by George G. Jones and Mark A. Luscombe

Internal Revenue Service Commissioner Charles O. Rossotti, in his recent "Report to the IRS Oversight Board - Assessment of the IRS and the Tax System," has created quite a buzz.

The main point made by the commissioner is that tax compliance remains in a crisis situation. The spin on the reasons behind the report’s forthcoming nature vary from having been prepared by a leader who is finally freed from political constraints (Rossotti’s term is up Nov. 12), to representing an attempt to get IRS funding levels raised, to being an admission made only after things have been turned around. (For additional reporting, see the story above.)

Rossotti primarily focuses on the state of tax compliance and examinations. The commissioner gives the past 10 years poor marks, strikes a few notes of cautious optimism, but is genuinely pessimistic about the future. The ultimate fate of voluntary compliance depends in large part on increased funding.

Anti-tax planning?

Some of the most disturbing and challenging concerns to come out of the report, however, are found in the commissioner’s general comments about tax planning and tax practitioners. Excerpts from the report include statements that:

  • "The majority of tax revenues now come from sources that are more subject to manipulation by those who wish to pay less than the law requires and much more difficult and time consuming for our agents to uncover."
  • "[The source of income now provides greater opportunities for] manipulation by those who wish to take advantage of the decline in IRS compliance resources."
  • "Some sophisticated tax professionals, including those in accounting and law firms and investment banks, are aggressively marketing tax shelters to their clients [at least some of which] turn out to be abusive tax avoidance transactions."
  • "Tax professionals ... are becoming more aware of our deteriorating ability to deal with compliance."
  • "Promoters and some tax professionals are selling a wide range of tax schemes ... ."
  • "The trend in attitudes of taxpayers and tax professionals poses a real threat to the health of the tax system."

Crisis in complianceCompliance has been, at best, an uphill fight, Rossotti painfully acknowledges. He admits that the IRS will never have the resources to attack every case of non-compliance. His goal for the agency, however, is to push the odds high enough, and to make the penalties onerous enough, to convince most taxpayers that cheating is not worth the risk of getting caught.

The commissioner warned that the health of the federal tax system is on a "serious long-term downtrend." He attributes the decline to two conflicting long-term trends: an expanding economy (along with increased tax complexity) paired with a steady decline in IRS resources caused by budget constraints.

The cumulative effect over the past 10 years, Rossotti reports, is a significant gap between "the number of taxpayers not filing, not reporting, or not paying what they owe and the IRS’s capacity to require them to comply ... . We are winning the battle, but losing the war ... . We are simply outnumbered."

Between 1992 to 2001, the IRS’s workload increased by 16 percent because there were more taxpayers, with more money, in the expanding econ-

omy. During the same period, federal tax examinations declined by 16 percent. That’s 115,205 federal tax examinations in 1992 dropping to 95,511 in fiscal year 2001. Field compliance personnel fell by 28 percent from the 1992 to 2002 period, from 29,730 in 1992 to 21,421.

While staff continues to decrease, Rossotti calculates that the IRS’s workload grows at a rate of 1.8 percent each year. This "double bind" creates a gap in what work the IRS should be doing through office and field examinations and what it has the capacity to do. It’s no wonder, therefore, that in-person examination of individuals, for example, fell from an average of 6 per 1,000 in 1995 to 1.5 per 1,000 in 2001.


To make certain that taxpayers think more than twice about their chances for audit, the commissioner reiterates what the IRS had already made public several weeks before. The IRS will shift most of its audit resources to five "high-problem" areas:

  • Promoters of tax schemes of all varieties;
  • Misuse of trusts and offshore accounts to hide income;
  • Abusive corporate tax shelters;
  • Under-reporting by higher-income taxpayers; and,
  • Employment tax non-compliance.

