Tax Compliance: Status of the Tax Year 1994 Compliance Measurement
Program (Letter Report, 12/30/94, GAO/GGD-95-39).

The Internal Revenue Service's (IRS) Taxpayer Compliance Measurement
Program plays an important role in tax policy and administration
decisions.  IRS uses the data for measuring compliance levels,
estimating the tax gap (the difference between the amount of income tax
owed and the amount voluntarily paid), identifying compliance issues,
developing formulas for objectively selecting returns to audit, and
allocating audit resources.  Congress as well as federal and state
agencies use the program's data for policy analysis, revenue estimating,
and research.  This report discusses the status of IRS' plans for
carrying out the program in tax year 1994.  It also identifies the
potential effects of these plans on measuring taxpayer compliance.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-95-39
     TITLE:  Tax Compliance: Status of the Tax Year 1994 Compliance 
             Measurement Program
      DATE:  12/30/94
   SUBJECT:  Tax administration
             Data collection operations
             Tax return audits
             Voluntary compliance
             Statistical methods
             Computerized information systems
             Taxpayers
             Planning
             Surveys
IDENTIFIER:  IRS Taxpayer Compliance Measurement Program
             IRS Totally Integrated Examination System
             TCMP
             
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Cover
================================================================ COVER


Report to the Joint Committee on Taxation, U.S.  Congress

December 1994

TAX COMPLIANCE - STATUS OF THE TAX
YEAR 1994 COMPLIANCE MEASUREMENT
PROGRAM

GAO/GGD-95-39

Tax Compliance

(268641)


Abbreviations
=============================================================== ABBREV

  DORA - District Office Research and Analysis
  IRS - Internal Revenue Service
  TCMP - Taxpayer Compliance Measurement Program
  TIES - Totally Integrated Examination System
  TIN - Taxpayer Identification Number

Letter
=============================================================== LETTER


B-259285

December 30, 1994

The Honorable Daniel Patrick Moynihan
Chairman
The Honorable Sam Gibbons
Acting Vice Chairman
Joint Committee on Taxation
Congress of the United States

This report presents the status of the Internal Revenue Service's
(IRS) plans for conducting the Taxpayer Compliance Measurement
Program (TCMP) for tax year 1994.\1 It also identifies the potential
effects of these plans on measuring taxpayer compliance.  This report
was prepared, not at the request of the Committee, but as part of our
continuing efforts to provide information and analysis to improve tax
administration. 

TCMP results play an important role in tax policy and administration
decisions.  IRS uses the data for measuring compliance levels,
estimating the tax gap (i.e., the difference between the amount of
income tax owed and the amount voluntarily paid), identifying
compliance issues, developing formulas for objectively selecting
returns to audit, and allocating audit resources.  Congress and
federal and state agencies use TCMP data for policy analysis, revenue
estimating, and research.  Because of TCMP's importance, we have been
monitoring IRS' plans to develop and implement the 1994 TCMP. 


--------------------
\1 IRS collects TCMP data by auditing every line on tax returns for a
random sample of taxpayers. 


   BACKGROUND
------------------------------------------------------------ Letter :1

After the last TCMP survey for tax year 1988, IRS concluded that TCMP
was too costly, too burdensome, and too time consuming.  To mitigate
these concerns, the former Commissioner of Internal Revenue asked IRS
staff to redesign TCMP, reducing the sample size by over half and
limiting the scope of the audits. 

In April 1993, we reported on the importance of TCMP, indicating that
the proposed changes to the size and scope of TCMP appeared
unjustified and would undercut its benefits.\2 We reported that TCMP
was not too costly because past TCMP results had been used to more
efficiently allocate billions of dollars in enforcement resources and
to recommend tax law changes that generated billions of dollars of
revenue a year.  We also noted that the burden was small compared to
the benefits derived from the TCMP audits.  TCMP audits actually
reduce overall burden on taxpayers to the extent that they reduce the
number of compliant taxpayers that are selected for other IRS audits. 
Finally, we identified ways in which IRS could make TCMP results more
timely. 

Congress' Joint Committee on Taxation also opposed IRS' proposed
changes to TCMP, arguing that the changes were unlikely to provide
data with the same quality and usefulness as those data found in
prior TCMP surveys.  Moreover, as IRS began organizing its compliance
efforts around more objective data, IRS recognized the value of TCMP
as an important source for such data.  Out of this recognition came
the 1994 TCMP for which audits are slated to begin in October 1995. 


--------------------
\2 Tax Administration:  IRS' Plans to Measure Tax Compliance Can Be
Improved (GAO/GGD-93-52, Apr.  5, 1993). 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

The 1994 TCMP survey may be the most comprehensive TCMP effort ever
undertaken.  Currently planned to include over 150,000 tax returns,
this TCMP is being designed to obtain compliance information for
individuals, small corporations (i.e., those with assets of $10
million or less), partnerships, and S corporations.\3 Across these
four types of taxpayers, IRS plans to further analyze compliance
characteristics by disaggregating the sampled returns into 24 types
of businesses and three types of individual taxpayers.  Most sample
results are planned to be sufficiently precise to measure compliance
at the national level as well as at smaller geographical areas across
the country. 

IRS plans to implement several promising changes to the way past TCMP
surveys were conducted.  First, IRS plans to have auditors use
computers to record audit adjustments, the tax issues involved, and
the reasons for the adjustments.  Moreover, IRS plans to provide
auditors with tax return data for 1994 and the 2 prior years as well
as other tax information on each taxpayer.  To help uncover erroneous
tax return information, IRS is training auditors to use an "economic
reality" audit technique, which compares the taxpayer's lifestyle to
the information reported on the tax return.  These planned changes
can improve the value of TCMP if the changes are implemented soon
enough for all auditors to be properly trained to use them and all
supporting data are available when needed. 

Recognizing these promising changes, we still are concerned with IRS'
ability to meet its milestones so that TCMP audits can begin as
planned in October 1995.  For example, as of November 16, 1994, IRS
had not met its September 1994 milestone for deciding on the data to
be recorded and the computer system on which the data are to be
entered.  IRS needs to make these decisions soon to allow enough time
for developing and testing the computer software and for training
auditors in how to use it.  IRS officials said that missing planning
milestones for determining TCMP data and software requirements would
not affect other milestones and that audits would begin as scheduled
in October 1995. 

