Internal Revenue Service
Challenges Remain in Combating Abusive Tax Shelters
Gao ID: GAO-04-104T October 21, 2003
Recent scandals involving corporations, company executives, and accounting, law, and investment banking firms heightened awareness of abusive tax shelters and highlighted the importance of the Department of the Treasury and the Internal Revenue Service (IRS) addressing them. During 1999, Treasury issued a report indicating that abusive shelters were a large and growing problem, involving billions of dollars of tax reductions. Treasury was concerned that abusive shelters could ultimately undermine the integrity of the voluntary compliance tax system. GAO's statement today is based on work done at the request of the Chairman and the Ranking Minority Member of the Senate Committee on Finance to examine IRS's strategy for dealing with abusive tax shelters. In reporting on abusive shelters, GAO is describing (1) their nature and scope; (2) IRS's strategy and enforcement mechanisms to combat them and the performance goals and measures IRS uses to track its major effort in that area; and (3) the decision-making process IRS used and the plans it has to devote more resources to addressing abusive shelters.
By their nature, abusive tax shelters are varied, complex, and difficult to detect and measure. Abusive shelters manipulate many parts of the tax code or regulations and may involve steps to hide the transaction within a tax return. In recent years, IRS has been accumulating information about them and, although it does not have a reliable measure of the size of the abusive shelter problem, has come to believe that abusive shelters deserve substantially increased attention. IRS continues to gather more information to better define the scope of the problem and has data sources, all with their own limitations, that suggest abusive tax shelters total tens of billions of dollars of potential tax losses over about a decade. IRS's broad-based strategy for addressing abusive shelters included: (1) targeting promoters to head off the proliferation of shelters; (2) making efforts to deter, detect, and resolve abuse; (3) offering inducements to individuals and businesses to disclose their use of questionable tax practices; and (4) using performance indicators to measure outputs and some outcomes and intending to go down the path it has started and develop long-term performance goals and measures linked to those goals. Without these latter elements, Congress would find gauging IRS's progress difficult. In allocating resources to shelters, IRS used a systematic decision-making process that relied on admittedly limited information. It planned to shift significant resources in fiscal years 2003 and 2004 to address abusive shelters but faces challenges, especially in the near term, in addressing abusive shelters due to a growing workload and limited information on how long it takes to examine shelter cases. IRS's understanding of how many staff will be needed to address the problem over what period will continue to evolve as it gains a better understanding of the problem's scope.
GAO-04-104T, Internal Revenue Service: Challenges Remain in Combating Abusive Tax Shelters
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Testimony:
Before the Committee on Finance, U.S. Senate:
For Release on Delivery Expected at 10:00 a.m. EDT Tuesday, October 21,
2003:
Internal Revenue Service:
Challenges Remain in Combating Abusive Tax Shelters:
Statement of Michael Brostek Director, Tax Issues:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-104T] GAO-04-
104T:
GAO Highlights:
Highlights of GAO-04-104T, a testimony to the Committee on Finance,
U.S. Senate
Why GAO Did This Study:
Recent scandals involving corporations, company executives, and
accounting, law, and investment banking firms heightened awareness of
abusive tax shelters and highlighted the importance of the Department
of the Treasury and the Internal Revenue Service (IRS) addressing
them. During 1999, Treasury issued a report indicating that abusive
shelters were a large and growing problem, involving billions of
dollars of tax reductions. Treasury was concerned that abusive
shelters could ultimately undermine the integrity of the voluntary
compliance tax system.
GAO‘s statement today is based on work done at the request of the
Chairman and the Ranking Minority Member of the Senate Committee on
Finance to examine IRS‘s strategy for dealing with abusive tax
shelters. In reporting on abusive shelters, GAO is describing
* their nature and scope,
* IRS‘s strategy and enforcement mechanisms to combat them and the
performance goals and measures IRS uses to track its major effort in
that area, and
* the decision-making process IRS used and the plans it has to devote
more resources to addressing abusive shelters.
What GAO Found:
By their nature, abusive tax shelters are varied, complex, and
difficult to detect and measure. Abusive shelters manipulate many
parts of the tax code or regulations and may involve steps to hide the
transaction within a tax return. In recent years, IRS has been
accumulating information about them and, although it does not have a
reliable measure of the size of the abusive shelter problem, has come
to believe that abusive shelters deserve substantially increased
attention. IRS continues to gather more information to better define
the scope of the problem and has data sources, all with their own
limitations, that suggest abusive tax shelters total tens of billions
of dollars of potential tax losses over about a decade.
IRS‘s broad-based strategy for addressing abusive shelters included:
* targeting promoters to head off the proliferation of shelters;
* making efforts to deter, detect, and resolve abuse;
* offering inducements to individuals and businesses to disclose their
use of questionable tax practices; and
* using performance indicators to measure outputs and some outcomes
and intending to go down the path it has started and develop long-term
performance goals and measures linked to those goals. Without these
latter elements, Congress would find gauging IRS‘s progress difficult.
In allocating resources to shelters, IRS used a systematic decision-
making process that relied on admittedly limited information. It
planned to shift significant resources in fiscal years 2003 and 2004
to address abusive shelters but faces challenges, especially in the
near term, in addressing abusive shelters due to a growing workload
and limited information on how long it takes to examine shelter cases.
IRS‘s understanding of how many staff will be needed to address the
problem over what period will continue to evolve as it gains a better
understanding of the problem‘s scope.
What GAO Recommends:
www.gao.gov/cgi-bin/getrpt?GAO-04-104T.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Michael Brostek at
(202) 512-9110 or brostekm@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I appreciate the opportunity to testify on the Internal Revenue
Service's (IRS) efforts to deal with abusive tax shelters. I am using
the term "abusive shelters" to describe very complicated transactions
promoted to corporations and wealthy individuals to exploit tax
loopholes and provide large, unintended tax benefits. Recent scandals
involving corporations, company executives, and accounting, law, and
investment banking firms heightened awareness of abusive shelters and
highlighted the importance of the Department of the Treasury and IRS
addressing the problem. During 1999, Treasury issued a report
indicating that abusive shelters were a large and growing problem,
involving billions of dollars of tax reductions.[Footnote 1] Treasury
was concerned that abusive shelters could ultimately undermine
voluntary compliance by eroding the integrity of the tax system. In
response to information pointing to the rapid growth of abusive
shelters, IRS formalized a strategic initiative in fiscal year 2000 to
strengthen its capacity to deal with abusive corporate shelters. One
element of IRS's initiative involved creating a central office within
the Large and Mid-Size Business (LMSB) Division to coordinate and guide
efforts to curb the growth of abusive shelters.
My statement today is based on work we have done at the request of the
Chairman and the Ranking Minority Member. In examining abusive
shelters, we focused on (1) their nature and scope, (2) IRS's strategy
and enforcement mechanisms to combat them and the performance goals and
measures IRS uses to track its major effort in that area, and (3) the
decision-making process IRS used to allocate resources to abusive
shelters and the plans it has to devote more resources to addressing
abusive shelters. We were also asked to provide information on IRS's
Schedule K-1 document matching program, which we are including in
appendix I.
To do our work, we:
* analyzed IRS's and other shelter reports, publications, data, and
other documentation providing insight into the characteristics,
complexity, size, and type of the problem;[Footnote 2]
* reviewed IRS's planning documents with information on its strategies,
measures, and resources;
* compared the contents of IRS's planning documents to Government
Performance and Results Act of 1993 (GPRA)[Footnote 3] criteria for
what elements strategic planning should include; and:
* interviewed agency officials about their views on, among other
things, the problem's nature and scope and IRS's strategy.
