This audit was part of our overall review of controls in the Examination Division to help ensure fair and consistent treatment of taxpayers. We evaluated actions examiners took during the examination process that could have added unnecessary burden to taxpayers. In addition, we determined whether the quality review process gave adequate attention to taxpayer burden and rights issues and whether the results of quality reviews were recorded accurately. Other recent reviews have addressed taxpayer rights and burden in the identification, selection, and closing of office and service center audits and in the resolution of unagreed cases.

Internal Revenue Service (IRS) employees appropriately handled most of the cases we reviewed. Most notably, IRS employees properly limited the use of intrusive, indirect methods to verify income. Some examination cases, however, demonstrated inconsistent or unfair treatment of taxpayers in assessing taxes and penalties.

Although controls are in place to verify examination quality, these controls were not always adequate or effective. In addition, we could not validate the reliability of the quality review information used as part of the IRS’ Balanced Measurement System.

Indirect methods to verify income can involve intrusive requests for detailed personal information and records from taxpayers. The IRS Restructuring and Reform Act of 1998 limited the use of intrusive audit methods to situations when the IRS has indications of unreported income. We reviewed a judgmental sample of 350 audited tax returns to evaluate the use of this audit method. Except for one case in our sample, examiners used indirect methods only when there were indications of unreported income.

In Fiscal Year 1998, the Examination Division assessed over $100 million in penalties for negligence or inaccuracies on over 76,000 tax returns. To help ensure taxpayers are treated fairly, examiners are required to discuss with taxpayers the reasons for assessing penalties and to document these reasons in the case files. Despite this requirement, 75 (42 percent) of the 180 examination case files in our sample did not contain adequate documentation to support the reasons why penalties were or were not assessed. Without adequate documentation, there is no assurance that examiners were fair and consistent in their decisions to assess or not assess penalties. Based on the facts and circumstances contained in the case files we reviewed, it appears that penalties were not assessed consistently.

When taxpayers do not respond to an IRS notice of audit, examiners should take additional steps to contact or locate the taxpayer. Otherwise, the taxpayer may be assessed additional tax and penalties without knowing about it. This can cause additional burden to the taxpayer and administrative problems for the IRS to resolve the issue after tax, penalties, and interest have already been assessed. Unfortunately, examiners did not use available resources to locate and contact taxpayers in 112 (91 percent) of 123 sample cases before assessing taxes and penalties. Using the IRS locator services and the Internet, we were able to find a more current taxpayer address or telephone number in 44 (39 percent) of the 112 cases. We estimate that using available IRS resources would have helped locate taxpayers before assessing additional tax on approximately 5,600 tax returns.

Examiners sometimes make assessments in the year under audit which should result in a refund the subsequent year. In a limited number of cases, examiners did not make adjustments for the subsequent year. As a result, taxpayers had to file amended tax returns to obtain refunds. Nationwide, approximately 290 taxpayers had to file claims because examiners did not properly address all affected tax years.

The Examination Quality Measurement System (EQMS) is an important control the IRS uses to ensure examinations are performed according to standards. The IRS is currently reorganizing its EQMS to emphasize new quality review standards that address customer relations, professionalism, communication, the reduction of taxpayer burden, and the protection of taxpayer rights. The quality measures reported by the EQMS are an important aspect in the new IRS Balanced Measurement System which is designed to help ensure that taxpayers are treated fairly. While the IRS has made improvements to the EQMS, cases reviewed by the EQMS were not adequately identified in the database to assist in validating system reports.

To help ensure fair and consistent treatment for taxpayers, Examination Division managers need to ensure that examiners follow IRS guidelines which require them to document the reasons for applying or not applying penalties. Additionally, the Examination Division should be required to use IRS locator resources early in the process to locate and contact taxpayers who do not respond to a notice of audit.

Improvements in the EQMS are also needed to help the IRS identify problems that could lead to unfair treatment of taxpayers. The EQMS quality rating criteria should be re-evaluated to ensure that the documentation and application of penalties is given adequate consideration when determining whether cases meet quality standards. Cases should be included for quality review if the tax assessment was made without locating the taxpayer. Finally, to help ensure that EQMS reports to IRS management are reliable, important additional data should be recorded in the EQMS database.

Management's Response: Management’s response was due on March 29, 2000. As of May 11, 2000, management had not responded to this draft report.