If a taxpayer, or a tax strategy, does not fall into one of these high-problem areas, at least short-term audit risks appear to be less than even in past years, since the IRS will have more - if not virtually all - of its compliance workforce focused on these five areas.The higher-income taxpayer category, which appears the most nebulous of the five on the IRS’s audit hit list, probably will be narrowed based on the numbers. Even with an increased audit level, 2.5 million taxpayers fall into the $200,000-or-over income category, making audit coverage further confined to either those with very high income (more than $1 million) or those who also participate in tax-sheltered investments. Schedule K-1 matching to catch unreported pass-through income also seems to be another audit trigger for taxpayers in the high-income category.
Rossotti noted that, until recently, anyone with income of over $100,000 had been grouped into the same exam category, while those taxpayers are responsible for 60 percent of all income tax revenues collected. The sources of the revenue stream flowing to those individuals, the commissioner also observes, provides greater opportunities for manipulation.

In that regard, the amounts that flow though pass-through entities, such as partnerships, S corporations and trusts, have increased the opportunities for underreporting. Fiscal year 2000 showed pass-through income of more than $660 billion. Yet from FY 1992 to 2001, the exam rate for pass-through entities plummeted from 0.51 percent to 0.29 percent.

Technological advances are also making inroads to boost compliance. New scoring models are being developed, with some already having been deployed, that use new filters to pinpoint noncompliance profiles more accurately. Document matching, first for W2s, and information returns on 1099s and 1098s, and recently matching Schedule K-1s to Form 1040s, promises to help.

However, full document matching is far from a reality. In fact, a rising tide of information returns seems to be flooding the IRS computer systems. In 1992, 33.1 cases per 1,000 were audited due to document matching; in 2001, the commissioner reports that the rate dropped to 9.1 cases per 1,000.

Rossotti also sees some gains for compliance by getting other parts of the IRS’s operations in order. For example, as the IRS is getting a handle on "customer service," fewer compliance personnel are needed for temporary support of customer service functions during tax season. Rossotti also stressed education as a key component of compliance to reduce the number of taxpayers who are led astray by misinformation (and by too-quick-to-please tax practitioners). He notes recent IRS efforts to educate individual taxpayers about common scams. For business taxpayers, pre-filing agreements and industry-specific guidance are boosting compliance.

Tax shelter assault continues

Rossotti’s highest praise - and gravest warning - however, are reserved for his toughest problem: abusive tax shelters.

The IRS is using multiple approaches to attack the use of tax shelters - contacting promoters to obtain required lists of investors; accepting 1,664 tax shelter disclosures under its "amnesty" program earlier in the year; and requesting tax accrual work papers when auditing returns that claim a tax benefit from listed tax avoidance transactions.

Criminal cases are being developed against abusive tax promoters. The IRS is also establishing a closer working relationship between field counsel and the various operating divisions on compliance work. The commissioner touts nine promoter injunctions granted, 14 pending, 150 promoters exams and information requests in progress, and 51 ongoing criminal investigations.


More money from Congress, properly directed, will slowly solve the problem. To close the compliance gap, staffing must grow by at least 2 percent each year through 2010, while productivity among the IRS workforce through modernization and internal productivity must grow by 3 percent annually during that period. At that rate of increase, however, by 2010, Rossotti observed, the size of the IRS would be smaller than in 1990, but the economy would have increased 86 percent.

Based on the commissioner’s recommended 2 percent staff growth and 3 percent productivity increase, he projects that the "work compliance gap" can be closed by 2010, when total examination output should rise to 149,376 (from 97,548 in 2002).

At present, money for staff growth may not be the most troublesome issue. The "productivity" issue could remain problematic for many tax practitioners. Just as it is productive for the IRS to lean on tax shelter promoters as a short cut to limiting tax-shelter abuses, so, too, pressure on the tax practitioner to curb aggressive tax planning might be a logical next step, and certainly one that may be inferred from the commissioner’s latest views toward tax practitioners as a group perhaps in need of a warning, if not intimidation.

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