TIGTA Suggests Improvements for Early Distribution Compliance

Additional Actions Could Improve Compliance With Early Retirement Distribution Tax Requirements

May 22, 2020

This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.

Redaction Legend:

1 = Tax Return/Return Information
2 = Law Enforcement Techniques/Procedures and Guidelines for Law Enforcement Investigations or Prosecutions.

Highlights

Final Report issued on May 22, 2020

Highlights of Reference Number: 2020-10-018 to the Commissioner of Internal Revenue.

IMPACT ON TAXPAYERS

Taxpayers who take an early distribution from their retirement accounts must pay a 10 percent additional tax unless they qualify for certain exceptions. The IRS's Automated Underreporter (AUR) Program systemically identifies taxpayers who took an early distribution but did not pay the tax. Failure to enforce taxpayer compliance with this tax creates an unfair burden on the majority of taxpayers who pay all of their taxes on time.

WHY TIGTA DID THE AUDIT

This audit was initiated to determine whether the AUR Program is identifying and working the most productive cases for which taxpayers potentially owe a 10 percent additional tax on early distributions from retirement plans.

WHAT TIGTA FOUND

Due to resource constraints, it is important the AUR Program work the highest priority cases with the most significant impact on tax administration. The AUR Program worked only 8 percent of Tax Year 2016 cases for which taxpayers reported an early distribution but did not pay the additional tax. Most cases selected for work were either later screened from further review or resulted in no assessment.

TIGTA compared the exceptions taxpayers claimed on Forms 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with internally available information and identified 6,899 cases with potentially invalid exception claims. The IRS could have potentially assessed approximately $7.5 million for these returns. TIGTA identified: 1) 5,450 cases for which the retirement distribution was made from a type of retirement account that * * * 2 * * * 2) 657 cases for which taxpayers did not * * * 2 * * * 3) 638 cases for which taxpayers did not have evidence of * * * 2 * * * and 4) 154 cases for which taxpayers received * * * 2 * * * Periodic analysis of Form 5329 filings would allow the IRS to identify and notify taxpayers about potential noncompliance issues.

The AUR Program selected to work 368 of the 6,899 cases with potentially invalid Form 5329 exception claims. However, the AUR Program generally did not * * * 2 * * * In these situations, AUR tax examiners closed the cases during screening without making changes to the taxpayers' accounts. AUR tax examiners did not make a determination about the * * * 2 * * *

In addition, AUR tax examiners * * * 2 * * * as part of the AUR Program. TIGTA estimates the IRS could have potentially assessed approximately $2.8 million in taxes for potentially invalid responses.

WHAT TIGTA RECOMMENDED

TIGTA made four recommendations including that the IRS ensure AUR examiners * * * 2 * * * periodically analyze non-selected cases * * * 2 * * * consider the feasibility of revising instructions for Form 5329; and ensure AUR examiners make * * * 2 * * *

In their response, IRS management agreed or partially agreed with three recommendations and plans to take corrective actions. However, the IRS * * * 2 * * * TIGTA believes these actions would improve tax compliance.

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May 22, 2020

MEMORANDUM FOR
COMMISSIONER OF INTERNAL REVENUE

FROM:
Michael E. McKenney
Deputy Inspector General for Audit

SUBJECT:
Final Audit Report — Additional Actions Could Improve Compliance With Early Retirement Distribution Tax Requirements
(Audit # 201810029)

This report presents the results of our review to determine whether the Automated Underreporter Program is identifying and working the most productive cases for which taxpayers potentially owe a 10 percent additional tax on early distributions from retirement plans. This review is included in our Fiscal Year 2020 Annual Audit Plan and addresses the major management challenge of Improving Tax Reporting and Payment Compliance.

Management's complete response to the draft report is included as Appendix VI.

Copies of this report are also being sent to the Internal Revenue Service managers affected by the report recommendations. If you have any questions, please contact me or Heather Hill, Acting Assistant Inspector General for Audit (Management Services and Exempt Organizations).

