Tax Administration: Sole Proprietor Identification Numbers Can Be
Improved (Letter Report, 09/18/95, GAO/GGD-95-160).
Pursuant to a congressional request, GAO reviewed whether the Internal
Revenue Service (IRS): (1) accurately cross references the two
identification numbers that self-employed individuals report on their
tax returns; and (2) needs to take any actions to improve the accuracy
of its cross-reference files.
GAO found that IRS: (1) uses information from different computer files
to identify sole proprietors that may have tax compliance problems; (2)
requires certain taxpayers to have a valid social security number (SSN)
and employer identification number (EIN) so that it can cross-reference
the taxpayers' accounts from one file to another; and (3) records a sole
proprietor's identification numbers on three computer files and uses the
SSN to establish an account on the Individual Master File. In addition,
GAO found that: (1) the identification numbers that IRS records for
cross-referencing purposes are not always reliable and cause IRS to
generate false underreporter leads; (2) the IRS computerized screening
process limits the number of false underreporter leads created by the
Cross-Reference Entity File; and (3) if IRS and the Social Security
Administration eliminate sole proprietors' EIN, they will have to modify
their computer programs to accept SSN instead of EIN.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-95-160
TITLE: Tax Administration: Sole Proprietor Identification Numbers
Can Be Improved
DATE: 09/18/95
SUBJECT: Tax administration systems
Tax nonpayment
Noncompliance
Reporting requirements
Taxpayers
Tax returns
Management information systems
Personal income taxes
Social security number
IDENTIFIER: IRS Tax System Modernization Program
IRS Business Master File
TSM
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Cover
================================================================ COVER
Report to the Joint Committee on Taxation, U.S. Congress
September 1995
TAX ADMINISTRATION - SOLE
PROPRIETOR IDENTIFICATION NUMBERS
CAN BE IMPROVED
GAO/GGD-95-160
Sole Proprietor Identification Numbers Can Be Improved
(268614)
Abbreviations
=============================================================== ABBREV
CREF - Cross Reference Entity File
EIN - Employer Identification Number
IRS - Internal Revenue Service
SSN - Social Security Number
TSM - Tax Systems Modernization
Letter
=============================================================== LETTER
B-261179
September 18, 1995
The Honorable Bill Archer
Chairman
The Honorable Bob Packwood
Vice Chairman
Joint Committee on Taxation
United States Congress
This report is part of work we did at your predecessors' request on
the tax compliance problems of sole proprietors.\1 Self-employed
individuals are referred to as sole proprietors for tax purposes.
According to Internal Revenue Service (IRS) research, the sole
proprietor group is among the worst with regard to the reporting of
all income.
Taxpayers are required to have identification numbers so that IRS can
establish accounts for them and record transactions such as the
payment of taxes. Most taxpayers are required to have only one
identification number. However, individuals who are self-employed
are sometimes required to have two identification numbers, a Social
Security Number (SSN) for their individual income tax returns and an
Employer Identification Number (EIN) for their business returns.
This report discusses whether IRS (1) accurately cross references the
two identification numbers that self-employed individuals report and
(2) needs to take any actions to improve the accuracy of its
cross-reference files.
--------------------
\1 We issued two other reports as a result of this request: Tax
Administration: IRS Can Better Pursue Noncompliant Sole Proprietors
(GAO/GGD-94-175, Aug. 2, 1994) and Tax Administration: Estimates of
the Tax Gap for Service Providers (GAO/GGD-95-59, Dec. 28, 1994).
RESULTS IN BRIEF
------------------------------------------------------------ Letter :1
IRS uses information from different computer files to identify sole
proprietors who may have tax compliance problems. To better identify
such proprietors, IRS requires certain taxpayers to have a valid SSN
and EIN so that it can cross-reference the taxpayers' accounts from
one file to another. However, the SSN and EIN cited by a sole
proprietor do not always identify that same taxpayer in IRS records.
IRS records a sole proprietor's identification numbers on three
computer files. It uses the SSN to establish an account on the
Individual Master File and includes the EIN in the account for
cross-referencing purposes. It uses the EIN to establish an account
on the Business Master File and adds the SSN as a cross- reference.
It uses cross-referenced SSNs and EINs from the two master files to
build the Cross-Reference Entity File, which is a file IRS created
expressly to consolidate income information on sole proprietors for
use in its underreporter program.
The identification numbers IRS records for cross-referencing purposes
are not always reliable. From work done at the Fresno Service
Center,\2 we arrived at the following estimates:
About 20 percent of EINs posted to tax year 1991 records on the
Individual Master File from Schedule C returns filed at the
Fresno Service Center were erroneous. Taxpayers had filed the
returns with inappropriate EINs; often the number already
belonged to another taxpayer. (Sole proprietors report nonfarm
business income on Schedule C returns.)
About 3 percent of the Business Master File records of sole
proprietors who filed 1991 Schedule C returns with the Fresno
Service Center contained inappropriate SSNs as cross-references.
About 10 percent of the accounts on the Cross-Reference Entity File
that related to tax year 1991 returns filed with the Fresno
Service Center contained erroneous cross-referenced taxpayer
identification numbers.
In addition to reducing the integrity of the files, these cross-
referencing errors caused IRS to generate false underreporter leads.
