Internal Revenue Service: Procedural Changes Could Enhance Tax	 
Collections (15-NOV-06, GAO-07-26).				 
                                                                 
GAO previously testified that federal contractors abused the tax 
system with little consequence. While performing those audits,	 
GAO noted that the Internal Revenue Service (IRS) records	 
sometimes contained inaccurate or outdated tax information that  
prevented IRS from taking appropriate collection actions against 
those contractors, including submitting their tax debt to the	 
Federal Payment Levy Program (FPLP) for collection. As a result, 
GAO was asked to review IRS's coding of tax debt excluded from	 
the FPLP to determine whether (1) IRS tax records contain	 
inaccurate status or transaction codes that exclude tax debt from
the FPLP, (2) IRS's monitoring could be strengthened to ensure	 
the accuracy of its status and transaction codes, and (3) other  
opportunities exist to increase the amount of tax debt included  
in the FPLP.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-26						        
    ACCNO:   A63385						        
  TITLE:     Internal Revenue Service: Procedural Changes Could       
Enhance Tax Collections 					 
     DATE:   11/15/2006 
  SUBJECT:   Collection procedures				 
	     Debt collection					 
	     Delinquent taxes					 
	     Federal taxes					 
	     Government information				 
	     Income taxes					 
	     Policy evaluation					 
	     Program management 				 
	     Records						 
	     Tax administration systems 			 
	     Tax law						 
	     Tax nonpayment					 
	     Tax returns					 
	     Tax violations					 
	     Taxpayers						 
	     Policies and procedures				 
	     IRS Automated Collection System			 
	     IRS Federal Payment Levy Program			 

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GAO-07-26

   

     * Results in Brief
     * Background

          * Federal Payment Levy Program
          * Improvements in the Levy Program

     * Coding Errors Excluded Tax Debt from the FPLP

          * Errors in Statutory Exclusion Codes
          * Errors in Policy Exclusion Codes

     * More Effective Monitoring Could Prevent Errors and Help Ensu

          * Monitoring Did Not Identify Tax Debt That Should Have Been E
          * Monitoring of Financial Hardship Cases Does Not Consider Tax

     * Policy Changes Could Allow Billions of Dollars in Tax Debt t

          * IRS Excludes Many Cases from the FPLP with Incomes Exceeding
          * IRS Continues to Exclude Substantial Tax Debt in ACS from th
          * IRS Excludes All Tax Debt from Levy during the Notification

     * Conclusions
     * Recommendations for Executive Action
     * Agency Comments and Our Evaluation

          * Data Reliability Assessment

     * GAO Contact
     * Acknowledgements
     * GAO's Mission
     * Obtaining Copies of GAO Reports and Testimony

          * Order by Mail or Phone

     * To Report Fraud, Waste, and Abuse in Federal Programs
     * Congressional Relations
     * Public Affairs
GAO

November 2006

INTERNAL REVENUE SERVICE

Procedural Changes Could Enhance Tax Collections

GAO-07-26

Report to the Permanent Subcommittee on Investigations, Committee on
Homeland Security and Governmental Affairs, U.S. Senate

Contents

Letter 1

Results in Brief 3
Background 6
Coding Errors Excluded Tax Debt from the FPLP 12
More Effective Monitoring Could Prevent Errors and Help Ensure Ongoing
Accuracy of Account Status 18
Policy Changes Could Allow Billions of Dollars in Tax Debt to Enter the
FPLP 23
Conclusions 32
Recommendations for Executive Action 33
Agency Comments and Our Evaluation 34
Appendix I Scope and Methodology 40
Appendix II Comments from the Internal Revenue Service 42
Appendix III GAO Contact and Staff Acknowledgments 48

Tables

Table 1: Results of GAO's Statistical Sample of IRS Statutory FPLP
Exclusions 14
Table 2: Results of GAO's Statistical Sample of IRS Policy FPLP Exclusions
17
Table 3: IRS's Financial Hardship Income Thresholds 25
Table 4: IRS's Financial Hardship Income Thresholds Ceilings 27
Table 5: Historical IRS Maximum Income Thresholds and Household Median
Incomes 28

Figures

Figure 1: Types of Taxes Owed, as of September 30, 2005 7
Figure 2: IRS Tax Debt by FPLP Status, as of September 30, 2005 10
Figure 3: Value of Levy Program Collections, Fiscal Years 2003 through
2006 12
Figure 4: Percentage of Tax Records in Statutory Exclusion Population
Categories, as of September 30, 2005 13
Figure 5: Percentage of Tax Records in Policy Exclusion Population
Categories, as of September 30, 2005 16
Figure 6: Tax Debt Associated with Debtors in Financial Hardship Who Can
Earn Over the 2004 National Median Income, as of September 30, 2005 26
Figure 7: Collections from IRS Notification Letters in Fiscal Year 2005 32

Abbreviations

ACS Automated Collection System

FMS Financial Management Service

FPLP Federal Payment Levy Program

IRS Internal Revenue Service

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separately.

United States Government Accountability Office

Washington, DC 20548

November 15, 2006

The Honorable Norm Coleman Chairman The Honorable Carl Levin Ranking
Minority Member Permanent Subcommittee on Investigations Committee on
Homeland Security and Governmental Affairs United States Senate

As the nation's tax collector, the Internal Revenue Service (IRS) collects
approximately $2 trillion in taxes from businesses and individuals
annually. The vast majority of the tax revenues flow into the federal
government by voluntary payments from compliant taxpayers. However, while
most taxpayers comply with the tax laws and pay their taxes as required, a
significant number do not. At September 30, 2005, IRS's records reflected
about $250 billion of unpaid taxes. In addition, IRS estimates that about
$300 billion in additional taxes go unassessed and therefore uncollected
every year.

IRS's collection process is heavily dependent upon its automated computer
systems and the information that resides within these systems. In
particular, the status and transaction codes in each taxpayer's account in
IRS's master file taxpayer database1 are critical to IRS in tracking the
collection actions it has taken against a tax debtor and in determining
what, if any, additional actions should be pursued. For example, IRS uses
a specific transaction code to identify tax debtors it has designated as
being in financial hardship and who are thus unable to pay their tax debt.
IRS uses these status and transaction codes to identify cases it should
exclude from the Federal Payment Levy Program (FPLP), which is an
automated method of collecting tax debt by offsetting federal payments
made to individuals and businesses, as well as from other collection
actions.

1IRS's master files contain detailed records of taxpayer accounts.

In congressional hearings held in February 2004 and June 2005,2 we
testified that Department of Defense and civilian agency federal
contractors abused the federal tax system with little consequence. In
those hearings, we noted that IRS excluded significant amounts of tax debt
from the FPLP for either statutory or policy reasons, thus limiting
opportunities to automatically collect from those who had not paid their
federal taxes. While performing those audits, we noted that IRS records
sometimes contained inaccurate or outdated tax information that prevented
it from taking certain collection actions against those contractors,
including using the FPLP to collect at least some of the outstanding tax
debt.

On the basis of those audits and your request, we initiated a review of
the status and transaction codes within IRS's master file database of
taxpayer accounts to assess the accuracy of these codes and the effect
inaccurate or outdated codes in the master file database could have on the
FPLP and IRS's other collection efforts. The specific objectives of this
report were to determine (1) whether and to what extent IRS tax records
contain inaccurate or out-of-date status or transaction codes that exclude
collection of tax debt through the FPLP; (2) whether IRS's monitoring
policies, procedures, and practices could be strengthened to ensure the
accuracy and timely updating of its status and transaction codes; and (3)
whether opportunities exist to increase the amount of tax debt subject to
collection through the FPLP.

Tax debts may be excluded from the FPLP for either policy or statutory
reasons.3 To meet our objectives, we selected statistical samples of IRS's
outstanding tax-due accounts that were excluded from the FPLP as of
September 30, 2005. We examined the underlying records to determine
whether or not IRS had documentation supporting the accuracy of the status
and transaction codes both when they were originally entered in IRS's
systems and at the point in time of our review. We supplemented our review
of IRS records with information gathered through data mining. For those
sample items for which we determined the codes were inaccurate or out of
date, we reviewed IRS's policies and procedures related to the FPLP to
determine whether and how IRS policies, procedures, or practices could be
strengthened to improve the ongoing accuracy of those codes and thus
increase the volume of tax debt that would be included in the FPLP.
Finally, we reviewed IRS's exclusion categories to identify opportunities
for IRS to modify its exclusion criteria so that more tax debt is subject
to collection through the FPLP. See appendix I for more detailed
information on the scope and methodology of our work.

2GAO, Financial Management: Some DOD Contractors Abuse the Federal Tax
System with Little Consequence, [27]GAO-04-414T (Washington, D.C.: Feb.
12, 2004), and Financial Management: Thousands of Civilian Agency
Contractors Abuse the Federal Tax Systems with Little Consequence,
[28]GAO-05-683T (Washington, D.C.: June 16, 2005).

3In the FPLP, IRS divides tax debt records into either included or
excluded categories based on the status and transaction codes in the tax
debt account. Further, IRS identifies excluded tax debt records as those
that are excluded because of a statutory requirement or because of an IRS
policy decision.

Our work was performed from November 2005 through September 2006 in
accordance with generally accepted government auditing standards.

Results in Brief

IRS's tax records contain inaccurate or out-of-date information that
resulted in IRS erroneously excluding tax debt from the Federal Payment
Levy Program (FPLP) and possibly other collection actions. Although our
review of tax debt excluded from the FPLP did not identify a high
percentage of FPLP-related coding errors, the errors did prevent IRS from
taking collection against tax debtors owing billions of dollars in tax
debt. Based on a review of two statistical samples of cases excluded from
the FPLP, we estimate that 6 percent of tax debts excluded from the FPLP
for statutory reasons and 1 percent excluded for policy reasons were in
error. On the basis of those error rates, we estimate that over a
half-million tax records with about $2.4 billion in tax debt were
erroneously excluded from the FPLP, as of September 30, 2005.

