Increased Attention Is Needed to Reduce Taxpayer Burden and
Ensure Fair and Consistent Tax Treatment When Filing Small Business Corporate
Tax Returns
September 2004
Reference Number 2004-30-172
This report has cleared the Treasury
Inspector General for Tax Administration disclosure review process and
information determined to be restricted from public release has been redacted
from this document.
September
23, 2004
MEMORANDUM FOR
COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Gordon C. Milbourn III /s/ Gordon C.
Milbourn III
Acting Deputy Inspector
General for Audit
SUBJECT: Final Audit Report - Increased Attention Is Needed to Reduce
Taxpayer Burden and Ensure Fair and Consistent Tax Treatment When Filing Small
Business Corporate Tax Returns (Audit #
200430006)
This
report presents the results of our review of the Internal Revenue Service’s
(IRS) actions to effectively address the burden and compliance issues related
to unprocessable U.S. Income Tax Returns for an S Corporation (Form
1120S). In a previous report, the Treasury Inspector General for Tax
Administration recommended that the IRS seek alternatives to make it easier for
first-time filers to be granted elections and file their Forms 1120S and that
the IRS clarify procedures for handling unprocessable Forms 1120S. The overall objective of this review was to
determine whether the IRS took the
necessary actions to effectively address the burden and compliance issues
related to unprocessable Forms 1120S.
In summary, more needs to be
done to address the burden and compliance issues related to unprocessable Forms
1120S. In the prior review, we reported
that the filing and processing of small
business corporate returns needed to be simplified to better enable small
businesses to successfully file their Forms 1120S. We estimated that each year, over 46,000
small businesses were unsuccessful in filing their Forms 1120S because the IRS
did not have valid elections on file to allow their returns to be
processed. In this review, we found the
IRS took actions to address the need for legislative changes. However, the IRS needs to continue to pursue
legislative changes and alternative measures to make the current election
process less burdensome. We recommended the
Director, Taxpayer Education and Communication, Small Business/Self-Employed
(SB/SE) Division, adopt interim measures, while the IRS pursues legislative
changes, including increasing the frequency and availability of taxpayer and
practitioner education regarding the requirements to file an election prior to
filing the first Form 1120S, and the evidence needed to document that the IRS
approved the election.
In the prior review, we also
reported the IRS did not consistently process Forms 1120S and determine the correct
taxes due from small business corporate taxpayers. We estimated that because returns were not
processed correctly, there was the potential for the erroneous assessment of taxes on $41
million of profits and the inability of taxpayers to claim $100.3 million in
losses. In addition, because of
unclear IRS procedures, we estimated that each year, approximately 3,700
taxpayers who file unprocessable Forms 1120S may have their rights violated
because the IRS assesses taxes on profits of approximately $6.7 million without
providing taxpayers with a statutory notice of deficiency. In this review, we found the IRS has not
taken sufficient actions to correct these conditions. Policies and procedures still need to be
developed and adequate staffing needs to be committed to correct the compliance
issues related to unprocessable Forms 1120S.
We recommended that the
Director, Customer Account Services, SB/SE Division, develop clear and
consistent guidelines for processing the Forms 1120S when either no elections
or delinquent elections are received. Also,
the Director, Compliance, SB/SE Division, should ensure that procedures are
clarified to assign responsibility for determining and assessing the correct
taxes and issuing statutory notices of deficiency for small business
corporations and their shareholders when Forms 1120S are converted to regular
corporate returns when there is no valid election on file. Additionally,
we recommended that the Commissioner, SB/SE Division, commit the
necessary resources to ensure unprocessable Forms 1120S and individual income
tax returns for their related shareholders are fairly and consistently taxed.
Management’s
Response:
The
Commissioner, SB/SE Division, agreed with our recommendations and the need to
continue expanding taxpayer education on requirements for filing small business
corporation elections. The IRS is
currently pursuing the options of legislative or regulatory change, while
increasing communication with taxpayers.
SB/SE Division management plans to add new language to the next edition
of their Small Business Tax Workshop materials to explain the requirement to
file an election prior to filing the first Form 1120S and describe the evidence
needed to document that the IRS approved the election. An article on Form 1120S elections will be
developed and distributed as a Taxpayer Education and Communication Headliner
to payroll and practitioner associations; trade, business, and professional
associations; government agencies; and educational organizations. Once distributed through the channels, the Headliner
will be posted on the IRS website.
