Tax Administration
IRS Should Take Steps to Improve the Accuracy of Schedule K-1 Data Gao ID: GAO-04-1040 September 30, 2004Over a trillion dollars in income was distributed in tax year 2002 by flow-through entities, such as partnerships, subchapter S corporations, and trusts, to their partners, shareholders, or beneficiaries, respectively. The Internal Revenue Service (IRS) estimates that from 6 to 15 percent of such income is unreported on individual tax returns. This income is reported to both IRS and to the recipients on a Schedule K-1 (K-1). IRS uses K-1 data in its document-matching program to identify noncompliance and for other purposes. GAO was asked to (1) assess the accuracy of K-1 data, specifically transcription errors and taxpayer identification numbers (TIN); (2) determine whether any limitations in the availability or accuracy of K-1 data have affected IRS's ability to identify noncompliance; and (3) identify the benefits and challenges of increasing e-filing of K-1s.
The accuracy of paper-filed K-1 data is reduced by transcription errors; paper and e-filed K-1s have inaccurate TINs. IRS estimates that transcription errors for tax year 2002 ranged from 5 and 9.5 percent and is taking steps to address such errors. Although e-filed K-1s do not require transcription, for tax year 2002, the percentage of invalid TINs for e-filed K-1s and paper-filed K-1s were comparable (7 and 6 percent, respectively). Due to potential burden on flow-through entities and resource constraints, IRS does not notify the entities of invalid TINs on K-1s for correction. If IRS did so, this would likely give e-filing entities enough time to correct invalid TINs before IRS runs its document-matching program. Inaccurate or limited K-1 data have created problems for IRS researchers and examiners. IRS research staff indicated that inaccurate TINs adversely affected their analysis of flow-through entity networks. Further, because IRS captures limited data from flow-through entity returns, including the K-1, IRS staff lack data they consider helpful, such as "Other Income" to help identify tax shelters. In at least 40 percent of closed examination cases we sampled, IRS examiners found errors with return line items not entered into IRS's databases when returns are received. If these lines were available up front, researchers say they would be able to better identify returns with potential noncompliance. Increased e-filing of K-1s would provide benefits and challenges to both IRS and taxpayers. Benefits for IRS include faster, more complete information and millions in annual cost reductions. Benefits for taxpayers include fewer IRS contacts with them because IRS would have more accurate information in its systems. The primary challenge for IRS is its current inability to electronically process all flow-through entity returns and related forms, including the K-1. For taxpayers, the primary challenge is the cost of converting from paper to e-filing.
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Director: Team: Phone:GAO-04-1040, Tax Administration: IRS Should Take Steps to Improve the Accuracy of Schedule K-1 Data
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Report to the Committee on Finance, U.S. Senate:
September 2004:
TAX ADMINISTRATION:
IRS Should Take Steps to Improve the Accuracy of Schedule K-1 Data:
GAO-04-1040:
GAO Highlights:
Highlights of GAO-04-1040, a report to the Committee on Finance, U.S.
Senate:
Why GAO Did This Study:
Over a trillion dollars in income was distributed in tax year 2002 by
flow-through entities, such as partnerships, subchapter S corporations,
and trusts, to their partners, shareholders, or beneficiaries,
respectively. The Internal Revenue Service (IRS) estimates that from 6
to 15 percent of such income is unreported on individual tax returns.
This income is reported to both IRS and to the recipients on a Schedule
K-1 (K-1). IRS uses K-1 data in its document-matching program to
identify noncompliance and for other purposes. GAO was asked to (1)
assess the accuracy of K-1 data, specifically transcription errors and
taxpayer identification numbers (TIN); (2) determine whether any
limitations in the availability or accuracy of K-1 data have affected
IRS‘s ability to identify noncompliance; and (3) identify the benefits
and challenges of increasing e-filing of K-1s.
What GAO Found:
The accuracy of paper-filed K-1 data is reduced by transcription
errors; paper and e-filed K-1s have inaccurate TINs. IRS estimates that
transcription errors for tax year 2002 ranged from 5 and 9.5 percent
and is taking steps to address such errors. Although e-filed K-1s do
not require transcription, for tax year 2002, the percentage of
invalid TINs for e-filed K-1s and paper-filed K-1s were comparable (7
and 6 percent, respectively). Due to potential burden on flow-through
entities and resource constraints, IRS does not notify the entities of
invalid TINs on K-1s for correction. If IRS did so, this would likely
give e-filing entities enough time to correct invalid TINs before IRS
runs its document-matching program.
Inaccurate or limited K-1 data have created problems for IRS
researchers and examiners. IRS research staff indicated that inaccurate
TINs adversely affected their analysis of flow-through entity networks.
Further, because IRS captures limited data from flow-through entity
returns, including the K-1, IRS staff lack data they consider helpful,
such as ’Other Income“ to help identify tax shelters. In at least 40
percent of closed examination cases we sampled, IRS examiners found
errors with return line items not entered into IRS‘s databases when
returns are received. If these lines were available up front,
researchers say they would be able to better identify returns with
potential noncompliance.
Increased e-filing of K-1s would provide benefits and challenges to
both IRS and taxpayers. Benefits for IRS include faster, more complete
information and millions in annual cost reductions. Benefits for
taxpayers include fewer IRS contacts with them because IRS would have
more accurate information in its systems. The primary challenge for
IRS is its current inability to electronically process all flow-through
entity returns and related forms, including the K-1. For taxpayers,
the primary challenge is the cost of converting from paper to e-filing.
Paper K-1s: Lengthy Processing Yields Incomplete Data:
[See PDF for image]
[End of figure]
What GAO Recommends:
To improve the availability and usefulness of K-1 data to IRS for
detecting noncompliance, GAO recommends that IRS conduct a pilot study
to determine the benefits and costs of obtaining corrected TINs from
flow-through entities as soon as they are found to be invalid.
IRS agreed with our recommendation.
www.gao.gov/cgi-bin/getrpt?GAO-04-1040.
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]
Contents:
Letter:
Results in Brief:
Background:
Data Transcription Errors and Erroneous TINs Reduce the Accuracy of K-
1 Data:
K-1 Data Accuracy and Availability Pose Problems in Research and
Examination Efforts:
Increasing E-Filing of K-1s Would Provide Benefits and Challenges for
IRS and Taxpayers:
Conclusions:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Comments from the Internal Revenue Service:
Table:
Table 1: Percentage of Invalid Schedule K-1 TINs That Were Not
Corrected and Corrected by IRS for Tax Year 2002 by Type of Entity
Return:
Figures:
Figure 1: IRS's Program to Match Flow-Through Income Reported by
Partnerships with Income Reported on a Partner's Federal Income Tax
Return:
Figure 2: Processing Flowchart for Paper and E-Filed Schedule K-1:
Figure 3: How Inaccurate TINs May Prevent IRS from Tracking Flow of
Income through a Chain of Financial Transactions:
Letter September 30, 2004:
The Honorable Charles Grassley:
Chairman:
The Honorable Max Baucus:
Ranking Minority Member:
Committee on Finance:
United States Senate:
Over a trillion dollars in income was distributed in tax year 2002 by
entities such as partnerships, subchapter S corporations (S-Corp), and
trusts that distribute net income--as well as losses--to partners,
shareholders, and beneficiaries.[Footnote 1] Such entities, called
flow-through entities, are required to report distributed income
annually to the Internal Revenue Service (IRS) on a Schedule K-1, thus
providing IRS with a way to determine whether individuals are reporting
the income on tax returns.[Footnote 2] IRS estimates that from 6 to 15
percent of such income is unreported on individual tax returns. In
addition, IRS is concerned about flow-through entities claiming
improper expenses or otherwise being used to evade tax liabilities.
Thus, IRS is concerned both with potential noncompliance by individuals
who fail to properly report income from flow-through entities and by
flow-through entities themselves, which ultimately leads to improper
income reporting by individuals as well.
Schedule K-1s are one of several forms and schedules included in the
annual return filed by a flow-through entity. Partnerships with more
than 100 partners are currently required by law to file their annual
returns, including all Schedule K-1s,[Footnote 3] electronically. Those
with 100 partners or less, as well as S-Corps and trusts, are not
required to do so.
