Errors in Failure to Pay Penalty Amounts Occur When the Penalty
Is Computed Manually
September 2004
Reference Number:
2004-30-184
This report has cleared the Treasury
Inspector General for Tax Administration disclosure review process and
information determined to be restricted from public release has been redacted
from this document.
September
27, 2004
MEMORANDUM FOR
COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Gordon C. Milbourn III /s/ Gordon C.
Milbourn III
Acting Deputy Inspector
General for Audit
SUBJECT: Final Audit Report – Errors in Failure to
Pay Penalty Amounts Occur When the Penalty Is Computed Manually (Audit # 200430007)
This
report presents the results of our review of manually computed Failure to Pay
(FTP) penalty amounts. The overall
objective of this review was to determine whether Internal Revenue Service
(IRS) employees manually computed the FTP penalty correctly, and manual
computations were limited to only those situations where IRS computers could not
make the computation. This review was
conducted because of the large number of taxpayer accounts affected, the
complexity of the manual FTP penalty computation, and prior IRS error rates for
manually calculated interest amounts.
Normally,
IRS computer programs automatically calculate the amount of the FTP
penalty. However, there are situations
where penalties are prohibited or limited to specific periods and must be
computed manually by IRS employees. We
identified approximately 164,000 manual computations of the FTP penalty during
Calendar Years 2001 through 2002. The
penalties are computed manually because the calculations contain variables that
are not programmed into IRS computers.
In these situations, an IRS employee enters a code into the computer to
“restrict” the computer from calculating the penalty. Manually performing these complex penalty
calculations significantly increases the potential for errors and is very
resource intensive. A prior Treasury
Inspector General for Tax Administration report discussed significant IRS
errors in manual calculations of interest on restricted accounts.
In
summary, IRS
is miscalculating restricted FTP penalty amounts and unnecessarily restricting
certain accounts. In a sample of 50
taxpayer accounts that were restricted and had manually calculated FTP
penalties, 24 percent contained errors in the penalty calculation, were
unnecessarily restricted, or both.
In
our opinion, several factors contributed to the penalty calculation errors,
including the complexity of the calculations and the limited amount of time IRS
employees perform such calculations relative to their other work. Most of the accounts restricted in error were
Substitute for Return (SFR) accounts. It
appears tax examiners are not familiar with the changes that simplified the FTP
penalty computation for SFR accounts that allows the computer to perform the
computation.
We
recommended the Director, Office of Penalties and Interest, consider including
the manual computation of the FTP penalty as part of the responsibilities of a
centralized group the IRS is forming to quality review restricted
interest. If not included, the Director
should provide training to IRS employees to ensure the FTP penalty, when
manually computed, is accurately calculated.
The Director should perform an independent review of SFR accounts to
determine if a high percentage of these accounts continue to be unnecessarily
restricted and, if so, ensure training is provided that emphasizes the
appropriate circumstances for restricting these types of accounts.
Management’s
Response: IRS management agreed with our
recommendations. They stated that a key
aspect of having the centralized group handle quality review of the manually
computed FTP penalties will be their ability to link this work with the other
work performed by the group. Therefore,
the Director, Payment Compliance, Small Business/Self-Employed Division, will
study whether the manual computation of the FTP penalty could be linked with
the centralized group once it becomes functional. In the meantime, efforts will be made to
ensure all affected employees receive the necessary training and timely receive
the related material for updates and reviews.
In addition, the Office of Penalties and Interest will conduct a review
of SFR accounts to determine the source of any unnecessary restrictions and, if
necessary, will advise the affected employees accordingly. Management’s complete response to the draft
report is included as Appendix IV.
Copies
of this report are being sent to the IRS managers affected by the report
recommendations. Please contact me at
(202) 622-6510 if you have questions or Richard J. Dagliolo, Acting Assistant
Inspector General for Audit (Small Business and Corporate Programs), at (631) 654-6028.
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix IV
– Management’s Response to the Draft Report
The Internal Revenue Service (IRS) imposes penalties on taxpayers to encourage voluntary compliance with tax laws. Voluntary compliance consists of preparing an accurate return, timely filing that return, and timely paying any taxes due.
A Failure to Pay (FTP) penalty is imposed when (1) any tax due on an original return is not paid by the due date of the return, or (2) the taxpayer is assessed additional tax that was not shown on the original return and does not pay the subsequent assessment within 21 days. The penalty is not imposed if the taxpayer shows the failure to pay was due to reasonable cause and not due to willful neglect.
Generally, the FTP penalty is calculated at 0.5 percent of the unpaid tax for each month the tax remains due, until a maximum penalty of 25 percent of the tax due is reached. There are circumstances when the FTP penalty rate changes. Taxpayers who timely file their returns and enter into installment agreements have the FTP penalty rate reduced from 0.5 percent to 0.25 percent. On the other hand, the rate increases from 0.5 percent to 1 percent when a notice of intent to levy or notice and demand for immediate payment is issued.
