Tax Administration: Factors Affecting Results from Audits of Large
Corporations (Letter Report, 04/17/97, GAO/GGD-97-62).

GAO reviewed the Internal Revenue Service's (IRS) program to audit the
tax returns of about 45,000 large corporations that are not in the
Coordinated Examination Program (CEP), focusing on factors that
contributed to the assessment rate and audit results.

GAO noted that: (1) IRS invested 25 percent more hours in audits of
large corporations during 1994 than it did in 1988, yet it recommended
23 percent less additional tax per hour and doubled the rate at which it
closed audits with no tax changes; (2) during this 7-year period, IRS
assessed 27 percent of the additional taxes revenue agents recommended;
(3) GAO's analysis of questionnaire responses and interviews of
officials from across IRS identified at least four factors that had a
negative effect on both the audit results and the assessment rate; (4)
the complexity and vagueness of the tax code caused legitimate
differences in interpretation between IRS and corporations over the
correct tax liability; (5) this complexity and vagueness made it
difficult for IRS revenue agents to find the necessary evidence to
clearly support any additional recommended taxes without investing a lot
of audit hours; (6) such recommended taxes were less likely to survive
the IRS Office of Appeals process and be assessed; (7) also, complex and
vague tax laws increased the tax burden on large corporations by
increasing their uncertainty about what actions they had to take to
comply with the tax code; (8) the IRS Examination Division and Office of
Appeals used different performance measures; (9) this difference in
measures resulted in a lower assessment rate; (10) these revenue agents
worked alone on complex audits without much assistance from district
counsel or their group managers, who tended to be responsible for
managing all types of audits; (11) further, audit staff had a limited
basis on which to classify and select returns that had the most audit
potential; (12) IRS' approach for these large corporate returns gave a
great deal of discretion to audit staff, however the staff had little
information on previously audited corporations or industry issues to
serve as guideposts; (13) all these aspects can contribute to a
reduction in the amount of taxes recommended per audit hour and, with
the possible exception of the problems in selecting returns, can affect
the assessment rate; (14) Appeals usually did not share with Examination
information that could be used to educate revenue agents; (15) even if
Appeals did share information, revenue agents did not always have time
to review the new information due to time pressures to do other audits;
(16) although Appeals usually shared the final settlement on disputed i*

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

 REPORTNUM:  GGD-97-62
     TITLE:  Tax Administration: Factors Affecting Results from Audits 
             of Large Corporations
      DATE:  04/17/97
   SUBJECT:  Tax administration
             Interagency relations
             Tax return audits
             Corporations
             Appellate procedure
             Auditing procedures
             Government collections
             Tax nonpayment
             Tax law
             Income taxes
IDENTIFIER:  IRS Coordinated Examination Program
             IRS Examination Operational Automated Database
             
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Cover
================================================================ COVER


Report to the Commissioner, Internal Revenue Service

April 1997

TAX ADMINISTRATION - FACTORS
AFFECTING RESULTS FROM AUDITS OF
LARGE CORPORATIONS

GAO/GGD-97-62

Audits of Large Corporations

(268661)


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

  AIMS - Audit Information Management System
  BMF - Business Master File
  CEP - Coordinated Examination Program
  IRM - Internal Revenue Manual
  IRS - Internal Revenue Service
  SEC - Securities and Exchange Commission
  TEI - Tax Executives Institute

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


B-261745

April 17, 1997

The Honorable Margaret Milner Richardson
Commissioner of Internal Revenue

Dear Ms.  Richardson: 

This report focuses on the second phase of our work on the Internal
Revenue Service's (IRS) program to audit the tax returns of about
45,000 large corporations that are not in the Coordinated Examination
Program (CEP)--IRS' program to audit the returns from the largest and
most complex corporations.\1 In the first phase, in a comparison of
data from fiscal years 1988 and 1994, we found that IRS had invested
additional time in these audits of large corporations but revenue
agents recommended fewer additional taxes per audit hour.\2 For these
years, IRS ultimately assessed 27 percent of the recommended taxes
against these corporations.\3

This assessment rate and these audit results raise issues about the
productivity of such audits.  Initiated under our basic legislative
authority, this review identified factors that contributed to the
assessment rate and audit results. 


--------------------
\1 We identified factors affecting CEP audits and appeals in an
earlier report.  See Tax Administration:  Compliance Measures and
Audits of Large Corporations Need Improvement (GAO/GGD-94-70, Sept. 
1, 1994). 

\2 Tax Administration:  Audit Trends and Taxes Assessed on Large
Corporations (GAO/GGD-96-6, Oct.13, 1995). 

\3 The assessment rate includes the amount of recommended taxes that
the large corporations agreed to pay at the end of the audit as well
as those amounts sustained after any appeal. 


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

For audit purposes, IRS splits large corporations (those reporting
$10 million or more in gross assets) into two groups.  Of the 46,700
large corporations in 1994, IRS placed about 1,700 corporations,
usually exceeding $250 million in assets, into CEP.  IRS audits the
large corporations not in CEP (hereafter referred to as "large
corporations") under the Examination Division's general program.\4
The Examination Division audits tax returns to determine whether
taxpayers paid the correct amount of tax. 

As discussed later in detail, IRS audit staff are to take various
steps before auditing a return.  First, the staff must classify and
select a return for audit.  IRS classifies returns to highlight tax
issues (e.g., income, deductions, credits) that should be audited. 
Then, an IRS revenue agent is to plan how to audit such issues and
collect information from the large corporation, as needed.  If the
corporation does not provide all requested information in a
reasonable period without a valid excuse, IRS may issue a legal
summons to compel the taxpayer to comply.  The Department of Justice
works with IRS to enforce the summons in court. 

For each audit issue, if the revenue agent views this information as
insufficient support for the position taken on the return, the agent
is to recommend adjustments to the return and compute a corrected tax
liability.  On the other hand, if the information supports the return
filed by the large corporation, the agent is to recommend no tax
change.  The revenue agent presents the audit results to the large
corporation officials, who may either agree or disagree.  If the
large corporation agrees, any additional tax that the revenue agent
recommended becomes assessed.  If the large corporation disagrees, it
may file a protest with IRS' Office of Appeals, which is tasked with
settling tax disputes without litigation on the basis of what is fair
to the government and the taxpayer. 

An appeals officer is to evaluate the relative strengths of the
government's and taxpayer's positions by reviewing the facts,
including additional information provided by the taxpayer, pertinent
court decisions, and the results of informal conferences with the
taxpayer.  To settle a tax dispute, an appeals officer can consider
the hazards of litigation.\5 The officer is then to negotiate mutual
concessions in an attempt to arrive at a settlement.  If a case is
settled, any additional tax is assessed and the appeals officer is to
prepare an Appeals case memorandum, or written summary, of how the
case was handled.  The summary is to include the issues raised;
pertinent facts; applicable regulations, rulings, and court
decisions; and the merits and hazards of litigation of each side.  If
a case is not settled, Appeals is required to issue a notice of
deficiency and the taxpayer has 90 days to file a petition with the
Tax Court.  Even after a case is docketed in court, IRS District
Counsel, by itself or by reengaging Appeals, may attempt to settle
the case prior to trial. 

IRS data showed that in fiscal year 1992, Examination sent 2,235
large corporate cases to Appeals.  As of late fiscal year 1995,
Appeals had settled about 1,800 of those cases.  Of those not settled
by Appeals, three were settled by District Counsel, two were settled
by trial, and the remainder were still open in Appeals. 


--------------------
\4 In fiscal year 1994, IRS audited about 10,400, or 24 percent, of
the large corporations. 

\5 Hazards of litigation include the probability of a taxpayer
prevailing in court. 


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

IRS is investing more in audits of large corporations and getting
less in return.  IRS invested 25 percent more hours in audits of
large corporations during 1994 than it did in 1988.  Yet it
recommended 23 percent less additional tax per hour and doubled the
rate at which it closed audits with no tax changes (i.e., no-change
rate).  During this 7-year period, IRS assessed 27 percent of the
additional taxes revenue agents recommended.  Our analysis of
questionnaire responses and interviews of officials from across IRS
identified at least four factors that had a negative effect on both
the audit results and the assessment rate. 

First, the complexity and vagueness of the tax code caused legitimate
differences in interpretation between IRS and corporations over the
correct tax liability.  This complexity and vagueness made it
difficult for IRS revenue agents to find the necessary evidence to
clearly support any additional recommended taxes without investing a
lot of audit hours.  Such recommended taxes, lacking clear evidence,
were less likely to survive the Appeals process and be assessed. 
Also, complex and vague tax laws increased the tax burden on large
corporations by increasing their uncertainty about what actions they
had to take to comply with the tax code. 

Second, Examination and Appeals used different performance measures. 
Examination focused on the amount of additional taxes recommended and
time spent to do the audit and Appeals focused on whether they
settled tax disputes without litigation and the time spent to do so. 
This difference in measures resulted in a lower assessment rate. 
Revenue agents may recommend as much tax as possible in some cases
without developing sufficient evidence, particularly with vague and
complex tax laws.  Appeals officers may settle some disputes without
litigation even when the recommended taxes have some justifiable
basis under the tax laws. 

Third, revenue agents had difficulty developing sufficient support to
recommend tax changes that could survive an appeal due to various
aspects in the audit process.  These revenue agents worked alone on
complex audits without much assistance from district counsel or their
group managers, who tended to be responsible for managing all types
of audits--not just large corporate audits.  Further, audit staff had
a limited basis on which to classify and select returns that had the
most audit potential.  Unlike the approaches for selecting other
corporate returns, IRS' approach for these large corporate returns
gave a great deal of discretion to audit staff.  However, the staff
had little information on previously audited corporations or industry
issues to serve as guideposts.  Finally, the agents had difficulty
obtaining information in a timely manner from large corporations.  In
sum, all of these aspects can contribute to a reduction in the amount
of taxes recommended per audit hour and, with the possible exception
of the problems in selecting returns, can affect the assessment rate. 

Fourth, Appeals usually did not share with Examination information
that could be used to educate revenue agents.  Appeals' staff shared
new information submitted by large corporations in less than half of
our sample cases because of the time pressures to settle cases or
their uncertainty in defining "significant." Appeals is required to
share only significant new information with Examination.  Without the
new information, revenue agents have a harder time understanding the
rationale(s) Appeals used in resolving a dispute.  Even if Appeals
did share information, revenue agents did not always have time to
review the new information due to time pressures to do other audits. 
Further, although Appeals usually shared the final settlement on
disputed issues, Examination management often did not distribute
those results to the revenue agents.  Such feedback can help agents
decide whether and how to audit similar issues in the future with
better support for any recommended taxes. 


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

Our objective was to determine what factors affected the results of
auditing large corporations as well as the amount of additional taxes
recommended in these audits that are ultimately assessed.  To
accomplish our objective, we used two methodologies.  First, we sent
questionnaires to IRS revenue agents, IRS appeals officers, and
corporate taxpayers associated with a nationally representative
sample of audits in which a large corporation agreed with the
additional recommended taxes at the end of either the audit or
appeals processes during fiscal year 1994.\6 To focus on larger
audits, we restricted this questionnaire study to the universe of
large corporate audits with $75,000 or more in recommended additional
taxes and concentrated about one-third of the sample in a stratum
with recommended taxes of $1 million or more.  Our sample of 500
included about $2.3 billion of the $2.6 billion in recommended
additional taxes and $648 million of the $810 million in taxes
assessed from the 1,266 large corporate audits in our universe. 
Appendix I provides a detailed description of our sample selection
methodology. 

We also sent a more general questionnaire to IRS group managers
because, being responsible for many types of audits, they were not as
likely as the above respondents to recall information about specific
audits of large corporations.  We randomly sampled group managers
nationwide who had large corporate audits in their inventories as of
August 1995.  Questionnaire results for revenue agents, group
managers, and appeals officers are presented in appendices II through
IV, respectively.  Because the questionnaires were sent to a sample
rather than all members of their respective universes, all of the
sample results are subject to sampling error.  Unless otherwise
noted, all estimates presented in this report have a 95 percent
confidence interval of less than plus or minus 10 percent. 
Questionnaire results for the large corporations are not included
because of a low response rate that did not allow us to develop
estimates. 

Second, we obtained input from various IRS staff.  We visited IRS'
National Office, its 4 regional offices, and 7 of its 33 district and
appeals offices to interview key officials.  During the design phase
of our review, we visited three additional districts and two
additional appeals offices.  In the National Office, we contacted
officials in the Examination Division, National Appeals Office, and
the Strategic Planning Division.  In conjunction with our site
visits, we interviewed selected Appeals, District Counsel, and
Examination officials to obtain their views.  Appendix V lists all
locations visited and the officials interviewed at each location.  In
addition, we asked the Examination Chiefs in all 33 IRS district
offices nationwide and Appeals Chiefs in all 33 appeals offices
nationwide to give us their written comments on certain factors
related to these large corporate audits.  We received responses from
31 (94 percent) of the Examination Chiefs and 30 (91 percent) of the
Appeals Chiefs.  Their views are incorporated throughout this report. 

We obtained oral comments on a draft of our report from IRS and the
Tax Executives Institute (TEI).\7 We discuss such comments and our
evaluation of them at the end of this letter.  Overall, we conducted
our work at IRS' National Office, 4 regional offices, 10 of the 33
district offices, and 9 of the 33 appeals offices.  In addition, we
used questionnaires received from all of IRS' 33 district offices. 
We also asked Examination Chiefs and Appeals Chiefs nationwide to
give us their comments on factors related to these large corporate
audits.  We did our work from May 1995 to November 1996 in accordance
with generally accepted government auditing standards. 


--------------------
\6 We chose fiscal year 1994 because it was the most recent year for
which data were available on such closed audits. 

\7 TEI represents about 3,600 of the largest corporations, including
most CEP corporations. 


   RECENT STATISTICS RAISE ISSUES
   ABOUT AUDITS OF LARGE
   CORPORATIONS
------------------------------------------------------------ Letter :4

Our 1995 report on large corporate audit trends provided statistics
on IRS audits of large corporations between fiscal years 1988 and
1994.  These statistics covered the audit results and assessment rate
over this 7-year period.  Neither we nor IRS knows what the
assessment rate should be, but these statistics indicate that IRS has
been investing a lot of time and money recommending additional taxes
that do not get assessed. 

For example, in a comparison of data for 1988 and 1994, we found that
IRS invested more resources in large corporate audits but recommended
less additional tax per hour.  IRS spent 25 percent more hours and
audited only 3 percent more returns.  Even so, the amount of taxes
recommended (in constant dollars) dropped 23 percent per audit hour
and 7 percent per audited return.  In addition, IRS' no-change rate
doubled from 8 percent to 16 percent. 

Further, for the 7-year period, we computed that IRS assessed, on
average, 27 percent of the additional taxes that IRS revenue agents
recommended in these audits.  The assessment rate includes the amount
of recommended taxes that the large corporations agreed to pay at the
end of the audit as well as those amounts sustained after any appeal. 
Over the 7 years, large corporations appealed between 66 and 85
percent of the additional taxes recommended and agreed to pay the
rest.  Since 1990, corporate taxpayers have been appealing a lower
percentage of the recommended taxes and agreeing to a higher
percentage. 


   FACTORS AFFECTING ASSESSMENT
   RATE AND AUDIT RESULTS
------------------------------------------------------------ Letter :5

We identified four factors that affected the assessment rate and/or
audit results, such as the lower recommended taxes per audit hour in
1994 compared to 1988.  Although the exact impact is unknown, each
factor can affect both the rate and results.  For example, three of
the four factors--complex tax laws, conflicting performance measures
between Examination and Appeals, and limited coordination between
these two IRS functions--can produce a lower assessment rate. 

As for lower audit results, the three factors can each have a
different impact.  Complex laws cause IRS' audits to be very time
consuming, which can lower the amount of recommended taxes per hour. 
Although Examination's performance measures would encourage higher
amounts of recommended tax, Appeals measures would not be as likely
to affect the audit results.  Limited coordination between Appeals
and Examination was unlikely to affect the audit results being
disputed by corporations because the audits had already been done. 
On the other hand, future audit results on similar tax issues were
likely to be reduced when revenue agents did not receive feedback on
which disputed issues were conceded and why; such knowledge could
enhance future audits. 

The fourth factor entailed a number of aspects of an audit that could
reduce the taxes recommended per audit hour or the assessment rate. 
Because revenue agents generally worked alone without much assistance
from counsel or their management, they needed more time to develop
enough support to recommend taxes that could be assessed after an
appeal.  These agents also did not have a sufficient basis for
selecting corporate tax returns with potential for significant tax
changes.  Generally, audits of returns with low potential were more
likely to result in recommendations for little or no tax change and
were less likely to be appealed.  Thus, these audits would generally
have little effect on the assessment rate.  However, when a revenue
agent tried to recommend taxes without sufficient support, such
recommended taxes would not likely be sustained in Appeals, and the
assessment rate would be lower.  The following sections discuss each
of these four factors in more detail. 


      TAX LAW COMPLICATES IRS'
      AUDITS OF LARGE CORPORATIONS
---------------------------------------------------------- Letter :5.1

IRS and large corporate taxpayers can have legitimate differences
over how tax laws should be interpreted.  We found that complex,
ambiguous laws have created opportunities for both large corporations
and IRS to interpret the tax laws differently.  This discretion, in
turn, increased the likelihood of tax disputes.  Without clear tax
laws, resolution of these disputes can get complicated and can
ultimately depend on the negotiating skills of the IRS and corporate
representatives.  Because the corporate representatives have usually
prevailed in Appeals or the courts, recommended additional taxes have
tended not to be assessed. 