While IRS can make up for missing this milestone, it is too early to
determine whether IRS can complete its TCMP planning tasks on time. 
It is important that IRS meet its October 1995 schedule to begin
auditing tax year 1994 returns.  Even with this start date, the TCMP
results cannot be used to fully measure compliance levels or develop
audit selection formulas until the end of 1998.  By this time, the
data will already be 4 years old.  The older the 1994 data get, the
less reliable those data will be as an indicator of compliance
problems.  Continued top management attention to planning could help
ensure that the 1994 TCMP will start on time and produce useful data. 

We also noted that IRS' TCMP plans were missing some important
pieces.  IRS is now working to address these issues. 

  -- IRS does not have a research plan that specifically defines the
     research questions and the data to be collected that would
     answer these questions.  With such a plan, IRS would be better
     able to collect all the necessary data with a minimum of
     superfluous data.  IRS officials believe they are collecting
     sufficient information to answer almost any questions that may
     arise. 

  -- IRS had not planned to collect information on all income and
     deduction items for partnership and S corporation returns.  Nor
     does it plan to collect data needed to determine the tax impact
     of audit adjustments to these returns.  With this information,
     IRS would be better able to more fully estimate the tax gap and
     more precisely measure voluntary tax compliance for these
     businesses, which represent 21 percent of the business taxpayers
     in the sample.  IRS now plans to collect all income and
     deduction data from these business returns, but not the data on
     tax impact. 

  -- IRS had not planned to collect information on employees who
     incorrectly file tax returns as self-employed workers.  With
     this information, IRS would be better able to identify the
     magnitude and nature of a problem on which it has devoted
     considerable resources.  IRS now plans to collect this
     information. 

  -- IRS had not planned to collect information on other known
     compliance problems such as those dealing with the earned income
     tax credit and wage reporting.  This information could be used
     to better determine the scope and causes of these problems.  IRS
     now plans to collect this information. 

  -- IRS had no plans for developing a mechanism that would
     electronically retrieve TCMP audit workpapers for IRS and other
     researchers.  Developing such a system would make it easier for
     IRS to obtain additional information on the reasons for
     noncompliance so that it can develop effective compliance
     strategies.  IRS is considering ways to accomplish this. 

We raise these concerns so that IRS can consider them and make any
necessary changes in an informed manner rather than waiting until the
last minute.  We have prepared this status report so that IRS, as
well as others, will have more confidence that the TCMP audits not
only will start in October 1995, but also produce more useful data. 


--------------------
\3 An S corporation is taxed similar to a partnership.  A qualifying
corporation may choose to be generally exempt from federal income
tax.  Its shareholders will then include in their income their share
of the corporation's separately stated items of income, deduction,
loss, and credit. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Our objectives were to (1) determine the status of IRS' 1994 TCMP
planning effort and (2) identify the potential effects of this plan
on measuring taxpayer compliance. 

To determine the status of the 1994 TCMP, we discussed IRS' TCMP
action plan with responsible officials in the Research Division and
the Examination Division.  We obtained information on the status of
the plan and discussed with IRS officials their progress in meeting
the milestones established by the plan. 

To identify the possible effects of the plan on measuring taxpayer
compliance, we talked to IRS officials responsible for planning the
survey and reviewed documents describing the scope of the 1994 TCMP. 
We discussed the sampling methodology with officials from IRS'
Statistics of Income who participated in the sample design phase.  We
also discussed IRS' plans for conducting the audits with officials
from IRS' Examination Division.  We also reviewed IRS' draft
documents on information to be gathered during the TCMP audits.  We
questioned IRS officials in various divisions and other users of TCMP
data, including staff from the Joint Committee on Taxation, on
whether this TCMP would meet their data needs. 

Our observations in this report are based on the work we have done
over the years on IRS' compliance programs as well as specific work
on TCMP over recent years.  We issued a report in May 1994 on all
such work.\4

We did our work between August and November 1994 in accordance with
generally accepted government auditing standards.  On November 16,
1994, we obtained oral comments from officials responsible for
planning and implementing TCMP in IRS' Examination and Research
Divisions, including the Director of Examination Quality and Support
and a representative for the Director of Research.  We have reflected
these comments in the appropriate sections of this report. 


--------------------
\4 Tax Gap:  Many Actions Taken, But a Cohesive Compliance Strategy
Needed (GAO/GGD-94-123, May 11, 1994).  This report has a
bibliography of tax compliance-related reports that we have completed
since 1982. 


   MANY POTENTIAL IMPROVEMENTS TO
   TCMP LOOK PROMISING
------------------------------------------------------------ Letter :4

Current plans indicate the 1994 TCMP will differ significantly from
previous TCMP surveys, ranging from the sample design to the audit
methods.  As discussed below, these changes should provide for more
comprehensive and useful data on compliance issues.  But the success
of each change depends on critical steps. 


      IMPROVED SAMPLE DESIGN
---------------------------------------------------------- Letter :4.1

For the 1994 TCMP sample, IRS plans to audit over 150,000 tax returns
filed by individuals, small corporations, S corporations, and
partnerships--about 40,000 more returns than the aggregate for these
entity types in prior surveys.  On the basis of our evaluation of
IRS' sampling plan, the sample is large enough to provide
sufficiently precise estimates to measure compliance both nationally
and for some of IRS' 29 District Office Research and Analysis (DORA)
sites, which are located throughout the country.\5

The 1994 TCMP sample stratifies tax returns by market segments--not
by type of return, income amount, or assets as in prior TCMP samples. 
A market segment represents a group of taxpayers with similar
characteristics, such as those in manufacturing.  This time, IRS
plans to stratify taxpayers into 24 business (including 1
international business) and 3 nonbusiness (individuals) market
segments.  IRS believes that stratifying in this manner will allow it
to more effectively use TCMP data for identifying noncompliance
trends and selecting cases for audit.  To ensure comparability with
previous TCMP surveys, the sample can also be stratified into the
traditional groupings (i.e., type of return).  Appendix I shows the
number of planned sample cases for each market segment by return
type. 