Normally, IRS computer programs automatically calculate the amount of the penalty. However, there are situations where penalties are prohibited or limited to specific periods and must be computed manually by IRS employees. They are computed manually because the calculation contains variables that are not programmed into IRS computers. In these situations, an IRS employee enters a code into the computer to “restrict” the computer from calculating the penalty.
A prior Treasury Inspector General for Tax Administration
(TIGTA) report discussed significant IRS errors in manual interest calculations
on restricted accounts. The IRS agreed
to take corrective actions to improve that process. During this current audit, we reviewed the
manual calculations of the FTP penalty on restricted accounts and determined if
they were computed accurately and only restricted when necessary.
This review was performed during the period January through June 2004 through analysis and review of tax return information obtained from the IRS’ Business Master File and Individual Master File. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
Using a computer program, we identified approximately 164,000 taxpayer accounts that became restricted in Calendar Years 2001 through 2002 and had manually calculated FTP penalties. In a random sample of 50 of these accounts, we found 12 (24 percent) contained errors in the penalty calculation, were unnecessarily restricted, or both.
Penalties
calculated incorrectly
Of the 50 accounts reviewed, 9 (18 percent) contained inaccurately computed FTP penalties. For five of the nine accounts, taxpayers had already paid the incorrect amounts and an IRS adjustment would be necessary to correct the error. The other 4, even though miscalculated, had reached the maximum 25 percent penalty amount, so the effect of the IRS employees’ errors was negated.
In our opinion, several factors contributed to the IRS employees’ penalty calculation errors:
· FTP penalty calculations can be very complex, involving several variables that must be factored into the calculation to obtain the correct penalty amount. Specifically, IRS tax examiners must determine the correct date to begin assessing the penalty. These dates may vary depending on the type of account. For example, qualifying taxpayers affected by natural disasters or serving in combat zones receive an extension to file and pay their taxes, extending the FTP penalty start date. Taxpayers in bankruptcy status have the FTP penalty suspended from computation. Also, the FTP penalty rate changes when the taxpayer enters into an installment agreement or receives a notice of intent to levy, or when a notice and demand for immediate payment is issued. In addition, since the FTP penalty is only assessed on the unpaid tax, any other accrued penalties and/or interest must not be included in the calculation.
· Many of the IRS employees calculating penalties do so a relatively small percentage of their work time and do not become skilled in applying the various rules associated with these calculations.
· Many employees in different functions within the IRS work restricted penalty accounts. Decisions regarding employee training and quality control are subject to the views of various IRS managers who may have differing opinions regarding the level of commitment their functions should give these matters.
Inherent in the IRS’ mission to apply the tax law with integrity and fairness is the concept to collect the proper amount of money from each taxpayer. If penalty amounts owed by taxpayers are not calculated accurately, the IRS risks collecting too little or too much money from taxpayers whose account balances are calculated in error. The average dollar amounts of the miscalculated penalties in our sample were relatively small. However, the percentage these calculations varied from the correct amount was significant. On average, the IRS computed amount differed from the correct amount by 112 percent.
Our sample was not valid for projecting the overall
dollar effect on taxpayers. However,
because our accounts were selected at random, it is reasonable to believe
similar error rates would apply over the population.
Accounts
Restricted in Error
Of the 50 accounts reviewed, 7 were unnecessarily restricted from computing the FTP penalty amount. It is important that only those tax accounts that require manual calculation of penalties be restricted for reasons including the following:
· Manually calculating penalties is very time-consuming. Because FTP calculations can often be very complex, the amount of time needed to perform the calculations can be significant. After an account is restricted, employees must periodically update the penalty calculation manually until the account is full paid or until the maximum penalty of 25 percent of the tax due is reached.
· Manually performing complex penalty calculations significantly increases the potential for errors. Calculation errors can occur when the account is initially restricted or later when the amount of penalty owed is manually updated.
Further review of the seven accounts that were unnecessarily restricted indicated a potential problem with a particular type of account in the sample. Specifically, we found accounts worked by the Substitute for Return (SFR) function, particularly those accounts with return due dates after July 30, 1996, were often unnecessarily restricted. Overall, 26 of 50 accounts reviewed were worked by the SFR function. Of these 26 accounts, 6 had return due dates after July 30, 1996, and 4 of the 6 were unnecessarily restricted.
The Congress enacted changes to the FTP penalty computation for SFR accounts with return due dates after July 30, 1996. Accounts with a return due date prior to this date still require manual computation of the FTP penalty; however, accounts with due dates after July 30, 1996, can be calculated by the computer.
