The Use of Anti-Money Laundering Referrals and Currency
Transaction Information in the Income Tax Examination Process Could Be Improved
March 2004
Reference Number:
2004-30-074
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.
March
30, 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 - The Use of
Anti-Money Laundering Referrals and Currency Transaction Information in the Income
Tax Examination Process Could Be Improved
(Audit # 200330012)
This report presents the results of our review of the Internal Revenue Service’s (IRS) use of Anti-Money Laundering (AML) Program referrals and currency transaction information in the income tax examination process. Our overall objective was to determine whether the IRS effectively used the referrals and information in that process.
The Bank Secrecy Act (BSA) requires banks and nonbank financial institutions, such as check cashing businesses and casinos, to file information reports regarding significant currency transactions. Pursuant to 31 C.F.R. Section 103.56(b)(8) and Treasury Directive 15-41 (December 1, 1992), the authority to examine nonbank financial institutions for compliance with the reporting requirements of the BSA was delegated to the IRS. The IRS performs compliance checks of nonbank financial institutions as part of its AML Compliance Program. If during the performance of an AML compliance check IRS examiners encounter large and suspicious currency transactions between the businesses under examination and their customer(s), an AML referral is prepared. AML referrals are forwarded to the Small Business/Self-Employed (SB/SE) Division Planning and Special Programs (PSP) function for consideration as an income tax examination.
Nationwide, income tax examinations based on AML referrals declined significantly in 2003. In the 3 Area Offices that we tested, income tax examinations based on AML referrals declined 57 percent from June 2002 to June 2003. A key reason for this decline was the refocusing of the IRS’ examination efforts on seven compliance priorities beginning in mid-2002. AML referrals were not one of the seven priority areas.
In addition, AML referrals were not always comprehensively reviewed and selected for examination. None of the 32 referrals we judgmentally sampled had evidence to support that they were thoroughly reviewed for consideration for an income tax examination. The 32 referrals each had $100,000 or more in documented suspicious cash transactions, but were not selected for an income tax examination. Fourteen (44 percent) of the 32 referrals involved taxpayers that did not file a tax return for the period in which the suspicious cash activity occurred. The total documented suspicious cash activity in the 32 referrals was $11 million.
We informed the IRS of our concerns regarding AML referrals in July 2003. Based on this information, along with its own observations and ongoing concerns, the IRS has already initiated a number of corrective actions. AML referrals were established as a separate priority area for Fiscal Year (FY) 2004. In addition, draft procedures have been prepared requiring that the disposition of referral reviews be documented and referrals not selected for examination be maintained in searchable order for 26 months from the date of review.
Currency transaction information reports from financial institutions, trades, and businesses could also be more effectively used in the identification of taxpayers for potential income tax examinations. These reports are included in the Currency Banking Retrieval System (CBRS). The IRS estimates there were over 300,000 potential nonfilers with $22 billion in currency transaction activity in Tax Year 2002. Although the IRS revised its priority examination areas to include AML referrals for FY 2004, it still does not consider all currency transaction information in the selection process. For example, the selection of nonfiling taxpayers for examination is based on the amount of known potential income, such as wages and dividends, and does not specifically consider whether the taxpayer also has large amounts of cash activity. While the filing of a currency transaction report may not equate to unreported income, the presence of large transactions does indicate the individual deals in large amounts of cash and may be involved in some type of ongoing business activity.
We recommended the Director, Centralized Workload Selection and Delivery, SB/SE Division, develop a referral review checklist or other similar methodology to assist in ensuring all relevant factors, including nonfiled tax returns, are considered in evaluating AML referrals. We also recommended the Director, Centralized Workload Selection and Delivery, SB/SE Division, begin using currency transaction information to aid in the selection of individuals and businesses (both nonfilers and potential underreporters) for income tax examinations.
Management’s Response: The IRS
agreed with the recommendations presented in the report. The Director, Centralized Workload Selection
and Delivery, SB/SE Division, will issue to the PSP Territory Managers written
instructions with screening and case-building procedures for AML
referrals. Also, the IRS noted all
field inventory that is case-built by PSP function offices or the campus
includes specific information to ensure consistency in classification and
selection. CBRS information for each
taxpayer is used during the classification and selection process. Field inventory is currently case-built for
training returns and all strategic priority inventory. In addition to using the CBRS to supplement
case file information, the Examination Return Selection function has been using
CBRS analysis as a source for identifying workload. Management’s complete response to the draft report is included as
Appendix IV.