We did our work from September 2002 through August 2003 in accordance
with generally accepted government auditing standards. As agreed, we
are also discussing the related problem of abusive tax schemes in a
report to be released in the near future. Abusive tax schemes are used
more by individuals than by large businesses and encompass such
distortions of the tax system as falsely describing the law (saying,
for example, that the income tax is unconstitutional), misrepresenting
facts (for instance, promoting the deduction of personal expenses as
business expenses), and using trusts or offshore bank accounts to hide
income. The boundary between what we are calling an abusive tax shelter
and an abusive scheme is not always clear. Organizationally, although
IRS's LMSB Division has lead responsibility for combating abusive
shelters, abusive shelters are pursued by IRS's Small Business/Self-
Employed Division when they are used by businesses with assets of less
than $10 million or by high-wealth individuals with complicated tax
returns.
My statement today will make the following points:
* By their nature, abusive shelters are varied, complex, and difficult
to detect and measure. Abusive shelters manipulate many parts of the
tax code or regulations and may involve steps to hide the transaction
within a tax return. In recent years, IRS has been accumulating
information about abusive shelters and the extent that they were
promoted, and it has come to believe that abusive shelters deserve
substantially increased attention. Suffice it to say, although they do
not have a reliable measure of the size of the abusive shelter problem,
Treasury and IRS believe that tens of billions of dollars of taxes are
being improperly avoided and the potential for the proliferation of
abusive shelters is strong. IRS continues to gather more information to
better define the scope of the problem and has several data sources,
each with certain limitations, that point to billions in tax losses. As
of September 30, 2003, a database on shelter transactions that IRS has
publicly declared to be tax avoidance transactions suggested the
potential tax loss to be about $33 billion, the majority of which was
concentrated from tax year 1993 through the present. This database
included only transactions disclosed to or discovered by IRS. In
addition, an IRS contractor estimating annual tax gaps resulting from
abusive shelters estimated that the annual average of foregone taxes
between 1993 and 1999 could have been as small as about $11.6 billion
or as large as about $15.1 billion. However, Treasury, IRS, the
contractor, and we all have concerns about the reliability of the
contractor's estimates because of methodological and data constraints
that the contractor faced.
* The broad-based strategy reflected in IRS planning documents included
various features as well as elements of strategic planning:
* targeting promoters to head off the proliferation of shelters;
* making efforts to deter, detect, and resolve abuse;
* coordinating efforts throughout IRS;
* offering inducements to individuals and businesses to disclose their
use of questionable tax practices; and:
* using performance indicators to measure outputs and some outcomes and
intending to continue down the path it has started and develop long-
term performance goals and measures linked to those goals. Without
these latter elements, Congress would find gauging IRS's progress
difficult.
* In developing this strategy, IRS has had to make decisions about
staffing allocations and what can be accomplished on the basis of
admittedly limited information. After using a systematic process to
determine staffing priorities, IRS planned a significant shift in
resources to address abusive shelters in fiscal years 2003 and 2004.
However, it faces challenges, especially in the near term, in
addressing abusive shelters due to a growing workload and limited
information on how long it takes to examine shelter cases. IRS's
understanding of how many staff will be needed to address the problem
over what period will continue to evolve as IRS gains a better
understanding of the problem's scope.
Background:
Although IRS has no single, authoritative definition of abusive
shelters, IRS generally characterizes abusive shelters as very
complicated transactions that sophisticated tax professionals promote
to corporations and wealthy individuals, exploiting tax loopholes and
reaping large and unintended tax benefits. As the Joint Committee on
Taxation has said, "taxpayers and tax administrators have struggled in
determining the line between legitimate 'tax planning' and unacceptable
'tax shelters.'" Even though, it continued, "there is no uniform
standard as to what constitutes a tax shelter — there are statutory
provisions, judicial doctrines, and administrative guidance that
attempt to limit or identify transactions in which a significant
purpose is the avoidance or evasion of income tax."[Footnote 4]
Abusive shelters have been promoted by some accounting firms, law
firms, and investment banks. Investors in these abusive shelters range
from large and small corporations to wealthy individuals. IRS
approaches the tax shelter enforcement problem from both the promoter
and investor perspectives. IRS promoter investigations are designed to
learn (1) what abusive shelters have been promoted, if the shelters are
registered,[Footnote 5] and possibly how much they cost investors, (2)
who purchased the shelters and what tax savings the investors expect,
and (3) whether promoters should pay penalties for their activities.
IRS examines investor and other tax returns to see if income, expenses,
taxes, and credits are accurately reported.
In a June 2002 letter, Treasury responded to congressional questions
about whether Treasury had a comprehensive strategy for combating tax
avoidance. In his letter to the then Ranking Member of the Committee on
Finance, then Secretary of the Treasury O'Neill addressed the actions
being taken to combat abusive shelters, referring to Treasury's March
20, 2002, enforcement proposals on the topic. The proposals said that
IRS had made significant organizational improvements to coordinate its
response to ongoing abusive tax shelters. Treasury, all of IRS's
operating divisions, and IRS's Office of Chief Counsel are involved in
combating abusive shelter activity.
Within IRS, LMSB has primary responsibility for combating abusive tax
shelter activity. LMSB's OTSA was created in February 2000 to
centralize and coordinate the IRS response nationwide. As shown in
figure 1, OTSA is the focal point for IRS shelter activities,
overseeing promoter tax shelter registrations; taxpayer disclosures of
tax shelters; hotline tip analysis and referral; and issue coordination
and interface between the Office of Chief Counsel, Treasury, the Tax
Shelter Committee, the 6700 Committee (referring to section 6700 of the
Internal Revenue Code), and external stakeholders.[Footnote 6] The Tax
Shelter Committee oversees LMSB's tax shelter program. The committee is
composed of the Commissioner and Deputy Commissioner of LMSB, the
Director of Pre-Filing and Technical Guidance, LMSB Division Counsel,
five Industry Directors, the Director of International, and the
Directors of Field Specialists and Research and Program Planning. The
6700 Committee serves under the Tax Shelter Committee and approves all
LMSB tax shelter promoter activities. The financial services' industry
director chairs this committee. IRS's appeals function receives and
evaluates taxpayer objections to IRS examination determinations and may
agree with those determinations or reduce or eliminate changes to tax
returns resulting from them. The Office of Chief Counsel plays an
integral role in combating shelters through summons enforcement and
targeted litigation. By litigating, IRS establishes case law supporting
IRS enforcement programs and aims to diminish the incentives taxpayers
find for investing in tax avoidance transactions by increasing the
risks and costs of IRS discovery.
Figure 1: OTSA's Role in Coordinating IRS Work on Abusive Shelters:
[See PDF for image]
[End of figure]
Nature of Abusive Shelters Is Varied and Complex:
Abusive shelters are complex transactions that manipulate many parts of
the tax code or regulations and are typically buried among "legitimate"
transactions reported on tax returns. Because these transactions are
often composed of many pieces located in several parts of a complex tax
return, they are essentially hidden from plain sight, which contributes
to the difficulty of determining the scope of the abusive shelter
problem. Often lacking economic substance or a business purpose other
than generating tax benefits, abusive shelters are promoted by some tax
professionals, often in confidence, for significant fees, sometimes
with the participation of tax-indifferent parties, such as foreign or
tax-exempt entities. They may involve unnecessary steps and flow-
through entities, such as partnerships, which make detection of these
transactions more difficult.