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Table of Contents

Background

Results of Review

Appendices

Abbreviations

AUR	Automated Underreporter
IRA	Individual Retirement Arrangement
IRS	Internal Revenue Service
SB/SE	Small Business/Self-Employed
TIGTA	Treasury Inspector General for Tax Administration
TY	Tax Year

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Background

Many individuals use retirement plans to save for retirement. These types of plans allow employees to accumulate retirement savings in an individual account based on employee and employer contributions. To encourage saving for retirement, these types of plans provide individuals tax advantages for setting aside money for retirement. Figure 1 describes the most common qualified retirement plans.

Figure 1: Description of Common Qualified Retirement Plans

Qualified Retirement Plans	Description
Pension Plan	Employer-sponsored plan for which the plan sponsor promises employees a specified monthly benefit at retirement based on a formula.
401(k) plan	A plan in which employees have individual accounts to which the employee, employer, or both make contributions. Benefits are based on contributions and investment returns (gains and losses) on the accounts.
403(b) plan	A plan designed for public education and tax-exempt entities. Both the plan sponsor and employees can make pretax contributions.
Federal Government's Thrift Savings Plan	A defined contribution plan, similar to a 401(k), for Federal employees.
Individual Retirement Arrangement (IRA)	An individual savings plan that provides tax advantages for setting aside money for retirement.
Source: IRS definitions of qualified retirement plans on IRS.gov.

To discourage the use of retirement funds for purposes other than normal retirement, the law imposes a 10 percent additional tax on certain early distributions.¹ Generally, any distribution before the age of 59½ from a qualified retirement plan is assessed a 10 percent additional tax.

However, the law permits early distributions without paying the additional taxes under certain circumstances. For example, individuals are not subject to the 10 percent additional tax if they:

• Purchase their first home.

• Have expenses for higher education.

• Separated from service when reaching the age of 55 (age 50 for public safety employees).

• Are unemployed and need to pay health insurance premiums.

• Made payments to another individual under a qualified domestic relations order.²

Financial institutions report retirement distributions to the Internal Revenue Service (IRS) on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Included on the form are distribution codes that explain why the taxpayer received the distribution. For distributions not subject to the 10 percent additional tax, individuals should attach Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to their tax return to indicate that they qualify for an exception to the early distribution tax. The form should include the reason the taxpayer qualifies for an early distribution.

Taxpayers should report distributions from these retirement plans as income on their tax returns. If the early distribution does not qualify as an exception, taxpayers should also report and pay the 10 percent additional tax owed.

The IRS's Automated Underreporter (AUR) Program systemically matches taxpayer income and deductions submitted on information returns by third-parties, e.g., employers, banks, and brokerage firms, against amounts reported by taxpayers on their individual income tax returns to identify discrepancies. Discrepancies are identified when there are mismatches between tax return data and third-party information. Due to resource constraints, the AUR Program cannot review every discrepancy. As a result, additional data analyses are performed on the population of individual tax returns with identified discrepancies to select the inventory that AUR tax examiners will review. The Information Return Case Selection program team should select cases that will: 1) yield the highest assessments, 2) address repeat offenders (taxpayers who have had potential discrepancies in more than one tax year), and 3) provide balanced coverage among all the different types of inventory that the AUR Program works.³

For cases subject to the 10 percent additional tax, the AUR Program matches the amounts reported by retirement plan trustees on Forms 1099-R to the amounts that taxpayers report on their tax return to identify discrepancies.⁴ Additionally, if the Form 1099-R has an early distribution, the AUR Program compares it to the tax return to ensure that taxpayers paid the 10 percent additional tax.⁵ AUR tax examiners are supposed to manually review the associated return along with other information received by the IRS during the case analysis phase. During this process, the tax examiner matches the information returns that were filed with the IRS to the information reported on the taxpayer's return. There is additional information present in the case files during the case analysis phase that is not present when matching third-party documents to the tax return. For example, the Form 5329 is not present during matching but is available to the examiners during case analysis. A determination is made as to whether the case can be closed without any further action (referred to as screening out a case), whether the case needs additional research, or whether a notice needs to be generated to inform the taxpayer of a proposed tax change.⁶

This review was performed in the Small Business/Self-Employed (SB/SE) Division Examination function at the AUR Program campus in Fresno, California, and with information received from the SB/SE Division Examination Operations office in Hartford, Connecticut, during the period July 2018 through October 2019. We conducted this performance audit in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objective. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objective. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.