The annual returns of flow-through entities are used to report the
income, deductions, gains, losses, and so forth of the respective
entities. These returns, including the K-1s, enable IRS to identify
compliance issues that may require an examination of the flow-through
entities' books and records. Further, during 2001, IRS began matching
K-1 information with information included on individual tax returns to
identify potential underreporting of income by individuals. To use K-1
information not filed electronically in its document-matching
program,[Footnote 4] IRS must first transcribe the data for use in its
computer systems. As reported in 2003, this is a costly and error-prone
process that can result in taxpayer burden.[Footnote 5]
Because of concerns about IRS's ability to effectively use K-1 data to
detect noncompliance, you asked us to assess IRS's current use of this
information. Specifically, our objectives were to (1) evaluate the
accuracy of K-1 data used by IRS, specifically transcription errors and
invalid TINs; (2) determine whether any limitations in the availability
or accuracy of K-1 data have affected IRS's ability to identify
noncompliance; and (3) describe the benefits and challenges of
increasing electronic filing (e-filing) of K-1s.[Footnote 6]
To meet our first objective, we discussed and obtained estimates from
IRS staff concerning the type of IRS transcription errors for paper-
filed K-1s. We also assessed IRS's procedures related to the processing
and transcription of K-1 information. In addition, we obtained and
analyzed the IRS K-1 database for tax year 2002[Footnote 7] to
identify, among other things, the size and type of entities that file
K-1s, the frequency of inaccurate taxpayer identification numbers
(TIN)[Footnote 8] included on these schedules, and the amount of income
associated with inaccurate TINs. On the basis of our data reliability
review of IRS's K-1 database, we determined that the data were
sufficiently reliable to enable us to identify the extent to which K-1s
have invalid TINs.
To address our second objective, we determined what portion of flow-
through entities' returns, including K-1s, is transcribed by IRS. We
also discussed with IRS staff and research consultants from MITRE
Corporation[Footnote 9] how IRS currently uses K-1 information and
whether and how data availability and accuracy affect their ability to
use these data. We also reviewed a projectable sample[Footnote 10] of
partnership and S-Corp closed examination files to determine the
compliance issues IRS identified, the related line items that were
adjusted, and whether having additional K-1 line items available would
help to identify potential noncompliance. We subsequently discussed our
findings with IRS classification[Footnote 11] and examination staff.
To meet our third objective, we discussed with both IRS officials and
officials from seven organizations that represent the taxpayer
community the costs, benefits, and challenges of requiring increased e-
filing of K-1s. We selected the organizations based on prior GAO
knowledge and referrals from some of the organizations that we
contacted. We also contacted the software companies that offer e-filing
for flow-through entities to obtain their current fees for preparing
and e-filing flow-through entity returns, including K-1s.
Our work was done from May 2003 through August 2004 in accordance with
generally accepted government auditing standards. (App. I describes our
overall objectives, scope, and methodology.)
Results in Brief:
The accuracy of K-1 data is reduced by IRS transcription errors on
paper-filed K-1s and by flow-through entities submitting invalid TINs
on both paper and e-filed K-1s. IRS estimates that the overall
transcription error rate for the almost 18 million tax year 2002 paper-
filed K-1s ranged from 5 to 9.5 percent based on its quality reviews.
E-filed returns are not transcribed and thus do not have these errors.
IRS is taking steps to reduce the transcription error rate, such as
implementing a bar-coding process that bypasses the transcription
process and taxpayer education and outreach efforts. In tax year 2002,
IRS processed almost 1.5 million K-1s with invalid TINs. The combined
income on these K-1s totaled $57.3 billion. IRS was able to correct the
TINs on about half of the K-1s with income totaling $20.6 billion. The
remaining 50 percent that had income of $36.6 billion could not be
corrected and thus could not be used in the document-matching program.
Regarding TIN accuracy, the percentage of invalid TINs for tax year
2002 e-filed K-1s was 7 percent, which was comparable to the 6 percent
invalid TIN rate on paper-filed K-1s. IRS is not notifying flow-through
entities of invalid TINs so they can take corrective actions due to
concern over taxpayer burden on flow-through entities and resource
constraints. If this were done, it would more likely give e-filing
entities enough time to correct many invalid TINs before IRS runs its
document-matching program because IRS could send error notices to e-
filers more quickly than to paper filers.
Inaccurate or limited K-1 data have created some problems in IRS's
research and examination efforts. IRS research staff studying flow-
through entity relationships indicated that missing or inaccurate TINs
have affected their ability to build more effective computer models to
analyze flow-through networks that may be used for tax evasion. In
addition, because of the limited number of line items captured from the
flow-through entity return, including the K-1, research and examination
staff lack certain data fields, such as "Other Income/(Loss)," that
would be helpful to identify compliance issues and better target
resources. Based on our sample of closed examination cases, in at least
40 percent of the examinations, IRS auditors corrected line items on
entities' returns that are not currently being transcribed.[Footnote
12] If these line items were available before IRS classifiers select
returns for examination, IRS researchers could use the data to support
more effective computer modeling and thereby focus examination
classifiers' attention on returns that are more likely to involve
noncompliance.
Increasing e-filing of K-1s from the current rate of about 24 percent
would provide benefits and challenges for IRS and taxpayers. For IRS,
the benefits include faster and more comprehensive information as well
as cost reductions due to the lack of transcription costs for e-filed
returns. For example, in fiscal year 2002, IRS spent over $13 million
for processing and transcribing paper-filed K-1s, much of which would
be eliminated. For taxpayers, the benefits of e-filing include the
receipt of an IRS acceptance acknowledgment; the quicker receipt of
rejection notices that would allow the taxpayers to correct problem
returns faster; and more accurate information in IRS databases due to
the lack of transcription errors, thus reducing the potential for
erroneous and burdensome taxpayer notices. IRS's primary challenge in
mandating increased e-filing of K-1s is its current inability to
electronically process all the other forms that may accompany the flow-
through entity return. IRS is scheduled to have this capability by
2007. The primary challenge for taxpayers is the cost of converting
from paper filing to e-filing. However, based on a limited review of
flow-through entity returns, most K-1s are currently computer
generated, which is a prerequisite for e-filing. Also, all of the
software companies that offer e-filing that disclosed their fees (about
half of those we contacted) do so for less than a dollar per K-1 or at
no additional cost. Both IRS and Congress are considering various
administrative and legislative proposals to increase mandatory e-filing
of information and tax returns, including those filed by flow-through
entities.
We are making a recommendation that IRS implement a pilot study to
determine the benefits and costs of requiring flow-through entities to
correct invalid TINs on K-1s as soon as it has been determined that the
TINs cannot be "perfected" via IRS's TIN validation program. The
Commissioner of Internal Revenue agreed with our recommendation and
said that IRS plans to study a number of options to ensure that TINs
included on Schedule K-1s are accurate.
Background:
Partnerships, S-Corps, and trusts are commonly referred to as flow-
through entities, as they do not generally pay taxes on income.
Instead, they distribute net income--as well as losses--to partners,
shareholders, and beneficiaries, respectively, who are subsequently
required to report the net income or loss on their individual tax
returns and to pay any applicable taxes. Distributed income is reported
to IRS on a K-1, which is included in the annual return filed by the
flow-through entity. Copies of the Schedule K-1 are provided to
partners, shareholders, and beneficiaries for use when filing their
respective annual returns. Partners receive a Form 1065 Schedule K-1,
"Partner's Share of Income, Credits, Deductions, etc."; shareholders
receive a Form 1120S Schedule K-1, "Shareholder's Share of Income,
Credits, Deductions, etc."; and beneficiaries receive a Form 1041
Schedule K-1, "Beneficiary's Share of Income, Deductions, Credits,
etc."
As shown in figure 1, as part of its overall underreporter program, IRS
has a specific K-1 document-matching program in which selected K-1
information reported by flow-through entities is compared to
information reported by individuals on their tax returns in order to
determine whether distributed income has been reported as required.
Figure 1: IRS's Program to Match Flow-Through Income Reported by
Partnerships with Income Reported on a Partner's Federal Income Tax
Return:
[See PDF for image]
[End of figure]
In like manner, income reported to IRS on a K-1 by S-Corps and trusts
can be matched with income reported on tax returns by shareholders and
beneficiaries, respectively.[Footnote 13] The purpose of this program
is to increase voluntary reporting of flow-through income by taxpayers
and to target K-1 related underreporter notices to noncompliant
taxpayers. IRS identified about $4.1 billion in underreported income
for tax years 2000 and 2001 via the K-1 matching program and assessed
about $110 million in additional taxes.[Footnote 14]
In addition to use in the matching program, IRS can also use K-1
information to aid in selecting flow-through entity returns for
examination. For example, IRS can use K-1 information to aid in
identifying flow-through entities involved in potential tax evasion
schemes and to develop computer models that may enable IRS to more
effectively select returns for examination with the greatest likelihood
for a tax change.[Footnote 15]
In order for IRS to use K-1 information in its matching program, the
information must either be e-filed by a flow-through entity or, if
filed via paper, transcribed by IRS staff for use in its computer
systems. Currently, only partnerships with over 100 partners are
required by law to e-file their annual returns, including any related
K-1s. As a result, for tax year 2002, less than one-quarter of 1
percent of partnerships was required to e-file.
