follow present the latest available information on income tax and
    adjusted gross income (AGI) for individuals by AGI level and for
    corporations by size of assets. For individuals, the information
    illustrates, in percentage terms, the tax burden borne by varying AGI
    levels. For corporations, the information illustrates, in percentage
    terms, the tax burden borne by these entities by various sizes of their
    total assets. The graphs are only representative of more detailed data and
    analysis available from the Statistics of Income (SOI) office.

    Total tax expenditures are the foregone federal revenue resulting from
    deductions and credits provided in the Internal Revenue Code. Since tax
    expenditures directly affect funds available from government operations,
    decisions to forego federal revenue are as important as decisions to spend
    federal revenue.

                                           32

                                Supplemental Information

    Page 123 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
                                Supplemental Information

    Page 124 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

    Appendix I

    Material Weaknesses, Reportable Conditions, and Compliance Issues

                                  Material Weaknesses

    During our audits of the Internal Revenue Service's (IRS) fiscal years
    2005 and 2004 financial statements, we continued to identify four material
    weaknesses in internal controls. These material weaknesses have given rise
    to significant management challenges that have (1) impaired management's
    ability to prepare financial statements and other financial information
    without extensive compensating procedures, (2) limited the availability of
    reliable information to assist management in effectively managing
    operations on an ongoing basis, (3) reduced IRS's effectiveness in
    enforcing the Internal Revenue Code, (4) resulted in errors in taxpayer
    accounts, (5) increased taxpayer burden, and (6) reduced assurance that
    data processed by its information systems are reliable and appropriately
    protected. The issues that we have identified and discuss in this report
    relate to IRS's controls over (1) financial reporting, (2) unpaid
    assessments,

    (3) federal tax revenue and refunds, and (4) information security. We
    reported on each of these issues last year1 and in prior audits. We
    highlight these issues in the following sections. Less significant matters
    involving IRS's system of internal controls and its operations will be
    reported to IRS separately.

                                  Financial Reporting

    In fiscal year 2005, as in prior years, IRS did not have financial
    management systems adequate to enable it to accurately and timely generate
    and report the information needed to both prepare financial statements and
    manage operations on an ongoing basis. To overcome these systemic
    deficiencies with respect to preparation of its annual financial
    statements, IRS was compelled to employ extensive compensating procedures
    that were costly and labor intensive. During fiscal year 2005, IRS (1) did
    not have an adequate general ledger system for financial reporting
    purposes, (2) could not determine and report on the specific amount of
    revenue collected for each of several of the federal government's largest
    revenue sources, and (3) did not have timely and reliable cost information
    related to its activities and programs. Although labor-intensive
    compensating procedures yielded financial statements that were fairly
    stated as of September 30, 2005 and 2004, they do not afford real-time
    data needed to assist in managing operations on a day-to-day basis, such
    as cost-based performance information to assist in making or justifying
    resource allocation decisions.

    1GAO, Financial Audit: IRS's Fiscal Years 2004 and 2003 Financial
    Statements, GAO-05- 103 (Washington, D.C.: Nov. 10, 2004).

    Page 125 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    As we noted in last year's report,2 during fiscal year 2005, IRS's general
    ledger system was not supported by adequate audit trails or integrated
    with its supporting records for material balances, including federal tax
    revenue, federal tax refunds, taxes receivable, and property and equipment
    (P&E). Because of these deficiencies, IRS's general ledger system does not
    conform to the U.S. Government Standard General Ledger (SGL) at the
    transaction level as required by the Core Financial System Requirements of
    the Joint Financial Management Improvement Program (JFMIP)3 or the
    requirements of the Federal Financial Management Improvement Act of 1996
    (FFMIA). Further, IRS's use of two separate general ledgers, one to
    account for its tax administration activities and another to capture the
    costs of conducting those activities, greatly complicates efforts to
    measure the cost of IRS's tax administration efforts. During fiscal year
    2004, we also reported that IRS's general ledger for its tax
    administration activities did not use the standard federal accounting
    classification structure, which is documented in the SGL. In fiscal year
    2005, IRS implemented an SGL crosswalk for its general ledger for tax
    administration activities, and this has brought this general ledger into
    conformance with the SGL classification structure at the account level.

    In November 2004, IRS implemented the first release of the Integrated
    Financial System (IFS), which now serves as IRS's core administrative
    financial management system. IRS expects that IFS will ultimately provide
    it with an integrated financial management system to account for and
    control resources. However, this will be achieved only with the
    implementation of all four of the planned releases of IFS and its
    integration with the financial management systems that account for its tax
    administration activities. The major components of this first release of
    IFS are accounts payable, accounts receivable, budget formulation, budget
    execution, general ledger, financial reporting, and cost accounting. The
    remaining future releases of IFS are planned to include property

    2 GAO-05-103.

    3JFMIP, Core Financial System Requirements, JFMIP-SR-02-01 (Washington,
    D.C.: November 2001). JFMIP was originally formed under the authority of
    the Budget and Accounting Procedures Act of 1950 as a cooperative
    undertaking of the Office of Management and Budget (OMB), the Department
    of the Treasury, the Office of Personnel Management, GAO, and operating
    agencies to improve financial management practices in the federal
    government. On December 1, 2004, JFMIP ceased to exist as a separate
    organization, with OMB's Office of Federal Financial Management assuming
    many JFMIP functions.

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    management, procurement, a workload management system, software and
    functional upgrades, and significant cost accounting enhancements.