Results of Review

Thousands of Potentially Productive Cases Are Not Worked

For Tax Year (TY) 2016, the AUR Program identified 102,988 cases for which the taxpayers reported an early distribution from their retirement account on their tax return but did not pay the 10 percent additional tax. Due to resource constraints, the AUR Program only reviews a fraction of the total number of tax returns it identifies as having discrepancies. During TY 2016, the AUR Program selected 8,429 (8 percent) of these cases to work.⁷ The remaining 94,559 cases (92 percent) were not selected. The majority of cases selected for work were either subsequently screened from further review or resulted in no assessment. Of the 8,429 cases selected for work, 2,737 (32 percent) resulted in additional assessments. Therefore, 3 percent of the 102,988 cases the AUR Program identified for which taxpayers reported an early distribution but did not pay the early distribution tax were ultimately assessed additional taxes by the AUR Program. Figure 2 shows how the AUR Program processed the 102,988 cases.

Given the relatively small number of cases that were worked, it is particularly important that the AUR Program work the highest priority cases with the most significant impact on tax administration. The AUR Program assessed additional taxes on 79 percent of cases worked (i.e. not subsequently screened out).

The IRS * * * 2 * * * listed on * * * 2 * * *

The AUR Program generally did * * * 2 * * * In total, 55,632 (54 percent) of the 102,988 taxpayers attached Forms 5329 to their tax returns. Figure 3 shows the exceptions claimed by these 55,632 taxpayers.⁸

Figure 3: Exceptions Claimed by Taxpayers on Forms 5329

Early Distribution Exception Number	Quantity
01 — Distributions (does not apply to IRAs) you receive after separation from service in or after the year you separate and reach age 55 (age 50 for qualified public safety employees)9	3,624
02 — Distributions made as part of a series of substantially equal periodic payments	2,020
03 — Distributions due to total and permanent disability	3,840
04 — Distributions due to death	1,573
05 — Distributions up to the amount you paid for unreimbursed medical expenses during the year (minus 7.5% of your adjusted gross income for the year)	11,690
06 — Distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs)	1,328
07 — IRA distributions made to certain unemployed individuals for health insurance premiums10	1,042
08 — IRA distributions made for qualified higher education expenses	5,296
09 — IRA distributions made for the purchase of a first home, up to $10,000	5,689
10 — Distributions made due to an IRS levy	287
11 — Distributions to reservists while serving on active duty for at least 180 days	120
12 — Other.11 Also, enter this code if more than one exception applies.	19,123
Total	55,632
Source: TIGTA analysis of Form 5329 exception numbers obtained from the Modernized E-File data and cases not worked by the IRS.

We analyzed the exceptions by using internal information available to AUR examiners for five of the 12 exception categories.¹² Our analysis identified 6,899 cases for which the exception to paying the 10 percent additional tax appeared invalid. For example:

• 5,450 taxpayers took a distribution from a type of retirement account that did not qualify for the exception claimed. For example, taxpayers may not take an early distribution from an employer-sponsored retirement plan, such as a 401(k) plan, * * * 2 * * *.¹³

• 657 taxpayers claimed the exception for * * * 2 * * *.

• 638 taxpayers did not have any evidence of * * * 2 * * * and claimed the exception on Form 5329 for * * * 2 * * *.

• 154 taxpayers took distributions * * * 2 * * *

The AUR Program selected to work, but examiners later screened out, 3,875 (7 percent) of the 55,632 cases for which the * * * 2 * * * Similarly, we analyzed the 3,875 cases by using internal information available to AUR tax examiners for five of the 12 exception categories.¹⁴ Of these 3,875 cases, we identified 368 (9 percent) cases which appeared to have an invalid exception. However, AUR tax examiners did not * * * 2 * * * information available to them in the AUR case management system.¹⁵ For example:

• 274 taxpayers took a distribution from a type of retirement account that did not qualify for the exception claimed.

• 42 taxpayers claimed the exception for * * * 2 * * *.