SB/SE Division management updated Internal Revenue
Manual procedures and issued a Program Enhancement to ensure clear and
consistent guidelines for handling unprocessable Forms 1120S. The SB/SE Division will clarify the
procedures to assign responsibility for determining and assessing the correct
taxes and issuing statutory notices of deficiency for small business
corporations and their shareholders when Forms 1120S are converted to Forms
1120 because there were no valid elections on file. Clarification was issued to campus operations
and related procedural changes were implemented regarding the requirement to
use Statutory Notice procedures on Form 1120S returns that were converted to
Forms 1120. SB/SE Division management is
also completing a comprehensive analysis and developing strategies for
committing the necessary resources to ensure that unprocessable Forms 1120S and
their related shareholders are fairly and consistently taxed. Management’s complete response to the draft
report is included as Appendix V.
Copies of this report are
also being sent to the IRS managers affected by the report
recommendations. Please contact me at
(202) 622-6510 if you have questions or Richard J. Dagliolo, Acting Assistant
Inspector General for Audit (Small Business and Corporate Programs) at (631)
654-6028.
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix V – Management’s Response to the Draft Report
Entities that request the Internal Revenue Service (IRS) to consider them a small business corporation so they may file a U.S. Income Tax Return for an S Corporation (Form 1120S) must first file an Election by a Small Business Corporation (Form 2553). The major advantages of filing as a small business corporation are, generally, the small business pays no corporate tax, and profits or losses are passed through to the shareholders to be reported on their individual income tax returns. A regular corporation that files a U.S. Corporation Income Tax Return (Form 1120) pays corporate taxes on its profits, and its shareholders cannot claim corporate losses on their individual returns. According to the IRS, small business corporations currently represent more than one-half of all corporate entities filing tax returns.
In September 2002, we issued a report entitled, The Internal Revenue Service Needs to Simplify Filing Requirements and Clarify Processing Procedures for Small Business Corporate Returns. Senator Christopher Bond, Ranking Member of the Senate Committee on Small Business and Entrepreneurship, stated in an October 15, 2002, letter to the IRS Commissioner and the Commissioner, Small Business/Self-Employed (SB/SE) Division, that this report, “sets out a number of recommendations for correcting the election-processing and return-filing problems facing S corporations and the IRS. I urge you and your staff to give these recommendations serious consideration.”
This audit was conducted during the period January through June 2004 at the Brookhaven IRS Campus covering work performed by the SB/SE Division’s Compliance and Customer Account Services functions. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
In our prior report, we recommended the IRS simplify the process of filing election Forms 2553 and Forms 1120S for new filers by identifying and implementing alternatives to make it easier for first-time filers to be granted elections and to file their Forms 1120S. We also recommended the IRS seek modification of the legal requirements.
In response to our report, the IRS formed a task force to study and resolve the causes identified in the report. The overall scope of the team’s efforts included the study of the Form 2553 election process, including delinquent elections, as well as the process for converting invalid Forms 1120S to Forms 1120. Part of the team’s efforts resulted in a Revenue Procedure being issued in June 2003 that granted relief for failing to file elections timely if the request for relief is filed within 24 months of the due date of the election.
Other actions considered or taken in this area include the following:
While there has been some attention given to correcting the problem, legislation and procedures still need to be changed to further reduce taxpayer burden in this area.
In the prior report, we estimated that, each year, over 46,000 small businesses are unsuccessful in filing their Forms 1120S because the IRS does not have valid elections on file to allow their returns to be processed. Although we were unable to quantify actual burden costs, we estimated taxpayers spend 3.2 million hours each year to prepare, copy, assemble, and send these returns to the IRS, which could not successfully process them. Also, it costs the IRS an estimated $264,000 annually to handle the Forms 1120S that could not be processed.
Taxpayers and the IRS still need to perform too many steps before Forms 1120S can be successfully processed for first-time filers (see Appendix IV). These steps are time-consuming and burdensome for the IRS and for first-time filers who are not familiar with all of the necessary steps. If the IRS continues with its current policies for the filing and recording of elections, many first-time filers of Forms 1120S will continue to be unsuccessful in filing their returns.
The Director, Taxpayer Education and Communication, SB/SE Division, should:
1. Adopt interim measures, while the IRS pursues legislative changes, to reduce taxpayer burden and the volume of unprocessable Forms 1120S. The Director should consider increasing the frequency and availability of taxpayer and practitioner education through publicity and online information regarding the requirements to file an election prior to filing the first Form 1120S, and the evidence needed to document that the IRS approved the election.
