DOCURBNT RESUME

04268 - [B3414668]

Repetitive IRS Audits o Taxpayers Are Justifiedi GGD-77-74;B-137762. November 18, 977. 33 pp. + 5 appandices (22 pp. )

Report to Rep. Al Ulluan, Chairman, Joint Committ.~e on TaxationsSen. Russell B. Long, fi:e Chairmav; by Elmer B. Staats,Comptroller General.

Issue Area: Tax Adainistr ttion (2;7C0).Contact: General Governme, t Div.Budget Function: Geiteral t4overnment (800).Organization Concerned: Internal Revenue Service; eparten+. ofthe Treasury.Congressional Relevance: .fluse Coamittee oa Ways arnl means;

Senate -Coumi-ttee on P1ian=e; Voint Com ittee on Taxation.*Ser. Russell B. Long.%

The Internal Revelue Service (IRS) audits ai relativelysmall number of individual taxpayers each year. Over ll,taxpayers who have been audited repetitively by the [lRS wereaudited because their returns fit the usual selectic, criteria.However, IRS should reduce the number of rpetitivei± auditedtaxpayers. Find:.ngs/Conclueions: All returns are -eeected foraudit through the same syste;, and the system generally protectsagainst selection abuse. Repetitive audits are likC atl auditsin terms of recommended tax increaeos, indicating that. taxpayerswere not repeatedly selectedjunless tax adjustments wt(reprobable. About 60% of repetitive audits resulted frow,: highs:ores under the computer-geiurated audit selection program,unrllowable items on the retu,:n, or selection hy an auditor as aresilt of auditing another year's return. Recoimendati.ons: TheCommissioner of Internal Revenue skould include repetit-.veaudits in the planned study of factors contributing to voluntarytaxpayer compliance with the tux .aws. When classifying returnsfor audit potential, the Comaicsioner should discontinue thepractice of not selecting returns because earlier audits did notchange the tax amount, unless ihforuation about the previousissues is available to make a mere informed audit/no-auditdecision. He should Bake changes in the taxpayer contactprocedure to prevent unnecessary, repetitive audits and require vwritten explanation and supervisory approval before auditihg areturn originally obtained for information or referencespurposes. (Author/SO)

Ca REPORT TO THE JOINT COMMITTEEN ON TAXATION

CONGRESS OF THE UNITED STATES

BY THE COMPTROLLER GENERALi-~ ', r OF THE UNITED :STATES

Repetitive IRS Audits OfTaxpayers Are Justified

GAO is satisfied that, overall, taxpayers whowere udited repetitively by the InternalRevenue Serice were audited because theirreturns fit the usual selection criteria. Allreturns are selected for audit through thesame system, 3nd the system generallyprotects against selection abuse. Repetitiveaudits are like all audits in terms of recom-mended tax increases, indicating that tax-payers were not repeatedly selected unless taxadjustments were probable. Nevertheless, IRSccn further reduce the number of repetitivelyaudited taxpayers.

GGD-77-74 NOVEMBER 18, 1977

i COMNOL ER GENERAL OF THE UNITED STATESWAMINOGTON. D.C. RUOS

B-137762

To the Chairman and lice ChairmanJoint Committee on ;ixationCongress of the Uni td States

This report, ol? of e series in response to yourCommnttep' request, addresses the reasons whv the Inter-nal Revenue Service 3udits some taxpayers repetitivelyand the dollar productivity of such audits. The reportfocuses on individual income tax payers. The Serviceagreed with our recommendations, and their impIementationshould further assure that only necessary repetitive auditsare performed.

As arranged with your Committee, unless you publiclyannounce its contents earlier, we plan no further distri-bution of this report until 30 days from the date of thereport. At that time, we will send copies to interestedparties and make copies available to others upon request.

Comptroller Generalof the United States

COMPTROLLER GENERAL'S REPORT TO REPETITIVE IRS AUDITS OFTHE JOINT COMMITTEE ON TAXATION TAXPAYERS ARE JUSTIFIEDCONGRESS OF THE UNITED STATES

DIGEST

The Internal Revenue Service (IRS) auditsa relatively small number of the individualtax returns filed each year. Even so, sometaxpayers are repetitively audited; thati-, IRS examines their returns for at leasttwo out of three successive tax years. DoesIRS have valid reasons for doing such au-dits?

Yes.

'--IRS' system f-or selecting returns for au-dit generally protects taxpayers againstabuse. All returns are selected throughthe same system, regardless of whether itis the taxpayer's first audit or the mostrecent of several. IRS has no specialsystem that would result in a particulartaxpayer'3 return being audited year afteryear.

-- In terms ef recommended tax increases, therep;lts c repetitive audits have been verysimilar to the results of all audits. Inother words, there is no indication thatIRS repeatedly selected taxpayers for auditunless their returns indicated a probabletax change.

Obviously, no system is perfect and GAOrecommends several ways to improve the se-lection process. But, overall, GAO is sat-isfied that taxpayers were audited repeti-tively because their returns fit the usualselection criteria.

FREQUENCY OF REPETITIVE AUDITS

GAO randomly sampled and analyzed over 2,800audits of 1,201 taxpayers who had been repe-titively audited. The taxpayers had filedtheir most receut returns in one of six IRSdistricts where GAO did its work. (Seepp. 2 and 41.)

h"W Amo a* on GGD-77-7ico ON should Abed nahorn.

Although a return is filed within an IRSdistrict, it can be audited by eithe: anIRS service center or district office.Most audits, however, have been done bydistrict offices. (See pp. 1 end 4.)

About 25 percent of the taxpayers in thesix districts who had an audit closed bya district office during 1975 were repe-titively audited. Including service cen-ter audits, about 16 percent of the tax-payers experienced repetitive audits.Neither GAO nor IRS can say for sure howmany taxpayers have been audited repeti-tively, because IRS does not have thisinformation. (See p. 3.)

For tax years 1966 through 1974, 57 percentof the sampled taxpayers had two of thereturns they filed examined. Another 26percent had their returns for three taxyears examined. (See p. 5.) While all in-come groups have been subject to repetitiveaudits, business taxpayers overall were re-petitively audited more often and nonbusi-ness taxpayers with incomes below $10,000lass often than average. Business taxpay-ers were audited more frequently primarilybecause the IRS examiner, while auditingone year's return, belipved returns fromother years should be audited as well.(Sae p. 5.)

WHY REPETITIVE AUDITS OCCUR

According to IRS, a return can be selectedfor audit for 1 of more than 60 reasons.The reasor.s apply whether it is the firsttime or the latest of several years a par-ticular taxpayer's return is selected.Overall, about 60 percent of the repetitiveaudits GAO reviewed resulted from one ofthree reasons:

-- The return received a high score underIRS' computer generated audit selectionprogram.

-- The return apparently had an unallowableitem(s) on it.

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-- It was selected by an examiner as a re-sult of auditing another year's return--amultiyear audit. (See p. 8.)

About 68 percent of the sampled taxpayerswho were repetitively audited by servicecenters fit into one of two selection pat-terns. They were successively audited forunallowable items or for questionable headof household filing status. Many of thesetaxpayers did not seem to understand whyIRS said an item was unallowable.

For example, about 44 percent of the tax-payers audited because of unallowable itemswere questioned for thesame item or itemsin later audits, even though generally thefirst audit was closed and the unallowableitem explained before the later return wasfiled. IRS officials agreed to see if theexplanations could be made clearer. (Seepp. 9 and 10.)

A taxpayer may be audited repetitively forthe same or different reasons. For GAO'srampled taxpayers, most first audits--about60 percent--were generated by computer.For these taxpayers, the second audit mostoften resulted from computer identification(55 percent) or multiyear examination (20percent). (See p. 12.)

IRf examiners can in some instances deter-m.ne on their own that specific returnsAhould be audited. GAO believes IRS shouldrequire audit personnel to provide morewritten justification when requesting aspecific return. (See pp. 15 and 22.)

DOLLAR RESULTS

If taxpayers were generally being repeti-tively audited unnecessarily, the resultingtax increase for each audit and for eachhour spent examining the returns would beless than that for all audits. No statis-tically significant difference of this kindwas found, either by return selection cate-gory or in total. The mean tax increase

iii

per return in GAO's repetitive audit samplewas $955, compared to $770 for all audits;and the ircrease per examiner hour was$178, compared to $140 for all audits. (Seep. 18.)

NO-CHANGE AUDITS: A PROBLEMRS Is WO RKI NG -O -

Repetitive audits more frequently resultedin tax changes than did audits generally.But, the amount of change per audit wasabout the same. Interestingly, the overallno-change rate for first, second, and thirdaudits remained about the same. Moreover,29 percent of the sampled taxpayers had atleast one audit that did not change theirtax. This incl-uded 8 percent whose taxdid not change for each audit. (See pp. 10and 20.)

Taxpayers who experience repetitive auditsthat result in no tax change may well findthem a source of irritation. Some personsmay consider the 8 percent figure too high.Whether it is or not, IRS can be reasonablyexpectea to minimize the number of such au-dits. While only a perfect selection sys-tem would eliminate 'hem all, IRS has beguntwo new procedures to reduce the number ofaudits resulting in no or small tax changes.