    If successfully implemented as originally planned, and if integrated with
    IRS's tax administration activities, IFS may enable IRS to address many of
    its most long-standing financial management issues, such as the inability
    to perform meaningful cost benefit analysis to support decision making.
    However, IRS has indefinitely deferred future releases of IFS due to
    funding constraints and pending resolution of issues related to
    implementation of the first phase of IFS, such as ensuring ongoing
    maintenance support. IRS also experienced technical difficulties recording
    some types of transactions in IFS during fiscal year 2005. In addition,
    implementing such a large and complex automated financial system entails
    substantial learning for personnel responsible for using the system, and
    this familiarization will take time to accomplish. Consequently, while IRS
    has begun to see some of the benefits of IFS, such as more readily
    accessible detailed transaction information and improved audit trails for
    significant balances, obstacles remain to be overcome before the full
    potential of the system can be realized. In addition, to account for and
    report on over $2 trillion in annual tax-related transactions, IRS
    continues to rely on legacy financial management systems that do not
    interface with IFS or benefit from its implementation.4

    In prior years, we reported that IRS did not timely record taxes
    receivable and the related balances due to Treasury in its general ledger.
    During fiscal year 2005, IRS began calculating taxes receivable on a
    monthly basis and reported the balances on its interim financial
    statements. However, these

    4IRS is also in the process of implementing the Customer Account Data
    Engine (CADE). CADE is intended to ultimately replace the legacy master
    file, which is the database of taxpayer account information. However,
    during fiscal year 2005, CADE was still in the early stages of
    implementation and processed less than $1 billion in refunds related to
    simple individual returns. IRS does not have detailed plans or schedules
    for completion of this project, and it is unclear when it will be fully
    implemented.

    Page 127 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    amounts are derived through statistical projections and do not reflect the
    total of actual transactions throughout the year.5

    During fiscal year 2005, IRS continued to be unable to determine the
    specific amount of revenue it actually collects for three of the federal
    government's four largest revenue sources-Social Security, hospital
    insurance, and individual income taxes. In addition, IRS continued to be
    unable to determine, at the time payments are received, collections for
    other trust funds that receive excise tax receipts, such as the Highway
    Trust Fund. This is primarily because the accounting information needed to
    validate the taxpayer's liability and record the payment to the proper
    trust fund is provided on the tax return, which is received months after
    the payment is submitted. Further, the information on the tax return
    pertains only to the amount of the tax liability, not how to distribute
    the amount previously collected among the appropriate trust funds. IRS
    does not require taxpayers to submit information identifying the type of
    tax at the time of payment because it has taken the position that imposing
    such a requirement would create an additional burden to those particular
    taxpayers. In addition, IRS's systems cannot at present routinely capture
    and report the information it does receive. IRS is working on systems
    improvements to accommodate this type of information. However, IRS will
    continue to be unable to timely report the specific amount of revenue it
    actually collects for these large revenue sources until it has the systems
    capability to record, and requires taxpayers to provide, this information.
    This condition also makes the federal government reliant on a complex,
    multistep process to distribute excise taxes to the recipient trust funds
    that continues to be susceptible to error.

    Now that all federal agencies are required by OMB to meet a reporting date
    of November 15, IRS's inability to timely report specific amounts of
    excise tax revenue to recipient trust funds is even more significant for
    these funds and their administrators. The annual excise tax receipts
    reported by recipient trust funds now include 6 months of estimated
    receipts. The trust funds must report 6 months of estimated receipts
    because, under its existing processes, IRS takes 5  1/2 months to complete
    its certification of

    5At the end of each fiscal year, IRS uses statistical sampling techniques
    to estimate the portion of its total balance of unpaid assessments that
    should be classified as compliance assessments, write-offs, and taxes
    receivable, and to estimate the portion of the taxes receivable balance
    that is likely to be collectible. Throughout the following year, the
    resultant rates derived through the sampling process are applied monthly
    to the total unpaid assessment balance to update these amounts for
    reporting purposes.

    Page 128 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    excise tax receipts and, therefore, does not complete the certifications
    for the third and fourth quarters of the fiscal year until after November
    15. To the extent that these estimates differ from the certified amounts,
    inaccurate distributions to the trust funds could result and, in the case
    of the Highway Trust Fund, allocations of revenues to states could be done
    incorrectly.6 In July 2003, we made recommendations to IRS for
    accelerating its certification process. In response to our
    recommendations, IRS has performed precertifications for the past 2 years
    to determine the extent to which an acceleration of the process would
    affect the amounts distributed to the trust funds. Our comparison of the
    precertification and actual certification amounts for the Highway Trust
    Fund and the Airport and Airway Trust Fund, which are the two largest
    trust funds receiving excise tax distributions, showed that over the past
    2 years there was little difference between precertification amounts and
    actual certification amounts.7 This indicates that the certification
    timeline could be accelerated without significantly affecting the accuracy
    of excise tax distributions to these trust funds, thereby reducing
    reliance on estimates and the inherent risk that actual collections will
    be materially different.

    During fiscal year 2004, we reported that IRS did not have a cost
    accounting system (1) capable of accurately and timely tracking and
    reporting the costs of IRS's programs and projects to assist it in
    managing its costs and (2) meeting the JFMIP System Requirements for
    Managerial Cost Accounting.8 During fiscal year 2005, IRS implemented a
    cost accounting module as part of the first release of IFS. Although this
    module has much potential and has begun accumulating cost information, IRS
    management has not yet determined what the full range of its cost
    information needs are or how best to utilize the module's existing
    capabilities to serve those needs. IRS has also not yet implemented a

    6The Transportation Equity Act for the 21st Century, Pub. L. No. 105-178,
    112 Stat. 107 (June 9, 1998), enhanced the link between the amount of
    funds received by states and the amount of tax receipts credited to the
    Highway Trust Fund by requiring that highway program funds be distributed
    to states on the basis of annual highway account receipts.

    7In implementing the American Jobs Creation Act of 2004, IRS issued
    guidance providing a one-time filing extension of 1 month for tax returns
    affecting the Highway Trust Fund and the Airport and Airway Trust Fund for
    the quarter ended March 31, 2005. See I.R.S. Notice 2005-4, S: 4(i),
    2005-2 I.R.B. 296-97 (Jan. 10, 2005); see also Pub. L. No. 108-357, S:
    853, 118 Stat. 1418, 1609 (Oct. 22, 2004). Therefore, the quarter ended
    March 31, 2005, was not included in our comparison.

    8Joint Financial Management Improvement Program, System Requirements for
    Managerial Cost Accounting (Washington, D.C.: February 1998).

