Tax Administration: Taxpayer Rights and Burdens During Audits of Their
Tax Returns (Testimony, 09/26/97, GAO/T-GGD-97-186).

GAO discussed the rights of taxpayers and their treatment during audits
of their tax returns by the Internal Revenue Service (IRS).

GAO noted that: (1) IRS has limited data on both the treatment of
taxpayers and the burdens imposed on them during audits; (2) IRS
recently created a system to track taxpayers' complaints about improper
treatment but IRS does not solicit input on all improper treatment; (3)
similarly, IRS has no comprehensive definition of, and little data on,
the burden its audits impose on taxpayers; (4) IRS has recently
developed a survey that will ask individual taxpayers about their
satisfaction with various parts of the audit process but results will
not be available until 1998; (5) IRS has various indicators and
standards on audit performance; (6) one measure of audit performance is
how much additional tax is recommended; (7) IRS does not have a
corresponding measure on how much of the recommended tax is ultimately
collected after taxpayer appeals; (8) without an indicator to balance
taxes recommended against those collected, IRS auditors could have an
incentive to recommend taxes that would be unlikely to withstand a
taxpayer challenge; (9) IRS has nine audit standards; (10) GAO's work on
one set of IRS audit techniques--those used in analyzing taxpayers'
financial status to identify unreported income--showed that IRS used
these techniques in less than a quarter of the audits completed in the
time periods covered by GAO's review; (11) in about one-quarter of the
audits in which financial status techniques were used, IRS did not have
to contact the taxpayer to obtain information on the taxpayer's
financial status beyond what was reported on the tax return; (12) GAO
also found that IRS' use of financial status techniques has not
increased in recent years; (13) regarding revenue impact, GAO found that
in about 16 percent of the cases where they were used, these techniques
did help to identify significant amounts of unreported income--$10,000
or more; (14) IRS is concerned that its ability to target the
potentially most noncompliant taxpayers for audits is deteriorating;
(15) IRS' concern arises because it has not been able to rely on its
past approach for developing statistically valid research data that
allowed IRS to create and periodically update formulas to target the
returns with the most potential for noncompliance; (16) IRS last
collected these data through audits of a random sample of taxpayers for
tax year 1988; and (17) IRS subsequently abandoned that approach due to
concerns about its costs and to concerns from the public and Congress
about the taxpayer burden involved with those audits.

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

 REPORTNUM:  T-GGD-97-186
     TITLE:  Tax Administration: Taxpayer Rights and Burdens During 
             Audits of Their Tax Returns
      DATE:  09/26/97
   SUBJECT:  Taxpayers
             Tax return audits
             Auditing procedures
             Auditing standards
             Tax administration systems
             Customer service
             Data integrity
             Auditors
             Tax nonpayment
             Financial records
IDENTIFIER:  IRS Taxpayer Compliance Measurement Program
             
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Cover
================================================================ COVER


Before the Subcommittee on Oversight, House Committee on Ways and
Means

For Release
on Delivery
Expected at
10:00 a.m.  EDT
Friday,
September 26, 1997

TAX ADMINISTRATION - TAXPAYER
RIGHTS AND BURDENS DURING AUDITS
OF THEIR TAX RETURNS

Statement of James White, Associate Director, Tax Policy and
Administration Issues, General Government Division

GAO/T-GGD-97-186

GAO/GGD-97-186T


(268819)


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

  CEP - Coordinated Examination Program
  DIF - discriminant function
  EQMS - Examination Quality Measurement System
  IRS - Internal Revenue Service
  TCMP - Taxpayer Compliance Measurement Program

TAX ADMINISTRATION:  TAXPAYER
RIGHTS AND BURDENS DURING AUDITS
OF THEIR TAX RETURNS
====================================================== Chapter SUMMARY

Taxpayers and Congress have expressed concerns with how the Internal
Revenue Service (IRS) treats taxpayers in audits and whether audits
are too burdensome.  Based on its ongoing and previous work, GAO
makes the following points on these issues: 

  -- IRS has limited data on both the treatment of taxpayers and the
     burdens imposed on them during audits.  IRS recently created a
     system to track taxpayers' complaints about improper treatment
     but IRS does not solicit input on all improper treatment. 
     Similarly, IRS has no comprehensive definition of, and little
     data on, the burden its audits impose on taxpayers.  IRS has
     recently developed a survey that will ask individual taxpayers
     about their satisfaction with various parts of the audit process
     but results will not be available until 1998. 

  -- IRS has various indicators and standards on audit performance. 
     One measure of audit performance is how much additional tax is
     recommended.  IRS does not have a corresponding measure on how
     much of the recommended tax is ultimately collected after
     taxpayer appeals.  Without an indicator to balance taxes
     recommended against those collected, IRS auditors could have an
     incentive to recommend taxes that would be unlikely to withstand
     a taxpayer challenge.  IRS has nine audit standards.  The
     standards focus on the efficient use of auditors' time and not
     on when they should use particular audit techniques.  To ensure
     adherence to the standards, IRS relies on oversight by the
     auditors' managers.  However, their workload limits their time
     for doing oversight. 