• 37 taxpayers did not have any * * * 2 * * * and claimed the exception on Form 5329 for * * * 2 * * *.

• 15 taxpayers took distributions * * * 2 * * *.

Although AUR employees have the information readily available to identify this noncompliance, management stated that the AUR Program is not an audit. When evaluating a taxpayer's explanation for unreported income it is not necessary to verify everything in the taxpayer's response. In general, the taxpayer's explanation will be taken at face value. However, the AUR tax examiner's position description requires examiners to determine the acceptability of the taxpayers' explanations and to make determinations using sound judgment concerning taxpayers' data.

If the IRS * * * 2 * * * it could have potentially identified 6,899 taxpayers who improperly took an exception to the 10 percent additional tax and assessed approximately $7.5 million in additional taxes.¹⁶ Failure to enforce compliance could lead to greater noncompliance in this area.

Taxpayers claimed exceptions * * * 2 * * * Analyses of Forms 5329 and 1099-R data identified 5,450 * * * 2 * * *. For example, * * * 2 * * * Taxpayers may not claim these exceptions if the distributions were made from another type of retirement plan, such as a pension plan or a 401(k). In addition, age-related exceptions and exceptions for distributions made to an alternate payee under a qualified domestic relations order do not apply if the distribution was made from an IRA.

AUR tax examiners are supposed to determine if the exception number claimed on the Form 5329 is clearly allowable based on the retirement plan.¹⁷ * * * 2 * * * Using data that were available to us, we were able to compare the exceptions reported on the Form 5329 with the retirement distribution types reported on the Forms 1099-R for 1,431 of the 3,875 cases that AUR examiners screened out. * * * 2 * * *.¹⁸ We estimate that the IRS could have potentially assessed $5.8 million in additional taxes for the 5,450 taxpayers who claimed exceptions from * * * 2 * * *.

Taxpayers * * * 2 * * * Analyses identified 657 * * * 2 * * *. We estimate that the IRS could have potentially assessed approximately $753,000 in additional tax if it * * * 2 * * *

Taxpayers did not * * * 2 * * *. Analyses identified 638 taxpayers who claimed the exception on Form 5329 * * * 2 * * *.¹⁹ We estimate that the IRS could have potentially assessed approximately $735,000 in additional tax if * * * 2 * * *.²⁰

Taxpayers took early distributions * * * 2 * * *. The law allows * * * 2 * * *.²¹ Analyses identified 154 taxpayers who took distributions * * * 2 * * * We estimate that the IRS could have potentially assessed approximately $230,000 in additional tax if * * * 2 * * *.²²

Thousands of taxpayers claimed the * * * 2 * * * exception number 12 “Other” on Forms 5329. The IRS instructs taxpayers who meet other criteria not included in the 11 exceptions or have more than one exception that applies to select the “Other” option when submitting Forms 5329.²³ * * * 2 * * * Analyses identified 19,123 (34 percent) of the 55,632 taxpayers who filed Form 5329 claimed the exception “Other” in TY 2016. * * * 2 * * *

Recommendations

The Commissioner, SB/SE Division, should:

Recommendation 1: * * * 2 * * *.

Recommendation 2: Use available data to periodically * * * 2 * * *. Notices should be sent to taxpayers who inappropriately took an early distribution and did not pay the additional tax.

Recommendation 3: Consider the feasibility of revising Form 5329 to instruct taxpayers to * * * 2 * * *.

Tax Examiners * * * 2 * * *

When working a case, AUR examiners send out notices advising taxpayers that additional taxes are owed because they took an early distribution from their retirement account.²⁴ The notice states:

Premature distributions from a qualified retirement plan are subject to a 10% additional tax. Exceptions may apply as indicated in the instructions for Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. If the distributions shown on this notice qualify for an exception, submit a completed Form 5329.

In response to AUR Program notices, taxpayers may provide Forms 5329 or supporting documentation that fully resolves the discrepancy. AUR tax examiners are expected to determine the acceptability of the taxpayers' explanations and to make determinations using sound judgment concerning taxpayers' data.

