According to a Government Accountability Office (GAO) report released on Monday, over a trillion dollars in income was distributed in tax year 2002 by flow-through entities, such as partnerships, subchapter S corporations, and trusts, to their partners, shareholders, or beneficiaries, respectively. The Internal Revenue Service (IRS) estimates that from 6 to 15 percent of such income is unreported on individual tax returns. This income is reported to both IRS and to the recipients on a Schedule K-1 (K-1).
The IRS uses K-1 data in its document matching program to identify noncompliance and for other purposes. The GAO was asked to (1) assess the accuracy of K-1 data, specifically transcription errors and taxpayer identification numbers (TIN); (2) determine whether any limitations in the availability or accuracy of K-1 data have affected IRS's ability to identify noncompliance; and (3) identify the benefits and challenges of increasing e-filing of K-1s.
The accuracy of paper-filed K-1 data is reduced by transcription errors; paper and e-filed K-1s have inaccurate TINs. The IRS estimates that transcription errors for tax year 2002 ranged from 5 and 9.5 percent and is taking steps to address such errors. Although e-filed K-1s do not require transcription, for tax year 2002, the percentage of invalid TINs for e-filed K-1s and paper-filed K-1s were comparable (7 and 6 percent, respectively).
Due to potential burden on flow-through entities and resource constraints, the IRS does not notify the entities of invalid TINs on K-1s for correction. If the IRS did so, this would likely give e-filing entities enough time to correct invalid TINs before IRS runs its document-matching program.
Inaccurate or limited K-1 data have created problems for the IRS researchers and examiners. IRS research staff indicated that inaccurate TINs adversely affected their analysis of flow-through entity networks. Further, because the IRS captures limited data from flow-through entity returns, including the K-1, IRS staff lack data they consider helpful, such as âOther Incomeâ to help identify tax shelters.
In at least 40 percent of closed examination cases we sampled, IRS examiners found errors with return line items not entered into IRS's databases when returns are received. If these lines were available up front, researchers say they would be able to better identify returns with potential noncompliance.
Increased e-filing of K-1s would provide benefits and challenges to both IRS and taxpayers. Benefits for the IRS include faster, more complete information and millions in annual cost reductions. Benefits for taxpayers include fewer IRS contacts with them because the IRS would have more accurate information in its
systems. The primary challenge for the IRS is its current inability to electronically process all flow-through entity returns and related forms, including the K-1. For taxpayers, the primary challenge is the cost of converting from paper to e-filing.
To improve the availability and usefulness of K-1 data to the IRS for detecting noncompliance, the GAO recommends that the IRS conduct a pilot study to determine the benefits and costs of obtaining corrected TINs from flow-through entities as soon as they are found to be invalid. The IRS agreed with the GAO report and recommendations.