Internal Revenue Service (IRS) centers and lockbox processing sites misapplied most gift tax payments made by taxpayers who filed Applications for Automatic Extension of Time To File U. S. Individual Income Tax Return (Form 4868). These payments were processed incorrectly to taxpayers’ individual income tax accounts. Further, extensions to file were usually processed only to individual income tax accounts, instead of to both individual and gift tax accounts.

Since 1989, IRS Inspection (now the Treasury Inspector General for Tax Administration) has issued three audit reports to IRS management that identified the misapplication of gift tax payments made by taxpayers who filed extensions. The objective of this review was to determine if the IRS is now processing gift tax extensions and the related gift tax payments to the proper accounts.

Our computer extracts identified 724,379 gift tax returns filed for Tax Years (TY) 1996, 1997, and 1998, and 47,589 of these taxpayers reported gift tax liabilities. Approximately 11,648 taxpayers who reported gift tax liabilities also requested extensions of time to file.

We found that taxpayers sent gift tax extensions with and without payments to either IRS centers or lockbox sites, and most were processed incorrectly no matter where they were sent. During our review, we issued a memorandum to IRS management outlining our concerns about the processing of these extensions and gift tax payments. Although management’s proposed actions would prevent some erroneous refunds and incorrect notices from being sent to taxpayers, additional actions need to be taken to address the root cause of the problem and all the effects of improper processing.

At least 8,626 extensions were processed to the taxpayers’ individual income tax accounts only. During a test of a statistical sample of 164 of the 8,626 taxpayer accounts, we found that IRS centers and lockbox sites misapplied $26 million in gift tax payments, and correctly processed none of the extensions to file to taxpayers’ gift tax accounts. Based on the results of our analyses, we estimate that $1.4 billion in gift tax payments were misapplied during the processing of TY 1996, 1997, and 1998 extensions. As a result, the IRS sent taxpayers an estimated $237 million in erroneous refunds and 18,357 incorrect notices. In addition, the IRS charged taxpayers an estimated $3.2 million for penalties that they did not owe and paid an estimated $8.1 million in interest to taxpayers for delayed refunds. Our limited study of TY 1999 case processing showed similar results.

The IRS allows its centers to choose how they wish to process extensions and related payments from among several methods. However, the instructions for some of the methods are unclear and incomplete. Functional processing areas, such as Code and Edit and Data Conversion, did not appear to be aware that the method they chose resulted in misapplied gift tax payments and ineffective processing of extensions to gift tax accounts. The incorrect processing was caused in part by the following:

• Some centers used incorrect program processing codes for extensions, which caused the payments and extensions to post automatically to the taxpayers’ individual income tax accounts, rather than to the proper gift tax accounts.
• The Integrated Submission and Remittance Processing (ISRP) System processes single payments to multiple accounts, but it is not currently capable of processing an extension to both a taxpayer’s individual income tax and gift tax accounts. In the mistaken belief that the ISRP System also processed the extensions to the gift tax accounts, some centers stopped the separate processing necessary to post the extensions to taxpayers’ gift tax accounts.
• An IRS report designed to identify the volume of gift tax payments and extensions processed at IRS centers did not reflect accurate figures.

For some situations, lockbox guidelines were clear but not followed, and in other ituations the processing guidelines were incomplete or unclear.

• Lockbox guidelines provided clear instructions for the processing of extensions submitted with payments for both the individual income tax and gift tax accounts, but the guidelines were not always followed.
• Lockbox guidelines did not provide complete instructions for the processing of extensions for both the individual income tax and gift tax accounts when taxpayers sent in payments for only one of the accounts.
• Lockbox guidelines did not provide clear direction for processing extensions and gift tax payments designated by taxpayers as "for gift tax only."

In addition, established controls were ineffective in alerting management to lockbox processing problems.

• Reviews of lockbox processing by IRS lockbox coordinators did not ensure that gift tax payments and extensions were processed correctly.
• The report designed to alert the National Headquarters Lockbox Analyst about lockbox processing problems required information on the number of gift tax payments and extensions processed, but this figure was not reflected on the version of the report used by lockbox coordinators.
• An IRS report designed to identify the volume of gift tax payments and extensions processed at lockbox sites did not reflect accurate figures.

During the review, we recommended that the Assistant Commissioner (Forms and Submission Processing) require the review of all balance due notices for gift tax returns. We further recommended that tax examiners be instructed to review the taxpayers’ corresponding individual income tax and gift tax accounts to determine if the taxpayers’ gift tax payments and extensions to file were applied correctly.

Management’s Response to Office of Audit Memorandum: IRS management provided a response to our memorandum (see Appendices V and VI) stating that they would work with the Customer Service function to determine if a 100 percent review of all balance due notices issued for gift tax returns could be implemented. They also indicated that a Request for Information Services would be prepared to effect an automated solution. When underpayments are present on gift tax accounts, the related individual income tax accounts will be automatically searched for equivalent payments. If any are found, they will be automatically transferred to the gift tax accounts.

Management’s complete response to the memorandum is included as Appendix VI.

Although management’s proposed actions would prevent some erroneous refunds and incorrect notices from being sent to taxpayers, the root cause of the problem and all the effects of improper processing will not be addressed. Management needs to take additional actions to ensure the effective processing of extensions to file gift tax returns and associated gift tax payments. Therefore, we recommend that the Assistant Commissioner (Forms and Submission Processing) take the following steps:

• The IRS guidelines containing IRS center processing instructions for extensions need to be revised to ensure that payments and extensions involving gift tax returns are processed to the proper taxpayer accounts. The IRS should explore the possibility of updating the ISRP System to permit the posting of payments and extensions to both individual income and gift tax accounts.
• Current lockbox guidelines covering the processing of extensions involving gift tax returns and/or gift tax payments need to be followed, while other guidelines need to be completed or made clearer. Reviews of lockbox performance need to be improved and the reporting of that performance enhanced.

Management’s Response to the Draft Report: Management’s response was due on September 21, 2000. As of September 22, 2000, management had not responded to the draft report.