Figure 2 illustrates that an e-filed K-1 goes through two basic steps
before the information is input into the Information Returns Master
File (IRMF). At Step A, the K-1 undergoes up-front checks prior to
final acceptance by IRS, whereby the K-1 data must pass specific checks
or the entire flow-through entity return is to be rejected until
corrected by the entity. The up-front checks include verifying the tax
year and proper formatting of names, addresses, and TINs. For example,
the partner's TIN on a K-1 filed by a partnership must be within a
specific range established by IRS; if not, the entire partnership
return is to be rejected. The only other step for an e-filed K-1 prior
to its going through IRS's document-matching program is the TIN
validation process, in which the TIN and name on the K-1 are
electronically matched with information in IRS's files to determine
whether the TIN is valid. Generally, this validation occurs several
months after IRS accepts the e-filed return.
Figure 2: Processing Flowchart for Paper and E-Filed Schedule K-1:
[See PDF for image]
Note: Does not reflect the processing changes to paper K-1s that IRS
began testing in April 2004 with the introduction of bar coding and
scanning.
[End of figure]
In contrast, a paper-filed K-1 goes through several manual steps,
including some of the up-front checks conducted electronically for e-
filed K-1s, before TIN validation takes place and the information can
be input into the IRMF. These steps, particularly transcription, can
take up to 6 months to complete, with transcription beginning in May.
For example, at Step 4, IRS staff are to edit the flow-through entity
return and contact the taxpayer if a required K-1 is missing. At Step
8, IRS staff are to transcribe selected K-1 line items. During the
transcription process, the computer conducts checks on select aspects
of the keypunched data, such as correlating zip code and state
information, and creates an error record for correction. Subsequently,
other IRS staff are to compare a sample of the transcribed K-1 data to
the original paper-filed K-1 to determine whether the data were
accurately transcribed. The TIN on a paper-filed K-1, as on an e-filed
K-1, is not computer validated until it reaches the stage where
electronic TIN validation occurs, generally several weeks or months
after the return was filed.
IRS's program to electronically validate TINs matches the TIN and name
on the K-1 to taxpayer identity information in its files. If there is
no match, IRS will attempt to "perfect" or correct an incorrect TIN/
name combination via a TIN validation process, which entails matching
the TIN and name control--the first four characters of an individual's
last name or the first four characters of a business name--with (1) a
file which contains all Social Security numbers (SSN) ever issued and
all name controls ever associated with them and (2) a file that
contains all employer identification numbers (EIN) ever issued and all
name controls associated with them. This TIN validation process occurs
four times per year, beginning about a month and a half after the end
of the filing season.
Data Transcription Errors and Erroneous TINs Reduce the Accuracy of K-
1 Data:
Data transcription errors made by IRS on paper-filed K-1 data and
invalid TINs submitted by flow-through entities on both paper-filed and
e-filed K-1s lower the accuracy of K-1 data. IRS transcription errors,
which occur only for paper-filed K-1s, ranged from 5 to 9.5 percent for
tax year 2002, and IRS is taking steps to reduce these errors. The
percentage of invalid TINs for e-filed K-1s is comparable to that for
paper-filed K-1s. However, due to potential taxpayer burden and
resource constraints, IRS is not notifying flow-through entities of
invalid TINs so they can take corrective actions, a step which would
likely give e-filing entities enough time to correct many invalid TINs
before IRS runs its document-matching program. Paper-filing entities
may not have sufficient time to correct invalid TINs before document
matching occurs.
Data from Paper-Filed K-1s Contain Transcription Errors, but IRS Is
Taking Steps to Reduce These Errors:
According to IRS K-1 quality reviews conducted at two IRS locations,
the overall K-1 transcription error rate for tax year 2002 ranged from
5 to 9.5 percent--errors that by definition are not made in e-filed
returns. The most frequent errors dealt with names and addresses. IRS
also found transcription errors in dollar amounts and TINs. Errors
detected during quality reviews are corrected before the K-1s are
posted to the IRMF, which IRS uses to detect potential underreporters
and nonfilers. However, less than 2 percent of all K-1s are selected
for the K-1 quality review. Transcription errors on all other K-1s are
included when the data are posted to the IRMF. Consequently, data from
an estimated 18 million tax year 2002 paper K-1s that were entered into
databases used by IRS for research and enforcement purposes have
transcription error rates from 5 to 9.5 percent.[Footnote 16] For
example:
* IRS's K-1 database for tax year 2002 included 16 paper-filed K-1s
each of which showed interest income of over $1 billion. These interest
income amounts appeared to be transcription errors. One partnership
filing paper K-1s had 73 partners. For 72 of the partners, the K-1
interest recorded in the IRMF was under $200,000. The remaining
partner's interest as recorded in the IRMF was $85.3 billion.[Footnote
17]
* According to an IRS data quality review of tax year 2001 K-1
document-matching cases, about 5 percent of the cases that were either
screened out before taxpayers were contacted or resulted in no change
to taxpayers' tax liabilities after an erroneous underreporter notice
was sent to the taxpayer were due to transcription errors. The
transcription errors included misplaced decimal points and positive
money amounts that were transcribed as negative numbers and vice versa.
According to IRS officials, it would be too costly to do more data
transcription quality review of paper-filed K-1s, such as reentry of K-
1 data. Instead, IRS is taking other measures to improve K-1 data
accuracy. For example:
* For tax year 2003, IRS began scanning all K-1s using optical
character recognition (OCR) equipment. Also, for tax year 2003, IRS is
accepting K-1s with bar codes that contain all the K-1 data. If the bar
code is present, the system will pick up the information from the bar
code, otherwise the system will image the K-1 and read the line entries
using OCR. Portions of the K-1 or bar code that cannot be read by OCR
are manually transcribed. Although IRS originally projected 30 percent
of K-1s would be bar coded in tax year 2003, as of July 2004 only 8
percent of K-1s submitted were bar coded. For the 92 percent of K-1s
without bar codes that OCR read, almost 20 percent required no
transcription, 60 percent required less than half of normal
transcription, and 20 percent were entirely transcribed. Although bar
coding and OCR bypass most of the manual data transcription, which
reduces some data transcription cost and errors, IRS officials still
prefer e-filing because bar coding is a paper process with accompanying
processing costs.
* To improve the accuracy of transcription, IRS has implemented new
software and improved transcription training. At two IRS locations, IRS
is using a new transcription software intended to increase
transcription productivity and accuracy, compared to the current
transcription software. In addition, transcription training for the K-
1 program has evolved. Each year, feedback is funneled to the IRS
transcription trainers to improve the K-1 transcription process.
* IRS is redesigning the K-1s for both partnerships and S-Corp returns
so that IRS can scan them into the computer instead of having to
transcribe the data manually. Although the redesigned partnership and
S-Corp K-1s are expected to be ready by tax year 2004, the redesigned
trust K-1 will not roll out until tax year 2005 because trust law makes
the trust K-1 different from the other two K-1s.
* IRS is conducting educational outreach to increase accurate K-1
filing and provide updates to changes in K-1 design. In April 2004, IRS
issued a news release to provide tips for businesses, individuals, and
tax professionals on accurate K-1 filing. For example, flow-through
entities are instructed to ensure the correct TINs are used on K-1s. In
addition, the six IRS Tax Forums in 2004 include a session on reporting
flow-through items, which addresses the redesign of K-1 forms and K-1
reporting reminders. IRS has also included updates on the K-1 matching
program and K-1 redesign in external speeches to stakeholder groups.
Finally, in late 2004, IRS plans to implement a multifaceted
communication plan to publicize the release of the redesigned K-1s.
IRS's K-1 Data Contain Incorrect Taxpayer Identification Information:
For IRS to use K-1 data in its document-matching program, the TINs and
names on K-1s need to be accurate so they can be linked to individuals'
tax returns and other tax documents. In tax year 2002, about 94 percent
of 24 million K-1s that IRS processed contained valid TINs. The
remaining 6 percent, or approximately 1.5 million K-1s, had invalid
TINs because either IRS made transcription errors or the flow-through
entities submitted invalid data. The 1.5 million K-1s with invalid TINs
had combined income gains of $57.3 billion and combined income losses
of $84.1 billion. IRS was able to correct the invalid TINS on about
750,000 of the K-1s, with income gains totaling $20.6 billion and
incomes losses totaling $6.8 billion, so that they could be used in
IRS's document-matching program or for other compliance and research
purposes. However, the remaining 740,000 K-1s with invalid TINs, with
income gains of $36.6 billion and incomes losses of $77.2 billion,
could not be perfected and thus were unmatchable. IRS did not have data
on the number of K-1s that had either corrected or unmatchable TINs in
the IRMF that resulted from transcription errors.