Office of Audit Comment: Although
SB/SE Division management agreed with our recommendations, the proposed
corrective action for Recommendation 2 does not fully address the
recommendation. The corrective action
indicated does not specifically provide for the consideration of CBRS
information during the initial identification of nonfiler inventory. Rather, the corrective action discusses the
subsequent consideration of CBRS information by classifiers in determining
which of the selected cases should be examined and references the general use
of CBRS data as a source for identifying workload. It is our opinion that the consideration of CBRS information in
the initial identification of nonfiler inventory will help ensure the best
cases are provided to the classifiers for examination consideration. As such, we believe
our recommendation is worthwhile in its entirety; however we do not intend to
elevate our disagreement to the Secretary of the Treasury for resolution.
Copies of this report are also being sent to IRS officials who are affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Richard 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
Businesses and individuals conduct numerous financial transactions on a daily basis. To aid in the tracking of financial transactions and to help the Internal Revenue Service (IRS) ensure compliance with Federal tax laws, the Congress enacted the Bank Secrecy Act (BSA). The BSA requires the filing of information reports, by both banks and nonbank financial institutions such as check cashing businesses and casinos, regarding currency transactions exceeding $10,000. Internal Revenue Code (I.R.C.) Section (§) 6050I requires trades or businesses not previously covered by the BSA, such as automobile and boat dealerships, to also keep records and file reports regarding large transactions. These records and reports are critical to the detection of illegally obtained funds as they move through financial institutions in an effort to appear unrelated or untraceable to illegal activities, which is commonly called money laundering. These records are also useful as an indictor of potentially unreported income.
Pursuant to 31 C.F.R. § 103.56(b)(8) and Treasury Directive 15-41 (December 1, 1992), the authority to examine nonbank financial institutions for compliance with the reporting requirements of the BSA was delegated to the IRS. IRS examiners perform compliance checks of nonbank financial institutions as part of its Anti-Money Laundering (AML) Compliance Program. These reviews seek to determine whether the businesses are complying with their obligations under the BSA to file information reports.
During these reviews, examiners may encounter large and suspicious currency transactions between the businesses under examination and their customers. If so, the examiner is required to prepare an AML referral, which is forwarded to the Small Business/Self-Employed (SB/SE) Division Planning and Special Programs (PSP) function. The PSP function is responsible for evaluating referrals for potential selection of individuals and businesses for an income tax examination.
In addition to receiving information from AML referrals, the IRS has access to the Currency Banking Retrieval System (CBRS) records of currency transactions from both bank and nonbank financial institutions. CBRS information can be useful in identifying cash activity that may not be accurately reported on the income tax return. In addition, it may lead the income tax examiner to discover sources of unreported income, sometimes derived from illegal activity.
This review was performed at the SB/SE Division Headquarters in New Carrollton, Maryland, and in the New York, New York; Los Angeles, California; and Philadelphia, Pennsylvania, SB/SE Division Area Offices. We performed the audit from May through December 2003 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.
The purpose of AML Program compliance checks is to ensure entities, such as check cashing companies, comply with their obligation to file information reports regarding currency transactions. When unusual cash activity regarding a particular individual or business is identified during an AML compliance check, an AML referral for the initiation of a potential income tax examination is prepared.
In the 3 Area Offices included in our review, income tax examinations based on referrals from the AML Program compliance checks declined 57 percent in 1 year, from 321 active examinations in June 2002 to 139 in June 2003. In the 3 Area Offices, 1,314 referrals were submitted for consideration during this period. Nationwide, income tax examinations that were the result of AML referrals declined 47 percent during the same period.
A key reason for the decline in income tax examinations based on referrals from AML compliance checks was the refocusing of the IRS’ examination priorities in 2002. Specifically, in July 2002, the IRS Commissioner presented seven new compliance priority areas and noted that Tax Year (TY) 2003 would be a year of transition. As existing examination inventories were closed, new workloads were to be assigned within one of the following priority areas:
· Abusive tax schemes and promoter investigations.
· Misuse of devices, such as offshore accounts, to hide or improperly reduce income.
· Abusive corporate tax avoidance transactions.
· High-risk, high-income individuals.
· Offshore credit card abuses.
· Unreported Income Discriminate Index Function.
· The National Research Program.
Integrating income tax examinations of AML referrals into the new priority-based approach, however, was sometimes problematic. While AML referrals are useful as indictors of potentially unreported income, they generally do not contain enough detailed information to allow them to be easily associated with one of the particular examination priorities. In addition, referrals that could not be readily associated with a specific strategic priority were to be forwarded to the Brookhaven Campus for further review. The IRS informed us the review of referrals that could not be associated with a specific priority was delayed due to other priority work. At the time of our review, the Brookhaven Campus had a significant backlog of referrals awaiting review.