                                 Unpaid Tax Assessments

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

    related workload management system intended to improve IRS's ability to
    effectively manage its large workforce and to provide the cost module with
    detailed labor cost information. In addition, because the cost module was
    implemented in fiscal year 2005, it does not yet contain the historical
    cost information needed to support meaningful future estimates and
    projections. Consequently, IRS cannot yet rely on this system as a
    significant planning and decision-making tool. It will likely require
    several years and implementation of additional components of IFS, such as
    the workload management system, as well as integration with its tax
    administration activities, before the full potential of IRS's cost
    accounting module will be realized. In the interim, IRS decision making
    will continue to be hampered by a lack of meaningful underlying cost
    information.

    As a result of these financial reporting weaknesses, IRS was compelled to
    expend far more time and effort to maintain its accounting records and
    generate financial management information than would otherwise have been
    necessary, and despite these monumental efforts, IRS continued to lack
    reliable and timely financial information to assist in managing operations
    throughout fiscal year 2005. Addressing the financial reporting
    deficiencies discussed above would enhance this process by providing
    management the reliable and timely information that it needs to support
    informed decision making without having to resort to costly and
    time-consuming procedures to compensate for information system
    deficiencies.

    During fiscal year 2005, we continued to find serious internal control
    issues that affected IRS's management of unpaid assessments. Specifically,
    we continued to find (1) IRS lacked a subsidiary ledger for unpaid
    assessments that would allow it to produce accurate, useful, and timely
    information with which to manage and report externally and (2) errors and
    delays in recording taxpayer information, payments, and other activities.
    These conditions continued to hinder IRS's ability to effectively manage
    its unpaid assessments.9

    9Unpaid assessments consist of (1) federal taxes receivable, which are
    taxes due from taxpayers for which IRS can support the existence of a
    receivable through taxpayer agreement or a favorable court ruling; (2)
    compliance assessments where neither the taxpayer nor the court has
    affirmed that the amounts are owed; and (3) write-offs, which represent
    unpaid assessments for which IRS does not expect further collections due
    to factors such as the taxpayer's death, bankruptcy, or insolvency. Of
    these three classifications of unpaid assessments, only federal taxes
    receivable are reported on the principal financial statements.

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    IRS's management of unpaid assessments is hindered by a lack of effective
    supporting systems. IRS continues to lack a detailed listing, or
    subsidiary ledger, that tracks and accumulates unpaid assessments and
    their status on an ongoing basis. As a result, IRS must continue to rely
    on a costly, labor-intensive manual compensating process for external
    reporting. Specifically, to report balances for taxes receivable and other
    unpaid assessments in its financial statements and supplemental
    information, IRS must apply statistical sampling and estimation techniques
    to data in its master files10 to estimate the balances at year-end. While
    IRS continues to refine this process, it continued to take several months
    to complete, required adjustments totaling tens of billions of dollars,
    and produced amounts that, after adjustments, were only reliable as of the
    last day of the fiscal year. Consequently, this information is not useful
    for ongoing management decisions. In addition, the lack of a subsidiary
    ledger inhibits IRS's ability to timely develop reliable financial and
    management reports and promptly identify and focus collection efforts on
    accounts most likely to prove collectible.

    IRS's management of unpaid assessments also continued to be hindered by
    inaccurate tax records. We continued to find errors and omissions in
    taxpayer records resulting from IRS's failure to accurately and timely
    record information. Errors in IRS records can cause frustration to
    taxpayers who either do not owe the debt or owe significantly lower
    amounts.

    For example, during our audit we found that IRS assessed over $2 million
    in penalties and interest against a business for failing to provide a
    required supporting schedule along with its quarterly payroll tax return.
    When IRS reviewed this case as part of the fiscal year 2005 financial
    audit process, it determined that the required schedule was in fact
    attached to the return. However, IRS had sent out a notice of taxes due to
    the business and, at the time of our testing, this amount was recorded as
    a valid tax assessment in IRS's records. In another example, IRS assessed
    over $48 million in interest against the estate of a deceased taxpayer for
    tax year 2005. When IRS reviewed the case as part of the fiscal year 2005
    financial audit process, it determined that the interest assessment should
    have been about $1 million.

    10IRS's master files contain detailed records of taxpayer accounts.
    However, the master files do not contain all the details necessary to
    properly classify or estimate collectibility for unpaid assessment
    accounts.

    Page 131 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    However, as of September 30, 2005, IRS had not corrected this error on the
    taxpayer's account.

    Some input errors and posting delays can cost the government money. For
    example, IRS erroneously abated11 the entire amount of a $26,000 penalty
    assessment when only $6,000 of the assessment should have been abated.
    When the taxpayer made a subsequent payment of $20,000 to satisfy the tax
    liability, IRS erroneously refunded the $20,000 to the business. IRS found
    this error as part of the fiscal year 2005 financial audit process and was
    ultimately able to recover this amount from the taxpayer.

    As in prior years,12 the most prevalent errors we continued to find
    involved IRS's failure to properly record payments to all related taxpayer
    accounts associated with unpaid payroll taxes.13 IRS's current systems
    continued to be unable to automatically link each of the multiple
    assessments made for the one tax liability. Consequently, if the business
    or an officer of that business paid some or all of the outstanding taxes,
    IRS's systems were unable to automatically reflect the payment as a
    reduction in the amounts owed on any related accounts. Over the past
    several years, IRS has taken several steps to compensate for the lack of
    an automated link between related accounts. For example, IRS manually
    inputs a code in each account that cross-references it to other related
    accounts. In addition, in August 2001, IRS established new procedures to
    more clearly link each penalty assessment against an officer to a specific
    tax period14 of the business account. In July 2003, IRS also began phasing
    in the use of an automated trust fund recovery penalty system that is
    intended to properly cross

    11Abatements are reductions to taxpayers' tax liabilities that can either
    result in reducing or eliminating a taxpayer's outstanding tax liability
    and, in some cases, may generate a refund to the taxpayer. IRS is
    authorized to abate assessments under certain conditions. For example,
    section 6404 of the Internal Revenue Code authorizes IRS to abate
    erroneous assessments, which can be caused by either IRS or taxpayer
    error.

    12GAO-05-103.