IRS Does Not Notify Flow-Through Entities of Invalid TINs That It Was
Unable to Correct:
After IRS checks the validity of TINs provided on K-1s, it does not
notify either paper-filing or e-filing flow-through entities of the
invalid TINs it finds so the entities can take steps to correct the
TINs, due to concerns about the potential burden on the entities and
resource constraints. Because e-filed returns do not go through time-
consuming paper processing steps, including transcription, if IRS were
to notify the originating entities of invalid TINs, they should have
time to correct invalid K-1s before IRS performs its document matching
in the fall following a tax filing year. For paper-filed K-1s, many
entities likely could not respond before the document matching occurs.
Because e-filed K-1s are not subject to transcription errors, none of
the keypunching errors associated with paper returns are in e-filed
data. However, as table 1 shows, in tax year 2002 the overall
percentage of invalid K-1 TINs IRS found with its TIN validation
program was comparable for e-filed (about 7 percent) and paper (6
percent).
Table 1: Percentage of Invalid Schedule K-1 TINs That Were Not
Corrected and Corrected by IRS for Tax Year 2002 by Type of Entity
Return:
Type of entity return: Partnership;
E-filed K-1s: Percentage of TINs found invalid by IRS's validation
program: 8.7%;
E-filed K-1s: Percentage of invalid TINs IRS was unable to correct:
62.1%;
E-filed K- 1s: Percentage of invalid TINs IRS corrected: 36.8%;
Paper K- 1s: Percentage of TINs found invalid by IRS's validation
program: 6.5%;
Paper K-1s: Percentage of invalid TINs IRS was unable to correct:
50.8%;
Paper K-1s: Percentage of invalid TINs IRS corrected: 49.2%.
Type of entity return: Trust;
E-filed K-1s: Percentage of TINs found invalid by IRS's validation
program: 3.7%;
E-filed K-1s: Percentage of invalid TINs IRS was unable to correct:
24.3%;
E-filed K-1s: Percentage of invalid TINs IRS corrected: 75.7%;
Paper K-1s: Percentage of TINs found invalid by IRS's validation
program: 7.1%;
Paper K-1s: Percentage of invalid TINs IRS was unable to correct:
56.3%;
Paper K-1s: Percentage of invalid TINs IRS corrected: 43.7%.
Type of entity return: S-Corp;
E-filed K-1s: Percentage of TINs found invalid by IRS's validation
program: n/a[A];
E-filed K-1s: Percentage of invalid TINs IRS was unable to correct:
n/a[A];
E-filed K-1s: Percentage of invalid TINs IRS corrected: n/a[A];
Paper K-1s: Percentage of TINs found invalid by IRS's validation
program: 5.0%;
Paper K-1s: Percentage of invalid TINs IRS was unable to correct:
36.0%;
Paper K-1s: Percentage of invalid TINs IRS corrected: 64.0%.
Type of entity return: Total all K-1s;
E-filed K-1s: Percentage of TINs found invalid by IRS's validation
program: 7.0%;
Paper K-1s: Percentage of TINs found invalid by IRS's validation
program: 6.1%.
Source: GAO analysis of IRS information.
Note: Numbers may not add up to 100 percent because of rounding.
[A] Not applicable because e-file was not available for S-Corp returns
until tax year 2003.
[End of table]
Factors that may be contributing to e-filed K-1s having TIN errors
comparable to those of paper K-1s include (1) large partnerships, which
are mandated to file K-1s electronically, submitting such large volumes
of K-1s that many may unknowingly submit one or more K-1s with invalid
TINs[Footnote 18] and (2) IRS not applying one of its up-front checks
for e-filed partnership K-1s.
According to our analysis of IRS's K-1 database, partnerships that
submit a higher volume of K-1s are more likely to submit a K-1 with an
invalid TIN compared to partnerships that submit only a few K-1s. In
tax year 2002, e-filed partnerships' K-1s had the highest rate of
invalid TINs (8.7 percent). That same year, 97 percent of the
partnerships with more than 100 partners, which are required to e-file,
submitted at least one K-1 with an invalid TIN. In contrast, 18 percent
of partnerships with 100 or fewer partners submitted at least one K-1
with an invalid TIN.
To encourage electronic filing of partnership returns, IRS is not
applying its up-front check that would reject an e-filed partnership's
return if it has even one TIN on a K-1 that falls outside the range of
numbers associated with SSNs and EINs. If IRS applied this validation
criterion in tax year 2002, 12 percent of the e-filed partnership K-1s
with unmatchable TINs would have been rejected and the originating
entities would have been asked to take steps to correct the TINs.
However, some partnerships have hundreds or thousands of partners,
making it more challenging for them to ensure that all partners' TINs
are correct. IRS officials have determined that accepting an e-filed
return when the vast majority of the K-1 TINs fall within the range of
numbers associated with SSNs and EINs, rather than rejecting the entire
entity return due to one or a few TINs that fall outside that range,
promotes e-filing.
In addition, IRS does not notify either e-filing or paper-filing flow-
through entities if submitted TINs are found to be invalid during the
TIN validation checks it performs subsequent to accepting entities'
returns. In tax year 2002, more than half of the K-1s submitted by 2
percent of the flow-through entities contained invalid TINs. The total
number of unmatchable K-1s submitted by these entities represented
about 29 percent of the total number of K-1s with unmatchable TINs. IRS
officials said that requiring flow-through entities to correct invalid
TINs could be a burden because the entities rely on information
supplied by individual taxpayers and the correct TINs may not be
readily available, particularly for those entities submitting a large
number of K-1s. In contrast, IRS does notify filers of missing or
invalid TINs submitted on other types of information returns, which
then may require the filers to contact third parties for corrected
information. For example, for tax years 2000 and 2001 combined, IRS
proposed just over $204 million in penalties against nonfederal payers
for information returns with invalid TINs. IRS officials acknowledged
that flow-through entities may have made mistakes themselves that
resulted in invalid TINs or may have the correct information on hand.
They also stated that sending such notices would entail some additional
cost to IRS and that they currently face resource constraints. However,
IRS officials do not have estimates of either the potential benefits,
such as increased revenue obtained from document matching utilizing
accurate TINs, or the cost to IRS of obtaining valid TINs from flow-
through entities.
If IRS were to notify flow-through entities of invalid TINs and ask
that they take steps to correct the TINs, it likely would be able to
receive many corrected TINs, particularly from e-filers, in time for
its annual document-matching program. IRS does its document matching
generally from November of the calendar year through January of the
following year. The time when document matching occurs changes somewhat
from year to year. IRS corrects TINs, including K-1 TINs, four times a
year: at the end of June, early September, mid-November, and late
November. Based on the IRS's 2001 Statistics of Income samples, at
least 97 percent of partnerships and S-Corps filed calendar year
returns.[Footnote 19] Consequently, all of these returns were due to be
filed prior to IRS's first TIN validation check in June.[Footnote 20]
Since IRS accepts e-filed returns within 2 days of their submission,
all e-filed returns for which filers have not requested extensions
should be available for IRS's June TIN validation program. In this
case, IRS would be able to notify the flow-through entities of the
invalid TINs and the entities would have several months to correct the
TINs and get them back to IRS before IRS posts the corrected K-1s to
the IRMF in time for use in the document-matching program. Even if a
flow-through entity did not submit the corrected TIN in time, the
entity would be aware of the error and could correct the TIN for the
following year.
For paper-filing flow-through entities, fewer entities likely would be
able to correct invalid TINs in time for inclusion in the document-
matching program. Transcription of paper-filed entity returns,
including K-1s, begins in May. Because transcription can take up to 6
months, a significant portion of paper-filed entity returns and
associated K-1 TINs likely would not be available for the June TIN
validation. For those not available until the early September TIN
validation, the entities would have much less time to correct TINs and
get back to IRS in time for IRS to include the corrected TINs in the
document-matching program. Because IRS's new return scanning and bar-
coding efforts should make paper-filed return data available more
quickly, IRS may be able to include more of them in the June TIN
validation and thus provide entities sufficient time to provide
corrected TINs if it sends notices of invalid TINs to flow-through
entities.
K-1 Data Accuracy and Availability Pose Problems in Research and
Examination Efforts:
In addition to using K-1 data in its document-matching program, IRS is
using K-1 data in its research programs to better understand flow-
through relationships. When data such as TINs are unavailable or
inaccurate, researchers are unable to establish a complete
understanding of the network of related entities and taxpayers. Data
limitations have also affected IRS's efforts to identify potentially
noncompliant taxpayers for examination. IRS researchers and examination
staff indicated that more complete and accurate data would enhance
their efforts to detect noncompliance.
