Expect renewed IRS compliance efforts.

The tax administration pendulum appears to be swinging back to the middle toward enforcement, resulting in an increase in IRS examinations and collections.

With the enactment of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA), the Service found its resources consumed by the dual demands of restructuring and reform. Conversion from its traditional geographical and functional structure to the four new business divisions consumed huge amounts of attention and resources. In addition, its renewed emphasis on improved customer service and efforts to implement the many requirements imposed by the IRSRRA necessitated a wholesale reassignment of staff from traditional field enforcement work (i.e., audits and collections) to customer service and IRSRRA initiatives. Most field personnel also participated in myriad mandatory IRSRRA-related training, which consumed additional work hours that would have ordinarily been devoted to traditional daily tasks.

Not surprisingly, the cumulative diversion of resources resulted in a significant reduction in audit and collection. However, because its four new business divisions are now operational, the IRS can reallocate its resources to deal with taxpayer compliance. In addition, with the recent Congressional hearings urging the Service to reinvigorate its enforcement activities, tax practitioners should expect an increase in enforcement initiatives.

Audit Coverage

The manner in which the IRS conducts its taxpayer audits is frequently focused on by the press and Congressional oversight. For example, periodically, Congress, the press and the Service evaluate the rate at which the IRS "audits" taxpayers in various economic strata, drawing conclusions about whether audit coverage has increased or decreased from one year to another. In recent years, the press has enjoyed reporting that the Service's audit rate for the wealthiest Americans has fallen, while the rate has risen for low-wage-earning taxpayers. Often overlooked in that "analysis" however, is the fact that Congress has mandated the IRS to aggressively pursue audits of earned income tax credit (EITC) claims, which increases the audit rate for taxpayers entitled to the EITC.

In absolute terms, the audit-cover age rate has been decreasing since the mid-1990s. For example, the total individual field audit rate (i.e., audits done by revenue agents) has fallen from 0.66% in 1996 to 0.16% in 2001. During that same period, individual taxpayers earning more than $100,000 have seen their audit rate fall from 2.08% to 0.49%. On the corporate side, the number of field audits of entities with less than $10 million in assets declined from 45,091 in 1996 to 13,169 in 2001. The largest corporate audits have shown a less dramatic decline, with a fall in field audits from 12,586 in 1996 to 8,465 in 2001.

The Service is planning to increase audits in most economic sectors. This plan relies on reengineering audit processes, redirecting resources and assimilating 733 newly hired revenue agents--the first installment of such hires in many years.

The Tax Exempt and Government Entities (TEGE), Large and Mid-Size Business (LMSB) and Small Business/ Self Employed (SBSE) divisions are all in the midst of reorienting their examination resources. TEGE is already operating under its new strategy, which involves centralizing return selection and key decision making in Dallas.

LMSB has actively sought input from its constituents on how best to save time, yet also refine the focus of its audits. Its goal is both to reduce the resource requirements of its coordinated industry cases (CICs) and expand its presence into more mid-sized businesses and passthrough entities. As a tool in its stepped-up evaluation of passthrough entities, the IRS will soon have access to the results of its first-ever comprehensive matching of Schedules K-1; nearly 17 million were issued for tax year 2000.

The SBSE audit program was hardest hit by resource diversions. However, many of SBSE's enforcement personnel have now returned to their regular positions and many of the newly hired revenue agents have been assigned to SBSE in an effort to replace the agents lost to attrition. SBSE also undertook a comprehensive review of its audit processes. It plans to implement a variety of changes designed to leverage auditors better across a spectrum of cases that reflect some of the lowest overall levels of compliance, yet have traditionally received only sparse audit attention.

National Research Program

The Service currently selects returns to be audited based on a formula derived from its historical Taxpayer Compliance Measurement Program (TCMP). The TCMP draws its data from an ongoing series of intensive line-by-line audits done on a selected sample of returns. During the mid-1990s, in the face of severe criticism from key Congressional leaders, the IRS suspended the TCMP. In the intervening years, however, without refreshed data from the TCMP or a comparable source, the precision of the return-selection formula has eroded. As the data aged, "no-change" rates rose. Rising no-change rates are a needless burden on audited taxpayers and increase the Service's opportunity costs, because sparse audit resources are diverted from noncompliant returns.

To counteract rising no-change rates, the IRS intends to launch the National Research Program (NRP) in 2002. Data from the program will be used to refresh the Service's overall compliance measurements and return-selection formula.