We informed the IRS of our concerns regarding the AML referral program in July 2003. Based on this information, along with its own observations and ongoing concerns, the IRS initiated a number of corrective actions. Specifically:
· The AML Compliance Program was established as a separate priority area for Fiscal Year (FY) 2004.
Controls over the review and evaluation of AML referrals need to be improved. From the 3 Area Offices included in our review, we judgmentally sampled 32 referrals, each involving $100,000 or more in suspicious cash transactions, which had not been selected for an income tax examination. We determined that all had indicators of examination potential, but the case files did not document why the 32 referrals were not selected. In fact, we could not even determine whether the referrals had been reviewed by the PSP function. The sampled referrals were submitted for consideration during the period January 2002 through June 2003.
The 32 referrals had $11 million in documented suspicious cash activity. The referrals included the following information, which indicates that the taxpayers may not have reported of all their income:
AML-related referrals are required to be reviewed within
30 days of receipt to determine whether there is sufficient basis to
warrant an income tax examination. This review is required to include a check
for unfiled tax returns. PSP function
managers informed us their primary focus is the assignment of new workload
within the seven compliance strategy areas as outlined by the IRS Commissioner
in mid-2002. A case would usually not
be selected if it did not meet one of the seven priority areas. As discussed previously, AML referrals were
not specifically identified as one of the seven original priority areas and
were often not easily associated with a priority area.
AML referrals contain indicators of suspicious cash activity that may be indicative of unreported income and, if not timely and comprehensively reviewed, could have a material effect on the IRS’ taxpayer compliance efforts. Two of the three PSP function offices we reviewed also informed us they routinely dispose of AML referrals that are not selected for an income tax examination. In addition, none of the three Area Offices keep sufficiently detailed records to determine how many referrals were forwarded to a campus. As a result, we could not readily determine the disposition of 1,861 (87 percent) of the 2,144 AML referrals submitted from January 2002 through June 2003 at the 3 Area Offices.
We informed the IRS of our concerns regarding the AML referrals in July 2003. Based on this information along with its own observations and ongoing concerns, the IRS has already prepared draft procedures requiring that the disposition of referral reviews be documented and referrals not selected for examination be maintained in searchable order for 26 months from the date of review. While the new procedures should result in better record retention practices, additional case file documentation is needed to ensure all required factors, including nonfiled tax returns, are considered in evaluating AML referrals.
1. The Director, Centralized Workload Selection and Delivery, SB/SE Division, should develop a referral review checklist or other similar methodology to assist in ensuring all required factors, including nonfiled tax returns, are considered in evaluating AML referrals.
Management’s Response: The Director, Centralized Workload Selection and Delivery, SB/SE
Division, will issue to the PSP Territory Managers written instructions with
screening and case-building procedures for AML referrals. The IRS has already provided draft
procedures for screening referrals to the PSP Territory Managers for
implementation.
Currency transaction information from Currency Transaction Reports (Form 4789) and Reports of Cash Payments Over $10,000 Received in a Trade or Business (Form 8300) could be more effectively used in the identification of taxpayers for income tax examinations. These documents are included in the CBRS.
As discussed previously, the IRS revised its priority examination areas to include AML referrals for FY 2004. Additionally, an addendum to the FY 2004 priorities, known as the substantial noncompliance factors, was developed. This document provides that a case with significant civil tax potential should still be considered for examination even though it does not specifically fall within a priority area. This approach, for example, expands the FY 2003 nonfiler priority area, which previously focused only on nonfilers with known sources of income such as wages and dividends over a certain dollar amount. The factors now include cases with less than the designated dollar amount in known income, if there is a significant potential for civil tax.
However, while it is a worthwhile enhancement, the strategy addendum relies primarily on referrals and informant claims in evaluating the possibility of substantial tax potential on a tax return. Neither the selection criteria for the priority areas nor the recently added substantial noncompliance factors addendum specifically consider currency transaction information from the CBRS in the examination selection process.
While the filing of a Form 4789 or 8300 may not equate to unreported income, the presence of large transactions does indicate the individual deals in large amounts of cash and may be involved in some type of ongoing business activity. The IRS informed us it estimates there were over 300,000 potential nonfilers with $22 billion in currency transaction activity in TY 2002. Including currency transaction activity in the return selection process would help ensure the IRS selects the best returns possible for examination and improve compliance with tax laws.