IRS did not identify and correct the coding errors we found because it did
not sufficiently monitor the timely updating of the status and transaction
codes or the effect of computer programming changes. In our sample
transactions, we found that IRS did not identify six
computer-programming-related coding errors because it did not fully assess
the effect of certain computer-programming changes on taxpayer account
status codes. Similarly, IRS did not identify a bankruptcy-related coding
error because it did not monitor the timely updating of the
bankruptcy-related transaction codes. In addition, although we found no
coding errors in the coding of cases designated as financial hardship
cases, our analysis revealed that IRS's policies for monitoring the status
of such cases are not sufficient to ensure the ongoing accuracy of
hardship designations. To illustrate, when IRS determines that a tax
debtor is in financial hardship and, as such, is deemed unable to pay, IRS
excludes the debt from the FPLP, as well as other collection actions. IRS
then limits its monitoring of the cases to an automated review of the tax
debtor's income as reported on the debtor's subsequent years' income tax
returns. However, for 24 of the 31 sample cases coded by IRS as being in
financial hardship, the tax debtor had ceased to file tax returns. As a
result of its policy to limit its monitoring of financial hardship cases
for tax debtors who ceased to file tax returns, IRS had no way to
determine whether the tax debtors' financial condition had improved such
that the tax debt should be included in the FPLP and other collection
actions.

IRS has increased the amount of tax debt subject to collection through the
FPLP by over $28 billion over the past 2 years. Nonetheless, opportunities
exist for IRS to amend its policies to allow billions of dollars in
additional tax debt to be included in the FPLP. For example, of the $247
billion in unpaid taxes owed as of September 30, 2005, $23 billion, or
almost 10 percent, is owed by tax debtors IRS has designated as being in
financial hardship; therefore, IRS does not attempt to collect their
outstanding tax debt. IRS allows tax debtors earning up to $84,000--almost
twice the median income for all households in the United States--to be
designated as being in financial hardship. In total, IRS has placed tax
debtors collectively owing over $6 billion in tax debt in its top
financial hardship income threshold of between $76,000 and $84,000.
Because they have been designated by IRS as being in financial hardship,
although they are earning relatively high incomes, these tax debtors are
excluded from the FPLP and do not face other tax collection action from
IRS. From 1992 to 2004, IRS almost tripled the maximum amount it allows
tax debtors to earn before being subject to collection action, far above
the rate of inflation. IRS could not provide us any data analysis that
supported those increases. As a result of those large increases, almost
two-thirds of all tax debt IRS has designated as being in financial
hardship is owed by tax debtors IRS allows to earn more than the national
median household income before their unpaid tax debt again becomes subject
to IRS collection action. In contrast, in 1992, no tax debtor with a
financial hardship designation was allowed to earn more than the median
household income without becoming subject to collection action.

IRS policies also continue to exclude from the FPLP about $5 billion of
tax debt that has been assigned to its Automated Collection System (ACS).
In ACS, IRS enforcement personnel attempt to make telephone contact with
tax debtors to collect the unpaid tax debt. By excluding tax debts in the
ACS from the FPLP, IRS may be limiting its ability to utilize a viable
collection mechanism. We also found that IRS's policies exclude all tax
debt from the FPLP until IRS completes its notification process. During
this process, IRS sends a series of up to four separate notices to tax
debtors demanding payment of their taxes--a process that by IRS policy can
take up to 6 months for individuals with income tax debt. IRS is
statutorily required to send two notices before initiating the levy
process, but IRS's current policies prevent cases from timely entering the
FPLP while it sends out multiple notice letters, a process that can take
almost twice as long as statutorily required. Although each notice letter
generates some collections of tax debt, IRS receives over 70 percent of
all notice collections from its first notification letter. Once IRS
fulfills the two-notice statutory requirement, IRS could submit the tax
debt to the FPLP while continuing to send the tax debtor additional
notifications. Doing so could facilitate the timely movement of tax debt
into the program and could thus expedite and increase tax collections.

We are making ten recommendations to the Commissioner of Internal Revenue
for executive action, including four recommendations designed to improve
IRS's monitoring of tax debt, to increase the amount of tax debt in the
FPLP, or to accelerate how quickly tax debt enters the program, and six
recommendations to help ensure IRS's financial hardship designations are
appropriate.

IRS agreed with five of our recommendations, partially agreed with two
other recommendations, and disagreed with the remaining three
recommendations. IRS agreed to (1) evaluate steps necessary to ensure the
timely termination of defaulted installment agreements, (2) evaluate the
appropriateness of its current financial hardship income thresholds, (3)
implement policy changes to govern how financial hardship thresholds are
changed in the future, (4) evaluate whether to include noncompliance with
filing requirements as a factor in reactivating cases in financial
hardship, and (5) evaluate the feasibility of referring tax debtors with
financial hardship designations to IRS's withholding compliance program
for special attention if they do not pay their current tax obligations.

IRS partially agreed with our recommendation to add language about IRS's
ability to levy income and assets to its early notification letters,
stating it would consider adding such language to some of the later
notices, but not the first notice. Based on IRS's comments, we have
modified our recommendation to add such language beginning with the second
notice. IRS also partially agreed with our recommendation to review tax
debtors' financial conditions to verify the continued validity of its
financial hardship designation, stating that it did not agree with
conducting such a review every 3 years, but that it would study and
consider including a time factor for such reviews. Based on IRS's
comments, we have modified our recommendation to conduct such verification
periodically.

IRS disagreed with our recommendation to put tax debt into the FPLP early
in the notice phase to accelerate the collection process, stating that
over two-thirds of tax debtors pay their tax debt in full after IRS
notifies them of the debt. IRS also did not agree with our recommendation
that it add additional tax debt to the FPLP when collection officials were
considering using other forms of levy. IRS was concerned with the
potential to inadvertently issue duplicate levies and thereby cause tax
debtors unanticipated hardship. In addition, IRS did not agree with our
recommendation that it change the closing codes for tax debt cases
designated as being in financial hardship prior to the income threshold
level changes that occurred in 2004. IRS stated that doing so may be
difficult and may not be cost effective.

We continue to believe that all ten current recommendations in this
report, if implemented, will assist IRS in its tax administration duties.
See the "Agency Comments and Our Evaluation" section of this report for a
more detailed discussion of the agency comments. We have reprinted IRS's
comments in appendix II of this report.

Background

In its role as the nation's tax collector, IRS is responsible for
collecting taxes, processing tax returns, and enforcing the nation's tax
laws. Since 1990, we have designated IRS's enforcement of tax laws as a
governmentwide high-risk area.4 In attempting to ensure that taxpayers
fulfill their obligations, IRS is challenged on virtually every front.
While IRS's enforcement workload--measured by the number of tax returns
filed--has continually increased, only recently have the resources IRS has
been able to dedicate to enforcing the tax laws begun to increase. IRS
estimates that the annual gross tax gap, that is, the difference between
what taxpayers should pay on a timely basis and what they actually pay, is
about $345 billion. IRS has reported that its enforcement activities,
coupled with late payments, recover about $55 billion of that amount,
leaving an annual net tax gap of almost $300 billion. IRS has a statutory
limitation on the length of time it can pursue unpaid taxes, generally 10
years from the date of the assessment.5

4Additionally, we designated IRS's financial management and systems
modernization as high-risk areas in 1995. GAO, High-Risk Series: An
Overview, [29]GAO/HR-95-1 (Washington, D.C.: February 1995). In 2005, two
of IRS's high-risk areas--collection of unpaid taxes and earned income
credit noncompliance--were consolidated to make a single high-risk area
called enforcement of tax laws. Also in 2005, IRS's high-risk areas of
business systems modernization and financial management were merged into a
single high-risk area called business systems modernization. GAO,
High-Risk Series, An Update, [30]GAO-05-207 (Washington, D.C.: January
2005).

The amount of cumulative outstanding tax debt that IRS has identified
either through taxpayer reporting or through its various compliance
programs is also substantial. As of September 30, 2005, IRS's master file
database of taxpayer accounts reflected about $250 billion in cumulative
outstanding taxes owed by businesses and individuals. The amount of unpaid
taxes ranges from small amounts owed by individuals for a single tax
period to millions of dollars owed by businesses. The taxes owed include
individual income, corporate income, payroll, and other types of taxes, as
shown in figure 1.

Figure 1: Types of Taxes Owed, as of September 30, 2005

As a part of its tax administration, IRS maintains over 24 million
separate tax debt account records in its master file database for
businesses and individuals. Within the master file database, IRS records
collection actions and the current status of tax debts through a series of
codes. The codes, referred to as status or transaction codes, display a
host of information, including the stage of the collection process the tax
debt is in; the capacity of a tax debtor to pay, such as whether a tax
debtor is considered to be experiencing financial hardship; or other data
such as whether the tax debtor is under an arrangement with the IRS to pay
the tax debt in installments. IRS uses these codes to monitor and manage
its inventory of outstanding tax debt and its tax collection efforts.

5The 10-year period can be extended or suspended under a variety of
circumstances, such as agreements by the taxpayer to extend the collection
period in connection with an installment agreement, bankruptcy litigation,
and court appeals. Consequently, some tax assessments can and do remain on
IRS's records for decades.

Federal Payment Levy Program

To improve the collection of unpaid taxes, the Congress, in the Taxpayer
Relief Act of 1997,6 authorized IRS to collect delinquent tax debt by
continuously levying (offsetting) up to 15 percent of certain federal
payments made to tax debtors.7 The payments include federal employee
retirement payments, certain Social Security payments, selected federal
salaries, and contractor and other vendor payments. Subsequent legislation
increased the maximum allowable levy amount to 100 percent for payments to
federal contractors and other vendors for goods or services sold or leased
to the federal government.8 The continuous levy program, now referred to
as the Federal Payment Levy Program (FPLP), was implemented in 2000. Under
the FPLP, each week IRS sends the Department of the Treasury's Financial
Management Service (FMS) an extract of its tax debt files. These files are
uploaded into the Treasury Offset Program.9 FMS sends payment data to this
offset program to be matched against unpaid federal taxes. The program
electronically compares the names and taxpayer identification numbers on
the payment files to the control names (first four characters of the
names) and taxpayer identification numbers of the debtors listed in the
offset program. If there is a match and IRS has updated the weekly data
sent to the offset program to reflect that it has completed all statutory
notifications, the federal payment owed to the debtor is reduced (levied)
to help satisfy the unpaid federal taxes.

6Pub. L. No. 105-34, 111 Stat. 788 (Aug. 5, 1997).

726 U.S.C. S 6331(h).

826 U.S.C. S 6331(h)(3).

9The Treasury Offset Program is an automated process administered by the
Department of the Treasury's FMS in which certain federal payments are
withheld or reduced (offset) to collect delinquent tax and nontax debts
owed to federal agencies, including IRS. For the FPLP, FMS matches federal
payments to the tax-debt records sent to it by IRS, and when a match
occurs, FMS offsets (levies) the federal payments and transmits the amount
levied to IRS to reduce the tax debtor's outstanding debt and sends the
residual to the debtor.