* * * 2 * * * We reviewed a random sample of 31 of the 716 cases that the AUR Program worked in TY 2016 but did not assess the 10 percent additional tax and identified 14 (45 percent) cases for which the taxpayers' claims for exception were * * * 2 * * *:

• Eight cases involved taxpayers who provided a Form 5329 in response to the notice of discrepancy.

  • Six taxpayers' claims appeared invalid based on other readily available tax information, such as taxpayers who claimed an exception not permitted for the type of retirement plan.

  • * * * 1 * * *

• Six cases involved taxpayers who responded with other documentation or called the IRS with an explanation for not paying the 10 percent additional tax. However, it is unclear why the AUR Program did not assess the 10 percent additional tax * * * 2 * * * For example, taxpayers responded to the notice with a letter explaining why they did not pay the early distribution tax. * * * 2 * * *.

For the remaining 17 (55 percent) cases, taxpayers provided explanations that were sufficiently supported by third-party documentation. For example, taxpayers responded with the exception to paying the early distribution tax because of higher education expenses. Third-party documents corroborated that the taxpayer took the early distribution for education expenses.

AUR tax examiners closed the cases with no changes to the taxpayer's account because, according to AUR Program management, the AUR Program is not an audit. When evaluating a taxpayer's explanation for unreported income it is not necessary to verify everything in the taxpayer's response. * * * 2 * * * However, we believe management should ensure that AUR employees take the appropriate steps to * * * 2 * * * We estimate the IRS could have potentially assessed approximately $2.8 million in additional taxes for an additional 323 cases if it had * * * 2 * * * rather than generally accepting the taxpayer's explanation at face value, before closing the case with no additional tax assessments.²⁵

Recommendation

Recommendation 4: The Commissioner, SB/SE Division, should ensure that AUR Program tax examiners * * * 2 * * *.

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Appendix I
Detailed Objective, Scope, and Methodology

Our overall objective was to determine whether the AUR Program is identifying and working the most productive cases for which taxpayers potentially owe a 10 percent additional tax on early distributions from retirement plans. To accomplish this objective, we:

I. Reviewed IRS processes and procedures to identify individuals who received an early distribution from their retirement plan and did not claim an exception to, or pay, the 10 percent additional tax.

II. Determined if the AUR Program is identifying and assigning the most productive cases for which taxpayers potentially owe a 10 percent additional tax on early distributions from retirement plans.

III. Assessed the AUR Program's review of cases for which a notice of discrepancy for the 10 percent additional tax was sent but no assessment was made to determine appropriateness.

Internal controls methodology

Internal controls relate to management's plans, methods, and procedures used to meet their mission, goals, and objectives. Internal controls include the processes and procedures for planning, organizing, directing, and controlling program operations. They include the systems for measuring, reporting, and monitoring program performance. We determined that the following internal controls were relevant to our audit objective: SB/SE Division Examination function's policies, procedures, and practices related to selecting early distribution cases subject to the 10 percent additional tax and determining the taxpayer's compliance with early distribution cases subject to the 10 percent additional tax. We evaluated these controls by interviewing IRS management and Examination function employees as well as conducting data analysis.

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Appendix II
Major Contributors to This Report

Deann L. Baiza, Acting Assistant Inspector General for Audit (Management Services and Exempt Organizations)

Heather M. Hill, Acting Assistant Inspector General for Audit (Management Services and Exempt Organizations)

Carl Aley, Director

David Bueter, Audit Manager

Jeffrey Stieritz, Lead Auditor

Kevin Nielsen, Information Technology Specialist (Data Analytics) — Applied Research and Technology Data Analyst

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Appendix III
Report Distribution List

Deputy Commissioner for Services and Enforcement

Commissioner, Small Business/Self-Employed Division

Director, Examination, Small Business/Self-Employed Division

Director, Headquarters Examination, Small Business/Self-Employed Division

Director, Enterprise Audit Management

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Appendix IV
Outcome Measures

This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. These benefits will be incorporated into our Semiannual Report to Congress.

Type and Value of Outcome Measure:

• Increased Revenue — Potential; approximately $7.5 million ($37.5 million over five years) in additional taxes for 6,899 cases with invalid exceptions claimed on Forms 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts (see page 4).¹

Methodology Used to Measure the Reported Benefit:

The AUR Program identified 102,988 cases for which the taxpayer reported the early distribution on the tax return but did not pay the 10 percent additional tax. We matched the 102,988 cases to the Forms 5329 and identified 55,632 cases for which taxpayers attached the form to their tax return for TY 2016. Using data available to IRS employees, we performed analysis to test the validity of five exception numbers claimed.² Our analysis identified 6,899 with invalid exceptions claimed on Forms 5329.³ We determined that * * * 2 * * * it could potentially assess $7,493,106 in additional taxes ($37,465,531 over five years.)

Type and Value of Outcome Measure:

• Increased Revenue — Potential; approximately $2.8 million (more than $13 million over five years) in additional taxes for 323 cases in which * * * 2 * * *.⁴

Methodology Used to Measure the Reported Benefit:

We reviewed a statistically valid sample of 31 cases of the 716 cases that the AUR Program worked but did not assess the 10 percent additional tax and identified 14 (45 percent) cases for which the * * * 2 * * *.⁵ We multiplied the number of errors by the average potential early distribution tax assessment for the 14 cases that did not follow established procedures. For these 14 cases, we took the early distribution amount subject to the 10 percent additional tax and multiplied by 10 percent to calculate the additional tax owed * * * 2 * * *. Based on the population of 716 such cases worked, we estimate the IRS could potentially assess taxes on an additional 323 cases,⁶ involving $2,758,672 of additional taxes each year ($13,793,360 over five years).⁷

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Appendix V
Exceptions to the Additional Taxon Early Distributions Reported on Form 5329

Exception Number	Definition
01	Qualified retirement plan distributions (does not apply to IRAs) you receive after separation from service when the separation from service occurs in or after the year you reach age 55 (age 50 for qualified public safety employees).
02	Distributions made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from an employer plan, payments must begin after separation from service).
03	Distributions due to total and permanent disability. You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A medical determination that your condition can be expected to result in death or to be of long, continued, and indefinite duration must be made.
04	Distributions due to death (does not apply to modified endowment contracts).
05	Qualified retirement plan distributions up to the amount you paid for unreimbursed medical expenses during the year minus 10% or (7.5% if you or your spouse were born before January 2, 1952) of your adjusted gross income for the year.
06	Qualified retirement plan distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs).
07	IRA distributions made to certain unemployed individuals for health insurance premiums.
08	IRA distributions made for qualified higher education expenses.
09	IRA distributions made for the purchase of a first home, up to $10,000.
10	Qualified retirement plan distributions made due to an IRS levy.
11	Qualified distributions to reservists while serving on active duty for at least 180 days.
12	Other. Also, enter this code if more than one exception applies. The following exceptions also apply: Distributions incorrectly indicated as early distributions by code 1, J, or S in box 7 of Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Include on line 2 the amount you received when you were age 59½ or older. Distributions from a section 457 plan, which are not from a rollover from a qualified retirement plan. Distributions from a plan maintained by an employer if: 1. You separated from service by March 1, 1986; 2. As of March 1, 1986, your entire interest was in pay status under a written election that provides a specific schedule for the distribution of your entire interest; and 3. The distribution is actually being made under the written election. Distributions that are dividends paid with respect to stock described in section 404(k). Distributions from annuity contracts to the extent that the distributions are allocable to the investment in the contract before August 14, 1982. For additional exceptions that apply to annuities, see Tax on Early Distributions under Special Additional Taxes in Publication 575, Pension and Annuity Income. Distributions that are phased retirement annuity payments made to Federal employees. See Publication 721, Tax Guide to U.S. Civil Servant Retirement Benefits, for more information on the phased retirement program.
Source: Instructions for Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

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Appendix VI
Management's Response to the Draft Report

February 24, 2020

MEMORANDUM FOR
MICHAEL E. McKENNEY
DEPUTY INSPECTOR GENERAL FOR AUDIT

FROM:
Eric C. Hylton
Commissioner, Small Business/Self-Employed Division

SUBJECT:
Draft Audit Report — Additional Actions Could Improve Compliance With Early Retirement Distribution Tax Requirements
(TIGTA # 201810029)

Thank you for the opportunity to review the subject draft audit report. The IRS's Automated Underreporter (AUR) Program is a document-matching program that systemically matches information returns submitted by third parties against amounts reported by taxpayers on their individual income tax returns. The AUR program issues notices to taxpayers to resolve the identified discrepancies through a process that is less burdensome to the taxpayer and more efficient to the Service than conducting an examination. To maintain the program's productivity and efficiency, it is imperative the tax examiner's role remains within the scope of the program's intended purpose.