For TCMP users, the 1994 sample is intended to provide reliable
comparative information across both return types and market segments,
at the national level.  For example, users should be able to estimate
the national compliance of a particular market segment, such as
health and medical services, and compare the compliance of these
businesses organized as corporations, partnerships, and sole
proprietors.  Due to limitations in the sample size, however, such
estimates at some DORA sites will be limited to either market segment
or return type.  In the example above, a DORA site may only be able
to measure either the compliance for all health and medical services
or the compliance of all corporations covered by the TCMP, regardless
of market segment.  Even so, the sample size and methodology are
likely to make the 1994 TCMP the most comprehensive survey ever
conducted and, therefore, potentially the most useful for measuring
compliance. 


--------------------
\5 IRS recently established 29 DORA sites throughout the country to
do compliance research at the district and regional office level. 


      IMPROVED CASE INFORMATION
---------------------------------------------------------- Letter :4.2

IRS plans to provide more information to its auditors on each sample
case in this TCMP.  For each case, auditors are to receive 3 years of
tax returns (1994 and the 2 prior years), information return
transcripts, and other taxpayer-specific tax data.  Additionally,
DORA sites are supposed to develop specific industry profiles for
each market segment in their geographical area.  These profiles may
include information such as average gross receipts and net profits by
industry.  DORA sites may also provide other information for the TCMP
cases, such as state and local tax data. 

IRS believes this additional information will help auditors identify
more sources of noncompliance and improve the value of TCMP audit
results.  The information, however, will only be useful to the extent
that auditors are properly trained and encouraged to use it.  Because
IRS established the DORA sites in 1994, information provided by these
sites may be limited until they have enough staff trained in research
and analysis techniques. 


      IMPROVED AUDIT TECHNIQUE
---------------------------------------------------------- Letter :4.3

IRS is training its auditors to audit the taxpayer as well as the tax
return.  Described as the economic reality approach, this audit
technique should help auditors look for inconsistencies between the
taxpayer's lifestyle and the amount of disposable income shown on the
return.  IRS believes that this approach will allow auditors to
identify noncompliance that might otherwise have gone undetected. 

This audit technique may require more time than simply auditing the
tax return, as has been done in the past.  However, IRS officials
believe that the benefits from identifying more noncompliance will
more than offset the cost associated with increased audit time. 
Finishing the training before the audits start and ensuring that
auditors use the technique will improve the likelihood of achieving
these benefits. 


      IMPROVED EFFORTS TO IDENTIFY
      CAUSES OF NONCOMPLIANCE
---------------------------------------------------------- Letter :4.4

Unlike prior surveys, IRS plans to require auditors to identify the
cause for most instances of noncompliance found on the return and
determine the associated tax issue.  IRS officials believe that
knowing the specific tax issue involved and understanding the reasons
for noncompliance will help IRS develop programs to more effectively
improve compliance. 

Identifying the cause of noncompliance will not be easy.  IRS has
identified and plans to use 27 causal codes in TCMP, ranging from
"engaging in illegal activities" to "relying on a friend's advice."
Some of the causal codes are very subjective, depending on the
auditors' judgment, while others rely primarily on the testimony of
the taxpayer.  The validity and usefulness of these causal codes
depend, in part, on auditors applying the codes uniformly.  Uniform
application of the codes will only be as good as the criteria,
instructions, and training provided to auditors as well as the
quality of supervisory reviews. 


      IMPROVED DATA COLLECTION
      MECHANISM
---------------------------------------------------------- Letter :4.5

In past TCMP surveys, auditors manually recorded audit adjustments on
a checksheet, which was later transcribed into the TCMP database by
regional or district office clerical staff.  IRS officials have long
had a concern about errors occurring during this data entry process
that were not detected until data analysis began, which was long
after the audits had been completed.  For the first time, IRS plans
to require that all TCMP audit information be entered onto computers
by the auditor.  To ensure that accurate data are entered, the
computer software is to be programmed to do consistency checks on the
data.  If data fail to pass the consistency checks, the auditor
should be able to correct the errors while audit workpapers are still
available for reference. 

Using such computerized input should reduce the potential for
transcription errors and improve the quality of the data transmitted
to the TCMP database maintained at IRS' Detroit Computing Center. 
While the concept of such computerization is commendable, the
computer system has not yet been developed and tested.  Until this is
done, it will not be possible for auditors to be trained in its use. 

Table 1 summarizes the potential improvements being planned for TCMP,
as well as the critical steps that remain if IRS is to achieve its
goals.  IRS officials recognize that these activities are necessary
to completely implement the improvements. 



                                     Table 1
                     
                     Potential Improvements to the 1994 TCMP
                                      Survey

Issue                Improvement                    Critical steps
-------------------  -----------------------------  ----------------------------
Sample size and      Covering four types of         Adequate data are needed to
methodology          taxpayers, the sample is to    allow analysis by either
                     be comprehensive enough to     return type or type of
                     allow some analysis at the     business at the local level.
                     local level. Although drawn
                     by type of business and
                     individual taxpayer, the
                     sample is also to be
                     stratified nationally by
                     income and assets, as in
                     previous TCMP surveys.

More information     In addition to the 2 prior     Properly trained auditors
provided to          years' tax returns and         and research staff will
auditors             information returns, profiles  improve the quality of
                     by type of business are        audits and data provided to
                     planned to be developed by     auditors.
                     local research staff and
                     included in each TCMP case.

Economic reality     Economic reality auditing      Any new approach relies on
audits               requires auditors to review    follow-through with
                     not only the tax return but    training, supervising, and
                     also the taxpayer's lifestyle  quality review to make it
                     and living conditions to       effective in practice.
                     identify potentially hidden
                     income and assets.