We have previously reported that the federal tax laws are complex,
difficult to understand, and in some cases indecipherable.\8 Some of
the large corporate officials who responded to our survey indicated
that a major reason for disputing recommended taxes was revenue
agents' interpretation of tax laws.  We estimate that revenue agents
judged that about 86 percent of the corporate tax disputes were due
to different interpretations of the tax laws.\9 Appeals officers in
our universe cited the hazards of litigation as the primary reason
for resolving these interpretive differences in favor of the
corporations for an estimated 56 percent of the additional taxes
being appealed.\10 The National Director of Appeals told us in a
letter that these audits often raise issues involving substantial
doubt or variances of opinion because these issues are complex and
not definitively answered by litigation. 

The complex tax laws also affected IRS' ability to conduct audits,
according to 21 of the 33 Examination Chiefs and 27 of the 33 Appeals
Chiefs nationwide.  Such complexity, in combination with the broad
scope of the tax laws, made it difficult for IRS to ensure that its
revenue agents stayed current in their tax law knowledge and for
large corporations to comply with the tax laws. 

Our interviews of Examination, Appeals, and Counsel officials at the
national and field levels showed a consistent belief that IRS' system
created little risk for corporations in appealing the recommended
taxes.  In a letter to us, the National Director of Appeals wrote: 

     "Taxpayers are aware of the difficulty of determining with
     exactness the liability that they have.  They are also aware
     that the courts cannot resolve all disputes arising out of the
     audit process.  Therefore, the Service must pursue the
     administrative resolution of these cases whenever possible.  The
     fact that the Service is highly motivated to resolve cases
     without litigation means that compromises on difficult and
     controversial issues will take place.  Knowing this, taxpayers
     naturally take advantage of the process to dispute those issues
     on which some doubt exists."

To help resolve problems with tax law complexity and recurring issues
in CEP audits, our 1994 report recommended that IRS should more
strongly propose changes to the tax laws.\11 IRS agreed and has
established a work group to evaluate ways to implement this
recommendation.  To the extent that IRS is successful in getting
Congress to simplify the various complex tax issues, large
corporations are likely to benefit as well as IRS. 


--------------------
\8 Tax System Burden:  Tax Compliance Burden Faced by Business
Taxpayers (GAO/T-GGD-95-42, Dec.  9, 1994). 

\9 Because the revenue agent and appeals officer questionnaires
pertain to a sample of tax returns, rather than to all returns, all
results are subject to sampling error.  Unless otherwise noted, all
estimates presented in this report have a 95 percent confidence
interval of less than plus or minus 10 percent. 

\10 The 95 percent confidence interval (plus or minus 32 percent)
ranges from 24 to 86 percent. 

\11 GAO/GGD-94-70, Sept.  1, 1994. 


      DIFFERING MEASURES IN
      EXAMINATION AND APPEALS MAY
      HAVE REDUCED THE ASSESSMENT
      RATE
---------------------------------------------------------- Letter :5.2

IRS' overall mission is to collect the proper amount of taxes in a
manner that is efficient and fair and promotes public confidence. 
The Examination and Appeals functions also have important missions
that should contribute to IRS' overall mission.  Revenue agents are
charged with protecting the government's interest in receiving the
proper amount of tax.  They are instructed to make their audit
recommendations without deviating from IRS' legal positions or
considering the hazards of litigation (i.e., the chance of losing in
court).  On the other hand, appeals officers are charged with
resolving tax controversies without litigation to the extent possible
while being fair and impartial to both the government and the
taxpayer.  They are instructed to consider the hazards of litigation
and may concede the recommended taxes in part or in whole on that
basis. 

Performance measures typically move a function toward desired ends
within a mission.  In doing so, the performance measures within the
two functions reflect their respective missions and may not encourage
the functions to work together effectively to accomplish IRS' overall
mission.  For example, Examination has traditionally focused on
measuring the amount of additional taxes recommended per audit and
per audit hour.  On the other hand, Appeals has focused on measuring
the number of tax disputes settled as quickly as possible without
litigation.  These different measures have the potential to lead to a
lower assessment rate.  The audit measures may encourage revenue
agents to propose tax adjustments regardless of whether they can be
sustained on appeal and discourage agents from fully developing
issues because of time pressures to close the audits.  Appeals'
measures may encourage appeals officers to settle more cases in less
time even when some of the recommended taxes have a justifiable basis
under vague or complex tax laws.  As a result, a high proportion of
recommended taxes may not be assessed, but Examination could claim
success for recommending high amounts of taxes and Appeals could
claim success for settling the case without litigation. 

In our 1994 CEP report, we reported a similar situation for CEP
audits and recommended that IRS add an IRS-wide measure, such as the
collection rate, to the functional measures.  Although IRS disagreed
with this recommendation when commenting on a draft of the CEP
report, IRS officials subsequently told us they plan to implement
such an IRS-wide measure in some form during fiscal year 1998.  Such
a measure could similarly be applied to various types of audits,
including audits of other large corporations. 

An IRS-wide measure such as the collection and/or assessment rate
could encourage IRS functions to work together to accomplish IRS'
overall mission of collecting the proper amount of tax.  National
Office Examination and Appeals officials expressed concerns about
possible unintended effects from creating such a measure.  For
example, they said an overall IRS measure such as the assessment rate
could encourage revenue agents to avoid raising difficult audit
issues or appeals officers to settle disputes just to drive up the
assessment rate.  However, this measure of the tax outcomes also
would be likely to encourage revenue agents to more fully develop
audit issues that could be sustained if appealed.\12 As discussed
later, such a measure also could encourage appeals officers to
coordinate with Examination while still remaining impartial and
independent in settling tax disputes. 

As measures are emphasized over time, they become ingrained, making
changes very difficult.  At every location we visited, we heard about
the driving force of existing measures from Examination or Appeals
officials and the difficulty of changing or adding to them.  These
officials noted that as new measures are introduced, the culture of
the organization will resist change and cling to the past. 

Many Examination and Appeals managers we contacted also expressed
concerns over using an assessment rate as a measure for the large
corporate program.  In part, they pointed to impurities in IRS'
databases that do not allow them to separate audit actions from
nonaudit actions, such as claims or net operating losses.  IRS has
been developing a new database to help identify these problems and
their impacts on the revenue collected due to audits and other
enforcement efforts. 

One case in our sample epitomizes the concerns about the assessment
rate being skewed by nonaudit actions.  In this case, the revenue
agent recommended several hundred million dollars in additional
taxes.  Appeals sustained 100 percent of the issues and the taxes
recommended by the revenue agent.  However, the large corporation
submitted additional information as well as a net operating loss and
other claims during the Appeals process.  Appeals accepted and
approved these losses and claims.  The losses and claims almost
completely offset the additional taxes recommended by the revenue
agent.  As a result, about 1 percent of the recommended taxes was
assessed.  Until the databases account for them, nonaudit actions
that are considered during the Appeals process will continue to
overstate or understate the rate at which taxes recommended in audits
get assessed. 

On the other hand, of the 40 regional and district officials we
interviewed, 14 told us they supported using the assessment rate. 
One Appeals Chief told us "The measurement standards would be more
appropriately based on dollars ultimately assessed and collected." In
addition, at least one official from each function--Appeals, Counsel,
and Examination--in the four regions told us that both Examination
and Appeals should be accountable for the assessment rate.  Further,
7 of 33 Chiefs of Examination said they already used a
cross-functional measure, such as the amount of additional taxes
recommended that gets assessed, as an additional way to evaluate
audit effectiveness. 


--------------------
\12 Given Examination's mission and the complex tax laws, revenue
agents still will raise some issues that are unlikely to be sustained
upon appeal. 


      AUDIT CIRCUMSTANCES HINDERED
      REVENUE AGENTS FROM
      DEVELOPING RECOMMENDED TAXES
      THAT COULD BE SUSTAINED
---------------------------------------------------------- Letter :5.3

Audits of these large corporations can be complex and technical but
are generally done by a single revenue agent.  Although they worked
alone, these revenue agents received little assistance from district
counsel or their group managers.  Also, IRS' approach for classifying
and selecting these large corporate returns did not help ensure that
revenue agents spent their audit time on the most noncompliant
returns.  Finally, the agents had difficulty obtaining information
from the large corporations.  In combination, these circumstances
made it difficult for revenue agents to recommend taxes that had
enough support to be assessed without investing a lot of time. 