When a transaction has certain abusive characteristics defined by
section 6111 of the Internal Revenue Code, the promoter or other tax
shelter organizer is required to register it, describing the
transaction and its tax benefits to the Secretary of the Treasury. This
registration requirement enables Treasury and IRS to identify and
evaluate questionable transactions. Under recently issued Treasury
regulations,[Footnote 7] effective February 28, 2003, there are six
categories of transactions for which promoters must maintain lists of
investors who have entered into the transactions, and investors must
disclose the transactions into which they have entered. The rules are
designed to allow IRS to use information from investors to identify
promoters who do not register transactions and to use promoter
registrations and investor lists to identify investors who fail to
disclose transactions. The six categories are:
* transactions offered under conditions of confidentiality,
* transactions including contractual protections to the investor,
* transactions resulting in specific amounts of tax losses,
* transactions generating a tax benefit when the underlying asset is
held only briefly,
* transactions generating differences between financial accounts and
tax accounts greater than $10 million, and:
* "listed transactions.":
A "listed transaction" is a transaction that is the same as or similar
to one of the types of transactions IRS has determined to be a tax
avoidance transaction. For a transaction to be a listed transaction,
IRS must issue a notice, regulation, or other form of published
guidance informing taxpayers of the details of the transaction. As of
mid-August 2003, IRS had listed 27 kinds of abusive tax shelter
transactions, a number that, as figure 2 shows, has grown more quickly
in recent years than it had grown earlier.
Figure 2: Cumulative Number of Listed Transactions over Time, 1990-mid-
August 2003, and Transaction Descriptions:
[See PDF for image]
[End of figure]
Disputes between IRS and taxpayers about the abusive nature of a
transaction may be litigated. In some, but not all, cases, the courts
have upheld the government position. The following cases illustrate
features of abusive shelters:
* In 1993, a corporation began a company-owned life insurance (COLI)
program in which the company purchased whole-life insurance on 36,000
employees for which the company was the sole beneficiary. The company
then borrowed money against the policies at interest rates that
averaged 11 percent and deducted the interest expense and
administrative fees from income on its tax returns. Over 60 years, the
interest costs and administrative fees would have exceeded the cash
surrender value of the policies and benefits paid by several billion
dollars. IRS disallowed the deductions and the case was litigated.
Despite the fact that the money the company made on this arrangement
may have been used to fund the company's benefits program, or for other
business purposes, the court found that the function of the program
itself was only to generate tax deductions. As a result, the Tax Court
sustained the IRS disallowance of deductions and concluded that the
COLI program was a sham.[Footnote 8] The Eleventh Circuit Court of
Appeals affirmed the Tax Court's decision.
* A company had a sizable gain from the sale of a subsidiary and wanted
to avoid or minimize paying tax on the gain. An investment bank
proposed forming an offshore partnership with a foreign corporation (a
tax-indifferent party) for the express purpose of sheltering the
capital gains of its corporate client. The partnership purchased and
quickly resold notes in a contingent installment sale transaction. The
partnership earned a large capital gain, most of which it allocated to
the foreign corporate partner. Later, related losses were allocated to
the U.S. corporation, generating an approximate $100 million capital
loss for the investment bank's client. The corporation used this
capital loss to shelter its U.S.-based capital gains. Both the Tax
Court and the Third Circuit Court of Appeals ruled that the transaction
lacked economic substance.[Footnote 9] The Third Circuit, in addition
to requiring economic substance, held that a transaction must have a
subjective nontax business motive to be respected for tax
purposes.[Footnote 10] For this transaction, the investment bank was to
earn a fee of $2 million. This was one of 11 such partnerships formed
over a 1-year period from 1989 to 1990 by the investment bank.
Several Sources Indicate That the Scope of Abusive Shelters Is in the
Tens of Billions of Dollars, Though All Are Based on Limited Data:
IRS has information that suggests the scope of abusive shelters totaled
tens of billions of dollars over about a decade,[Footnote 11] but those
estimates are based on limited data. This information comes from an
OTSA database, examinations of large corporations, and a contractor
study. Information contained in the OTSA database includes transactions
disclosed to or discovered by IRS and estimates of potential tax
losses. The tax loss estimates vary from being IRS officials'
recommended taxes based on examining some transactions to taxpayer
judgments regarding potential losses in cases where examinations have
not been done. In addition to being based on judgments, the database
does not include any reductions resulting from examination, appeal,
litigation, or other sources. Information from examinations of the
largest corporations, which may overlap information in the OTSA
database, shows proposed income adjustments in the tens of billions of
dollars before reductions, but data were not available from IRS on the
results of examinations of smaller corporations, partnerships, trusts,
S corporations, or individuals. Information from IRS's contractor study
estimates an annual tax gap due to abusive shelters but has data and
methodological limitations.
OTSA Database:
As shown in table 1, as of September 30, 2003, an OTSA database
included estimated potential tax losses of about $33 billion from
investments in listed transactions, before considering any reductions
resulting from examination, appeal, litigation, or other sources and
another $52 billion in potential tax losses from nonlisted transactions
with some characteristics of abusive shelters. This database contains
information on promoters and investors and the amount of potential tax
savings resulting from listed and nonlisted transactions. Nonlisted
transactions are transactions that needed to be registered because they
have some characteristics of abusive shelters but were not, at least
yet, determined to be abusive. According to an IRS official, IRS was
studying nonlisted transactions with about $12 billion in potential tax
losses for possible listing. The database only includes information on
abusive or possibly abusive transactions that had been disclosed to or
discovered by IRS.
Table 1: IRS's Compilation of Tax Shelter Amounts as of January 14,
2003, and September 30, 2003:
[See PDF for image]
Source: IRS OTSA database.
[A] The potential tax loss covers a multiyear period and does not
consider reductions that may result from examination, appeal,
litigation, or other sources.
[B] The numbers do not add to the total due to rounding.
[End of figure]
The estimated tax losses contained in the OTSA database cover a wide
range of years from at least as far back as tax year 1989 and extending
even to future tax years since, for instance, improperly claimed
deductions may be used in some cases to reduce future taxes. For the
$29 billion in estimated tax losses associated with listed transactions
contained in the January 14, 2003, database, about 82 percent of the
potential tax losses were concentrated in the period from 1993 through
2002.
According to data IRS provided in mid-October 2003, OTSA had
information on almost 300 firms that had possibly promoted abusive
shelters as well as other tax planning products that contain at least
some features of abusive transactions. It was also aware of about 6,400
investors, including individuals and corporations that bought abusive
shelters and other aggressive tax planning products.
Examinations of Large Corporations:
IRS has proposed shelter-related adjustments to large corporations'
income in examinations it has closed and in examinations still open as
of early May 2003. In cases closed between October 1, 2001, and May 6,
2003, IRS proposed about $10.6 billion in abusive shelter-related
adjustments to the income of 42 large corporations for tax years 1992-
2000. These proposed adjustments would result in about $3.5 billion in
tax revenue if the adjustments were not reduced. The corporations were
in what is known as the Coordinated Industry Case (CIC) program, which
includes the nation's largest corporations.[Footnote 12] They agreed
with about $1.2 billion of the $10.6 billion in proposed adjustments to
income.[Footnote 13] As of early August 2003, Appeals research showed
that few of the issues comprising the $9.4 billion unagreed amount had
been resolved yet by Appeals or through a settlement initiative,
although the database did not track all of them.[Footnote 14] For the
141 large corporations with cases still open in early May 2003, the
amount of proposed shelter-related income adjustments was $47.6
billion, translating to about $16 billion in tax if not reduced. IRS
did not have similar information for smaller corporations. Also, since
one of the sources of information in the OTSA database is shelter-
related adjustments proposed in examinations, the proposed adjustments
in the CIC program may overlap the information in the OTSA database.
Contractor Study:
In July 2003, an IRS contractor estimated the tax gap resulting from
abusive shelters for different years. For 1993 through 1999, based on
the contractor's estimates, the average annual tax gap could have been
as small as about $11.6 billion or as large as about $15.1 billion of
forgone tax. However, the reliability of the contractor's estimates is
questionable because of methodological and data constraints the
contractor faced when developing them.
The estimates followed a September 2001 recommendation by the Treasury
Inspector General for Tax Administration (TIGTA) that LMSB obtain a
more precise estimate of the shelter problem to lay a better foundation
for its strategy for addressing abusive shelters.[Footnote 15] In
response, IRS contracted for models to predict the likelihood of
finding abusive shelters within certain tax returns and to estimate the
annual "tax gap" due to abusive shelters. Both IRS and contractor
officials believe the contract results are more useful to predict
returns with abusive shelters than they are to value the size of the
abusive shelter problem.
Nevertheless, as table 2 shows, the contractor produced estimates of
the size of the problem for each year from 1993 through 1999. Yearly
low-end estimates ranged from $9.0 billion of foregone tax in 1993 to
$14.5 billion in 1999. On the other hand, the high-end estimates ranged
from $12.1 billion in 1993 to $18.4 billion in 1999.[Footnote 16]
Averaging the estimates over time results in the $11.6 billion to $15.1
billion range cited earlier.
Table 2: Contractor Estimates of the Size of the Abusive Shelter
Problem (Dollars in Billions):
Year: 1993; Lower bound: $ 9.0; Upper bound: $12.1.
Year: 1994; Lower bound: 9.5; Upper bound: 12.7.
Year: 1995; Lower bound: 10,3; Upper bound: 13.6.
Year: 1996; Lower bound: 11.4; Upper bound: 14.9.
Year: 1997; Lower bound: 12.7; Upper bound: 16.4.
Year: 1998; Lower bound: 13.6; Upper bound: 17.3.
Year: 1999; Lower bound: 14.5; Upper bound: 18.4.
Year: 1993-1999 average; Lower bound: 11.6; Upper bound: 15.1.
Source: Report provided by IRS.
Note: As computed by the contractor, the lower and upper bounds are the
boundaries of 90 percent confidence intervals associated with the
estimates.
[End of table]
The tax gap model used three different kinds of data: (1) IRS's
Statistics of Income data for the largest U.S. companies, those with
assets over $250 million falling within the CIC program, (2) Standard
and Poor's Compustat financial data, and (3) surveys of IRS field
offices. IRS conducted surveys from 1999 through 2001 that asked field
managers to identify abusive tax shelters in their open inventory of
examinations--relying on each manager's understanding of what an
abusive tax shelter is. Since survey data are included in the OTSA
database, some of the same information used by the contractor appears
in the OTSA information cited earlier.
Treasury, IRS, the contractor, and we have concerns about the
contractor estimates. First, it is difficult to determine whether these
estimates might be overstating or understating the true extent of the
tax gap because of the uncertainties in the underlying data and the
elusive nature of the problem. In identifying abusive shelters in the
IRS surveys, field managers might have anticipated that some abusive
shelters existed where there were none or where the assertion of abuse
might not be sustained. On the other hand, they might not have
identified all the abusive shelters in their open inventory of
examinations because their definitions of abusive shelters might have
differed from each other. Finally, the data might not be representative
of all transactions, especially those that closed, because survey
responses were only to include open cases.
Second, the Statistics of Income data only included U.S. corporations
with assets of over $250 million falling within the CIC program. Many
shelters may be reflected in tax returns of smaller corporations,
partnerships, Subchapter S corporations, and wealthy individuals and
were not included in this study. Since these transactions were not
included in the contractor's estimate, the resulting tax gap estimate
is incomplete.
Third, the estimates are based on known shelters. They were developed
using 1990s' ideas of what constituted abusive shelters. Since then,
more shelters have been disclosed or identified by IRS and still others
are under consideration for listing. Since the definition of an abusive
shelter can change over time, and the data cannot reflect unknown or
unidentified shelters, the operational definition of abusive shelters
was a conservative one.
While the last two concerns argue that the contractor's estimates
understate the true level of abusive shelters for recent years, the
contractor's estimates and other indicators of the problem's size based
on past data may also be of limited use as guides to current and future
activity for other reasons. According to Treasury and IRS officials,
the legal and economic environment has changed since the data for this
study were developed. First, they said, IRS has taken many
administrative actions to address abusive shelters. For instance, it is
their belief that nothing puts more of a damper on taxpayer
participation in a particular type of transaction than IRS listing it.
Similarly, although corporate-owned life insurance transactions may
heavily influence the contractor's estimates, legislation addressed the
problem in 1996 and 1997, and therefore current and future estimates
would not reflect that problem--although they could reflect problems
not identified in the period covered by the contractor's study. Second,
court cases have largely supported IRS's assertions about the need for
business purpose requirements and about requirements for economic
substance in transactions. Third, today's economy is not as robust as
the economy in the late 1990s, generating less profit to protect.
Finally, the publicity surrounding numerous corporate scandals may
create a chilling effect in the market for aggressive transactions.
Countering these points, however, are other opinions appearing in the
press that (1) the courts could uphold some tax shelters and (2) IRS's
capacity to stem abusive shelters is limited.
IRS Strategy to Combat Abusive Shelters Is Broad-Based but Generally
Has No Long-Term Performance Goals or Measures Linked to Goals:
IRS developed a broad-based strategy for combating abusive shelters
that included various features as well as elements of strategic
planning. Deeming it a strategic initiative, IRS is executing a
strategy incorporating four principal elements: (1) an emphasis on
promoters, (2) efforts to deter, detect, and resolve abuse, (3)
coordination of efforts throughout IRS, and (4) inducements provided
for taxpayers to come forward and expedite case resolution. IRS is
implementing a variety of initiatives designed to reduce taxpayer
incentives to participate in abusive transactions and discourage
promoters from marketing these transactions. Although IRS documents
outline an overall strategy for combating abusive shelters, IRS has
generally not yet defined long-term performance goals for the effort
and the measures it would use to track progress in achieving those
goals.[Footnote 17] However, IRS is planning to establish such goals
and measures when it has more information on the abusive shelter
activities it is currently tracking.
IRS Is Actively Pursuing Promoters:
IRS is actively pursuing abusive promoters to ensure (1) that tax
strategies containing characteristics of potentially abusive shelters
are registered, (2) that information about transactions is disclosed to
IRS as required by sections 6111 and 6112 of the Internal Revenue Code,
and (3) that, according to IRS's OTSA manager, those who generate
noncompliance change their behavior or go out of business. With 98
abusive shelter promoters approved for investigation as of June 30,
2003, IRS uses investigations to gain access to lists of the clients
who buy promoters' products and devise a roadmap to audit shelters
included in the tax returns of the investors. IRS is also using
promoter investigations to enforce the transaction registration
requirements, which, in turn, assist in its efforts to understand,
track, and close abusive shelters. IRS announced the completion of
three large promoter investigations in 2001 through July 2003. They
resulted in, among other things, three substantial payments and
promoter promises to work with IRS to ensure ongoing compliance with
shelter registration and list maintenance requirements.