Inaccurate TINs Affect Research Efforts to Link Related Entities:
IRS researchers are using K-1 data to visualize how taxpayers are
related to different entities and to evaluate whether compliance issues
may exist with flow-through entities. However, inaccurate TINs have
sometimes prevented researchers from establishing all relevant links in
a network of related entities. As a result, IRS is less able to track
the flow of income and losses among entities and could be missing
opportunities to address areas of noncompliance.
Figure 3 illustrates how inaccurate TINs may prevent IRS from tracking
the flow of income through a chain of financial transactions. In this
example, an S-Corp distributes losses to an individual shareholder,
possibly to allow the shareholder to offset other gains, and
distributes income to another shareholder, a trust. Since trusts are
flow-through entities and may be nontaxable, the individual shareholder
may be using the trust to reallocate income (perhaps to someone in a
lower tax bracket) that would otherwise need to be reported and taxed
on that individual's return.
Figure 3: How Inaccurate TINs May Prevent IRS from Tracking Flow of
Income through a Chain of Financial Transactions:
[See PDF for image]
[End of figure]
In our example, the S-Corp transfers income to Trust A, which in turn
transfers the income to Trust B. In both transactions, the S-Corp and
Trust A submit K-1s with accurate TINs to IRS, so IRS can track the
flow of income between the entities. Trust B then transfers the income
again to Trust C and submits a K-1 with an inaccurate TIN to IRS.
Because of the inaccurate TIN on the K-1, IRS would likely be unable to
identify that Trust C is related to the other entities or track the
flow of income to its final destination and ultimately determine
whether any income was underreported.
Limited Transcription Lines Do Not Fully Meet the Needs of Examination
and Research Programs:
IRS transcribes limited line items from K-1s that accompany partnership
and S-Corp returns. According to IRS staff, at least some of the
nontranscribed lines would provide useful information. Similarly, IRS
does not transcribe many of the lines from the flow-through entity's
return to which the K-1s are attached. Since e-filing of the full
entity's return is part and parcel of achieving e-filing of K-1s, e-
filing of K-1s would have the additional effect of making the complete
entity's tax return information available to IRS examiners and
researchers. Complete entity data also would provide useful information
for research and examination purposes. For K-1s, IRS identified the
line items to be transcribed based on the needs of its document-
matching program and not on other potential uses.
Regarding K-1s, IRS transcribes about 14 percent of partnership K-1
line items and about 17 percent of S-Corp K-1 line items. Research and
examination staff indicated that the nontranscribed information would
provide useful information. For example:
* The "Other Income/(Loss)" line is not captured from the K-1 because
it is not useful for document matching, but it can be helpful to
researchers in identifying abusive shelters, for example, where the
gain is allocated to a tax haven country and the loss is allocated to a
domestic investor.
* Transcribing the shareholder's ownership percentage from the K-1
would more easily allow classifiers to determine if the taxpayer has a
controlling interest in the S-Corp and if income/losses are distributed
evenly.
Regarding the flow-through entity's return, IRS currently transcribes
about 23 percent and 20 percent of the line items for partnership and
S-Corp returns, including the K-1, respectively. As discussed below,
additional data from the full entity return would potentially benefit
examination and research programs. For example:
* The IRS Examination Guide for Abusive Tax Shelters and Transactions
lists partnership (Form 1065) and S-Corp (Form 1120S) tax return lines
that when examined with other information, may indicate tax shelter
transactions. For partnership returns, about 80 percent of the line
items listed in the guide as useful to detect tax shelters are not
captured in IRS's database. For S-Corp returns, about 87 percent of
line items listed are not captured. When selecting returns to be
examined, IRS classifiers who focus on tax shelter issues lack
information that may identify taxpayers most likely to be using tax
shelters.
* IRS researchers developed a computer model to better identify S-Corp
returns for examination by helping classifiers separate accurate
returns from those needing further investigation. The model uses data
from IRS's database of business returns, including Form 1120S and
accompanying schedules. From the approximately 23,000 returns that the
model analyzed, IRS identified about 58 percent of the returns as
having low potential for noncompliance and therefore eliminated them
from the universe that might be examined. The remaining 42 percent of
returns could not be classified because the model did not have enough
data to evaluate them. As a result, IRS has continued to rely on
examination staff who focus on S-Corp compliance issues to manually
review the returns that the model has not been able to classify. To
help address the lack of 1120S data, IRS will be capturing 10
additional line items from the 1120S for tax year 2003. One IRS
researcher estimated that the 10 additional 1120S line items would
enable the computer model to identify 15 S-Corp compliance issues
compared to its current capability of identifying 2 compliance issues.
From our file review of closed S-Corp and partnership tax return
examination cases and discussions with IRS examination and research
staff, we also found that additional line items from the K-1 and other
parts of the entity's return may assist IRS in selecting tax returns to
examine. Based on our sample of closed examination cases,[Footnote 21]
in at least 40 percentof the examinations, IRS corrected line items
that are currently not transcribed. IRS examination and research staff
we interviewed indicated that if IRS captured this information and made
it available to them, it would help them identify those returns with
errors or omissions that IRS should examine. Most of the nontranscribed
line items that were corrected were from Schedule A (Cost of Goods
Sold) and Schedule K[Footnote 22] (Partners' Shares of Income, Credits,
Deductions, etc., or Shareholders' Shares of Income, Credit,
Deductions, etc.) for both partnerships and S-Corps. IRS identified two
of these line items, both from Schedule K and K-1, as important for
improving the effectiveness of computer modeling and mentioned other
nontranscribed lines, such as "Short Term Capital Loss," from the
entity return that would be useful.
Increasing E-Filing of K-1s Would Provide Benefits and Challenges for
IRS and Taxpayers:
Increasing e-filing of K-1s provides benefits and challenges for IRS
and taxpayers. The benefits for IRS are faster and more comprehensive
information as well as cost reductions. The benefits to taxpayers are
the receipt of acknowledgment notices, faster rejection notices that
allow taxpayers to resolve problems faster, and more accurate
information. Currently IRS's main challenge is the lack of complete e-
filing capacity, but IRS is scheduled to have this capacity by 2007.
The main challenge for taxpayers is the cost of converting from paper
to e-filing. However, limited data indicate that most K-1s are computer
generated, which is a prerequisite for e-filing. Also, all of the
software companies that offer e-filing that disclosed their fees (about
half of those we contacted) do so for less than a dollar per K-1 or for
no additional charge. Congress has mandated that IRS increase e-filing
to at least 80 percent of all tax and information returns by 2007.
Currently, both IRS and Congress are considering increasing mandatory
e-filing of flow-through entity returns.
Increasing E-Filing of K-1s Would Provide Better Information and Cost
Reductions for IRS:
Currently, IRS electronically receives about a quarter of the K-1s
filed, although only partnerships with more than 100 partners are
mandated to e-file. Increasing e-filing of K-1s would benefit IRS
because of the following:
E-filing K-1s provides IRS with faster and more complete information
for use in compliance and research programs. A recent Treasury
Inspector General for Tax Administration (TIGTA) report stated that the
savings in processing time resulting from e-filing would significantly
affect IRS's attempt to reduce its lengthy corporate examination
process. In addition, the TIGTA report stated that comprehensive
electronic information would minimize the number of no change audits by
enabling IRS to better target resources to issues that have the
greatest compliance risk.[Footnote 23]
* E-filing K-1s would save IRS millions of dollars a year because it
would eliminate the processing and transcription costs of paper K-1s.
According to IRS, the cost to process e-filed K-1s is minimal once the
systems are in place, while processing and transcribing paper K-1s cost
IRS $14.6 million in fiscal year 2001 and $13.1 million in fiscal year
2002. If IRS was able to re-allocate these cost savings, IRS could, for
example, pay the salaries of 284 additional field collection revenue
officers. While, as noted earlier, some of the processing and
transcribing costs will be reduced because of bar coding and scanning,
IRS regards bar coding as a lesser alternative to e-filing. In
addition, bar coding results in incomplete information because only the
transcribed lines are scanned into the computer systems, and the K-1s
are the only part of the entity return that is bar coded. Also, there
is limited availability of software that has bar-coding capacity; only
four software companies provide bar-coding capability compared to 19
software companies that provide e-filing.
The primary benefits for taxpayers of increasing e-filing are as
follows:
* Taxpayers that e-file will receive electronic acceptance or rejection
notices within 2 days of submitting tax returns. The tax form is
electronically transmitted to the software company and then the
software company transmits the tax return to IRS. IRS sends the
software company an electronic acceptance or rejection notice within 2
days, and the software company then sends the notice to the taxpayers.