         REVENUE AGENTS' CORPORATE
         AUDIT EXPERIENCE AND
         TRAINING LIMITED
-------------------------------------------------------- Letter :5.3.1

IRS officials said the level of large corporate auditing experience
for revenue agents was not as high as they would like it to be.  For
the large corporations in our study, the average return was audited
by a single revenue agent with about 8.5 years of corporate auditing
experience.\13 IRS has lost about 1,800 experienced revenue agents
over the past 3 years.  IRS National Office Examination officials as
well as regional and district officials interviewed noted that if IRS
continues to lose its senior revenue agents without being able to
replace them, corporate audits will become less productive.\14
Furthermore, these agents could not easily develop corporate
expertise because they generally conducted many other types of
audits, such as those of partnerships and individuals. 

Given the level of experience of these revenue agents and the
complexity of the tax law, training in corporate income tax practices
and the tax laws is important.  In this regard, the revenue agents in
an estimated 38 percent of the audits in our study population
believed that they needed, but had not received, training that would
have improved their ability to conduct their audits.  A common need
cited was for more industry-related training.  Further, 25 of the 33
Examination Chiefs nationwide indicated that additional training in
specific industries would enhance audits of complex, technical
issues.  A regional task force cited a need for additional training
so revenue agents could become more proficient in recognizing and
developing corporate issues.\15 In February 1997, National Office
Examination officials told us they were developing a specific course
that will be used to train all revenue agents assigned to large
corporate audits.  To help guide revenue agents doing large corporate
audits, they also planned to have audit criteria and procedures in
place by the end of calendar year 1998. 

However, six Examination Chiefs pointed out the difficulty in
providing additional training when training funds have been diverted
to other areas because of budget limitations.  For example, one
Examination Chief told us that for fiscal year 1996 the training
budget was cut so severely that Examination could not conduct
continuing professional education for revenue agents.\16 National
Office Examination officials told us during November 1996 that IRS
added $10 million to fiscal year 1997 training funds across IRS, of
which Examination received $1.4 million.  According to one of the
officials, these funds should help Examination provide most, but not
all, of the basic continuing professional education training to its
revenue agents.  Moreover, this official said funding for training is
unlikely to improve for fiscal year 1998 under the current budget
environment. 


--------------------
\13 For comparison, CEP revenue agents averaged about 18 years of
corporate auditing experience.  Unlike revenue agents conducting
large corporate audits, CEP revenue agents also tended to continually
audit CEP corporations.  Further, CEP revenue agents were assisted by
other revenue agents and specialists, including counsel.  An on-site
team coordinator directed the work of the agents and reported to a
CEP case manager, who usually oversaw several audits. 

\14 According to a National Office official, IRS compliance staffing,
including revenue agents, is expected to decrease further during
fiscal year 1997. 

\15 The Western Region Corporate Results Task Force Report, dated
March 1995. 

\16 The purpose of continuing professional education is to provide
revenue agents with the current knowledge and skills needed to
successfully conduct audits. 


         LIMITED COUNSEL AND
         MANAGERIAL ASSISTANCE
-------------------------------------------------------- Letter :5.3.2

Working alone on these corporate audits, revenue agents may need
assistance in planning and developing their audits.  However, we
found that revenue agents usually did not request assistance from
district counsel or their group managers on planning and doing the
audits. 

Revenue agents for most of the 1,266 audits in our study population
said they did not request any legal assistance on matters of tax law
or overall issue development.  We estimate that revenue agents
reported requesting assistance from the Office of District Counsel
for about 14 percent of the audits, and from the Office of Chief
Counsel for about 8 percent of the audits.  However, for an estimated
55 percent of those audits in which revenue agents requested
assistance, they judged that such assistance had a positive or very
positive effect on their ability to obtain the taxpayers'
agreement.\17 Appeals officers consulted with district counsel during
resolution of an estimated 20 percent of the most significant issues
raised by revenue agents.  For about half of these consultations, the
appeals officers indicated that District Counsel helped them to
resolve the disputes to a great or very great extent. 

Our interviews with district office officials identified a major
reason for infrequent requests for legal assistance.  These officials
were concerned about revenue agents and appeals officers not
receiving the assistance in a timely manner.  Counsel officials in
the four districts we visited acknowledged that responding to
requests for formal legal assistance can be time-consuming.  However,
these officials told us they could help improve the effectiveness of
the large corporation audits by assisting the revenue agent in
developing audit issues and obtaining requested information.  They
believed that such involvement could be justified and helpful.  In
February 1997, National Office Examination officials told us that
Counsel involvement in CEP cases is working well and support looking
for ways to increase Counsel's involvement in the large corporate
cases.  However, Counsel officials cautioned that increased
involvement would have to be on a selective and informal basis due to
staffing constraints.\18

Less than half of the revenue agents in our universe indicated their
group managers were involved in identifying audit issues, discussing
complex audit issues, obtaining information from the taxpayer, or
resolving disputed issues.  In well over half of those audits in
which revenue agents indicated their managers were involved, the
revenue agents indicated that such involvement helped them.  For
example, we estimated that in 207 of the audits in our population,
revenue agents indicated that their group managers were involved in
obtaining requested information from taxpayers; in an estimated 83
percent of those audits, the revenue agents viewed such involvement
as either very positive or somewhat positive. 

Examination officials and the regional task force report provided
insights on why managers were not more frequently involved in agents'
audits.  For example, they said most group managers did not have
sufficient experience or time to substantially assist revenue agents. 
Examination officials from the districts we visited told us that
group managers were responsible for many revenue agents and other
auditors who audit a range of tax entities, from individual returns
through complex corporate returns, that involve different tax rules
and issues.  Officials said that group managers tended to focus their
attention on newer staff and administrative duties.  They said that
as a result, revenue agents were left to conduct these corporate
audits with minimal managerial involvement, and group managers lost
the opportunity to develop their corporate audit experience. 

Both the Examination officials and the regional task force report
concluded that these large corporate audits were more effective when
group managers with corporate audit experience were actively
involved.  For example, 20 of the Examination Chiefs nationwide
indicated that group manager involvement was crucial to the success
of these audits. 

To increase managerial involvement and audit effectiveness, four
districts we visited had recently created groups of existing revenue
agents that specialized in large corporate audits.  Managers with
extensive corporate auditing experience led these groups to help
their agents get assistance in selecting, planning, and doing audits. 
District officials believed that these groups, although fairly new,
have improved the effectiveness of large corporate audits because, in
part, of the focus and assistance of group managers. 

IRS' National Office has not yet issued any uniform guidance on how
to measure the success of these groups.  Accordingly, not all
districts were consistently measuring the impacts; some were focusing
on different audit results (e.g., recommended taxes per hour versus
no-change rate).  National Office Examination officials told us that
they would like to learn more about the impacts of these specialized
groups across the districts that had created them. 

In evaluating these groups, it is important to recognize that some
districts may not have enough corporate workload or revenue agents to
justify these specialized groups.  That is, such districts may wish
to maintain flexibility in using revenue agents on other than large
corporate audits.  At least one Examination Chief was concerned about
the potential impacts on audit results in the short term.  Even so,
officials in these districts believed that these specialized groups
will ultimately yield better large corporate audit results,
cancelling out any initial decline in the results.  And, if the
districts who were experimenting with such groups maintain a similar
level of investment in large corporate audits, shifting the agents
into specialized groups would not necessarily increase IRS' costs or
reduce resources for other types of audits. 


--------------------
\17 The 95 percent confidence interval (plus or minus 15 percent)
ranges from 40 to 70 percent. 

\18 District Counsel officials said they can provide informal
assistance more quickly at a lower cost compared to formal
assistance.  They did not provide data on the differences. 


         INCONSISTENT APPROACH
         AMONG DISTRICTS FOR
         SELECTING CORPORATE
         RETURNS FOR AUDIT
-------------------------------------------------------- Letter :5.3.3

Compared to CEP tax returns, the approach for selecting these large
corporate returns was more subjective and varied.  To determine which
large corporations to select for CEP, IRS scores corporate tax
returns on specific criteria, such as corporate structure, assets,
and income.  IRS does not have a consistent approach or criteria for
classifying and selecting tax returns for large corporations not in
CEP.  The approach and criteria varied by district. 

In general, revenue agents and/or their group managers selected the
returns to audit, depending on the IRS district.  Many districts
charged revenue agents with both classifying and selecting issues for
audit, and some districts had other auditors do the initial selection
and classification.  Some districts relied on service center staff to
classify large corporate returns, using criteria provided by that
district, or subjectively without using any such criteria before
sending the selected returns to the district. 

In sum, our analysis of questionnaire responses and our interviews
with IRS officials showed that the IRS staff doing the selection and
classification had to ultimately rely on their experience and
judgment about audit potential.  They had limited criteria and little
information on (1) any previous audits of the large corporation or
(2) overall large corporate audit results by issue and industry to
guide their decisions.  Some of these staff may be sufficiently
experienced to find returns that would be productive to audit. 
However, the audit results in fiscal year 1994 showed that more
returns were audited without any recommended tax changes or with
lower amounts of recommended tax per audit hour than in fiscal year
1988. 

