DEPARTMENT OF THE TREASURY WASHINGTON, D.C. 20220

INSPECTOR GENERAL for TAX�� ADMINISTRATION

October 31, 2002

The Honorable Paul H. O�Neill
Secretary of the Treasury
Washington, D.C. 20220

Dear Mr. Secretary:

I am pleased to submit to you the Treasury Inspector General for Ta x Administration�s (TIGTA) Semiannual Report to Congress for the reporting period April 1, 2002 through September 30, 2002. I am proud to say that despite the turmoil caused by the terrorist attacks last year and the increased demands on our staff, TIGTA has successfully produced results that aided tax administration and taxpayers nationwide.

This has been a very productive period for TIGTA�s Offices of Audit and Investigations.� Highlights of the Office of Audit�s accomplishments include issuing 118 audit reports that identified over $54 million in cost savings or funds put to better use, and an additional $237.6 million in increased revenue and/or revenue protected. The Fiscal Year (FY) 2002 total is $730 million. The Office of Audit also continues to identify significant issues related to information systems security, business systems modernization, returns processing, voluntary compliance and the earned income tax credit.

The Office of Investigations received 4,254 complaints of alleged criminal wrongdoing and/or administrative misconduct, of which 1,926 warranted further investigation. In addition, 3,061 investigations were opened and 2,430 were closed. The closed investigations included issues such as bribery, misuse of Internal Revenue Service (IRS) computer systems, fraud, and employee misconduct.� Investigative recoveries totaled $3.1 million for this reporting period. The total for FY 2002 is $12.7 million. I look forward to continuing to work with you, Congress and IRS officials to help the IRS address current and future challenges.

Sincerely,

Pamela J. Gardiner Acting Inspector General

TABLE OF CONTENTS

Table of Contents(CLICK ON ENTRY TO ACCESS REPORT SECTION)

Page

Dedicated to Our Future: A Message From the Acting Inspector General ....................... 3

Proud of Our Past: Legacy of the First IG .......................................................................... 5

Congressional Testimony ........................................................................................................ 7

Results of Work: TIGTA - A Performance-Driven Organization ....................................... 9

TIGTA Strategic Goal: Improving the Economy, Efficiency and
Effectiveness of Tax Administration ......................................................................... 10

TIGTA Strategic Goal: Detecting and Deterring Fraud in IRS Programs
�and Operations .......................................................................................................... 28

TIGTA Organization ............................................................................................................. 37

External Recognition ............................................................................................................. 43

Appendices ............................................................................................................................. 47

Appendix I Office of Audit�s Statistical Reports

Audit Reports with Questioned Costs .......................................... Appendix I-1

Reports With Recommendations That Funds Be
�� Put to Better Use I-2

....................................................................... Appendix Reports with Additional Quantifiable Impact on Tax
Administration I-3

.......................................................................... Appendix Prior Period Reports .................................................................... Appendix I-5

Appendix II Office of Investigation�s Statistical Reports

Investigations Opened and Closed ............................................ Appendix II-1

Financial Accomplishments ....................................................... Appendix II-1

Status of Closed Criminal Investigations ................................... Appendix II-2

Closed Dispositions .................................................................... Appendix II-2

Administrative Dispositions on Closed TIGTA
�Investigations .......................................................................... Appendix II-3

Complaints/Allegations Received by TIGTA .............................. Appendix II-4

Status of Complaints/Allegations Received� by TIGTA .............. Appendix II-4

Allegations of Misconduct Against IRS Employees .................. Appendix II-5

Appendix III Statistical Reports � Other

Audit Reports With Significant Unimplemented
�� Corrective Actions III-1

.................................................................. Appendix Statistical Reports � Others ..................................................... Appendix III-14

Appendix IV Audit Products (April 1, 2002 � September 30, 2002) ...... Appendix IV-1

Appendix V�� Statutory TIGTA Reporting Requirements ................. Appendix V-1

Appendix VI� Section 1203 Standards ................................................ Appendix VI-1

Hotline Information

Message From the Acting Inspector General

Despite the turmoil caused by the terrorist attacks last year and the increased demands on our staff, TIGTA has achieved its goals and produced results that aided tax administration and taxpayers nationwide. During this reporting period, the Office of Audit (OA) issued 122 audit products - 118 audit reports and the Inspector General (IG) and Deputy IG for Audit (DIGA) testified before Congress four times. The Office of Investigations Pamela J. Gardiner has (OI) opened 3,061 investigations and closed 2,430. ^{been Acting Inspector}Between April 1st and September 30th, Counsel ^{General since August 2002.}reviewed 142 proposed regulations and legislation.