Taxpayers' assistance

In June 1976 IRS began asking taxpayers totell it when a scheduled audit is going toreview tax issues previously examin-o in ano-change audit. If the issues are the same,IRS will probably not continue the audit.The procedure is a welcome change. But oneproblem is that, to be effective, the tax-payer must provide IRS with information.IRS cannot quickly get this informationfrom its records. It should be able towhen its computer system is expanded. Un-til then, IRS will need the cooperation oftaxpayers. (See pp. 23 and 26.)

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Another problem is more immediately solv-able: the procedure does not apply to cer-tain audits done by revenue agents or tocases in which an earlier audit resultedin the taxpayer's receiving a small refund.Taxpayers in such cases should also begiven the opportunity to avoid a later au-dit. (See pp. 29 and 30.)

Prior tax issues not considered

The other procedure IRS implemented alsogives GAO concern. When classifying returnsfor audit potential, IRS will generally passthose of taxpayers whose tax did no- changein previous audits, regardless of the issuesexamined. IRS does not have a system forknowing, at tbhe time of :elction, what taxissues were previously examined. Thus, cur-rent returns which could be audited for is.sues different from those previously examinedcan pass undetected. (See pp. 25 and 26.)

Statistics GAO developed show that the pro-cedure may not be in the Government's andthe taxpayers' best interests. About 55percent of the sampled taxpayers who had areturn audited without a tax change had alater return examined. Of that number, 48percent had their tax changed. Changes thatincreased tax averaged about $480 per tax-payer and those that decreased tax averagedabout $282 per taxpayer. Usually, thechange audit included one or more issuesdifferent from those examined in the no-change audit. Unless IRS gets informationon prior issues before it decides which re-turns to audit, its procedure will not befully effective. (See p. 31.)

As GAO noted in a previous report, IRS doesnot know the extent to which audits affecttaxpayer compliance. IRS plans to studythis. As part of that study, IRS should as-sess the effect that repetitive audits haveand, if warranted, reevaluate its proceduresfor such audits.

Tear SVet

RECOMMENDATIONS

The Commissioner of Internal Revenue should:

-- Include repetitive audits in the plannedstudy of factors contributing to voluntarytaxpayer compliance with the tax laws.

-- When classifying returns for audit poten-tial, discontinue the practice of not se-lecting returns because earlier audits didnot change the tax amount, unless informa-tion about the previous issues is avail-able to make a more informed audit/no-audit decision.

---Make the changes specified on page 32 tothe taxpayer contact procedure, to preventunnecessary repetitive audits.

--Require a written explanation and super-visory approval before auditing a returnoriginally obtained for information orreference purposes.

INTERNAL REVENUE SERVICE COMMENTS

IRS agreed with all of GAO's recommenda-tions. The Commissioner of Internal Revenuesaid the recommendations will provide tax-payers and IRS with further assurance thatonly necessary repetitive audits are per-formed. He also believes the report re-flects favorably on existing IRS policiesand procedures concerning repetitive audits.(See app. I.)

vi

Con tents

Page

DIGEST i

CHAPTER

! l' TRODUCTION 1IRS audits 1Scope of review 2

2 THE EXTENT, BASIS, AND PRODUCTIVITY OFREPETITIVE AUDITS 3Extent of repetitive audits 3Sasis for repetitive audits 8IRS policy on consecutiveŽ audits by

the same examiner 16Productivity of repetitive audits 16Conclusions 21Recommendation to the Commissioner

of Internal Revenue 22Intr..nal Revenue Service comments 22

3 WHAT IRS IS DOING TO AVOID UNNECESSARYREPETITIVE AUDITS 23Availability of past audit infor-mation 23

Computerized approach to curtailDiF selected repetitive audits 24

Classification approach to preventrepetitive audits 25

Taxpayer notification approach toreduce repetitive audits 26

Conclusions 31Recommendations to the Commissionerof Internal Revenue 32Internal Revenue Service comments 32

APPENDIX

I Letter dated September 23, 1977, fromthe Commissioner of Internal Revenue 34

IL How the repetitive audit sample wasselected and analyzed 41

III Service center audit programs opera-tional during the period covered bythe repetitive audit sample 45

APPENDIX Page

IV Audit selection categories and reasons

used by IRS district offices 49

V Principal officials responsible for ad-

ministering activities discussed in

this rzegort 55

ABBREVIATIONS

DIF discriminate function

GAO General Accounting Office

IRS Internal Revenue Service

CHAPTER 1

INTRODUCTION

The Internal Revenue Service (IRS) audits a small frac-tion of the total tax returns filed annually. Even so, sometaxpayers incur repetitive audits--IRS examination of twoout of three successive tax years. Such examinations promptmany questions: How often are taxpayers repetitively au-dited? Why is a taxpayer repeatedly selected for audit? Isone group of taxpayers being singled out? Are such auditsdollar productive? What is IRS doing to avoid unnecessaryrepetitive audits? Our review answered these Questions.

IRS AUDITS

As part of its missin, JRS strives to encourage thehighest possible de-e-lc'l c,).tsL'y cacmpliance with thetax laws--that is, %i'e :ailA.i;yam: , willlnqneis of taxpayersto accurately assess e;' Tr; r'rornb ' rxpliance,IRS communicates the re uiretMtrt.. .f the eaw to the public,determines the extert agnd causes of noncomtl'lnon. and doeswhatever necessary to enforce 'h. law.

Of all its enforenteren' acci it.esb, IK lies the audit oftax returns as the primary mexns to encouurage voluntary com-pliance. According to IRS, About 36 percent $S504 million)of its fiscal year 197C a&pDopriation related to audit ac-tivity. During fiscal year 1976, IRS audited about 4.2 mil-lion 1/ of the 113 million tax returns (all types of taxes)filed in calendar year 1975. About $5.1 billion in recom-mended additional tax and penalties resulted from these exa-minations.

IRS determines how many returns it will examine each yearthrough an annual planning process. The audits are then doneby 10 service centers and 58 district offices located acrossthe country. A district covers part or all of one State whilea service center covers a number of district offices.

At the district level, the audit of a return is accomp-lished through correspondence, or can take place in an IRSoffice, the taxpayer's home or place of business, or in the

1/IRS does not ccnsider all of these to be audits. Seepage 41 and our report "How The Internal Revenue ServiceSelects Individual Income Tax Returns For Audit," GGD-76-55,Nov. 5, 1976.

office of the taxpayer's accountant or attorney. Auditmethod and location are governed by such factors as returncomplexity and the best interest cf the Government and thetaxpayer. Service centers audit by correspondence, examin-ing returns containing less complex issues.

SCOPE OF REVIEW

The Joint Committee on Taxation requested this study,which focused on filers of individual income tax returns(Form 1040 type returns). To do this study, we reviewed IRSpolicies, procedures, and records for selecting and auditingindividual income tax returns; interviewed IRS examiners andother personnel responsible for the return selecting and au-diting processes; and reviewed taxpayers' letters complainingabout repetitive audits and IRS responses. We also reviewedthe audit histories of 1,201 randomly selected taxpayers whohad experienced repetitive audits, and analyzed 2,812 auditsof their returns. The procedures followed in selecting andanalyzing the sample are presented in appendix II.

We did our work primarily at the IRS national office inWashington, D.C., and at the Philadephia, Reno, San Francisco,St. Louis, Wichita, and Wilmington district offices. The sixdistrict offices are responsible for the eastern half of Penn-sylvania, Nevada, the northern half of California, Missouri,Kansas, and Delaware, respectively.

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CHAPTER 2

THE EXTERT, BASIS AND

PRODUCTIVITY OF REPETITIVE AUDITS

While tfe IRS develops an annual plan as to the numberof returns it will examine, it does not plan :he number ofrepetitive audits that will be performed. However, inaccomplishing the annual plan, repetitive audits do occur.

Whether an audit is repetitive or not, IRS uses the samesystem to select the returns. The structure of this systemgenerally protects against abuse in the selection process.However, IRS can take additional measures to make sure tax-payers are not unnecessarily inconvenienced.

The average dollar yields of repetitive audits are aboutthe same as those of all audits. Repetitive audits, however,more often result in a tax change. On the other hand, sometaxpayers have experienced repeat audits tfiat have producedlittle or no tdx change. IRS is trying to avoid such audits.

EXTENT OF REPETITIVE AUDITS

Because of data limitations, neither we nor IRS knowprecisely how many taxpayers have been repetitively examined.But it is clear from our sample data that repetitive auditsere done more often by districts than service centers. About16 percent of the taxpayers incurring either a district orservice center audit during 1975 had experienced repetitiveaudits. For districts alone, the percentage of repetitivelyexamined taxpayers was 25 percent.

Repetitive audit frequency can also be viewed in terms ofthe number of times taxpayers are audited. IRS records showthat most of our sampled taxpayers had not more than three taxyeaIs examined over a 9-year period. Taxpayers, however,have complained of more audits than are shown by IRS records.This may be due to a difference between IRS' definition andtaxpayer perception of what constitutes an audit.

