IRS's Use of Information on Taxpayers Claiming Many Allowances or Exemption From Federal Income Tax Withholding
Gao ID: GAO-04-79R November 6, 2003In September 2003, we responded to a request from Representative Elton Gallegly to provide information on the number of taxpayers who claimed more than 10 withholding allowances and taxpayers who claimed exemption from federal income tax withholding. The Internal Revenue Service (IRS) calls such claims questionable Form W-4s. However, in the course of performing our work, we became concerned about the reliability of the information that IRS maintains on these taxpayers and decided that we could not use it to answer Representative Gallegly's questions. The objectives of this letter are to summarize our findings about the reliability of the information IRS maintains on taxpayers who claimed more than 10 withholding allowances or exemption from federal tax withholding and to bring to the attention of the Commissioner, Internal Revenue, some resulting questions about the value of IRS continuing to collect the information.
We have two concerns about the information that IRS maintains on taxpayers who claimed more than 10 withholding allowances or exemption from federal tax withholding that precluded us from using it to respond to Representative Gallegly's questions. First, we are concerned about the completeness of the information because a significant number of employers may not send IRS the required forms. According to IRS's information, about 75 percent of the large employers with 1,000 or more employees in its Large and Medium-Size Business (LMSB) and Small Business/Self-Employed (SB/SE) divisions that filed employment tax returns in tax year 2001 did not send IRS any forms. Although the number of questionable Form W-4s IRS might receive from individual employers can vary, it seems unlikely that 75 percent of employers with 1,000 or more employees could have no employees who submitted questionable Form W-4s. Second, some of the information may not be current--it may not reflect the current withholding status of some taxpayers. If an employee who previously claimed more than 10 allowances or claimed exemption from federal income tax withholding submitted a new Form W-4 claiming 10 or fewer allowances or not claiming exemption from withholding, the database would continue to show the earlier information. There is no requirement for employers to submit Form W-4s other than those claiming 10 or more allowances or exemption. We could not quantify the significance of our concerns about the reliability of IRS's data; however, the uncertainty about how complete and current the data were precluded us from using them to respond to Representative Gallegly's questions. Considering what we learned about the reliability of the data, questions may be raised about the value and fairness of IRS's enforcement efforts that rely on the database. One question is whether it is worth devoting IRS's resources to maintaining a database of questionable reliability. According to information IRS provided us in July 2003, 32 full time equivalent staff was dedicated to the Questionable Form W-4 program. A related question is whether it is worth the burden borne by those taxpayers who send IRS forms. Another question is about the evenhandedness of IRS's use of the database as a compliance tool. Taxpayers whose employers are not submitting questionable Form W-4s are less likely to face compliance checks under the program than taxpayers whose employers do submit the forms.
RecommendationsOur 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.
Director: James R. White Team: Government Accountability Office: Strategic Issues Phone: (202) 512-5594GAO-04-79R, IRS's Use of Information on Taxpayers Claiming Many Allowances or Exemption From Federal Income Tax Withholding
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November 6, 2003:
The Honorable Mark W. Everson:
Commissioner of Internal Revenue:
Subject: IRS's Use of Information on Taxpayers Claiming Many Allowances
or Exemption From Federal Income Tax Withholding:
Dear Mr. Everson:
In September 2003, we responded to a request from Representative Elton
Gallegly to provide information on the number of taxpayers who claimed
more than 10 withholding allowances and taxpayers who claimed exemption
from federal income tax withholding. The Internal Revenue Service (IRS)
calls such claims questionable Form W-4s. However, in the course of
performing our work, we became concerned about the reliability of the
information that IRS maintains on these taxpayers and decided that we
could not use it to answer Representative Gallegly's questions. For
background, see our letter to Representative Gallegly in enclosure 1.
The objectives of this letter are to summarize our findings about the
reliability of the information IRS maintains on taxpayers who claimed
more than 10 withholding allowances or exemption from federal tax
withholding and to bring to your attention some resulting questions
about the value of IRS continuing to collect the information.
