However, the bulk of flow-through  business activity was concentrated in a smaller number of entities. Due to Undetected Misreporting, Incomplete Compliance Data, and Double Counting of Income within Networks, the Full Extent of Partnership and S Corporation Income Misreporting Is Unknown

There is substantial uncertainty surrounding the extent of income  misreporting by partnerships and S corporations themselves, and by the  individual taxpayers to whom the income is allocated. For  those two years, using a weighted average, IRS estimated that S  corporations misreported about $55 billion per year in net income. Because IRS has not conducted a similar study of partnerships since  1988, and does not have plans to conduct one, it does not have a similar  estimate for partnerships. Without a strategy for better estimating the extent and nature of  partnership misreporting, IRS cannot make fully informed decisions on  how to allocate resources across enforcement programs and across  different types of business entities and taxpayers. Using this information, and  considering various caveats and uncertainties, we estimated a rough  order of magnitude of the misreporting to be $91 billion per year for tax  years 2006 through 2009. This estimate does not cover all flow-through income. IRS Identified a Relatively Small Percentage of Estimated Misreported Income through Examinations and K-1 Matching and Lacks Reliable Information on Examination Results

		Examinations

IRS examinations have not been effective at finding most of the  misreported income discussed above. According to information that IRS  collected for revenue agent examinations closed in fiscal years 2011 and  2012, IRS proposed increasing the total income reported by partnerships  and S corporations by an annual average of about $16.3 billion. Options for IRS to Improve Identification of Partnerships and S Corporations to Consider Examining Involve Challenges, Some of Which Could Be Mitigated

There are various means through which IRS could improve how it selects  partnership and S corporation tax returns to examine. IRS officials  said that having more return information available electronically might  improve examination selection. Currently, partnerships with more than 100 partners are required by law  to e-file. However, as noted before, IRS will not be able  Unless all returns are digitized, IRS will not be able to use all return line  items in its examination selection process. IRS’s Computer Scoring System for Identifying Partnership Returns to Examine Uses Outdated Formulas, but Upgrading Faces Challenges

SB/SE’s partnership discriminant function (DIF) model to identify entities  to examine was built on data that are now outdated, and does not capture  partnership compliance issues related to tiering. Further,  expanded e-filing would reduce IRS’s tax return processing costs. Matter for Congressional Consideration

Congress should consider expanding the mandate for partnerships and  corporations to electronically file their tax returns to cover a greater share  of filed returns. Appendix I: Objectives, Scope, and Methodology

The objectives of this report are to (1) describe what is known about the  extent of income misreporting by partnerships and S corporations, and by  the individuals to whom these entities allocate that income; (2) assess  how much misreported partnership and S corporation income IRS  identifies and assesses taxes on; and (3) analyze how IRS could improve  its use of data to better identify partnerships and S corporations to  consider for examination. From various documents, including GAO and Treasury Inspector General  for Tax Administration (TIGTA) reports and recommendations, and  interviews with IRS and Treasury officials, we evaluated the costs and  benefits of various approaches we encountered that could improve IRS’s  use of data to better identify partnerships and S corporations to consider  for examination and reduce the no-change rate for partnership and S  corporation examinations. Appendix III: Additional Information about Misreporting

	Methodology for Estimating Individuals’ Total Misreporting of Income from Partnerships and S Corporations

The Internal Revenue Service (IRS) estimated that individual taxpayers  misreported, in net terms, 15 percent of the total income from  partnerships and S corporations that they should have reported on their  tax returns. According to IRS, information reporting increases voluntary tax  compliance because taxpayers know that IRS is aware of their income.
Why GAO Did This Study

Since 1980, partnerships' and S corporations' share of business receipts increased greatly. These entities generally do not pay income taxes. Instead, income or losses (hundreds of billions of dollars annually) flow through to partners and shareholders to include on their income tax returns. GAO has previously reported that the misreporting of income by partners and shareholders poses a tax compliance risk.
GAO was asked to assess IRS's efforts to ensure compliance by partnerships and S corporations. This report (1) describes what is known about misreporting of flow-through income, (2) assesses how much misreporting IRS identifies, and (3) analyzes possible improvements in IRS's use of data to better identify partnerships and S corporations to consider examining. Comparing partnership, S corporation, and other entities' examination results, GAO analyzed 2003-2012 IRS data and evaluated possible improvement ideas stemming, in part, from prior GAO work, for how IRS identifies examination workload.

What GAO Found

The full extent of partnership and S corporation income misreporting is unknown. The Internal Revenue Service's (IRS) last study of S corporations, using 2003-2004 data, estimated that these entities annually misreported about 15 percent (an average of $55 billion for 2003 and 2004) of their income. IRS does not have a similar study for partnerships. Using IRS data and the study results, GAO derived a rough-order-of-magnitude estimate of $91 billion per year of partnership and S corporation income being misreported by individuals for 2006 through 2009.
IRS examinations and automated document matching have not been effective at finding most of the estimated misreported income. For example, IRS reported that examinations identified about $16 billion per year of misreporting in 2011 and 2012, the bulk of which related to partnerships. However, such information about compliance results is not reliable. IRS estimated that 3 to 22 percent of the misreporting by partnerships was double counted due to some partnership income being allocated to other partnerships or related parties. Further, IRS does not know how income misreporting by partnerships affects taxes paid by partners. IRS does not have a strategy to improve the information. As a result, IRS does not have reliable information about its compliance results to fully inform decisions about allocating examination resources across different types of businesses.
IRS's processes for selecting returns to examine could be improved. Not all partnership and S corporation line items from paper returns are digitized, and IRS officials said that having more return information available electronically might improve examination selection. In 2011, about 65 percent of partnerships and S corporations electronically filed (e-filed). Certain large partnerships and S corporations are required by statute to e-file. Expanding the mandate would increase digitized data available for examination selection. Further, in 1995 GAO found that IRS's computer scoring system for selecting partnership returns to examine used outdated information. IRS does not have a strategy to update and use this information to select partnerships for examination. Relatively few partnerships are examined compared to other business entities, and many examinations result in no change in taxes owed. Improved examination selection based on more current information could generate more revenue and reduce IRS examinations of compliant taxpayers.

What GAO Recommends

GAO suggests that Congress consider requiring more partnerships and corporations to e-file their tax returns. GAO recommends, among other things, that IRS (1) develop a strategy to improve its information on the extent and nature of partnership misreporting, and (2) use the information to potentially improve how it selects partnership returns to examine. IRS stated it would consider all the recommendations and identify appropriate actions.