IRS resumes K-1 matching program.

• Author: Ely, Mark H.

The "voluntary" nature of the U.S. self-assessment tax system works best when three powerful forces--withholding, information reporting and information matching--reinforce it. Even when withholding is not feasible, the combination of information reporting and matching helps motivate high levels of compliance. Mindful of this reality, the IRS announced in early 2002, that it would expand its matching of K-1s from partnerships, S corporations and trusts with the Forms 1040 filed by the beneficial owners of these flowthrough entities.

As partial rationale for expanded matching, the IRS pointed to an internal study that documented the recent significant growth in the number of flowthrough entities. The study also estimated that between 6% and 15% of a total of $1.2 trillion in flowthrough income would not be reported on 2001 returns. Coincidentally, these revelations came at a point at which the IRS was making very little compliance use of the K-1 information it possessed.

In the first year of the matching program, the IRS processed more than 18 million tax-year (TY) 2000 Schedules K-1. It screened approximately 378,000 potential mismatches down to a universe of 69,000 taxpayers, to whom notices were issued. In evaluating the approximately 300,000 cases for which notices were not issued, the primary reasons for screening cases out included: combining K-1 income and expenses, or offsetting income by employee business expenses or by at-risk or flowthrough losses; and reporting K-1 income elsewhere on the return.

Of the 69,000 notices issued, more than 60% were ultimately closed as "no-change" (i.e., the IRS accepted the returns and Schedules K-1 as originally filed). The primary reasons cases were closed as no-change closely mirrored the original screen-out results. Approximately 22,000 cases were closed as "agreed"; taxpayers agreed to $25 million in additional assessments attributable to misreported K-1 items.

Before launching the K-1 matching program, the AICPA and other stakeholder groups cautioned the IRS to proceed slowly. They warned the IRS of the potential for error attributable to the wide variation in the way K-1 information flows onto various Form 1040 lines and schedules. Because of the significant number of erroneous notices (i.e., notices that lead to no-change cases), on Aug. 1, 2002, the IRS ceased issuing K-1 mismatch notices. It characterized its actions as a pause and promised to consult fully with interested parties before...