Results:
We have two concerns about the information that IRS maintains on
taxpayers who claimed more than 10 withholding allowances or exemption
from federal tax withholding that precluded us from using it to respond
to Representative Gallegly's questions. First, we are concerned about
the completeness of the information because a significant number of
employers may not send IRS the required forms. According to IRS's
information, about 75 percent of the large employers with 1,000 or more
employees in its Large and Medium-Size Business (LMSB) and Small
Business/Self-Employed (SB/SE) divisions that filed employment tax
returns in tax year 2001 did not send IRS any forms. Although the
number of questionable Form W-4s IRS might receive from individual
employers can vary, it seems unlikely that 75 percent of employers with
1,000 or more employees could have no employees who submitted
questionable Form W-4s. Second, some of the information may not be
current--it may not reflect the current withholding status of some
taxpayers. If an employee who previously claimed more than 10
allowances or claimed exemption from federal income tax withholding
submitted a new Form W-4 claiming 10 or fewer allowances or not
claiming exemption from withholding, the database would continue to
show the earlier information. There is no requirement for employers to
submit Form W-4s other than those claiming 10 or more allowances or
exemption. We could not quantify the significance of our concerns about
the reliability of IRS's data; however, the uncertainty about how
complete and current the data were precluded us from using them to
respond to Representative Gallegly's questions.
While acknowledging the limitations of the information in the
Questionable Form W-4 database, IRS's Wage and Investment (W&I)
Division officials stated that the information in the database was
useful to them for tax compliance purposes. The officials said that
they use the database to identify useful leads in determining possible
underwithholding issues that can lead to noncompliance. For example,
tax examiners at IRS's Fresno Computing Center routinely review the
withholding information of certain taxpayers to substantiate their
claims. If the taxpayers cannot substantiate their claims, the
examiners would require that the taxpayers' withholdings be adjusted to
appropriate levels. According to the Treasury Inspector General for Tax
Administration, about 70 percent of the cases closed by the examiners
in fiscal year 2001 resulted in no changes to the taxpayers'
withholding claims.[Footnote 1]
However, considering what we learned about the reliability of the data,
questions may be raised about the value and fairness of IRS's
enforcement efforts that rely on the database. One question is whether
it is worth devoting IRS's resources to maintaining a database of
questionable reliability. According to information IRS provided us in
July 2003, 32 full time equivalent staff was dedicated to the
Questionable Form W-4 program. A related question is whether it is
worth the burden borne by those taxpayers who send IRS forms. Another
question is about the evenhandedness of IRS's use of the database as a
compliance tool. Taxpayers whose employers are not submitting
questionable Form W-4s are less likely to face compliance checks under
the program than taxpayers whose employers do submit the forms.
IRS has reengineering efforts underway to improve the Questionable Form
W-4 database, which we discuss in our report to Representative
Gallegly. Based on information from program officials, these efforts
were being implemented when we were preparing this report. Although we
did not assess IRS's reengineering plans, it was not clear to us that
the plans would address the data reliability concerns we discussed in
this report and in our report to Representative Gallegly. The
reengineering efforts address database improvements to enhance
compliance checks.
In addition to summarizing our concerns, our letter to Representative
Gallegly contains details of the scope and methodology of the work that
we performed from October 2002 through June 2003 in accordance with
generally accepted government auditing standards.
Conclusions and Recommendation:
We have questions about the value and fairness of using the
Questionable Form W-4 program database for compliance purposes because
of uncertainties about the extent that the data are complete and
current.
Because of these questions we recommend that you assess the value of
IRS's Questionable Form W-4 program and determine whether the program
should continue in its current form.
Agency Comments and Our Evaluation:
On October 28, 2003, we received comments from the Commissioner of
Internal Revenue on a draft of this report. The Commissioner agreed
with our recommendation, stating that he will undertake a comprehensive
review of the Questionable Form W-4 Program to determine its
effectiveness and relevancy in the current environment. Further, he
said that the Commissioner of the W&I Division is to lead the effort.