Percentage of taxpayers audited duringT9 Who hadb eenrepetltlve examined

IRS records the audits of individual taxpayers o.n acomputerized master file. According to master file in£;rma-tion, about 16 percent of the 389,000 taxpayers in the si1districts who had a service center or district audit closedduring 1975 had incurred repetitive audits.

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However, taxpayers audited by district offices are morelikely to incur repetitive audits. To illustrate, districtoffices performed about 70 percent of all individual returnaudits during fiscal year 1974. In contrast, district of-fices performed about 83 percent of our sample audits donein fiscal year 1974. Based on certain assumptions I/ appliedto the master file data, we estimate that 25 percent ofthe taxpayers who incurred a district audit in .975 hadbeen repetitively examined.

Tne higher number of repetitive audits at the districtlevel is probably related to the differences in contentand timing between district and service center examinationprograms. Most service center examinations begin soon after:RS receives a return and, because they Involve relativelyuncomplicated issues, can usually be completed before thenext return is filed. Districts, however, generally beginauditing returns later than service centers and take longerto complete them because of the issues involved. Thedistrict-audited taxpayer, therefore, usually has less op-portunity than the service-center-examined taxpayer to avoidrepeating any previous error when filing the next return.

Neither we nor IRS know the exact number of taxpayers whohave been repetitively examined. IRS has maintained statis-tics on the number of returns examined but not the taxpayers.Further, the Individual Master File, the onl- practicalsource for identifying repetitively examined taxpayers andmeasuring repetitive frequency, does not include every tax-payer and tax year that has been audited. After varyingperiods of inactivity, taxpayer accounts and tax years areremoved from the file. The percentages we computed, there-fore, are conservative estimates based on the besL availabledata.

1/Two assumptions were used: (1) the service center todistrict audit ratio for the districts reviewed doesnot differ from the national ratio, and (2) the servicecenter to district audit ratio for repetitively examinedtaxpayers audited in 1975 does not differ from the 1974ratio in our sample. The use of a national ratio inthe first assumption was necessary because IRS does notmaintain statistics showing service center audits accordingto district.

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Number of audits pers ampled taxpayer

Repetitive frequency includes no- only how many taxpayersare affected but how often each is examined. We thereforedetermined how many tax years our sampled taxpayers had beenaudited over a 9-year priod--tax yeais 1966 through 1974.For the returns that had been filed, most taxpayers had twoor three tax years examined as shown by the following table:

Number of tax Percent of tax-years examined payers in sample

2 573 264 105 or more 7

P te: The greatest number of tax years examined for a giventaxpayer was seven.

To cover the 9-year period for each sampled taxpayer, wesupplemented the master file listings primarily with datafrom IRS microfilm records. However, our analyses of whyrepetitive audits occur, their dollar productivity, etc. werelilwited to those audits shown by the listings. The resultsof these analyses are presented in this chapter.

Repetitive audits by income grou

IRS records the number of returns examined by taxpayers'adjusted gross incomes, or audit classes. At the time of ourreview, incomes were grouped into seven audit classes, threefor business and four for nonbusiness taxpayers. The busi-ness classes are composed of those individuals who attach aSchedule C (Profit and Loss from Business or Profession)or Schedule F (Farm Income and Expenses) to their returns.The nonbusiness classes include all other iadiv dualtaxpayers.

To determine if one income group was being repetitivelyaudited more than another, we used the seven audit classes tocompare the audit classes for the district audits in our sam-ple to the total combined audit closings of the six districtsreviewed. 1/ The comparison disclosed that while all incomegroups have been subjected to repetitive audits, businesstaxpayers, overall, were repetitively audited more often

1/See app. II for thp procedure we foilowed to make thisand other comparisons presented in tl is chapter.

and nonbusiness taxpayers with incomes below $10,000 lessoften than average. The major reason business taxpayers havebeen repetitively examined more often stems from the frequencywith which they receive "multiyear" audits. Such audits occurwhen the examiner, while auditing one return, believes it nec-essary to audit the same type of return filed by that taxpayerfor another year(s). In our sample, multiyear audits caused25 percent of the business examinations but only 6 percent ofthe nonbusiness examinations.

The following table presents the comparison between thesample and the total district data.

Audit frequencyRepetitive AAudit class audit t a) audits

(percent)

Nonbusiness:Less than $10e000 (standard

deduction) 9 11Less than $10,000 (itemizeddeductions) 26 34$10,000 to less than $50,000 34 34$50,000 or more 3 3

Business:Less than $10,000 10 8$10,000 to less than $30,000 10 6$30,000 or more 8 4

100 100

a/Based on our sample analysis.

Taxeayers have complained of moreaudits than IRS records show

Taxpayers have written IRS and/or their congressionalrepresentatives to complain about being audited repeatedly.The number of audits mentioned by the taxpayers is sometimesgreater than shown by IRS records. Of 69 complaint letterLreceived by the six districts that we reviewed, about 40 per-cent were in this category. IRS, in replying to thee let-ters, usually indicated that its records showed fewer examinedtax years out did not explain why there might be a dlifetance.

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One possible explanation for the difference concernsIRS' audit definition versus the taxpayer's perception ofan audit. I/ IRS says an audit occurs only when the tax-payer's books and records are examined--for example, whenthe taxpayer provides receipts and canceled checks tosubstantiate claimed deductions. Pragmatically, taxpayersmay perceive that any IRS question about their return wasgenerated by an audit. This could certainly be the case ifthe taxpayer provides an IRS examiner copies of prior orsubsequent year returns. This situation is-discussed below.

Inspection versus examination

During the course of auditing one year's return, theIRS examiner may ask to see or inspect the taxpayer's copyof another year's return. An inspection, according to theInternal Revenue Manual, is "* * * es entially equivalentto the classification of a return to determine if anexamination is necessary. This means that no records shouldbe examined and no questions asked the taxpayer concerningthe copy inspected."

The number of inspected returns differs among districts.In one district reviewed, for example, the general policyis for revenue agents to inspect both the preceding and sub-sequent tax year returns, while in another district agentsare required to inspect subsequent year returns only.

Taxpayers may be confused about inspections because IRSdoes not require that they be told that an inspection ratherthan an audit is occurring or, if told, may not understandor accept the difference. We spoke to 56 examiners abouttheir practice of informing taxpayers of inspections.Eighty-four percent said they inform taxpayers, and 16 per-cent said they did not. Some of those who informed tax-payers believed that even when the difference between auditand inspection is explained, taxpayers can still be confusedabout the matter.

1/IRS considers few taxpayer contacts made by its servicecenter audit divisions to be audits but, because of theway they are recorded, such contacts would not cause thedifference between the tax year numbers cited by taxpayersand IRS records.

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Examiners are also confused about the Difference. Weasked the 56 examiners to describe what they do when inspect-ing returns. All but one said they would not ask to see thetaxpayer's books and records. However, when it comes toasking taxpayers questions, about 36 percent said they wouldask general or specific questions about the inspected returnThe other 64 percent said they would not ask any questions.Therefore, what one examiner considers an inspection, anothermay consider an audit.

We discussed our observations with IRS officials. Toreduce the confusion about the differen e between an inspec-tion versus an audit, they agreed to

--remind all examiners of the Internal Revenue Manualprocedure concerning inspections, and

-- amend the manual to require examiners to inform tax-payers about the purpose and results of inspections.

BASIS FOR REPETITIVE AUDITS

All returns, whether a taxpayer is examined repetitivelyor nonrepetitively, are selected through the same auditselection system. In a previous report we concluded thatthere generally is little chance for abuse in the selectionprocess. 1/

IRS has identified more than 60 reasons for selectingreturns for audit. 2/ Any one or a combination of thesereasons may cause a taxpayer to be repetitively examined.Cumulatively, about 60 percent of the audits we reviewedresulted from three reasons--computer score, identificationof unallowable items, and expanding Ln audit to cove- alater return (multiyear audits).

Why service centers selectedtaxpayers fo, repetitive audits

In years past, IRS neglected from an audit standpointmillions of individual income tax returns containing smallerrors because correcting such errors through full-fledged

1/Report to the Joint Committee on Taxation, "How The Inter-nal Revenue Service Selects Individual Income Tax ReturnsFor Audit," GGD-76-55, Nov. 5, 1976.

2/IRS calls the reasons source codes.

district audits was considered too costly. In searchingfor ways to obtain additional audit impact, IRS turned toits service centers and focused on these returns beginningin 1972. Since then IRS has developed a number of servicecenter examination programs, 12 of which were operationalduring our review. (See app. III.)

C'r sample incl ded 425 service center audits, brokendown by program as follows:

Percent

Unallowable items 58Head of household filing status 22Discriminate function (DIF) (note a) 11Claims 5All other 4

100

a/See p. 49 for an explanation of the DIF system.

These 425 audits involved 286 taxpayers, about 24 percentof our taxpayer sample. Of the 286 taxpayers, 125, or about44 percent, were audited more than once by a service center.

There were many combinations of reasons why the 125taxpayers were audited more than once by service centers.But two combinations most commonly occurred--an unallowableitems audit followed by another unallowable items audit, or ahead of household audit followed by another head of house-hold audit. About 68 percent of the 125 taxpayers reackvedmultiple unallowable item or head of household examinations.