In creating the weekly extracts of tax debt to forward to FMS for
inclusion in the offset program, IRS uses the status and transaction codes
in the master file database to determine which tax debts are to be
included in or excluded from the FPLP. For example, IRS cannot levy the
assets of individuals and businesses to recover tax debts while the tax
debtor is involved in a bankruptcy proceeding. In such cases, IRS uses the
bankruptcy status code in the master file to block the tax debt from being
submitted to the FPLP. Under other circumstances, IRS collection personnel
can enter a transaction code into the tax debtor's tax account to block
the debt from being levied through the FPLP. Consequently, the accuracy
and appropriateness of status and transaction codes is vital to the
effective operation of the FPLP. We reported in 2004 that incorrect or
out-of-date IRS status and transaction codes in IRS's records had
inappropriately blocked delinquent tax debt from being referred to the
FPLP.10

IRS currently excludes 62 percent of all tax debt from the FPLP because of
either statutory or policy reasons. As shown in figure 2, at September 30,
2005, IRS excluded over $73 billion (29 percent) from the FPLP for
statutory reasons and about $82 billion (33 percent) for policy reasons.

10GAO, Financial Management: Thousands of Civilian Agency Contractors
Abuse the Federal Tax System with Little Consequence, [31]GAO-05-637
(Washington, D.C.: June 16, 2005).

Figure 2: IRS Tax Debt by FPLP Status, as of September 30, 2005

Cases excluded from the FPLP for statutory reasons include tax debt that
had not completed IRS's notification process, or tax debtors who filed for
bankruptcy protection or other litigation, who agreed to pay their tax
debt through monthly installment payments, or who requested to pay less
than the full amount owed through an offer in compromise.11

Cases excluded from the FPLP for policy reasons include those tax debtors
whom IRS has determined to be in financial hardship, those filing an
amended return, certain cases under criminal investigation, and those
cases in which IRS has determined that the specific circumstances of the
cases warrant excluding it from the FPLP.

Improvements in the Levy Program

Since the inception of the FPLP, we have identified numerous issues that
have impeded the levy program from achieving its full potential. In
response to many of the issues we raised, IRS and other agencies have made
numerous improvements to the levy program that have contributed to
increased tax collections. IRS and FMS officials, along with Department of
Defense, General Services Administration, Office of Management and Budget,
and Department of Justice officials, created a multiagency task
force--referred to as the Federal Contractor Tax Compliance Task Force--in
2004, primarily to address the issues raised in our 2004 report related to
defense contractors and the FPLP.12 The multiagency nature of the task
force reflected that the involvement of several agencies was required for
the FPLP to reach its full potential. The task force, which has now become
a semipermanent body, has worked toward its stated goals and, along with
the efforts of the individual agencies, has been instrumental in making
significant improvements in the program. For example, the task force has
achieved its goal of adding most of the Department of Defense's payment
systems to the FPLP.

11An offer in compromise is an agreement between a tax debtor and IRS that
resolves the tax debtor's tax debt by accepting less than full payment.

IRS, in conjunction with the task force, has made several policy changes
directed toward increasing the amount of unpaid tax debt that it is
submitting to the FPLP. For example, IRS altered its policies to include
the following tax debt in the levy program that had previously been
excluded:

           o cases waiting in a "queue" to be actively worked by an IRS
           collections official--formerly IRS blocked such cases from the
           FPLP for a year each time a case entered the queue;
           o nearly half of the cases assigned to its Automated Collection
           System (ACS);13 
           o most cases in the field that are being worked by an IRS revenue
           officer; and
           o cases that have low dollar balances and cases for which the IRS
           has been unable to locate or contact the tax debtor.

IRS has also worked with FMS to improve the process of matching tax debtor
names between FMS's payment files and IRS's tax debt files to increase the
number of payments and debts that are matched. This work was important
because the FPLP relies on matching both the tax identification number and
the control name in the payment to those in the tax files to identify a
federal payment for levy.

12Federal Contractor Tax Compliance Task Force, Report to Senate Committee
on Governmental Affairs Permanent Subcommittee on Investigations
(Washington, D.C.: Oct. 26, 2004).

13The ACS is an automated telephone-based system designed to schedule and
follow up on incoming calls from, and outgoing calls to, tax debtors. ACS
personnel make contact with tax debtors by phone to attempt to collect
outstanding tax debt.

The FPLP has proved to be a cost-effective means of collecting outstanding
tax debt from tax debtors who receive payments from the federal
government, and the improvements IRS and other agencies have made in the
program have significantly increased tax collections since 2003, as shown
in figure 3.

Figure 3: Value of Levy Program Collections, Fiscal Years 2003 through
2006

Although the FPLP collected almost $300 billion dollars in previously
unpaid taxes during fiscal year 2006, the program has an even greater
effect on total tax collections. In previous reports, we have estimated
that IRS collects three times the amount of the direct levy collections
through voluntary revenues received as a result of taxpayers responding to
IRS's notice that their federal payments would be levied.14

Coding Errors Excluded Tax Debt from the FPLP

To maximize the effectiveness of the FPLP as a tool to collect outstanding
federal taxes, it is crucial that IRS record and maintain accurate status
codes for all tax debt within its systems. To test the accuracy of the
codes, we selected statistical samples of tax debt excluded from the FPLP
for both statutory and policy reasons to determine if these status codes
appropriately reflected the current condition of the tax debt. Our testing
of IRS's exclusion codes consisted of samples of 100 tax debts excluded
for statutory reasons, and 100 tax debts excluded for policy reasons as of
September 30, 2005. While our review of the sample of tax debts excluded
for policy reasons did not identify a significant number of coding errors
that would affect the FPLP, our review of the sample of tax debts excluded
for statutory reasons did. On the basis of our samples, we estimate that
over a half-million tax records with over $2.4 billion in tax debt were
erroneously excluded from the FPLP.

14GAO, Tax Administration: Federal Payment Levy Program Measures,
Performance, and Equity Can Be Improved, [32]GAO-03-356 (Washington, D.C.:
Mar. 6, 2003).

Errors in Statutory Exclusion Codes

At September 30, 2005, IRS had about $73 billion of outstanding tax debt
associated with about 9 million tax records that were excluded for
statutory reasons. As shown in figure 4, these tax records were almost
exclusively in four statutory exclusion categories: notice, bankruptcy,
offers in compromise, and installment agreements.

Figure 4: Percentage of Tax Records in Statutory Exclusion Population
Categories, as of September 30, 2005

In reviewing the 100 tax records coded as statutorily excluded tax debt,
we identified six instances in which the records were incorrectly coded.
Table 1 presents the number of errors we found by exclusion category.15

Table 1: Results of GAO's Statistical Sample of IRS Statutory FPLP
Exclusions

Statutory exclusions       Number of cases Number of errors 
Installment agreements                  44                4 
Notice phase                            40                1 
Bankruptcy/litigation                   11                1 
Offers in compromise                     5                0 
Total statutory exclusions             100                6 

Source: GAO analysis of IRS data.

As indicated in table 1, four of the errors we identified involved tax
debtors erroneously coded as paying on an installment agreement and thus
excluded from the FPLP.16 In each of the four cases, IRS had not
terminated the installment agreement within 5 months after the tax debtor
stopped making agreed-to payments. Although IRS's guidance on the
installment agreement termination process does not contain a specific time
frame, 5 months is the minimum amount of time that would elapse if IRS's
Internal Revenue Manual requirements on terminating installment agreements
were laid out in a timeline. In one of the cases, IRS took 23 months to
terminate the agreement after the tax debtor had stopped making payments.

One error involved tax debt that had been erroneously kept in IRS's notice
phase. The notice phase is IRS's first phase in the tax debt collection
process and consists of a series of letters IRS sends to tax debtors
informing them of the tax debt and requesting payment. Each letter is
represented by a specific status code. The one error we identified in this
exclusion category resulted when an IRS computer programming change in
2005 inadvertently blocked certain status codes from being updated and
thus prevented the related tax debt from exiting the notice phase. IRS
personnel took action to correct this systemic error after we informed
them of the issue.

15We did not project an error rate for the individual statutory exclusion
subcategories because a statistical projection was valid only for the
statutory exclusion category as a whole.

16As noted in their titles, fig. 4 shows the percentage of tax records in
the population by category, whereas table 1 shows number of tax records in
our sample by category.

We also found one bankruptcy-related case erroneously excluded from the
FPLP due to IRS failing to reverse a bankruptcy transaction code after the
bankruptcy had ended. According to IRS officials, IRS's time frame for
initiating action to reverse a bankruptcy code is 30 days after bankruptcy
actions have been completed. However, in this case, the bankruptcy had
ended almost a year before the time of our review, yet IRS had not updated
the status code in the tax debtor's account. IRS reversed the bankruptcy
code after we informed IRS personnel of the issue. However, as a result of
the error, the tax debt had been erroneously excluded from the FPLP and
all other collection action for almost a year. We found no errors in the
status codes for the five offer in compromise cases we reviewed.17

In total, the errors we found in the sample of tax records excluded for
statutory reasons equate to a 6 percent projected error rate. As a result
of these errors, we estimate that over a half-million tax records
containing about $2.4 billion in uncollected tax debt were erroneously
excluded from the FPLP.18

Errors in Policy Exclusion Codes

At September 30, 2005, IRS had about $82 billion of outstanding tax debt
associated with about 7 million tax-period records that were excluded for
policy reasons. As shown in figure 5, tax records were excluded primarily
for three reasons: cases designated as financial hardship, cases currently
in or awaiting assignment to IRS's collection function,19 and cases
designated as currently not collectible for reasons other than financial
hardship, including low-dollar cases.

17When tax debtors believe that they cannot pay their delinquent tax debt
in full, they can make an offer to IRS to pay something less than the full
amount to satisfy their debt. IRS may accept offers that are commensurate
with the tax debtor's ability to pay, which IRS determines through an
analysis of the taxpayer's financial condition. IRS is statutorily
prohibited from levying the property of the tax debtor while it considers
the tax debtor's offer.

18The 95 percent confidence interval associated with the projected 6
percent error rate ranges from 2.2 percent to 12.6 percent. This range
means that we are 95 percent certain that the true error in the entire
population of statutorily excluded tax debt is between 2.2 percent and
12.6 percent. The range means that between 202,000 and 1,142,000 tax
records equating to between $56 million and $6.8 billion in tax debt were
erroneously excluded from the FPLP.

19When IRS has completed sending its initial series of notices to the tax
debtor, IRS assigns the tax debt to active collection whether through the
ACS system or to a revenue officer in the field, or it puts the tax debt
into a queue awaiting assignment to active collection.