Management’s Response: The Commissioner, SB/SE Division, agreed with
our recommendation and the need to continue expanding taxpayer education on
requirements for filing small business corporation elections. The IRS is currently pursuing the options of
legislative or regulatory change, while increasing their communication with
taxpayers. SB/SE Division management
plans to add new language to the next edition of their Small Business Tax
Workshop materials due to be published in late spring 2005. The additional information will explain the
requirement to file an election prior to filing the first Form 1120S and
describe the evidence needed to document that the IRS approved the election.
An article on Form 1120S elections will be developed and distributed as a Taxpayer Education and Communication Headliner through their stakeholder distribution channels to payroll and practitioner associations; trade, business, and professional associations; government agencies; and educational organizations. Once distributed through the channels, the Headliner will be posted on irs.gov/smallbiz.
In the prior audit, we also reported the IRS did not consistently determine the correct and proper taxes due from small business corporate taxpayers. In the current review, we found that more needs to be done to ensure IRS compliance efforts are effective with regard to unprocessable Forms 1120S. The IRS did not take sufficient actions to promote fair and equitable compliance practices for small business corporate taxpayers in the following areas:
· Policies and procedures have still not been developed to calculate and assess the correct taxes for taxpayers who filed unprocessable Forms 1120S.
· The IRS did not provide the staffing needed to correct unprocessable Forms 1120S compliance issues.
Policies and procedures have still not been
developed to calculate and assess the correct taxes for taxpayers who filed
unprocessable Forms 1120S
IRS compliance policies and procedures for the conversion of unprocessable Forms 1120S to Forms 1120 have been unclear for at least the last 5 years and have led to inconsistent treatment of taxpayers. IRS policies and procedures have resulted in the conversion of Forms 1120S to Forms 1120 without the calculation and assessment of correct tax liabilities.
In the prior review, we also reported the IRS did not consistently process Forms 1120S and determine the correct taxes due from small business corporate taxpayers. We estimated that, because returns were not processed correctly, there was the potential for the erroneous assessment of taxes on $41 million of profits and the inability of taxpayers to claim $100.3 million in losses. In addition, because of unclear IRS procedures, we estimated that each year, approximately 3,700 taxpayers who file unprocessable Forms 1120S may have their rights violated because the IRS assesses taxes on profits of approximately $6.7 million without providing taxpayers with a statutory notice of deficiency.
In response to the prior report, the IRS cited the following causes for the inconsistent handling of unprocessable Forms 1120S:
We have not developed clear and consistent guidelines for processing
the Form 1120S when delinquent elections are received. Taxpayers are subject to inconsistent
treatment when invalid 1120S returns are converted to Form 1120.
Current
IRM procedures do not clearly explain how these cases should be processed.
Thus far, the IRS has not developed formal procedures to calculate and assess the correct taxes for unprocessable Forms 1120S. Although the IRS had procedures in place for a local project in one campus, they were used only for a relatively small number of tax returns worked in the Correspondence Examination function and not for all incoming unprocessable Forms 1120S.
The IRS has the authority and responsibility for providing procedures and consistently applying them to determine the correct taxes due by corporate taxpayers. In addition, the Government Accountability Office Standards for Internal Controls in the Federal Government indicate internal controls should provide reasonable assurance that the effectiveness and efficiency of operations are achieved.
Because these procedures have not been revised or clarified, taxpayers who file unprocessable Forms 1120S will continue to be subjected to inconsistent handling of the profits and losses from Forms 1120S that were converted to Forms 1120. The following list demonstrates the adverse effects and the need for developing and revising current policies and procedures:
· Unprocessable Forms 1120S are being converted to Forms 1120 without calculation of the correct taxes. IRS instructions provide for putting a blank copy of a Form 1120 over an unprocessable Form 1120S, renumbering the blank Form 1120 to appear as though a Form 1120 was filed, and recording a zero dollar tax assessment for that return, regardless of whether there is a gain, so IRS records indicate a corporate return was filed. There is a legal requirement that there must be sufficient data with which to calculate the tax liability on a Form 1120S to convert the Form 1120S to a Form 1120. However, the IRS is not using this data to calculate the correct tax liabilities.