Notwithstanding the relatively few service center audits,

there are indications that taxpayers do not understand whyIRS said an item was jnallowable. Under the unallowable itemsprogram, IRS sends the taxpayer a letter which tells him (1)about the problem with his return, (2) how the problem af-fects his reported tax liability, and (3) what to do if heagrees or disagrees with IRPS' finding.

When the taxpayer does not understand the problem ordoes not accept IRS' explanation, he probably will file hissubsequent return as he did before. In our sample, about44 percent of the taxpayers who experienced multiple un-allowable item examinations had the same item(s) questionedin the later audit. This occurred even though the firstaudit was generally closed and the unallowable item ex-plained before the subsequent return was filed, Forexample, IRS disallowed the automobile license fees

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deducted by one taxpayer in successive returns and theamount of ch'.A care expenses claimed successively bycnother taxpayer.

IRS is -rying several approaches to improve taxpayerperformance in these areas. In reply to previous recom-mendations, 1/ IRS said it would change its letters notify-ing taxpayers of an unallowable item by (1) revising theletters' format and (2) asking taxpayers to explain whythey believe a questioned item is allowable.

We discussed with IRS officials the indication fromour current analysis that taxpayers are having difficultyin understanding the unallowable explanations. The offi-cials agreed to review the current explanations and changethe language as necessary to make them more easily under-stood by taxpayers.

Why districts selected taxpayersfor repetitive audits

Most returns selected for audit by district officesinvolve issues that are not as readily identifiable or aseasily resolved as those examined by service centers. Atthe district level, the reasons for selecting and examiningreturns are usually grouped into six major categories. Eachcategory is listed below with the percentage it representedof the district audits we reviewed.

Percent of district auditsReturn selection category (notea) in our repetitive sample

Computer identified returne, 53Audits initiated by IRS and others 11Claims and other refund requests 6Related pickups 9Multiyear audits 12Miscellaneous 9

100

a/'App. IV describes the selection categories, lists the rea-sons witnin each category, and provides the percentageof district audits we reviewed by selection reason.

1/See pp. 12 and 13 of our report to the Joint Committee onTaxation, 'Audit Of Individual Income Tax Returns By TheInternal Revenue Service," GCD-76-54, Dec. 2, 1976.

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In many instances the reason recorded for selecting areturn for audit is a ju'dgmental decision on the part ofaudit personnel. They select the one reason which, in theirjudgment, best explains why the return is being selected.Because of the nature of service center audit programs, thisjudgmental decision comes into use more at districts thanservice centers. The selection reasons IRS had recordedfor the returns in our sample were generally appropriate.

Selection pattern betweenrepetitve and all a-its

Repetitive audits done by districts were generated fromthe same selection categories as audits in general. However,as shown below, the proportion of repetitive audits generatedfrom each selection category differs from that found in thetotal audit population.

All audits closedDistrict audits by the six districtsin sample closed reviewed from

Reason category after 9/72 (note a) 7/72 to 6/75 (note a)

(percent)

Computer identified 54 68Initiated Ac IRS andothers 10 12

Claims 6 4Related pickups 8 4Multiyear audits 12 5Miscellaneous 10 7

100 100

a/The comparison covered approximately the same time frame.See pp. 43 and 44.

These differences result from a characteristic which ismore common to repetitive audits than to the total auditpopulation. Many of the sampled audits, while repetitivein number, were performed simulta;ieously--that is, two ormore of the taxpayer's returns were audited at the same time.Excludir.q computer identified audits, the number of simul-aneous atJits in our sample ranged from 58 percent in the"initiated by IRS" category to 93 percent in the multiyearcategory.

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Simultaneoup audits are not as common in the total auditpopulation. Rather, computer identification is the princi-pal way IRS selects returns to audi' and this process isindependent from year to year. TE, the computer identi-fication category in a sample of r itive audits wouldlogically decline relative to other selection categories.Conversely, the other selection categories would logicallyincrease relative to the computer identification category.

The differencea discussed above indicate that manyrepetitive audits ae based on audit personnel belief thatthe potential tax consequences are significant enough towarrant examination of more than one return filed by a giventaxpayer. Therefore, from a practical standpoint, thereasonablene ss of auditing taxpayers repetitively can bestbe evaluated by analyzing dollar yields achieved. Our com-r-rison of dollar yields between repetitive and all auditsshowed that they are about the same. (See pp. 18 through19,)

Selection atterns amonrepet itively ex mne axpayers

A taxpayer may be audited repetitively for the same ordifferent reasons. To determine if a pattern of reasonsexisted among repetitively audited taxpayers, we identifiedthe most frequent reason for first audits and then related itto the reasons for the second and third audits. The auditswere those shown on the master file listings for our sampledtaxpayers. While both service center and district auditswere included, the patterns found generally represent dis-trict selection reasons.

Most first audits--about 60 percent--were computeridentified. The next most frequent reason was the unlallow-able items program which caused 7 percent of the firstaudits.

The computer identified first audits were most fre-quently followed by computer identified second audits. Com-puter identified returns are generally examined indepen-dently of one another. The next most common reason for thesecond audits was multiyear pickups. Tax returns selectedbecause of multiyear pickups would, by definition, be ex-amined during the audit of the computer identified returns,and would not be considered epetitive by IRS. Computeridentified and multiyer audits accounted for 55 and 20 per-cent, respectively, of the related becond auditE.

12

Only a small number--14 percent--of the sampled taxpayerswho experienced a computer identified first audit also hada third audit within our sample. Fiowever, for those who did,it too was usually computer identified (47 percent) or causedby a multiyear audit (16 percent).

Because of the small number, we did not analyze reasonrelationships beyond the third audit. We did, however, as-certain the primary reason sampled taxpayers incurred morethan 3 audits. We considered a reason as being "primary" ifit accounted for half or more of -he tote! audits the tax-payers had incurred as P'-&-n on the master file listinos.Seventy-two oZ the i,zol sampled taxpayers had more than 3audits. The primary reasons for these audits were generallyin the computer-identified, examiner-initiated, or taxpayer-caused areas. For abcut 24 percent of .he 72 taxpayers, nosingle reason was frequent enough to auslify as primary.Following is a summary of the reasons why sampled t.:xpayersincurred more than three audits.

Primary reason Percent of taxasers

Computer-identified 25Examiner-initiated: 22

Multiyear audits 13Related pickup of partner,

shareholder, or corporateofficer 9

T rpayer-caused: 29Reauests for r .Cunds 11Delinquent returns 5Fraud 4

Intelligence division referrals 6Other 3No primary reason 24

100

Examiner initiated repetitive audits

In most instances, the person who examines the returndoes not initiate the selection process. But examiners canand do select specific returns to audit. For example, anexaminer, while auditing one year's return, can requestand audit the taxpayer's return for another year. While noservice center audits in our sa ple were examiner initiated,about 27 percent of the district audits were.

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Audits initiated from information reports

After auditing a taxpayer, the examiner may write aninformation report which can lead to a future audit of thetaxpayer. Because of its particular nature, we reviewed the"information" selection reason in more detail.

Under the information report procedure, the examinercompletes a form providing the reasons, and their source,for another possible audit. The form or report can applyto either a filed return or the next return that should befiled. The examiner submits the completed form to hisimmediate supervisor for approval. The supervisor shouldapprove it only if the audit effcrt required would generatea material amount of additional or delinquent tax. Anapproved report is next screened for potential by districtclassification personnel. 'A report may be rejected if theclassifier believes, for example, that it contains insuffi-cient information to permit an efficient followthrough orcites a tax issue not worthy of a followup audit.

A report accepted by a district classifier is sent tothe appropriate set ice center where it is evertually as-sociated with the affected return. The report and returnthen go to the service center audit division where a clas-sifier decides whether the return should be examined. Theclassifier may select the return for audit because of issuesother than those raised in the information report. A returnselected for audit is sent to the district that generatedthe report, where it may again be classified in terms ofneed for audit.

The Internal Revenue Manual directs examiners to pre-pare information reports in specified instances. For exam-ple, the manual states that an information report will becompleted when the examiner finds that the taxpayer hasfailed to keep adequate records to properly substantiateentertainment and other business expenses. When the infor-mation report is about inadequate business records, themanual instructs classifiers to select the associated re-turns for audit unless it appears that the taxpayer is nolonger in business or is no longer claiming deductions forbusiness expenses.

We reviewed 319 information reports provided by IRS andwritten by audit personnel from the six districts studied.The reasons cited in the reports generally dppeared tojustify classification of the subject returns. For example:

14

-- 96 reports (30 percent) concerned an adjustment madeto income or income that should be reported.

-- 46 reports (14 percent) noted that the taxpayer hadno support for questioned items, maintained inadequaterecords, or apparc-%ly did not file a return.

-- 42 reports (13 percent) involved items that wouldbe carried forward to future returns or itemsinvolving capital gains and losses.

--18 reports (6 percent) discussed the currentdisallowance of claimed exemptions.