We bade farewell to David C. Williams, the first presidentially appointed
TIGTA Inspector General who retired in August 2002.� His leadership was
instrumental in the success of TIGTA as an organization and the significant
accomplishments achieved.

Our future holds many of the same challenges we have always faced. We will
continue to streamline our processes and leverage technology to provide audit
and investigative services effectively.�� We believe our recently-implemented
telecommuting program, which we call the Virtual Resource Solution (VRS),
will ultimately help us achieve greater efficiency in how we perform
our work.

In light of the terrorist attacks of September 11, 2001, TIGTA faces great
challenges in combating terrorism and cyber-terrorism targeted at the IRS.
In response to heightened security concerns and TIGTA�s responsibility for
investigating threats against the IRS and its employees, we have established a
Counter-Terrorism Section (CTS).� The CTS coordinates investigative efforts
and is the centralized repository and dissemination point of threat information
to the IRS. The CTS proactively identifies domestic and international threats
made to the IRS by participating on nationwide Federal Bureau of
Investigation (FBI) Joint Terrorism Task Forces (JTTFs), evaluating
information developed by JTTFs and other sources, initiating investigations,

and issuing intelligence reports and advisories notifying TIGTA and IRS management of potential threats.

Additionally, we have initiated a review of our performance goals to ensure that we are in alignment with the President�s Management Agenda and that our measures are guiding our agency�s workload focus.� We will continue implementing the President�s Management Agenda by competing functions with the private sector (as prescribed in the Office of Management and Budget�s Circular A-76) while improving our financial accountability.

Finally, we will continue to align our organization and focus, as appropriate and advisable, with that of the IRS. As IRS modernizes and changes, how TIGTA performs its oversight role may change.� All of our staff will need to stay current and well trained on the latest technology enhancements as well as the new ways IRS conducts its business.

We look forward to welcoming a new IG and a new Commissioner of Internal Revenue and seek to further a productive relationship that results in improved tax administration.

Legacy of the First IG

PROUD OF OUR PAST

In May 1999, David C. Williams
became the first presidentially
appointed IG for the
�newly-established TIGTA

s a result of the Internal Revenue Restructuring and Reform Act of 1998 (RRA 98),¹ Mr. Williams helped to transition the former IRS Inspection Service into an independent IG office tasked with providing independent oversight of IRS activities, the IRS Oversight Board, and the IRS Office of Chief Counsel.� He established the mission and vision of the organization, ensured that TIGTA remained independent and objective in both perception and reality, and that its products were timely and of high quality.

He always reminded staff that TIGTA should be �a good deal for the taxpayers.� To ensure this happened, he realigned TIGTA.� The Office of Audit was organized to parallel IRS� new structure, allowing audit teams to focus on specific issue areas. Office of Investigations (OI) Special Agents-in-Charge were strategically placed across the country to respond to allegations of fraud, waste, and abuse as well as threats and assaults. OI established the divisions of Complaint Management, Strategic Enforcement, Special Inquiries and Intelligence, Technical and Forensic Support, and Operations.

Additionally, Mr. Williams realized that TIGTA�s investigative training section would be a valuable asset to the entire IG community.� In July 1999, a President�s Council on Integrity and Efficiency (PCIE) working group proposed that the IG Academy and the TIGTA Training Section be merged. Both the PCIE and the Executive Council on Integrity and Efficiency� (ECIE) endorsed the consolidation and the specific recommendations for structuring the newly expanded Academy.� Congress recently passed legislation that established the Criminal Investigator Academy within the Department of the Treasury for the

¹Pub. L. No. 105-206, 112 Stat. 685.

purpose of performing investigator-training services for offices of Inspectors General.

Mr. Williams integrated TIGTA�s budget and performance functions in the Office of Performance and Investment before this became one of the top issues of President George W. Bush�s management agenda.� To ensure TIGTA was positioned to meet 21st century challenges, he began the Engines of Change Initiative, designed to realign the organization efficiently and effectively, leverage state-of-the-art technology, address human capital needs and reinforce TIGTA�s position as a performance-driven organization.

He also embraced the idea of telecommuting and instituted TIGTA�s model program entitled the Virtual Resource Solution.� Realizing that the rest of the Inspector General community would benefit from this effort, Mr. Williams established a working group and advised other OIGs on the means and benefits of mobilizing their workforce.