However, we found that IRS' computerized screening process to
identify inaccurate taxpayer identification numbers on the master
files and on information returns limited the number of false
underreporter leads that were created by the Cross- Reference Entity
File. IRS data showed that 4,700 tax year 1991 potential
underreporter cases were created using the Cross- Reference Entity
File for the Fresno Service Center. IRS examiners manually screened
out 1,582, or 34 percent, of the cases because the income had been
reported on the return or the income belonged to another taxpayer.
According to Fresno Service Center officials, only 0.6 percent of the
cases screened out by examiners were wrong because of erroneous
cross-references on the file.
Valid identification numbers could help IRS to properly cross-
reference a taxpayer's various records. IRS could take action, such
as earlier computer screening of EINs, to help prevent the posting of
erroneous cross-references.
Another way to reduce the number of invalid identification numbers on
IRS' master files would be to eliminate the requirement that sole
proprietors use EINs. IRS requires sole proprietors to use EINs so
that it can record their business returns, such as employment tax
returns, on the Business Master File, which generally uses EINs as
the primary account number.
Eliminating the sole proprietor's EIN would require both IRS and the
Social Security Administration to modify their computer programs to
accept SSNs instead of EINs. We were not able to calculate how much
the reprogramming would cost. IRS and Social Security Administration
officials said that, without further study, they could not state
whether such a change was operationally feasible or cost-effective.
--------------------
\2 All IRS service centers are subject to the same returns processing
procedures. IRS officials said that we could expect to find the same
conditions that we found at the Fresno Service Center at the other
nine service centers.
BACKGROUND
------------------------------------------------------------ Letter :2
Sole proprietors are to file Form 1040, Individual Income Tax Return,
and attach to it Schedule C, Profit or Loss From Business (Sole
Proprietorship), or Schedule F, Profit or Loss From Farming. IRS
requires most sole proprietors to write their SSN on Form 1040 and to
write both their SSN and EIN on Schedules C and F. However, not all
sole proprietors are required to have and use EINs. IRS requires
only those sole proprietors who also file employment, pension, or
excise tax returns to have and use EINs.\3 IRS received about 15
million 1040 returns from sole proprietors for tax year 1991, and
about 2.2 million included an EIN on a Schedule C.
The Internal Revenue Code requires taxpayers to include taxpayer
identification numbers on tax returns and gives IRS the authority to
decide what identification system will be used. The Social Security
Administration issues SSNs to individuals. IRS issues EINs to
businesses, which must apply to IRS to obtain an EIN.
IRS has two master files containing the tax accounts of individuals
and businesses. Data from Form 1040 returns, including Schedules C
and F, are posted to the Individual Master File using the primary SSN
as the primary account number. Data from employment and excise tax
returns filed by sole proprietors are posted to the Business Master
File using the EIN as the primary account number. If a sole
proprietor has an account on each file, IRS can connect them by
cross-referencing account numbers. The proprietor's SSN is recorded
in the Business Master File account, and the EIN is recorded in the
proprietor's Individual Master File account.
IRS records sole proprietor information on a third file, the
Cross-Reference Entity File (CREF).\4 IRS created CREF in response to
a recommendation we made in 1987.\5 We reported then that IRS could
make better use of information returns in determining whether
businesses filed returns and fully reported their income.
Information returns are the documents that third-party payers, such
as employers, corporations, and financial institutions, send to
taxpayers and IRS to report such payments as wages, dividends,
interest, and other types of income.
In addition to listing the taxpayer's name, information returns
identify taxpayers by either SSN or EIN. IRS created CREF so that it
could consolidate information returns filed under a sole proprietor's
SSN with those filed under its EIN. By computer matching these
consolidated data with income tax return data, IRS can determine
whether sole proprietors filed tax returns and reported all income
shown on information returns.
--------------------
\3 Employment, pension, and excise tax returns are filed separately
from Form 1040. Employment tax returns are Form 941, Employer's
Quarterly Federal Tax Return, and Form 940, Employer's Annual Federal
Unemployment Tax Return; pension returns include Form 5500, Annual
Return/Report of Employee Benefit Plan; and excise taxes are
generally reported on Form 720, Quarterly Federal Excise Tax Return.
\4 CREF includes sole proprietors who, since 1986, either filed a
Schedule C or F under an EIN or simply received an EIN. It also
includes sole proprietors whose Business Master File account contains
a cross-reference to an SSN and does not show an active business
filing requirement except for employment tax returns.
\5 See The Merits of Establishing a Business Information Returns
Program (GAO/T-GGD-87-4, Mar. 17, 1987).
OBJECTIVES, SCOPE, AND
METHODOLOGY
------------------------------------------------------------ Letter :3
As agreed with the Joint Committee, our objectives were to determine
whether IRS (1) accurately cross-references sole proprietor
identification numbers on the Individual Master File, Business Master
File, and CREF and (2) needs to take any actions to improve the
accuracy of its cross-reference files.
To accomplish these objectives, we reviewed IRS' procedures for (1)
issuing EINs, (2) processing sole proprietor tax returns, and (3)
entering SSNs and EINs on the two master files. We interviewed
various IRS officials who were responsible for (1) updating
Individual and Business Master File records, (2) creating and
updating CREF, and (3) managing and operating the
information-returns-based programs for identifying taxpayers who may
have failed to file returns or report all income. In addition, we
reviewed samples of sole proprietor accounts to determine the
accuracy of SSNs and EINs posted to them.