Obtaining causes     In past TCMP databases, the    Causal codes will only be as
for                  causes of noncompliance were   good as their definitions
noncompliance by     not shown. Knowing the causes  and uniform application.
tax issue            can help IRS to develop        Instructions, training, and
                     better compliance programs.    follow-through will be
                                                    needed.

Use of computers     Instead of collecting most     This approach depends on
to                   information manually on        computer software being
collect              checksheets, auditors are to   developed and tested early
information          start entering all             enough so that auditors can
on returns           information directly into the  receive adequate training
                     computer, thereby reducing     before the 1994 TCMP audits
                     the chance of errors.          begin.
--------------------------------------------------------------------------------

   GAO CONCERNS WITH THE 1994 TCMP
------------------------------------------------------------ Letter :5

The 1994 TCMP offers IRS an opportunity to obtain information on the
compliance characteristics of a broad segment of the taxpaying
population.  Below, we discuss our concerns that IRS may not be
taking full advantage of this opportunity and may not be able to meet
its goal of starting audits in October 1995.  We also discuss our
concerns about the data that IRS does not plan to collect. 


      MEETING MILESTONES IS
      CRITICAL TO THE SUCCESS OF
      TCMP
---------------------------------------------------------- Letter :5.1

A key element of any undertaking of this magnitude is effective
planning.  With less than a year remaining until the planned start of
audits, our review showed that a significant amount of work remains
to be done.  To provide perspective, table 2 outlines the status of
IRS' key TCMP planning efforts. 



                                Table 2
                
                Status of Key Planning Milestones as of
                           November 16, 1994

                                                Estimated
                                    Planned     completion  Current
Key planning elements               start date  date        status
----------------------------------  ----------  ----------  ----------
Data recording
----------------------------------------------------------------------
Develop sampling plan and sample    Unknown\a   February    Completed
size                                            1994

Determine data needs and define     Unknown\a   September   Draft
data recording requirements                     1994        completed

Develop and test data recording     October     June        Started
mechanism                           1994        1995


Training auditors
----------------------------------------------------------------------
Develop training program            Unknown\a   March       Not
                                                1995        started

Train auditors                      Unknown\a   September   Not
                                                1995        started


Collecting audit data
----------------------------------------------------------------------
Select sample cases                 January     December    Not
                                    1995        1995        started

Compile data on sample cases        March       June        Not
                                    1995        1996\       started

Begin sample case distribution      August      June        Not
                                    1995        1996        started

Begin auditing sample cases         October     April       Not
                                    1995        1998        started
----------------------------------------------------------------------
\a IRS' Action Schedule does not show dates for these items. 

Source:  IRS Action Schedule dated September 26, 1994, and subsequent
discussions with IRS officials. 

IRS has many preparatory tasks to complete before TCMP audits can
begin in October 1995.  All of these tasks must be completed with
five staff members, about half the nine staff members employed during
the planning stage in the last TCMP survey, even though this 1994
TCMP survey is more complex with about three times as many returns. 
It is important that IRS meet its October 1995 schedule to begin
auditing tax year 1994 returns.  Even with this start date, the TCMP
results cannot be used to fully measure compliance levels or develop
audit selection formulas until the end of 1998.  By this time, the
data will already be 4 years old.  The older the 1994 data get, the
less reliable those data will be as an indicator of compliance
problems. 

It is too early in the planning stage to tell whether IRS' specific
milestones will be met.  IRS has missed its September 1994 milestone
for defining data needs and data collection requirements.  IRS
officials indicated that IRS could make up the time lost from missing
this milestone, even with the increased workload and reduced
staffing.  The officials said that work had been continuing and that
audits would begin by October 1995.  Continued close monitoring by
IRS management of these milestones can help to determine whether
additional actions may be required to meet the milestones. 


      IRS HAS NO RESEARCH PLAN
      THAT IDENTIFIES USES OF TCMP
      DATA
---------------------------------------------------------- Letter :5.2

A key element of any research project is a plan that defines the
goals and describes the questions the researcher hopes to answer. 
The research plan defines the data to be gathered and data analysis
to be done.  We are concerned that IRS has no such research plan for
the 1994 TCMP survey even though it will be much more complex and
comprehensive than prior surveys. 

The very elements of this TCMP that make it unique (e.g., 4 entity
types stratified by 27 market segments) require that certain research
questions be addressed before IRS finalizes the TCMP data
requirements.  For example, IRS has not determined how market segment
compliance levels will be measured or how compliance levels for
income and deduction items will be measured across return types. 
Such determinations may have an impact on the types of data IRS
collects. 

A research plan would be useful for explaining how compliance will be
measured by DORA sites.  IRS has emphasized that DORA sites will be a
primary customer for the 1994 TCMP data.  According to IRS officials,
however, the 1994 TCMP data may have limited use at some DORA sites
because the sample size is often too small to be useful to
statistically estimate compliance by both market segment and return
type.  Consequently, analysis of compliance data at the DORA sites
will have to be done on entire market segments, without regard to
entity type.  IRS officials said that these sampling concerns can be
addressed by consolidating the samples either by market segments,
DORA sites, or return types. 

IRS has not developed a compliance measure across the four entity
types.  IRS' primary measure of compliance is the tax liability that
was voluntarily reported divided by the reported tax liability plus
the additional tax recommended in the audit.  This measure, called
the Voluntary Compliance Level, can only be used as a compliance
measure for individuals and corporations because they are taxable
entities.  Partnerships and S corporations are not taxed directly. 
The income (or loss) of these entities flow to the partners or
shareholders who calculate and pay the tax.  A standard measure of
compliance across entity types would aid in analyzing TCMP data. 

Also, IRS has no measure to account for differences in specific types
of income and deductions across return types.  For example, the types
of income reported on the corporate tax return include income from
gross receipts, rents, interest, royalties, and capital gains.  In
contrast, income reported on returns for sole proprietors consists
primarily of gross receipts.  Similar differences exist for business
deductions, such as commissions and car and truck expenses, that sole
proprietors are to itemize on their tax returns but that corporations
are to aggregate under a tax return line for "other" expenses.  A
detailed research plan could help IRS devise a measure to account for
such differences. 