Mr. Williams has left a legacy which will enable TIGTA to continue the successes achieved in the past.

CONGRESSIONAL TESTIMONY

its information

taxpayers� calls to the appropriate IRS employee; an Internet ^{technology systems, but}application that allows taxpayers to progress has been slower check the status of their returns and _{and more costly than}refunds; an IRS-wide secure technology environment; and a ^expectedsystem designed to improve the availability and performance of modernized systems. IRS also released an update to its Enterprise Architecture

²Floyd D. Spence National Defense Authorization Act for FY 2001, Pub. L. No. 106-398, 114 Stat. 1654.

that serves as the roadmap for current and future modernization projects, and is
working on several key projects that are scheduled for release late in 2002 and
early 2003. One of the new projects, the Customer Account Data Engine, will
eventually replace the existing Masterfile of taxpayer accounts.

However, IRS and its PRIME³contractor have struggled with developing and integrating the discipline and repeatable processes needed to modernize the agency�s technology effectively and efficiently.� IRS and the PRIME contractor have to rely on the dedication of their employees to deliver the projects. IRS and the PRIME contractor are challenged with implementing and integrating mature processes, while facing increased expectations and scrutiny from Congress and other stakeholders. In addition, the BSM projects IRS is designing and developing now will be significantly more complex as these process improvements are made. This creates a significant risk that costs will continue to exceed estimates, along with a delay of benefits to taxpayers.

Some of the BSM issues OA is monitoring include:

Meeting project cost and schedule estimates. Virtually all of the BSM projects
the PRIME contractor controls have experienced delays and have incurred cost
increases. For the projects OA reviewed, delays of project dates were from four
to nine months, while cost increases ranged from nearly $700,000 to more than
$13 million from original estimates. As of September 30, 2002, IRS had spent
or obligated almost $1 billion in modernization funds. The agency plans to
spend or obligate about $450 million in 2003. IRS intends to deliver several
projects with direct taxpayer benefits in 2003. However, some of these projects
will be deployed later than planned, and others have been scaled back in order to
meet delivery dates.

Implementing performance-based contracting processes. Although there have been improvements in obtaining agreements on contract requirements and reducing modifications, improvements in the application of performance-based contracting techniques are needed. For example, plans for monitoring contractor performance were not consistent among projects, subjective monitoring methods often were used, and determinations of whether or not the PRIME contractor met performance standards often were not made or documented.

Maintaining a consistent strategic direction. The Commissioner of Internal Revenue, who will complete his term in November 2002, has been a key player in

^�3IRS has contracted with a group headed by the Computer Sciences Corporation (also known as the PRIME contractor) to manage its efforts in modernizing its information technology systems.

For example, taxpayers have several options from which to choose when they need assistance from IRS in answering tax law questions. These options include walk-in service at nationwide Taxpayer Assistance Centers (TACs) and toll-free telephone assistance. However, OA found variations in the quality of service received by taxpayers who use these options.

The audit results indicate that taxpayers who choose to use the telephone are more likely to receive a correct answer to their tax law question than taxpayers who choose to visit a TAC.� The TACs are the only option for assistance that provides face-to-face contact with an IRS employee. IRS statistics showed that during the 2002 Filing Season, IRS handled more than six million calls from taxpayers who had tax law questions and wished to speak to a telephone assistant.⁵Also, during the filing period, approximately

6.2 million taxpayers visited IRS TACs.� OA will issue a roll-up report during the next reporting period that will include recommendations to address improving the accuracy rate in the TACs.

IRS management has made significant progress in selecting more than 400 IRS sites nationwide to list their telephone numbers and addresses, but these have yet to be published in local telephone books as required. OA made recommendations to correct this issue and IRS has taken or planned appropriate corrective actions.

Also, the quality measurement system for IRS� Internet site has not been changed to reflect the new organizational structure.� Without a separate measure, IRS is unable to reliably determine the quality of service being provided to each of its major customer segments. OA recommended that IRS take action to develop reliable measures of the quality of service provided to each customer segment.

IRS management agreed and will conduct a study to determine the feasibility of implementing the recommendation.

�Customer Service reports are listed in Appendix IV and can be found at http://www.treas.gov/tigta/oa_auditreports.html

⁵OA did not validate the accuracy of these statistics.