Figure 5: Percentage of Tax Records in Policy Exclusion Population
Categories, as of September 30, 2005

IRS is authorized to exclude tax debt from the FPLP based on a policy
determination of financial hardship.20 Tax debt in the other two
categories is excluded on a case-by-case basis. In other words, the
categories, themselves, are not explicitly excluded from the FPLP, but
individual cases in those categories may be excluded by IRS personnel
based on the circumstances of the particular case. For example, cases that
are in IRS's field collection status being worked by a revenue officer are
generally eligible for the FPLP; however, the revenue officer can block
the tax debt from inclusion in the FPLP when the officer determines that
pursuing other collection actions may be more effective.

20IRS is required to release the levy on all or part of the tax debtors'
property, including property subject to FPLP, if IRS determines that
levying the property is creating a financial hardship on the tax debtor.
26 U.S.C. S 6343(a)(1).

In reviewing the 100 tax records coded as excluded for policy reasons, we
identified one instance in which the records were incorrectly coded. Table
2 presents the results of our review of the sampled cases.

Table 2: Results of GAO's Statistical Sample of IRS Policy FPLP Exclusions

Policy exclusions                         Number of cases Number of errors 
Cases in, or awaiting assignment to,                   36                1 
collection                                                                 
Cases IRS considers not currently                      33                0 
collectible, other than hardship,                                          
including low-dollar cases                                                 
Financial hardships                                    31                0 
Total policy exclusions                               100                1 

Source: GAO analysis of IRS data.

The one coding error we found involved a tax debtor who defaulted on an
offer in compromise, but IRS did not put the tax debt into the FPLP.
Although IRS correctly coded the tax debtor as having defaulted on the
agreed-to payment terms of the offer, IRS's system had not been programmed
to reverse the original "pending" code that IRS personnel placed in the
tax debt record while IRS was considering the tax debtor's offer.21 Even
though the tax debtor had defaulted on the offer, the unreversed pending
offer code continued to exclude the case from the FPLP. On the basis of
our finding, IRS implemented a computer programming change to reverse
existing pending codes for defaulted offer in compromise cases.

We found no errors in the cases that IRS had designated as currently not
collectible for reasons other than financial hardship. Although IRS is not
going to actively seek collection from them, these cases are generally
included in the FPLP. However, IRS tax collections personnel can exclude
these cases from the FPLP on a case-by-case basis.

21When a tax debtor submits an offer in compromise, IRS personnel place a
transaction code in the computer system indicating that they are
considering the merits of the offer. This "pending" transaction code also
stops all tax collection actions until IRS has decided whether or not to
accept the tax debtor's offer. Once accepted, IRS places an additional
code in the system indicating that there is an "active" offer in
compromise. Both the pending and the active offer codes need to be
reversed before a tax debt can be made eligible for the FPLP.

Our review of the limited data IRS retains related to financial hardship
cases and our own review of the tax debtor's financial condition using
available IRS information and outside data sources did not identify any
cases in which we believe IRS had erroneously coded a tax debtor as being
in financial hardship. However, as discussed later, we do believe that
IRS's existing processes increase the risk that outdated status codes
related to financial hardship cases could occur and not be detected.

In total, the errors we found in the sample of tax records excluded for
policy reasons equate to a 1 percent projected error rate.22

More Effective Monitoring Could Prevent Errors and Help Ensure Ongoing Accuracy
of Account Status

IRS's current monitoring of the ongoing status of accounts did not
identify and correct the errors in our sample. In addition, although we
found no errors in the coding of financial hardship cases, our analysis
revealed that the design of IRS's policies for monitoring the status of
such cases is not sufficient to ensure the ongoing accuracy of hardship
designations.

Monitoring Did Not Identify Tax Debt That Should Have Been Eligible for Levy

The coding errors we identified in our samples of tax debts excluded from
the levy program for statutory and policy reasons could have been avoided
if IRS had more effectively monitored the ongoing status of accounts to
detect and prevent delays in putting tax debt into the FPLP.

In the one case from our sample of statutory exclusions involving a
bankruptcy-related coding error, the transaction code blocking the case
from inclusion in the FPLP was not reversed within IRS's stated time
frame. IRS policy is that bankruptcy codes should be reversed within 30
days after a bankruptcy judge has dismissed the case.23 In such cases, the
tax debtor again becomes liable for repaying the tax debt. IRS did not
reverse the bankruptcy code in a timely manner because the case was
repeatedly transferred to different IRS personnel without anyone taking
action to reverse the code. As a result of confusion caused by the
repeated transfer of the case within IRS and no one person having
responsibility for monitoring the disposition of the case, IRS did not
recognize that the bankruptcy code had not been reversed until we notified
IRS officials during our review of the case.

22The estimated error is 1 percent and is associated with a 95 percent
confidence interval of from 0.03 percent to 5.4 percent. We did not
project an error rate for the dollars associated with policy error rate.
We also did not project an error rate for the individual policy exclusion
subcategories because a statistical projection was valid only for the
overall policy exclusion category as a whole.

23When a judge dismisses a bankruptcy case, the debtor is denied any debt
relief.

In the four coding errors we identified involving installment agreement
cases, the errors were caused by a computer programming problem--corrected
in January 2006--that prevented the installment agreement codes from
automatically reversing within IRS's systems.24 Generally, IRS's computer
systems automatically begin the process to reverse an active installment
agreement code after a tax debtor fails to make two scheduled monthly
payments, but that did not happen in these cases. IRS officials were
unable to determine specifically why this occurred, and stated that they
do not monitor whether installment agreement transaction codes are
reversed within the 5-month time frame indicated by IRS's Internal Revenue
Manual for terminating installment agreements.25 Until the installment
agreement code is reversed in the system, the tax debt remains excluded
from the FPLP. Had IRS been monitoring the timely termination of
installment agreements, these cases would have come to IRS's attention and
afforded it an opportunity to investigate the cause.

Two coding errors--one statutory exclusion case and the other a policy
exclusion case--were also caused by deficiencies in IRS's computer
programs. In the statutory exclusion case, the tax debt did not
automatically move through the notice process because IRS did not include
one of its several notice status codes in a computer programming change.
As a result, when the programming change was implemented, the existing
cases in that notice status were prevented from automatically continuing
their movement through the notice phase and into collection. As a result,
these cases remained excluded from the FPLP and other collection actions.
After we brought this case to IRS's attention, it took corrective action
to address this programming deficiency. In the second case, involving a
policy exclusion related to a defaulted offer in compromise, IRS continued
to exclude the tax debt from the FPLP because, although IRS personnel
properly entered a code indicating a default on an offer in compromise,
IRS's systems did not reverse the code indicating the case had an initial
pending offer. IRS had recently implemented a programming change to the
way it processes offer in compromise-related transaction codes so that the
code that reverses an active offer in compromise transaction code also
reverses any pending offer in compromise codes related to the same tax
case. However, the programming change only affected offer in compromise
cases occurring subsequent to the date the change was implemented; it did
not affect pending offer codes that existed prior to the programming
change. After we notified IRS personnel of the error we identified, they
took corrective action to reverse the status code in this and similar
cases.

24When IRS agrees to allow a tax debtor to repay tax debt through
installment payments, IRS personnel place a transaction code into IRS
computer systems. This transaction code stops all tax collection actions
except the installment agreement payments until the code is reversed.

25The 5-month time frame is not specifically cited in the Internal Revenue
Manual. Rather, the manual lays out the process for terminating an
installment agreement as follows. IRS waits 1 month after the tax debtor
misses the first payment. If the tax debtor does not send in the next
payment, IRS's computer system generates a letter informing the tax debtor
that IRS intends to terminate the agreement. IRS gives the tax debtor 90
days--3 months--to respond. IRS allows a total of about a month for
processing and mailing, bringing the total time to 5 months.

Monitoring of Financial Hardship Cases Does Not Consider Tax Debtors Who Fail to
File Tax Returns or Pay Current Taxes

As discussed earlier, in our sample of tax debt cases excluded from the
FPLP for policy reasons, we found that all 31 cases that were excluded due
to the tax debtor being designated by IRS as being in financial hardship
were correctly coded based on IRS's existing policy and our review of the
limited documentation IRS maintained regarding the tax debtor's income.
However, we found deficiencies in IRS's procedures for monitoring the
ongoing status of financial hardship cases, which hinders IRS's ability to
ensure the ongoing accuracy of the financial hardship designation. This,
in turn, could result in additional tax debt that should be eligible for
levy not being forwarded to the FPLP.

To make the determination of whether a tax debtor is facing financial
hardship and thus does not have the means to pay the tax debt, IRS
analyzes the tax debtor's financial condition using guidelines for
allowable costs. On the basis of these guidelines, IRS officials place
individuals in one of nine income categories, or income thresholds. These
thresholds represent income level ceilings above which the tax debtor
again becomes subject to IRS's collection actions, including forwarding of
the tax debt to the FPLP. Once IRS designates a tax debtor as being in
financial hardship, it performs an automated evaluation of the debtor's
income based upon their annual tax return filings. Specifically, IRS
compares the income reported on the tax debtor's tax return to the
threshold level assigned to the tax debtor. If the reported income exceeds
the threshold, the financial hardship designation is terminated and the
tax debt becomes subject to collection and can be put into the FPLP.

IRS policy discourages any other monitoring or follow-up of financial
hardship cases beyond the automated match. IRS does not routinely update
the tax debtor's allowable expenses or perform a periodic review--such as
once every 3 years--of the tax debtor's overall financial condition. In
fact, the Internal Revenue Manual directs IRS personnel working financial
hardship cases to not request future follow-up reviews to check on
compliance with future income tax filing requirements or to update a tax
debtor's financial condition.

Consequently, IRS relies only on the accuracy of the information reported
in the tax return filed by the tax debtor, with no review of income
information reported to IRS by third parties, such as Form W-2 and Form
1099 information reports,26 to assess the ongoing accuracy of hardship
designations. IRS's procedures do not require it to remove a tax debtor
from the financial hardship status if the tax debtor fails to file a tax
return, and failing to file does not flag the case for IRS personnel to
perform a review of the financial hardship designation. Because of its
monitoring policy, when a tax debtor with a financial hardship designation
does not subsequently file an annual income tax return, IRS has no means
of determining whether the tax debtor's financial condition has improved
and the hardship designation should be terminated. Since individuals
designated as being in financial hardship are excluded from the FPLP--as
well as all other tax collection actions--not knowing whether the hardship
designation remains valid can result in IRS inappropriately excluding the
tax debt from the FPLP.