    13When a company does not pay the taxes it withholds from employees'
    wages, such as Social Security or individual income tax withholdings, IRS
    has the authority to assess all responsible officers individually for the
    taxes withheld from employees. Although assessed to multiple parties, the
    liability need only be paid once. Thus, IRS may record assessments against
    each of several individuals for the employee-withholding component of the
    payroll tax liability of a given business in an effort to collect the
    total tax liability of the business. The assessments made against business
    officers are known as trust fund recovery penalties.

    14A tax period is the period over which the tax liability was created. For
    payroll taxes, this period is typically a calendar quarter.

                                Tax Revenue and Refunds

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

    reference payments received and thus eliminate the opportunity for errors
    that plague the current manual process.

    Although IRS is making improvements in its processes for recording trust
    fund recovery penalties, our work in fiscal year 2005, as in prior years,
    continued to find errors. In our testing of 80 statistically selected
    payments recorded on trust fund recovery penalty accounts established
    since August 2001, we found 6 instances in which IRS did not properly
    record payments received on all related taxpayer accounts. Of these 6
    payments, 5 were not properly recorded in all related accounts even though
    the accounts contained the required cross-referencing at the time that the
    payments were made. Based on our testing, we estimate that 7.5 percent of
    trust fund recovery payment transactions posted to accounts established
    since August 2001 and still outstanding during fiscal year 2005 could
    contain inaccuracies.15

    Although IRS has implemented a number of compensating procedures, the
    ultimate solution to many of the issues related to IRS's management of
    unpaid assessments, such as the lack of a subsidiary ledger and the lack
    of an automated link between related accounts, continues to be the
    successful modernization of IRS's systems.

    During fiscal year 2005, we continued to find that IRS's controls were not
    fully effective in maximizing the federal government's ability to collect
    what is owed and in minimizing the risk of payment of improper refunds.
    IRS recognized this in its fiscal year 2005 Federal Managers' Financial
    Integrity Act of 1982 (FIA) assurance statement to the Treasury, in which
    it reported material weaknesses in the collection of unpaid taxes and in
    earned income tax credit (EITC) noncompliance. IRS's taxpayer compliance
    programs identify billions of dollars of potentially underreported taxes
    and erroneous EITC claims each year. However, due in large part to
    perceived resource constraints, IRS selects only a portion of the
    questionable cases it identifies for follow-up investigation and action.
    In addition, IRS often does not initiate follow-up on the cases it selects
    until months after the related tax returns have been filed and any related
    refunds disbursed, adversely affecting its chances of collecting amounts
    due on these cases. Consequently, the federal government is exposed to
    potentially

    15We are 95 percent confident that the error rate does not exceed 14.3
    percent.

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    significant losses from reduced revenue and disbursements of improper
    refunds.

    The options available to IRS in its efforts to identify and pursue the
    correct amount of taxes owed and to ensure that only valid refunds are
    disbursed continue to be limited. For example, third-party information,
    such as the data provided on IRS 1099 forms,16 that can corroborate the
    amount of income reported by taxpayers is not required to be filed until
    after the start of the tax filing season.17 Consequently, comparison of
    such information with tax return data is problematic because IRS does not
    have time to prepare the third-party data for matching prior to the
    receipt of individual tax returns. Additionally, while it processes
    hundreds of millions of tax returns each filing season, IRS must issue
    refunds within statutory time constraints or be subject to interest
    charges.18

    As we previously reported, IRS has some preventive controls that help to
    reduce the magnitude of underreported taxes owed and improper refunds
    issued. For example, IRS's Examination Branch is responsible for
    performing examinations on tax returns with potentially erroneous EITC
    claims to determine the validity of the claims.19 When performed before
    refunds are disbursed, these examinations are an important control to
    prevent disbursement of improper refunds. However, in some cases these
    examinations are performed after any related refunds are disbursed, which
    negates their effectiveness as a preventive control and instead serves
    only as a basis for pursuing recovery after the fact.

    16IRS 1099 forms are used by third parties, such as financial
    institutions, to report taxpayers' interest income, dividend
    distributions, and other miscellaneous income.

    17The tax filing season for individuals primarily occurs from January 1
    through April 15 of each year.

    18By statute, IRS must pay interest on refunds not paid within 45 days of
    receipt or due date, whichever is later (26 U.S.C. S: 6611).

    19Because it is a refundable tax credit, an EITC claim always results in a
    reduction of the taxpayer's calculated tax liability. However, depending
    on the taxpayer's amount of taxes withheld, and the amount of tax due on
    the taxpayer's return before application of any credits, it may or may not
    result in a refund for a particular tax year.

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    In its guidance to heads of federal agencies issued in accordance with the
    Improper Payments Information Act of 2002 (IPIA),20 OMB identified the
    EITC as a program subject to IPIA and required that Treasury accordingly
    report estimates of EITC-related improper payments to the President and
    Congress. EITC claims totaled approximately $40.3 billion in fiscal year
    2005, of which approximately $35 billion was refunded to taxpayers and
    approximately $5.3 billion was used to reduce assessed taxes. During
    fiscal year 2005, IRS used the preliminary results of the National
    Research Program study of tax year 2001 data to estimate the level of
    compliance of individual filers. Based primarily on the results of the
    study, IRS estimated that from 23 percent to 28 percent of the value of
    EITC payments disbursed during fiscal year 2005 were improper. This error
    rate indicates that of the approximately $35 billion of EITC-related
    refunds disbursed during fiscal year 2005, at least $8 billion, and
    potentially as much as $9.8 billion, was likely to have been improper.

    Due to time and other constraints noted above, IRS relies extensively on
    detective controls, such as automated matching of tax returns with
    third-party data such as W-2s (wage and tax statements), to identify for
    collection underreported taxes and improper refunds. However, these
    programs are not run until months after the returns have been filed and,
    as a result, cannot be used to prevent improper refunds from being
    disbursed. In addition, although IRS's matching program for individual tax
    returns identifies billions of dollars of potentially underreported taxes
    each year, IRS only follows up on a portion of these cases to determine
    how much tax is actually due and to pursue collection of those amounts.
    For example, for tax year 2003, IRS's matching program for individuals
    identified 14.5 million individual tax returns, with potential
    underreported taxes totaling $15 billion.21 Because the volume of cases
    IRS can follow up on depends on resource availability, IRS conducts an
    analysis that identifies case characteristics that have historically
    yielded greater assessments as a

    20Pub. L. No. 107-300, 116 Stat. 2350 (Nov. 26, 2002). IPIA requires the
    head of each federal agency to annually review all programs and activities
    the federal agency administers to identify those that may be susceptible
    to significant improper payments and to estimate the amount of improper
    payments in those susceptible programs in accordance with guidance
    prescribed by OMB. Agencies are required to submit these estimates to
    Congress before March 31 of the following applicable year. OMB,
    Implementation Guidance for the Improper Payments Implementation Act of
    2002, P. L. 107-300, M-03-13 (Washington, D.C.: May 21, 2003).