Returns Processing The Small Business/Self-Employed (SB/SE) Division serves approximately 45 million taxpayers, including fully or partially self-employed individuals and small businesses. Many of these taxpayers are required by law to file a number of complex tax forms and schedules, which increases the inherent risk of filing and processing errors on the part of taxpayers and IRS. A strategic goal of IRS is to reduce the burden placed on these taxpayers. To help reduce taxpayer burden through improved business practices, IRS has shifted its focus from addressing taxpayer problems well after returns are filed to addressing them as early in the process as possible, thereby preventing problems wherever possible.

The following summarizes the results of OA�s significant reviews in this area.

The Internal Revenue Service Needs to Simplify Filing Requirements and Clarify Processing Procedures for Small Business Corporate Returns (Reference No. 2002-30-186)

�http://www.treas.gov/tigta/auditreports/2002reports/200230186fr.html

Each year IRS is unsuccessful in processing U.S. Income Tax Returns for an S Corporation (Form 1120S) for an estimated 46,000 small businesses. In these instances, IRS did not have the necessary Elections By a Small Business Corporation (Form 2553) on file to allow the Form 1120S returns to be processed. These taxpayers spent an estimated 3.2 million hours each year preparing, copying, assembling and sending these returns, which IRS then could not successfully process.

In addition, IRS did not consistently process _{IRS
did not}Forms 1120S and determine the correct taxes due from small business taxpayers. In ^consistentlyCalendar Year (CY) 2000, IRS did not process _{determine the}an estimated 9,000 returns as small business corporations, even after the taxpayers verified ^{correct and
proper}that their election requests were granted. ^{taxes due by small}Instead, IRS converted these Forms 1120S to _{business
corporate}Forms 1120 and processed them as regular corporate returns without considering the fact ^taxpayersthat the taxpayers verified the elections were granted. Because these returns were not processed correctly, there is the potential for the erroneous assessment of taxes on $41 million of profits and the inability of taxpayers to claim over $100 million in losses. Further, because of unclear IRS procedures, approximately 3,700 taxpayers who filed unprocessable Forms 1120S may have their rights violated when IRS assesses taxes on an estimated $6.7 million in profits without sending a statutory notice of deficiency.

OA recommended the development of procedures that would improve and simplify the process for approving, recording, and controlling elections and the related notification process. This will make it easier for taxpayers to file their Forms 1120S and ensure the accuracy of the IRS� records.� Implementation of these recommendations should reduce taxpayer burden for an estimated 232,000 taxpayers over a five-year period and reduce erroneous assessments and violations of taxpayer rights for approximately 50,000 taxpayers.

IRS management�s response was not received prior to the issuance of the audit report.

Although the 2002 Filing Season Was Completed Timely,
Customer Service Can Be Improved During Error Processing
(Reference No. 2002-40-200)

http://www.treas.gov/tigta/auditreports/2002reports/200240200fr.html

Overall, IRS had a successful 2002 Filing Season. As of May 31, 2002, it had received 123.2 million individual income tax returns - including

46.3 million received electronically - representing a small increase over2001. Despite an unusually large number of unexpected errors, IRS completed processing all refund returns in a timely way.� The increase in errors was caused primarily by taxpayer confusion in correctly reporting any additional Rate Reduction Credit (RRC) due after receiving the advance RRC credit refund in the summer of 2001.

IRS management could further improve its quality of _{2002
Filing Season}taxpayer service by using a proactive approach when _{completed
timely}correcting error returns while in the Error Resolution System (ERS). When IRS identified and despite large number corrected errors related to an incorrect RRC during _{of unexpected
errors at}normal tax return processing, these corrections resulted in 132,672 taxpayers becoming eligible for ^{processing centers}the Additional Child Tax Credit (ACTC) totaling $25.7 million. Although IRS acknowledged the eligibility of these taxpayers and stated that applying the credit during error processing was feasible within the automated adjustment process available, IRS chose not to.

IRS� decision not to apply the credit during original return processing was based on the assumption that these returns would be identified later and the taxpayers given the appropriate credit during the planned outreach initiative. However, IRS subsequently cancelled this initiative.⁶

OA recommended that IRS consider developing a proactive approach in the ERS to apply appropriate credits affected by the corrections made during error processing. IRS declined this recommendation, citing limited capability and capacity and the complicated computer programming required as the primary obstacles preventing it from using the ERS as a proactive tool. However, IRS did acknowledge the recommendation�s intent and agreed to notify the 132,672 taxpayers identified as to their potential eligibility for $25.7 million in unclaimed ACTC.� OA responded that while it believes this recommendation is worthy of further consideration, it recognizes the limitations expressed by IRS and believes IRS will continue working to overcome such limitations in the future.