To help us obtain samples, IRS gave us a computer file of the 1.8
million tax year 1991 Schedule Cs filed with the Fresno Service
Center in calendar year 1992, the most recent year for which complete
data were available when we began our work. We picked the Fresno
Service Center because it was a logistically and geographically
convenient location in which to do our work. According to IRS
officials, we could expect to find similar conditions at all IRS
service centers.
We analyzed the file to identify Schedule Cs that were filed with an
EIN; 243,289 Schedule Cs included a unique EIN and a primary SSN or
secondary SSN that was not duplicated.\6 We matched these 243,289
EINs against EINs listed on the tax year 1991 CREF, which we had
obtained from IRS. This match showed that 217,279 of these Schedule
C EINs were on CREF and 26,010 were not.
From the 217,279 EINs that matched, we selected a random sample of
250 accounts to determine whether the identification numbers on CREF,
the Individual Master File, and the Business Master File were
accurate. For each account, we reviewed the Individual and Business
Master File entity and tax year 1991 records. We judged the
information on the files to be accurate when the EIN and SSN on CREF
matched those on the Individual and Business Master File records.
From the 26,010 Schedule C EINs that were not on CREF, we randomly
selected 250 to determine whether there were valid reasons for their
absence from CREF. We made this determination by searching IRS
master file and tax return records for EINs in our random sample and
analyzing the records when a match occurred. We also reviewed and
evaluated IRS' procedures for excluding records from CREF. Our
sampling methodology, which is described in more detail in appendix
I, allowed us to project the results of our samples to 217,279 of the
243,289 tax year 1991 Schedule Cs that contained EINs and were filed
with the Fresno Service Center.
We also reviewed the legislative history of the Code provision that
authorizes the use of taxpayer identification numbers on tax returns.
In addition, we discussed the need for both numbers with IRS and
Social Security Administration officials.
We did our work from January 1994 to March 1995 at IRS' National
Office in Washington, D.C., and its Fresno Service Center in
accordance with generally accepted government auditing standards. We
requested comments on a draft of this report from the Commissioner of
Internal Revenue. On June 13, 1995, IRS officials provided us IRS'
comments. IRS representatives at that meeting included the National
Director of Submission Processing and representatives of the
Assistant Commissioners for Taxpayer Services and Collections. Their
comments are summarized on pages 14-17 and incorporated in this
report where appropriate.
--------------------
\6 There were also 23,583 Schedule Cs in which more than one taxpayer
used the same EIN.
SOLE PROPRIETORS ARE THE ONLY
TAXPAYERS REQUIRED TO HAVE TWO
IDENTIFICATION NUMBERS
------------------------------------------------------------ Letter :4
Sole proprietors are the only type of business entity that has one
identification number for income tax purposes and another for
business tax purposes. Other business taxpayers, such as
corporations, use their EINs for all tax purposes.
Sole proprietors report tax information that other individual
taxpayers report, such as filing status, number of exemptions
claimed, alimony paid, medical and dental expenses, interest paid on
home mortgages, and taxable income. They also report tax information
about their businesses, such as the accounting method used to keep
the business' books, business expenses (e.g., advertising, utilities,
employee wages), and cost of goods sold. They report the business
information on Schedule C or F and carry to Form 1040 the net profit
or loss from the sole proprietorship.
IRS records the tax information sole proprietors report on two
different master files. It records the individual tax information,
including Schedule C and F data, on the Individual Master File and
the business tax information, such as data from employment and excise
tax returns, on the Business Master File. As their names suggest,
the Individual Master File holds the tax information of persons who
file individual income tax returns, and the Business Master File
holds the tax information submitted by sole proprietors,
corporations, partnerships, and other businesses.
IRS requires sole proprietors to use two different identification
numbers because each master file will accept only one type of
identification number as the primary account number. The Individual
Master File will accept only SSNs as the primary number for Form
1040. The Business Master File will only accept EINs as the primary
account number for Form 941 employment tax returns and other business
returns.\7 Therefore, in order to record tax information about them
on the two files, IRS requires sole proprietors to file Form 1040
with an SSN and employment and excise tax returns with an EIN.
--------------------
\7 All tax forms on the Business Master File are filed under EINs
except for Form 706, Estate Tax Return, and Form 709, Gift Tax
Return, which are filed under the taxpayer's SSN.
IRS PROBLEMS IN
CROSS-REFERENCING SOLE
PROPRIETORS' ACCOUNTS
------------------------------------------------------------ Letter :5
IRS cross-references the SSN and EIN that a sole proprietor reports.
However, we found that the cross-references were not always correct.
Better validation of sole proprietor SSNs and EINs by IRS when
processing returns could mitigate the problem but would not eliminate
it.
EIN ERRORS ON THE INDIVIDUAL
MASTER FILE
---------------------------------------------------------- Letter :5.1
As previously mentioned, we sampled 250 of the 217,279 tax year 1991
Schedule Cs filed at the Fresno Service Center in 1992 and listed on
CREF and 250 of the 26,010 returns that were not on CREF. We
reviewed these cases to determine whether EINs on the Schedule Cs
belonged to the taxpayers who entered them.
