Full Text of National Taxpayer Advocate 2005 Report to Congress Available

The 21 problems described in the report are as follows:

1. Trends in Taxpayer Service. As the IRS proposes to allocate more resources to collection, examination, and criminal investigation functions and fewer resources to taxpayer service functions, the IRS is also increasing efforts to "migrate" taxpayers toward electronic services and away from face-to-face contact. Before altering the mix of service and enforcement, the National Taxpayer Advocate believes the IRS should spend more time studying what types of services different taxpayer segments need and how best to deliver these services to help taxpayers remain compliant. The National Taxpayer Advocate recommends that the IRS undertake a research-driven needs-assessment, from the taxpayers' perspective, to help identify what services taxpayers need and want and how best to deliver them. An assessment of needs will also help identify groups of taxpayers that may be resistant to, or unable to access, certain services. Once the IRS conducts a detailed assessment and understands how any proposed changes to taxpayer service may affect compliance, the IRS should develop a detailed strategy for migrating taxpayers from the current to the proposed model of delivering taxpayer service.

2. Criminal Investigation Refund Freezes. The IRS Criminal Investigation function (CI), through its Questionable Refund Program (QRP), places a "freeze" on hundreds of thousands of refund claims each year that it believes may contain indicia of fraud. CI personnel currently review the refund claims and "determine" whether they are fraudulent -- without notifying taxpayers that their claims are under review and without giving taxpayers an opportunity to present documentation supporting their positions. Last year, the Taxpayer Advocate Service (TAS) received more than 28,000 requests for assistance from taxpayers whose refunds had been frozen. TAS studied a randomly selected sample of nearly 500 cases to determine the ultimate disposition of these cases. When TAS assisted the taxpayers, CI ultimately agreed to issue the full amount of the refund claimed (or more) in 66 percent of the decided cases and to issue a partial refund in an additional 14 percent of the decided cases. Thus, taxpayers received a full or partial refund in 80 percent of frozen-refund cases brought to TAS. The median Adjusted Gross Income (AGI) of these taxpayers was $13,330, and the median refund was $3,519. Thus, the refund constituted, on average, more than 26 percent of the claimant's AGI for the year, and the taxpayers were required to wait, on average, more than 8-1/2 months to receive their refunds. The National Taxpayer Advocate believes that the QRP is an important program to protect against tax fraud, but the IRS must implement procedures to notify taxpayers that their refunds have been frozen, provide taxpayers with an opportunity to submit documentation, and bring cases to a quicker resolution.

3. The Cash Economy. Underreported income (and related self-employment tax) from the so-called "cash economy" is probably the single largest component of the "tax gap." It may exceed $100 billion per year. Because income from the cash economy is not subject to information reporting, many of the IRS's traditional means of enforcement are unlikely to be effective in addressing it. The IRS has a number of initiatives that could be effective if coordinated and pursued more aggressively. However, no single function coordinates research, outreach, and compliance initiatives aimed at improving reporting compliance among cash economy participants. Nor does the IRS give these initiatives the same level of attention as other initiatives, such as those addressing tax shelters or the Earned Income Tax Credit (EITC). The IRS must develop a comprehensive strategy for addressing the cash economy if it is to significantly reduce the tax gap.

4. Training of Private Debt Collection Employees. In or around July of 2006, the IRS's Private Debt Collection (PDC) initiative will go into operation. The PDC initiative marks a dramatic departure from traditional federal tax collection practice in that private collection firms will now be seeking payment from taxpayers with delinquent accounts, arranging installment agreements, and obtaining taxpayers' financial information over the phone. The National Taxpayer Advocate is concerned about taxpayers interacting with private collection agents who have no understanding of important tax laws and will be trained by the contractors instead of the IRS. With the abundance of tax experts employed at the IRS, it only makes sense to use the IRS's expertise to directly train private collectors at a level that approximates the training received by new IRS collection employees.

5. EITC Exam Issues. In the past few years, the IRS has made significant progress in improving the administration of the EITC. Despite this progress, problems still exist for taxpayers subject to EITC examinations and recertification. These problems include delays in exam and recertification procedures, low taxpayer response rates, a lack of standardized treatment in recertification cases, and problems with documentation. The National Taxpayer Advocate recommends that the IRS continue to identify and adopt measures designed to ease the burden on taxpayers and improve the current EITC examination and recertification processes.

6. Levies on Social Security Payments. In general, recipients of Social Security benefits are elderly or disabled workers, or the surviving dependents of deceased workers. The IRS continues to process levies on Social Security payments without sufficient managerial review, causing undue burden on a vulnerable population of taxpayers. The National Taxpayer Advocate urges the IRS to implement safeguards that would prevent levies from being imposed on Social Security payments to low income and other at-risk taxpayers.

7. Appeals Campus Centralization. The IRS Office of Appeals ("Appeals") has centralized its work on certain types of cases at six IRS campuses; these cases previously were resolved in field offices closer to taxpayers. Appeals campus centralization is aimed at decreasing the time it takes for a taxpayer to resolve a case. While this aim is appropriate and admirable, the National Taxpayer Advocate is concerned that centralizing Appeals case resolution may actually increase taxpayer burden. Centralization may reduce opportunities for taxpayers to have their cases resolved at the local level, diminish working relationships between taxpayers and Appeals employees, increase emphasis on processing at the expense of independent judgment, and diminish service for low income and unrepresented taxpayers. The National Taxpayer Advocate urges Appeals to alleviate these problems and protect taxpayers' appeal rights by developing specific training that will help employees carry out Appeals' independent mission in the campus environment. We recommend that Appeals monitor campus activity to ensure that taxpayers -- particularly low income taxpayers -- receive full and fair consideration of their cases and are adequately notified of their right to request a case transfer to a local Appeals office.

8. Refund Anticipation Loans: Oversight of the Industry, Cross-Collection Techniques, and Payment Alternatives. Given that a significant percentage of RAL customers are EITC recipients, the IRS has a compelling reason to consider improved oversight of the industry as well as seriously consider alternative refund delivery methods. The IRS contributes to the demand for Refund Anticipation Loans (RALs) by: (1) failing to deliver refunds in the quickest manner possible and (2) failing to provide RAL alternatives for the "unbanked." It is also unclear if RAL customers fully understand the ramifications of cross-collection provisions in standardized RAL contracts, or if customers would even purchase the products if they were adequately informed of the cross-collection practices. The National Taxpayer Advocate recommends that the IRS review the effect of its Revenue Protection Strategy (RPS) on refund turnaround times and work with the Department of Treasury to develop alternative means of delivering refunds to taxpayers.

9. Identity Theft. Identity theft occurs when someone uses another individual's personal information without permission to commit fraud or other crimes. Although the most common type of identity theft involves consumer fraud, an increasing number of identity theft victims find they need to contact the IRS to untangle their tax accounts. The National Taxpayer Advocate urges the IRS to resolve the tax issues faced by victims of identity theft more quickly and efficiently, which may require coordination between the IRS and other federal agencies.

10. Complexity of the Employment Tax Deposit System. The Internal Revenue Code places significant responsibilities on employers for depositing, reporting, filing, and paying employment taxes. Recent data shows that the IRS assesses failure to deposit (FTD) penalties on one out of every 16 employment tax returns, yet eventually abates more than 60 percent of the FTD penalty amounts it originally assessed. This suggests that the rules and regulations governing federal employment tax deposits are overly complex, presenting significant compliance problems for employers and administrative challenges for the IRS.

11. Automated Collection System Levy Releases. Collection efforts through the IRS's Automated Collection System (ACS) can result in levies of bank accounts, wages, or other income such as Social Security. In response to these levies, taxpayers will contact the IRS seeking to enter into a collection alternative, such as an installment agreement. The IRS can also designate an account as "currently not collectible" if the taxpayer can demonstrate a financial hardship. The Internal Revenue Code and Treasury Regulations require that the IRS promptly release levies when taxpayers enter into installment agreements or when they demonstrate the existence of a hardship. Some taxpayers encounter problems with the levy release, including clerical errors, delays that result in additional levies on taxpayer assets or income, or the IRS not returning levy proceeds when a delayed levy release results in additional levies. Delays are also due in part to taxpayers' failure to request expedited levy releases so that the release can be faxed to the third party levy source. The IRS has improved the levy release process for currently-not-collectible accounts and has agreed to consider similar system changes for installment agreements, and require additional training for employees. We encourage the IRS to consider revising its procedures so that all levy releases are assumed to require expedited procedures.

12. Regulation of Electronic Return Originators. Electronic Return Originators (EROs), along with return preparers, are taxpayers' entry point into the tax system and have unprecedented access to taxpayers' financial data and social security numbers. As such, EROs should be closely monitored to protect taxpayers, but the IRS's current regulation of EROs is minimal. The National Taxpayer Advocate recommends the IRS increase its efforts, in part by making more visits to EROs, tracking EROs that are not filing any tax returns, and requiring those non-active EROs to recertify. The National Taxpayer Advocate further recommends that the IRS consolidate end-to-end responsibility for EROs, from approval of applications to monitoring ERO activities, in one IRS organization and develop a long-term strategic plan for the e-file program and EROs to ensure adequate and effective oversight.

13. Limited Scope of Backup Withholding Program. Underreporting of individual income tax is the single largest source of the tax gap, accounting for over half of the gross tax gap. Backup withholding is one of the tools available to the IRS as it attempts to narrow the gap. The IRS has the authority to require payors to deduct and withhold tax under certain conditions, such as when a recipient fails to furnish a valid Taxpayer Identification Number. However, the IRS has not implemented the backup withholding program effectively and has failed to provide noncompliant taxpayers with sufficient incentive to fulfill their reporting obligations.

14. Accessibility of e-Services for Tax Practitioners. The IRS's web-based e-Services suite is available to tax practitioners who are active participants in the IRS e-file program and electronically file five or more accepted individual income tax returns in a filing season. The IRS uses e-Services "as a reward and incentive for e-filing" rather than addressing it from a customer service-oriented perspective. This policy of limiting access to e- Services deprives many highly trained and experienced tax practitioners of an extremely useful and efficient tool, and has the unintended result of making the Electronic Account Resolution program available to preparers without regard to their professional qualifications. The National Taxpayer Advocate recommends that the IRS provide access to e-Services to all practitioners qualified to practice before the IRS pursuant to Circular 230. She also recommends that the IRS expand access to the Transcript Delivery System in e-Services to all taxpayers, while taking the necessary security measures to safeguard confidential tax data on the Internet.

15. Mandatory Briefings for IRS Employees on TAS. Internal Revenue Code § 7803(c)(2)(C)(ii) requires the National Taxpayer Advocate to develop guidance for all IRS officers and employees, outlining the criteria for referral of cases to the Taxpayer Advocate Service (TAS). The IRS has denied the request of the National Taxpayer Advocate to include TAS training among its annual mandatory briefings for all employees. Instead, the IRS has agreed to provide TAS training to contact employees in the Wage and Investment and Small Business/Self-Employed operating divisions on a one-time basis, and urges TAS to train the rest of the employees through methods such as the IRS intranet, inserts in employee Earnings & Leave statements, and "wallet cards." The National Taxpayer Advocate urges the IRS to rethink its position and grant her request to make TAS training mandatory for all employees.

16. Allowable Expense Standards for Collection Decisions. Each year the IRS publishes schedules of national and local expense allowance standards. These standards reduce the subjectivity involved when IRS employees consider the collection alternative to pursue when a taxpayer is having difficulty paying the IRS (e.g., an offer-in-compromise, installment agreement, or suspension of collection). However, for any given taxpayer, the expense amounts provided by the standards will not necessarily cover his or her reasonable basic living expenses. The IRS relies on the subjective judgment of its employees to allow more than the standard amounts when appropriate. Many practitioners report that the IRS often fails to allow such additional amounts and uses the standards as an excuse to reject reasonable collection alternatives. Our report discusses a number of reasons that the standards are often inadequate and provides recommendations for improving them, encourages IRS employees to allow additional amounts when appropriate, and addresses practitioner concerns.

17. Inadequate Taxpayer Service to Exempt Organizations, Resulting in Unnecessary Penalties. Most tax exempt organizations are very small entities with meager resources and modest budgets that rely largely on the services of volunteers. Tax filing requirements for these organizations are complicated and time consuming. The IRS automatically assesses penalties on these organizations when they do not comply precisely with these complex requirements. Over the last 13 fiscal years, however, the IRS has abated almost 75 percent of the dollars assessed for filing-error penalties on exempt organizations because the organizations later corrected their mistakes. This high abatement rate is an unnecessary waste of IRS resources and indicates that exempt organizations would avoid filing errors if better informed of their filing obligations. Currently, however, the IRS substantially underfunds customer service to exempt organizations; for example, only 60 percent of organizations that call the IRS Tax Exempt and Government Entities Division toll-free help line receive service. The National Taxpayer Advocate urges the IRS to reconsider its funding decisions with respect to exempt organization customer service and better utilize the resources available.

18. Direct Deposit of Income Tax Refunds. Under present law, there are no procedures for the IRS, the government's Financial Management Service, and financial institutions to address inadvertent errors by taxpayers relating to direct deposits of tax refund checks. The taxpayer and the financial institution must resolve any dispute over the accuracy of a direct deposit refund, with little assistance from the IRS. The National Taxpayer Advocate recommends that the IRS consider all of the recommendations put forth by the Direct Deposit Task Force as well as other procedural improvements that can eliminate the potential for a misdirected direct deposit refund. The National Taxpayer Advocate also encourages the IRS to continue to work with financial institutions in an effort to recover misdirected funds.

19. Innocent Spouse Claims. One spouse (called the "innocent spouse") may apply to the IRS for relief from joint liability for deficiencies or underpayments attributable to the other spouse. The IRS has difficulty communicating with taxpayers regarding the requirements for relief and how to fill out related forms. As a result, the IRS is able to grant fewer than three in ten requests for relief, and despite recent cuts in processing time, the IRS collectively takes more than two years to process requests that are appealed. Various IRS computer systems contain inconsistent information about innocent spouse claims processed by the Appeals function. These inconsistencies make it more difficult for the IRS to identify the source of any processing delays.

20. Limitations of Collection Account Databases. The lack of access to full taxpayer account histories in one place makes it difficult for IRS contact employees to respond to taxpayers' questions or provide proper guidance on potential case resolutions. This inaccessibility often leads taxpayers to seek the assistance of the Taxpayer Advocate Service. The Desktop Integration (DI) system provides IRS employees with greater access to the information needed, but not all systems interface with DI and not all IRS employees are required to use DI. The National Taxpayer Advocate urges the IRS to expand the number of systems interfacing with DI as well as requiring all IRS contact employees to use DI.

21. Reasonable Cause Assistant (RCA). The IRS does not utilize the Reasonable Cause Assistant (RCA) program -- a computer-based decision support tool -- for all determinations of penalty abatements for reasonable cause. In addition, the high rate of RCA abatement conclusions indicates that the IRS needs to eliminate unnecessary penalty assessments. Because existing IRS data does not sufficiently differentiate RCA cases from non-RCA cases, the IRS cannot effectively analyze the penalty systems in place. The low rate at which RCA users abort the program's conclusions may indicate that RCA does not encourage users to override an RCA decision even when appropriate. The National Taxpayer Advocate urges the IRS to review RCA and all related training and guidance materials to determine whether the application actually gives the user the flexibility to fully consider unique facts and circumstances.

KEY LEGISLATIVE RECOMMENDATIONS

Tax Reform Core Principles: A Taxpayer-Centric Approach. Two months ago, the President's Advisory Panel on Federal Tax Reform submitted a report to the Secretary of the Treasury proposing significant revisions to the Internal Revenue Code, and it appears that Congress may give serious consideration to fundamental tax reform in the next year or two. We recommend that Congress give priority emphasis to six core principles as it considers various tax-reform proposals: (1) the tax system should not "entrap" taxpayers; (2) the tax laws should be simple enough so that taxpayers can prepare their own returns without professional help, simple enough so that taxpayers can compute their tax liabilities on a single form, and simple enough so that IRS telephone assistors can fully and accurately answer taxpayers' questions; (3) the tax laws should anticipate the largest areas of noncompliance and minimize the opportunities for such noncompliance; (4) the tax laws should provide some choices, but not too many choices; (5) the tax laws should not necessarily avoid refundable credits but, if it includes them, should design them in a way that is administrable; and (6) the tax system should incorporate a periodic review of the tax code -- in short, a sanity check.

Measures to Reduce Noncompliance in the Cash Economy. The IRS estimates that the annual federal tax gap for 2001 was between $257 billion and $298 billion. The IRS receives about 130 million income tax returns each year. Thus, every taxpayer is forced to pay an average $2,000 "surtax" each year to subsidize noncompliance. IRS data show that the highest rate of noncompliance by far is attributable to transactions that are not reported to the IRS on a Form W-2, Form 1099, Schedule K-1, or similar form. These unreported transactions occur largely in the so-called "cash economy." To reduce the tax burden on compliant taxpayers, we recommend that Congress (1) create a three-pronged reporting and payment system that encourages compliance in certain cash economy transactions by (a) instituting backup withholding on payments to taxpayers who have demonstrated "substantial noncompliance"; (b) releasing backup withholding on payments to "substantially noncompliant" taxpayers who have demonstrated "substantial compliance" and agree to schedule and make future estimated tax payments through the IRS Electronic Funds Transfer Payment System (EFTPS); and (c) providing that payors will not be required to institute backup withholding on payments to independent contractors that present payors with a valid IRS "compliance certificate"; (2) require the IRS to promote the making of estimated tax payments through EFTPS; (3) authorize voluntary withholding agreements between independent contractors and service recipients; and (4) require third-party information reporting for certain payments to corporations with 50 or fewer shareholders.

Tax Reform for Families: A Common Sense Approach. The Internal Revenue Code contains six provisions related to a taxpayer's family status: the Earned Income Tax Credit (EITC), the Child Tax Credit (CTC), the Child and Dependent Care Credit, personal and dependency exemptions, the head-of-household filing status, and the "separated spouse" rules of IRC § 7703(b). Each of these six provisions directly or indirectly confers a tax benefit on taxpayers who meet the various eligibility requirements, and at least one of these six provisions impacts every U.S. individual taxpayer. To build upon the recently enacted Uniform Definition of Child and to further simplify the family status provisions, we recommend that Congress (1) combine the exemptions, CTC, and part of the EITC and head of household filing status into a refundable Family Credit comprising two components -- one for the taxpayer (and his or her spouse) and one for whomever is the "main carer" of a child or children based on a per-child amount; (2) separate the Child and Dependent Care Credits into two credits; (3) eliminate head-of-household filing status; (4) modify the EITC so that it provides a refundable credit to low income workers based solely on the taxpayer's earned income and is available to workers age 18 and over, regardless of the existence of children in the household; (5) permit married taxpayers who have a legal and binding separation agreement and who live separate and apart as of the last day of the calendar year to be considered "not married" for purposes of filing status; and (6) provide a separate credit for noncustodial parents of Qualifying Children who pay all child support obligations due for that calendar year.

Another Marriage Penalty: Taxing the Wrong Spouse. The federal income tax liabilities of married persons are often imposed on or collected from a spouse who did not earn the income subject to tax, i.e., the "wrong" spouse. Current law provides some relief to a spouse held liable for tax on the other spouse's income, at least in cases where the first spouse did not know about the income and did not significantly benefit from it. However, the relief rules are sometimes overly narrow, complex, costly for the IRS to administer, and burdensome for taxpayers. Even if relief rules apply so that one spouse is not liable for his or her spouse's tax, the IRS may be able to collect the liability from the non-liable spouse in community property states. We recommend that Congress amend the law to tax the "right" spouse in the first instance and to prevent the IRS from undermining this rule through its collection efforts. Our recommendation would better align each person's tax with his or her individual ability to pay, significantly reduce complexity, and minimize the impact of state property and collection laws that subject taxpayers to different amounts of federal income tax solely because they reside in different states.

Requiring Brokers to Track and Report Cost Basis for Stocks and Mutual Funds. Many financial institutions through which investors own stocks and mutual funds ("brokers") do not currently keep track of an investor's basis in the stocks or mutual funds, and no brokers report basis information to both taxpayers and the IRS on a Form 1099-B. The absence of information reporting creates serious problems for many taxpayers and the government alike. For taxpayers, tracking basis can be extraordinarily complex and many taxpayers seeking to comply with the law find that they simply cannot do so with accuracy, leaving them exposed if audited. From the government's perspective, the absence of information reporting enables underreporting by taxpayers who deliberately overstate their basis (thereby reducing their gain or even generating a loss), because they know the IRS generally cannot detect errors in basis reporting in the absence of an audit. One recent estimate puts the revenue loss to the government from such underreporting at $250 billion over the next 10 years. We recommend that brokers be required to keep track of an investor's basis, transfer basis information to a successor broker if the investor transfers the stock or mutual fund holding, and report basis information to the taxpayer and the IRS (along with the proceeds generated by a sale) on Form 1099-B. To offset the cost of implementing a tracking system, we note that Congress could provide a one-time tax credit for brokers.

Tracking Cost Basis as a Result of Estate Tax Repeal. Under the current estate tax regime, persons acquiring property from a decedent are able to use a "stepped-up" basis equal to the fair market value of the property at the date of the decedent's death (or, if they so elect, on the date six months after the decedent's death). Once the estate tax is repealed in 2010, these taxpayers must use the modified carryover basis, which may require extremely complex calculations to determine the property's adjusted basis in the hands of the decedent just prior to death. Reconstructing adjusted basis in property is difficult enough while taxpayers holding such assets are alive; after death, it can become impossible. Congress should explore ways to lessen this compliance burden.

Restructuring and Reform of Collection Due Process Provisions. Collection Due Process (CDP) hearings afford taxpayers the opportunity to obtain meaningful review of IRS collection actions by an impartial IRS Appeals Officer and the courts, either after the initial filing of a Notice of Federal Tax Lien or before an initial levy on a taxpayer's assets. The current statutory CDP rights are both under-inclusive and over-inclusive, denying judicial review of some lien and levy actions while encouraging counterproductive behavior on the part of some taxpayers and the IRS. To enhance taxpayer protections in the tax collection process while ensuring that the IRS's ability to collect the correct amount of tax is not unreasonably impaired, we recommend that Congress (1) require the IRS to issue a separate CDP Right to Hearing notice at the time it undertakes the first levy action with respect to a tax, describing with specificity the levy source and date such levy will occur and providing the taxpayer with the name and contact information of an IRS employee to call about the levy action; (2) consolidate judicial review of CDP hearings in the United States Tax Court, clarify the role and scope of Tax Court oversight of Appeals' continuing jurisdiction over CDP cases, and address the Tax Court's standard of review for the underlying liability in CDP cases; and (3) codify both the IRS Collection Appeals Program and the IRS Audit Reconsideration Process and specifically include Audit Reconsideration as an alternative to be considered at CDP hearings.

ADDITIONAL LEGISLATIVE RECOMMENDATIONS

Direct Deposit of Income Tax Refunds. Under present law, there are no procedures in place for the IRS, the government's Financial Management Service, and financial institutions to address inadvertent errors by taxpayers relating to direct deposits of tax refund checks. Disputes over the accuracy of a direct deposit refund due to taxpayer or preparer error must currently be resolved between the taxpayer and the financial institution itself, with little assistance from the IRS. The National Taxpayer Advocate recommends that Congress amend the Internal Revenue Code to create a process through which the IRS and financial institutions work together to identify the incorrect recipient of a direct deposit refund and require the return of the improperly deposited funds.

Social Security Levies. Current law exempts from IRS levy certain pension and annuity payments (including payments under the Railroad Retirement Act), but it does not exempt from levy retirement, survivors, and disability insurance payments made under the Social Security Act. Levies by the IRS on Social Security benefits can cause particularly severe hardships for low income taxpayers who rely on these payments as their primary or sole source of income. The National Taxpayer Advocate recommends that Congress exempt Social Security payments altogether from IRS levy. In the alternative, the National Taxpayer Advocate recommends that Congress extend the exemption amount applicable to manual levies to automated levies under the Federal Payment Levy Program.

Debt Collection Techniques on EITC Benefits by the Refund Anticipation Loan Industry. Refund anticipation loan (RAL) customers may not completely understand the ramifications of the debt offset collection provisions included in standardized RAL contracts. The provisions give the contracting financial institution or bank the authority to offset RAL proceeds to satisfy outstanding delinquencies owed on RALs previously issued by either the contracting bank or a third-party bank. The practice allows banks to effectively seize EITC benefits and transfer the funds to themselves or third-party banks to satisfy these prior delinquencies. The National Taxpayer Advocate recommends that Congress amend IRC § 32 to prohibit banks from exercising their right to set off on EITC benefits, a protection that currently exists for Social Security benefits. At the very least, the law should prohibit banks from transferring any portion of a federal tax refund representing the EITC to a third-party bank.

Appeals from Collection Due Process Hearings under IRC §§ 6320 and 6330. Collection Due Process (CDP) hearings provide taxpayers an opportunity for independent review of the first lien filed by the IRS or the first proposed levy action with respect to a tax liability. As in 2003 and 2004, CDP was the most frequently litigated tax issue in the federal courts. We reviewed 209 decisions during the current period. Our analysis shows that collection alternatives were litigated more than any other such issue in these cases (40 out of 209 cases). Taxpayers prevailed in five cases. Taxpayers also attempted to litigate the underlying liability in 39 cases; however, in 26 cases the courts ruled that taxpayers were unable to litigate that issue because they had another opportunity to do so earlier in the process.

Gross Income under IRC § 61 and Related Sections. The issue of what constitutes gross income for purposes of Internal Revenue Code (IRC) § 61 has been among the Most Litigated Issues since 1998, the first year that the National Taxpayer Advocate was required to report on litigated issues. Gross income is again the second most litigated issue this year. The cases generally fell into one of four categories: (1) awards or settlements, (2) disability and Social Security income, (3) constructive dividends, and (4) unreported income. Taxpayers prevailed, in whole or in part, in 25 out of 108 cases. While no clear patterns are evident, taxpayers appeared to have the most difficulty in cases where other sections of the Internal Revenue Code exclude income items that would otherwise be taxable.

Failure to File Penalty under IRC § 6651(a)(1). The number of cases involving the failure to file penalty under IRC § 6651(a)(1) increased by 60 percent from last year to make this the third most litigated issue. We reviewed 75 cases involving the failure to file penalty in federal courts. Taxpayers seek relief from the penalty by asserting "reasonable cause" for the failure to file a timely return. Taxpayers argued that varying excuses constitute reasonable cause, including illness of the taxpayer or family member, reliance on a tax professional, reliance on a spouse, or ignorance of the law. Taxpayers prevailed in five of 75 cases (7 percent).

Trade or Business Expenses under IRC § 162 and Related Code Sections. The deductibility of trade or business expenses is perennially one of the ten most litigated tax issues in the federal courts. We reviewed 67 cases that included trade or business expense issues. The courts affirmed the IRS position in nearly 75 percent of the cases, while taxpayers prevailed just seven percent of the time; the remaining cases resulted in split decisions. Substantiation of trade or business expenses was the primary sub-issue litigated by taxpayers, who often failed to provide sufficient documentation of expenses they incurred, causing them to lose otherwise permissible deductions. The IRS can assist these taxpayers, and minimize litigation, by continuing to provide clear guidance on the deductibility of trade or business expenses.

Frivolous Issues Penalty under IRC § 6673. We reviewed 67 cases in which taxpayers litigated the IRC § 6673 penalty for advancing frivolous arguments or conducting litigation solely for delay. This represents a 90 percent increase over last year's 35 cases. In these cases, the Tax Court considers whether taxpayers' arguments or actions warrant application of the penalty. IRS counsel can move for imposition of the penalty or the court can do so on its own initiative. Courts consistently held that penalties were warranted where the same type of "boiler-plate" arguments had been held by other courts to be frivolous, having no basis in law or fact. The increase in these cases suggests that the IRS is more willing to seek imposition of the penalty and courts are more willing to sustain it.

Negligence Penalty under IRC § 6662(b)(1). We reviewed 57 cases involving the accuracy-related penalty under IRC § 6662(b)(1). This penalty is assessed against taxpayers for underpayment of tax due to the taxpayer's negligence or disregard of tax rules or regulations and was generally decided in conjunction with other issues. The IRS prevailed in 39 cases (or 68 percent), while taxpayers prevailed in 13 cases (23 percent), and five cases ended in split decisions. A common reason for rulings against taxpayers was the lack of any evidence that there was reasonable cause and the taxpayers acted in good faith. However, the taxpayer victories raise the question of whether the IRS always exercises proper oversight on the imposition of the negligence penalty. The IRS abates a large percentage of other types of penalties. This fact and the relatively significant number of taxpayers who prevailed on reasonable cause indicate that the IRS should study whether the accuracy-related penalty is achieving its original goal of promoting voluntary compliance by encouraging accurate tax returns.

Family Status Issues under IRC § 2, 21, 24, 32, and 151. The Earned Income Tax Credit (EITC), dependency exemption, head of household filing status, child tax credit, and child and dependent care credit frequently arise in the same cases and involve similar factual determinations. We reviewed 45 cases concerning these issues, two-thirds of them dealing with multiple credits and issues where the determination of one issue often affected others. Our analysis shows that taxpayers who wish to claim the family status credits and deductions often do not understand the qualification requirements or how to properly satisfy them. Taxpayers were represented by counsel in only six of the 45 cases, even though many were highly fact-specific and involved a complicated web of statutory provisions.

Relief from Joint and Several Liability under IRC § 6015. Spouses filing joint federal income tax returns are jointly and severally liable for any deficiency or tax due. IRC § 6015 provides three avenues for relief from joint and several liability. We reviewed 45 federal court opinions involving relief under IRC § 6015, with 33 cases decided in favor of the IRS, 11 in favor of the taxpayer, and one split decision. While the courts considered many factors in determining the appropriateness of relief, the most significant was whether the requesting taxpayer had actual or constructive knowledge of the tax deficiency. Taxpayers' success or failure often turns on their willingness and ability to provide documentation to support their claims.

Summons Enforcement under IRC § 7604. The IRS has the authority to summon the production of books, records, or testimony from witnesses when investigating either a civil or criminal tax liability. The court ruled in favor of the IRS in 42 of the 44 cases reviewed, while a taxpayer prevailed in one case and another ended in a split decision. In at least nine of the cases, the summons in question was issued to third parties who the IRS believed were marketing unlawful tax shelters to taxpayers, reflecting the IRS's increased attention to shelter activity. As the IRS becomes more aggressive in its enforcement initiatives, it will likely increase its use of the summons enforcement tool, and the courts will see a growing number of these cases.

Trust Fund Recovery Penalty under IRC § 6672. The Trust Fund Recovery Penalty is a means by which the government holds certain persons responsible for willfully failing to withhold or remit the trust fund portion of payroll taxes. We reviewed 34 opinions in which the TFRP was an issue. Taxpayers prevailed in whole or in part in 13 of the 34 cases, though in three cases the court was denying the IRS's motion for summary judgment, thereby requiring the parties to go to trial. The cases often involved officers of small businesses who had some role in determining expenditures. As one court noted, these cases often reflect the difficult choices for corporate officers who are faced with the dilemma in a struggling business between losing one's job or violating the nation's tax laws. Still, these choices do not excuse the responsibility of paying payroll taxes.

I respectfully submit for your review the National Taxpayer Advocate's 2005 Annual Report to Congress. This is the fifth such report I have submitted as the National Taxpayer Advocate. More than anything else, this year's report is a call for tax reform. Our tax code has grown so complex it creates opportunities for taxpayers to make inadvertent mistakes as well as to game the system. As the Code gets more complex -- especially for individual taxpayers and small businesses -- it becomes more difficult for the IRS to provide comprehensive, quality taxpayer service.

As taxpayers become confused and make mistakes, or deliberately "push the envelope", the IRS understandably responds with increased enforcement actions. The exploitation of "loopholes" leads to calls for new legislation to crack down on abuses, which in turn makes the tax law more complex. Thus begins an endless cycle -- complexity drives inadvertent error and fraud, which drive increased enforcement or new legislation, which drives additional complexity. In short, complexity begets more complexity. This cycle can only be broken by true tax simplification, followed by ongoing legislative and administrative discipline to avoid subsequent "complexity creep".

Our own contribution to the tax reform debate, though modest, is taxpayer-centric. Among the legislative recommendations included in this report, we first set out some general principles for tax reform, from the perspective of taxpayers. We then submit nine further legislative proposals -- some substantive, some procedural, but all involving issues that impose significant burden on taxpayers. Our proposals run the gamut from reform of the Code's six "Family Status" provisions and repeal of joint and several liability for taxpayers who file returns under married-filing-jointly status, to proposals to protect Social Security benefits from IRS levy action. However diverse these proposals may be, we advocate in each for simplification and reduced compliance burdens.

Our report also highlights some significant contrasts. These contrasts are illustrated by the first three issues we identify as Most Serious Problems for taxpayers -- trends in taxpayer service, criminal investigation refund freezes, and the cash economy. I am concerned that the IRS is decreasing the level of resources it dedicates to taxpayer service, including lowering the level of service on its toll-free lines and restricting the types and amount of service provided in its walk-in sites. The IRS justifies this reduction in service funding by the need to dedicate more resources to IRS enforcement functions. Yet the IRS is doing little to address the largest component of the tax gap -- the cash economy.¹ Meanwhile, the IRS is expending significant resources on a Criminal Investigation program that probably freezes over 300,000 refunds each year (the IRS doesn't keep track of the number), classifies taxpayers as "criminals" without providing them an opportunity to produce exculpatory evidence, continues to automatically freeze those taxpayers' refund claims for years into the future, and causes financial hardship for tens of thousands of taxpayers whose claims are legitimate but are nonetheless forced to wait 8 1/2 months or longer to receive their refunds. While the first two issues raise questions of resource allocations and organizational priorities, the last issue raises significant taxpayer rights and due process concerns.

Even where there are real successes, we see contrasts. Take the Earned Income Tax Credit (EITC), for example. Although we identify the EITC as a Most Serious Problem, the EITC Program Office and Examination staff have, in fact, been working hard to improve the program by analyzing and redesigning its procedures, learning about the characteristics and limitations of the EITC's target population, and applying that learning to its processes. EITC personnel are open to stakeholder and Taxpayer Advocate Service suggestions and engage them in dialogue. Thus, we identify many significant improvements even as we recommend additional steps.

It is important that the EITC program is making significant improvements, because 48 percent of IRS individual examinations involve the EITC despite the fact that only 7 percent of individual tax returns claim the EITC. This disproportionate attention is driven, in part, by the mandates of the Improper Payments Improvement Act. Here is another contrast: the IRS is vigorously attacking improper payments to taxpayers in the EITC but not pursuing equally vigorously the improper nonpayment of tax by taxpayers in the cash economy. The IRS is overly focusing on $9 billion of the annual tax gap attributable to low income taxpayers, while inadequately focusing on the estimated $ 00 billion-plus of the annual tax gap attributable to the cash economy.

We have tried, in our report, to point out alternative approaches to problems, both administrative and legislative, that are taxpayer-friendly and cost-effective, particularly in the long run. Over the next year, the Office of the Taxpayer Advocate will advocate for these positions and thereby seek to help the IRS fulfill its mission of serving taxpayers.

But to return to my initial premise, there comes a time when the only effective systemic change is tax reform grounded in simplification. There is a big constituency for tax simplification, after all -- the taxpayers themselves. They are speaking up for reform daily, through the phone calls they make and the letters they send to the IRS, through the number of errors they make on tax returns, through the reluctant decision of a majority of them to pay professionals to prepare their tax returns for them, through their growing awareness of the Alternative Minimum Tax. We encourage Congress to listen to these folks and take action. I hope this report will assist in that endeavor.

HONORABLE MEMBERS OF CONGRESS:

I respectfully submit for your review the National Taxpayer Advocate's 2005 Annual Report to Congress. This is the fifth such report I have submitted as the National Taxpayer Advocate. More than anything else, this year's report is a call for tax reform. Our tax code has grown so complex it creates opportunities for taxpayers to make inadvertent mistakes as well as to game the system. As the Code gets more complex -- especially for individual taxpayers and small businesses -- it becomes more difficult for the IRS to provide comprehensive, quality taxpayer service.

As taxpayers become confused and make mistakes, or deliberately "push the envelope", the IRS understandably responds with increased enforcement actions. The exploitation of "loopholes" leads to calls for new legislation to crack down on abuses, which in turn makes the tax law more complex. Thus begins an endless cycle -- complexity drives inadvertent error and fraud, which drive increased enforcement or new legislation, which drives additional complexity. In short, complexity begets more complexity. This cycle can only be broken by true tax simplification, followed by ongoing legislative and administrative discipline to avoid subsequent "complexity creep".

Our own contribution to the tax reform debate, though modest, is taxpayer-centric. Among the legislative recommendations included in this report, we first set out some general principles for tax reform, from the perspective of taxpayers. We then submit nine further legislative proposals -- some substantive, some procedural, but all involving issues that impose significant burden on taxpayers. Our proposals run the gamut from reform of the Code's six "Family Status" provisions and repeal of joint and several liability for taxpayers who file returns under married-filing-jointly status, to proposals to protect Social Security benefits from IRS levy action. However diverse these proposals may be, we advocate in each for simplification and reduced compliance burdens.

Our report also highlights some significant contrasts. These contrasts are illustrated by the first three issues we identify as Most Serious Problems for taxpayers -- trends in taxpayer service, criminal investigation refund freezes, and the cash economy. I am concerned that the IRS is decreasing the level of resources it dedicates to taxpayer service, including lowering the level of service on its toll-free lines and restricting the types and amount of service provided in its walk-in sites. The IRS justifies this reduction in service funding by the need to dedicate more resources to IRS enforcement functions. Yet the IRS is doing little to address the largest component of the tax gap -- the cash economy.¹ Meanwhile, the IRS is expending significant resources on a Criminal Investigation program that probably freezes over 300,000 refunds each year (the IRS doesn't keep track of the number), classifies taxpayers as "criminals" without providing them an opportunity to produce exculpatory evidence, continues to automatically freeze those taxpayers' refund claims for years into the future, and causes financial hardship for tens of thousands of taxpayers whose claims are legitimate but are nonetheless forced to wait 8 1/2 months or longer to receive their refunds. While the first two issues raise questions of resource allocations and organizational priorities, the last issue raises significant taxpayer rights and due process concerns.

Even where there are real successes, we see contrasts. Take the Earned Income Tax Credit (EITC), for example. Although we identify the EITC as a Most Serious Problem, the EITC Program Office and Examination staff have, in fact, been working hard to improve the program by analyzing and redesigning its procedures, learning about the characteristics and limitations of the EITC's target population, and applying that learning to its processes. EITC personnel are open to stakeholder and Taxpayer Advocate Service suggestions and engage them in dialogue. Thus, we identify many significant improvements even as we recommend additional steps.

It is important that the EITC program is making significant improvements, because 48 percent of IRS individual examinations involve the EITC despite the fact that only 7 percent of individual tax returns claim the EITC. This disproportionate attention is driven, in part, by the mandates of the Improper Payments Improvement Act. Here is another contrast: the IRS is vigorously attacking improper payments to taxpayers in the EITC but not pursuing equally vigorously the improper nonpayment of tax by taxpayers in the cash economy. The IRS is overly focusing on $9 billion of the annual tax gap attributable to low income taxpayers, while inadequately focusing on the estimated $ 00 billion-plus of the annual tax gap attributable to the cash economy.

We have tried, in our report, to point out alternative approaches to problems, both administrative and legislative, that are taxpayer-friendly and cost-effective, particularly in the long run. Over the next year, the Office of the Taxpayer Advocate will advocate for these positions and thereby seek to help the IRS fulfill its mission of serving taxpayers.

But to return to my initial premise, there comes a time when the only effective systemic change is tax reform grounded in simplification. There is a big constituency for tax simplification, after all -- the taxpayers themselves. They are speaking up for reform daily, through the phone calls they make and the letters they send to the IRS, through the number of errors they make on tax returns, through the reluctant decision of a majority of them to pay professionals to prepare their tax returns for them, through their growing awareness of the Alternative Minimum Tax. We encourage Congress to listen to these folks and take action. I hope this report will assist in that endeavor.

INTRODUCTION

The Internal Revenue Code requires the National Taxpayer Advocate to discuss at least 20 of the most serious problems encountered by taxpayers; this year, the Taxpayer Advocate Service (TAS) analyzed and commented on 21 problems.¹ Taxpayers who contact TAS are a subset of taxpayers who actually encounter problems with the IRS. While it is vital that TAS works to resolve individual cases, we must also pursue an integrated approach to advocacy to successfully identify and resolve recurring, systemic taxpayer problems. The most serious problems reflect a combination of case and systemic issues; particularly in the areas of taxpayer service and criminal investigation refund freezes -- the top two most serious problems identified in the 2005 Annual Report to Congress.

Methodology of the Most Serious Problems List

TAS considers a number of factors when evaluating and ranking the most serious problems. The problems discussed in the following section were ranked using the following criteria:

• Impact on taxpayer rights;

• Number of taxpayers affected;

• Interest to the taxpayers, stakeholders, Congress, and the National Taxpayer Advocate;

• Impact of noncompliance on tax administration;

• Barriers to taxpayer compliance, including expense, time, and burden; and

• TAS management information data.

Taxpayer cases are tracked on the Taxpayer Advocate Management Information System (TAMIS). These cases can be multifaceted and include problems with more than one tax year. The top 25 case issues listed in Appendix 1 reflect cases in TAMIS based on taxpayer contacts from October 1, 2004 to September 30, 2005.

IRS Response

TAS provides the IRS Operating Division Commissioners with the opportunity to comment on the issues and analysis. The unedited IRS response is published at the end of each most serious problem under the heading "IRS Comments." The National Taxpayer Advocate then remarks on the IRS response and outlines her recommendations.

MOST SERIOUS PROBLEM: TRENDS IN TAXPAYER SERVICE

RESPONSIBLE OFFICIALS

Since the late 1990s the IRS has increased its delivery of quality customer service to taxpayers. In fact, in its current strategic plan, the IRS's first goal is to improve taxpayer service.¹ There are recent signs, however, that this trend may be reversing as the IRS proposes to allocate more resources to collection, examination, and criminal investigation functions and fewer resources to taxpayer service functions. For example, in the last calendar year, the IRS:

• Proposed the elimination of 68 of 400 walk-in sites;²

• Eliminated Telefile, Tax Fax, and Package X;³

• Discussed the elimination of Electronic Tax Law Assistance (ETLA);⁴

• Reduced the "level of service" on the toll-free phone lines from 87 percent to 83 percent and established a long-term level of service goal of 82 percent beginning in FY 2005;⁵ and

• Declared 225 questions "out of scope" for walk-in and 117 questions "out of scope" for toll-free phone assistors.⁶

The Senate Committee on Appropriations recently noted that the IRS lacks a concrete plan to provide adequate alternative services to replace the services proposed for reduction or elimination.⁸ Additionally, a recent Government Accountability Office (GAO) report observed that the IRS lacks long-term goals for taxpayer service as well as reliable data to understand how changes in service will impact taxpayers.⁹

Despite the lack of long-term goals and an understanding of how changes to service affect taxpayers and voluntary compliance, the IRS is continuing its efforts to "migrate" taxpayers toward electronic services and away from face-to-face contact. In a time of budget constraints, it is understandable that the IRS would make every effort to deliver services to taxpayers through the least costly means possible. In the absence of adequate research and a comprehensive strategy, however, the IRS should not continue with a radical restructuring of taxpayer service. Simply stated, before it alters the mix of service and enforcement, the IRS should spend more time studying what types of services different taxpayer segments need and how best to deliver these services to help taxpayers remain compliant. This study should attempt to describe and quantify the impact any changes to taxpayer service will have on compliance and, ultimately, on revenue collection.

ANALYSIS PROBLEM

In the aftermath of the IRS Restructuring and Reform Act of 1998,¹¹ the IRS rightly focused on building up its taxpayer service functions. At that time, its fundamental customer service measures were abysmal. The IRS's level of service on the phones was 51 percent and its telephone tax law accuracy rate stood at 74 percent.¹² In short, for many taxpayers seeking assistance from the IRS in complying with their tax obligations, the IRS simply was not at home.

Today, there is real improvement in these same taxpayer service measures. For fiscal year 2005, the IRS's quality measures include toll-free level of service of 83 percent and telephone tax law accuracy of 89 percent.¹³

However, these FY 2005 numbers do not tell the full story. Since 2003, the IRS has correctly sought to increase the staffing available to its traditional enforcement activities after several years of stagnation. But this build-up has come at the expense of customer service -- partly because Congress has not accepted the IRS's assessment of its needs and partly because the IRS has apparently decided that the IRS is delivering "good enough" service for United States taxpayers.

In the last three fiscal years, the IRS has:

• Proposed eliminating 68 Taxpayer Assistance Centers (TACs);¹⁴

• Declared 117 topics out-of-scope for toll free assistors and 225 topics out of scope for TACs;¹⁵

• Eliminated the ability of taxpayers to talk with remote assistors about out-of-scope questions by phone at many TACs;

• Reduced the number of tax returns prepared in TACs from 665,868 tax returns in FY 2003 to a proposed 305,000 tax returns in FY 2006;¹⁶

• Eliminated Telefile and TaxFax, despite the IRS's claim that it wants taxpayers to migrate to electronic self-help;¹⁷

• Discussed the possibility of eliminating ETLA;¹⁸

• Reduced taxpayer service staffing in TACs while increasing collection personnel in the sites, and directing these compliance personnel to conduct collection activities in the TACs during filing season instead of performing traditional filing assistance, despite prior assurances to the contrary;¹⁹

• Declared disaster relief questions out-of-scope for Stakeholder Partnerships Education and Communication (SPEC) personnel;²⁰

• Reduced its Taxpayer Education and Communication (TEC) staffing by 133 positions and reassigned these employees to traditional collection and examination functions;²¹ and

• Inadequately staffed its outreach and education function for the Exempt Organizations sector at a time of increased scrutiny of that sector, and underfunded the printing and publishing of excellent educational materials developed by the staff of seven to the point that taxpayers calling to obtain copies are told they are not available.²²

Similarly, in FY 2005, the tax law accuracy rate was a very impressive 89 percent, up from 80 percent in FY 2004 and 82 percent in FY 2003.²⁹ What these numbers hide is the IRS's decision to weed out the more difficult questions from the measured base and declare them "out-of-scope." Thus, the quality rate in FY 2004 includes more difficult -- and less accurately answered -- questions than those measured for FY 2005. This approach might be reasonable if the IRS proposed alternative avenues for taxpayers to obtain answers to their more complicated questions, or at least point them in the right direction. However, this year the IRS discussed eliminating ETLA. More importantly, it declared certain questions completely out-of-scope for R-mail -- the program designed to provide taxpayers with guidance on more difficult questions.³⁰

Significantly, these actions are taking place without any empirical evidence that the reductions will not harm taxpayers and not result in decreased compliance. Although the IRS maintains that it is difficult to measure the impact of high quality taxpayer service on compliance, the National Taxpayer Advocate finds that position unpersuasive. Too much is at stake not to conduct the appropriate research and develop cutting edge strategies that will provide world-class taxpayer service.

Assessing the Scope of IRS Service Channels

To develop a long-term strategic plan for delivering world-class taxpayer service, the IRS should start by determining the scope of taxpayer needs. To effectively assess this scope, the IRS should identify all of the taxpayer services it currently offers and all possible channels of communication for offering these services. For each service offered, the goal should be to determine which channel is most effective for delivering the service.

The IRS offers taxpayers a number of pre-filing and post-filing services. The main taxpayer services the IRS provides are tax law assistance, account resolution, return preparation, outreach and education, and the distribution of tax forms and publications. Typically, the IRS delivers most taxpayer services through conventional channels of communication -- telephone, correspondence, and face-to-face. Recently, the IRS has attempted to deliver a number of services through electronic channels, including the Internet and kiosks.³¹ The IRS also uses a number of outside sources to deliver services, including Low Income Taxpayer Clinics (LITCs),³² Volunteer Income Tax Assistance (VITA), Tax Counseling for the Elderly (TCE),³³ and other programs.

There are additional channels for taxpayer service that the IRS is either under-utilizing or not using at all. These channels include mobile vans, email, instant messaging, text messaging, and interactive voice response software. While some of these options may not be viable at this time, the IRS should explore whether they can be valuable communication channels in the future.

An analysis of the scope of IRS service channels should examine which services each communication channel can deliver and to which demographic group(s). The results of such a study would allow the IRS to quantify the current and projected needs of taxpayers for each possible service and channel. By quantifying the number of taxpayers in each group, the IRS could track how the number of taxpayers using each channel is changing over time. The IRS will also be able to see what the usage of a particular service offered through a specific channel would be if the IRS were delivering the service effectively. This information would be particularly helpful as the IRS continues to migrate toward the electronic delivery of services.

Such research would also allow the IRS to determine the effectiveness of alternative channels in providing different services, including whether taxpayers are able to use the information provided. Similarly, research will determine the efficiency of delivering services through a particular channel. This analysis should include identifying the cost per unit of service delivered, as well as any downstream costs of delivering a service through a particular channel.³⁴ For example, if a taxpayer goes to the IRS website to obtain a tax form and is unable to figure out which form he or she needs, that taxpayer may eventually end up visiting a walk-in site to obtain the correct forms. When determining the cost per unit of delivering tax forms and publications though the Internet, the calculation should attempt to include the downstream cost of the taxpayer having to go into the walk-in site (or other channel) when he was not able to resolve his issue through the Internet. This approach would provide a more accurate estimate of the costs involved in delivering services through various channels.

Finally, the proposed research should identify barriers that inhibit some taxpayer groups from effectively using certain channels to obtain a service. This information may provide insight into why some taxpayers do not use lower cost channels such as the Internet to obtain assistance, but instead continue to use more costly face-to-face services.

Understanding How Taxpayers Prefer to Communicate with the IRS

IRS Research into Taxpayer Preferences

Currently, the IRS only has general information about taxpayer preferences. The most recent information comes from a 2004 IRS Oversight Board Taxpayer Attitude Survey.³⁵ Since 2002, the IRS Oversight Board has contracted with a professional survey firm to conduct telephone surveys of taxpayers' attitudes, including expectations of IRS customer service. The survey results indicate that individuals rely most highly on IRS publications, IRS representatives, and the IRS website for tax information.³⁶

The survey also polled individuals about the importance of various taxpayer services and the likelihood that an individual would use each one. The services with the highest "receptivity" -- those services individuals rated as very important and very likely to be used -- were an IRS toll-free phone number, an Internet site, walk-in sites, and the ability to email the IRS.³⁷ These preferences have remained relatively constant since the IRS Oversight Board began this study in 2002.

The Wage and Investment Division (W&I) has conducted the majority of IRS research regarding taxpayer preferences to better understand its customer base. Much of W&I's research focuses on the IRS's goal of moving toward the electronic delivery of services. The research has examined taxpayers' online usage and willingness to use electronically delivered services. Although previous research is valuable, the research examined specific issues or demographic groups and does not provide a broad-based view of the preferences of all taxpayers regarding specific services and communication channels.

External Research about Taxpayer Preferences

Most existing information about taxpayers' preferences comes from external sources. While the IRS should consider this information in developing a plan for taxpayer service, the information is not IRS-specific, and its value in identifying taxpayer preference is therefore limited.

The Pew Internet and American Life Project recently conducted a study that examined how Americans get in touch with the government.³⁸ When asked how they prefer to contact the government, the individuals surveyed favored telephone conversations and websites over in-person contacts and correspondence. Forty percent of respondents preferred the telephone and 24 percent preferred a website, compared with 13 percent preferring in-person contact and 10 percent preferring correspondence.³⁹

Individuals' preferences change, however, when they are contacting the government with a very complex or urgent issue or to solve a problem. Although telephone contact remains the most preferred means for these transactions, in-person contact becomes more important, while a website becomes less so.⁴⁰

When asked specifically about contacting the government about tax issues, a majority of respondents prefer the telephone -- 51 percent -- compared with the 40 percent of respondents who preferred the telephone for non-tax questions.⁴¹ Additionally, 27 percent of respondents who have contacted the government with a tax issue switched their means of contact and almost half of those -- 49 percent -- changed because they were not getting the response they needed.⁴²

With the IRS's focus on migrating toward electronic delivery of services, another study by the Pew Internet and American Life Project may shed light on which groups of taxpayers are most likely to embrace this change. This Pew study looked specifically at which individuals use government websites.⁴³ The study found that use of government websites was almost the same for males and females, with 53 percent of males and 47 percent of females having used a government website.⁴⁴ The study also found that use of government websites was almost the same despite differences in education levels, with 52 percent of individuals with less than a college education and 48 percent of individuals with a college education or higher having used a government website.⁴⁵

However, disparity in government website usage among certain age groups may highlight an area of particular concern for the IRS. Of those surveyed, only 21 percent of individuals between 18 and 29 have used a government website, while 49 percent of those age 30-49 reported using a government site.⁴⁶ As individuals get older, their usage of these sites declines, with 21 percent of individuals between 50 and 64, and only six percent of those 65 and older, reporting they have used a government website.⁴⁷

Similar disparities exist based on income level, with the highest usage of government websites occurring among individuals with the highest income. Individuals in the lowest income bracket were the least likely to use a government site, with 15 percent of individuals with income between $0 -- $30,000 reporting use of a government website.⁴⁸ Only 22 percent of individuals with income between $30,000 -- $50,000 and 19 percent of individuals with income between $50,000 -- $75,000 reported having used a government website.⁴⁹ Individuals with income over $75,000 were most likely to use a government site, with 30 percent reporting having done so.⁵⁰

While these percentages almost certainly have risen since the study was conducted three years ago, the Pew studies and other similar studies have laid the groundwork for the type of research the IRS must perform. Although current IRS research and various outside studies provide some insight into what taxpayers prefer, the IRS still lacks a comprehensive study indicating what services different groups of taxpayers want and how they prefer to obtain those services. This is the first step we recommend the IRS take to develop a comprehensive strategic plan for taxpayer service.

How Taxpayers Need to Communicate with the IRS

Once the IRS understands what taxpayers prefer, it should next attempt to determine whether taxpayers' preferences can be changed and if there are any limitations on the IRS's ability to change them.

Although taxpayers may indicate they prefer to use a certain channel, it does not mean that channel is the only one they are willing to use. If a group of taxpayers prefers a higher cost channel, such as face-to-face interaction, the IRS must examine why those taxpayers prefer that channel. By understanding the reasons for the preference, the IRS can determine if, despite the preference, the taxpayers are willing and able to migrate to a different, lower cost channel of communication. This information could also help the IRS determine whether it can modify a lower cost channel to make it more appealing to taxpayers. If taxpayers remain unwilling to migrate, the IRS should have sufficient information to determine whether the compliance benefits justify its continuing to provide the preferred channel, even though it has a lower cost channel for delivering the same service.

In some cases, a taxpayer may indicate she prefers to use a certain channel; however, this preference does not mean she can or will use that channel. In conjunction with looking at taxpayer preferences, the IRS should also look at limitations on a taxpayer's ability to use a certain channel. The characteristics of some groups of taxpayers may prevent them from using certain channels of communication, even if those channels are ones they say they prefer. The IRS must have sufficient information to deal with these challenges.

Disabled Taxpayers

In a 1997, one in five adult Americans reported having a disability and one in eight reported a severe disability.⁵¹ The IRS needs to conduct research as well as review more recent research to determine the most appropriate communications channel for individuals with various disabilities.

Elderly Taxpayers

In 2000, 59 million taxpayers were age 55 or older.⁵² This number is expected to grow to 75 million by 2010.⁵³ This group of taxpayers is significantly less willing to use the Internet to obtain services than the rest of the population. In 2000, only about 13 percent of people over age 65 had access to the Internet.⁵⁴ Although Internet usage among older Americans is increasing -- 39 percent of Americans over age 50 used the Internet in 2000, compared with 25.5 percent in 1998 -- migrating older taxpayers to obtain IRS services electronically will prove difficult.⁵⁵ According to the recent IRS Oversight Board study, older individuals (age 65 and older) view the IRS website as the least valuable resource for tax information. Only 19 percent of these older individuals viewed the IRS site as a valuable resource -- a 32 point difference in comparison with the total population.⁵⁶

As the IRS continues its move towards the electronic delivery of services, it must plan for and meet the needs of disabled and elderly taxpayers, who have demonstrable difficulty in moving to the Internet.

Low Income Taxpayers

More than 25 percent of W&I filers can be defined as low income.⁵⁷ Of those low income taxpayers, over 40 percent live in rural areas or towns.⁵⁸ This geographic dispersion can make it extremely difficult for many low income taxpayers to travel long distances to an IRS walk-in site. Although walk-in sites may be inconvenient for many low income taxpayers, these taxpayers are also much less likely than others with higher incomes to have phone or Internet access at home.⁵⁹ Low income individuals are more likely to have limited English proficiency and therefore face additional barriers in communication with the IRS.⁶⁰

ESL and LEP Taxpayers

Individuals who speak English as a second language (ESL taxpayers) and those with limited English proficiency (LEP taxpayers) also pose a challenge for the IRS. In 2004, 34.2 million foreign-born persons lived in the U.S.⁶¹ The number of people who do not speak English at home increased from 31.8 million in 1990 to 44.9 million in 2000.⁶² An additional 11.6 to 12.8 million people report speaking English "not well" or "not at all."⁶³ The IRS must address the difficulties associated with communicating with ESL and LEP taxpayers in order to deliver services effectively to this taxpayer group.

The 2003 IRS Oversight Board Compliance Study found that certain demographic groups, specifically Hispanics and Asians, are more likely than average to rely on non-IRS sources for tax advice, such as paid preparers, family, and friends.⁶⁴ This tendency may be due in part to a language barrier between the taxpayer and the IRS. This information should be used in deciding whether to offer a specific service through the IRS or through one of the IRS's outside sources. In making this decision, the IRS must assess the accuracy of information provided by such third parties.

Literacy Level of Taxpayers

A study by the Department of Education raises questions about some taxpayers' ability to understand the information the IRS provides. The National Adult Literacy Survey found that between 21 and 23 percent of adult Americans -- 40 million to 44 million people -- fall at the lowest literacy level.⁶⁵ Although many individuals at this level could perform tasks involving simple texts and documents, all individuals in this category had difficulty using certain necessary skills for functioning in everyday life. Individuals at the lowest literacy level can sign their name to and total a bank deposit entry; however, they usually cannot identify and enter background information on a Social Security card application or calculate total costs or purchases from an order form.⁶⁶ Given that almost one quarter of all adult Americans fall at the lowest literacy level, the IRS must ascertain how to provide information and services to this segment of the population in a way they can understand. Channels that enable direct observation of the taxpayer's difficulties of communication and comprehension are generally preferable to remote or non-interactive channels.

Impact of Taxpayer Service on Compliance

While it is critical for the IRS to know what services taxpayers need and how best to deliver those services, it is also important for the IRS to understand how any change in taxpayer service will affect compliance. Our current tax system functions on the principle of self-assessment and has resulted in a largely compliant taxpaying population. The IRS's working equation -- "Service + Enforcement = Compliance" -- recognizes that taxpayer service plays a central role in ensuring taxpayers are complying with the tax code. If, however, the IRS reduces or changes the way it delivers certain taxpayer services, such action may affect taxpayers' willingness or ability to comply with an increasingly complex tax system.

Although the impact taxpayer service has on compliance is important, it is not easy to determine. Changes to taxpayer service will affect compliance differently within different demographic groups. Some taxpayers may be forced to use paid preparers or volunteer organizations for assistance. Other taxpayers may simply become noncompliant because they are unable or unwilling to obtain help elsewhere. For those taxpayers who are pushed into noncompliance, this will ultimately result in downstream costs to the IRS in the form of more examinations and collection efforts.

Once it is better informed about the possible effects of changes in taxpayer service on compliance, the IRS can assess whether it is willing to accept a possible reduction in compliance in exchange for altering the channel through which it provides a particular service. For example, if research indicated that a change in how the IRS distributes tax forms and publications might lead to a slight decrease in compliance but would result in a huge cost savings for the IRS, the IRS can determine whether it is willing to make the trade-off of cost reduction in exchange for a lower compliance.

At the moment, however, the IRS has not conducted any serious research on this issue, so it is impossible to determine how any of the recent or proposed changes to taxpayer service will affect compliance.

Migration Strategy

Once the IRS conducts an in-depth taxpayer needs assessment and identifies the effect any changes may have on compliance, the IRS could develop a strategy for implementing changes to the current taxpayer service structure. The IRS cannot simply eliminate certain channels and push taxpayers to alternate channels to receive services. Instead, the IRS must have a comprehensive strategy for migrating taxpayers to different communication channels as well as a plan for providing channels taxpayers need.

For a migration strategy to be successful, the IRS must know how effective different communication channels are in delivering services to various groups. The IRS cannot migrate taxpayers to a channel that does not work. If research indicates a channel is not effective, the IRS needs to find out why and how it can fix the channel. Conversely, the IRS needs to ensure that a certain channel is effective before taxpayers are encouraged to use it. Additionally, once the IRS understands what taxpayers need, it may be possible to revamp a lower cost channel to respond to those needs.

The first goal of the migration strategy should be to migrate taxpayers who can be serviced by a lower cost channel to that channel. In determining the number of taxpayers that can be migrated to a low cost channel, the IRS must look first at the group of taxpayers who can be serviced by that channel. Out of that population that can use the channel, the IRS should next look at the subset that will use the channel. This subset is the initial target audience. Although this initial group of taxpayers will likely be easy to migrate -- they have indicated both ability and a willingness to use the specific channel -- the IRS must also develop a communication strategy to reach these taxpayers. The IRS should tailor its outreach efforts to make the migration strategy is as effective as possible.

Once the IRS has successfully migrated the initial group of taxpayers to the lower cost channel, the second phase of the migration strategy is to identify by channel and demographic those channels that taxpayers are not willing to use and why they are not used. By understanding why certain taxpayer groups are not using specific channels, the IRS can determine whether it needs to revamp an existing channel or find an alternate method of delivering services. Once the IRS has determined how it will provide services to this second group of taxpayers, the IRS must again develop a targeted outreach strategy. Given the resistance this group of taxpayers may have in migrating to a different channel, research will allow the IRS to craft an outreach strategy to address specific taxpayer concerns. With a targeted outreach message, the IRS may be able to alleviate taxpayers' concerns and convince them to migrate to the lower cost channel they were previously unwilling to use.

It may be that the resistance of several groups to migrate is so great, and the size of the initial, more easily migrated group so small, that it is not feasible or efficient to offer this lower cost channel. That is, the analysis described above may show that the lower cost channel is not, in fact, lower cost after all. The potential for such a result demonstrates the need for research before acting upon cuts to taxpayer service.

What Do We Know Now about Taxpayer Needs and Preferences?

While a taxpayer-centered needs assessment should form the basis of any IRS decisions regarding taxpayer service, such research may take years to complete. The results of the needs assessment should impact not only how the IRS provides taxpayer service, but also how the IRS interacts with taxpayers in all aspects of the tax system. While the impact of this research would be far-reaching, there are steps the IRS can take in the meantime to improve its interaction with taxpayers. The IRS should examine the way in which it is currently doing business and how it is or is not working. Identifying current problems in how the IRS operates may shed light on what might be wrong with current channels and the ways these channels are attempting to communicate information. Additionally, the IRS can begin to identify the downstream costs that can be reduced or eliminated if the IRS simply altered it current practices.

EITC Audit Reconsideration Study

One indication of a problem in how the IRS conducts business is the Taxpayer Advocate Service recent EITC Audit Reconsideration Study. In 2004, TAS, in conjunction with W&I, studied 679 EITC audit reconsideration cases.⁶⁷ The study focused on identifying ways to improve the accuracy and effectiveness of EITC audit reconsideration and the overall EITC correspondence exam process, while minimizing taxpayer burden.⁶⁸

The study's findings raise questions about how the IRS conducts correspondence examinations and the IRS's reluctance to contact taxpayers via telephone. The study also underscores the importance of improving communication with taxpayers during the initial portion of the audit process. If the IRS can remedy the current lack of communication with taxpayers during the initial audit stage, it could save the downstream costs associated with many audit reconsideration cases.⁶⁹ The study also demonstrates the importance of providing taxpayer service within traditional enforcement functions and activities.

EITC Audit Barriers Study

Results from the focus groups conducted as the first phase of the EITC Audit Barriers Study also suggest problems in the way the IRS conducts business. In 2005, the Taxpayer Advocate Service, in conjunction with the EITC Program Office and W&I Research Division, conducted qualitative research into some of the challenges tax examinations pose for low income taxpayers, particularly EITC claimants.⁷⁰ The research was designed to determine if EITC eligible taxpayers are adversely impacted by IRS procedures established to reduce EITC overclaims, and if so, what specifically causes the taxpayers' problems.⁷¹

Two of the areas identified as barriers EITC taxpayers face during IRS exams are related to IRS correspondence and contacting the IRS.⁷² The IRS's reliance on correspondence causes problems for many EITC taxpayers, who are unable to understand many of the IRS letters they receive. This observation echoes the finding of the TAS EITC Audit Reconsideration Study and supports the idea that the IRS must reevaluate the way it communicates with taxpayers to better meet their needs and avoid downstream costs.

Focus groups also noted that some EITC taxpayers are more comfortable visiting an IRS walk-in site rather than calling or writing the IRS to resolve a problem. This preference stems in part from language barriers and trust issues experienced by some low income taxpayers. Again, this research supports the IRS's need to reevaluate the way it interacts with taxpayers to help them better understand their tax obligations and avoid subsequent problems for taxpayers and costs for the IRS.

The Next Steps

The existing research demonstrates that there is still much we do not know about how best to provide taxpayer service. The IRS should take a number of steps to remedy this situation. In September 2005, the IRS formed the IRS Taxpayer Assistance Blueprint (TAB) team. The team, created in response to concerns raised by the Senate Appropriations Committee,⁷³ is composed of employees from multiple IRS functions and is responsible for developing a five-year plan to improve taxpayer service. The team is an important first step in recognizing that the IRS needs a long-term strategy for meeting taxpayers' needs.

As part of the five-year plan for taxpayer service, the IRS must engage in a detailed needs assessment, undertaken from the taxpayers' perspective. As discussed above, a clear understanding of what services taxpayers need, and how those services should be delivered to ensure compliance, is critical to any discussion of taxpayer service. Without adequate and reliable research, any changes by the IRS are based on speculation and not on actual taxpayer needs.

While conducting a needs assessment, the IRS should maintain its current level of service. The IRS does not yet know what taxpayers want or need and any changes to the level of taxpayer service are premature. Maintaining current services will also avoid the "gap" period that occurs when old services are discontinued while new services are not yet implemented.

In addition to a needs assessment, the IRS should look at other state and federal agencies to see if anything can be learned from the ways in which they provide services.⁷⁴

Any results from other agencies are not IRS-specific and therefore their value admittedly will be somewhat limited. However, the IRS could benefit by identifying a particular service, communication channel, or demographic group, and then examining how other agencies use those service methods to meet the needs of various demographic groups. In this way, the IRS could study alternative approaches and truly develop world class taxpayer service.

IRS COMMENTS

The IRS strongly disagrees with the National Taxpayer Advocate's assessment of our service program for America's taxpayers. In virtually all service areas, our performance and accuracy have improved, even while we are revitalizing our enforcement program. As important, we have continued to respect taxpayer rights as we have rebalanced our service and enforcement program. We are particularly proud that we have sustained these performance levels, notwithstanding the diversion of substantial resources, both human and technical, in order to answer almost one million telephone calls for FEMA as our employees rose to the challenge of assisting taxpayers impacted by this year's devastating hurricane season.

The IRS continually strives to balance service and compliance initiatives while attempting to meet the needs of a wide-ranging taxpayer population amid fiscal limitations. As an organization, we are committed to providing the proper balance between these two complementary activities to ensure continued voluntary compliance and to address the estimated net tax gap, which is between $257 and $298 billion per year as reported in the National Taxpayer Advocate's Most Serious Problem -- The Cash Economy.

It is important to recognize that the IRS has been able to obtain these significant improvements in taxpayer service through constantly striving to align more efficient and effective methods of providing services with the evolving needs and preferences of taxpayers. For example, the IRS has --

• Employed advanced call routing technology;

• Developed interactive job aids for our employees;

• Improved our information systems;

• Strengthened our managerial and executive involvement in service delivery;

• Analyzed the tax law changes to determine the impact on our service to walk-in, telephone, and tax assistance customers;

• Expanded service to alternative locations, (such as post offices, federal and state offices, libraries, and community organizations) during the filing season;

• Provided return preparation service using volunteers and Taxpayer Assistance Center (TAC) personnel; and

• Realigned support functions and expanded the use of technology to improve efficiency in pre-filing and outreach efforts.

Following are responses to particular statements by the National Taxpayer Advocate in her report that are factually incorrect or imply that the IRS has made business decisions exclusively on an interest in increasing enforcement:

Directing Compliance Personnel to Collection Activities during the Filing Season

In May 2003, TAC offices expanded their services to compliance collection work in order to assist taxpayers with a wide range of tax problems. TAC employees work an inventory of Taxpayer Delinquent Account (TDA), Taxpayer Delinquency Investigations (TDI), and high income (over $100,000) non-filer cases. Field Assistance is aware of the importance of balancing taxpayer assistance and compliance work and, as a result, has stressed that collection cases are worked only during the non-filing season (May through December) and never to the detriment of assistance work. In only rare situations, cases in progress prior to the filing season or initiated by the taxpayer may be completed during the filing season.

Declared Disaster Relief Questions Out-of-Scope for Stakeholder Partnerships, Education and Communication (SPEC) personnel

In order to meet the needs created by recent natural disasters, the Katrina Emergency Tax Relief Act of 2005 was enacted and included 11 provisions directed at individual taxpayers. As with all recently issued tax law changes, a determination was made as to which provisions will be in-scope and out-of-scope. SPEC determined that eight provisions were within the scope of the Volunteer Income Tax Assistance/Tax Counseling for the Elderly (VITA/TCE) program, and three (casualty loss, cancellations of indebtedness, and involuntary conversions) were not in scope due to the complexity of the tax law for volunteers.

SPEC recognizes the need to provide some high level training to the VITA/TCE volunteers that will enable them to recognize questions relating to the three out-of-scope provisions. This training, and the new Disaster Services Referral Guide that lists where taxpayers may obtain disaster services, is currently being developed.

Alleged IRS Decision to "dumb down" its Quality Goals

The IRS did not "dumb down" its quality goals for taxpayer service functions to benefit quantity goals for collection, examination, and Criminal Investigation. Achievement of an 89 percent tax law accuracy rate in 2005, up from 82 percent in 2003 and 80% in 2004, took a concentrated effort of managers and employees. The achievement had nothing to do with defining certain calls as being out-of-scope.

The IRS did not "weed out the more difficult questions" from 2003 or 2004 in order to achieve a higher tax law accuracy rate in 2005. Out-of-scope issues have existed since the IRS began offering toll free service over 30 years ago. Highly complex issues, beyond the skill level of assistors, such as tax planning issues, requests for legal advice, and other highly technical questions have always been considered out-of-scope. In the past, however, these issues had not been uniformly or clearly delineated in any written procedural guidance for employees. In order to achieve consistent application of this "unwritten" policy, out-of-scope guidelines were added to the Wage & Investment Accounts Management Program Letter directive and became effective in fiscal year 2006. Therefore, defining out-of-scope questions is not a change in business practice; it is simply clarifying longstanding policy to improve service, consistency, and quality. Implementation of this guidance did not change the level of difficulty relating to in-scope and out-of-scope issues.

Level of Service (footnote 26)

The National Taxpayer Advocate's comments concerning Level of Service are not accurate.

• The FY 2004 Enterprise Snapshot report shows 35.5 million Assistor Calls Answered. The statement that, "Customer Account Services (CAS) received approximately 40.9 million phone calls directed to telephone assistors in FY 2004." cannot be verified.

• The statement, "These are calls relating only to taxpayer service issues, and do not include compliance-related telephone calls" is incorrect. CAS does receive and answer compliance related telephone calls. The first, third and final collection notices (CP 501/503/504), as well as the annual reminder notices (CP 71s), are compliance notices that contain the CAS telephone numbers. In FY 2005, 56 percent of all notices generated were compliance notices containing the CAS telephone numbers. In FY 2004, 51 percent of notices generated were compliance notices with the CAS telephone numbers.

• The statement that, "Setting the level of service at 82 percent indicates a decision not to answer 18 percent of phone calls, or approximately 7.4 million taxpayer phone calls" is an improper conclusion. Setting a Customer Service Representative (CSR) Level of Service goal of 82 percent means that we plan to answer 82 percent of anticipated "call demand" for CSR assistance within a given period of time. There is not a direct one-to-one ratio of callers to call demand because each call attempt does not constitute a unique single customer attempt to receive service during a measured time period. During the measurement period, call demand would consist of all callers who successfully connected as well as those who did not connect and redialed and those who received a busy signal and re-dialed multiple times.

The statement that "kiosks are Internet-enabled . . ." is not correct. IRS kiosks are currently not Internet-enabled, but provide information such as Frequently Asked Questions, and forms and publications. The Concepts of Operations (CONOPS) describe the future state of Field Assistance and include a scenario of a Virtual TAC that uses kiosks to provide services offered at a traditional TAC. The footnote is presented as the current state of kiosks when it should be the future state.

Strategies to Deliver Taxpayer Service

The IRS does not agree with the National Taxpayer Advocate's inference that it is not assessing service channels or taxpayer service needs and preferences. The IRS already has a strategy team in place.

Over the last five years, the IRS has focused on improving service to individual taxpayers. The IRS Taxpayer Assistance Vision, W&I's Concept of Operations, our Strategic Plans, the "Service + Enforcement = Compliance" equation -- all addressed a common theme of improved service. In September 2005, the Taxpayer Assistance Blueprint (TAB) Team was formed to address fundamental questions regarding today's IRS customer and their tax assistance needs from the customer point of view. While TAB builds upon several years of strategic planning efforts, it also addresses a recent Congressional directive to ascertain taxpayer needs and preferences and develop a five year plan to address them. The TAB's project objectives are:

• Develop a credible baseline by assessing current service offerings and delivery channels, and customer needs, behaviors, and preferences across various demographic segments.

• Develop long-term metrics by which the effectiveness of taxpayer assistance can be gauged.

• Develop a repeatable and reliable process that can be institutionalized and integrated into the IRS' existing strategic planning and budgeting processes to ensure the continuous evaluation of taxpayer assistance.

• Develop recommendations and plan for addressing gaps in customer needs and preferences, and evaluate innovative approaches to assistance that will be implemented over the next two to five years.

• Assess the impact of the recommendations on current and future planning, funding, and modernization processes.

Phase 1 will include secondary research, surveys of third-party stakeholders, partners and employees, and blueprint design and development where we will determine customer needs, preferences, and demands and perform a gap analysis of those needs, preferences, and demands. Phase 2 will include additional research, development of an implementation plan for recommendations, integration of recommendations into the budgeting process, and integration of the blueprint into the IRS Strategic Plan.

The IRS will also identify and use leading practices from the private sector, government agencies and international and state tax administration organizations to develop improvements.

To ensure key stakeholders are informed and engaged, a comprehensive stakeholder engagement plan has been developed and is currently being implemented. This plan is being executed to ensure that we have input from customers, employees, intermediaries that either serve or represent taxpayers and oversight bodies.

CONCLUSION

The reality is that the IRS is embracing technological changes, improving accuracy, providing better alternatives to taxpayers, and expanding its scope and services amid more stringent fiscal responsibilities. The IRS recognizes that it cannot provide service to all taxpayers through all channels of its operations. However, current research efforts will identify taxpayer needs, which will allow the IRS to continue to analyze and explore more cost effective means of delivering quality service to taxpayers.

TAXPAYER ADVOCATE SERVICE COMMENTS

Throughout the above discussion on taxpayer service, the National Taxpayer Advocate focused on the IRS's lack of a long-term plan for delivering taxpayer service. This is not to say that the IRS has not made efforts to improve and modernize taxpayer service. In fact, the National Taxpayer Advocate recognizes the improvements the IRS has made to the level of service since 1998; however, these changes to taxpayer service have been made based on what the IRS believes taxpayers want and need, as opposed to what taxpayers indicate they want and need from the IRS.

While "Service + Enforcement = Compliance" is the IRS's working equation that guides many of its actions, the "Service" portion of the equation, including the level of service and types of services offered, remains undefined. Until the recent formation of the Taxpayer Assistance Blueprint (TAB) Team, the IRS has never taken a systematic view of all aspects of taxpayer service to determine how best to meet the needs of all taxpayers. The goal of this piece is to begin a conversation with the IRS on conducting research and developing a taxpayer-focused plan for delivering world-class taxpayer service.

The above discussion lays out issues the IRS should consider as it works to develop a long-term plan for delivering taxpayer service. As one of the parties responsible for developing the five-year plan for taxpayer service, the National Taxpayer Advocate (with the IRS and the IRS Oversight Board), is concerned that the IRS should not act hastily in developing a plan for taxpayer service. Instead, the National Taxpayer Advocate believes the IRS must engage in a research-intensive needs assessment, undertaken from the taxpayers' perspective. This needs assessment will help the IRS identify what services taxpayers need and want, and how best to deliver those services. Additionally, a needs assessment will help identify those groups of taxpayers that may be resistant or unable to access certain services. Once the IRS conducts a detailed needs assessment, and understands how any proposed changes to taxpayer service may affect compliance, the IRS should develop a detailed strategy for migrating taxpayers from the current service model to the proposed model of delivering taxpayer service. In the interim, the National Taxpayer Advocate believes the IRS should maintain the current level of taxpayer service to prevent a "gap" in taxpayer service that may occur if taxpayers are directed towards new service vehicles that are not yet fully capable of responding to taxpayers' needs.

Collection Activities in the TACs during the Filing Season

The IRS states that it will only work collection cases in the Taxpayer Assistance Centers during the non-filing season, except in rare instances. As a general matter, the National Taxpayer Advocate supports providing the full spectrum of assistance in the TACs, including collection and examination case resolution, answering tax law questions, preparing income tax returns, and providing taxpayers with transcripts of their accounts. However, with the reduction of field assistance personnel in the TACs, it is vitally important that all available personnel be dedicated to taxpayer service during the filing season, when deadlines are looming. Contrary to the IRS's statement, its internal guidance states that where there is a conflict between "counter work" and "collection work," the counter can be temporarily closed in order to address the collection matter. This guidance was issued in September 2004, and does not exclude the filing season from its effect.⁷⁵

Declared Disaster Relief Questions Out-of-Scope for SPEC personnel

In its response, the IRS states that it determined that certain disaster-related tax topics "were not in scope due to the complexity of the tax law for [VITA and TCE] volunteers." In our analysis, we did not address issues of disaster questions with respect to volunteers. Rather, we noted that the IRS had determined IRS SPEC employees would not be authorized to answer questions about tax-related disaster relief provisions in conducting outreach and stakeholder relations activities. Since SPEC is the primary outreach function of the IRS for individual taxpayers, we are not clear on who in the IRS will be conducting outreach and education on these important issues, other than TAS.

