For reporting purposes flow-through income is broken into several  categories. Scope and Methodology

In order to describe IRS’s implementation of its Schedule K-1 matching  program, reasons for suspending the issuance of notices, impact/burden  on taxpayers, and results of the program, we:  reviewed and analyzed IRS management plans, risk  assessments, and other discussions of how the matching  program would operate, including work group meeting minutes;  interviewed IRS officials regarding the efforts required to plan  and implement the program, including preliminary program  testing, early plans for the program, changes made in program  plans, problems with stakeholder communication, and the  suspension of notices related to Schedule K-1 income;  reviewed documents issued by external parties regarding  concerns with the Schedule K-1 matching program;  interviewed stakeholders from outside IRS, including enrolled  agents and members of professional organizations, IRS advisory  committees; and  reviewed data and statistics resulting from the Schedule K-1  matching program, including number of taxpayers sent notices  and tax revenue assessed. IRS Stopped Issuing Schedule K-1 Notices after Complaints about Burden Imposed by Program Changes

In its original plan for the Schedule K-1 matching program, IRS intended to  focus on two categories of income: interest and dividends. In the face of complaints about  the burden imposed on compliant taxpayers, IRS stopped sending K-1  underreporter notices. IRS based its decision on a risk matrix  that summarized the risk of sending a notice to a compliant taxpayer for  the various categories of flow-through income. IRS began sending notices about the  discrepancies to taxpayers in April 2002. The  compliant taxpayers or their preparers who responded to the notices were  required to submit information to IRS in writing or via telephone that  explained how they reported the flow-through income on their tax return. IRS responded by stopping the K-1 matching program notices as of August  1, 2002. These cases  resulted in about $41.4 million of additional taxes assessed of which   $26.9 million related exclusively to Schedule K-1 income. However, IRS did not timely implement two parts of the plan. First, IRS  did not test the feasibility of focusing the program on interest and dividend  income until after recommending such a focus and communicating the  recommendation to taxpayers, tax preparers, and other stakeholders. Second, after changing the plan, IRS did not clearly communicate with  taxpayers, tax preparers or other stakeholders about the changes. Also this year,  IRS is taking steps intended to reestablish communication with external  stakeholders and reducing the burden on compliant taxpayers. More specifically, it is not known how ambitious  IRS’s goal to reduce notices sent to compliant taxpayers by at least 50  percent is nor is it known whether IRS can reduce notices sent to  compliant taxpayers while maintaining the ability to act against  noncompliant taxpayers.
Why GAO Did This Study

About $1 trillion in income was distributed in 2001 by flow-through entities such as partnerships and trusts. These entities do not pay taxes on flow-through income. They report it to the Internal Revenue Service (IRS) on a Schedule K-1 and their partners or beneficiaries pay any tax. Concerned about underreporting, IRS began matching the flow-through income reported on Schedule K-1s with that reported on individuals' returns. In 2002, IRS began sending notices to taxpayers about suspected noncompliance. After complaints that many notices were going to compliant taxpayers, IRS stopped sending notices. Concerned about the burden, Congress asked GAO to, among other things, (1) describe the burden caused by the notices and IRS's rationale for stopping them, (2) assess IRS's management of the program, and (3) describe the steps IRS will take to address any problems.

What GAO Found

IRS stopped issuing Schedule K-1 notices after complaints about the burden the program imposed on compliant taxpayers. Originally, IRS intended to focus the program on two categories of income--interest and dividends--wherein matching was straightforward, and therefore the number of notices sent to compliant taxpayers could be minimized. However IRS changed the matching program to cover additional categories of flow-through income without clearly informing taxpayers and tax preparers. Matching these additional categories of income was less straightforward. As a result, IRS sent notices about suspected noncompliance to more compliant taxpayers than it intended. In fact, about two-thirds of the notices were sent to taxpayers later determined to be compliant. After taxpayers complained, and after sending out about 70 percent of the planned notices, IRS responded by stopping the notices. IRS has assessed about $41.4 million in additional tax from the notices that were sent and approximately $26.9 million was directly attributable to Schedule K-1 underreporting. IRS did not timely implement two parts of the plans for managing the Schedule K-1 matching program. First, IRS did not test the feasibility of focusing the program on interest and dividend income until after recommending such a focus and communicating the recommendation to taxpayers, preparers, and other stakeholders. Second, after changing the plan, IRS did not clearly communicate the changes. IRS is taking steps to improve communications and reduce the burden on compliant taxpayers. However, neither IRS nor GAO knows whether these changes will improve communications and reduce burden while maintaining the effectiveness of the Schedule K-1 matching program as a compliance tool.