After reviewing a draft of this report, IRS officials acknowledged
that they had no research plan, but said that they believe sufficient
data will be collected to develop compliance measures.  While
agreeing that such measures are needed, IRS officials indicated that
they needed to see the data before developing these measures. 
Although IRS will be collecting a lot of data, we cannot judge such
sufficiency without seeing the research plan and the related
measures.  Developing these measures as soon as possible before the
audits start could help ensure sufficient data collection and
analysis to meet the goals for TCMP. 


      IRS HAD NOT PLANNED TO
      COLLECT SIGNIFICANT
      COMPLIANCE DATA ON
      PARTNERSHIPS AND
      S CORPORATIONS
---------------------------------------------------------- Letter :5.3

The compliance of partnerships and S corporations is becoming an
important issue as these entity types become a larger proportion of
the business population.  However, IRS' draft data collection
instrument indicated that significant partnership and S corporation
data will not be collected.  These two entities each report income
and deductions as well as the allocations of net profits or losses on
two tax documents.  Partnerships report on Form 1065, "U.S. 
Partnership Return of Income," and Schedule K, "Partners' Shares of
Income, Credits, Deductions, etc.," while S corporations use two
similar forms, Form 1120S (i.e., their income tax return) and
Schedule K. 

IRS planned to collect data from Forms 1065 and 1120S, but not the
Schedules K because it could not determine how to fit such data into
the data collection instrument.  This would have left out certain
types of income such as rental income and portfolio income (e.g.,
interest, dividends, and royalties) that are generally reported only
on Schedule K.  For tax year 1992, Statistics of Income data indicate
that about one-half of partnership net income appeared only on the
Schedule K.  Collecting Schedule K data would allow IRS to get a more
complete picture of tax compliance by partnerships and S
corporations, which represent about 21 percent of the TCMP sample
population for business taxpayers. 

IRS also does not plan to collect information on partners and
shareholders because of the potential volume of such information. 
While IRS officials told us that the Taxpayer Identification Number
(TIN) of corporate officials shown on the Form 1120S is to be
transcribed into the TCMP database, IRS does not plan to transcribe
the TINs of individual partners and shareholders.  As a result, IRS
will not be able to accurately track the tax consequences of
adjustments to partnership and S corporation returns to the
individual taxpayers. 

IRS has recently stated an objective of increasing voluntary
compliance to 90 percent by the year 2001.  Tracking the tax impacts
of all adjustments to partnership and S corporation returns would
help IRS measure its progress towards achieving this objective. 

We obtained comments on a draft of this report from IRS Research
Division officials who said that they now plan to obtain Schedule K
data for partnerships and S corporations, but not data on individual
partners and shareholders.  As an alternative to collecting data on
these individuals to estimate the tax impacts of partnership and S
corporation audit changes, IRS could calculate a rough estimate by
multiplying the marginal tax rate for individuals by the amount of
the audit adjustments. 


      IRS HAD NOT PLANNED TO
      COLLECT COMPLETE INFORMATION
      ON POTENTIALLY MISCLASSIFIED
      WORKERS
---------------------------------------------------------- Letter :5.4

Workers can be classified as either "employees" or "independent
contractors" (self-employed individuals who provide services).  Under
common law, the degree of control, or right to control, that a
business has over a worker governs the classification.  If a worker
must follow instructions on when, where, and how to do the work, he
or she is more likely to be an employee.  It is important for IRS to
know whether a worker is correctly classified because employees who
have their taxes withheld are generally more compliant than
independent contractors.\6

This classification issue has plagued IRS for decades.  Because of
the tax and nontax impacts, many concerns have also been expressed by
the business community over worker misclassification and IRS'
enforcement approach to it.  Having information that is more recent
and statistically based may help to resolve some of the concerns
expressed by both IRS and the business community. 

For the 1994 TCMP survey, IRS officials told us that auditors will
evaluate businesses with workers to determine whether the workers
were properly classified as employees or independent contractors. 
Auditors will be instructed to indicate on the TCMP data collection
instrument whether businesses with questionable classification
practices were referred to IRS' Employment Tax Branch for a more
detailed audit of the classification issue. 

This approach may allow IRS to estimate the number of businesses
represented by the TCMP population that potentially misclassified
workers.  However, it will not allow IRS to fully estimate the number
of workers who are misclassified, the potential income tax loss
associated with misclassified workers, or the compliance
characteristics of misclassified workers.  To make these estimates,
IRS would have to record data on the misclassified workers identified
in the classification audits.  This would allow IRS to estimate the
number of workers misclassified by the businesses represented by the
TCMP sample.\7

Another approach to estimating the tax compliance of misclassified
workers would be to have TCMP auditors identify self-employed
individuals who may have been misclassified.  IRS employment tax
specialists could develop criteria to help TCMP auditors identify
these workers.  This approach would allow IRS to estimate the
magnitude of the problem as well as the compliance characteristics of
the potentially misclassified workers.  Determining whether these
workers were actually misclassified would require separate IRS
audits. 

IRS has devoted considerable enforcement resources to the
misclassified worker problem on the premise that it is a sizable one. 
Information on the magnitude and compliance characteristics of
misclassified workers can be used to improve IRS' compliance
programs.  It also can help answer policy questions that have been
long debated on the use of employees versus independent contractors. 

After reviewing a draft of this report, IRS officials agreed with our
points and indicated that they will provide a space for the auditor
to indicate whether a return was referred to the employment tax group
for a classification audit.  The officials said they still needed to
finalize the criteria for referral and the magnitude of employment
tax audits for which the results will be collected in a separate TCMP
database. 


--------------------
\6 Classification also has significant nontax impacts.  Federal and
state laws governing employee benefits, unemployment compensation,
minimum wage and hours, among others, protect employees but also
raise employers' costs.  These issues are further discussed in our
report entitled Tax Administration:  Approaches for Improving
Independent Contractor Compliance (GAO/GGD-92-108, July 23, 1992). 

\7 The TCMP sample excludes some employers such as governments,
corporations with assets over $10 million, and nonprofit groups. 