Generally, individuals with a financial hardship designation who do not
file a tax return are treated like other nonfilers: they can be eventually
subject to review by IRS's automated substitute-for-return process. In
that review, IRS examines other available data on the taxpayer, assesses
whether a tax return should have been filed, and estimates the amount of
tax due. However, that process generally does not occur for more than a
year after the failure to file, and only individuals who meet certain
criteria are reviewed. A financial hardship designation is not one of the
criteria and, therefore, these cases do not have a high priority.

26IRS receives various information returns from third parties, including
forms W-2 and 1099, that are used to report an individual's income. The
W-2, the wage and tax statement, reports wages, salaries, and tips paid to
employees and the taxes withheld from them. The Form 1099 is used to
report various types of income other than wages, salaries, and tips.

On the basis of our review of the sample cases, ceasing to file is not an
uncommon occurrence for tax debtors with hardship designations.
Twenty-four of the 31 tax debtors designated as financial hardship in our
sample cases had ceased filing tax returns after IRS had determined the
tax debtor was in financial hardship.

IRS's current practices also do not prevent tax debtors with a financial
hardship designation from accumulating additional tax debt by not paying
their current taxes. A financial hardship designation puts a tax debtor's
past debt in abeyance, but the hardship designation does not automatically
exempt the tax debtor from paying current taxes. However, we found that
IRS does little to prevent the further accumulation of tax debt by these
tax debtors. Of the 31 tax debtors with financial hardship designations in
our sample cases, we found that 4 filed but had not paid income taxes
subsequent to being identified as a financial hardship case. As with not
filing a tax return, accumulating new tax debt does not cause IRS to
automatically terminate the financial hardship designation, and IRS's
procedures allow IRS personnel to include the newly acquired tax debt into
the hardship designation, sometimes without any additional analysis of the
tax debtor's financial condition. Thus, a tax debtor's ever-increasing tax
debt can remain excluded from the FPLP as well as other collection
actions.

The effect of IRS's collection policy regarding financial hardship tax
debtors who accumulate new debt is essentially to both cease collection of
old debt and not require tax debtors to pay the current taxes they owe.
Allowing such tax debtors to continually not pay current taxes without
consequence appears to be giving tax debtors with financial hardship
designations an additional exemption from paying current taxes as well as
old tax debt and may contribute to the noncompliance of other taxpayers.

In fiscal year 2006, IRS initiated a withholding compliance program that
has potential to help prevent wage-earning tax debtors from accumulating
more unpaid tax debt. The program is designed to identify individuals who
incur tax debt because they did not have their employer withhold
sufficient wages to cover their taxes due for the current year. The
program identifies those debtors and requires their employers to increase
the withholdings. However, due to resource constraints, IRS actively
pursues only a small portion of the tax debtors who underwithhold.
Additionally, while the program prioritizes cases for review, a financial
hardship designation is not a prioritization criterion.

Policy Changes Could Allow Billions of Dollars in Tax Debt to Enter the FPLP

IRS has significantly improved the effectiveness of the FPLP by making an
additional $28 billion in unpaid tax debt eligible for the program since
2004. However, certain changes in IRS's policies could result in
additional billions of dollars in tax debt entering the levy program for
potential collection or entering the program earlier. Under current IRS
policy, all tax debt for which the debtor is designated as being in
financial hardship, including those debts associated with tax debtors
earning relatively high income levels, are excluded from the levy program.
In addition, half of the cases in IRS's ACS are excluded from the program,
as are all cases throughout IRS's notification process.

IRS Excludes Many Cases from the FPLP with Incomes Exceeding the National Median
Income

IRS has established policies that allow it to designate tax debtors
earning up to $84,000--nearly twice the national median income of about
$44,00027--as being in financial hardship. IRS is authorized to grant tax
debtors a designation of financial hardship when collection of the tax
debt would cause the tax debtor to be unable to pay his or her reasonable
basic living expenses.28 IRS's Internal Revenue Manual provides examples
of financial hardship cases, such as a disabled taxpayer who lives in a
modest house that has been equipped to accommodate the disability and
whose fixed income is not sufficient to both meet his or her living
expenses and pay the tax debt. IRS has the authority to determine
allowable living expenses according to the unique circumstances of
individual tax debtors; however, unique circumstances do not include the
maintenance of an affluent or luxurious standard of living.

Once designated as being in financial hardship, the tax debtors are
excluded from the FPLP and are also exempt from any other IRS collection
action until their self-reported income rises above one of nine designated
income thresholds. Since 1992, IRS has almost tripled the income it allows
tax debtors in financial hardship to earn without pursuing collection, but
IRS does not have documentation of any data analysis that justified the
large increases. Consequently, as of September 30, 2005, about 65 percent
of the tax debt in the financial hardship category was owed by tax debtors
who were allowed to earn more than the national median income before being
subject to collection actions. Of the $247 billion total tax debt in IRS's
records, IRS is not pursuing collection of almost 10 percent of that
amount--$22.6 billion--as a result of its financial hardship
determinations.

27Department of Commerce, Economics and Statistics Administration, U.S.
Census Bureau, Income, Poverty, and Health Insurance Coverage in the
United States: 2004, issued August 2005. National median income is based
on 2004 data for all races and all households. Fifty percent of households
have incomes below and 50 percent have incomes above the median.

28See 26 C.F.R. S301.6343-1(b)(4).

As discussed previously, IRS makes a determination as to whether a tax
debtor qualifies as a financial hardship case based on an analysis of the
amount of income earned and the allowable expenses owed by the tax
debtor.29 If IRS determines that a tax debtor is unable to pay the
outstanding tax liability due to financial hardship, it places a financial
hardship transaction code in the tax debtor's account. The transaction
code is assigned one of nine subcodes (called closing codes) indicating
the income threshold level ceilings at which IRS has determined that the
tax debtor should be able to begin repaying the tax debt. Tax debtors will
not face any IRS collection action30 until their total positive
income--roughly equivalent to adjusted gross income--exceeds the
designated income threshold ceiling. IRS's financial hardship income
thresholds range in $8,000 increments from $20,000 to $84,000, as depicted
in table 3.

29IRS's Internal Revenue Manual describes allowable expenses as those
expenses that are necessary to provide for a tax debtor's family's health
and welfare and/or production of income. The allowable expenses must be
reasonable and are based in part on national and regional standards.

30Although IRS does not engage in active collection actions against a tax
debtor with a financial hardship designation, IRS does retain any future
income tax refunds and uses them to reduce the tax debtor's outstanding
tax debt.

Table 3: IRS's Financial Hardship Income Thresholds

           Income threshold                                                   
         ceilings effective        Number of tax  Total tax debt at September 
                            records at September         30, 2005 (dollars in 
               2004-present             30, 2005                    billions) 
1                $20,000              306,900                         $2.1 
2                 28,000              173,600                          1.3 
3                 36,000              213,900                          2.0 
4                 44,000              223,000                          2.5 
5                 52,000              203,700                          2.5 
6                 60,000              169,000                          2.3 
7                 68,000              148,900                          2.3 
8                 76,000               91,300                          1.2 
9                 84,000              286,600                          6.4 
Total                               1,816,900                        $22.6 

Source: GAO analysis of IRS data.

Five of the nine income thresholds included in IRS's financial hardship
designation have upper range ceilings above the 2004 national median
household income of $44,389. Of the approximately 1.8 million tax debt
records designated as financial hardship in IRS's unpaid assessments
database at September 30, 2005, approximately half--about 900,000--were
debts owed by tax debtors in one of the five income threshold categories
above the national median. Over 286,000 tax records--with associated tax
debt of about $6.4 billion--were for tax debtors in the top income level
threshold for financial hardship of up to $84,000.

The exclusion of tax debt from collection actions may be appropriate in
many circumstances to provide relief for those experiencing financial
difficulty. However, as shown in figure 6, $14.8 billion in tax debt (65
percent of the tax debt) in financial hardship is owed by tax debtors whom
IRS will allow to earn more than the national median household income
before they have to begin repaying their tax debt.31

31Due to the rounding used in table 3, there is a 0.1 difference between
the sum in the table and the sum in the text and fig. 6 for those tax
debtors allowed to earn more than the national median household income.

Figure 6: Tax Debt Associated with Debtors in Financial Hardship Who Can
Earn Over the 2004 National Median Income, as of September 30, 2005

As shown in table 4, IRS's income thresholds used to determine whether tax
debtors are experiencing financial hardship and therefore cannot currently
pay their outstanding tax debt have not always been this high. IRS
significantly increased each of the nine income thresholds in 1997 and
again in 2004. IRS had previously set rates in 1992. The 2004 increases
averaged 77 percent but the individual threshold increases ranged from 100
percent for the lowest threshold to 68 percent for the highest.

Table 4: IRS's Financial Hardship Income Thresholds Ceilings

                                                            Income thresholds 
     Income thresholds ceilings Income thresholds ceilings                    
                      effective                  effective ceilings effective 
                                                                              
                      1992-1997                  1997-2004       2004-present 
1                     $6,000                    $10,000            $20,000 
2                      9,000                     15,000             28,000 
3                     12,000                     20,000             36,000 
4                     15,000                     25,000             44,000 
5                     18,000                     30,000             52,000 
6                     21,000                     35,000             60,000 
7                     24,000                     40,000             68,000 
8                     27,000                     45,000             76,000 
9                     30,000                     50,000             84,000 

Source: IRS.

In justifying the large increases from previous threshold ceilings, IRS
stated that the new 2004 thresholds more accurately reflected current
economic conditions and that the new values were supported by Bureau of
Labor Statistics data and were consistent with the allowable expenses in
IRS guidance. IRS also stated that the revised income thresholds were
based on an analysis of allowable expense standards for high-cost
geographic areas considered in conjunction with current Bureau of Labor
Statistics poverty levels. Though it raised the top threshold to $84,000,
IRS had considered raising its top threshold for financial hardship to
$100,000.

Other than the above statements, IRS could not provide documentation of
any data analysis that supported its reasons for the large increases since
1992. However, measures of median income raise questions about the size of
the increases to the income thresholds for financial hardship
determinations. As table 5 depicts, IRS's increases in the financial
hardship income thresholds has had the effect of raising the maximum
income threshold from about equivalent to the national median income in
1992 to almost twice the median income in 2004. With respect to high-cost
areas, New Jersey's $61,359, the highest state median income in 2004,32
was well below IRS's 2004 top three income threshold levels. The lowest
state median income in 2004 was $31,500.

32Department of Commerce, Economics and Statistics Administration, U.S.
Census Bureau, Income, Earnings, and Poverty From the 2004 American
Community Survey, (Washington, D.C.: August 2005).