The Commissioner's comments are reprinted in enclosure 2.
This report contains a recommendation to you. The head of a federal
agency is required by 31 U.S.C. 720 to submit a written statement on
actions taken on this recommendation. You should send your statement to
the Senate Committee on Governmental Affairs and the House Committee
on Government Reform within 60 days after the date of this report.
A written statement also must be sent to the House and Senate
Committees on Appropriations with the agency's first request for
appropriations made over 60 days after the date of this report.
We are sending copies of this report to the Secretary of Treasury and
to interested congressional committees. This report will also be
available at no charge on GAO's Web Site at http:www.gao.gov.
If you have any questions about this report, please contact me at (202)
512-9110 or by E-mail at whitej@gao.gov. Key contributors to this
assignment were Charlie Daniel and Arthur L. Davis.
Sincerely yours,
James R. White:
Director, Strategic Issues:
Signed by James R. White:
Enclosures:
Enclosure 1: Report to Representative Elton Gallegly:
September 15, 2003:
The Honorable Elton Gallegly:
House of Representatives:
Subject: Reliability of Information on Taxpayers Claiming Many
Withholding:
Allowances or Exemption from Federal Income Tax Withholding:
Dear Mr. Gallegly:
When taxpayers claim more withholding allowances than they are entitled
to or improperly claim exemption from withholding, either no tax or too
little tax is withheld from their wages. As a result, some taxpayers
end up owing the Internal Revenue Service (IRS) additional taxes, and
if the taxes are not paid on time, they become delinquent. This report
responds to your request for information on these taxpayers.
Specifically, you asked that we provide you with information on (1) how
many taxpayers claimed more than 10 allowances for federal income tax
withholding purposes and (2) how many taxpayers claimed exemption from
federal income tax withholding and, of those taxpayers, what proportion
did not file federal income tax returns and had invalid Social Security
numbers. However, because of concerns about the completeness and
currency of the information reported to IRS on taxpayers who claimed
more than 10 withholding allowances or taxpayers who claimed exemption
from withholding, we could not use it to respond to your questions.
This report discusses why we could not use IRS's information to answer
your questions and briefly describes IRS's proposals to help address
this problem. To perform our work, we analyzed information from IRS's
Questionable Form W-4 database[Footnote 1] and interviewed IRS
officials responsible for managing the Questionable Form W-4 program.
Further details on our scope and methodology are provided later in this
report.
Results in Brief:
We have two concerns about the information that IRS maintains on
taxpayers who claimed more than 10 withholding allowances or exemption
from federal tax withholding that preclude us from using it to answer
your questions. First, we are concerned about the completeness of the
information because a significant number of employers may not send IRS
the required forms. Second, some of the information may not be current-
-it may not reflect the current withholding status of some taxpayers.
While acknowledging the limits of the information for answering your
questions, IRS officials told us that the information is useful for tax
compliance purposes. Also, the officials said that IRS has efforts
under way intended to influence employers to comply with the reporting
requirement. IRS provided oral comments on a draft of this report
stating that it generally agreed with our findings. IRS's comments are
summarized later in this report.
Background:
Section 3402 of the Internal Revenue Code requires employers to
withhold income tax from wages and other forms of income. It outlines
the basis for claiming withholding allowances or exemption from
withholding and specifies the general content of the IRS Form W-4--
Employee's Withholding Allowance Certificate (Form W-4) that employees
submit to employers when making their withholding allowance claims.
Each employee is required to submit a completed Form W-4 to his or her
employer. Employees are to use the worksheet attached to the Form W-4
to determine the number of withholding allowances they should claim.
The worksheet's instructions consider, among other things, a taxpayer's
filing status, number of dependents he or she claims on the tax
returns, and eligibility for the child tax credit. For example, a
married taxpayer filing a joint tax return who has four dependent
children and large itemized deductions may be eligible to claim more
than 10 allowances. Some taxpayers not claiming a specific number of
allowances may claim exemption from federal income tax withholding.