Outreach Initiatives Need to Ensure Taxpayers Receive the Benefit of the Child Tax and Additional Child Tax Credits (Reference No. 2002-40-203)

�http://www.treas.gov/tigta/auditreports/2002reports/200240203fr.html

After the 2002 Filing Season, IRS planned to conduct a proactive outreach initiative that would identify and contact eligible taxpayers who failed to claim the Child Tax Credit (CTC) or the ACTC on their 2001 Individual Income Tax Returns. Analysis of tax returns processed between January 1 and May 31, 2002 determined that approximately 1.6 million taxpayers claimed the ACTC.

Additionally, OA identified 611,560 Tax Year (TY) 2001 tax returns where taxpayers did not claim potential ACTC totaling $238 million. Of these, 87 percent qualified under the new tax law provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), with 74 percent having earned income of less than $25,000 per year.

Taxpayers who appeared eligible, but did not claim or receive the credit, fell into two categories.⁷The larger consisted of 478,888 tax returns where taxpayers

⁶See related audit report, Reference No. 2002-40-203, September 2002.

⁷OA only addressed this category in this report.� The remaining taxpayers are addressed in a related report, Reference No. 2002-40-200, September 2002.

failed to claim the ACTC - totaling $212.3 million - on their original tax returns and were not identified during IRS processing. IRS has no method in place to detect tax returns meeting this condition during normal IRS processing.

In April 2002, OA issued a memorandum recommending that IRS consider modifying its planned outreach initiative, accelerating the issuance of notices by using TIGTA�s computer extract⁸of affected returns as a means to quickly notify taxpayers of their potential ACTC eligibility.� However, in May 2002, IRS cancelled the initiative. IRS is currently looking at other options such as mailing a flyer to potentially eligible taxpayers.

Integrating Performance and Financial Management

Improving performance is an overall goal of the federal government. Without accurate and timely financial information, it is not possible to accomplish the President�s Management Agenda to secure the best performance and highest measure of accountability for the American people.

The following summarizes the results of OA�s significant reviews in this area.

Computers Used to Provide Free Tax Help and That Contain Taxpayer Information Cannot Be Accounted For (Reference No. 2002-40-144)

�http://www.treas.gov/tigta/auditreports/2002reports/200240144fr.html

IRS� Volunteer Income Tax Assistance and Tax Counseling for the Elderly (VITA/ TCE) program provides free tax assistance to people for whom professional assistance may be too expensive. In an effort to promote IRS electronic filing (e-filing), IRS provides more than 6,600 computers and the tax preparation software necessary to enable volunteers to offer taxpayers who receive assistance the option of e-filing their tax returns. For Filing Season 2001,

⁸To claim the ACTC, taxpayers must first claim the CTC.� TIGTA�s computer extract identified all taxpayers claiming the CTC and then analyzed the return data for the potential eligibility of taxpayers that had not also claimed the ACTC.� OA�s extract did not identify potentially eligible taxpayers that did not claim the CTC.

volunteers prepared approximately 1.1 million tax returns, with more than 700,000 (64 percent) e-filed.

IRS does not have adequate internal controls and accountability over the computers it provides to VITA/TCE sites. It cannot physically account for computers provided to volunteers, did not ensure that taxpayer e-file data were removed from volunteer computers at the end of Filing Season 2001, and did not ensure that only authorized software was loaded on volunteer computers when provided.

OA recommended that IRS management perform a physical inventory of all computers in its VITA/TCE program. Procedures should be developed, distributed, and implemented to ensure that property records are updated for all computer equipment obtained from external agencies, e-filed taxpayer data is erased from volunteer computers at the conclusion of a tax filing season, and only authorized software is loaded onto volunteer computers. IRS management should pursue legislative changes that would allow IRS to transfer ownership of the computers to the volunteer organizations.� Presently, the Federal Property and Administrative Services Act of 1949⁹prohibits IRS from donating computers to volunteers. As a result, IRS must continue to maintain control and accountability over these computers, as well as to protect taxpayer data saved on these computers.

IRS management agreed with the recommendations and is taking appropriate corrective action.