· Taxpayers’ rights are potentially being violated because required statutory notices of deficiency are not always being issued. Our review showed that 12.7 percent (24 of 189) of the applicable taxpayers in our sample had taxes assessed of approximately $927,000 on $2.7 million in gains without statutory notices being issued.
The IRS did not provide the staffing needed to
correct unprocessable Form 1120S compliance issues
While the IRS has recognized the need to work unprocessable Form 1120S cases, more needs to be done to commit sufficient resources to ensure fair and equitable compliance practices.
As a result of our September 2002 report, the IRS stated,
Correspondence Examination (Corr. Exam) has agreed to begin working
these cases in FY 04 [Fiscal Year 2004].
The number of cases that will be worked has yet to be determined. The invalid election issues, both IMF and BMF,
will be worked by tax examiners who will have assistance from other technical
employees as needed.
The IRS also indicated it needed additional time to review the process in place since the issuance of policy and procedural changes in June 2003. Consequently, it has delayed implementation of the corrective actions from January 1, 2004, to January 15, 2005.
The IRS policy and procedural changes issued in June 2003 granted relief for failing to file elections timely if the request for relief is filed within 24 months of the due date of the election. However, this change may not necessarily reduce the volume of unprocessable Forms 1120S or affect the staffing needed to process these returns.
We were informed that, as of March 2004, the Cincinnati Submission Processing Site was still not working unprocessable Form 1120S conversion cases and related investors’ returns due to inadequate staffing and the requirement to use statutory deficiency procedures. A year before, in March 2003, S Corporation task force minutes also indicated that the Cincinnati Submission Processing Site, one of the two sites responsible for processing Forms 1120S, did not work the investor side of the Form 1120S conversion issue because of inadequate staffing. In March 2003, the Ogden Submission Processing Site also requested permission not to work approximately 6,500 converted S corporation returns for the same reason.
The SB/SE Division Inventory Delivery Report for FY 2004 showed the IRS was going to work only 300 unprocessable Form 1120S cases. We have not been provided with any evidence that additional funding or staffing was requested for this purpose.
In FY 2003, an S Corporation Project was conducted in only
one (
Unless sufficient resources are devoted to working these
cases, compliance efforts for this taxpayer segment will not be sufficient or
fairly administered. Although the volume
of unprocessable Forms 1120S has continued to increase over the last 6 years,
fewer cases are planned or expected to be worked. Working so few cases reduces recommended
dollar assessments and hampers the IRS’ ability to foster taxpayer compliance.
The Director, Customer Account Services, SB/SE Division, should:
2. Develop clear and consistent guidelines for handling unprocessable Forms 1120S. The Internal Revenue Manual (IRM) procedures should clearly explain how these cases should be processed.
Management’s Response: SB/SE Division management updated IRM
procedures and issued a Program Enhancement to ensure clear and consistent
guidelines for handling unprocessable Forms 1120S.
The Director, Compliance, SB/SE Division, should:
3. Clarify the IRM procedures to assign responsibility for determining and assessing the correct taxes and issuing statutory notices of deficiency for small business corporations and their shareholders when Forms 1120S are converted to Forms 1120 because there were no valid elections on file.
Management’s Response: SB/SE Division management will clarify the IRM
procedures.
4. Clarify the role of the Examination function with regard to unprocessable Forms 1120S that were converted to Forms 1120. The clarification of these procedures needs to take into account that the Assistant Chief Counsel’s opinion indicated statutory notices of deficiency are needed in these conversion cases before taxes are assessed.
Management’s Response: SB/SE Division management issued clarification to campus operations regarding the requirement to use Statutory Notice procedures on Form 1120S returns that were converted to Forms 1120. Accompanying IRM changes were also implemented.
The Commissioner, SB/SE Division, should:
5.
Commit the necessary resources to ensure unprocessable Forms
1120S and their related shareholders, who filed these returns without valid
elections on file, are fairly and consistently taxed.
Management’s Response: SB/SE Division management completed
preliminary analysis and will compile additional data from a statistically
valid sample of audits involving invalid Form 1120S elections and/or their
corresponding shareholders. Once the
comprehensive analysis is completed, appropriate strategies will be developed.
Appendix I
Detailed
Objective, Scope, and Methodology
The overall objective was to determine whether the Internal Revenue Service (IRS) took the necessary actions to effectively address the burden and compliance issues related to unprocessable U.S. Income Tax Returns for an S Corporation (Form 1120S). To accomplish this objective, we:
I.