-- 17 reports (5 percent) dealt with depreciation items.

Although an examiner initiates the information reportprocess, a return is selected for audit only after numerousIRS personnel separate from the examiner evaluate the needfor an audit. We believe the procedures for using the infor-mation report process are generally adequate to protectagainst abuse in selecting taxpayers for audit.

Other examiner initiated audits

The examiner can obtain a given return through his owninitiative by preparing a requisition which must be approvedby his immediate supervisor. On the requisition the examinerindicates, by a code number, the reason he is requesting thereturn. For example, one code indicates that the return isbeing requested because it was filed by the taxpayer's part-ner. The examiner is not reauired to provide any more infor-mation to justify the request. If the requisition is ap-proved, the return is forwarded from storage directly to theexaminer. This requisition procedure is generally followedunder all the examiner initiated selection reasons.

In our report "How The Internal Revenue Service SelectsIndividual Income Tax Returns For Audit" (GGD-76-55, Nov. 5,1976), we recommended that IRS, to further protect againstabuse during the audit selection process, require its exam-iners to explain on the requisition why they need the re-turn. IRS did not agree with that recommendation and saidthe codes are sufficiently comprehensive in most instancesto determine why the return was requested. IRS added thatit was reviewing the selection codes to insure their propeidefinition. Since then, IRS has revised certain code defi-nitions but has not required eras-.iers to provide writtenexplanations fot returns the% it to audit. Because of

the many examiner initiated audits (about 27 percent) in oursample and the reasons given in our previous report, we con-tinue to believe the examiner should explain in the reouisi-tion why the return is requested.

In addition to requisitioning returns directly foraudit, examiners obtain returns for information purposes.These returns may later be examined. Although the examinerindicates on the requisition why the return was requestedfor information purposes, he is not required to eitherdocument why the audit was necessary or seek the writtenapproval of his supervisor to audit the return. Both ofthese steps should be taken to provide greater taxpayerprotection against unwarranted audits.

IRS POLICY ON CONSECUTIVEAUDITS BY THE SAME-XAMINER

When the same examiner repetitively audits a taxpayer,audit objectivity may suffet and the taxpayer may feelharassed. To avoid this situation, IRS has a policy gene-rally restricting an examiner from auditing--exceptsimultaneously--a taxpayer's return for consecutive years.There is, however, no implementing system. Rather, IRSgenerally relies on the memory of its personnel to preventviolations.

About 32 percent of the IRS examiners and supervisorswe interviewed were unaware of the policy. Nevertheless,we found only 15 violations among our sampled taxpayercases. In those cases where the policy was violated, theexaminer usually did not identify the taxpayer's returnsfor audit, and when the examiner did, it appeared to be areasonable extension of the closed initial audit.

That there were not more violations can b attributedmore realistically to the return selection and assignmentsystem than to the policy's existence, especially sincethe policy has not been formally implemented. Repetitiveaudits by the same examiner are more of a problem in someoffices because of staffing numbers. However, the numberand nature of the policy violations do not indicate the needfor a formal and probably costly procedure to implement thepolicy.

PRODUCTIVITY OF REPETITIVE AUDITS

IRS' aud4t selection methods are designed to identifyreturns with potential for tax change. Therefore, if

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taxpayers were generally being repetitively audited unneces-sarily, the average amount of tax change from repetitiveaudits would be less than the average from all audits. Thiswas not the case in our sample. While some sampled tax-payers incurred audits resulting in little or no tax change,the average dollar productivity of the repetitive auditswas similar to that for all audits.

Productivity of service center audits

While each service center serves more than one IRSdistrict, IRS does not accumulate service center statisticsby the districts served. In the absence of such statisticsfor the six districts in our review, we compared the serv-vice center audits in our sample that were closed afterSeptember 1972 to the combined national service centeraverages for fiscal years 1973, 1974, and 1975.

With the exception of head of household audits, therewas no statistically significant difference between thedollar yield of repetitive audits and all audits for eachservice center program. For the head of household program,the no-change rate 1/ of repetitive audits was significantlyhigher than that for all head of household audits.

Qualified taxpayers can use the head of household taxrate to compute their tax liability. To generally aualifyfor this lower rate, taxpayers must be single or lecallyseparated on December 31 and have paid more than half thecost of maintaining the principal home of a relative orfoster child. The relative must be the taxpayer's dependentfor tax purposes unless he or she is the taxpayer's unmarriedchild, grandchild, stepchild, or foster child. IRS' currentreturn preparation instructions specify that when claimingthe head of household rate, names of nondependent relativesmust be written in the space provided on the return. How-ever, prior to tax year 1974, the return did not includethis space and taxpayers were not instructed to list thenondependent relative.

To be fi.ed correctly, the head of household returnshould include at least two exemptions--one for the taxpayerand one for the dependent relative--unl 4ss the relative isa nondependent. Under IRS' head of household program,

1/The rate of audits resulting in no change to the taxliability reported by the taxpayer.

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returns are identified by computer when the head of householdrate is used but.only one exemption has been claimed. Thesereturns are then manually screened to determine if a non-dependent relative is listed. If not, the taxpayer's use ofof the rate is questioned. Prior to 1974 returns, the tax-payer's use of the rate was questioned once the return wascomputer identified because manual screening for nondependentrelatives was not possible.

All of the audits for 29 of the 33 sampled taxpayerswho incurred multiple head of household audits ended withoutchange to the reported tax liability. These audits generallyinvolved 1972 and 1973 returns which did not require thatnondependents be listed. Whether the no-change rate forrepetitive audits lessened when taxpayers were instructedto list nondependents is unknown.

Productivity of district audits

If taxpayers are generally incurriing unnecessary repeti-tive audits, the resulting dollar yield per audit and perexaminer hour would be less than that for all audits. More-over, repetitive audits would more frequently result in notax change than would all audits.

Our comparisons showed that, on the average, repetitiveaudit productivity per audit and per examiner hour was aboutthe same as the productivity of audits in general. Therewas no statistically significant difference between repeti-tive audit dollar yield--either by selection category or intotal--and the dollar yield for all audits. The mean taxincrease per return in our repetitive audit sample was $955compared to $770 for all audits, and yield per examinerhour was $178 compared to $140 for all audits.

Our comparisons also showed that repetitive audits morefrequently resulted in tax change than did audits in general.As shown below, the no-change rate differences between repe-titive and all audits were statistically significant forfour of the six selection categories and for all categoriescombined.

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StatisticallyPercent no-chan e returns significant

Selection catego_ Re retitive All audits difference

Computer identified 22 33 YesInitiated by IRS

and others 18 24 YesClaims (note a) 12 3 YesRelated pickup 4 10 YesMultiyear audits 7 9 NoMiscellaneous 24 27 NoAll categoriescombined 18 28 Yes

a/For claims a no change represents nonacceptance of theclaim.

In summary, our comparisons show that repetitive auditsare more likely to result in a tax change than are audits ingeneral, but the amount of tax change per audit is about thesame. Consecuently, we believe there is no reason, from thestandpoint of overall productivity, why repetitive auditsshould not be performed.

Audit productivity ona taxpayer basis

The preceding analysis indicates that the productivityof repetitive audits on the average compares favorably withthat of all audits. It does not, however, address the extentto which individual taxpayers ae subjected to repetitiveaudits that consistently result in low yields or no changes.In terms of yield, such an analysis is complicated by twomajor factors. First, IRS does not maintain statistics ona per-taxpayer basis, thus there is no general benchmarkagainst which to compare the yield per audit for individualtaxpayers. Second, the results of service center and dis-trict audits must be combined since taxpayers may expe:ienceboth types over any given period of time. Because servicecenter and district audits have different average yieldsand no-change rates, combining them could result in distor-tion leaving the question of relative productivity unan-swered. Recognizing these factors, we analyzed the produc-tivity of repetitive audits on an individual taxpayer basis.

Dollar yield of frequent audits

We selected those taxpayers in our sample who had beenaudited three or more times to assess the productivity ofrepeatedly auditing the same taxpayer. We excluded audits

19

of taxpayers' claims and IRS employees from our analysis and,as in our other productivity computations, audits completedprior to October 1972.

Of our sampled taxpayers, 145 (12 percent) had beenaudited three or more times. These taxpayers incurred anaverage of $2,000 per audit in recommended additional taxesand penalties. This amount exceeds the $144 average for allservJ 'e center repetitive audits and the $955 average forall district repetitive audits in our sample. However, theadditional taxes plus penalties per taxpayer varied con-siderably. Of the 145 taxpayers, 20 (14 percent) had anaverage increase of $50 or less per audit. Conversely,the average increase for 26 other taxpayers (18 percent)ranged from about $2,000 to $69,000.

Because of the small number of sampled taxpayers wnowere audited three or more times, the variation in taxchanges experienced by them, and the absence of a benchmarkfor identifying a productive audit, it is impossible todetermine the relative productivity of repeatedly auditingthe same taxpayer. However, we believe that these taxpayers,on the whole, were not audited unnecessarily since 86 percentof them incurred an average increase of more than $50 per audit.