IRS Toll-Free Level of Service

Contrary to the IRS's statements, in TAS's discussion about the IRS phone level of service, TAS did not refer to the number of "callers" or "taxpayers" calling the IRS. In all of our references to the phone level of service, we referred to "phone calls" and "taxpayer phone calls." TAS derived its level of service calculations for FY 2004 from the Wage and Investment Operating Division's Business Performance Review report dated October 27, 2004, an accompanying PowerPoint presentation produced by W&I, and the IRS's Enterprise Telephone Data Warehouse. If W&I's numbers in these reports are incorrect, we stand corrected. The underlying point, however, remains -- the IRS is reducing its level of service from previous levels and as a consequence it will either not answer millions of taxpayer calls or force taxpayers to abandon their calls and call again.

RECOMMENDATIONS

The National Taxpayer Advocate looks forward to working with the IRS in developing a strategic plan for delivering taxpayer service that focuses not only on what services taxpayers need, but how best to deliver those services to ensure that all taxpayers receive world-class service from the IRS. In order to achieve this world-class taxpayer service, the National Taxpayer Advocate recommends that the IRS:

• Engage in a detailed needs assessment, from the taxpayers' perspective, as part of the IRS' five-year plan for taxpayer service.

• Identify all of the taxpayer services currently offered and all possible channels of communication for offering these services in order to determine which channel is most effective for delivering the service.

• Develop an understanding of what taxpayers prefer, as well as whether taxpayer preferences can be changed and if there are any limitations on the IRS' ability to change those preferences.

• Examine both internal and external research regarding taxpayer preferences.

• Explore how any changes to taxpayer service will affect compliance.

• Develop a strategy for implementing changes to the current taxpayer service structure, including a plan for migrating taxpayers to different communication channels.

• Maintain the current level of taxpayer service until the completion of the IRS' five-year plan for taxpayer service.

• Examine other state and federal agencies to determine if anything can be learned from the ways in which they provide services.

² IRS, IRS to Create Efficiencies with Taxpayer Assistance Centers, IR-2005-63 (Jun. 27, 2005).

³ IRS, IRS E-File Available for Extension Filers through Aug. 15 and Beyond, IR-2005-75 (Jul 20, 2005); IRS, IRS TaxFax Services, available at http://www.irs.gov/formspubs/article/0,,id=97730,00.html (last visited Nov. 9, 2005); IRS, Package X Soon to be Obsolete, available at http://www.irs.gov/taxpros/article/0,,id=139287,00. html (last visited Nov. 9, 2005).

⁴ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-152, Electronic Tax Law Assistance Program Responses Are Timely and Generally Accurate 1 (Sept. 2005) (noting the IRS is considering whether to discontinue ETLA for fiscal year 2006). Currently, ETLA is still available on the IRS website at http://www.irs.gov/help/page/0,,id=120294,00.html. Electronic Tax Law Assistant (ETLA) is an IRS service offered through a link on www.irs.gov through which taxpayers and practitioners can email tax law questions directly to the IRS. IRS employees can then pull responses to questions from a database of prewritten answers, thus saving time researching and responding to frequently asked questions.

⁵ Statement of Mark W. Everson, IRS Improves Enforcement and Services in 2005 (Nov. 3, 2005); IRS, FY 2005 Enforcement and Service Data, available at http://www.irs.gov/pub/irs-news/fy05_enforcement_and_service_ chart.pdf (last visited Nov. 10, 2005). Level of service is the relative success rate of taxpayers calling for assistance and seeking services from a Customer Service Representative. Part of the calculation of results for this measure includes the percentage of call attempts made by taxpayers compared to the number of calls answered by IRS. IRS, Pub. 3744, IRS Strategic Plan 2005-2009 18 (June 2004).

⁶ IRM § 21.3.4-1, Scope of Services (Nov. 01, 2005); IRM § 21.1.1.6.1, Out of Scope and Limited Service (Oct. 06, 2005); Accounts Management Out of Scope Procedures, Attachment #1 -- Identified Out of Scope Issues.

⁷ House Committee on Ways and Means, Statement of Mark Everson, Commissioner, Internal Revenue Service (Apr. 15, 2005).

⁸ S. Rep. No. 109-109, at 133 (2005). See also Joint Congressional Review, Written Testimony of Raymond T. Wagner, Jr., Chairman, IRS Oversight Board (May, 19, 2005); Senate Committee on Appropriations, Written Statement of James R. White, Director, Strategic Issue, Government Accountability Office and David A. Powner, Director, Information Technology Management Issues, Government Accountability Office (Apr. 27, 2005); Senate Committee on Appropriations, Written Statement of J. Russell George, Treasury Inspector General for Tax Administration (Apr. 7, 2005); Senate Committee on Appropriations, Written Statement of Nina E. Olson, National Taxpayer Advocate, Internal Revenue Service (Apr. 7, 2005).

⁹ Government Accountability Office, GAO-06-51, IRS Improved Some Filing Season Services, but Long-Term Goals Would Help Manage Strategic Trade Offs (Nov. 14, 2005).

¹⁰ IRS National Headquarters Office of Research, Tax Gap Facts and Figures, March 29, 2005 (after IRS enforcement activities).

¹¹ Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 112 Stat. 685.

¹² Annual IRS Restructuring and Reform Act of 1998 Joint Congressional Review, Testimony of Mark W. Everson, Commissioner, Internal Revenue Service (May 20, 2003) (indicating level of service on the telephones for fiscal year 1998); Internal Revenue Service, Publication 55B, 1999 Data Book, Table 28 (Apr. 2001) (indicating tax law accuracy rate for fiscal year 1999).

¹³ Statement of Mark W. Everson, IRS Improves Enforcement and Services in 2005 (Nov. 3, 2005).

¹⁴ IRS, IRS to Create Efficiencies with Taxpayer Assistance Centers, IR-2005-63 (Jun. 27. 2005).

¹⁵ IRM § 21.1.1.6.1, Out of Scope and Limited Service (Oct. 06, 2005); Accounts Management Out of Scope Procedures, Attachment #1 -- Identified Out of Scope Issues; IRM § 21.3.4-1, Scope of Services (Nov. 01, 2005).

¹⁶ Wage and Investment, Business Performance Review, Wage and Investment Operating Division, FY 2006; Wage and Investment, Business Performance Review, Wage and Investment Operating Division, FY 2005; Wage and Investment, Business Performance Review, Wage and Investment Operating Division, FY 2004; Wage and Investment, Business Performance Review, Wage and Investment Operating Division, FY 2003.

¹⁷ IRS, IRS E-File Available for Extension Filers through Aug. 15 and Beyond, IR-2005-75 (Jul 20, 2005); IRS, IRS TaxFax Services, available at http://www.irs.gov/formspubs/article/0,,id=97730,00.html (last visited Nov. 9, 2005).

¹⁸ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-152, Electronic Tax Law Assistance Program Responses Are Timely and Generally Accurate, Ref. No. 2005-40-152 1 (Sept. 2005) (noting the IRS is considering whether to discontinue ETLA for fiscal year 2006). Currently, ETLA is still available on the IRS website at http://www.irs.gov/help/page/0,,id=120294,00.html.

¹⁹See National Taxpayer Advocate 2004 Annual Report to Congress 15-16.

²⁰ Information provided by Operating Division.

²¹ As of February 2005, 133 TEC employees accepted voluntary reassignment to compliance positions. Small Business Self-Employed, Business Performance Review, SBSE Division (Feb. 7, 2005).

²²See Tax Exempt Government Entities Penalty Abatement Most Serious Problem, infra.

²³ Treas. Reg. §§ 801.2T, 801.3T, 801.6T.

²⁴ IRS, FY 2005 Enforcement and Service Data, available at http://www.irs.gov/pub/irs-news/fy05_enforcement_ and_service_chart.pdf (last visited Nov. 10, 2005); Wage and Investment, Business Performance Review, Wage and Investment Operating Division 12 (Jul. 28, 2004) (noting FY 2004 goal of 83 percent).

²⁵ Annual IRS Restructuring and Reform Act of 1998 Joint Congressional Review, Testimony of Mark W. Everson, Commissioner, Internal Revenue Service (May 20, 2003).

²⁶ Customer Account Services (CAS) received approximately 40.9 million phone calls directed to telephone assistors in FY 2004. These are calls relating only to taxpayer service issues, and do not include compliance-related telephone calls. Setting the level of service at 82 percent indicates a decision not to answer 18 percent of phone calls, or approximately 7.4 million taxpayer phone calls. Enterprise Telephone Data Warehouse, Enterprise Snapshot for FY 2004 (Oct. 13, 2004).

²⁷ Department of Treasury FY 2005 Appropriations, H.R. 5025, § 204.

²⁸ Senate Committee on Appropriations, Testimony of Mark W. Everson, Commissioner, Internal Revenue Service (Apr. 7, 2005).

²⁹ IRS, FY 2005 Enforcement and Service Data, available at http://www.irs.gov/pub/irs-news/fy05_enforcement_ and_service_chart.pdf (last visited Nov. 10, 2005).

³⁰ For the 2006 filing season, the IRS is revising procedures for referring taxpayers who contact the IRS with out-of-scope questions. Field Assistance and Customer Account Services (CAS) employees who receive out-of-scope inquiries will refer the taxpayer to "seek the services of a tax attorney, certified public accountant (CPA), or other tax professional." The IRS is in the process of updating the IRM to reflect these changes.

³¹ Kiosks are Internet-enabled locations that provide all of the services offered at a traditional walk-in site, including return preparation, tax law assistance, ordering of forms and publications, and account management. Wage & Investment Division, Strategic Assessment, Fiscal Year 2005 11 (2004); Wage & Investment CARE, Appendix B: Field Assistance ConOps, slide 2. For a more detailed discussion of the kiosk program, see National Taxpayer Advocate 2004 Annual Report to Congress 34-35.

³² IRC § 7526. The Low Income Taxpayer Clinic (LITC) program provides matching IRS grants to organizations that provide representation to low income taxpayers with a controversy with the IRS or provide outreach and education on tax rights and responsibilities to English as a second language and limited English proficiency taxpayers.

³³ The Volunteer Income Tax Assistance (VITA) program provides free tax preparation to individuals who are unable to afford professional assistance. The Tax Counseling for the Elderly (TCE) program is part of VITA and these sites receive IRS grants to provide free tax assistance to individuals age 60 and older.

³⁴ Downstream costs refer to additional activity "downstream" that results when an initial action (i.e., processing a tax return, resolving a tax dispute, answering a tax law question, or conducting an audit) is not conducted correctly or to the satisfaction of the taxpayer. This additional activity, which may cost the IRS and the taxpayer both time and money, would not have occurred if the initial action operated correctly and effectively. Examples of downstream costs include a tax dispute that goes to Appeals because the dispute could not be resolved during regular processing, a case that comes to TAS because it was not resolved during routine processing, or an original audit that results in an audit reconsideration.

³⁵ RoperASW, 2004 IRS Oversight Board Taxpayer Attitude Survey (2004).

³⁶ In determining the value of IRS-provided information, 82 percent of individuals found IRS representatives and IRS printed publications to be very/somewhat valuable, followed by 77 percent for the IRS website. The only non-IRS information source that ranked equally as high was a paid tax professional, which 81 percent of individuals viewed to be very/somewhat valuable. RoperASW, 2004 IRS Oversight Board Taxpayer Attitude Survey (2004).

³⁷ RoperASW, 2004 IRS Oversight Board Taxpayer Attitude Survey (2004). The services with low receptivity -- those services individuals rated as least important and least likely to be used -- were community-based tax clinics, tax assistance vans, and kiosks.

³⁸ Pew Internet and American Life Project, How Americans Get in Touch With Government (May 24, 2004).

³⁹Id. at 5. Other responses included email, with 11 percent of respondents preferring this means of contact.

⁴⁰ In cases of a very complex or urgent problem, 46 percent of respondents preferred to contact the government via telephone, followed by 16 percent preferring in-person and 14 percent preferring a website. When contacting the government to solve a problem, 47 percent of respondents preferred the telephone, compared with 17 percent preferring a web site and 15 percent preferring in-person contact. Pew Internet and American Life Project, How Americans Get in Touch With Government 6 (May 24, 2004).

⁴¹ Pew Internet and American Life Project, How Americans Get in Touch With Government 13-14 (May 24, 2004).

⁴² In comparison, 22 percent of individuals with a non-tax question switched their method of contact and 38 percent of them did so because they were not getting the answer they needed. Pew Internet and American Life Project, How Americans Get in Touch With Government 14 (May 24, 2004).

⁴³ Pew Internet and American Life Project, The Rise of the E-Citizen: How People Use Government Agencies' Web Sites (Apr. 3, 2002).

⁴⁴Id.

⁴⁵Id.

⁴⁶Id.

⁴⁷Id.

⁴⁸Id.

⁴⁹Id.

⁵⁰Id.

⁵¹ A person with a disability has difficulty performing functional tasks or daily living activities, or meets other criteria, such as a learning or developmental disability. A person with a severe disability has a complete inability to perform a task or activity, or needs personal assistance to complete an activity. Wage & Investment, Computer and Internet Use Among People With Disabilities, slide 3-4.

⁵² Wage & Investment, W&I's Senior Population (Age 55 and Over), slide 5 (2003).

⁵³Id.

⁵⁴ Wage & Investment, Senior Internet Users, slide 4.

⁵⁵ Wage & Investment, Senior Internet Users, slide 4.

⁵⁶ RoperASW, 2003 IRS Oversight Board Compliance Study Report 17 (2003).

⁵⁷ Wage & Investment, How Low Income People Are Affected by Commute/Travel Needs, slide 1 (undated).

⁵⁸ Wage & Investment, How Low Income People Are Affected by Commute/Travel Needs, slide 8 (undated).

⁵⁹ Wage & Investment, How Low Income People Are Affected by Commute/Travel Needs, slide 13 (undated).

⁶⁰ Wage & Investment, How Do People Learn English and Progress From One Level of Proficiency to Another?, slide 17 (2003).

⁶¹ Wage & Investment, America's Workforce: Immigrant Workers. 4 (2005).

⁶² Wage & Investment, How Do People Learn English and Progress From One Level of Proficiency to Another? slide 2 (2003).

⁶³Id.

⁶⁴ RoperASW, 2003 IRS Oversight Board Compliance Study Report.17 (2003) (cautioning that results may be unreliable given small base of Asian individuals participating in study).

⁶⁵ Department of Education, The State of Literacy in America: Introduction, available at http://www.nifl.gov/ reders/intro.htm (last visited Oct. 15, 2005). The National Adult Literacy Survey classifies literacy into three categories -- prose literacy, document literacy, and quantitative literacy. Within each category, an individual's level of literacy is ranked on a scale of one to five, with Level five representing the highest level of literacy and Level one representing the lowest level of literacy.

⁶⁶ Department of Education, The State of Literacy in America: Introduction, available at http://www.nifl.gov/ reders/intro.htm (last visited Oct. 15, 2005).

⁶⁷ National Taxpayer Advocate 2004 Annual Report to Congress vol. II. For this study, a random sample of more than 900 EITC cases was reviewed. Ultimately, 679 cases (340 Examination cases and 339 Taxpayer Advocate Service cases) were analyzed in detail for the study. The confidence level for this sample is 95 percent.

⁶⁸ For a detailed discussion of the study and its results, see National Taxpayer Advocate 2004 Annual Report to Congress vol. II.

⁶⁹ National Taxpayer Advocate 2004 Annual Report to Congress vol. II at 40.

⁷⁰ Taxpayer Advocate Service, Challenges for Taxpayers Claiming the Earned Income Tax Credit (EITC), From Interviews with Low Income Tax Clinics (Sept. 2005). For this study, eight attorneys were interviewed about barriers EITC taxpayers face because of an examination of their tax return. The specific sites were selected based on the number of EITC filers in the area, geographic location, and the proximity of an LITC.

⁷¹ Taxpayer Advocate Service, Challenges for Taxpayers Claiming the Earned Income Tax Credit (EITC), From Interviews with Low Income Tax Clinics (Sept. 2005). This research will be used to develop a quantitative study to identify and investigate burdens EITC taxpayers face when their returns are selected for examination. W&I Research, in cooperation with TAS, will design and implement the follow-up study in late 2005.

⁷² Taxpayer Advocate Service, Challenges for Taxpayers Claiming the Earned Income Tax Credit (EITC), From Interviews with Low Income Tax Clinics (Sept. 2005).

⁷³ Citing concerns about the IRS's proposed reductions to taxpayer service and inability to explain the impact these changes will have on taxpayers, the Senate Appropriations Committee directed the IRS to:

⁷⁴See, e.g., American Judicature Society, Courts and the Self-Represented -- The Road Ahead, available at http://www.ajs.org/prose/pro_editorial.asp; National Center for State Courts, Access to Justice: Meeting the Needs of Self-Represented Litigants (Executive Summary), available at http://www.ncsconline.org/WC/Publications/Res_ProSe_AccessJustMeetNeedsExecSumPub.pdf; National Center for State Courts, The Future of Self-Represented Litigation: Report from the March 2005 Summit, available at http://www.ncsconline.org/WC/Publications/Res_ProSe_FutSelfRepLitfinalPub.pdf.

⁷⁵ IRS, Field Assistance Collection Work: Questions and Answers (Sept. 2004).

MOST SERIOUS PROBLEM: CRIMINAL INVESTIGATION REFUND FREEZES

RESPONSIBLE OFFICIAL

The IRS Criminal Investigation Questionable Refund Program (QRP) serves an important tax administration purpose by identifying fraudulent returns, stopping the payment of fraudulent refunds, and referring fraudulent refund schemes to Criminal Investigation (CI) field offices. Each year, the QRP places "freezes" on hundreds of thousands of refunds claimed on individual tax returns because CI believes the returns contain or are likely to contain elements of fraud. Clearly, the QRP helps prevent tax fraud that ultimately steals money from law-abiding taxpayers.

It is no easy task to design a program capable of sorting annually through a large volume of returns and catching enough of the "bad guys" without ensnaring honest taxpayers. As CI officials have repeatedly stressed to us, fraudulent returns and proper returns are often difficult to distinguish on their face. Moreover, the IRS is under pressure from Members of Congress and the Treasury Inspector General for Tax Administration to reduce refund fraud.

Nonetheless, there are significant problems with the QRP as currently designed and administered that we believe the IRS should address quickly.¹ The number of taxpayers whose refund claims are legitimate yet whose refunds are frozen by the IRS is at least in the tens of thousands and quite possibly in the hundreds of thousands each year.² CI does not notify these taxpayers that their refunds have been frozen, and most taxpayers who inquire must wait many months to receive their refunds -- often only after the intervention of the Taxpayer Advocate Service (TAS).

In processing year 2005, CI "froze" over 120,000 refunds due to a determination of current-year fraud and CI froze an unknown but probably much greater number of refunds due to its determination of prior-year fraud.³ During fiscal year 2005, TAS received over 28,000 QRP cases. These cases represent the largest single category of cases in TAS's inventory as well as the highest percentage of cases coming to TAS from any IRS program.

A study of closed TAS cases, presented in Volume II of this Report, shows that the consequences to taxpayers whose refunds are incorrectly frozen are severe. In 66 percent of the decided CI cases in the sample, TAS found no evidence of current-year fraud and the taxpayers ultimately received a full refund (or more) of the amount originally claimed on the taxpayers' returns.⁴ Put differently, it appears CI had frozen the refunds of taxpayers fully entitled to receive them in nearly two-thirds of the cases that came to TAS.⁵ The median Adjusted Gross Income (AGI) of "no fraud" taxpayers in our study was $13,330, and the median refund received was $3,519. The median AGI of "no fraud" taxpayers who received the Earned Income Tax Credit (EITC) was $11,956, and the median refund received was $3,685. The median cycle time for both categories was 37 weeks, or more than 8 1/2 months. Clearly, the amounts at issue and the lengthy delays cause significant hardship for many of these taxpayers, and the high percentage of "no fraud" findings in the study has important implications for tax administration.

Fraud -- in contrast to inadvertent error -- is a serious infraction that carries with it significant consequences.⁶ Criminal tax fraud can result in monetary penalties or imprisonment, and civil tax fraud can result in a penalty of 75 percent of the tax underpayment.⁷ Further, where there is a finding of fraud, the three-year statutory limitations period for assessing additional tax after a return is filed is inapplicable; that is, the IRS may assess additional tax in perpetuity.⁸

Because of the seriousness of fraud, the government generally affords taxpayers an extra measure of protection before making determinations. Indeed, the general rule that the taxpayer bears the burden of proof in tax liability disputes is reversed where the IRS asserts fraud; the government bears the burden of proving fraud in court.⁹ Yet despite the serious consequences of a finding of fraud, the IRS often freezes refunds without advising the taxpayer that it has made a determination of fraud, of the reasons for the determination, or of the consequences of that determination. Unless the taxpayer takes the affirmative step of contacting the IRS to inquire about his or her refund, the taxpayer may never know the IRS's position with respect to that return.

One particularly harsh consequence of a QRP determination of fraud is that the taxpayer's refund claims will automatically be frozen until the taxpayer has filed a certain number of consecutive "legitimate" returns (as determined by CI).¹⁰ Considering that a significant majority of taxpayers in our sample whose refunds were frozen were ultimately awarded full relief and that taxpayers are not notified by CI that there has been a finding of fraud, CI's policy to automatically freeze refunds for a certain number of years after a "finding" of fraud imposes a significant burden on large numbers of law-abiding taxpayers and in our view constitutes a fundamental violation of taxpayer rights.

The automatic freeze imposed due to prior-year fraud is also questionable as a matter of policy. We are not aware of any reliable studies that show the look-back period CI currently uses is optimal for detecting future fraud. To the contrary, our study found that in cases where a refund was frozen because of prior-year fraud, taxpayers ultimately received a full refund 79 percent of the time.

Finally, the results of our study suggest that the "revenue protection" benefits of the QRP are somewhat limited. The IRS asserts that for processing year 2004, the QRP identified more than 118,000 fraudulent tax returns and stopped fraudulent refunds totaling more than $2.1 billion.¹¹ Several elements of these claims warrant comment. First, a single scheme with two tax returns accounted for $1.8 billion of the $2.1 billion total.¹² These huge refunds are not representative of the QRP's historical or overall performance and therefore skew the program's typical results dramatically.¹³ Without these two returns, the fraud potentially detected during the 2004 processing year came to about $300 million. Second, CI officials have repeatedly told us that approximately 20 percent of amounts identified by the QRP are paid out prior to the imposition of refund freezes. Again leaving aside the two unusual returns, that reduces the amount potentially protected to about $240 million. Third, CI's statement that these 118,000 returns are "fraudulent" reflects simply its own initial assessment to that effect. Among taxpayers whose returns CI deemed "fraudulent" and who then sought assistance from TAS, CI ultimately agreed that the taxpayers were entitled to a full refund in a significant percentage of the cases.¹⁴ Thus, even the remaining $240 million deemed "protected" is probably a significant overstatement. Rather, it appears that the measurable revenue gains of the QRP are limited after taking into account the resources devoted to the program by CI, TAS and the IRS Examination function -- which is required to forego higher dollar cases to handle some low- dollar CI QRP referrals -- plus the amount of interest the IRS pays out on improperly frozen refunds.

An analysis of decided frozen-refund cases in our study shows that 158 percent of the dollars frozen by the QRP was ultimately and correctly paid out. The amount the IRS froze in our sample was $1,551,574, yet the IRS ultimately paid out to these taxpayers $2,457,309, including interest of over $81,000.¹⁵

Notwithstanding the important tax administration purpose served by the QRP, the TAS study results suggest several significant problems with the program:

• CI's fraud detection methods are not as effective as they should be at screening out non-fraudulent refund claims, and therefore cause undue burden for a significant number of taxpayers.

• CI generally does not notify taxpayers that their returns are frozen as fraudulent or provide them with the reasons for such freezes. Thus, taxpayers are not given an opportunity to substantiate their claims or to show that any overclaims identified were due to honest error rather than to fraud.

• Current IRS procedures subject QRP returns to inordinate delays. If a taxpayer subject to a QRP freeze contacts the IRS, IRS employees, including TAS employees, are generally prohibited from providing any information to the taxpayer for 180 days (or six months) from the date the taxpayer first contacted the IRS to inquire about the delayed refund.

• Where the IRS detects fraud on a taxpayer's return, the IRS automatically freezes future refund claims of the taxpayer until the taxpayer files a certain number of "legitimate" returns (as determined by CI), even though the initial IRS determinations of fraud are often incorrect and even though there is little evidence that a taxpayer is particularly likely to repeat refund fraud after he or she is identified and deterred in the initial attempt.

• In many cases, refund returns of taxpayers who are victims of identity theft are automatically classified as fraudulent for successive years. These identity theft victims are subject to both the delays inherent in the QRP process and the delays caused by the need to demonstrate for each successive year that they are in fact the victims and not the perpetrators.

• CI does not have the resources to investigate all of the refunds it freezes in a timely manner. Thus, some refund cases are left in permanent "freeze" status for long periods of time without being referred to the IRS Examination function for determination of the correct tax due.

• Other IRS functions, especially Examination, do not have the resources to effectively deal with the spill-over effect from the large number of CI refund freezes without detracting from their ability to address higher priority cases. The large number of freezes creates problems for both taxpayers and the IRS. When Examination does not work a case and no notice of deficiency is issued, taxpayers are placed in the position of having to sue in a United States district court or the United States Court of Federal Claims to obtain their refunds.¹⁶ Low and middle income taxpayers may not be able to afford to litigate and thus would remain in limbo in the IRS. From an IRS standpoint, Examination is forced to work a significant number of low-dollar QRP cases when it could probably do more to close the tax gap if it devoted its limited resources to higher dollar cases.

IRS Criminal Investigation and the Questionable Refund Program

Criminal Investigation (CI) is the law enforcement arm of the IRS and is responsible for investigating tax-related crimes. CI's primary investigatory focus is "Legal Source Investigations," which are investigations of intentional violations of the Federal tax laws by taxpayers who have legally earned income.¹⁷ The Legal Source Tax Crimes Program includes the Questionable Refund Program (QRP).¹⁸

The QRP is a nationwide multifunctional program established in January 1977 and is an important part of the IRS's overall Revenue Protection Strategy.¹⁹ The QRP was designed to identify fraudulent returns, stop the payment of fraudulent refunds, and refer identified fraudulent refund schemes to CI field offices.²⁰ It principally uses datamining software to analyze the tax return information submitted by taxpayers seeking refunds, although other methods of fraud detection are used as well.²¹ When QRP data-mining identifies certain taxpayer-specific information, the system delays the issuance of a refund for one week. If CI does not validate the taxpayer's entitlement to the refund after a week, it may place the refund request into a "freeze" status so that the refund is not issued until the IRS assures itself that no fraud is present. QRP schemes are also detected through communications from electronic return originators (EROs), financial institutions, return preparers, and concerned citizens.²² The QRP is operated out of CI's ten Fraud Detection Centers (FDCs), which are co-located with the IRS's ten campuses.

When a taxpayer comes to TAS complaining of refund delays and TAS verifies that CI has frozen the refund, TAS must seek permission from CI to provide information to the taxpayer. TAS will then work with the taxpayer to obtain documentation that substantiates the refund claim. TAS cannot obtain any refund relief for a taxpayer unless CI concurs in the result.

Study of TAS QRP Cases

For the last two years, TAS received more cases involving CI refund freezes than any other issue in its case inventory. Over the last four years, the TAS volume of CI cases has increased by over 400 percent.

                 TABLE 1.2.1, TAS'S CI CASE INVENTORY

The large number of CI cases in TAS's inventory and the high incidence of full relief in these cases led TAS to undertake a study of a statistically representative sample of its CI refund freeze cases. The goals of the study were to determine (1) the accuracy of TAS's own inventory results (i.e., did TAS case outcomes, as recorded on its databases, accurately reflect what occurred in the cases?); (2) the accuracy of the QRP in identifying and freezing cases involving actual fraud; and (3) the impact of the QRP program on taxpayers.²⁴

TAS analyzed a sample of 473 cases from closed TAMIS (Taxpayer Advocate Management Information System) inventory from FY 2004 through the first six months of FY 2005.²⁵ Although some cases in the sample involved multiple tax years, the study focused only on the most recent tax year at issue. Notwithstanding the focus on the most current year, the study took into consideration CI's policy of freezing refund claims filed by taxpayers who CI believes submitted false claims in the recent past. The researchers considered the taxpayers' filing histories and attempted to identify taxpayers who had a "Z freeze" placed on refunds within the recent past that would cause an automatic freeze to be imposed for the current year.²⁶ A "Z freeze" is a transaction code used to show CI's determination that the refund claim is fraudulent or to indicate that CI made a prior-year determination of fraud with respect to that taxpayer. In both situations, the Z freeze blocks the issuance of a refund.

The study used two methods of collecting information. Primarily, senior TAS research staff retrieved and analyzed data from the IRS Master File data system. Secondarily, TAS and CI personnel performed a manual review of the cases, collecting information from various tax databases and reviewing multiple years of data on each taxpayer in the sample. Because the latter method relied to some extent on the subjective judgments of the individual reviewers, the TAS-CI study is based almost exclusively on the information and analysis provided and analyzed by the TAS research staff.²⁷

TAS applied the following definitions to identify the presence or absence of fraud:

• No Fraud: For both current and prior-year tax periods, fraud was not considered to be present if the taxpayer received a full refund after the tax module had been placed in freeze status (i.e., the refund issued must have equaled or exceeded the amount claimed on the original return).

• Fraud: For both current and prior-year tax periods, fraud was considered to be present if the taxpayer's refund was reduced or reversed while the module was in freeze status. Since CI sometimes identifies fraud after a refund is released, we also considered fraud to be present if a full refund was released but a freeze was later placed on the module during the same calendar year.

• Undecided: For both current and prior-year tax periods, we treated a case as undecided if we found no indication that the refund claimed on the return was reduced or reversed but also found no indication that a refund had been issued. These cases appeared not to have been worked to completion.

TAS CI QRP Study Results

Out of our sample of 473 TAS cases, 398 cases were decided at the time the study was conducted, and TAS found no evidence of current-year fraud in 66 percent, or 263, of the decided cases. In these 263 cases, taxpayers ultimately received the full amount -- or more -- of their originally claimed refunds. In an additional 14 percent, or 57, of the decided cases, taxpayers received a partial refund. Thus, taxpayers received full or partial refunds in fully 80 percent of the decided cases in our sample (320 out of 398 decided cases).²⁸

The median cycle time, measured from the week the return posted to the IRS Master File to the week the refund was released, was 37 weeks, or 259 days (more than 8 1/2 months).

TAS identified 135 cases in the study where there appeared to be some indicia of fraud. Of those 135 cases, only 29 clearly involved instances of repeat fraud.²⁹

In 75 of the cases in the sample, CI appeared not to have worked the case to completion at the time TAS began its study and TAS therefore was unable to determine whether fraud was present based on the Master File data. In a subsequent manual review of these cases, we discovered that some of these cases were worked to completion after our initial extract.³⁰

 TABLE 1.2.2, PRESENCE OR ABSENCE OF FRAUD IN FULL TAS

More than 74 percent of the taxpayers in the total sample (352 taxpayers) claimed the Earned Income Tax Credit (EITC), and 294 of the EITC cases have been finally decided. Of the taxpayers in those cases, 66 percent (193) received full refund relief. We determined that 116 of the 193 taxpayers who ultimately received their full refunds (60 percent) had had their refunds frozen because of a determination of fraud by CI in a prior year.

Twenty-seven cases in the sample involved identity theft, covering 55 refund modules (or periods). The IRS froze 30 of these 55 modules after it had already had a full year to resolve the identity theft case.

CI initially placed $1,551,574 in freeze status among the decided cases in our sample. However, the IRS ultimately paid out $2,457,309, including interest of over $81,000, to 320 taxpayers in the sample. Thus, the IRS actually paid out $905,735 more than taxpayers had claimed on their original returns.³²

Implications of TAS-CI QRP Study

In principle, the refund freeze process is necessary from a tax administration standpoint for several reasons. First, returns selected through data-mining show some indication that there may be a problem with a refund request, and it is important that the IRS protect revenue while it evaluates these concerns. The Treasury pays out hundreds of billions of dollars in refunds annually.³³ This volume of dollars presents opportunities for some measure of fraud.³⁴ Second, validating a refund request requires a policy decision: Should the IRS pay out the refund first and try to recoup the tax later if the taxpayer is not entitled to the refund, or should the IRS freeze the refund until the return can be validated? In most instances, it is difficult and costly for the IRS to recoup refunds already paid to persons who are committing fraud.

Thus, we share the IRS's premise that the balance of interests necessitates an initial freeze on questionable refunds. However, fairness and due process considerations require that the IRS put in place adequate procedures to minimize the harm to nonfraudulent taxpayers and to bring all frozen refunds to final resolution in a prompt manner. There are several specific problems related to the QRP program as currently administered that have a negative impact on taxpayers and on the IRS.

CI Fraud Detection Methods Do Not Effectively Screen Out Non-fraudulent Refund Claims

Fraud detection methods, such as data mining, allow CI to easily search and freeze significantly more refund claims than in the past. However, the ability of CI to manage its caseload has not kept pace with the growing number of freezes.³⁵ In light of the increasing volume of CI refund freezes and our finding that significant numbers of refunds are incorrectly classified as fraudulent, CI should consider reevaluating and recalibrating its freeze criteria and introducing additional screens and other artificial intelligence techniques as well as speedier and more accurate reviews by CI employees. A recent TAS case demonstrates the need for CI to pay close attention to refund freeze criteria.

It may be that the QRP data-mining criteria are as good as they can be. If this is the best that the software can do, then it is all the more incumbent on the IRS to make sure its processes promptly identify potentially non-fraudulent frozen refunds. The IRS must immediately notify these taxpayers and provide them with an accessible avenue for challenging CI's assertions.

Current IRS Procedures Subject QRP Taxpayers to Inordinate Delay

IRS procedures do not allow a taxpayer with a CI freeze code on his or her account to be given information about the freeze by any part of the IRS, including TAS, until 180 days have elapsed from the date of the taxpayer's initial contact with the IRS.³⁷ Because of its high volume of cases, CI cannot always make a determination on a case within 180 days. This delay results in taxpayers' returning to TAS after the 180-day period expires and in TAS's reopening closed cases. Moreover, it is likely that some taxpayers with legitimate refund claims do not continue to pursue their refund claims and do not return to TAS.³⁸ Even after expiration of the 180-day period, CI may designate a case as a "no contact" case, which means that TAS is not permitted to provide account information to the taxpayer.³⁹

CI established the 180-day period to enable it to investigate frozen refund claims. As noted, however, the 180-day period begins on the date the taxpayer contacts the IRS rather than on the date CI freezes the taxpayer's account. Thus, CI may place a case in a temporary freeze status where it can sit for 180 days or more until a taxpayer calls and is told that he or she must then wait another 180 days. When TAS contacts CI after expiration of the 180 days, we often find that CI has not investigated the case. Moreover, Local Taxpayer Advocates have reported cases where taxpayers have been told to wait 180 days so that the IRS can complete its review -- only to be told when they call back 180 days later that the case has been referred to Examination and that they must wait another 180 days for Examination to complete its review. Finally, the 180-day delay period causes "re- work" for other IRS functions, which must tell the taxpayer to come back another time rather than deal with the taxpayer at the time of initial contact.

The following steps might give CI a reasonable period of time to investigate cases while protecting taxpayer rights:

• Limit the no-contact delay period to 60 or 90 days;

• Begin counting this period from the return-receipt date or the freeze date rather than from the taxpayer-contact date; and

• Develop expedited procedures for certain circumstances, including economic hardship, EITC, and identity theft cases.

Although CI freezes hundreds of thousands of refunds, it does not notify taxpayers that their refunds have been frozen. Thus, taxpayers do not have an opportunity to present documentation to support their refund claims until after CI has made a determination of fraud, if at all. CI's procedures also complicate the efforts of other functions within the IRS, such as Accounts Management (which handles the toll-free customer service lines) and TAS, to answer taxpayer questions about CI refund freezes. For example, as noted above, TAS initially is not permitted to inform the taxpayer about the freeze on the refund or any action that the taxpayer may be able to take to expedite a refund release.⁴⁰

When the IRS cannot communicate with taxpayers who are calling about their refunds, CI and the IRS are missing an important opportunity to move the case along. Communication encourages taxpayers making legitimate refund claims to substantiate their claims, puts the IRS on notice that it has possibly frozen a non- fraudulent claim, and demonstrates to fraudulent taxpayers that the IRS is looking at their returns and may take action.

In March of 2005, certain CI Fraud Detection Centers (FDCs) began issuing letters to some taxpayers in response to the taxpayers' inquiries about their delayed refunds. The letters advise the taxpayer that a problem with the return has been identified, invite the taxpayer to provide additional information to substantiate the refund claim, and indicate that falsifying refund claims is a crime. These letters are a positive development. However, not all FDCs send the letters, and some FDCs that did send them initially have stopped doing so, opting to give TAS language to utilize in its own letter. ⁴¹ A recent survey of Local Taxpayer Advocates indicates that four out of ten FDCs do not send the letters at all, while the other six send the letters only in some cases.⁴² Additionally, these letters are not standardized, as CI has not placed them on the IRS Correspondex system.⁴³ Thus, some similarly situated taxpayers are receiving different letters, while others are receiving no letters at all.⁴⁴

We recommend that all CI FDCs provide letters to taxpayers whose refunds are frozen by CI. In appropriate cases, notices should be sent at two points in the process:

• When CI temporarily freezes a refund, the letter should include an indication of how much delay the taxpayer might expect.

• When CI has determined not to issue a refund, the letter should include an explanation and a description of the taxpayer's procedural rights to challenge the claim disallowance, including access to TAS.

CI's Policy of Freezing Refunds Automatically For a Certain Number of Years After It "Determines" the Presence of Fraud on a Refund Claim Is Harming Too Many Law-Abiding Taxpayers

When CI determines fraud is present on a refund claim and places a Z freeze on the account, it automatically places a Z freeze on future refund claims until the taxpayer files a certain number of returns that CI deems legitimate. This policy negatively impacts taxpayers by subjecting them to the refund freeze process without regard to likely changes in their behavior. The policy is not based on statistical evidence that fraud is likely to recur within the specified number of years after fraud is found in an earlier year. Instead, the policy seems to be based on a generalized assumption that a taxpayer who has committed refund fraud is likely to repeat the fraudulent behavior in future years.

Given that a significant majority of taxpayers whose refunds were frozen were ultimately awarded full relief in our sample and that CI generally does not notify taxpayers that there has been a finding of fraud, the automatic freeze in future years is harsh and in our view reflects an absence of adequate taxpayer protections. In fact, among the decided cases in the TAS-CI study in which we could determine conclusively that there was a CI finding of prior-year fraud, 79 percent of the taxpayers (149 out of 189) ultimately received a full refund for the year at issue.

The burden on the IRS as a result of this policy is significant. Every year, the QRP freezes more cases because of both the volume generated by its annual data-mining and its policy of freezing anew any return placed into Z freeze status in the recent past. Moreover, the policy burdens other IRS functions -- including Accounts Management and TAS -- because they must handle increasing numbers of cases for which they did not plan.

We recommend that CI study the effects of its Z freeze procedures to determine what the optimum number of automatic freezes should be, if any. CI should consider developing "prior fraud" criteria based on sound research into the correlation of prior-year refund fraud and current-year fraud. The study should separately consider the likelihood of recurrent fraud where (1) the taxpayer has been put on notice that the IRS suspected fraud in a prior year and (2) the taxpayer has no reason to believe that the IRS suspected prior-year fraud.

CI Policy to Freeze Refund Claims Filed by Identity Theft Victims Automatically Is Overly Broad and Causes Significant and Continuing Inconvenience to Identity Theft Victims

The refund freeze process does not provide an adequate procedure to manually remove certain taxpayers once they are identified as compliant. Certain fact patterns will automatically generate a Z freeze each year, regardless of whether a prior-year return with identical circumstances was resolved in the taxpayer's favor. For example, when CI determines that two people have used the same Social Security Number (SSN) on different tax returns, it automatically enters a Z freeze on both taxpayers' returns. With the prevalence of identify theft, this situation is more common than in the past.⁴⁵ Although CI tells us that freezes in stolen identity cases may be released at any time, our experience indicates that CI often freezes refunds of the taxpayers involved year after year, even when the victim has been clearly identified. Thus, an honest taxpayer faces significant delays and burdens, in addition to the other problems associated with identity theft, to obtain his or her rightful refund.

In 27 cases reviewed in the TAS-CI study (six percent of the full sample), the taxpayers were victims of identity theft. In one case, the taxpayer fully expected that she would have to return to TAS each year to assist in a release of the refund freeze even though the IRS had long since identified this taxpayer as the rightful owner of the SSN. Other taxpayers in the TAS-CI study had Z freezes placed on their previous six or seven years' tax returns even though the IRS ultimately found no reason to have withheld any portion of the refunds claimed in any of those years.

The issue of identity theft -- and the problems the IRS faces in trying to address it systemically without placing greater burdens on the innocent taxpayer -- reaches far beyond QRP refund freezes.⁴⁶ In fact, we believe that a true fix for the QRP will require an IRS-wide system that identifies and notates which taxpayer is the victim. In the short term, however, we recommend that CI develop a method for identifying and screening out certain SSNs and names from the freeze process so that it does not harm taxpayers who have previously proven that their identities were stolen.

CI Lacks Adequate Resources to Promptly Investigate All Frozen Refund Claims

Once CI identifies a potentially fraudulent refund claim, it has one week to complete a verification process designed to validate the taxpayer's reported income and withholding. Due to the high volume of cases, there is often insufficient time within the allotted week to verify all cases. Refund claims not verified during the one-week process are designated with a P freeze (i.e., a temporary hold status).

In the post-verification stage, CI personnel are supposed to review the refund claims designated with P freezes that CI was unable to review in the verification process. The IRS releases frozen refunds if CI determines that a Z freeze is not warranted; however, the imposition of a Z freeze places the account in a permanent freeze status unless and until CI releases the freeze.

Once a case is designated with a Z freeze code, it may be referred to the Examination function for a correspondence audit.⁴⁷ CI refers cases to the Examination function electronically in bulk twice a year.⁴⁸ Once a case is accepted, Examination is required to log it onto the Audit Information Management System (AIMS) database so that other IRS personnel can determine which Examination office has responsibility for the audit.

However, CI does not refer many, perhaps most, refund freezes to Examination for final resolution. In processing year 2004, for example, CI reported that it identified more than 118,000 fraudulent returns, and it imposed freezes due to prior-year fraud and temporary freezes on perhaps 210,000 additional returns. For this same period, the Examination function indicated that CI referred approximately 56,000 cases for audit. Thus, the majority of returns were not referred to the Examination function for final disposition. If a case is not referred to Examination or is rejected by Examination because it does not meet referral criteria, the case remains in Z freeze status and the taxpayer may never be told of either the fact that the refund has been frozen or the reasons therefor unless the taxpayer initiates contact with the IRS.

If frozen-refund cases are never referred to or rejected by Examination, they may be left in permanent freeze status. In the TAS- CI QRP Study, TAS identified numerous cases that remained in Z freeze status for over three years. Moreover, CI was unable to tell us how many cases sit in the temporary P freeze status, and for how long, before CI personnel could determine whether the refunds should be released or placed in permanent Z freeze status. It is clear that CI is freezing more cases than it can timely work.⁴⁹

Other IRS Functions Have Inadequate Resources to Promptly Address the "Downstream" Consequences of CI Refund Freezes

As discussed above, the 180-day no-contact rule and the subsequent CI workload delays create work not only for TAS but also for IRS employees who answer the toll-free lines and handle IRS correspondence. Moreover, Examination appears to have difficulty handling the volume of cases that CI refers.⁵⁰ Because Examination must set aside potentially more productive cases to work some of CI's low-dollar QRP referrals and because the TAS-CI study demonstrates that a significant number and percentage of taxpayer refund claims deemed by CI to be fraudulent are legitimate, we recommend that CI recalibrate both the quality and number of refund freezes to match the resources available to work them.

Through the TAS-CI case study and a survey of Local Taxpayer Advocates co-located with FDCs, TAS identified at least two significant problems in the Examination referral process.

CI has suggested that TAS be responsible for transferring the case to the appropriate Examination office rather than waiting until Examination establishes the case on the AIMS database.⁵² However, this suggestion fails to recognize that the Examination function controls where its examinations are performed, and AIMS is TAS's only means of knowing to which Examination office the case is assigned. At a minimum, CI should better coordinate its Examination referrals so that other functions within the IRS, including TAS, can identify which Examination office has responsibility for the case.

These back-and-forth exchanges between CI and Examination and the continued control by CI over QRP Examination referrals duplicate work and lead to long delays for taxpayers. Examination should be fully informed of CI's concerns with respect to the refund claim and should be trusted to bring the cases it works to resolution. In our view, CI cases referred to Examination should be fully released to Examination. The Examination function can refer any case back to CI if Examination uncovers additional evidence of fraud.

CONCLUSION

The National Taxpayer Advocate believes that it is generally necessary to freeze questionable refunds before the refunds are issued. However, six core principles must guide this effort:

• Maximum effort needs to be devoted to reducing the high number and percentage of non-fraudulent refund claims that the IRS is now freezing.

• All taxpayers whose refunds are frozen should be notified of the freeze, given an opportunity to present substantiation in support of their claims, and advised of the availability of TAS and Low Income Taxpayer Clinics (LITCs) to assist them with their cases.

• Priority must be given to investigating cases quickly and achieving a reasonable degree of certainty about the existence of fraud prior to imposing a permanent freeze on the account.

• Cases referred to Examination should be referred for all issues and should be resolved in Examination without CI's continued control of the case.

• Innocent taxpayers should be systemically identified so that they do not have to go through the refund freeze process year after year.

• All refund claims require timely closure and a full and fair disposition.

In her discussion of Criminal Investigation refund freezes, the National Taxpayer Advocate correctly underscores the importance of the IRS Criminal Investigation (CI) organization as a key component of our nation's tax administration system. She also acknowledges that CI keeps millions of dollars from the hands of criminals each year. Unfortunately, the conclusions she reaches about the effect of the Questionable Refund Program (QRP) on eligible taxpayers are drawn from a significantly biased sample and therefore do not accurately represent the effects of the program.

The IRS is constantly working to strengthen our approaches in identifying and preventing fraud -- a number of recent changes are discussed later in this response. While we recognize there are opportunities for improvement, we believe the NTA has significantly overstated the problem.

CI performs an invaluable service to the American taxpayer. Since 1977 the IRS has stopped over $5.7 billion in fraudulent refund claims. Since 1999, IRS effectiveness in stopping fraudulent claims improved dramatically through enhanced technological systems and an increased dedication of resources. From 1999 until today the IRS has stopped over $3.1 billion in fraudulent refunds exclusive of two claims totaling $1.8 billion stopped in processing year 2004. Based on our experience -- identified fraud has jumped by 322 percent over the past six years -- we expect our workload to continue to grow substantially through the rest of the decade.

Part of the CI mission is to detect and stop schemes designed to steal money by people who file false and fraudulent returns. These claims, which defraud every law abiding American taxpayer, attempt to steal hundreds of millions of dollars each year and are proliferated through a broad variety of schemes, including false claims of the Earned Income Tax Credit and prisoner refund schemes. By temporarily delaying less than one half of one percent of refund requests, CI has stopped literally billions of dollars of false refunds to criminals of the legitimate tax dollars paid by honest taxpayers. This excludes the deterrent effect of preventing other refund fraud schemes when criminals learn that this crime does not pay.⁵⁵

We appreciate that the National Taxpayer Advocate acknowledges that the IRS cannot retreat from its critical efforts to stem fraud. Congress also holds the IRS accountable to stop theft from taxpayers and, just in 2005 has held hearings related to important areas that can be subject of refund fraud including the fuel tax credit, prisoner refund schemes and unscrupulous return preparers.

The IRS is constantly working to improve our fraud detection systems. We are keenly aware of the impact our fraud detection activities can have on legitimate taxpayers whose refunds may be temporarily suspended by our systems. That is why we continually strive to eliminate burden on compliant taxpayers through strategic approaches involving systemic and procedural improvements designed to surgically cull out fraudulent returns with minimal impact to legitimate refund returns.

Enhanced data mining systems have allowed Criminal Investigation to increase the detection rate of fraudulent returns and pass over legitimate returns with greater accuracy. In addition, CI evaluates data mining methodologies annually and modifies them based on known identified fraudulent returns. As a result of these enhancements, the accuracy of our identification process has increased. In 2004, the total number of potentially fraudulent returns identified by CI systems numbered approximately 500,000, which represent less than one half of one percent of the over 106 million refund returns filed during the 2004 processing year. Of all potentially fraudulent returns, CI verified that over 118,000 of those were in fact fraudulent which represented $2.2 billion in false claims (including 2 claims for $1.8 billion). In processing year 2005, so far, CI systems have identified approximately the same number of potentially fraudulent claims (500,000) but a higher percentage of those have verified as fraudulent.

The National Taxpayer Advocate's report contains several misleading analytical conclusions. Of particular concern to the IRS is the inaccurate extrapolation of TAS cases to the total universe of CI refund freezes and the erroneous characterization of CI statistics.

First, TAS's conclusion regarding the pool of innocent taxpayers negatively affected by CI account freezes was based on an extrapolation from a limited sample of TAS cases. Innocent taxpayers are much more likely to contact TAS than those who have filed false or fraudulent returns. To extrapolate their conclusions from TAS cases to the whole universe of stopped refunds inflates the universe of innocent taxpayers affected by CI fraud detection programs. TAS acknowledges its extrapolated conclusion is unreliable.⁵⁶

Second, the TAS report relies on inaccurate and misleading data. The TAS report erroneously included returns on which CI had not yet made a final fraud determination in the pool of cases on which they based their statistical conclusions. Thus, they are inflating the number of frozen refund cases that are ultimately resolved in the taxpayer's favor through TAS intervention. Only those returns conclusively determined to be false are placed in CI's Scheme Tracking and Referral System (STARS) and reported in our revenue protection statistics.

The IRS is taking a number of steps to improve our Refund Crimes Program. We concur with TAS that additional resources and improved technological efficiencies would help address the growth in fraud. We also agree that we should ensure taxpayer accounts involving withheld refunds are reviewed and resolved expeditiously, so legitimate refunds are released in a timely manner. Criminal Investigation is currently taking the following steps to improve the Refund Crimes Program by enhancing fraud detection while minimizing negative impact on legitimate taxpayers:

• The new Web-based Electronic Fraud Detection System (EFDS) is scheduled for implementation in processing year 2006. One of the major features in this new system will make the Fraud Detection Centers (FDC) more efficient at stopping refunds and provide better management oversight of those refunds that have been stopped.

• Comparison of Earned Income Tax Credit (EITC) returns to the Health and Human Services National Directory of New Hires (NDNH) database is scheduled during processing year 2006. The integration of the HHS system with Web EFDS will enhance the validation process by reducing the burden on employers to verify W2 information/employment and will reduce the impact on legitimate taxpayers by allowing CI to verify income and release legitimate refunds more quickly.

• Recently, CI forwarded letters to employers requesting a more efficient manner of wage verification through fax only contact or electronic media payroll information. This will supplement the NDNH process since not all taxpayers flagged by our process claim EITC or have NDNH data.

• Criminal Investigation will continue to review workload and reallocate employee verification work among FDCs to resolve staffing imbalances.

• In March 2005, CI began issuing Taxpayer Refund Inquiry Letters advising taxpayers that their employer has indicated the wages/withholding were incorrect or that they were not employed. Taxpayers are advised to send any further information to resolve tax matters. CI acknowledges that communications with taxpayers on potentially fraudulent returns is an issue. These communications are limited due to the sensitivity of the potential criminal investigation.

• In June 2005, CI entered into a Service Level Agreement (SLA) with TAS to formalize our mutual concerns and commitment to seek satisfactory remedies.

• Criminal Investigation is partnering with the Federal Trade Commission (FTC) in an attempt to alleviate the impact CI has on victims of identity theft.

TAXPAYER ADVOCATE SERVICE COMMENTS

We appreciate the openness the CI leadership has shown in discussing its Questionable Refund Program (QRP) with us and in working with us to address the ballooning inventory of CI cases in TAS. We acknowledge the efforts that CI is making to address problems in the QRP. However, the QRP program, as currently administered, raises serious questions about the adequacy of protection for taxpayer rights to a greater degree than any program previously evaluated by the National Taxpayer Advocate.

Based on data from FY 2004, CI may be freezing more than 1.6 million refund claims over a five-year period on a suspicion of taxpayer fraud -- without notifying the taxpayers involved of its suspicion of criminality or giving the taxpayers an opportunity to provide documentation to support their refund claims. In hundreds of thousands of these cases, CI claims to have made a "conclusive" determination of taxpayer fraud -- and in its Comments above even brands the individuals who filed the claims as "criminals." Yet even in cases where CI has made "conclusive" determinations of fraud and characterized the taxpayers as "criminals," it has not provided the affected taxpayers with any notice or opportunity to present documentation to rebut CI's suspicion before a final "determination" is made.⁵⁷

At a minimum, this procedure constitutes an extraordinary violation of fundamental taxpayer rights and fairness. In our view, it may also constitute a violation of due process of law.

Our concern is heightened by the QRP's limitations in identifying appropriate refund claims for freezes and in making accurate determinations about whether fraud has occurred. As detailed in our initial write-up above and in a research study presented in Volume II of this Report, TAS conducted a survey of a statistically representative sample of cases that were closed by TAS during FY 2004 and the first six months of FY 2005. Among all decided cases in our study where CI had frozen a taxpayer's refund, 66 percent ultimately received a full refund (or more) and an additional 14 percent received a partial refund. Among the decided cases in our study where CI had made a "conclusive" determination of taxpayer fraud, taxpayers ultimately received a full refund in 46 percent of the cases.

TAS estimates that the number of taxpayer refund claims frozen over a five-year period may exceed 1.6 million, although CI does not maintain data on the overall number of refund claims it freezes.

There are at least three distinct categories of refund freezes that affect taxpayers:

• The first category includes refund freezes imposed after CI has reviewed a return and made a "determination" of fraud.

• The second category includes refund freezes imposed on all returns where CI has previously made a "determination" of fraud and until the taxpayer has filed a certain number of "legitimate" returns, as determined by CI ("prior-year fraud").

• The third category includes temporary refund freezes imposed while CI investigates whether to classify a refund claim as fraudulent.

For FY 2004, CI reports that more than 118,000 returns were fraudulent. Among the sample of TAS cases we reviewed for FY 2004 and the first half of FY 2005, we believe that the percentage of the total number of cases in which CI made a determination of fraud was 36 percent. If the percentage of cases in TAS could be accurately projected to the full universe of CI cases, one could extrapolate that the number of cases frozen for other reasons, primarily automatic freezes due to a finding of prior-year fraud, is about 210,000, which in turn suggests a total of 328,000 freezes in FY 2004.⁵⁸ This estimate is generally consistent with statements made by CI officials that they believe the number of freezes imposed due to prior-year fraud determinations probably exceeds the number of freezes imposed due to determinations of current-year fraud. Although the TAS sample included 37 cases in temporary-freeze status (about eight percent of TAS's frozen-refund cases), extrapolating this number almost certainly understates the overall number of temporary freezes CI imposes because most temporary freezes are released prior to the time a taxpayer would seek assistance from TAS.

We acknowledge that TAS's caseload is not necessarily representative of the total universe of QRP refund-freeze cases. However, in the absence of any CI data on the total number of refund freezes and in light of CI's statements to TAS that the number of freezes imposed due to prior-year fraud determinations probably exceeds the number of freezes imposed due to determinations of current-year fraud, we believe our estimate of 328,000 freezes in FY 2004 provides the most useful ballpark number obtainable. We make no projection about the number of additional temporary freezes.

If our ballpark estimate of freezes in FY 2004 were extended over a five-year period, it suggests that more than 1.6 million refund claims are frozen. In its Comments, CI states that it expects its QRP workload will "continue to grow substantially through the rest of the decade," and that in FY 2005, it has made administrative determinations of fraud in a higher percentage of cases than in FY 2004. More current-year fraud determinations mean that more refund claims will be frozen in future years due to CI's policy of freezing refund claims when it has previously found fraud. The increasing number of refund freezes thus compounds each year and is projected to continue to increase.

In the sample of TAS cases reviewed, a significant majority of taxpayers whose refund claims were frozen were ultimately found not to have committed fraud -- and the financial burden of the freezes on these taxpayers was significant.

Among the decided cases in our sample of QRP cases, CI ultimately agreed to release the full amount of the refunds claimed in 66 percent of the cases. It awarded partial refunds in 14 percent of the cases. Thus, taxpayers received full or partial refunds in fully 80 percent of the decided cases in our sample.

The median Adjusted Gross Income (AGI) of taxpayers whose refunds were frozen but ultimately released was $13,330, and the median refund was $3,519. Thus, the refund constituted, on average, more than 26 percent of the claimant's AGI for the year, and these taxpayers were required to wait, on average, more than 8 1/2 months to receive their refunds. The financial impact on these taxpayers was substantial.

At this point, we do not know whether the results of cases that come to TAS are representative of the full universe of QRP cases. CI believes that TAS cases are not representative, stating, "Innocent taxpayers are much more likely to contact TAS than those who have filed false or fraudulent returns."

The IRS has long suspected that taxpayers who choose to pursue refund claims may be more likely to deserve refunds than taxpayers who do not pursue their claims. While that view has intuitive appeal to individuals who know how to navigate the bureaucracy, many deserving taxpayers do not pursue legitimate refund claims. Many low income taxpayers do not speak English, do not keep complete records, and have no idea how to approach an agency like the IRS. Lacking knowledge of the tax laws, they may even mistakenly assume the IRS has processed their returns properly. Alternatively, taxpayers may be afraid that if they stand up for their rights, the IRS will retaliate, however groundless such a fear may be.

Last year, TAS conducted a study of EITC audit reconsideration cases that, in part, was designed to determine whether taxpayers who respond to IRS notices are more likely to be entitled to receive refunds than taxpayers who ignore IRS notices. Significantly, the study found that the two groups were equally likely to be entitled to refunds.⁵⁹

We do not claim that the results of TAS's cases are representative of the full universe of QRP cases, but neither do we concede that the results are not representative. Unless and until a more thorough study is conducted, the truth is that no one knows. If the results of TAS cases turn out to be representative of the full universe of QRP cases -- which is quite possible -- then it would appear that out of roughly 1.6 million refunds frozen over a five- year period based on FY 2004 data, taxpayers in more than one million of those cases are entitled to the full amount of the refunds they claimed.⁶⁰

Existing QRP procedures clearly violate taxpayer rights and may violate due process rights as well.

Transparency is a bedrock requirement for a fair tax system. Taxpayers should understand how their tax liabilities are computed, and taxpayers should be advised of any adverse actions the IRS takes or is planning to take as well as the basis for those actions. Where the IRS proposes to take adverse action against taxpayers, due process requires that taxpayers be informed of their rights to challenge that action. Moreover, the tax collector, in particular, owes taxpayers a duty of basic courtesy and fair dealing. It is not courteous and it is not fair dealing for the government to freeze hundreds of thousands of refund claims every year without advising the affected taxpayers of the contemplated action and giving the taxpayers an opportunity to present evidence to support their positions.

The National Taxpayer Advocate further believes that the existing QRP procedures may violate due process protections. It is a central tenet of American law that the government must notify an accused person of the offense it suspects he committed and must give the accused person an opportunity to present exculpatory evidence to show his innocence. In defending its policy of making fraud determinations before notifying taxpayers and before giving them an opportunity to present documentation, CI likely would point out (1) that the IRS ordinarily is not required to respond to a refund claim⁶¹ and (2) that the government does not criminally prosecute the overwhelming majority of the taxpayers whose refunds it freezes, and in the absence of a criminal prosecution, these taxpayers do not acquire due process rights.⁶²

It is clear that the IRS is not obligated to respond to routine refund requests (although we believe it is preferable that the IRS respond). However, it is longstanding IRS policy that where a taxpayer asserts a refund claim on a tax return, the IRS should proceed under deficiency procedures. Where deficiency procedures are not possible or practicable because the statutory period for assessment is about to or has already expired, the IRS advises the taxpayer of his or her right to file a suit in federal district court or the U.S. Court of Federal Claims. Where CI controls a case, however, its procedures do not require that taxpayers be advised of any such protections until considerable time has expired, if ever, and CI does not have the authority to issue notices of deficiency.

In QRP cases, moreover, the IRS is investigating whether individuals have committed fraud. There is a significant distinction between a mere overclaim and fraud. A finding of fraud represents a determination that an individual has deliberately sought to steal money from the government. The government, in these cases, may seek to assess criminal or significant civil penalties. Even where it does not take these steps, the three-year period of limitations on assessing additional tax does not apply to returns determined to be fraudulent, so the authority of the IRS to assess additional tax never expires. Moreover, the IRS automatically freezes future refund claims filed by the taxpayer until the taxpayer has filed a certain number of "legitimate" returns -- again, as determined by CI without consulting with the taxpayer.

The National Taxpayer Advocate believes violations of due process of law exist where (1) IRS's criminal investigation function (2) makes more than 100,000 "final determinations" of fraud each year which means that (3) the standard three-year period of limitation on assessing additional tax never expires, (4) CI characterizes these tax filers as criminals, and (5) CI automatically freezes future refund claims filed by these individuals⁶³ -- all without notifying the taxpayers of CI's suspicion of fraud or giving the taxpayers an opportunity to rebut the suspicion before a determination is made.

The "revenue protection" claims made by CI are inaccurate precisely because CI makes final determinations without providing taxpayers with a meaningful opportunity to rebut its allegations of fraud.

On its website, in congressional testimony, and in its response above, CI makes assertions regarding the amount of "revenue protected" by the QRP as if its data are infallible -- almost as if the data reflect the results of criminal prosecutions.

In its response, for example, it states that "[s]ince 1977, the IRS has stopped over $5.7 billion in fraudulent refund claims," "[o]f all potentially fraudulent returns [identified in FY 2004], CI verified that over 118,000 of those were in fact fraudulent," and "[o]nly those returns conclusively determined to be false are...reported in our revenue protection statistics."

In fact, CI's revenue protection statistics are inaccurate, and we find it remarkable that a criminal investigation function of the United States government is making "final," "conclusive[]" determinations of fraud without notifying the individuals it suspects of committing the fraud. To be clear, individuals accused of committing an offense are not generally required to be notified solely as a courtesy. They are notified because they often possess information that would lead a decision maker to reach a different conclusion about guilt or innocence. Because CI does not give individuals an opportunity to present their cases before reaching its conclusions, it is hardly surprising that its revenue protection statistics are inflated.

Among cases that came to TAS, our study examined a subset of returns in which we believe CI reached a conclusive determination of current-year fraud and thus included the taxpayers and the associated amount of frozen refunds in its "revenue protection" statistics. After we assisted these taxpayers in presenting their cases, CI ultimately agreed that 46 percent of the taxpayers were entitled to full refunds.

Moreover, as noted above, there is a significant distinction between an overclaim that results from error and an overclaim that results from fraud. Even leaving aside the percentage of cases included in CI's revenue protection estimates in which taxpayers are entitled to full refunds, we suspect that a significant percentage of additional claims reflect mere error, or even negligence, rather than fraud. To label all such cases as fraud is misleading, subjects the affected taxpayers to automatic refund freezes in the future, and constitutes a disservice to the integrity of this country's taxpayers.

RECOMMENDATIONS

² For FY 2004, CI stated that it identified 118,000 fraudulent returns. In addition, CI automatically froze a significant number of refunds in cases where CI had determined fraud to exist in a prior year but had not yet made a determination about current-year fraud. CI does not track how many refund freezes it imposes due to prior-year fraud. However, CI officials have told us that the number of refunds frozen due to prior-year fraud determinations probably exceeds the number of refunds frozen due to current-year fraud determinations. A research study of QRP cases that come to TAS showed that about 36% of the cases involved current-year fraud determinations, about 56% involved freezes imposed due to prior-year fraud, and about 8% reflected temporary freezes imposed to give CI more time to conduct investigations. If the TAS sample is projected to the full universe of CI cases, the result suggests that CI froze 210,000 cases, primarily due to prior-year fraud and secondarily to temporary freezes, for a total of 328,000 frozen returns (118,000 for current-year fraud and 210,000 for prior-year fraud and temporary freezes). In fact, this projection almost certainly understates the number of temporary freezes CI imposes because most temporary freezes are imposed prior to the time a taxpayer would seek assistance from TAS and thus would not be reflected in our numbers. In the TAS sample, taxpayers received a full refund (or more) in 66 percent of all decided cases and a partial refund in an additional 14 percent of decided cases. Taken together, these numbers suggest that the number of refunds improperly frozen could well be in the hundreds of thousands each year. We emphasize that the TAS sample cannot be reliably projected to the full universe of CI cases to reach a firm conclusion on this point. However, the numbers involved are sufficiently high that we believe CI should undertake an immediate review of its own to determine the number of taxpayers entitled to full refunds whose returns are now being frozen. This study should separately assess (1) cases where CI has frozen refunds and determined current-year fraud, (2) cases where CI has frozen refunds based on prior-year fraud, and (3) cases where CI has imposed temporary refund freezes.

³ "Processing year" refers to the year in which taxpayers file their returns at the IRS Submission Processing sites. Thus, tax returns processed in a processing year may include returns filed for earlier tax years.

⁴ For purposes of the TAS study, we considered a current or prior year return as having an element of fraud if the taxpayer's refund was reduced or reversed while the module was in freeze status. Because CI sometimes identifies fraud after the refund is released, we also considered fraud to be present if the refund was released and CI later placed a freeze on the module during the same calendar year. Thus, the TAS study uses a very broad definition of fraud. Because TAS did not determine the reason why all or part of the refund was disallowed, it is likely that the study overstates the number of cases that have elements of fraud.

⁵ We cannot project whether the CI error rate in QRP cases that come to TAS is representative of the CI error rate for all QRP cases. On the one hand, it is certainly possible that taxpayers who choose to pursue their claims are more likely to be entitled to their refunds than taxpayers who do not pursue their claims. On the other hand, TAS conducted a study last year of taxpayers whose EITC claims were denied and sought audit reconsideration. When the IRS contacted these taxpayers to request more information during the original audit, 58 percent responded timely and 42 percent either did not respond or responded after the deadline. Although many research and academic experts who have examined the EITC program had assumed that non-responders and late responders would be less likely to qualify for EITC benefits than taxpayers who timely responded to requests for information, the study showed that both groups qualified at the same rate. This result is not altogether surprising. For EITC taxpayers -- many of whom have low education levels, keep limited records, and may be intimidated at the prospect of battling against the IRS -- the failure to pursue a claim may reflect nothing more than difficulty in determining how to pursue it. See National Taxpayer Advocate 2004 Annual Report to Congress, Vol. II, Earned Income Tax Credit (EITC) Audit Reconsideration Study. The population of taxpayers whose refunds are frozen by the QRP is probably similar. In our sample, about 75 percent of taxpayers whose refunds are frozen claim the EITC and the median adjusted gross income of these taxpayers was under $14,000.

⁶ For a more detailed discussion of the legal standards and penalties relating to fraud, see Volume II of this Report.

⁷ IRC §§ 7201 & 7206 (criminal sanctions); IRC § 6663 (civil sanctions).

⁸ IRC § 6501(c)(1).

⁹ IRC § 7454(a).

¹⁰ In stolen identity cases, CI reports that freezes may be released at any time.

¹¹See Hearing before the Senate Committee on Finance on the Tax Gap, 109th Cong. (April 14, 2005) (statement of Nancy J. Jardini, Chief, IRS Criminal Investigation) ("During processing year 2004 CI reviewed nearly 500,000 questionable refund returns. Of those, they identified more than 118,000 fraudulent tax returns and stopped fraudulent refunds totaling more than $2.1 billion."); see also Hearing before the HouseWays and Means Subcommittee on Oversight on Prisoner Fraud, 109th Cong. (June 29, 2005) (statement of Nancy J. Jardini, Chief, IRS Criminal Investigation) (making essentially the same statement).

¹²See Hearing before the House Ways and Means Subcommittee on Oversight on Prisoner Fraud, 109th Cong. (June 29, 2005) (statement of Nancy J. Jardini, Chief, IRS Criminal Investigation) (stating that the overall 2004 estimate includes one scheme with two tax returns totaling $1.8 billion).

¹³ To provide perspective, an Inspector General's study of the QRP for the January through September period in 1999 (during which substantially all 1998 refund claims were filed) noted that the QRP detected about $108 million in fraudulent refund claims. See Treasury Inspector General for Tax Administration, Ref. No. 2001-40-025, Revised Questionable Refund Program Procedures Were Not Consistently Implemented (Jan. 2001).

¹⁴ As noted elsewhere in this discussion, CI ultimately agreed that the taxpayers were entitled to a full refund in about two-thirds of all decided cases in our sample and to full or partial refunds in 80 percent of the decided cases in our sample. For purposes of its "revenue protection" estimates, however, CI told us that it only includes cases that it has determined to be fraudulent in the current year -- not cases flagged solely because of a prior- year fraud determination. In the sample of cases we examined, we identified 171 returns in which we believe potential fraud was detected for the first time (i.e., the returns were placed into "Z freeze" status yet there was no history of "Z freezes" in prior years). Of these 171 returns, 65 resulted in full refunds, and 29 were still undecided. Thus, it appears that in about 46 percent of the decided cases in our sample where CI had determined that taxpayers had submitted fraudulent returns and included the taxpayers and the dollars frozen in its "revenue protection" estimate, CI ultimately agreed that the taxpayers were entitled to receive the full amount of the refunds they claimed on their original returns.

¹⁵ The overall refund amount in the sample includes a single refund of $1,359,175. It is possible that this refund renders the overall result unrepresentative of overall cases. Even if we exclude this refund, however, 71 percent of the dollars frozen in the sample ($1,098,134) was ultimately and correctly paid out.

¹⁶ For a more detailed discussion of the refund claim and refund suit procedures, see Volume II of this Report.

¹⁷ IRS Pub. 55B, Data Book, FY 2003, (rev. 3- 2004), Table 18, 52; see also IRM § 9.5.3.2.1.

¹⁸ CI also maintains the Return Preparer Program (RPP), which attempts to identify returns prepared by tax return preparers who engage in tax fraud. IRM § 9.5.3.2.6. Because the vast majority of frozen refunds are frozen through the QRP, this analysis focuses primarily on the QRP. For FY 2004, CI determined that 118,075 refunds were deemed fraudulent through the QRP, as compared with 2,426 in the RPP. Over a recent 3-month period, only 35 cases of the approximately 3,436 new CI refund freeze cases in TAS were related to the RPP.

¹⁹ The IRS Revenue Protection Strategy consists of four elements:

• Understanding Fraud: Knowledge of the Revenue Protection Strategy and its relationship to the overall mission of the IRS;

• Prevention: Outreach and education efforts to ensure that taxpayers understand how, when and where to file complete and accurate returns;

• Detection: Identification of areas that must be protected against fraud and abuse before refunds are paid; and o Enforcement: A combination of criminal prosecution and other enforcement initiatives.

²⁰Id.

²¹ In processing year 2004, CI screened more than 100 million refund returns through data-mining software. Criminal Investigation, Presentation to the Taxpayer Advocate on the Questionable Refund Program (March 2005).

²² IRS Criminal Investigation FY 2000 National Operations Annual Report 33; see IRM § 9.5.3.2.2.2 (Sources of Refund Fraud Investigations).

²³ Virtually all of the CI cases received by TAS relate to QRP refund freezes. However, the statistics for years prior to FY 2005 include all CI-controlled cases received by TAS, and a very small number related to other issues. Beginning in FY 2005, TAS began to track refund-freeze cases separately, so the numbers in this chart reflect exclusively QRP and Return Preparer Program (RPP) cases. In FY 2005, there were 26,318 QRP cases and 187 RPP cases. (In FY 2005, there were 26,206 cases excluding 112 cases coded as Criteria 9 -- the Local Taxpayer Advocate has determined it is in the best inerest of the taxpayer for TAS to be involved).

²⁴ The full results of the TAS-CI Frozen Refund Study are set forth in Volume II of this Report.

²⁵ A sample size of at least 384 cases was required to obtain a 95 percent confidence level in the results of the review. A 95 percent confidence level means that conclusions with respect to the sample have a 95 percent likelihood of being applicable to the population from which the sample was drawn. Originally, 500 cases were selected for the study. Twenty-seven of those cases were subsequently removed from the sample because they did not fall within the sample parameters (i.e., they involved closed TAS-CI cases with frozen refunds) or because of lack of available data.

²⁶ Data were extracted from the Compliance Research Information Tracking System (CRITS). CRITS extracts the requested data elements for the specified taxpayer identifying numbers (TINs) from the online Master File. Because of the relationship between the limited number of past years for which CRITS data are available and the number of years for which IRS freezes refund claims based on its finding of prior-year fraud, TAS could not conclusively determine the full applicability of the look-back rule for the earliest tax years potentially involved.

²⁷ While the TAS research staff used Master File data, the staff also compared the results of the Master File analysis to the results of the manual review in order to identify and resolve any discrepancies between the two approaches.

²⁸ As noted above, a sample size of 384 cases was required to obtain a 95 percent confidence level in the results of our study. The number of decided cases in the sample was 398. Therefore, our sample size of decided cases is large enough to permit analysis within the established parameters of statistical reliability.

²⁹ In 25 of those 29 cases, the taxpayer had already received a refund and was probably unaware that CI subsequently detected possible fraud. Significantly, the study results show that when taxpayers were clearly aware that the IRS suspected fraud, very few taxpayers committed fraud in future years.

³⁰ In these 75 cases, as of the time TAS researchers first reviewed the sample, the IRS had not yet made any adjustments to the refunds and had not yet made any referrals of these cases to the Examination function. Of the 75 cases, 19 involved tax year 2002 and had been in frozen status for two years without any action being taken, while 47 of the cases involved tax year 2003 and thus had been frozen for at least one year without any adjustments or referrals to Examination taking place. TAS researchers have since reexamined these 75 cases and found that the IRS has taken action on 20 of these cases, giving full refund relief to 15 of the taxpayers and denying full refund relief to five of the taxpayers.

³¹ These percentages add to more than 100 percent due to rounding.

³²See note 14, supra.

³³ For FY 2004, the Treasury Department paid out more than $227 billion in refunds to individual taxpayers. IRS Data Book, FY 2004, Publication 55B (rev. 3-2005), Table 1.

³⁴ For example, representatives from CI provided examples of fraudulent returns with fake Forms W-2 that were of excellent quality.

³⁵ CI has told us that the use of data mining has resulted in a 73 percent reduction in workload and a 55 percent increase in fraudulent returns identified. These statistics are commendable on their face, but in light of the significant percentage of refunds frozen where no fraud exists and the lengthy delays taxpayers experience as a result of the large number of freezes that require employee work, these statistics do not necessarily demonstrate that the fraud detection process has improved overall.

³⁶ In order to prevent questionable refunds from being automatically issued, CI delays -- or "resequences" -- these claims for one week so that it can determine whether it should freeze the claims. CI routes cases through a verification process designed to validate the taxpayer's reported income and withholding. Here, CI either releases the refund or freezes the case under one of two codes. A "Z freeze" indicates that CI views the refund claim as fraudulent and is viewed as a permanent freeze. A "P Freeze" is a temporary freeze that allows the IRS to perform further investigation of the refund claim. A P freeze indicates that CI was unable to review the refund claim during the one-week period allotted by resequencing.

³⁷ IRM § 13.1.10.9. An exception exists for TAS economic hardship cases. For a description of the exception, see Service Level Agreement Between The National Taxpayer Advocate And The Chief, Criminal Investigation (effective June 1, 2005).

³⁸ For a detailed discussion about the types of and reasons for noncompliance, see Leslie Book, The Poorand Tax Compliance: One Size Does Not Fit All, 51 Kan. L. Rev. 1145 (2003). Professor Book draws largely from the social science perspective offered by Professors Robert Kidder and Craig McEwen. See Robert Kidder & Craig McEwen, Taxpaying Behavior in Social Context: A Tentative Typology of Tax Compliance and Noncompliance, 2 Taxpayer Compliance 47 (1989).

³⁹ IRM § 13.1.10.9(5).

⁴⁰ IRM § 13.1.10.9(1).

⁴¹ Effective June 1, 2005, CI and TAS entered into a Service Level Agreement (SLA) which sets forth procedures governing how cases will be worked. The SLA also provides that either CI will send the letter when the taxpayer inquires about a frozen refund or CI will provide language to TAS so that TAS can send the letter.

⁴² Of the six FDCs that send the letter, one FDC sends the letters only on Z freeze cases (i.e., when the IRS has made a final determination on the case), but not when the case is still in P freeze (temporary freeze) status. Another FDC sends the letter in some but not all circumstances, such as when the case is being referred to Examination.

⁴³ Correspondex is the IRS's correspondence system. Use of Correspondex ensures that IRS letters are evaluated for tone, clarity and content.

⁴⁴ Current refund-freeze procedures contrast sharply with the description of QRP procedures provided by then-IRS Commissioner Margaret Milner Richardson in 1996:

⁴⁵ Identity theft is increasingly common throughout the United States, with 500,000 to 700,000 people becoming victims every year. Identity Theft: The Nation's Fastest Growing Crime Wave Hits Seniors, Hearing Before the Senate Special Committee on Aging, 107th Cong. (2002) (statement of Alice S. Fisher, Deputy Assistant Attorney General, Department of Justice Criminal Division).

⁴⁶ For a more detailed discussion of the IRS challenges in dealing with identity theft, see Most Serious Problem: Identity Theft, infra.

⁴⁷ IRS employees are also instructed to make referrals to CI when they identify potentially fraudulent taxpayer behavior in the course of their regular official duties. Numerous Internal Revenue Manual sections describe how referrals should be made to CI, including IRM § 5.1.11.4.7, which describes how Collection personnel make referrals to CI; IRM § 8.2.1.2.2, which describes how Appeals personnel make referrals to CI; and IRM § 4.1.4.16, which describes Examination personnel's referral obligations to CI.

⁴⁸ If a TAS Operations Assistance Request or a refund inquiry is submitted on a case scheduled to go to Examination, the case is handled as a manual QRP referral.

⁴⁹ At one FDC, volumes of refund freeze cases were so vast that the FDC asked TAS to detail its employees to work through CI's caseload. While this practice was the product of well-meaning IRS employees, the National Taxpayer Advocate stopped this practice immediately when she learned about it due to concerns about the ethical and legal implications of TAS employees' working on behalf of CI.

⁵⁰ In FY 2004, CI referred 25,096 cases to the IRS Examination function in the Small Business/Self-Employment Division (SB/SE). In FY 2005, CI case referrals increased by 13,470 cases to 38,566. In FY 2004, SB/SE accepted 23,687 CI cases for assignment, but closed only 17,890 with examined disposal codes. With respect to the Wage & Investment Division (W&I), 20,465 CI referrals were accepted for audit but only 16,140 were audited and closed with audit indicators. These data were provided in responses to TAS information requests by the Small Business/Self Employed Division (July 29, 2005) and the Wage & Investment Division (July 22, 2005).

⁵¹ This problem also impacts taxpayers and their representatives when they try to determine where in the IRS their refund claim cases reside.

⁵² In its response to a TAS information request provided on Aug. 26, 2005, and supplemented on Sept. 14, 2005, the Criminal Investigation Division suggests:

⁵⁴Id.