    21Tax year 2003 is the most recent year for which complete matching
    program results are available.

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

    result of follow-up efforts. In deciding which or how many cases to
    pursue, IRS does not consider historical collection experience or the
    costs incurred to work the related cases. Based on its analysis for tax
    year 2003, IRS investigated 4.1 million (28 percent) of these returns,
    which accounted for about $10.1 billion (67 percent) of the total
    potential underreported taxes. There are factors that affect IRS's ability
    to accelerate the timing of its automated matches, such as the limitations
    of its current automated systems and the timing of filing requirements for
    preparers of third-party documents, some of which are beyond IRS's
    control. Nonetheless, the information from IRS's automated matching
    program suggests that a substantial amount of additional revenue might be
    realized if additional resources, coupled with more timely receipt of
    information and more effective systems to compare such information, were
    devoted to follow-up efforts. At present, billions of dollars in
    underreported taxes could remain uncollected and improper refunds could be
    disbursed.

    Information Security To effectively fulfill its tax processing
    responsibilities, IRS relies extensively on interconnected computer
    systems to perform various functions, such as collecting and storing
    taxpayer data, processing tax returns, calculating interest and penalties,
    generating refunds, and providing customer service. Consequently,
    weaknesses in controls over its information systems could impair IRS's
    ability to perform these vital functions and increase the risk of
    unauthorized disclosure, modification, or destruction of taxpayer data.

    Information security weaknesses-both old and new-continue to impair the
    agency's ability to ensure the confidentiality, integrity, and
    availability of financial and other sensitive data. During our fiscal year
    2005 audit, we identified continuing and new serious information security
    weaknesses in IRS's general controls intended to protect computing
    resources such as networks, computer equipment, software programs, data,
    and facilities. For example, access controls did not adequately prevent
    unauthorized access to taxpayer and other sensitive data by users granted
    access to IRS computer systems. Further, monitoring activities over
    critical computer systems were not adequately performed to record and
    track security-related events. As a result, sensitive data and computing
    resources are at increased risk of unauthorized use, modification, loss,
    and disclosure, possibly without detection.

    A key reason for IRS's information security weaknesses was that it has not
    yet fully implemented an agencywide information security program to

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    ensure that controls are effectively established and maintained. In
    December 2002, Congress enacted the Federal Information Security
    Management Act of 2002 (FISMA),22 which is intended to strengthen the
    information security of federal information and systems by requiring
    agencies to develop, document, and implement agencywide information
    security programs. Some of the information security program elements
    required by FISMA are

         o periodic testing and evaluation of the effectiveness of information
           security policies, procedures, and practices;
         o security awareness training for agency personnel, including
           contractors;
         o a process for planning, implementing, evaluating, and documenting
           remedial action to address information security deficiencies; and
         o plans and procedures to ensure continuity of operations for
           information systems that support the operations and assets of the
           agency.23

    Although IRS had begun implementing elements required by FISMA, we
    identified several shortcomings. For example, (1) certain system tests and
    evaluations were insufficient, (2) security awareness training was not
    consistently established across the agency, (3) remedial plans to address
    information security deficiencies were lacking, and (4) disaster recovery
    and business resumption plans for critical systems were not completed. IRS
    has taken actions to improve information security management; however, it
    still needs to take additional steps to address all key elements of an
    information security program. Such a program is critical to provide IRS
    with a solid foundation for resolving existing information security
    problems and continuously managing information security risks.

    While IRS has corrected many previously identified information security
    weaknesses, we continued to observe weaknesses identical or very similar
    to those we previously identified, in addition to several new ones.
    Collectively, these problems represent a material weakness in IRS's
    internal controls over information systems and data. Specifically, the
    continuing

    22FISMA was enacted as title III of the E-Government Act of 2002, Pub. L.
    No. 107-347, 116 Stat. 2946 (Dec. 17, 2002).

    23See 44 U.S.C. S: 3544.

    Page 137 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

    and newly identified weaknesses increase the risk that data processed by
    IRS's computer systems are not reliable. If IRS does not adequately
    mitigate these weaknesses, unauthorized individuals could gain access to
    critical hardware and software, where they may intentionally or
    inadvertently add, alter, or delete sensitive data or computer programs,
    possibly without being detected. These individuals could also obtain
    personal taxpayer information and use it to commit financial crimes using
    taxpayers' names (identity fraud), such as fraudulently establishing
    credit and running up debts. Until IRS successfully manages its
    information security risks, management will not have assurance of the
    integrity and reliability of the information generated from the new
    financial management systems. We will be issuing a separate report on
    issues we identified regarding information security at IRS.

    In addition to the material weaknesses discussed above, we identified two

      Reportable Conditions

    reportable conditions concerning weaknesses in IRS's internal controls
    over (1) hard-copy tax receipts and taxpayer information and (2) P&E, both
    of which we have reported on in prior audits.