National Office Examination officials have expressed similar concerns
about their selection and classification system for large corporate
audits.  They established a task force to develop a more structured
system, but budget constraints have stalled the task force's efforts. 
In lieu of the task force, the National Office is testing the
benefits of providing additional information on a corporation, such
as Securities and Exchange Commission (SEC) reports, to the revenue
agent reviewing the corporate return.  Examination is also testing
potential improvements to the classification system; none of the
tests are far enough along to have useable results.  Selected IRS
districts are testing classification of returns by market segment.\19

Also, IRS is developing the Examination Operational Automated
Database in an attempt to capture audit results by issue and
industry.  Examination officials believe that this database could be
used to enhance any selection and classification system by providing
feedback on tax issues (e.g., unreported gross receipts, overstated
travel expenses) by industry (e.g., manufacturing, wholesale trade)
that have proven to be productive to audit.  That is, IRS could
identify issues and industries in which audits generated more
recommended taxes per audit hour.  By tracking such audit results,
Examination officials believed that this database will be
particularly helpful in classifying audit issues.  These officials
said IRS already had most of the necessary hardware and software. 
They estimated that enhancements in fiscal year 1997 would cost about
$320,000 and that administrative costs would average a staff year per
district.  This system is being tested in two IRS districts and is
expected to be operational by the end of calendar year 1998. 

Further, IRS officials from some districts with groups specializing
in audits of large corporations told us such groups have helped
improve the return selection and classification processes at these
districts.  These groups can improve not only the selection process
but ultimately the productivity of these corporate audits.  For
example, in one district, an Examination official told us that while
the overall percentage of audits closed with no additional tax
recommended was about 10 percent, the rate within the specialized
group was only about 3 percent.\20 Such audits can result in
ineffective use of IRS' as well as the corporations' resources. 


--------------------
\19 A market segment is a specific group of taxpayers that share
certain characteristics and behaviors. 

\20 As discussed earlier, the nationwide no-change rate doubled (not
decreased) between fiscal years 1988 and 1994. 


         DIFFICULTY IN OBTAINING
         INFORMATION TO SUPPORT
         TAX RECOMMENDATIONS
-------------------------------------------------------- Letter :5.3.4

During audits, revenue agents may question items on the return, such
as income, deductions, or credits.  If a corporation cannot provide
adequate information as support, the revenue agent may adjust the
items, which usually results in additional taxes being recommended. 
Both the revenue agents and large corporations contributed to
problems in obtaining such information.  Not having the information
hindered IRS' ability to do effective audits and support tax
recommendations. 

Appeals and Counsel officials in all four districts we visited told
us that revenue agents do not always have adequate information to
support recommended taxes.  Taxpayers provided information to Appeals
that had not been provided to the revenue agents in an estimated 53
percent of the disputed audits.\21 Appeals officers for some of the
audits noted that revenue agents had provided insufficient
information to justify their development of an audit position.  For
example, appeals officers for an estimated 27 percent of the disputed
audits indicated that not all of the top three dollar issues had been
fully developed by the revenue agents during the audit. 

Examination and Appeals officials told us that some corporate
taxpayers did not always provide requested information in a timely
manner, if at all.  Corporations can have difficulty providing
information when IRS' requests are vague, for old data, or made late
in the audit.  On the other hand, corporations have little incentive
to provide all information, particularly if it will lead revenue
agents to make adjustments or to audit other areas on the tax return. 
IRS officials we interviewed believed that problems in obtaining all
the information needed to support tax recommendations were becoming
more prevalent. 

Examination, Appeals, and Counsel officials said agents should ensure
that they have adequate information to support tax recommendations. 
They also expressed the opinion that the recently formed specialized
groups can increase managerial and counsel involvement in helping
revenue agents obtain the information needed to support their
recommended taxes.  They noted that these group managers, when
involved, were usually able to help agents obtain requested
information from taxpayers. 

Counsel officials told us that their involvement, including the
discussion and issuance of summons when needed, could help secure
information.  They noted that revenue agents need to make information
requests early in the audit so that the summons process, if needed,
can begin as soon as possible, enhancing its effectiveness.  IRS
generally uses a summons as a last resort, meaning IRS has tried all
other administrative means of obtaining requested information. 
Although used infrequently, a summons can prompt large corporations
to provide the requested information.  If it does, the investment in
time and money can prove to be worthwhile compared to spending time
awaiting information that may not be received. 


--------------------
\21 Because large corporations can appeal numerous issues, our
questionnaire focused on the three disputed issues involving the
highest amounts of recommended adjustments.  In these instances
taxpayers may have provided Appeals new information on at least one
of the top three dollar issues. 


      COORDINATION BETWEEN APPEALS
      AND EXAMINATION WAS LIMITED
---------------------------------------------------------- Letter :5.4

During the appeals process for large corporate audits, coordination
between Appeals and Examination was limited.  Appeals generally did
not share with Examination new information from large corporations. 
Sharing this information would give revenue agents the opportunity to
review it and provide their comments to Appeals before the
settlement.  After the final settlement, Examination did not always
distribute Appeals' summary of that settlement to its revenue agents. 
Our work showed that such limited coordination resulted from
insufficient requirements and incentives to coordinate.  Although
Appeals' independence in settling tax disputes is critical, limited
coordination between the two functions can hinder IRS' efforts to
reach a balanced settlement as well as to improve future audits. 

Appeals officers for an estimated 25 percent of the disputed audits
indicated they had no interaction with revenue agents while resolving
the disputed tax issues.  Appeals and Examination officials have
acknowledged such limited coordination overall.  An Appeals task
force draft report cited Examination's concerns about the current
Appeals process not providing Examination with an opportunity to
present its views on key issues prior to resolution.\22 Knowing that
large corporations usually have unlimited access to the appeals
officer to discuss the dispute, Examination officials said limited
involvement and coordination with Appeals creates the appearance that
the government's interest is not fairly represented and that the
Appeals process is not balanced. 

This appearance of bias can be aggravated when an appeals officer
does not share with Examination staff new information provided by
large corporations.  Appeals officers for an estimated 53 percent of
the disputed audits in our study population indicated that large
corporations provided additional factual information for at least one
of the top three dollar issues.  However, the appeals officers asked
Examination to review the new information in 139, or an estimated 43
percent, of those disputed audits in which corporations provided new
information.\23 Revenue agents reported a similar lack of
coordination.  They indicated that Appeals asked them about new
information in only an estimated 17 percent of all disputed audits. 
Neither we nor IRS knows whether the appeals officers should have
shared the new information in these cases.  Our CEP work indicated
that CEP corporations are more likely to win more disputes when they
provide information to Appeals that Examination has not had the
opportunity to review. 

In addition, Examination officials told us that Appeals seldom shared
the proposed settlement with Examination so that revenue agents could
have one last look at how the dispute was to be settled and whether
any new information played a part.  National Office Examination
officials told us in February 1997 that they do not believe it is
realistic for Appeals to share proposed settlements in every case. 
However, Examination wanted the opportunity to review and discuss new
information submitted after the audit closed. 

Two reasons help explain this limited sharing with Examination staff. 
First, although IRS does require appeals officers to share
significant new information with Examination, it left the definition
of "significant" to the discretion of each appeals officer,
recognizing that sharing all new information would not be realistic. 
Given the uncertainty over this requirement, Appeals could not ensure
that the significant information had been shared.  Without a
definition of significant and without adequate controls to ensure
that all significant new information is shared, neither we nor IRS
knew whether the appeals officers involved with our study population
had met the requirement for sharing significant new information. 
Also, IRS did not require Appeals to share its proposed settlements
with Examination. 

Second, the limited sharing partially resulted from the differing
roles and incentives driving the work of Examination and Appeals. 
Appeals Chiefs we interviewed said they encourage appeals officers to
involve the revenue agents in reviewing new information but advised
their appeals officers to be conscious of the time and costs to do
so.  That is, if the appeals officers believe they can review the
information in a shorter period of time than a revenue agent can, the
appeals officers should most likely do it.  Our interviews with
Examination officials also indicated that many revenue agents have
little incentive to spend time reviewing new information on a case
that Examination has already closed.  Further, both Appeals and
Examination officials at the National Office said that sharing all
new information would be unnecessary and too time-consuming.  In
February 1997, these Appeals officials told us they believed much of
the new information submitted by taxpayers was not significant. 