The Internal Revenue Service Does Not Penalize Employers that File Wage and Tax Statements with Inaccurate Social Security Numbers (Reference No. 2002-30-156)

�http://www.treas.gov/tigta/auditreports/2002reports/200230156fr.html

Both the Social Security Administration (SSA) and IRS have critical interests in ensuring the accuracy of information provided by employers on Wage and Tax Statements (Forms W-2). SSA is required to maintain accurate earnings records and calculate Social Security benefits. IRS uses the Social Security Number (SSN) to ensure that information submitted by taxpayers is properly processed to the IRS� Masterfile¹⁰and to rely on the accuracy of Forms W-2 in programs to verify filing and reporting compliance with tax laws.

To achieve more accurate name/SSN reporting by employers, SSA requested in November 1998 that IRS more strictly enforce the �information return� penalty against employers.¹¹As a follow-up, in August 2000 SSA provided IRS with a list of the most egregious non-compliant employers for TYs 1997 and 1998. SSA provided this information so IRS could determine whether or not to assess penalties.

OA determined that IRS does not impose available penalties on employers who file Forms W-2 with inaccurate name/SSN combinations. Also, IRS has not

¹⁰The Masterfile is the main IRS computer system that stores various types of taxpayer account information, including individual and business data.

¹¹Internal Revenue Code (I.R.C.) � 6721.

developed a regularly scheduled program for administering the information return penalty for those forms.

In this context, IRS did not determine whether penalties should be assessed against the most egregious non-compliant employers. As a result, IRS did not propose and, subsequently assess when justified, an estimated $26 to $29.7 million in penalties against 93 employers for TY 1997 and

�98 employers for TY 1998.

OA apprised IRS of this concern through a memorandum issued during the audit. OA recommended that IRS ascertain if penalties could be assessed before the three-year statute of limitations expired¹² and meet with SSA to develop jointly a method for SSA to refer formally to IRS the most egregious non-compliant employers for penalty consideration in future years. Moreover, OA apprised IRS of the need for a separate, regularly scheduled penalty program.

IRS management determined that assessing penalties so close to the statute expiration date would be contrary to the IRS� due process procedures and could compromise taxpayers� rights. However, IRS management agreed with the remaining recommendations and is taking corrective action. IRS also advised that it is exploring the ramifications of not pursuing this area of non-compliance.

The Large and Mid-Size Business Division�s Program Controls Could Be Improved to Ensure More Timely and Accurate Examinations of Large Corporations¹³

http://www.treas.gov/tigta/oa_auditreports.html

The Large and Mid-Size Business (LMSB) Division has responsibility for examining the nation�s largest corporations.� For examination purposes, the LMSB Division divides the nation�s 58,000 large corporations into two segments. About 1,300 are classified as Coordinated Industry Cases (CIC), while the remaining are referred to as Industry Cases (IC). The CIC and IC corporate examinations account for about two-thirds of all recommended additional taxes from all IRS examinations. However, the length of time it takes to complete the burdensome examinations has been an ongoing concern of both IRS and stakeholders.

¹²I.R.C. � 6501.

¹³Reference Nos. 2002-30-147, 2002-30-148, and 2002-30-149, September 2002.

Due to the complexity of the tax issues in large corporate examinations, examiners are often required to call upon Engineer Specialists, Financial Products Specialists, and Computer Audit Specialists for assistance.� OA�s reviews of the processes for requesting and providing these types of specialized assistance indicated the time taken to do so might hamper LMSB Division�s efforts to meet its goals for timely completing examinations and reducing the burden lengthy examinations have on taxpayers.

For example, the LMSB Division has a FY 2003 goal of closing IC and CIC examinations in 29 and 54 months, respectively, after the returns are filed. However, OA analysis showed that after returns were filed, Engineer Specialists were taking an average of 36 months to complete their portion of an IC examination and about 56 months to complete a CIC examination. Similarly, Financial Products Specialists were taking an average of 37 months to complete their portion of an IC examination and about 43 months to complete a CIC examination. OA reviews also identified that examiners were not consistently requesting the assistance of the specialists in IC examinations when they should. As a result, issues involving approximately $724 million of potential tax revenue were overlooked.

To address the timeliness of requesting and delivering Engineer and Financial Products Specialist services, OA recommended:� (1) ensuring management�s information system has complete data so problems that affect timeliness can be identified and addressed; and, (2) providing guidance to managers on establishing specific time frames for completing examinations that are aligned with the LMSB Division goals. OA also recommended establishing a control process that ensures the three types of specialists have an opportunity to assist in all large corporate examinations.

IRS management agreed with these findings and is taking action to implement the recommendations.