⁵⁵ Over the past two years CI has recommended prosecution on 442 individuals who have engaged in refund fraud. For the same time period, 286 individuals were sentenced by federal district courts for this conduct and received an average of 20 months incarceration.

⁵⁶ TAS report to Congress dated 12/31/05, MOST SERIOUS PROBLEM: Criminal Investigation Refund Freezes; Footnote 1. "We emphasize that the TAS sample cannot be reliably projected to the full universe of CI cases to reach a firm conclusion on this point."

⁵⁷ At most, CI advises taxpayers that their employers' wage reports do not agree with the information provided by the taxpayers. These letters are not sent to taxpayers on a consistent basis. Moreover, they do not advise taxpayers that failure to present evidence will result in a "determination" of criminal fraud.

⁵⁸ The TAS sample included 473 frozen-refund cases, and as best we could determine, 171 of those cases, or 36 percent, reflected "final determinations" of fraud. In FY 2004, CI states that it determined fraud in 118,000 cases. Thus, the TAS sample suggests that the total number of frozen-refund cases was about 328,000 (i.e., 118,000 divided by 36 percent), which includes about 210,000 cases in which CI had not made determinations of fraud. We reiterate that the TAS sample is not necessarily representative of non-TAS cases, so we cannot make projections to the broader universe of CI cases with a high degree of confidence. But in the absence of any CI data on the total number of refund claims it freezes, we believe this is the best ballpark estimate available.

⁵⁹ National Taxpayer Advocate 2004 Annual Report to Congress vol. II, at 9. Among the cases analyzed in TAS's EITC audit reconsideration study, half the cases were generated by taxpayers who approached the IRS directly and half the cases were generated by taxpayers who approached TAS for assistance in dealing with the IRS. Although taxpayers who worked through TAS fared slightly better, the relief rate was substantially the same for both groups. This result further suggests CI's assumption that innocent taxpayers are more likely to come to TAS is not necessarily accurate.

⁶⁰ CI officials have shown us numerous cases that, on their face, appear to be flagrant examples of fraud. For example, there are cases where taxpayers report Form W-2 wages to obtain EITC refunds but where the employer's name and identifying number on the W-2 do not exist. We don't doubt that there are thousands of these egregious cases every year. But our own experience with CI's frozen- refund cases illustrates that there are also many cases where taxpayers are fully entitled to receive their refunds, and if taxpayers are not afforded an opportunity to submit documentation, it is difficult to know when an apparently egregious violation may be easily and persuasively explained.

⁶¹ IRC § 6532(a) provides that a taxpayer may file a refund suit for up to two years from the date the IRS issues a notice of disallowance in response to a refund claim. Implicit in this statute is that the IRS is not obligated to issue a notice of disallowance and that, in such cases, the taxpayer retains the right to file a refund suit in perpetuity.

⁶² In its response, CI speaks of a "deterrent effect" of the QRP "when criminals learn that this crime does not pay." By CI's own statistics, however, it determined fraud in more than 118,000 cases in FY 2004, yet over the past two years, it recommended only 442 individuals for prosecution and persuaded a court to sentence only 286 individuals. If we assume half the recommended prosecutions and convictions over the two-year period occurred in FY 2004, these statistics indicate that only about 1.9 out of every 1,000 individuals who file fraudulent returns are recommended for prosecution and only about 1.2 out of every 1,000 such individuals are convicted and sentenced. If CI routinely sent letters to taxpayers suspected of committing fraud and engaged them earlier in the process, it appears to us that the existence of its Refund Crimes Program would become more widely known and the deterrent effect would increase substantially.

⁶³ CI's policy of automatically freezing future refund claims is particularly questionable. Not only does CI make a determination of fraud that may be erroneous in Year 1 without advising the taxpayer, but it then automatically freezes future refunds based on the Year 1 determination until the taxpayer has filed a certain number of "legitimate" returns (again, as determined by CI). We are not aware of any studies showing that the look-back period CI uses is optimal for detecting future fraud, and in fact, four out of every five taxpayers in our survey of TAS cases whose refunds were frozen due to CI's "finding" of prior-year fraud ultimately received a full refund.

MOST SERIOUS PROBLEM: THE CASH ECONOMY

RESPONSIBLE OFFICIALS

Underreporting of tax is the single largest component of the "tax gap," accounting for 80 percent of the tax gap or $251 billion to $291 billion per year.¹ Although the IRS has no direct estimate of the portion of the tax gap attributable to the so called "cash economy," IRS researchers estimate that taxpayers primarily underreport income that is not subject to withholding or information reporting, i.e., income from the cash economy.² According to the IRS, taxpayers report:³

• 99 percent of the income subject to withholding (e.g., wages),

• 96 percent of the income subject to third-party information reporting (e.g., interest),⁴ and

• 68 percent of the income not subject to withholding or information reporting (e.g., inventory sales proceeds).

Except for costly field examinations, the IRS's traditional enforcement tools are unlikely to be effective in detecting unreported income from the cash economy because they rely on information reporting. The IRS has a number of initiatives that could be effective if coordinated and pursued more aggressively. However, no single function coordinates research, outreach, and compliance initiatives aimed at improving reporting compliance among cash economy participants. Nor does the IRS give these initiatives the same level of attention as other initiatives, such as those addressing tax shelters or the Earned Income Tax Credit. The IRS must develop a comprehensive strategy for addressing the cash economy if it is to significantly reduce the tax gap.

ANALYSIS OF THE PROBLEM

Background

The Tax Gap

The tax gap generally represents the gap between the amount of tax that taxpayers are required by law to pay each year and what they actually pay on a timely basis. The IRS's most recent estimates, based upon returns for the 2001 tax year, indicate that the gross tax gap is between $312 billion and $353 billion.⁶ After accounting for amounts the IRS receives as late voluntary payments or as a result of collection activity, the net tax gap is between $257 billion and $298 billion per year.⁷

The collective failure by certain taxpayers to pay their taxes imposes greater burdens on others. Given the size of the net tax gap, the average tax return includes a "surtax" of about $2,000 to make up for tax revenue lost to noncompliance.⁸ The tax gap may also impose significant costs on businesses in the form of unfair competition by noncompliant competitors who can pass along a portion of their tax "savings" to customers by charging lower prices. Moreover, a continuing and persistent tax gap could create a cycle of noncompliance as it erodes confidence in the government's ability to enforce the law and makes compliant taxpayers feel foolish for reporting all of their income and paying all of their taxes.

The Cash Economy

The IRS has no direct estimate of the portion of the tax gap attributable to the so called "cash economy." However, according to IRS estimates:

• More than 60 percent of the tax gap is attributable to self- employed individuals.⁹

• Eighty percent of the tax gap is attributable to underreporting of tax.¹⁰

• About 43 percent of the tax gap, $134 billion to $155 billion, is attributable to underreporting by self-employed individuals.¹¹

• Over 80 percent of all individual underreporting is attributable to understated income rather than overstated deductions.¹²

Research suggests that the cash economy is growing. According to one estimate the "underground economy," which includes both the cash economy and illegal activities, increased from four percent of the U.S. Gross National Product in 1970 to nine percent in 2000.¹⁶ recent study suggests that between nine and 29 percent of the workers in Los Angeles County California are paid in cash and do not have federal or state payroll taxes withheld.¹⁷ The cash economy may grow even faster as cash transactions move to the Internet.¹⁸

Traditional Enforcement Tools Not Effective for Cash Economy

Except for costly field examinations, the IRS's traditional enforcement tools heavily rely on information reporting. The IRS frequently uses its Examination, Automated Underreporter (AUR, also called Document Matching), and Automated Substitute for Return (ASFR) programs to contact taxpayers to resolve unreported income and nonfiling issues. The AUR program automatically matches the items reported on a tax return with information reported by third parties on information returns.¹⁹ Similarly, ASFR relies on data from information returns or prior year returns to prepare substitute returns and assessments for individuals who fail to file after the IRS sends them a notice.²⁰ Correspondence examinations, which are generally limited to a single issue, also rely heavily on information reporting.²¹

In contrast to Correspondence Examiners, the Revenue Agents and Tax Compliance Officers who conduct field and office examinations, respectively, are not limited to a single issue and will change their focus in response to new information.²² This approach allows Revenu Agents to find unreported income that a limited-scope correspondence examination would not detect. For example, agents are supposed to conduct certain "filing checks" to ensure that taxpayers have filed all of their returns, including information returns.²³ These checks may lead to an expansion of the audit to include additional years or other taxpayers, which can uncover unreported income.²⁴ Revenue Agents can also use more sophisticated methods to detect unreported income. For example, they can observe the taxpayer's business operation.²⁵

Ineffective Enforcement Tools May Reduce Voluntary Compliance

Because AUR, ASFR, and correspondence examinations rely so heavily on information reporting, they may actually teach noncompliant taxpayers who operate in the cash economy that they do not have to report income unless it is subject to information reporting.²⁶ Indeed, a taxpayer with a significant amount of income from the cash economy may be happy to pay the tax liability shown on a return generated by the ASFR Program because the return will only reflect the fraction of his or her income subject to information reporting.²⁷

The IRS's over-reliance on information reporting may reinforce the belief held by some cash economy participants that only income subject to information reporting is subject to tax.²⁸ Such perception may result from the fact that the IRS is unlikely to detect underreported income unless it is subject to information reporting.

Effective Enforcement Tools are Costly and Used Sparingly

Field examinations (and possibly office examinations), which do not rely as heavily on information reporting, are more expensive than processes that do, such as AUR, ASFR and correspondence examinations. Typically, Revenue Agents who conduct field examinations are more highly paid than Tax Compliance Officers who conduct office examinations and Correspondence Examiners who conduct correspondence examinations, as well as the IRS employees working ASFR and AUR processes.²⁹ Field examinations also take much longer than office and correspondence examinations. In FY 2004, on average, field examinations took 318 days, office examinations took 256 days, and correspondence examinations took 205 days.³⁰ The IRS conducts ASFR and AUR processes, which are highly automated, even more rapidly and at less (initial) cost than correspondence examinations.³¹

Because of the time and cost involved in field examinations, the IRS uses them sparingly. In FY 2004, the IRS closed 1,948,363 AUR cases, 1,585,259 ASFR cases, and 1,007,874 individual income tax return examinations.³² However, it only examined 195,054 individual returns using either field or office examinations.³³

IRS Enforcement Priorities

The IRS currently places priority emphasis on combating tax shelters and abusive schemes used by corporations and high income individuals to facilitate underreporting.³⁴ The publicity resulting from this strategy may be useful to curb the public's perception that low and middle income taxpayers should not bother to report and pay their taxes since high income taxpayers and corporations do not properly report and pay theirs.³⁵ In addition, the direct revenue gains from each audit are generally higher for corporations and high-income taxpayers than for low and middle income participants in the cash economy.³⁶ However, if the IRS is to significantly reduce the tax gap it must have a strategy to address the largest portions of the tax gap, including the cash economy. There is simply no way to make significant progress in reducing the tax gap if the IRS fails to focus on its largest component. If taxpayers operating in the cash economy believe that the IRS is devoting most of its attention to going after tax shelters, they may be emboldened to cheat even more.

The IRS's Current Efforts to Address the Cash Economy

The IRS is pursuing a number of initiatives that could be effective in addressing noncompliance in the cash economy, especially if it improved, coordinated, and pursued them more aggressively. These efforts include:

• The Unreported Income Discriminant Function (UI-DIF). UI-DIF is a tool for identifying returns that are most likely to have unreported income.³⁷ IRS research recently concluded that a high UI-DIF score may be a good predictor of unreported income by Schedule C filers (non-farm sole proprietorships) with gross income in excess of $25,000.³⁸ However, the UI-DIF needs to be refined. Examinations of returns that included Schedule C but did not claim the Earned Income Tax Credit (EITC), which were selected using other methods, resulted in higher recommended tax deficiencies in FY 2004 than examinations of non-EITC Schedule C returns selected using UI-DIF.³⁹

• Examining More Sole Proprietors in the Field. A field examination is the most effective type of examination for detecting unreported income from the cash economy. Although the likelihood that the IRS would examine a sole proprietor did not change significantly between FY 2003 and FY 2004, the likelihood that a sole proprietor selected for examination would be examined in the field increased. The percentage of all non-EITC Schedule C examinations that were conducted in the field (rather than in an office or by correspondence) increased from 35 percent in FY 2003 to 47.5 percent in FY 2004.⁴⁴ We understand that the IRS tentatively plans to examine more non-EITC Schedule C examinations in the field in FY 2006 than in FY 2005.⁴⁵

• Obtaining State and Local Tax Information. The IRS receives information from state and local governments. As of February 2004, the IRS had 1,925 agreements and initiatives in place to share information with and receive information from federal, state, and local government agencies.⁴⁶ Although the IRS's primary focus is to use state information to identify business non-filers and tax shelter investors, a number of these initiatives may address compliance by cash economy participants, such as the following:⁴⁷

• • The State Revenue Agent Report Initiative. The IRS regularly receives examination reports from some states that it can use to identify corresponding federal tax adjustments.⁴⁸ For example, the IRS receives individual income tax audit reports from Alabama, Iowa, Michigan, Montana, New York, North Carolina, Virginia, and Wisconsin.⁴⁹ On March 11, 2005, the IRS began contacting state and local agencies to seek more state examination reports.⁵⁰

  • The State Sales Tax Matching Project. Some states provide the IRS with sales tax records that it can match against income tax records to identify potential unreported income.⁵¹ For example, the IRS receives sales tax audit reports from California, Illinois, Iowa, Massachusetts, Minnesota, Missouri, New York, North Carolina, North Dakota, South Dakota, and Tennessee.⁵²

  • Ad Hoc Initiatives. The IRS has a variety of ad hoc information sharing initiatives with various states and localities. For example, the IRS obtains lists of current business license holders to identify nonfilers.⁵³

• Obtaining Information on Cash Transactions in Excess of $10,000. Any person who, in the course of a trade or business, receives more than $10,000 in cash in one transaction (or two or more related transactions) is required to inform the IRS by filing Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business.⁵⁷ The IRS uses information from Form 8300 to identify returns that may have unreported income.⁵⁸ In FY 2005, the IRS reviewed 2,366 Forms 8300 and had 170 open examinations that resulted from Form 8300 reviews.⁵⁹

• Entering Into Voluntary Compliance Agreements. The IRS sometimes enters into voluntary compliance agreements, including TIP agreements, to improve reporting compliance.⁶⁰ Instead of auditing employer and employee tax returns for tip-related issues, which burdens employers, employees, and the IRS, the IRS negotiates TIP agreements with employers.⁶¹ The TIP agreements generally increase the amount of tip income reported by employees who receive tips and the amount of employment taxes paid by employers on employee wages received as tips.⁶² TIP agreements are generally used in the food and beverage, cosmetology, and gaming industries. There are two basic types: Tip Rate Determination Agreements (TRDAs) and Tip Reporting Alternative Commitments (TRACs).

• Making it Easier to Pay Taxes Electronically or by Phone. Taxpayers may use the Electronic Funds Transfer Payments System (EFTPS) to make estimated tax payments or deposits electronically or by telephone.⁶⁵ EFTPS makes it easier for all taxpayers, including cash economy participants, to pay their taxes. The IRS encourages taxpayers who pay depository taxes, such as employment taxes, to enroll in EFTPS by waiving one prior failure to deposit penalty for new enrollees.⁶⁶

What Else Can the IRS Do to Address the Cash Economy?

Create a Cash Economy Program Office to Coordinate Initiatives

The IRS should consider creating a cash economy program office to coordinate research, outreach, and compliance efforts aimed at improving income reporting compliance among cash economy participants. The Earned Income Tax Credit (EITC) Program Office coordinates EITC related activities.⁷⁰ It also measures the results of its initiatives and takes responsibility for ensuring that the program works as intended, even though it relies on many other parts of the IRS to achieve its goals.⁷¹

As with EITC initiatives, responsibility for initiatives that may improve income reporting by cash economy participants is dispersed throughout the IRS. For example:

• SB/SE's Bank Secrecy Act (BSA) program checks Form 8300 submissions for compliance with the BSA, but does not conduct the income tax examinations that may arise from those checks;

• SB/SE's Examination program conducts income tax examinations;

• SB/SE Office of Governmental Liaison, which is part of Communications, Liaison & Disclosure, coordinates information sharing agreements with states and localities;

• W&I Submission Processing, which is a part of Customer Account Services, administers EFTPS;

• SB/SE Stakeholder Liaison (formerly Taxpayer Education and Communication) is responsible for practitioner outreach and communications regarding EFTPS; and

• SB/SE's Specialty Programs function administers TIP agreements.

Moreover, underreporting by cash economy participants probably represents more than one-third of the tax gap, whereas less than four percent of the tax gap is associated with EITC overclaims.⁷⁴ Thus, a cash economy program office may be justified on the basis that the EITC has a program office and the tax gap attributable to cash economy participants far overshadows the tax gap attributable to EITC claimants.

Obtain More and Better Research

The IRS needs research to show the most effective use of its resources after taking into account the direct and indirect effects of its activities on tax revenues.⁷⁵ In most cases, the indirect effects are probably greater than the direct effects. Assume, for example, that the IRS increases the rate at which it audits a cash-based industry like construction and conducts the audits effectively so that it discovers all unreported income. The indirect revenue gains resulting from these audits would probably exceed the direct gains by a large margin as word spreads throughout the industry that cash income is actually subject to tax and each industry participant realizes that the IRS is examining taxpayers just like him or her. IRS researchers have estimated that the indirect effect of an average examination on voluntary compliance is between six and 12 times the amount of the proposed adjustment.⁷⁶

However, not all audits have the same effect on compliance. A dollar spent auditing cash economy industries with high rates of noncompliance may have a very different effect than a dollar spent auditing corporate tax shelters. A dollar spent on an ineffective audit may actually have a negative effect on compliance if it teaches taxpayers that they will not be caught even if audited. On the other hand, a dollar spent on making it easier for taxpayers to comply with their tax obligations, for example by revising forms, improving EFTPS, and answering tax law questions, has a positive indirect effect on compliance.⁷⁷ The IRS does not have current research to show where the next dollar is best spent. We do not even know whether a dollar is best spent on enforcement or taxpayer service.⁷⁸ Thus, in the absence of better research, the IRS cannot make fully informed resource allocation decisions.⁷⁹

Each taxpayer is compliant or noncompliant for a different reason, and a comprehensive approach to reducing the tax gap must recognize these differences.⁸⁰ Because unreported income from the cash economy is so difficult and costly for the IRS to detect and deter through traditional enforcement methods, the indirect effect of the IRS's activities is even more important in fostering compliance among these taxpayers than for the general population. Thus, research in this area is very important.

Revise Tax Forms

The IRS should revise Form 1040, Schedule C, Profit or Loss From Business (Sole Proprietorship), to include separate lines showing (1) the amount of income reported on Forms 1099 and (2) other income not reported on Forms 1099. IRS research shows that taxpayers are more likely to report income that is reported to the IRS by third parties on information returns, such as Form 1099.⁸¹ Some taxpayers appear to believe that income not reported on information returns is not subject to tax or at least that the IRS will not notice if they do not report it.⁸² Separating out gross receipts on the income tax form would likely improve compliance by emphasizing to taxpayers that income not reported on information returns is still subject to tax. It may also suggest to taxpayers that the IRS will notice if they do not report any other income. Another benefit of such a revision is that it would allow the IRS to match the income reported on Schedule C with income reported on Forms 1099 more easily.

The IRS should also require all businesses (e.g., sole proprietors, corporations and partnerships) to answer two questions on their income tax returns:

• Did you make any payments over $600 in the aggregate during the year to any unincorporated trade or business?

• If yes, did you file all required Forms 1099?

Increase Information Reporting and Withholding

Since we know that the compliance rate is approximately 96 percent when payments are reported to the IRS and 99 percent when payments are subject to withholding, increasing information reporting and withholding will decrease the amount of income that is not reported. The IRS has the authority to require payors to deduct and withhold tax from payments to payees under certain conditions, such as when a payee fails to furnish a valid Taxpayer Identification Number (TIN).⁸³ However, under current IRS procedures such backup withholding may not occur for a significant period.⁸⁴ The IRS should require mandatory backup withholding to begin more quickly when taxpayers provide an invalid TIN to the payor.

The IRS should explore the feasibility of entering into voluntary withholding agreements with businesses and their service providers.⁸⁵ Pursuant to a voluntary withholding agreement, a payor, a payee, and the IRS may agree that payments for services will be subject to withholding even if the payments are not wages. Unlike payments to independent contractors, payments to employees are subject to withholding and subject the payor to liability for employment taxes.⁸⁶ Businesses sometimes have difficulty determining if service providers should be classified as employees or independent contractors and the IRS often challenges such determinations.⁸⁷ The IRS could encourage taxpayers to enter into voluntary withholding agreements by agreeing not to challenge the classification of workers who are a party to such an agreement. These agreements could reduce both underreporting by payees and the controversy associated with worker classification.

Use Available Information

The IRS should use more of the information available from state and local governments, Forms 8300, and its audit selection tools to audit taxpayers who are operating in the cash economy and underreporting their income. Although the IRS has access to state and local tax information, reporting on large cash transactions and computer-based tools to identify underreporting, it used very few of these resources in FY 2005.⁸⁸

Many states and localities impose business license taxes or require different classes of licenses, which are sometimes based on gross receipts.⁸⁹ The IRS should consider seeking access to business license tax filings and compare gross receipts, as reported on those filings, with gross income reported on the taxpayer's federal income tax return. This comparison could help the IRS identify businesses that may be underreporting income.

Many states and localities impose property taxes based on the value of real and personal property. The IRS should consider obtaining access to property tax records and comparing taxpayer property holdings with income reported on federal returns. Taxpayers whose property holdings are disproportionately large in comparison to the income reported on their federal income tax returns may be underreporting their income.⁹⁰ The IRS could use such information in conjunction with other factors to select returns for examination.

Educate Cash Economy Participants about the Benefits of Reporting

The IRS should do more to educate certain cash economy participants about the benefits of reporting their income. In addition to the satisfaction of obeying the law and avoiding potential civil and criminal penalties and interest charges, such benefits may include, for example, an increase in:

• Retirement benefits;

• Disability benefits;

• Survivors benefits;

• Medicare benefits;

• Access to credit;

• Earned income tax credits; and

• Ability to gain admission to the U.S. or a visa status adjustment for family members or employees.⁹¹

Reestablish Local Compliance Planning Organizations

Because tax compliance trends and norms are frequently local, it will be difficult for the IRS to effectively address them without local feedback about how its strategies are affecting taxpayers in a given community. The IRS needs such information and feedback so that it can adjust its strategy to effectively address local compliance issues. The IRS previously recognized the importance of a local response when it created local Compliance Planning Councils in the mid-1990s and gave them the authority to allocate local compliance resources and research.⁹⁴

If noncompliance is so commonplace in a local market that the price of a good or service does not reflect tax compliance costs, suppliers may be unable to both pay their taxes and compete.⁹⁵ However, if the IRS could convince a critical number of market participants to report their income to obtain the benefits described above and avoid the risk of detection, then the market price for their goods or services would increase so that taxpayers could both compete and pay their taxes.

Just a few market participants usually cannot change the market price by themselves. Such a change generally requires collective action, which is difficult to achieve without some form of organization or a credible threat that the IRS will enforce the law.⁹⁶ If the IRS could focus its enforcement and educational efforts on a particular local market, however, it may be able to shift market prices and improve tax compliance among large numbers of market participants. As the IRS's activity starts to affect market prices, it could produce a dramatic increase in voluntary compliance in the local cash economy as it changes local norms.⁹⁷ A local planning organization could work to identify local compliance challenges, direct the IRS's local response, and measure its effectiveness. A national cash economy program office could replicate successful local strategies nationwide.

Make It Easy to Pay Estimated Taxes

The IRS should make it just as easy for taxpayers to make their estimated tax payments as it is to pay other bills.⁹⁸ Most other creditors send customers a bill to remind them when a payment is due and offer the option of paying via automatic monthly withdrawals from the customer's bank account free of charge.⁹⁹ Similarly, the IRS could send letters to self- employed taxpayers each quarter to remind them to make their estimated tax payments. These reminders could point out that taxpayers can use EFTPS, a free service, to make estimated tax payments electronically or by phone and to schedule payments in advance, just like automatic payments to a mortgage lender or utility.¹⁰⁰ The letters should also offer to accept estimated payments monthly or even bi-weekly, just like most other recurring bills.¹⁰¹

Taxpayers may inadvertently fall behind on their estimated tax payments because the payment process is cumbersome. Estimated tax payments are due on the following oddly-spaced dates: April 15, June 15, September 15, and January 15.¹⁰² These dates do not consistently coincide with calendar quarters, and some taxpayers do not believe the dates make sense.¹⁰³ It may also be difficult for taxpayers to save enough to pay their taxes on a quarterly basis. One study for tax year 1999 showed that 31 percent of the taxpayers who made (or were required to make) estimated tax payments were assessed estimated tax penalties.¹⁰⁴ A year 2000 telephone survey found that approximately two-thirds of taxpayers with a balance due prior to filing their return did not plan to owe a balance upon filing.¹⁰⁵ Taxpayers who want to comply with their estimated tax payment obligations sometimes fail because the process of estimating income, remembering odd payment dates, and saving enough money each quarter is cumbersome, especially for self-employed taxpayers who are juggling many different duties and many competing demands on both time and funds.

Anything that the IRS can do to help taxpayers make their estimated tax payments more easily and lessen the burden of saving to make such payments is likely to increase compliance.¹⁰⁶ A recent IRS study found that "investors" receiving reminder letters increased both estimated tax payments and withholding by a statistically significant amount.¹⁰⁷ The study recommended that the IRS consider a large scale "soft notice" program (i.e., reminder letters).¹⁰⁸ According to IRS research, taxpayers who owe a balance upon filing their return are more likely to understate their tax liability than other taxpayers.¹⁰⁹ Moreover, more than 20 percent of such taxpayers with a balance due fail to pay it in full.¹¹⁰ Self-employed taxpayers are often participants in the cash economy and need to make estimated tax payments. Thus, if the IRS could reduce estimated tax payment shortfalls it could increase both reporting and payment compliance by cash economy participants.

IRS COMMENTS

Create a Cash Economy Program Office to Coordinate Initiatives

The IRS does not agree that creating a Program Office would be an efficient way to address noncompliance in the Cash Economy. The analogy to the Earned Income Tax Credit (EITC) Program Office is misleading. The EITC population is comprised of wage earning taxpayers who, while not a homogeneous group, have many common issues that allow the IRS to segment and approach them with a coordinated and comprehensive strategy through a program office. The Cash Economy, as the National Taxpayer Advocate reports, is unknown in composition and size and, as a result, would be difficult to address in a similar fashion.

The IRS recently completed the first phase of the National Research Program (NRP) and the data is just becoming available for use. While the IRS believes that a comprehensive and well-coordinated strategy among the various IRS offices might be successful in addressing the issues of the Cash Economy, we must assess the magnitude of the problem and the characteristics of the population before deciding whether to create such a strategy. The SB/SE Division will ask the IRS Office of Research, Analysis and Statistics to assist in that effort.

Obtain More and Better Research

The IRS agrees that based on available research, there appears to be an indirect benefit to compliance from audits. However, other than the recent Criminal Investigation-sponsored study, the existing estimates are dated. Data from the first phase of the NRP, which have just become available, might be used to update these estimates. To date, only estimates of direct benefits have been developed from NRP. Additional research to help determine with more certainty the audits with the greatest indirect benefit may be useful, but defining and building an accurate resource allocation model that actually measures indirect benefit would be difficult, if not impossible.

Revise Tax Forms

The IRS disagrees with the National Taxpayer Advocate's suggestion that the IRS should include a separate line on Form 1040, Schedule C, for the amount of income reported on Form 1099, U.S. Information Return. Currently, accounting systems ordinarily do not separate Form 1099 and non-Form 1099 income. Requiring all taxpayers to do so would be costly and burdensome, particularly for small businesses. In addition, the Form 1099 data is not required to process the tax return; asking for that information runs counter to the Paperwork Reduction Act.

Further, we believe a separate line would burden compliant taxpayers more than it would change the behavior of noncompliant taxpayers. If noncompliant taxpayers are not deterred from submitting an erroneous return by the penalty of perjury, it is unlikely that an additional line will cause them to list income they intentionally omitted elsewhere.

The National Taxpayer Advocate also suggests adding questions on Form 1040, Schedule C, to prompt information return filing. The instructions to Schedule C already inform taxpayers of the filing requirements for such returns and refer them to the General Instructions for Forms 1099, 1098, 5498, and W-2G, catalog # 11409F. These actions might improve compliance and enhance enforcement activities, but only if the taxpayer responds correctly on the forms. Otherwise, the IRS could verify the answers only upon audit.

Increase Information Reporting and Withholding

Payees may benefit by having more accurate information concerning their tax liability, but there is a trade off on the additional burden to payors where the law does not mandate reporting. In addition, there are many and substantial issues with voluntary withholding agreements. In part, the IRS is concerned about the resource impact of entering into voluntary withholding agreements with businesses and their service providers. We believe that we would have to significantly reallocate resources in the field in order to use voluntary withholding agreements effectively.

Use Available Information

The National Taxpayer Advocate recommends increasing the use of information from state and local governments, Forms 8300, and UI-DIF tools. Examiners have access to the information the National Taxpayer Advocate suggests. They use the information appropriate for the issues identified on the tax returns assigned to them for examination, including public record information such as real and personal property records.

Reestablish Local Compliance Planning Organizations

The IRS has in place a process for Areas to identify local non- compliant industry segments for audits. The process also requires alternative treatments, such as interaction with local chapters of national organizations and industry representatives. Further, the SB/SE Communications Liaison and Disclosure Division signs off on each Compliance Initiative Project, which permits the IRS to identify educational opportunities.

Make It Easy to Pay Estimated Taxes

The National Taxpayer Advocate suggests expanding and promoting EFTPS for estimated tax payments. These reminders are already part of EFTPS Online Version 3.0, which is under development and should be delivered no later than FY 2007.

TAXPAYER ADVOCATE SERVICE COMMENTS

Improving tax compliance in the cash economy is a difficult challenge. The National Taxpayer Advocate applauds the IRS's ongoing efforts and initiatives to address it. For example, although we have not seen EFTPS Online Version 3.0, if it truly makes paying taxes as easy as paying other bills it will be a significant step in the right direction.

RECOMMENDATIONS

However, the National Taxpayer Advocate recommends that the IRS seriously consider her other recommendations, discussed above, rather than summarily dismissing them. She recommends the IRS:

• Complete research into the magnitude of the cash economy noncompliance problem and characteristics of the taxpayer population involved before concluding that a cash economy program office would not be effective.

• Request additional research into the indirect effect of compliance activities before concluding that any such research could not be used to allocate resources.

• Study the National Taxpayer Advocate's proposed tax form revisions before concluding that they would not improve compliance.

• Test using voluntary withholding agreements before concluding that they are not practical based on resource constraints.

• Analyze how feedback from local Areas to the national office could be improved before concluding that the existing organization is superior to the organizational

² We use the term "cash economy" to mean payments for transactions that are not reported to the IRS. For a similar definition of cash economy, see Bridging the Tax Gap: Hearing Before the Committee on Finance, United States Senate, 108th Cong., 21 (July 21, 2004) (statement of Professor Joseph L. Bankman defining the cash economy as "legal business transactions conducted in cash (or checks) that are not subject to withholding or third-party information... your gardener, the family that owns the corner restaurant. Anyone that is getting cash or checks that is not subject to third-party reporting").

³ IRS National Headquarters Office of Research, Interactive Tax Gap Map for Year 2001 22-23 (Feb. 24, 2004).

⁴ This percentage drops to 93 percent for income that is only subject to some information reporting (e.g., capital gains). Id.

⁵ IRS National Headquarters Office of Research, Interactive Tax Gap Map for Year 2001 22-23 (Feb. 24, 2004).

⁶ IRS National Headquarters Office of Research, Tax Gap Map for Year 2001 (June 7, 2005). The tax gap estimates do not include taxes due on illegal transactions.

⁷Id.

⁸ The IRS receives approximately 133 million individual income tax returns each year. IRS Pub. 1136, Statistics of Income Bulletin, Spring 2005 (Feb. 2004) (Table 22). The lower range of the net tax gap ($257 billion) divided by the number of individual income tax returns (133 million) is $1,932 per return. The upper range of the net tax gap ($298 billion) divided by the number of individual income tax returns (133 million) is $2,240 per return.

⁹ IRS National Headquarters Office of Research (unpublished projections furnished for TY 2001) (indicating that self-employed taxpayers are responsible for about 67 percent of the tax gap). This estimate includes underreporting, non-filing and non- payment of income, self-employment, and employment taxes by self- employed taxpayers. It is consistent with prior estimates. See Small Business/Self-Employed, Strategic Assessment Report FY 2005- 2006, 5 (Feb. 23, 2004) (stating that SB/SE taxpayers are responsible for 56 percent of the tax gap); SB/SE Research, Small Business/Self-Employed Compliance Risk Assessment, FY 04-05 Strategic Planning Cycle 28 (Jan. 31, 2003) (stating that Schedule C filers are responsible for 59.2 percent of the tax gap).

¹⁰ IRS National Headquarters Office of Research, Tax Gap Map for Year 2001 (June 7, 2005).

¹¹ IRS estimates indicate that taxpayers who underreport business income on individual returns account for $83 to $99 billion of the tax gap and taxpayers who underreport self- employment taxes accounts for another $51 to $56 billion. IRS National Headquarters Office of Research, Tax Gap Map for Year 2001 (June 7, 2005).

¹²Id.

¹³See IRS, Office of Research, Analysis, and Statistics (RAS), Preliminary Update of the TY 2001 Individual Income Tax Underreporting Tax Gap Estimates 8-16 (June 7, 2005); James Alm & Brian Erard, Estimating the Informal Supplier Tax Gap, 2005 IRS Research Conference (June 7, 2005) available at http://aysps. gsu.edu/people/working/IRS2005ResearchConference-Alm_Erard- Abridged.doc. See also, Government Accountability Office, GAO- 05-753, Tax Compliance: Better Compliance Data and Long-term Goals Would Support a More Strategic IRS Approach to Reducing the Tax Gap 12 (July 2005).

¹⁴ IRS National Headquarters Office of Research, Interactive Tax Gap Map for Year 2001 22-23 (Feb. 24, 2004).

¹⁵ SB/SE Research -- Brooklyn/Hartford, Project 01.08.003.04, TEC Practitioner Focus Group Interviews, 2004IRS Nationwide Tax Forums Emerging Issues Focus Groups 12 (Dec. 2004). For a comparative analysis of compliance by self-employed taxpayers operating in the cash economy, see Piroska Soos, Self-Employed Evasion and Tax Withholding: A Comparative Study and Analysis of the Issues, 24 U.C. Davis L. Rev. 107 (Fall 1990).

¹⁶See Friedrich Schneider & Dominik Enste, Economic Issues No. 30 -- Hiding in the Shadows: The Growth of the Underground Economy, IMF, March 2002. For more recent discussion see Jim McTague, Underground Economy, Barron's, Jan. 3, 2005.

¹⁷See Pascale Joassart-Marcelli and Daniel Flaming, Workers Without Rights: The Informal Economy in Los Angeles, Economic Roundtable Briefing Paper, 2002.

¹⁸ According to practitioners, Internet sales frequently go unreported. SB/SE Research -- Brooklyn/Hartford, Project 01.08.003.04, TEC Practitioner Focus Group Interviews, 2004 IRS Nationwide Tax Forums Emerging Issues Focus Groups 12 (Dec. 2004) (noting that practitioners believe there is a lot of unreported income from internet sales, such as income generated on the E-Bay website). See also, Treasury Inspector General for Tax Administration, Ref. No. 2005-30-010, The Internal Revenue Service Is Making Progress in Addressing Compliance Among Small Businesses Engaged in Electronic Commerce (Nov. 2004) (citing a March 2004 estimate that the tax gap among small businesses that are doing business over the Internet may be as high as $1 billion and growing quickly).

¹⁹See, e.g., Department of the Treasury, Internal Revenue Service, Report to Congress: IRS Tax Compliance Activities 5 (July 15, 2003).

²⁰See IRM § 5.1.11.6.5 (May 27, 2003).

²¹See, e.g., IRM § 4.10.1 (May 14, 1999) (providing that Revenue Agents and Tax Auditors (not Correspondence Examiners) use sophisticated income probes); IRM § 4.19.1.2.3.1(12) (Oct. 1, 2004) (providing that Correspondence Examiners rely on information reporting to detect unreported income).

²² IRM § 4.10.4.1(2) (June 1, 2004).

²³ IRM § 4.10.5 (July 31, 2001). We have not analyzed how often such filing checks actually occur.

²⁴See IRM § 4.10.5 (May 14, 1999).

²⁵ IRM § 4.10.4 (June 1, 2004); IRM § 4.10.4.3.5 (June 1, 2004). Similarly, when a revenue officer (i.e., an IRS collection employee working in the field) files a substitute for return for a high income nonfiler, he or she is required to observe the taxpayer to determine if sufficient income is reflected on the information reporting documents before filing the substitute for return. See IRM § 5.1.11.6.3.1 (May 5, 2003).

²⁶ As early as 1996, IRS researchers observed:

²⁸ One IRS focus group found that "[P]ractitioners say cash businesses are wide open for tax cheating. `Cash doesn't count' is what many of their clients think." SB/SE Research -- Brooklyn/Hartford, Project 01.08.003.04, TEC Practitioner Focus Group Interviews, 2004 IRS Nationwide Tax Forums Emerging Issues Focus Groups 9 (Dec. 2004).

²⁹ United States Office of Personnel Management, Operating Manual, Qualification Standards for General Schedule Positions (Mar. 22, 1999); AWSS Human Resources Systems Office (HRSO), Workforce Information by Organization (June 11, 2005).

³⁰ SB/SE, AIMS Closed Case Database, IRS Examination Table 37 (Aug. 2005).

³¹ In FY 2004, 278 full time equivalent employees (FTEs) handled 1,585,259 ASFR cases (5,702 per FTE), 1,639 FTEs handled 1,948,363 AUR cases (1,189 per FTE), and 1,569 FTEs handled 810,486 correspondence examinations (517 per FTE). Id; IRS Pub. 55B, Data Book, Table 26 -- Taxpayer Contact Information, by Type of Math Error and Selected Program, FY 2004; Senior Tax Analyst, SB/SE Campus Compliance Services, Campus Reporting Compliance, Workload Selection & Delivery, Response to TAS Information Request (Oct. 7, 2005).

³² IRS Pub. 55B, Data Book, Table 26 -- Taxpayer Contact Information, by Type of Math Error and Selected Program, FY 2004 (ASFR and AUR statistics); IRS Pub. 55B, Data Book, Table 10 -- Examination Coverage: Recommended and Average Recommended Additional Tax After Examination, by Type and Size of Return, FY 2004. However, 48 percent of the individual income tax returns examined (487,461 returns) claimed the earned income tax credit, leading the Internal Revenue Service Advisory Council (IRSAC) to conclude that EITC has been singled out for disproportionate emphasis as compared to other areas of tax noncompliance. Id; Internal Revenue Service Advisory Council, Public Meeting, Wage & Investment Subgroup 7 (Nov. 17, 2005) available at http://www.irs.gov/pub/irs-utl/2005_irsac_public_ meeting.pdf.

³³ IRS Pub. 55B, Data Book, Table 10 -- Examination Coverage: Recommended and Average Recommended Additional Tax After Examination, by Type and Size of Return, FY 2004. To its credit, however, the IRS was more likely to examine non-EITC Schedule C returns using a field examination in FY 2004 than in FY 2003. SB/SE, AIMS Closed Case Database, IRS Examination Table 37 (Apr. 2005).

³⁴See IRS Pub. 3744, Strategic Plan 2005- 2009 19 (June 2004).

³⁵ However, this strategy could have the reverse effect by emphasizing to the public how little tax high income taxpayers and corporations actually pay, reducing their incentive to pay their share. Further, one study found that high income taxpayers did not increase compliance in response to audit threats, perhaps because they viewed an audit as a negotiation and they wanted to start negotiating from a low number. See Stephen Coleman, The Minnesota Income Tax Compliance Experiment: State Tax Results, Minnesota Department of Revenue (Apr. 1996).

³⁶See generally, IRS Pub. 55B, Data Book, Table 10 -- Examination Coverage: Recommended and Average Recommended Additional Tax After Examination, by Type and Size of Return, FY 2004.

³⁷See generally, Treasury Inspector General for Tax Administration, Ref. No. 2003-30-146, Tax Returns With the Potential for Unreported Income Are Being Identified, but Some Challenges Still Exist With the Program (July 2003).

³⁸ Denver SB/SE Research, Project 03.08.002.03, Research Report: Utilize Exam Results to Further Evaluate UIDIF Scores iii (Mar. 2005) (analyzing returns for tax years 1999- 2001). However, the study did not reach statistically valid conclusions, in part, because an unexpectedly low percentage of the examinations included an adequate unreported income probe. Id.

³⁹ SB/SE, AIMS Closed Case Database, Extract of FY 2004 Audit Results (Oct. 28, 2005).

⁴⁰See IRS Pub. 3744, IRS Strategic Plan 2005-2009 19 (June 2004); SB/SE Strategy and Program Plan FY 2004 -- FY 2005 28 (Sept. 25, 2003).

⁴¹ Senior Program Analyst, SB/SE, Exam Planning & Delivery, Exam Return Selection, Response to TAS Information Request (Oct. 21, 2005). The IRS closed 15,873 such examinations in FY 2005. Id.

⁴² SB/SE, AIMS Closed Case Database, Extract of FY 2004 Audit Results (Oct. 28, 2005).

⁴³ IRS Response (Dec. 23, 2005).

⁴⁴ SB/SE, AIMS Closed Case Database, Examination Table 37 (Apr. 2005).

⁴⁵ IRS Response (Dec. 23, 2005).

⁴⁶ IRS Office of Governmental Liaison, Response to TAS Information Request (July 27, 2005).

⁴⁷See IRS Pub. 3744, IRS Strategic Plan 2005-2009 20 (June 2004); Bridging the Tax Gap: Hearing Before the Committee on Finance, United States Senate, 108th Cong., 2nd Sess. 50 (July 21, 2004) (statement of Commissioner Everson). See also IR-2004-77 (June 7, 2004).

⁴⁸ IRS Office of Governmental Liaison, Response to TAS Information Request (July 27, 2005).

⁴⁹Id. The IRS reports that the SB/SE Government Liaison & Disclosure is currently receiving reports from 38 states under this initiative. IRS Response (Dec. 23, 2005).

⁵⁰ Memorandum from Director, Governmental Liaison & Disclosure, SB/SE for Area Managers, Governmental Liaison & Disclosure, Interim Procedures for Obtaining State Tax Audit Results While Revisions are Made to the Existing Implementing Agreements (Mar. 11, 2005).

⁵¹ IRS Office of Governmental Liaison, Response to TAS Information Request (July 27, 2005).

⁵²Id.

⁵³ IRS Office of Governmental Liaison, Response to TAS Information Request (July 27, 2005). For example, the New York State Department of Taxation and Finance provides information about liquor license holders, licensed cosmetologists, real estate agents, appraisers, architects, and accountants to the IRS. The Michigan Bureau of Revenue, North Carolina Department of Revenue, Virginia Department of Alcoholic Beverage Control, and Washington Department of Licensing provide similar information to the IRS. Id.

⁵⁴ Director, Examination Planning & Delivery, Response to Information Request (Oct. 12, 2005). Prior to March 2005, the IRS did not track how many items of information it received from states. IRS Office of Governmental Liaison, Response to TAS Information Request (Nov. 2, 2005). Since March 2005, the IRS has received 14,377 state income tax audit reports, but has not evaluated any of them. Senior Program Analyst, SB/SE Campus Compliance Services, Campus Reporting Compliance, Workload Selection & Delivery, Response to TAS Information Request (Nov. 10, 2005).

⁵⁵ Director, Examination Planning & Delivery, Response to Information Request (Oct. 12, 2005). However, IRS computer systems only reflect 233 closed examination cases resulting from state information referrals in FY 2005. SB/SE, AIMS Closed Case Database, Examination Table 37 (Nov. 9, 2005) (source code 77).

⁵⁶ We understand that the IRS's Office of Governmental Liaison refers its leads to Exam and that some leads are not actionable.

⁵⁷See IRC § 6050(I).

⁵⁸See IRM § 4.26.15.4 (Jan. 1, 2003).

⁵⁹ Acting BSA Compliance Policy Program Manager, SB/SE, Fraud/BSA, BSA Policy & Operations, Response to TAS Information Request (Oct. 14, 2005).

⁶⁰ SB/SE Strategy and Program Plan FY 2004 -- FY 2005 21 (Sept. 25, 2003).

⁶¹ For useful background information about TIP agreements, see IRM § 4.23.7.3 (Mar. 1, 2003); IRS Pub. 1875, Tips on Tips (Apr. 2004); SB/SE Research, Brooklyn/Hartford, Project No. 01.08.004.03, Update the Report on 'The Effect of Tip Compliance Efforts on Tip Reporting,' (July 2003); General Accounting Office, GAO-03-378, IRS Should Continue to Expand Reporting on Its Enforcement Efforts 49 (Jan. 2003); Treasury Inspector General for Tax Administration, Ref. No. 2001-30- 076, Opportunities Exist to Improve the Tip Rate Determination and Education Program (May 2001). One variation of a TRAC, called an Employer-designed Tip Reporting Alternative Commitment Agreement (EmTRAC) allows employers to modify the TRAC agreement.

⁶² Tips are treated wages for certain employment tax purposes. See IRC § 3121(q); Treas. Reg. § 31.3102-3.

⁶³See IRM § 4.23.7.3(4) (Mar. 1, 2003). See also, Tip Reporting Alternative Commitment (Sept. 16, 2004), available at http://www.irs.gov/pub/irs- utl/hairtrac.pdf.

⁶⁴ Acting Sr. Ops. Advisor, Specialty Programs, SB/SE, Response to TAS Information Request (Oct. 18, 2005).

⁶⁵ EFTPS is the Treasury's electronic remittance processing system for making federal tax deposits and payments. Once enrolled in EFTPS, a taxpayer may initiate electronic payments with a telephone call or by using a computer. See IRM Exhibit 3.0.273-2 (Jan. 1, 2005) and www.EFTPS.gov.

⁶⁶ IRS Pub. 4048, EFTPS: Special IRS Penalty Refund Offer for Businesses (Feb. 2004).

⁶⁷ The SB/SE Strategy and Program Plan said that it planned to develop a national marketing campaign to promote EFTPS and receive 73 million payments, more than 61 percent of all payments, through EFTPS in FY 2005. See SB/SE Strategy and Program Plan FY 2004 -- FY 2005, 20, 59 (Sept. 25, 2003).

⁶⁸ Senior Tax Analyst, Wage and Investment Division, Customer Account Services, Submission Processing, Response to TAS Information Request (Oct. 5, 2005).

⁶⁹See IRC § 6302(h). Congress should consider expanding the statutory mandate. See Key Legislative Recommendation: Measures to Reduce Noncompliance in the Cash Economy, infra.

⁷⁰See, e.g., Treasury Inspector General for Tax Administration, Ref. No. 2002-40-020, Better Controls Are Neededto Ensure Appropriated Funds Are Used to Improve the Application of the Earned Income Credit (Nov. 2001).

⁷¹See, e.g., Government Accountability Office, GAO-05-92, Earned Income Tax Credit: Implementation of Three New Tests Proceeded Smoothly, But Tests and Evaluation Plans Were Not Fully Documented (Dec. 30, 2004).

⁷² Memorandum from Director, Governmental Liaison & Disclosure, SB/SE for Area Managers, Governmental Liaison & Disclosure, Interim Procedures for Obtaining State Tax Audit Results While Revisions are Made to the Existing Implementing Agreements (Mar. 11, 2005).

⁷³See, e.g., Government Accountability Office, GAO-06-208T, Multiple Strategies, Better Compliance Data,and Long- Term Goals Are Needed to Improve Taxpayer Compliance (Oct. 26, 2005); Written Statement of Russell George, Treasury Inspector General for Tax Administration, Hearing Before the Senate Committee on Appropriations Subcommittee on Transportation, Treasury, the Judiciary, Housing and Urban Development, and Related Agencies, On the Internal Revenue Service's Fiscal Year 2006 Budget Request (Apr. 7, 2005).

⁷⁴ IRS National Headquarters Office of Research, Tax Gap Map for Year 2001 (June 7, 2005). Further, about 48 percent of all examinations involve EITC claimants, whereas only about nine percent of examinations involve non-EITC Schedule C filers. SB/SE, AIMS Closed Case Database, IRS Examination Table 37 (Apr. 2005). However, it is difficult to reconcile the number of EITC examinations with the EITC budget allowance. In FY 2004, the IRS allocated only about 5 percent of its tax law enforcement resources to EITC compliance. See IRS Doc. 9940, Budget in Brief, Fiscal Year 2005 4 (Feb. 2004); Treasury Inspector General for Tax Administration, Ref. No. 2005-40-133, Administration of the Earned Income Tax Credit Program Has Improved, but Challenges Continue 3 (Aug. 2005).

⁷⁵See generally, Government Accountability Office, GAO-05-753, Tax Compliance: Better Compliance Data and Long-term Goals Would Support a More Strategic IRS Approach to Reducing the Tax Gap (July 2005).

⁷⁶ Alan H. Plumley, Pub. 1916, The Determinants of Individual Income Tax Compliance: Estimating The Impacts of Tax Policy, Enforcement, and IRS Responsiveness 35-36 (Oct. 1996); Jeffrey A. Dubin, Michael J. Graetz and Louis L. Wilde, The Effect of Audit Rates on the Federal Individual Income Tax, 1977-1986, 43 Nat. Tax J., 395, 396, 405 (1990).

⁷⁷ IRS researchers previously estimated that every dollar the IRS spent on return preparation generated $396 dollars of additional tax revenue. See Alan H. Plumley, Pub. 1916, The Determinants of Individual Income Tax Compliance: Estimating The Impacts of Tax Policy, Enforcement, and IRS Responsiveness 41 (Oct. 1996).

⁷⁸ For a more detailed discussion, see National Taxpayer Advocate 2004 Annual Report to Congress 211-225 (Most Serious Problem: IRS Examination Strategy); Statement of Nina E. Olson, National Taxpayer Advocate, before the United States Senate Committee on Finance on The Tax Gap (Apr. 14, 2005); Statement of Nina E. Olson, National Taxpayer Advocate, before the United States Senate Appropriations Subcommittee on Transportation, Treasury, The Judiciary, Housing And Urban Development, and Related Agencies (Apr. 7, 2005). See also Government Accountability Office, GAO-05- 753, Tax Compliance: Better Compliance Data and Long-term Goals Would Support a More Strategic IRS Approach to Reducing the Tax Gap (July 2005); Treasury Inspector General for Tax Administration, Ref. No. 2005-10-159, A Better Model Is Needed to Project the Return on Additional Investments in Tax Enforcement (Sept. 2005).

⁷⁹ The Government Accountability Office has also recommended that the IRS obtain more and better research regarding the reasons that taxpayers fail to comply with the law. See, e.g., Government Accountability Office, GAO-06-208T, Tax Gap: Multiple Strategies, Better Compliance Data, and Longterm Goals Are Needed to Improve Taxpayer Compliance (Oct. 26, 2005).

⁸⁰ For a discussion of the categories of taxpayer noncompliance, see Leslie Book, The Poor and Tax Compliance: One Size Does Not Fit All, 51 U. Kan. L. Rev. 1145 (2003).

⁸¹ IRS National Headquarters Office of Research, Interactive Tax Gap Map for Year 2001, 22-23 (Feb. 24, 2004).

⁸²See SB/SE Research -- Brooklyn/Hartford, Project 01.08.003.04, TEC Practitioner Focus Group Interviews, 2004 IRS Nationwide Tax Forums Emerging Issues Focus Groups 9 (Dec. 2004).

⁸³See generally IRC § 3406. A TIN may be a Social Security number (SSN) issued by the Social Security Administration (SSA), an Employer Identification Number (EIN), or an Individual Taxpayer Identification Number (ITIN).

⁸⁴ For a more detailed discussion, see Most Serious Problem: Limited Scope of Backup Withholding Program, infra. See also Treasury Inspector General for Tax Administration, Ref. No. 2001-30-132, Significant Tax Revenue May Be Lost Due to Inaccurate Reporting of Taxpayer Identification Numbers for Independent Contractors (Aug. 2001).

⁸⁵See IRC § 3402(p)(3). The IRS may need to work with the Treasury Department to issue regulations before it can use this authority. For further discussion see Key Legislative Recommendation: Measures to Reduce Noncompliance in the Cash Economy, infra.

⁸⁶See e.g., IRC §§ 3102(a), 3111, 3301, 3402.

⁸⁷ One recent electronic search for cases citing Rev. Rul. 87-41, 1987-1 C.B. 296, which sets out a 20 factor test for determining whether a worker is an employee or an independent contractor, found 90 reported cases.

⁸⁸ As noted above, in FY 2005 the IRS considered 1,092 state information items for examination potential, reviewed 2,366 Forms 8300, and closed 15,873 examinations of non-EITC Schedule C returns selected using UI-DIF.

⁸⁹See, e.g., Fairfax County Code §§ 4- 7.2-1 through 4-7.2-36 (2005) (imposing a Business, Professional and Occupational License (BPOL) tax based on gross receipts). See also, 18 VAC 50-22-10 (2005) through 18 VAC 50-22-270 (2005), available at http://www.state.va.us/dpor/Contractors%20Web.pdf (requiring contractors to obtain different contractor's license classes based on the value of the contractor's jobs).

⁹⁰ This screen should take into account a taxpayer's age as well as median income in the industry because older taxpayers or those who are retired would be expected to have property holdings that are disproportionate to their current income.

⁹¹See, e.g., Social Security, Survivors Benefits, Pub. No. 05-10084, 5 (Jan. 2005) (indicating that survivors benefits are based on average lifetime earnings); Social Security, What Every Woman Should Know, Pub. No. 05-10127, 1, 6 (Apr. 2003) (indicating that Medicare, death and disability benefits are based on earnings); IRC § 32 (Earned Income Tax Credit); 8 USC § 1182(a)(4) (requiring a sponsor to provide an affidavit of support for persons seeking admission to the U.S. or a visa status adjustment); 8 USC § 1183a (defining affidavit of support); Form 1-864, Affidavit of Support Under Section 213A of the Act (Oct. 5, 2001), available at http://uscis.gov/graphics/formsfee/forms/files/I-864.pdf (requiring sponsors to attach three tax returns to the Affidavit of Support).

⁹² The IRS already lists many of these benefits in an obscure publication for employers in the food and beverage industry. See Pub. 1875, Tips on Tips 3 (Apr. 2004).

⁹³ Joshua D. Rosenberg, The Psychology Of Taxes: Why They Drive US Crazy, And How We Can Make Them Sane, 16 Va. Tax Rev. 155, 227-232 (Fall 1996).

⁹⁴See General Accounting Office, GAO/GGD-96- 109, Tax Research: IRS Has Made Progress but Major Challenges Remain 30 (June 1996); IRS, District Office of Research and Analysis (DORA), Phase I Training Material: IV. Framework; NORA, DORA roles 8.

⁹⁵See, e.g., Joseph Bankman, Tax Enforcement: Tax Shelters, The Cash Economy, and Compliance Costs, 104 Tax Notes 185, 189 (July 12, 2004). IRS focus group discussions suggest that workers sometimes pass along much, if not all, of their tax "savings" from underreporting to their customers or employers. See SB/SE Research -- Brooklyn/Hartford, Project 01.08.003.04, TEC Practitioner Focus Group Interviews, 2004 IRS Nationwide Tax Forums Emerging Issues Focus Groups 12 (Dec. 2004) (noting that workers will work for "half wages" if they are paid in cash).

⁹⁶ Interestingly, the author of a study on the cash economy concludes that unions may help to reduce the number of workers in the cash economy by formalizing employment conditions of informal workers. See Pascale Joassart-Marcelli & Daniel Flaming, Workers Without Rights: The Informal Economy in Los Angeles, Economic Roundtable Briefing Paper, 2002.

⁹⁷Accord Jon S. Davis, et. al., Social Behaviors, Enforcement, and Tax Compliance Dynamics, 78 Acct. Rev. 39 (2003) (finding that noncompliant populations respond to increasing enforcement by gradually increasing compliance until enforcement reaches a threshold level, and then suddenly shifting to very high levels of compliance).

⁹⁸ The IRS could also make it possible for taxpayers to sign up for EFTPS and make a payment on the same day. Under its current process taxpayers must wait at least seven to 10 days to use EFTPS, even if they are in the "Express Enrollment" program. See Pub. 4276, Express Enrollment Q & A's (Jan. 2004). Taxpayers must wait two weeks if they do not participate in the "Express Enrollment" program.

⁹⁹ TIGTA previously recommended that IRS clearly communicate to taxpayers that EFTPS is free. See Treasury Inspector General for Tax Administration, Ref. No. 2004-30-040, While Progress Toward Earlier Intervention With Delinquent Taxpayers Has Been Made, Action Is Needed to Prevent Noncompliance With Estimated Tax Payment Requirements, 24 (Feb. 2004). This recommendation was based on a taxpayer focus group consensus indicating that taxpayers would not use credit cards to make estimated tax payments because credit card companies charge a convenience fee. Id.

¹⁰⁰ Mortgage lenders often require borrowers to pay property taxes into escrow on a monthly basis to ensure that borrowers do not forget to make quarterly property tax payments or spend the funds elsewhere.

¹⁰¹ Some mortgage companies offer programs to electronically deduct mortgage payments bi-weekly rather than monthly.

¹⁰² Pub. 505, Tax Withholding and Estimated Tax Payments, 24 (Dec. 2004).

¹⁰³See Treasury Inspector General for Tax Administration, Ref. No. 2004-30-040, While Progress Toward Earlier Intervention With Delinquent Taxpayers Has Been Made, Action Is Needed to Prevent Noncompliance With Estimated Tax Payment Requirements 19 (Feb. 2004).

¹⁰⁴See Id.

¹⁰⁵See Wage and Investment Division, Research Group 5, Project No. 5-03-06-2-028N, Experimental Tests of Remedial Actions to Reduce Insufficient Prepayments: Effectiveness of 2002 Letters 7 (Jan. 16, 2004), citing W&I Customer Research Group 5, Causes and Potential Treatments for Underwithholding and Insufficient Estimated Payments (2000).

¹⁰⁶ Signing taxpayers up for EFTPS could make estimated tax payments almost as automatic as withholding. As previously noted, taxpayers subject to withholding report 99 percent of their income. IRS National Headquarters Office of Research, Interactive Tax Gap Map for Year 2001, 22-23 (Feb. 24, 2004). For further discussion, see Key Legislative Recommendation: Measures to Reduce Noncompliance in the Cash Economy, infra.

¹⁰⁷See Wage and Investment Division, Research Group 5, Project No. 5-03-06-2-028N, Experimental Tests of Remedial Actions to Reduce Insufficient Prepayments: Effectiveness of 2002 Letters, 6-7 (Jan. 16, 2004). The study defined "investors" as taxpayers with a balance due of between $100 and $10,000 with non- wage income in excess of $4,000 and wages of less than $500,000. Id. at 8.

¹⁰⁸ Both GAO and TIGTA previously recommended that the IRS test a soft notice program to improve estimated tax payment compliance. See General Accounting Office, GAO/GGD-99-18, Billions In Self-Employment Tax Are Owed 8 (Feb. 1999) and Treasury Inspector General for Tax Administration, Ref. No. 2004-30- 040, While Progress Toward Earlier Intervention With Delinquent Taxpayers Has Been Made, Action Is Needed to Prevent Noncompliance With Estimated Tax Payment Requirements, 19 (Feb. 2004) (recommending that IRS implement a soft notice for estimated tax payments and noting that although IRS planned to implement GAO's soft notice recommendation, it delayed and then canceled the planned implementation).

¹⁰⁹ Wage and Investment Division, Research Group 5, Project No. 5-03-06-2-028N, Experimental Tests of Remedial Actions to Reduce Insufficient Prepayments: Effectiveness of 2002 Letters, 7 (Jan. 16, 2004).

¹¹⁰Id.

MOST SERIOUS PROBLEM: TRAINING OF PRIVATE DEBT COLLECTION EMPLOYEES

RESPONSIBLE OFFICIAL

In July of 2006, the IRS will begin using private collection agencies to collect tax delinquencies under the authority granted to it by the American Jobs Creation Act of 2004 (AJCA).¹ The Private Debt Collection (PDC) initiative marks a dramatic departure from IRS collection practice and procedure and implicates many, if not all, of the taxpayer rights built into the federal tax laws and procedures relating to IRS collection practice.

Tax collection by private agencies raises several broad concerns, including the introduction of private contractors into an inherently governmental function,² the disclosure of private taxpayer information to non-governmental entities,³ and the use of less highly trained employees in the collection process. However, as the IRS completes its PDC processes and procedures and works towards the July 2006 implementation date, one issue is paramount: the adequacy of training for private collection representatives.

ANALYSIS OF THE PROBLEM

Background: The Federal Tax Collection Environment

The landscape of federal tax debt collection has changed dramatically since 1996 when the IRS last attempted private debt collection.⁴ Changes to the tax laws have established more protections for taxpayers while simultaneously creating a more complex tax collection system for the IRS to administer. These changes include:

• Independent reviews of any rejection of a proposed offer-in- compromise or installment agreement before such rejection is communicated to taxpayers, and appeal rights on the rejection or termination of installment agreements;⁵

• Collection Due Process (CDP) hearings which offer taxpayers a chance to obtain a hearing from an independent Appeals officer after the IRS places a lien on taxpayers' property and before the IRS can first levy on taxpayers' property;⁶

• Expanded spousal relief available from joint deficiencies, including equitable consideration as a basis for relief;⁷

• The termination of certain taxpayer waivers of the running of the collection statute expiration date (CSED) as of December 31, 2002, thereby preventing the IRS from collecting certain accounts beyond this date;⁸

• Restrictions on productivity-based evaluations of IRS employees;⁹

• Prohibited conduct on the part of IRS employees;¹⁰ and

• Establishment of the National Taxpayer Advocate position and reorganization of the Office of the Taxpayer Advocate, with the designation of at least one Local Taxpayer Advocate in each state to assist taxpayers with their IRS problems.¹¹

In FY 2005, the National Taxpayer Advocate assigned Taxpayer Advocate Service (TAS) staff to work with the IRS team designing the PDC initiative. Underpinning the justification for the PDC initiative is the belief that private collectors can effectively make contact with a high volume of taxpayers and resolve delinquent tax debts at least as efficiently as the IRS.¹² Thus, TAS participation was in part guided by the principle that private collectors should not be provided advantages in the collection process over the IRS at the expense of either taxpayers' rights or the long-term goal of increased rates of voluntary tax compliance. In other words, private collectors should be subject to the same limitations and restrictions as the IRS in the collection process and should be required to play on a "level playing field" with the IRS.¹³

We have only praise for the hardworking individuals in the IRS who seek to make the private collection effort successful under difficult time constraints. However, the current plan shortchanges taxpayers by exempting private collectors from the type of training required of IRS employees in similar functions. A review of the PDC process design demonstrates that private collectors will have broad interaction with taxpayers. The IRS has analogized the use of private collectors to the IRS Automated Collection System (ACS), where IRS collection representatives interact with taxpayers on the telephone. When taxpayers claim an economic hardship during collection efforts, ACS collection representatives must determine whether to designate the account "currently not collectible" or refer the case to TAS.¹⁴ Thus, ACS collection representatives have the significant responsibility of deciding whether to take the first step in the process toward assisting a taxpayer experiencing a hardship. Like ACS employees, private collectors will be granted discretion on whether to take the important first step towards obtaining relief for taxpayers alleging hardship. Yet, the private collectors will not receive even a small fraction of the training that is given to the IRS employees in similarly situated positions. Moreover, the private collectors themselves will administer the PDC training.

PDC Process Design

The AJCA legislation placed some parameters around the PDC program by authorizing the IRS to contract with private collectors for specific activities, including:

• To locate and contact any taxpayer specified by the IRS;

• To request full payment from such taxpayer and if such request cannot be met by the taxpayer, to offer an installment agreement providing for full payment of such amount during a period not to exceed five years; and

• To obtain financial information.

The AJCA explicitly prohibits private contractors from:

• Committing any act or omission which IRS employees are prohibited from committing; and

• Utilizing subcontractors to provide quality assurance services, compose debt collection notices, or directly interact with taxpayers.¹⁶

Case Selection & Referral

The PDC process described in the revised RFQ is very similar to that in the original RFQ. The IRS has created two new units that will play important roles: the Oversight Unit and the Referral Unit. The process begins with the Oversight Unit, which will retrieve and select a population of cases from the IRS's Unpaid Collections Assessment file.¹⁷ Cases selected for private collection inventories meet certain criteria designed to maximize the likelihood of collection.¹⁸ These cases will be sent to the Referral unit which will prepare the case files for delivery to the IRS contract representative (COTR), who will in turn deliver the cases to the private collectors. The IRS will then send notices to those taxpayers whose accounts are being transferred to inform them that assignment of the account has been made and notify them of the particular collection agency that received the assignment. The private collectors will then begin trying to contact taxpayers using the available contact information. If the information for a particular taxpayer proves out of date, the collector will use skip tracing techniques to locate the taxpayer.¹⁹

When a case is selected for the private collector inventory, most IRS collection efforts will cease. However, in the revised RFQ the IRS clarified that systemic offset and levy programs will continue while the case is with private collectors.²⁰ Thus, while private collectors will not have the power to impose liens or levies, they will demand payment from taxpayers under current enforcement action.

Taxpayer Contact

Once the private collector establishes contact with the taxpayer, it will make a demand for payment of the outstanding tax liability. Within five days of contacting the taxpayer, the collection company must send the taxpayer a written notice about the debt, pursuant to the Fair Debt Collection Practices Act (FDCPA).²¹ The FDCPA applies to the private collectors working on behalf of the IRS.²² Therefore, at this point in the process, or any time hereafter while the account is in the possession of the private collection company, the taxpayer may write a letter to the IRS Referral Unit opting out of private debt collection by indicating that he or she refuses to pay the debt or wishes the debt collector to cease further communication.²³ After the IRS receives the letter, the private collector must stop communication with the taxpayer.²⁴

Payment Demands & Installment Agreements

If the taxpayer continues to engage with the private collector, he or she may indicate an inability to immediately satisfy the debt. The private collector is then permitted to notify the taxpayer of the availability of installment agreements in which the taxpayer can satisfy the outstanding liability over 36 months. While the AJCA enables the IRS to accept installment agreements with repayment terms up to 60 months,²⁵ the IRS requires approval by the Referral Unit for any installment agreement longer than 36 months.

Like IRS collection personnel, private collectors will be able to approve taxpayers for installment agreements where the liability is up to $25,000 if the taxpayer has otherwise remained in filing compliance over the previous five years, and the terms of the agreement will fully satisfy the liability within three years.²⁶ In these cases, the IRS does not conduct an independent financial analysis of the taxpayers' ability to pay, and private collectors will also be exempt from performing such analyses. However, the collectors will be required to determine whether the taxpayer is in filing and payment compliance for those submitting proposed installment agreements for liabilities under $25,000. The taxpayers' filing and payment history will not be available to the private collectors, who will therefore need to rely on the verbal assurances of taxpayers that they are otherwise in compliance. If the IRS finds a taxpayer is not in compliance, it will not approve the installment agreement.²⁷

If the proposed installment agreement is for a liability in excess of $25,000, the private collector is required to complete a financial analysis of the taxpayer's ability to pay and refer the analysis and the proposed installment agreement to the IRS Referral Unit for final approval. Private collectors will not be permitted to explore other collection alternatives that involve compromising the liability, such as offers in compromise.²⁸

Inability to Pay & Economic Hardship

If, in response to a collector's demand for payment, the taxpayer alleges a financial hardship, the private collector is required to obtain the taxpayer's financial information over the phone on IRS Form 433-F, Collection / Information Statement ACS. However, the taxpayer can elect to send the financial information directly to the IRS. The financial information will be forwarded to the IRS Referral Unit for review and verification of the hardship. If the taxpayer's hardship condition is verified, the account will be returned to the IRS and designated as Currently Not Collectible (CNC) on the IRS's system.²⁹ In certain circumstances, the financial verification requirement is waived.³⁰

Congress established the National Taxpayer Advocate, Taxpayer Advocate Service, and Local Taxpayer Advocates for the protection of taxpayers experiencing significant hardships, including delays, in their dealings with the IRS.³¹ If taxpayers request TAS assistance from the private collector or describe circumstances suggesting that they are experiencing a significant hardship, the TAS telephone number (1-877-ASK-TAS1) will be provided and collection will pause for 30 days to give the taxpayer time to contact TAS. TAS will assist taxpayers with significant hardships and will interact with private collectors where necessary to ensure that the taxpayer understands all of his or her payment options or other alternatives for resolving the debt.

Complaint Process

The RFQ establishes a complaint process for taxpayers and their representatives.³² When the IRS receives a written complaint from a taxpayer, the IRS will notify the collection contractor who must then cease collection activity and provide the IRS contracting representative (COTR) with a copy of the account history. The contractor may not resume collection activities until directed to do so by the IRS. The contractor must also provide any written complaints to the COTR by close of business the following day and must also provide notes of verbal complaints made by taxpayers. The contractor is required to keep a log of all complaints made by taxpayers, which will be accessible by the COTR and other parts of the IRS, including TAS.³³

Once the IRS receives the complaints, the COTR will label the complaints as falling within three possible categories:

• Type One Complaints: These are complaints concerning rude behavior or incompetent performance. Type One complaints may, at the discretion of the IRS COTR, be re-categorized as Type Two Complaints.³⁴

• Type Two Complaints: These complaints involve overly aggressive tactics by collectors that may involve intimidation but do not reach the level of statutory violations. Contractors are required to investigate the complaint and provide a report to the COTR.

• Type Three Complaints: These complaints involve violations of statutory protections of taxpayers, including the Fair Debt Collection Practices Act³⁵, the Privacy Act,³⁶ disclosure statutes,³⁷ Taxpayer Bill of Rights,³⁸ Taxpayer Bill of Rights 2,³⁹ and other applicable laws. Upon validation of Type Three Complaints by the COTR, the IRS will revoke all necessary clearances of the offending employee. The COTR is required to notify the Treasury Inspector General for Tax Administration of any validated Type Three Complaints.

Payment, Private Collector Compensation and Performance

Private collectors are instructed to direct all payments to the IRS. Collectors will be paid commission fees based on dollars collected from assigned accounts, provided the IRS receives those payments 11 or more calendar days after the account was assigned.⁴² The IRS will evaluate private collectors quarterly, based on a balanced metrics scorecard that measures:

• Percentage of dollars collected;

• Case resolution percentage;

• Taxpayer satisfaction;

• Employee satisfaction; and

• Validated complaints.⁴³

TRAINING

In working with the IRS on the training initiative, TAS advocated training of private collection employees in two respects:

• Responsibility for providing training; and

• The scope and delivery of training topics.

Responsibility for Training

To create a level playing field between the IRS and private collectors and ensure that private collectors are taught by knowledgeable trainers, the IRS should assume responsibility for training collectors on core topics -- at least for the first batch of private collection employees, with videotapes of those initial sessions forming the basis of training for later hires. As designed, however, the PDC initiative assigns training responsibility on taxpayer rights and IRS procedures to the private collectors themselves, as follows:

Scope and Delivery of IRS Training

IRS employees receive substantial training before they handle collection matters. Table 1.4.1 below lists a small sample of the training required of entry level IRS employees.

 __________________________________________________________________________

In contrast to the types of introductory and continuing education received by IRS employees, private collectors will watch a video entitled "Safeguarding IRS Confidential Information" and a two hour training video with time allotted to 5 topics as follows:

• 20 minutes for "Privacy Awareness;"

• 20 minutes for "Disclosure & Safeguards Awareness;"

• 20 minutes for "Taxpayer Rights and the Taxpayer Advocate Service;"

• 20 minutes for § 1203 of the IRS Restructuring and Reform Act of 1998; and

• 20 minutes for "The Role of the Treasury Inspector General for Tax Administration.

While it may not be feasible or necessary from a time or resource perspective to require private collectors to undergo the same amount of training as IRS employees, at a minimum, the IRS should offer classes on the following topics to collection contractor employees:

• Taxpayer Rights: This course would cover the development of taxpayer rights protections, including the Taxpayer Bill of Rights,⁴⁷ Taxpayer Bill of Rights 2,⁴⁸ and the IRS Restructuring and Reform Act of 1998.⁴⁹ Since taxpayers do not forfeit any rights by virtue of the PDC initiative, private collectors must be intimately aware of their obligations towards taxpayers. As described above, the IRS has planned for a 20-minute video presentation on taxpayer rights and the Taxpayer Advocate Service. Because the National Taxpayer Advocate believes this level of training to be inadequate, she has requested that the IRS allow her to augment the 20 minutes devoted to taxpayer rights with an additional two-hour video presentation. The IRS has agreed in principle to allow the additional taxpayer rights training.

• Financial Information Interviews: Private collectors will obtain financial information from taxpayers. While contractors may provide some financial training to their collection representatives, private collectors need instruction on Internal Revenue Manual procedures for the conduct of taxpayer interviews, including explanations of IRS Allowable Expense Guidelines, including deviations from the allowable national and local expense standards.⁵⁰

• Installment Agreements: The installment agreement procedure to be utilized by private collectors corresponds to the IRS procedures for guaranteed and streamlined installment agreements, and thus, private collectors must be trained on IRS installment agreement procedures and scenarios.⁵¹

• Confidentiality: There are numerous provisions protecting taxpayers from disclosure of their tax return information to third parties.⁵² A detailed review of legislative provisions protecting from disclosure of taxpayer information is essential to public confidence in the PDC initiative. This course should contain scenarios of various fact patters in addition to covering the technical requirements of these laws.

• Liens & Levies: The IRS will continue certain collection actions while the cases are on assignment to private collectors, and private collection representatives must be knowledgeable about the ongoing consequences of collection actions and aware of the rights and protections available to taxpayers subject to lien or levy.⁵³

• IRS Office of Appeals: The Office of Appeals acts as an independent reviewer for many examination and collection actions taken by the IRS.⁵⁴ Taxpayers may request or may have already requested assistance from the Office of Appeals while the case is with private collectors. At a minimum, private collection representatives must understand at what point in the collection process taxpayers can seek the assistance of the Office of Appeals.

• Taxpayer Advocate Service: The AJCA provides that the Taxpayer Assistance Order (TAO) applies to private collectors.⁵⁵ TAS will work with private collectors on cases, and thus, collectors need familiarity with TAS authority and procedures. TAS has training materials and knowledgeable training staff ready to provide training in a classroom setting for private collection representatives.

The Fair Debt Collection Practices Act contains a section devoted to Congressional findings about the debt collection industry in our country:

The process by which taxpayers can complain about the treatment from private collectors and by which collectors are held accountable is largely a matter of self-regulation to the extent that taxpayers make complaints to the collection contractor but do not send a copy of the complaint to the IRS.⁵⁸ Verbal complaints must be reduced to notes and kept in a complaint log that is submitted to the IRS contracting representative.

There are significant ambiguities in the Type One, Two, and Three Complaint descriptions. Type One Complaints (rudeness) trigger a different set of obligations on the contractor than Type Two (intimidation or heavy-handed behavior) or Type Three (statutory violations) complaints. For example, Type One Complaints do not require an immediate investigation by the contractor followed by a written report to the IRS contracting representative. On the other hand, Type Two and Three Complaints do require an immediate investigation by the contractor to be followed by a written report of the findings. Given the self-regulated nature of the complaint process, the IRS itself should train the contractors, with clear examples and case studies, on the types of complaints and their documentation requirements.

CONCLUSION

The Private Debt Collection initiative is a major departure from traditional IRS collection practice. There will need to be a significant adjustment in the minds of taxpayers to get accustomed to private collectors acting on behalf of the IRS. The IRS cannot afford to let the initiative diminish the respect that most U.S. taxpayers have for our tax system. The IRS has decided that it does not want to assume the obligation to train private collectors, even on subjects as central to the tax system as taxpayer rights. Erring on the side of too much training rather than not enough would be the most prudent strategy, at least at the inception of this initiative. Providing adequate training, especially on taxpayer rights and the complaint process, not only "levels the playing field" between the IRS and contractor employees, but also protects taxpayers.

IRS COMMENTS

The IRS regards the appropriate training of private collection agency personnel as critical to the success of this new program and has taken great care to craft a training program that will ensure the same level of proficiency for private collection agency (PCA) employees that is demonstrated by IRS employees. We are, however, in basic disagreement with the conclusions outlined in this Most Serious Problem reported by the National Taxpayer Advocate. While no PCAs have yet been awarded contracts, and no training has actually begun, we believe the content and delivery of IRS specific training material has been properly planned and will be executed in a highly professional manner by both the IRS and PCA personnel involved.

The procedures and processes for the implementation of private debt collection for federal taxes have been created so that the distinction is clear between the inherently governmental functions involved and the tasks to be performed by the PCAs. When contracts are awarded to the selected PCAs, the IRS will supply all materials outlined in the Request for Quotations (RFQ) issued October 13, 2005, and include a comprehensive handbook of procedures developed for use by the PCAs as well as specific documents and videos on: confidentiality of return information, privacy and safeguards, taxpayer rights, the Taxpayer Advocate Service (TAS), the application of the provisions of the Internal Revenue Restructuring Act of 1998, and the role of the Treasury Inspector General for Tax Administration. Documents developed for IRS employees on these subjects will be provided where available. In addition, based on discussions with TAS personnel, the IRS will also include a special video on additional TAS issues. These materials will include specific text and chapters on all necessary topics including data security, taxpayer rights, securing an installment agreement, accounts requiring special processing, recall and return of accounts and the complaint process. Supplying these materials is but the first step in working with the PCAs on a well-developed training plan. The PCAs are also required to submit a training plan for IRS approval. All of these documents will be used as the base for a class taught by the IRS for the instructors and key personnel designated by the PCAs. The IRS expects that topics of interest outlined by the National Taxpayer Advocate will be discussed in detail and the complexity of the materials will reflect appropriately the needs of the PCA employees in performing their assigned tasks.

This "train-the-trainer" session will be part of the pre- operational certification phase for the PCAs. The IRS plans to monitor the training provided by each firm to ensure that a quality presentation is made. All PCA employees working on this program will also be required to execute the same certifications of training required by IRS employees for critical topics. Support organizations within the IRS will be established to assist the PCAs in working the assigned inventories. IRS employees assigned to these units will be trained and available to work with the PCA employees as each case is worked to ensure the appropriate resolution is achieved. If on-the- job training needs are identified by either the IRS or a PCA, the support units will assist in delivering "just-in-time" training as needed. The IRS will monitor phone calls with taxpayers made by the PCAs and review casework; these review results will assist in identifying any additional training needs on an on-going basis. PCAs and their employees will be held to the same standards of service and rights protection as IRS employees and a customer satisfaction survey will be employed to track taxpayer feedback.