Taxpayers that file paper returns do not receive acceptance notices and
thus do not have proof that the returns were filed on time in case the
tax returns are lost. E-filing taxpayers also receive rapid rejection
notices and are thus informed of problems much faster than paper-filing
taxpayers, who may wait for 6 months for IRS to process tax returns.
* The information on an e-filed tax return should be more accurate
because of the lack of IRS transcription errors. More accurate
information would reduce the potential for burdensome taxpayer notices
resulting from transcription errors. To respond to IRS notices,
taxpayers and preparers are required to collect, organize, and submit
information to IRS to explain any discrepancies cited in the notices,
which requires an investment of both the taxpayers' time and money. In
recent reports, TIGTA noted that e-filing would eliminate transcription
errors that result in erroneous and burdensome taxpayer
notices.[Footnote 24]
Increasing Electronic Filing of K-1s Requires Complete IRS E-Filing
Capacity and Taxpayers' Conversion from Paper Filing to E-Filing:
The primary challenge for IRS of mandating increased e-filing is to
implement computer systems that can electronically process the complete
set of tax documents that flow-through entities may file with K-1s.
Although IRS currently has the capacity to electronically process K-1s
that accompany flow-through entity returns, IRS is unable to
electronically process all the forms that accompany those of trusts and
partnerships. This impedes e-filing of the flow-through returns with
accompanying K-1s because taxpayers that submit partnership and trust
returns (that include three-fourths of K-1s) have to submit both paper
and electronic documents--a disincentive for e-filing. For example,
signature forms have to be sent in on paper. In contrast, IRS currently
has complete e-filing capacity for the entire S-Corp return, so no
forms have to be filed on paper. IRS is scheduled to have complete e-
filing capacity for partnerships and trusts, but has pushed the
completion date for this effort from 2006 to 2007 due to limited
resources.
The main challenge to expanded use of e-filing for taxpayers is the
cost of converting from paper filing to e-filing. In separate reviews
of flow-through entity returns by IRS and GAO, the majority of the tax
returns were found to be computer generated, prepared by a paid
preparer, or both, which might make the conversion to e-filing easier.
Based on our sample of Audit Information Management System agreed
closed case examinations of partnerships and S-Corps with tax years
ending in 2000 or 2001, paid preparers prepared at least 84 percent of
the returns, and at least 90 percent of the returns were computer
generated.[Footnote 25] Of the nonprojectable sample of 200 partnership
and trust returns that IRS reviewed, a paid preparer prepared 169
returns, and 173 were computer generated.[Footnote 26]
Since the above-mentioned reviews of flow-through entity returns
indicate that a paid preparer prepares the majority of returns that
accompany K-1s by computer, the cost to convert to e-filing may be
marginal or nonexistent. If a paid preparer is using software that has
e-filing capacity, then taxpayers can simply choose to use this option,
which can entail a marginal cost increase. According to our survey of
the software companies that offer e-filing of partnership, trust, and
S-Corp returns, all of the software companies that disclosed their fees
(about half of those we contacted) either charge from $0.30 to $0.90
per e-filed K-1 or include the option to e-file in the price of the
software. In order to e-file, flow-through entities have to buy the
software and e-file the entire flow-through entity return, at costs
that vary from $3.50 per return to over $15,000 for comprehensive
support for partnership returns, corporate income tax returns, and
affiliated forms. For partnerships, if the paid preparer does not use
software with e-filing capacity and the data are formatted according to
IRS's specifications, paid preparers can send the partnership return
electronically to a software company that will then electronically
transmit the partnership return. One software company stated that it
would generally charge $0.40 per K-1.
IRS and Congress Are Considering Increasing E-Filing:
According to IRS officials, IRS is considering mandating increased e-
filing of information and tax returns, including those of flow-through
entities. In recent reports, TIGTA has recommended that IRS should work
with the Department of the Treasury to mandate increased e-filing of
flow-through entity returns, either through current regulatory
provisions or through legislative action.[Footnote 27] As a result, IRS
is currently studying the possibility of increasing mandated e-filing
of flow-through entities' returns with accompanying K-1s under Internal
Revenue Code (I.R.C.) Section 6011 as part of an agencywide initiative
to increase e-filing to meet a congressionally mandated goal of having
at least 80 percent of all tax and information returns filed
electronically by 2007.[Footnote 28] IRS's study includes the cost for
taxpayers to convert from paper filing to e-filing, the cost for IRS to
initiate and administer increased mandated e-filing, the perspective of
the paid tax preparer and business communities, and how to implement
increased mandated e-filing. In addition, according to IRS officials,
IRS is also considering mandating e-filing for those returns for which
IRS has complete e-filing capacity.
In addition, Congress is currently considering the Tax Administration
Good Government Act of 2004,[Footnote 29] which would permit IRS to
mandate increasing e-filing of flow-through entity returns and
accompanying forms, such as K-1s, in two new ways. First, the law would
remove the present restrictions in I.R.C. Section 6011 that prevent IRS
from mandating individuals, estates, and trusts to e-file. Since the
law would remove the restriction on mandating e-filing of individuals,
IRS would then be able to mandate e-filing by paid preparers that
prepare individual tax returns. Second, the law would lower the
threshold at which IRS could mandate e-filing of information and tax
returns for any taxpayer to 5 returns. Currently, the threshold is 250
returns. Thus, IRS could mandate e-filing by paid preparers who file 5
or more flow-through entity returns or individual tax returns.
Conclusions:
Although there are some costs to taxpayers to e-file and to IRS in
processing e-filed flow-through entity returns and related K-1s, in
general e-filed K-1s offer substantial advantages for both IRS and
taxpayers. We are not making a recommendation for further action to
expand e-filing of flow through-entities' returns, including K-1s,
because IRS agreed to take steps to do so pursuant to a TIGTA
recommendation and is currently studying the costs of increasing e-
filing to IRS and taxpayers. One step, upgrading its overall capability
to accommodate an increase in e-filed flow-through entity returns,
including K-1s, is under way. However, we are concerned that IRS's
estimated date for having this capacity has been pushed back to 2007
due to limited resources. The sooner this can be accomplished, the
sooner IRS can reap the potential benefits of an increase in e-filed
Schedule K-1s while moving closer to achieving the congressionally
mandated goal of having 80 percent of all federal tax returns and
information returns filed electronically by 2007.
Regardless of whether e-filing is expanded, IRS is missing an
opportunity to improve the accuracy of TINs associated with K-1s and
thereby is undermining the benefits that can be realized from its
document-matching program, efficient targeting of examination
resources, and new research to identify noncompliance. Although IRS
officials expressed concern about the possible burden on flow-through
entities of dealing with TIN error notices and about IRS's ability to
deal with the costs of sending such notices given its resource
constraints, IRS does not have information on the likely benefits and
costs of sending TIN error notices to flow-through entities. Given the
high concentration of TIN errors among a small portion of flow-through
entities, even if costs are high compared to the benefits of sending
notices to some flow-through entities, the situation may be much
different for error-prone flow-through entities.
Recommendation for Executive Action:
To improve the availability and usefulness of Schedule K-1 data to IRS
for detecting noncompliance, we recommend that IRS conduct a pilot
study to determine the benefits and costs of requiring flow-through
entities to correct invalid TINs on K-1s as soon as it has been
determined that the TINs cannot be "perfected" via IRS's TIN validation
program.
Agency Comments and Our Evaluation:
We received written comments on a draft of this report from the
Commissioner of Internal Revenue, which are reprinted in appendix II.
The Commissioner agreed with our assessment of Schedule K-1 TIN
accuracy and that a pilot project would be useful in identifying ways
to improve TIN accuracy. He said that IRS plans to study a number of
options to ensure that TINs included on Schedule K-1s are accurate,
including our recommendation that IRS conduct a pilot study to
determine the benefits and costs of obtaining corrected TINs from flow-
through entities. The Commissioner said that IRS's Flow-Through
Compliance Committee recently initiated a project to study invalid TINs
on Schedule K-1s to determine their potential compliance impact. In
addition, he also mentioned other initiatives, such as form redesign,
outreach efforts, and scanning Schedule K-1s, to improve the overall
effectiveness of flow-through compliance efforts.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its date. At that time, we will send copies to the Chairman and
Ranking Minority Member, House Committee on Ways and Means, and the
Chairman and Ranking Minority Member, Subcommittee on Oversight, House
Committee on Ways and Means. We will also send copies to the Secretary
of the Treasury, the Commissioner of Internal Revenue, and other
interested parties. The report will also be available at no charge on
GAO's Web site at [Hyperlink, http://www.gao.gov].