2. The Director, Centralized Workload Selection and Delivery, SB/SE Division, should begin using currency transaction information to aid in the selection of individuals and businesses (both nonfilers and potential underreporters) for income tax examinations. The selection process should focus on those individuals with a large dollar amount of transactions.
Management’s Response: All field inventory that is case-built by PSP function offices or the campus includes specific information to ensure consistency in classification and selection. CBRS information for each taxpayer is used during the classification and selection process. Field inventory is currently case-built for training returns and all strategic priority inventory. In addition to using the CBRS to supplement case file information, the Examination Return Selection function has been using CBRS analysis as a source for identifying workload.
Office of Audit Comment: Although SB/SE Division management agreed with our recommendations, the proposed corrective action for Recommendation 2 does not fully address it. The corrective action indicated does not specifically provide for the consideration of CBRS information during the initial identification of nonfiler inventory. Rather, the corrective action discusses the subsequent consideration of CBRS information by classifiers in determining which of the selected cases should be examined and references the general use of CBRS data as a source for identifying workload. It is our opinion that the consideration of CBRS information in the initial identification of nonfiler inventory will help ensure the best cases are provided to the classifiers for examination consideration. As such, we believe our recommendation is worthwhile in its entirety.
Appendix I
The overall objective of this review was to determine whether currency transaction information and Anti-Money Laundering (AML) Program referrals were effectively used in the income tax examination process. To accomplish this objective, we:
I.
Determined whether the Small Business/Self-Employed
(SB/SE) Division’s Compliance function Headquarters (HQ) effectively provided
oversight and monitored referrals from the AML Program.
A.
Interviewed AML and SB/SE Division Planning and Special
Programs (PSP) HQ management to discuss and review the process for monitoring
referrals from the AML Program.
B.
Identified Management Information System data that Area
Offices forward to the HQ regarding the AML Program.
C.
Evaluated the methodology employed at the national
level and determined the effectiveness of income tax examinations of AML
referrals.
II.
Determined whether the SB/SE Division Examination
function had effective controls over the evaluation of referrals received from
the AML Program.
A.
Interviewed HQ and selected Area Office PSP function management
and determined what procedures were employed to identify, classify, and examine
taxpayers with referrals received from the AML Program.
B.
Interviewed three Area Office AML Coordinators to
determine if referrals were screened or prioritized for potential income tax
examination. We selected the three
audit sites for the work in this audit step, as well as C and D below, because
we were advised they were representative of the AML Program nationwide.
C. Interviewed three AML group managers on the policies and procedures for preparing and forwarding referrals to the PSP function.
D. Selected a judgmental sample of 32 referrals having over $100,000 in cash activity that were not selected for examination and evaluated the reason they were not selected. We used this sampling methodology to allow for the onsite review of referral case files within the constraints of our available staffing. The cases were chosen from the inventory of all cases physically located in the selected offices at the time of our review. However, because two of the three sites frequently disposed of nonselected referrals, we were unable to reliably establish the case population.
III. Determined whether the Examination function had effective controls over the identification and examination of taxpayers having Currency Banking Retrieval System (CBRS) information on file.
A. Interviewed selected field personnel and determined the methodology used in identifying tax returns with CBRS data on file.
B. Ascertained whether examiners were required to research the CBRS for information as part of the examination case-building process.
IV.
Determined whether the HQ used CBRS information to
identify nonfilers.
A. Interviewed HQ PSP function personnel and determined how CBRS information was used in the SB/SE Division’s high-income nonfiler strategy.
B. Determined
to what extent high-income nonfilers with Currency Transaction Report records
on file with the CBRS were considered for examination.
Appendix II
Major Contributors to This Report
Richard Dagliolo, Acting Assistant Inspector
General for Audit (Small Business and Corporate Programs)
Parker F. Pearson, Director
Anthony J. Choma, Audit Manager
Doris A. Cervantes, Senior Auditor
Joseph F. Cooney, Senior Auditor
Rashme Sawhney, Auditor
Appendix III
Commissioner C
Office of the Commissioner – Attn: Chief of Staff C
Deputy Commissioner for Services and Enforcement SE
Acting Deputy
Commissioner, Small Business/Self-Employed Division SE:S
Acting Director,
Compliance, Small Business/Self-Employed Division SE:S:C
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
Deputy
Director, Compliance Policy, Small Business/Self-Employed Division SE:S:C:CP
Appendix IV
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.