  -- GAO's work on one set of IRS audit techniques--those used in
     analyzing taxpayers' financial status to identify unreported
     income--showed that IRS used these techniques in less than a
     quarter of the audits completed in the time periods covered by
     GAO's review.  In about one-quarter of the audits in which
     financial status techniques were used, IRS did not have to
     contact the taxpayer to obtain information on the taxpayer's
     financial status beyond what was reported on the tax return. 
     GAO also found that IRS' use of financial status techniques has
     not increased in recent years.  Regarding revenue impact, GAO
     found that in about 16 percent of the cases where they were
     used, these techniques did help to identify significant amounts
     of unreported income--$10,000 or more.  However, in over
     three-quarters of the total audits in which these techniques
     were used, no changes resulting from the use of these techniques
     were made to the income reported.  Most of the audits did result
     in some tax change for other reasons.  Data are not available to
     permit GAO or IRS to determine the additional burden imposed on
     taxpayers from the use of the techniques in audits. 

  -- IRS is concerned that its ability to target the potentially most
     noncompliant taxpayers for audits is deteriorating.  IRS'
     concern arises because it has not been able to rely on its past
     approach for developing statistically valid research data that
     allowed IRS to create and periodically update formulas to target
     the returns with the most potential for noncompliance.  IRS last
     collected these data through audits of a random sample of
     taxpayers for tax year 1988.  IRS subsequently abandoned that
     approach due to concerns about its costs and to concerns from
     the public and Congress about the taxpayer burden involved with
     those audits. 


TAX ADMINISTRATION:  TAXPAYER
RIGHTS AND BURDENS DURING AUDITS
OF THEIR TAX RETURNS
==================================================== Chapter STATEMENT

Madam Chairman and Members of the Subcommittee: 

We are pleased to be here today to assist the Subcommittee in its
inquiry into the rights of taxpayers and their treatment during
audits of their tax returns by the Internal Revenue Service (IRS). 
Recently, taxpayers, tax professionals, and Congress have expressed
concerns about how IRS treats taxpayers during audits and whether
audits are overly burdensome.  You asked us to discuss IRS' data on
taxpayer complaints and the burden imposed on taxpayers as well as
IRS' indicators for measuring audit performance.  You also asked us
to discuss our ongoing work for the Chairman of the House Committee
on Ways and Means on IRS' use of a particular audit
technique--reviews of taxpayers' financial status (i.e., their flow
of income and expenses)--and IRS' methodology for selecting tax
returns for audit. 

Today, I would like to make four points taken from this ongoing work
as well as from previous reports and testimonies. 

  -- First, IRS has limited data on both the treatment of taxpayers
     and the burdens imposed on them during audits.  IRS recently
     created a system to track taxpayers' complaints about improper
     treatment but IRS does not solicit input on all improper
     treatment.  Similarly, IRS has no comprehensive definition of,
     and little data on, the burden its audits impose on taxpayers. 
     IRS has recently developed a survey that will ask individual
     taxpayers about their satisfaction with various parts of the
     audit process but results will not be available until 1998. 
     While recognizing the difficulties in collecting data from
     taxpayers about treatment and burden, we believe that this
     survey may have the potential to provide better information than
     presently exists. 

  -- Second, IRS' Examination Division has various indicators and
     standards on audit performance.  One measure IRS uses for audit
     performance is how much additional tax is recommended.  IRS does
     not have a corresponding measure on how much of the recommended
     tax is ultimately collected after taxpayer appeals.  Without an
     indicator to balance taxes recommended against those collected,
     IRS auditors could have an incentive to recommend taxes that
     would be unlikely to withstand a taxpayer challenge.  IRS has
     nine audit standards.  The standards focus on the efficient use
     of auditors' time and not on when they should use particular
     audit techniques.  To ensure adherence to the standards, IRS
     relies on oversight by the auditors' managers.  However, their
     workload limits their time for doing oversight. 

  -- Third, our work on one set of audit techniques--those used in
     analyzing taxpayers' financial status to identify any unreported
     income--provided several interesting statistics.  We estimated
     that IRS auditors used these techniques in less than a quarter
     of the audits completed in the time periods covered by our
     review.  When used, financial status techniques were always part
     of an audit that included other techniques or methodologies.  In
     about one-quarter of the audits in which financial status
     techniques were used, IRS did not have to contact the taxpayer
     to obtain information on the taxpayer's financial status beyond
     what was reported on the tax return.  We also found that the use
     of financial status techniques has not increased in recent
     years.  Regarding revenue impact, we found that in about 16
     percent of the cases where they were used, these techniques did
     help to identify significant amounts of unreported
     income--$10,000 or more.  However, of the total audits in which
     these techniques were used, in over three-quarters no changes
     resulting from the use of these techniques were made to the
     income reported, although most of the audits resulted in some
     tax change for other reasons.  Data are not available to permit
     either us or IRS to determine the additional burden imposed on
     taxpayers from the use of financial status techniques in audits. 

  -- Fourth, IRS is concerned that its ability to target the
     potentially most noncompliant taxpayers for audits is
     deteriorating.  IRS' concern arises because it has not been able
     to rely on its past approach for developing statistically valid
     research data that allowed IRS to create and periodically update
     formulas to target the returns with the most potential for
     noncompliance.  IRS last collected these data through audits of
     a random sample of taxpayers for tax year 1988.  IRS
     subsequently abandoned that approach due to concerns about its
     costs and to concerns from the public and Congress about the
     taxpayer burden involved with those audits.  For context, we
     note that from the 1960s, when IRS first created its
     research-based audit formulas until it stopped gathering that
     research data after 1988, it had reduced the rate to which its
     audits made no recommended tax change from more than 40 percent
     to around 10 to 15 percent, depending on the type of return and
     the year of the audit. 