If you have any questions concerning this report, please contact me at
(202) 512-9110 or [Hyperlink, brostekm@gao.gov] or Jonda Van Pelt at
(415) 904-2186 or [Hyperlink, vanpeltj@gao.gov]. Key contributors to
this report were Ralph Block, Maya Chakko, Keira Dembowski, Elizabeth
Fan, Robert McKay, and Samuel Scrutchins.
Signed by:
Michael Brostek:
Director, Tax Issues:
[End of section]
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Our objectives were to (1) evaluate the accuracy of K-1 data used by
the Internal Revenue Service (IRS), specifically transcription errors
and invalid taxpayer identification numbers (TIN); (2) determine
whether any limitations in the availability or accuracy of K-1 data
have affected IRS's ability to identify noncompliance; and (3) describe
the benefits and challenges of increasing electronic filing of K-1s.
To evaluate the accuracy of K-1 data used by IRS, we requested,
obtained, and analyzed data from IRS's K-1 database for tax year
2002.[Footnote 30] We examined two versions of the database, both of
which had been modified from the original K-1 database by IRS research
analysts. One, called the K-1 "cleaned database," has original K-1s
removed when possible where duplicate or amended K-1s for the same
taxpayer were subsequently submitted by the parent flow-through entity.
The second, called the "money-cleaned database," also has all amounts
that were obvious transcription errors removed. Generally, these were
amounts in excess of $900 million and that exceeded the total amount
reported on the parent flow-through entity's Schedule K for the
particular line item. We used the "cleaned database" to identify one
such transcription error.
We analyzed the "money-cleaned" database to identify the number of K-1s
that were filed with inaccurate TINs by type of flow-through entity
(partnership, subchapter S corporation (S-Corp), or trust) and by type
of submission (e-filed versus paper filed). We subsequently analyzed
this subset of K-1s to determine the number and total income of K-1s
with invalid TINs that IRS (1) was able to perfect via its TIN
Perfection Program and (2) could not perfect and thus remained invalid
and, in effect, unusable for compliance or research purposes. Because
specific data were unavailable from the K-1 database concerning
transcription errors, we conferred with IRS analysts to identify the
type of transcription errors found during K-1 product reviews they
conducted from July through November 2003.
To identify whether any limitations in the availability or accuracy of
K-1 data have affected IRS's ability to identify noncompliance, we
obtained from IRS the line items the agency transcribes from the K-1
and related flow-through entity returns. When we calculated the
percentage of line items transcribed from the entity return, we
included the K-1 as part of the return. To count line items, we
included all labeled lines and sub lines, but excluded certain fields,
including calendar or tax year, name and address, supplemental
information/attachments, signature and date, preparer's signature and
date, preparer's self-employment, and preparer's firm name and address.
We also interviewed IRS examination and research staff, as well as
outside research consultants from the MITRE Corporation, with whom IRS
contracted to analyze flow-through entities. Specifically, we discussed
how IRS currently uses K-1 data to select flow-through entity returns
for examination, how IRS research staff and research consultants are
using K-1 data to develop analytical tools to aid IRS in better
targeting returns for examination, and how data limitations affect
their ability to effectively use K-1 information.
To determine the compliance issues IRS identified and the related line
items that were adjusted, we reviewed a stratified probability sample
of partnership and S-Corp tax returns. We selected these returns from
the population of 253 partnership and 1,121 S-Corp agreed closed
examination cases listed in the IRS Audit Information Management System
2002 Closed Case database with tax years ending in 2000 or 2001. We
reviewed a sample of 107 returns of which 91 returns, consisting of 52
of the partnership and 39 of the S-Corp returns, could be analyzed. The
remaining 16 returns could not be analyzed, generally because the
examination workpapers were not available or the case adjustments were
based on unusual circumstances, such as amended return submissions from
taxpayers. We used this sample of 91 returns to estimate several
characteristics[Footnote 31] of this population of all 1,374 agreed
partnership and S-Corp cases.
Because these estimates are based on a probability sample, our sample
is only one of a large number of samples that we might have drawn.
Since each sample could have provided different estimates, we express
our confidence in the precision of our particular sample's results as a
one-sided 95 percent confidence interval. For example, paid preparers
prepared an estimated 93 percent of the returns, and a one-sided 95
percent confidence interval for this estimate has a lower bound of 84
percent. Since the actual population value would be contained in this
interval for 95 percent of the samples we could have drawn, we are 95
percent confident that the proportion of paid preparer returns in the
study population exceeds 84 percent. Similarly, for the adjusted lines
found in the file review, we are 95 percent confident that adjustments
made to nontranscribed line items occur in at least 40 percent of the
examinations.
We subsequently discussed our file review findings with IRS research
and examination staff to obtain their views regarding whether having
additional K-1 data available, such as line items not currently
transcribed, would increase their ability to identify returns with
compliance issues.
To describe the benefits and challenges of increasing e-filing of K-1s,
we discussed this issue with IRS officials and officials from seven
organizations that represent the taxpayer community. We selected the
organizations based on prior GAO knowledge and referrals from some of
the organizations that we contacted. From IRS officials, we obtained
estimates of the cost to transcribe K-1 information, to help identify
the potential cost savings if K-1s were e-filed. We also discussed
IRS's current requirements for mandating e-filing K-1s and IRS's
experience in enforcing these requirements, and obtained data on
penalties levied for failure to e-file required K-1s. Finally, we
discussed IRS's current and future ability to electronically process an
increase in the number of e-filed flow-through entity returns,
including K-1s. We also contacted all 19 of the software companies that
offer e-filing for flow-through entities and received e-mail responses
from just over half of the companies. From officials with the software
companies, we obtained their current fees for preparing and e-filing
flow-through entity returns and K-1s.
To determine how many flow-through entities filed on a calendar year
basis we used the 2001 Partnership and Corporation Statistics of Income
(SOI) samples.[Footnote 32] The SOI partnership data we used included
the entire sample, but the SOI corporation data we used were limited to
the flow-through S-Corps. Because these are probability samples, the
SOI estimates are subject to sampling error. We produced estimates from
these samples using SOI's sampling weights and methods that are
appropriate for stratified probability samples. In this report we
present these estimates as intervals, reporting the lower bound on one-
sided 95 percent confidence intervals.[Footnote 33]
We did our work at IRS headquarters in Washington, D.C., as well as at
the Ogden, Utah, Processing Center and the Oakland, California, Area
Office from April 2003 through July 2004 in accordance with generally
accepted government auditing standards.
Data Reliability:
We assessed whether the information contained in the K-1 databases, the
two SOI databases, and the Audit Information Management System (AIMS)
database were sufficiently reliable for the purposes of this report. We
ensured that the copies of all five databases we received from IRS were
identical to the original databases based on record counts and analyses
of control totals, comparison to published data, or both. In addition,
we performed electronic tests on the each database to search for
missing data and obvious errors.
For the original K-1 database from which the two cleaned versions we
used originated, we assessed IRS's procedures for processing and
transcribing Schedule K-1 data. We also assessed other procedures and
methodologies IRS research analysts used to remove duplicate records
and obvious errors from transcribed monetary fields. We anticipated the
K-1 database would have some reliability issues because our engagement
was designed in part to assess the sufficiency of the data
transcription effort. While large monetary transcription errors were
removed from the "money-cleaned" database, additional, undetectable
transcription errors of amounts within normal ranges may remain.
For the AIMS 2002 Closed Case database, we relied exclusively on
variables that allowed us to identify agreed closed case partnerships
and S-Corps, as this was the population of cases from which we drew our
sample. We interviewed IRS personnel who manage the AIMS databases and
found that groups in IRS conducting examinations are required to
validate annually that completed examination cases are actually shown
as having been closed. In addition, we collected data from original
returns during our data collection effort and compared those data to
data contained in the AIMS database. We found no indication that our
sample contained ineligible cases.
SOI samples are widely used for research purposes. We have documented
for recent reports[Footnote 34] that IRS performs a number of quality
control steps to verify the internal consistency and completeness of
SOI sample data. The agency uses similar quality control procedures for
all types of SOI samples. For example, the agency performs electronic
tests to verify the relationships between values on the returns
selected as part of the SOI samples and manually edits data items to
correct for problems, such as inaccurate and missing items. Because we
used the partnership and corporate samples only to determine the
percentage of partnerships and S-Corps that were calendar year filers,
we needed no more than four variables from each database to make this
analysis. We checked these variables for completeness and accuracy and
found no missing or out of range values.
On the basis of our data reliability reviews of the five IRS databases,
we believe all five contain data that are sufficiently reliable for the
purposes of this report.