In the initial phase, the NRP will focus on approximately 50,000 of the 132 million 2001 individual returns filed. Of that number, about 2,000 "calibration" audits will be performed. These audits will approximate the intensity of prior TCMP audits, but the IRS promises that it will not generally require taxpayers to provide line-by-line substantiation. The bulk of the NRP will consist of "partial audits" of 30,000 returns. In these audits, the Service plans to develop enough preliminary information so that the actual audits can focus only on items that the IRS cannot independently verify. NRP audits should take roughly the same amount of time to complete as traditional individual audits, in contrast with TCMP audits, which usually took twice that amount of time.

Collection

In addition to the impact felt from the diversion of collection resources to other work, the collection workload itself was dramatically affected by the IRSRRA. Collection due process (CDP) procedures (which provided new rules for the processing and appeal of liens and levies) introduced new players and increased the time and resources necessary for Collections to close a case. The liberalized Installment Agreement and Offer-in-Compromise (OIC) provisions added additional steps and time to the collection process. Similarly, increased levels of review and approval for seizures and sales also added time and complexity to cases.

Beyond the specific process changes brought about by the IRSRRA in general, Section 1203 caused collections to ebb. This section (often referred to as the "10 deadly sins") provides 10 acts, which, if committed by a Service employee, result in mandatory dismissal. One of the "sins" is harassing taxpayers. Many employees in Collections feared being accused of harassment if they pursued their cases too vigorously. Despite management assurances to the contrary, many chose to avoid risk and were less aggressive.

Backlogs still exist in the number of CDP appeals and OICs awaiting resolution, but plans are in place to improve both processes. The original Section 1203 "chill" also seems to have abated; IRS reports show that collection activity has increased and is expected to continue to do so in the coming year. On a related note, Service officials recently testified that the IRS was again considering the merits of using private contractors to collect certain types of delinquent accounts.

Criminal Investigation

The Criminal Investigation Division (CID) focuses on the most egregious forms of taxpayer noncompliance. It has increased the resources it applies to investigations and the number of cases it investigates in traditional tax-noncompliant areas. Perhaps because the CID underwent less fundamental restructuring than some other divisions of the Service, it has been able to orchestrate a series of well-publicized initiatives addressing such areas as employment tax fraud, a variety of frivolous claim scares and EITC fraud.

The CID is also integral to the Service's recently publicized strategy to uncover the identities of U.S. citizens using credit cards to access what is allegedly substantial amounts of unreported income located in offshore bank accounts. As an antidote to a perceived reduction in cases arising from traditional fraud referral, the CID has also reenergized its fraud referral process, by encouraging the operating divisions to identify dedicated fraud coordinators and creating national Lead Development and Fraud Detection centers. Both of these strategies are designed to increase the number and quality of fraud referrals that derive from intentional noncompliance.

Institutionalizing ADR Initiatives

In addition to reviving traditional audit and collection enforcement techniques, the IRS continues to expand its use of alternate dispute resolution (ADR) methods. Following successful pilots, both the Pre-filing Agreement (PFA) and the Industry Issue Resolution (IIR) programs have been made permanent. A more recent initiative, LMSB's Fast Track Dispute Resolution Pilot, is the newest ADR tool. Unveiled in December 2001 in Notice 2001-67, the new procedure involves Appeals Officers mediating or settling issues or both, while the taxpayer's returns are still under LMSB's jurisdiction. Approximately 19 of the 38 cases accepted into this new program have already been successfully resolved, and the other 19 are pending. In addition, LMSB is evaluating 24 other cases for inclusion in the program. Initial reactions from both taxpayers and the Service have been positive, and substantial issues have been resolved at a fraction of the normal time and cost. The IRS remains convinced that PFA, IIR and "Fast Track" will allow it to refocus its efforts and reduce the amount of audit time traditionally applied to the largest (CIC) examinations, while enabling it to expand its audit presence in lower coverage areas.

Conclusion

As the Service continues to modernize its computer systems and business practices, old techniques for encouraging voluntary compliance will give way to new approaches. At some level, however, an effective enforcement program is likely to remain a powerful compliance incentive for many and a noncompliance deterrent for others. Tax professionals should expect to see the IRS increase its conventional audit and collection activity, while it simultaneously seeks new opportunities to advance compliance across-the-board.

FROM MICHAEL P. DOLAN, NATIONAL DIRECTOR, IRS--POLICIES & DISPUTE RESOLUTION, TAX CONTROVERSY SERVICES, WASHINGTON NATIONAL TAX, KPMG LLP, WASHINGTON, DC

Editor:
Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC