If the IRS were truly taxpayer-centric and designed its compliance programs from a taxpayer-rights foundation, it would look at the data presented by the Taxpayer Advocate Service in this year’s report, as well as all the past reports, and conclude that the process isn’t working for the lowest income taxpayers.  It would ask itself how it could improve the audit process so that taxpayers engage with the auditor and learn what, if any, error they made and how to avoid it going forward.  That engagement and education is at the heart of voluntary compliance, and while it appears to require more upfront resources, it is way more cost effective in the long run than current correspondence exams, which have little educational value.  For example, in a 2007 TAS survey of taxpayers who experienced correspondence examinations for EITC claims, 45% did not understand how the documents requested by the IRS related to the questions the IRS had.  One study found that only 39.7% of Schedule C taxpayers audited by correspondence recalled being audited at all, as compared to 72% of field audited taxpayers and nearly 80% of office audited taxpayers.

The IRS doesn’t need to look far or use much more in the form of resources to be both more effective and in greater compliance with taxpayer rights.  In this post I will set several recommendations for improving the correspondence exam process.  All of these can be accomplished with a modicum of resources, and you can pay for the rest by minimizing, if not eliminating, the expensive downstream work caused by poorly handled correspondence exams (for a sense of this downstream cost, see Figure 2.9.7, page 156 of the 2021 Most Serious Problems for a chart of average pay of downstream employees).

First, the IRS should rename correspondence exam as “virtual office exam.”  Specifically, the IRS should reap the benefits of the pandemic-spurred “zoom” revolution by designing a virtual correspondence exam process that more closely follows in-person office exam procedures.  With this approach the IRS would still send the taxpayer an audit initiation letter, with a suggested date and time for a virtual audit appointment.  Behavioral researchers have found that people are more likely to respond when an appointment time is set, even if the response is to request a different appointment time. 

Second, the audit initiation letter should set out – in common parlance/plain language — the issue that is being examined (since IRS insists correspondence exams are “single issue” exams) and describe the types of documentation that may be helpful to establish eligibility for a credit or deduction.  Here’s an excerpt of an actual Notice CP-75 (correspondence exam audit initiation letter) sent to a low income taxpayer in February 2022:

Notice how vague the letter is about what, precisely, the IRS is auditing; the letter lists 5 different possible issues, each of which have different eligibility criteria.  This sure doesn’t look like a single-issue audit to me.

This notice goes on to identify the “audit items that require documentation” to be: EIC, Dependents, Filing Status, AOC, CDC Credit.  The notice helpfully includes the following enclosures:

• Form 14824, 14824, Supporting Documents To Prove Filing Status
• Form 886-H-DEP, 886-H-DEP (Spanish Version) , Supporting Documents for Dependency Exemptions
• Form 886-H-AOC, Supporting Documents to Prove American Opportunity Credit
• Form 14801, Child and Dependent Care Credit-Explanation of Items
• 886-H-EIC

According to the 2021 Annual Report to Congress, only 3% of taxpayers with Total Positive Income under $50,000 were represented in individual correspondence exams.  For unrepresented taxpayers, the above enclosures will be overwhelming and the sheer volume of them could lead an unrepresented taxpayer to just give up.  It is no wonder that the no-response rate for correspondence exam is higher than any other form of exam.  The inability to reach a live assistor to ask questions increases the administrative burden exponentially.  (In FY 2019, IRS answered the correspondence exam phone line 40% of the time.) 

Third, the IRS should completely trash its current notice system and use some of the IT funding it is getting for FY 2022 to replace it with a 21^st century system that is flexible and graphically robust in terms of layout, type, and design.  IRS letter format is currently dictated by an aged, obsolete correspondence system that is completely inflexible.  Trying to get a change in wording to an IRS letter can take more than a year of endless reviews and negotiations, and even then you have to wait for the programming to be complete.  There is lots of good research, some conducted by IRS and TAS, about how to communicate complex information.  The benefits field, in particular, has lots of studies about how to plan effective communication.  IRS needs to apply that research to its correspondence exam notices and make them salient to the taxpayer’s specific situation.  Presumably, the IRS knows the exact reason the taxpayer’s return was selected for audit.  The audit initiation letter should include that specific reason, not a list of “and/or” possibilities.  The enclosures should relate to that specific reason.  (If there is more than one reason, then the audit should be conducted as an office or field exam, per the IRS’s own justification for “single issue” correspondence exams.)  The IRS should apply its IT resources to get this done, ASAP.

Fourth, the IRS should assign one audit employee to each case.  The audit initiation letter should include the name, badge number, and phone number of the employee to whom the case is assigned, as is required by IRC §7602(a).  Providing this information “personalizes” the process.  It reassures the taxpayer there is a live human being who will work with you on the case, rather than the impersonal, faceless IRS.  The letter should also encourage taxpayers to contact the office immediately if they need to reschedule or would prefer to conduct the audit by phone or correspondence.  By inviting the taxpayer to call to state their preference, the IRS not only signals its willingness to meet the needs of the taxpayer but also gains an opportunity to talk to the taxpayer about the issues.  This approach also increases IRS accountability.  As it stands today, no one employee is accountable for the conduct of a correspondence exam.  If the taxpayer does not respond, the assigned audit employee should be required to make at least two outbound call attempts (or emails/texts if that is available) at different days of the week and times of day. 

(I note that the IRS frequently justifies its “next available assistor” approach to correspondence exam by saying it is good for the taxpayer.  But all IRS functions where employees maintain case inventories – field exam and collection, Appeals, Counsel, and the Taxpayer Advocate Service – have established some type of buddy system to cover for vacations, sick leave, or training.  And the IRS could treat these taxpayers as adults and give them the choice of speaking to their assigned auditor or the next available assistor.)

Fifth, the audit initiation letter should also include a separate sheet providing information for signing on to the virtual appointment, including the requirement for a phone or other device that has a camera, and providing a contact for the taxpayer to discuss any technological challenges the taxpayer may face.  This is where QR code technology could be helpful, providing links to appropriate sites and information.  If the taxpayer is unable to sign on via a device with a camera, a telephone appointment should be arranged.  When the taxpayer requires specific reasonable accommodations, the audit should be converted to an in-person office exam or conducted via telephone, whichever is best for the taxpayer.

Sixth, when the taxpayer attends the virtual office audit appointment, the auditor should iteratively explain the specific issue that is being reviewed and what the IRS needs to see to establish eligibility.  If the taxpayer has documentation, the IRS auditor should look at it via the taxpayer’s device camera and instruct the taxpayer on how to upload, email or fax it.  As with an in-person office audit, at the close of the appointment the taxpayer should know what additional documentation, if any, is needed to prove eligibility.  The employee should memorialize the requested additional documentation in a letter to the taxpayer (or email if allowed).

Seventh, in order for this approach to work, the IRS must test its Documentation Upload Tool (DUT) or similar technology (such as the virtual office platform) with low income taxpayers to determine whether they are able to access and utilize it.  It should work with both the National Institute of Standards and Technology (NIST) and other government agencies and external groups to identify secure but accessible methods for low income taxpayers to sign on and submit information and documentation digitally.

Eighth, the IRS should adopt in correspondence exams the same procedures it uses in office and field exams for identifying alternative mailing addresses.  This approach will minimize the number of default assessments due to taxpayers moving around, especially low income taxpayers who comprise more than half of the correspondence exam population.

Ninth, with respect to all CTC/EITC audits, the IRS should allow taxpayers to establish proof of residency by using Form 8836 and its accompanying Schedule A.  These forms walk taxpayers through how to prove their child or relative lived with them for more than 6 months by having certain officials or professionals attesting under penalties of perjury and completing the periods of time they either have personal or official-records knowledge of the child’s residence.  In an exhaustive 2005 IRS study, this form was shown to be more reliable and probative than the usual documents and notarized statements the IRS currently accepts.  Since that time, I have recommended the IRS use this form in all EITC audits, which the IRS has steadfastly refused to do.  Given its obvious benefits, including reducing taxpayer burden, the IRS’s refusal is just plain baffling and counterproductive.

Tenth, the IRS should conduct a research study to test the effectiveness of certain messages in eliciting a response from low income taxpayers.  Several studies have already been conducted, including one by Day Manoli and Nicholas Turner on Nudges and Learning: Evidence from Informational Interventions for Low-Income Taxpayers.  This study found that timely reminder notices about the availability of the EITC increased take up of the childless worker EITC by 80% among the test population in the year of the notice.  A similar study designed around increasing responsiveness to correspondence exams, including focus groups exploring how letter recipients perceived the messages, could greatly enhance taxpayer communication and participation. 

The IRS should also build upon the important research conducted by TAS in 2016 and 2017 in which it sent out educational letters, under the signature of the NTA, to taxpayers whose returns claiming children had broken certain rules in the Dependent Database.  The letter referenced the specific issue and explained the eligibility rule in plain language.  One part of the study offered a toll-free Extra Help line to get questions about eligibility for the EITC and the CTC.  The letters had significant future compliance effects in several areas, without the cost of an audit.  The IRS should conduct a follow up study including focus groups to determine whether taxpayers understood the eligibility rules as a result of the letter.