IRS Efforts Are to Deter, Detect, and Resolve:
IRS focuses its efforts on deterring future marketing and sales of
abusive tax shelters and on detecting and resolving existing shelters.
TIGTA described IRS's abusive shelter approach along the lines of
deter, detect, and resolve in September 2001.[Footnote 18] IRS
considers its efforts to provide guidance as early as possible to
taxpayers and promoters in the form of recently proliferating IRS and
Treasury determinations, notices, and rulings on abusive transactions
and of registration, list maintenance, disclosure, and other
requirements to be a key deterrent. (See fig. 2.) Also designed to
deter abusive tax shelters, accuracy-related penalties aim at investors
who use abusive shelters to substantially undervalue true tax
liability. Other penalties are for promoters who market shelters that
aid and abet the understatement of tax liability or who fail to
register shelters. IRS's Examination Returns Control System showed IRS
assessing 21 investor penalties totaling about $73 million between July
1, 2002, and May 1, 2003, which taxpayers had not necessarily agreed to
pay. During our review, Treasury included proposed legislation in the
Administration's revenue proposals to strengthen the penalties that
could be used in abusive shelter situations.
IRS's ability to detect abusive shelters increased in the last 3 years
due to OTSA's hotline, through which callers provide tips about
transactions or investors; disclosure, registration, and list
maintenance requirements; increased attention by IRS management; and
increased use of IRS examination resources to look for shelter
irregularities. For instance, between May 31, 2000, and July 30, 2003,
the hotline received 729 shelter-related telephone calls and e-mails,
some of them leading IRS to new listed transactions, promoters, and
investors. As another example, IRS expanded its disclosure requirements
in June 2002 to include noncorporate taxpayers. Finally, as evidence of
increased management attention, IRS established a new senior position
reporting to the IRS Chief Counsel to supervise staff and lead task
force initiatives to more quickly identify and deal with abusive
shelters.
Cases may be resolved at the examination level if taxpayers agree with
IRS findings. If taxpayers do not agree, cases are resolved at the
appeals level, through litigation, or by alternative dispute
resolution.
In addition to these detection and case resolution efforts, IRS is
using Schedule K-1 data to research better methods of detecting abusive
shelters that involve multiple levels of flow-through
entities.[Footnote 19] These complex structures of related entities
pose challenges in analyzing tax compliance by creating opportunities
for taxpayers to disguise noncompliance. In the future, IRS hopes to
use advanced data analysis tools such as link analysis and graph-based
data mining to identify potential abusive shelters. Link analysis is
the process of building networks of related entities, such as flow-
through entities and Schedule K-1 recipients, in order to expose
patterns and trends. Graph-based data mining, a form of link analysis,
is intended to enable IRS to identify structures of known abusive
shelters and find similar patterns in the population of flow-through
networks to discover previously undisclosed potential abusive shelter
transactions. IRS has paid a contractor $200,000 so far to assess the
feasibility of these technologies and plans to spend $575,000 over the
next 1.5 to 2 years to develop these concepts into models.
IRS Emphasizes Internal Coordination:
Coordination within IRS and interface with Treasury on abusive shelters
is a core objective in IRS's plans for addressing those shelters. OTSA
is the focal point for all shelter-related activity performed in the
Tax Shelter Committee, the 6700 Committee, Counsel, Appeals, and LMSB.
For example, if a taxpayer discloses an investment in a tax shelter to
IRS, OTSA is to enter the transaction into its database, and OTSA
reviews the transaction in collaboration with IRS technical advisors
and counsel. OTSA may also forward it to LMSB examiners for compliance
action.
At the IRS-wide level, an executive steering committee provides a forum
for coordinating work on both abusive shelters and abusive schemes. It
meets monthly and includes participants from LMSB, the Small Business/
Self Employed Division, Appeals, Counsel, and other organizations. It
operates under the auspices of IRS's Enforcement Committee, which was
chartered in July 2003. Chaired by the Deputy Commissioner for Services
and Enforcement, a new position created in May 2003, the Enforcement
Committee is to guide IRS-wide enforcement strategies, focusing on
high-visibility issues involving many divisions or potentially having
significant compliance impact.
Although we did not systematically measure whether coordination is
facilitated by these mechanisms, we did review minutes of selected
executive steering committee meetings. In doing so, we saw such
evidence of coordination as the discussion of an LMSB and SB/SE working
group on who would work a corporate officer case when LMSB works on a
corporation.
IRS Offers Inducements for Taxpayers to Disclose Shelters and Expedite
Case Resolution:
LMSB attempts to leverage its limited resources by using inducements to
achieve compliance. These tools include penalty relief, "fast track"
issue resolution, and various structured settlement programs that allow
participating taxpayers to keep a percentage of a shelter's benefits in
exchange for conceding most benefits and expediting case resolution.
For example, under a disclosure initiative that expired on April 23,
2002, taxpayers who revealed shelters and their respective promoters
avoided accuracy-related penalties. IRS's aim was to more readily
identify promoters who had not registered shelters and, through the
promoters, find taxpayers who had not disclosed their shelter
participation. As a result of this initiative, IRS received 1,664
disclosures from 1,206 taxpayers, disclosing tens of billions of
dollars of losses and deductions.
IRS offered taxpayers various alternative dispute resolution mechanisms
as inducements to settle abusive shelter issues with IRS, mitigating
the hazards of litigation for both sides and moving more cases through
the administrative system quickly. For example, from October 2001
through April 7, 2003, 17 taxpayers agreed with IRS on their respective
shelter issues in the Fast Track Issue Resolution program, resolving
about $1.6 billion in proposed adjustments to income (potentially about
$540 million in tax). In another example, IRS announced initiatives in
October 2002 to resolve disputes related to three shelters: COLI,
basis-shifting shelters, and contingent liability shelters.[Footnote
20] In these initiatives, if taxpayers agreed to settle their cases
with IRS by a certain date, with the last initiative closing March 5,
2003, they would pay a large percentage of the full amount IRS
disallowed. A summary as of early May 2003 of the number of investors
involved in the three settlement initiatives and the potential tax
dollars conceded or to be conceded appears in table 3.[Footnote 21]
Table 3: Investors Accepting Abusive Shelter Settlement Initiative
Offers and Potential Tax Dollars Conceded or to Be Conceded as of Early
May 2003:
Settlement initiative: COLI; Number of taxpayers accepting IRS
settlement offer: 24; Number of taxpayers for whom IRS had information
on taxes conceded or to be conceded: 14; Potential tax dollars
conceded or to be conceded (billions): $0.2.
Settlement initiative: Basis shifting; Number of taxpayers accepting
IRS settlement offer: 267; Number of taxpayers for whom IRS had
information on taxes conceded or to be conceded: 33; Potential tax
dollars conceded or to be conceded (billions): 0.6.
Settlement initiative: Contingent liability; Number of taxpayers
accepting IRS settlement offer: 62; Number of taxpayers for whom IRS
had information on taxes conceded or to be conceded: 62; Potential
tax dollars conceded or to be conceded (billions): 2.8[A].
Settlement initiative: Total; Number of taxpayers accepting IRS
settlement offer: 353[B]; Number of taxpayers for whom IRS had
information on taxes conceded or to be conceded: 109[B]; Potential
tax dollars conceded or to be conceded (billions): $3.6.