Table 5: Historical IRS Maximum Income Thresholds and Household Median
Incomes

             IRS's maximum                                                    
        financial hardship National median income    Percentage maximum level 
Year   income threshold    for all householdsa   above/below median income 
1992            $30,000                $30,636                      - 2.1% 
1997             50,000                 37,005                      + 35.1 
2004             84,000                 44,389                      + 89.2 

Source: IRS and U.S. Census Bureau.

aMedian income is stated in 2004-equivalent dollars.

As a result of these large increases, almost two-thirds of all tax debtors
with IRS financial hardship designations are allowed to earn more than the
national median household income in 2004 before their unpaid tax debt
again becomes subject to IRS collection action. In contrast, in 1992, no
tax debtor with a financial hardship designation was allowed to earn more
than the median income without becoming subject to collection action.

Measures of inflation also raise questions about the size of IRS's
increases. Bureau of Labor Statistics national inflation rate data
indicate that the effects of inflation would have justified lower
increases. For example, using inflation data from 1997 to 2004, the top
2004 threshold would have been about $60,000,33 far below IRS's $84,000
level, and would have kept the top threshold at roughly 35 percent above
the national median income as it was in 1997.

Exacerbating the effect of IRS's increases in its hardship thresholds was
the policy it used to implement the increases. IRS did not change the
subcodes indicating the income threshold ceilings or reexamine the
financial condition of tax debtors when it raised the income thresholds
ceilings. For example, the IRS subcodes indicating that tax debtors were
in the highest income threshold of $50,000 prior to the threshold
increases were not updated to reflect the new thresholds. Thus the tax
debtors remained in the highest income threshold and were allowed to earn
up to $84,000 before IRS would begin taking collection action. Therefore,
after the 2004 increases, the tax debtors in the top income threshold
category were allowed to earn $34,000 more annually before IRS would
remove the tax debtor from the financial hardship exclusion category and
begin pursuing collection of the outstanding tax debt. IRS neither
reassessed the financial condition of tax debtors with existing financial
hardship designations nor changed their existing designation to one that
closely matched their original income threshold amount.

33Department of Labor, Bureau of Labor Statistics, Consumer Price Index -
All Urban Consumers, [33]http://www.bls.gov , downloaded August 16, 2006.

Allowing relatively high income tax debtors, such as those earning
$84,000, to avoid tax collection action calls into question the fair
application of the tax system and may contribute to noncompliance by other
taxpayers. In addition, dramatically increasing the financial hardship
income threshold ceilings has effectively resulted in increasing the
number of tax debtors IRS classifies as being in financial hardship. This,
in turn, reduces the portion of IRS's inventory of tax debt under active
collection and reduces the portion eligible for inclusion in the FPLP.

IRS Continues to Exclude Substantial Tax Debt in ACS from the FPLP

Although IRS made policy changes in 2004 to allow about 40 percent of the
tax debt in ACS to enter the FPLP, IRS continues to exclude the other 60
percent. The ACS is an automated call system designed to schedule and
follow up on IRS's outgoing calls to, and incoming calls from, tax
debtors. ACS personnel's primary activity is to contact tax debtors by
phone to attempt to collect outstanding tax debt. At September 30, 2005,
the ACS contained an inventory of about $8 billion of unpaid tax debt. To
manage the large inventory of tax debt in ACS, IRS has divided the ACS
inventory into 40 subcategories. In general, those subcategories describe
the status of IRS collection actions within ACS, such as indicating that
an installment agreement is pending or specifying a collection action that
is awaiting approval by a supervisor.

Prior to 2005, all the tax debt in ACS was excluded from the FPLP. In
2005, in response to issues raised in our 2004 review of Department of
Defense contractors with outstanding tax debt,34 IRS changed its policies
to allow some of the tax debt assigned to ACS to enter the FPLP. However,
IRS has continued to exclude tax debt in 19 of the 40 ACS subcategories
from the FPLP. Those 19 subcategories contain 60 percent, or about $5
billion, of the total tax debt in the ACS inventory. Two of the excluded
subcategories, which IRS calls R-5 and I-6, contain approximately $3.9
billion of tax debt, and involve cases in which IRS is placing a levy
against a tax debtor's assets. These "paper" levies, as IRS refers to them
to distinguish them from automated FPLP levies, are generally one-time
levies placed against a tax debtor's bank accounts or other financial
assets, although they can also be an ongoing garnishment of wages. FPLP
levies, in contrast, are continuous levies of all federal payments,
including federal salaries, pensions, social security, and
contractor-related payments.

34GAO, Financial Management: Some DOD Contractors Abuse the Federal Tax
System with Little Consequence, [34]GAO-04-95 (Washington, D.C.: Feb. 12,
2004).

IRS has the authority to levy a tax debtor's assets to collect outstanding
tax debt. Therefore, simultaneously levying through both the paper levy
process and the FPLP would seem to be appropriate, especially since many
paper levies are one-time levies of a tax debtor's assets. Additionally,
the FPLP is a cost-effective means of collecting from tax debtors. By
excluding tax debt from the FPLP while IRS personnel are working on a
paper levy, IRS is relegating the FPLP to a secondary role in the tax
collection process. Because of its potential, we have previously
recommended that IRS use the FPLP as one of the first steps in the IRS
collection process and keep the debt in the levy program until the taxes
are fully paid.35

IRS Excludes All Tax Debt from Levy during the Notification Process

At September 30, 2005, IRS had excluded $25.1 billion from the FPLP
because it was in the process of notifying the tax debtor of the taxes
owed. The Internal Revenue Code prohibits IRS from levying a tax debtor's
assets, including doing so through the FPLP, until the tax debtor has been
given time to respond to a notice from IRS that a tax debt exists. IRS's
process of issuing a series of notice letters and waiting for the tax
debtor to respond can take 6 months for individuals. IRS excludes tax debt
from the FPLP during the entire notice phase.

For individuals, the notification process consists of sending a series of
three or four computer-generated letters with increasingly urgent language
notifying the tax debtor of the debt and requesting payment. Per the
Internal Revenue Manual, IRS waits 5 weeks between letters and up to 10
weeks after the last letter before moving the tax debt into one of IRS's
active collection statuses such as ACS. Consequently, the notification
process can take up to 6 months or longer to complete, during which time
IRS excludes the tax debt from other collection activity, including the
FPLP.

35 [35]GAO-04-95 .

Although IRS excludes all tax debt from the FPLP during the entire notice
process, legally, tax debt could be included in the FPLP in about 3
months--about half way through the general notice process for
individuals.36 IRS must allow the tax debtor 90 days after notification of
a potential tax debt liability to respond. If IRS does not receive a
response within that period, it can issue a notice of tax deficiency and
demand for payment. If the tax debt is not paid within 10 days after
notice and demand for payment, IRS can initiate the procedures for levy,
including forwarding the tax debt to the FPLP. Under this scenario, IRS
could forward tax debt to the FPLP about 14 to 15 weeks after the first
notice is sent to the tax debtor, and IRS could fulfill its statutory
requirement with only two notices before initiating the levy process.37
For business tax debt, IRS essentially follows this sequence. The notice
process for business tax debt consists of only two notices and is
generally completed in about 15 weeks, at which time the tax debt can be
included in the FPLP.

In addition to putting tax debt into the FPLP sooner in the overall tax
collection process, IRS could potentially enhance the tax collection
potential of notices by informing the tax debtor early in the process of
sending notice letters that unpaid tax debt can be subject to levy. As
shown in figure 7, about 70 percent of tax collections resulting from
notice letters are received as a result of IRS's first notice letter. Very
little is collected from subsequent notices until the last notice letter,
which includes specific language of IRS's authority to levy or place a
lien on the tax debtor's property.

3626 U.S.C. SS 6212(a), 6303(a), and 6331(a),(d). The time frames
described in the text assume the tax debtor does not contest the amount of
the tax assessment. If contested, the time frames are extended until there
is resolution as to the amount owed.

37Prior to initiating the levy process, IRS is required to assess the tax
due liability in accordance with 26 U.S.C. S 6201. Prior to actually
making the levy, IRS is required to send a notice of intent to levy, 26
U.S.C. S 6331(a), and a prelevy Collection Due Process hearing notice that
informs the tax debtor of his or her right to a hearing, 26 U.S.C. S
6330(a). Both the intent to levy and the Collection Due Process notice can
be combined on one letter. IRS typically waits 10 weeks after issuing the
Collection Due Process notice before actually making the levy through the
FPLP. IRS can inform the taxpayer of IRS's levy authority within the first
communication to the taxpayer, including the deficiency notice, or in any
other notice letters.

Figure 7: Collections from IRS Notification Letters in Fiscal Year 2005

The FPLP is a powerful tool for encouraging collection that goes beyond
the direct taxes collected through federal payment levies. We have
previously estimated that the threat of a levy brings in over three times
more collections than the levy itself.38 IRS could take advantage of this
potential during the notice phase if it were to inform tax debtors early
in the notice process that their tax debt could be included in the FPLP.

Conclusions

Although the collection of taxes is always important, it takes on added
prominence in times of severe budgetary uncertainty. As the nation's tax
collector, IRS must seek out and utilize the most cost-effective means of
collection at its disposal and apply those means to the broadest
application of tax debt. The FPLP is a cost-effective program that has
enabled IRS to greatly increase collection. The program's full success is
dependent on the accuracy of IRS's status and transaction codes as well as
the appropriateness of IRS's policies, procedures, and practices regarding
the exclusion of tax debt from the FPLP. Improvements are needed in both
arenas. The errors we identified in the status and transaction codes of
tax debt cases highlight potential problem areas that have led to tax debt
being inappropriately excluded from levy action and therefore require
IRS's attention. With regard to its current policies, IRS continues to
exclude over 60 percent of all tax debt from the FPLP and does not appear
to have fully adopted our previous recommendation to use the FPLP as one
of the first steps in the tax collection process. Viewing the FPLP as a
primary and efficient collection tool could lead IRS to reevaluate its
FPLP exclusion policies and to reduce the extent and length of time tax
debt is excluded. Such changes hold the potential to subject billions of
dollars in additional tax debt to the FPLP, thus increasing the
government's chances of collecting some of this tax debt.

38 [36]GAO-03-356 .

IRS faces tough challenges in balancing its tax collection activities
against its available resources. In times of tough budgetary constraints,
this can provide an incentive to close cases quickly or otherwise reduce
the active tax collection inventory, possibly at the expense of maximizing
tax collections. While reducing the number of active cases does, in fact,
reduce the resources required, it can also have the effect of reducing
collections, diminishing compliance, and eroding the public's confidence
in the fairness of the tax system. For instance, in financial hardship
cases, beyond those tax debtors granted relief from paying tax debt due to
unexpected financial difficulty, each tax debtor who is allowed to avoid
filing required tax returns or paying current taxes, or who is perceived
to live well while facing little tax collection consequence, represents
not only less money for vital federal programs but one more advertisement
for others to do the same. Therefore, in setting financial hardship or
other tax collection policies, it is incumbent upon IRS to be particularly
judicious in setting income threshold levels and monitoring tax debt to
ensure that it is acting fairly toward all taxpayers.