I would like to discuss each of these points in more detail after
providing an overview on why IRS audits tax returns and how IRS is
supposed to do the audits. 


   OVERVIEW OF IRS AUDITS OF TAX
   RETURNS
-------------------------------------------------- Chapter STATEMENT:1

IRS' Examination Division audits tax returns to ensure that taxpayers
report and pay the amount of tax they owe.  Because our tax system is
based on self-assessment, IRS also does audits to induce taxpayer
compliance and promote public confidence in the tax system.\1

The income tax gap--the difference between taxes owed and taxes paid
voluntarily and on time--is one reason why IRS seeks to provide an
audit presence.  Under IRS' most recent estimate, the 1992 income tax
gap for individuals exceeds $90 billion, of which about two-thirds
can be attributed to individuals not reporting income on their tax
returns. 

In recent years, IRS has been auditing about one to two percent of
the 100-million plus income tax returns filed annually by individual
taxpayers.\2 IRS' policies and procedures are generally directed at
selecting returns that appear to be most noncompliant.  After
selecting the returns, IRS audits them either (1) through 1 of its 33
district offices by meeting with taxpayers or their representatives
or (2) through 1 of its 10 service centers by corresponding with the
taxpayers.  Since fiscal year 1992, these audits have been
recommending between $5 billion to $8 billion in additional taxes
each year.  Appendix I of my statement summarizes selected audit
statistics since fiscal year 1992. 

IRS auditors are instructed to not only verify the eligibility and
amounts for various types of tax deductions, credits, and exemptions,
but to also look for any indications of unreported income.  If
auditors find such indications, they are to exercise their judgment
in deciding whether to do further probes in an effort to determine
whether the taxpayer underreported income. 

To guide auditors, IRS manuals and publications have identified the
rights of taxpayers during audits and the manner in which auditors
should treat taxpayers.  For example, IRS documents say that
taxpayers have the right, among others, to know why IRS is asking for
information about the tax return and to authorize another person to
represent them during the audit.  Through its documents and training
programs, IRS instructs its audit staff to explain these rights to
the audited taxpayer and to protect those rights.  In addition, audit
staff are instructed to protect taxpayers' privacy as well as treat
them with professionalism and courtesy. 


--------------------
\1 IRS also induces compliance through taxpayer assistance,
third-party reporting to IRS of payments (such as wages and interest)
made to taxpayers, computer matching of tax returns to third-party
data, income tax withholding, and penalties for noncompliance. 

\2 IRS also annually audits tens of thousands of income tax returns
filed by corporations and partnerships as well as thousands of other
types of returns such as those filed to report estate tax, gift tax,
employment tax, and excise tax. 


   IRS DATA ON AUDIT BURDEN AND
   TAXPAYER COMPLAINTS ABOUT
   TREATMENT
-------------------------------------------------- Chapter STATEMENT:2

Recently, taxpayers, tax professionals, and Congress have criticized
IRS for treating taxpayers improperly and imposing unnecessary
burdens during audits.  At a general level, these criticisms have
asserted that auditors lacked sufficient experience, training,
motivation, or competence.  Specific criticisms have focused on a
range of asserted IRS behaviors, including: 

  -- subjecting compliant taxpayers to unnecessary audits, resulting
     in no change to the tax liability reported on the tax returns;

  -- wasting taxpayers' time during the audit by asking for
     irrelevant documentation or by delving into issues that are
     minor or personal; and

  -- treating taxpayers unprofessionally or abusively, regardless of
     whether they underpaid their taxes, by lying, making threats,
     applying pressure, and the like. 

IRS has limited data for use in responding to such assertions.  With
respect to unprofessional or improper treatment, in 1994 and 1996, we
reported that IRS lacked comprehensive data on the nature and
magnitude of the complaints as well as their resolutions.\3 Nor did
IRS have clear definitions that allowed it to determine whether these
complaints indicated auditor behaviors that were "abusive" or
"unnecessary."

Since our 1996 report, IRS has developed a definition and tracking
system for complaints about improper treatment.  IRS defines a
complaint as an allegation by taxpayers or their representatives that
an IRS employee violated the law, regulation, or IRS rules of conduct
or used inappropriate behavior (e.g., rude, overzealous,
discriminatory, intimidating) or that an IRS system failed to
function properly or within the prescribed time frame. 

IRS' complaint tracking system does not systematically solicit input
from taxpayers on their treatment during audits; rather, it records
only those complaints initiated by taxpayers.  As a result, neither
we nor IRS have representative data on the extent to which auditors
treat taxpayers improperly across the roughly 2 million audits. 

Nevertheless, IRS does report the data the system collects on
taxpayer complaints.  For the first quarter of fiscal year 1997, IRS
reported that taxpayers initiated 1,203 complaints, of which 290 (25
percent) involved audit staff.  Of the 290 audit-related complaints,
almost half involved assertions of inappropriate behavior by an
auditor and about one-quarter of these complaints were addressed
through counseling or administrative action or through the employee
leaving IRS; for the remaining three-quarters of the complaints, IRS
concluded that the employee's behavior was appropriate or that
information provided by the taxpayer was not complete enough to take
disciplinary action against the employee. 