Source: Compiled by GAO from IRS data.
[A] GAO estimated this number using an average of certain capital loss
percentages to be conceded.
[B] We do not know if a particular taxpayer was involved in more than
one type of settlement initiative.
[End of table]
Generally IRS Does Not Have Long-Term Performance Goals or Measures
Linked to Goals:
Although IRS has outlined and begun to implement a multipart strategy
for combating tax shelters, it has not yet generally defined
performance goals for the effort and established the measures it would
use to track progress in achieving those goals. Performance goals
define what an organization is trying to achieve over time, preferably
focusing on the outcome desired rather than activities or outputs. To
date, according to IRS officials, their shelter-related goals cover the
number of staff years to be devoted to shelter examinations and the
number of shelter examinations to be closed. Also, LMSB planning
documents have a few short-term goals. For example, LMSB had a short-
term goal to begin compliance actions on all voluntary shelter
disclosures by June 30, 2003, a goal IRS officials told us was met. IRS
management officials recognize that developing other performance goals
and associated measures to track progress is desirable but point to
challenges they face in assessing the scope of the abusive shelter
problem. Nonetheless, IRS intends to establish such goals in the future
when it has more information on activities it is currently tracking.
IRS has already started down this road by developing several measures
that, while not tied to longer-term performance goals, are to be used
in tracking its progress in combating abusive tax shelters. It devised
these measures for fiscal year 2003 responding to a September 2001
TIGTA recommendation to develop performance measures so managers could
better target problem areas, highlight successes, evaluate
alternatives, and track whether OTSA is achieving desired outcomes. IRS
is mostly tracking outputs related to case management, such as the
number of tax shelter examinations closed and tax shelter return cycle
time, and is using output measures of IRS program activities, such as
published guidance issued and hotline contacts. IRS is also using some
measures that track tax enforcement outcomes, namely adjustments
proposed to tax returns from disallowing abusive shelters and tax
shelter penalties proposed.[Footnote 22] Since fiscal year 2003 was the
first year IRS used these measures, it had no baseline data with which
to evaluate its performance measures. However, LMSB plans to evaluate
its measures over time to assess their usefulness.
Resource Shifts Are Significant but IRS Faces Challenges in Addressing
Abusive Shelter Workload:
Using admittedly limited information, IRS used a systematic decision-
making process in deciding to shift a large portion of LMSB examination
staff resources toward addressing abusive shelters. From fiscal year
2002 through fiscal year 2004, LMSB expected to increase the portion of
its examination resources devoted to combating abusive shelters from 3
percent in 2002 to 20 percent in 2004. In doing so, it will have
shifted resources out of examining the category of cases including such
areas as net operating losses and claims for refunds. Even so, IRS
faces challenges, especially in the near term, in addressing expected
increases in its shelter workload because of the growing number of
shelter cases and limited information it has on how long it takes to
conduct shelter examinations. As will be described, GAO has previously
raised questions about IRS's ability to shift compliance resources as
planned.
IRS Used Systematic Planning and Budgeting Process to Determine
Staffing Priorities:
At an agencywide level, IRS decided staffing resource levels to be
devoted to addressing abusive shelters through a systematic planning
and budgeting process based on experience and professional judgment
because IRS did not and does not have a reliable measure of the abusive
shelter problem. Early in calendar year 2002, IRS's divisions completed
strategic assessments in which they studied trends, issues, and
priorities affecting their operations. In April 2002, IRS's senior
management team, including the Commissioner, Deputy Commissioner,
division heads, and others used two rounds of considering IRS's
programs to rank the needs for new or redirected funding for fiscal
year 2004. Of 33 programs considered, the program including tax
shelters received the third most votes. According to an IRS official,
this process also informed how funds already requested for fiscal year
2003 would actually be spent. After the senior management team reached
consensus, the Commissioner issued overall planning guidance for fiscal
years 2003 and 2004 to reflect the jointly set strategic direction, and
the divisions wrote fiscal year 2003 and 2004 "strategy and program
plans" outlining staffing resources needed.
IRS Shifts Significant Levels of Examination Resources to Shelters:
In 2002, LMSB put forward plans to increase its work on abusive
shelters from 3 percent of its examination resources to 20 percent
between fiscal years 2002 and 2004, assuming congressional funding. To
support this shift in examination resources, LMSB needed to allocate
examination resources away from other areas. One area to receive less
audit coverage was
industry audits.[Footnote 23] As shown in table 4, from fiscal year
2003 to fiscal year 2004, IRS planned to move resources away from
specific types of mandatory examinations and from some high-risk
nonmandatory returns.[Footnote 24] IRS's strategy is to mitigate the
impact of resource reallocations away from nonshelter areas by using
such issue management strategies as fast-track resolution and prefiling
agreements, thereby requiring less staff time to close cases and
freeing staff to be used in other areas.
Table 4: Percentage of LMSB Examination Resources in Different
Examination Areas:
Examination area: Shelters; FY 2002[A]: 3%; FY 2003: 15%; FY 2004: 20%.
Examination area: Other mandatory examinations (including coordinated
industry,[B] claims for refunds, net operating losses, compliance
initiative projects, and flow-through entities related to wealthy
individuals); FY 2002[A]: N/A; FY 2003: 55%; FY 2004: 54%[C].
Examination area: Related returns; FY 2002[A]: N/A; FY 2003: 5%; FY
2004: 4%[C].
Examination area: High-risk, nonmandatory returns; FY 2002[A]: N/A; FY
2003: 15%; FY 2004: 13%.
Examination area: Nonreturn examination activities; FY 2002[A]: N/A; FY
2003: 10%; FY 2004: 10%.
Examination area: Total; FY 2002[A]: --; FY 2003: 100%; FY 2004:
100%[D].
Source: LMSB September 20, 2002, presentation to the IRS Oversight
Board, as amended after the presentation.
[A] Information for most of the rows in this column was not available,
as the presentation to the Oversight Board did not include it.
[B] Coordinated industry cases are examinations of the nation's largest
corporations, those under continual IRS audit.
[C] At the time of the September 20, 2002, presentation to the
Oversight Board, the 54 and 4 percent were 52 and 5 percent,
respectively.
[D] The column does not add to 100 percent because of rounding.
[End of table]
In addition to LMSB examination staff, IRS has managers, attorneys, and
others who work on abusive shelters. For instance, in February 2003,
OTSA and its parent body, the Office of Pre-Filing and Technical
Guidance, had 39 full-time and 34 part-time technical experts, program
analysts, and managers. Also at that time, a contact list for listed
transactions included 17 attorneys. These numbers did not include many
of the IRS legal resources involved with abusive shelters. In addition,
as of September 30, 2003, LMSB had assigned about 1,900 abusive and
potentially abusive shelter transactions involving non-LMSB taxpayers
to IRS's Small Business/Self-Employed Division, which supplies
examination staff resources of its own.
IRS Faces Challenges in Addressing Increasing Shelter Workload:
Although IRS appeared to be on track to shift planned resources to
shelter work in fiscal year 2003, it faces challenges in addressing the
abusive shelter workload, especially in the near term. This is because
of (1) the growing numbers of transactions and promoters to be examined
and (2) limited information on how long it takes to conduct shelter
examinations.
From fiscal year 2002 through fiscal year 2004, LMSB planned to use
1,879 full-time equivalents (FTE) to address abusive shelters. During
fiscal year 2002, LMSB used 239 FTEs to address tax returns that
included abusive shelters.[Footnote 25] According to IRS's fiscal year
2004 congressional budget justification, LMSB planned to allocate 691
and 949 FTEs in fiscal years 2003 and 2004, respectively. In a draft
strategy and program plan dated September 2003, LMSB projected it would
actually use 615 FTEs for shelter work in fiscal year 2003, or 88
percent of the planned amount and an increase of 157 percent over the
fiscal year 2002 FTE level including this work.
Because (1) the known abusive shelter workload has increased, (2) IRS
has limited experience to judge how many resources will be needed to
work the cases for how long a period, and (3) the workload may continue
to increase, it remains uncertain whether the substantial shift of
resources to shelter work will enable IRS to examine in a timely manner
the growing workload associated with shelters. For instance, the number
of potential examinations of listed transactions disclosed has grown
since the inception of OTSA, adding significantly to IRS resources
required to address the problem. Table 5 shows the number of listed
transactions disclosed by taxpayers grew from 51 to 2,182 between
December 31, 2000, and September 30, 2003, and other transactions
disclosed to IRS grew from none to 663. The total of all listed and
nonlisted LMSB-related transactions in the OTSA database, not only
those disclosed by taxpayers, as of September 30, 2003, was 4,897.
Table 5: Taxpayer Disclosures of Listed and Other Reportable
Transactions between 2000 and September 30, 2003:
Section 6011 disclosures: Listed transactions disclosed; Calendar year
(CY) 2000: 51; CY 2001: 63; CY 2002: 1,251; CY 2003 through September
30: 817; Total: 2,182.
Section 6011 disclosures: Other reportable transactions disclosed;
Calendar year (CY) 2000: 0; CY 2001: 214; CY 2002: 308; CY 2003 through
September 30: 141; Total: 663.
Source: IRS.
[End of table]
IRS workload from promoter investigations has also grown since May
2002. At that time, IRS planned that 7 promoter investigations would be
ongoing in fiscal year 2003. As of June 30, 2003, IRS had 98 promoter
investigations approved. Based on early promoter investigations, an IRS
official stated that promoter investigations can take thousands of
hours to develop, and several have been litigated, each requiring a
large expenditure of resources.
LMSB has limited information on the amount of time required to examine
abusive shelter cases. LMSB developed estimates of the amount of
examination time required for such cases based on its experience
examining various types of shelters but acknowledged that examiners can
spend hundreds or thousands of hours depending on the type of shelter
examined and the facts and circumstances of the case. For example,
according to an LMSB official, based on personal experience, OTSA
estimated that it would take about 800 hours to examine a potentially
abusive transaction reflected in the return of a CIC corporation
although LMSB had little data to support the estimate. During fiscal
year 2003, IRS began collecting data on examination time that it plans
to use for estimating the resources needed to address its abusive
shelter workload.
The future abusive shelter workload also could increase, at least in
the short term. For example, as IRS learns more about the use of
shelters, it may identify and list new kinds of transactions as being
abusive. As IRS conducts the 98 promoter investigations approved as of
June 2003, more investors are likely to be identified, and investor
cases could lead to identifying more promoters. In addition, IRS
expanded the types of taxpayers subject to disclosure requirements to
include taxpayers like individuals, partnerships, and S corporations.
According to IRS officials, disclosures from these types of taxpayers
are first due to IRS for filing year 2003 and generally do not yet
appear in the OTSA database.
In the longer term, what happens to the abusive shelter workload is
less certain. To the extent that IRS actions and other factors reduce
the size of the abusive shelter problem, IRS might not need to continue
devoting as large a percentage of its examination resources to abusive
shelters. How much and how soon such a drop may occur in abusive
shelter cases is uncertain.
We have previously raised questions about IRS's ability to shift
compliance resources as planned. We recently testified that many
parties have expressed concern about declining IRS compliance--
especially audit--and collection trends for their potential to
undermine taxpayers' motivation to fulfill their tax
obligations.[Footnote 26] Concerned about these trends, IRS has sought
more resources, including increased staffing for compliance and
collections since fiscal year 2001. Despite receiving requested budget
increases, staffing levels in key occupations were lower in 2002 than
in 2000. These declines occurred for reasons such as unbudgeted
expenses consuming budget increases and other operational workload
increases. Based on past experience and uncertainty regarding some
expected internal savings, fiscal year 2004 anticipated staff increases
might not fully materialize. Thus, if IRS carries through with its
intentions to increase resources devoted to abusive shelters, it may
not have the desired level of resources in other areas of compliance.
Concluding Observations:
Abusive tax shelters represent a potentially significant, although
imprecisely understood, loss in tax revenues. IRS developed and is
following a broad-based, multifaceted strategy to combat abusive
shelters even though it had limited data on the full scope of the
problem. IRS's strategy generally does not contain long-term
performance goals and associated measures that can help Congress
evaluate IRS's progress. Although establishing performance goals and
measures is inherently difficult since the scope and nature of abusive
shelters is elusive, the need for such goals and measures is heightened
because IRS is shifting large amounts of examination staff resources to
support combating abusive shelters. IRS's initial decisions on shifting
resources might need to be reevaluated as IRS develops better
information on the size of the abusive shelter problem and the amount
of time it takes to examine abusive shelter cases. We encourage IRS to
continue its efforts to obtain a better analytic basis for determining
the resources needed to address schemes and shelters-while providing
sufficient attention to other tax compliance areas-and to develop goals
and measures that it and Congress can use to gauge IRS's progress.
:
Mr. Chairman, this concludes my prepared statement. I would be happy to
respond to any questions you or other Members of the Committee may have
at this time.
Contact and Acknowledgements:
For further information on this testimony, please contact Michael
Brostek at (202) 512-9110 or [Hyperlink, brostekm@gao.gov] b
[Hyperlink, brostekm@gao.gov] rostekm@gao.gov. Individuals making key
contributions to this testimony include Ralph Block, Elizabeth Fan, Amy
Friedheim, Lawrence Korb, Signora May, and James Ungvarsky.
[End of section]
Appendix I: IRS Compliance and Research Programs Using the Schedule K-1:
Schedule K-1s are information returns that link flow-through entities
with their income recipients and therefore can be used for various
compliance and research purposes, such as the automated underreporter
(AUR) program[Footnote 27] and profiling potential nonfilers.
Partnerships, S corporations, trusts, and estates are collectively
known as flow-through entities because they can legally pass net income
or loss through to their partners, shareholders, and beneficiaries.
Flow-through entities are required to provide IRS and each partner,
shareholder, or beneficiary with a Schedule K-1 stating the individual
share of net income or loss to be reported. These individuals are then
responsible for reporting this income or loss on their individual
income tax returns and paying any applicable tax. According to IRS in
tax year 2001, over 9 million flow-through entities reported passing
through almost $1 trillion to approximately 24 million partners,
shareholders, or beneficiaries. IRS research efforts suggest that 6 to
15 percent of the K-1s attached to flow-through returns are currently
being omitted from beneficiary, partner, and shareholder returns. To
better detect such noncompliance, IRS began transcribing
nonelectronically submitted Schedule K-1s for tax year 2000 at a cost
of about $20 million.
In 2001, IRS added Schedule K-1 document matching to its AUR program.
It began matching Schedule K-1 data to individual tax returns to
identify taxpayers who had underreported flow-through income and had
consequently underpaid their taxes. IRS estimated that K-1 matching
program costs would be about $23.5 million total for both K-1
transcription and AUR program operations and that program yield would
be $36 million in direct tax assessed. IRS also estimated that if
voluntary compliance improved one percent due to the matching program,
approximately $1.23 billion of additional tax would be generated
annually. In the first year of the program, IRS issued about 69,000
notices to taxpayers and assessed about $29 million in additional taxes
directly attributable to Schedule K-1 underreporting.[Footnote 28] GAO
estimates that when program assessments are compared to the costs of
the program's AUR operations, the return per dollar of the K-1 matching
program was about $9.31. If the cost of transcribing the K-1 data is
included, the return per dollar decreases to about $1.25.[Footnote 29]
Both of these assessment-to-cost ratios are substantially lower than
that for the AUR program as a whole.[Footnote 30] The AUR program
returned about $25 for every dollar spent in tax year 2000.[Footnote
31]
IRS has also used Schedule K-1 data to determine characteristics of
potentially noncompliant taxpayer populations. Its preliminary
profiling efforts identified over 227,000 business entities with almost
$64 billion in Schedule K-1 income for tax year 2000 that potentially
did not file tax returns. As of September 2003, IRS had begun to
discuss ways of analyzing these cases to determine whether these
businesses were required, but failed, to file returns, or whether
inaccuracies in Schedule K-1 data produced false nonfiler leads. In
addition, in response to a Treasury Inspector General for Tax
Administration report issued in September 2002,[Footnote 32] the agency
has begun to research the effectiveness of using information returns,
such as the K-1, to identify business nonfilers.
(440158):
:
:
FOOTNOTES
[1] Department of the Treasury, The Problem of Corporate Tax Shelters
(Washington, D.C.: July 1999).
[2] As part of this work, we tested the tax shelter database maintained
by the Office of Tax Shelter Analysis (OTSA) by reviewing related
documentation, interviewing knowledgeable agency officials, and doing
electronic testing, finding that the required data elements were
sufficiently reliable for the purposes of our work. This finding does
not mean, however, that the database contains all the information that
would be needed to estimate the full size of the abusive shelter
problem.
[3] Pub. L. No.103-62.
[4] Joint Committee on Taxation, Background and Present Law Relating to
Tax Shelters, JCX-19-02 (Washington, D.C.: Mar. 19, 2002).
[5] A promoter or other tax shelter organizer must register a tax
shelter with the Secretary of the Treasury by describing it and its tax
benefits. The Secretary assigns the shelter an identification number.
[6] Section 6700 covers penalties for promoters of abusive shelters.
[7] Treas. Reg. Sec. 301.6112-1 and Treas. Reg. Sec. 1.6011-4.
[8] Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999),
aff'd, 254 F. 3d 1313 (11TH Cir. 2001).
[9] ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998),
aff'g, 73 T.C.M. 2189 (1997), cert. denied, 526 U.S. 1017 (1999).
[10] Id. at 248.
[11] For the decade from 1993 through 2002, corporations paid almost $2
trillion in income taxes.
[12] Under the CIC program, IRS continually audits about 1,100 of the
nation's largest corporations, all of which have assets of more than
$250 million.
[13] IRS did not track the additional tax payments these corporations
actually made related just to the shelter-related adjustment. However,
according to data provided by IRS, they paid about an additional $552
million in taxes related to all issues raised by IRS, including the
abusive shelter issues.
[14] In mid-August 2003, IRS gave us information showing that for the
14 abusive shelter transactions Appeals had closed in fiscal year 2003
for CIC and other cases, Appeals sustained about 71 percent of the
dollar amounts proposed as adjustments to income. Similar information
was not available for earlier years.
[15] TIGTA, Management Advisory Report: The Strategy for Curbing
Abusive Corporate Tax Shelter Growth Shows Promise but Could Be
Enhanced by Performance Measures, Report Number 2001-30-159
(Washington, D.C.: Sept. 13, 2001).
[16] Because the contractor found that estimating the problem's size
was difficult and problematic, it applied a statistical technique to
the estimates and produced other estimates for each year. However,
because it did not believe the statistical technique improved the
original estimates, we are not including the second set of estimates
here.
[17] Although GPRA is generally applied to agencywide strategic plans,
its framework is useful to guide any type of planning. GPRA requires
long-term strategic and annual performance goals and associated
measures, preferring measures relating to outcomes (results) versus
outputs (activities). The Office of Management and Budget says that
strategic plans set out long-term goals, outlining planned
accomplishments and their implementation schedule.
[18] TIGTA, Report Number 2001-30-159.
[19] Appendix I describes the Schedule K-1, flow-through entities, and
other compliance efforts using Schedule K-1 data.
[20] IRS Notice 2001-51 identifies certain listed transactions. It
describes basis-shifting transactions as "certain redemptions of stock
in transactions not subject to U.S. tax in which the basis of the
redeemed stock is purported to shift to a U.S. taxpayer." It describes
contingent liability transactions as "transactions involving a loss on
the sale of stock acquired in a purported [Internal Revenue Code
section] 351 transfer of a high basis asset to a corporation and the
corporation's assumption of a liability that the transferor has not yet
taken into account for federal income tax purposes."
[21] Some of these investors are also included in the fast track
program just described.
[22] LMSB called the tracking of adjustments a "record of tax
enforcement results." IRS does not use performance measures for outcome
measures like these because the IRS Restructuring and Reform Act of
1998 prohibited it from using tax enforcement results to evaluate any
employee or to impose or suggest production quotas or goals.
[23] IRS defines an "industry" case return as the return of an
organization with assets of more than $10 million but without being
part of the largest corporations that are under continual IRS audit.
[24] According to LMSB officials, mandatory examinations are those LMSB
knows it will do, such as those for abusive shelters and promoters.
Nonmandatory examinations are what remain after mandatory work is
accommodated. High-risk nonmandatory examinations are those in the
nonmandatory category that have the highest probability that a taxpayer
needs compliance activity.
[25] According to LMSB officials, the fiscal year 2002 FTEs include
time spent on the entire returns containing shelters, not on the
shelter issues alone. The estimates for fiscal years 2003 and 2004 are
focused more on the shelter issues.
[26] U.S. General Accounting Office, Compliance and Collection:
Challenges for IRS in Reversing Trends and Implementing New
Initiatives, GAO-03-732T (Washington, D.C.: May 7, 2003).
[27] The AUR program matches information return data, such as Forms W-
2 and 1099 and Schedule K-1, with individual tax return data to verify
that all income is reported.
[28] IRS began notifying taxpayers of potential discrepancies between
income reported on the K-1 and individual tax returns in April 2002.
However, after receiving complaints that notices were being sent to
compliant taxpayers, IRS stopped issuing notices in August 2002. IRS
data on number of notices sent and tax assessed were provided in August
2003.
[29] To increase efficiency and improve the accuracy of K-1 data, IRS
is exploring two-dimensional bar coding of Schedule K-1s. Instead of
transcribing K-1 data, IRS would scan a bar code on the K-1 and
electronically upload the information.
[30] Because the Schedule K-1 document matching program is new, its
return on investment may be low compared to mature AUR programs.
[31] Information about the AUR program is based on IRS data from
December 28, 2002.
[32] Treasury Inspector General for Tax Administration, The Internal
Revenue Service Should Evaluate the Feasibility of Using Available
Documents to Verify Information Reported on Business Tax Returns,
Report Number 2002-30-185 (Washington, D.C.: Sept. 18, 2002).