Even though we cannot reliably project our sample results, there are indications tax examiners are not familiar with the change in the requirements to restrict SFR accounts. Unnecessarily restricting accounts increases both the workload for IRS employees and the opportunity for calculation errors.
2.
Perform an independent
review of SFR accounts with return due dates after July 30, 1996, to determine
if, in fact, a high percentage of these accounts continue to be unnecessarily
restricted. If warranted, the Director
should then ensure training is provided that emphasizes the appropriate
circumstances for restricting these types of accounts.
Management’s Response: The Office of
Penalties and Interest will conduct a review of SFR accounts to determine the
source of any unnecessary restrictions and, if necessary, will advise the affected
employees accordingly.
Appendix I
Detailed
Objective, Scope, and Methodology
The overall objective of this review was to determine whether Internal Revenue Service (IRS) employees manually computed the Failure to Pay (FTP) penalty correctly, and manual computations were limited to only those situations where IRS computers could not make the computation.
To accomplish our objective, we:
I.
Determined the
policies and procedures followed by the IRS for manually computing the FTP
penalty and whether these procedures were compliant with the appropriate tax
laws.
A.
Reviewed the penalty
Internal Revenue Manual instructions.
B.
Interviewed applicable
IRS management and employees to determine the procedures being used to manually
compute FTP penalties on taxpayer and business accounts.
C.
Reviewed
applicable/available training material for processing manual computations of
FTP penalties.
D.
Reviewed the
appropriate Internal Revenue Code sections, revenue procedures, and any IRS
Counsel rulings relating to the manual computation of FTP penalties.
II.
Determined the volume
of manual FTP penalties found on the Individual Master File and the Business
Master File that were manually computed for the last 2 tax years prior to
January 1, 2003. We obtained a computer
extract of all accounts found on these Master Files for the last 2 tax years
prior to January 1, 2003, containing taxpayer accounts (modules, both
individual and business) with computer codes indicating a manually computed FTP
penalty.
III.
Determined whether
manual FTP penalties were correctly computed and whether the FTP penalties were
unnecessarily restricted.
A.
Selected a random
sample of taxpayer accounts with a manually computed FTP penalty for the last 2
tax years prior to January 1, 2003.
B.
Reviewed the sampled accounts
to determine if the amount of the manual FTP penalty was computed correctly on
the accounts.
C.
Reviewed the sampled
accounts to determine if the IRS unnecessarily restricted taxpayers’ accounts
from normal computer-generated penalty computations.
D.
Obtained review
assistance from qualified penalty experts within the IRS to determine if our
analysis of the manual FTP penalty computations and restricted accounts was
correct.
Appendix II
Major Contributors to This
Report
Richard J.
Dagliolo, Acting Assistant Inspector General for Audit (Small Business and
Corporate Programs)
Kyle R.
Andersen, Acting Director
Bill R. Russell, Audit
Manager
Scott D. Critchlow,
Lead Auditor
Douglas C. Barneck,
Senior Auditor
Roy E. Thompson,
Senior Auditor
Arlene Feskanich, Information Technology Specialist
Appendix
III
Commissioner C
Office of the
Commissioner – Attn: Chief of Staff C
Deputy Commissioner
for Services and Enforcement SE
Commissioner, Wage
and Investment Division SE:W
Deputy
Commissioner, Small Business/Self-Employed Division SE:S
Deputy
Commissioner, Wage and Investment Division
SE:W
Acting Director,
Compliance, Small Business/Self-Employed Division SE:S:C
Director,
Compliance, Wage and Investment Division
SE:W:CP
Director, Customer
Account Services, Small Business/Self-Employed Division SE:S:CAS
Director, Customer
Account Services, Wage and Investment Division
SE:W:CAS
Director, Payment
Compliance, Small Business/Self-Employed Division SE:S:C:CP:PC
Director, Reporting
Enforcement, Small Business/Self-Employed Division SE:S:C:CP:RE
Deputy Director,
Compliance Services, Small Business/Self-Employed Division SE:S:C:CS
Director, Office of
Penalties and Interest, Small Business/Self-Employed Division SE:S:C:CP:PC
Chief Counsel CC
National Taxpayer
Advocate TA
Director, Office of
Legislative Affairs CL:LA
Director, Office of
Program Evaluation and Risk Analysis
RAS:O
Office of
Management Controls OS:CFO:AR:M
Audit Liaisons:
Commissioner, Small
Business/Self-Employed Division SE:S
Commissioner, Wage and Investment
Division SE:W
Appendix IV
Management’s
Response to the Draft Report
The response was removed due to its
size. To see the response, please go to
the Adobe PDF version of the report on the TIGTA Public Web Page.