IRS: Too Many No-Change Audits of S-Corps, Partnerships

By Anne Rosivach

More than half of IRS audits of partnerships and S-corporations for 2011 closed with no change, according to two reports released recently by the Treasury Inspector General for Tax Administration (TIGTA). 
 
Fiscal Year 2011 statistics from the Small Business/Self-Employed Division (SB/SE Division) showed that about 50 percent of partnership returns, after selection by or related to the Discriminant Index Function (DIF), closed with no change. An even higher number, 62 percent, of audits of S-corporations showed no adjustments, according to TIGTA's analysis. 
 
"These results are troubling because, according to the IRS, a high no-change percentage means the agency is spending a significant amount of resources on unproductive audits and burdening compliant taxpayers with unnecessary audits," said J. Russell George, Treasury Inspector General for Tax Administration.
 
The TIGTA reports state that the high percentage of no-change audits is likely related to the selection method used by the IRS rather than to quality issues with the examinations. 
 
The IRS tries to select returns where examiners are likely to find areas of noncompliance and recommend changes to a tax return using the DIF system, the report states. The DIF system uses mathematical formulas to calculate and assign a score to returns based on their audit potential.
 
In his letter to the IRS about partnership audits, George stated that the IRS should analyze its selection methods. "SB/SE Division researchers should consider exploring partnership data files to determine whether the most productive returns are selected for audit. . . . SB/SE Division researchers are uniquely qualified to suggest alternative audit selection methods and explore details, such as evaluating whether examiners should audit more partnership returns with international features or assessing the revenue impact from partnership audits."
 
IRS officials agreed with the recommendation and stated that the Director, Research, SB/SE Division, plans to work in collaboration with the SB/SE Division's Examination function to analyze partnership data files in order to better identify productive partnership returns for audit.
 
The TIGTA report on S-corporation audits pointed to selection methods, including the design of the DIF system, as possible reasons for the high number of no-change audits. 
 
"S-corporation returns selected by DIF mathematical formulas do not identify the specific items to audit. Instead, examiners use their experience and judgment to screen the returns manually to identify the items that are questionable and should be included in the audit," the TIGTA report states. 
 
Furthermore, a new DIF formula completed in 2008 for selecting S-corporation returns uses new compliance data. However, National Research Program officials told the TIGTA examiners that they have not formulated plans to assess the effectiveness of the new DIF formula due to other workload priorities.
 

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TIGTA examiners concluded that outdated compliance data and unintentional errors inherent in any manual process are factors that contribute more to the higher no-change percentages in the DIF and the DIF-related S-corporation audits than the quality and scope of the audits.

 
TIGTA recommended that:
  • SB/SE Division researchers should consider exploring using S-corporation data files to determine if examiners are auditing the most productive returns. 
  • Additional steps could be taken to strengthen controls over the return classification process to further minimize the risk of selecting returns for audit that have limited audit potential. 
  • The IRS should pursue alternative selection techniques by using existing databases containing S-corporation data to help identify additional productive returns for audit.
 
IRS management agreed with the recommendations.
 
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