Determined the status of any actions taken or
planned to address the compliance issues related to converting unprocessable
Forms 1120S to U.S. Corporate Income Tax Returns (Form 1120).
A. Met with national and local management officials to obtain information regarding the status of the corrective actions to address our recommendation regarding clarifying the procedures and assigning responsibility for determining and assessing the correct taxes on converted Forms 1120 resulting from unprocessable small business corporate returns.
B. Determined whether any problems and solutions were identified by reviews conducted by the Government Accountability Office and the Taxpayer Advocate Office relating to assessing and completely processing converted Forms 1120.
C. Determined whether the IRS had received or justified the need for additional funding or staffing to work the converted corporation returns and related shareholders’ individual income tax returns.
II. Determined whether policies and procedures were established to ensure taxes were properly assessed on Forms 1120S that could not be processed.
A. Reviewed the Internal Revenue Manual (IRM) and other written instructions to determine the procedures established to convert unprocessable Forms 1120S to Forms 1120.
B. Reviewed procedures established to evaluate the examination potential of Forms 1120 converted from unprocessable Forms 1120S.
C. Held discussions with national and local management officials (including the Office of Chief Counsel) to obtain information regarding:
1. The proper method of assessing taxes on small business corporate returns that could not be processed.
2. Any specific IRM or Law Enforcement Manual procedural changes that affect the examination screening and conversion processes.
III. Determined whether IRS processing procedures and examination screening adequately ensured taxes were accurately assessed and compliance goals were achieved for Forms 1120S that could not be processed.
A. Selected
and reviewed a statistical sample of 215 taxpayer
accounts. We used attribute
sampling at a 95 percent confidence level and an expected error rate not over
10 percent with a precision level of +/- 4 percent. We used a computer extract to determine the
volume (71,931) of unprocessable small business corporate returns (Unpostable
Code 310 with Reason Codes 2, 4, 5, and 6, which relate primarily to Forms
1120S) that were resolved with an Unpostable Resolution Code (URC) 8 for
Calendar Year 2002. We then identified
the 49,999 returns for Tax Year 2001 that were worked by the
B.
Reviewed the sample of 215 accounts by analyzing
various IRS records and the related tax returns to determine whether elections
were present in accounts, Forms 1120S were successfully processed, there was
evidence that the converted Forms 1120s were sent for examination screening,
tax returns were transshipped to other IRS sites for examination screening, and
Statutory Notices of Deficiency were used before taxes were assessed on
converted Forms 1120.
C. Matched the 215 cases against the IRS Schedule K-1 matching files to potentially quantify income and losses from the corporations.
D. Analyzed information gathered to determine whether there were any trends or patterns to indicate the IRS’ traditional screening practices and processing procedures relating to unprocessable Forms 1120S needed to be more vigorously addressed and revised.
Appendix
II
Major Contributors to This
Report
Richard J.
Dagliolo, Acting Assistant Inspector General for Audit (Small Business and
Corporate Programs)
Robert K. Irish, Audit
Manager
Michael D. Luongo,
Lead Auditor
Bernard Kelly, Senior
Auditor
Philip Peyser, Senior Auditor
Appendix III
Commissioner C
Office of the Commissioner - Attn: Chief of Staff C
Deputy Commissioner for Services and Enforcement SE
Deputy Commissioner, Small Business/Self-Employed Division SE:S
Director, Compliance, Small Business/Self-Employed Division SE:S:C
Director,
Customer Account Services, Small Business/Self-Employed Division SE:S:CAS
Director, Taxpayer Education and Communication, Small Business/Self-Employed
Division SE:S:T
Assistant Director, Customer Account Services, Small Business/Self-Employed Division SE:S:CAS
Director, Internal/External Stakeholders, Small Business/Self-Employed Division SE:S:C:CP:I
Chief Counsel CC
National Taxpayer Advocate TA
Director, Office of Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk
Analysis RAS:O
Office of Management Controls OS:CFO:AR:M
Audit Liaison:
Commissioner, Small Business/Self-Employed Division SE:S
Appendix IV
The process generally includes the following steps:
· The IRS is required to send the tax return to the Compliance Services/Classification function for screening.
· The IRS would then have to determine the correct and proper tax due by the corporate taxpayer.
Appendix V
Management’s
Response to the Draft Report
The response was removed due to its
size. To see the response, please go to
the Adobe PDF version of the report on the TIGTA Public Web Page.