Generally, taxpayers can claim exemption from withholding if they had
no tax liability for the previous year and expect to have none in the
current year.
Treasury regulations[Footnote 2] require that employers send IRS
"questionable Form W-4s."[Footnote 3]
According to IRS, a questionable Form W-4 is any Form W-4 on which a
taxpayer claims more than 10 withholding allowances or claims exemption
from withholding with over $200 per week in wages. The information that
IRS receives from employers on questionable Form W-4s is maintained in
the Questionable Form W-4 database.
IRS uses information in the database to identify potential
noncompliance with its withholding guidelines. IRS's tax examiners at
the Fresno Computing Center review selected questionable Form W-4 cases
to determine if the withholding is appropriate based on the taxpayer's
filing history and may contact the taxpayer if additional information
is needed to substantiate the withholding allowances claimed. If the
tax examiners determine that the withholding allowances claimed are
incorrect or if taxpayers do not respond to IRS contacts, the tax
examiners mail "lock-in" letters to the taxpayers' employers directing
them to disregard the taxpayers' Form W-4s as filed and to withhold at
the rate for a single person with zero allowances or at some other rate
determined by the tax examiners.
Findings:
Because of concerns about the completeness and currency of the
information in IRS's Questionable Form W-4 database, we cannot respond
to your questions. According to our guidance for assessing the
reliability of computer-processed data,[Footnote 4] we cannot use data
that are significantly incomplete, inaccurate, and not up to date and
subsequently could lead to an unintentional or incorrect message.
We are concerned about whether the information in IRS's Questionable
Form W-4 database is sufficiently complete because some employers
likely do not send IRS withholding information on employees who claim
more than 10 allowances or claim exemption from federal income tax
withholding, as required. IRS program officials told us that they do
not know the extent to which employers might not be sending in
questionable Form W-4s.[Footnote 5] However, IRS's analysis of large
employers with 1,000 or more employees that sent in questionable Form
W-4s provides some evidence that a significant number of large
employers may not be reporting Form W-4 information to IRS. This
analysis showed that 25 percent of the employers with 1,000 or more
employees in its Large and Medium-Size Business (LMSB) and Small
Business/Self-Employed (SB/SE) divisions that filed employment tax
returns in tax year 2001 sent in questionable Form W-4s to IRS (1,933
of 7,713 employers). Similarly, 16 percent of the employers with 1,000
or more employees in IRS's Tax Exempt/Government Entities Division had
submitted questionable Form W-4s (610 of 3,888 employers). Although the
number of questionable Form W-4s IRS might receive from individual
employers can vary, we question whether 75 percent of large employers
with 1,000 or more employees in IRS's LMSB and SB/SE divisions could
have no employees who submitted questionable Form W-4s. Information
from IRS showed that IRS received about 800,000 questionable Form W-4s
from 33,000 employers in calendar year 2002 or, on average, about 25
forms from each employer who submitted. This average includes many
employers with fewer than 1,000 employees.
Under current law, IRS does not have statutory authority to impose a
penalty to enforce employer compliance with the reporting requirement.
The reporting requirement was promulgated in Treasury regulations.
In addition, IRS's questionable Form W-4 database may not accurately
reflect the current withholding status of some taxpayers. In
particular, if an employee who previously claimed more than 10
allowances or claimed exemption from federal income tax withholding
submitted a new Form W-4 claiming 10 or fewer allowances or not
claiming exemption from withholding, the database would continue to
show the earlier information. This is because employers are only
required to send questionable Form W-4s to IRS.[Footnote 6] There is no
requirement for employers to forward to IRS new Form W-4s that do not
meet the questionable Form W-4 criteria.