The IRS recently announced the permanent establishment of the Customer Experience Office.  From the announcement, it appears the office will primarily focus on taxpayer service.  I hope the office defines “taxpayer service” more broadly, to include how taxpayers are served by the audit and collection process of the IRS (answer = poorly).  If it does so, the correspondence exam process is a good place to start.  While it is at it, the office can look at how to create a ”feedback loop” so correspondence auditors can learn what happens to the cases after they leave correspondence exam, as this post suggests.  Taxpayers who are under audit, and their representatives, will be enormously grateful for any improvements, and the rest of us taxpayers will be very happy that the IRS no longer wastes resources and violates taxpayer rights in this audit process.

Over the decades, advocates for taxpayers, myself included, have consistently criticized this method and maintained it does not adequately protect taxpayer rights, including the right to be informed, to pay no more than the correct amount of tax, to challenge the IRS and be heard, and to a fair and just tax system.  Recently, The Tax Law Center at New York University and the Center for Taxpayer Rights published a paper about this topic, Exclusionary Effects of the IRS Correspondence Audit Process Warrant Further Study, in which we question the effectiveness of correspondence exams and propose additional research and pilots.

To get a sense of the disproportionate impact the IRS overall audit strategy has on Earned Income Tax Credit taxpayers, and why it is so important not only to revise that strategy but also to reform the audit process, please take a look at some rather stunning statistics from the IRS Statistics of Income compliance webpage.  Table 17 sets forth Exam Coverage and Recommended Additional Tax After Exam, by Type and Size of Return, for Tax Years 2010-2018.  (I am using Tax Year (TY) 2018 because it best aligns with the NTA Annual Report numbers, which use Fiscal Year (FY) 2019, discussed later in this post). 

Total TY 2018 individual tax returns filed:                                                      153,927,628

Total TY 2018 individual tax returns with EITC:                                              26,492,486

EITC returns are 17.2% of all TY 2018 individual returns.

Total audit closures of TY 2018 individual tax returns:                                  234,543

Total TY 2018 individual tax return audit closures selected for EITC:            165,611

EITC returns are 70.6% of all TY 2018 individual audit closures.

Total TY 2018 individual audit closures with no change:                                41,276

Total TY 2018 individual audit closures, selected for EITC,with no change: 28,277

EITC returns are 68.5% of all TY 2018 individual no-change audits.

What this data tell us is that over 70% of all IRS individual audit closures for TY 2018 returns involved EITC despite the fact that only 17.2% of individual income tax returns claim the EITC.  This is up from what I reported in the 2005 Annual Report to Congress, when 48% of IRS individual examinations involved the EITC despite only 17% of individual income tax returns claim the EITC.  And remember – these “audit” numbers don’t include “unreal audits” involving EITC, such as math errors under IRC § 6213.  Further, EITC audits constitute more than 2/3 of the no-change individual audit closures.  Now, this figure does not take into account downstream adjustments to proposed assessments in appeals or Tax Court, or abatements in audit reconsiderations.  Given the low response rate for correspondence exams, that there are any no-change audits is stunning to me.  At any rate, the IRS spent resources forcing 28,000 people – 12% of all TY 2018 EITC audit closures! — to produce documentation of eligibility, when they were eligible all along.

These numbers are all the more outrageous when you consider the fact that the dollar amount of EITC improper payments are only $16 billion or 3.6% of the IRS’s current $441 billion gross tax gap estimate.  (It is only 1.6 % if you buy the Commissioner’s $1 trillion tax gap estimate, which I don’t).  Why would the IRS focus so much on low income taxpayers?  Certainly, the fact that EITC is subject to improper payment reporting requires the IRS to audit some EITC returns.  But the requirement to audit some returns is not a justification for adopting an assembly-line approach to the most low-income taxpayers.  Could it possibly be the IRS uses that approach because it beefs up the overall audit coverage rate and the number of audits, at really low cost?

Now comes the National Taxpayer Advocate’s 2021 Annual Report to Congress, with its 9^th Most Serious Problem focusing on Correspondence Exams.  Let’s take a look at some of the data (relating to FY 2019) presented in the report: 