[End of section]
Appendix II: Comments from the Internal Revenue Service:
DEPARTMENT OF THE TREASURY:
INTERNAL REVENUE SERVICE:
WASHINGTON, D.C. 20224:
COMMISSIONER:
September 24, 2004:
Mr. Michael Brostek:
Director, Tax Issues:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Brostek:
I reviewed your draft report titled, Tax Administration-IRS Should Take
Steps to Improve the Accuracy of Schedule K-1 Data (GAO-04-1040). We
agree that improving the accuracy of taxpayer identification numbers
(TI Ns) on Schedules K-1' will help us to better detect taxpayer non-
compliance and that a pilot project would be useful in identifying ways
to do so.
The complexity of this issue requires that we analyze a number of
options to ensure we use the best methodology for TIN perfection. In
fact, the issue of invalid TINs is currently being analyzed by the
Flow-Through Compliance Committee (FTCC), which is composed of
representatives from the Large and Mid-Size Business (LMSB) and Small
Business/Self-Employed (SB/SE) Divisions. The FTCC's mission is to
identify key risks associated with flow-through entities. It also
serves as the focal point for the development of new tools and
techniques for addressing flow-through issues. The committee recently
initiated a project to explore issues related to invalid TINs on
Schedules K-1. The project will involve studying a sample of schedules
with invalid TINs to determine the potential compliance impact. As part
of this study, we will also study options for perfecting TINs. We will
weigh the cost of the options against the potential benefits and
determine if a pilot program is appropriate.
We have already implemented several initiatives to enhance Schedule K-
1 reporting compliance, including the redesign of forms and extensive
outreach efforts. The form and instructions for the tax year 2003
Schedule E, Supplemental Income, contained enhancements designed to
improve Schedule K-1 reporting accuracy. The redesigned Schedules K-1
for Partnerships and `S' Corporations will be available for tax year
2004. In addition, a variety of communication efforts have taken place
during the past two years to educate taxpayers and tax professionals on
how to reduce errors in reporting income from flow-through entities.
Partner's Share of Income, Credits, Deductions, etc. (Form 1065,
Schedule K-1); Shareholder's Share of Income, Credits, Deductions, Etc.
(Form 1120S, Schedule K-1); and Beneficiary's Share of Income,
Deductions, Credits, etc. (Form 1041, Schedule K-1).
Other actions we have taken include numerous enhancements to our
matching program and the implementation of 2-D bar coding and Optical
Character Recognition scanning to reduce transcription errors on paper
schedules. All of these initiatives have helped to improve the overall
effectiveness of our flow-through compliance efforts.
We will continue to seek additional ways to enhance the Schedule K-1
Program. If you have any questions, please contact Robert L. Hunt,
Acting Deputy Director, Compliance Policy, Small Business/Self-
Employed Division, at (202) 283-2200.
Sincerely,
Signed by:
Mark W. Everson:
[End of section]
(440139):
FOOTNOTES
[1] An S-Corp is a domestic corporation with no more than 75
shareholders, all of which are individuals, estates, exempt
organizations, or certain trusts. A trust is an arrangement by which
trustees take title to property for the purpose of protecting or
conserving it for beneficiaries.
[2] Although for simplicity we refer only to individuals' returns,
corporations, partnerships, and trusts may also be recipients of flow-
through entities' income or losses.
[3] For the remainder of this report, we will refer to Schedule K-1s
simply as K-1s.
[4] The document-matching program matches information concerning
selected tax issues reported on tax returns by individual taxpayers and
reported on information returns by third parties, such as employers,
banks, flow-through entities, and other payers of income. Transcription
involves manually keypunching the information for use in IRS's computer
systems.
[5] GAO, Tax Administration: Changes to IRS's Schedule K-1 Document
Matching Program Burdened Compliant Taxpayers, GAO-03-667 (Washington,
D.C.: May 30, 2003).
[6] Because the K-1 is part of the flow-through entity return,
increased e-filing of the K-1 would require increased e-filing of the
flow-through entity return.
[7] At the time of our review, this was the most recent year that
complete K-1 data were available from IRS.
[8] The TIN is a unique nine-digit number, usually a Social Security
number (SSN) for an individual, an employer identification number (EIN)
assigned by IRS for a partnership or corporation, and either an SSN or
an EIN for a sole proprietor.
[9] We talked with MITRE because IRS has a contract with MITRE to
conduct flow-through entity data analysis.
[10] The population from which the sample is drawn is agreed 2002
closed case examinations of partnerships and S-Corps listed in IRS's
Audit Information Management System with tax years ending in 2000 or
2001. Agreed cases are cases where the IRS has made adjustments to a
taxpayer's tax return, and the taxpayer has actively or passively
accepted the adjustment.
[11] Classification staff, called classifiers, review returns and
related documentation and select returns to be examined.
[12] Estimates from our sample are subject to sampling error. We are 95
percent confident that corrected line items not transcribed occur in at
least 40 percent of the 2002 closed case examinations based on our
sample evidence.
[13] For this report we focused upon the K-1 and did not assess the
accuracy of the dollar amounts reported by the flow-through entity.
[14] As of May 2004, the final results for tax year 2000 were complete,
while the final results for tax year 2001 were still to be determined.
[15] An IRS examination of a taxpayer's books and records that results
in no tax change is generally inefficient for IRS because it has spent
resources to audit an accurate return. No tax change audits also burden
taxpayers, who are forced to go through the audit process even though
they are compliant.
[16] Some transcription errors are corrected during processing after
the point of transcription. IRS did not have data on what percentage of
transcription errors are later corrected.
[17] Because each partner's distributive share of income is determined
by the partnership agreement (and this will be respected for tax
purposes unless the allocations agreed to lack "substantial economic
effect"), income may not always be distributed evenly. However, this
example was selected because $85.3 billion appears to be an excessive
dollar amount for interest income.
[18] Each partner has a unique TIN.
[19] These figures are based on sample data and subject to sampling
error. We are 95 percent confident that the percentages exceed the
value shown for the tax year 2001 partnerships and S-Corps.
[20] In general, for calendar year filers, S-Corp returns are due to be
filed by March 15 and partnership returns are due by April 15.
[21] See app. I for information regarding the sample population.
[22] Schedule K is a summary schedule of all partners' or shareholders'
shares of the partnership's or S-Corp's income, credits, deductions,
and so forth. Schedule K-1 shows each partner's or shareholder's
separate share. In our file review, we noted adjustments on Schedule K,
unless the adjustment was specific to Schedule K-1.
[23] Treasury Inspector General for Tax Administration, New Regulations
Are Needed to Take Full Advantage of the Opportunities Offered by
Filing Large Corporate Income Tax Returns Electronically, 2003-30-123
(Washington, D.C.: May 30, 2003).
[24] Treasury Inspector General for Tax Administration, The Internal
Revenue Service Could Reduce the Number of Unnecessary Notices Sent to
Taxpayers Regarding Unreported Income From Schedule K-1, 2003-30-071
(Washington, D.C.: Mar. 14, 2003), and New Regulations Are Needed to
Take Full Advantage of the Opportunities Offered by Filing Large
Corporate Income Tax Returns Electronically.
[25] These figures are subject to sampling error. We are 95 percent
confident that the percentages exceed the values shown.
[26] IRS reviewed a nonprojectable sample of tax year 2000 partnership
and trust returns from the Austin Service Center.
[27] Treasury Inspector General for Tax Administration, The Internal
Revenue Service Could Reduce the Number of Unnecessary Notices Sent to
Taxpayers Regarding Unreported Income From Schedule K-1 and New
Regulations Are Needed to Take Full Advantage of the Opportunities
Offered by Filing Large Corporate Income Tax Returns Electronically.
[28] The TIGTA report noted that although there are restrictions under
current law prohibiting IRS from requiring individuals, estates, or
trusts to file electronically, there are no restrictions against IRS
requiring through regulations that corporate and other types of returns
be filed electronically.
[29] H.R.1528.
[30] At the time of our review, tax year 2002 was the most recent year
for which complete K-1 data was available from IRS.
[31] These estimates are the percentage of returns with adjusted line
items not currently transcribed, percentage of paid preparer prepared
returns, and percentage of computer-generated returns.
[32] SOI last published information for estate and trust returns for
tax year 1997.
[33] Additional information regarding the IRS's SOI program and its
stratified probability samples is available on the Internet at
www.irs.gov/taxstats/.
[34] GAO, Tax Administration: Comparison of the Reported Tax
Liabilities of Foreign-and U.S.-Controlled Corporations, 1996-2000,
GAO-04-358 (Washington, D.C.: Feb. 27, 2004). GAO, International
Taxation: Tax Haven Companies Were More Likely to Have a Tax Cost
Advantage in Federal Contracting, GAO-04-856 (Washington, D.C.: June
30, 2004).
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