Regardless, sharing significant new information, especially that
relating to issues that may not be sustained, would help IRS to
maintain its designed separation of duties--revenue agents could
audit the new information and appeals officers could focus on
settling the entire dispute.  To help meet this end, our 1994 CEP
report recommended that IRS improve controls to ensure that Appeals
provides CEP teams an opportunity to comment on proposed settlements. 
IRS disagreed at the time, but Appeals subsequently proposed a
procedure to promote better communication with Examination and better
settlement of key issues in CEP cases.  Under that proposal,
Examination could identify five key issues in a case nearing
settlement and Appeals would not settle the key issues until it had
considered feedback from Examination.  This way, Examination would
have the opportunity to review the proposed settlement and advise
Appeals of any significant facts, laws, or other factors that may
need further consideration.  According to many Examination and
Appeals officials we interviewed in the districts, allowing
Examination to provide this input could add balance to the appeals
process without adversely affecting Appeals' independence.  The
proposed procedure also could help ensure that Appeals provides
Examination with significant new information that taxpayers submit
and an opportunity to comment just prior to settling a case. 

Recognizing that taking these steps could involve some additional
time, both Examination and Appeals officials told us during our field
visits in early 1996 that the steps were worth taking.  However, in
November 1996, National Office Appeals officials told us that IRS had
recently decided not to implement testing of this proposed procedure
because of concerns by both Appeals officials and large corporations
that such a procedure could impede Appeals' ability to independently
settle tax disputes.  However, these Appeals officials said that
Appeals' independence would not necessarily have to suffer under this
proposal. 

Regarding final settlements, Appeals has a procedure for sending a
copy of the final written summary to Examination, but Examination has
no process in place to ensure that this feedback reaches the
appropriate revenue agent.  Revenue agents indicated that they
received the written summary in an estimated 61 percent of the
disputed audits.  Examination officials and revenue agents told us
that this summary can provide insights on why a recommended tax
adjustment was or was not sustained on appeal.  For example, the
summary typically discusses the reasons for settling the disputes,
such as hazards of litigation.\24 Without knowledge of significant
facts or laws followed in the settlement, the revenue agents lose an
opportunity to learn about the types of tax issues involved in the
case and the support needed to sustain future tax disputes. 

In summary, Appeals attempts to provide large corporations with a
review of their tax disputes that is independent of Examination or
other IRS functions before these corporations decide whether to
litigate.  However, both Examination and Appeals officials told us
that increased coordination and communication could help to improve
their working relationship and to correct the appearance of
imbalances during appeals without reducing the independence.  To
illustrate this point, a Regional Chief Compliance Officer told us
about the need for more balance whenever large corporations withhold
information during the audit but provide that information to Appeals. 
Examination Chiefs told us more interaction would afford an
opportunity for their agents to better explain their recommended
taxes as well as any difficulties they may have had in obtaining
information to support their recommendations. 


--------------------
\22 Proposed Procedure for Settlement of CEP Cases in Appeals
(Western Region). 

\23 The 95 percent confidence interval (plus or minus 14 percent)
ranges from 29 to 57 percent. 

\24 Appeals is studying the effectiveness of the written summary and
whether it can be shorter.  One Appeals official told us about
concerns with reducing the discussion of important settlement
considerations.  Any reduction could also reduce insights that
revenue agents garner from the summaries. 


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

Our analysis of questionnaire responses and interviews with IRS
officials identified at least four factors that contributed to the
low assessment rate or decline in audit results for 1988 to 1994. 
First, complex tax laws impeded revenue agents' efforts to determine
the correct tax liability and appeals officers' efforts to fairly
settle tax disputes.  Second, differing performance measures prompted
revenue agents to recommend as much tax as soon as possible and
appeals officers to settle tax disputes without litigation as soon as
possible.  We recommended in our 1994 report that IRS more strongly
propose legislative changes to reduce tax law complexity and consider
cross-functional measures, such as the collection and/or assessment
rate.  IRS is taking action on both of these recommendations.  We
make no new recommendations on these issues because our 1994
recommendations can also apply to audits of other large corporations. 

Third, various aspects of the audit process impeded revenue agents'
ability to develop recommended taxes that can survive appeals.  IRS
recognized these aspects but faced constraints in surmounting them. 
Budget pressures limited the use of team auditing to buttress agents'
lack of expertise in auditing large corporations.  The broad and
complex nature of tax administration complicated efforts to carve out
more time for group managers and district counsels to formally assist
revenue agents--who often work alone without much assistance. 
Revenue agents viewed such assistance, whether formal or informal, as
helpful in identifying and discussing audit issues, requesting
corporate information, and pursuing requests that have not been
answered.  Further, IRS initiated efforts, such as a task force to
study ways to improve return selection and classification, but these
efforts stalled due to budget constraints. 

Some IRS districts have taken a step that could address many of these
problems.  They have combined senior revenue agents and managers into
groups that specialize in large corporate audits.  Examination
officials in districts that created these groups believed that their
initial experiences indicated that the groups helped improve return
selection and classification, information gathering, and audit
productivity.  They also believed that the groups allowed managers
and agents to share knowledge and assistance in a focused, timely
way.  However, the districts generally had limited data on the actual
impacts of these groups, and IRS' National Office has not provided
criteria or oversight to guide the measurement of the impacts. 
National Office Examination officials said they would like to learn
about the impacts of these groups across the districts. 

Fourth, the Appeals and Examination functions did not always share
information.  Unlike CEP teams that have an ongoing audit presence,
revenue agents who audit these large corporations move on to other
audits.  We recognize that sharing all information would not be
realistic; however, Appeals could inform Examination officials of any
new information that would cause the appealed issues to not be fully
sustained.  Doing so would help IRS to maintain the intended
separation of duties.  Examination could have an opportunity to audit
the new information and Appeals officers could then focus on their
responsibility for settling the entire dispute.  After a dispute was
settled, Examination did not have a system for regularly sharing
Appeals' summaries of the final settlements with revenue agents. 
Knowing about the final settlement could help agents to learn about
and support tax issues that could sustain appeals.  For any form of
enhanced sharing, maintaining Appeals' independence would be
paramount. 

In recommending improvements, we tried to recognize the costs and
constraints to IRS.  Most of our recommendations will entail limited
costs.  For example, providing more specific, objective guidance and
criteria on return selection need not be an expensive proposition,
particularly if the new database on audit results helps to identify
the types of large corporations and tax issues that have proven
productive to audit.  The use of more informal legal assistance would
create some costs, but that assistance could be provided more quickly
and at less cost than formal assistance.  Further, providing more
structure and guidance to districts on evaluating the impacts of the
specialized audit groups should not cost much and could provide big
dividends if IRS had more certainty about the impacts of these groups
on the productivity of large corporate audits.  Appeals' sharing of
significant new information with Examination could add some time to
resolving the disputes, but that investment should be worthwhile if
the revenue agents learn how to do better audits or help to determine
the correct tax liability.  Even if some costs increase, the
accompanying improvements should help IRS to better invest its
limited enforcement funds in trying to ensure that large corporations
are paying the correct amount of taxes. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :7

To improve the audits of tax returns filed by large corporations, we
recommend that the IRS Commissioner

  -- provide more specific objective criteria and procedures to guide
     the selection of large corporate tax returns and classification
     of tax issues with high audit potential across the districts;

  -- develop criteria and procedures to guide the evaluation across
     the districts of the impacts of groups specializing in audits of
     large corporations;

  -- encourage District Examination management to work with District
     Counsel officials on finding cost-effective ways to provide
     revenue agents with the necessary legal assistance;

  -- require Appeals to notify Examination of new information
     received from a large corporation that could cause the appealed
     issues to not be fully sustained, and require Examination to (1)
     indicate whether it wishes to review the new information and, if
     so; (2) review the information and notify Appeals of the results
     of the review as soon as possible; and

  -- require Examination management to provide feedback to its
     revenue agents on the final settlements that Appeals reaches
     with large corporations. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

We obtained comments on a draft of this report in a meeting on
February 20, 1997, with IRS officials who represented you.  These
officials included a representative of the Commissioner's Office of
Legislative Affairs, a representative of the Chief of Staff to the
Assistant Commissioner of Examination, as well as representatives of
the Large Business Examination Programs, and representatives of the
National Director of Appeals. 

In general, they agreed with our findings and conclusions and
provided a few technical comments on specific sections of the draft. 
We have incorporated these comments, such as on additional training
funds for revenue agents, Appeals' discretion to share significant
new information, and performance measures, in the sections of the
report where appropriate. 

As for our five recommendations, IRS agreed to implement four, as
discussed below. 

  -- First, IRS officials said they have already started to analyze
     closed large corporation audits to develop an objective system
     for better classifying and selecting large corporation returns
     to audit.  IRS plans to begin testing this system in selected
     districts within each IRS region by the summer of 1997 and to
     implement it by the end of 1998. 

  -- Second, IRS officials said they plan to develop criteria and
     procedures to guide the evaluation of the district groups that
     specialize in audits of large corporations.  IRS hopes to finish
     these actions during 1998. 

  -- Third, IRS officials said they plan to issue an IRS-wide memo by
     May 1997 to encourage district Examination management to work
     with District Counsel officials on finding cost-effective ways
     to provide revenue agents with the necessary legal assistance,
     including the use of field service advice and technical advice
     memoranda. 

  -- Fourth, IRS Examination management said it plans to change the
     Internal Revenue Manual to require that revenue agents be
     provided with feedback on Appeals' final settlements with large
     corporations.  Because the next series of changes to the Manual
     will not be done until the end of fiscal year 1997, Examination
     officials plan to issue a memorandum on this requirement during
     May 1997. 

IRS officials did not agree to implement the fifth recommendation
that would require Appeals to share its proposed settlements with
Examination so that Examination could see whether the large
corporation provided new information that affected the settlement. 
Examination officials said they want to see significant new
information, but requiring Appeals to share all proposed settlements
may be too formalized and too strong a process for obtaining the new
information. 

Appeals officials expressed concern that sharing proposed settlements
could create perceptions that Appeals' settlement authority would be
subject to an Examination veto.  This perception could prompt large
corporations to close off Examination's reinvolvement by taking the
dispute to court.  They also believed that this sharing would add
time to the settlement process that usually would be significant and
would not change the final settlement.  Finally, they believed that
reinvolving Examination could produce an adversarial relationship to
the extent that appeals officers felt pressured to justify their
settlement proposals. 

We also asked TEI to provide comments on the same draft report.  We
met with TEI officials on February 21, 1997, to obtain their
comments.  They also supported or had no opposition to the same four
recommendations that IRS agreed to implement.  Although we made no
recommendations on these topics, they supported creating an IRS-wide
performance measure and more training for revenue agents as well as
applying CEP processes to non-CEP audits.  Like IRS, they expressed
similar concerns with the recommendation on sharing proposed
settlements with Examination so that it could see how new information
affected the settlements.  They also expressed the concern that
sharing the proposed settlement may prompt Examination to go beyond
the new information and try to re-audit other issues. 

In recommending that Appeals share proposed settlements to allow
Examination to see whether new information significantly affected the
settlement, we did not intend to undercut Appeals' settlement
authority or grant Examination veto power over settlements; in fact,
our draft report pointed to the importance of retaining Appeals'
independence in settling disputes.  Thus, we did not envision that
the act of sharing would require a highly formalized process or much
time in the majority of cases. 

Rather, our intent was, and still is, to provide an inducement for
appeals officers as well as large corporations to share significant
information with Examination.  We believed that some control or check
was needed to better ensure that Examination had the opportunity to
play its appropriate role in reviewing information to determine the
correct tax liability and protect the government's revenue.  We
intended that the requirement to share would provide a control over
the appeals officers' use of discretion in judging the need to share
new information.  We also intended that this requirement would send a
signal that large corporations cannot intentionally bypass the audit
process by providing new information to appeals officers during
negotiations over tax liability. 

Our focus on the need for a control stems from responses to our
questionnaires and to our interviews with district office officials
during 1996.  Although Examination officials recognized that
communication with Appeals has been improving, Examination officials
and staff still pointed to instances in which they did not have a
chance to review significant new information that a large corporation
had provided to Appeals.  In some cases, they noted that they had
asked for similar information during the audit. 

Even so, we understand the concerns expressed by Appeals and TEI
officials about sharing the significant new information through the
proposed settlements.  We discussed several other ways to address the
concerns and still have IRS provide a control over Appeals' sharing
of new information with Examination.  These discussions prompted us
to change our recommendation on how to better ensure that Examination
has an opportunity to review the new information.  Under our changed
recommendation, Appeals would notify Examination as soon as possible
after a large corporation provided new information that could cause
the disputed issues to not be fully sustained.  Upon notification,
Examination could choose to do nothing, ask for details, or ask to
review the information.  Examination and Appeals would need to
develop procedures on how much time Examination has to request and
review the information, how the information would be shared, how
extensive the review would be, and how the results of the review
would be communicated to Appeals. 

We believe that this option would provide Examination the opportunity
to fulfill its intended roles--determine the correct tax liability
and protect the government's revenue--while mitigating the concerns
raised by Appeals and TEI.  As we envision it, this recommendation
would not delay or disrupt many final settlements because the
information would be shared soon after being received.  One
exception, of course, would be if the information was significant
enough and the review was revealing enough to change the settlement
that the appeals officer would have made without Examination's
involvement.  Even with this exception, settlement authority would
still rest with the appeals officers. 


---------------------------------------------------------- Letter :8.1

This report contains recommendations to you.  As you know, the head
of a federal agency is required by 31 U.S.C.  720 to submit a written
statement on actions taken on the recommendations to the Senate
Committee on Governmental Affairs and the House Committee on
Government Reform and Oversight not later than 60 days after the date
of this letter.  A written statement also must be sent to the House
and Senate Committees on Appropriations with the agency's first
request for appropriations made more than 60 days after the date of
this letter. 

Copies of this report are being sent to the Chairmen and Ranking
Minority Members of the House Committee on Ways and Means and the
Senate Committee on Finance, various other congressional committees,
the Director of the Office of Management and Budget, the Secretary of
the Treasury, and other interested parties.  We also will make it
available to others upon request.  Major contributors to this report
are listed in appendix VI.  Please contact me on (202) 512-8633 if
you or your staff have any questions about this report. 

Sincerely yours,

Lynda D.  Willis
Director, Tax Policy and
 Administration Issues


SAMPLING AND DATA ANALYSIS
METHODOLOGY
=========================================================== Appendix I

This appendix describes how we identified our universe of large
corporate audits closed agreed in Examination or Appeals during
fiscal year 1994 and our sampling methodology.  In addition, it
discusses our methodology for developing and administering
questionnaires to IRS audit and Appeals staff and taxpayers for our
sample. 


   SAMPLE SELECTION METHODOLOGY
--------------------------------------------------------- Appendix I:1

In order to send questionnaires to IRS audit and Appeals staff and
taxpayers, we identified a universe of corporate taxpayers related to
corporate audits closed agreed in Examination or Appeals during
fiscal year 1994.  We chose fiscal year 1994 for two reasons.  First,
it provided us with the most recent cases closed agreed in
Examination or Appeals.  Second, IRS revenue agents and appeals
officers and taxpayers would be more likely to recall specific case
information on the most recent closed cases. 

Our computer analysis of IRS' databases identified a total population
of 1,266 audits closed in fiscal year 1994 with $75,000 or more in
additional taxes recommended.  Table I.1 shows the division of the
1,266 audits by additional taxes recommended. 



                                    Table I.1
                     
                        Corporate Audits Closed Agreed in
                       Examination or Appeals During Fiscal
                        Year 1994 With $75,000 or More in
                           Additional Taxes Recommended

Range of
additional                                     Dollars                   Dollars
taxes                                      recommended                  assessed
recommended on     Number of   Percent of          (in   Percent of          (in
returns               audits        total    millions)        total    millions)
---------------  -----------  -----------  -----------  -----------  -----------
$3 million and           117            9     $1,961.5           76       $459.5
 more
$1 million to            194           15        343.0           13        162.1
 $2,999,999
$300,000 to              334           26        188.9            7        118.7
 $999,999
$75,000 to               621           49         96.9            4         69.5
 $299,999
================================================================================
Totals                 1,266          100     $2,590.4          100       $809.8
--------------------------------------------------------------------------------
Source:  GAO analysis using IRS data. 

We determined that a survey of the revenue agents, appeals officers,
and taxpayers associated with a nationally representative, stratified
random sample of 500 audits would be sufficient to accomplish our
objective.  The sample is divided into six strata based on the
assessment rate and the amount of additional taxes recommended. 
Since those audits with the greatest amount of dollars recommended
have the most affect on the assessment rate, the sample includes a
relatively large number of the larger dollar cases.  We included in
our sample all of the 117 audits with $3 million or more in
additional taxes recommended; 133 of those audits with between
$1,000,000 and $2,999,999 in additional taxes recommended; 120 of
those audits with between $300,000 and $999,999 in additional taxes
recommended; and 130 of those audits with between $75,000 and
$299,999 in additional taxes recommended. 

The 500 cases in our sample accounted for $2.3 billion, or 88
percent, of the total $2.6 billion in additional taxes recommended in
our population.  Similarly, the $648 million in additional taxes
recommended that were assessed accounted for 80 percent of the total
$810 million assessed from the corporate audits shown in table I.1. 
In the study analyses, the sample selections have been properly
weighted to represent the total population of 1,266 audits with $2.6
million in recommended additional taxes. 