Recommendations for Executive Action

To increase the amount of tax debt eligible for, and to expedite the entry
of tax debt into, the FPLP, we recommend that the Commissioner of Internal
Revenue take the following actions:

           o monitor the timely termination of defaulted installment
           agreements to help ensure tax debt is made available to the FPLP
           as soon as possible;
           o place tax debt in the notice phase into the FPLP as soon as
           legally possible;
           o consider adding language to IRS's second communication in the
           notice process informing the tax debtor that IRS has the authority
           to collect the debt by levying the tax debtor's income and assets
           if the tax debt is not paid voluntarily; and
           o modify FPLP exclusion policy to allow tax debt in ACS
           subcategories R-5 and I-6 that is being considered for a levy on
           financial assets through paper levies to be concurrently included
           in the FPLP.

To help ensure that IRS's financial hardship FPLP exclusions are
appropriate, we recommend that the Commissioner of Internal Revenue take
the following actions:

           o reevaluate whether the dollar ranges for existing financial
           hardship income thresholds, especially those that exceed the
           national median income, are appropriate and reasonable;
           o consider changing the financial hardship closing codes for tax
           debtors designated as being in financial hardship prior to the
           2004 income threshold increases to a closing code that most
           closely corresponds to the originally designated income
           threshold--for example, tax debtors who were in a threshold of
           $50,000 prior to the change would be given a different subcode
           (closing code) so that the tax debtor's income ceiling stays as
           close to the original $50,000 ceiling as possible under the new
           income thresholds;
           o establish a policy so that in implementing future financial
           hardship income threshold changes, tax debtors' financial hardship
           subcodes (closing codes) are changed to ones that maintain the tax
           debtor's income ceiling as close as possible to the ceiling prior
           to the change;
           o establish a policy to review tax debtors' financial condition
           periodically to verify the continued validity of the financial
           hardship designation;
           o evaluate the ongoing validity of the financial hardship
           designations whenever tax debtors fail to file their annual tax
           returns by comparing third-party income information to the tax
           debtors' designated financial hardship income threshold ceilings;
           and
           o refer tax debtors with a financial hardship designation to IRS's
           withholding compliance program for special attention if those tax
           debtors do not pay their current income tax obligations.

Agency Comments and Our Evaluation

In commenting on a draft of this report, IRS noted improvements made to
the FPLP and the extent to which such improvements have resulted in
increased collections while at the same time ensuring that taxpayer rights
have been protected. IRS also described several initiatives it had
undertaken to improve its program for taxpayer accounts classified as
currently not collectible, including a study to determine whether changes
to IRS's allowable living expense tables, used in the determination of
financial hardship status, would be appropriate given the availability of
additional economic data. We made 10 recommendations: IRS agreed with 5,
partially agreed with 2, and disagreed with 3. We modified the 2
recommendations with which IRS partially agreed in order to address issues
raised by IRS while retaining the intent of our recommendations.

With respect to the four recommendations we made to either increase the
amount of tax debt eligible for the FPLP or expedite the entry of tax debt
into the FPLP, IRS agreed with one recommendation, partially agreed with
another, and disagreed with the remaining two recommendations. IRS agreed
with our recommendation that it monitor the timely termination of
defaulted installment agreements, and noted it would identify those
taxpayer accounts in installment agreement status but which show no
payment activity within the last 60 days and determine if it needs to
change the way it monitors installment agreements. While IRS disagreed
with our recommendation that it add language about its legal authority to
levy income and assets to its first notice letter, it stated that it would
consider adding stronger language regarding possible enforcement activity
in subsequent collection notices. As an explanation for its reluctance to
include this course of action in the event of nonpayment, IRS noted that
it had received criticism in the past for early aggressiveness and not
affording taxpayers an opportunity to voluntarily satisfy their liability.
While IRS is not legally precluded from providing language concerning its
enforcement powers in the initial taxpayer notice, we understand IRS's
desire to attempt to provide sufficient opportunity for taxpayers to
voluntarily comply with their tax obligations without threat of
enforcement action. Accordingly, we have modified our recommendation to
add informative language about IRS's levy starting with the second
taxpayer notice rather than the first. The important point to us is that
IRS inform the tax debtor of its levy authority earlier in the process.

IRS disagreed with our recommendation that it place tax debt in the notice
phase into the FPLP as soon as legally possible, stating that it believed
its current notification process was the most cost effective. In stating
its position, IRS noted that over three-fourths of tax debtors pay their
tax debt after receiving the first notice, and that it believed the action
recommended is not appropriate for individual taxpayers who have a high
payment rate during the notice process. We do not believe that our
recommendation would diminish the effectiveness of IRS's notice process,
especially the voluntary tax collections resulting from the first notice.
In fact, those tax debtors who would typically pay their debt upon receipt
of the initial notice would be unaffected by the action we are
recommending. Although implementing our recommendation would allow IRS to
begin levy procedures during the notice phase, in practice, the tax debt
generally would not be levied before IRS completes the notice phase. As we
discuss in our report, tax debt could be included in the FPLP about three
months after IRS notifies the tax debtor of the tax liability, giving the
tax debtor sufficient time to respond to both the first and second notices
before the levy process would actually commence. Additionally, once the
levy process begins, IRS must still send the tax debtor a Collection Due
Process notice and wait about two and one-half months before levying a
payment through the FPLP. Consequently, tax debt would not generally be
levied before the notice phase is completed. However, by starting the levy
process during the notice phase, IRS would be able to begin levying
payments earlier than would otherwise be the case if the tax debtor does
not voluntarily fully pay or otherwise resolve the tax debt during the
notice phase because IRS would not have to continue to delay levy action
while it issues the Collection Due Process notice and waits for the tax
debtor to respond.

IRS also disagreed with our recommendation that it modify its FPLP
exclusion policy to allow tax debt in two subcategories of its ACS to be
eligible for the FPLP, citing concern that this could result in duplicate
levies and thereby create unanticipated hardships for taxpayers. IRS also
noted that it attempts to issue levies on cases within these ACS
subcategories that could generate more in collections than would be
collected through the FPLP due to the program's limit of 15 percent of
each federal payment made to the tax debtor. We do not believe these
concerns have merit. We believe that IRS's current process for manually
blocking tax debt from the FPLP would provide a sufficient safeguard
against duplicate levies while at the same time preserving adequate
flexibility for other collection actions. As we discuss in our report, IRS
has the ability to block, and, on a case by case basis, does block
individual tax debt accounts from levy through the FPLP. IRS could apply
this same approach to these two ACS subcategories. To manually block tax
debt from the FPLP, IRS can place a transaction code in the tax debtor's
account that blocks the FPLP from automatically levying the tax debt. The
same transaction code can be placed in the tax record if IRS wants to levy
more than the 15 percent allowable under the FPLP. This process would
allow IRS to increase the effectiveness of the FPLP while preserving its
ability to use paper levies when appropriate and minimizing the risk of
duplicate levies.

With respect to the six recommendations we made to help ensure that IRS's
financial hardship FPLP exclusions are appropriate, IRS agreed with four
recommendations, partially agreed with one recommendation, and disagreed
with the remaining recommendation. Specifically, IRS agreed with our
recommendations to (1) reevaluate whether the dollar ranges for existing
financial hardship income thresholds are appropriate and reasonable; (2)
establish a policy that when future financial hardship thresholds are
changed, tax debtors' hardship closing codes are changed to ones that
maintain the tax debtor's original income ceiling; (3) evaluate the
ongoing validity of financial hardship designations whenever tax debtors
fail to file their annual tax returns; and (4) refer tax debtors with a
financial hardship designation to IRS's withholding compliance program for
special attention if those tax debtors do not pay their current income tax
obligations. Although IRS agreed to reevaluate whether the dollar ranges
for existing financial hardship income thresholds are appropriate and
reasonable, it raised concerns that imposing a rigid national median
amount would disregard circumstances such as family size, medical needs,
and geographic variations in average income. It is important to note that
our recommendation does not advocate imposing the national median amount
as a rigid maximum threshold limit. We recognize that IRS attempts to
accommodate the needs of tax debtors with varying family sizes,
geographical locations, and various other circumstances. However, as our
report discusses, between 1992 and 2004, IRS raised its top financial
hardship income threshold ceiling from an amount equal to the median
national household income to an amount almost twice the median income
without any detailed analysis supporting either the large increases or the
deviation in the relationship of these thresholds from the national median
income.

While IRS disagreed with our recommendation that it establish a policy to
review tax debtors' financial condition every 3 years to verify the
continued validity of the financial hardship designation, IRS did agree to
consider including a time factor. Specifically, IRS noted that as part of
its initiatives to improve its program for taxpayer accounts classified as
currently not collectible, of which financial hardship is a significant
aspect, it will consider including a time factor. Accordingly, we have
modified our recommendation, replacing "every 3 years" with "periodically"
to reflect IRS's willingness to consider including a time factor for
reviewing a tax debtor's financial condition. However, in deciding upon
the time factor to use, we believe that IRS should take into account that
tax debt is typically only legally available for collection for 10 years.
Thus, implementing a time period of greater than 3 years could result in
IRS affording itself only one opportunity to reconsider the validity of
the financial hardship designation.

Finally, IRS stated that it could not agree with our recommendation that
it consider changing the financial hardship closing codes for tax debtors
designated as being in financial hardship prior to the 2004 increases it
implemented in the income thresholds until it has determined how many tax
debt accounts would be affected by the recommendation. IRS said that
implementing the recommendation to change existing closing codes would
require significant computer programming and system changes that it may
not be able to implement, and which may not be cost effective. Our
recommendation is for IRS to consider changing the hardship closing codes
for the affected accounts; we are not recommending that IRS must do so.
Implicit in our use of the word "consider" in our recommendation is a
cost-benefit determination. In considering whether to change the hardship
closing codes, IRS should take into account the work and cost involved in
making this change as well as the potential for increased collections in
determining the cost effectiveness of any modifications. However, we do
believe that IRS erred in not changing the financial hardship closing
codes for existing cases when it implemented the 2004 increases in the
income thresholds. As discussed in our report, by not changing the closing
codes, IRS allowed tax debtors who it previously believed could begin
paying off their tax debt at a certain income threshold to immediately
begin earning up to, on average, 77 percent more before IRS would hold
them liable for their tax obligations. This created the potential for
inequitable treatment between taxpayers in these same income brackets who
pay their taxes and tax debtors who do not, especially when some of those
tax debtors, on the day IRS changed the thresholds, were thereafter
allowed to earn up to $34,000 more income without IRS considering whether
they continued to warrant the hardship designation. Consequently, in
considering whether or not it is cost effective to implement a change in
the closing codes of the effected accounts, IRS should also consider the
issue of fairness with respect to the taxpayer population as a whole.