        Hard-Copy Tax Receipts and Taxpayer Information

    IRS manually processes hundreds of billions of dollars of hard-copy
    taxpayer receipts and related taxpayer information at its service center
    campuses and field offices and at commercial lockbox banks that operate
    under contract with Treasury's Financial Management Service (FMS) to
    provide tax receipt processing services on behalf of IRS. In previous
    audits, we reported that weaknesses in IRS's controls designed to
    safeguard these taxpayer receipts and information increase the risk that
    receipts in the form of checks, cash, and the like, could be
    misappropriated or that the information could be compromised.24 IRS has
    continued to take actions to address these weaknesses, such as conducting
    periodic security reviews of receipt processing areas and improving its
    policies and procedures. For

    24GAO, Internal Revenue Service: Status of Recommendations from Financial
    Audits and Related Financial Management Reports, GAO-05-393 (Washington,
    D.C.: Apr. 29, 2005); Management Report: Improvements Needed in IRS's
    Internal Controls, GAO-05-247R (Washington, D.C.: Apr. 27, 2005); IRS
    Lockbox Banks: More Effective Oversight, Stronger Controls, and Further
    Study of Costs and Benefits Are Needed, GAO-03-299 (Washington, D.C.: Jan.
    15, 2003); Financial Audit: IRS's Fiscal Years 2002 and 2001 Financial
    Statements, GAO-03-243 (Washington, D.C.: Nov. 15, 2002); and Internal
    Revenue Service: Progress Made, but Further Actions Needed to Improve
    Financial Management, GAO-02- 35 (Washington, D.C.: Oct. 19, 2001).

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    example, to enhance security over disposal of taxpayer information at
    lockbox banks, IRS changed its policy during fiscal year 2005 to require
    that the shredding of such information be conducted on bank premises
    rather than at the premises of an offsite contractor, as had been common
    practice. However, during our testing in fiscal year 2005, we continued to
    find that IRS's controls over receipts and related hard-copy taxpayer
    information received from taxpayers were inadequate to sufficiently limit
    the risk of theft, loss, or misuse of such funds and information. This
    condition resulted primarily from inconsistencies in the establishment and
    implementation of, and compliance with, policies at IRS service center
    campuses, field offices, and lockbox banks.25 Specifically, we found the
    following:

         o Weaknesses in physical security controls designed to prevent
           unauthorized access to IRS's receipt processing facilities. For
           example, during our audit we observed (1) weaknesses in physical
           safeguards intended to control access to IRS facilities (at one
           lockbox bank and one service center campus) and to the facility itself
           (at one lockbox bank); (2) alarms that were either not working or not
           working properly (at one lockbox bank, one service center campus, and
           one taxpayer assistance center); and (3) security guards who did not
           respond timely to door alarms during our tests (at two service center
           campuses and one lockbox bank). These weaknesses increase the risks
           that the integrity of IRS facilities and the taxpayer receipts and
           information they process may be compromised.
         o Weaknesses in the implementation and execution of procedural
           safeguards and controls designed to account for, control, and protect
           taxpayer receipts and related taxpayer information while they are
           being processed within IRS facilities. For example, during our audit
           we found (1) inadequate segregation of duties in that the tasks of
           receiving payments from taxpayers, logging them in for internal
           control purposes, and preparing documents to record the payments in
           IRS's records were

    25IRS's field office structure includes service center campuses, which
    process tax returns and payments submitted by taxpayers and deposit tax
    payments in depository institutions; taxpayer assistance centers, which
    accept payments from and provide assistance directly to taxpayers; and
    other business operating divisions that provide taxpayer audit and
    assistance services. These other business operating divisions are
    organized along the following business lines: Large and Mid-Size
    Businesses, Small-Business/Self-Employed, and Tax Exempt/Government
    Entities. In addition, commercial lockbox banks operate under contract
    with FMS to provide tax receipt processing services on behalf of IRS.

    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    often performed by the same person (at six of the eight taxpayer
    assistance centers we visited);26 (2) inadequate security over mail
    containing taxpayer receipts and related taxpayer information and over the
    security of this information once extracted from the envelopes (at four
    Small Business/Self-Employed groups, three service center campuses, two
    taxpayer assistance centers, and one Tax Exempt/Government Entities
    group); and (3) weaknesses in controls over access to controlled or
    restricted areas in which taxpayer receipts are received and processed (at
    four taxpayer assistance centers and one service center campus). These
    weaknesses increase the risk that taxpayer receipts and information may be
    compromised during processing at IRS facilities.

    o  Weaknesses in controls designed to safeguard hard-copy taxpayer
    receipts and related taxpayer information during transport between IRS
    business units and to or from third parties, such as depository
    institutions and post offices. For example, during our audit we found
    internal control weaknesses relating to (1) couriers who physically
    deliver hard-copy taxpayer receipts and related taxpayer information to
    IRS from post offices and between lockbox banks and associated service
    center campuses, and who deliver receipts to depository institutions (at
    three lockbox banks and one service center campus); (2) compiling and
    preparing taxpayer receipts and related taxpayer information for shipment
    to the associated service center campuses (at three taxpayer assistance
    centers); and (3) tracking hard-copy taxpayer receipts and related
    taxpayer information shipped to the service centers for processing or
    archiving, and verifying that they are received by the respective service
    center campuses (at all eight taxpayer assistance centers we visited, 18
    Small Business/Self Employed groups, four Large and Mid-Sized Business
    groups, and two Tax-Exempt/Government Entities groups). These weaknesses
    increase the risk that taxpayer receipts may be lost, misappropriated, or
    delayed in transit between offices and that their loss, misappropriation,
    or delayed arrival may not be timely detected.

    26Many taxpayer assistance centers are operated at times by only one IRS
    employee, or tasks are performed by Revenue Agents or Officers working
    away from the field office. In these situations, segregation of these
    duties is problematic. IRS recognized these situations and is considering
    potential solutions.

    Page 140 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

                                 Property and Equipment

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

    These internal control weaknesses increase IRS's vulnerability to theft or
    loss and expose taxpayers to increased risk of losses from financial
    crimes committed by individuals who inappropriately gain access to
    taxpayer receipts and confidential information entrusted to IRS. While IRS
    has made progress in this area, our findings from our fiscal year 2005
    audit indicate that much more remains to be done to effectively address
    these matters, which are critical to IRS's success in meeting its customer
    service goals.

    During fiscal year 2005, IRS implemented two initiatives to help address
    weaknesses at its lockbox banks and taxpayer assistance centers. In
    conjunction with FMS, IRS developed and implemented a joint pilot program
    of lockbox performance measures aimed at providing quantitative measures
    of performance in, and holding bank management more accountable for, among
    other areas, physical security, courier and other personnel security, and
    internal controls over receipts and receipt processing. IRS also
    implemented a pilot program at the field office taxpayer assistance
    centers with the objective of improving internal controls and creating,
    where feasible, segregation of duties over receiving, preparing the
    posting documents, reviewing, and transmitting taxpayer receipts and
    related taxpayer information to the service center campuses. These
    initiatives, if effectively implemented, could improve IRS's controls over
    hard-copy taxpayer receipts and data at these offices in future years.