The depth of the interaction between a PCA employee and a taxpayer will not be analogous to a contact between an IRS employee and the same taxpayer. The IRS has designed the inventory selection to include only those cases whose attributes allow the type of case resolution intended by the statute. We have excluded cases that would require the additional knowledge of an IRS employee for resolution. When taxpayers claim an economic hardship, PCA employees will not be able to determine if an account can be designated "currently not collectible." They may only gather financial information and submit the case for an IRS employee to make a decision. The training designed for the PCAs is explicit in this regard. PCA employees will not require the same training as an IRS employee in many instances, and the training program has been tailored to reflect that reality. Complete training on referring cases to the Taxpayer Advocate Service is included in this program. The IRS related training is in addition to any conducted by each PCA on their own topics; most reputable PCAs routinely train their employees on many detailed topics including the provisions of the Fair Debt Collection Practices Act. As an additional note, PCA employees will be requesting payment from taxpayers whose outstanding liability will not be actively assigned within the IRS and meets the criteria for placement with the PCA. While a refund offset or systemic attachment to a governmental payment may occur on these cases, this would have occurred while the cases remain open, even if not assigned to the PCA.

The process for surfacing and tracking complaints from taxpayers has been constructed to provide multiple avenues of access by the taxpayer as well as several review points by the IRS to regulate compliance with the RFQ requirements. Clearly, one avenue of access is the PCA employee or manager who is required to track complaints. IRS monitoring of phone calls, case reviews, and a survey of taxpayers handled by the PCAs are intended to ensure that this avenue of identification functions properly. A second avenue of identification is the specific IRS support unit created to assist both taxpayers and PCAs in case resolution. A letter to each taxpayer assigned to a PCA is planned, and this letter will include a special telephone number for the support unit that the taxpayer can use to contact the IRS. This is in addition to the regular toll-free assistance, a third avenue. Fourth, TAS can also be contacted directly and that number will also be furnished to the taxpayers as part of the notifying letter. Training on the complaint process is included in the "train-the-trainer" session and the handbooks provided to the PCAs, but will also likely be part of a continuous dialogue with the vendor collection agency.

The PCAs that are awarded task orders for this program have already been awarded contracts under the GSA schedule. As a contract awardee, these companies are required to fully train their employees to fulfill the requirements of any task order. Second, while appropriated funds may be used for the training of contractors and other non-Federal employees where such training is necessary to the implementation of a Federal program, there is no requirement that the training be provided directly or via any other particular format such as the "train-the-trainer" or on-the-job. Also, the training program can be ongoing and require various actions to implement it over the course of its lifespan. It is within the discretion of the agency as to how to provide training necessary for the implementation of this program throughout the term of the PCA contract. In deciding how to train PCA employees, the IRS considered the potential cost of providing IRS employees to train each and every PCA employee both now and in the future as the PCAs hire new employees.

In conclusion, the IRS has assumed its responsibility for the success of the Private Debt Collection initiative, including the delivery of a quality, cost-effective training program for PCA employees on IRS specific issues. The IRS has instituted a comprehensive package of materials and planned an extensive process for training key PCA personnel in addition to several layers of review and feedback to ensure the appropriate handling of all cases assigned to private collection agencies.

TAXPAYER ADVOCATE SERVICE COMMENTS

We agree that there is a "basic disagreement" between the IRS and the National Taxpayer Advocate on the approach to training private debt collectors. The National Taxpayer Advocate reiterates her praise for all of the IRS employees who have participated in the development of the Private Debt Collection initiative. Thus, our concerns are not that the training efforts will lack professionalism. As indicated in the report, our concerns extend to the adequacy of the training delivery system and the scope of that training.

Train-the-Trainer

The Request for Quotations, i.e. the procurement document which solicited bids from PCAs, does not reference the train-the- trainer concept in any way, and the IRS's comments above do not explain the nature and extent of this training in any detail other than to indicate that the foundation of the materials will consist of the two training videos and the PCA procedural guide provided by the IRS. Thus, there are few details about the train-the-trainer concept. We understand that the development of the training plan is still a work in progress.

However, we have fundamental concerns about utilizing a train- the-trainer methodology for the Private Collection Agencies (PCAs). In this report, we demonstrated that the business of federal tax collection has become eminently more complex over the last two decades with the passage into law of the Taxpayer Bill of Rights, the Taxpayer Bill of Rights 2, the Internal Revenue Service Restructuring and Reform Act of 1998 and other collection reforms. We do not believe the IRS can avoid this complexity through its inventory selection software. Moreover, the IRS has tax law experts in abundance, many of whom played important roles in the implementation of IRS procedures to conform to the changes in the laws. This type of experience cannot be passed on to trainers in the private collection industry (some of whom may possess no tax law expertise) in a short training session. There is no reason for depriving front-line collection employees (and the taxpayers who will have to deal with them) of this type of first-hand experience and expertise.

The IRS has indicated that it considered the potential cost of providing IRS employees to train each and every PCA employee both now and in the future as the PCAs hire new employees. However, we believe that more effective training methods may be less expensive (both in terms of out-front expenditures and in terms of the costs to our tax administration system of having poorly trained employees interacting with taxpayers) than what the IRS is proposing. For example, the IRS is proposing to have available "just-in-time" training for PCAs when deficiencies are spotted. We applaud this innovative idea. On the other hand, there are costs associated with having IRS teams on stand-by to provide just-in-time training that might not be needed if the IRS simply provided direct comprehensive training on the front- end of the process. Similarly, the IRS plans to have monitors present when the PCAs train themselves. If the IRS is going to incur the costs associated with having its personnel at training sessions, it may be more efficient to simply have IRS trainers present rather than monitors. In other words, the costs associated with correcting incomplete training may be eliminated or reduced if the IRS provided the training that is required of IRS employees.

Moreover, since first writing our initial analysis, we have learned there will be significant turnover among PCA employees working IRS accounts. That is, unlike IRS employees who work in the same collection positions for several years and reinforce their awareness, knowledge, and understanding of taxpayer rights through annual training and day-to-day practice, PCA employees will start and end their work on the IRS account on an ongoing basis. There will, in short, be no accretion of expertise or experience in protecting taxpayer rights specific to the Internal Revenue laws. More than any other aspect of the PCA initiative, this employee turnover poses serious risks to taxpayers and shows that the playing field is indeed not level between the IRS and PCAs. This turnover also increases the importance of the IRS conducting such training itself.

Scope

We believe the scope of the materials to be covered in PCA training is too narrow and should be expanded as recommended below. We are pleased that the IRS has agreed to include material about the complaint process in its train-the-trainer session. However, we again point out that ambiguities in the complaint process can best be addressed through scenario-driven training provided to the PCAs by IRS employees.

RECOMMENDATIONS

In consideration of the issues raised above, the National Taxpayer Advocate makes the following recommendations:

² U.S.C.A. Const. Art. I § 8, cl. 1 confers the power to collect taxes upon Congress:

⁴ The 1996 pilot private debt collection initiative was discontinued for multiple reasons, including that the revenue collected was less than the IRS's direct costs plus revenues lost from using IRS employees to support private collection rather than collect taxes. General Accounting Office, GAO/GGD-97-129R, Internal Revenue Service: Issues Affecting IRS's Private Debt Collection Pilot 2 (July 18, 1997).

⁵ Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206 § 3462(a); now codified in IRC § 7122(d).

⁶ Pub. L. No. 105-206 § 3401(b), now codified in IRC §§ 6330 and 6320.

⁷ Pub. L. No. 105-206 § 3201, now codified in IRC § 6015.

⁸ IRC § 6502 provides that the IRS generally has 10 years from the date of assessment to collect tax. Certain actions by taxpayers either suspend or extend the collection statute of limitations, such as submission of an offer in compromise. IRC § 6331(i)(5) and 6331(k)(1). RRA 98 reduced the extent to which these waivers could be enforced, as follows:

⁹ Pub. L. No. 105-206 § 1204.

¹⁰ Pub. L. No. 105-206 § 1203, prohibiting the following conduct on part of IRS employees: willful failure to obtain approval signatures on documents authorizing the seizure of a taxpayer's home, personal belongings, or business assets; providing false statements under oath with respect to material matter involving a taxpayer or taxpayer representative; falsifying or destroying documents to avoid uncovering mistakes made by any employee with respect to a taxpayer or a taxpayer representative; assault or battery on a taxpayer or taxpayer representative; violation of a taxpayer's or taxpayer representative's civil rights; violations of the Internal Revenue Code, or regulations or policies, for the purpose of retaliating against or harassing a taxpayer or taxpayer representative; willful failure to file a federal tax return; willful understatement of a federal tax liability; threatening audit to a taxpayer to extract personal gain; or willful misuse or violation of IRC § 6103.

¹¹ Pub. L. No. 105-206 § 1102(a) and (c), now codified in IRC §§ 7803(c) and 7811.

¹² 150 Cong. Rec. H8411-01, 109th Cong., 2nd Sess. (Oct. 7 2004).

¹³Use of Private Collection Agencies to Improve IRS Debt Collection, House Committee on Ways & Means, 108th Cong. (May 13, 2003) (statement of Nina E. Olson, National Taxpayer Advocate).

¹⁴ IRM § 5.16.1.1; see also § IRM 5.8.1.6.

¹⁵ Pub. L. 108-357, Title VIII, § 881; now codified in IRC § 6306.

¹⁶Id.

¹⁷ As of December 2004, the IRS had $7.7 billion of tax debt classified as potentially available for the implementation of the Private Debt Collection Initiative. IRS, Request for Quotations, April 25, 2005, I-23.

¹⁸ In order to minimize disputes on the issue of whether the tax is owed, cases selected will be those where the taxpayer has filed a tax return or has made three or more payments on a compliance related assessment. See IRS Request for Quotations, ¶ J.4.3.1.

¹⁹ "Skip tracing" refers to utilizing various databases to detect current contact information. See IRS Request for Quotations, ¶ J.3.2.3.

²⁰See IRS Request for Quotations, ¶ J.4.3.4. The IRS has authority to impose a continuous levy on "any Federal payment other than a payment for which eligibility is based on the income or assets of the payee." IRC § 6331(h)(2)(A). Additionally, the IRS has the authority to offset against overpayments to the IRS amounts owed to other federal agencies, past- due family support obligations, legally enforceable state income tax obligations, or amounts owed with respect to other federal tax obligations. IRC § 6402.

²¹ The Fair Debt Collection Practices Act (FDCA) applies to private collectors working on behalf of the IRS. See IRC § 6306. Pursuant to 15 U.S.C.A. § 1692g, all collectors are required to send written notices to taxpayers within five days of the contact giving notice of: (1) the amount of the debt; (2) the name of the creditor to whom the debt is owed; (3) a statement that unless the consumer, within thirty days after receipt of the notice, disputes the validity of the debt, or any portion thereof, the debt will be assumed to be valid by the debt collector; (4) a statement that if the consumer notifies the debt collector in writing within the thirty-day period that the debt, or any portion thereof, is disputed, the debt collector will obtain verification of the debt or a copy of a judgment against the consumer and a copy of such verification or judgment will be mailed to the consumer by the debt collector; and (5) a statement that, upon the consumer's written request within the thirty-day period, the debt collector will provide the consumer with the name and address of the original creditor, if different from the current creditor.

²² IRC § 6306(e).

²³ 15 U.S.C.A. § 1692c(c).

²⁴Id.

²⁵ IRC § 6306(b)(1)(B).

²⁶ IRC § 6159(c) guarantees that installment agreements will be approved if the liability is $10,000 or less, the taxpayer has been in filing and payment compliance for the past five years, the liability will be satisfied within three years and the IRS determines that the taxpayer cannot immediately satisfy the liability. The Internal Revenue Manual also authorizes collection personnel to accept "streamlined installment agreements" up to $25,000 under the same general procedures without requiring verification of taxpayers' finances. IRM § 5.14.1.2.

²⁷See IRS Request for Quotations, ¶ J.4.4.6.2.

²⁸ IRS Request for Quotations, 33, ¶ J.4.4.7.

²⁹ The provisions with respect to designating accounts as Currently Not Collectible are derived from existing IRS procedures. IRM § 5.16.1.1.

³⁰ No financial analysis is required of the taxpayer's claim of financial hardship if the liability is less than a certain threshold and one of the following conditions exist: the taxpayer has a terminal illness or excessive medical bills; taxpayer's only source of income is Social Security, welfare, or unemployment; or the taxpayer is unemployed with no source of income. This exception is contained in IRM § 5.16.1.2.9.

³¹ Pub. L. No. 105-206 § 1102(a) and (c); now codified in IRC §§ 7803(c) and 7811.

³² IRS Request for Quotations, 38-39 (¶ J.5).

³³Id.

³⁴ Although the RFQ does not clarify the circumstances for when a Type One complaint could be reclassified as a Type Two Complaint, presumably this reclassification will occur when it appears that a particular collector is systematically incurring Type Two Complaints. See IRS Request for Quotations, 39 (¶ J.5.5.1).

³⁵ 15 U.S.C.A. § 1692 et seq.

³⁶ 5 U.S.C.A. § 552a.

³⁷ IRC §§ 6103, 7213, 7213A, 7431.

³⁸ Taxpayer Bill of Rights, Subtitle J of Title VI of Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Pub. L. No. 100-647, §§ 6226 -- 6247.

³⁹ Taxpayer Bill of Rights 2, Pub. L. 100-647, §§ 6226 -- 6247 (1996).

⁴⁰ The Validated Type Two or Three Complaint Deduction Schedule is as follows:

                   Type II Complaints             Type III Complaints

⁴¹ The COTR may waive repercussions where the complaint was inadvertent, e.g. the result of a temporary systems problem, isolated incident, etc.

⁴² IRS Request for Quotations, 20.

⁴³ IRS Request for Quotations, Attachment 1.

⁴⁴ IRS Request for Quotations, Attachment 1.

⁴⁵ National Taxpayer Advocate 2004 Annual Report to Congress 350.

⁴⁶ IRS Request for Quotations, ¶ J.4.2.

⁴⁷ Pub. L No. 100-647, 102 Stat 3342 (1988).

⁴⁸ Pub. L No. 104-168, 110 Stat 1452 (1996).

⁴⁹ Pub. L. No. 105-206, 112 Stat. 685 (1998).

⁵⁰ IRM § 5.15.1.

⁵¹ IRM § 5.14.1.2.

⁵² IRC §§ 6103 (Confidentiality and disclosure of returns and return information); 7213 (Unauthorized disclosure of information); 7213A (Unauthorized inspection of returns or return information), and 7431 (Civil damages for unauthorized inspection or disclosure of returns and return information).

⁵³See IRS Request for Quotations, 20 (¶ J.4.3.4).

⁵⁴ Pursuant to IRC §§ 6320 and 6330, the Office of Appeals administers Collection Due Process (CDP) hearings before levies and after the imposition of liens at which taxpayers may raise a number of issues, including spousal defenses, collection alternatives and the underlying liability (where the taxpayer has not received a notice of deficiency or otherwise had an opportunity to argue the liability). The Office of Appeals also administers the Collection Appeals Program, an administratively created program where taxpayers may obtain an independent review by Appeals of certain IRS collection actions. IRM § 8.7.2.

⁵⁵ Pub. L. No. 108-357, Title VIII, § 881, 118 Stat. 1625 (2004); now codified in IRC § 7811(g). The authority for the National Taxpayer Advocate's Taxpayer Assistance Orders is provided for in IRC § 7811(a)(1)(A): The National Taxpayer Advocate may issue a Taxpayer Assistance Order if -- (A) The National Taxpayer Advocate determines the taxpayer is suffering or about to suffer a significant hardship as a result of the manner in which the internal revenue laws are being administered by the Secretary.

⁵⁶ 15 U.S.C.A. § 1692

⁵⁷ Federal Trade Commission Annual Report 2005: Fair Debt Collection Practices Act 2.

⁵⁸ IRS Request for Quotations, 38 (¶ J.5).

MOST SERIOUS PROBLEM: EARNED INCOME TAX CREDIT EXAM ISSUES

RESPONSIBLE OFFICIAL

In its efforts to improve the administration of the Earned Income Tax Credit (EITC), the IRS continues to focus on both EITC noncompliance by making improvements to the EITC examination process and providing education and outreach to ensure that eligible taxpayers are receiving the EITC. Despite significant improvements, however, problems remain for EITC examinations and recertification. These problems include EITC correspondence exams, which typically involve minimal personal interaction and can have negative consequences for low income taxpayers. Confusing IRS requests for information, lost taxpayer correspondence, lack of acknowledged correspondence, and a lack of personal contacts all contribute to problems for taxpayers in the EITC exam process.

Problems with the EITC exam process include:

• Delays in exam procedures;

• Taxpayer response rate; and

• Problems with documentation.

• Delays in the recertification process;

• Inconsistent treatment of recertification cases; and

• Problems with documentation.

Background

In July 2002, the IRS took steps to improve EITC administration by creating the EITC Program Office.¹ The creation of the EITC Program Office allowed the IRS to create a comprehensive strategy for the administration of the EITC. In August 2002, the IRS established the EITC Advisory Council, a policy-making body responsible for providing strategy, budget, and operational reviews and recommendations for the Wage and Investment (W&I) Commissioner.²

In June 2003, Commissioner Everson announced a five-point initiative to improve service, fairness, and compliance with EITC rules.³ The initiative was designed to:

• Reduce the backlog of pending EITC examinations to ensure that eligible taxpayers whose returns are being examined receive their refunds quickly;

• Minimize burden and enhance the quality of communications with taxpayers by improving the existing audit process;

• Encourage eligible taxpayers to claim the EITC by increasing outreach efforts and making the requirements for claiming the credit easier to understand;

• Ensure fairness by refocusing compliance efforts on taxpayers who claimed the credit but were ineligible because their income was too high; and

• Pilot a certification effort to substantiate qualifying child residency eligibility for claimants whose returns are associated with a high risk for error.

The IRS has a number of projects underway to improve the EITC and address areas of the Commissioner's five-point initiative. One aspect of this program is a series of studies designed to examine the three major sources of errors identified in a 1999 EITC compliance study: qualifying child errors, filing status errors and income reporting errors.⁴

The primary initiative is the implementation of the EITC Qualifying Child Residency Certification Study (hereinafter referred to as certification).⁵ The certification study looked at a random sample of 25,000 EITC claimants for whom the IRS could not establish qualifying child residency eligibility through available data.⁶ The study sought to determine the impact of a residency certification requirement on:

• The amount of EITC claimed including the amount of erroneous claims;

• The number of children claimed;

• Taxpayer participation in the EITC;

• Taxpayer burden; and

• The amount of erroneous claims that were prevented from being paid to ineligible taxpayers.⁷

The IRS also engaged in an EITC Filing Status Study focused on taxpayers who improperly file as single or head of household, when they should have filed as married filing jointly or married filing separately.¹⁰ The study examined the impact of requesting certain EITC taxpayers to document their marital status, to validate the filing status claimed on their tax return.¹¹

The final study was an Automated Underreporter (AUR) Study to focus compliance efforts on taxpayers who claim the EITC but are either ineligible because their incomes are too high or are eligible but overclaim the EITC because they misreport their incomes.¹² The AUR Study used tax returns filed in tax year 2002 to identify, through document matching, EITC claimants with a high likelihood of income reporting errors. The focus of the study was to improve the method of selecting AUR cases to specifically address EITC overclaims due to misreported income.¹³

In December 2004, the Taxpayer Advocate Service released the EITC Audit Reconsideration Study, conducted by TAS and W&I. The EITC Audit Reconsideration Study focused on identifying ways to improve the accuracy and effectiveness of EITC audit reconsideration and the overall EITC correspondence exam process, while minimizing burden to taxpayers.¹⁴ The results raised questions about the current audit reconsideration process and broader questions about the general EITC exam process.¹⁵

The IRS is currently engaged in a number of other research initiatives, the result of which may help improve the administration of the EITC, for both taxpayers and the IRS. In fiscal year 2004, TAS and the IRS Office of Research partnered to design a study to evaluate the impact of representation on the ultimate outcome of EITC audits.¹⁶ The study will look at tax year (TY) 2002 EITC audit outcomes to determine if the presence of representation in an EITC audit increases the likelihood of a favorable outcome.¹⁷

TAS, the EITC Program Office and W&I Research are collaborating on a research initiative to collect information from EITC taxpayers to enable the IRS to better understand their customer service needs.¹⁸ The first phase of the research consisted of focus group sessions with EITC claimants to determine and describe the most relevant EITC customer service issues.¹⁹ The feedback from the focus groups will be used to design a survey that will be sent to a representative sample of all EITC claimants, the results of which will be used to recommend potential improvements in EITC customer service.²⁰

Finally, TAS is also collaborating with the EITC Program Office and W&I Research on a study to identify the most significant barriers that taxpayers encounter during the EITC correspondence audit process. The IRS has conducted the first phase of the research, consisting of interviews with Low Income Taxpayer Clinic (LITC) representatives who have assisted taxpayers undergoing EITC correspondence audits.²¹ The results from the interviews will be used to design a survey that will be sent to a representative sample of taxpayers who have recently experienced EITC correspondence audits to quantify the impact these barriers have on taxpayers. TAS will use the results of the study to recommend potential improvements to the EITC correspondence audit process.

EITC Exam Improvements

The IRS has also made a number of improvements to the EITC exam process over the past few years. Previously, the IRS sent one letter that denied the EITC claimed on the tax return, asked the taxpayer to substantiate the EITC, and triggered the opportunity for the taxpayer to appeal his case to the Office of Appeals.²² This combination letter was very confusing for many EITC taxpayers who did not understand that they needed to preserve their appeal rights even though they were not yet sure whether the IRS would accept the information they submitted to substantiate their EITC claim.

Beginning in fiscal year 2005, the IRS eliminated the combination letter. Taxpayers subject to an EITC correspondence exam now receive two separate notices regarding the examination of their EITC claim. The first notice informs the taxpayer that their EITC claim is under examination and requests information to substantiate the EITC claim. If the taxpayer fails to respond to the first notice, or if the information provided is insufficient to substantiate the EITC, the taxpayer receives a second, 30-day letter. The 30-day letter disallows the EITC and gives the taxpayer the opportunity to appeal the IRS' decision.

In conjunction with eliminating the combination letter, the IRS has also created a new Publication 3498-A, The Examination Process (Examinations By Mail). This new publication outlines the correspondence exam process and provides an Appeals request tear off form that the taxpayer can use to request an appeal of an IRS decision.

Prior to January 2004, when a taxpayer was subject to an EITC exam, the IRS froze the taxpayer's refund until the exam was complete. Beginning in January 2004, W&I changed its processes and limited the frozen amount only to the EITC portion of the taxpayer's refund.²³

The IRS has also made significant progress by training correspondence examination employees to exercise judgment in evaluating the documentation taxpayers provide in a correspondence exam. In determining whether to allow or deny an EITC claim, IRS employees are encouraged to use judgment, based on the facts of the case and the information available, to determine whether to allow a taxpayer's claim in whole or in part. This focus on using sound judgment is beneficial in cases where a taxpayer is able to provide some documentation to support the claim, but is unable to obtain documentation for all bills and expenses.

Despite the progress made in the past few years, there is still room for improvement, especially in light of the recent EITC research.

EITC Correspondence Examination Process

The IRS's Revenue Protection Strategy (RPS) guides the processing of most tax returns selected for EITC Correspondence Examination.²⁴ Under the RPS, the IRS generally freezes a taxpayer's EITC claim until the exam is complete.²⁵ Once the IRS selects a tax return for a correspondence exam, the IRS sends the taxpayer a series of letters with information requests, and the case continues through an automated batch process.²⁶

A correspondence exam begins with the IRS sending the taxpayer an initial contact letter explaining the audit process and the issues the IRS is examining, and requesting documentation specific to these issues.²⁷ The IRS generally gives a taxpayer 30 days to respond to the initial letter. If the taxpayer sends documentation, and the IRS determines it is inadequate, the taxpayer receives another letter requesting additional information.²⁸ If the IRS receives documentation from a taxpayer but is unable to review it timely, the IRS generally sends an interim letter acknowledging receipt and giving a reply date.²⁹

If the taxpayer does not respond to the initial contact letter within the given period, the IRS issues a second letter, commonly referred to as the 30-day letter. The 30-day letter includes an examination report showing the tax liability resulting from the adjusted issues. The taxpayer has the opportunity to send documentation to the IRS to verify the issues, agree with the exam report, or appeal the tax by returning a form included in the mailing.

If the taxpayer does not respond to the 30-day letter, the IRS issues a Statutory Notice of Deficiency, known as the 90-day letter. The taxpayer has 90 days from the date of this notice to petition the United States Tax Court.³⁰ If the taxpayer does not respond to a notice of deficiency, the IRS will close the case and assess the taxpayer's account for the tax, interest, and any penalties. Because the Batch Processing system automatically moves cases through creation, statutory notice, and closing unless the IRS receives a taxpayer response, the taxpayer's failure to respond to any of the IRS' letters leads to the correspondence examination closing with no involvement from an IRS examiner.³¹

EITC Examination Statistics

In TY 2003, over 21 million taxpayers received the EITC.³² In FY 2004, the IRS closed nearly 445,000 EITC correspondence exams.³³ Table 1.5.1 shows the results of these cases, with approximately 40 percent closing as a "no response" or "undeliverable," meaning that, according to the IRS examiners, the taxpayer did not contact the IRS with respect to the exam. The table also shows that approximately 17 percent of the exams close as "Default with Correspondence," meaning taxpayers attempted to engage in the audit process but left the system.

        TABLE 1.5.1, BREAKDOWN OF EITC CORRESPONDENCE EXAMS BY

           TABLE 1.5.2, IRS AUDIT COVERAGE, FY2004⁴⁵

One of the major issues with the EITC examination function is that taxpayers experience long delays during the exam process. The IRS has made a number of efforts to clarify the correspondence sent to taxpayers as part of the process, but many taxpayers are still unsure why the IRS is contacting them and what information they need to provide to the IRS. The average cycle time of EITC exams for FY 2005 is 181 days.⁵³ The cycle time has continued to improve over the past few years and is down from 220 days in FY 2002, 203 days in FY 203, and 185 days in FY 2004.⁵⁴ The reduction in average cycle time for EITC exams is a significant improvement on the part of W&I Compliance, particularly in light of the fact that the IRS has recently added days to the exam process by eliminating the combination letter. Despite this progress, however, 181 days is still a long time for taxpayers who need the EITC funds at issue in the exam.

While the somewhat lengthy cycle time can be frustrating for taxpayers, increasing cycle time is not always a negative thing when it allows the taxpayer additional time to respond to IRS requests. The IRS designed the 2004 certification test to give taxpayers sufficient time to respond to IRS requests. The certification process included both an additional letter and extra time that are not part of standard IRS procedures for EITC examinations.⁵⁵ IRS standard procedures allow taxpayers 30 days to respond to the report of proposed changes. The IRS extended this timeframe to 45 days for certification. The IRS also sent a second letter and report of proposed changes -- which is not standard procedure -- to taxpayers who did not respond to the first letter. This additional letter could add up to 45 days to the process. These two procedural changes added an extra letter and up to 60 days to the process.

Although the changes in the certification study added days to the cycle time for an EITC audit, the changes were designed to ensure taxpayers have adequate time to respond to IRS requests and provide adequate documentation to support an EITC claim. It is unclear whether the additional letter and time increased a taxpayer's ability to meet IRS requests. We recommend further study of whether an increase in cycle time improves a taxpayer's ability to prove EITC eligibility.

When a taxpayer responds to the IRS's request for documentation for an EITC examination, the taxpayer often encounters a new set of problems. The IRS may not associate these documents with the taxpayer's case and may ultimately misplace the documents. For FY 2004, the W&I received nearly 215,000 pieces of mail associated with EITC examinations.⁵⁶ At the end of FY 2004, almost 43 percent of the total EITC mail at the W&I campuses was characterized as overaged.⁵⁷ The taxpayer often must resubmit the documentation, some of which he or she no longer possesses because the taxpayer sent originals to the IRS.

A review of TAS cases through the Taxpayer Advocate Management Information System (TAMIS)⁵⁸ shows the problems associated with the IRS' untimely processing of EITC examinations. In FY 2005, 48 percent of all EITC Revenue Protection Strategy (RPS) cases came into TAS because of a delay in the exam process. This is an improvement over prior years, as 52 percent of RPS cases in FY 2004 and 61 percent of RPS cases in FY 2003 came into TAS due to delay. Table 1.5.3 shows that TAS accepted the majority of these cases because the taxpayer experienced a delay of more than 30 days in resolving an account problem or had not received a response or resolution to their problem or inquiry by the date promised.⁵⁹ Although these problems may seem trivial, their effect on taxpayers is significant.

     TABLE 1.5.3, TAS EITC REVENUE PROTECTION STRATEGY RECEIPTS --

Another TAS case reveals further burdens placed on taxpayers and additional delays in the examination process. The IRS denied a taxpayer's EITC and EITC recertification for tax years 2001 through 2004. The IRS is working the cases for 2001 and 2002 at one campus and the 2003 and 2004 cases at a second campus, even though they all involve the same taxpayer and the same issue. This approach places an undue burden on the taxpayer, who is attempting to navigate the EITC exam process while having to deal with two different IRS offices.

W&I Compliance is aware of the problems taxpayers experience when their cases are worked at various campuses. W&I has indicated it will request an expansion of current programming that will allow for EITC recertification cases to be assigned to the same campus as the initial EITC exam.⁶³ Additionally, W&I has indicated a willingness to update the Internal Revenue Manual (IRM) to ensure that multiple year audits are assigned to the same IRS examiner to reduce taxpayer burden.⁶⁴ TAS commends W&I Compliance for these efforts.

Taxpayer Response Rate

Approximately 40 percent of EITC correspondence exams close as a "no response" or "undeliverable," indicating that the taxpayer did not respond to the IRS exam notice.⁶⁵ Acknowledging the problems associated with the high non-response rate, W&I Research conducted an EITC Pre-Refund Audit Non-Response Survey in March 2004.⁶⁶ The IRS surveyed employees and volunteer representatives that came in direct contact with EITC taxpayers when they sought assistance.⁶⁷ The survey responses suggest that most taxpayers categorized as non-responsive did attempt to make some form of contact with the IRS.⁶⁸ Of the taxpayers surveyed, 87 percent attempted to make some form of contact with the IRS, with 68 percent of taxpayers sending the requested documents via mail or fax. Only 13 percent of taxpayers surveyed indicated that they did not attempt to respond to the audit notice. Of the taxpayers who responded to the IRS notice, 68 percent mailed the requested documents and 67 percent sought assistance by calling the IRS or visiting an IRS office.⁶⁹ The survey results indicate a failure on the part of the IRS to handle taxpayers' attempts to engage in the audit process, thereby affecting a taxpayers' ability to prove their EITC claims.

While a high percentage of EITC correspondence exams close as "no response," an additional 16.7 percent of EITC correspondence exams close as "default with correspondence," indicating that the taxpayer attempted to engage in the audit process but ultimately left the system.⁷⁰ Taxpayers' reasons for dropping out of the exam process can be as simple as the fact that the taxpayer did not receive subsequent IRS correspondence regarding his or her audit. The 2004 certification study showed that approximately six percent of the letters the IRS sent to taxpayers in December 2003 were returned as undeliverable, even though the addresses were current as of the spring of 2003.⁷¹ More importantly, almost half of the taxpayers selected for the follow-up telephone survey on the certification test could not be reached by mail or telephone. Of the taxpayers who were surveyed, approximately seven percent indicated that they lived in their current address for less than six months. The highly mobile nature of the EITC population suggests that one reason why some taxpayers do not respond to IRS correspondence is that they may never have received the correspondence in the first place.

More complicated reasons can also explain why so many taxpayers drop out of the system. A taxpayer may have a bad experience with the IRS and become discouraged with the exam process. Some taxpayers may realize that they were ineligible to receive the EITC and accept the result by not continuing to communicate with the IRS. Other taxpayers may be eligible to receive the EITC but realize they are unable to provide the required proof. Still other taxpayers may be suspicious of the government for various reasons and be reluctant to continue engaging with the IRS.

Given the myriad of reasons why taxpayers may engage with the IRS during the audit process and later drop out the system, we believe the IRS needs to better understand why taxpayers drop out in order to better serve these taxpayers. We recommend that the IRS conduct a study or survey of taxpayers to understand why some taxpayers do not follow through on the audit process. Moreover, we believe the IRS should develop a strategic goal to lessen the percentage of taxpayers in this category.

Problems with Documentation

Taxpayers who do respond to IRS exam correspondence and whose documentation is processed face still other hurdles in providing complete and accurate information. The two main problems are inconsistency as to which documents the IRS will accept (a document is accepted in one office, but not in another) and inflexibility in accepting proof (failure to accept other types of documents where the taxpayer cannot provide the standard documentation).⁷²

Further, taxpayers are often unable to meet the IRS requirements for acceptable documentation, which do not take into account the realities of the type of documentation that low income taxpayers can provide.⁷³ While IRS requests for documentation are typically limited to bills and records, the IRS piloted the use of affidavits during the 2004 and 2005 certification studies. The 2004 certification study marked the first time IRS examination used affidavits for tax administration purposes.⁷⁴

As part of the 2004 certification study, taxpayers were able to submit a completed affidavit to prove they met the qualifying child residency requirement. The majority of taxpayers in the test group of the certification study received a standard third party affidavit, Form 8836, Qualifying Child Residency Statement (Schedule A), that could be completed by any of the following individuals: attorney, child-care provider, clergy, community-based organization, court or placement agency official, employer, healthcare provider, Indian tribe official, landlord or property manager, law enforcement officer, school official, or social service agency or other government official.⁷⁵ Of the 25,000 taxpayers in the test group, the IRS also selected a subsample of 1,000 taxpayers to test a modified version of the affidavit.⁷⁶ The modified third party affidavit (Schedule B) could be completed by anyone who had personal knowledge or records showing that the taxpayer and qualifying child lived together during the tax year, except a spouse, dependent, qualifying child, or a parent of the qualifying child. These third parties include most relatives, friends, and neighbors. In testing the modified affidavit, the IRS was responding to concerns that taxpayers might have difficulty using the other approved sources and might easily prove that they meet the qualifying child residency requirement using the alternate affidavit.⁷⁷

Within all taxpayers in the test group, 38 percent of all documents submitted were records, 20 percent were official letters, and 42 percent were third party affidavits.⁷⁸ The overall acceptance rate of documents was 64 percent. The affidavits, however, had the highest acceptance rate of 82 percent, followed by letters with an acceptance rate of 55 percent, and records with an acceptance rate of 48 percent.⁷⁹ The acceptance rate of Schedule B affidavits was slightly lower than Schedule A affidavits, at 76 percent; however, this is still higher than the other methods of documentation provided.⁸⁰ The high acceptance rate of the Schedule B affidavits is encouraging because all Schedule B affidavits underwent a mandatory verification process, including contacting the affiant to validate the affidavit.⁸¹ The 2004 certification study results conclude that, "[i]n general, the affidavits seemed to provide a reliable way to substantiate claims in this context."⁸²

The problems associated with documentation were discussed at a recent IRS Nationwide Tax Forum⁸³ and a participant cited the following experience she had with a client:

EITC Recertification

In 1997, Congress enacted legislation to help prevent taxpayers from incorrectly receiving the EITC, and in 1998 the IRS implemented the EITC recertification process.⁸⁵ The EITC recertification process places a recertification indicator on the account of a taxpayer whose EITC claim was audited and denied completely or in part. The indicator prevents the payment of future EITC claims until the taxpayer successfully completes the recertification process and demonstrates his or her eligibility to receive the EITC.⁸⁶ Once the taxpayer meets the requirements necessary to prove eligibility, the taxpayer is "recertified" and the IRS should remove the recertification indicator from the taxpayer's account.

Generally, there are two ways to begin the EITC recertification process. Taxpayers can request audit reconsideration, asking the IRS to reevaluate the prior exam that resulted in the IRS denying the EITC and placing a recertification indicator on the taxpayer's account.⁸⁷ More commonly, a taxpayer can file Form 8862, Information to Claim Earned Income Credit After Disallowance, which alerts the IRS to begin the recertification process.⁸⁸ The recertification process generally takes the form of an examination of a taxpayer's EITC claim, very similar to an EITC correspondence examination. Once the taxpayer meets the eligibility requirements, he or she is considered "recertified" and the IRS should remove the recertification indicator. If the IRS determines that the taxpayer's original EITC error was due to reckless or intentional disregard of rules and regulations, the taxpayer cannot receive the EITC for two years.⁸⁹ If the IRS determines the original EITC error was due to fraud, the taxpayer cannot receive the EITC for ten years.⁹⁰

Although the recertification process was designed to prevent incorrect EITC payments, the process has resulted in numerous problems for taxpayers. Both the Government Accountability Office (GAO) and the Treasury Inspector General for Tax Administration (TIGTA) recently audited the recertification program and noted the process is inconsistent and confusing to taxpayers.⁹¹ The IRS has taken steps to correct some of the problems taxpayers encounter during recertification, including revising letters, simplifying Form 8862, Information to Claim Earned Income Credit After Disallowance, incorporating guidelines in the Internal Revenue Manual (IRM), and including additional information on the two and ten year recertification bans in Publication 596, Earned Income Credit. While the IRS has made progress, taxpayers continue to experience numerous problems with the EITC recertification process.

EITC Recertification Statistics

The EITC recertification program began in 1998, when the IRS disallowed, in whole or in part, EITC claims for approximately 312,000 tax year 1997 returns and placed recertification indicators on those taxpayers' accounts.⁹² The size of the recertification program continues to grow and by December 2004, the IRS placed over 1.2 million recertification indicators on taxpayer accounts.⁹³

Once the IRS places a recertification indicator on a taxpayer's account, the process of recertifying is difficult and lengthy. A taxpayer must undergo an examination of his or her EITC eligibility, which results in the same delays and documentation problems taxpayers face in standard EITC examinations, as well as additional problems associated with recertification. One result is that the IRS does not release many recertification indicators timely, affecting taxpayers future ability to receive the EITC.

A recent TIGTA report notes that as of April 2003, 52,000 taxpayers did not have recertification indicators removed from their accounts, even though the IRS allowed subsequent EITC claims. By March 2004, 17,000 of the 52,000 taxpayers still had the recertification indicator on their account, even though a year had passed.⁹⁴ The delays experienced in getting the recertification indicator lifted from the 52,000 taxpayers resulted in 10,500 taxpayers having almost $21 million in future EITC claims improperly denied, while 17,000 taxpayers had their EITC claims unnecessarily examined.⁹⁵

Delays in Recertification Process

Once the IRS places a recertification indicator on a taxpayer's account, the taxpayer must undergo a lengthy recertification process. Even in cases where the taxpayer is not subject to a two or ten-year ban, the time necessary to recertify can prevent the taxpayer from receiving their EITC claim for a significant period of time. Table 1.5.4 demonstrates the cycle time for different types of EITC recertification cases in fiscal years 2004 and 2005.

  TABLE 1.5.4, WEIGHTED CYCLE TIME FOR EITC RECERTIFICATION CASES FOR

Although the reasons for the lengthy cycle time are unclear, the effects of delay can be great. During calendar year 2003, TIGTA identified over 3,200 taxpayer accounts with EITC refunds totaling over $3.9 million that were not timely released, with delays averaging over one year. After TIGTA referred the problem to the IRS, additional delays of one year or more preceded the release of approximately 1,000 of the 3,200 refunds.⁹⁹ Additionally, TIGTA noted that during 2003, the IRS sent taxpayers approximately 850,000 letters or electronic messages that did not clearly or accurately communicate EITC recertification requirements, did not specifically inform taxpayers that they were recertified, or referred to an enclosed recertification form that was not in fact enclosed. The unclear communication made it harder for taxpayers to understand and comply with recertification requirements and may have resulted in delays in the recertification process.¹⁰⁰

Inconsistent Treatment of Recertification Cases

Some of the problems associated with the recertification process stem from IRS' inconsistent application of the rules and requirements for recertification. One of the most notable cases of inconsistent treatment comes from IRS imposition of the two-year ban. The IRS generally does not place a ban on an account during the first year of an EITC examination unless the taxpayer has demonstrated blatant disregard for the rules and regulations surrounding the EITC.¹⁰¹ Where the IRS previously informed the taxpayer about EITC rules and the taxpayer provides inadequate documentation that results in another EITC disallowance, the IRS will place a two-year ban on the taxpayer's account in the year of the subsequent EITC disallowance.¹⁰²

A recent TIGTA audit found significant differences in the criteria used to apply the ban at different IRS compliance sites and among different examiners. The audit found that examiners used inconsistent criteria, and applied some bans incorrectly and others unintentionally, with the result that taxpayers were not treated consistently.¹⁰³ This confusion and inconsistent treatment was due in part to the fact that IRS guidelines for bans were not clear, complete, or consistent, and did not always reflect current law.¹⁰⁴

Problems with Documentation

The biggest problem with EITC recertification cases, as with most EITC examinations, is a taxpayer's ability to provide the IRS with adequate documentation to substantiate EITC eligibility. According to a recent TIGTA audit, some of the cases where a taxpayer submits insufficient documentation result in the IRS imposing a two- year ban because the taxpayer was unable to provide sufficient documentation in the subsequent examination of their EITC claim. Given the documentation difficulties associated with the EITC, TIGTA stated that imposing a two-year ban where there is a lack of documentation is inappropriate. TIGTA indicated the IRS should only impose a two-year ban where the taxpayer clearly did not meet the legal requirements for claiming the EITC and the taxpayer was made aware of the legal requirements.¹⁰⁵

A GAO report echoes the documentation difficulties experienced in the recertification processing, noting that low income taxpayers often have difficulty obtaining documents that IRS examiners will accept and, when they do submit documentation, IRS examiners' assessment of the documents is inconsistent.¹⁰⁶ GAO noted that the toughest EITC eligibility requirement for taxpayers to meet is the qualifying child residency requirement. Of the IRS examiners GAO questioned regarding the recertification process, 80 percent said that when a taxpayer fails the recertification process, most or all of the time the taxpayer's inability to substantiate that the child lived with them led to the failure to recertify.¹⁰⁷ The failure to provide adequate supporting documentation is due in part to the tendency of many low income taxpayers to move frequently, have no medical insurance, and use informal child care arrangements. These characteristics of low income taxpayers prevent them from being able to provide formal documentation to substantiate their EITC claim.¹⁰⁸

In addition to presenting time and documentation difficulties, the current EITC recertification process makes no allowance for taxpayers who are subject to a two-year ban, but whose returns show legitimate changes that would make them eligible to receive the EITC. EITC taxpayers' situations are subject to change (e.g., the taxpayer remarries and has children who were not included on the return originally audited, custody arrangements change, dependents move into the taxpayer's household for more than six months of the year) while the two-year ban is in effect. The current statute does not allow for a reevaluation of a taxpayer's EITC eligibility prior to the expiration of the two-year ban.

Approaches to Improving the EITC Exam Function

As discussed above, the current EITC examination structure creates significant problems for taxpayers required to navigate this complicated process. One component of the IRS's five-point initiative is to minimize burden and enhance the quality of communications with taxpayers by improving the audit process.¹⁰⁹ The importance of the audit process cannot be undervalued, as the way in which the IRS conducts audits can have a dramatic effect on the audit outcome, as demonstrated by the recent EITC Audit Reconsideration Study.¹¹⁰ As part of the EITC Audit Reconsideration study results, the National Taxpayer Advocate set forth a number of recommendations to improve the EITC audit and audit reconsideration process. Those recommendations, and others, should begin a discussion about ways to improve the current EITC examination process, including EITC recertification.

Improved Communication

One of the biggest problems in the current EITC exam process is the need for improved communication with EITC taxpayers, particularly during the initial audit. Of the cases reviewed for the EITC Audit Reconsideration Study, nearly 80 percent of the audit reconsideration requests resulted from difficulties with documentation, non-response or late response from the taxpayer. Improved communication could help resolve many of these problems and significantly reduce the number of costly and burdensome examinations, recertifications, and audit reconsiderations.

Some communication improvements can come from increased use of the telephone, which allows taxpayers to better understand what supporting documentation is needed to substantiate their claims and affords the IRS an opportunity to educate the taxpayer. The opportunity for interaction is especially important for low income, Limited English Proficient (LEP) and underrepresented taxpayers, who make up a large part of the EITC population. IRS exam units currently have a toll-free number with individual extensions for each examiner, but the examiners rarely utilize this opportunity for phone contact with the taxpayer. In January 2006, the W&I exam function will begin using a single toll-free telephone number that will route taxpayers to an available examination employee and will also have an option to key in an individual extension number.¹¹¹ We commend W&I exam for making it easier for taxpayers to communicate with the IRS and hope examination employees will be encouraged to call taxpayers for information and provide the toll-free phone number for taxpayers' responses.

This is not to say that IRS examiners should call taxpayers in every examination. The IRS should train its examiners to identify instances in which calling the taxpayer will help clarify an issue or obtain a response from a taxpayer. This type of targeted communication with taxpayers will ultimately save time and money down the line. During these communications, IRS employees can also work with the taxpayer to help explain the type of documentation that the IRS needs to resolve his or her case.

Expand Acceptable Documentation

The current exam process has raised questions about the ability of low income taxpayers to provide sufficient documentation to substantiate an EITC claim. The 2004 certification study piloted the use of an affidavit as a method of proving the qualified child residency requirement for the EITC. The study results indicate that the affidavit was the most effective means of proving eligibility; taxpayers preferred using the affidavit to providing documents, records, or letters.¹¹²

Given the effectiveness of the affidavit, and taxpayers' willingness to use the new form, we believe use of the affidavit should be expanded to all correspondence examinations, as well as the recertification process. Allowing all taxpayers subject to a correspondence exam or attempting to recertify to submit affidavits to substantiate their EITC claims can help resolve exams early on and may encourage increased participation by taxpayers if they know they are capable of sending the IRS the requested information. Additionally, in light of recent natural disasters, the IRS is grappling with the issue of how to handle taxpayers who will not be able to provide documentation to verify claims. In these circumstances, the affidavit can provide an effective alternative means of verifying taxpayers' information, preferably the Schedule B affidavit, which allows neighbors and family members to certify that a child lived with the taxpayer.

Case Assignments

The problems with the EITC exam process also raise the need for a specialized examination group dedicated to EITC as part of the larger EITC Program Office. A specialized exam group can help to enhance taxpayer service and reduce audit time for EITC taxpayers. The IRS closes a large number of EITC exam cases due to a late response or no response by the taxpayer. The lack of response or late response may be closely tied to the IRS' use of batch processing, with very limited involvement by a tax examiner.

With an exam case handled through batch processing, when a taxpayer contacts the IRS regarding his or her case, the taxpayer does not have an assigned tax examiner with whom he or she can communicate. This causes frustration for taxpayers who must repeat their stories to a different IRS employee every time they call. This frustration can eventually cause taxpayers to drop out of the audit process and stop trying to reply to IRS requests. We believe a better approach is for the IRS to assign EITC exam cases to specific exam employees early in the process to ensure that taxpayers have an assigned caseworker with whom they can communicate. The IRS is moving towards a caseworker approach by creating the toll-free phone number taxpayers can use to reach an examination employee to discuss their case.

The caseworker approach is one reason why the Taxpayer Advocate Service (TAS) is so effective in working with taxpayers. When a taxpayer comes to TAS for assistance, TAS assigns one caseworker to the taxpayer's case. This allows the taxpayer to develop a relationship with the caseworker and may encourage the taxpayer to respond to calls and requests for information. The taxpayer is not shuttled from person to person and they can be confident that their information is not getting lost. A similar approach could benefit EITC examinations and may help resolve exams earlier in the process.

Training on Working With EITC Taxpayers

To ensure consistent application of EITC law and acceptance of documentation, we believe EITC examiners should receive updated, specialized training, including information on how to deal effectively with low income and low literacy taxpayers. The Taxpayer Advocate Service (TAS) provided this type of training to the IRS employees in Kansas City who handle the EITC Precertification Program. This training, tailored to dealing with the EITC population, was very well received. The Taxpayer Advocate Service is working to expand this training and make it available to a wide range of IRS employees.

IRS COMMENTS

The National Taxpayer Advocate's discussion of Earned Income Tax Credit (EITC) examination issues highlights some of the challenges the IRS faces in administering one of the nation's largest anti- poverty programs through the tax code. In fact, the IRS has been steadily working to address the problems the National Taxpayer Advocate identifies. In some cases, we already implemented solutions. In others, we are working on alternatives. In a few instances, we believe the National Taxpayer Advocate's proposed solutions may warrant additional analysis.

Overall, however, we appreciate the National Taxpayer Advocate's acknowledgement of the progress that the IRS made to administer a balanced EITC program, one that encourages participation while reducing EITC paid in error. We also agree that there is still room for improvement. For tax year (TY) 2003, more than 21 million taxpayers filed EITC returns with over 26.8 million qualifying children. The $38 billion in EITC that taxpayers received makes the credit program one of the largest anti-poverty programs in the country.

The IRS has a robust strategy to address the challenges in the EITC program. Among other things, we developed numerous business process enhancements -- including some that rely on private sector best practices -- aimed at improving both the way in which we examine EITC returns and the effectiveness of our communications with EITC taxpayers. In particular, these enhancements enable us to use data- driven scoring and selection methods to better identify egregious cases for examination and to then apply the most effective and efficient compliance treatments.

We are also working with the National Taxpayer Advocate to explore the use of new notices to improve the rate of taxpayer response as well as to enhance the overall quality of our communications with taxpayers. We developed a comprehensive research strategy to increase our understanding of the EITC taxpayer so we can better focus our educational and compliance activities. We will continue the final phase of testing in fiscal year (FY) 2006 to evaluate the effect of a residency certification requirement on claim accuracy, participation, and burden. Our communication outreach plan includes a strategy to develop a bilingual integrated marketing campaign and a special focus on victims of hurricanes Katrina and Rita.

EITC Examination Cycle Time

We appreciate the National Taxpayer Advocate's recognition of our work to improve EITC cycle time. Over the past several years, the IRS made significant improvements in our EITC examination process. For example, we reduced the average time it takes to complete an exam (cycle time) by 20 days -- despite the implementation of a new letter process adopted at the request of the National Taxpayer Advocate which added 36 days. We continue to look for ways to achieve further improvements in EITC cycle time and will include the NTA in our process.

EITC Audit Rates

The National Taxpayer Advocate correctly notes that EITC examinations make up a significant portion of the audits the IRS performs each year and that EITC taxpayers face a higher chance of audit than most taxpayers do. It is important to place these figures in context. First, EITC erroneous payments were the subject of significant Congressional attention -- including a mandate of and funding for a special, five-year compliance initiative aimed at combating EITC error.

More recently, with the adoption of the Improper Payments Improvement Act (IPIA), erroneous EITC payments are under additional statutory scrutiny. The Act requires the IRS to estimate EITC error annually and take measurable steps to reduce it. The EITC examination approach is part of the IRS' plan to comply with IPIA -- as are our numerous outreach and education activities. EITC is the only IRS program currently covered by the IPIA.

EITC Recertification Program

In her discussion, the National Taxpayer Advocate refers to a number of problems with the EITC Recertification program -- problems discussed in TIGTA and GAO reports dating from the end of TY2003. Since the issuance of these reports, the IRS made a variety of improvements to the process.

We believe the EITC Recertification Program is an essential enforcement tool that promotes compliance, protects revenue, and reduces erroneous payments. Here is an overview of actions we took to address weaknesses in the Recertification Program:

• In January 2004, we implemented programming that would automatically release the EITC Recertification Indicator on most closed examinations, and audit reconsiderations. This has significantly reduced the number of EITC Recertification indicators not properly removed.

• Effective January 2004, we began immediately refunding the portion of taxpayers' refunds that are not in question and automatically releasing the EITC portion for which taxpayers are eligible upon closure of the audit. This drastically reduced the number of "delayed" refunds when the audit is closed.

• For the few situations not addressed by the programming enhancements detailed above, we adjusted our problem correction reports to make them more convenient and exact. These reports will help us identify any accounts needing the EITC Recertification indicators removed or refunds released. Adjustments to these reports were available in March 2005.

• We incorporated informal recertification guidelines into the Internal Revenue Manual (IRM), and successfully delivered a Continual Professional Education (CPE) lesson on EITC Recertification to all tax examiners in 2004.

• Working with the National Taxpayer Advocate's staff, we improved Form 8862, Information to Claim Earned Income Credit after Disallowance in 2005 to reduce taxpayer burden. Our improvements reduced the estimated amount of time taxpayers need to comprehend and complete the form by 68 minutes or 49 percent less time.

• Starting in 2005 for EITC Recertification and all EITC programs, we now send two separate notices (CP 75 series and Letter 525) to taxpayers rather then one initial contact letter requesting supporting documentation for EITC. We also redesigned the notices to make them clearer. This provides taxpayers with more opportunities to reply to our information requests.

• During 2006, we plan further improvement to CP 79 (mailed to taxpayers when Examination denies EITC) and other EITC notices to improve communications regarding the EITC Recertification and documentation requirements to taxpayers.

• We developed special Audit Reconsideration Reports that will allow us to track the results of the reconsideration process. They show the total reconsideration requests we handle each year, the type of case worked (EITC, Discretionary and Proof of Concept), the results of the reconsiderations (full/partial reversal, full/partial disallowance), and the monetary value of the abatements.

• Beginning in February 2005, we established a process that enabled us to review all case files (Audit Workpapers, Reports, Statutory Notice of Deficiency, and Letters issued), monitor the population of the Audit Reconsideration Reports, and automatically track all actions taken with regard to each reconsideration case.

• A special Audit Reconsideration Task force reviewed the Audit Reconsideration Manual (IRM) 4.13, and related materials used in the process (Publication 3598, What You Should Know About the Audit Reconsideration Process, Letters, Training Manuals). Task Force members included Wage and Investment (W&I) and Small Business/Self-Employed Reporting Compliance and Taxpayer Advocate Service (TAS). As a result of the Task Force's work, we completely revised the IRM § 4.13, updated the Publication 3598, reviewed letters used in the program, revised our training materials, and established an Audit Reconsideration website that can be accessed by the taxpayer.

Improved Communications

We realize the importance of improving our communications with the EITC taxpayers. In FY 2005, we completed several studies that showed extension-routed calls went directly to voice-mail, thus creating frustration for the taxpayers. This also created frustration for our examiners when they attempted to return the calls. In response, we tested the feasibility of expanding the coverage on these types of calls with positive results.

We realize that live contact with the taxpayer not only improves customer satisfaction, it also improves the examination process by educating the taxpayer on what they need to do. We now encourage examiners to attempt contact with taxpayers by telephone to explain fully what they need to complete the examination before sending a letter. To underscore our commitment to this approach, we will now hold senior IRS officials responsible for improving coverage on extension routed calls. In 2006, we will roll out Intelligent Call Management (ICM), which will enable us to provide better service to our taxpayers by routing calls received in the toll-free phone operations through an enterprise queue, then directing the calls to an assistor at one of our sites based on availability. In addition, bi-lingual taxpayers will receive better service because we will direct calls from our Spanish-speaking taxpayers to campuses with bi- lingual examiners. ICM provides better management control of telephone traffic, staffing by time zones, and demand.

Expand Acceptable Documentation

We recognize obtaining documentation can put a burden on taxpayers. That is why taxpayer burden is one of the factors we consider when we evaluate potential new approaches to reducing EITC error. It is also, why, as part of the test of a residency certification requirement, we tested affidavits as a form of proof. As the National Taxpayer Advocate notes, we found affidavits to be a reliable and effective means of documentation. However, we believe it is premature to conclude affidavits should become a regular part of the EITC examination process. While affidavits do appear to offer significant promise as a way to reduce taxpayer burden, our testing did not replicate the "real world" conditions of many EITC taxpayers.

In fact, the test was conducted on 25,000 taxpayers who were randomly distributed across the United States. Thus, the awareness of affidavits was very limited as was the potential for "gaming" these documents. The real question is whether a broader understanding and awareness of affidavits through the EITC population would encourage non-compliant taxpayers to use affidavits as a means of erroneously claiming the credit. Because of this potential for abuse, we need further testing of affidavits in a variety of different scenarios before we adopt affidavits on the scale recommended by the National Taxpayer Advocate.

We also believe that we can address some of the National Taxpayer Advocate's concern by improving our business processes to ensure consistency across our examiners. To this end, we developed an integrated decision support tool that guides our employees through each EITC examination and focuses their work on the specific audit issue for which each return was selected. Thus, no matter where taxpayers are located, similar situations will receive similar treatment.

At the same time, we want to tap into the collective expertise of our examiners. That is why our Correspondence Examination Procedural training emphasizes the importance of examiners using their judgment in evaluating taxpayer replies and analyzing their cases. Using judgment in all examinations is an established policy that we reinforce at every opportunity. In our training material, examples and exercises explain the different documentation scenarios an examiner may come across when working a case. We encourage the instructors to use "real-life" case situations to make the training as accurate and real as possible.

We also reinforce the use of judgment by examiners as an integral part of the 80/20 concept. We trained all examination employees in the use of this concept. We visited each of the campuses and reviewed cases to determine its usage, and gave spot awards to employees who used it. We also visited each of the campuses in FY 2005, held focus groups to determine where we were at and what we needed to do to take this concept to the next level.

Case Assignments

The National Taxpayer Advocate recommends early assignment of cases to a specific examiner and acknowledges the difficulty in doing so in a batch processing system. We realize the need to provide taxpayers specialized services and the benefits of keeping taxpayers in the audit process. In FY 2005, we enabled our telephone assistors to receive a universal "view" of any taxpayer case so they could identify specific items needed to resolve the case and provide this information to the taxpayer. We are now working on a further enhancement that will allow universal "access" so any employee receiving a call can actually take control of the case and perform the necessary actions to resolve the case. This approach is consistent with private sector best practices and, we believe, will be even more effective than limiting service to taxpayers to an assigned caseworker.

Training on Working with EITC Taxpayers

We are pleased the National Taxpayer Advocate found that training for dealing with the EITC population was very well received by the employees in Kansas City who work in the Precertification Test Program. We welcome the opportunity to partner with TAS in delivering this training for Examination employees in the future.

Another recent partnering effort was "Getting to Know You," the W&I Compliance/TAS joint collaboration held in September 2005. The theme, "Getting to Know You," reflected the partnering of both organizations by sharing improvement initiatives implemented in FY 2005, reviewing strategies planned for FY 2006 and preparing best practices. Participants included representatives from all W&I Compliance campuses and functions as well as representatives from TAS Headquarters and all seven TAS Area offices.

We worked closely with the National Taxpayer Advocate's office on many issues that affect EITC taxpayers and believe this collaboration resulted in many improvements to the process.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate acknowledges the challenges the IRS faces in administering the Earned Income Tax Credit (EITC) and is very pleased with the improvements the IRS has made in recent years. The IRS's response above demonstrates that it has developed a strategy to address current challenges in the EITC program, including business process enhancements, notice improvements, a comprehensive research strategy, improved communication outreach plan, and continued study of a possible certification requirement. Moreover, the IRS has taken significant steps to address weaknesses in the EITC Recertification Program, using analysis and technology to improve service to low income taxpayers. We are especially pleased with the improvements to the examination and audit reconsideration process. In particular, encouraging examiners to attempt telephone contact with taxpayers and holding senior IRS officials responsible for improving coverage on extension routed calls model exam practices and strike the proper balance between taxpayer rights and efficiency. We applaud these efforts, along with the use of ICM and improved bilingual call routing, and look forward to continuing to work with the IRS to ensure ongoing improvements in the EITC program.

While we acknowledge that erroneous EITC payments continue to be subject to significant Congressional and OMB scrutiny, the National Taxpayer Advocate remains concerned that as a result, EITC taxpayers have a much higher audit rate than other groups of taxpayers. Although the National Taxpayer Advocate is mindful of the problems associated with improper payment of the EITC, the IRS should consider that, given the complexity of the EITC, auditing low income taxpayers may not be the most effective way to reduce erroneous payments.

Expand Acceptable Documentation

The IRS recognizes the burden EITC taxpayers experience in trying to provide the IRS with acceptable documentation to support an EITC claim. The IRS has also recognized that thus far, affidavits have been a reliable and effective means of providing documentation. While we support additional testing of the affidavit concept, we are concerned by the IRS's comments that a broader use of affidavits might provide non-compliant taxpayers with the means to erroneously claim the EITC. The proven benefit to taxpayers from affidavits should not be overshadowed by potential abuses. Thus, we encourage the IRS to consider expanding the use of affidavits to all EITC examinations, particularly in light of the documentation difficulties faced by taxpayers affected by the recent disasters.

Case Assignments

We applaud the IRS's move to provide telephone assistors a "universal view" of any taxpayer case so that any assistor can answer a taxpayer's question. The IRS is working on a universal "access" system that will allow any employee to not only view a taxpayer's case, but work it to resolution as well. Universal access should be helpful in resolving EITC exam cases, particularly in situations where there are recertification, audit reconsideration, and EITC exams of the same taxpayer. We encourage the IRS to use "universal access" technology to allow an IRS examiner to look at all of these actions together and take the necessary steps to resolve all of the taxpayer's outstanding EITC issues as one case. This approach minimizes taxpayer burden, eliminates delays, and reduces redundant IRS actions.

Training on Working with EITC Taxpayers

The National Taxpayer Advocate is pleased that TAS and Wage and Investment Compliance have collaborated on several occasions in providing training to W&I employees. The National Taxpayer Advocate looks forward to continuing these joint efforts.

RECOMMENDATIONS

The National Taxpayer Advocate recommends that the IRS:

• Continue developing correspondence (including letters, publications, and document requests) that will lessen taxpayer confusion and generate a greater response from taxpayers during the examination process.

• Ensure that procedures are in place so that taxpayer correspondence is timely processed and acknowledged.

• Continue to develop research initiatives and recommendations to improve the administration of the EITC program, including the TAS study to evaluate the impact of representation on the outcome of EITC audits and the study to identify the most significant barriers taxpayers encounter during EITC audits.

• Ensure that all employees receive clear guidance and training on the application of the two and ten year EITC recertification bans.

• Continue developing new processes (such as the use of alternative methods of documentation, the decision support tool, and encouraging examiners to use judgment) that will ease the burden taxpayers encounter when trying to provide the IRS with the requested documentation during the exam process.

• Continue to train EITC examination employees, utilizing real case examples (including TAS cases), on the importance of using judgment when deciding whether to allow or deny an EITC claim.

• Use "universal access" in EITC cases to enable any Exam employee to access a taxpayer's case and take the steps necessary to resolve the case, including consolidating all EITC issues pertaining to that taxpayer -- examination, audit reconsideration, and recertification -- under one employee.

² The EITC Advisory Council includes executive level representatives from each IRS function responsible for administering the EITC and was designed to ensure an integrated strategic approach to EITC issues. IRS, Earned Income Tax Credit (EITC) Program Effectiveness and Program Management FY 2002 -- FY 2003 iv (Aug. 8, 2003).

³ IRS, IRS Announces Steps to Improve EITC Administration, Seeks Public Comment, IR-2003-78 (June 13, 2003). The five-point initiative was the result of a Treasury-IRS joint task force formed in 2002 to study ways to improve the administration of the EITC. IRS, Earned Income Tax Credit (EITC) Program Effectiveness and Program Management FY 2002 -- FY 2003 28 (Aug. 8, 2003).

⁴ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 (Oct. 2005). See also IRS, Compliance Estimates for Earned Income Tax Credit Claimed on 1999 Returns (Feb. 28, 2002). The IRS recently issued the final report to Congress containing the findings for each of the three EITC studies.

⁵ The IRS conducted the first certification study during tax year 2003. The IRS conducted a second certification study during tax year 2004, with some modifications from the 2003 test. The results of the 2004 certification test are not yet available.

⁶ The 25,000 taxpayers in the test group were compared with a similarly sized control group with characteristics similar to the test group. IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 4 (Oct. 2005).

⁷ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 5 (Oct. 2005).

⁸ For a more detailed discussion of the affidavit requirement, see infra notes 74-82 and accompanying text.

⁹ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 7 (Oct. 2005).

¹⁰Id. at 47.

¹¹Id. at 49. The EITC Filing Status Study looked at a random sample of 36,000 taxpayers who filed single, head of household, or married filing separately in tax year 2002 and had previously filed as married filing separately or married filing jointly at least once within the prior three years. If a taxpayer in the test group filed his or her return in tax year 2003 as single or head of household and claimed EITC with qualifying children, the taxpayer was required to provide additional documentation about marital status. During the period that the taxpayer's filing status was under examination, the EITC portion of the taxpayer's refund was frozen. Once the IRS confirmed filing status, the EITC was allowed and paid to the taxpayer.

¹²Id. at 56. The Automated Underreporter Program is the automated analysis and processing of potential under- reported and/or over-reported tax return issues identified through information return matching. IRM § 4.19.3.1, Overview of IMF Automated Underreporter (Sept. 1, 2005).

¹³ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 p. 56 (Oct. 2005). The study looked at a sample of 300,000 taxpayers, selected from the tax year 2002 AUR inventory, who claimed the EITC and for whom there were indications of income misreporting for tax year 2002. The returns selected for the AUR study had undergone initial processing months prior to the study, so the IRS did not hold the taxpayers' EITC while conducting the study.

¹⁴ For a detailed discussion of the study and its results, see National Taxpayer Advocate 2004 Annual Report to Congress vol. 2.

¹⁵ For a more detailed discussion of the Audit Reconsideration Study, see discussion: Approaches to Improving the EITC Exam Function, infra.

¹⁶ National Taxpayer Advocate Fiscal Year 2006 Objectives Report To Congress 37 (June 2005).

¹⁷Id. at 37-38. The target completion date for the audit outcome portion of the study is December 2005, but some results for cases in Appeals or litigation may not be available for reporting.

¹⁸Id. at 38-39.

¹⁹ Wage and Investment, Identifying EITC Taxpayer Customer Service Needs Report, Research Project 6-05-12-3-018E (Oct. 18, 2005).

²⁰ TAS is currently working with W&I Research to develop the survey that will be conducted in early 2006.

²¹ Taxpayer Advocate Service, Challenges for Taxpayers Claiming the Earned Income Tax Credit (EITC), From Interviews with Low Income Tax Clinics (Sept. 2005). The Low Income Taxpayer Clinic (LITC) Program is a grant program under IRC § 7526 where qualified organizations receive matching federal grants to represent taxpayers in controversies before the IRS or provide tax outreach and education to English as a second language (ESL) taxpayers.

²² For a detailed discussion of the combination letter, see National Taxpayer Advocate, 2003 Annual Report to Congress 87-98.

²³ IRM § 4.19.1.5.5, Dependent Database (Apr. 07, 2005).

²⁴ IRM § 25.12.1.5, Revenue Protection Strategy (Dec. 01, 2000). The revenue protection strategy is a program developed to focus on problematic tax returns and is built on a four-pronged approach to address the returns: Understanding, Prevention, Detection, and Enforcement.

²⁵ IRM § 4.19.1.5, EITC/Revenue Protection Strategy (Oct. 1, 2001). Prior to January 2004, a taxpayer's entire refund was frozen until the exam was complete. Beginning in January 2004, at the urging of the National Taxpayer Advocate (NTA) and others, the frozen amount is limited to the EITC portion of the taxpayer's refund. The NTA commends W&I for addressing this issue so quickly.

²⁶ IRM § 4.19.1.12, Batch Processing Overview (Oct. 1, 2004). Batch Processing is an IRS-developed, multifunctional software application that fully automates the initiation, aging, and closing of certain EITC and non-EITC cases. Using the Batch System, Correspondence Exam can process specified cases with minimal to no tax examiner involvement until a taxpayer reply is received. Because the batch system will automatically process the case through creation, statutory notice, and closing, tax examiner involvement is eliminated entirely on no-reply cases. Once the IRS considers a taxpayer reply, in most instances the case can be reintroduced into Batch Processing for automated aging and closing.

²⁷ A correspondence examination (audit) is handled through written correspondence (rather than a face-to-face meeting), normally can be completed in a few hours, is limited in scope to a few issues and does not include a review of detailed account records.

²⁸ IRM § 4.19.1.4.9, Taxpayer Replies (April 25, 2005).

²⁹Id. If a reply is thirty days old or older, then an acknowledgement letter is sent advising taxpayer that a reply was received and an answer will be issued within thirty days. IRM 4.19.1.4.10, Monitoring Overage Replies (Jan. 1, 2001). When possible, all correspondence should be addressed before a statutory notice of deficiency is issued to a taxpayer.

³⁰ IRC § 6213.

³¹ IRM § 4.19.1.12, Batch Processing Overview (Apr. 7, 2005). These cases are referred to as no-reply or no response cases.

³² For TY 2003, approximately 21.4 million taxpayers received the EITC, for a total of over $38 billion in EITC claims. These numbers are current through July 19, 2005 and do not account for all TY 2003 EITC claims. EITC Factsheet, TY 2001, 2002, 2003 returns (updated July 19, 2005).

³³ AIMS Closed Case Database (Correspondence audit defined by using Employee Group Codes for Campuses, Disposal Codes, and Technique Codes 2, 6, or 7).

³⁴ AIMS Closed Case Database W&I and SBSE (Correspondence audit defined by using Employee Code for Campuses, Disposal Codes, and Technique Codes 2, 6, or 7 listed by Disposal Code).

³⁵ Disposal Code 10 and Technique Codes 6 & 7.

³⁶ Disposal Code 13.

³⁷ Disposal Code 2.

³⁸ Disposal Code 1.

³⁹ Disposal Codes 3, 4, 8, 9 & 12.

⁴⁰ Disposal Codes 7 & 11.

⁴¹ Disposal Code 10 and Technique Code 10.

⁴² The non-correspondence EITC audits include Small Business/Self-Employed (SB/SE) and W&I office and field audits.

⁴³ IRS, Data Book 2004, Table 10, Examination Coverage. See Footnote 7 (Total Individual income tax returns examined 1,007,874, includes 487,461 returns examined with an earned income tax credit claim). These numbers do not include Automated Underreporter (AUR) EITC cases, they are listed as other compliance contacts. EITC Exam, however, is now tracking the 300,000 cases that are part of the AUR EITC Proof of Concept test.

⁴⁴ Statistics of Income, Tax Year 2002 Complete Data, Table 4 -- 2002, Individual Income Tax Returns with Earned Income Credit, by Size of Adjusted Gross Income., for TY2002 -- 21,703,187 million returns filed with Earned Income Tax Credit claimed and Table 1.--2002, Individual Income Tax, All Returns: Sources of Income and Adjustments, by Size of Adjusted Gross Income -- 130,076,443 individual returns were filed in TY 2002 (21.7 million / 130.1 million = 16.7 percent).

⁴⁵ Table shows selected income categories. IRS, Data Book 2004, Table 10, Examination Coverage, includes returns examined by Tax Examiners (by way of correspondence), Tax Auditors, and Revenue Agents. Correspondence exams account for approximately 80% of the individual return audits. This chart does not include the 768,036 EITC math errors that do not result in an examination, IRS Data Book 2004, Table 26.

⁴⁶ Statistics of Income, Table 4 -- 2002, Individual Income Tax Returns with Earned Income Credit, Tax Year 2002 Complete Data, by Size of Adjusted Gross Income.

⁴⁷ Total Positive Income (TPI) is, in general, the sum of all positive amounts shown for the various sources of income reported on the individual income tax return and, thus, excludes losses. These are non-business returns.

⁴⁸ These are non-business returns.

⁴⁹ Approximately 1,400 of the returns examined in this class of taxpayers also had an EITC claim. The number of EITC returns filed within this class was approximately 13,500 resulting in an audit rate of 10 percent for the EITC returns within this class. Source: MACS Processing Year 2003

⁵⁰ These are non-business returns.

⁵¹ Approximately 400 of the returns examined in this class of taxpayers also had an EITC claim. The number of EITC returns filed within this class was approximately 1,300 resulting in an audit rate of 30 percent for the EITC returns within this class. Source: MACS Processing Year 2003.

⁵² Approximately 3,600 of the returns examined in this class of taxpayers also had an EITC claim. The number of EITC returns filed within this class was approximately 268,000 resulting in an audit rate of 1.3 percent for the EITC returns within this class. Source: MACS Processing Year 2003.

⁵³ W&I Reporting Compliance, PMA Stoplight Measures Report: (Cycle Time EITC). FY2005 is through August 2005. Tax Reporting Compliance -- Electronic/Correspondence Examination -- PAC- 7F. Service Center Exam cycle time is the average number of calendar days from the start of an examination (Status 10 or higher) to closure and includes returns where EITC was disallowed. The cycle time for "no change" cases was 135 days, but other dispositions may still result in the retention of at least some EITC.

⁵⁴ W&I Reporting Compliance, PMA Report: Exam EITC Measures September 04.

⁵⁵ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 9 (Oct. 2005).

⁵⁶ W&I Reporting Compliance, PMA Stoplight Measures Report: Mail EITC FY2004. This represents the sum of the total mail at each FY 2004 month end. The EITC Audit Reconsideration study found that, on average, taxpayers submitted four different documents in connection with their case. National Taxpayer Advocate 2004 Annual Report to Congress vol. II at 21.

⁵⁷ W&I Reporting Compliance, PMA Stoplight Measures Report: Mail EITC. At 9/30/04, Total Mail was 17,080 of which 7,289 (or 42.7 percent) was overaged. The range of overage mail was as high as 76.7 percent for October 2003 and as low as 1.5 percent for April 2004. The overall average for all months combined was approximately 28 percent overaged. Overaged is defined as Status 55 (taxpayer correspondence unanswered for more than 30 days) and Status 57 (taxpayer correspondence unanswered for more than 60 days).

⁵⁸ The Taxpayer Advocate Management Information System (TAMIS) is a TAS database exclusively dedicated to the recording, control, and processing of TAS taxpayer cases and to the capturing and analysis of core tax issues, laws, policies, and internal IRS functional processes that are the sources of taxpayer significant hardship and other critical problems.

⁵⁹ TAS uses Criteria Code 5 for cases where the taxpayer has experienced a delay of 30 or more days to resolve a problem. TAS uses Criteria Code 6 for cases where the taxpayer has not received a response or resolution by a date promised.

⁶⁰ Information extracted from the Business Performance Management System (BPMS), TAS Discretionary Report, Business Operating Division Report, Core Issue by Criteria Code on November 15, 2005. During FY 2004, TAS began reporting the EITC-RPS cases under additional Primary Issue Codes to capture more specific case issues.

⁶¹ IRC § 6212.

⁶² TAS received this information through the Systemic Advocacy Management System (SAMS). SAMS is a database of issues submitted to the TAS Office of Systemic Advocacy. It is designed to identify tax problems and monitor, analyze and resolve systemic issues submitted by TAS, IRS employees and external stakeholders.

⁶³ Information provided by Operating Division in response to research request.

⁶⁴ IRM § 4.19.1, Campus Examination Operations outlines W&I and SB/SE's campus examination procedures.

⁶⁵ AIMS Closed Case Database W&I and SB/SE.

⁶⁶ W&I Research Group 2, EITC Pre-Refund Audit Non- Response Survey, 2-03-12-2-021E (Mar. 2004).

⁶⁷ The individuals surveyed included IRS employees from TAS and Appeals, and Low Income Taxpayer Clinic (LITC) representatives. Taxpayers' themselves were not surveyed, rather the survey collected information about taxpayers' actions from taxpayer representatives.

⁶⁸ W&I Research Group 2, EITC Pre-Refund Audit Non- Response Survey, 2-03-12-2-021E 6 (Mar. 2004).

⁶⁹ W&I Research Group 2, EITC Pre-Refund Audit Non- Response Survey, 2-03-12-21E6 (Mar. 2004). The percentages do not add up to 100 percent because respondents were allowed to choose more than one response.

⁷⁰ AIMS Closed Case Database W&I and SB/SE.

⁷¹ IRS, Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 23 (Oct. 2005). For background on the EITC certification study, see supra notes 5- 9 and accompanying text.

⁷² General Accounting Office, GAO-02-449, Opportunities To Make Recertification Program Less Confusing and More Consistent 21 (April 2002). Twenty-one examiners from four processing centers (campuses) were given five scenarios involving differing sets of supporting documents from EITC recertification cases and in no case did all examiners agree that the documents either supported or did not support the eligibility. In two of the five scenarios, the results varied significantly: Case A -- 13 examiners accepted the documents and eight did not; Case D -- seven examiners accepted the documents and 14 did not.

⁷³ The problems with documentation are also discussed in TAS' recent EITC Audit Reconsideration study. See National Taxpayer Advocate 2004 Annual Report to Congress vol. II. Documentation difficulties or deficiencies with the original audit were the cause of audit reconsideration in 45 percent of the cases examined during the period of July 1, 2002 through January 31, 2003.

⁷⁴ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 8 (Oct. 2005).

⁷⁵Id. at 7.

⁷⁶Id. at 6.

⁷⁷Id. at 8.

⁷⁸ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 28 (Oct. 2005).

⁷⁹ For a document to be accepted, it must have been completed, in its entirety. Only ten percent affidavits underwent mandatory validation. These statistics do not reflect the validity of the information provided in the documents. For a document to be accepted it had to include all required information (name, address, dates of residence), statements or letters had to be on official letterhead, Third Party Affidavits had to be filled out completely and signed, all information had to be legible, and the document had to be from an allowable source. For documentation subject to mandatory validation (selected documents for 10 percent of Schedule A subgroup cases and all of Schedule B subgroup cases) the validity of the document itself was verified.

⁸⁰ IRS, IRS Earned Income Tax Credit (EITC) Initiative: Final Report to Congress, October 2005 33 (Oct. 2005).

⁸¹Id.

⁸²Id.

⁸³ IRS Nationwide Tax Forum 2005, TAS Focus Group, EITC Exams and Documentation Requirements, San Francisco, California (June 29, 2005).

⁸⁴ IRS Nationwide Tax Forum 2005, TAS Focus Group, EITC Exams and Documentation Requirements, San Francisco, California (June 29, 2005).

⁸⁵ Taxpayer Relief Act of 1997, Pub. L. No. 105-34, 111 Stat. 788 (codified as amended in scattered sections of 5 U.S.C., 19 U.S.C., 26 U.S.C., 29 U.S.C., 31 U.S.C., 42 U.S.C., and 46 U.S.C. app.).

⁸⁶ IRM § 21.6.3.4.2.7.15.1 Once EITC is disallowed through statutory procedures, the taxpayer must file Form 8862 with the next tax return on which the taxpayer claims EITC. Examination reviews all returns with Form 8862 to determine if EITC is allowable (once the taxpayer meets evidentiary requirements, they are "recertified" and the IRS should remove the recertification indicator). For years after 2001, if the taxpayer is claiming the EITC without a qualifying child, a Form 8862 is not required.

⁸⁷ IRM § 4.13.1.2, Definition of an Audit Reconsideration (Feb. 1, 2003).

⁸⁸ A taxpayer should file Form 8862 with the next tax return on which they claim the EITC with qualifying children.

⁸⁹ IRC § 32(k)(1)(B)(ii).

⁹⁰ IRC § 32(k)(1)(B)(i).

⁹¹ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-039, The Earned Income Credit Recertification Program Continues to Experience Problems (Mar. 2005); Treasury Inspector General for Tax Administration, Ref. No. 2005-40-015, Application of the Earned Income Credit Two-year Ban Could Be More Consistent, Accurate, and Clear to Taxpayers (Dec. 2004); General Accounting Office, GAO-02-449, Earned Income Credit Opportunities To Make Recertification Program Less Confusing and More Consistent (Apr. 2002).

