IRS resumes K-1 matching program.

The "voluntary" nature of the U.S. self-assessment tax system works best when three powerful forces--withholding, information reporting and information matching--reinforce it. Even when withholding is not feasible, the combination of information reporting and matching helps motivate high levels of compliance. Mindful of this reality, the IRS announced in early 2002, that it would expand its matching of K-1s from partnerships, S corporations and trusts with the Forms 1040 filed by the beneficial owners of these flowthrough entities.

As partial rationale for expanded matching, the IRS pointed to an internal study that documented the recent significant growth in the number of flowthrough entities. The study also estimated that between 6% and 15% of a total of $1.2 trillion in flowthrough income would not be reported on 2001 returns. Coincidentally, these revelations came at a point at which the IRS was making very little compliance use of the K-1 information it possessed.

In the first year of the matching program, the IRS processed more than 18 million tax-year (TY) 2000 Schedules K-1. It screened approximately 378,000 potential mismatches down to a universe of 69,000 taxpayers, to whom notices were issued. In evaluating the approximately 300,000 cases for which notices were not issued, the primary reasons for screening cases out included: combining K-1 income and expenses, or offsetting income by employee business expenses or by at-risk or flowthrough losses; and reporting K-1 income elsewhere on the return.

Of the 69,000 notices issued, more than 60% were ultimately closed as "no-change" (i.e., the IRS accepted the returns and Schedules K-1 as originally filed). The primary reasons cases were closed as no-change closely mirrored the original screen-out results. Approximately 22,000 cases were closed as "agreed"; taxpayers agreed to $25 million in additional assessments attributable to misreported K-1 items.

Before launching the K-1 matching program, the AICPA and other stakeholder groups cautioned the IRS to proceed slowly. They warned the IRS of the potential for error attributable to the wide variation in the way K-1 information flows onto various Form 1040 lines and schedules. Because of the significant number of erroneous notices (i.e., notices that lead to no-change cases), on Aug. 1, 2002, the IRS ceased issuing K-1 mismatch notices. It characterized its actions as a pause and promised to consult fully with interested parties before resuming the matching program.

At a meeting in January 2003, the IRS previewed its plans for resuming a modified K-1 matching program, outlining both short- and long-range steps to improve K-1 matching. For the longer term, the IRS said it was evaluating modifications to Schedules K-1 (1065, 1120S and 1041) as well as to Schedule E. However, it does not expect any resulting changes to be effective until sometime in TY 2004. Until then, the IRS will process TY 2001 K-1 matches in a manner it hopes will drastically reduce the likelihood that taxpayers will receive notices that result in no changes.

As this item went to press, the IRS was still finalizing its approaches, but provided an overview of the primary elements of the TY 2001 program. Notices will be issued when it appears information from a K-1 is completely absent on a return. When the information reflected on the K-1 and the corresponding returns and schedules mismatch significantly, the IRS will check to see if the taxpayer received a K-1 mismatch notice for the prior-return year. If a notice was received and a change resulted, the IRS will issue a TY 2001 notice. Conversely, if the prior-return-year notice resulted in a "no-change," the IRS will not automatically issue a TY 2001 notice. The IRS reserves the right to issue a notice when the two primary conditions are not met (complete absence on return and prior-year adjustment), but a large discrepancy exists between the totals reported on the K-1s and the amount reflected on Form 1040.

Despite its early "foot faults," the IRS is committed to K-1 matching. Notwithstanding an unacceptably high level of "no-change" case results, Service personnel view the 2000 results as evidence that there is a sufficient level of noncompliance to warrant continued focus on K-1 matching. To its credit, the Service has accepted both the input and assistance from stakeholder groups and appears intent on tackling both the short- and long-range issues in collaboration with these groups.

Even with the modified program in place, considerable potential for confusion remains. Tax professionals will continue to be called on to help IRS tax examiners reconcile differences that will often be the result of return preparation and software protocols, rather than actual underreporting. The good news is that the Service has taken several constructive steps toward eliminating the instances in which a taxpayer will be drawn into an unnecessary controversy. However, the K-1 matching program will continue to produce uneven results until the longer-term cures can be affected.

MICHAEL P. DOLAN, J.D., NATIONAL DIRECTOR, IRS--POLICIES & DISPUTE RESOLUTION, WASHINGTON NATIONAL TAX, KPMG LLP, WASHINGTON, DC