With respect to taxpayer burden, IRS has limited data on the
burden--whether necessary or not--imposed by audits.  For example, in
fiscal year 1996, IRS tax auditors made no changes to 14 percent of
the individual tax returns.  However, IRS does not know the amount of
burden imposed by these or other audits. 

Data on burden can be difficult to collect for various reasons. 
Neither IRS nor its stakeholders have clear definitions or agreement
on what constitutes audit burden as well as unnecessary burden. 
Further, our work has shown that taxpayers do not keep records on the
amount of audit burden in terms of time or money.\4

IRS has recently developed a survey that will ask individual
taxpayers about their satisfaction with the audit process.  Results
will not be available until 1998.  Recognizing the difficulties in
collecting data about treatment and burden, we believe that this
survey may begin to provide better information about taxpayer
treatment and burden but its usefulness will need to be evaluated. 


--------------------
\3 Tax Administration:  IRS Can Strengthen Its Efforts to See That
Taxpayers Are Treated Properly (GAO/GGD-95-14, Oct.  26, 1994), and
Tax Administration:  IRS Is Improving Its Controls for Ensuring That
Taxpayers Are Treated Properly (GAO/GGD-96-176, Aug.  30, 1996). 

\4 Tax System:  Issues in Tax Compliance Burden, (GAO/T-GGD-96-100,
Apr.  3, 1996) and Tax System Burden:  Tax Compliance Burden Faced by
Business Taxpayers, (GAO/T-GGD-95-42, Dec.  9, 1994). 


   IRS' INDICATORS TO MEASURE THE
   IMPACTS OF AUDITS
-------------------------------------------------- Chapter STATEMENT:3

IRS has established some indicators for measuring its audit
performance.  However, existing indicators primarily focus on interim
results without also considering final results from the audits. 
Similarly, IRS has established nine audit standards to guide its
auditors.  However, the standards do not provide objective criteria
on when to use particular audit techniques. 

IRS' Examination Division has used additional tax recommended as an
important indicator of audit performance (see app.  II for the fiscal
year 1997 indicators).\5 We expressed concerns in previous work that
overreliance on additional taxes recommended as an indicator of
performance could create undesirable incentives for auditors (and
other Examination staff) to recommend taxes that would be unlikely to
withstand a taxpayer challenge.\6 While we recognize the complexity
of the Internal Revenue Code and the difficulties faced by both IRS
and the taxpayer in determining the "correct tax," the fact remains
that audit recommendations that do not withstand such a challenge may
have imposed an unnecessary burden on the taxpayer.  For this reason,
in our previous work, we supported the need to measure taxes
recommended but advocated balancing that indicator with others such
as taxes ultimately collected. 

Our work also pointed out that developing an indicator of taxes
ultimately collected from audits would be challenging.  For example,
the time lag between an audit and the ultimate tax collected makes
linking the two problematic.  IRS is working on developing a way of
determining the ultimate taxes collected. 

In addition to indicators of audit performance, IRS also has nine
audit standards to provide guidance to auditors on minimizing the
time spent on an audit, checking large and unusual claims on tax
returns, probing for unreported income, and preparing adequate audit
workpapers (see app.  III for all nine standards).  These nine
standards do not address the proper treatment of taxpayers.  Further,
although the standards provide guidance on the proper depth and
breadth of audits given the time available, they provide little
objective guidance to auditors on when to use particular audit
techniques such as those related to an analysis of a taxpayer's
financial status. 

To ensure adherence to the standards, IRS relies on managers'
oversight of auditors.  However, according to IRS officials, these
managers cannot review all audits because their workloads limit the
time available for review.  As audits close throughout the year,
separate groups of IRS staff supplement the managerial review process
by reviewing a small sample of audits to measure adherence to the
nine standards (see appendix III for measurement results in fiscal
years 1992 through 1996). 


--------------------
\5 Taxpayers do not necessarily have to pay the recommended taxes. 
Taxpayers may challenge them through administrative channels within
IRS or the courts.  If they win the challenge, the recommended taxes
will not be assessed as owed.  If they lose or raise no challenge,
the recommended taxes are assessed. 

\6 Tax Administration:  Compliance Measures and Audits of Large
Corporations Need Improvement (GAO/GGD-94-70, Sept.  1, 1994) and Tax
Administration:  Factors Affecting Results From Audits of Large
Corporations (GAO/GGD 97-62, Apr.  17, 1997). 


   IRS' USE OF FINANCIAL STATUS
   TECHNIQUES
-------------------------------------------------- Chapter STATEMENT:4

Given recent complaints about the asserted burdens and intrusions
associated with IRS' financial status audit techniques, the Chairman
of the House Committee on Ways and Means asked us to report on the
frequency and results of IRS' use of these techniques.  IRS uses
these techniques to identify unreported income.  During our analyses
of audits done in 1992-93 and 1995-96, we found that IRS relied
primarily on two financial status techniques:\7

1)Cash transaction analysis (or cash-T), in which the auditor uses
the tax return and other sources to ensure that adequate income has
been reported on the return to cover expenses.  In deciding to use
this technique, auditors may first do a preliminary cash-T.  It
differs from the regular cash-T in that the auditor does it before
meeting with taxpayers, relying on information reported on tax
returns. 