⁹² General Accounting Office, GAO-02-449, Earned Income Credit Opportunities To Make Recertification Program Less Confusing and More Consistent 5 (Apr. 2002).

⁹³ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-039, The Earned Income Credit Recertification Program Continues to Experience Problems 36 (Mar. 2005).

⁹⁴Id. at 6.

⁹⁵Id.

⁹⁶ AIMS Closed Database (not limited to correspondence audits). The weighted average cycle time for all EITC recertification cases in FY 2004 was 183.8 days.

⁹⁷ AIMS Closed Database -- FY 2005 Data Extract Cycle 20056 (not limited to correspondence audits) The weighted average cycle time for all EITC recertification cases in FY 2005 was 168.1 days.

⁹⁸ These are cases in which the taxpayer did not originally claim the EITC on his or her return, but filed a 1040X, Amended Return claiming the EITC and the taxpayer has a recertification indicator on their account.

⁹⁹ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-039, The Earned Income Credit Recertification Program Continues to Experience Problems 13 (Mar. 2005).

¹⁰⁰Id. at 3.

¹⁰¹ IRM § 4.19.1.5.4.1 EITC 2/10 Year Ban, Table 1, Example 1.

¹⁰² IRM § 4.19.1.5.4.1 EITC 2/10 Year Ban, Table 1, Example 2.

¹⁰³ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-015, Application of the Earned Income Credit Two Year Ban Could Be More Consistent, Accurate, and Clear to Taxpayers (Dec. 2004).

¹⁰⁴Id. An example provided on page 5 reads as follows: "Some examiners routinely applied the ban in the subsequent examination when, in our opinion, there was no clear indication of "reckless or intentional disregard" of EIC rules". IRS Management agreed with the TIGTA findings and have revised sections of the IRM regarding the two-year ban and updated the Service Center Exam Continuing Professional Education for 2005 to incorporate more examples. Page 30.

¹⁰⁵ Treasury Inspector General for Tax Administration, Ref. No. 2005-40-015, Application of the Earned Income Credit Two Year Ban Could Be More Consistent, Accurate, and Clear to Taxpayers, Ref. No. 2005-40-015 (Dec. 2004).

¹⁰⁶ General Accounting Office, GAO-02-449, Earned Income Credit Opportunities To Make Recertification Program Less Confusing and More Consistent (Apr. 2002).

¹⁰⁷ General Accounting Office, GAO-02-449, Earned Income Credit Opportunities To Make Recertification Program Less Confusing and More Consistent 14 (Apr. 2002).

¹⁰⁸Id. at 19.

¹⁰⁹ IRS, IRS Announces Steps to Improve EITC Administration, Seeks Public Comment, IR-2003-78 (June 13, 2003).

¹¹⁰ National Taxpayer Advocate 2004 Annual Report to Congress vol. 2.

¹¹¹ Information provided by operating division.

¹¹² For a complete discussion of the use of the affidavit during the 2004 certification study, see supra notes 74- 82 and accompanying text.

MOST SERIOUS PROBLEM: LEVIES ON SOCIAL SECURITY PAYMENTS

RESPONSIBLE OFFICIALS

Under the Federal Payment Levy Program (FPLP), the IRS may issue continuous levies up to 15 percent of a taxpayer's federal disbursements. FPLP levies on Social Security benefits may cause economic hardship to low income and other at-risk taxpayers, especially since the IRS has no effective mechanism for excluding low income taxpayers from this continuous levy. The IRS continues to process FPLP levies without managerial approval, causing undue burden on Social Security recipients.

When the IRS places manual (non-FPLP) levy on a taxpayer's Social Security benefits, the 15 percent limitation does not apply. Despite guidance to the contrary, the IRS sometimes subjects taxpayers to both FPLP and manual levies simultaneously.

ANALYSIS OF PROBLEM

Background

The Social Security Administration (SSA) provides benefits to 48 million individuals annually, paying out $493 billion in 2004.¹ The SSA provides two general categories of benefits -- Supplemental Security Income (SSI) and Old-Age, Survivors, and Disability Insurance (OASDI). The SSI program provides needs-based (means-tested) benefits to individuals who are age 65 or older, blind, or disabled. The OASDI program protects against the loss of earnings due to retirement, death, or disability.

When a recipient of an OASDI Social Security payment incurs a federal tax debt, the IRS may place a levy² on that payment via a continuous levy³ under the FPLP or a manual levy on a specific payment, but not both.⁴ Continuous FPLP levies are limited to 15 percent of the federal payment, but there is no such restriction on how much the IRS can levy manually.⁵

Federal Payment Levy Program

In the Taxpayer Relief Act of 1997 (TRA 97), Congress authorized the IRS to issue continuous levies up to 15 percent of a taxpayer's federal disbursements using a paperless process.⁶ The FPLP is an automated levy program that systemically matches IRS records against the records of the Financial Management Service (FMS)⁷ to locate federal payment recipients who have delinquent income tax debts.

When a match occurs, the IRS attempts to notify the recipient of the potential levy by sending a letter with information about the tax liability and the taxpayer's appeal rights.⁸ As an additional precaution for levies involving a benefit paid by the SSA, the IRS sends a second notice (CP 91 or CP 298, Final Notice Before Levy on Social Security Benefits) before transmitting the levy to the FMS.⁹ When FMS levies a payment, it sends a notice to the taxpayer's address of record on file with the appropriate federal agency.¹⁰

Taxpayer Notification

The National Taxpayer Advocate is concerned that taxpayers may not receive ample notice prior to levy. The IRS policy is to send FPLP notices to the last known address on the master file. However, because many Social Security recipients are retired and have not had tax filing obligations for several years, the IRS often does not have their correct contact information. As a result, the notices may go to old addresses, leaving taxpayers with little or no opportunity to arrange payments with the IRS before being subjected to a levy. Moreover, the IRS does not send FPLP notices to the addresses of Social Security alternate payees, such as nursing homes or guardians, unless those payees have a Form 2848, Power of Attorney and Declaration of Representative, on file with the IRS.

Use of Specific Response Date

When the IRS sends out a Final Notice Before Levy on Social Security Benefits (CP 91 or 298 notice), the taxpayer has 30 days to respond.¹¹ To improve notice clarity, the National Taxpayer Advocate recommends that the IRS include a specific due date for response, given the nature of the population receiving these notices.

The IRS has declined to use a specific due date on the grounds that taxpayers would be confused if the date specified fell on a federal holiday. We strongly believe that taxpayers will recognize that when a response is due on a holiday (or a weekend, for that matter), it will be reasonable to wait until the next business day. We urge the IRS to reconsider this recommendation to use a specific date on CP 91 and CP 298 notices.

Inadequate Safeguards to Exclude Low Income Taxpayers

Levies on Social Security benefits can cause particularly severe hardships for low income taxpayers, despite commendable IRS efforts to identify and exclude low income and other at-risk taxpayers from the program. A significant number of Social Security recipients rely on these payments as their primary or even their only source of income.

• In August 2005, Social Security recipients received an average monthly benefit of $877.20;¹²

• Social Security provides at least half of the total income for 65 percent of beneficiaries aged 65 and over, and is the only source of income for more than 20 percent of this population;¹³

• The median income for seniors aged 65 and over was $24,509;¹⁴ and

• The poverty rate for seniors aged 65 and over was 9.8 percent in 2004.¹⁵

However, the TPI criterion was imperfect at best. Because the TPI calculation was based on a taxpayer's last filed return and did not necessarily represent his or her current financial condition, the TPI criterion was both under-inclusive and over-inclusive. Some taxpayers may have reported relatively little income on their last filed returns, yet have substantial assets and the ability to pay the tax. Conversely, other taxpayers who reported high incomes on their last filed returns may now lack the wherewithal to pay.

The General Accounting Office (GAO, now the Government Accountability Office) concluded in a 2003 study that the TPI criterion is "an inaccurate indicator of a taxpayer's ability to pay."¹⁷ In response to this report, the IRS convened a cross-functional task force to develop alternatives to the TPI criterion. This task force, organized in 2003, has struggled to come up with a reliable, systemic method of predicting current economic hardship. The National Taxpayer Advocate urges the IRS to continue searching for a method of excluding low income taxpayers from the FPLP. One possible solution would be to evaluate interest and dividend income received by Social Security beneficiaries to develop assumptions about their ability to pay.¹⁸

In June 2005, the IRS stopped using the TPI to predict hardship status. It is estimated that this change will impact an additional 90,000 Social Security beneficiaries.¹⁹ These additional FPLP levies may result in economic hardships to the taxpayers if safeguards are not in place.

We note that the IRS could entirely avoid the problem of identifying low income taxpayers if tax debts were treated like other federal payments. For nontax federal debts, the first $750 per month ($9,000 per year) of federal benefits is statutorily exempt from levy.²⁰ Because the FPLP is used to satisfy tax debts, however, the IRS may levy on the first dollar of Social Security benefits, regardless of the amount. If tax debt were treated like other federal debt, Social Security recipients would be entitled to exclude a minimum of $9,000 per year in benefits from IRS levy²¹

Lack of Managerial Approval

One of the appealing features of the FPLP is that it is an automated matching program requiring minimal oversight from IRS collection employees. However, automation does not guarantee error- free processing.²² If the IRS erroneously places a levy on a taxpayer's Social Security payments, the taxpayer will face an undue burden, since Social Security recipients often rely heavily on that income for necessary living expenses. The IRS may spend more resources undoing improper levies than it would have spent if a manager reviewed at least some of the proposed levies. It is less than clear that this automated system results in overall efficiency for the IRS.

To protect taxpayers from unnecessary hardship, Congress instructed the IRS to develop procedures to ensure a determination to file a levy would, where appropriate, be reviewed by a supervisor before the levy action was taken. Section 3421 of the IRS Restructuring and Reform Act of 1998 (RRA 98) requires that a supervisor, where the Secretary deems appropriate, take the following steps prior to the issuance of a levy: (1) review the taxpayer's information; (2) verify that a balance is due; and (3) affirm that the action proposed to be taken is appropriate given the taxpayer's circumstances, considering the amount due and the value of the property or right to property.²³

In accordance with this instruction, Delegation Order 5-3 sets forth the procedures for approving levies.²⁴ Delegation Order 5-3 requires approval at certain levels of management prior to levying on Social Security payments.²⁵ Although IRS guidelines regarding FPLP make reference to Delegation Order 5-3, they omit the order's requirement for supervisor approval prior to processing FPLP levies.²⁶

At first glance, it appears there is a conflict between the provisions TRA 97 authorizing continuous levies under the automated FPLP and the provisions of RRA 98 requiring managerial review prior to the processing of levies. Typically, when two pieces of legislation are in conflict, the latter piece is given greater deference because one can conclude that the legislators were aware of the earlier measure and chose to override any conflicting provisions.²⁷ However, one must give effect to both statutes to the extent possible.²⁸

The National Taxpayer Advocate believes it is possible to reconcile the provisions of TRA 97 and RRA 98. Congress recognized the value of an automated levy program and authorized the FPLP in TRA 97. However, Congress was also concerned enough about the potential harm to taxpayers caught in the system that it directed the IRS in RRA 98 to develop some sort of review system for all levies. Reading the two statutory provisions together, it is apparent that Congress intended the IRS to continue with the automated FPLP levies, but also to institute some type of review process for all levies (including FPLP levies).

Given the potential harm to taxpayers, and Congress' clear intent to minimize that harm by requiring managerial reviews, it is appropriate for the IRS to devise procedures that identify cases that need greater scrutiny before being processed as an FPLP levy. It is up to the IRS to consider what type of review is appropriate for FPLP cases, but some type of mechanism should be in place to protect taxpayers who suffer from financial hardship, especially now that there is no income filter that systematically screens out low income taxpayers. Understandably, it will not be feasible for the IRS to require manual review of all FPLP cases, as that would defeat the purpose of having an automated levy program. Perhaps the IRS can use automation to identify potential high-harm cases (e.g., where IRS records indicate that a taxpayer's income is derived solely from the SSA or where there is an alternate payee for Social Security benefits on file, such as a nursing home) and require managerial review in those cases.

Inadequate Outreach & Education Strategy

In the absence of safeguards for taxpayers with economic or other hardships, the IRS needs to bolster its communication strategy for the FPLP. We urge the IRS to conduct additional outreach as early as possible, targeted to those most likely to receive FPLP notices. TAS developed an outreach strategy targeting the population likely to receive FPLP levies aimed at SSA benefits, since these taxpayers are likely to experience economic hardship and thus qualify for TAS assistance. TAS, in conjunction with the Wage & Investment division and other key stakeholders, developed a consumer tax alert brochure, a PowerPoint presentation, and a fact sheet discussing changes to the FPLP program and how the changes may affect taxpayers receiving Social Security benefits. This brochure has been disseminated via multiple channels, including the AARP, Low Income Taxpayer Clinics, and the Taxpayer Advocacy Panel.

The IRS should not merely rely on TAS outreach and education efforts. The IRS, on its own and through stakeholders, needs to let taxpayers know how changes in the FPLP rules may affect them, and where to find assistance. Stakeholders, Partnerships, Education, and Communication (SPEC), the IRS organization responsible for education of individual (e.g., non-business) taxpayers, should develop contacts and educational materials for those affected by FPLP. The National Taxpayer Advocate recommends that SPEC partner both locally and nationally with stakeholders such as the AARP and elder care facilities (e.g., nursing homes, assisted living centers, and retirement communities) to spread the message.

Selective Use of FPLP to Target Vulnerable Population

The FPLP is intended to encourage tax compliance among individuals and businesses receiving federal payments. Taxpayers subject to levy under the FPLP include federal contractors whose payments are processed by the FMS, recipients of federal retirement payments from the Office of Personnel Management, and recipients of Social Security payments.²⁹ Yet in practice, the overwhelming majority of FPLP levies involve benefit payments administered by the SSA. An astonishing 79 percent of the FPLP levies issued in fiscal year 2005 involved SSA payments.³⁰ Over the last four fiscal years, 84 percent of FPLP levies issued were from SSA recipients.³¹

The IRS seemingly recognizes that those receiving SSA payments are more likely to experience financial hardship, as its guidance suggests levying on Social Security income should be a last resort.³² Yet the IRS disproportionately utilizes its FPLP authority primarily to aid its collection efforts against the segment of the population receiving Social Security benefits.

Need for Improved Training of Employees

The IRS needs to keep in mind the need for taxpayer service within its enforcement measures. A 2002 TAS research study showed that the underserved population of taxpayers is not homogenous, but can be broken down into several distinct segments, each with differing demographic and psychographic characteristics.³³ The IRS should conduct similar research on the unique needs of the population of taxpayers receiving OASDI payments. Once it identifies the needs of this segment, the IRS should provide its employees with specific guidance to ensure that it provides the appropriate level and type of taxpayer service.

Manual Levies

Under prior IRS guidance, manager approval was required for manual levies in excess of 15 percent of the Social Security payment.³⁴ Now, the only restriction is that the taxpayer is to be left with some minimum amount of exempt income.³⁵ Under the current rules, it is possible for manual levies to reach 100 percent of a taxpayer's OASDI payments if he or she has other sources of income.

IRS guidelines state that a manual levy on Social Security income should be a last resort, in part because issuing levies through the FPLP is less labor intensive.³⁶ An FPLP levy takes precedence over a manual levy.³⁷

OASDI Payments: Retirement Asset or Retirement Income?

The IRS acknowledges it should exercise particular care before levying on retirement assets. For example, the IRS will not levy on retirement assets, such as an IRA, unless the taxpayer has engaged in "flagrant" conduct.³⁸ However, there is no similar restriction for levies on retirement income, as current IRS procedures allow manual levies on OASDI payments even in cases that are not flagrant.³⁹

The IRS's rationale for levying on a series of OASDI payments using a single manual levy is that this series of payments is a single retirement asset (consisting of a fixed and determinable property right to future benefits).⁴⁰ If the IRS views OASDI payments as being a retirement asset, then the IRS should limit manual levies on OASDI payments to flagrant cases, as it does on levies on other retirement assets. On the other hand, if the IRS wishes to treat OASDI payments as retirement income, then it should levy no more than 15 percent of such payments pursuant to IRC § 6331(h). Instead, it appears that the IRS is having its cake and eating it, too, by treating OASDI payments as both a retirement asset and as retirement income, depending on its particular objective.

Payments Subject to Double Levy

Under IRS procedures, the same payment source should not be subject to both an FPLP levy and a manual levy.⁴¹ However, TAS has encountered a number of cases where the IRS applied manual levies in addition to FPLP levies on the same payment.⁴² Taxpayers may experience unnecessary hardship when the IRS imposes manual levies before FPLP levies cease.

Situations where taxpayers are subject to both continuous levies and manual levies should not occur. IRS guidelines clearly state that "[i]f a paper levy is issued to a federal agency while the taxpayer is being levied through the FPLP for the same payment, the federal agency will return the paper levy to the originator."⁴³ The fact that some taxpayers are in fact subject to double levy indicates a lack of training or oversight of IRS collection employees. The IRS needs to ensure its employees follow the procedures set forth in the IRM.

Delay in Releasing Levies

Levy releases are not always processed promptly, and taxpayers may suffer hardship because of the difficulty of obtaining a release of manual levies from the SSA. Although TAS has been working with the SSA to expedite releases, the SSA can still take up to three months to process IRS levy releases while it continues to send payments to the IRS. This delay causes the IRS to process multiple manual refunds to return these payments in cases when the taxpayer is experiencing financial hardship.

The SSA has no automated processing system for levies and releases. Employees must manually input all documents at seven processing centers around the country, which all have their own programs and procedures. Nor does the SSA have a required timeframe for processing levy releases.

The Taxpayer Advocate Service and the SSA have reached an interim solution, under which the SSA has agreed to expedite levy releases for taxpayers experiencing financial hardships, and has provided an updated list of contacts and fax numbers for the seven Processing Centers. The Small Business/Self-Employed division management has alerted Automated Collection System (ACS) sites to the problem and instructed employees to follow the procedures in IRM § 5.19.4.4.12 for faxing levy releases immediately when these situations arise. While this interim solution has seemed to work, the IRS should continue to partner with the SSA and FMS to develop permanent procedures that will ensure prompt processing of levy releases.

IRS COMMENTS

Understanding the sensitive nature of levying Social Security benefits, we believe both Congress, in enacting legislation authorizing the levy, and the Service carefully scrutinized the administration of this authority in the development of both the Federal Payment Levy Program (FPLP) and manual (paper) levy operational procedures.

Managerial Approval and Continued External Oversight

We believe sufficient managerial approval and oversight exist in the administration of the FPLP, in both the authority to levy a taxpayer's case and the notification to the taxpayer. Because of its intended automated environment, the types of taxpayer cases systemically selected into the FPLP are carefully considered and subjected to many levels of review. These cases include taxpayers with unresolved tax accounts receiving Social Security benefits. Because the FPLP allows for a large number of taxpayer cases that may be subjected through an efficient levy process, Congress limited the FPLP levy to 15 percent of the federal payment. Also, in order for SSA taxpayers to have additional time to resolve their accounts prior to being levied through the FPLP, they are provided an additional pre-levy notice (in addition to the statutory due process notice provided to all taxpayers subject to any levy.) These special notices identify their specific Social Security benefit subject to levy.

In addition, GAO continues to administer additional oversight over the FPLP, including the review of the operational policies on Social Security levies as the Advocate's report cites. Also, representatives from the IRS, along with Financial Management Service (FMS), briefed Congressional Social Security subcommittee members during the ongoing development phase of the FPLP's Social Security levies.

While the decision to issue manual paper levies is no longer under a "flagrant case only" standard, managerial approval is still necessary due to the nature of the levied benefit. Also, part of the benefit may be statutorily exempt from a manual paper levy. In order to improve the quality of the administration of these levies, we continue to work with the SSA to lessen the burden that these levies may have on taxpayers. One major system enhancement will eliminate the operational error of double levies on a benefit and will be in operation in 2006. We continue to work with SSA to ensure levy releases on manual paper levies are efficiently and promptly released.

Potential Financial Hardship

While a levy may place a financial hardship on some taxpayers, the 2003 GAO audit report cited in the Advocate's report found that a small number of taxpayer's face financial hardships as a result of FPLP actions. A separate FPLP statistical report revealed that there were significantly more SSA taxpayers who fully paid their accounts or were placed in an installment agreement, than those who claimed a financial hardship.

Based on this information regarding financial hardship and the fact that separate GAO and IRS studies found the income exclusion criterion was inaccurate, we agreed with the GAO recommendation to eliminate the exclusion criterion and rely on the additional final notice process to resolve taxpayer cases. The Taxpayer Advocate Service was represented on the cross functional group that participated in this decision.

The income exclusion criterion will be eliminated in January 2006, and the IRS will continue to monitor the results stemming from FPLP actions on taxpayers whose Social Security payments are levied.

Response to Notice Language Clarity and SPEC Outreach and Education Recommendations

Last year, the IRS and TAS staff worked together to enhance the language of the FPLP's additional pre-levy Social Security notice. As the Advocate's report indicates, one outstanding issue was to determine if a specific date should be indicated on the notice by when the taxpayer needed to respond. After careful consideration, IRS decided that this notice would conform with all other IRS notices that follow a formal notice clarity process where it is not the standard to define a specific deadline date, but rather provide how much time the taxpayer has to respond.

Prior to adding Social Security levies to the FPLP, the IRS published a news release encouraging taxpayers to resolve their accounts in order to avoid such actions. The SSA and FMS also provided news content to the public through their venues. IRS believes sufficient information has been provided to the public and interested stakeholders based on the relatively low volume of impact that these levies may have compared to the millions of taxpayers who receive Social Security benefits.

While we feel we have taken the appropriate actions to educate our customers, we will review options for Stakeholder, Partnership, Education, and Communication (SPEC) partnering both locally and nationally with various stakeholders to further educate our customers on how changes in the FPLP rules affect them and where to find assistance.

Conclusion

The IRS recognizes the National Taxpayer Advocate's efforts to ensure that these taxpayers are well protected under adverse situations such as a levy, but the IRS has and will always ensure that the administration and operation of any levy program follow all taxpayer rights and provide for mutual taxpayer case resolution. This would include deeming an account uncollectible if a financial hardship exists based upon the taxpayer's response to the pre-levy notification as well as after the levy has been effected.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate commends the IRS for the many improvements to its levy process. In particular, she is pleased with the IRS's continuing efforts to improve clarity in taxpayer correspondence and its commitment to work with stakeholders to educate taxpayer regarding changes to the program. The IRS should distribute TAS' revised FPLP brochure for Social Security recipients when it becomes available again.

However, the National Taxpayer Advocate questions the IRS claim that "the types of taxpayer cases that are systematically selected into the FPLP are carefully considered and subject to many levels of review." The experiences of TAS and Low Income Taxpayer Clinics when they intercede on behalf of taxpayers facing hardship indicate that the current system of review can be improved.

The National Taxpayer Advocate is especially concerned that the IRS, despite its best efforts, has been unable to devise a method of screening out low income taxpayers from the FPLP. Effective screening eliminates the need for these elderly or disabled taxpayers to call the IRS and seek relief from a levy. Thus, the National Taxpayer Advocate recommends that Congress exempt Social Security payments from the FPLP, or in the alternative provide an automatic statutory exemption amount for Social Security recipients.⁴⁴ Pending legislative action, the IRS should explore developing an algorithm for screening out low income taxpayers from FPLP and manual levies on Social Security benefits. This algorithm could be based on the taxpayer's total positive income and Information Return Program (IRP) data. Moreover, the IRS should work with the Social Security Administration to develop a method of identifying Social Security payments made to Alternate Payees such as nursing homes.

The National Taxpayer Advocate would also like to emphasize the need for the IRS to improve training for all employees who deal with the release of levies and return of levy proceeds. TAS case advocates are trained to help taxpayers who need assistance resolving their Social Security levy issues with the IRS, but operating division employees must also be able to recognize hardship and take immediate action.

RECOMMENDATIONS

The National Taxpayer Advocate makes the following recommendations:

• The IRS should include a specific due date for response for CP 91 and CP 298 notices.

• The IRS to continue should develop an algorithm for screening out low income taxpayers from FPLP and manual levies on Social Security benefits.

• The IRS should come up with procedures to identify cases that need greater scrutiny before being processed as an FPLP levy.

• The IRS, on its own and through stakeholders, needs to let taxpayers know how changes in the FPLP rules may affect them, and where to find assistance.

• The IRS should conduct research on the unique needs of the population of taxpayers receiving OASDI payments and provide its employees with specific guidance to ensure that it provides the appropriate level and type of taxpayer service.

• The IRS should limit manual levies on OASDI payments to flagrant cases, as it does on levies on other retirement assets, or in the alternative, it should levy no more than 15 percent of such payments.

• The IRS should ensure that its employees follow the procedures set forth in the IRM so that taxpayers are not subject to double levy.

• The IRS should continue to partner with the SSA and FMS to develop permanent procedures that will ensure prompt processing of levy releases.

² A levy is a legal seizure of property to satisfy a tax debt. IRC § 6331 provides the IRS with the general authority to levy funds held by a third party (such as an employer).

³ A continuous levy remains in effect from the date it is first made until the levy is released. IRC § 6331(h)(1).

⁴See IRM § 5.19.9.3.3 (Rev. 7-14-2005). If an FPLP levy is already in place, the IRS can issue a manual levy on other levy sources, but not the same FPLP levy source.

⁵See IRM § 5.11.6.1.1. A manager may approve a manual levy that could attach more than the 15 percent through FPLP. In practice, the extra work and the uncertain proceeds usually make FPLP a more popular option.

⁶ IRC § 6331(h)(2)(A); IRM § 5.11.7.2 (Rev. 7- 26-2002). Payments subject to the FPLP include any federal payments other than those for which eligibility is based on the income or assets of the recipients. Thus, SSI payments (for which eligibility is based on the income) are not subject to continuous levy under the FPLP, while OASDI payments (which are not means-tested) fall within the purview of the FPLP.

⁷ The FMS is the Department of the Treasury agency that processes payments for various federal agencies.

⁸ IRM § 5.19.9.3.2.7 (Rev. 7-14-2005): CP 90/297, Notice of Intent to Levy and Notice of Your Right to a Hearing.

⁹ IRM § 5.19.9.3.2.7(5) (Rev. 7-14-2005): CP 91/298, Final Notice Before Levy on Social Security Benefits.

¹⁰ IRM § 5.19.9.3.2.8(2) (Rev. 7-14-2005).

¹¹ Treas. Reg. § 301.6331-2(a)(1) provides that the levy may be made no less than 30 days after notice of intent to levy.

¹² Social Security Administration Office of Policy, Research, Evaluation and Statistics, Monthly Statistical Snapshot, Table 2, Social Security Benefits (August 2005).

¹³ Social Security Administration, Fast Facts & Figures About Social Security, 2005 (September 2005).

¹⁴ U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2004, available at http://www.census.gov/hhes/www/income/income04/.

¹⁵ U.S. Census Bureau, Current Population Survey, 2005 Annual Social and Economic Supplement, available at http://www.census.gov/hhes/www/poverty/poverty04/. The Census Bureau uses a set of income thresholds that vary by family size and composition to determine who is in poverty. The poverty guidelines issued each year in the Federal Register by the Department of Health and Human Services may differ from the Census Bureau's poverty threshold.

¹⁶ TPI is calculated by summing the positive values from the following income fields from a taxpayer's most recently filed individual income tax return: wages; interest; dividends; distributions from partnerships, small business corporations, estates, or trusts; Schedule C net profits; Schedule F net profits; and other income such as Schedule D profits and capital gains distributions. Losses reported for any of these values are treated as a zero. IRM Exhibit 4.1.7-1(33).

¹⁷ General Accounting Office, GAO 03-356, Tax Administration, Federal Payment Levy Program Measures, Performance and Equity Can Be Improved 11 (March 6, 2003).

¹⁸ One possible approach would require the IRS to determine taxpayers' total positive income in the last two years (by looking at filed tax returns or Forms 1099). If the only income is from the SSA, the IRS would not levy. If the income is from the SSA plus dividends and interest under "x" amount, or from wages under "y" amount, the IRS would also not levy.

¹⁹http://www.irs.gov/advocate.

²⁰ Debt Collection Improvement Act of 1996, Pub. L. No. 104-134 (1996).

²¹See Additional Legislative Recommendation: Social Security Levies, infra.

²² For example, a disabled taxpayer with a balance due of $133 was subjected to an FPLP levy. She earned $35 per month working part-time (due to her disability, her employment prospects are limited) and relied primarily on OASDI payments from the SSA to pay for her living expenses. Because there is no provision for discretion or managerial review, the IRS levied the taxpayer's disability payments under the FPLP. The taxpayer, unable to make her rent payments or even to purchase groceries, came to TAS for assistance. See Taxpayer Advocacy Management Information System (TAMIS).

²³ Section 3421 of the IRS Restructuring and Reform Act of 1998, Pub. L. No. 105-206 (1998) provides as follows:

²⁵ Delegation Order 5-3 (Rev. 9-22-2005), §§ 8, 9.

²⁶ IRM § 5.11.1.2.4(1) (Rev. 7-01-2004).

²⁷ As the Supreme Court has explained: "[I]n interpreting a statute a court ... must presume that a legislature says in a statute what it means and means in a statute what it says there." Connecticut Nat'l Bank v. Germain, 503 U.S. 249, 253-254 (1992). See also United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241-242 (1989); Whitney v. Robertson, 124 U.S. 190, 194 (1988); United States v. Hansen, 772 F.2d 940, 944-45 (D.C. Cir. 1985). Note that the provisions in RRA 98 requiring managerial review of levies came about after the provisions in TRA 97 authorizing continuous levies under the FPLP.

²⁸See Connecticut Nat'l Bank v. Germain, 503 U.S. 249, 253 (1992).

²⁹ IRM § 5.19.9.3.1 (Rev. 7-14-2005).

³⁰ Per email message from W&I Payment Compliance, Acting Sr. Program Manager, dated September 28, 2005. 656,000 SSA Levies/832,000 Total Levies = 78.9 percent.

³¹ Per email message from W&I Payment Compliance, Acting Sr. Program Manager, dated September 28, 2005. 331,946 (FY02 SSA Levies) + 477,434 (FY03 SSA Levies) + 562,000 (FY04 SSA Levies) + 656,000 (FY05 SSA Levies)/382,887(FY02 Total Levies) + 521,390 (FY03 Total Levies) + 671,000 (FY04 Total Levies) + 832,000 (FY05 SSA Levies) = 84.2 percent.

³² IRM § 5.19.9.3.3(2) (Rev. 7-14-2005).

³³ Russell Marketing Research, Findings from Task 149 -- The Taxpayer Advocate Service Research Program with a Focus on the Detailed Study of the Underserved Segment -- Phase II, Study #3 (July 2002).

³⁴ IRM § 5.19.9.4.1.1(6) (Rev. 12-29-2003) provides that a "manager may approve a manual levy to SSA that could attach more than the 15 percent through FPLP."

³⁵ The term "exempt amount" is calculated by adding the standard deduction and the aggregate amount of dependent exemptions. For example, a single taxpayer who is paid weekly and claims three exemptions (including one for the taxpayer) will be able to exempt $14,600 from levy ($280.77 per week). See IRC § 6334(a)(9); Treas. Reg. § 301.6334; Publication 1494 (Rev. 2005).

³⁶ IRM § 5.19.9.3.3 (Rev. 7-14-2005).

³⁷ IRM § 5.11.7.2.5.5(3) (Rev. 7-26-2002).

³⁸ IRM § 5.11.6.2(5) (Rev. 3-15-2005).

³⁹ IRM § 5.17.3.2.1(4) (Rev. 10-31-2000) provides that "[l]evies on pension benefits seize a taxpayer's current right to payments . . . and are no longer restricted to cases of flagrant noncompliance."

⁴⁰See IRM § 5.6.11.1(3) (Rev. 6-29-2001); IRM § 5.17.3.5.24(3) (Rev. 10-31-2000); Rev. Rul. 55-210, 1955-1 C.B. 544 (only one notice of levy needs to be served to effectively reach vested benefits subsequently payable in other contexts).

⁴¹See IRM § 5.19.9.3.3 (Rev. 7-14-2005). If an FPLP levy is already in place, the IRS can issue a manual levy on other levy sources, but not the same FPLP levy source.

⁴²See TAMIS (taxpayer was subject to FPLP levies of $152.02, $99.37, and five payments of $102.49 from December 2004 to June 2005 while concurrently subject to manual levies of $640.50, $665.50, and five payments of $644.67); TAMIS (in October 2004, taxpayer subject to FPLP levy of $89.29 and manual levy of $739.70; TAMIS (in December 2004, taxpayer subject to FPLP levy of $77.86 and manual levy of $636.90).

⁴³ IRM § 5.11.7.2.5.5(3) (Rev. 7-26-2002).

⁴⁴See Additional Legislative Recommendation: Social Security Levies, infra.

MOST SERIOUS PROBLEM: APPEALS CAMPUS CENTRALIZATION

RESPONSIBLE OFFICIAL

In the 2004 Annual Report to Congress, the National Taxpayer Advocate reported that one of the most serious problems facing taxpayers was the erosion of independence in the IRS Office of Appeals (Appeals), and raised concerns about Appeals' Campus Centralization Initiative.¹ Under this initiative, Appeals has centralized case inventory from certain workstreams at six IRS campuses.² With campus centralization, Appeals hopes to improve case cycle time and increase efficiency by "getting the right work to the right employee."³ Cases that would have been worked in Appeals field offices will now be transferred to the applicable IRS campus -- generally without regard to taxpayers' geographic locations. Thus, a case could be worked by an Appeals employee in a location distant from the affected taxpayer or the taxpayer's representative.

Appeals campus centralization may indeed reduce Appeal case cycle time (although that is yet to be determined conclusively). However, Appeals campus centralization also has the potential to negatively impact taxpayers by:

• Reducing face-to-face or local office conference opportunities;

• Diminishing working relationships between Appeals' employees, taxpayers, and taxpayer representatives and increasing taxpayer burden when cases are worked outside of a taxpayer's geographic area;

• Moving work that has traditionally required a high level of independent judgment and discretion to an environment that has traditionally focused on processing; and

• Diminishing service and effectively eliminating appeal rights for low income and less sophisticated taxpayers.

Campus Centralization

Appeals began centralizing certain workstreams at IRS campuses in late 2003 and early 2004.⁴ Appeals' campus centralization objectives are to:

• Improve case cycle time by shifting the large inventory of casework in Appeals field offices to the campuses.⁵

• Increase customer satisfaction by resolving high volumes of work earlier in the process.⁶

• Increase Appeals' operating cost effectiveness.⁷ Achieve greater efficiency through specialization.⁸

• "Get the right work to the right employee" -- i.e., match the case work to the skills and grade level of the individual employee.⁹

• Work less complex cases in Appeals campuses to "resolve [a] high volume of less complex work earlier" and to "more effectively work [the] most complex cases . . . in the field, . . . [which] is best equipped to do that complex work."¹⁰

• Work cases in the campuses that are generated in the campuses and allow Appeals field employees to work cases generated by field compliance.

• Dedicate staffing to time sensitive workstreams (such as economic hardship cases).¹¹

² IRS Campuses were formerly known as IRS Service Centers.

³ Appeals Strategy and Program Plan, FY 2005-2006. Appeals has updated this strategy to provide, "getting the right work to the right employee at the right time to get the right decision." Appeals Strategy and Program Plan, FY 2006-2009 2.

⁴ Diane Hiser and Ray Wolff, Welcome Aboard, Brookhaven Appeals Campus!, IRS Office of Appeals, Friday Report (October 17, 2003). Ray Wolff, New Campus Teams = Employee Satisfaction, IRS Office of Appeals Friday Report (April 9, 2004).

⁵Id.

⁶ David B. Robison, Appeals: Dedicated to Continuous Improvement, J. Tax Practice and Procedure (Feb.-Mar. 2005), 59, 61.

⁷ Diane Hiser and Ray Wolff, Welcome Aboard, Brookhaven Appeals Campus!, IRS Office of Appeals, Friday Report (October 17, 2003).

⁸Id.

⁹ SB/SE Executive Conference Presentation Materials (5/5/2005); Appeals Strategy and Program Plan, FY 2005/2006.

¹⁰ SB/SE Executive Conference Presentation Materials (5/5/2005); Appeals Strategy and Program Plan, FY 2005/2006; IRS/TEI Night Presentation Materials (3/17/2005); Videotape: Update on Campus Rollout. By David Robison and Ray Wolff, Web Stream Broadcasting (3-1-2005).

¹¹ IRS Office of Appeals, FY 2005 Campus Implementation, Taxpayer Advocate Briefing (March 31, 2005).

 TABLE 1.7.2, CENTRALIZED CAMPUS COURSE CASE ROUTING BY APPEALS CAMPUS

     TABLE 1.7.3, APPEALS CASE ASSIGNMENTS -- CAMPUS VS. FIELD (BY

 TABLE 1.7.4, APPEALS CAMPUS STAFFING -- FY 2005¹⁸

At the same time, however, the number of Appeals field employees greatly decreased. Table 1.7.5 shows Appeals field staffing numbers for FY 2005.

       TABLE 1.7.5, APPEALS FIELD STAFFING -- FY 2005²⁰

Appeals Procedures

Appeals intends to work its campus cases in much the same way that it works field cases. In both the field and campuses, Appeals typically receives a case when: (1) a taxpayer does not agree with the determinations of an IRS compliance function;²⁴ (2) a taxpayer wishes to Appeal certain IRS collection actions through a Collection Due Process (CDP) hearing or the Collection Appeals Program (CAP);²⁵ or (3) the IRS Office of Chief Counsel ("Counsel") refers a case docketed in the United States Tax Court to Appeals for consideration of settlement under Rev. Proc. 87- 24.²⁶

Appeals cases are forwarded to an Appeals Team Manager (ATM), who evaluates the case for complexity and assigns it to an Appeals Officer (AO) or Settlement Officer (SO).²⁷ The ATM makes these assignments based on each case's dollar value, issue types, complexity, and workload considerations.²⁸ The ATM assigns less complex cases to lower graded employees and more complex cases to higher graded employees.

When Appeals accepts a case, it notifies the taxpayer by letter. The type of letter Appeals sends differs by case, but all initial contact letters generally acknowledge Appeals' receipt of the case and instruct the taxpayer to contact Appeals to arrange a conference. Some initial contact letters pre-schedule a conference by instructing the taxpayer to call the AO or SO at a specific date and time. In docketed cases, the initial contact letter acknowledges that the taxpayer has filed a Tax Court petition and notifies the taxpayer that the case has been referred to Appeals for settlement.²⁹ After a taxpayer receives the initial contact letter and contacts Appeals, Appeals and the taxpayer work together to try and settle the case.

Docketed "S" Case Procedures

A docketed S case is a case docketed in the United States Tax Court with a deficiency of $50,000 or less (including tax and penalties) for a taxable period and elects to be treated under the Court's small case procedures.³⁰ S cases are more informal than other docketed cases and are given expeditious consideration by the Tax Court. The Tax Court's decisions in S cases are final and cannot be appealed.³¹

Under Rev. Proc. 87-24, Counsel is to refer most docketed Tax Court cases that have not yet received Appeals consideration -- including S Cases -- to Appeals for settlement.

Appeals generally has sole settlement authority over docketed S cases until it returns a case to Counsel. Appeals returns docketed S cases to Counsel when a case appears on the Tax Court trial calendar.³²

Although Appeals is centralizing several workstreams at IRS campuses, it has developed separate written campus procedures for docketed S cases only. Appeals is working docketed S cases in the Fresno, Brookhaven, and Philadelphia campuses.³³

Appeals intends to work campus docketed S cases in a similar manner to field docketed S cases.³⁴ There are, however, some differences. One difference is that campus Appeals will only work cases graded at the GS-12 level or lower.³⁵ All higher graded cases will be assigned to the field. Another difference is the addition of campus S case screeners ("Screeners"). Screeners are GS-9 level Appeals employees who review new case receipt files to make sure they are complete and determine if there is any additional information that would be helpful or relevant to resolve the case.³⁶ Screeners also set appointments for conferences, perform pre- and post-decision analysis, prepare some case write-up, and set the AO's prescheduled telephone conference calendars.³⁷

According to Appeals Campus docketed S case written procedures, Screeners can also resolve certain cases on their own without sending the case to an AO.³⁸ These procedures state that Screeners can close non-Grade 13 cases that involve individual taxpayer returns,³⁹ and that do not involve certain issues.⁴⁰ If a case does not meet all of these "Screener criteria," the Screener must send the case to a campus AO.⁴¹ In certain cases received from a Screener, the AO is to use the adjustment schedule prepared by the Screener and not rework the case. The AO will hold the conference as scheduled in the initial contact letter; any follow up conference must be scheduled within 30 days of the first. The AO can grant one 30 day extension of time for the taxpayer to provide additional information without managerial approval -- any additional time extensions must be approved by the ATM.⁴² Because campus Appeals works only Grade 12 cases or lower, generally all campus assigned docketed S cases will initially be routed to a Screener.⁴³

It is our understanding from verbal conversations with Appeals management that the campus Screeners' primary responsibility is determining initial case processing. Screeners review only GS-11 cases (GS-12 and GS-13 cases go directly to AOs), and have authority to resolve cases that do not involve the exercise of discretion. According to Appeals' management, campus Screeners can close cases involving (1) no change decision documents; (2) simple cases involving only one issue; and (3) cases where the taxpayer has not responded to two Appeals contact letters and one Appeals phone call (no response cases).⁴⁴ This explanation of the Screener's duties and responsibilities is not entirely consistent with the Appeals written campus docketed S case procedures and may lead to disparate treatment of taxpayers.

Face-to-Face and Local Office Hearings

Some taxpayers may prefer to deal with Appeals on a face-to-face basis or with an AO that is familiar with local circumstances. Thus, these taxpayers may request that their cases be transferred to a field office near the taxpayers. Appeals has stated publicly that these requests will be granted.⁴⁵ However, there appears to be some uncertainty concerning case transfers from campuses to local offices. Appeals' Breakthrough S Case procedures explain that when a taxpayer requests that his or her case be transferred to a local Appeals office, the screener will refer the request to the ATM for evaluation. If the ATM determines that the request will be granted, the Screener will prepare the administrative file for transfer or reassignment. Additionally, the S case initial contact letter is not particularly clear about a taxpayer's face-to-face or transfer options. The initial contact letter mentions face-to-face conferences, but does not specifically state that these conferences will be granted upon request. The letter states,

We have found that most taxpayers prefer to have an Appeals conference by telephone or correspondence. Since the time period for Appeals to work your case is very limited, we have planned a phone conference for the time and date shown above. Before that date, please call the number listed above to:

• discuss whether a face-to-face conference at the Appeals office closest to your residence/business might be better for you. Face-to-face conferences are more appropriate for cases involving complex issues or a substantial volume of documentation.⁴⁶

CONCERNS WITH CAMPUS CENTRALIZATION

There is nothing inherently wrong with Appeals working certain cases at IRS campuses. The IRS has been conducting various activities at its campuses (formerly known as service centers) for many years. In fact, the Taxpayer Advocate Service (TAS) has offices in each campus that handle taxpayer problems and work taxpayer cases. Appeals campus centralization, however, is driven largely by Appeals' desire to streamline its inventory and reduce case cycle time.⁴⁷ While shortening Appeals' case cycle time is a worthy objective, an Appeals-wide campus centralization policy that is driven by the goal of improving cycle time numbers may ultimately have a negative impact on taxpayer burden and taxpayer rights. Inventory management goals must be balanced with training and procedures that ensure that the rights and interests of all taxpayers -- particularly those of lower income and without representation -- are protected.

TAS is concerned that Campus Appeals is replacing many of the services Appeals traditionally offered in the field. Appeals experienced both a significant decrease in field employees and a significant increase in campus employees in FY 2005.⁴⁸ While the FY 2005 staffing numbers alone do not definitively establish that Appeals campus hires directly replaced field attrition, they do demonstrate that Appeals' field presence is shrinking at the same time its campus presence is growing, and that the number of highly skilled Appeals officers in the field is declining overall. This workforce shift has the potential to negatively impact taxpayer rights if Campus Appeals fails to provide the same quality taxpayer services that have been traditionally found in Appeals field offices.

In the paragraphs below, we discuss our specific concerns with Appeals campus centralization. We realize that some of these concerns may be considered "prospective" because Appeals campus centralization is fairly new. However, surfacing even "prospective" concerns now will allow Appeals to develop and implement remedies to existing problems, as well as procedures designed to prevent problems in the future.

Campus Screeners

A primary concern with Appeals campus centralization is the role of the campus Screeners. According to Appeals written campus docketed S case procedures, all campus Appeals cases will initially be routed to a Screener. Depending on the case grade level and the issues in the case, the Screeners will then forward certain cases to AOs and resolve certain cases themselves. The written procedures also state that when an AO receives certain non grade 13 cases from a Screener, the AO is to use the adjustment schedule prepared by the Screener and not rework the case.⁴⁹

If Appeals' written campus docketed S case procedures are correct, TAS is concerned that Appeals may be using GS-9 Screeners as substitute AOs in the campus setting, or even to "screen out" an AO's discretion in certain cases. There is no indication that campus Screeners are receiving the training or oversight necessary to perform discretionary duties.

We understand that Appeals' management does not intend for campus Screeners to function in a discretionary capacity. According to verbal conversations with Appeals management, Screeners can only close cases in very limited circumstances. The Screeners' primary roles are case intake processing and appointment scheduling. TAS urges Appeals to reconcile its written procedures with management's intent. Campus employees are typically not privy to management's intent on a day to day basis. These employees, however, do have ready access to written procedures and will follow these procedures when questions arise. TAS believes it is imperative that campus Screeners responsibilities be limited to processing and appointment setting functions in order to provide taxpayers with a meaningful and independent administrative appeal.

Lost Face-to-Face and Local Office Opportunities

Another significant concern with Appeals campus centralization is the effect it will have on the taxpayer's opportunity to have a face-to-face Appeals conference, or to have his or her case assigned to a local AO. When a taxpayer's case is worked in a campus rather than a local Appeals office, it is almost certain that the case will be worked outside of the taxpayer's geographic area -- perhaps thousands of miles away. Thus, if a taxpayer desires to meet personally with an Appeals employee, Appeals will have to transfer the case to a field office near the taxpayer.

Appeals has stated both publicly and internally that taxpayers requesting a face-to-face conference will receive one. When a taxpayer requests a face-to-face Appeals conference, Appeals is to transfer the taxpayer's case to the field office nearest the taxpayer. There appears to be some uncertainty, however, about Appeals' case transfer policy.

As an initial matter, when Appeals officials have addressed the face-to-face issue with respect to campus centralization, they generally also explain that "most people don't want a face-to-face interview."⁵⁰ Appeals supports this assertion by citing the low percentage of taxpayers who have had face-to-face conferences in recent years (14 percent from April 1, 2004 to March 31, 2005).⁵¹ Appeals does not explain, however, how many of these taxpayers specifically declined the opportunity for a face-to-face conference versus how many did not request one at all. In other words, Appeals knows the population of taxpayers who did not have face-to-face conferences, but it does not appear to know why these taxpayers failed to utilize a face-to-face opportunity. How many of these taxpayers did not request a face-to-face conference because they did not know it was an option? And how many taxpayers requested a face-to-face conference but did not receive one? Appeals does not currently capture any of this information.

Additionally, Appeals fails to differentiate face-to-face meetings from a taxpayer's need to have a local conference. Some taxpayers may not want or need a face-to-face conference, and may even find such a hearing burdensome. But in many cases, taxpayers do need a local AO who understands the particular environment or occupation of the taxpayer. One example is a taxpayer requesting a penalty abatement in a payroll agent fraud case.⁵² It would be much more beneficial to this taxpayer to have his or her case assigned to a local AO who is familiar with the payroll agent case through local press coverage and who understands specifically how the case is affecting local small business taxpayers. Another example is a taxpayer who claims the Earned Income Tax Credit (EITC) and whose income is based on tobacco sales and subsidies in Virginia or North Carolina. A local AO would be much better equipped with the background information necessary to resolve these issues than would a campus AO in Fresno. Appeals' written guidance, however, does not address transfers based on local or regional issues.

There also appears to be some uncertainty about how the campus face-to-face/local transfer requests are actually working. Appeals' campus docketed S case transfer procedures seem to conflict. One set of procedures states that face-to-face/local transfer requests will be granted and no contingencies are mentioned.⁵³ Another set of procedures, however, states that face-to-face/local transfer requests must be approved by an ATM.⁵⁴ Additionally, the docketed S case initial contact letter is not entirely clear about whether Appeals will grant face-to-face conference or case transfer requests. And if Appeals will not automatically grant these requests, the criteria for granting or denying these requests are not set forth.

TAS believes that Appeals must immediately clarify these procedures to avoid both taxpayer and IRS confusion. Appeals campus employees will be familiar with procedures, but they may not be aware of senior Appeals officials' public statements. These employees may not know that the Chief of Appeals has assured practitioners that campus Appeals will routinely grant face-to-face/local transfer requests. If procedures tell campus employees to do something different, they will follow procedures. Additionally, it does not appear that any version of Appeals campus procedures is publicly available to taxpayers. Until correct campus procedures are included in the IRM -- or at least available on the IRS web site -- taxpayers and practitioners must rely on Appeals' public statements only. If procedures conflict with public perception, taxpayers and practitioners will lose confidence in Appeals.

Anecdotal evidence suggests that Appeals may not be granting face-to-face/local transfer requests without a fair amount of effort on the taxpayers' or representatives' part. Some practitioners have related less than positive experiences with campus transfer requests. One practitioner explained that he asked Appeals to transfer an OIC case from a campus to a local field office, only to be told that his case was not a good candidate for a face-to-face conference and it should stay in the campus.⁵⁵ At least two other practitioners came to TAS because they had specifically requested a face-to-face conference and a transfer to their respective taxpayers' local offices, but were told that their cases were part of a "project" and therefore face-to-face conferences and transfers would be granted only at Appeals' discretion. Another practitioner explained that her client did not have a face-to-face conference because Appeals did not inform the taxpayer that a face-to-face conference was an option. This particular taxpayer was less educated, sophisticated, or articulate than many taxpayers -- factors which led the practitioner to believe that the taxpayer would have benefited greatly from a face-to-face meeting with the AO. According to the representative, this taxpayer received an unfavorable result from a phone conference because the AO misunderstood several key facts that would have been easier to flesh out in a face-to-face conference. In a face-to-face setting, the AO would have had a first hand, in-person look at the taxpayer's supporting documentation, which clearly laid out the relevant facts. More importantly, the AO also would have been able to actually see the taxpayer and determine that she was having trouble communicating. A more meaningful conversation could have taken place that would have better facilitated communication and drawn out relevant facts. Instead, the representative had to subsequently rework the case through both TAS and Appeals to ensure that Appeals was aware of and considered all relevant facts.

TAS does not believe that local face-to-face Appeals conferences are necessary in all cases. In fact, TAS agrees with Appeals that in many instances the case may be best resolved via telephone conference, or, in rare instances, solely through correspondence. We are concerned, however, that Appeals campus centralization will result in lost face-to-face and local office opportunities for taxpayers who would be best served by in-person conferences or working with a local AO. We encourage Appeals to make good on its promise to grant local face-to-face conferences when taxpayers ask for them. We also urge Appeals to immediately clarify its face-to-face and case transfer procedures and clarify its initial contact letter to ensure that (1) taxpayers receive a local face-to-face conference when requested; (2) taxpayers know that they can request such a conference when desired; and (3) Appeals procedures address the need for local office transfers based on geographic specific issues -- even when a face-to-face conference may not specifically be necessary.

DIMINISHED WORKING RELATIONSHIPS

In addition to lost face-to-face and local case assignment opportunities, TAS is concerned that Appeals campus centralization will also result in diminished personal working relationships between Appeals employees and taxpayers and their representatives. When Appeals works a case in the field, the Appeals employee working the case is typically located within a reasonable distance from the taxpayer or the taxpayer's representative. Geographic proximity facilitates an efficient and collaborative working relationship between the taxpayer and Appeals during the Appeals process. It is easier to exchange documents. If the taxpayer desires a face-to-face conference, one can be conveniently scheduled without transferring the case. A continuing telephone dialogue can be established. Local Appeals personnel are likely better equipped to handle any geographic specific issues. And, perhaps most importantly, the Appeals employee and taxpayer (and/or taxpayer's representative) can quickly address issues that arise as the case progresses by the most efficient and effective means available: documents can be hand delivered, the Appeals officer, taxpayer, or representative can be quickly contacted by telephone, and face-to-face meetings can be scheduled as necessary.

These efficient working relationships will be more difficult, if not impossible, to establish in a campus Appeals environment. Documents will have to be delivered long distance, with added time and expense for the taxpayer. In fact, it is our understanding that not all campus Appeals offices currently have toll-free fax numbers; thus, if a taxpayer needs to quickly deliver a document, he or she will have to incur overnight mail or long-distance phone charges. Low income taxpayers may not be able to afford to send documents by either method. Taxpayers can, of course, contact campus Appeals by telephone, but it is not clear if taxpayers will have a direct line to an Appeals employee or if they will have to navigate an automated phone system to reach the person working their case. Time zone differences may also complicate phone communications as business hours at the campus may be different from where the taxpayer lives. We also understand that some campus Appeals offices have not yet set up tollfree phone lines, forcing taxpayers to incur long-distance charges in order to speak with Appeals about their case. And most burdensome, when issues arise during the Appeals process that would best be discussed on a face-to-face basis, the taxpayer's case must be transferred to a local office mid-stream, if it is transferred at all. This scenario will lengthen the Appeals process, burdening both the taxpayer and Appeals.

THE IRS CAMPUS

The IRS campus culture has traditionally been production oriented with limited employee discretion and decision-making. Generally, campus procedures do not easily lend themselves to the facts and circumstances analyses that are essential in resolving cases in Appeals. Furthermore, since many Appeals cases now originate in IRS campus enforcement, taxpayers may not believe that their case will receive a truly independent review from Campus Appeals. These taxpayers may not communicate or respond to Campus Appeals under the mistaken belief that Campus Appeals and campus enforcement are not separate.

TAS does not believe that Appeals campus operations are impossible, or that Appeals should not operate in IRS campuses. To the contrary, TAS operates successfully at each IRS campus using employees that once worked in campus taxpayer service and enforcement functions. We do believe, however, that training campus employees to successfully transition from processing and production to independent thinking and discretionary judgment requires a concentrated effort and focused strategy. At this time, however, Appeals does not provide campus specific training for its campus employees. TAS encourages Appeals to develop campus specific training to help its employees effectively operate in the IRS campus environment.

We are also concerned that Appeals campus centralization may fall victim to the problems that have plagued other IRS campus centralization efforts. The IRS has moved to campus centralization in several areas in addition to Appeals. The IRS processes "simple" Offers in Compromise at the Brookhaven and Memphis campuses; Innocent Spouse cases at the Covington (Cincinnati) campus, and EITC audits are virtually entirely conducted at campuses. Practitioner reviews of campus centralization have not been favorable. One Low Income Taxpayer Clinic director offered this critique of centralized EITC audits being conducted through IRS campuses via correspondence:

[These] audits for the most part are based on notices that are computer generated.

CONCERNS FOR LOW INCOME TAXPAYERS

TAS is particularly concerned with the effects of Appeals campus centralization on low income and unrepresented taxpayers. "Low income taxpayer" is not synonymous with "simple return." Many low income taxpayers are small business owners who must file quarterly tax estimates, pay self-employment taxes and file Schedule C.⁵⁸ Many low income taxpayers also claim the Earned Income Tax Credit (EITC). The Treasury Inspector General for Tax Administration called the EITC a "program that is so complicated it is difficult for both taxpayers and the IRS to consistently and accurately determine eligibility."⁵⁹ The EITC provisions contain 2,680 words and require at least a twelfth-grade education to understand; the EITC information package (IRS Publication 596) contains 53 pages of forms, instructions and worksheets; and in tax year 2003, more than 70 percent of EITC claimants used a paid preparer.⁶⁰ In addition to the EITC, many low income taxpayer returns also contain issues with the child tax credit, the dependent care credit, education credits, head of household filing status, income from disability pensions, in-kind charitable contributions, premature IRA distributions, and gambling losses.⁶¹

In addition to these complex tax return issues, low income taxpayers possess several characteristics that pose significant communication challenges. For instance, many low income taxpayers have limited English proficiency or have literacy problems. These taxpayers also tend not to keep good records and have limited or no access to computers, the internet, or even copiers and fax machines.⁶² Low income taxpayers also typically cannot afford tax representation; and when they can, the competency of that representation is suspect.⁶³

We are concerned that Appeals' centralization objective of "getting the right work to the right employee" is based on faulty assumptions concerning low income taxpayers. "Getting the right work to the right employee means matching case work to the skills and grade level of the individual employee."⁶⁴ On its face, this is a legitimate goal. When employees are either over-tasked or under-utilized efficiency suffers. TAS is concerned, however, that Appeals right work/right employee strategy does not accurately account for the complexity of some low income taxpayer cases.

Appeals believes that its campus cases are "relatively straightforward, limited issue cases" that lend themselves to a "resolution through a telephone conference or by looking at a few pieces of documentation submitted by correspondence."⁶⁵ However, many of Appeals' centralized workstreams involve low income taxpayers whose cases do not fit the "relatively straightforward/limited issue" mold. For example, a self-employed low income taxpayer with limited English and literacy proficiency claims the EITC. Numerous complex issues could arise in an audit of this taxpayer that would be later considered by Appeals. If Appeals assigns this taxpayer's case to a campus, additional problems would likely ensue. The case will be worked by a GS-12 employee (or lower). The taxpayer will receive a letter, in English, containing a pre-scheduled telephone conference date and time and requesting additional documentation. If the taxpayer understands the letter well enough to respond, he will likely have limited ability to copy the applicable documents and get them to the appropriate Appeals person and to call in for his conference at the pre-scheduled time. If he can call in, he will most likely have difficulty navigating the campus phone system and communicating with the AO. If, on the other hand, this taxpayer does not understand the letter, he will lose his Appeal rights. In short, Appeals campus centralization will provide taxpayers in the low income demographic limited, if any, Appeal rights.

IRS COMMENTS

In general, the IRS disagrees that the Appeals Campus Centralization issue described by the National Taxpayer Advocate should be considered a most serious problem for taxpayers as they interface with the IRS. Her stated premise is the Appeals strategy has a ". . . potential to negatively impact taxpayers." This MSP statement is a hypothesis supported with little objective data. However, the IRS does appreciate the underlying concern the National Taxpayer Advocate expresses -- the need for a strong, independent and technically excellent Appeals staff. Taxpayers need and demand this, and the IRS has been, and continues to be, committed to providing taxpayers with just such an Appeals function.

Appeals Goals

The creation of campus operations has been part of the Appeals strategy since Appeals submitted its 2003-2004 Strategic Plan to the Commissioner in September 2002. It has been part of every strategic plan since then. It's a strategy driven by Appeals' goal to address customer satisfaction issues and reduce taxpayer burden. It's a strategy based on maintaining high decision quality.

Taxpayers said they are concerned about the length of the Appeals process, the time it takes to make the first contact and the time it takes to schedule a conference. The campus operations are part of the breakthrough and reengineering initiatives developed to address taxpayer concerns about the length of the Appeals process. The campus operations are being monitored to ensure the efficiencies realized are not at the expense of quality and customer satisfaction.

Appeals' goal is to provide excellent customer service and high quality case resolution. Cycle time is only one aspect of that measure. Appeals will continue to use a balanced measures approach to evaluate its campus strategy, and if those measures support a need to modify their strategy they will do so.

FY 2005 found Appeals in its final implementation phase of campus operations. The hiring and training is now complete and campus operations will be entering into full operations this year. Appeals expects changes in planning and procedures throughout the year, and will consider the issues the National Taxpayer Advocate has suggested as they modify their campus operations.

Balanced measures data is available showing the effectiveness of the campus operations. While the campus operations are relatively new, the data reflects favorably on them. The IRS believes the following data clearly indicates the Appeals campus employees are able to deliver the same quality service to taxpayers as the Appeals field employees.

Customer Satisfaction Measure -- Survey Results:

FY 2005 full-year results haven't been received from the vendor. These are FY 2004 results:

 TABLE 1.7.6

The National Taxpayer Advocate expresses a concern that "since many Appeals cases now originate in IRS campus enforcement, taxpayers may not believe that their case will receive a truly independent review from Campus Appeals." The Appeals customer satisfaction survey results do not support a finding that Appeals independence is negatively impacted by being co-located with IRS campuses. The customer satisfaction data for Appeals campus operations indicate taxpayers who had their Appeals case decided in a campus setting rated Appeals independence higher (3.99) than the overall Appeals score for independence (3.69).

Business Measure -- Quality (AQMS) Results:

(Period covered 10/1/04 thru 6/30/05--Score out of a possible 100)

 TABLE 1.7.7

(Cycle time is number of days from the date the case is received in Appeals until the date closed.)

 TABLE 1.7.8

Appeals has completed its major transition of staffing between campus and field operations. Depending on budgetary limitations the plans are to allow attrition hiring in both campus and field operations.

The redeployment of staffing between campus and field was a carefully devised plan that began to take shape in Appeals in 2002. In September 2002, it was formally introduced in the Appeals 2003-2004 Strategic Plan. This redeployment of staffing did not come at a detriment to the field. The transition was accompanied by a corresponding shift of inventory to the campuses. The campus operations provide for the matching of case work to the skills and grade level of the individual employees. The result has been an overall balancing of inventories and is enabling Appeals to provide more efficient and effective service to all taxpayers.

Appeals Procedures

The IRS would like to correct a few misapprehensions given in the National Taxpayer Advocate's statement regarding procedural issues.

S Docketed Procedures:

The National Taxpayer Advocate states "Appeals returns docketed S cases to Counsel when a case appears on the Tax Court trial calendar." Once a case appears on a trial calendar, Appeals has always retained docketed cases for settlement if Counsel and Appeals agree it's appropriate for a particular case. The campus S docketed procedures generally call for retention of the case file for settlement until three weeks prior to the trial calendar. If Appeals has been unsuccessful in their attempts to contact the taxpayer, the case will be forwarded to Counsel for trial preparation. Appeals campus operations like field operations make multiple attempts--both by letter and by phone--to reach taxpayers to discuss settlement. If after these attempts Appeals has not been able to resolve the case, it will transfer the case to Counsel for trial preparation. In the event taxpayers wish to initiate settlement discussions immediately prior to the calendar, local Appeals field offices will attempt to resolve these cases. Generally, these cases are not in the midst of settlement negotiations when they are forwarded to Counsel as the National Taxpayer Advocate believes. The IRS believes that these procedures more than adequately ensure taxpayers can enter into settlement discussions if they wish.

Use of "screeners:"

The National Taxpayer Advocate states, "According to Appeals Campus Docketed S case written procedures, screeners can also resolve certain cases on their own without sending the case to an AO." These case screeners do not enter into settlement negotiations with taxpayers--they schedule appointments, request documentation from taxpayers, and refer cases for trial preparation if a taxpayer doesn't contact Appeals. These are administrative tasks; they are not case "settlement" tasks.

The Appeals Campus Docketed S Case procedures are very specific in the description of screener duties and responsibilities and in the description of screener case criteria. The procedures do not provide for the screener to do any evaluations of information for case settlement purposes, no matter what the issue is or how many issues there are. There is nothing in the written procedures that suggests that the screeners may be used as substitute AO's in a campus. The Campus Appeals Team Managers are following the written procedures for screeners and are not utilizing screeners to perform the duties of an AO.

The National Taxpayer Advocate discusses three examples of conflict between Appeals management's explanation of screener duties and the written procedures. The first example cited is that screeners can close cases involving no-change decision documents. This is not an exercise of discretion; these cases are reviewed by the manager before closing. The written procedures specifically provide that the no-change letter is to be from the source of the case and is to be dated after the issuance of the notice of deficiency. If these are the circumstances, the screener will prepare no-change decision documents or forward the case to Counsel for preparation of decision documents. This is an administrative task, not a "decision-making" one. Another example cited by the National Taxpayer Advocate has to do with screeners closing no show or no response cases. Again, the screener is not closing these cases. These cases are reassigned or returned to a screener after an AO makes the determination that the case is a no show or no response. This is specifically explained in the written procedures. Furthermore, all docketed S cases are reviewed and approved by a manager before closing.

Finally, while the docketed S case screeners serve as aides to the appeals officers and aren't used for decision making, the job series (GS-526) for this position is a technical one. This position can serve as a training position for promotional opportunities to the appeals officer position.

Face to Face Conferences

There is no lost face-to-face opportunity. The right to a face-to-face conference is clearly explained in the initial contact letter. It states that the taxpayer can call and discuss whether a face-to-face conference might be better. The National Taxpayer Advocate reports there is some uncertainty concerning case transfers from campuses to local offices. The report supports the finding of uncertainty by citing the written procedures that state the screener will refer the request to the ATM for approval if the taxpayer asks for a transfer to a local Appeals office. This procedure is an example of the use of screeners for administrative duties and not decision making. This doesn't raise doubt about the allowance of transfers to local offices for face-to-face conferences. Management evaluation of the request is required to ensure the taxpayer is not raising issues such as the constitutionality of the tax system or using the request as part of a scheme to avoid or delay the resolution of the case. It would be inappropriate to state in the letter that the taxpayer need only ask for a transfer to a local office and it will be granted. This would provide an avenue to taxpayers who only want to delay. It is appropriate to state, as the letter does, that the taxpayer may make the request. Appeals has demonstrated not only by its words but by its actions that requests for a face-to-face conference are being granted.

Regarding Appeals face-to-face conferencing practices, current data indicates for cases considered in Appeals field operations the following:

 TABLE 1.7.9

Appeals recognizes that the National Taxpayer Advocate's objective with her report is to ensure taxpayers are provided quality Appeals case resolution services. Appeals' goal is to provide timely quality service by having a strong technically trained Appeals staff in all locations -- campus and field. Appeals is gratified one of the teams in its initial campus operation -- Brookhaven -- is a 2005 Commissioner's Award recipient. The Brookhaven team was formed in March 2004 and ". . . quickly became a model of success" for all the campus operations. The IRS believes this is a very strong indicator of Appeals' commitment to its stated goals.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate has identified Appeals Campus Centralization because of its potential to impair the quality of Appeals' review. As with our discussion of the IRS's Private Debt Collection initiative herein, we have attempted to identify potential problems that, if not addressed and monitored, could harm taxpayers and undermine tax administration. To this end, we raised specific concerns about Appeals' centralization initiative. In its response, Appeals describes its efforts to address these concerns. We believe this transparency increases taxpayers' confidence in an independent Appeals function.

TAS remains concerned, however, about the adequacy of Appeals' staffing levels in the field and training in the campuses, and the access of taxpayers to local hearings. Appeals has also not addressed the needs of low income taxpayers, who may particularly benefit from local or face-to-face hearings.

In particular, the centralization of Appeals operations creates two classes of Appeals conferences and has the potential to deprive low income taxpayers of important taxpayer rights. Most of the work that Appeals categorizes as "noncomplex" is generated by campus operations -- OIC, ACS, EITC correspondence examinations -- which involve unrepresented low income and working poor taxpayers. TAS's EITC Audit Reconsideration Study demonstrated that in many of the cases in which taxpayers sought audit reconsideration from campus EITC correspondence audits, it was the campus procedures themselves that contributed to the IRS not getting the correct result the first time around.⁶⁶

These taxpayers will now be seeking relief from an Appeals office that operates in the same environment as campus compliance functions. Even if Appeals were to take a different approach from traditional campus procedures -- which it has not fully demonstrated that it is -- Appeals cannot deny that some taxpayers, perhaps even a significant percentage of taxpayers, will view the Appeals conference as more of the same old IRS. As the IRS becomes more remote, it has to work harder to earn taxpayers' confidence that they are not just some cog in a machine.

Ultimately, only those taxpayers who are represented by savvy practitioners will obtain hearings in local offices. Unrepresented poor and middle income taxpayers will not know either that they can ask for such a hearing or how a hearing in a local office can benefit their cases. And even if taxpayers wanted such hearings, Appeals' staffing -- including a significant decrease in Appeals Officers in the field -- means that taxpayers would have to wait an extremely long time before they got that hearing. Appeals itself says that timeliness is extremely important to taxpayers. Thus, Appeals' procedures and Appeals' staffing decisions are stacked against taxpayers getting a local hearing, much less a face-to-face one. They are self-fulfilling prophecies.

Timeliness vs. Quality

We again emphasize that there is nothing inherently wrong with Appeals working certain cases at IRS campuses. In fact, we believe that Appeals' goal to reduce case cycle time through campus centralization is a worthy objective. The IRS response indicates that Appeals is meeting this objective as campus case cycle times appear to be more than 100 days shorter than overall Appeals case cycle times.

We are concerned, however, that if Appeals campus operations are not carefully monitored and measured for quality as well as quickness, the taxpayer burden of resolving a case through Appeals may ultimately increase. The National Taxpayer Advocate commends Appeals for recognizing the importance of quality as well as timely case resolution and committing to monitor campus operations "to ensure that the efficiencies realized are not at the expense of quality and customer satisfaction." We also appreciate Appeals' willingness to consider our recommendations as it continuities to develop campus planning and procedures and modify its campus operations throughout the coming year. In turn, the Taxpayer Advocate Service commits to assist Appeals in monitoring Appeals campus case quality and to quickly inform Appeals of any problems with campus centralization that taxpayers bring to our attention.

Appeals Campus Procedures

In its response, the IRS suggests we presented a misleading, if not incorrect, picture of Appeals campus procedures. Our presentation of these procedures was based primarily on four documents:

We recognize that Appeals campus centralization is a new program that the respective procedures are continuing to be developed and refined. Appeals campus operations are up and running, however, and the National Taxpayer Advocate believes Appeals should quickly publish consistent and uniform campus procedures and make those procedures available publicly through the IRS website. Practitioners and taxpayers can rely on the Internal Revenue Manual to obtain guidance about general Appeals procedures, but they are currently in the dark with respect to Appeals campus procedures. Because taxpayers are currently in the Appeals campus system, Appeals should make publishing these procedures a priority.

Face-to-Face and Local Office Conferences

We agree with Appeals in that not every taxpayer needs to meet personally with an Appeals Officer to fairly resolve his or her case. On the contrary, many taxpayers may find it more efficient to resolve their cases over the phone (and perhaps in very rare instances solely through correspondence). Reduced face-to-face conferencing opportunities are only an ancillary piece of our overall concern with the shift towards campus Appeals: the loss of personal working relationships between taxpayers, practitioners, and local Appeals Officers. Local relationships with Appeals better serve taxpayers because local Appeals Officers are generally familiar with local issues and concerns; it is easy to deliver and distribute documents and correspondence; if a face-to-face conference is needed, one can be easily arranged without transferring the case; and relationships of trust between taxpayers, practitioners and the IRS can be developed, maintained and continued. These constructive characteristics of local relationships will be difficult to replicate in the campus environment.⁶⁷

The National Taxpayer Advocate urges Appeals to continue to monitor its campus operations and implement appropriate measures to identify and correct taxpayer burden and fairness problems in the campuses. TAS will also continue to monitor Appeals campus operations for taxpayer problems and bring these to Appeals' attention so they can be addressed.

RECOMMENDATIONS

• Develop campus specific training for campus Appeals employees that will help them carry out Appeals' unique independent mission in the campus environment.

• Develop quality measures to monitor the impact of campus centralization on taxpayer Appeal rights and burdens.

• Work with TAS and the Low Income Taxpayer Clinics to identify low income taxpayer problems with campus centralization.

• Track requests for local office transfers and face-to-face conferences. Also, track both transfer requests granted and denied and the reasons for denial.

• Publish consistent and uniform campus Appeals procedures and make these procedures available publicly on the IRS website.

• Revise the Initial Contact Letter (Letter 3808(CG)) to clearly indicate that taxpayers have a right have their case transferred to a local office, provided that taxpayers make their transfer request as soon as possible, and that the request is not intended to unreasonably delay the Appeals process.

¹³ Cases docketed in the United States Tax Court with a deficiency of $50,000 or less (including tax and penalties) for a taxable period, where the petitioner elects to be treated under small case procedures. IRC § 7463.

¹⁴ Formerly called Coordinated Examination Program (CEP) cases.

¹⁵ IRS Office of Appeals, Campus Implementation, Taxpayer Advocate Briefing (March 31, 2005).

¹⁶ Appeals Centralized Database System (ACDS), Appeals Receipts Reports -- FY 2005 (October 7, 2005).

¹⁷ David B. Robison, Chief Appeals, IRS, "IRS Appeals Service Improvements via a Campus Strategy Approach," Vol. 23, No. 5, Enrolled Agent Journal, p. 21, September-October 2005.

¹⁸ Employee Service Record Report (ESRR) for pay periods ending October 31, 2004 and October 1, 2005.

¹⁹Appeals Officers are responsible for handling issues and cases generated by various compliance functions in campus and the field and for arriving at the final dispositions and to approve the final settlements of the cases. Settlement Officers are responsible for resolving collection cases generated and referred to Appeals by various compliance components in the campus and in the field. Tax Specialists are responsible for resolving tax issues that are generated and referred to Appeals by various campus compliance and accounts management components. Case Screeners review new receipts, determine initial case processing, and prepare the administrative file for transfer or reassignment. Case Processors provide administrative and clerical support in processing and closing cases. Tax Examiners are responsible for reviewing cases, processing adjustments, computing normal interest and simple restricted interest cases, and closing pipeline and special processing cases.

²⁰ Treasury Integrated Management Information System (TIMIS) Workforce Reports for pay periods ending October 31, 2004 and October 1, 2005.

²¹Tax Computation Specialists prepare all complex computations and schedules reflecting adjustments resulting from Appeals or Counsel's disposition of the case. For a description of other listed positions, see footnote 19 supra.

²² Ten year average calculated based on year end decreases and increases in total Appeals staffing for fiscal years as follows: FY 1995 (2,287); FY 1996 (2,148); FY 1997 (2,148); FY 1998 (2,172); FY 1999 (2,154); FY 2000 (1,943); FY 2001 (1,864); FY 2002 (1,963); FY 2003 (1,838); FY 2004 (1,901); FY 2005 (1,850); TIMIS Workforce Reports and ESRR for pay period ending October 1, 2005.

²³ Overall Appeals staffing decreased from 1,901 to 1,850 in FY 2005. IRS Office of Appeals Response to Taxpayer Advocate Service Information Request (Sept. 16, 2005); TIMIS Workforce Reports and ESRR for pay period ending October 1, 2005

²⁴See generally, IRS Pub. 5, Your Appeal Rights and How To Prepare a Protest If You Don't Agree (Rev. 01- 1999).

²⁵See IRS Pub. 1660, Collection Appeal Rights (Rev. 05-2000), 1987-1 C.B. 720.

²⁶ 1987-1 C.B. 720; see discussion below.

²⁷ IRS Office of Appeals, Overview of Appeals Case Work, Training Document No. 6137-002 (06-2003).

²⁸See IRM § 8.1.4.2 (Dec. 18, 2001) and Appeals ATM Reference Guide at 71. Cases are initially graded based on "work unit dollar value." A work unit dollar value is computed by determining the amount of deficiency and penalty, overassessment, or the amount of claim on all tax years/periods included in the work unit. IRM § 8.1.4-1 (Dec. 18, 2001). Once the work unit dollar value is determined, cases are initially graded as follows: GS-11: $1-300; GS-12: $301-6,000; GS-13: $6,001-99,999; GS-14: $100,000 or higher. IRM § 8.1.4.2.2.1 (Dec. 18, 2001). ATMs also consider other factors when grading cases, including factual complexity, legal complexity, impact of case, and the Appeals employee's conferencing and negotiating skills. IRM 8.1.4-2 (Dec. 18, 2001). For example, a GS-11 employee can expect to be assigned cases with established or easily determined facts that impact limited parties and tax years and that have no legal disputes, or are governed by clear legal principles, and that require "normal meet and deal skills." On the other hand, a GS-14 employee will be assigned cases with very complex or novel factual issues with conflicting interpretations that impact numerous unrelated taxpayers or entire industries, or that have "high potential for adverse impact on overall voluntary compliance" that involve very complex applicable law requiring extensive legal research and that require "exceptional conferencing and negotiating skills." Id.

²⁹ Letter 3808(CG) (S-Docketed Initial Contact Letter) (Rev. 8-2005).

³⁰ IRC § 7463; U.S. Tax Ct. R. 170; IRM § 8.4.1.1.1 (June 1, 2002).

³¹Id.

³² Rev. Rul. 87-24, 1987-1 C.B. 720. Counsel is to refer docketed cases to Appeals for settlement unless the statutory notice of deficiency was issued by Appeals, the IRS Employee Plans/Exempt Organizations function (now part of the IRS Tax Exempt and Government Entities Division (TE/GE)), or by a District Director based on a National Office ruling or technical advise in that case involving employee plan qualification or tax exemption and/or an organization's foundation status. Counsel also does not refer cases to Appeals that are docketed under IRC sections 6110, 7428, 1476, 7477 or 7478. Appeals is to return cases for $10,000 or less fifteen days before the trial calendar call and return cases over $10,000 "promptly" after a case appears on the trial calendar. Id.

³³See Table 1.7.2 above. The majority of campus generated docketed S case work will be centralized in Fresno, thus, the specific docketed S case procedures are targeted to Appeals' Fresno campus operations.

³⁴See memorandum Appeals Area Directors, April 13, 2005, from Appeals Director, Field Operations-East and Appeals Director, Field Operations-West, Appeals Continuing Commitment to Settle S-Docketed Cases Before Trial.

³⁵ IRS Office of Appeals, Campus Implementation, Taxpayer Advocate Briefing (March 31, 2005).

³⁶ Appeals campus S case screeners are similar to Appeals Collection Specialists. Collection Specialists are Grade 11 employees who's duties include: (1) independently reviewing cases for issues such as statutes of limitation and initiating further contact with taxpayers and their representatives to resolve problems; (2) analyzing taxpayer responses and initiating further contact with taxpayers; (3) researching and analyzing information retrieved from automated and manual systems to verify issues relating to compliance history and other matters to resolve disputes between Compliance and the taxpayer; (4) advising management of problems and recommending solutions; (5) making financial determinations as to processibility of offers; (6) maintaining appropriate liaison professional contact with other divisions of IRS; and (7) acting as liaison for Appeals with the other Compliance functions to improve case processing. IRS Modernization Position Description, Appeals Account Resolution Specialist, MPD# 94146.

³⁷ E-mail from Director, Appeals, Area 8 to Director, Appeals Tax Policy and Procedure, September 29, 2005. For each AO, screeners are to schedule up to four conferences a day (preferably at least two hours apart) three days per week. Workload permitting, AO's are to keep this conference schedule for at least two weeks but no more than three weeks, per month. IRS Office of Appeals, Timeline for Breakthrough S Cases (June 18, 2004).

³⁸ IRS Office of Appeals, Appeals Breakthrough Performance Plan, Small Docketed Cases ("S" Cases) (June 18, 2004).

³⁹ Generally filed on the Form 1040 Series.