On the basis of our sample results, we estimate that 48,608, or 20
percent, of the 243,289 EINs posted to Individual Master File tax
year 1991 records as cross-references to the Business Master File
were erroneous.\8 That is, the EIN would not serve as a bridge to the
sole proprietor's account on the Business Master File. Before
posting, IRS did not screen EINs to detect those incorrectly reported
on Schedule C.
As table 1 shows, in filing Schedule Cs, sole proprietors used EINs
that either belonged to another business, did not exist on the
Business Master File, or were the same as the sole proprietor's SSN.
Table 1
Estimates of Erroneous EINs on Tax Year
1991 Schedule Cs Filed at the Fresno
Service Center in 1992
Estimated number Percent of total
EIN status of EINs EINs
------------------------------ ------------------ ------------------
EIN on the 194,681 80%
Individual Master
File was correct
EIN belonged to 28,067 12%
another taxpayer
EIN was not on the 18,564 8%
Business Master
File
EIN was identical 1,977 1%
to the taxpayer's
SSN
======================================================================
Total 243,289 100%
----------------------------------------------------------------------
Note: Percentages do not add to 100 due to rounding.
Source: Random samples taken from tax year 1991 Form 1040 returns
with Schedule Cs filed with IRS' Fresno Service Center.
Cases involving an EIN belonging to another taxpayer included those
where sole proprietors received an information return for services
provided to another business and then used the EIN of that business
as shown on the information return. Cases involving an EIN not on
the Business Master File included those in which sole proprietors
transposed digits of their EINs or otherwise entered numbers that did
not reflect valid EINs.
IRS transcribed EINs from Schedule Cs but did not perform validity
checks to determine whether EINs belonged to the sole proprietors who
used them. As the returns are filed, they are received at service
centers and go through various processing steps. As part of
processing, data from the returns, including SSNs and EINs, are put
into computer form. Once the data are in computer form, IRS makes
certain computerized validity checks to ensure that the data are
accurate. IRS checks SSNs against its computer file of valid SSNs to
determine whether they are valid and attempts to correct those that
are invalid before they are posted to the Individual Master File.
However, the Fresno Service Center's computers were not programmed to
check EINs on Schedule Cs against a computer file of valid EINs to
identify those that were invalid.
--------------------
\8 There were also 23,583 Schedule Cs in which more than one taxpayer
used the same EIN. There were 7,423 unique EINs associated with the
23,583 schedules.
ERRONEOUS SSNS ON THE
BUSINESS MASTER FILE
---------------------------------------------------------- Letter :5.2
In 1987, IRS began entering sole proprietors' SSNs on the Business
Master File as accounts were established. In 1992, IRS added sole
proprietors' SSNs to accounts that were established before 1987. To
add SSNs to pre-1987 accounts, IRS matched EINs from Schedules C and
F to EINs on the Business Master File. When they matched, IRS added
the sole proprietor's SSN to the account. More specifically, SSNs
were added when the EINs matched; the Business Master File account
did not contain an SSN; and the account holder was not a corporate,
partnership, or tax-exempt return filer. The SSNs that were added
were reported by sole proprietors on Schedules C and F for tax years
1987 through 1990.
IRS did not validate the Schedule C and F EINs before matching them
with EINs on the Business Master File. As noted earlier, it is not
uncommon for sole proprietors to use EINs that are assigned to other
taxpayers. Therefore, some EINs that matched may have belonged to
different taxpayers. In such instances, the SSN that was added to
the account would not have been the account holder's SSN.
On the basis of our two samples of 250 EINs, we estimated that about
6,360, or 3 percent, of the 243,289 tax year 1991 Schedule Cs with
EINs on Business Master File accounts that were filed with the Fresno
Service Center contained inappropriate SSNs.\9 The types of Business
Master File accounts with inappropriate SSNs included the following:
Corporation and partnership accounts that were inactive and for
which returns were no longer required to be filed: SSNs were
posted to these accounts because the unverified EIN on the sole
proprietor's Schedule C matched the account EIN.
Governmental agencies and churches: The match criteria did not
include a routine to screen out these entities when a Schedule C
EIN matched.\10
Spousal accounts of primary taxpayers: In this case, SSNs of
primary taxpayers--that is, taxpayers that appeared first on the
name line of the Form 1040 for married couples filing joint
returns--were affixed to the Business Master File records of
their spouses.
--------------------
\9 The two samples consisted of 250 unique EINs for the 217,279 EINs
that were on the CREF and 250 unique EINs for the 26,010 EINs that
were not on CREF. At the 95-percent confidence level, the sampling
error for the 2.6 percent was plus or minus 1.7 percent.
\10 The Business Master File contains an employment code that
identifies governmental agencies, churches, and other nonprofit
entities that are on the file because of the employment returns they
must file.
CREF CONTAINED ERRONEOUS
EIN/SSN COMBINATIONS
---------------------------------------------------------- Letter :5.3
CREF reflects those taxpayer identification numbers cross-referenced
on the Individual and Business Master Files. Erroneous
cross-references present on the two master files can appear on CREF
as well. IRS' computer screening process prevented certain erroneous
identification numbers from being posted to CREF. Even so, for the
records we reviewed, CREF frequently contained EIN-SSN
cross-references that were incorrect.