2)Bank deposit analysis, in which the auditor verifies that the
taxpayer's bank deposits are consistent with the income reported on
the tax return. 

To do our work, we randomly sampled from the universe of audits
closed in IRS districts in which IRS scheduled meetings with
taxpayers to review their records.  These samples covered 1992-93 and
1995-96 and were both projectable to universes of about a half
million audits. 

On the basis of our analysis of these two samples, we estimate that
the use of financial status techniques had not increased over the
time frames we reviewed--the techniques were used in about
one-quarter of the audits in each of our two universes.  Financial
status techniques were never used alone; they were always part of
audits that included other audit techniques to explore issues other
than unreported income, such as overstated deductions. 

These techniques imposed no or little additional burden on taxpayers
in some of the audits where they were used.  For example, IRS
auditors used just the preliminary cash-T in 23 percent of the
1995-96 audits that used financial status techniques.  The
preliminary cash-T technique imposes no additional burden on the
taxpayer because the auditor relies on the information on the tax
return and does not have to contact the taxpayer to obtain additional
information or explanations to complete this technique. 

We found that use of the financial status techniques in some cases
helped to identify significant amounts of unreported income--$10,000
or more--that IRS would not have otherwise found.  However, over
three-quarters of the audits in which these techniques were used
resulted in no changes that were directly attributable to the use of
these techniques, even though IRS did find noncompliance in most of
these audits through other techniques. 

While neither we nor IRS know the actual burden imposed on taxpayers,
our review of IRS' workpapers illustrated some conditions under which
use of certain techniques may impose additional burdens.  For
example, a bank deposit analysis can be very burdensome if the
auditor asks for records on many bank accounts and asks many
questions about the deposits in those accounts.  A regular cash-T may
or may not be very burdensome, depending on the number of contacts
with taxpayers to request information and the amount of information
requested. 


--------------------
\7 Other techniques include an analysis of (1) a taxpayer's net worth
and (2) a business taxpayer's reported cost of goods sold and data on
average markups within the specific business to estimate gross
receipts generated by that taxpayer. 


   BARRIERS TO SELECTING THE MOST
   NONCOMPLIANT TAX RETURNS FOR
   AUDIT
-------------------------------------------------- Chapter STATEMENT:5

As discussed in previous reports, IRS is concerned about its ability
to objectively select tax returns so that it focuses on the most
noncompliant taxpayers.\8 IRS' concerns arise because it has not been
able to rely on its past approach for developing statistically valid
research data that allowed IRS to create and periodically update
formulas to target the returns with the most potential for
noncompliance.  IRS refers to these as discriminant function (DIF)
formulas, which have served as the major method for selecting returns
for audit.\9 IRS fears that its DIF formulas have become imprecise
because the formulas use outdated statistical data. 

In past years, IRS collected the statistically valid research data
under its Taxpayer Compliance Measurement Program (TCMP).  TCMP
involved full-scale audits of a random sample of tax returns--
usually for about 50,000 individual taxpayers every 3 years.  In
1995, IRS abandoned this approach due to concerns about its costs and
to concerns from the public and Congress about the taxpayer burden
involved with those audits.  As a result, IRS' last TCMP covered tax
year 1988. 

In a 1996 report, we discussed IRS' need for compliance data that are
statistically valid and more current.\10 IRS needs the data not only
to update its DIF formulas but also to support most of its compliance
programs.  Accordingly, we recommended that IRS develop a
cost-effective, long-term strategy to ensure the continued
availability of such compliance data. 

Since IRS started to use DIF in the 1960s to better target its audits
through fiscal year 1996, IRS has reduced the rate at which its
auditors made no tax changes from more than 40 percent of the audited
returns to around 10 to 15 percent, depending on the type of return
and the year of the audit.  IRS is concerned that as time passes,
DIF's precision in identifying noncompliant returns may decrease
unless IRS updates the formulas with valid data, and that as a
result, more and more compliant taxpayers will be unnecessarily
burdened with an audit.  We are now designing a study of this issue
at the request of the Chairman of the House Committee on Ways and
Means. 


--------------------
\8 Tax Research:  IRS Has Made Progress But Major Challenges Remain,
(GAO/GGD-96-109, June 5, 1996); Tax Administration:  Alternative
Strategies to Obtain Compliance Data (GAO/GGD-96-89, Apr.  26, 1996);
Tax Gap:  Many Actions Taken, But a Cohesive Compliance Strategy
Needed (GAO/GGD-94-123, May 11, 1994); and Tax Administration:  IRS'
Plans to Measure Tax Compliance Can Be Improved (GAO/GGD-93-52, Apr. 
5, 1993). 

\9 Tax Administration:  Audit Trends and Results for Individual
Taxpayers (GAO/GGD-96-91, Apr.  26, 1996).  IRS has up to 40 methods
for identifying returns to audit.  Appendix IV summarizes the number
of audits selected by the major methods for fiscal years 1992 through
1996. 

\10 Tax Administration:  Alternative Strategies to Obtain Compliance
Data (GAO/GGD-96-89, Apr.  26, 1996). 


------------------------------------------------ Chapter STATEMENT:5.1

Madam Chairman, this concludes my testimony.  I would be pleased to
answer any questions you or other members of the Subcommittee may
have. 