Because group managers are responsible for a large number of audits
of different entities, not just corporations, we sampled these
managers without respect to their involvement in any particular
audit.  To do this we asked the 63 district offices to identify all
group managers having large corporate audits in their inventories as
of August 1995.\25

The districts identified 555 group managers meeting this criterion. 
From this universe we randomly selected a sample of at least a third
of the group managers at each of the 63 district offices.  This
resulted in a total sample of 215 group managers.  In our analyses,
the 215 sample selections have been properly weighted to represent
the total population of 555 group managers. 


--------------------
\25 In August 1995, IRS was organized with 63 district offices
nationwide.  However, those 63 district offices were consolidated
into 33 districts as of October 1995. 


      QUESTIONNAIRE METHODOLOGY
------------------------------------------------------- Appendix I:1.1

We developed four mail-out questionnaires to obtain the views of IRS
revenue agents, appeals officers, group managers, and corporate
taxpayers on the factors affecting the audit and appeals processes,
such as obtaining needed information, the effect of the tax laws, and
the interaction between Appeals, Counsel, and Examination staff
involved with these audits. 

We pretested the questionnaires on several separate occasions for
technical accuracy.  We tested the revenue agent and group manager
questionnaire in the Baltimore, Chicago, and St.  Louis District
Offices; the appeals officer questionnaire in the Baltimore and St. 
Louis Appeals Offices; and the taxpayer questionnaire in the St. 
Louis District Office.  In addition to these pretests, we asked
National Office Examination and Appeals officials to review, for
technical accuracy, all questionnaires for IRS staff.  We asked the
Tax Executives Institute (TEI) officials to review the taxpayer
questionnaire for technical accuracy.  From comments received from
both IRS and TEI, we made changes to the questionnaires as
appropriate. 

In August 1995, we sent letters to IRS' 33 district offices
requesting the names and addresses of the revenue agents responsible
for the 500 corporate audits in our sample.  We also requested the
districts to provide us the names and addresses of their group
managers who had corporate income tax audits in their inventories as
of that date.  In addition, we requested from the National Appeals
Office the names and addresses of the appeals officers who considered
any tax disputes involving any of our sample cases. 

We initially mailed revenue agent and group manager questionnaires in
October 1995.  We subsequently sent follow-up questionnaires in
November 1995.  We initially mailed the appeals officer
questionnaires in November 1995 and sent follow-up questionnaires in
December 1995.  We initially mailed the taxpayer questionnaires in
January 1995 with follow-up questionnaires sent in February 1996. 
Table I.2 shows the response rate and disposition of initial sample
selection by type of questionnaire. 



                               Table I.2
                
                Response Rate and Disposition of Initial
                      Sample Selection by Type of
                             Questionnaire

                                 Revenue   Appeals     Group
                                   agent   officer   manager  Taxpayer
------------------------------  --------  --------  --------  --------
Initial sample size                  500       500       215       500
Ineligible sample selections           0     199\a      20\b       3\c
Eligible sample selections           500       301       195       497
Questionnaires not completed         174       161        28       333
No response                         97\d      21\e        21       333
Recipient no longer                   64        21         7         0
 available\f
IRS could not locate                  13       119         0         0
 individual associated with
 case
Questionnaires received              326       140       167       164
Response rate\g                      65%       47%       86%       33%
----------------------------------------------------------------------
\a Included 196 audits in which the taxpayers did not exercise their
appeal rights; two audits in which the taxpayers exercised their
right to appeal, but Appeals subsequently returned the case to
Examination, where it was ultimately settled; and one audit that was
still open in Appeals. 

\b Managers were not responsible for any large corporate audits. 

\c Taxpayers involved in ongoing disputes with IRS. 

\d Included one audit in which the revenue agent could not remember
the case well enough to complete the questionnaire. 

\e Included three audits in which the appeals officers did not
complete the questionnaire because they lacked support records. 

\f Included individuals who had retired prior to receiving the
questionnaire, transferred to another agency, or had died. 

\g Computed response rate by dividing the number of questionnaires
received by the eligible sample selection. 

Questionnaire results for the revenue agent, group manager, and
appeals officer questionnaires are presented in appendixes II, III,
and IV respectively.  Results from the taxpayer questionnaire are not
presented in this report nor are they used in the report because of
the low response rate to the questionnaire. 


      SAMPLING ERRORS FOR KEY
      ESTIMATES USED IN THE REPORT
------------------------------------------------------- Appendix I:1.2

Because the survey results come from samples, all results are
estimates that are subject to sampling errors.  We calculated
sampling errors for all of the survey results presented in this
report.  These sampling errors measure the extent to which samples of
these sizes and structure can be expected to differ from their total
populations.  Each of the sample estimates is surrounded by a 95
percent confidence interval.  This interval indicates that we are
95-percent confident that the results for the total population fall
within this interval. 

In addition to the reported sampling errors, the practical
difficulties of conducting any survey may introduce other types of
errors, commonly referred to as nonsampling errors.  For example,
differences in how a particular question is interpreted, in the
sources of information that are available to respondents, or in the
types of people who do not respond can introduce unwanted variability
into the survey results.  We included steps in our audit for the
purpose of minimizing such nonsampling errors.  For example, we
carefully pretested the questionnaires and made follow-up mailings to
people who did not initially respond. 




(See figure in printed edition.)Appendix II
REVENUE AGENT QUESTIONNAIRE
RESULTS
=========================================================== Appendix I



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(See figure in printed edition.)Appendix III
GROUP MANAGER QUESTIONNAIRE
RESULTS
=========================================================== Appendix I



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(See figure in printed edition.)Appendix IV
APPEALS OFFICER QUESTIONNAIRE
RESULTS
=========================================================== Appendix I



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OFFICES VISITED AND OFFICIALS
INTERVIEWED
=========================================================== Appendix V

This appendix describes the various IRS offices we visited and the
officials we interviewed.  In addition, it discusses the scope of our
requests to selected officials for written comments on factors
related to large corporate audits.  Included in this appendix is
table V.1, which shows the offices we visited and officials we
interviewed. 

In addition to the questionnaires, we interviewed numerous IRS
National Office, regional, district office, and Appeals officials to
obtain their views on the factors that affected the amount of
additional taxes recommended by revenue agents that were ultimately
assessed.  At the National Office we interviewed the Executive
Director, Corporate Audits Section; the National Director, Strategic
Planning Division; the National Director of Appeals; and selected
members of their staffs.  At each of IRS' four regional offices we
interviewed the Regional Compliance Chief, Regional Counsel, and the
Assistant Regional Director for Appeals.  In addition, we visited 10
of IRS' 33 district offices and 9 appeals offices.  Table V.1 shows
the district offices and appeals offices we visited and the titles of
the individuals we interviewed. 



                                    Table V.1
                     
                     District and Appeals Offices Visited and
                              Officials Interviewed

                           Distric
                           t        Chief of    Examination
                           Directo  Examinatio  Branch       District   Chief of
Offices visited            r        n           Chiefs       Counsel    Appeals
-------------------------  -------  ----------  -----------  ---------  --------
Atlanta, Georgia           ï¿½        ï¿½           ï¿½            ï¿½          ï¿½

Baltimore, Maryland                             ï¿½                       ï¿½

Chicago, Illinois                   ï¿½           ï¿½                       ï¿½

Dallas, Texas              ï¿½        ï¿½           ï¿½            ï¿½          ï¿½

Hartford, Connecticut      ï¿½        ï¿½                                   ï¿½

Manhattan, New York        ï¿½        ï¿½           ï¿½            ï¿½          ï¿½

Oklahoma City, Oklahoma    ï¿½        ï¿½                                   ï¿½

San Francisco, California  ï¿½        ï¿½           ï¿½            ï¿½          ï¿½

San Jose, California       ï¿½        ï¿½                                   ï¿½

St. Louis, Missouri        ï¿½        ï¿½           ï¿½

================================================================================
Totals                     8        9           7            4          9
--------------------------------------------------------------------------------
Further, we also asked Examination Chiefs in all 33 IRS district
offices nationwide and Appeals Chiefs in all 33 appeals offices
nationwide to give us their comments on certain factors related to
these large corporate audits.  We received written responses from 31
of the Examination Chiefs and 30 of the Appeals Chiefs.  Their views
are incorporated throughout this report where appropriate. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Thomas D.  Short, Assistant Director
James M.  Fields, Senior Social Science Analyst
Stuart M.  Kaufman, Senior Social Science Analyst

KANSAS CITY REGIONAL OFFICE

Royce L.  Baker, Tax Issue Area Coordinator
Terry Tillotson, Evaluator-in-Charge
Kirk R.  Boyer, Senior Evaluator
Kathleen J.  Squires, Evaluator
Bradley L.  Terry, Evaluator
Thomas N.  Bloom, Computer Specialist


*** End of document. ***