As reported in a previous section, we estimated that 48,608 of the
EINs reported on 1991 Schedule Cs filed with the Fresno Service
Center were in error (e.g., because the EIN the sole proprietor
reported belonged to another taxpayer). Before data are posted to
CREF, IRS subjects them to certain computerized tests to screen out
"bad" data. IRS' screening process prevented 26,010 of the 48,608
errors from being posted to CREF. The screening process searched for
EINs that belonged to businesses that were not sole proprietorships
and EINs that matched a sole proprietor's SSN.\11
However, on the basis of our sample of 250 EINs for the 217,279 CREF
records, we estimated that 22,598 of the 48,608 erroneous EINs were
posted to CREF.\12 The screening process was not designed to catch
the types of errors that the 22,598 EINs represented; namely:
EINs affixed to Business Master File accounts of corporations and
partnerships no longer required to file returns. In these
situations, the computer could not determine that the account
holder was not a sole proprietor because there were no active
filing requirements.
EINs from Schedule Cs that were not on the Business Master File.
The estimated 22,598 erroneous EINs represented about 10 percent of
the 217,279 CREF accounts related to tax year 1991 Schedule Cs filed
with the Fresno Service Center.
--------------------
\11 The Business Master File shows whether the account holder is an
active filer. In the case of an active filer, it shows what type of
return the account holder should be filing, such as corporation or
partnership. The screening process for CREF uses this information to
determine when the EIN the sole proprietor reported belongs to
another business entity.
\12 The associated statistical confidence interval at the 95-percent
confidence level for the 22,598 EINs ranges from 13,845 to 31,349.
ERRONEOUS CROSS-REFERENCES
CAN LEAD TO FALSE
UNDERREPORTER LEADS
---------------------------------------------------------- Letter :5.4
IRS collects tax information by taxpayer identification number and
decides whether to contact a taxpayer for potentially underreporting
income on the basis of the information collected. When taxpayer
identification numbers are erroneously cross-referenced, the
information generated for a taxpayer may be inaccurate and thus
provide IRS examiners with false leads to pursue. IRS examiners have
been instructed to screen the information manually to detect
inaccuracies so that taxpayers will not be inappropriately contacted.
The problem associated with erroneous cross-referencing is
highlighted by the underreporter leads that CREF generates. For tax
year 1991, IRS received about 5.9 million information returns with
EINs for about 1.1 million sole proprietors. Using CREF data, IRS
developed a nationwide list of about 28,400 sole proprietors who may
have underreported their income for tax year 1991. About 4,700 of
these cases were handled by the Fresno Service Center.
These potential underreporter cases were created because the sole
proprietor's tax return appeared not to have reported all of the
income shown in information returns. (IRS computers match the tax
return and information return data to produce the potential
underreporter list.) However, Fresno Service Center examiners
manually screening these 4,700 cases found that for 1,582, or 34
percent, either the income had been reported on the return or the
information returns were wrong.\13 For example, the sole proprietor
may have reported interest income on the state income tax refund line
of the Form 1040, or the name on the information return may not have
been that of the sole proprietor.
According to Fresno Service Center officials, 10, or 0.6 percent, of
the 1,582 cases screened out before taxpayer contact were caused by
erroneous cross-referencing of taxpayer identification numbers. IRS
had no data on how many potential underreporting cases were generated
nationwide through erroneous cross- referencing of taxpayer
identification numbers. IRS has no information on whether any
underreporting case generated by erroneous cross-referencing slipped
through the manual screening process, resulting in taxpayer contact.
--------------------
\13 For the remaining 3,118 cases, the taxpayers were sent notices
inquiring about the potential unreported income.
EARLIER SCREENING FOR ERRONEOUS
IDENTIFICATION NUMBERS IS
POSSIBLE
------------------------------------------------------------ Letter :6
As shown by our tests, the Individual Master File, the Business
Master File, and CREF all contain inappropriate cross-references of
SSNs and EINs. IRS is faced with the problem of locating and
removing erroneous cross-references already on the files and
preventing cross-referencing errors in the future. As discussed
below, some aspects of the problem may be more readily correctable
than others.
Having accurate taxpayer records is extremely important as IRS moves
forward with its multibillion-dollar Tax Systems Modernization (TSM)
efforts. IRS envisions that under TSM it will have an integrated
case processing system in place by the year 2001, and that this
system will allow all compliance issues for a taxpayer to be
identified and investigated at the same time. However, IRS needs
valid cross-referenced taxpayer identification numbers to properly
integrate its various taxpayer records. Without accurate
cross-referencing, IRS could create false noncompliance leads and
have a less effective integrated case processing system than
envisioned.
There are several validity checks that IRS could run to help prevent
certain types of erroneous EINs from being added to sole proprietor
records on the Individual Master File and CREF. One check would
involve programming service center computers to identify instances
where the EIN listed on Schedule C or F is the same as the sole
proprietor's SSN. When the two are identical, the EIN would not be
added to the Individual Master File.
The first two digits of an EIN represent an IRS district. The second
validity check would involve programming service center computers to
identify EINs that are invalid because the first two digits are not
an IRS district code. Our analysis of the tax year 1991 CREF showed
that almost 1 percent of the 4.3 million EINs on CREF had invalid
district office codes.
The third validity check would involve validating EINs in a way
similar to that used by IRS to validate SSNs. IRS could computer
match EINs against its file of valid EINs to identify those that are
invalid. And, where appropriate, procedures could be developed to
notify taxpayers that the EIN they used was invalid or wrong and to
obtain the correct EIN from them.