NLlmber of taxpayers experiencingno-change audits

The repetitive audits in our sample, when consideredoverall, have statistically significant lower no-changerates than those for audits in general. However, contraryto expectation, the overall no-change rate for first, second,and third audits remain about the same. Although factorssuch as simultaneous audits help explain why the rate doesnot change as audits increase in number, we believe anotherreason is the limited use made of information obtained fromprior audits. Chapter 3 discusses the procedure IRS is pre-sently implementing to make better use of this information.

We also analyzed 1/ our taxpayer sample to determinethe extent to which individual taxpayers were experiencingrepetitive no-change audits. The analysis showed that 29percent of the sampled taxpayers had experienced at leastone no-change audit. This total was composed of

1/All audits listed by the master file for each sampledtaxpayer were used in this analysis, excluding audits oftaxpayers' claims and of IRS employees.

20

--20 percent who had one no-changes and one or morechange audits,

--1 percent who had two or Sore no-change audits plusone or more change audits, and

--8 percent who had all no-change audits.

Taxpayers who experience repetitive no-change audits

may well find them a source of irritation and some may view

the 8-percent figure as being too large. As discussed n.-chapter 3, IRS has taken recent actions which should reduce

the number of repetitive no-change audits, but some willcontinue to occur. Only a perfect selection system would

eliminate all such audits.

Number of taxpayers experiencingsmall-change audits

We also analyzed 1/ the extent to which taxpayers were

being repetitively audited but experiencing only small tax

changes. We defined "small" as being tax increases of less

than $50 or refunds of less than $10. Only 12 percent (150)

of the sampled taxpayers were in this category, about two-

thirds of whom were the taxpayers discussed above who ax-

perienced all no-change audits.

Service center audit programs were developed to cor-

rect small tax errors and, as might be expected, many of

the 150 taxpayers had two or more service center audits.

For example, 9 percent had two or more tax returns examined

under the unallowable items program, and 19 percent had two

or more audits under the head of household program. IRS

does not consider actions under those programs to be audits.

Although our analysis shows that small change audits

occur, many are probably unavoidable given existing servicecenter selection criteria. We did not attempt to determine

whether this criteria should be changed.

CONCLUSIONS

Among the important elements of a repetitive audit

situation is why a taxpayer was selected for audit and the

dollar results of those audits. Taxpayers' returns are

selected by IRS for repetitive audit for any number of

l/All audits listed by the master file for each sampledtaxpayer were used in this analysis, excluding audits of

taxpayers' claims and of IRS employees.

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reasons However, these reasons are the same reasonsall audits are generated.

Our previous review of IRS' return selection processfound that taxpayers are generally protected against selec-tion abuse but that IRS should require examiners to explainon the requisition form why they need a return. IRS hastaken steps to help insure that audit personnel are obtain-ing returns for valid reasons. For example, the computerwill not accept return requisitions prepared by audit per-sonnel when the reason provided is DIF or unallowable items.However, while we found no evidence to indicate that examin-ers were initiating audits for the purpose of intentionallyharassing taxpayers, we continue to believe that IRS canfurther strengthen the return selection process by requiringmore written justification for obtaining and auditing areturn.

Repetitive audits, overall, are as productive as auditsin general. Therefore, considering that average repetitiveaudit productivity is equal to that for audits in general,that the related dollar amounts are significant, and thatthere is no legal reason for forgiving a taxpayer a signifi-cant amount of tax owed, we believe repetitive audits shouldbe performed.

On the average, repetitive audits have a lower no-changerate than do audits in general. Even so, some taxpayers ex-perience repetitive audits resulting in little or no taxchange. Reducing the number of such audits would increaseaverage productivity and enhance IRS' public image. IRSactions to reduce the number of repetitive no-change auditsare discussed in the following chapter,

RECOMMENDATION TO THE COMMISSIONEROF INTERNAL -.EVENUE

We recommend that the Commissioner require a writtenexplanation and supervisory approval before auditing a re-turn originally obtained for information and referencepurposes.

INTERNAL REVENUE SERVICE COMMENTS

The Commissioner of Internal Revenue agreed with ourrecommendation and will require supervisory approval beforean examiner begins an audit of a return initially obtainedfor information and reference purposes. (See app. I.)

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CHAPTER 3

WHAT IRS IS DOING TO AVOID

UNNECESSARY REPETITIVE AUDITS

When deciding whether to select a return for audit,IRS personnel generally know if the taxpayer was auditedpreviously and the dollar results of the audit. However,they generally do not know what tax issues were previouslyexamined because such information is not readily available.

To avoid unnecessary repetitive audits, however, IRSamplified its classification procedures in 1975, and laterbegan asking taxpayers to ilentify, in certain cases, a pend-ing repetitive audit dealing with issues examined previously.After being notified by the txDoayer, IRS may terminate theaudit. We believe the classification procedure in its pres-ent form should be discontinued and the types of casescovered by the taxpayer notification measure broadened.

AVAILABILITY OF PAST AUDIT INFORMATION

After an audit is closed, districts send the return andthe examination workpapers--the audit file--to the appro-priate service center. There, the audit results (dollar in-crease, decrease, or no-change) are recorded in computerform but tie tax issues (for example, medical expenses, costof goods sold) that were examined are not. Then the auditfiles are shipped to Federal records centers located invarious section_ of the country. 1/ Returns ex mined byservice center audit divisions are processed in the samemanner as district-examined returns.

The dollar results of an audit are ultimately posted tothe taxpayer's Individual Master File account. The accountis also posted to show instances where the audit divisionreviews a return for audit potential and decides to acceptthe return as filed.

Audit division knows past auditresults buEt ot issues exam.neTe

Returns requested by the audit division are accompaniedby a control record showing the most current tax year audit

I/Nonexamined returns are also stored in the records centers.

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information in the taxpay2r's master file account. BeforeOctober 1976, this information was provided only for compu-

ter identified return-; since then it has been provided forall rC-urns. This ddta helps audit division personnel knowwhether :he taxpayer has been previously audited and, ifso, the latest tax year examined and the dollar resultsof that examination.

The control record, however, does not tell what taxissues were previously examined. To obtain this information,the past audit file must be requested from the Federal recordscenter or a document listing the issues must be kept locallyfor referene?. Neither is generally done because, accordingtc IRS, the time and costs involved would be significant.

IRS is developing a computerized system to replace theone currenAcly used for tax administration. IRS is consider-ing, as part of this system, the computerization of issuedata foL reference if a taxpayer's subseauent return entersthe audit selection process. While a fully operational sys-;em is some time away, an interim measure, c:,eduled to begin

in calendar year 1978, has been approved for use when anaudit results in no tax change. In such cases, up to fiveexamined issues will be computerized.

To date, IRS has taken three X stinct approaches to try

to prevent unnecessary repetitive audits. Two of these didlot require that specific information about previouslyexamined tax issues be obtained. The third and most recentapproach relies on taxpayers to pinpoint cases where issueinformation should be obtained.

COMPUTSRIZED APPROACH TO CURTAILDIF SELECTED REPETITIVE AUDITS

In January 1972, IRS initiated a computerized Procedureto exclude from the DIF inventory those returns where the

last audit resulted in no change. Under the DIF system(see p. 49), high scored returns are listed on the DIF in-ventory file. When a district or service center audit divi-sion orders DIF scored returns to classify and audit, thosein the inventory are sent.

Under the computerized procedure, IRS went back two taxyears from the one being filed to see if an audit had oc-curred. The most recent year audited and the results ofthat audit determined whether the current return would be

excluded from tr.e DIF inventory. The proceduLe, in effect,permitted two tax years to pass after a no-change audit

24

before the taxpayer would again be selected for audit throughDIF. 1/ However, the taxpayer's current return could beselected for audit under another selection method. For ex-ample, the return would be examined if it was "picked up"because of a partnership audit.

The computer procedure was terminated ir March 1975,essentially because:

--The public became aware of the procedure causingIRS to be concerned about future compliance prob-lems3. IRS feared some taxpayers might take ad-vantage of the possibility that their subsequentreturns would be free from audit.

--IRS was not completely satisfied with the procedurebecause it excluded certain returns from DIF in-ventory that should have been examined. Thesereturns contained issues such as a capital gainor casualty loss which are inherently differenteach year and, therefore, susceptible to annualaudit.

The procedure was replaced with a manual screening process.

CLASSIFICATION APPROACH TOPREVENT REPETITIVE AUDe'-

The classification approach involves a visual screeningof the return by audit personnel and applies basically to theDIF selection method (see p. 49). Like its computerizedpredecessor, it requires that the taxpayer's previousno-change audit be considered when evaluating the need foranother audit. Returns, however, are not automatically ex-cluded from audit solely due to the no-change examinationbecause audit personnel must consider also the tax issuespresent in the current return.

1/IRS used two years to avoid auditing the taxpayerindefinitely. Also, if the taxpayer's return was selectedfor audit in the third year and found to have an issue thatwould be present in earlier years, IRS could still auditthe two prior returns. by law, IRS generally has 3 yearsin which to audit a retu;n.

