The Examination function of the Internal Revenue Service (IRS) examines tax returns to determine whether taxpayers accurately report their tax liabilities. If the liability was not accurately reported, examiners recommend changes to adjust the liability to an amount that reflects income and expenses which are supported with documentation provided by the taxpayer.

For years, managers and examiners paid little attention to whether taxpayers could pay any additional taxes due resulting from examinations. In the early 1990’s, the IRS became concerned about the sources of the growing volume of accounts that were not collectible. One reason for the increase in these accounts was the additional tax identified during examinations. To address the problem, the Examination function developed procedures to consider the potential collectibility of accounts before selecting or examining tax returns of taxpayers with known collection problems and to solicit payments from taxpayers when closing examinations.

Our overall objectives were to determine whether the field Examination function appropriately considered collectibility before opening examinations, limited the scope of examinations in process once there was an indication of low collection potential, and took appropriate actions to collect additional tax identified when closing examinations. We focused our review on tax returns filed by self-employed and small corporate taxpayers who will generally come under the IRS’ new Small Business/Self-Employed (SB/SE) Division.

The Examination function’s payment solicitation efforts were frequently successful when closing cases where the taxpayer agreed with the recommended tax changes. However, our review of cases with collectibility indicators showed that examiners sometimes conduct examinations on taxpayers who appear to be a collection risk. On the other hand, collectibility indicators appear on some accounts that may not actually present a collection risk; these tax returns may inappropriately be kept from being examined. In addition, at the time of our review, the collectibility indicator was not part of the design of a new system that will be used to screen tax returns for examination potential.

The Examination function’s payment solicitation efforts were frequently successful when closing cases where the taxpayer agreed with the recommended tax changes. A payment or payment arrangement was made prior to issuance of the first balance due notice in 83 (66 percent) of the 125 agreed cases we reviewed. IRS reports also indicate payment solicitation is mostly successful. For Fiscal Year (FY) 1999, these reports show that 68.5 percent of the tax and interest the Examination function assessed to taxpayers’ accounts was collected before issuance of the second balance due notices.

Of the 90 cases we reviewed with collectibility indicators, 35 (39 percent) showed poor collection potential when the examination started. The managers and examiners did not document in the case files why these examinations were conducted, nor was there evidence of an overriding compliance justification for conducting the examinations. National Examination statistics also showed that collectibility was not always considered. For FY 1999, the Examination function’s quality review process determined that collectibility was not considered prior to first contact in about 28 percent of the applicable cases reviewed.

Managers were not effectively addressing collectibility before assigning cases. In addition, not all examiners were fully aware of how to identify collectibility indicators on cases, and most felt that once they were assigned a case they were responsible for conducting the examination.

As a result, only 4 of the 35 cases have been fully paid. Full payment is not likely in another 18 of the cases because they were removed from the active collection inventory, closed as not collectible or the taxpayers applied for bankruptcy or an offer in compromise. The remaining cases are currently in one of the various collection stages and ultimately may not be collected.

Of the 90 cases mentioned in the preceding section, 63 had the "uncollectible" collectibility indicator. Thirteen (21 percent) of the 63 cases may not actually be a collection risk. The indicator in these cases shows that the taxpayer has an account previously closed as not collectible, but in:

• Six cases the "uncollectible" liabilities were fully paid before the current examination started.
• Five cases the accounts were closed as not collectible because of the minimal amount due (tolerance) on the account.
• Two cases the accounts were closed as not collectible up to 13 years ago, and the collection statute on the accounts expired at least 4 years ago, well before the current examination started. A long time span between an uncollectible determination and a subsequent examination may not be a valid indication of the taxpayer’s current ability to pay.

This occurred because the computer program to identify taxpayers that may present a potential collection risk was not working properly.

Payment results on the current examination liability show that these conditions do not necessarily indicate poor collection potential. Only 2 of the 13 cases have been closed as not collectible. We could not determine how many potential examinations were closed primarily because the uncollectible indicator was present.

The IRS plans to implement a new system for screening tax returns to identify examination potential. However, this system does not include collectibility indicators. Based on our inquiries, the Examination function initiated corrective action by preparing a request to have collectibility indicators added to the new system.

We recommend that the Director, Compliance (SB/SE Division), monitor and stress the importance of considering collectibility indicators before and during examinations with both managers and examiners and consider making the indicator more obvious on the tax return charge out. In addition, the computer program to identify taxpayers’ accounts that were closed as not collectible should be modified to exclude those accounts where collection was not or may no longer be at risk.

Management’s Response: Management’s response was due on September 27, 2000. As of September 28, 2000, management had not responded to the draft report.