• 53% of individual (IMF) audits were on taxpayers with Total Positive Income (TPI) under $50,000. Of this 53%, 82% of the taxpayers claimed refundable credits including the EITC.  (TPI includes “only total positive income values from wages, interest, dividends, other income, distributions, Schedule C net profits, and Schedule F net profits.  Losses are treated as zero.”  MSP #9, endnote 7.)
• 92% of IMF audits on taxpayers with TPI under $50,000 were conducted by correspondence exam. 
• The average direct time spent by an IRS auditor on a correspondence exam for taxpayers with TPI under $50k was 2 hours, compared to 11 hours for office exam and 41 hours for field exam.
• 4% of Wage & Investment Division correspondence exam resources was spent answering phone calls; 96% was spent on handling correspondence.  The Level of Service on the correspondence exam line was 40.7% (Note that this is for 2019, so it is pre-pandemic ….)
• 35% of 361,000 IMF audits closed in FY 19 for taxpayers with TPI under $50,000 were the result of no taxpayer participation, of which 14% involved undeliverable mail.
• Unlike field auditors, who can use both internal and external sources, including USPS trace, to locate better addresses, correspondence examiners can only use internal sources.
• Only 3% of taxpayers with TPI under $50,000 were represented in correspondence audits.
• Of the 24,700 petitions to Tax Court in FY 19, 17,700 originated in correspondence exam.
• 94% of audit reconsiderations originated in correspondence exam; 44% of these original audits closed because there was either no record of a taxpayer response or IRS correspondence was undeliverable.
• 88,000 of taxpayers audited in FY 19 with TPI under $50,000 were placed in collection; 45% of these were in Currently Not Collectible-Hardship status as of 10/28/21.

So.  The primary method of auditing low income individual taxpayers is by correspondence.  If you are more affluent, you are more likely to have a single auditor assigned to your case in office or field exam, but not if you are low income – i.e., in correspondence exam, no one employee is assigned to your case.  If you are more affluent, the IRS is more likely to spend more time looking at your documentation, and communicating with you.  Not so if you are low income.  If you are more affluent, the IRS makes more of an effort to actually locate a more current address if mail is returned undeliverable.  Not so if you are low income.

It’s not just that mail is undeliverable.  IRS audit notices are incomprehensible to taxpayers.  In 2007, the Taxpayer Advocate Service did a survey of a representative sample of taxpayers who had been audited about their EITC claims.  More than 25 % of those taxpayers said they did not understand from the initial letter that they were under audit.  More than 70% said the audit letter was difficult to understand, including they did not understand what documentation the IRS wanted them to provide.  If you don’t understand you are under audit, that will affect your response.  And if you don’t understand what you should send in to prove your eligibility, that will affect your audit outcome.

And in fact, we see this in the no-response and agreed rates of audits of low income taxpayers versus more affluent ones, who are more likely to have a single auditor assigned to the case.  Here’s a chart from the 2021 Annual Report to Congress:

To make matters worse, past TAS studies have compellingly shown that correspondence exam procedures actively harm taxpayers.  In 2012 TAS reviewed a representative sample of taxpayers whose EITC claims were disallowed in correspondence exam and later conceded in full by Chief Counsel when the taxpayer filed a United States Tax Court petition.  In that study we found that these taxpayers, on average, contacted the IRS five times during the audit (one taxpayer contacted the IRS 21 times!).  78 % were ultimately able to submit documentation that was accepted by IRS appeals officers or counsel attorneys after the Tax Court petition was filed.  In 20% of those cases, appeals/counsel accepted documented that IRS auditors had rejected. 

Correspondence exams have been a recurring topic in the Annual Reports to Congress when I was the National Taxpayer Advocate.  At a quick glance, I found Most Serious Problems on various aspects of correspondence exam in Annual Reports from 2001 (my first), 2002, 2003, 2005, 2006, 2007, 2008, 2009, 2011, 2013, 2014, 2015, 2016, 2018, 2019, and 2020.  (My recollection is, in the years we didn’t write about some aspect of correspondence exam, we were just tired of it and decided to give it a rest for one year.)  TAS has conducted numerous research studies on the topic.  And yet the IRS response has been unchanged over the years.

Why does the IRS persist in believing correspondence exam is an efficient, cost-effective method of auditing?  First of all, because it defines efficiency and cost-effectiveness from the IRS perspective – that is, correspondence exam works for the IRS.  It doesn’t have to dedicate (human) resources to the task; it can churn out a lot of audits and get a lot of assessments, all of which feed into its reports of audit coverage and enforcement results.

In fact, correspondence exams are a classic example of IRS assessing efficiency from a superficial cost-benefit analysis, disregarding the administrative burden these exams impose on taxpayers, especially low income taxpayers.  As Les, Keith and I discuss in an upcoming article, the learning, compliance, and psychological burdens of an administrative process can significantly undermine the policy goals of a program, and can even be used to deliberately deter eligible taxpayers from benefitting from a program.

In this blog post, we’ve seen that IRS intransigence over years regarding the correspondence exam process has created a procedural justice nightmare for taxpayers, especially low income ones, as well as generating lots of unnecessary and expensive downstream work for itself.  In part 2 of this “How Did We Get Here?,” I’ll discuss some recommendations for fixing this mess.