We discussed the technical possibility and usefulness of creating
these computerized screens with officials of the Fresno Service
Center. They believed that there were no technical barriers to
creating the screens, although there would be some cost involved in
creating and testing them. They believed as well that the screens
would be useful for creating accurate files. The officials did not
know what the cost of creating the screens would be nor whether the
screens would save examiners time in reviewing potential
underreporter cases.
The erroneous cross-referenced SSNs that were incorrectly added to
Business Master File records of governmental agencies and other
non-income tax paying entities in 1992 are readily identifiable by
computer. A computer program could be written to remove the
erroneous cross-referenced SSNs from these records. However, other
types of errors may not be readily identifiable by computer because
they contain SSNs that were attached to Business Master File records
of inactive businesses, such as defunct corporations. Therefore, IRS
may have to effect these removals on a case-by-case basis, such as
when underreporter examiners detect cases with erroneous
cross-reference data. IRS does not currently have procedures that
instruct examiners to initiate action to correct erroneous
cross-references on the master files or CREF.
TWO IDENTIFICATION NUMBERS MAY
BE UNNECESSARY
------------------------------------------------------------ Letter :7
IRS' difficulties with regard to cross-referencing a sole
proprietor's two identification numbers could be eliminated if sole
proprietors used a single identification number for all tax
information. In addition to aiding IRS, the use of a single
identification number would lessen the compliance burden that sole
proprietors shoulder, which would be in keeping with IRS' long-range
business plan and Congress' intent when it gave IRS the authority to
require taxpayer identification numbers.
The Social Security Administration uses EINs to track employers'
contributions to the Social Security trust funds. Therefore, any
change in EIN structure or use affects the Social Security
Administration and its records. Social Security Administration
officials with whom we talked saw no major technical obstacles for
their agency if IRS eliminated the EIN requirement for sole
proprietors. However, the officials said that, without further
study, they could not determine whether it would be cost- effective
or operationally feasible to use SSNs in place of EINs on agency
computer files.
Having sole proprietors use only their SSNs for all tax purposes
would be in keeping with the legislative history behind the taxpayer
identification system and with the concept of the sole proprietor.
Section 6109 of the Internal Revenue Code requires that taxpayer
identification numbers be included on tax information and gives IRS
the authority to decide what identification system will be used.
Section 6109 further provides that, except as otherwise specified by
regulation, the Social Security account number shall be used as the
identifying number for individuals. The legislative history of
section 6109 includes a request to IRS to work out an identification
system that would involve the least possible burden to taxpayers.
Sole proprietors differ from other business entities in that the
business does not exist separately from the owner. The sole
proprietor accepts the risks of business, including tax obligations,
to the extent of all of his or her assets, whether used in the
business or personally. For that reason, it appears unnecessary to
treat sole proprietors as two separate entities, requiring two
identification numbers, for tax purposes. IRS officials said that,
although sole proprietors are different from other business entities,
eliminating their EIN requirement would require computer programming
and possible reconfiguration changes to be made to the Business
Master File. The officials did not know how much these changes would
cost or whether the changes would be operationally feasible.
CONCLUSIONS
------------------------------------------------------------ Letter :8
Under certain conditions, sole proprietors are required to file tax
returns using two different identification numbers, a filing
requirement not extended to other business taxpayers. However, sole
proprietors frequently report the wrong identification number,
especially in the case of the EINs that must be obtained from IRS.
For its part, IRS has not screened out all erroneous identification
numbers, which means that the numbers posted to sole proprietors'
records as cross-references may identify someone other than the
intended taxpayer. No data are available to discern the total
effects of such mispostings; however, several false underreporter
cases conducted by the Fresno Service Center were created because of
erroneous cross-references. More screening is also needed if IRS is
to properly integrate a taxpayer's various records under TSM.
The problems of cross-referencing identification numbers could be
avoided entirely if sole proprietors could use their SSNs for all tax
information. However, IRS would have to evaluate the feasibility of
eliminating the EIN requirement for sole proprietors before such a
change could be made.
RECOMMENDATIONS
------------------------------------------------------------ Letter :9
We recommend that the Commissioner of Internal Revenue
establish returns-processing and compliance-screening procedures to
help remove erroneous cross-referenced taxpayer identification
numbers from sole proprietors' tax records, and
evaluate the feasibility of eliminating the requirement that sole
proprietors use EINs for filing business returns.
AGENCY COMMENTS AND OUR
EVALUATION
----------------------------------------------------------- Letter :10
We requested comments on a draft of this report from the Commissioner
of Internal Revenue. Responsible IRS officials, including the
National Director of Submission Processing and representatives of the
Assistant Commissioners for Collections and Taxpayer Services
provided IRS' comments in a meeting on June 13, 1995. IRS' Chief
Compliance Officer also provided us with comments on our draft report
on July 5, 1995. These officials generally agreed that data on CREF
should be perfected and said that IRS will begin evaluating how to do
this. They also said that a single taxpayer identification number
would facilitate reporting compliance by sole proprietors. However,
they said that, due to major obstacles to implementing such a change,
IRS does not agree with our recommendation to evaluate the
feasibility of having sole proprietors use their SSNs instead of EINs
on business returns.\14 A more detailed discussion of IRS' comments
follows.