⁴⁰ IRS Office of Appeals, Appeals Breakthrough Performance Plan, Small Docketed Cases ("S" Cases) (June 18, 2004). Screeners must forward cases to an AO that involve spousal defense, unreported income using indirect methods, IRC § 183 (activities not engaged in for profit), TEFRA, or abusive trusts. Additionally, an ATM may assign certain non-Grade 13 cases involving "sufficiently complex" issues directly to an AO, bypassing the Screener. Id.

⁴¹ IRS Office of Appeals, Appeals Breakthrough Performance Plan, Small Docketed Cases ("S" Cases) (June 18, 2004).

⁴²Id.

⁴³Id.

⁴⁴Id.

⁴⁵ Treasury Inspector General for Tax Administration Ref. No. 2005-10-141, The Overall Independence of the Office of Appeals Appears to be Sufficient (Sept. 2005); see also IRS Office of Appeals, Campus Implementation, Taxpayer Advocate Briefing (March 31, 2005).

⁴⁶ Letter 3808(CG) (S-Docketed Initial Contact Letter) (Rev. 8-2005) (emphasis in original).

⁴⁷ Appeals Strategy and Program Plan, FY 2005/2009; Videotape: January 2005 Video on APS by Phil Mahler (on file with IRS Office of Appeals).

⁴⁸See Table 1.7.4, Appeals Campus Staffing FY-2005, and Table 1.7.5, Appeals Field Staffing FY-2005.

⁴⁹ IRS Office of Appeals, Appeals Breakthrough Performance Plan Small Docketed Cases ("S" Cases), June 18, 2004.

⁵⁰ Allen Kenney, IRS Appeals Chief Claims Independence, 2005 TNT 98-5 (May 20, 2005); see Treasury Inspector General for Tax Administration Ref. No. 2005-10-141, The Overall Independence of the Office of Appeals Appears to be Sufficient (Sept. 2005); see also IRS Office of Appeals, Campus Implementation, Taxpayer Advocate Briefing (March 31, 2005).

⁵¹ Appeals Centralized Database System-CASES and CARATS Report (April 29, 2005).

⁵² In these cases, a small business taxpayer contracts with a payroll agent to collect and deposit payroll taxes with the IRS. The payroll agent collects the taxes from the small business, but does not deposit the taxes with the IRS. The small business owner is then left with tax liability, interest and penalties for taxes already turned over to the payroll agent. For a more in depth discussion of this issue, see National Taxpayer Advocate 2004 Annual Report to Congress, 394-398 (Protection from Payroll Service Provider Misappropriation).

⁵³ Campus Appeals -- Field Counsel Fresno "S" Case Procedures, Aug. 12, 2004.

⁵⁴ IRS Office of Appeals, Appeals Breakthrough Performance Plan Small Docketed Cases ("S" Cases), June 18, 2004.

⁵⁵ Appeals eventually granted the transfer request in this case.

⁵⁶ Janet Spragens and Nancy Abramowitz, Low Income Taxpayers and the Modernized IRS: A View from the Trenches, 107 Tax Notes 1407 (June 13, 2005) (quote includes text of footnote 20).

⁵⁷ Robert A. Zarzar, AICPA Submits Survey Results on Offer-in-Compromise Program, 2003 T.N.T. 200-38 (Oct. 16, 2003). The survey also reflected the "nearly unanimous opinion . . . that the IRS intentionally looks for reasons to reject an OIC." Id. The American Bar Association expressed similar concerns about the COIC program:

⁵⁸ Janet Spragens and Nancy Abramowitz, Low Income Taxpayers and the IRS: A View From the Trenches, 107 Tax Notes 1407 (June 13, 2005).

⁵⁹ J. Russell George, Treasury Inspector General for Tax Administration, Testimony Before the Senate Committee on Finance, available at http://finance.senate.gov/hearings/testimony/2005test/rgtest041405.pdf (April 14, 2005); see also IRS Announces Steps to Improve EITC Administration, Seeks Public Comment (June 13, 2003) (IRS Commissioner Mark Everson noted that EITC audits are too time consuming and burdensome for taxpayers).

⁶⁰ Nina E. Olson, National Taxpayer Advocate, Bestimony before the President's Advisory Panel on Federal Tax Reform, available at http://www.taxreformpanel.gov/meetings/docs/olson_03032005.ppt (March 3, 2005).

⁶¹ Janet Spragens and Nancy Abramowitz, Low Income Taxpayers and the IRS: A View From the Trenches, 107 Tax Notes 1407 (June 13, 2005).

⁶²Id.; See also Leslie Book, CDP and Collections: Perceptions and Misperceptions, 107 Tax Notes 487 (March 31, 2005).

⁶³See National Taxpayer Advocate, 2004 Annual Report to Congress, 67-88; Janet Spragens and Nancy Abramowitz, Low Income Taxpayers and the IRS: A View From the Trenches, 107 Tax Notes 1407 (June 13, 2005).

⁶⁴ Appeals Strategic Plan 2005-2006.

⁶⁵ David B. Robision, IRS Appeals: Service Improvements Via a Campus Strategy Approach, E.A. Journal (Sept.-Oct. 2005) at 21.

⁶⁶ National Taxpayer Advocate 2004 Annual Report to Congress vol II.

⁶⁷ Moreover, in S case litigation, transferring a case from the campus to the local counsel office, only to have it reopened by a local Appeals employee who is unfamiliar with the case and with the taxpayer, creates inefficiencies and could actually impede settlement.

MOST SERIOUS PROBLEM: REFUND ANTICIPATION LOANS: OVERSIGHT OF THE INDUSTRY, CROSS-COLLECTION TECHNIQUES, AND PAYMENT ACTIVITIES

RESPONSIBLE OFFICIALS

The IRS contributes to the demand for Refund Anticipation Loans (RALs) by not offering an alternative method for taxpayers to obtain tax refunds quickly and at zero cost. Moreover, the IRS assists RAL providers by offering the Debt Indicator (DI). Although the DI program benefits taxpayers, the IRS needs to review its operation to properly balance competing tax administration concerns.

The IRS does not meaningfully review RAL marketing practices during e-file monitoring visits to Electronic Return Originators (EROs). This issue is of particular concern because many EROs have financial incentives to market RALs, and under IRS guidelines can own up to 49 percent of the RAL product. Further, the high rate of sanctions imposed during these visits indicates that the IRS needs to strengthen its oversight of EROs.

While RAL agreements may fully disclose the cross-collection practices of the banks that issue the loans, it is unclear whether RAL customers fully understand the ramifications of their consent to these practices. It is also questionable whether these provisions are enforceable under modern contract principles.

Background

Description of RALs¹

A refund anticipation loan (RAL) is a short-term loan based on the taxpayer's anticipated income tax refund. The taxpayer borrows against all or part of his or her expected refund and is responsible for paying the loan in full, no matter how much of the anticipated refund the IRS actually provides. Banks issue RALs, but commercial tax preparation businesses facilitate or broker the products. Before transferring any funds to the taxpayer, the bank first deducts fees for return preparation, filing, finance charges, and processing. The taxpayer receives the balance of the refund by check, direct deposit, debit card, or as a down payment on a good or service. Once the IRS issues the actual refund, the IRS transfers the funds directly to the bank to repay the loan.²

Demand for RALs

After increasing from tax years 1999 to 2001, the demand for RALs declined for tax year 2002 and rose slightly for tax year 2003.³ As of the end of April 2005, the IRS received approximately 10.7 million RAL indicators on tax year 2004 individual income tax returns.⁴ In contrast, the IRS received approximately 13.5 million RAL indicators for tax year 2002 individual returns. However, the 2002 and 2005 data are not necessarily comparable. The 2002 RAL indicator figure includes Refund Anticipation Checks or RACs, which are described in more detail below, and although the 2005 data was intended to include only RALs, the IRS has acknowledged that the data still includes an unquantifiable number of RACs.⁵

A recent study conducted by the McDonough School of Business at Georgetown University found that over 75 percent of calendar year (CY) 2004 RAL customers were either (1) under the age of 45 and married with children or (2) unmarried (any age) with children. Approximately 74 percent of CY 2004 RAL customers had a lower or moderate household income (under $39,999). Further, the study showed that many RAL customers have limited ability to borrow because their current resources are constrained, and they use the loan proceeds to resolve a specific problem such as bills or unexpected expenses.⁶

RALs are attractive to taxpayers for a variety of reasons, including the following⁷:

• Quick Turnaround Time. One main reason taxpayers enter into RALs is the quick turnaround time associated with these products. Taxpayers can receive the loan proceeds as soon as an hour after transmission.⁸ Taxpayers value this feature of RALs if they have a real or perceived immediate financial need.

• The Unbanked. Taxpayers may be unable to receive their tax refunds via direct deposit because they do not have bank accounts. To the "unbanked," a RAL may seem like the only way to receive a quick tax refund.

• Payment of Preparation and Filing Fees. Taxpayers who are unable to pay tax preparation fees may also choose a RAL product, because the loan proceeds are first applied to the tax preparation fees.⁹

RAL fees combined with return preparation and electronic filing fees significantly reduce a taxpayer's refund.¹⁰ For example, at H&R Block's corporate owned offices, the bank's loan fee on a $3,000 loan amounts to $99.95 with a 114 percent annual percentage rate (APR), in addition to the tax preparation, filing and loan processing fees.¹¹

Existing Alternatives

Taxpayers who are due a refund have the following alternatives to RAL products.

Filing Without Purchasing a Product. The taxpayer may choose to file the return without purchasing a product to expedite the refund. Each of the following options has a different turnaround time, but these periods will likely decrease as the IRS further implements the Customer Account Data Engine (CADE), which has the potential to deliver refunds more rapidly:¹²

• E-File/Direct Deposit. The quickest method of receiving a refund is to electronically file the return and direct the IRS to deposit the refund into the taxpayer's bank account. This option allows the taxpayer to receive the refund in as little as 10 days.

• E-File / Paper Check. If the taxpayer e-files and directs the IRS to send a paper check, the refund will be issued within three weeks after the acknowledgement date.

• Paper Filing / Direct Deposit. If the taxpayer files by paper and chooses to receive the refund by direct deposit, the taxpayer will receive the funds within approximately five weeks from the date the IRS receives the return.

• Paper Filing / Paper Check. The slowest way to obtain a refund is to file a return by paper and choose to receive a paper check in the mail. Here, the taxpayer will receive the funds within six weeks of the date the IRS receives the return.

Debit Cards. Preparers are beginning to offer prepaid debit cards as another option for unbanked taxpayers. Debit cards allow the taxpayer to receive the refund in approximately one to two weeks, which is no different than the e-file/direct deposit option described above. These cards usually have an initial sign-up fee of approximately $25 as well as additional transaction fees. Opponents of this method have raised concerns that such cards do little to encourage saving.¹⁴

IRS Drives the Demand

The IRS must take responsibility for driving taxpayers to purchase RALs. The IRS influences the demand for bank products by: (1) failing to deliver refunds in the quickest manner possible and (2) failing to provide RAL and RAC alternatives for the "unbanked."

Delays in Refund Delivery

Currently, if a taxpayer does not purchase a bank product, the quickest way to receive a tax refund is to file electronically and request a direct deposit into a bank account. As discussed above, the refund turnaround time for this method is as few as 10 days.¹⁵ In fact, with the implementation of the Customer Account Data Engine (CADE), the IRS can turn around a refund within two to three days, but pursuant to its Revenue Protection Strategy (RPS), the IRS first runs the refunds through Criminal Investigation screens and the Dependent Database, increasing the turnaround time to five days.¹⁶ For taxpayers who purchase bank products due to the speed of the refund turnaround time, shortening the time to three days might make a world of difference, especially if the taxpayers are sufficiently informed about their options and the cost of alternatives. Given that the RPS delays the delivery of refunds, competing tax administration concerns contribute to the demand for RALs. It is incumbent on the IRS, then, to review the timeframes for RPS screening and shorten them as much as possible.

Offering Alternatives for the Unbanked

The IRS also drives "unbanked" taxpayers to bank products by not offering these taxpayers a method of receiving refunds that does not involve a bank account. Further, given the high demand for RAL products by Earned Income Tax Credit (EITC) recipients,¹⁷ the IRS and the Department of Treasury need to develop alternative means of refund delivery to ensure that taxpayers do not unnecessarily spend EITC benefits on high fees. Two methods worthy of serious consideration are Electronic Benefit Transfer (EBT) and Electronic Transfer Accounts (ETA):

Electronic Benefits Transfer (EBT): As the name implies, Electronic Benefits Transfer (EBT) is the electronic transfer of public entitlement payments, such as welfare or food stamps. This delivery system is replacing paper food stamps in all 50 states, the District of Columbia, and three territories (Puerto Rico, the U.S. Virgin Islands, and Guam).¹⁸ Individuals who receive food stamps access those benefits at Point of Sale (POS) terminals at retailers. EBT has also been expanded to other assistance programs involving cash benefits, such as Temporary Assistance to Needy Families (TANF), and Women, Infants and Children (WIC). EBT systems typically involve issuing a benefit card, resembling a debit card or stored-value card, which the recipient can use together with a personal identification number (PIN) to access benefits through an electronic network, such as ATMs.¹⁹

An EBT system could deliver EITC benefits and keep the associated fees low, as is the case with other programs using this method of delivery.²⁰ Further, the IRS could deliver the non-EITC portion of refunds through a similar stored-value card format.

The private sector also uses stored value cards to serve the unbanked. For example, an increasing number of employers have replaced paper paychecks with electronic payroll cards, a mechanism by which an employee's pay is loaded on a stored-value card. A Celent Communications study estimates that 10 percent of unbanked households were using payroll cards in 2002, with the number expected to rise to 30 percent in 2005.²¹

Payroll cards benefit both employers and employees. For employers, payroll cards facilitate payments to employees who do not make use of direct deposit, including the unbanked, and reduce the cost of replacing lost or stolen paychecks. Employees benefit by not having to pay check-cashing fees. They may also be able to manage their cash flow better by not having to cash out their entire paychecks at once.²² However, some consumer advocates say the cards simply transfer costs from employer to employee. While the first withdrawal of each pay period is typically free, cardholders do incur fees for any number of transactions, such as opening or maintaining an account, ATM withdrawals, balance inquiries, purchase transactions and increasing the card balance. Nonetheless, the accumulation of fees on payroll cards is still significantly lower than check cashing fees, and individuals can learn how to avoid certain fees through outreach and education.²³

Expand electronic transfer accounts (ETA) eligibility to include EITC benefits.

Electronic Transfer Accounts (ETA) are low-cost bank or credit union accounts set up to receive benefits. Participating federally insured financial institutions make ETAs available to individuals who receive federal benefits, wages, salaries, or retirement payments. The account allows recipients to receive federal payments (except tax refunds) electronically in accordance with the Electronic Funds Transfer (EFT) provision of the Debt Collection Improvement Act of 1996 (DCIA).²⁴ Linking EITC and other tax refunds to low-cost bank accounts may (1) facilitate account ownership among the unbanked, (2) integrate these taxpayers into the financial mainstream, (3) encourage saving, and (4) promote asset purchase.²⁵

Free File

The IRS currently allows members of the Free File Alliance to market RALs and other products through the Free File electronic filing program. The agreement reached between the Free File Alliance and the IRS on October 25, 2005 allows alliance participants to market RALs with the following additional requirements:²⁶

• Free return preparation and filing cannot be contingent on purchasing a RAL;

• RAL offers must contain "clear language" disclosing terms to taxpayers; and

• Pursuant to a new "consent measure," vendors must obtain the consent of the customer before offering a RAL.

Debt Indicator Program

The IRS plays a significant role in making RAL products less risky for banks and loan retailers by offering the Debt Indicator (DI) program. With the taxpayer's consent, DI signals to participating authorized IRS e-file providers whether taxpayers' refunds will be reduced by outstanding tax liabilities or other debts. For example, the IRS could schedule such offsets for previously assessed liabilities, or by the federal government's Financial Management Service (FMS) for child support or federal debts such as student loans.²⁸ Participating providers use the program to evaluate the eligibility of taxpayers applying for RALs. The taxpayer must sign a consent form for the Debt Indicator program to disclose information to the provider.²⁹

The IRS facilitates RAL transactions when it discloses Debt Indicator information to RAL providers to determine a customer's eligibility for a RAL. Given the high cost of RALs and the below-discussed high sanction rate of EROs, the IRS needs to assess whether the perceived benefits of the program outweigh the risk of the inevitable and reasonable perception that the agency implicitly endorses RAL transactions.³⁰ The National Taxpayer Advocate is aware that the Debt Indicator Program may keep RAL bank fees lower by reducing the associated risk to the banks.³¹ Further, the program benefits all taxpayers who e-file by informing them of outstanding federal and certain other debts.³² Thus, before deciding to continue or terminate the program, the IRS should evaluate the potential impact of termination on taxpayers as well as on refund fraud, RAL fees, and e-file rates.

Inadequate Oversight by the IRS

The IRS denies any responsibility for the oversight of the RAL industry.³³ Despite this claim, Publication 1345, Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns, lists several requirements to which authorized IRS e-file providers must adhere to avoid sanctions, including (1) certain communications to taxpayers to ensure that they are well informed about the terms and fees of the RAL, (2) fee restrictions, and (3) advertising standards, as well as a number of administrative rules not directly pertaining to RALs.³⁴

The IRS has the authority to either issue a warning or sanction a violation of Publication 1345, the latter of which could entail a written reprimand or the suspension or expulsion of the ERO from the e-file program.³⁵ The Small Business / Self-Employed Operating Division (SB/SE) conducts e-file monitoring visits at ERO establishments to verify compliance with Publication 1345 as well as Revenue Procedure 2000-31.³⁶ The ERO Visitation Checksheet, which SB/SE employees use during visits, asks a series of questions including two significant RAL-related ones: (1) "How do you inform the client that the bank product is a loan?" and (2) "Do you assist your clients in the negotiation/ cashing of their refund check or RAL?" There is no indication on the checksheet that the visitation confirms the actual procedures followed with respect to the communication of RAL terms, fees, or alternatives.³⁷ Further, once an ERO is found to be noncompliant, the sanctions imposed are nonmonetary and in many cases allow the ERO to continue preparing returns and marketing RALs.³⁸

During the 2004 calendar year, more than 197,000 EROs were registered with the IRS and approximately 142,000 of them filed at least one Form 1040, Individual Income Tax Return. During the same period, SB/SE conducted 1,294 visits, which resulted in the following warnings and sanctions:³⁹

           TABLE 1.8.1, ERO SANCTIONS AND WARNINGS FOR 2004

Perhaps more troubling is the fact that IRS currently allows EROs to purchase up to a 49 percent ownership interest in each RAL sold.⁴² When EROs can own the RALs they sell, they have a financial incentive to market these products, which may compromise their ability to look to the best interests of the taxpayers.

The National Taxpayer Advocate continues to support her previously stated proposal to regulate return preparers, which would include EROs. To date, however, the IRS has devoted few resources to researching the need for or the feasibility of this regulatory program.⁴³

Cross-Collection

Standard RAL contracts typically include cross-collection provisions, to which the taxpayer must consent to receive RAL proceeds.⁴⁴ The provisions grant the contracting bank the authority to share information with third party banks that have entered into a cooperative agreement for cross-collection purposes, specifically sharing information about delinquencies owed to other banks by RAL applicants. Under this cross-collection arrangement, a taxpayer who signs a RAL contract consents to allow the contracting bank to share information with participating banks, deduct from the loan proceeds any outstanding amounts owed on a RAL issued to the taxpayer by a third party bank, and transmit the funds to the third party bank.⁴⁵ It is unclear if RAL customers fully understand the ramifications of these cross-collection provisions or if they would purchase the products if they knew these agreements exist.

It is questionable whether cross-collection terms included in RAL contracts are enforceable under the modern case law approach to contracts of adhesion or standard form contracts. In general, each party to a contract has the duty to read its terms. However, modern contract law has not strictly applied the "duty to read" principle in standard form contracts where there is no true assent to a particular term, the term contravenes public policy, or the term is unconscionable. These three rationales are often treated as interchangeable, but the modern approach generally evaluates whether a disparity of bargaining power renders one party at the mercy of another with no ability to negotiate the particular provision in question. In addition, the courts consider whether the term in question is used to the stronger party's advantage and is unknown to the weaker party. In such cases, the courts generally impose on the stronger party the burden to prove that the terms were explained to the weaker party and that both parties reached a voluntary meeting of the minds.⁴⁶ In addition, the Restatement (Second) of Contracts goes one step further and holds a provision of a standardized agreement unenforceable if a reasonable person would not have expected to find such a clause in the contract.⁴⁷

Thus, based on contract law principles, we believe a cross- collection provision in a standardized RAL agreement may be unenforceable. The banks have a grossly disproportionate bargaining power in relation to the taxpayer and the provision unilaterally benefits the bank. Moreover, a reasonable person may not expect a RAL agreement to provide that the contracting bank may act as the debt collector for a third party bank.

It is interesting to note that federal law prohibits banks from exercising their right to off-set Social Security benefits.⁴⁸ Although no current statutory provision prohibits banks from offsetting federal tax refunds, it would make sense to protect EITC benefits in the same manner as Social Security. At the very least, the National Taxpayer Advocate believes that banks should be barred from transferring EITC under a cross-collection arrangement to satisfy a debt to a third party bank.⁴⁹

Legislative Action

Members of the U.S. Senate have identified refund anticipation loans as a problem. The high cost of RALs was the subject of a hearing held in St. Paul, Minnesota on April 15, 2005 by the Permanent Subcommittee on Investigations.⁵⁰ Further, RAL practices are addressed in S. 324, the Taxpayer Abuse Prevention Act, introduced on February 9, 2005 by Senators Akaka, Bingaman, Dayton, and Durbin. The bill (1) prohibits the debt collection techniques in which RAL providers engage (cross-collection),⁵¹ (2) prohibits RALs that utilize EITC benefits, (3) terminates the Debt Indicator program, (4) prohibits mandatory arbitration clauses for RALs, (5) requires Treasury to provide the opportunity for lower and moderate income taxpayers to open low-cost deposit accounts at FDIC insured banks through the use of appropriate tax forms, and (6) excludes any electronically filed returns that resulted in refunds distributed by RALs from counting toward the electronic filing goal of 80 percent.⁵²

Several states and localities have passed laws requiring disclosures to RAL customers regarding the products' associated fees, terms, and alternatives.⁵³ While these laws protect RAL customers, the lack of uniformity among the requirements actually creates an administrative burden on the banks. Several financial institutions have indicated to the National Taxpayer Advocate that they favor a comprehensive federal law that would supersede the individual state requirements.⁵⁴

CONCLUSION

Despite its claim to the contrary, the IRS plays a significant role in the RAL industry. The IRS drives demand by delaying refund turnaround time under its Revenue Protection Strategy. Further, although its full impact is currently unknown, the availability of the Debt Indicator aids RAL providers. Given that a significant percentage of RAL customers are EITC recipients, the IRS has a compelling reason to consider improved oversight of the industry as well as seriously consider alternative refund delivery methods. Finally, cross-collection provisions in RAL contracts reduce risks for RAL providers but raise serious legal questions.

IRS COMMENTS

Although most taxpayers in fact do not get RALs (in 2005, only 16 percent of all e-filers requested RALs, and RAL usage by EITC taxpayers appears to be dropping), the IRS is committed to helping ensure that taxpayers, and in particular, low income taxpayers, have adequate information to make informed financial decisions with regard to their tax refunds. Indeed, we recognize that low income taxpayers may be particularly attracted to RALs because the loans appear to deliver refunds almost immediately and the cost of the tax preparation is rolled into the transaction. That is why we prescribe specific disclosure requirements, fee restrictions, and advertising standards on return preparers who file electronically, and impose penalties on tax return preparers who make unauthorized disclosures or uses of information furnished to them in connection with the preparation of income tax returns.

We do not agree, however, that the IRS drives the demand for RALs. In fact, the IRS' ability to affect taxpayer behavior with regard to RALs is relatively limited. Availability of RALs and the related demand for them is due to a number of factors. First, legislation increasing the size of refunds for low income working taxpayers provided a large financial asset with which taxpayers could seek credit. Second, the National Bank Act (12 U.S.C. §§ 85- 86) enables lenders to operate nationally without being subject to state or local regulation. Finally, many RAL users do not have bank accounts. Thus, they are drawn to alternatives like RALs, which do no require them to be "banked." Taken together, these factors explain much of the reason why consumers continue to purchase RALs.

While we continue to work to reduce the time it takes to deliver refunds, it is unclear whether, in the near term, the IRS will be able to approach or match the near "instantaneous" availability of RALs -- nor is it clear, given fraud and accuracy concerns, whether such a process is advisable. Moreover, much of the regulatory oversight of RALs is in banking law and therefore not administered by the IRS. Thus, the IRS has little say over interest rates or other banking-related fees associated with RALs, as well as cross- collection issues.

Despite these limitations, the IRS continues to explore ways to help taxpayers make informed choices and to ensure they understand the implications of the decisions they make. Recently, the IRS issued proposed guidance updating the rules under IRC § 7216 on unauthorized disclosure and use of tax return information by tax return preparers to take into account the commonplace practice of electronic return preparation and filing. These new rules were proposed, in part, because existing regulations are silent on taxpayers' consent to the disclosure and use of tax return information in an electronic environment. Additionally, over the next several months, the IRS will conduct a thorough evaluation of RALs as part of our response to a recent legislative mandate. In doing so, we will work with the National Taxpayer Advocate to develop objective data that can be used to help guide IRS policy with regard to RALs. We also recognize that the relationship between the tax preparer and the RAL provider deserves special scrutiny and will consider this issue as part of our report.

Before that analysis for the report is conducted, however, we believe that several of the points identified by the National Taxpayer Advocate are not necessarily supported by existing evidence. Here are responses to the points raised in the National Taxpayer Advocate's discussion of RALs.

The IRS is continually working to deliver taxpayer refunds in as short as time as possible -- an approach which we believe will lessen, but not eliminate, demand for RALs. Despite decreasing waits for refunds, large numbers of taxpayers continue to use RALs. There are a number of theories to explain this behavior, but the evidence is only anecdotal. Perhaps the strongest explanation is that RAL consumers have a very short time value of money -- that is, they are willing to pay what constitutes an extraordinarily high price to gain near immediate access to their refunds (or a loan equivalent to most of their refunds), rather than wait just a few days and not pay a fee. Even more telling is the high degree of satisfaction RAL users appear to experience -- at least according to the Georgetown University monograph the National Taxpayer Advocate cites. In that paper, Dr. Elliehausen makes a strong case that people who use RALs are happy with the product and at least somewhat aware of the financial transaction in which they have engaged.

It is unlikely that the IRS will ever be able, or necessarily want, to deliver refunds in the near "instantaneous" fashion that taxpayers can obtain RALs. While we will continue to work to shorten the wait time, fraud and error correction screens may add days to the process -- days some taxpayers are unwilling to wait if a RAL is available.

The IRS assists ALL taxpayers by offering the Debt Indicator (DI). Removing the DI could actually hurt low income taxpayers. Critics of RALs often focus on the IRS' provision of the DI as a way of facilitating RALs. While the DI does serve as a way to reduce risk for lenders, it also reduces risk to borrowers. In fact, as acknowledged by the National Taxpayer Advocate in her report, discontinuing the DI could have a significant detrimental impact on the very low-income taxpayers about whom the National Taxpayer Advocate and the IRS are concerned.

Many RAL consumers have shown little responsiveness to the prices they must pay to obtain the loans. Thus, while lenders may raise RAL fees to compensate for the increased risk posed by the loss of the DI, borrowers are still likely to be willing to pay these higher rates for the same product or simply opt for another financial product with lower, but still high fees. Without the DI, however, those taxpayers who do have their refunds offset will find out only after they receive their RALs -- and then find themselves with a new, high-interest loan without funds to repay it. In 2004 alone, 1.1 million taxpayers were spared delinquencies or defaults because of the DI.

In short, the IRS believes that eliminating the DI could leave many low-income taxpayers with more debt and fewer resources to repay that debt than they would have had the IRS provided an indicator. It is also important to note that the DI goes to all taxpayers who file electronically and claim a refund, not just to those who want to purchase a RAL. Thus, eliminating the DI would reduce service to taxpayers generally -- not only those taxpayers who want to purchase RALs.

The IRS conducts meaningful reviews of RAL marketing practices during its reviews of Electronic Return Originators (EROs). Far from indicating a problem, the high rate of sanctions of EROs shows that the IRS selection methodology is effective. It is true that in 2004 nearly 50 percent of EROs who underwent a compliance visit received either a warning (30 percent) or a sanction (20 percent). However, instead of indicating massive problems as the National Taxpayer Advocate contends, this high rate suggests we have an effective selection methodology. In other words, the EROs we visited were selected because we believed they had problems -- and it turned out that we were right. It is also important to note that RAL marketing practices by EROs are only one component of the compliance visit. Therefore, the sanctions that have been imposed are not necessarily attributable to noncompliant behavior involving RALs.

In general, EROs tend to be highly compliant. When the IRS visited EROs at random, only 7.8 percent were sanctioned. The National Taxpayer Advocate's discussion of this subject draws exactly the wrong conclusion from the data.

TAXPAYER ADVOCATE SERVICE COMMENTS

Congress has mandated that the IRS and the National Taxpayer Advocate work together to draft a report to be submitted by June 20, 2006, addressing many issues discussed in this Most Serious Problem. We look forward to working closely with the IRS on issues related to the Debt Indicator program, cross-collection practices, the use of RALs, and refund delivery alternatives.⁵⁵

IRS Role in Regulating RAL

The IRS states that the regulation of RAL is beyond its purview and cites the National Bank Act as a bar to action on the part of the IRS. The National Taxpayer Advocate finds this demurral to be beside the point. Throughout this report, the IRS describes cross-agency initiatives that is undertaking and even spearheading to address problems it deems to be important.⁵⁶ The IRS's failure to actively engage with regulators and other overseers of national banks, such as the Office of Comptroller of the Currency, the Office of Thrift Supervision, the Federal Reserve, and even the Treasury's Office of Financial Education, to address these problems, indicates a failure of commitment to an issue that harms taxpayers. The IRS should serve as a convener of these oversight agencies and take the lead in addressing this issue comprehensively through a cross- government approach. Indeed, the IRS is the one agency whose constituents are most harmed by the lack of oversight.

Taxpayer Satisfaction and Financial Literacy

We support the IRS's initiatives to increase financial literacy and improve disclosure requirements. These initiatives will help taxpayers make informed decisions regarding refund delivery methods. We understand that to some extent demand for RALs will always exist because these products satisfy the need of some taxpayers to receive refunds almost instantaneously. We note, however, that it is not surprising that taxpayers who use RALs are highly satisfied with this product. After all, these taxpayers have few financial options and need their refunds quickly. No one would argue that RAL users would be even more satisfied if they could receive their refunds as quickly as RALs, but at less (or no) expense. The IRS can take steps to minimize demand by reducing the refund turnaround time to the extent possible and offering alternative methods of refund delivery. Given the public policy justification for delivering the EITC, the IRS -- working with other federal agencies -- should develop a method to deliver the EITC quickly and at no cost to taxpayers. The above- referenced report will address this issue.

Debt Indicator

The National Taxpayer Advocate clearly acknowledged in our discussion above that offering the Debt Indicator (DI) program carries both risks and benefits. That is why we recommend that the IRS evaluate the potential impact of RAL termination on all aspects of tax administration. We look forward to exploring this issue further with the IRS pursuant to the above-referenced legislative mandate. The resulting report will address the uses of DI as well as whether the IRS facilitates the use of RALs by offering the program.

IRS Oversight of EROs

In its response, the IRS states that the high rate of ERO noncompliance found during e-file monitoring does not apply to the general ERO population. We acknowledge that the IRS's selection methodology played a contributing role in the high noncompliance rates found during visits and that the noncompliance is an estimate, at best. Moreover, we have noted that the IRS compliance policies limit per-ERO sanctions to only one each year; thus, noncompliance is most likely understated. Although the 7.8 percent rate of noncompliance found during past random visits is encouraging, without more information regarding the selection process, we cannot apply this rate to the general ERO population. As in other areas relating to oversight of preparers that serve the majority of taxpayers, the IRS has not conducted any statistically valid or comprehensive studies of noncompliance among the ERO population. We would certainly be willing to work with the IRS in the future regarding the methodology used to select ERO sites at random.

RECOMMENDATIONS

The National Taxpayer Advocate recommends that the IRS take the following actions:

• Pursuant to Congressional mandate, work closely with the National Taxpayer Advocate to fully analyze and report on such issues as the Debt Indicator program, cross-collection practices, the use of RALs and refund delivery alternatives.

• Work with the Department of Treasury, bank regulators, and banking and consumer stakeholders to develop refund delivery alternatives, with a particular focus on EITC benefit delivery alternatives to ensure that taxpayers do not unnecessarily spend EITC benefits on high fees. Two methods worthy of serious consideration are Electronic Benefit Transfer (EBT) and Electronic Transfer Accounts (ETA).

• Review the effect of the Revenue Protection Strategy (RPS) on refund turnaround times. The IRS should review the feasibility of shortening the RPS timeframes as much as possible.

• Review the ERO Visitation Checksheet used by SB/SE employees during e-file monitoring visits to determine whether it adequately addresses the requirements of IRS Publication 1345 related to RALs and RACs.

• Work closely with the Taxpayer Advocate Service to determine the methodology for randomly selecting ERO sites for e-file monitoring visits. By choosing a representative sample, the IRS can determine the rate of noncompliance among the general ERO population. If the rate of noncompliance found during the resulting random visits is high, the IRS needs to review whether the existing warning and sanction structure actually deters noncompliance in a meaningful manner.

² Alan Berube, Anne Kim, Benjamin Forman, and Megan Burns, The Price of Paying Taxes: How Tax Preparation and Refund Loan Fees Erode the Benefits of the EITC, The Brookings Institution and The Progressive Policy Institute, 5 (May 2002); Gregory Elliehausen, Senior Research Scholar, Credit Research Center, McDonough School of Business, Georgetown University, Consumer Use of Tax Refund Anticipation Loans, Monograph No. 37, 1 (Apr. 2005).

³ The nationwide usage of RALs declined by approximately 4.3 percent between tax years 2001 and 2002, with a usage in tax year 2001 of 14.1 million and a usage of approximately 13.5 million in tax year 2002 (4.3 percent decline). RAL Indicators rose to 13.8 million in tax year 2003. The overall decline in RAL usage among Non-EITC taxpayers was approximately 7.9 percent during this period. In contrast, the percentage of decline among EITC taxpayers was only approximately 1.9 percent. Alan Berube and Tracy Kornblatt, The Brookings Institution, Step in the Right Direction: Recent Declines in Refund Usage Among Low-Income Taxpayers (Apr. 2005); IRS Compliance Data Warehouse, Individual Returns Transaction File (Tax Years 2002, 2003, 2004) and IRS ETA Data: RAL Indicator (Tax Years 2002, 2003, 2004).

⁴ PowerPoint Presentation to the Senior Leadership Team, Refund Anticipation Loans (RALs), 9 (June 2005); Draft RAL Anticipation Loans (RALs) PowerPoint Presentation, 5 (Oct. 24, 2005).

⁵ ETA Response to TAS Information Request (Aug. 25, 2005).

⁶ Gregory Elliehausen, Senior Research Scholar, Credit Research Center, McDonough School of Business, Georgetown University, Consumer Use of Tax Refund Anticipation Loans, Monograph No. 37, 40-50, 59-66 (Apr. 2005) (This study, which analyzed the findings of a national telephone omnibus survey, was supported, in part, by a grant from Jackson Hewitt Tax Services).

⁷Id. at 1.

⁸ H&R Block, Inc., 10-K (Apr. 30, 2003).

⁹ Tax Related Financial Products Can be Costly: Field Hearing Before the U.S. Senate Committee on Homeland Security and Governmental Affairs, Permanent Subcommittee on Investigations, 109th Cong. (Apr. 15, 2005) (Statement of Robert A. Weinberger, H&R Block).

¹⁰ RALs are similar to payday loans, which are short-term cash loans based on personal checks held for future deposit or electronic access to the borrower's bank account. Borrowers write a personal check for the amount borrowed plus the finance charge and receive cash. Lenders hold the personal checks until the next payday when payment is due. Borrowers can redeem the check for cash, allow the check to be deposited, or pay the finance charge to roll the loan over for another pay period. Payday loans range from $100 to $500 and have average terms of about 14 days. See Loan Sharks in the Water: Payday Lending, at http://www.nypirg. org/consumer/payday/default.html) (last viewed on Oct.13, 2005). Typical annual percentage rates (APR) for payday loans range from 391 percent to 443 percent. Keith Ernst, John Farris, Uriah King, Quantifying the Economic Cost of Predatory Payday Lending, The Center for Responsible Lending 3 (Dec. 2003).

¹¹ Tax Related Financial Products Can Be Costly: Field Hearing Before the U.S. Senate Committee on Homeland Security and Governmental Affairs, Permanent Subcommittee on Investigations, 109th Cong., (Statement of Robert A. Weinberger, H&R Block). (Apr. 15, 2005).

¹² IRS Pub. 17, Your Federal Income Tax 11 (2004); IRS, Topic 152-Refunds-How Long They Should Take, at http://www.irs.gov/taxtopics/tc152.html; IRS, IRS e-file and Direct Deposit Continue to Outpace Last Year's Results, at http://www.irs.gov/newsroom/article/0,,id=136599,00.html.

¹³ RAL Industry Briefing to the National Taxpayer Advocate (Oct. 27, 2004).

¹⁴ Caroline E. Mayer, Preparers Moving to Tax-Refund Debit Cards, Washington Post, F01 (Apr. 10, 2005).

¹⁵ IRS Pub. 17, Your Federal Income Tax 11 (2004).

¹⁶ Draft RAL Anticipation Loans (RALs) PowerPoint Presentation, 5 (Oct. 24, 2005).

¹⁷ Over 61 percent of RALs processed in 2005 included EITC funds. In tax year 2002, approximately 57 percent of RAL customers were EITC recipients. IRS Compliance Data Warehouse, Individual Returns Transaction File (Tax Years 2002, 2003, 2004); IRS ETA Data: RAL Indicator (Tax Years 2002, 2003, 2004); Alan Berube and Tracy Kornblatt, The Brookings Institution, Step in the Right Direction: Recent Declines in Refund Usage Among Low-Income Taxpayers (Apr. 2005). Further, in a recent Brookings Institution study focusing on Cleveland taxpayers for Tax Year 2002, 47 percent of EITC claimants purchased RALs and ten percent of taxpayers without EITC purchased RALs. Alan Berube, Connecting Cleveland's Low Income Workers to Tax Credits, Presented at the Levin College Forum, available at http://www.brookings.edu/metro/ speeches/20050113_connectingcleveland.htm, 17 (Jan.13, 2005). Proponents of RALs state that the data provided by IRS actually combines RALs and Refund Anticipation Checks (RACs) and that at least onehalf of the number of RAL customers in the IRS data actually received RACs. RAL Industry Briefing to the National Taxpayer Advocate (Oct. 27, 2004). However, the IRS has no way to verify these claims that are based on data collected by the RAL/RAC industry.

¹⁸ USDA, FNS, The Food Stamp Program State by State EBT Map, at: http://www.fns.usda.gov/fsp/ebt/ebt_map. htm (Jul. 2004).

¹⁹ Food stamps are only available to purchase food at POS terminals while recipients can access cash benefits at ATMs. Michael A. Stegman, et. al., The State of Electronic Benefit Transfer (EBT), Center for Community Capitalism: Chapel Hill, NC, December 2003, 5-7; Federal Reserve Bank of Chicago, Consumer Information: Electronic Money, available at http://www.chicagofed.org/consumer_information/electronic_ money.cfm. See Stored Value Cards: An Alternative for the Unbanked?, available at http://www.ny.frb.org/regional/stored_value_cards.html.

²⁰ For example, the U. S. Department of Agriculture regulates the EBT of food stamps by preventing state agencies from charging food stamp retailers any fees associated with the EBT of food stamps. Food Stamp Act, § 7(h)(2), 7 U.S.C. § 2016(h)(2). Currently, USDA regulations prohibit merchants from charging fees and surcharges on purchases made with electronic food stamps. However, these regulations do not apply to non-food stamp benefits like TANF. Excluding New Mexico, all states that deliver cash benefits (like TANF) allow EBT vendors to restrict the number of allowable free cash transactions. Many states offer four free ATM transactions per month to a recipient. After that, the EBT vendor is allowed to charge fees. In most states the vendor fee is $ 0.85 or $ 1.00. In many states, recipients can get cash back from their (non-food stamp) benefits at a POS machine at a grocery store; again, many states offer a number of free transactions and then charge for transactions above that number. Michael A. Stegman, et. al., The State of Electronic Benefit Transfer (EBT), Center for Community Capitalism: Chapel Hill, NC, 19 (December 2003), Joulia Dib, et. al, Electronic Benefit Transfer (EBT) Programs: Best Practices to Serve Recipients, Consumers Union, August 2000, 27-28.; See Electronic Benefit Transfer (EBT) Programs in the States, at http://www.consumer-action.org/english/canews/1998_July_EBT- eft/index.php#topic_06 (last viewed on Oct. 17, 2005). As a direct Federal payment to the taxpayers, the U.S. government could set terms for EBT vendor transactions by contract with the vendors (e.g., the services provided for free or for additional charges).

²¹ Ellen Seidman, Jennifer Tescher, From Unbanked to Homeowner: Improving the Supply of Financial Services for Low-Income, Low-Asset Customers, Presented at "Building Assets, Building Credit: A Symposium on Improving Financial Services in Low-Income Communities," organized by the Joint Center on Housing Studies at Harvard University, 16 (Nov. 18, 2003).

²² Federal Reserve Board, U.S. Consumers and Electronic Banking, 1995-2003 at http://www.federalreserve.gov/ pubs/bulletin/2004/winter04_ca.pdf 5 (Jan. 1, 2004).

²³ Barbara Kiviat, Bye Bye Paycheck, Time, at http://www.time.com/time/insidebiz/printout/ 0,8816,493290,00.html (Oct. 6, 2003); OCC, Payroll Cards: An Innovative Product for Reaching the Unbanked and Underbanked, at http://www.occ.treas.gov/cdd/payrollcards.pdf 11 (Jun. 2005). Moreover, with respect to tax refunds, the Federal government can establish the fee schedule as part of the agreement with EBT vendors.

²⁴ Debt Collection Improvement Act of 1996 (DCIA), Pub L. No. 104-34, § 31001, 110 Stat. 1321-358. See Electronic Transfer Accounts: Common Questions, available at http://fms.treas.gov/eta/questions.html.

²⁵ Sondra G. Beverly, et al., Linking Tax Refunds and Low-Cost Bank Accounts: Findings from the Extra Credit Savings Program, 31 (Sept. 2001) (Describing the results from the Shore Bank Study).

²⁶ Allen Kenney, IRS, Industry Reach Agreement on Free File, Tax Analysts Tax Notes Today, 2005 TNT 206-2 (Oct. 26, 2005).

²⁷Free Electronic Filing and National Taxpayer Advocate Annual Report: Hearing Before the Subcomm. on Oversight of the House Comm. on Ways and Means, 108th Cong. 29 (2003). Rep. Pomeroy stated, "I am interested in when the Commissioner said there is no express or implicit endorsement of products, the fact that there is a public-private partnership and you can access these vendors through the IRS Web site leaves me a little concerned that there may be an implicit statement by the IRS that these are appropriate products, and yet there does not seem to be an active review of whether the products are indeed appropriate. So, maybe we can install that going forward."

²⁸ IRC § 6402(d). Notice 99-58, 1999-2 C.B. 693, 1999-51 I.R.B. 693 (Dec. 20, 1999); IRS Communications and Liaison, Operations Flash, Direct Deposit Indicator, 2000-6 (Dec. 10. 1999).

²⁹ The IRS requires tax preparers who receive the Debt Indicator to have return preparation software that includes a mandatory consent to disclose the debt indicator. IRS Publication 3614, Application for Memorandum of Agreement -- Debt Indicator; Notice 99-58, 1999-2 C.B. 693, 1999-51 I.R.B. 693 (Dec. 20, 1999). However, it is unclear whether preparers adequately explain the arrangement and whether taxpayers feel compelled to consent in order to get their money quickly.

³⁰ The IRS believes the program (1) significantly increases electronic filing, (2) increases service to taxpayers, (3) decreases RAL fees, and (4) assists RAL lenders in identifying fraudulent returns. Amy Hamilton, Taxwriters Zeroing in on Rapid Refund Loans, Tax Analysts Tax Notes Today, 2001 TNT 67-3 (Apr. 5, 2001); Notice 99-58, 1999-2 C.B. 693, 1999-51 I.R.B. 693 (Dec. 20, 1999).

³¹ When the IRS eliminated the program in 1995, RAL fees increased and e-filing decreased by approximately 16 percent. PowerPoint Presentation to the Senior Leadership Team, Refund Anticipation Loans (RALs) 7 (Jun. 2005).

³² In fact, 84 percent of e-filers did not request a RAL in 2005. Draft RAL Anticipation Loans (RALs) PowerPoint Presentation, 15 (Oct. 24, 2005); Information Provided to TAS and Taxpayer Advocacy Panel (Sept. 23, 2005).

³³ Publication 1345, Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns, states: The IRS is in no way involved in or responsible for RALs. All parties to RAL agreements, including electronic return originators (EROs), must ensure that taxpayers understand that RALs are interest bearing loans and not substitutes for a faster way of receiving a refund. The ERO should advise the taxpayer that if a Direct Deposit is not received within the expected time frame for whatever reason, the taxpayer may be liable to the lender for additional interest on the RAL. The Service has no responsibility for the payment of any fees associated with the preparation of a return, the transmission of the electronic portion of a return, or a RAL. IRS Pub.1345, Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns 50-52 (Rev. 01-2001). In a response to a Taxpayer Advocacy Panel Elevated Recommendation, the IRS noted that three locations within the Free File website inform taxpayers that they are under no obligation to purchase or use products and or services made available by Alliance members. Taxpayer Advocacy Panel Annual Report 19 (Dec. 31, 2004).

³⁴ IRS Pub. 1345, 44-45. See also Pub. 1345A, Filing Season Supplement for Authorized IRS e-file Providers: Tax Year 2004, 15.

³⁵ Rev. Proc. 2000-31, 2000-31 I.R.B. 146, § 7. To become an ERO, an applicant must submit to a suitability check that covers all principals of his or her firm and all responsible officials listed on Form 8633, Application to Participate in the IRS e-file Program. A suitability check may entail an FBI criminal background check, a credit history review, an IRS records search to ensure a history of tax compliance, and/or a history check for prior non-compliance in IRS electronic filing programs. See Internal Revenue Service, Publication 3112, The IRS e-file Application Package (Rev. 08-2003); Internal Revenue Service, Publication 1345, Handbook for Authorized IRS E-File Providers of Individual Income Tax Returns, 77-78 (Rev. 2001).

³⁶ IRM § 4.21.1 (Jan. 2003).

³⁷ IRM Exhibit 4.21.1-6, ERO Visitation Checksheet (Jan. 2003). The completed checksheet compiles over 50 different information items.

³⁸ For a detailed discussion of IRS due diligence of EROs as well as the National Taxpayer Advocate's legislative proposal to increase monetary penalties imposed on EROs, see National Taxpayer Advocate 2003 Annual Report to Congress 270-301.

³⁹ SB/SE exceeded its goal to visit 1,181 EROs. SB/SE, Examination General Processes, Response to Information Request (Apr. 14, 2005).

⁴⁰ These figures cannot be generalized to the total population because the sites selected for visitation were not all selected on a random basis. A portion of the sites were selected randomly, but the dataset used to calculate these figures do not have sufficient detail to conduct the analyses for solely the randomly selected site visits. Additionally, after providing a copy of the document to operations for review and comment, a different dataset was provided that included counts somewhat different from the original data. Due to time constraints, it was not possible to identify which dataset was most accurate, so the figures reported here are based on the originally supplied data.

⁴¹ The preliminary data for a partial calendar year 2005 shows improvement in the compliance rate. Of the 1,104 visits conducted, 143 warnings (13 percent) and 179 sanctions (16 percent) were imposed, which totals an approximate 29 percent rate of noncompliance for the partial year. It is our understanding that SB/SE only imposes one of the listed warnings or sanctions per year. Therefore, EROs will not receive multiple warnings and sanctions within a single year. However, the estimated noncompliance rate may be an inflated figure due to the fact that visits were not conducted in an entirely random manner. There are four types of e-file monitoring visits: (1) random visits based on a non-discriminatory sample, (2) targeted visits based on selection criteria, (3) mandatory referral visits, and mandatory follow-up visits. SB/SE Responses to TAS Information Request (Apr. 14, 2005 and Sept. 24, 2005). Unlike with the Taxpayer Assistance Centers (TACs) and the Volunteer Income Tax Assistance program, the IRS does not conduct "shopping visits" or "undercover" testing of EROs to verify that procedures are actually followed. Volunteer Return Preparation Program Quality Improvement Process (VRPP QIP) TAS Briefing, PowerPoint screens 5 -- 11 (Oct. 18, 2005) (The IRS conducts shopping visits of the TACs. Further, although the IRS does not conduct shopping visits on VITA sites, it has partnered with the AICPA to conduct such visits. It has also invited TIGTA to return to conduct future undercover visits of the sites). For more information, see National Taxpayer Advocate 2004 Annual Report to Congress 119 -120.

⁴² IRS Pub. 1345, Handbook for Authorized IRS E-File Providers of Individual Income Tax Returns 44 (Rev. 2001); IRC § 267(b)(2).

⁴³ For more a more detailed discussion of this proposal and the IRS's response, see National Taxpayer Advocate 2002 Annual Report to Congress 216-230; National Taxpayer Advocate 2003 Annual Report to Congress 270-301; National Taxpayer Advocate 2004 Annual Report to Congress 67-88.

⁴⁴ For example, the Santa Barbara Bank & Trust Refund Processing and Refund Anticipation (RAL) Application and Agreement (Rev. 10/25/04) contains a provision on the first page informing the customer that the bank may deduct the amount of delinquencies on third party RALs. However, the agreement does not mention that the bank will share private tax return information with other banks until provision 6.a, on page 3 of the 5-page document.

⁴⁵ Alan Berube, Anne Kim, Benjamin Forman, and Megan Burns, The Price of Paying Taxes: How Tax Preparation and Refund Loan Fees Erode the Benefits of the EITC, The Brookings Institution and The Progressive Policy Institute 5 (May 2002).

⁴⁶ 7 Joseph M. Perillo, Corbin on Contracts §§ 29.8 -- .10.

⁴⁷ Restatement (Second) of Contracts § 211.

⁴⁸ 42 U.S.C. § 407(a).

⁴⁹See Additional Legislative Recommendation: Debt Collection Techniques on EITC Benefits by Refund Anticipation Loan Industry, infra.

⁵⁰Tax Related Financial Products Can Be Costly: Field Hearing Before the Permanent Subcomm. on Investigations, Senate Comm. on Homeland Security and Governmental Affairs, 109th Cong. (2005) (Statement of Sen. Norm Coleman).

⁵¹ Sec. 3(a) of S. 324, "Prohibition on Debt Collection Offset" provides "No person shall, directly or indirectly, individually or in conjunction or in cooperation with another person, engage in the collection of an outstanding or delinquent debt for any creditor or assignee by means of soliciting the execution of, processing, receiving, or accepting an application or agreement for a refund anticipation loan or refund anticipation check that contains a provision permitting the creditor to repay, by offset or other means, an outstanding or delinquent debt for that creditor from the proceeds of the debtor's Federal tax refund." S. 324(3)(a) 109th Cong. (2005).

⁵² S. 324, 109th Cong. (Feb. 9, 2005). See also H.R. 969, 109th Cong. (Feb. 17, 2005). The Low Income Taxpayer Protection Act, S. 832, 109th Cong. (Apr. 18, 2005) and H.R. 894, 109th Cong. (Feb. 17, 2005) required the registration of income tax preparers and RAL providers and curbs demand for RALs by speeding up the e-file process.

⁵³See, e.g., Conn. Gen. Stat. § 42-480; Minn. Stat. § 270.30; N.C. Gen. Stat. §§ 53-245 to -254; Wis. Stat. §§ 421.301 and 422.310; N.Y.C. Admin. Code § 20-739.

⁵⁴ Industry Briefing to the Taxpayer Advocate Service (Oct. 27, 2004).

⁵⁵ H.R. Conf. Rep. No. 109-307 (Nov. 18, 2005) provides:

MOST SERIOUS PROBLEM: IDENTITY THEFT

RESPONSIBLE OFFICIAL

Identity theft is a fast-growing crime that affects millions of taxpayers. The rate of fraudulent tax returns filed by identity thieves doubled from calendar years 2002 to 2003.¹ Victims of identity theft often find themselves faced with serious tax consequences, and possibly must wait years for their tax account problems to be resolved.

The IRS recently established the Identity Theft Program Office. This office must ensure the IRS (1) revises its procedures to provide consistent, timely, and effective relief to victims of identity theft; (2) develops an effective outreach strategy; and (3) works with other agencies on preventive measures.

ANALYSIS OF THE PROBLEM

Background

Identity theft occurs when someone uses another individual's personal information without permission to commit fraud or other crimes. Examples of identity theft include tax fraud, stealing from the victim's financial accounts, making unauthorized purchases with stolen credit cards, and applying for services or benefits in the victim's name.

Several large data brokers, which compile and sell personal information (such as names, addresses, Social Security numbers (SSNs) and credit reports) to government agencies and private companies have recently reported major breaches of sensitive records. In February 2005, ChoicePoint, Inc. notified more than 140,000 consumers in California that unauthorized parties may have accessed their personal data.² In April 2005, Lexis-Nexis reported that up to 310,000 people may have had their profiles stolen from a database that contained sensitive information.³

The Federal Trade Commission (FTC) is the lead government agency assigned to monitor identity theft. The FTC's 2004 annual report on fraud listed identity theft as the top fraud-related complaint for the fifth year in a row, with more than 246,000 reported incidents.⁴ Although the most common type of identity theft involves consumer fraud, an increasing number of identity theft victims find they need to contact the IRS to untangle their tax accounts.⁵

There are two common situations in which an identity thief can wreak havoc on a victim's tax account. In the first type of theft, the perpetrator files a fraudulent tax return early in the tax filing season using another person's name and SSN, typically seeking a large refund. Later, when the victim tries to file his or her real return, the IRS will reject it and send the taxpayer a notice that a return has already been filed under this taxpayer identification number (TIN).

The second type of tax identity theft occurs when a person not legally entitled to work in the United States purchases or "borrows" a valid SSN to obtain employment. Taxpayers who are not eligible for an SSN are required to file tax returns under an Individual Taxpayer Identification Number (ITIN).⁶ However, because employers cannot accept ITINs as authorization to work, an unauthorized worker may provide a stolen SSN to an employer. When the IRS receives a Form W-2, Wage and Tax Statement, reflecting income earned under the SSN, the identity theft victim will receive an IRS notice indicating that he or she failed to report this income on his or her tax return.

In July 2005, the Treasury Inspector General for Tax Administration (TIGTA) released a report on the IRS response to the growing problem of identity theft.⁷ The report concluded that "the IRS currently has no corporate strategy to address identity theft issues... Until the IRS develops an agency-wide strategy, it will be unable to help taxpayers and the Federal Government combat the growing threat of identity theft."⁸

In response, the IRS drafted an identity theft policy statement and in August 2005, established the Identity Theft Program Office to develop a corporate strategy. This office identified three strategic initiatives: Victim Assistance, Outreach, and Prevention.

Victim Assistance

Current IRS Procedures

Because the words "identity theft" did not appear in the Internal Revenue Manual (IRM) until recently, IRS employees had to utilize several different sections of the IRM to resolve identity theft issues. Table 1.9.1 illustrates the various types of identity theft and the IRS processes involved.

 TABLE 1.9.1, IRS RESPONSES TO IDENTITY THEFT

Cases involving multiple taxpayers using the same TIN are classified as either a "mixed entity" case or a "scrambled SSN" case. Mixed entity procedures address situations where the IRS can identify the true owner of the common number, whereas scrambled SSN procedures cover those situations where the true owner cannot be determined.¹¹ IRS guidelines require Accounts Management (AM) employees to conduct preliminary research before labeling a case as a mixed entity or scrambled SSN case.¹²

If, after preliminary research, the AM employee locates the correct TIN for each taxpayer, then the IRS should follow the mixed entity procedures. The true owner of the common number will continue using the SSN, and the IRS will instruct the other taxpayer to use his or her correct TIN or be assigned a temporary Internal Revenue Service Number (IRSN).¹³

Example: Taxpayer A, John Smith and Taxpayer B, Jane Smythe are both using the common number. NUMIDENT¹⁴ indicates that the common number was assigned to John Smith and does not indicate that it was ever assigned to Jane Smythe. Research and correspondence with Taxpayer B do not provide a valid TIN for Taxpayer B, Jane Smythe. Taxpayer A, John Smith is the correct common number owner and would remain on the common number. Taxpayer B, Jane Smythe is the incorrect taxpayer and would be moved to an IRSN.¹⁵

If the AM employee cannot determine from preliminary research the rightful owner of the common number, then the IRS must follow the scrambled SSN case procedures. The IRS sends 239C letters to both taxpayers indicating that there was a problem with their SSN and advising them to contact the SSA and request a "Social Security Administration Social Security Number Verification" printout, which the IRS will accept as proof of SSN ownership.¹⁶

If neither (or both) of the taxpayers responds to the 239C letter and produces proof of SSN ownership, the IRS considers the case "scrambled" and sends it to the SSA for resolution.¹⁷ The IRS uses Form 3857, Request for SSN Clarification, to seek SSA assistance in unscrambling a common number. However, the SSA has up to two years to unscramble a case and respond to the IRS! In the meantime, the IRS freezes any refunds and puts the cases in the "two year file" to await response from the SSA.¹⁸

While the SSA conducts its research, the IRS assigns a temporary IRSN to taxpayers involved with the duplicate tax return situation to use when filing future returns. Because the IRSN is not a valid SSN, these taxpayers will not be allowed to claim certain credits and deductions requiring an SSN, including the refundable earned income tax credit (EITC) and dependent exemptions. This prohibition can cause extreme hardship for taxpayers who rely on these credits and deductions.

SCENARIO 2: ITIN/SSN MISMATCH

The IRS uses an automated underreporter (AUR) program to match wages reported on Form W-2, Wage and Tax Statement, against wages reported on tax returns.¹⁹ If an identity thief uses a stolen SSN to obtain employment, he or she will receive a Form W-2 from the employer showing income under the stolen number. The AUR program will identify the underreported income, and the IRS will issue a CP 2000 notice to the identity theft victim proposing an assessment of additional taxes owed on the underreported wages. The victim must then contact the IRS to resolve the mismatch of wages by trying to prove that he or she was a victim of identity theft.

If this is the taxpayer's only AUR notice, and the tax liability is less than a predetermined threshold, the IRS will accept the taxpayer's written or oral statement that he or she was a victim of identity theft. However, if the taxpayer has received multiple AUR notices or the liability exceeds the predetermined threshold, the taxpayer will be required to provide proof of the identity theft.

Unreasonable Delays in Resolving Taxpayer Accounts

In fiscal year 2005, the IRS sent 9,916 scrambled SSN cases to the SSA (up from 8,644 cases in FY 2004).²⁰ As mentioned earlier, scrambled SSN procedures require input from the SSA and allow up to two years for the SSA to respond to the IRS. The IRS needs to resolve the tax issues faced by victims of identity theft more quickly and efficiently. This may require coordination between the IRS and the SSA to develop a more efficient process.

Further, IRS employees are often confused as to which set of procedures to apply when assisting a victim of identity theft. Understandably, the victims would like to avoid the scrambled SSN process if possible. In some instances, the IRS used scrambled SSN procedures when it should have followed the mixed entity process. The recently revised IRM provides that "[e]very effort should be made to locate a correct TIN for both taxpayers BEFORE using scramble procedures."²¹ To ensure that employees follow the revised IRM and limit the burden imposed on identity theft victims, the IRS needs to conduct appropriate training for employees who determine whether to send a case to the SSA.

Coordination within IRS Functional Groups

Like many large organizations, the IRS is composed of groups that are responsible for specific areas or functions, each with its own rules and operating procedures. For example, a victim of identity theft may have to correspond separately with employees from Automated Underreporter, Accounts Management, and Automated Collection System (ACS) to untangle his or her tax account. Requiring taxpayers to deal with these multiple points of contact results in inefficiencies for the IRS, and more importantly, places an unnecessary burden on the impacted taxpayers.

The IRS functional groups must do a better job of sharing information to make the process more efficient and taxpayer-friendly. Under current procedures, a taxpayer would be required to present different sets of documents to establish his or her identity each time he or she deals with an IRS functional group. The identity theft task force recognized the need for a uniform list of acceptable documents that can establish identity and has recommended that identity theft victims be required to provide:

• Copy of Social Security card

• Copy of document verifying current home address, such as:

• • Bank statement;

  • Lease agreement;

  • Mortgage statement; or

  • Utility bill

• Copy of document verifying identity, such as:

• • Driver's license;

  • Passport; or

  • Other federal or state government-issued ID

• Copy of document reporting incident of identity theft, such as:

• • Police report;

  • FTC Identity Theft Affidavit;²² or

  • Correspondence with a credit bureau.

The IRS should also consider using an electronic indicator on its master files to mark the accounts of taxpayers who have verified that they have been victims of identity theft. Such an indicator would alert IRS personnel in other functions that this taxpayer may have special needs based on the circumstances, and relieve the taxpayer of the burden of proving again that he or she was a victim of identity theft. Use of an indicator would also raise awareness that this taxpayer may have identity theft-related issues in future filing seasons.

"Fencing Off" Wages

Employers are required to obtain proof of any prospective employee's identity and immigration status before employing that person. Undocumented workers may submit an SSN to a prospective employer. Thus, the worker's Form W-2 will reflect an incorrect SSN while his individual income tax return shows his actual ITIN.

A mismatch between an ITIN on a tax return and a SSN on a Form W-2 creates two undesirable consequences. First, the identity theft victim will receive a notice from the IRS that he or she underreported income. Second, the undocumented worker will not receive credit from the SSA for wages earned. The National Taxpayer Advocate urges the IRS to develop procedures that will protect victims of identity theft from having to spend unnecessary time and effort proving that they did not earn the wages reported under their SSNs.

One possible approach would be to permit the undocumented worker to submit a substitute information document (Form 4852, Substitute for Form W-2, Wage and Tax Statement), listing his or her ITIN accompanied by proof that the taxpayer is indeed the person who earned the income shown on the form (e.g., a year-end paycheck stub). Upon receiving such proof, the IRS can continue to process the return and issue any refund due.

Under this approach, the IRS would be able to "fence off " the wages or other income from being attributed to the victim of identity theft, thereby protecting the victim from unnecessary audits and collection actions. The SSA, after receiving notification from the IRS of the correct number (the ITIN) to associate the income, would remove the earnings credited to the identity theft victim's account and place the earnings in a suspense fund.²⁴

Communication and Outreach

Because "identity theft" was not a recognized term within the IRS until recently, communication and outreach on identity theft had been non-existent. In the summer of 2005, the IRS finally developed a web page devoted to identity theft on its www.irs.gov Internet site.

However, no information on identity theft is available through more traditional communication vehicles. The IRS toll-free telephone line does not inform victims of identity theft what they should do. Key instructions and publications, including the U.S. Individual Income Tax Return (Form 1040) instruction booklet and Your Federal Income Tax (Publication 17), also omit any reference to identity theft. As a result, the millions of taxpayers without Internet connectivity will not have access to information on what they should do if they believe they are victims of identity theft.

Prevention

Identity theft is a growing problem nationally and internationally. It would be unrealistically optimistic to think that the IRS or any agency can successfully combat and fully eliminate this crime. However, there are steps the IRS can and should take to help curb the spread of the problem, and, at a minimum, ensure that the IRS does not contribute to the problem.

Coordination with Other Federal Agencies

The FTC maintains a database of identity theft cases to aid law enforcement agencies in their investigations. This database contains information provided voluntarily by victims, including name, address, SSN, and date of birth.²⁵

The IRS is generally restricted from sharing tax return information with other federal agencies.²⁶ However, there is no prohibition against the IRS receiving information from other agencies. Even if not 100 percent reliable, the information in the FTC database may still be of value to the IRS. For example, if a notation is included whenever a match appears in the FTC identity theft database, the IRS would be alerted that there is a greater probability of duplicate filing and could take proactive measures.

Protection of Taxpayer Information

As discussed above, IRC § 6103 generally prohibits the IRS from disclosing tax return information to other agencies. However, an exception allows the IRS to share returns and return information with state tax agencies, which the IRS routinely does.²⁷

TIGTA recently released an audit that examined whether federal tax information was at risk while in possession of state tax agencies.²⁸ The report identified significant weaknesses in "physical security, user account management, access controls, audit trails, intrusion detection, and firewall systems" in each of the four state agencies reviewed.²⁹ These weaknesses place taxpayer information at increased risk of unauthorized use by state government employees or theft by hackers.

Prior to sharing information with any entity, the IRS should require adherence to certain security controls. It does no good for the IRS to expend resources safeguarding taxpayer information if it then allows the information to escape through the back door.

IRS COMMENTS

Recognizing that identify theft was a growing national consumer problem, this year the IRS refocused its efforts to update internal processes and to enhance interagency collaboration and coordination. We established a multi-agency working group that includes representatives from the Department of Treasury, Federal Trade Commission (FTC), the Social Security Administration (SSA), and the Department of Homeland Security (DHS) to better enable federal agencies to provide consistent information and services to assist victims from a macro level. This group serves as a role model to demonstrate the power that interagency collaboration can bring to communication, outreach activities, and process improvements.

Victim Assistance

While the percentage and number of taxpayers affected by identity theft is small, it can be very frustrating for each individual victim. Therefore, we are committed to improving processes to better assist those taxpayers that are victims of identity theft. Based on the total number of complaints in the Identity Theft Data Clearinghouse (ITDC) maintained by the FTC, fraudulent tax returns accounted for only 1.9 percent, 3.7 percent, and 3.8 percent of identity theft information misuse for calendar years 2002, 2003, and 2004, respectively.

The Scrambled SSN process was originally intended to resolve cases where the SSA issued the same SSN to two different taxpayers. The IRS collects information to enable the SSA to conduct an investigation to verify the true owner of the SSN. A joint IRSSSA team began working in December 2004 to modernize this process and has recently completed its work. We believe that this redesigned process will dramatically reduce the time required to resolve the duplicate SSN usage before the taxpayer is required to use the temporary Internal Revenue Service number (IRSN) to file the next year's returns.

The multi-agency Scrambled SSN process reengineering includes the development of a category code and systemic control of cases that still require routing to the SSA. Unfortunately, it is not possible to distinguish a true Scrambled SSN case from an identity theft case. In the near term, the Identity Theft Program Office will periodically consolidate the information from these cases when closed. Future plans include incorporating the case tracking codes for Scrambled SSN cases in the Correspondence Imaging System.

Coordination within IRS Functional Groups

The IRS has established the Identity Theft Program Office to provide a cross-functional central point of contact for identity theft related issues. The Identity Theft Program Office has taken the lead in developing and implementing a servicewide Enterprise Strategy designed to address the issues pertaining to identity theft in the tax administration environment. The three prongs of our Enterprise Strategy are: Victim Assistance, Prevention, and Outreach.

The Enterprise Strategy is working to alleviate taxpayer burden through internal collaboration by distributing updates on the identity theft strategy via our internal intranet. These updates include information about internal process improvements, answers to frequently asked questions, and updates to the Internal Revenue Manual (IRM). Additionally, our Criminal Investigations (CI) Division applies several processes to identify and refer unlawful tax refund schemes through the Questionable Refund Program at the Fraud Detection Centers.

The IRS has closing codes in place for the majority of the taxpayer cases impacted by identity theft. These codes differentiate identity theft cases in CI, Taxpayer Advocate Service (TAS), and the Automated Underreporter (AUR) program.

The IRS will accumulate this data as well as data from other sources, such as the FTC, to determine trends. These trends will be used to develop or enhance outreach activities, communication vehicles, focus resources on enforcement initiatives, and add additional closing codes as warranted.

The IRS will continue to look for ways to collaborate both internally and externally in an effort to reduce taxpayer burden related to identity theft.

"Fencing Off " Wages

Generally, the situations described in the National Taxpayer Advocate's report involving undocumented workers using a stolen or fabricated SSN do not result in the identity theft victim receiving a notice from the IRS of underreported income. Moreover, the IRS is developing the capability to match the W-2 to the ITIN on the individual income tax return.

The IRS has developed and implemented new standards for documentation. These standards are used to validate the identity of the taxpayer, the taxpayer's address and the fact of the theft. The documentation required and used in Automated Underreporter Program and Submission Processing is consistent with documentation required by the FTC and SSA. We agree with the National Taxpayer Advocate that all IRS functions should adopt the uniform list and as part of the risk assessment we are reviewing our processes to ensure this is the case.

In addition, since many victims of identity theft are unaware of this problem until they are contacted by the IRS, we have modified our taxpayer correspondence. To this end, we have added the FTC's identity theft affidavit document to our correspondence and updated notices as an additional way for taxpayers to validate the fact of identity theft to the IRS.

Communication and Outreach

The IRS has developed a comprehensive communication strategy, which encompasses multiple outreach channels including information for the 2006 Filing Season. For example, we have launched comprehensive identity theft Web pages on both www.irs.gov and the IRS intranet. In addition, to educating taxpayers about identity theft prevention techniques, these sites include "alerts" on new identity theft schemes. Also, the tax year 2005 Publication 17 and the 1040 Instruction Booklet have recently been updated to incorporate guidance, which seeks to both prevent and respond to identity theft. In addition, we plan to capitalize on existing distribution channels established through Taxpayer Education and Communications (TEC) and Stakeholder Partnerships, Education & Communication (SPEC).

Protecting Taxpayers' Federal Tax Information

The IRS is currently conducting a comprehensive risk assessment designed to identify potential security vulnerabilities related to identity theft. As part of this process, we are assessing the integrity of our internal security controls as well as certain external security controls collateral to the IRS such as state agencies.

State agencies are governed by IRC § 6103 (p)(4) and as such, they are required to protect federal tax information (FTI) in accordance with the requirements of the U.S. Code as well as the policies and procedures outlined in Publication 1075, Tax-Information Security Guidelines for Federal, State and Local Agencies. Collectively, these information security requirements include computer security (i.e. physical and logical) controls designed to protect FTI from unauthorized access, use, or disclosure. The IRS Safeguards Office performs onsite assessments of state agency facilities to evaluate the security posture and operating effectiveness of such computer security controls. Currently, adherence to the Federal Information Security Management Act (FISMA) and the applicable National Institute of Standards and Technology (NIST) standards are not mandated for the state agencies receiving FTI.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate is pleased that the IRS has recognized identity theft as a growing national problem and has established the Identity Theft Program Office. Through this office's leadership, the IRS functional groups should do a better job sharing information to make the process of resolving identity theft problems more efficient and taxpayer-friendly.

We applaud the IRS as it conducts a comprehensive risk assessment designed to identify potential security vulnerabilities related to identity theft. It is important to assess the integrity of internal security controls as well as external security controls collateral to the IRS, such as state agencies.

We also appreciate the efforts the IRS has made to participate in multi-agency working groups to address identity theft issues. Such collaborative efforts can lead to significant improvements. For example, the IRS and the Social Security Administration (SSA) were able to work together to redesign the Scrambled SSN process to significantly reduce the time necessary to resolve tax issues. To ensure that its employees understand the new procedures, the IRS should conduct appropriate training.

When an undocumented worker uses another's name and SSN to obtain employment, the IRS Automated Underreporter (AUR) unit sends a CP 2000 notice to the identity theft victim proposing an additional assessment of tax. In its response, the IRS states that an ITIN/SSN mismatch generally does not result in the victim receiving a notice from the IRS of underreported income, and suggests there is no need to develop a mechanism to "fence off " these wages. The National Taxpayer Advocate disagrees with this statement. A recent TIGTA report suggests the IRS could have saved $676,000 in the 2004 tax year if the AUR program did not have to process the 30,000 cases where an identity theft victim was sent a CP 2000 notice in an ITIN/SSN mismatch.³⁰ This savings does not take into account the compliance burden placed on the identity theft victim. While she commends the IRS for developing the capability to match W-2s to ITINs on a tax return, the National Taxpayer Advocate continues to urge the IRS to explore ways to fence off the wages from being attributed to a victim of identity theft.

Finally, although the National Taxpayer Advocate is pleased that the IRS is developing excellent web-based materials, we encourage it to create a simple brochure describing the tax issues that may arise from identity theft. Many identity theft victims do not have access to the internet. Moreover, IRS employees could send this brochure to taxpayers who call about this problem, and IRS outreach employees could distribute the brochure at their outreach sessions. The Taxpayer Advocate Service will work with the Identity Theft Program Office to develop such a brochure.

RECOMMENDATIONS

The National Taxpayer Advocate makes the following recommendations to the IRS:

• To ensure employees follow the revised IRM guidance to make every effort to locate a correct TIN for both taxpayers before using scramble procedures and limit the burden imposed on identity theft victims, the IRS should conduct appropriate training for employees who determine whether to send cases to the SSA.

• In addition, the IRS should integrate awareness of identity theft into various training modules throughout the operating divisions and functions, so all employees are sensitive to this issue and can refer taxpayers to the appropriate IRS function.

• The IRS should use an electronic indicator on its master files to mark the accounts of taxpayers who have verified that they have been victims of identity theft.

• The IRS should meet with Low Income Taxpayer Clinics regarding their experiences representing identity theft victims, who have spent unnecessary time and effort interacting with the Automated Underreporter function to untangle their tax accounts. If there is still a need for procedures that will fence-off wages and protect victims of identity theft, the IRS should develop such procedures immediately.

• The IRS should create a simple brochure, available in multiple languages, describing the tax issues that may arise from identity theft.

• Prior to sharing information with any entity, the IRS should require adherence to certain security controls.

² The New York Times, Purloined Lives, available at http://nytimes.com (Mar. 17, 2005).

³ MSNBC, LexisNexis Theft Much Worse than Thought, available at http://msnbc.msn.com/id/7475594/ (Apr. 12, 2005).

⁴ Federal Trade Commission, National and State Trends in Fraud & Identity Theft, January -- December 2004 (Feb. 1, 2005), available at http://www.consumer.gov/idtheft/.

⁵ Federal Trade Commission, National State Trends in Fraud and Identity Theft, January-December 2004 (Feb 1, 2004), available at http://www.consumer.gov.idtheft.

⁶ ITINs are for federal tax reporting only, and are not intended to serve any other purpose.

⁷ Treasury Inspector General for Tax Administration, Ref. No. 2004-40043, A Corporate Strategy Is Key to Addressing the Growing Challenge of Identity Theft (July 2005).

⁸Id. at 2.

⁹ The common thread in tax-related identity theft is that the perpetrator uses a stolen SSN.

¹⁰See IRM § 21.6.2 (Rev. 10-01-2005).

¹¹ IRM § 21.6.2.4.2 (Rev. 10-01-2005). A "common number" is the TIN being used by both taxpayers.

¹² IRM § 21.6.2.4.2(1) (Rev. 10-01-2005).

¹³ Internal Revenue Service numbers (IRSNs) are assigned internally for the processing of tax returns and payments only. See IRM § 3.13.5.23.1(1).

¹⁴ NUMIDENT stands for the Numeric Identification database, which includes information from an individual's application for a Social Security card containing the individual's name, parents' names, and date and place of birth.

¹⁵ IRM § 21.6.2.4.3.2(1) (Rev. 10-01-2005).

¹⁶ IRM § 21.6.2.4.4 (Rev. 10-01-2005).

¹⁷ IRM § 21.6.2.4.4(12) (Rev. 10-01-2005).

¹⁸ IRM § 21.6.2.4.4.3 (Rev. 10-01-2005); IRM § 21.6.2.4.4.7 (Rev. 10-01-2005).

¹⁹ If there is no tax return filed for the income reported, the IRS considers it a nonfiler situation or Taxpayer Delinquency Investigation (TDI).

²⁰ W&I, Customer Account Services, Count of Form 3857 referrals to the Social Security Administration FY 2004 and FY 2005 updated as of November 15, 2005.

²¹ IRM § 21.6.2.4.4(1) (Rev. 10-01-2005).

²² In certain jurisdictions, identity theft victims will be unable to obtain a police report. In these cases, the victim is encouraged to file an identity theft affidavit with the FTC. This affidavit is available for download at http://www.consumer.gov/idtheft/pdf/affidavit.pdf.

²³ The scrambled SSN procedures were revised in October 2005 to include the list of acceptable documents. See IRM § 21.6.2.4.4.3, Determining if the Refund Should be Released (Rev. 10-01-2005).

²⁴ The SSA does not maintain accounts under ITINs. When an ITIN holder uses his or her own name with the SSN on a W-2, a mismatch occurs and the earnings are placed in the suspense file.

²⁵ FTC, ID Theft Complaint Input Form, available at http://www.consumer.gov/idtheft/.

²⁶See IRC § 6103.

²⁷ IRC § 6103(d).

²⁸ Treasury Inspector General for Tax Administration, Ref. No. 2005-20005, Increased IRS Oversight of State Agencies Is Needed to Ensure Federal Tax Information Is Protected (September 2005).

²⁹Id.

³⁰ Treasury Inspector General for Tax Administration, Ref. No. 2004-40043, A Corporate Strategy Is Key to Addressing the Growing Challenge of Identity Theft (July 2005).

MOST SERIOUS PROBLEM: COMPLEXITY OF THE EMPLOYMENT TAX DEPOSIT SYSTEM

RESPONSIBLE OFFICIALS

The rules and regulations governing federal employment tax deposits are overly complex, presenting significant compliance problems for employers and administrative challenges for the IRS. Recent data shows that the IRS assesses Failure To Deposit (FTD) penalties on one out of every 16 employment tax returns.¹ The large number of FTD penalties imposed each year suggests that complying with deposit requirements is unreasonably challenging for employers.

The FTD rules are so complex that even the IRS has difficulty enforcing them correctly. The IRS eventually abates more than 60 percent of the FTD penalty amount it originally assessed, and must spend considerable time and incur significant cost dealing with FTD penalty issues.²

ANALYSIS OF PROBLEM

Background

The Internal Revenue Code places significant responsibilities on employers for depositing, reporting, filing, and paying employment taxes. Employers are required to withhold federal and state income taxes, Medicare taxes, and Social Security taxes from their employees' wages and pay matching Medicare and Social Security taxes on behalf of their employees.³ Employers must deposit these taxes in the prescribed manner and complete quarterly, monthly, or annual tax returns and information returns to report wages paid and taxes withheld. In fiscal year 2004, employers filed 30.4 million employment tax returns,⁴ and deposited $1.4 trillion of the $2 trillion in tax revenue that the IRS collected.⁵

The IRS uses penalties to encourage voluntary compliance.⁶ Indeed, penalties are an important tool in collecting the proper amount of revenue. Taxpayers who do not follow the rules for depositing employment taxes are subject to the FTD penalty.⁷ The rate of taxpayer compliance with the tax laws in 2001 ranged from 83.4 percent to 85.0 percent.⁸ However, when wages paid to employees are subject to withholding and third-party reporting, the compliance rate increases to almost 100 percent.⁹ This statistic underscores the importance of tax withholding and collection at the source by employers. Basically, when a taxpayer knows the IRS is aware of a tax payment, the taxpayer will generally report it on his or her return.