    In prior years, we identified significant internal control deficiencies
    that hampered IRS's ability to have reliable and timely information on its
    balance of P&E throughout the year.27 Over the past several years, IRS has
    made substantial progress in addressing internal control deficiencies
    related to its P&E. In fiscal year 2005, we noted further improvements in
    IRS's controls and procedures that enhanced its ability to account for
    P&E. Specifically, IRS improved the timeliness of recording P&E activity
    in its accounting system. However, fundamental deficiencies in IRS's
    financial management system continued to exist, which precluded IRS from
    generating detailed property records that reconcile to the financial
    records.

    Prior to the implementation of the first release of IFS in November 2004,
    IRS recorded all property purchases as operating expenses and later
    extracted the costs of property acquisitions from operating expenses by

    27 GAO-05-103.

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

    recording adjustments to remove property purchases from expenses and
    capitalize them as P&E. IRS performed this analysis and updated the P&E
    accounting records monthly. With implementation of the first release of
    IFS, IRS is now able to record the majority of P&E activities as assets at
    the time of acquisition. However, because of funding constraints, IRS
    deferred indefinitely implementation of a property management module of
    IFS. This module was intended to generate detailed property records that
    reconcile to the financial records. Due to uncertainty over implementation
    of a property management module, IRS continues to refine its compensating
    procedures to address the lack of an integrated accounting and property
    system. However, significant and costly efforts are required to perform
    these compensating procedures. For example, IRS must still go through a
    labor-intensive and time-consuming process to link the detailed property
    records to the financial records. In addition, some P&E activity, such as
    internal use software projects, are still initially recorded as expenses
    and later extracted and capitalized as P&E because of the complexity of
    measuring the full costs of the projects.28 An integrated accounting and
    property system would provide management with the ability to maintain
    control over P&E to ensure that assets are properly accounted for and
    safeguarded.

    Our tests of compliance with selected provisions of laws and regulations

      Compliance Issues

    disclosed one area of noncompliance that is reportable under U.S.
    generally accepted government auditing standards and OMB guidance. This
    area relates to the release of federal tax liens against taxpayers'
    property. We also found that IRS's financial management systems do not
    substantially comply with the requirements of FFMIA.

    Release of Federal Tax The Internal Revenue Code grants IRS the power to
    file a lien against the property of any taxpayer who neglects or refuses
    to pay all assessed federal

        Liens

    taxes. The lien becomes effective when it is filed with a designated
    office, such as a courthouse in the county where the taxpayer's property
    is located. The lien serves to protect the interest of the federal
    government

    28For internal use software, capitalized costs include direct costs, such
    as salaries of IRS employees assigned to the project and contractor fees,
    and indirect costs, such as overhead incurred during the development
    phase. The development phase includes developing the software
    configuration and interfaces, coding, installing the software to the
    hardware, and testing.

    Page 142 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    and as a public notice to current and potential creditors of the
    government's interest in the taxpayer's property. For example, federal tax
    liens are disclosed in credit reports of individuals. Under section 6325
    of the Internal Revenue Code, IRS is required to release a federal tax
    lien within 30 days after the date the tax liability is satisfied or has
    become legally unenforceable or the Secretary of the Treasury has accepted
    a bond for the assessed tax.

    In each year beginning with our audit of IRS's fiscal year 1999 financial
    statements, we found that IRS did not always release the applicable
    federal tax lien within 30 days of the tax liability being either paid off
    or abated, as required by the Internal Revenue Code.29 We found that this
    condition continued to exist in fiscal year 2005. Specifically, in our
    testing of 59 statistically selected tax cases with liens in which the
    taxpayers' total outstanding tax liabilities were either paid off or
    abated during fiscal year 2005, we found 13 instances in which IRS did not
    release the applicable federal tax lien within the statutorily mandated 30
    days. The time between satisfaction of the liability and release of the
    lien ranged from 36 days to 233 days. In 4 cases, the lien still had not
    been released at the time of our review. In 1 of these cases, it had been
    269 days since the taxpayer had fully satisfied the tax liability. Based
    on our work, we estimate that for 22 percent of unpaid tax assessment
    cases in which IRS had filed a tax lien that were resolved in fiscal year
    2005, IRS did not release the lien within 30 days.30

    In at least 5 of the 13 cases in which liens were not released timely, the
    release was delayed because IRS did not properly credit all of the
    taxpayer's outstanding accounts when the taxpayer sent in one payment to
    satisfy the tax liability of multiple tax accounts. Consequently, one or
    more of the taxpayer's accounts remained open even though the taxpayer had
    fully satisfied the total tax liability. This, in turn, prevented
    initiation of the lien release process for these cases. We issued a report
    in January 2005 that discusses other issues that contribute to IRS's
    failure to timely release federal tax liens, along with our
    recommendations to address those

    29 GAO-05-103 .

    30We are 95 percent confident that the percentage of cases in which the
    lien was not released within 30 days does not exceed 33 percent.

    Page 143 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements

      Appendix I Material Weaknesses, Reportable Conditions, and Compliance Issues

        Financial Management Systems' Noncompliance with FFMIA

    issues.31 The failure to promptly release tax liens could cause undue
    hardship and burden to taxpayers who are attempting to sell property or
    apply for commercial credit.

