There are significant unresolved differences between the tax information employers reported to the Internal Revenue Service (IRS) and the information they reported to the Social Security Administration (SSA). These discrepancies bring in to question the accuracy of many Employer’s Quarterly Federal Tax Returns (Form 941), including taxes employers are reporting and paying to the IRS as well as refunds they are receiving.

Employers file Forms 941 with the IRS when they pay wages subject to income tax withholding, social security, and Medicare taxes. There were approximately 23 million Forms 941 filed in Tax Year (TY) 1998. Of these Forms 941, nearly 1.5 million resulted in refunds totaling approximately $1.5 billion. The payment of employment taxes accounts for over $500 billion of the federal budget and is a large part of our voluntary tax system.

We conducted this audit to identify ways the IRS can improve its compliance efforts to help ensure accurate reporting of employment tax information on Forms 941.

The IRS can increase compliance efforts and identify potential unreported taxes from Forms 941 by using data received from the SSA and from the Forms 941 themselves. We believe that there is a unique opportunity under the new Small Business/Self-Employed Division and Large and Mid-Size Business Division for the IRS to focus its compliance efforts to ensure accurate reporting of employment tax information on Forms 941.

The IRS can use data it receives from the SSA and from Forms 941 to identify potential unreported taxes in the following two areas.

• Employers may have underreported income, social security, and Medicare taxes on Forms 941. By using the IRS’ data, we identified 491 employers that potentially reported $5.4 billion less in wages to the IRS on their Forms 941 than they reported to the SSA on Forms W-2 for TY 1998.
• Employers potentially reported more advanced Earned Income Credit (EIC) on their Forms 941 than they paid to their employees. The amount of advanced EIC reported on Forms 941 nationwide was $170 million for TY 1998, but the amount individual taxpayers reported on their income tax returns was only $97 million.

The 491 employers we identified potentially claimed nearly $300,000 more in advanced EIC on Forms 941 than on Forms W-2. Employers can deduct a dollar-for-dollar credit against their Form 941 taxes for advanced EIC payments made to their employees. While only 1 percent of employers claimed advanced EIC on their Forms 941, these employers received 19 percent of the Form 941 refund dollars issued by the IRS.

The IRS has not focused its efforts to ensure the accurate reporting of employment tax information on Forms 941. Some examples include:

• Due to insufficient funding, the IRS’ Combined Annual Wage Reporting (CAWR) program has not addressed 683,000 "IRS Revenue Producing Cases" in Fiscal Year 1999. Those cases are similar to those we identified.
• The Examination function performs few Form 941 audits. The latest statistics available indicate that the Examination function audits less than one half of one percent of all Forms 941.
• Criminal Investigation (CI) investigates potential tax fraud, but until this year had not captured the necessary data to identify Form 941 refund fraud. Recently, CI proposed expanding its involvement in employer-based refund fraud schemes. It has also indicated that much of its resources have been dedicated to individual taxpayer fraud.

Limited compliance efforts combined with the results of our tests indicate there is a high risk of unreported employment taxes and erroneous refunds.

We recommend that the Commissioners of the Small Business/Self-Employed Division and the Large and Mid-Size Business Division, and the Chief, Criminal Investigation, increase Form 941 compliance efforts. We believe that under the new IRS Business Divisions, the CAWR program and the Examination function can work together to ensure that employment tax information is accurately reported on Forms 941. The CI should follow through with its plan to expand its involvement in employer-based refund fraud schemes.

The IRS should initially focus on the 491 employers identified in our review that received refunds on TY 1998 Forms 941. These taxpayers potentially reported significantly less wages and more advanced EIC on their Forms 941 than they reported on their Forms W-2. If these efforts identify significant noncompliance, additional compliance efforts could include reviewing all taxpayers that report significantly less wages on their Forms 941 than they report on Forms W-2.

Management’s Response: Management’s response was due on September 11, 2000. As of September 12, 2000, management had not responded to this draft report.