25

Audit Personnel are not to selectcertain returno for examination

The Internal Revenue Manual instructs audit personnelto review the return control record to see if an audit forone of the two immediately preceding tax years ended withoutadjustment. If it did, the return being considered foraudit is not to be examined unless the aquestionable issue(or issues)

-- was not considered during the no-change audit(for eyample, capital gains, casualty losses,and other nonrecurring items);

--wa!; erroneously considered during the no-changeaudit; and/or

-- was considered, but should be reconsidered becausethe facts and circunstances are subject to changeand there is a high probability of change.

To determine whether the Questionable issues meet thecriteria, audit personnel are instructed to use their bestjudgment when the audit file is nct at hand. The manualdoes not require that the file be obtained. If there issome question whether to select the return, the manualstipulates that it not be selected.

IRS is saying, in effect, that taxpayers generally willnot be audited if they experienced a recent no-change exami-nation. Without the audit file, which is generally not ob-tained, the classifier or examiner cannot be sure what i.sueswere previously examined. Because the past issues and cir-cumstances are not known, the current return, according tothe manual, will not be examined. Taxpayers whose currencreturns contain issues different from those previouslyexamined without change may benefit from this procedure.

TAXPAYER NOTIFICATION APPROACHTO REDUCE REPETITIVE AUDITS

IRS has taken another measure to further reduce unneces-sary repetitive audits. It is asking taxpayers to bring toits attention scheduled audits which will cover the same taxissues previously examined without adjustment. IRS will thendecide whether to continue the audit. This procedure, whichbecame effective in June 1976, does not apply to certainexaminations conducted by revenue agents or to cases wherethe prior audit resulted in the taxpayer's receiving a smallrefund.

26

How taxpayers are informedof the procedure

IRS notifies most individual taxpayers by letter that

their return is under examination. The letter tells the tax-

payer what issues will be examined, what supporting documents

are needed, and whether to mail IRS the documents or bring

them to an IRS office. IRS is using 'he letter to inform

the taxpayer of the notification procedure, and has revised

it to say:

"* * * if your tax return was examined in either

of the two previous years for the same items

checked on this letter and the examination re-sulted in no change to your tax liability, please

notify [IRS] as soon as possible. The examina-

tion olf your return will the- be suspended pend-

ing a review of our files to determine whether it

should proceed."

Att. ugh the procedure became effective in June 1976, the

letters (IRS uses more than one form) were not availablefor district use until early 1977.

While the letter doesn't mention it, the procedure

also applies to cases where the prior audit resulted only

in a small tax increase. This is not mentioned becaureIRS intends to treat future examinations ending in small

tax increases as regular no-change audits. The taxpayer

will not have to pay the increase and IRS will record it

as a no-change audit. This change became effective in

December 1976.

Ending the examination

When a taxpayer responds that a past audit ended with-

out adjustment, examiners are instructed to take the follow-

ing actions:

-- If the taxpayer reasp nds before a scheduled

interview that his return for either of t:.e two

preceding years has been audited for the same

issues and the audit resulted in no change Zr

a small tax change, the examiner should advise

the taxpayer that his appointment is postponedpending a review of his files and should obtain

a transcript of the taxpayer's master fileaccount for the two preceding tax years.

27

-- If the taxpayer alleges such prior audit activityduring an interview and is reluctant to substantiatethe deduction for the current year, the interviewshould be concluded and the examiner should obtaina transcript of the taxpayer's account for thetwo preceding years.

-- If the taxpayer volunteers prior year records show-ing that the issues in the prior audit are the sameas in the current year, the examiner will obtain atranscript of the two tax years preceding the oneunder audit. The examiner may conclude the currentexamination when the transcript shows no change ora small tax change for the corresponding audit andno substantive change for the remaining year. Incases where a substantive change occurred, the auditfiles will be obtained and reviewed as though thetaxpayer did not furnish records.

-- If the taxpayer does not furnish prior year records,the examiner will requisition the return(s) and therelated case files for the year(s) showing auditactivity on the taxpayer's transcript of accounts.The examiner will determine from the case fileswhether the issues currently under examination relateclearly enough to a prior year no-change or small taxchange to warrant a similar determination.

--Whenever the examiner decides to conclude the examina-tion based on a prior year no-change or small-changeaudit, he should obtain his supervisor's approval andproperly document the workpapers.

-- If both prior years were examined for the issues inquestion and one year resulted in no change or asmall tax change and the other year resulted in asubstantive adjustment, the current year examinationshould be continued as a regular examination. Thesupervisor will indicate his approval in theworkpapers.

The procedure does not define a "substantive adjustment"but does indicate that all issues in the two returns mustbe alike before the examination can be terminated. If thereturn being considered contains one or more issues thatdiffer from those in the previous return, the examiner andsupervisor must decide whether the expected tax outcomefrom those issues is worth the audit effort. This decisionis not unlike any other when selecting returns for examina-tion.

The notification procedure as initially implemented didnot include returns examined through the service centeraudit programs. We asked IRS officials why these programswere excluded, especially those like DIF correspondencewhich IRS considers as return audits. We were told thatthe programs were not intentionally excluded end IRS hassince taken steps to expand the procedure to its servicecenter DIF and claims programs.

According to IRS officials, revenue agents are not pre-cluded from using the new procedure but, because of theirresponsibilities, are not required to inform taxpayers ofit. Revenue agents usually examine more complex returnsthan do ax auditors and are not limited to specific, pre-determined issues. Rather, they are responsible for examin-ing all issues that come to light as the audit progresses.Because of this, there is less assurance that the audit willnot lead to additional tax issues.

Revenue agents generally notify taxpayers of a sched-uled audit by telephone rather than by letter. Even so, IRSprovides revenue agents a form letter for use in contactingthose taxpayers that cannot be reached by telephone. Thisletter explains that the audit will be suspended if theissues being examined have been previously examined withoutchange. We believe all individual taxpayers should be toldof the procedure, however contacted.

The audit division has requested IRS' Internal auditdivision to review the notification procedure's effective-ness, and internal audit will do so as part of its regularlyscheduled reviews.

Small refund cases not covered

Although it addresses small tax increases, the proce-dure does not apply to cases where the prior audit resultedin a small refund. IRS believes that taxpayers are entitledto receive all refunds due them regardless of the amount in-volved. And, that if a prior audit resulted in the taxpayerreceiving a refund, the present return may also containerrors which will result in a reftlnd. Therefore, taxpaycLwho have received refunds from previous audits are excludedfrom the notification procedure--that is, they are againsubject to audit.

We agree that taxpayers who may receive refunds shouldbe examined. But, from the taxpayer's point of view, the in-convenience and expense of an audit may outweigh the receipt

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of a small refund. We believe that taxpayers who receivedsmall refunds from prior audits should have the opportunityto forego a repetitive examination if the other require-ments of the procedure are met.

Current procedures canreduce the number ofrepetitive audits

We reviewed complaint letters received by the six dis-tricts about repetitive audits and estimated the number ofthese taxpayers who might have received relief had IRS' cur-rent procedures been in effect at the time. The six dis-tricts provided 69 such letters which had been received overa period of at least a year--the period varied by districtbut ended during 1975 or 1976.

The complaint letters were generally prompted by anoterIRS audit. In addition to the number of audits they hadalready experienced, the taxpayers frequently complainedabout the resulting personal time and expense (loss of work,accountant fees, etc.) incurred and/or expressed a feelingof being harassed or singled out. Fifteen specificallymentioned their limited incomes.

IRS had responded to each of the letters. While occa-sionally telling the taxpayer to attach a statement to thenext year's return explaining any large or unusual deduc-tions or explaining the previous no-change audit, our test-ing indicated that the districts took no apparent measuresto preclude the specific taxpayer, regardless of audithistory, from further audit. Neither were any apparentmeasures taken to earmark the taxpayer for future audit.

The current procedures--classification approach andtaxpayer contact letters--for preventing certain repetitiveaudits could have affected the audit history of 32 (46 per-cent) of the 69 taxpayers. Nineteen of these taxpayerscould have incurred fewer audits because an examination(s)followed one that resulted in little or no tax change. Thelast recorded audit for another 13 taxpayers ended in nochange.

The remaining 37 taxpayers (54 percent) would probablynot have been affected by the current procedures generallybecause of the time lapse between past audits or the prioraudit results. For example, one of these taxpayers, accord-ing to IRS records, had four of six consecutive tax yearsaudited and all resulted in tax increases from about $200

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to $1,000. Another had five consecutive years examined withresulting tax increases ranging from $150 to almost $400.Others, however, had smaller tax changes. Five of the 37taxpayers had experienced tax changes averaging less than$100.

!RS is relying on the new procedures to reduce com-plaints concerning repetitive audits. Our evaluation of howthe current procedures cculd have affected the 69 taxpayersis not a statistical measure of the reduction that can beexpected. It does, however, indicate that a reduction isprobable, that some taxpayers do not necessarily view repe-titive audits in terms of tax results, and that some tax-payers affected by the procedures will still incur examina-tions resulting in small or no tax change.

CONCLUSIONS

IRS is concerned about repetitive audits and hasimplemented procedures to reduce the number of unnecessaryones performed. These procedures include the acceptanceof a return based on past audit results generally withoutregard to the issues previously examined--the classificationapproach. Under this approach, taxpayers whose current re-turns contain issues different from those previously examinedwithout change can pass undetected.

In our sample, 199 (55 percent) of the taxpayers who in-curred a no-change audit had a later return examined. Ofthat number, 48 percent incurred a tax change. Cnanges thatincreased tax averaged about $480 per taxpayer and those thatdecreased tax averaged about $282 per taxpayer. Usually, thechange audit included one or more tax issues that weredifferent from the prior no-change audit._ For those auditsthat ended without change, the tax issues were usually thesame as in the previous no-change audit. Thus, the classifi-cation procedure is not fully effective without prior issueinformation.

Additionally, taxpayers who previously received smallrefunds should also be giveh the opportunity to possiblyeliminate a subsequent audit, and revenue agents should usethe notification procedure consistently. This will helpinsure that all taxpayers are treated equally and shouldfurther reduce the number of no- and small-changle repetitiveaudits.

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As administrator of the tax law, IRS' primary concern isto encourage the highest possible voluntary compliance bytaxpayers. Audit activity is IRS' primary method for accom-plishing this objective. Therefore, whether IRS should expandits current procedures tc prevent even more repetitive au-dits depends on the effect audits have on compliance.

But IRS does not know exactly how audit coverage andother factors affect compliance. It plans, however, to studycompliance and hopes to identify those factors that producethe greatest stimulus. The study should include repetitiveaudits, especially theit effect in terms of increasing volun-tary compliance. Based on the study results, IRS should re-evaluate its current posture and procedures concerning re-peated audits of the same taxpayer.

RECOMMENDATIONS TO THE COMMISSIONEROF INTERNAL REVENUE

We recommend that the Commissioner:

--Discontinue the classification approach to reducingrepetitive audits unless information about the no-changed issues is available to make a more informedaudit/no-audit decision.

-- Inform all individual taxpayers scheduled for auditabout the process for suspending certain repetitiveaudits.

-- Amend the procedures for preventing repetitive auditsto permit audit personnel to terminate---under certainconditions--scheduled audits of taxpayers whose prioraudits for the issues currently questioned resultedin refunds. The taxpayer, as a condition to the pro-cedure, must initiate the action to terminate theaudit.

-- Include repetitive audits in IRS' compliance study.

INTERNAL REVENUE SERVICE COMMENTS

IRS agreed to implement all of our recommendations.In commenting on the recommendations, the Commissioner ofInternal Revenue pointed out that:

-- IRS recognized that the classification procedure wasnot foolproof but implemented it because of concernabout unnecessary repetitive audits.

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-- Taxpayers who receive small refunds as the result ofaudits were inadvertently excluded from the taxpayernotification procedure.

-- IRS anticipates some difficulty in including repeti-tive audits in its study of factors that affectvoluntary compliance.

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APPENDIX I APPENDIX I

Department of the Treasury / Internal Revenue Service / Washington, D.C. 20224

Commissioner

SEP 2 3 1977Mr. Victor LoweDirectorGeneral Government DivisionU.S. General Accounting OfficeWashington, D.C. 20548

Dear Mr. Lowe:

Thank you for the opportunity to review your draft report to theJoint Committee on Taxation entitled, '"Repetitive Audits of Taxpayersare Justified." Representatives of your office and our Audit Divisionmat on September 2, 1977 to discuss and resolve technical problems inthe draft report.

Readers of your report will learn that the Service has strivedto protect taxpayers from unnecessary repetitive audits. We defineunnecessary repetitive audits as multiple examinations of taxpayersthat result in little or no tax change.

On the other hand, .s your report states, some repetitive auditsare necessary, because of some taxpayers' continued low compliance.As your report notes, successive audits performed on these taxpayershave been shown to be productive.

We define repetitive audits to be those successive audits ofother tax years of the same taxpayer that are not done simultaneouslywith other years. Also the audit of other taxpayers even thoughconnected in some way with the taxpayer is not a repetitive audit ofthat taxpayer.

Our emphasis on the definition of repetitive audit and the dis-tinction between necessary and unnecessary repetitive audits isimportant because different conclusions regarding repetitive auditscan be reached depending on how these audits are defined.

We do appreciate your report citation of our definition as towhat constitutes an audit of a tax return. We continue in our viewthat an audit is when an examination is made of all or part of a tax-payer's books and records that a taxpayer produces to support the income,deductions, and credits claimed on his/her return. We believe thatlimited contacts, such as our Unallowable Items Program, should not beconsidered audits because they do not require the examination of booksand records.

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APPENDIX IAPPENDIX I

Mr. Victor Lowe

The difference is important since it is possible for a taxpayer tobe included in our Unallowable Items Program for one year and lateraudited by an examiner for the same or a subsequent year. In ouropinion this taxpayer has not experienced a repetitive audit.

We believe the recommendations in the report will further provideus with procedures whereby taxpayers and the Service can be assuredthat only necessary repetitive audits are performed. We also believethe report reflects favorably on existing Service policies and proce-dures on repetitive audits.

In general, we agree with the recommendations. Attached are ourcour-ante regarding specific recommendations and other statements in thedraft report. The comaents are referred to the applicable page numberin the report.

With kind regards,

Sincerely,

Attachment

GAO notes: 1. IRS' definition of repetitive audit differsfrom that used by GAO. See p. 41.

2. Page number references in IRS' comments maynot correspond to pages in this report.

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APPENDIX I APPENDIX

GAO Report Title:

Repetitive Audits of Taxpayert are Justified

Recommendation, Page 29

Require written explanation and supervisory approval beforeauditing a return originally obtained for information and referencepurposes.

Comments:

We agree with this recommendation. To ensure review of anexaminer's determination to audit a return requisitioned for infor-mation or reference purposes, we will require group manager approvalbefore an examiner begins the audit of such a return.

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APPENDIX I APPENDIX I

GAO Report Title:

Repetitive Audits of Taxpayers are Justified

Recommendation. Page 42

Discontinue the classification approach to reducing repetitiveaudits, unless information about the no-changed issues is availableto make a more informed audit/no-audit decision.

Comments:

We agree with this recommendation. When we instituted theclassification procedure to reduce unnecessary repetitive audits,we were not using the so-called notification procedure. In imple-menting the classification procedure, we recognized that it was notfoolproof and, because of our concern about unnecessary repetitiveaudits, we instructed our classifiers to resolve questions of doubtin favor of taxpayer. In June 1976, we implemented the notificationprocedure. It is more effective in preventing unnecessary repetitiveaudits and has the added advantage of more fully protecting theinterests of the Government. Accordingly, we will discontinue theexisting classification procedure.

On January 1, 1978, we plan to implement a procedare for recordingissue codes on no-change cases using the computer. Thus, informationon a no-change issue in a prior year will be available for considera-tion by classifiers. This should enable us to reduce unnecessarytaxpayer contact and further prevent repetitive audits of the same issue.

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APPENDIX I APPENDIX I

GAO Report Title:

Repetitive Audits of Taxpayers are Just'?ied

Recommendation, Page 42

Inform all individual taxpayers scheduled for audit about theprocess for suspending certain repetitive audits.

Comments:

We agree with this recommendation. When we imp mented the newrepetitive audit procedures ir. June 1976, we did not include auditsconducted by Revenue Agents because of extremely limited applicationas explained in your report. Notwithstanding our original intention,we subsequently revised all audit contact letters, including thoseused by Revenue Agents, to incorporate the repetitive audit proce-dures. This created the possibility of treating similarly situatedindividual taxpayers iifferently when a Revenue Agent did not use aletter to arrange an appointment. To eliminate this possibility andconsistent with our objective of preventing all unnecessary reptitiveaudits, we will require Revenue Agents when not using letters toarrange appointments to advise individual taxpayers of our repetitiveaudit procedures.

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APPENDIX I APPENDIX I

GAO Report Title:

Repetitive Audits of Taxpayers are Justified

Recounendation, Pag. 42

Amend the procedures for preventing repeeitive audits to oermitaudit personnel to tor-minate-under certain conditious-scheduledaudits of taxpayers whose prior audits for the issues currentlyquestioned resulted in refunds. The taxpayer, as a condition to theprocedure, must initiate the action to terminate the audit.

Comments:

We agree wit' this recnmiendation. Taxpayers who received smallrefunds as the result of an audit were inadvertently excluded from theJune 1976 repetitive audit procedures. We will correct this situation.

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APPENDIX I APPENDIX I

GAO Report Title:

Repetitive Audits of Taxpayers are Justified

Recommendation, Page 42

Include repetitive audits in IRS' compliance study.

Comments:

We agree with this recommendation. We will attempt to includeas part of our study on factors that affect compliance an analysisof repetitive audits and the affect they have on voluntary compliance,We anticipate, however, some difficulty in designing this aspect ofthe study and determining how best to use the data.

We have data from a TCMP Panel Study which involved the repeataudit of the same taxpayer in subsequent TCMP cycles to determineif the taxpayer was more compliant than other control group taxpayers.The overall results showed, in general, that the group of taxpayersthat had been examined in the past were more compliant than thecontrol group.