      IRS DID NOT PLAN TO COLLECT
      OTHER IMPORTANT DATA
---------------------------------------------------------- Letter :5.5

We found that IRS was not planning to collect causal data describing
the reasons for noncompliance on some tax return items.  Nor did IRS
plan to collect data on compliance in filing certain information
returns. 

IRS' draft data collection instrument indicates that causal data will
not be collected on several important items, such as on erroneously
claimed earned income tax credits.  The preliminary results of an IRS
study of returns filed in a 2-week period in January 1994 showed that
an estimated $358 million of $1.5 billion (24 percent) in earned
income tax credits claimed in this period were erroneously claimed. 
Considering the size of this compliance problem and the limited
information available, it is important to determine its cause so that
corrective action can be taken. 

IRS planned to collect data on payor compliance in filing information
returns on income such as interest and rent.  However, IRS did not
plan to collect similar data on taxpayers' compliance with filing
Forms W-2, Wage Statement.  IRS uses the Forms W-2 to detect
taxpayers who underreport wage income or fail to file tax returns. 
Knowing the Form W-2 compliance level is important given the size of
the potential noncompliance.  In its 1987 small corporation (assets
of $10 million or less) TCMP, the data showed that these corporate
employers failed to file Forms W-2 on $4.5 billion in wages, about 1
percent of the total wages that should have been reported. 

Similarly, IRS was not planning to collect data on whether the TCMP
taxpayer filed other types of required returns such as employment tax
returns.  Further, while IRS plans to collect information on
adjustments to prior and subsequent years for individual returns, no
similar information will be collected for corporate or partnership
returns.  This information would be important for estimating the
total amount of noncompliance found as a result of the TCMP audit. 

After reviewing a draft of this report, IRS Research Division
officials said that they plan to collect causal data on the earned
income tax credit.  The officials also said that they will collect
data on payor compliance on which we raised concerns. 


      TWO DATA COLLECTION
      MECHANISMS ARE BEING
      DEVELOPED
---------------------------------------------------------- Letter :5.6

It is important to develop a data collection mechanism as soon as
possible because other steps in the planning process, such as auditor
training, depend on it.  IRS is concurrently developing two data
collection mechanisms for TCMP.  One system, the Totally Integrated
Examination System (TIES), has been under development for use in
non-TCMP audits.  TIES is intended to increase auditors' productivity
by automatically calculating the new tax liability that would be
based on audit adjustments the auditor enters into the system.  TIES
is also intended to automatically generate the Revenue Agent Report,
which would explain the audit adjustments to the taxpayer. 

Because TIES is still in the development stage, IRS was uncertain
whether TIES would be able to meet the TCMP data requirements. 
Consequently, IRS is developing a backup system designed specifically
for collecting TCMP data.  Regardless of which system is used, IRS
will need to test the system, develop training materials, and train
auditors on how to use it.  Our concern is that IRS has little time
to complete these tasks and address the inevitable problems that
arise in systems development.  The sooner IRS makes a decision on the
data collection system it will use for the TCMP audits, the sooner it
can test the system and train auditors. 

IRS officials acknowledged the difficulty of developing two systems
for the same purpose.  They emphasized, however, that the second
system was an insurance plan to be used in case the primary system
does not work. 


      ACCESS TO TCMP WORKPAPERS
      WOULD BENEFIT ANALYSIS
---------------------------------------------------------- Letter :5.7

IRS plans to enter codes into its TCMP database on the causes of
noncompliance and the related tax issue.  However, these data may not
be sufficient for developing compliance strategies.  The TCMP
workpapers to be created by auditors potentially provide more
detailed information on the reasons for noncompliance. 

In recent years, we have used such workpapers to help us more clearly
understand the nature and causes of noncompliance.  For example, we
used workpapers from the 1988 individual TCMP to determine the
potential for identifying taxpayers, through computer matching, who
inappropriately claimed dependent exemptions.\8 We would have been
unable to make such a determination using the TCMP database because
it lacked information on why the dependent exemption had been
disallowed (e.g., insufficient financial support or lack of
documentation). 

IRS' recent strategic plans have identified the need for detailed
information on noncompliance.  For example, IRS envisions using DORA
sites to develop strategies to address reporting accuracy by cash
businesses.  Without detailed information on the reasons for this
noncompliance and the audit techniques used to identify the
noncompliance, DORA sites will find it difficult to develop and test
compliance strategies. 

To obtain such detailed information from the workpapers, however,
requires that each audited return be ordered from IRS storage
facilities and the workpapers reviewed manually.  This is
time-consuming and, in some cases, the returns and workpapers are not
available.  These problems limit the usefulness of the workpapers.  A
more effective strategy could be to make the workpapers available
through electronic media.  That way, the workpapers would be readily
accessible for compliance research. 

After reviewing a draft of our report, IRS officials agreed that
access to TCMP workpapers would provide valuable information, but
they were concerned about costs.  At a minimum, IRS agreed to explore
the feasibility of retaining the computer disks on which auditors
prepare their workpapers. 

Table 3 summarizes our concerns with the status of the TCMP planning,
data needs, and collection mechanisms and IRS' responses. 



                                     Table 3
                     
                      GAO Concerns With the 1994 TCMP Survey

Concern              Conditions                     Agency comments
-------------------  -----------------------------  ----------------------------
Planning needs
--------------------------------------------------------------------------------
Will IRS meet its    Fewer staff were assigned to   IRS believes it will meet
TCMP action plan     planning and designing the     its milestones but it will
schedule?            1994 TCMP than other less      continue to monitor the TCMP
                     complex TCMP surveys. Some     plan.
                     IRS milestones had not been
                     met.

Does IRS have a      IRS did not have a plan that   IRS believes it will gather
research plan for    identified data needs and      sufficient information to
TCMP?                uses. IRS may not be           make compliance estimates.
                     gathering sufficient
                     information to measure
                     compliance.


