Tax Administration

Each year, the Internal Revenue Service (IRS) identifies billions of dollars in additional income taxes owed through audits of individual taxpayers. Increasingly, the way IRS conducts its audits has been criticized by taxpayers, tax professionals, and Congress as being overly intrusive and burdensome. Much of this criticism has stemmed from IRS' renewed emphasis on detecting unreported income. In a 1994 initiative, IRS launched a training program that stressed the need to consider a taxpayer's financial status by focusing on whether his or her income and expenses were roughly proportional. The training program emphasized certain audit methods, sometimes referred to as financial status audit techniques, to identify unreported income. This report (1) estimates how often IRS used financial status audit techniques in audits closed in tax years before the 1994 initiative (1992 and 1993) and in tax years after the initiative (1995 and 1996); (2) considers how IRS' need to contact taxpayers for additional information when using financial status techniques might be intrusive; (3) estimates the audit results from using financial status audit techniques in terms of the amount of adjustments to reported income; and (4) determines how IRS applied its audit standards, quality controls, and measurement of audit quality to the use of financial status techniques.

GAO noted that: (1) on the basis of its review of samples of IRS audits completed before and after IRS reemphasized the use of financial status techniques, GAO found no statistically significant change in the frequency with which these techniques were used or in the types of returns for which the techniques were used; (2) during both periods, over 75 percent of the audits using financial status techniques involved individual returns with business or farm income--the types of taxpayers that IRS has historically found to be the most likely to underreport income; (3) financial status audit techniques vary in the need for taxpayer contact and how much additional burden or intrusiveness may be perceived by the taxpayer; (4) financial status audits have been criticized by tax professionals and others for, among other things, seeking information about financial status without having evidence of unreported income; (5) such intrusions into taxpayers' spending patterns could occur before the initial interview and during the initial interview; (6) IRS used the Personal Living Expense (PLE) form to inquire about expenses at the time of the notification letter in fewer than 5 percent of the audits for both the 1992 and 1993 and 1995 and 1996 periods; (7) the case files showed that auditors infrequently asked intrusive, financial status type questions at the initial interview; (8) concerning the results, auditors made no adjustments to the individual's reported income attributable to the use of financial status audit techniques in 83 percent of the audits in which these techniques were used; (9) IRS has three tools to oversee the use of financial status audit techniques: (a) audit standards to guide auditors; (b) supervisory review of auditors' adherence to the standards; and (c) a system to measure adherence to the standards; (10) while these tools offered important controls over the use of the financial status techniques, they each have limitations; and (11) on the basis of GAO's review of IRS audit workpapers, the lack of specific criteria may have contributed to the relatively large percentage of audits in which the use of financial status audit techniques resulted in no adjustments to income.

Recommendations

Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.

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