We are sending copies of this report to the congressional committees with
jurisdiction over IRS and its activities, the Secretary of the Treasury,
the Commissioner of Internal Revenue, and interested congressional
committees and members. We will also make copies available to others upon
request. In addition, this report will be available at no charge on the
GAO Web site at [37]http://www.gao.gov .

If you have any questions about this report, please contact me at (202)
512-3406 or [38][email protected] . Key contributors to this report are
listed in appendix III. Contact points for our Offices of Congressional
Relations and Public Affairs may be found on the last page of this report.

Steven J. Sebastian Director Financial Management and Assurance

Appendix I: Scope and Methodology

To determine whether and to what extent Internal Revenue Service (IRS) tax
records contain inaccurate or out-of-date status or transaction codes that
exclude them from the Federal Payment Levy Program (FPLP), we used IRS's
unpaid assessments database as of September 30, 2005, to select two
statistical samples. We used IRS's criteria for the statutory and policy
exclusions from the FPLP to segment the tax records in the unpaid
assessments database into the two categories. The population of statutory
exclusions consisted of 9,068,508 tax records that contained tax debt of
$72,167,432,455. The population of policy exclusions consisted of
7,183,880 tax records that contained tax debt of $81,492,531,369. We
selected a statistical sample of 100 tax debts that were excluded from the
levy program based on IRS's designation of their tax record as being
excluded because of a legal--statutory--requirement of the Internal
Revenue Code. We also selected a statistical sample of 100 tax debts that
were excluded from the levy program based on IRS's policy determinations.

We randomly selected probability samples from the populations of tax debt
accounts excluded from the FPLP for statutory reasons and policy reasons.
With these probability samples, each tax account in each of the
populations had a nonzero probability of being included and that
probability could be computed for any account. Each sample tax account
selected was subsequently weighted in the analysis to account
statistically for all the tax accounts of its respective population. The
sample we selected from each population was only one of a large number of
samples that we might have drawn because for each sample we followed a
probability procedure based on random selections. Since each sample could
have provided different estimates, we express our confidence in the
precision of each sample's result as 95 percent confidence intervals,
which are intervals that would contain the actual population value for 95
percent of the samples we could have drawn. As a result, we are 95 percent
confident that the confidence intervals presented in this report will
include the true values in the respective study populations. For the
statistical error rate projection, we used a point estimate with a 95
percent confidence interval. The projected point estimate combined with
the confidence interval surrounding the point estimate means that although
we estimate the error rate to be at the point, we are 95 percent confident
that the true error rate is somewhere between the interval's lower and
upper limits.

For each sampled tax period, we obtained and reviewed IRS records on the
status and history of tax collection action with particular emphasis on
actions that affected the FPLP status of the tax debt. We performed
additional searches of criminal, financial, and public records. We
compared each sampled tax debt to IRS's FPLP exclusion and inclusion
criteria and determined the accuracy of the status or transaction code
that excluded the tax debt from the FPLP. We categorized a sample tax debt
as an error if the tax period did not meet at least one exclusion
criterion or had exceeded IRS's time frame for ending an exclusion, such
as the time frame for terminating an installment agreement. In some cases,
the time frame for terminating an installment agreement was exceeded at
the time IRS provided us records to review rather than at the September
30, 2005, date of the unpaid assessments database.

To determine whether IRS's policies, procedures, and practices could be
strengthened to ensure the accuracy and timeliness of its status and
transaction codes, we reviewed IRS's Internal Revenue Manual and
interviewed IRS officials to obtain criteria, guidance, and internal
controls on (1) coding cases for inclusion and exclusion from the FPLP (2)
processing cases in the notice phase; and (3) processing and terminating
cases in installment agreements, offers in compromise, and financial
hardship.

To determine whether opportunities exist to increase the amount of tax
debt included in the FPLP, we analyzed the effect of IRS's exclusion
criteria as well as the potential effect of changes in the exclusion
criteria on the amount of tax debt included in the FPLP. In assessing the
effect of potential changes in the statutory exclusions, we compared the
potential for modifying IRS's existing FPLP exclusion criteria within the
exclusion's legal framework, and we discussed the potential changes with
cognizant IRS officials.

Data Reliability Assessment

For the IRS database we used, we relied on the work we perform during our
annual audit of IRS's financial statements. While our financial statement
audits have identified some data reliability problems associated with the
coding of some of the fields in IRS's tax records, including errors and
delays in recording taxpayer information and payments, we determined that
the data were sufficiently reliable to address this report's objectives.
Our financial audit procedures, including the reconciliation of the value
of unpaid taxes recorded in IRS's master file to IRS's general ledger,
identified no material differences.

Appendix II: Comments from the Internal Revenue Service

Note: Subsequent to providing the draft report to IRS, numbered
[39]GAO-06-743 , we renumbered the report to [40]GAO-07-26 .

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Steven J. Sebastian, (202) 512-3406 or [41][email protected]

Acknowledgements

The following individuals made major contributions to this report: William
J. Cordrey, Amy Bowser, Ray Bush, Kenneth Hill, Inna Livits, Dave
Shoemaker, Sidney Schwartz, and Mark Yoder.

(196078)

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[48]transparent illustrator graphic

www.gao.gov/cgi-bin/getrpt?GAO-07-26.

To view the full product, including the scope
and methodology, click on the link above.

For more information, contact Steven J. Sebastian at (202) 512-3406 or
[email protected].

Highlights of GAO-07-26, a report to the Permanent Subcommittee on
Investigations, Committee on Homeland Security and Governmental Affairs,
U.S. Senate

November 2006

INTERNAL REVENUE SERVICE

Procedural Changes Could Enhance Tax Collections

IRS tax records had inaccurate information that resulted in it erroneously
excluding cases from the FPLP and other tax collection actions. The FPLP
is a cost-effective automated system used to collect unpaid taxes from
certain federal payments. GAO estimates that as of September 30, 2005,
over 500,000 tax records--equating to about $2.4 billion in tax
debt--contained inaccurate codes that IRS systems used to exclude tax
debts from the FPLP. Inaccuracies included tax debts coded as having
active installment agreements even though the tax debtor had stopped
making payments.

IRS's monitoring of cases was insufficient to identify and correct the
coding errors GAO identified. Additionally, IRS's monitoring of financial
hardship cases is not sufficient to ensure their ongoing accuracy. IRS
grants tax debtors experiencing financial difficulty a hardship
designation that excludes them from the FPLP and other tax collection
activities until their income increases. To measure this, IRS solely uses
the income reported on the tax debtor's annual tax returns. However, IRS
does not monitor those tax debtors to ensure they are filing and paying
current taxes. For 31 financial hardship cases GAO examined, 24 had ceased
to file tax returns.

Although IRS has increased the amount of tax debt it submits to the FPLP,
additional policy changes could further improve the program's
effectiveness. Since 1992, IRS has almost tripled the maximum income it
allows tax debtors in financial hardship to earn; raising it to $84,000 in
2004--almost double the national median income. As a result, whereas in
1992 no one earning above the median income was considered to be in
financial hardship (and therefore excluded from the FPLP), in 2005 almost
two-thirds of the tax debt in financial hardship was owed by individuals
earning over the median income. Although a financial hardship designation
may be appropriate in many situations, allowing relatively high-income tax
debtors to avoid tax collection action, including the FPLP, calls into
question the fair application of the tax system and may contribute to
noncompliance.

Tax Debt Associated With Debtors in Financial Hardship Who Can Earn Over
the 2004 National Median Income

IRS policy also limits the amount of tax debt in the FPLP by excluding $5
billion in tax debt from the program while IRS is pursuing levies from
other assets or income sources. Additionally, during notification IRS
excludes individuals' tax debt from the FPLP about twice as long as
legally necessary.

GAO previously testified that federal contractors abused the tax system
with little consequence. While performing those audits, GAO noted that the
Internal Revenue Service (IRS) records sometimes contained inaccurate or
outdated tax information that prevented IRS from taking appropriate
collection actions against those contractors, including submitting their
tax debt to the Federal Payment Levy Program (FPLP) for collection.

As a result, GAO was asked to review IRS's coding of tax debt excluded
from the FPLP to determine whether (1) IRS tax records contain inaccurate
status or transaction codes that exclude tax debt from the FPLP, (2) IRS's
monitoring could be strengthened to ensure the accuracy of its status and
transaction codes, and (3) other opportunities exist to increase the
amount of tax debt included in the FPLP.

[49]What GAO Recommends

GAO makes four recommendations to IRS to increase the amount of tax debt
eligible for the FPLP and six recommendations to evaluate the
appropriateness and ongoing validity of IRS's hardship designations. IRS
agreed with five of our recommendations and partially agreed with two
others. IRS disagreed with three recommendations due to workload, cost, or
taxpayer rights considerations. GAO reiterated its support for its
recommendations.

References

Visible links

  27. http://www.gao.gov/cgi-bin/getrpt?GAO-04-414T
  28. http://www.gao.gov/cgi-bin/getrpt?GAO-05-683T
  29. http://www.gao.gov/cgi-bin/getrpt?GAO/HR-95-1
  30. http://www.gao.gov/cgi-bin/getrpt?GAO-05-207
  31. http://www.gao.gov/cgi-bin/getrpt?GAO-05-637
  32. http://www.gao.gov/cgi-bin/getrpt?GAO-03-356
  33. http://www.bls.gov/
  34. http://www.gao.gov/cgi-bin/getrpt?GAO-04-95
  35. http://www.gao.gov/cgi-bin/getrpt?GAO-04-95
  36. http://www.gao.gov/cgi-bin/getrpt?GAO-03-356
  37. http://www.gao.gov/
  38. file:///home/webmaster/infomgt/d0726.htm#mailto:[email protected]
  39. http://www.gao.gov/cgi-bin/getrpt?GAO-06-743
  40. http://www.gao.gov/cgi-bin/getrpt?GAO-07-26
  41. file:///home/webmaster/infomgt/d0726.htm#mailto:[email protected]
  44. http://www.gao.gov/fraudnet/fraudnet.htm
  
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