The AUR program may identify as many as 25 million discrepant cases per year and completes additional data analytics to identify the discrepancies that will: 1) yield the highest assessments, 2) address repeat offenders (taxpayers who have had potential discrepancies in more than one tax year), and 3) provide balanced coverage among all the different types of inventory the AUR program works. Effective case selection is critical to minimizing taxpayer burden, maximizing compliance, and ensuring the IRS is using its limited resources as effectively as possible. As TIGTA was able to show and as the IRS proved, we consistently select the most productive cases that address non-compliance with early retirement distribution tax requirements.

Your report includes several recommendations and outcome measures. We agree with some of your recommendations. However, we do not agree with any of your outcome measures. We believe the small sample size undermined the reliability of the test. The resulting margins of error, even when computed at the low 90% confidence level, yield a large amount of imprecision and uncertainty about the outcome measures. In addition, the five-year projection amplifies the potential revenue without considering the high probability of subsequent compliance after a taxpayer has been subjected to a compliance activity. Lastly, pursuing the cases suggested in this audit report comes with an opportunity cost and potentially a negative impact to voluntary compliance due to the redirection of resources from other compliance activities.

Attached is our detailed response to your recommendations. If you have any questions, please contact me or Scott Irick, Director, Examination Operations, Small Business/Self-Employed Division.

Attachment

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Attachment

RECOMMENDATION 1:

The Commissioner, Small Business/Self-Employed (SB/SE) Division, * * * 2 * * *.

CORRECTIVE ACTION:

We partially agree with this recommendation. The implementation of necessary programming changes to accomplish this objective is subject to budgetary constraints, limited resources, and competing priorities. Consequently, and due solely to those constraints, we cannot provide an implementation date at this time. However, we do not agree to change the AUR program to * * * 2 * * *

IMPLEMENTATION DATE:

N/A

RESPONSIBLE OFFICIAL:

Director, Exam Field and Campus Policy, SB/SE Division

CORRECTIVE ACTION MONITORING PLAN:

IRS will monitor this corrective action as part of our internal management system of controls.

RECOMMENDATION 2:

The Commissioner, SB/SE Division, should use available data to * * * 2 * * * Notices should be sent to taxpayers who inappropriately took an early distribution and did not pay the additional tax.

CORRECTIVE ACTION:

We agree. We will use available data to periodically * * * 2 * * * and take the appropriate compliance action.

IMPLEMENTATION DATE:

May 15, 2021

RESPONSIBLE OFFICIAL:

Director, Exam Case Selection, SB/SE Division

RECOMMENDATION 3:

The Commissioner, SB/SE Division, should consider the feasibility of revising Form 5329 to instruct taxpayers to * * * 2 * * *

CORRECTIVE ACTION:

We disagree. Updating the instructions to * * * 2 * * * Implementing this change would require significant resources including programming changes. The benefit to these extensive changes is currently unknown and we do not believe this additional data will enhance or enrich our compliance efforts.

IMPLEMENTATION DATE:

N/A

RESPONSIBLE OFFICIAL:

N/A

CORRECTIVE ACTION MONITORING PLAN:

N/A

RECOMMENDATION 4:

The Commissioner, SB/SE Division, should ensure AUR tax examiners * * * 2 * * *

CORRECTIVE ACTION:

We partially agree. We will update the IRM procedures to assist tax examiners in * * * 2 * * * the information available in the AUR system.

IMPLEMENTATION DATE:

December 15, 2020

RESPONSIBLE OFFICIAL:

Director, Exam Field and Campus Policy, SB/SE Division

CORRECTIVE ACTION MONITORING PLAN:

IRS will monitor this corrective action as part of our internal management system of controls