Additional data needs
--------------------------------------------------------------------------------
Will IRS obtain      IRS had not planned to         IRS now plans to collect all
adequate data on     collect data on some audit     adjustments to partnership
partnership and S    adjustments to partnerships    and S corporation returns.
corporation          and S corporations returns.    It does not plan to collect
returns?             As nontaxable entities, their  partner and shareholder
                     income and losses flow to the  adjustments.
                     partners or shareholders. IRS
                     did not plan to track
                     adjustments to this level.

Will IRS collect     IRS did not plan to collect    IRS now plans to collect
data on potentially  data that are needed to        these data.
misclassified        determine the number of
workers?             misclassified workers or the
                     compliance of those who are
                     being misclassified.

Will IRS fulfill     IRS did not plan to collect    IRS now plans to collect
other TCMP data      data on the (1) causes of      these data.
needs?               noncompliance with the earned
                     income tax credit, (2)
                     compliance with wage
                     reporting requirement, and
                     (3) changes to related
                     returns.


Data collection mechanisms
--------------------------------------------------------------------------------
Will data            IRS planned to develop two     IRS believes it needs a
collection           data collection mechanisms.    backup system in case the
mechanism be ready   One is already under           primary system does not
when needed?         development, the other is      work.
                     being developed specifically
                     for TCMP.

Will IRS analysts    TCMP workpapers have been      IRS agreed to explore the
be able to readily   useful for obtaining more      feasibility of retaining
obtain audit         comprehensive data on          disks on which workpapers
workpapers?          compliance issues than are     are prepared.
                     shown on the TCMP database.
                     However, the workpapers can
                     be hard to obtain and use.
--------------------------------------------------------------------------------

--------------------
\8 Tax Administration:  Erroneous Dependent and Filing Status Claims
(GAO/GGD-93-60, Mar.  19, 1993). 


   CONCLUSIONS
------------------------------------------------------------ Letter :6

In its 1994 TCMP plans, IRS has gone a long way in improving its
collection of compliance data.  Better data provide the foundation
for better compliance efforts that may also lessen the burden for
compliant taxpayers.  The TCMP sample, about one-third larger than
the total for all entity types from past TCMP efforts, allows for
more sophisticated and powerful analyses.  New audit techniques and
more information should help auditors do higher quality audits. 
However, the many changes and added complexity (e.g., causal codes,
four types of taxpayers) increase the importance of adequate training
and supervisory review for the auditors. 

This TCMP offers great promise; but, it is important that IRS obtain
the results as soon as possible.  We are concerned that IRS may not
complete the significant amount of work that remains before the
planned October 1995 starting date for audits.  For example, the TCMP
data collection system has to be designed and tested, training
courses have to be developed and provided to auditors, and tax
returns have to be selected and prepared for audits.  These steps
take time.  However, IRS has already missed its September 1994
milestone for defining TCMP data requirements.  Subsequent
milestones, such as computer software development and testing, cannot
be met without these data requirements.  IRS officials said that
missing this milestone would not delay the October 1995 milestone for
starting audits. 

Given that IRS plans to extensively use data from this TCMP for
compliance research, we were also concerned about data that IRS was
not planning to collect.  We believe that obtaining audit adjustment
data on all partnerships and S corporations income and deductions
would enhance IRS' compliance planning and research.  Similarly,
obtaining better information on misclassified workers would be very
useful for identifying their compliance.  Finally, obtaining
additional data on the causes of noncompliance, and the compliance
with wage reporting requirements would allow IRS to make better use
of TCMP information in designing compliance programs. 

IRS agreed that these data were important for compliance planning and
research, and IRS now plans to collect these data.  Also, IRS
officials said that they would consider ways of making audit
workpapers more readily available to analysts to help them clarify
the tax issues identified in the audits. 

As noted in our April 1993 report on TCMP, we continue to believe
that TCMP is a good investment.  TCMP is IRS' principal tool for
objectively measuring compliance with tax laws.  Accordingly, it is
important that IRS managers monitor the TCMP planning and development
effort closely to ensure that TCMP remains on target. 


---------------------------------------------------------- Letter :6.1

Copies of this report are being sent to 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 this report are listed in appendix II.  Please
contact me on (202) 512-5407 if you have any questions about the
report.

Jennie S.  Stathis
Director, Tax Policy and
 Administration Issues


SAMPLE POPULATIONS FOR IRS' 1994
TCMP
=========================================================== Appendix I



                               Table I.1
                
                  Market Segments and Sample Sizes for
                      IRS' 1994 TCMP--Individuals


                                                            Percent of
                                                               sampled
                                                                  1040
Market segment                         1040s  All returns      returns
-------------------------------  -----------  -----------  -----------
Nonbusiness--no schedules              5,042        5,042        100.0
Nonbusiness--no Schedules C, E,       15,175       15,175        100.0
 or F
Nonbusiness with Schedule E            7,958        7,958        100.0
Very small business                    5,105        5,105        100.0
Farm business                          6,852        8,602         79.7
Building trade contractors             3,135        5,851         53.6
All other construction                 2,759        6,049         45.6
Manufacturing                          1,502        6,313         23.8
Mining and minerals                    1,502        3,457         43.4
Agricultural services                  1,506        3,067         49.1
Wholesale trade                        2,167        7,792         27.8
Direct sales to individual             1,506        1,595         94.4
Auto and boat dealers and              1,504        3,965         37.9
 service stations
Food and beverage                      2,841        4,931         57.6
Apparel, furniture, and general        1,506        3,540         42.5
 merchandise
Retail--all other                      1,526        4,268         35.8
Real estate                            1,506        5,759         26.2
Finance and insurance                  1,758        4,040         43.5
Air, bus, and taxi                     1,508        2,805         89.4
Other transportation                   1,522        3,703         41.1
 and utilities
Amusement, recreation, and             1,507        3,671         41.1
 motion pictures
Medical and health                     2,042        5,034         40.6
Business and personal                  1,682        6,144         27.4
 services
Hotel, lodging, and                    1,509        5,473         27.5
 automotive
Unable to classify                    12,024       15,317         78.5
Miscellaneous business                 2,382        2,382        100.0
 and personal
 services
Miscellaneous services                 3,159        5,496         57.5
======================================================================
Total                                 92,185      152,534         60.4
----------------------------------------------------------------------
Source:  IRS' 1994 TCMP Sampling Plan. 