Erroneous Payments Improper payments include inadvertent errors, unsupported or inadequately supported claims, services not rendered, ineligible beneficiaries, and payments resulting from outright fraud and abuse by program participants or federal employees.

In early CY 2002, the U.S. Chief Financial Officers Council and the PCIE jointly chartered a work group to address improper and erroneous payments government-wide. The work group�s mission is to assist in fostering changes in federal government policies and practices that will reduce the risks associated with the expenditure of program and administrative funds. It is seeking to identify and benchmark methods to reduce and, where possible, eliminate improper and erroneous payments made by federal agencies. TIGTA is participating in this important effort.

The following summarizes the results of OA�s significant reviews in this area.

The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations (Reference No. 2002-30-125)

�http://www.treas.gov/tigta/auditreports/2002reports/200230125fr.html

A corporation electing to become a Subchapter S Corporation (S Corporation) may pass through its income and losses to its shareholders for federal income tax purposes. In addition, S Corporations are required to pay their officers a reasonable salary for any personal services rendered in the administration or management of the corporation.

Some S Corporations have historically paid very small salaries to their officers and passed through most of the S Corporation�s income directly to the officers. This action enables the S Corporation and the officers to avoid paying the Federal Insurance Compensation Act (FICA)¹⁴tax on a reasonable amount of compensation or salary.� As recently as 1998, IRS conducted a study of S Corporation officer compensation.� The study results indicated that as much as $284 million in FICA taxes might have been unreported for TY 1995.

OA reviewed 84 S Corporation cases, of which 58 had officer distributions, but examiners did not address officer compensation issues in 13 (22 percent) of the 58 cases. In the cases reviewed, the shareholders reported an average of only $5,300 of wages on the Form W-2, while reporting an average distribution of $349,323. OA also determined that examiners have limited access to sophisticated tools, such as software and databases, which are necessary to identify S Corporations that attempt to evade paying FICA taxes on reasonable officer salaries. Additionally, IRS management could improve its outreach efforts to improve S Corporation compliance through more educational activities.

¹⁴ I.R.C. �3101.

OA recommended that IRS management improve its technical guidelines to ensure that examiners are aware of the requirements to search for S Corporation non-compliance and to increase the educational outreach through IRS� Taxpayer Education and Communication function.� Additionally, OA recommended programming changes to computer systems, which would enhance the IRS� ability to identify non-compliant S Corporations.

IRS management agreed with the recommendations and is taking corrective action.

Despite Some Problems, the Internal Revenue Service Properly Identified Returns With Rate Reduction Credit Errors During the 2002 Filing Season (Reference No. 2002-40-142)

�http://www.treas.gov/tigta/auditreports/2002reports/200240142fr.html

The Economic Growth and Tax Relief Reconciliation Act of 2001¹⁵ provided that eligible taxpayers who had not received their maximum advance refund may be able to claim a Rate Reduction Credit (RRC) or use the new ten percent tax rate on their TY 2001 returns.� Overall, IRS propery identified and referred for correction returns with RRC and 10 percent tax rate errors during the 2002 Filing Season. However, IRS did experience problems related to the RRC and its unexpectedly large volume of errors (over six million compared to an expected three million).

OA identified a problems with the advance refund information that was added to the National Account Profile (NAP).¹⁶Thirty-five million taxpayers who did not receive an advance refund in CY 2001 did not have a zero advance refund amount information added to the NAP to assist them in determining if they were entitled to the RRC.

Also, no advance refund amount was placed on the surviving secondary spouse�s NAP account for a jointly filed TY 2000 return with a deceased taxpayer.� If the surviving secondary spouse filed a TY 2001 return, IRS

¹⁵ Pub. L. No. 107-16, 115 Stat. 38.
¹⁶The NAP database contains taxpayer entity information (taxpayer name and SSN).� This
database is used to validate tax return entity information during processing.

IRS did not timely or correctly input notification dates or properly include weekends or holidays in the calculation of the notification period. OA also identified that IRS computer programming incorrectly over-assessed interest on Earned Income Tax Credit (EITC) adjustments for an estimated 2,000 taxpayers, totaling approximately $26,000 in interest.

OA recommended IRS identify all suspension of interest taxpayers with applicable under-assessed interest due and zero out any under-assessed amounts. OA also recommended IRS provide a systemic reminder about suspension of interest when employees close audits; update computer programming to consider weekends and holidays in the calculation of the suspension of interest notification period; and adjust applicable taxpayer accounts with incorrectly suspended EITC interest amounts.

IRS management agreed with the recommendations and is taking corrective action.

TIGTA Strategic Goal:

Detecting & Deterring Fraud

�in IRS Programs and Operations

TIGTA is responsible for conducting investigations and audits to help prevent, detect, and deter waste, fraud and abuse in IRS programs and operations. This includes: investigating allegations of misconduct by IRS employees; protecting IRS against external attempts to corrupt or threaten its employees; and performing reviews of activities related to fraud, waste, abuse and mismanagement of IRS and related entities, such as the IRS Oversight Board and IRS Chief Counsel.

TIGTA�s efforts serve as a deterrent against those contemplating illegal actions that would undermine the integrity of federal tax administration.

Strategic Enforcement Division (SED) SED conducts proactive investigative initiatives that are based on research and analysis or information developed from criminal referrals. The methodology of

SED, within the Office of Investigations, is
comprised of three components:

�� Special agents, forensic data analysts, and computer programmers who execute proactive programs to detect internal fraud in IRS operations and unauthorized access to IRS computer systems.

�� Special agents and computer programmers

-the System Intrusion Network Response Attack Team (SINART) - who investigate attempts to interfere with the security, integrity, and reliability of IRS computers.

�� Special agents assigned to the Computer Investigative Support Program (CIS) who provide forensic processing of computers and other media in support of TIGTA investigations.

the crime is used to develop computer database applications that will identify other individuals who may be perpetrating the same crime. These investigative initiatives use computer matching and are included in Computer Matching Act agreements, Pub. L. No. 100-503. During this period, there were 14 ongoing proactive initiatives that produced 184 criminal and administrative referrals to field special agents for investigation.

One of SED�s initiatives identifies employees who have made potential unauthorized accesses to electronic taxpayer information on IRS computer systems. For example, in July 2002, a former IRS employee was sentenced to five years probation for accessing and disclosing tax return information. Additionally, the employee�s father, a certified public accountant, pled guilty to a misdemeanor count of procuring the unlawful access to confidential tax records. The investigation, assisted by SED, revealed that the employee assisted the father with several client accounts by altering confidential computerized taxpayer records so that the tax collections would be delayed and penalties eliminated.

During this six-month reporting period,

SED OPERATIONS

TIGTA has identified and analyzed

CRIMINAL CASE REFERRALS AND FIELD ASSISTANCE

1206 leads of potentially unauthorized accesses to tax information by IRS employees. Also, TIGTA referred 174

COUNTER-

criminal cases to field special agents for

TERRORISM _UNAXASSISTANCE _CRIMINAL

investigation for violations of the

^2%REFERRALS

34%

Taxpayer Browsing Protection

Act of 1997. Since April 2002, there

FIELD CASE ASSISTANCE ^OTHER

has been one criminal prosecution and

CRIMINAL/

56%

ADMIN.

41 adverse administrative actions

REFERRALS 11%

against IRS employees involved in the unauthorized accesss of tax information.

The CIS program provides support and advice concerning: the search and seizure of computers and computer related media; the processing of seized electronic evidence; and, Internet related crimes and investigations.

Computer forensic examination was instrumental in the investigation of a check-cashing scheme involving stolen Treasury checks in Texas. As a result of the investigative work, which identified photographs and driver license templates used in the scheme, an individual was arrested for theft of government checks and manufacturing counterfeit driver licenses. The individual was sentenced to 33 months incarceration and ordered to make $41,304 in restitution.

Since April 2002, CIS special agents have conducted forensic examinations in 70 TIGTA investigations, reviewing 140 devices containing 1,520 gigabytes of storage space.

Internal Fraud OI conducts investigations that protect taxpayers from IRS employees who commit criminal violations and administrative misconduct. These inquiries may involve allegations of unauthorized access to and disclosure of confidential taxpayer information, bribery, financial fraud, false statements and abuse of taxpayer rights.

Investigative highlights follow.

IRS Special Agent Arrested and Indicted for Soliciting $60,000 Bribe

In April 2002, an IRS special agent was arrested after the attorney representing an individual reported that the IRS special agent solicited a cash bribe of $60,000 in exchange for disclosure of grand jury and tax return information.

With assistance from OI�s Technical Services Section, electronic audio and video evidence was gathered which showed the IRS special agent accepting $6,000 as a down payment for the information. The agent was arrested before leaving the meeting.