IRS officials acknowledged the limitations of IRS's Questionable Form
W-4 database for answering your questions. However, the officials said
that the database provides IRS with useful leads in determining
possible underwithholding issues that may lead to noncompliance. They
told us that they use the database for identifying taxpayers who may be
underwithholding taxes since those taxpayers also may not file tax
returns. IRS's tax examiners review certain questionable Form W-4s to
substantiate taxpayers' withholding claims.[Footnote 7] When the
taxpayers' claims cannot be substantiated, the tax examiners issue
"lock-in" letters to both the taxpayers' employers and the taxpayers
stating that the taxpayers' withholdings are to be adjusted based on
IRS's investigation.
We asked IRS officials if they had plans to improve employers'
compliance with the reporting requirement. IRS officials told us that
they have initiated reengineering efforts to improve the existing
system and database, allowing them to, among other things, improve the
integration of other compliance databases to detect noncompliance and
expedite the issuance of lock-in letters. In February 2003, all of IRS
operating divisions and a panel of external stakeholders participated
in a Form W-4 compliance summit. During the summit, the participants
identified a number of suggestions to improve employer and taxpayer
compliance with withholding requirements, including improvements to
forms, on-line information, and services such as W-4 calculator and
development of frequently asked questions for IRS's Web site. The
officials also said that IRS's divisions will continue to work together
to identify outreach and educational strategies to educate employers,
stem noncompliance, and encourage voluntary employer reporting of
potential abusive schemes related to withholding evasion. Because the
activities were new or being implemented, we did not evaluate them to
determine their effectiveness in improving employers' compliance with
the reporting requirement.
Concluding Observations:
Considering what we learned about the reliability of the data,
questions may be raised about the value of IRS's efforts to maintain
the Questionable Form W-4 database. For this reason, we are sending a
separate letter to the Commissioner of Internal Revenue describing what
we learned and recommending that he assess whether IRS's Questionable
Form W-4 program should continue in its current form.
Agency Comments and Our Evaluation:
We asked IRS to provide us oral comments on a draft of this report. On
August 27, 2003, we received comments from the Director of Filing and
Payment Compliance, Wage and Investment Division. The Director
generally agreed with our findings and acknowledged the limitations of
the Questionable Form W-4 database in providing information we could
use to respond to your questions. IRS stated that although the database
did not meet our standards for responding to your questions, it
believes that the database serves its intended purpose of housing data
to facilitate its efforts to address underwithholding at its source,
thereby increasing compliance early and preventing future delinquencies
that can be both costly for IRS to resolve and burdensome to taxpayers.
The comments also stated that reengineering efforts were recently
initiated to improve the Questionable Form W-4 program as we mentioned
earlier in our report.
Scope and Methodology:
To perform our work, we interviewed IRS's W&I Operating Division staff,
who were responsible for managing the Questionable Form W-4 program,
and IRS Detroit Computing Center staff, who were responsible for
maintaining the Questionable Form W-4 database. Based on these
contacts, we obtained an understanding of how the program operates,
determined how IRS monitors employers' compliance with Form W-4
reporting requirements to help us assess the reliability of the
Questionable Form W-4 database, and obtained relevant documentation.
We analyzed IRS's Questionable Form W-4 database to determine what
information IRS maintains on taxpayers who claimed more than 10
withholding allowances or claimed exemption from federal income tax
withholding. According to IRS, the database primarily covers a 4-year
period. The database we reviewed primarily covered tax years 1998-2002.
We assessed the reliability of IRS's Questionable Form W-4 database by
performing electronic testing, reviewing existing information about the
data and the system IRS created, and interviewing agency officials
knowledgeable about the data and the system. As stated in the report,
we determined that the data were not sufficiently reliable to answer
your questions.
In addition, we reviewed various IRS documents and publications
pertaining to tax withholding that indicate the responsibilities of
taxpayers and employers. We also reviewed IRS and Treasury Inspector
General for Tax Administration reports related to IRS's questionable
Form W-4 program. We conducted our work from October 2002 through June
2003 in accordance with generally accepted government auditing
standards.
- - - - -:
We are sending copies of this report to the Commissioner of Internal
Revenue and other interested parties. We will make copies available to
others upon request. This report will also be available at no charge on
GAO's Web site at http://www.gao.gov.