--------------------
\14 In our draft report, we recommended that IRS undertake this
evaluation as part of an initiative in its Business Master Plan that
dealt with changing the EIN system. IRS officials said that this
initiative was no longer valid, and thus we deleted references to the
initiative from this report.
CLEANING UP TAXPAYER RECORDS
--------------------------------------------------------- Letter :10.1
The officials said that while IRS' goal is to ensure accurate
taxpayer account information, the cost of implementing the
recommendation to clean up taxpayer records must be weighed against
other competing resource demands. They said IRS must first determine
the scope and impact of the problem before any decision can be made
about correcting the records. IRS plans to begin evaluating the
extent of the problem and to decide by May 1996 on how to address the
errors in CREF.
We recognize that IRS has limited resources and needs to use those
resources judiciously. At the same time, we also recognize that
accurate taxpayer identification numbers are vital for an effective
and efficient tax administration system. Therefore, although we are
encouraged that IRS plans to clean up its taxpayer records, we do not
believe that IRS has to wait until May 1996 before starting to do so.
For example, IRS could begin now to institute some procedures to
clean up the records. As one approach, it could have examiners who
work underreporter cases correct erroneous cross-reference data when
they are detected.
IRS officials stated that our suggestions to establish EIN validity
checks that would identify erroneous EINs may not work. They said
that, prior to 1985, taxpayers could request a specific EIN from IRS
and that many taxpayers chose to use their SSNs as their EINs. They
also said that, prior to 1985, if taxpayers filed business returns
under their SSNs--and if there were no EINs with the same sequence of
digits, and the taxpayers did not already have EINs--then IRS would
assign the SSNs as EINs and process the business returns.\15
Therefore, in the view of these officials, if IRS were to adopt our
validity-check suggestions, it would potentially remove valid EINs
from its records.
We believe that these problems could be overcome by validating EINs
in a way similar to that used to validate SSNs. IRS does this by
computer matching reported SSNs against a computer file of valid
SSNs. It seems that IRS could computer match EINs against its file
of valid EINs to identify those that are invalid.
--------------------
\15 IRS officials told us that since 1985, when new computer systems
were placed in service centers, each service center has been given
blocks of EINs to issue to taxpayers. The officials also said that
taxpayers can no longer chose their own EIN and that IRS will not
process business returns in cases where taxpayers have used their
SSNs instead of EINs.
ALLOWING SOLE PROPRIETORS TO
USE SSNS INSTEAD OF EINS
--------------------------------------------------------- Letter :10.2
The officials said that relieving sole proprietors of the requirement
of using EINs, and permitting them to use their SSNs for all tax
reporting purposes, might reduce reporting errors to some extent.
However, IRS officials said that IRS will not pursue such a change
due to major implementation obstacles, including the necessity of
extensively reprogramming IRS, Social Security Administration, and
private sector record systems;
massively reconfiguring the Business and Information Returns Master
Files;\16
allocating significant IRS resources to educate taxpayers in the
new requirement;
imposing the added burden on the majority of sole proprietors who
now report correctly of changing their reporting
responsibilities; and finally,
requiring sole proprietors to disclose their SSNs on Forms W- 2,
which raises privacy concerns.
Our draft report had already noted that computer programs and
computer files would have to be changed. We did not know how
extensive the changes would have to be, which is why we are
recommending that IRS make an evaluation rather than recommending the
actual changes. Also, we agree with IRS that taxpayers would need to
be educated in the new requirement and to change their reporting
responsibilities. We assumed that these factors and their costs
would be part of IRS' evaluation. With regard to having sole
proprietors disclose their SSNs on Forms W-2, sole proprietors who do
not have EINs currently submit information returns under their SSNs.
IRS noted another obstacle concerning the use of SSNs and, in doing
so, provided us with information that we were not aware of when we
did our work. The officials stated that there are about 23 million
pairs of EINs and SSNs on the Individual and Business Master Files
that share the same sequence of digits. They said that, while some
of these pairs may be due to error, others may be valid.
In our view, the problem of having EINs and SSNs with the same
sequence of digits could be overcome without causing major
complications. IRS currently receives information returns in which
the EIN of one taxpayer has the same sequence of digits as the SSN of
another taxpayer. In these situations, IRS has computer checks that
allow it to associate these information returns with the proper
taxpayer. Similar computer checks could be developed for business
returns. The feasibility and costs of this solution to the problem
of having matching EINs and SSNs could be part of IRS' evaluation.
--------------------
\16 The Information Return Master File is where INS captures the data
from information returns (such as W-2s) filed by third parties. The
privacy concerns associated with having all sole proprietors use
their SSN rather than an EIN could also be included in this effort.
PLANNED IRS STUDY COULD ADDRESS
MULTIPLE CONCERNS
----------------------------------------------------------- Letter :11
Although IRS is opposed to our recommendation, we still believe that
eliminating the EIN requirement for sole proprietors is worthy of
further evaluation before a decision is made on its feasibility and
cost-effectiveness, especially since in the past IRS allowed sole
proprietors to use their SSNs as EINs. A similar policy for those
cases where IRS has not assigned an EIN with the same digits as the
sole proprietor's SSN should not involve major Business Master File
reprogramming and reconfiguration. As previously discussed, IRS is
proposing to do a study on the extent of the problems with CREF and
ways to address them. This study could also include an evaluation of
the feasibility of sole proprietors using their SSN rather than an
EIN. Thus, we encourage IRS, as it proceeds with its modernization
and simplification efforts, to include in its study a reconsideration
of its position not to undertake an evaluation of the sole proprietor
EIN requirement.
--------------------------------------------------------- Letter :11.1
As agreed with Committee staff, we will send copies of this report to
the Ranking Minority Members of the House Committee on Ways and Means
and the Senate Committee on Finance, the Secretary of the Treasury,
the Commissioner of Internal Revenue, and other interested parties.
We will also make copies available to others upon request. Major
contributors to the report are listed in appendix II. If you have
any questions, please contact me at (202) 512-8633.
Lynda D. Willis
Associate Director, Tax Policy
and Administration Issues
SAMPLING AND DATA ANALYSIS
METHODOLOGY
=========================================================== Appendix I
This appendix describes our sampling approach for selecting sole
proprietors with EINs to achieve a 95-percent confidence level for
our estimates. Statistical sampling enables us to make estimates and
draw conclusions about the universe on the basis of information in a
sample of that universe. Our samples were of sole proprietors who
reported EINs on tax year 1991 returns filed with the Fresno Service
Center.
SAMPLE SELECTION AND SCOPE
We obtained from IRS a computer file of the 1.8 million tax year 1991
Schedule Cs filed with the Fresno Service Center in calendar year
1992. Our analysis of the file identified 266,872 Schedule Cs that
were filed with an EIN. Further analysis showed that there were
23,583 Schedule Cs in which more than one taxpayer used the same EIN.
There were 7,423 unique EINs associated with the 23,583 Schedule Cs.
We matched the remaining 243,289 EINs against EINs on the tax year
1991 CREF, which we had obtained from IRS and which contained about
4.3 million records (i.e., EIN/SSN combinations).
This match showed that, of the 243,289 Schedule Cs with EINs, 217,279
of these EINs were on CREF and 26,010 were not. From the 217,279
EINs that matched, we selected a random sample of 250 accounts to
determine whether the information on CREF, the Individual Master
File, and the Business Master File was accurate. For each account,
we reviewed the Individual and Business Master File entity record and
tax return data. We determined that the information on the files was
accurate when the EIN and SSN on CREF were the same as those on the
Individual and Business Master File entity records.
Table I.1 shows the point estimates and the statistical confidence
intervals at the 95-percent level of our case analysis by types of
erroneous EINs listed on the Schedule Cs found on CREF.
Table I.1
Point Estimates and Confidence Intervals
by the Types of Erroneous EINs Found on
CREF
Point Lower Upper
EIN status Percent estimate limit limit
------------------------------ -------- -------- -------- --------
No erroneous 90% 194,681 185,930 203,434
EINs
EIN was not on 8% 18,252 12,675 25,266
the Business
Master File
EIN belonged 2% 4,346 1,545 9,384
to another
taxpayer
======================================================================
Total 100% 217,279 Not Not
applicab applicab
le le
----------------------------------------------------------------------
Source: Tax year 1991 Schedule Cs filed with the Fresno Service
Center.
From the 26,010 Schedule C EINs not on CREF, we randomly selected 250
to determine whether there were valid reasons for their omission from
CREF. We made this determination by searching IRS master file and
tax return records for EINs in our random sample and analyzing the
records when a match occurred. Table I.2 shows the point estimates
and the statistical confidence intervals at the 95-percent level of
our analysis of cases not on CREF.
Table I.2
Point Estimates and the Statistical
Confidence Intervals at the 95-percent
Level for the Reasons Why EINs Were Not
on CREF
Point Lower Upper
Reason Percent estimate limit limit
------------------------------ -------- -------- -------- --------
EIN belonged 91% 23,721 22,749 24,693
to another
taxpayer
EIN was 8% 1,977 1,337 2,794
identical
to the SSN
EIN was not 1% 312 70 853
on the
Business
Master File
======================================================================
Total 100% 26,010 Not Not
applicab applicab
le le
----------------------------------------------------------------------
Source: Tax year 1991 Schedule Cs filed with the Fresno Service
Center.
Table I.3 shows the overall results of our analysis of EINs on tax
year 1991 Schedule Cs filed at the Fresno Service Center.
Table I.3
Statistical Results of the Estimated
Numbers of Erroneous EINs
Point Lower Upper
EIN status Percent estimate limit limit
------------------------------ -------- -------- -------- --------
EIN correct 80% 194,681 185,930 203,434
EIN belonged 11% 28,067 24,183 31,951
to another taxpayer
EIN not on 8% 18,564 11,074 26,054
Business Master File
EIN was taxpayer's SSN 1% 1,977 1,337 2,794
======================================================================
Total 100% 243,289 Not Not
applicab applicab
le le
----------------------------------------------------------------------
Source: Tax year 1991 Schedule Cs filed with the Fresno Service
Center.
MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
Ralph Block, Assistant Director, Tax Policy and Administration
Issues
Nancy Peters, Assignment Manager
SAN FRANCISCO FIELD OFFICE
Arthur L.Davis, Evaluator-in-Charge
Sam Scrutchins, Technical Advisor
Hans Bredfeldt, Statistician