SELECTED INFORMATION ABOUT THE
RETURNS FILED AND EXAMINED AND
RECOMMENDED ADDITIONAL TAXES
(FISCAL YEARS 1992-96)
=========================================================== Appendix I

Descriptio
n                   1992          1993          1994          1995          1996
----------  ------------  ------------  ------------  ------------  ------------
Number of returns
--------------------------------------------------------------------------------
Filed        152,031,900   153,453,600   152,732,800   154,293,700   155,279,600
Examined       1,452,009     1,300,230     1,426,573     2,100,144     2,136,819
Percent              .96           .85           .93          1.36          1.38
 coverage
Recommende         $26.9         $23.1         $23.9         $27.8         $28.1
 d
 additiona
 l tax and
 penalties
 (in
 billions)
Individual           6.3           5.7           6.2           7.8          $7.6
 returns
Corporate           18.1          14.7          15.1          17.7         $18.0
 returns
All                  2.5           2.7           2.6           2.3          $2.5
 other\a

Average tax and penalty per return examined by
--------------------------------------------------------------------------------
Revenue          $25,161       $24,704       $18,177       $21,237       $24,407
 agent for
 non-
 CEP\b
Revenue        3,940,148     2,700,352     3,279,298     4,032,528     3,998,409
 agent for
 CEP
Tax                2,280         2,625         3,113         3,497         3,051
 auditor
Service            2,541         2,934         1,945         1,427         1,733
 center
--------------------------------------------------------------------------------
\a Other includes fiduciary, estate, gift, employment, excise,
windfall profit, and miscellaneous taxes. 

\b CEP = Coordinated Examination Program, under which IRS audits the
largest corporations. 


IRS EXAMINATION DIVISION MEASURES
FOR 1997
========================================================== Appendix II

Basic measures across Examination activities include

1.Amount of additional tax and penalties recommended. 

2.Percentage of additional recommended amounts plus interest amounts
that were collected before IRS issued the second notice on the
amounts that were assessed. 

3.Average number of days that an audit case remains open. 

4.Amount of additional tax and penalty recommended as well as the
amount of tax protected in audits divided by the total
full-time-equivalent staffing invested. 

For the Coordinated Examination Program (CEP), additional measures
include

1.Average number of tax years for tax returns filed by a CEP taxpayer
that have not yet been audited. 

2.Amount of additional tax and penalty recommendations that CEP
taxpayers agreed to pay minus amount overassessed divided by the
total full-time-equivalent staffing invested. 

3.Amount of total adjusted revenues divided by the total
full-time-equivalent staffing invested. 


IRS' EXAMINATION QUALITY
MEASUREMENT SYSTEM
========================================================= Appendix III

The Office of Compliance Specialization, within IRS' Examination
Division, has responsibility for Quality Measurement Staff operations
and the Examination Quality Measurement System (EQMS).  Among other
uses, EQMS measures the quality of closed audits against nine IRS
audit standards.  The standards address the scope, audit techniques,
technical conclusions, workpaper preparation, reports, and time
management of an audit.  Each standard includes additional key
elements describing specific components of a quality audit.  Table
III.1 summarizes the standards and the associated key elements. 



                                   Table III.1
                     
                       Summary of IRS' Examination Quality
                        Measurement System (EQMS) Auditing
                          Standards (as of October 1996)

No.       Standard      Key elements       Purpose            Overview
--------  ------------  -----------------  -----------------  ------------------
1         Considered    A.Balance sheet    Measures whether   This standard
          large,        and Schedule M     consideration was  encompasses, but
          unusual, or   considered         given to the       is not limited to,
          questionable  B.Income,          large, unusual,    the following
          items         deduction, and     or questionable    fundamental
                        credit items       items in both the  considerations:
                        considered         precontact stage   absolute dollar
                        C.Scope of         and during the     value, relative
                        examination was    course of the      dollar value,
                        appropriate        examination.       multiyear
                                                              comparisons,
                                                              intent to mislead,
                                                              industry/business
                                                              practices,
                                                              compliance impact,
                                                              and so forth.

2         Probes for    A.Consideration    Measures whether   Gross receipts
          unreported    of internal        the steps taken    were probed during
          income        controls for all   verified that the  the course of
                        business returns   proper amount of   examination,
                        B.Consideration    income was         regardless of
                        of books and       reported.          whether the
                        records                               taxpayer
                        C.Consideration                       maintained a
                        of financial                          double entry set
                        status                                of books.
                        D.Appropriate use                     Consideration was
                        of indirect                           given to responses
                        methods                               to interview
                                                              questions, the
                                                              financial status
                                                              analysis, tax
                                                              return
                                                              information, and
                                                              the books and
                                                              records in probing
                                                              for unreported
                                                              income.

3         Required      A.Consideration    Measures whether   Required filing
          filing        of prior and       consideration was  checks consist of
          checks        subsequent year    given to filing    the analysis of
                        tax returns        and examination    return information
                        B.Consideration    potential of all   and, when
                        of related         returns required   warranted, the
                        returns            by the taxpayer,   pick-up of
                        C.Compliance       including those    related, prior,
                        items considered   entities in        and subsequent
                                           taxpayer's sphere  year returns. In
                                           of influence/      accordance with
                                           responsibility.    Internal Revenue
                                                              Manual 4034,
                                                              examinations
                                                              should include
                                                              checks for filing
                                                              information
                                                              returns.