If you have any questions about this report, please contact me at (202)
512-9110 or by E-mail at whitej@gao.gov. Key contributors to this
report were Charlie Daniel and Arthur L. Davis.
Sincerely yours,
James R. White:
Director, Strategic Issues:
Signed by James R. White:
(440170):
FOOTNOTES
[1] This refers to IRS's Questionable Form W-4 Case Control System.
[2] Treasury Regulation §31.3402(f)(2)-1(g)(1)-(2).
[3] If a new employee does not give the employer a completed Form W-4,
the employer is to withhold tax as if the employee is single, with no
withholding allowances.
[4] U.S. General Accounting Office, Applied Research and Methods:
Assessing the Reliability of Computer-Processed Data (External Version
1), GAO-03-273G (Washington, D.C.: October 2002).
[5] IRS conducted questionable Form W-4 compliance checks in the 1980s
based on a representative sample of 3,331 employers. Less than 50
percent of the questionable Form W-4s received by employers were
reported to IRS.
[6] The database also includes information on employees whose
questionable Form W-4s were reviewed by IRS tax examiners and were
subsequently adjusted to levels below the criteria for submission to
IRS.
[7] IRS's tax examiners were reviewing cases of taxpayers who have
histories of noncompliance, that is, nonfilers and balance due
taxpayers.
[End of section]
Enclosure 2: Comments from the Internal Revenue Service:
COMMISSIONER:
DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE WASHINGTON, D.C.
20224:
October 28, 2003:
Mr. James R. White:
Director, Tax Issues:
U.S. General Accounting Office
441 G Street, N W
Washington, D.C. 20548:
Dear Mr. White:
Thank you for the opportunity to provide comments regarding this
report. Withholding compliance is a vital component of our voluntary
tax administration system. We believe that by addressing under-
withholding at its source, we increase compliance early in the process,
preventing future delinquencies that can be both costly to the Service
to resolve and burdensome to the taxpayers.
During the 1980s, regulations were established that required employers
to submit to the IRS, any Form W-4 on which an employee claimed more
than 10 withholding allowances, or claimed exemption from withholding
and wages were expected to be over $200 per week. The Questionable Form
W-4 (QW-4) program was implemented as a vehicle to intervene on
instances of improper withholding through issuance of a lock-in
letter.[NOTE 1] This program and the related regulations were designed
to respond to abusive schemes that had emerged in particular industries
where there were widespread instances of employees opting out of the
voluntary tax administration system by claiming excessive withholding
allowances and/or exempt status.
Your report raises valid questions regarding the current state of the
QW4 program. Given that this program evolved in the 1980s, it could
certainly benefit from a comprehensive review to determine its
effectiveness and relevancy in the current environment. I have asked
Henry Lamar, Commissioner Wage and Investment Division, to lead this
effort. This will include a review of the filing and processing
requirements, the use and impact of lock-in letters, and potential
alternatives to identify and address withholding noncompliance. During
fiscal year 2004, the resources applied to the QW4 program are being
directed to this review, including testing and evaluating potential
improvements. Your findings and concerns will be a valuable resource as
we assess the program. We look forward to sharing our progress with
you.
If you have any questions, or if you would like to discuss this
response in more detail, please contact Floyd Williams, Director,
Legislative Affairs, at (202) 622-3720.
Sincerely,
Mark W. Everson:
Signed for Mark W. Everson:
NOTES:
[1] If tax examiners determine that the withholding allowances claimed
are incorrect or if taxpayers do not respond to IRS contacts, the tax
examiners mail "lock-in" letters to the taxpayers' employers directing
them to disregard the taxpayers' Form W-4 as filed and to withhold at a
rate for a single person with zero allowances or at some other rate
determined by the tax examiners.
(450248):
FOOTNOTES
[1] Treasury Inspector General for Tax Administration, Improvements to
the Questionable Form W-4 Program Are Needed to Determine Program
Impact on Taxpayer Compliance, Reference Number: 2003-40-006
(Washington, D.C.: October 2002).