Federal Tax Deposit Rules and Regulations

IRC § 6302 grants the Secretary of the Treasury broad authority to determine the time and method for collection of federal taxes. The Secretary has the additional authority to designate financial institutions as depositaries or financial agents to accept tax payments and establish an electronic fund transfer system for collection of depository taxes.

In general, there are two schedules for depositing employment taxes -- monthly and semi-weekly.¹⁰ An employer's deposit schedule for a calendar year is based on its employment tax reporting history during a 12-month look-back period ending on June 30 of the preceding year.¹¹ An employer must make monthly deposits if the aggregate amount of employment tax reported in the look-back period is $50,000 or less, and must deposit employment taxes accrued in a calendar month by the 15th day of the following month.¹²

An employer must make semi-weekly deposits if the aggregate amount reported in the look-back period is greater than $50,000. Semi-weekly depositors have three banking days in which to make deposits.¹³

The following are exceptions to the deposit rules:

• One-Day Deposit Rule. Employers that accrue $100,000 or more in employment taxes within a deposit period (monthly or semi-weekly) must deposit the taxes with a financial institution by the close of the next banking day.¹⁴ A monthly depositor that makes a next-day deposit automatically becomes a semi-weekly depositor for the remainder of the calendar year and the following year.¹⁵

• Safe Harbor Rule. When an employer fails to deposit the full amount of tax due, the employer will be considered to have satisfied its deposit obligation if the amount of its shortfall does not exceed the greater of $100 or two percent of the amount of employment taxes required to be deposited.¹⁶ The employer is required to make up the difference on or before the "shortfall make-up date."¹⁷

• De Minimis Rule. If the total accumulated employment taxes for the return period are less than $2,500 and the amount is fully deposited or remitted with a timely filed return for the return period, the amount deposited will be deemed timely deposited.¹⁸

Generally, taxpayers do not make payments directly to the IRS but to an authorized bank depositary.¹⁹ Taxpayers submit a Form 8109, Federal Tax Deposit Coupon Book, or use the Electronic Federal Tax Payment System (EFTPS).²⁰ Some taxpayers are mandated to use electronic fund transfer (EFT) when their total depository taxes (such as employment tax, excise tax, and corporate income tax) exceed the $200,000 threshold.²¹ Once a taxpayer is required to make deposits using EFT, he or she must make all future deposits by EFT, regardless of whether the threshold is reached in each calendar year.²²

Failure to Deposit Penalty

When employers do not follow the rules for depositing employment taxes, they are subject to a Failure To Deposit penalty.²³ The IRS may impose the FTD penalty if a taxpayer does not deposit the correct amount of tax when due and in the appropriate manner, unless the taxpayer can show that failure is due to reasonable cause and not willful neglect.²⁴ The applicable penalty is two percent if the deposit is one to five days late; five percent if the deposit is six to 15 days late; 10 percent if the deposit is more than 15 days late; and 15 percent if the deposit is not paid within 10 days of the date of the notice of demand for payment.²⁵ Taxpayers who deposit the correct amount but use the wrong method (e.g., not using the EFTPS when required to do so) are subject to a 10 percent FTD penalty.²⁶

Failure to Deposit Penalty Waivers and Abatements

Under the provisions of IRC § 6656(c), the IRS may waive an FTD penalty on a person's inadvertent²⁷ failure to deposit any employment tax, if:

IRC § 6656(e) gives taxpayers the ability to designate the allocation of payments to minimize multiple penalty assessments. For deposits made after December 31, 2001, the IRS automatically applies deposits to the most recent period unless the taxpayer designates otherwise. The taxpayer has 90 days from the date of the penalty notice to contact the IRS to designate the application of its deposits for a specific tax period to minimize the FTD penalty.²⁹

Complexity of the Federal Tax Deposit Rules and Regulations

The framework for the current federal employment tax deposit rules and regulations was borne out of an earlier set of rules and regulations that were unduly complicated and cumbersome.³⁰ The former deposit rules caused IRS employees significant problems, particularly with respect to the application of FTD penalties.³¹ IRS employees cited complexity of the law, difficulty in computing penalties, and lag time in implementing computerized changes in computation as areas that created difficulties.³² The IRS recognized that this level of complexity resulted in unintentional noncompliance and sought to simplify the rules and regulations in the early 1990s.³³

Today, however, the rules and regulations governing employment tax deposits continue to present compliance and administrative challenges for employers and the IRS alike, frustrating taxpayers and draining IRS resources.

TAS has repeatedly raised concerns regarding the administration of employment tax penalties. In her 2003 Annual Report to Congress, the National Taxpayer Advocate recommended the IRS assemble a team or group to perform a comprehensive analysis of the federal tax deposit system, identify problems encountered by taxpayers, and recommend measurable solutions that would lessen taxpayer burden.³⁹

In response, the IRS Office of Penalty and Interest Administration (OPIA) convened a task group to address systemic assessments and abatements of FTD penalties. The group included representatives from IRS operating divisions, OPIA, and TAS. The task group identified several factors that contribute to the high assessment rates and offered six recommendations to improve IRS processes, taxpayer education, notices, and forms.⁴⁰

Abatement Rate of FTD Penalties

We commend the IRS for addressing these issues, but note that FTD penalty abatement is still a problem. In fiscal year 2004, the IRS abated 23 percent of the FTD penalties and 61 percent of the dollars it originally assessed. As Table 1.10.1 shows, the number of FTD penalties assessed decreased slightly but steadily from FY 2002 to FY 2004, but the percentage of penalties abated remains unacceptably high.

    TABLE 1.10.1, FTD PENALTY ASSESSMENTS AND ABATEMENTS⁴¹

Assessing FTD penalties only to abate them later is an inefficient use of IRS resources. The IRS needs to determine why so many FTD penalties are abated, and commit to lowering the abatement rate significantly. The IRS should research the cause of FTD penalty assessments, especially where taxpayers encounter recurring problems. For example, the IRS could study this population's filing and depositing history and target those taxpayers with appropriate educational and outreach material on the FTD requirements.

Complexity Baffles Taxpayers and IRS Employees Alike

Although the IRS mission includes helping taxpayers understand their tax responsibilities, the IRS does little to help taxpayers determine why they continually incur FTD penalties and how to avoid them.⁴³ In some instances, the IRS fails to inform the taxpayer when it waives an FTD penalty.⁴⁴ Educating taxpayers about these penalties can help them avoid future errors.

IRS employees are equally challenged by the procedures and computations of FTD penalty administration. In fiscal years 2004 and 2005, TAS received numerous reports of problems regarding FTD penalty calculations from TAS and IRS operating division employees. Generally, employees identified cases where taxpayers deposited withheld taxes timely but the IRS computer posted the deposits late, causing an FTD penalty to be assessed. In cases involving Form 945, Annual Return of Withheld Federal Income Tax, taxpayers make frequent (sometimes daily) deposits, but the computer fails to recognize the frequent payment method or otherwise misapplies the payment, resulting in an FTD penalty assessment. One employee commented that because of the amount of work involved in figuring out the correct FTD penalty and IRS computer limitations, IRS employees may be inclined to deny FTD penalty abatement requests.

Administration of Penalty Relief

Another significant problem with FTD penalty administration relates to the relief provided for cascading penalties. The IRS Restructuring and Reform Act of 1998 (RRA 98) provided relief for taxpayers by allowing them to designate the period to which a payment will be applied. Further, for deposits made after December 31, 2001, the IRS is supposed to automatically apply deposits to the most recent period unless the taxpayer designates otherwise.⁴⁵ Taxpayers have 90 days from the date of the penalty notice to contact the IRS to designate the application of its federal tax deposits for a specific tax period to minimize the FTD penalty.⁴⁶

The IRS has experienced difficulty administering FTD penalty relief. In some instances, procedures are so unclear and confusing that IRS customer service representatives (CSRs) have adopted their own interpretation. TAS has learned of instances where CSRs have designated payments without the taxpayer's consent.⁴⁷ While this may benefit the impacted taxpayers, it exposes the difficulties and challenges the IRS faces in administering the tax law consistently and fairly.

IRS Correspondence with Taxpayers

Because employment tax rules are so confusing, the IRS must use plain language when communicating with taxpayers and provide sufficient information for taxpayers to respond properly. Dealing with penalty notices is an expensive and lengthy process for employers, especially when the notices contain unclear, incomplete, or incorrect information.⁴⁸

CP 207 Notice

The CP 207 is one of the many confusing notices the IRS sends to taxpayers to inform them of problems with tax returns. The notice indicates that the Schedule B to Form 941 is missing, incomplete, or illegible, but does not specifically inform the taxpayer how to cure the defect, and threatens to impose a penalty if the taxpayer fails to act. The vagueness of the notice often leads to unnecessary communication between the taxpayer and the IRS.

For certain taxpayers, the IRS will assess the FTD penalty and issue the first collection notice without generating a CP 207 seeking additional information.⁴⁹ For example, employers who have a balance due or credit balance are not afforded an opportunity to resolve the matter prior to assessment. These taxpayers should be afforded the same opportunity to correct the problem before the IRS assesses FTD penalty.

CP 136 Notice

A 2002 TAS study revealed that notification of changes in deposit schedules was one of the major problems for taxpayers trying to comply with FTD requirements.⁵⁰ The IRS sends out more than 1.3 million CP 136 notices each year to inform taxpayers of changes to their deposit schedule and method of deposit for Form 941, Employer's Quarterly Tax Return, and each year the taxpayers, practitioners, and IRS employees encounter significant problems.⁵¹ Taxpayers who rely on the instructions on the notice may still incur penalties for using the wrong deposit schedule. The IRS position is that it remains the taxpayer's responsibility to determine its deposit schedule and the notice is for informational purposes only.⁵²

IRS Efforts to Reduce the Compliance Burden

Over the years, the IRS has attempted to reduce taxpayer burden, educate taxpayers about their responsibilities, and improve customer service. In fiscal years 2004 and 2005, the IRS launched a number of initiatives to simplify employment tax compliance. The IRS redesigned tax forms, waived FTD penalties, and offered incentives to reduce common errors that caused penalties. In fiscal year 2006, the IRS plans to introduce a new employment tax filing program to reduce burden for the smallest employers.

We applaud the efforts to improve customer service and reduce taxpayer burden, but question whether some of these initiatives will result in more complexity and taxpayer frustration.

Employers' Annual Federal Tax Program

In 2006, the IRS will launch its new Employers' Annual Federal Tax Program for employers who owe $1,000 or less in employment taxes per year. Employers who meet the criteria will be mandated to file employment tax returns annually rather than quarterly. The IRS estimates that 950,000 of the more than six million Form 941 filers will be eligible for the new program.⁵³ This group of employers will be required to file Form 944, Employer's Annual Federal Tax Return, and pay their annualized employment tax liability by January 31st of each year. The first Form 944 will be due January 31, 2007.

While we commend the IRS for its efforts to reduce taxpayer burden, we question whether the benefits of the program outweigh the burdens imposed on taxpayers. It is undeniable that a new program, attendant with new forms and new rules aimed at a specific subset of taxpayers, increases complexity. Affected taxpayers may not feel that the IRS has eased their employment tax paperwork burden.

The National Taxpayer Advocate is also concerned about the program's potential "yoyo" effect, given its mandatory nature. Small business employers who straddle the $1,000 threshold for annual employment tax liability will not know with any certainty whether they must file quarterly or annually.⁵⁴ Employers who anticipate that their annual employment tax liability will exceed $1,000, or who want to opt out to electronically file Form 941, must contact the IRS by April 1st of that year to change their filing requirement from Form 944 to Form 941. Taxpayers calling after April 1st will be told they must remain Form 944 filers for the year. If this population undergoes significant "churning" (i.e., alternating between quarterly and annual filing), the initiative could increase the number of FTD penalties and abatements.

Further, if an employer's total tax liability exceeds the threshold amount for annual filing, the employer is responsible for knowing whether it must make deposits in accordance with the appropriate schedule (monthly or semiweekly, if over the de minimis threshold of $2,500). Employers will be required to monitor this situation because they may be subject to an FTD penalty if deposits are not made appropriately.

The National Taxpayer Advocate recommends that the IRS test the Employers' Annual Federal Tax Program on a statistically valid sample of taxpayers before making these changes mandatory to determine if the benefits of taxpayer burden reduction outweigh the costs of increased complexity. The potential impact of this program on very small businesses is cause for concern because the cost and difficulty of complying with the tax code can be overwhelming for these taxpayers.⁵⁵

Incentives to Use EFTPS

FTD penalty transactions are among the highest volume and most adjusted tax transactions for small businesses. In fiscal year 2001, the IRS issued approximately 1.2 million notices to taxpayers indicating that FTD coupons (Form 8109) were incomplete or contained errors, resulting in late or misapplied payments and an assessment of FTD penalties. The volume decreased incrementally after the IRS revised the form in 2002. By fiscal year 2005, the number of FTD penalty notices fell to approximately 826,000.

The IRS believed the number of errors would be reduced significantly if business taxpayers used the Electronic Filing and Tax Payment System (EFTPS). In fiscal year 2004, the IRS launched EFTPS Express Enrollment for New Businesses, which automatically enrolls a new business in EFTPS when it applies for an employer identification number. However, use of EFTPS did not rise as much as anticipated, possibly due to some employers (1) not having any employees at that time; (2) preferring to use the paper coupon; (3) not having access to a computer; or (4) not wanting the IRS to have access to their bank account information.⁵⁶ In FY 2004, 4.6 million businesses were enrolled in EFTPS; by end of FY 2005, 5.9 million businesses had enrolled.⁵⁷

Redesign of Form 941 and Schedule B

The IRS recognized that employers were making a significant number of errors on Form 941, Employer's Quarterly Tax Return, and Schedule B, Report of Tax Liability for Semiweekly Schedule Depositors, in part because many did not understand the difference between semi-weekly and monthly deposit schedules.⁵⁸ In February 2005, the IRS unveiled a rewritten and redesigned form and schedule that was intended to make the instructions more clear and simplify deposit reporting by adopting the method used by most employers and practitioners to calculate wages and taxes.⁵⁹

However, initial results have been less than stellar. The processing of the first quarter filing of the newly redesigned Form 941 and Schedule B revealed a high error rate. Historically, the error rate on Form 941 returns had been around five percent. The initial error rates for the newly redesigned Form 941 and Schedule B nearly tripled (13.9 percent in the Ogden campus and 14.6 percent in the Cincinnati campus).⁶⁰

The National Taxpayer Advocate recognizes that it is reasonable to expect more errors in the first quarter of processing a new form, but remains concerned about the increased error rate and how the changes will impact the more than 6.6 million employers required to file Form 941. She encourages the IRS to monitor the process to ensure that the redesigned Form 941 and Schedule B are working as intended. The continuing changes to the employment tax depositing, filing, and reporting process bring pressure on employers to keep up or face penalties. Ironically, for many employers, keeping up with all of the various "burden reduction" initiatives results in increased burden.

IRS COMMENTS

The IRS realizes certain taxpayers find the requirements for depositing their Federal Employment Taxes confusing and has continued its efforts to provide educational material to business taxpayers, as well as clearer instructions and publications. The IRS also has continued its efforts to reduce the burden on taxpayers where possible.

Complexity of the Federal Tax Deposit Rules & Regulations

Abatement Rate of FTD Penalties

There has been a steady decrease in the number of FTD penalties assessed/abated and the related dollars in those categories. The IRS acknowledges the high dollar abatement rate, but that was addressed by the Office of Penalties and Interest and TAS' 2004 Task Group's six recommendations. We believe that full implementation of these recommendations in 2006 and 2007 will impact the dollar abatement rate.

The IRS continues to address educational elements that can help taxpayers avoid FTD penalties, but also recognizes that some businesses choose to use withheld taxes to continue business operations. Some of those taxpayers would rather pay the penalty than deposit the funds timely.

Complexity Baffles Taxpayers and IRS Employees Alike

The IRS provided information in the 2005 Publication 15, Circular E; advising taxpayers on how to properly complete the Record of Federal Tax Liability (ROFTL), Schedule B or the Monthly Liability and of ways to avoid an averaged FTD penalty and will issue the information notice (CP 276) in 2007 advising taxpayers that the penalty was due but not assessed due to an administrative waiver.

IRS employees have comprehensive job aids available to properly compute an FTD penalty. Those instructions, along with IDRS Command Codes, allow employees to properly apply deposits against the correct liabilities to compute an FTD penalty.

Administration of Penalty Relief

The instructions for granting a decrease to the FTD penalty, based on the taxpayer's redesignation of deposits against liabilities, are clearly covered in the Job Aid available to all IRS employees. The instance where one site's employees were designating without taxpayer consent was addressed in an alert issued on November 4, 2005. IRS employees are provided annual training, which covers FTD penalties.

IRS Correspondence with Taxpayers

CP Notices 207 & 136

The CP Notice 136 was reviewed to improve the wording of the notice using a more "plain English" style. The opportunity to reduce the complexity of the language is somewhat limited by the federal tax deposit requirements themselves; nevertheless, the 2006 version of this notice will be more "user friendly" than previous versions reviewed by the National Taxpayer Advocate. The 2006 version will show the four look-back quarters' net taxes, so taxpayers will know what IRS records indicate and can contact the IRS regarding any discrepancies. In addition, we will work on using a more "plain English" style for the 2007 CP 207.

IRS Efforts to Reduce the Compliance Burden

Employers' Annual Federal Tax Program

In developing the Employers' Annual Federal Tax Return Program (Form 944), the IRS considered the National Taxpayer Advocate's recommendation to run a "test" of the program. After careful deliberation, the IRS decided to deploy the program for all taxpayers who owe $1,000 or less in total Employment Tax annually. Various small businesses entities are extremely pleased that the IRS is offering this program and have asked the IRS to explore raising the eligibility threshold.

As to whether a taxpayer will know whether he or she can file a 944 and when to deposit, the IRS will send notices and information to all eligible "944" taxpayers regarding their 944 filing requirement. The eligibility extract, run on November 21, 2005, identified approximately 646,000 taxpayers for the 2006 annual filing program. The IRS estimates another 150,000 new businesses may be eligible as well as an estimated 150,000 businesses that "reactivate," both of which will be advised in writing of their eligibility.

The IRS also recognizes that some businesses will grow and the taxpayer may need to make FTDs. Historic data indicates this may be six to seven percent of the population, but, similar to the filing provision for farmers (Form 943), all taxpayers need to be aware of their accruals and make FTDs as appropriate. In addition, included in the 944 regulations is a safe harbor provision for those who "grow out" of 944 and must make monthly deposits in the subsequent year, allowing them to deposit their January 2007 FTD with their February deposit by March 15, 2007, without incurring any late deposit penalty.

Incentives to Use EFTPS

The EFTPS/FTD Penalty Refund initiative brought in 87,644 taxpayers who enrolled in EFTPS, made timely EFTPS deposits for four quarters and received one-time FTD penalty abatements of $56,056,619.05 through December 8, 2005. This initiative was offered to taxpayers not required to use EFTPS and who had been penalized for making late FTDs using coupons (Form 8109) or sending payments directly to the IRS.

Redesign of Form 941 and Schedule B

In a transition year, a temporary spike in errors is normal as taxpayers and practitioners learn about any new form. By far, the most common error IRS has encountered with the redesigned Form 941 is the failure to sign the form on the appropriate signature line or to sign the form at all. This confusion results from the new signature line and other information requested of paid preparers, which was added to enhance preparer compliance.

To deal with the failure to sign the Form 941 on the correct line or at all, the IRS has made certain changes to the Form 941 that will be published for the tax year 2006. These changes include a larger signature line, a bigger "X" next to that line, and changes to the paid preparer section to ensure taxpayers who self-prepare better understand that they do not sign in this section.

IRS efforts at reducing burden are in response to requests from taxpayers, practitioners, the Small Business Administration and others, virtually all of whom have strongly endorsed the Form 941 redesign effort and the resultant redesigned Form 941. The IRS tested the redesigned form extensively using focus groups and cognitive testing. The 8th grade education standard was used for the form and its instructions and a nationally recognized "plain language" expert was employed in the redesign effort. In addition, a representative from TAS was on the redesign team and helped to craft the final product.

The IRS will continue to monitor Form 941 trends to determine that the forms are working as intended and whether the changes made to the 2006 revision of Form 941 are reducing the confusion with signatures.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate commends the IRS for its efforts to help taxpayers comply with federal employment tax rules and regulations and avoid FTD penalties. She recognizes that the IRS is making a concerted effort to simplify employment tax forms, instructions and tax publications. Further, she appreciates the invitation extended to the Taxpayer Advocate Service to participate on cross-functional teams charged with carrying out these efforts.

Complexity of the Federal Tax Deposit Rules and Regulations

In her 2004 report, the National Taxpayer Advocate identified the confounding complexity of the tax code as the most serious problem facing taxpayers and the IRS alike.⁶¹ The rules and regulations governing federal employment tax deposits are complex and do present significant challenges for taxpayers and the IRS. Small business taxpayers in particular struggle to keep pace with the federal employment tax requirements in a constantly changing and uncertain tax environment.

Abatement Rate of FTD Penalties

The National Taxpayer Advocate applauds the IRS's efforts to help taxpayers avoid FTD penalties. She understands that the IRS will implement recommendations from the 2004 FTD Penalty Task Group to further reduce the number of high dollar FTD penalties, but urges the IRS to do more.

The IRS should identify and study the characteristics of the population of taxpayers who experience recurring FTD penalty problems. The IRS should determine why certain taxpayers repeatedly incur these penalties and the penalties are subsequently abated. The IRS should also focus its efforts on taxpayers who repeatedly incur and pay FTD penalties. The IRS should target these groups with specific messages and implement strategies to reverse the trends including doing routine follow ups.

IRS Correspondence with Taxpayers

CP Notice 136

The rules for depositing federal employment taxes are complex and create challenges for the IRS to communicate clearly and effectively about them. The National Taxpayer Advocate acknowledges the IRS efforts to improve the Annual Notice of Federal Tax Deposit Requirements (CP 136 notice). This notice is one of a series of early intervention notices the IRS uses to help taxpayers meet their depositing requirements and avoid FTD penalties.

Unfortunately, each year there are problems with the notice. For example, the CP 136 notices sent out in late 2005 contained look-back information for the 2006 tax year, but contained references to the 2005 tax year. In 2004, the notices included incomplete tax liability information, which was used to determine a taxpayer's deposit schedule. We urge the IRS to make every effort to ensure the correct information is sent out to taxpayers so that it can avoid costly errors that impact both employers and the IRS alike.

CP Notice 207

We strongly believe the IRS can improve the clarity of the notice, but agree with the agency's position that the opportunity to reduce the complexity of the language is somewhat limited by the federal tax deposit requirements. We applaud the decision to use a "plain English" style for the 2007 version of the notice.

IRS Efforts to Reduce the Compliance Burden

Employers' Annual Federal Tax Program

We are disappointed by the IRS decision to implement this new program without sufficient testing. This is a major change for nearly one million of the very smallest businesses and contains some risk of increasing payment noncompliance. The Taxpayer Advocate Service will monitor the implementation of this program to ensure that the risks are minimized.

Incentives to Use EFTPS

The EFTPS/FTD Penalty Refund initiative is an innovative approach to increasing EFTPS enrollment, resulting in the abatement of $56 million in FTD penalties. The National Taxpayer Advocate supports the IRS's efforts to increase use of EFTPS. However, she remains concerned about another initiative -- EFTPS Express Enrollment for New Businesses. New businesses are not activating their EFTPS accounts as expected. And some taxpayers continue to prefer using the paper coupon. Conducting focus groups with these taxpayers and their preparers may help to identify new incentives to move those employers to EFTPS. TAS will be pleased to assist the IRS in this research.

Redesign of Form 941 and Schedule B

Forms are a bridge between taxpayers and the tax law, enabling taxpayers to comply in a consistent manner.⁶² The National Taxpayer Advocate commend the IRS for simplifying the Form 941 and Schedule B, Report of Tax Liability for Semiweekly Schedule Depositors. We recognize that a temporary spike in errors is to be expected in a transition year as taxpayers and practitioners learn about the new form. We are especially pleased that the IRS will continue to monitor Form 941 trends to determine that the forms are working as intended and whether the changes made to the 2006 revision of Form 941 are reducing the confusion with signatures.

RECOMMENDATIONS

The National Taxpayer Advocate makes the following recommendations to the IRS to improve its administration of the employment tax deposit process:

• The IRS should conduct research to determine why so many FTD penalties are abated, and commit to lowering the abatement rate significantly.

• The IRS should use plain language when communicating with taxpayers and provide sufficient information for taxpayers to respond properly.

• The IRS should test the Employers' Annual Federal Tax Program on a statistically valid sample of taxpayers before making these changes mandatory to determine if the benefits of taxpayer burden reduction outweigh the costs of increased complexity.

• The IRS should monitor the compliance rates of taxpayers using the redesigned Form 941 and Schedule B to determine if the improvements are working as intended.

² IRS, Data Book 2004, Table 27.

³ IRC §§ 3101, 3102, 3111 -- 3113, and 3121 -- 3128 (Federal Insurance Contributions Act); IRC §§ 3201, 3202, 3211, 3221, 3231 -- 3233 and 3241 (Railroad Retirement Tax Act); IRC §§ 3301 -- 3311 (Federal Unemployment Tax Act); IRC §§ 3401 -- 3407 (collection of income at source on wages); IRC §§ 3501 -- 3511 (general provisions related to employment taxes); IRC § 6011 (general requirement of return, statement, or list); IRC § 6051 (receipt for employees); IRC § 6302(g) (deposits of Social Security taxes).

⁴ IRS, Data Book 2004, Table 2.

⁵ IRS, Data Book 2004, Table 1.

⁶ IRS Penalty Policy Statement (P-1-18) (August 1998).

⁷ The FTD penalty is assessed under IRC § 6656. See Treas. Reg. § 301.6656-1 for a complete explanation of federal tax deposit rules for withheld income taxes and taxes under FICA.

⁸ The estimated noncompliance rate was is in the range of 15.0 percent to 16.6 percent for tax year 2001. IRS National Headquarters Office of Research, Tax Gap Facts and Figures, (March 29, 2005).

⁹ IRS National Headquarters Office of Research, (July 2004.)

¹⁰ Treas. Reg. § 31.6302-1.

¹¹ For example, the look-back period for calendar year 2005 is the four calendar-quarters from July 1, 2003, through June 30, 2004. See Treas. Reg. § 31.6302-1(b)(1).

¹² Treas. Reg. § 31.6302-1(c)(1).

¹³ Employers with payment dates that fall on Wednesday, Thursday, or Friday must deposit the employment taxes on or before the following Wednesday. Employers with payment dates that fall on Saturday, Sunday, Monday, or Tuesday must deposit employment taxes on or before the following Friday. If any of the three weekdays following the close of a semi-weekly period is a holiday, then the employer will have an additional banking day to make the deposit. Thus, the term "semi-weekly" does not mean the taxes must be deposited twice per week, but only that the week is divided in half for the purposes of determining when a deposit is due.

¹⁴See IRC § 6302(g): Treas. Reg. § 31.6302-1(c)(3).

¹⁵ Treas. Reg. § 31.6302-1(b)(2)(ii).

¹⁶ Treas. Reg. § 31.6302-1(f)(i).

¹⁷ Treas. Reg. § 31.6302-1(f)(ii).

¹⁸ Treas. Reg. § 31.6302-1T(f)(4). Over the years, the IRS has increased the threshold for depositing employment taxes to simplify the rules for small businesses. In 1993, the threshold amount was $500. In June 1998, the IRS raised the threshold amount to $1,000. In 2001, the IRS raised the threshold from $1,000 to $2,500.

¹⁹ Taxpayers can mail or deliver a check to a financial institution. Taxpayers accruing less than $2,500 in tax liability (reduced by any advanced earned income credit) during the quarter can remit payment when filing the employment tax return. See Treas. Reg. § 31.6302-1(f)(4).

²⁰ IRC § 6302(h).

²¹See Treas. Reg. § 31.6302-1(h)(2)(i)(A). Taxpayers required to begin paying federal taxes electronically through EFTPS will receive notification from the IRS. The notification includes an EFTPS taxpayer enrollment form with instructions for completing the enrollment process.

²²See Treas. Reg. § 31.6302-1(h)(2)(C)(ii).

²³ IRC § 6656 sets forth the provisions for failure to deposit penalty.

²⁴ IRC § 6656(a).

²⁵ The date of the notice of demand for payment is either the date on which a notice is issued under IRC § 6303 or the date on which the IRS issues an immediate demand for payment (in jeopardy cases).

²⁶See IRC §§ 6302 (h) and 6656 (a). In her 2004 Annual Report to Congress, the National Taxpayer Advocate proposed a legislative recommendation to amend IRC § 6656 to clarify that (1) the reasonable cause exception to the FTD penalty shall specifically apply to instances where a taxpayer has made a timely deposit, but failed to make the deposit in the prescribed manner and such failure is not due to willful neglect; and (2) in no circumstance shall the FTD penalty exceed two percent of the underpayment amount when a taxpayer has made a timely deposit, but failed to make the deposit in the prescribed manner. See also National Taxpayer Advocate 2001 Annual Report to Congress 222; H.R. 1528, 108th Cong. (2004).

²⁷ The IRS will determine if a failure to deposit is inadvertent based on all the facts and circumstances.

²⁸ Section 3304(b) of RRA 98 expanded the waiver for first-time depositors subject to a change in deposit frequency.

²⁹ IRC § 6656(e)(1).

³⁰ Under the deposit rules and regulations effective prior to January 1, 1993, employers had to monitor and accumulate employment taxes from payday to payday until one of four separate deposit rules (quarterly, month, eight-monthly, or daily) was triggered. Deposit requirements could change from month to month, depending on the amount of taxes accrued.

³¹ IRS Research Division, Final Report on Penalty Desk Guide Focus Groups (March 1991).

³²Id.

³³ General Accounting Office (now Government Accountability Office), GAO/GGD-95-8, GAO Reports on Revision of Federal Employment Tax Deposit Regulations 4 (December 29, 1994).

³⁴ When taxpayers file Form 941, they may be required to file a Schedule B, Report of Tax Liability for Semiweekly Schedule Depositors. Taxpayers are required to list their tax liability for each day including the income tax withheld from employees paycheck and both employee and employer Medicare and social security taxes. The IRS uses the Form 941 return information, the Schedule B, and deposit records to determine if the taxpayer has deposited the correct amount of taxes on time and in the right manner. The IRS matches the tax liability information listed on the Schedule B to the payment information from the taxpayers' deposits. If the Schedule B is incorrect, incomplete, or missing, the IRS will assess an FTD penalty.

³⁵ Treasury Inspector General for Tax Administration, Ref. No. 2005-30-136, Federal Tax Deposit Penalties Have Been Significantly Reduced, but Additional Steps Could Further Reduce Avoidable Penalty Assessments 3-4 (September 2005).

³⁶ IRS, Data Book 2004, Table 27.

³⁷ FTD penalty issues are the highest volume and most adjusted set of transactions for the Small Business/Self-Employed Division. IRS, SB/SE Federal Tax Deposit Penalty Improvement Project Team Report (October 21, 2002).

³⁸Id.

³⁹ National Taxpayer Advocate 2003 Annual Report to Congress 204.

⁴⁰ The task group issued a final report in March 2005 with six recommendations:

⁴² Department of the Treasury Office of Tax Policy, Report to the Congress on the Penalty and Interest Provisions of the Internal Revenue Code (Doc 1999-34492) (October 1999).

⁴³ Treasury Inspector General for Tax Administration, Ref. No. 2005-30-136, Federal Tax Deposit Penalties Have Been Significantly Reduced, but Additional Steps Could Further Reduce Avoidable Penalty Assessments 3-4 (September 2005).

⁴⁴ When the IRS waives FTD penalties, it does not inform taxpayers that the amount falls below the administrative tolerance amount.

⁴⁵ Pub. L. No. 105-206, § 3304(c) (1998). The IRS states that in certain situations (five percent of all penalties assessed) the application of deposits to the most recently ended tax deposit period will not always eliminate cascading penalties and may actually lead to higher penalties than the FIFO method.

⁴⁶ IRC § 6656(e)(1).

⁴⁷ E-mail from instructor cadre on most recent payment allocation method job aid (October 13, 2005).

⁴⁸ Treasury Department, Office of Tax Policy, Report to Congress on Penalty and Interest Provisions of Internal Revenue Code 222 (October 1999).

⁴⁹ IRM § 20.1.4.11.5 (Rev. 09-10-1999).

⁵⁰ National Taxpayer Advocate 2002 Annual Report to Congress 116.

⁵¹ IRM § 21.3.1.4.76. CP 136, Annual Notification of FTD Requirements, is issued yearly to filers of Form 941 and 941SS to advise the employer of which deposit method to use for the upcoming calendar year. In calendar years 2005, the IRS sent 1,366,003 notices advising taxpayer of their deposit schedule for 2006.

⁵² One SB/SE manager commented that the IRS is "telling them [taxpayers] one thing, and then holding them to another." Memo from SB/SE compliance manager (November 26, 2002), on file with TAS Office of Systemic Advocacy.

⁵³ SB/SE Research, 944 Program Extract Chart (November 4, 2005).

⁵⁴ The IRS estimates that 130,000 of the 950,000 businesses eligible for annual filing will increase and outgrow the $1,000 threshold amount by the following year. SB/SE Research, 944 Program Extract Chart (November 4, 2005).

⁵⁵ In 2000, the typical small business with fewer than 20 employees spent over $1,200 per employee to comply with tax paperwork, recordkeeping, and reporting requirements. Testimony of Thomas Sullivan, Chief Counsel for Advocacy of Small Business Administration, before the U.S. House of Representatives Committee on Small Business (April 27, 2005).

⁵⁶ E-mail from SB/SE TEC (EFTPS Group) (September 21, 2005).

⁵⁷ IRS Electronic Tax Administration, e-Submissions Statistical Dashboard (July 2005).

⁵⁸ IRS Form 941 Redesign Team, A Review of Our Recommendations -- IRS Form 941 Employer's Quarterly Federal Tax Return (February 19, 2002).

⁵⁹See IRS Introduces Redesigned Employment Tax Return, Tax Notes Today, 2005 TNT 36-9 , (Feb 23, 2005); TaxTalk Today Discusses New Form 941 and Year-End, Payroll Guide Newsletter, 2004 WL 2709175 (RIA).

⁶⁰ E-mail from SB/SE Program Analyst on the results of the First Quarter Filing of Form 941 (May 17, 2005).

⁶¹ National Taxpayer Advocate 2004 Annual Report to Congress 2.

⁶² Written Testimony of Commissioner of Internal Revenue Service Mark Everson before the Committee on Government Reform's Subcommittee on Regulatory Affairs, United States House of Representatives Hearing on Paperwork Burden 2 (May 25, 2005).

MOST SERIOUS PROBLEM: AUTOMATED COLLECTION SYSTEM LEVY RELEASES

RESPONSIBLE OFFICIALS

The IRS Automated Collection System (ACS) is a part of the IRS collection process that uses automated systems to collect from delinquent taxpayers via collection notices and in some cases by levies on taxpayer assets.¹ The ACS sites are supported by collection representatives who communicate with taxpayers by telephone. When the IRS and the taxpayer agree to certain collection alternatives, the Internal Revenue Code and Treasury Regulations require prompt release of any existing levies on taxpayers' property.² However, in too many cases, levy releases do not occur promptly or do not occur at all. This situation results in additional levies, which may constitute violations of the law, but certainly constitute violations of the agreements reached with taxpayers. Additionally, in too many cases, the IRS does not release property that has been levied upon in violation of the law, or in other cases, the property is returned only after the taxpayers surmount significant procedural hurdles.

ANALYSIS OF PROBLEM

Levies upon taxpayers who have entered into installment agreements or whose accounts have been designated as currently not collectible because of economic hardship are prohibited by the Internal Revenue Code.³ In a 2004 survey of Local Taxpayer Advocates across the country, inappropriate levies and untimely levy releases by the ACS were consistently ranked among the top most serious problems affecting taxpayers.⁴

Inappropriate levies can have a harmful effect on the IRS's efforts to bring noncompliant taxpayers back into compliance. For example, taxpayers who have entered into installment agreements with the IRS have done so in reliance upon the representation that existing continuous levies will be released and no new levies shall occur while the installment agreement is in place. When erroneous levies occur, the IRS fails to honor its representations to the taxpayer. Likewise, when the IRS agrees to designate an account as currently not collectible (CNC) because of the taxpayer's economic hardship, it is acknowledging that the taxpayer cannot satisfy his or her basic living conditions.⁵ When erroneous levies occur, the IRS is exacerbating the problems of taxpayers in varying degrees of financial distress. In each instance, taxpayers may decide that because the IRS has not honored the terms of the agreement, the taxpayer need not.

Our analysis addresses three issues with respect to levy releases in the ACS:⁶

• Levies not released that should be released;

• Levies not released in a timely fashion; and

• Wrongfully levied property not returned.

Legal Requirements on Levy Releases and Return of Levy Proceeds

Installment Agreements

Installment agreements provide taxpayers the ability to make periodic payments to resolve outstanding tax liabilities.⁸ The IRS is prohibited from levying during certain times, including:

• The period when a proposed installment agreement is pending;⁹

• The period when an accepted installment agreement is in place;¹⁰

• For 30 days following the rejection of an installment agreement;¹¹

• For 30 days immediately following the termination of an installment agreement;¹² and

• The period while the matter is pending before the Office of Appeals. If the IRS rejects a proposed installment agreement and the taxpayer files a timely appeal to the Office of Appeals, the IRS cannot levy during the period while the matter is pending before the Office of Appeals.¹³

Accounts Designated as "Currently Not Collectible"

If the IRS determines that an account is currently not collectible (CNC), the IRS must promptly release the levy if it is causing an economic hardship for the taxpayer.¹⁵ In order to establish hardship for purposes of obtaining a CNC account designation, the taxpayer must demonstrate an inability to meet his or her basic living expenses.¹⁶

Return of Levied Upon Property

The IRS has the authority to return levied property to taxpayers under IRC § 6343(d)(2)(A)-(D) in certain situations where:

• The levy was premature or otherwise not in accordance with IRS administrative procedures;

• The taxpayer has entered into an agreement (unless the agreement provides otherwise);

• The return of such property will facilitate the collection of the tax liability; or

• The return of the property would be in the best interest of the taxpayer (as determined by the National Taxpayer Advocate) and the United States.

Automated Collection System (ACS)

The ACS collects delinquent taxes through a combination of human and automated processes. The ACS is only one component of the IRS collection process. Generally, the IRS collection process is comprised of three stages: the notice stream, the ACS, and the Collection Field Function (CFF). In the notice stream, the IRS typically sends a series of collection notices to taxpayers -- four notices to individual taxpayers and two to business taxpayers. If the taxpayer does not arrange to make payments during the notice stream, the account is assigned to either the ACS or to the CFF, depending on the type of tax and the taxpayer. The ACS typically handles most individual taxpayer accounts.

The ACS systems are programmed to search IRS databases for levy sources so that the IRS will be in a position to take levy action if the taxpayer does not make an effort to contact the IRS.¹⁹ Collection representatives are also trained to seek levy sources from taxpayers with whom they are in contact. When taxpayers exhaust or fail to make a timely request of their Collection Due Process rights, the IRS will levy on taxpayers' income or other assets. These levies can take many forms, including one-time bank account levies or continuous levies upon a taxpayer's income until the tax liability is satisfied.²⁰ When taxpayers realize their assets are being levied, they often contact the ACS to try to establish a collection alternative so that the levy can be released.²¹

Taxpayers encounter two related problems with levy releases. The first situation involves levy releases that are not processed at all and would not be released but for the persistence of the taxpayer or the intervention of TAS or some other function in the IRS. The other situation involves levy releases that are systemically processed in an untimely fashion.

Levies Not Released

When the IRS is determining whether to designate an account as CNC, the ACS employee typically takes the taxpayer's financial information over the phone. If the taxpayer provides sufficient information to demonstrate an economic hardship, the collection representative is authorized to designate the account as CNC while talking with the taxpayer. Levy releases in CNC hardship cases are supposed to result in an automatic levy release. However, the automatic levy release involves a week-long processing cycle. This one-week delay can result in additional levies on the taxpayer's wages or other property; thus, collection representatives are authorized to input manual levy releases to speed the levy release process.

As the collection representative is processing the CNC request, the ACS systems are programmed to prompt the representative with the query: "ANY LEVY RELEASES NEEDED?" This prompt was installed into IRS data systems for CNC cases as a result of a 2002 audit by the Treasury Inspector General for Tax Administration (TIGTA), which determined that levies were not being promptly released in economic hardship cases.²² While the IRS systems are designed so that levies are released automatically when a CNC hardship case is entered into the system, the levy release prompt acts as an extra safeguard to ensure levies are always released promptly in such cases.

A review of the Taxpayer Advocate Service's case inventory system (known as the Taxpayer Advocate Management Inventory System or "TAMIS") demonstrates that the number of inappropriate levies on CNC accounts has declined since 2003 when the levy prompt was added for economic hardship cases. However, a recent example provided by a Local Taxpayer Advocate demonstrates that taxpayers still encounter situations when the ACS fails to process levy releases for taxpayers encountering economic hardships.

There are similarities in the ACS process for evaluating accounts for CNC and for installment agreements, but there are also important differences. The processes are similar in that ACS collection representatives can enter into installment agreements with taxpayers over the phone provided the taxpayer has his or her financial information available. Certain installment agreements do not require managerial approval, and can therefore be processed relatively quickly.²⁴ Agreements falling outside the guaranteed and streamlined installment agreements require managerial approval.²⁵

Unlike CNC cases, however, processing levy releases for installment agreements requires the collection representative to manually input the levy release code. Thus, the likelihood of human error increases the chances of levies not being released. Moreover, the levy release prompt that has reduced inappropriate levies for CNC taxpayers suffering economic hardship is not available for collection representatives who are placing taxpayers into installment agreements. Consequently, the problems observed with CNC levy releases at the time of the 2002 ACS audit by the Treasury Inspector General for Tax Administration are still being experienced with installment agreements. Installment agreements are processed through the IRS Integrated Data Retrieval System (IDRS) rather than through the ACS system. Thus, the levy prompt added to the ACS system in 2003 does not facilitate levy releases in conjunction with installment agreements.

ACS sites communicate with millions of taxpayers annually, and not all taxpayers who call the IRS are attempting to enter into collection alternatives. Of those taxpayers who are trying to obtain collection alternatives, not all will seek to release a continuous levy. Both the IDRS and ACS systems need a systemic warning signal that will cause ACS collection representatives to assess whether a taxpayer who is entering into an installment agreement is experiencing an ongoing levy that needs to be released.

Local Taxpayer Advocates report numerous cases where the ACS did not release the levy according to procedures when a taxpayer entered into an installment agreement. The following example illustrates how the different parts of the IRS collection system do not effectively communicate to timely release ACS levies.

Levies Not Released Timely

The problem most frequently reported to TAS by taxpayers regarding levy releases involves the processing time. The Internal Revenue Code and accompanying Treasury Regulations require the IRS to release levies promptly when a taxpayer is suffering an economic hardship or when a taxpayer enters into an installment agreement.²⁶ Although the regulation does not define the term promptly, its ordinary meaning is "at once, immediately."²⁷

To begin the levy release process, a collection representative must input the levy release code on an account. If normal procedures are followed, the levy will not actually be released on IRS data systems until the close of the next processing cycle, i.e. one week. All levy releases input during the cycle are released at the end of the cycle. IRS procedures provide levy releases will then be mailed to the levy source, i.e. the employer or other source of taxpayer income.²⁸ Thus, standard levy release procedures can routinely take 10 days, including mailing time.

Levy release procedures may be expedited if a faster release is necessary to prevent over collection or to relieve hardship.²⁹ In that case, a manual levy release is processed by the collection representative and is faxed to the levy source. However, both the Wage and Investment Operating Division (W&I) and the Small Business/Self-Employed Operating Division (SB/SE) interpret this exception to mean the taxpayer must suggest the expedited procedures and prove the expedited relief is warranted. The predictable result is that taxpayers who will be subject to additional interim levies do not know enough to ask for the expedited procedures and others who ask for the expedited procedure will be turned down because the collection representative does not believe expedited procedures are warranted.

In another example provided by a Local Taxpayer Advocate, the taxpayer and ACS entered into an installment agreement that called for the IRS to release a bank account levy.³² The ACS representative insisted on mailing a levy release to a bank rather than faxing it and refused to fax a copy of the release to the taxpayer. The result was the levy release arrived at the bank after the funds in the account were sent to the IRS.

These cases suggest the ACS needs to conduct more training on IRC § 6343(a) with ACS employees. Additionally, the ACS should reverse the burden related to expedited procedures and presume taxpayers suffering economic hardships or entering into installment agreements need the levy released before their next paycheck is issued. The ACS should require its representatives to inform taxpayers about expedited procedures and ask for a fax number for the levy source. With the advent of fax machines, expediting levy releases when the taxpayer is suffering an economic hardship or has entered into an installment agreement should not be viewed as an excessive burden for the IRS. In fact, this taxpayer-friendly approach encourages compliance.

Return of Levy Proceeds

Another problem facing taxpayers working with the ACS is that in some cases, the IRS refuses to return funds levied in the interim period between the dates when a collection agreement is agreed to and when the levy source receives the levy release. The IRS's internal procedures previously acknowledged the systemic release process may be too slow to prevent over-collection and encouraged collection staff to take steps to prevent this situation. However, this section of the Internal Revenue Manual (IRM) was deleted in 2003.³³ In one recent TAS case, an ACS representative cited the deletion of IRM § 5.19.4.4.14 as a basis to retain funds levied during the interim period when an installment agreement was entered into and when the levy source received the levy release.

The IRS's internal procedures for permitting return of levied property follow IRC § 6343(d). That is, the IRM instructs the employee to return levy proceeds where the levy is premature, IRS procedures were not followed, an installment agreement is made for a liability included on the levy, returning the payment facilitates collection, or where returning the property is in the best interest of the taxpayer (as determined by the National Taxpayer Advocate) and the government.³⁴ The Treasury Regulations provide that it is in the best interests of the taxpayer and the IRS to return levy proceeds where there has been a violation of the law.³⁵ The IRS does not always release levies "promptly" (as is required by IRC § 6343(a)(1)(C) in cases where taxpayers enter into installment agreements or are suffering economic hardships) or "as soon as practicable" (as is required by IRC § 6343(e) in cases where the taxpayer and the IRS agree that the tax is not collectible). As the example below demonstrates, when the IRS levies on additional funds after agreeing to a levy release, it does not always readily agree to return the proceeds, even when it appears not to have satisfied the timeliness standard.

CONCLUSION

It is essential that the IRS acts to release levies in a timely fashion when taxpayers come forward to resolve their outstanding liabilities and either enter into installment agreements or demonstrate they are suffering economic hardships. The IRS can improve its levy release response by embedding a levy release warning for installment agreements on the IDRS. Additionally, the IRS should utilize expedited levy release procedures where possible so that the IRS does not take additional funds from taxpayers after agreeing that no further levies will occur. Finally, the IRS should provide additional training to ACS collection representatives to sensitize them to the importance of returning property levied upon in violation of the law. Although it may be a subjective judgment as to whether a levy release was "prompt" as the law requires, the IRS should err on the side of returning levied proceeds in cases where it has agreed that no further levies are warranted. As evidenced by examples in this Most Serious Problem, the IRS's failure to communicate levy release information ends up costing the IRS valuable collection, managerial, and TAS resources, not to mention imposing a significant burden on taxpayers who are trying to be compliant.

IRS COMMENTS

As recognized by the National Taxpayer Advocate, it is essential that the IRS release levies in a timely fashion when taxpayers either enter into installment agreements or demonstrate that they are suffering economic hardships. The IRS has multiple programming and procedural processes in place to address levy releases appropriately as required by the law.

Levies Not Released

The National Taxpayer Advocate's report notes that levy releases in currently not collectible (CNC) hardship cases should result in an automatic levy release. When the IRS determines an account is currently not collectible, the Automated Collection System (ACS) takes the appropriate actions, which can occur systemically or manually, to ensure prompt release of existing levies.

While the CNC levy release is an automatic prompt, levy releases for installment agreements require manual input. However, installment agreements are currently input directly through IDRS, so there is nothing on the ACS system at this time that would trigger a reminder to check for needed levy releases. As suggested by the Advocate, we will determine the feasibility of adding a systemic prompt for installment agreements.

Levies Not Released Timely

The Service is required to release levies promptly when a taxpayer is experiencing economic hardship. When a taxpayer enters into an installment agreement, if the terms of the agreement include partial payment from a wage or bank levy that is considered an initial payment towards the liability, the levy will be released through normal processing, unless economic hardship is determined.

ACS employees have the authority to provide a faxed copy of a levy release to the taxpayer and employer if circumstances warrant it, e.g., release needed to prevent overcollection or relieve hardship. Employees are aware of these procedures and make use of its capability when appropriate. W&I campuses have dedicated clerical staff to ensure that fax levy releases are provided when needed. However, if the taxpayer cannot furnish a fax number or contact number, the only option available is to mail the levy release.

To decrease the timeframe of releasing levies timely, a system enhancement will be implemented January 2006 that will update the levy release with the most current levy source address from the electronic levy system. This will prevent delays in levy releases reaching the most current third-party source.

The IRS has worked diligently to put processes and programming in place to reduce the instances of full paid accounts that continue to receive payments from the source:

• Effective January 2005, our systems were updated to generate transcripts for ACS Support (ACSS) when accounts are full paid and levy payments are received. Employees use Remittance Transaction Research to identify the source of the payment and send levy releases.

• We are working in partnership with Submission Processing Cashiers for accounts that are full paid to be identified and controlled on IDRS, then worked in ACS to determine the source of payment and issue the release. This process will become effective in FY 2006.

The report indicates that in some cases, IRS refuses to return funds levied between the date a collection agreement is agreed to and when the levy source receives the levy release. Additionally, the report asserts that ACS employees need additional training and guidance on levy releases and returning levied property. ACS employees explain the levy release process and its timing to taxpayers when they call requesting levy release. At that time, the assistor should address the timing issues between levy release issuance and IRS receipt of levy proceeds, and make those proceeds part of the collection agreement, if applicable. In those instances where the return of levy proceeds is appropriate, the IRM clearly outlines the procedures for our assistors. We feel the training material currently used for CPE adequately addresses the situations in which we should be releasing levies and returning funds. However, we will include a special emphasis on releasing levies promptly as well as the identification of situations in which consideration should be given to returning levy proceeds.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate is pleased that the IRS recognizes the importance that the levy release issue holds for taxpayers who have entered into installment agreements or for taxpayers who have demonstrated to the IRS that they are suffering economic hardships. We are also pleased that the IRS will study the feasibility of adding a systemic prompt for installment agreements in order to reduce the risk of levy release failure. In the case of installment agreements, we appreciate that the terms of the installment agreement will sometimes address the issue of levies in between the period when the installment agreement is approved and the levy is released. However, the IRS needs to consider that the Internal Revenue Code and governing Treasury Regulations require prompt levy release when an installment agreement is entered into. Thus, generally, the terms of installment agreements should not contemplate additional levies after the installment agreement is entered into.

With respect to timely levy releases, it is very encouraging that the IRS is implementing a new system enhancement that should reduce the levy release timeframe. With respect to expedited levy release procedures (i.e. where the ACS employees obtain a fax number for the levy source in order to fax the levy release), it is also important for ACS employees to consider the mind-set of taxpayers who have entered into an installment agreement or demonstrated an economic hardship. Most taxpayers do not understand IRS procedure nor do they always consider the processing time involved in levy releases. Thus, we again recommend that the IRS reverse the burden, which currently rests upon taxpayers to raise the issue of an expedited levy release. The IRS is in the best position to inform the taxpayer about expedited procedures and the implications of not sending a levy release by fax.

We are also very pleased that the IRS will include special emphasis on levy release procedure as part of its ACS training, and we offer the assistance of the Taxpayer Advocate Service for offering the "taxpayer perspective" on these issues. Such emphasis is particularly important now that the IRS is levying against Social Security benefits under both the Federal Payment Levy Program and ACS Systemic Levies since these elderly and disabled taxpayers are likely to experience economic harm as a result of an IRS levy.³⁸

² IRC § 6343(a) and accompanying Treasury Regulation § 301.6343-1(a) require levies to be promptly released if the taxpayer enters into an installment agreement with the IRS or if the IRS determines that the taxpayer is suffering a hardship; IRC § 6343(e) provides that the IRS must release levies as soon as practicable when it determines that an account is not collectible.

³ IRC § 6331(k)(2) (prohibiting levies while proposed installment agreements are under consideration and after installment agreements have been accepted); IRC § 6343(a)(1)(D) (requiring release of levy when taxpayer is experiencing hardship); and IRC § 6343(e) (requiring release of levy when taxpayer's account is determined to be currently not collectible).

⁴ LTAs are part of the Office of the Taxpayer Advocate (also known as the Taxpayer Advocate Service) provided for in IRC § 7803(c), which requires at least one LTA for each state. In developing the Most Serious Problems discussed throughout this Annual Report to Congress, the LTAs were asked to report on the top five most serious problems experienced by the taxpayers in their states. In ranking various issues, LTAs considered the number of taxpayers affected and the degree of severity of the issue. Levy releases were consistently ranked among the top five most serious problems.

⁵ Treas. Reg. § 301.6343-1(b)(4)(i)-(iii).

⁶ For additional problems related to levies and levy releases in this report, see Most Serious Problem, Levies On Social Security Payments, supra; and Additional Legislative Recommendation, Social Security Levies, infra.

⁷ IRM § 5.19.4.4.12.5.

⁸ There are several types of installment agreements. For example, IRC § 6159(c) provides for a guaranteed installment agreement if the liability is under $10,000, the taxpayer agrees to pay the liability within 3 years, the taxpayer is unable to pay the liability in full, and within the last 5 years, the taxpayer has filed tax returns, paid all other Federal tax obligations and not entered into any other installment agreements. The IRS also provides for a streamlined installment agreement if the liability is under $25,000, the taxpayer cannot afford to immediately full-pay the liability (no in-depth verification of the taxpayer's financial circumstances or IRS manager approval is required), the liability will be fully paid within 60 months, and all of the taxpayer's returns have been filed. IRM § 5.14.5.2. Taxpayers can also qualify for installment agreements above $25,000; however, the IRS requires verification of the taxpayer's financial situation, as well as managerial approval for such agreements. IRM § 5.14.1.2.

⁹ IRC § 6331(k)(2)(A). An installment agreement is "pending" with the IRS when accepted for processing and remains pending until the IRS accepts the proposal or rejects the proposal or is voluntarily withdrawn by the taxpayer. Treas. Reg. § 301.6331- 4(a).

¹⁰ IRC § 6331(k)(2)(C).

¹¹ IRC § 6331(k)(2)(B).

¹² IRC § 6331(k)(2)(D).

¹³Id.

¹⁴ Treas. Reg. § 301.6343-1(b)(3) provides that the IRS is not required to release the levy if the IRS determines that the collection of the tax is in jeopardy.

¹⁵ IRC § 6343(a)(1)(D).

¹⁶See Treas. Reg. § 301.6343-1(b)(4)(i)- (iii) definition of economic hardship. The IRS has also established other non-hardship criteria where it may be appropriate to designate an account as CNC including taxes owed by inactive businesses with no assets or certain bankruptcies where the IRS is unlikely to receive further proceeds from the bankruptcy estate. IRM § 5.16.1.1.

¹⁷ Treas. Reg. § 301.6343-3(d).

¹⁸Id.

¹⁹ Before a levy action is taken, the IRS must send a notice of its intent to levy to the taxpayer. IRC § 6331(d). The IRS must also provide to the taxpayer notice of the taxpayer's right to a Collection Due Process hearing with the IRS Office of Appeals in which taxpayer can raise a number of issues, including collection alternatives such as installment agreements or offers in compromise. IRC § 6330(c)(2).

²⁰ IRC § 6331(h).

²¹ IRM § 5.19.4.4.12(2) provides that in addition to collecting delinquent taxes, levies are also a tool to compel the taxpayer to contact the IRS to resolve the liability.

²² Treasury Inspector General for Tax Administration, Ref. No. 2002-10-078, The Internal Revenue Service's Levy Process Can be Improved to Ensure Compliance with the Internal Revenue Code (March 29, 2002).

²³ The taxpayer met several TAS case criteria in that he was suffering a significant hardship (criteria 1) and had experienced a delay of more than 30 calendar days to resolve a tax account problem (criteria 5).

²⁴See description of Guaranteed and Streamlined Installment Agreements, infra.

²⁵ IRM § 5.14.1.2.

²⁶See IRC § 6343(a) and Treas. Reg. § 301.6343-1(a).

²⁷Webster's Third New International Dictionary, 1816 (1991).

²⁸ IRM § 5.19.4.4.12(4).

²⁹ IRM § 5.19.4.4.12(5).

³⁰See IRC § 6343(a) and Treas. Reg. § 301.6343-1(a).

³¹ Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 150-206, § 3432 (1998)(now codified in IRC § 6343(e), provides that "In the case of a levy on the salary or wages payable to or received by the taxpayer, upon agreement with the taxpayer that the tax is not collectible, the Secretary shall release such levy as soon as practicable." However, earlier versions of the provision required "immediate" release of such levies. See S. Rep. No.105-174. In arriving at the "as soon as practicable" language, the Conference Committee Report notes that the IRS "is not to intentionally delay until after one wage payment has been made and levied upon before releasing the levy." See also IRS Restructuring and Reform Act of 1998, Hearing Before the Senate Finance Committee, 105th Cong., 2nd Sess. (Feb. 5, 1998) (Statement of Nina E. Olson, then Executive Director of the Community Tax Law Project) testifying:

³³ IRM § 5.19.4.4.14(2).

³⁴ IRM § 5.11.2.3.2(1).

³⁵ Treas. Reg. § 301.6343-3(d); but see IRM 5.11.2.3.2(1) which provides:

³⁷ Treas. Reg. § 301.6343-1(a).

³⁸See Most Serious Problem: Levies on Social Security Payments, supra.

MOST SERIOUS PROBLEM: REGULATION OF ELECTRONIC RETURN ORIGINATORS

RESPONSIBLE OFFICIALS

The National Taxpayer Advocate has repeatedly raised the issue of the lack of IRS oversight of tax return preparers,¹ while the IRS has expressed its own concerns about the quality of preparer services and tax practitioners' standards of professional conduct.² The Treasury Inspector General for Tax Administration (TIGTA) has also voiced concerns about the IRS's authorizing individuals to participate in the e-file Program without ensuring they have met all required screening checks.³

Despite these persistent questions from inside and outside the IRS, there are still significant gaps in the IRS's regulatory regime for return preparers.

• The IRS's current e-file application process may not ensure that the IRS certifies only qualified individuals or groups to become part of the program.

• The IRS does not conduct adequate oversight of the activities of certified providers nor does it take sufficient steps to impose sanctions and penalties against those who violate the regulations.

• The IRS lacks a long-term strategic plan for the e-file Program and EROs that would unify the various IRS functions involved and ensure effective oversight of all EROs.

Electronic Return Originators (EROs)

Background

A participant in the IRS e-file Program is an Authorized IRS e-file Provider.⁴ Authorized e-file providers can be broken down into the following categories:⁵

• Electronic Return Originator (ERO),

• Intermediate Service Provider,⁶

• Software Developer,⁷ and

• Transmitter.⁸

• Electronically sending the return to a Transmitter that will transmit the return to the IRS;

• Directly transmitting the return to the IRS; or

• Providing a return to an Intermediate Service Provider for processing prior to transmission to the IRS.¹⁰

To become an ERO, an individual must apply to and be authorized by the IRS. Revenue Procedure 2005-60 informs authorized e- file providers of their obligations to the IRS, taxpayers and other participants in the program.¹³ EROs must adhere to this revenue procedure and all publications and notices governing the e-file program. Failure to comply with the rules may lead to sanctioning by the IRS. Serious questions remain as to whether the ERO approval process is strict enough and whether the IRS is working to ensure that all taxpayers receive quality service by actively enforcing the requirements for EROs and imposing sanctions against those who fail to act appropriately.

Becoming an ERO

To become an ERO, a business must submit an application identifying its Principals and at least one Responsible Official.¹⁴ The IRS conducts suitability checks on the applicant and all Principals and Responsible Officials listed.¹⁵ The "suitability" process may include:

• A criminal background check;

• A credit history check;

• A tax compliance check to ensure that all required returns are filed and paid, and to identify fraud and preparer penalties; and

• A check for prior non-compliance with IRS e-file requirements.¹⁶

Although the elements of the IRS suitability check are significant, the IRS indicates only that it may include these items and does not guarantee that it will check on all elements before authorizing an ERO. The IRS conducts a full tax compliance check as well as a check for prior noncompliance in the e-file Program on approximately 95 percent of applicants.¹⁸ However, the IRS does not conduct credit history checks. Further, it only requests Federal Bureau of Investigation (FBI) fingerprint checks for approximately 25 percent of applicants.¹⁹

Given the number of registered EROs, the IRS cannot perform in-depth suitability checks on all individuals listed on each application. However the current process may not be stringent enough to ensure that only qualified individuals become registered EROs. Table 1.12.1 shows that the number of registered EROs has grown each year since 2001.

    TABLE 1.12.1, REGISTERED AND ACTIVE EROS SINCE 2001²⁰

A significant discrepancy exists between the number of registered EROs and the number of active EROs. An individual accepted to the e-file Program must file at least one tax return within two years in order to remain in the program. The IRS initially ran a computerized program to identify EROs who failed to file returns within the two-year period, placed them in "Dropped" status, and notified them they were no longer part of the e-file Program.²⁴ However, since the IRS implemented the Third Party Data Store, it can no longer determine which EROs do not file returns.²⁵ The National Taxpayer Advocate is very concerned that the IRS is not tracking which EROs are not submitting returns and removing them from the e-file Program. The IRS should resume the tracking and require non-filing EROs to recertify.

Current Regulation of EROs

Once approved as an Authorized e-file Provider, an ERO's general responsibilities include:

• Timely originating of the electronic submission of returns;

• Submitting any required supporting paper documents to the IRS;

• Providing copies to taxpayers;

• Retaining records and making records available to the IRS;

• Accepting returns only from taxpayers and Authorized IRS e-file Providers; and

• Using only one EFIN for the same business entity at that location unless the IRS has issued more than one EFIN to a business entity at the same location.²⁶

If an ERO advertises the availability of a RAL or other financial product, the advertisement must be easy to read and identify, and make clear that the taxpayer is borrowing money against his or her anticipated refund and is not receiving the actual refund.³⁰ The ERO must also ensure that the advertisements refer to RAL funds as a loan or other financial product, and not as a refund.³¹

Under Treasury Regulation § 301.7216, an ERO may disclose tax return information among Authorized IRS e-file Providers for the purpose of preparing a tax return.³² However, if a taxpayer chooses to receive a RAL or other financial product, the ERO must obtain the taxpayer's written consent to disclose tax information to the financial institution providing the product.³³ Disclosing tax return information to receive a RAL or other financial product is not covered by the exemption in § 301.7216 for e-file providers. Failure to obtain written consent can result in penalties under IRC § 7216 or civil penalties under IRC § 6713 for unauthorized disclosure or use of tax return information.³⁴

Current IRS Oversight

An authorized e-file Provider must comply with all other requirements or provisions contained in other publications and notices that govern IRS e-file. The Compliance function in the Small-Business Self-Employed (SB/SE) Operating Division is responsible for monitoring e-file Providers and sanctioning noncompliant ones.³⁵ This program includes monitoring visits to providers by the SB/SE Electronic Monitoring Coordinator (EMC), Tax Compliance Officers, and Revenue Agents.

The IRS may sanction a provider for the same reasons that it may deny an application. Before sanctioning, the IRS may issue a warning letter that describes specific corrective action the provider must take, though the IRS can also impose sanctions without a warning letter. An Authorized IRS e-file Provider that violates any of the requirements in Publication 1345 may receive a written reprimand, suspension, or expulsion from the e-file program.³⁶

Depending on the seriousness of the infraction, the IRS may also publicize the name and owner of any entity suspended or expelled from participation in e-file and the sanction's effective date. The IRS may warn or sanction Authorized IRS e-file Providers that use the services of a denied, suspended, or expelled Provider, because such a business relationship is prohibited. However, if the IRS deems it appropriate, it may sanction the Provider without such warning.

The IRS categorizes sanctions -- Level One, Level Two, or Level Three -- according to the seriousness of the infraction.³⁷

• Level One -- The infraction has little or no adverse impact on the quality of the electronically filed returns or on IRS e-file. The IRS may issue a letter of reprimand for a Level One infraction.³⁸

• Level Two -- The infraction has an adverse impact on the quality of electronically filed returns or on IRS e- file.³⁹ Depending on the infraction, the IRS may either restrict a Provider's participation in e-file or suspend the provider from participating in e-file for the remainder of the current year and one additional year.⁴⁰

• Level Three -- The infraction has a significant adverse impact on the quality of electronically filed returns or on IRS e-file.⁴¹ The IRS may suspend a Provider from participating in e-file for the remainder of the current year and one or two additional years for a Level Three infraction.⁴²

Once notified of a sanction, the Provider has the opportunity to appeal through an administrative review process.⁴⁴ Within 30 days of issuance of the notice of sanction, the Provider may mail a detailed explanation of why the IRS should withdraw the sanction.⁴⁵ The IRS will either withdraw the sanction or affirm it in writing, in which case the Provider may appeal to the Office of Appeals.⁴⁶

Inadequate ERO Monitoring and Oversight Design

The current structure of IRS monitoring of EROs appears inadequate. The responsibility for certifying EROs is in the hands of Electronic Tax Administration (ETA) within Modernization & Information Technology Services (MITS). However, SB/SE is responsible for monitoring and sanctioning. This split oversight creates problems because no one in the IRS has complete responsibility for EROs. We believe end-to-end responsibility for EROs, from approval of applications to monitoring ERO activities, should rest within one IRS organization to ensure adequate and effective oversight.

The IRS cannot adequately assess the quality of ERO services and integrity of an ERO without conducting random and other site visits. Table 1.12.2 shows the number of EROs that receive an IRS visit each year.

                  TABLE 1.12.2, ERO VISITS⁴⁷

SB/SE headquarters, in conjunction with ETA, annually decides the number of planned ERO visits. The number is usually one percent of all active e-file Providers in the local database; however, visits are limited to Providers that have electronically filed at least 25 individual tax returns.⁵² Once SB/SE establishes the total number of visits, it schedules them in the following priority:

• Referral Visits -- Referral visits are based on receipt of a complaint of alleged misconduct in the current year, or the issuance of a warning or written reprimand in the previous year.

• Follow-Up Visits -- Follow-up visits are based on a previous year's referral where the visit resulted in an identified violation.

• Random Visits -- Random visits are based on a non-discriminatory sampling of active e-file Providers selected from a central database.

• Targeted Visits -- Targeted visits are based on specific selection criteria indicating e-file compliance issues may be present.⁵³

Although the IRS appears to have a well-developed plan for ERO visits, it actually does very little to enforce the ERO regulations. Even as the number of EROs has increased, the percentage of EROs visited has steadily fallen, as less than one percent of registered or active EROs received an IRS visit in the past three years. Many EROs may believe they do not need to meet the ERO requirements because there is little chance they will ever receive a visit from the IRS.

Further, IRS monitoring visits focus on infractions that affect the quality of the e-file Program instead of taking a broad-based look at whether a provider's activities affect the entire tax system. This form of oversight does not appear to take into account any actions by an e-file Provider outside of the e-file Program. According to IRS guidelines, the visits do not review whether an ERO is also a Circular 230 practitioner and has engaged in any Circular 230 violations. The narrow scope of these visits prevents the IRS from obtaining a complete and accurate picture of the activities of registered EROs.

Despite the low number of visits conducted each year, the number that result in enforcement action indicates the IRS needs to be more actively involved in monitoring EROs. Table 1.12.3 illustrates IRS actions against EROs for the past five years.

              TABLE. 1.12.3, IRS ERO SANCTIONS⁵⁴

• Typing, reproduction, or other mechanical assistance in the preparation of a return or claim for refund; or

• Making nonsubstantive changes, such as correcting a transposition, spelling, or arithmetic error (considered "mechanical assistance").⁵⁶

In addition, penalties against EROs are useless unless the IRS assesses and collects them. The IRS is virtually a nonexistent presence in the preparer community, assessing only $8.5 million net in preparer penalties in the last five years and collecting less than 15 percent of the net assessed.⁵⁹

   TABLE 1.12.4 IRS ASSESSMENT AND COLLECTION OF AL RETURN PREPARER

IRS regulatory regime for return preparers.

The National Taxpayer Advocate addresses the e-file application suitability process and monitoring of Authorized IRS e-file Providers (Providers) as "significant gaps in the IRS' regulatory regime for return preparers." The IRS does not agree that return preparers should be regulated in the same manner as an ERO (Electronic Return Originators). Return preparers have responsibility for preparation of tax returns, which are not the same as the specific e-file responsibilities of EROs.

Firms apply and are accepted as Authorized IRS e-file Providers by the IRS upon meeting specific suitability checks. Return preparers, working for an ERO firm, are not required to obtain approval or complete a suitability process to prepare the tax return. The e-file application process for EROs, including the suitability process, does not include authorization for the preparation of tax returns.

Number of registered EROs versus the number of active EROs.

The National Taxpayer Advocate states that due to the implementation of the Third Party Data Store (TPDS), the IRS can no longer identify which EROs are not meeting the requirement to file tax returns and therefore should no longer be part of the e- file program.

The IRS disagrees with the assertion that this is an important regulatory regime. There is no requirement that an ERO must file a tax return to remain an Authorized IRS e-file Provider. The IRS monitors the activities of EROs to determine if they are complying with requirements to continue to participate as an ERO.

Monitoring of EROs.

The Electronic Tax Administration (ETA) within Modernization & Information Technology Services (MITS) authorizes EROs while SB/SE is responsible for monitoring and sanctioning. The National Taxpayer Advocate recommends that the responsibility for approval of ERO applications and monitoring of ERO activities should reside within one IRS organization to ensure adequate and effective oversight.

The ETA was originally responsible for both certification and monitoring of the EROs. However, TIGTA issued a report dated September 13, 1999, reference #199940062, and recommended removing the responsibility for monitoring the activities of EROs from ETA. The IRS adopted this recommendation.

Assessing the quality of ERO services.

The National Taxpayer Advocate states that the IRS cannot assess the quality of ERO services, or the integrity of an ERO, without conducting random and other site visits. The IRS generally accomplishes monitoring through four types of visits scheduled in the following priority: Referrals, Follow-Up, Random, and Targeted. The total number of visits in 2005 were 1,100 of which 268 of the visits were Random (24%) and 385 were Targeted (35%) visits, which is more than half of the total visits.

Planning number of ERO visits.

SB/SE independently determines the number of planned visits using volume of ERO data provided to it by ETA.

Enforcement of ERO regulations.

The National Taxpayer Advocate acknowledges that the IRS has a well-developed plan for ERO visits, but needs to do more to enforce the ERO regulations. The National Taxpayer Advocate states that the number of EROs has increased while the percentage of EROs visited has decreased in the past three years.

The increase in EROs is primarily attributable to e-filers that prepare less than 25 returns per year. The IRS determines the appropriate mix of ERO visits within its available resources allocated to monitor EROs.

Focus of Monitoring

The National Taxpayer Advocate comments that the IRS monitoring visits should take a broad-based look at whether a provider's activity affects the entire tax system.

The IRS procedures call for employees to refer to the appropriate function other issues of noncompliance noted during monitoring visits not related to the e-file program. An exception to this general rule applies in cases where there are applicable penalties under IRC Section 6695(g) relating to Earned Income Tax Credit due diligence requirements. In addition, when warranted, monitors have sent referrals to the Area Return Preparer Coordinators (RPCs) for consideration of Program Action Cases (PACs).

TAXPAYER ADVOCATE SERVICE COMMENTS

Electronic Return Originators, along with return preparers, are the entry point for taxpayers into the tax system, and as such should be closely monitored in order to protect taxpayers. With the advent of e-file, many entities not traditionally involved with tax filing have entered the industry. These entities have unprecedented access to taxpayer financial data and social security numbers. While the IRS conducts suitability checks on all ERO applicants, the current checks are not enough to ensure that only qualified individuals become and continue as authorized EROs.

Despite the IRS's comments, the National Taxpayer Advocate remains concerned about the discrepancy between the number of registered EROs and the number of active EROs. Although the IRS states it monitors the activities of EROs to ensure they are complying with program requirements in order to remain a registered EROs, the IRS is unable to monitor every ERO. Moreover, since the IRS only visits EROs that prepare 25 or more returns, it does not visit inactive EROs and is not in fact monitoring them. These inactive EROs are still authorized to use and display the IRS's e-file logo. Yet the IRS sees no reason to investigate what these inactive but authorized EROs are doing with this IRS "imprimatur." One way to ensure that EROs are meeting program requirements is to require all EROs that have not filed a return in a certain amount of time (two years) to repeat the authorization process. This check on non-active EROs will monitor, in an economical manner, those EROs who received their authorization but never actively engaged in the e-file program, and are now looking to begin filing returns electronically.

The IRS moved responsibility for monitoring EROs from ETA to SB/SE following a September 1999 Treasury Inspector General for Tax Administration (TIGTA) audit, The Internal Revenue Service Can Improve Its Electronic Return Preparer Fraud Activities.⁶² As discussed in the TIGTA report, the National Taxpayer Advocate recognizes that there is an inherent conflict of interest within the IRS -- the Service is striving to meet its goal of 80 percent electronic filing, while also having to monitor and sanction those individuals responsible for facilitating electronic filing.⁶³ This conflict still exists in the ETA's authorizing of EROs. If ETA were to promote e-filing, but another function oversees authorization and monitoring, the internal conflict is eliminated. In order to ensure adequate and effective oversight of EROs, end-to-end responsibility for EROs, from approval of applications to monitoring ERO activities, should rest within one IRS organization.

Although the IRS states that more than half of the visits to EROs each year are random and targeted visits, the National Taxpayer Advocate remains concerned that overall, the IRS is still not visiting enough EROs. The IRS conducted random visits on only 0.17 percent of the active ERO population in FY 2005, and only 0.24 percent of the active ERO population received targeted visits. This is hardly a meaningful presence in the ERO community. The IRS acknowledges that over the past three years, the number of EROs has increased, while the percentage of EROs visited has decreased. The IRS attributes this increase in EROs to e-filers that prepare less than 25 returns per year. Although these EROs may e-file a small number of returns, any improper action on their behalf affects the IRS and taxpayers the same as an ERO who e-files a large number of returns, and they should be treated the same as any other ERO. The National Taxpayer Advocate remains concerned that the number of IRS visits to EROs is not increasing in proportion to the number of registered EROs.

The National Taxpayer Advocate is pleased to learn that IRS employees refer any issues of noncompliance discovered during an ERO visit to the appropriate operating function. The National Taxpayer Advocate encourages the IRS to include on the ERO visit checklist items that would constitute grounds for a referral.

RECOMMENDATIONS

The National Taxpayer Advocate recommends that the IRS:

• Reevaluate the current e-file application and certification process to ensure that the IRS certifies only qualified individuals or groups to become part of the program.

• Resume tracking which EROs are not filing any tax returns and require these nonactive EROs to recertify.

• Consolidate end-to-end responsibility for EROs, from approval of applications to monitoring ERO activities, in one IRS organization to ensure adequate and effective oversight.

• Increase the number of IRS visits to EROs, including random visits, to ensure that registered EROs are operating within IRS guidelines.

• Strengthen the current sanction and penalty structure for violations of the e-file Program guidelines.

• Ensure that current sanctions and penalties are imposed and collected consistently as a means to ensure compliance with program guidelines and deter future noncompliance.

• Develop a long-term strategic plan for the e-file Program and EROs that would unify the various IRS functions involved and ensure effective oversight of all EROs.

² National Taxpayer Advocate 2004 Annual Report to Congress 82. See also House Committee on Ways and Means, Testimony of Nancy J. Jardini, Chief, Criminal Investigation Division, Internal Revenue Service (Jul. 20, 2005).

³ Treasury Inspector General for Tax Administration, Ref. No. 203-30-039, Improvements Are Needed in the Screening and Monitoring of E-File Providers to Protect Against Filing Fraud (Jan. 2003).

⁴ An Authorized IRS e-file Provider (Provider) is a business authorized by the IRS to participate in IRS e-file. The business may be a sole proprietorship, partnership, corporation, or other entity.

⁵ The Authorized IRS e-file Provider categories are not mutually exclusive and a participant can fall under one or more of the different categories.

⁶ Rev. Proc. 2000-31. An "Intermediate Service Provider" receives tax return information from an ERO (or from a taxpayer who files electronically using a personal computer, modem, and commercial tax preparation software), processes the tax return information, and either forwards the information to a Transmitter, or sends the information back to the ERO (or taxpayer).

⁷ Rev. Proc. 2000-31. A "Software Developer" develops software for the purposes of formatting electronic tax return information according to Publication 1346, Electronic Return File Specifications and Record Layouts for Individual Income Tax Returns, or transmitting electronic tax return information directly to the Service.

⁸ Rev. Proc. 2000-31. A "Transmitter" transmits electronic tax return information directly to the Service.

⁹ Rev. Proc. 2000-31. The IRS e-file Program allows taxpayers to file their income tax returns through an Electronic Return Originator, or by using a personal computer, modem, and commercial tax preparation software (the Form 1040 IRS On-Line Filing Program).

¹⁰ IRS Pub. 3112, IRS e-file Application and Participation (Nov. 2004).

¹¹Id.

¹² An ERO that chooses to originate returns that it has not prepared, but only collected, becomes an income tax return preparer of the returns when, as a result of entering the data, it discovers errors that require substantive changes and then makes the changes. A nonsubstantive change is a correction limited to a transposition error, misplaced entry, spelling error, or arithmetic correction. All other changes are considered substantive and upon making a substantive change, the ERO is considered an income tax return preparer. As such, the ERO may be required to sign the tax return as the income tax return preparer. Treas. Reg. § 301.7701- 15(d); IRS Pub.1345 Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns (Nov. 2004).

¹³ IRS, Internal Revenue Bulletin 2005-35 (Aug. 29, 2005).

¹⁴ IRS Pub. 3112, IRS e-File Application and Participation (Nov. 2004). The roles are not mutually exclusive; a Principal may also serve as the Responsible Official. Each Principal or Responsible Official must be a U.S. citizen (or alien lawfully admitted for permanent resident), be 21 years of age as of the date of the application, and must meet applicable state and local licensing or bonding requirements for the preparation and collection of tax returns.

¹⁵Id. Applicants that only apply to be a Software Developer are not subject to a suitability check.

¹⁶Id.

¹⁷ Applicants denied participation in IRS e-file will be notified in writing. The denied applicant may appeal the decision. If the IRS upholds the denial on appeal, the applicant may not reapply to become an Authorized IRS e-file Provider for the period specified in the denial letter. Id.

¹⁸ Those individuals who do not receive a full tax compliance check are not for profit organizations, large taxpayers, delegated users, and contacts or alternate contacts. Information provided by Operating Division in response to research request.