4         Examination   A.Adequate         Measures whether   The depth of the
          depth and     interviews         the issues         examination was
          records       conducted          examined were      determined through
          examined      B.Adequate exam    completed to the   inspection,
                        techniques used    extent necessary   inquiry,
                        C.Fraud            to provide         interviews,
                        adequately         sufficient         observation, and
                        considered and     information to     analysis of
                        developed          determine          appropriate
                        D.Issues           substantially      documents,
                        sufficiently       correct tax.       ledgers, journals,
                        developed                             oral testimony,
                                                              third-party
                                                              records, etc., to
                                                              ensure full
                                                              development of
                                                              relevant facts
                                                              concerning the
                                                              issues of merit.
                                                              Interviews
                                                              provided
                                                              information not
                                                              available from
                                                              documents to
                                                              obtain an
                                                              understanding of
                                                              the taxpayer's
                                                              financial history,
                                                              business
                                                              operations, and
                                                              accounting records
                                                              in order to
                                                              evaluate the
                                                              accuracy of books
                                                              or records.
                                                              Specialists
                                                              provided expertise
                                                              to ensure proper
                                                              development of
                                                              unique or complex
                                                              issues.

5         Findings      A.Correct          Measures whether   This standard
          supported by  technical or       the conclusions    includes
          law           factual            reached were       consideration of
                        conclusions        based on a         applicable law,
                        reached            correct            regulations, court
                                           application of     cases, revenue
                                           tax law.           rulings, etc., to
                                                              support technical
                                                              or factual
                                                              conclusions.

6         Penalties     A.Recognized,      Measures whether   Consideration of
          properly      considered, and    applicable         the application of
          considered    applied            penalties were     appropriate
                        correctly          considered and     penalties during
                        B.Penalties        applied            all examination is
                        computed           correctly.         required.
                        correctly

7         Workpapers    A.Fully disclose   Measures the       Workpapers
          support       audit trail and    documentation of   provided the
          conclusions   techniques         the examination's  principal support
                        B.Legible and      audit trail and    for the examiner's
                        organized          techniques used.   report and
                        C.Adjustments in                      documented the
                        workpapers agree                      procedures
                        with 4318, 4700,                      applied, tests
                        and reports                           performed,
                        D.Activity record                     information
                        adequately                            obtained, and the
                        documents exam                        conclusions
                        activities                            reached in the
                        E.Disclosure                          examination.

8         Report        A.Applicable       Measures the       Addresses the
          writing       report writing     presentation of    written
          procedures    procedures         the audit          presentation of
          followed      followed           findings in terms  audit findings in
                        B.Correct tax      of content,        terms of content,
                        computation        format, and        format, and
                                           accuracy.          accuracy. All
                                                              necessary
                                                              information is
                                                              contained in the
                                                              report, so that
                                                              there is a clear
                                                              understanding of
                                                              the adjustments
                                                              made and the
                                                              reasons for those
                                                              adjustments.

9         Time span or  A.Examination      Measures the       Time is an
          time charged  time               utilization of     essential element
                        commensurate       time as it         of the auditing
                        B.Exam             relates to the     standards and is a
                        initiation         complete audit     proper
                        C.Examination      process.           consideration in
                        activities                            analyses of the
                        D.Case closing                        examination
                                                              process. The
                                                              process is
                                                              considered as a
                                                              whole and at
                                                              examination
                                                              initiation,
                                                              examination
                                                              activities, and
                                                              case-closing
                                                              stages.
--------------------------------------------------------------------------------
Source:  IRS data. 


   STANDARD SUCCESS RATE
------------------------------------------------------- Appendix III:1

EQMS quality reviewers use the key element definitions to determine
whether an audit adhered to the standard.  Thus, adherence to audit
quality is measured by the presence or absence of associated key
elements.  For a standard to be rated as having been met, each of the
associated key elements must also be rated as met or not applicable. 
If the audit does not demonstrate the characteristics described by
one of the key elements, then the standard is rated as not met. 

One measure that IRS uses to evaluate the audit quality is the
standard success rate.  It measures the percentage of cases for which
all the underlying key elements of each standard are rated as having
been met.  According to IRS, this measure is useful for determining
whether a case is flawed and in what area.  Figures III.1 and III.2
show the standard success rates for each of the standards for fiscal
years 1992-96 for office and field audits, respectively. 

   Figure III.1:  Standard Success
   Rates for Office Audits (Fiscal
   Years 1992-96)

   (See figure in printed
   edition.)

Source:  IRS data. 

   Figure III.2:  Standard Success
   Rates for Field Audits (Fiscal
   Years 1992-96)

   (See figure in printed
   edition.)

Source:  IRS data. 


   KEY ELEMENT PASS RATE
------------------------------------------------------- Appendix III:2

IRS also uses the key element pass rate as a measure of audit
quality.  This measure computes the percentage of audits
demonstrating the characteristics defined by the key element. 
According to IRS, the key element pass rate is the most sensitive
measurement and is useful when describing how an audit is flawed,
establishing a baseline for improvement, and identifying systemic
changes.  Figures III.3 and III.4 show the pass rates for the key
elements of standard 2 for fiscal years 1992 through 1996 for office
and field audits, respectively. 

   Figure III.3:  Key Element Pass
   Rates for Key Elements of
   Standard 2 for Office Audits
   (Fiscal Years 1992-96)

   (See figure in printed
   edition.)

Source:  IRS data. 

   Figure III.4:  Key Element Pass
   Rates for Key Elements of
   Standard 2 for Field Audits
   (Fiscal Years 1992-96)

   (See figure in printed
   edition.)

IRS data. 


NUMBER AND PERCENT OF INDIVIDUAL
RETURNS AUDITED BY AUDIT SOURCE
(FISCAL YEARS 1992-96)
========================================================== Appendix IV

                                    Fiscal year 1992          Fiscal year 1993       Fiscal year 1994       Fiscal year 1995       Fiscal year 1996
                              ----------------------------  ---------------------  ---------------------  ---------------------  --------------------
Audit sources                        Number        Percent      Number    Percent      Number    Percent      Number    Percent     Number    Percent
----------------------------  -------------  -------------  ----------  ---------  ----------  ---------  ----------  ---------  ---------  ---------
DIF/DIF related                     452,445            38%     372,116        35%     239,557        20%     263,200        14%    351,867        18%
Nonfilers                           119,865             10     190,809         18     402,435         33     410,612         21    212,226         11
Tax shelter related                 101,453              8      48,070          5      29,687          2      27,473          1     20,300          1
Self-employment tax                  71,126              6      46,310          4      43,032          4      48,578          3     40,601          2
Regular classification               52,528              4      50,709          5      47,170          4      46,637          2     48,534          3
State information                    48,418              4       3,564          0       4,573          0       3,210          0     71,582          4
Service center studies and           43,333              4      20,059          2      22,825          2      25,026          1     18,684          1
 tests
Compliance projects                  40,403              3      44,267          4      41,959          3      38,624          2     45,680          2
Claims for refund                    33,163              3      37,203          4      26,412          2      23,175          1     31,495          2
Return preparers                     27,706              2      28,231          3      27,708          2      26,542          1     33,637          2
Non-DIF multiyear                    26,866              2      29,373          3      26,742          2      24,926          1     29,927          2
Unallowable items                    13,117              1      12,099          1     134,007         11     761,886         40    824,721         42
Other sources                       175,596             15     176,156         16     179,600         15     219,548         11    212,306         11
=====================================================================================================================================================
Total                             1,206,019           100%   1,058,966       100%   1,225,707       100%   1,919,437       100%  1,941,560       100%
-----------------------------------------------------------------------------------------------------------------------------------------------------
Note 1:  For this table, we used the format from our 1996 report on
audit trends (GAO/GGD-96-91, Apr.  1996).  That format listed the top
10 sources for each of the fiscal years 1992 through 1994.  Using
that format, we updated the numbers and percentages for those
categories for fiscal years 1995 and 1996. 

Note 2:  See next page for definitions of terms used in this table. 

Note 3:  Percentages are the percent of total audits for the year and
have been rounded to the nearest whole percent. 

Source:  GAO analysis of IRS data. 


DEFINITIONS OF AUDIT SOURCES
=========================================================== Appendix V


      CLAIMS FOR REFUND
------------------------------------------------------- Appendix V:0.1

Ammended returns audited because of taxpayers' claims for refunds. 


      COMPLIANCE PROJECTS
------------------------------------------------------- Appendix V:0.2

Returns identified through IRS' information gathering projects. 


      DIF/DIF RELATED
------------------------------------------------------- Appendix V:0.3

Returns selected on the basis of a computer-generated score (the
scoring is based on an analysis technique known as discriminant
function).  Also included are related returns identified during an
audit of a DIF-source return and related returns from prior or
subsequent years for the same taxpayer. 


      NON-DIF MULTIYEAR
------------------------------------------------------- Appendix V:0.4

Related returns from prior or subsequent years for the same taxpayer,
when the initial source was other than a DIF-source return. 


      NONFILERS
------------------------------------------------------- Appendix V:0.5

Audits initiated against known taxpayers who did not file a return
with IRS. 


      OTHER SOURCES
------------------------------------------------------- Appendix V:0.6

Over 25 other audit sources, such as referrals from other IRS
Divisions, which were not one of the 10 largest sources during the
period of our review. 


      REGULAR CLASSIFICATION
------------------------------------------------------- Appendix V:0.7

Manually selected returns for audit that do not result from other
specified audit sources. 


      RETURN PREPARERS
------------------------------------------------------- Appendix V:0.8

Returns identified for audit due to questionable tax preparers. 


      SELF-EMPLOYMENT TAX
------------------------------------------------------- Appendix V:0.9

Returns involving self-employment tax issues identified by IRS
service center examination staff. 


      SERVICE CENTER STUDIES AND
      TESTS
------------------------------------------------------ Appendix V:0.10

Returns identified through service center projects initiated by the
IRS National Office. 


      STATE INFORMATION
------------------------------------------------------ Appendix V:0.11

Returns identified from various state sources, generally under
exchange agreements between IRS and the states. 


      TAX SHELTER RELATED
------------------------------------------------------ Appendix V:0.12

Related returns of partners, grantors, beneficiaries, and
shareholders identified during audits of either partnerships,
fiduciaries, or Subchapter S corporations involving potential tax
shelter issues. 


      UNALLOWABLE ITEMS
------------------------------------------------------ Appendix V:0.13

Returns involving refundable credits and dependency exemptions, such
as the Earned Income Tax Credit, identified by service center
examination staff. 

*** End of document. ***