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
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its entirety without further permission from GAO. However, because this
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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 [email protected]. 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.

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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

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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.

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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.

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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

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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

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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
Year Ended September 30, 2005

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
Year Ended September 30, 2005

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.

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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 (*)

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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.

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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)

45

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:

46

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)

51

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.

52

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.

53

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;

56

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.

59

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).

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