    In fiscal year 2005, we continued to find that IRS's financial management
    systems did not substantially comply with the requirements of FFMIA.
    Specifically, IRS's systems did not comply with Federal Financial
    Management System Requirements (FFMSR), applicable federal accounting
    standards (U.S. generally accepted accounting principles), and the SGL at
    the transaction level. We found that IRS (1) cannot rely solely on
    information from its general ledger to prepare its financial statements;
    (2) lacks a subsidiary ledger for its unpaid assessments; and (3) lacks an
    effective audit trail from its general ledger back to detailed records and
    transaction source documents for material balances, such as tax revenues
    and tax refunds. IRS's implementation of the first release of IFS
    represents a major step forward. If fully implemented as planned, it has
    the potential to address many of the issues IRS has experienced in the
    past with its automated financial management systems, such as the
    inability to provide current, reliable information for managers' use to
    support decision making. However, as noted earlier in this report,
    primarily because of funding constraints, IRS has put on hold future
    releases of IFS that were to include features essential to IRS's ability
    to realize the system's full potential. Additionally, IRS continues to
    rely on obsolete legacy systems to process tax revenues, tax refunds, and
    unpaid tax assessments. These systems do not interface with IFS, which
    accounts for and reports only IRS's nontax administrative activities.

    This noncompliance with FFMIA ties in with our earlier discussions of
    material weaknesses related to the inability of IRS's financial management
    systems to produce auditable financial statements and related disclosures
    that conform with U.S. generally accepted accounting principles without
    substantial compensating processes and significant adjustments. These
    weaknesses also indicate that IRS's systems cannot routinely accumulate
    and report the full cost of its activities. Since IRS's systems do not
    comply with FFMSR, U.S. generally accepted accounting principles, and the
    SGL, they also do not comply with OMB Circular No. A-127, Financial
    Management Systems (revised July 23, 1993). In its FIA assurance

    31GAO, Opportunities to Improve Timeliness of IRS Lien Releases,
    GAO-05-26R (Washington, D.C.: Jan. 10, 2005).

    Page 144 GAO-06-137 IRS's Fiscal Years 2005 and 2004 Financial Statements
    Appendix I Material Weaknesses, Reportable Conditions, and Compliance
    Issues

    statement to Treasury, IRS reported that its financial management systems
    did not substantially comply with the requirements of FFMIA in fiscal year
    2005.

    IRS has established a remediation plan to address the conditions affecting
    its systems' ability to comply substantially with the requirements of
    FFMIA. This plan outlines the actions to be taken to resolve these issues,
    but future corrective actions are on hold and are currently unfunded. Due
    to the long-term nature of IRS's systems modernization efforts, which IRS
    expects will resolve many of the most serious issues, many of the planned
    time frames exceed the 3-year resolution period specified in FFMIA.
    However, for these instances IRS has received a waiver from this
    requirement from OMB, as authorized by FFMIA.

    Appendix II

    Details on Audit Methodology

    To fulfill our responsibilities as the auditor of the Internal Revenue
    Service's (IRS) financial statements, we did the following:

         o Examined, on a test basis, evidence supporting the amounts and
           disclosures in the financial statements. This included selecting
           statistical samples of unpaid assessment, revenue, refund, accrued
           expenses, payroll, nonpayroll, property and equipment, accounts
           payable, and undelivered order transactions. These statistical samples
           were selected primarily to substantiate balances and activities
           reported in IRS's financial statements. Consequently, dollar errors or
           amounts can and have been statistically projected to the population of
           transactions from which they were selected. In testing these samples,
           certain attributes were identified that indicated either significant
           deficiencies in the design or operation of internal control or
           compliance with provisions of laws and regulations. These attributes,
           where applicable, can be and have been statistically projected to the
           appropriate populations.
         o Assessed the accounting principles used and significant estimates made
           by management.
         o Evaluated the overall presentation of the financial statements.
         o Obtained an understanding of internal controls related to financial
           reporting (including safeguarding assets), compliance with laws and
           regulations (including the execution of transactions in accordance
           with budget authority), and performance measures reported in the
           Management Discussion and Analysis.
         o Tested relevant internal controls over financial reporting (including
           safeguarding assets) and compliance, and evaluated the design and
           operating effectiveness of internal controls.
         o Considered the process for evaluating and reporting on internal
           controls and financial management systems under 31 U.S.C. S: 3512 (c),
           (d), commonly referred to as the Federal Managers' Financial Integrity
           Act of 1982.
         o Tested compliance with selected provisions of the following laws and
           regulations: Anti-Deficiency Act, as amended (31 U.S.C. S: 1341(a)(1)
           and 31 U.S.C. S: 1517(a)); Purpose Statute (31 U.S.C. S: 1301);
           Release of lien or discharge of property (26 U.S.C. S: 6325); Interest
           on underpayment,

    Appendix II Details on Audit Methodology

    nonpayment, or extensions of time for payment of tax (26 U.S.C. S: 6601);
    Interest on overpayments (26 U.S.C. S: 6611); Determination of rate of
    interest (26 U.S.C. S: 6621); Failure to file tax return or to pay tax (26

    U.S.C.
               S: 6651); Failure by individual to pay estimated income tax (26

    U.S.C.
               S: 6654); Failure by corporation to pay estimated income tax (26

    U.S.C.
               S: 6655); Prompt Payment Act (31 U.S.C. S: 3902(a), (b), and (f)
               and 31 U.S.C. S: 3904); Pay and Allowance System for Civilian
               Employees (5

    U.S.C.
               S:S: 5332 and 5343, and 29 U.S.C. S: 206); Federal Employees'
               Retirement System Act of 1986, as amended (5 U.S.C. S:S: 8422,
               8423, and 8432); Social Security Act, as amended (26 U.S.C. S:S:
               3101 and 3121 and 42 U.S.C. S: 430); Federal Employees Health
               Benefits Act of 1959, as amended (5 U.S.C. S:S: 8905, 8906, and
               8909); Transportation, Treasury, and Independent Agencies
               Appropriations Act, 2004, Pub. L. No. 108199, div. F, tit. II, 118
               Stat. 314 (Jan. 23, 2004); and Transportation, Treasury,
               Independent Agencies, and General Government Appropriations Act,
               2005, Pub. L. No. 108-447, div. H, tit. II, 118 Stat. 3235 (Dec.
               8, 2004).

    o  Tested whether IRS's financial management systems substantially comply
    with the three requirements of the Federal Financial Management
    Improvement Act of 1996 (Pub. L. No. 104-208, div. A, S: 101(f), title
    VIII, 110 Stat. 3009, 3009-389 (Sept. 30, 1996).

                                      Appendix III

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