                               Table I.2
                
                  Market Segments and Sample Sizes for
                      IRS' 1994 TCMP--Corporations


                                                            Percent of
                                                               sampled
                                                                  1120
Market segment                         1120s  All returns      returns
-------------------------------  -----------  -----------  -----------
Nonbusiness--no schedules                  0        5,042          0.0
Nonbusiness--no Schedules C, E,            0       15,175          0.0
 or F
Nonbusiness with Schedule E                0        7,958          0.0
Very small business                        0        5,105          0.0
Farm business                            538        8,602          6.3
Building trade contractors             1,615        5,851         27.6
All other construction                 2,175        6,049         36.0
Manufacturing                          3,662        6,313         58.0
Mining and minerals                      665        3,457         19.2
Agricultural services                    444        3,067         14.5
Wholesale trade                        4,502        7,792         57.8
Direct sales to individual                 0        1,595            0
Auto and boat dealers and              1,369        3,965         34.5
 service stations
Food and beverage                        936        4,931         19.0
Apparel, furniture, and general          917        3,540         25.9
 merchandise
Retail--all other                      1,625        4,268         38.1
Real estate                            2,967        5,759         51.5
Finance and insurance                    994        4,040         24.6
Air, bus, and taxi                       382        2,805         13.6
Other transportation and                 963        3,703         26.0
 utilities
Amusement, recreation, and               963        3,671         26.2
 motion pictures
Medical and health                     1,708        5,034         33.9
Business and personal services         3,173        6,144         51.6
Hotel, lodging, automotive             2,680        5,473         49.0
Unable to classify                     2,002       15,317         13.1
Miscellaneous business and                 0        2,382          0.0
 personal services
Miscellaneous services                 1,080        5,496         19.7
======================================================================
Total                                 35,360      152,534         23.2
----------------------------------------------------------------------
Source:  IRS' 1994 TCMP Sampling Plan. 



                               Table I.3
                
                  Market Segments and Sample Sizes for
                     IRS' 1994 TCMP--S Corporations


                                                            Percent of
                                                               sampled
Market segment                         1120S  All returns        1120S
-------------------------------  -----------  -----------  -----------
Nonbusiness--no schedules                  0        5,042          0.0
Nonbusiness--no Schedules                  0       15,175          0.0
 C, E, or F
Nonbusiness with Schedule E                0        7,958          0.0
Very small business                        0        5,105          0.0
Farm business                            591        8,602          6.9
Building trade contractors               598        5,851         10.2
All other construction                   594        6,049          9.8
Manufacturing                            595        6,313          9.4
Mining and minerals                      597        3,457         17.3
Agricultural services                    596        3,067         19.4
Wholesale trade                          595        7,792          7.6
Direct sales to individual                 0        1,595          0.0
Auto and boat dealers and                596        3,965         15.0
 service stations
Food and beverage                        597        4,931         12.1
Apparel, furniture, and general          596        3,540         16.8
 merchandise
Retail--all other                        593        4,268         13.9
Real estate                              594        5,759         10.3
Finance and insurance                    598        4,040         14.8
Air, bus, and taxi                       599        2,805         21.4
Other transportation and                 594        3,703         16.0
 utilities
Amusement, recreation, and               594        3,671         16.2
 motion pictures
Medical and health                       595        5,034         11.8
Business and personal                    593        6,144          9.7
Hotel, lodging, and automotive           593        5,473         10.8
Unable to classify                       595       15,317          3.9
Miscellaneous business and                 0        2,382          0.0
 personal services
Other miscellaneous services             598        5,496         10.9
======================================================================
Total                                 12,501      152,534          8.2
----------------------------------------------------------------------
Source:  IRS' 1994 TCMP Sampling Plan. 



                               Table I.4
                
                  Market Segments and Sample Sizes for
                      IRS' 1994 TCMP--Partnerships


                                                            Percent of
                                                               sampled
                                                                  1065
Market segment                         1065s  All returns      returns
-------------------------------  -----------  -----------  -----------
Nonbusiness--no schedules                  0        5,042          0.0
Nonbusiness--no Schedules                  0       15,175          0.0
 C, E, or F
Nonbusiness with Schedule E                0        7,958          0.0
Very small business                        0        5,105          0.0
Farm business                            621        8,602          7.2
Building trade contractors               503        5,851          8.6
All other construction                   521        6,049          8.6
Manufacturing                            554        6,313          8.8
Mining and minerals                      693        3,457         20.0
Agricultural services                    521        3,067         17.0
Wholesale trade                          528        7,792          6.8
Direct sales to individual                89        1,595          5.6
Auto and boat dealers and                496        3,965         12.5
 service stations
Food and beverage                        557        4,931         11.3
Apparel, furniture, and general          521        3,540         14.7
 merchandise
Retail--all other                        524        4,268         12.3
Real estate                              692        5,759         12.0
Finance and insurance                    690        4,040         17.1
Air, bus, and taxi                       316        2,805         11.3
Other transportation and                 624        3,703         16.9
 utilities
Amusement, recreation, and               607        3,671         16.5
 motion pictures
Medical and health                       689        5,034         13.7
Business and personal services           696        6,144         11.3
Hotel, lodging, and automotive           691        5,473         12.6
Unable to classify                       696       15,317          4.5
Miscellaneous business and                 0        2,382          0.0
 personal services
Miscellaneous services                   659        5,496         12.0
======================================================================
Total                                 12,488      152,534          8.2
----------------------------------------------------------------------
Source:  IRS' 1994 TCMP Sampling Plan. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Ralph Block, Assistant Director, Tax Policy and Administration Issues
Tom Short, Assistant Director, Tax Policy and Administration Issues

PROGRAM EVALUATION AND METHODOLOGY
DIVISION, WASHINGTON, D.C. 

Harry Conley, Assistant Director, Technical Resources

SAN FRANCISCO REGIONAL OFFICE

Louis Roberts, Evaluator-in-Charge

*** End of document. ***