¹⁹ Information provided by Operating Division in response to research request.

²⁰Id.

²¹ An active ERO is a registered ERO that filed at least one Form 1040 during the year.

²² Wage and Investment Research, Practitioner Counts by Number of Returns Filed, W&I Research Project 1-02-14-1-033.

²³ IRS Master File is a system consisting of all tax data and related information pertaining to an individual or business taxpayer. The Master File is designed to reflect a continuously updated and current record of each taxpayer's account. The IRS has a system for both individuals -- Individual Master File (IMF) -- and businesses -- Business Master File (BMF).

²⁴ Information provided by Operating Division in response to research request.

²⁵ The Third Party Data Store is an IRS database used to create and update IRS e-file applicant information. IRM 3.42.10.3, The Third Party Data Store (Oct. 1, 2004).

²⁶ For this purpose, the business entity is generally the entity that reports on its return the income derived from electronic filing. The IRS may, for example, issue more than one EFIN to accommodate a high volume of returns. IRS Pub. 3112, IRS e-File Application and Participation (Nov. 2004).

²⁷ A Refund Anticipation Loan (RAL) is money a taxpayer borrows based on his or her anticipated income tax refund. For a detailed discussion of RALs, see Most Serious Problem: Refund Anticipation Loans: Oversight of the Industry, Cross-Collection Techniques, and Payment Alternatives, supra.

²⁸ The disclosures include ensuring taxpayers understand that by agreeing to a RAL or other financial product they will not receive their refund from the IRS as the IRS will send their refund to the financial institution; advising taxpayers that RALs are interest bearing loans and not a quicker way of receiving their refunds from the IRS; advising taxpayers that if a Direct Deposit is not received within the expected time frame for whatever reason, the taxpayers may be liable to the lender for additional interest and other fees, as applicable for the RAL or other financial product; advising taxpayers of all fees and other known deductions to be paid from their refund and the remaining amount the taxpayers will actually receive; and ensuring that if the ERO is also the return preparer, it is not a related taxpayer to the financial institution or other lender that makes a RAL or other financial product agreement within the meaning of § 267 or § 707A. IRS Pub. 3112, IRS e-File Application and Participation (Nov. 2004).

²⁹ IRS Pub.1345, Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns (Nov. 2004).

³⁰Id.

³¹Id.

³² The Treasury Regulations provide exceptions to the disclosure rules in IRC § 7216. For example, an ERO may pass on tax return information to an Intermediate Service Provider or a Transmitter for purposes of formatting and transmitting an electronic return to the IRS.

³³ IRS Pub.1345, Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns (Nov. 2004).

³⁴Id.

³⁵ Information provided by Operating Division in response to research request.

³⁶ IRS Pub. 3112, IRS e-File Application and Participation (Nov. 2004).

³⁷Id.

³⁸Id.

³⁹ Level Two infractions include Level One violations that continue after the IRS has notified the Provider of the initial infraction.

⁴⁰ IRS Pub. 3112, IRS e-File Application and Participation (Nov. 2004). If, as a the result of a sanction, a Principal or Responsible Official is suspended or expelled, every entity that listed the suspended or expelled Principal or Responsible Official on its IRS e-file Application may also be suspended or expelled.

⁴¹ Level Three infractions include Level Two violations, which continue after the IRS has notified the Provider of the initial infraction. Id.

⁴²Id.

⁴³Id. The IRS reserves the right to suspend or expel an Authorized IRS e-file Provider prior to administrative review for Level Three Infractions.

⁴⁴ IRS Pub. 3112, IRS e-file Application and Participation (Nov. 2004). In most circumstances, a sanction is effective thirty days after the date of the letter informing the Provider of the sanction, or the date the sanction is upheld by the reviewing offices or the Office of Appeals, whichever is later.

⁴⁵ During this administrative review process, an immediate sanction remains in effect.

⁴⁶ The appeal must be in writing and mailed to the IRS office that issues the recommended sanctioning letter within thirty calendar days of the date of the letter recommending the sanction. The Provider's written appeal must contain detailed reasons, with supporting documentation, to show why the recommended suspension or expulsion should not be imposed. Failure to respond within thirty calendar days of the date of any sanction letter irrevocably terminates the Provider's right to an administrative review or appeal.

⁴⁷ Information provided by Operating Division in response to research request.

⁴⁸ Wage and Investment Research, Practitioner Counts by Number of Returns Filed, W&I Research Project 1-02-14-1-033.

⁴⁹ As of September 24, 2005 (date of research request).

⁵⁰ Information provided by Operating Division in response to research request.

⁵¹ Information provided by Operating Division in response to research request.

⁵²Id.

⁵³ To select targeted visits, the area Electronic Monitoring Coordinator (EMC) must gather information needed to develop a list of potentially problematic e-file Providers.

⁵⁴ Information provided by Operating Division in response to research request.

⁵⁵ Preparer penalties that may be asserted under appropriate circumstances include but are not limited to those set forth in IRC §§ 6694, 6695, and 6713.

⁵⁶ Treas. Reg. § 301.7701-15(d).

⁵⁷ Treas. Reg. § 301.7701-15; Rev. Rul. 85-189, 1985-2 C.B. 341. EROs are defined as return preparers for purposes of IRC § 7216 and § 6713. Treas. Reg. § 301.7216-1(b)(2)(i) defines tax return preparer to include any person engaged in the business of preparing tax returns or providing auxiliary services in connection with the preparation of tax returns. The IRS also reserves the right to assert all appropriate preparer and nonpreparer penalties against an Authorized IRS e-file Provider as warranted. IRS Pub. 1345, Handbook For Authorized IRS e-File Providers of Individual Income Tax Returns (Rev. 11-04).

⁵⁸ National Taxpayer Advocate 2003 Annual Report to Congress 273, 294-95.

⁵⁹ Net penalties assessed are equal to the total amount of preparer penalties assessed, minus the total amount of penalties abated. Information provided by Operating Division in response to research request.

⁶⁰ These statistics are for all preparer penalties -- the IRS does not specifically track those preparer penalties imposed on preparers involved in the e-file Program. Information provided by Operating Division in response to research request.

⁶¹ While FY 2002-2005 data was extracted as of August 2005, the FY 2001 data was obtained from a prior September 2004 extract. Therefore, additional dollars collected or penalty abatements may have occurred in the intervening period.

⁶² Treasury Inspector General for Tax Administration, Ref. No. 1999-40-062, The Internal Revenue Service Can Improve Its Electronic Return Preparer Fraud Activities (Sept. 1999).

⁶³ Treasury Inspector General for Tax Administration, Ref. No. 1999-40-062, The Internal Revenue Service Can Improve Its Electronic Return Preparer Fraud Activities (Sept. 1999)..

MOST SERIOUS PROBLEM: LIMITED SCOPE OF BACKUP WITHHOLDING RULES

RESPONSIBLE OFFICIAL

The latest estimate of the annual federal income tax gap¹ ranges from $312 billion to $353 billion.² Underreporting of individual income tax is the single largest source of the gap, accounting for over half of the gross tax gap.³ Backup withholding is one of the tools available to the IRS as it attempts to narrow the tax gap.

Internal Revenue Code § 3406 provides the IRS with authority to require payors to deduct and withhold tax under certain conditions, such as when a recipient fails to furnish a valid Taxpayer Identification Number (TIN).⁴ This system of "backup withholding" is designed to encourage compliance with tax laws.⁵ However, the IRS has not implemented the backup withholding program effectively and has failed to provide noncompliant payors with sufficient incentive to fulfill their reporting obligations.

ANALYSIS OF THE PROBLEM

Background

Banks and other payors of certain kinds of payments (including interest, dividends, rents, royalties, and non-employee compensation) must file information returns with the IRS, even though these payments are generally not subject to withholding.⁶ The IRS uses an automated matching program to determine whether the payee listed on the information return actually filed a return and reported the income. For the matching to succeed, the IRS must have a correct TIN for each payee who receives a reported payment. The payor may use Form W-9, Request for Payee's Identification Number, to obtain the payee's name, TIN, and entity type prior to making a reportable payment.⁷

The matching program fails when a payee gives the payor an invalid TIN (or no TIN at all). The absence of a valid TIN on an information return often makes it difficult and expensive for the IRS to match and verify the proper reporting of income on the tax return of the payee. The IRS considers a TIN missing if it is not provided or is obviously incorrect.⁸

If a payee fails to supply his or her TIN to the payor, or the Secretary notifies the payor that the TIN furnished by the payee is incorrect, the payor will impose withholding to assist the payee in complying with his or her tax obligation.⁹ The payor will also implement backup withholding (at a rate of 28 percent for 2005¹⁰) if:

"B" and "C" Backup Withholding Programs

The IRS administers two separate backup withholding programs. The "B" program provides notices to payors who file information returns with incorrect TINs.¹⁵ The IRS sends notices to advise payors that backup withholding could become necessary if payees fail to certify their TINs. The "B" program includes Forms 1099-B, -DIV, -INT, -MISC, -OID, and -PATR information returns.¹⁶

The "C" backup withholding program provides notices to payees who have underreported interest or dividend income or failed to file a tax return reporting such income when required.¹⁷ These notices inform the payee what must be done to prevent backup withholding. The "C" program includes Forms 1099-DIV, -INT, -OID, and -PATR information returns.

This analysis will focus on backup withholding on non-employee compensation.¹⁸ We limit our discussion to the "B" withholding program, as the "C" program pertains only to dividend and interest income.¹⁹

Processing of Information Returns

The IRS subjects information returns to numerous validity checks and eventually compares them to information on individual and business returns. Underreporter and nonfiler cases may result if these amounts do not match.

The IRS sends notices to payors who file information returns with incorrect TINs, advising them that backup withholding could become necessary if payees fail to certify their TINs.²⁰ Large volume filers receive a CP2100; filers of 50 or fewer information returns will receive a CP2100A.

The CP2100/CP2100A notice includes a list of the incorrect name/TIN combinations, which should be compared to the payor's list.²¹ The payor is not required to notify the payee if the payee name/TIN combination on the notice is not the same combination in the payor's records.²²

If the payor's records contain the same name/TIN combination for the payee that the IRS has identified as incorrect, then the payor must determine if this is the first or second time within three calendar years it received notification of an invalid combination.²³ Payors are responsible for tracking the status of the notices they receive; the IRS does not designate whether a First or Second "B" notice is indicated.²⁴ A payor must take different actions for First and Second "B" notices:

First "B" Notice:

• A payor must send a First "B" notice and a copy of Form W-9, Request For Taxpayer Identification Number and Certification, to the payee within 15 business days of the date of the CP2100/CP2100A or the date the payor received it, whichever is later.

• A payor should include the return date, which should be no more than 30 business days after the payor received the CP2100/CP2100A, on the First "B" notice.

• A payor must begin backup withholding on payments to payees who do not respond to the First "B" notice by returning a signed W-9 by the return date specified on the "B" notice.

• The payor may begin backup withholding on payments to payees listed on the CP2100/CP2100A after notices are sent to the payee. A payor must stop backup withholding within 30 calendar days after receiving the W-9 from the payee.

If this is the second time within a three-year period that the same taxpayer²⁵ is listed on a CP2100/CP2100A notice, the payor must send the Second "B" notice to the payee. Unlike the First "B" notice, the Second "B" notice instructs the payee to contact the IRS or Social Security Administration (SSA) to obtain the correct name/TIN combination.

• A payor should send the Second "B" notice to the payee within 15 business days of the date of the CP2100/CP2100A notice or the date the payor received it, whichever is later.

• A payor should include the return date, which should be no more than 30 business days after the payor received the CP2100/CP2100A, on the Second "B" notice.

• The payee must contact the SSA to validate a Social Security number²⁶ or the IRS to validate an EIN.²⁷

• The payor may begin backup withholding on payments to the payee during the 30 business day period. If the payor does not receive the required validation²⁸ within 30 business days, the payor must begin backup withholding on payments to the payee if not already doing so.

• When the payor receives the required validation, the payor must stop backup withholding within 30 business days.

Problems with Backup Withholding Program

The IRS received 346,101 Forms 1099-MISC for the 2003 tax year that did not include the payee's TIN. These documents reported payments of more than $2.5 billion.³¹ The IRS received 314,934 Forms 1099-MISC with incorrect (not currently issued) TINS that reported payments of more than $2.7 billion for the 2003 tax year.³² The IRS received more than 4 million Forms 1099-MISC for the 2003 year with name/TIN mismatches. These documents reported payments of between $31.7 billion to $53.7 billion.³³ The IRS issued 814,716 CP2100/CP2100A notices for the 2003 tax year.³⁴

Limited Use of TIN Matching Program

In 2004, the IRS introduced an electronic TIN matching program allowing authorized payors³⁵ of income subject to backup withholding to match Form 1099 payee information against IRS records over the Internet before filing information returns. The TIN matching program will provide a "Match Indicator" for each name/TIN combination.³⁶

Interactive TIN Matching will accept up to 25 payee TIN/name combinations on-screen, while Bulk TIN Matching can match up to 100,000 payee TIN/name combinations via a text file submission. The Bulk TIN Matching file is usually returned to the user within 24 hours.

The TIN matching program is strictly voluntary. IRS data shows that only 3,181 payors have used the program.³⁷ Because the program is expected to decrease backup withholding and penalty notices and reduce the error rate in TIN validation, the IRS should do more to promote TIN matching.³⁸

Immediate Imposition of Backup Withholding

A major problem with the current backup withholding system is the delay in processing notices to payors. For backup withholding to effectively enhance compliance, the IRS should match withholding with income as it is earned. By the time a payor receives a backup withholding notice from the IRS, the payee (service provider) may no longer be receiving payments from the service recipient, meaning the IRS has lost the opportunity for backup withholding.

Payors must file Forms 1099 with the IRS by the end of February of the year following payment. Under current processing procedures, however, the IRS does not generate backup withholding notices until September or October of the year following payment (i.e., October 2005 for payments made during 2004).³⁹

In addition to improving the accuracy of information returns reporting non-employee compensation, the TIN matching program also represents a major opportunity to expedite the backup withholding notification process. For example, notification from the TIN matching program that a TIN/name combination is invalid could serve as notice to the payor to impose backup withholding.⁴⁰ This approach would eliminate significant delays and bring taxpayers into compliance sooner. At a minimum, when a TIN cannot be validated through the TIN matching program, this should serve the same purpose as a CP2100/CP2100A notice so that the payor is required to initiate contact with the payee to validate the information. If the correct information is not provided within a specified period, backup withholding should commence.

Lack of Reconciliation Process for Form 1099

The Combined Annual Wage Reporting (CAWR) program enables the IRS to ensure employers pay and withhold the proper amount of taxes and administer the advance Earned Income Tax Credit (AEITC) properly.⁴¹ This program compares the Forms W-3/W-2/W-3c/ W-2c⁴² totals and the Forms 94X⁴³ employment tax returns. Under the CAWR program, the IRS matches five fields:

• Social Security wages;

• Social Security tips;

• Medicare wages;

• Federal tax withheld; and

• Advance earned income tax credit (AEITC).

Without adequate follow-up, information return filers have little incentive to comply with their tax payment obligations. The IRS needs to develop a method of reconciling information returns with backup withholding.

Information Return Penalties Should Be Consistently Assessed

The IRS requires service recipients to file Forms 1099 with correct and complete information or face penalties of up to $50 per incorrect return. If the failure to file a correct information return is due to intentional disregard, the penalty increases to the greater of $100 or ten percent of the aggregate amount of the items required to be reported, with no limitation to the total amount of the penalties.

The IRS administrative criteria used to assess information return penalties exclude most of the payors who submit information returns with missing or invalid TINs.⁴⁵ To achieve any deterrence, the IRS needs to consistently assess penalties and make payors understand that there will be consequences if they do not take their responsibilities seriously.

IRS COMMENTS

The CP2100 and 2100A notices advise payors that there may be a discrepancy between the payee's name/taxpayer identification number (TIN) combination as listed on the payee's tax return and in the payor information documents provided to the IRS. The Small Business/Self-Employed Division (SB/SE) provides guidelines for issuing these notices in accordance with IRC § 3406.

The number of CP2100/2100A notices issued may not correlate to the number of payors imposing backup withholding for several reasons, such as errors in the payor records or that some recipients of Form 1099 are exempt from backup withholding. In the case of Form 1099-MISC, there can be a large difference between the CP2100/2100As issued and the imposed backup withholding when the 1099-MISC payees are classified as employees rather than independent contractors.

When backup withholding is required, payors must remit the backup withholding quarterly using Form 8109 and reflect the withheld amounts on the yearly Form 945 (Annual Return of Withheld Federal Income Tax). SB/SE reviews and reconciles the amounts withheld and imposes any payor penalties as a component of Employment Tax examinations. This process includes Forms 1099-MISC, which were the subject of the Advocate's review.

Specifically, examiners review transcripts to determine payor accounts that may be in violation of IRC § 3406. The examiners determine whether payors report wage data on Forms 1099-MISC for employees mistakenly classified as independent contractors. Furthermore, the examiners will verify that the IRS has notified the payors using CP 2100 and 2100A Notices.

Limited Use of TIN Matching Program

We believe that the TIN matching program is highly successful and widely promoted. The program successfully processed over 42 million name/TIN combinations through our bulk processes between March 2004 and June 2005. The program usage has demonstrated a remarkable level of proactiveness on the part of payors. They clearly are not waiting for the IRS to issue the backup withholding notices; rather, they are taking advantage of the TIN matching program at a time that suits their needs. Most of our participants have reported using the program throughout the tax year. Current reports show 4,188 payor entities (individual organizations or businesses) and 6,704 users participate in the program. On average, we have enrolled 2,094 payor entities during the two-year program operation period (October 2003 -- October 2005).

The Treasury Department has proposed legislation twice to expand use of the program, most recently in the Good Government Act, although neither proposal was enacted. Further, IRS "markets" the program to employee groups, as well as external users, through the following efforts:

• Including TIN matching program announcements in quarterly communication plans, including providing informational packets to external payer groups and supplying materials to be posted on their web pages.

• Participating in payor group conferences throughout the year.

• Establishing an intranet site to post informational package materials, FAQ document, PowerPoint presentation, and publications for use by LMSB, SB/SE and TE/GE field industry agents.

• Establishing an email address for internal and external customers to communicate directly with a program analyst.

• Participating in tax forums and outreach efforts for the public.

We agree that the system could be more effective if backup withholding were imposed immediately by payors who learn of a name/TIN mismatch. It would, however, create a "pay as you go" system for backup withholding similar to the requirements for 941s. This would be an additional filing requirement and burden for payors. The IRS also would face both internal and external systemic issues that could be cost prohibitive.

Lack of Reconciliation Process for Form 1099

We do not concur that a Form 1099 reconciliation process should be a part of the Combined Annual Wage Reporting (CAWR) program. The IRS and the Social Security Administration (SSA) agreed to establish the CAWR program specifically to secure the missing Forms W-2 from employers that SSA could not obtain and to reconcile discrepancies between these documents and return filings.

Information Return Penalties

Internal Revenue Code § 6721(3)(d)(2) establishes exceptions for a de minimis number of failures to report correct or missing identification numbers. It states in part,

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate commends the IRS for its efforts in establishing the electronic TIN matching program. She urges the IRS to continue exploring ways to increase usage by payors.

Tax compliance among non-wage workers has repeatedly been identified as a significant problem. For backup withholding to enhance compliance, the IRS should match withholding with income as it is earned. The IRS agrees that the system could be more effective if backup withholding were imposed immediately by payors who learn of a name/TIN mismatch, but expresses concern that this would create a "pay as you go" system for backup withholding, causing an additional filing requirement and burden for payors. We share this concern; this burden can be kept to a minimum by adding a validation requirement to the TIN program -- that is, if in response to a mismatch, the payor requests verification from the payee and the payee is unresponsive, the payor must institute backup withholding. This approach drives resolution of TIN problems early in the hiring process and helps avoid TIN mismatches on annual documentation.

Currently, there is no automatic reconciliation of backup withholding information returns other than through employment tax examinations. The IRS does not agree with the National Taxpayer Advocate's recommendation that a Form 1099 reconciliation process should be a part of the Combined Annual Wage Reporting (CAWR) program. If there are better ways to reconcile backup withholding information, the National Taxpayer Advocate encourages the IRS to explore those alternatives.

RECOMMENDATIONS

The National Taxpayer Advocate's recommendations for improving administration of the backup withholding program are as follows:

• Explore the benefits and costs of making the TIN matching program mandatory for most payors and study the impact of excluding small payors (less than 10 employees);

• Require payors to impose backup withholding when a TIN cannot be validated;⁴⁶

• Implement an automatic reconciliation process for backup withholding; and

• Consistently assess information return penalties under IRC § 6721.

² IRS Office of Research, Analysis, and Statistics, National Research Program: Early Results & Future Efforts 2 (June 15, 2005).

³Id. Individual income tax accounts for $198 billion to $234 billion of the tax gap, of which $150 billion to $187 billion is due to underreporting. Self-employment tax adds an additional $51 billion to $56 billion to the gross tax gap.

⁴ A TIN may be a Social Security number (SSN) issued by the Social Security Administration (SSA), an Employer Identification Number (EIN), or an Individual Taxpayer Identification Number (ITIN).

⁵ "The committee believes that if a taxpayer fails to supply his correct TIN to another person, withholding should be imposed to assure that taxpayers comply with the law." S. Rep. No. 97-494, 97th Cong. 2d. Sess. Vol. 1 (1982).

⁶See generally IRC §§ 6041-6049.

⁷ Form W-9 shows not only the TIN, but also the entity type of the payee (e.g., corporation, partnership, or sole proprietor).

⁸ A TIN is also considered missing if it has more or less than nine numbers or it has an alpha character as one of the nine numbers.

⁹ IRC § 3406(a)(1)(A).

¹⁰ IRC § 3406(a) requires the payor to deduct and withhold from such payment a tax equal to the product of the fourth lowest rate of tax applicable under IRC § 1(c).

¹¹ IRC § 3406(a)(1)(C).

¹² IRC § 3406(a)(1)(D).

¹³ IRC § 6721(a) imposes a $50 penalty for each information return with respect to which such a failure occurs. The total amount imposed on such person for all such failures during any calendar year shall not exceed $250,000.

¹⁴ IRC § 6721(e).

¹⁵ Treas. Reg. § 31.3406(d)-5(d). Notice CP2100/CP2100A informs a payor that he or she may be responsible for backup withholding and includes a listing of the information returns that the payor filed that had missing, incorrect, or not currently issued TIN(s).

¹⁶ Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, reports sales or redemptions of securities, future transaction, commodities, and barter exchange transactions of all amounts. Form 1099-DIV, Dividends and Distributions, reports distributions, such as dividends, capital gain distribution, or nontaxable distributions, that were paid on stock, and liquidation distributions of $10 or more ($600 or more for liquidations). Form 1099-INT, Interest Income, reports interest income of $10 or more. Form 1099-MISC, Miscellaneous Income, reports (1) rent or royalty payments; prizes and awards of $600 or more ($10 or more for royalties), (2) payments to crew members of fishing boats of all amounts, (3) payments to physicians and other suppliers of health and medical services of $600 or more, (4) payments for services performed for a trade or business by people not treated as its employees, or $600 or more, (5) fish purchases paid in cash or $600 or more, (6) substitute dividend and tax-exempt interest payments reportable by brokers or $10 or more, (7) crop insurance proceeds of $600 or more, and (8) gross proceeds or fees paid to attorneys of $600 or more. Form 1099-OID, Original Issue Discount, reports original issue discount of $10 or more. Form 1099-PATR, Taxable Distributions Received from Cooperatives, reports distributions from cooperatives to their patrons of $10 or more.

¹⁷ Treas. Reg. § 31.3406(c)-1.

¹⁸ Non-employee compensation includes payments made on Form 1099-MISC, Miscellaneous Income, for services performed for a trade or business by people not treated as its employees (e.g., money paid to subcontractors).

¹⁹ IRC § 3406(a)(1)(C).

²⁰ Treas. Reg. § 31.3406(d)-5(d).

²¹ IRC § 6103(a) prohibits the IRS from disclosing tax return information, including the taxpayer's identity. Accordingly, the IRS can inform the payor that the information, which was provided by the payor on the information returns, is not correct, but cannot provide the correct name/TIN combination to the payor.

²² It is possible that a payor's records disagree with the name/TIN combination identified by the IRS as incorrect due to a recent update to SSA records, an error in the information the payor submitted, or an IRS processing error. If this type of error occurred, the only thing the payor should do is correct or update its records if necessary. The requirement to send the payee the backup withholding "B" notice is only triggered if the payor's records contain the same incorrect name/TIN combination that is included in the list with the notice CP2100/CP2100A received by the payor.

²³ Two notices received during the same year count as one notice.

²⁴ A "B" notice is a backup withholding notice that warns the taxpayer that the TIN does not match IRS records and tells the taxpayer how to avoid backup withholding.

²⁵ With the same TIN and name combination.

²⁶ If the TIN is an SSN, the payee must request a Form SSA-7028, Notice to Third Party of Social Security Number Assignment, be provided to the payor. Form SSA-7028 is the form on which the SSA certifies that a SSN is assigned to a particular person. Also, the payee must give a copy of the Second "B" notice to SSA. The payor should use the corrected information on any future information returns (Forms 1099) he or she may file.

²⁷ If the TIN is an EIN, the payee must write to the service center where he or she files his or her tax return, ATTN: Entity Section, and ask for IRS Letter 147C. Letter 147C is a letter from the IRS that is used to validate an EIN/name combination. The payee must enclose a copy of the Second "B" notice with the request. The backup withholding regulations require that a payee request Letter 147C in writing. The payor should use the corrected information on any future information returns (Forms 1099) it may file.

²⁸ SSA Form 7028 or IRS Letter 147C.

²⁹ The CP2100 and CP2100A also list accounts with missing TINs, on which payors should have been backup withholding.

³⁰ IRC § 3406(a)(1)(A).

³¹ SB/SE response to Taxpayer Advocate Service Information Request (Oct. 24, 2005). Individual document report 406-10-14Aug. 6, 2004 and Feb. 15, 2005. Individual document report 406-10-14 provides stratified counts by ranges of income rather than an exact dollar amount. There were 346,101 documents with missing TINS that reported payments of between $2,456,552,446 and $3,995,007,600.

³² Response provided by SB/SE to Taxpayer Advocate Service Information Request (Oct. 24, 2005). Individual document report 406-10-14 provides stratified counts by ranges of income rather than an exact dollar amount. There were 314,934 documents with incorrect or not currently issued TINs that reported payments between $2,710,980,346 and $4,397,566,900.

³³ Response provided by SB/SE to Taxpayer Advocate Service Information Request (Oct. 24, 2005). Individual document report 406-10-14 provides stratified counts by ranges of income rather than an exact dollar amount. There were 4,058,761 documents with name/TIN mismatches that reported payments between $31,676,332,553 and $53,700,505,700.

³⁴ Campus operations does not follow-up after the issuance of a CP2100/2100A notice. However, the LMSB and TE/GE functions both include a review of backup withholding activity within their individual industry reviews and audits. Response provided by SB/SE to Taxpayer Advocate Service Information Request (Sept. 22, 2005).

³⁵ An authorized payor is one that has filed information returns with the IRS in at least one of the two past tax years.

³⁶ The results or "Match Indicator" returned to the user is in a numerical format labeled as follows: "0" indicates the name/TIN combination matches IRS records; "1" indicates TIN is not a 9 digit number; "2" indicates TIN entered is not currently issued; "3" indicates the name/TIN combination does not match IRS records; "4" indicates an invalid TIN matching request; and "5" indicates a duplicate TIN matching request (the same name/TIN combination can only be submitted through the TIN matching program by the same payor one time).

³⁷ SB/SE response to Taxpayer Advocate Service Information Request (Oct. 17, 2005). The number of payors using the program is cumulative from October 16, 2003, through date of response. During the period October 1, 2004, through June 30, 2005, 1.9 million TINs were submitted for verification in 700,000 interactive sessions. The program also successfully processed over 42 million name/TIN combinations through bulk processes between March 2004 and June 2005.

³⁸ TIGTA recommended mandatory use of the matching program by payors, but this proposal may increase noncompliance by certain segments of taxpayer population (e.g., it may cause undocumented workers to enter the cash economy and not file tax returns). See Treasury Inspector General for Tax Administration, Ref. No. 2001-30132, Significant Tax Revenue May Be Lost Due to Inaccurate Reporting of Taxpayer Identification Numbers for Independent Contractors 20 (Aug. 2001).

³⁹ IRM § 2.7.7.15(6). There are two mailings for each tax year, a staggered one in September and October and another in March the following year (i.e., March 2006 for payments made during 2004).

⁴⁰ This approach would require a change to Treas. Reg. § 31.3406(j)-1(b), which states that matching details received by a payor through a matching program will not constitute a notice regarding an incorrect name/ TIN combination under Treas. Reg. § 31.3406(d)-5 for purposes of imposing backup withholding.

⁴¹ IRM § 4.19.4.1.

⁴² Form W-2, Wage and Tax Statement. Form W-3, Transmittal of Wage and Tax Statements, contains totals for W-2s being transmitted. Form W-2c, Corrected Tax Statement. Form W-3c, Transmittal of Corrected Wage and Tax Statements.

⁴³ Forms 941, 943, 945, Schedule H (Forms 1040/1041).

⁴⁴ Filers of Form 1099 report backup withholding on line 2 of Form 945, Annual Return of Withheld Federal Income Tax.

⁴⁵ Treasury Inspector General for Tax Administration, Ref. No. 2001-30132, Significant Tax Revenue May Be Lost Due to Inaccurate Reporting of Taxpayer Identification Numbers for Independent Contractors 9 (Aug. 2001).

⁴⁶ The payor should be required to contact payee to verify data. If correct data is not supplied within the same timeframe as under CP 2100 notice procedures, the payor should be required to commence backup withholding.

MOST SERIOUS PROBLEM: ACCESSIBILITY OF E-SERVICES FOR TAX PRACTITIONERS

RESPONSIBLE OFFICIAL

E-Services is a suite of web-based products available to tax practitioners who are active participants in the IRS e-file Program and electronically file five or more accepted individual income tax returns in a filing season.¹ The IRS Office of Electronic Tax Administration (ETA) uses the program "as a reward and incentive for e-filing."² The policy of limiting access to e-Services based on the number of e-filed returns deprives many highly trained and experienced tax practitioners, including practitioners associated with Low Income Taxpayer Clinics (LITCs), of this extremely useful and efficient tool.³ At the same time, while denying access to highly skilled practitioners, the IRS allows others who may not even be authorized to practice before the IRS to use services that enable them to provide assistance beyond the mere preparation of tax returns.⁴

ANALYSIS OF PROBLEM

Background

E-Services allows registered tax professionals to do business with the IRS electronically 24 hours per day, seven days per week.⁵ While e-Services is not available to the public,⁶ all tax professionals currently have access to the following products:

• Registration. Through this program, tax professionals create electronic accounts to use e-Services products.⁷ Over 86,000 tax professionals registered online between the launch of e-Services in summer 2004 and May 2, 2005.⁸

• Preparer Tax Identification Number (PTIN) Application. This application provides an option for each tax professional to choose a PTIN instead of his or her Social Security number (SSN).⁹ The IRS received over 50,000 online PTIN requests from the program's launch through May 2, 2005.¹⁰

• Online e-file Application. This program provides a new online and paper e-file application process.¹¹

• Taxpayer Identification Number (TIN) Matching. TIN Matching is a pre-filing service offered to payers listed in the IRS Payer Account File (PAF) database and their authorized agents, who submit information returns subject to backup withholding (Forms 1099-B, INT, DIV, OID, PATR, and MISC). Interactive TIN Matching provides payers the ability to match up to 25 payees' TIN and name combinations against IRS records. Bulk TIN Matching matches up to 100,000 TIN and name combinations.¹² Through May 2, 2005, e-Services processed over 39 million Bulk TIN Match requests and more than 1.5 million Interactive TIN Match requests.¹³

• Disclosure Authorization (DA) -- DA allows eligible tax professionals to complete authorization forms¹⁵ as well as view and modify existing forms online. DA expedites processing and immediately acknowledges accepted submissions.¹⁶ The program received over 16,000 Form 2848, Power of Attorney and Declaration of Representative, requests between its inception in the summer of 2004 and May 2, 2005.¹⁷

• Electronic Account Resolution (EAR) -- Tax professionals with a Form 2848, Power of Attorney and Declaration of Representative, on file can electronically send and receive taxpayer account-related inquiries on such topics as individual or business accounts, refunds, installment agreements, missing payments and notices. The IRS delivers responses to a secure electronic mailbox within three business days. Through May 2, 2005, EAR received and processed over 4,700 requests.¹⁸

• Transcript Delivery System (TDS) -- Practitioners with a Form 2848 on file can request and receive account transcripts, wage and income documents, tax return transcripts, and verification of non-filing letters for both individual and business taxpayers. Through May 2, 2005, TDS received over 69,000 requests for transcripts via the Registered User Portal.¹⁹

Limited Access Policy

As the IRS developed e-Services in 2002, the Electronic Tax Administration Advisory Committee (ETAAC) strongly supported the IRS's plan to offer participating practitioners a "basket" of related electronic services as a reward and incentive for e-filing.²³ ETAAC believed the IRS should initially use e-Services to reward those practitioners who e-file at the highest rates by looking at the percentage rather than the number of returns e-filed. The committee believed this approach would open the program to low-volume filers who e-file a high percentage of their clients' returns. ETAAC also took the position that the IRS should eventually make the program available to all tax professionals.²⁴

In response to the ETAAC recommendations, the IRS initially limited access to the e-Services incentive products (i.e., Disclosure Authorization, Electronic Account Resolution, and Transcript Delivery System) to tax professionals whose firms e-filed 100 or more accepted Forms 1040 in the current or prior year.²⁵

In ETAAC's 2004 Annual Report to Congress, the committee signaled recognition of an e-Services access problem. Although it had previously recommended that the IRS use e-Services as an incentive for high rate e-filers, ETAAC questioned whether the e-file threshold of 100 or more returns actually led substantial numbers of practitioners to e-file. ETAAC further stated that the restriction kept smaller practitioners from using e-Services and penalized tax professionals, most notably tax attorneys, who prepare few if any tax returns, much less e-file them, as a part of their tax practices. According to the committee, allowing all practitioners access to e-Services would demonstrate the benefits of operating in a digital world and in turn assist in the adoption of e-file.²⁶

The IRS subsequently (in March 2005) lowered the e-file threshold from 100 or more accepted individual tax returns in a calendar year to five or more accepted individual or business returns. The IRS accelerated its expansion of the e-Services incentive products to a larger audience due to high demand and requests from tax professionals.²⁷

ETAAC's most recent Annual Report to Congress applauded the IRS for lowering the threshold. However, the committee reiterated that the IRS is now positioned to open registration to all practitioners.²⁸

E-File Incentive Questioned

The IRS has adapted an "IRS-centric" approach to e-Services rather than addressing it from a customer service-oriented perspective.²⁹ Electronic Tax Administration (ETA) data demonstrates that the current policy prevents over 665,000 tax practitioners from utilizing the program. This number represents approximately 60 percent of all practitioners included in the IRS preparer database.³⁰ It is important to note that this database does not track practitioners who do not prepare tax returns but operate solely by providing representational services to clients, such as controversy, transactional, and consulting services. Thus, the population of practitioners who are prevented from utilizing e- Services to better serve their clients, based on their low e-file rate, is likely to be far greater than 665,000.

Years before the launch of e-Services, the Treasury Inspector General for Tax Administration (TIGTA) urged caution in using electronic services as incentives for e-filing. In 2001, TIGTA stated that ETA's strategic plan could be interpreted as a decision to provide some electronic return originators (EROs) with an unfair advantage. This disparate treatment would inevitably affect taxpayers solely based on their selection of an ERO.³¹

Many tax practitioners who are ineligible for e-Services under the current policy could better serve their clients if they received access to these products The LITCs represent just one example of a group of practitioners that does not formally qualify to use e- Services but would greatly benefit from access. In fact, many knowledgeable tax practitioners who regularly represent clients before the IRS and have demonstrated a specific need for these services will never gain access under current policy simply because they do not e-file tax returns.³²

Now that IRS Taxpayer Assistance Centers have drastically reduced their tax return transcript services, it is more important than ever to provide paid and volunteer tax practitioners access to the Transcript Delivery System feature of e-Services.³³ Further, practitioners at the 2005 IRS Tax Forums related how valuable TDS is when they receive new clients, as the system allows the practitioner to independently research tax histories rather than rely on clients to provide complete and accurate information. Just a few groups of practitioners who could benefit from TDS include:

• Bankruptcy lawyers filing petitions, who need TDS to ensure that all the tax-related debts of their clients are properly listed;

• Attorneys and Certified Public Accountants filing offers in compromise, who need copies of their clients' transcripts for all tax years at issue;

• Attorneys assisting clients with disaster claims, who need tax transcripts for complete and accurate information; and

• Attorneys handling decedent estates of taxpayers and preparing estate tax returns.

It is uncertain whether the IRS's policy of using e-Services as an incentive to e-filing has achieved its goal. While the e-file rate has clearly risen since the launch of the program in 2004,³⁴ it is unclear whether there is any clearly defined relationship between this increase and the growth in e-Services registration. In a 2004 IRS survey, 68 percent of practitioner V-Coders³⁵ indicated that they would switch to e-file if they had access to e- Services.³⁶ Subsequently, a 2005 IRS survey found that 29 percent of the previously surveyed V-coders had moved to e-file but did not give the reason for the change. In 2005, 47 percent of the former V-coders indicated that they were more likely to use e- Services. The IRS has acknowledged that this increased willingness to use e-Services does not prove that the product was the determining factor in the shift. Rather, the increase in interest may just reflect the increased usage of e-file. Nonetheless, the IRS has concluded that the survey clearly indicates that e-Services was at least a contributing factor due to the significant number of mentions it received in the survey.³⁷ The IRS appears to base the current policy on a conclusion for which there is no concrete data.

It has been brought to the attention of the Taxpayer Advocate Service that some practitioners who are ineligible for e-Services actually work out arrangements with other practitioners who can make use of the program. Under some of these arrangements, the names of e- Services eligible practitioners are added to the Form 2848, Power of Attorney and Declaration of Representative, merely to gain access to the program, in particular the Transcript Delivery and EAR features. These types of arrangements, although legal, are just one additional and unnecessary burden placed on practitioners and taxpayers by the IRS' policy of limiting access to e-Services.³⁸ They heighten both the disparity and inefficiency present in the policy.

Inappropriate Access

Basing access to e-Services on the rate of e-file has the unintended result of making the Electronic Account Resolution (EAR) program available to preparers without regard to their professional qualifications. Allowing access to any practitioner -- no matter what training, experience, or knowledge of IRS representation he or she may possess -- is not a logical policy. On the one hand, highly trained, experienced, and knowledgeable practitioners are denied e-Service products because they do not e-file enough returns; on the other hand, inexperienced or untrained practitioners are granted access to EAR.³⁹

Although many Electronic Return Originators' activities are limited to tax return preparation, much of the information made available through e-Services does not apply to tax return preparation as a discrete function. In the case of untrained or inexperienced unenrolled preparers, access to such a program will not benefit taxpayers. Further, this practice may be counterproductive to effective and efficient tax administration.⁴⁰ For example, EROs could obtain account data that would enable them to prepare offers in compromise and financial statements, for a fee, without having to make their involvement known to the IRS.⁴¹

The National Taxpayer Advocate is concerned that the current accessibility policy of the e-Services program may enable unenrolled preparers to actually represent taxpayers behind the scenes using EAR. In effect, to increase electronic filing, the IRS may compound the problem of unauthorized practice.⁴²

Conclusion

The current policy of limiting access to e-Services based on the practitioners' rate of electronic filing denies highly qualified tax professionals access to a product that could help them better serve their clients.⁴³ The program is extremely useful to practitioners and should not be merely a tool to entice preparers to e-file. It is not even completely clear whether the current policy has actually accomplished the goal of increasing the rate of practitioner e-file.

At the same time the IRS denies access to highly qualified tax professionals, e-Services may provide untrained and inexperienced tax professionals a way to practice before the IRS. Thus, the IRS needs to limit access to the EAR system to those tax practitioners who are qualified to practice before the IRS pursuant to Circular 230.⁴⁴

IRS COMMENTS

We agree that the expansion of e-Services would benefit the IRS, the practitioner community, and taxpayers. As outlined below, we are pursuing options for adding additional groups to e-Services. One of our Information Technology Modernization Vision and Strategy long term goals is to expand the groups and numbers of customers that do business with the IRS through the web. The ultimate long range goal is to provide universal "E" to all taxpayers and tax professionals.

Currently, we have over 100,000 registered users of e-Services and over 200,000 participants in the IRS e-file program in our e- Services Third-Party-Database System. This is significant progress, since the e-Services incentive products, Electronic Account Resolution (EAR), Disclosure Authorization (DA), and Transcript Delivery System (TDS), have only been available for slightly over a year. We are pleased with these practitioners' acceptance and use of our e-Services products. However, expansion of these services must be balanced against the security risks associated with delivering tax return data over the Internet and the capacity of our data systems to service additional participants.

So far this year, the IRS has received over 68 million individual e-file returns and, for the first time, e-file receipts exceed paper. The IRS elected to make e-Services available to the vast majority of e-filing tax practitioners as an incentive because e-file generates significant cost savings to the government and reduces taxpayer errors. We attribute part of this year's e-file success to electronic return originators' acceptance of our e-Services suite of applications.

Consistent with our ability to address authentication issues and implement the necessary system changes, we agree that there are opportunities to expand access to the e-Services incentive products. The Low Income Taxpayer Clinics are one of the groups under active consideration. We also agree in principal that the others mentioned by the National Taxpayer Advocate should at some point have access to e-Services, particularly the TDS application.

Allowing access to "non-preparer" users is not as simple as lowering or eliminating the threshold of filing five returns. The current engineering and design of e-Services is tied to the e-file application process and the return threshold requirement. The e-file application process serves as an underpinning for sub-systems that drive the e-Services processes. This authentication process is crucial in order to know with whom we are doing business electronically to ensure that all IRC § 6103 provisions are followed when disclosing tax return information through the Internet. Adding access for those outside of the e-file application process will be a challenge requiring careful security planning, as well as additional programming and redesign.

We do not agree that e-Services changed any of the risk factors associated with "inappropriate access." The information available through e-Services is also available to practitioners and the public through our traditional telephone, correspondence, or walk-in channels. The only difference is in the method of delivery. Providing tax information to a properly authorized taxpayer representative is not inappropriate access, regardless of his or her level of training or enrollment, and denying such access would be inappropriate. In addition, the deployment of e-Services did not change any rules regarding practice before the IRS by electronic return originators or any other tax practitioners.

TAXPAYER ADVOCATE SERVICE COMMENTS

The National Taxpayer Advocate is pleased that the IRS is pursuing options to expand access to e-Services to additional practitioner groups. We understand that the IRS faces a formidable task in balancing expansion of the program against the security risks associated with data transmittal over the Internet. Nonetheless, we encourage the IRS to make all efforts to expand access to the program as quickly as possible, while at the same time maintaining compliance with IRC § 6103 by carefully taking the necessary security measures to ensure that confidential tax data is highly safeguarded.

The IRS response indicates that expanding access would be a complex endeavor. It is our understanding that IRS data systems have the current capacity to handle expanded access to e-Services. Further, other than additional programming and redesign, the IRS has not provided any clear obstacles to prevent non-ERO practitioners from completing the authentication process, which is currently tied solely to the e-file application. By redesigning the system to apply the authentication process to non-ERO practitioners, the IRS would provide additional access to e-Services while ensuring that it safeguards data and complies with IRC § 6103.

Without supporting data, we cannot support the IRS policy of using e-Services access as an incentive to e-file. The Electronic Tax Administration Advisory Committee (ETAAC) has also taken the position that the IRS should stop using the program as an incentive. Although both e-file and e-Services have recently experienced impressive rates of growth, the IRS has not provided any tangible evidence to confirm its belief that access to e-Services is a main factor that causes a significant number of practitioners to increase their rate of e-file.

The National Taxpayer Advocate still has concerns that the e-Services suite is available to preparers without regard to their professional qualifications. The IRS claims that e-Services provide access to the same information already available through the telephone, correspondence, and face to face services. However, it makes no sense to provide easy access to tax account information to unenrolled preparers while at the same time precluding access for some highly qualified practitioners who are authorized to practice before the IRS under Circular 230. We encourage the IRS to confirm that e-Services does not provide a means for unenrolled preparers to practice beyond the parameters of "limited practice" as detailed in § 10.7(c) of Circular 230.

Finally, it has come to our attention through conversations with knowledgeable parties that some EROs are charging taxpayers fees of approximately $25 to receive expedited electronic transcripts. This is an example of how the IRS policy to limit access to such a useful program, the Transcript Delivery System (TDS) in particular, has had a detrimental and unintended effect on taxpayers. The IRS has created the opportunity for private industry to establish a commercial market for federal data that used to be and should be available free to all taxpayers.

RECOMMENDATIONS

The National Taxpayer Advocate recommends that the IRS take the following actions:

• Expand access to e-Services to all practitioners qualified to practice before the IRS pursuant to Circular 230, while maintaining high security standards. This would entail redesigning the system to allow non-EROs to complete the authentication process.

• Confirm that access to e-Services, Electronic Account Resolution (EAR) in particular, does not create an opportunity for unenrolled preparers to practice before the IRS in a manner that goes beyond the limits of Circular 230.

• Develop e-Services access for all taxpayers to receive transcripts free of charge, while carefully taking the necessary security measures to ensure that confidential tax data is highly safeguarded as it is transmitted over the Internet.

² Kevin Belden, Chairman Electronic Tax Administration Advisory Committee, Reducing Taxpayer Burden -- Expanding e-Filing and e-Services, Remarks Before the IRS Oversight Board (Jan. 29, 2002).

³ The National Taxpayer Advocate is currently working to gain formal access to e-Services for the LITCs. The LITC program provides matching grants for qualifying organizations that represent low income taxpayers involved in controversies with the IRS and for organizations that provide tax education and outreach to taxpayers who speak English as a second language (ESL) or who have limited English proficiency (LEP). Qualifying clinics may not charge for their services or may charge only a nominal fee. IRC § 7526. In addition, they are prohibited from charging a fee for tax preparation.

⁴ Statement of James D. Leimbach, Enrolled Agent, National Association of Enrolled Agents, Panama City, Florida, Testimony Before the Subcommittee on Oversight of the House Committee on Ways and Means (March 30, 2004); Statement of Claudia Hill, Government Relations Committee, National Association of Enrolled Agents, Gaithersburg, Maryland, Testimony Before the Subcommittee on Oversight of the House Committee on Ways and Means (April 08, 2003).

⁵ IRM § 3.42.7.1.1.1 (Oct. 2004).

⁶ IRS Pub. 3187, IRS e-Strategy for Growth, Expanding e-Government for Taxpayers and Their Representatives (Jan. 2005); IRM § 3.42.1.3.1 (Jan. 2005)

⁷ The registration process is a one-time automated process where the user selects a username, password and PIN. An on- screen acknowledgment confirms that the user has successfully completed the initial registration process.

⁸ Wage & Investment Operating Division, Filing Season Update, 15-17 (May 2005). 36,532 registered in FY 2004 and 49,920 registered in FY 2005 through May 2nd. Note: Not all who register are eligible for services.

⁹ The PTIN application enables a preparer to apply for and receive online a PTIN or look up a forgotten PTIN. An actual PTIN card can be sent if requested.

¹⁰ Wage & Investment Operating Division, Filing Season Update, 15-17 (May 2005).

¹¹ The online e-Services program allows the application to be saved in progress and an acknowledgment of completion sent via email. Applications can be maintained and updated electronically and a new delegation of authority feature allows principals or responsible officials of the firm or organization to delegate e-Services to their employees.

¹² Interactive and Bulk TIN matching are not available if the firm has not filed information returns with the IRS in one of the past two tax years.

¹³ Wage & Investment Operating Division, Filing Season Update, 15-17 (May 2005).

¹⁴ ETA Fact sheet, e-Services Expands Incentive Products Access to More Tax Professionals starting March 16, 2005.

¹⁵ Authorization forms include Form 2848, Power of Attorney and Declaration of Representative, and Form 8821, Tax Information Authorization.

¹⁶ During the 2005 IRS Nationwide Tax Forums, tax professionals expressed frustration over the processing of Power of Attorney forms. This electronic platform may alleviate some of their concerns.

¹⁷ Wage & Investment Operating Division, Filing Season Update, 15-17 (May 2005).

¹⁸Id.

¹⁹Id. It is interesting to note that the usage increased significantly in 2005. There were 9,610 request in FY 2004 and 59,943 requests in FY 2005 through May 2nd.

²⁰ The study broke the results down based on the following four groups: (1) 750 total practitioners excluding H&R Block and Jackson-Hewitt preparers (2) 400 practitioners serving mainly Spanish-speaking taxpayers excluding H&R Block and Jackson-Hewitt preparers, (3) 127 H&R Block preparers, and (4) 124 Jackson-Hewitt preparers. FCB & Russell, Findings From the 2004 e-file Practitioner Tracking Study, PowerPoint Presentation to IMF Integration 3 (July 2004).

²¹ Only 54 percent of H&R Block practitioners expressed that they were very or somewhat interested in using e-services. With 61 percent seasonal employees, the study found that H&R Block has a larger percentage of seasonal employees than the other groups. Jackson Hewitt had 41 percent seasonal employees and total practitioners excluding the two aforementioned tax preparation firms had 27 percent seasonal employees. FCB & Russell, Findings From the 2004 e-file Practitioner Tracking Study, PowerPoint Presented to July IMF Integration 2004, 6 & 19.

²²Id at 34.

²³ The Electronic Tax Administration Advisory Committee (ETAAC) is authorized under the Federal Advisory Committee Act, Pub. L. No. 92-463. ETAAC's provides continuous input into the development and implementation of the IRS's strategy for electronic tax administration. IRS ETAAC Factsheet.

²⁴ Kevin Belden, Chairman Electronic Tax Administration Advisory Committee, Reducing Taxpayer Burden -- Expanding e-Filing and e-Services, Remarks Before the IRS Oversight Board (Jan. 29, 2002).

²⁵ IRS Pub. 3187, IRS e-Strategy for Growth, Expanding e-Government for Taxpayers and their Representatives (Jan. 2005); IRM § 3.42.1.3.1.

²⁶ Electronic Tax Administration Advisory Committee, Annual Report to Congress, Recommendation 4.4, (June 2004).

²⁷ Electronic Tax Administration, Factsheet, e-Services Expands Incentive Products Access to More Tax Professionals starting March 16, 2005.

²⁸ Electronic Tax Administration Advisory Committee, Annual Report to Congress, 9 (June 2005).

²⁹ Kevin Belden, Chairman Electronic Tax Administration Advisory Committee, Reducing Taxpayer Burden -- Expanding e-Filing and e-Services, Remarks Before the IRS Oversight Board (Jan. 29, 2002). The IRS currently uses the same tactic in the Volunteer Income Tax Assistance program (VITA) by providing more services to those VITA sites that e-file above a certain rate. IRM § 22.30.1.4.3.4(6).

³⁰ BMF 2005-010. The ETA Preparer database included 665,866 practitioners who filed between one and five tax returns during Processing Year 2003. This number represented 62 percent of the 1,073,995 total number of unique preparer IDs.

³¹ Treasury Inspector for Tax Administration, Ref. No. 2001-40-049, Management Advisory Report: Risks Should Be Weighed When Using Electronic Services as Incentives 8-9 (Feb. 2001).

³² In the communications plan for the e-Services revised threshold change, the IRS acknowledged data indicating sufficient capacity to expand accessibility to cover all EROs currently e-filing. Communication Plan, E-Services Threshold Change, 3 (Feb. 17, 2005).

³³ For a more in depth discussion of the IRS policy to restrict distribution of transcripts at TACs, see National Taxpayer Advocate 2004 Annual Report to Congress 8-25; United States Senate Appropriations Subcommittee on Transportation, Treasury, the Judiciary, Housing and Urban Development, and Related Agencies, 109th Cong. (April 7, 2005) (Statement of Nina E. Olson, National Taxpayer Advocate); Joint Review of the Strategic Plans and Budget of the Internal Revenue Service: Hearing Convened by the Chairman of the Joint Committee on Taxation, 109th Cong. (May 19, 2005) (Statement of Nina E. Olson, National Taxpayer Advocate).

³⁴ IRS News Release, 2005 Tax Filing Season Sets Records, IR-2005-53, (April 28, 2005) ("The 66 million e-file returns accepted through April 22 topped the 62 million electronic returns received for all of 2004.").

³⁵ V-coders are practitioners who prepare tax returns on computer software but print out paper returns and file by mail.

³⁶ FCB & Russell Research, Presentation of Findings, Practitioner Business Impact Study: Committed e-file Users vs. Committed V-Coders, BMF Integration Meeting, screen 32 (September 2004).

³⁷ FCB & Russell Research, Findings from Practitioner Business Impact Research, PowerPoint Presentation, screens 21-23 (July 2005) (The IRS stated, "with the quantitative evidence inconclusive on the issue of what tipped these former Committed V-Coders toward e-file we looked to their qualitative responses to a direct question about what made them change."); ETA Response to TAS Information Request (Sept. 19, 2005).

³⁸ TAS Attendance at Electronic Tax Administration Focus Group on E-Services, IRS National Tax Forum (Aug. 10, 2005)

³⁹ Statement of James D. Leimbach, Enrolled Agent, National Association of Enrolled Agents, Panama City, Florida, Testimony Before the Subcommittee on Oversight of the House Committee on Ways and Means (March 30, 2004).

⁴⁰ Circular 230 authorizes unenrolled preparers to practice before the IRS on a limited basis. Preparers can represent taxpayers before revenue agents, customer service representatives and similar IRS employees or officials on examinations of the tax period covered by the prepared return. Preparers are not authorized to represent taxpayers before Appeals, revenue officers, Counsel or other similar IRS employees or officials. 31 C.F.R. § 10.7(c)(1)(viii). Further, before the launch of the e-Services, practitioners in a focus group setting indicated that they had reservations about security and privacy with respect to the EAR. E- Services Focus Groups Results From the Nationwide Tax Forums 4 (2001).

⁴¹ Preparers of offers in compromise are not statutorily required to sign such submissions. For a more detailed discussion of this issue, see National Taxpayer Advocate 2003 Annual Report to Congress 270. See Most Serious Problem: Regulation of Electronic Return Originators, supra.

⁴² National Taxpayer Advocate 2004 Annual Report to Congress 67.

⁴³ In conjunction with providing greater general access to the product, the IRS needs to ensure that it provides adequate training on the product's features as well as how to navigate through the product.

⁴⁴ Statement of Claudia Hill, Government Relations Committee, National Association of Enrolled Agents, Gaithersburg, Maryland, Testimony Before the Subcommittee on Oversight of the House Committee on Ways and Means (April 08, 2003).

MOST SERIOUS PROBLEM: MANDATORY BRIEFINGS FOR IRS EMPLOYEES ABOUT THE TAXPAYER ADVOCATE SERVICE

RESPONSIBLE OFFICIAL

Internal Revenue Code § 7803(c)(2)(C)(ii) requires the National Taxpayer Advocate and the Commissioner to develop guidance for all IRS officers and employees, outlining the criteria for referral of cases to the Taxpayer Advocate Service (TAS). Moreover, in her 2004 Annual Report to Congress, the National Taxpayer Advocate observed that two of the most serious problems facing taxpayers are access to TAS and a lack of adequate IRS training on taxpayer rights.¹

To fulfill the statutory requirement and address the two problems referenced above, the National Taxpayer Advocate requested that the IRS include TAS training among its annual mandatory briefings for all IRS employees.² A required TAS briefing would make employees aware of the role and responsibilities of TAS, as well as when and how to refer a case to TAS. However, despite its assertion that training on taxpayer rights and TAS is "imperative," for employees,³ the IRS refuses to make a TAS briefing mandatory for all employees.

ANALYSIS OF PROBLEM

Background

Taxpayer Access to TAS

Congress created the Office of the Taxpayer Advocate in part to help taxpayers solve their problems with the IRS.⁴ To qualify for the Taxpayer Advocate Service's assistance, taxpayers must meet certain criteria based on the finding of "significant hardship" as outlined in IRC § 7811. Once a taxpayer meets the criteria, the taxpayer becomes eligible to receive free, independent, confidential, and personalized service from a knowledgeable Taxpayer Advocate. The advocate listens to taxpayers' situations, helps them understand what needs to be done to resolve their issues, and stays with them every step of the way until their problems are resolved to the fullest extent permitted by law.

Independent market research indicates that many taxpayers who could benefit from TAS services simply do not know about the organization. TAS reaches only about four percent of the approximately 5.25 million taxpayers eligible for assistance.⁵ More than 84 percent of those eligible taxpayers have never even heard of TAS.⁶ The research group concluded that between 1.2 million and two million taxpayers with a TAS qualifying problem would be very likely to use TAS -- if only they knew it existed.⁷

IRS Case Referrals

Aside from becoming aware of TAS through necessary public outreach initiatives, taxpayers could learn about TAS from referrals by IRS employees. Congress contemplated the importance of such referrals by directing the National Taxpayer Advocate and the Commissioner to develop guidance for IRS employees about TAS referral criteria. In her 2004 Annual Report to Congress, the National Taxpayer Advocate noted that without adequate training of IRS employees about the organization, TAS will remain the best-kept secret in the IRS -- and, as a consequence, taxpayers will not receive the help they need to resolve problems.⁸

In fiscal year (FY) 2005, TAS has seen an increase of TAS cases identified as meeting TAS criteria by the IRS operating and functional division.⁹

                  TABLE 1.15.1, IRS REFERRALS TO TAS

Statutory Requirement for TAS Training

IRC § 7803(c)(2)(C)(ii) requires the National Taxpayer Advocate to develop guidance for distribution to all IRS officers and employees outlining the criteria for referral of taxpayer inquiries to local Taxpayer Advocate Service offices. In October 2001, the Treasury Inspector General for Tax Administration (TIGTA) conducted a review to determine if the National Taxpayer Advocate had implemented the provisions of IRC § 7803(c).¹¹ TIGTA found that TAS had developed the required guidance about TAS case eligibility criteria and educated IRS employees about those criteria. However, TIGTA also found that TAS could not ensure that the IRS provided the criteria awareness training to all intended employees. TAS had published its case criteria on its internal IRS website and worked to update Internal Revenue Manual (IRM) references to these criteria. Local TAS instructors also presented criteria awareness training to IRS employees during continuing professional education (CPE) seminars, workshops, and group discussions. The reach of this training was limited, however, because TAS does not have authority to require IRS functions to participate, and had no process in place to track those employees who received TAS training.¹²

TAS Briefing Development

In response to the TIGTA audit, TAS developed TAS Annual Guidance for IRS Officers and Employees (Document 11189 Certification Process). Initially, in an effort to correct the deficiencies TIGTA identified, Local Taxpayer Advocates and other TAS employees attended many IRS CPE programs annually to provide specific training on TAS case acceptance criteria and manually record attendance.¹³ In FY 2004, TAS conducted 945 of these briefings.¹⁴

In FY 2005, TAS converted its training materials to a web-based (IRS intranet) briefing that teaches employees about TAS criteria and how to properly refer qualifying cases, while also identifying TAS' mission, roles, structure, and responsibilities. It takes 20 minutes for an IRS employee to complete the briefing,¹⁵ which tracks participants and completion.

IRS Position on TAS Mandatory Briefing

The IRS currently requires all employees to complete several mandatory briefings.¹⁶ In FY 2005, they included:

• Ethics Awareness;¹⁷

• Prevention of Sexual Harassment (POSH);¹⁸

• Computer Security Awareness;¹⁹

• Unauthorized Access Awareness (UNAX);²⁰

• Safety and Health;²¹ and

• No FEAR Act.²²

In FY 2004, the National Taxpayer Advocate requested the IRS to include the TAS web-based training as one of the IRS mandatory employee briefings. This request was an effort to meet the statutory requirement to deliver guidance to all IRS employees -- and a recognition that taxpayers are best served by IRS employees who are mindful of taxpayer rights.²³ The IRS rejected this request. TAS then requested that the IRS include TAS training for all employees in the FY 2006 mandatory briefings, and then only for public contact employees in FY 2007. The IRS also rejected this follow-up request. The IRS did agree, however, to deliver the TAS training to Wage & Investment (W&I) and Small Business/Self-Employed (SB/SE) division contact employees and managers (excluding IRS Accounts Management employees) in FY 2005. The IRS also suggested that TAS send an e-mail or a memorandum to the remainder of the workforce to provide guidance or instructions on where to find the TAS training.²⁴

To reach the applicable "contact" employees, the TAS Learning and Education staff worked with representatives from the operating divisions to ensure the successful coordination and delivery of TAS training. During FY 2005, over 27,000 IRS employees completed the TAS training.²⁵ Despite the usefulness and economy of the mandatory training approach, for FY 2006 the IRS has made a preliminary determination not to include TAS training as a mandatory briefing.

Current IRS Training is Not Adequate

In FY 2005, the TAS Office of Systemic Advocacy formed a task force to review certain compliance-related IRS training course materials for taxpayer rights protection content, including whether the materials adequately addressed the role and authority of TAS.²⁶The task force found that, with one exception, the role and possible involvement of TAS was rarely discussed in the evaluated courses and that there was little coverage on non- enforcement case resolution alternatives in the courses dealing with collection enforcement techniques.²⁷ Based on these findings, it appears that IRS employees are not receiving the information they need to know when and how to refer taxpayers to TAS.

The IRS's FY 2005 plans to deliver TAS training to certain public contact employees and managers were a step in the right direction. However, the limited training was a disservice to taxpayers and did not comply with the spirit -- if not the letter -- of IRC § 7803(c)(2)(C)(ii). All IRS employees interact with taxpayers on a constant basis, both professionally and personally. To a large extent, all IRS employees are public contact employees. When a person realizes that he or she is speaking to an IRS employee, tax and IRS related questions generally ensue. Taxpayers ask questions regardless of the IRS employee's title or job description. Invariably, many of these questions relate to the inquiring taxpayer's own experiences and problems with the IRS. TAS may be able to help solve some of these problems, but only if taxpayers know TAS is available.

It is not unreasonable to conclude that many taxpayers would receive TAS help if they learned about TAS through formal or informal conversations with an IRS employee. Unfortunately, because only select IRS employees receive TAS training, TAS awareness is unnecessarily limited. When a taxpayer speaks to an untrained IRS employee about specific problems, the employee may not know how to contact TAS, may not know whether TAS can help the taxpayer, or may not even know that TAS exists. Mandatory training for all IRS employees will help ensure that employees have the information necessary to refer a taxpayer to TAS when the opportunity arises.

Mandatory Briefings are an Efficient Training Method

Although an ideal approach would be to provide face-to-face TAS criteria training to all IRS officers and employees, a better use of the IRS's limited resources would be to provide basic, issue- recognition training by computer. TAS could supplement the computer training by directing face-to-face training resources to public contact areas of high importance. This targeted approach would deliver interactive training with case studies specific to each particular IRS program (examination, collections, etc).

The IRS has recommended that TAS work out arrangements with the operating divisions to include TAS training in their continuing professional education (CPE) programs as an alternative to the IRS mandatory briefing.²⁸ However, service-wide face-to-face presentations are very labor intensive and require a large human resources commitment. The IRS also suggested that TAS provide an email or memo to employees instructing them where to find additional guidance. However, this approach does not guarantee that a significant percentage of employees will actually take the training, nor does it provide a method to track which employees complete the training. Including the training as part of the web-based IRS mandatory briefing is an efficient mode of delivery to all IRS officers and employees and provides a method of tracking participation.

Mandatory web-based training is also a cost benefit to the IRS in a more indirect way. If IRS employees are adequately informed about TAS criteria, they will refer cases to TAS early on in the process where appropriate, rather than allowing the cases to languish unnecessarily in various parts of the IRS.

IRS employees also respond well to web-based training and briefings. After the second year of online mandatory employee briefings, the IRS Human Capital Office (HCO) reported that, on a scale of 1 to 5 (with 5 being very satisfied and 1 being very dissatisfied), IRS employees gave online mandatory briefings a rating of 4.3 or higher for content, usability, and understanding.²⁹ HCO stated that these high ratings indicated that employees had a "very positive experience" with online briefings and "the understanding of the key messages of the briefings increased significantly for all."³⁰

CONCLUSION

Generally, training and developing employees has many benefits, including increased job satisfaction, productivity, and employee motivation. In the IRS's current environment of increased compliance, referring a case to TAS when it meets TAS criteria is not only good for taxpayers -- it is simply good customer service. Customer service plays an important role in enforcement activities and often makes the difference in resolving an issue. Good customer service is not just the responsibility of the IRS public contact employees or managers, it is the responsibility of every IRS employee.

Pursuant to the Congressional directive in IRC § 7803(c)(2)(C)(ii), the IRS must fully commit to train all of its employees about the role of TAS and TAS criteria. An efficient manner to provide this training to all IRS officers and employees would be to include a TAS briefing in the IRS mandatory briefings. These annual briefings are a good introduction to TAS Case Acceptance Criteria, and can be supplemented with program-specific training about the availability and importance of TAS assistance through interactive case studies.³¹

IRS COMMENTS

The IRS agrees with the National Taxpayer Advocate that our employees are encouraged to take responsibility for assisting taxpayers in resolving inquiries if this can be accomplished within the scope of their position.

The IRS workforce is comprised of "contact" and "non-contact" employees. The two largest IRS divisions, Wage and Investment (W&I) and Small Business/Self-Employed (SB/SE) have a significant workforce of "contact" employees. The W&I Division serves 116 million individual taxpayers with wage and investment income only. The SB/SE Division serves approximately 45 million taxpayers that are fully or partially self-employed individuals and small businesses. The contact employees in these Divisions are the primary points of contact for most taxpayers and constitute the employee base that resolves inquiries within the scope of their positions.

Because all IRS employees do not have public contact, the IRS does not agree with the Advocate that all IRS employees interact with taxpayers on a constant basis, both professionally and personally. Therefore, the IRS does not agree that all employees need to be trained on TAS roles and responsibilities and when/how to refer a case to TAS. The TAS training delivered to contact employees in W&I and SB/SE, specifies the criteria for referring taxpayers to TAS, which includes making determinations on whether a taxpayer meets economic or systemic hardship. The TAS training would not be relevant to the roles performed by our other contact and non-contact employees.

Consequently, the IRS does not want all employees trained to evaluate the taxpayer's situation, determine if the case meets TAS Case Acceptance Criteria, and refer the case to the local TAS office. Making these determinations is outside the scope of our other contact and non-contact positions, and will likely result in inappropriate referrals to TAS, which is a disservice to taxpayers. The IRS encourages TAS to promote all-employee awareness of their organization by using established internal communication products and services.

In its final audit report, The National Taxpayer Advocate Needs to Ensure Operations Employees Receive Training to Identify Cases (Audit 200110023), the Treasury Inspector General's Office "found that the Taxpayer Advocate Service (TAS) developed guidance outlining the criteria for identifying cases to be referred to the TAS. The TAS provided guidance through internal manuals, the IRS Intranet, and criteria awareness training." Where TAS needed to take corrective action was to "ensure it has provided the training on identifying cases to the intended IRS employees." Our new training administration system (Enterprise Learning Management System) tracked completion of all students and managers, allowing TAS to ensure that training on identifying cases was provided to the intended employees.

The law requires the National Taxpayer Advocate to develop guidance to be distributed to all Internal Revenue Service (IRS) officers and employees outlining the criteria for referral of taxpayer inquiries to local offices of the taxpayer advocate. The law does not require the IRS to commit to train all of its employees on the role of TAS and TAS criteria. The IRS is training all appropriate contact employees about TAS but recommends that TAS initiate other actions to promote program awareness to all IRS employees, such as, posting information on the IRS's intranet page, inserting a pamphlet in Leave & Earning statements, and developing and distributing wallet cards.

TAXPAYER ADVOCATE SERVICE COMMENTS

Internal Revenue Code § 7803(c)(2)(C)(ii) requires the National Taxpayer Advocate and the Commissioner to develop guidance and distribute it to all IRS officers and employees outlining the criteria for referring taxpayer inquires local taxpayer advocate offices. The National Taxpayer Advocate recognizes that the statute does not specifically require the IRS to "commit to train all of its employees on the role of TAS and TAS criteria," but she does not believe her statutory obligation can be adequately fulfilled without some means of ensuring that each IRS employee is made aware of the Taxpayer Advocate Service's role and when it is appropriate to refer a case to a local TAS office. The IRS response indicates that it is content to read the statute so narrowly as to construe "distribute" to mean exactly that -- and nothing more.

The IRS suggests that the National Taxpayer Advocate fulfill her statutory obligation by posting information on the IRS intranet page, inserting pamphlets in employee Leave & Earning statements, and distributing "wallet cards." To be sure, each of these suggestions would "distribute" TAS information to IRS employees, but they are no replacement for interactive training. The IRS intranet page typically contains more than 50 links to numerous topics ranging from IRS research tools, to employee directories, to local weather forecasts. There is no assurance that a significant number of IRS employees would even find a TAS criteria link on the IRS intranet, let alone voluntarily click on the link and read the material provided. Distributing pamphlets in Leave & Earning statements or "wallet cards" to employees would in fact be a literal distribution (and we already plan to conduct such efforts), but there would be no means of tracking employee receipt or use of such cards. Moreover, these "passive" outreach initiatives are best used as a supplement to interactive learning.

The National Taxpayer Advocate believes that the most effective and efficient way to fulfill her statutory obligation to make all IRS employees aware of TAS and TAS criteria is through mandatory web-based computer training. Including the training as part of the web-based IRS mandatory briefings is an efficient mode of delivery to all IRS officers and employees and provides an effective method of tracking participation. This training should be supplemented by face-to-face sessions with public contact employees in appropriate national and local settings, as well as distribution of such "passive" memory aids as wallet cards.

The National Taxpayer Advocate recognizes the IRS cooperation in providing web-based mandatory briefings to many contact employees. She notes, however, that the statute makes no distinction between "contact" and "non-contact" employees. The National Taxpayer Advocate appreciates that some IRS employees have more public contact than others and that some employees may have very limited public contact while performing their official duties. However, to say that some IRS employees have no public contact either professionally or personally simply ignores reality. All IRS employees can expect to be asked questions about the IRS. The National Taxpayer Advocate believes that Congress contemplated this very reality when specifying that TAS guidance be given to all IRS employees. An employee adequately informed about TAS and TAS criteria will know how to contact a local TAS office and when it is appropriate to refer a taxpayer question to TAS.

Mandatory web-based training would improve taxpayer service and provide a cost benefit to the IRS. If all IRS employees are adequately informed about TAS criteria, they will refer cases to TAS early on in the process where appropriate, rather than allowing the cases to languish unnecessarily in various parts of the IRS.

RECOMMENDATION

The National Taxpayer Advocate recommends that the IRS assist the Taxpayer Advocate Service and the Commissioner in complying with the requirements of IRC § 7803(c)(2)(C)(ii) by including TAS training among its annual mandatory briefings for all IRS employees. The TAS developed training will cover the role of the National Taxpayer Advocate and the Taxpayer Advocate Service in assisting taxpayers and improving tax administration as well as the criteria for referral of taxpayer inquiries to local offices of the taxpayer advocate.

²Id. at 373.

³Id. at 350.

⁴ IRC § 7803(c)(2)(A)(i).

⁵ Russell Market Research conducted a study for TAS, Findings From Task 149 -- The Taxpayer Advocate Service Research Program: With a Focus on the Detailed Study of the Underserved Segment -- Phase II, Study # 3, (July 2002), and estimated that between 3.9 million and 6.6 million taxpayers were eligible for TAS services. TAS used the midpoint range for its discussion in the 2004 Annual Report to Congress.

⁶ The Russell Marketing study stated: "As hypothesized in Phase 1 of the study lack of awareness of TAS is clearly part of the underutilization problem, with only three percent who met the TAS qualifying criteria for being Underserved aware of TAS voluntarily and with only 16 percent aware after prompting." Russell Marketing Research, The Taxpayer Advocate Service Research Program: With a Focus on the Detailed Study of the Underserved Segment -- Phase II, Study # 3, (July 2002).

⁷See National Taxpayer Advocate 2004 Annual Report to Congress 367.

⁸Id. at 356-376.

⁹ TAS 2004 and 2005 case receipts were extracted from the Taxpayer Advocate Management Information System (TAMIS).

¹⁰ The IRM contains numerous cites directing IRS employees to refer cases to TAS. See, e.g., IRM § 3.12.3.3.15 -- Form 911 Hardship (Submission Processing), 4.2.1.14 -- Taxpayer Advocate Program (Examinations); IRM 5.19.9.3.7.1-Taxpayer Advocate Service Cases (Collections); 21.1.3.18 -- Taxpayer Advocate Service (TAS) Guidelines (Customer Account Services).

¹¹ Treasury Inspector General for Tax Administration, Ref. No. 2002-10-002, The National Taxpayer Advocate Needs to Ensure Operations Employees Training to Identify Cases (Oct. 2001).

¹²Id.

¹³ Service Level Agreement Between the National Taxpayer Advocate and The Commissioner, Wage and Investment Division; Service Level Agreement Between the National Taxpayer Advocate and the Commissioner, Small Business / Self-Employed Division.

¹⁴ National Taxpayer Advocate 2004 Annual Report to Congress 370.

¹⁵ There is also an Annual TAS Guidance for IRS Public Contact Managers. On average, it should take approximately 45 minutes to complete the briefing. See Annual TAS Guidance for IRS Public Contact Managers.

¹⁶ In a memo titled New Hire Policy from Human Capital Office to IRS Heads of Office: The IRS New Hire Policy clarifies the requirements for new hires on taking the annual Mandatory Briefings. New hires or seasonal employees who are returning to duty and complete the briefings on or after January 1, do not need to retake the briefings during the May -- September cycle, except when a briefing has been significantly revised.

¹⁷ Ethics Awareness as prescribed by Article 52, Section 5 of the IRS/NTEU National Agreement.

¹⁸ IRS Policy Against Sexual Harassment, Document 7591 (Rev. 5-2001); Memorandum from Mark W. Everson, Commissioner of Internal Revenue to all IRS employees on Prevention of Sexual Harassment Policy Statement, (June 2, 2004).

¹⁹ Computer Security Awareness as required by the Computer Security Act of 1987, Pub. L. No. 100-235, 100 Stat. 1724 § 5; IRM § 25.10.1.

²⁰ Unauthorized Access Awareness as required by the Taxpayer Browsing Protection Act 1997, Pub. L. 105-35.

²¹ Safety and Health as mandated by the Department of Treasury, Treasury Directive 71-05, Departmental Safety and Health Programs (Aug. 19, 2002).

²² No FEAR Act as required by the Notification and Federal Employee Anti-Discrimination and Retribution Act, Pub. L. No. 107-174, 116 Stat. 566.

²³ National Taxpayer Advocate 2004 Annual Report to Congress 373-374. TAS plans to supplement this web-based training with face-to-face training in certain functions on specific issues directly related to the function's workload.

²⁴ Human Capital Office Response to TAS Information Request (Oct. 14, 2005); Office of the Commissioner Response to TAS Information Request (April 11, 2005).

²⁵ In FY 2005, 11,178 Wage and Investment (W&I) Division and 15,828 Small Business and Self-Employed (SB/SE) Division managers and employees have completed the briefings. W&I Response to TAS Information Request (Oct. 6, 2005); SB/SE Response to TAS Information Request (Oct.13, 2005).

²⁶ Taxpayer Rights Training Team, Taxpayer Rights Training FY 2005 Report (Sept. 30, 2005), on file with the Taxpayer Advocate Service. The Taxpayer Rights Training Team reviewed compliance related training for Revenue Officers, Revenue Agents, Tax Compliance Officers, Tax Examiners and Automated Collection System (ACS) employees in the IRS Small Business/Self-Employed Division.

²⁷Id at 4. The Report noted that there was one "standout exception" to the general finding that the evaluated courses did not adequately address TAS issues. Course 17402, Revenue Officer CPE, Part 1: Enforcement & Investigative Tools, Part 2: Seizures (Rev. May 2005) contained discussions of taxpayer rights related to seizure actions and covered the requirement to advise affected taxpayers about TAS and provide and explain IRS Form 911, Application for Taxpayer Assistance Order.

²⁸ Office of the Commissioner Response to TAS Information Request (April 11, 2005); National Taxpayer Advocate 2004 Annual Report to Congress 372.

²⁹ IRS Human Capital Office, Leadership and Education, Report on the Successful FY 03 Online Delivery of Mandatory Employee Briefings (Oct. 28, 2003).

³⁰Id.

³¹ National Taxpayer Advocate 2004 Annual Report to Congress 342-355, 370-371. Taxpayer Rights Training Team, Taxpayer Rights Training FY 2005 Report (Sept. 30, 2005).

MOST SERIOUS PROBLEM: ALLOWABLE EXPENSE STANDARDS FOR COLLECTION DECISIONS

RESPONSIBLE OFFICIAL

The IRS is required to publish schedules of national and local expense allowances to be used as guidelines for making offer in compromise (OIC) decisions.¹ The IRS also uses these guidelines to determine how much a taxpayer should pay under an installment agreement and whether to pursue collection or place a taxpayer's account in "currently not collectible" (CNC) status.²

The guidelines (called "standards") are an important tool that the IRS must use carefully to resolve collection matters appropriately. If the IRS uses unrealistic expense allowance standards or applies them rigidly, it will resolve fewer collection matters through installment agreements or offers, force taxpayers to endure economic hardships (or force them into bankruptcy), and reject offers and installment agreements that represent its best opportunity for collection. If the IRS allows too few expenses, taxpayers who obtain installment agreements or offers will be more likely to default on them because the payment terms will not be realistic. Conversely, if the IRS allows too many expenses, it may forego revenue that it could collect. Despite their importance, the standards have a number of important limitations:

• Standards omit significant expenses. If the IRS, taxpayers, or practitioners rely solely on the standards, they may overlook significant costs such as healthcare and childcare because no standards exist for these expenses.

• Standards not realistic for some. Even if the IRS has an allowance standard for a given expense, the standards are unrealistic for some individuals because they are based on aggregate expense statistics for large groups of people in wide geographic areas.

• Standards not used to ensure that taxpayers can provide for basic living expenses. The IRS does not use the standards as a floor to prevent its collection activities from depriving a taxpayer of basic living expenses. For example, if a taxpayer does not have a basic living expense because he or she cannot currently afford the item, then the IRS does not automatically take the expense into account, even if it is for something as important as housing or health care.³

• Perception that IRS uses the standards to avoid responsibility for rejecting reasonable collection alternatives. Many practitioners feel that the standards are sometimes unreasonable and that the IRS often applies them rigidly, using them as an excuse to reject reasonable collection alternatives.⁴

• The IRS does not track how often employees fail to allow necessary expenses that exceed or are not included in the standards. The IRS cannot reliably assess practitioner concerns that IRS employees use the standards as an excuse to reject reasonable collection alternatives because the IRS does not track how often taxpayers request deviation from the standards or how often the IRS employees improperly deny such requests.

Background

Legislation enacted in 1998 requires the IRS to prescribe guidelines to determine whether to accept an offer in compromise.⁵ The legislation states that: