Executive Summary

Objective and Scope

Background

Recommendation

conclusion

Appendix I – Detailed Objective, Scope, and Methodology

Appendix II – Major contributors to This Report

Appendix III – Report Distribution List

Appendix IV – Management's Response to the Draft Report

Executive Summary

We conducted this review at the request of the Assistant commissioner (Forms and Submission Processing) to assist Internal Revenue Service (IRS) management in determining whether the threshold requirements for individual taxpayers to make estimated (ES) tax payments should be further increased to reduce taxpayer burden and lower the IRS’ processing costs. Our review showed that raising the threshold level would reduce burden for a significant number of taxpayers and lower costs. However, raising the threshold level would also delay the collection of taxes and result in significant additional government borrowing costs. In addition, removing the legal requirement and discipline for making quarterly payments could have a detrimental impact on taxpayer compliance.

In 1943, the congress established statutory requirements for withholding on salaries and wages and for making ES tax payments on certain other sources of income, such as self-employment, interest, dividends, and rent. The ES tax system "levels the playing field" between wage earners and other taxpayers and supports the "pay as you go" concept by requiring quarterly deposits.

For Tax Years (TY) 1985 through 1997, individual taxpayers were required to make ES tax payments if they expected to owe at least $500 in tax after subtracting their withholding and other credits. This threshold level was increased to $1,000 for TY 1998.

Raising the ES tax payment threshold level would reduce burden on a significant number of taxpayers. At every $500 increment up to $3,500, most of the taxpayers, who would no longer be required to make ES tax payments if the threshold was increased, are in the "age 65 or over" group.

For example, we estimate that raising the ES tax payment threshold from $1,000 to $2,000 would:

• Require 1.6 million fewer taxpayers to make ES tax payments. These would include approximately 942,000 taxpayers (58 percent) who are age 65 or older.
• Save taxpayers from 4.5 to 5.1 million hours that are spent in preparing and submitting the necessary forms to comply with the law.
• Save taxpayers $2.1 million in postage costs.
• Avoid the assessment of ES tax penalties against 194,000 taxpayers.

Raising the ES tax payment threshold requirements would also reduce IRS operating costs. For example, we estimate that raising the threshold from $1,000 to $2,000 would result in more than $5.9 million in printing, mailing, and processing cost savings for the IRS.

However, one potential issue with raising the ES tax payment threshold level is that currently compliant taxpayers may become accounts receivable problems for the IRS once the legal requirements and the discipline for making quarterly ES tax payments are removed. For TY 1996, we estimate that approximately $2.6 billion was received through ES tax payments made by taxpayers with ES tax liabilities ranging from $1,000 to $1,999. Although our analysis indicates that these taxpayers were generally compliant (i.e., approximately 94 percent were fully paid by the regular return due date), we cannot conclusively predict their future behavior under a different set of circumstances.

A second issue with raising the ES tax payment threshold is the additional government borrowing costs that would be incurred as a result of the delayed cash flow into the Treasury. For example, we estimate that raising the threshold from $1,000 to $2,000 would delay the IRS’ receipt of approximately $2.6 billion in taxes and cause the government to incur more than $66 million in additional annual borrowing costs.

Raising the current ES tax payment threshold level would result in a cost to the government that would exceed the process cost savings that could be realized. Therefore, any decision by the Assistant commissioner (Forms and Submission Processing) to recommend changes to the payment requirements must be made on a basis that weighs other factors more heavily than a cost/benefit analysis.

As a result, we make no specific recommendation as to whether the ES tax payment threshold level should be further increased. We believe that the Assistant commissioner (Forms and Submission Processing) needs to carefully balance the benefits (e.g., taxpayer burden reduction and processing cost savings) that could be realized with a higher threshold against the downsides (e.g., a potentially undesirable impact on taxpayer compliance and additional government borrowing costs) before recommending to the congress that the Internal Revenue code be amended to raise the threshold.

One method which the Assistant commissioner (Forms and Submission Processing) could effectively use to evaluate the inherent compliance risk associated with any future increases to the ES tax payment threshold level would be to study the impact that the increase from $500 to $1,000 had on taxpayer behavior in TY 1998. This information would be available at the conclusion of the 1999 filing season.

Management’s Response: The chief Operations Officer expressed his appreciation for the analysis that we provided at the request of the Assistant commissioner (Forms and Submission Processing). He stated that the report contains valuable information that will be taken into consideration when making any future policy decisions regarding ES tax payments.

Objective and Scope

Our objective was to assist Internal Revenue Service (IRS) management in determining whether the threshold requirements for individual taxpayers to make estimated (ES) tax payments should be further increased to reduce taxpayer burden and lower the IRS’ processing costs. To achieve this objective, we analyzed tax account information for almost 1.1 million taxpayers who filed quarterly ES payments for Tax Year (TY) 1996. We evaluated the potential impact that various higher threshold levels would have on taxpayer burden, operating costs, taxpayer compliance, and government borrowing costs.

We conducted the review from April through September 1998 using Government Auditing Standards. Details of our audit objective, scope, and methodology are presented in Appendix I. Major contributors to this report are listed in Appendix II.

Background

Taxpayers who are wage earners have income taxes and Social Security taxes withheld from their paychecks on a regular basis. The ES tax system supports the "pay as you go" concept by requiring quarterly deposits from taxpayers who are self-employed and/or have earnings from such sources as interest, dividends, rent, alimony, and unemployment compensation.

Approximately 11 million individual taxpayers make ES tax payments each year. During Fiscal Year (FY) 1997, the IRS collected nearly $140 billion from the 39.1 million ES tax payments that were received.

Beginning in TY 1998, individual taxpayers will generally be required to make ES tax payments if they expect to owe at least $1,000 in taxes after subtracting their withholding and other credits. This is the first change to the ES tax payment threshold level since 1985. Previously, the threshold had been set at $100 beginning in TY 1981, $200 in TY 1982, $300 in TY 1983, $400 in TY 1984, and $500 in TY 1985.

Results

Any changes to the ES tax payment requirements for individual taxpayers involve a consideration of both tangible and intangible factors. The Assistant commissioner (Forms and Submission Processing) needs to carefully weigh the intangible value of taxpayer burden reduction against the potential risks and cost factors before proposing any changes to the current tax law.

If the threshold level was increased, our analyses showed that:

• Taxpayer burden would be reduced.
• IRS operating costs would be reduced.
• Accounts receivable could be increased.
• Additional government borrowing costs would be incurred.

We make no specific recommendation as to whether the ES tax payment threshold level should be further increased. Instead, the balance of this report presents the results of our analysis of the factors that the Assistant commissioner (Forms and Submission Processing) needs to consider before proposing any changes to the current payment requirements.

Raising the Estimated Tax Payment Threshold Level Would Reduce Taxpayer Burden

We estimate that the recent tax law change which increased the threshold from $500 to $1,000 removed the requirement for making ES tax payments from 1,002,000 taxpayers who had made one or more quarterly payments in TY 1996. Of these, we estimate that 605,000 (60 percent) were age 65 or over.

Taxpayer burden would be reduced for a significant number of taxpayers if the threshold requirement for making ES tax payments was further increased. Most of the taxpayers who would benefit from moderate increases to the threshold level are those in the "age 65 or over" group.

For example, we estimate that doubling the threshold from $1,000 to $2,000 would:

• cause 1.6 million taxpayers who made ES tax payments in TY 1996 to no longer be required to make them. These would include nearly 942,000 taxpayers (58 percent) who are age 65 or older.
• Save taxpayers from 4.5 to 5.1 million hours that are spent in preparing and submitting the necessary IRS forms.
• Save taxpayers $2.1 million in postage costs.
• Avoid the assessment of ES tax penalties against 194,000 taxpayers.

For TY 1996, over 11 million individual taxpayers made one or more ES tax payments. The following table, which is arranged according to estimated tax liability, is presented to show our estimate of the number of taxpayers who made ES tax payments within each $500 increment:

At each increment up to $3,500, taxpayers who were age 65 or over comprised more than 50 percent of the population who made ES tax payments. The following table shows our estimate of the cumulative number of taxpayers, including those age 65 or older, who would no longer be required to make ES tax payments at various higher ES tax payment threshold levels:

We estimate that the 11 million individual taxpayers who currently make ES tax payments spend approximately 29.3 million hours in complying with the basic paperwork requirements of the existing ES tax payment laws. We estimate that about 1.6 million of these taxpayers spend an additional 1.6 million hours (short method) to 6 million hours (long method) in completing the form used to compute ES tax penalties.

The IRS provides a Form 1040-ES/V package to those taxpayers who make ES tax payments. The package includes a worksheet for determining how much ES tax to pay and four payment vouchers (Forms 1040-V) which are preprinted with the taxpayer's name, address, and social security number.

For TY 1998, the IRS’ estimate of the average amount of time that taxpayers would need to spend on completing the worksheets and preparing and filing the payment vouchers was 2 hours and 40 minutes.

The table on the following page shows our estimate of how taxpayer burden associated with Forms 1040-ES/V would be affected at various higher ES tax payment threshold levels:

Underpayment of ES Tax by Individuals, Estates, and Trusts (Form 2210)

Taxpayers are instructed to use Form 2210 to determine if they are liable for an ES tax penalty and, if so, to calculate the penalty. Because the Form 2210 is complicated, the IRS encourages taxpayers to let the IRS compute the penalty and bill them for the amount due.

Of the approximately 11 million taxpayers who made ES tax payments for TY 1996, 1,923,000 taxpayers incurred ES tax penalties. Of these taxpayers, 1,605,000 (83 percent) self-assessed the penalties using Forms 2210.

As shown in the following table, for TY 1997, the IRS estimate of the average amount of time that taxpayers would need to spend completing and filing Form 2210 ranged from 61 minutes, if taxpayers used the "short method", to 3 hours and 44 minutes, if taxpayers used the "long method."

The following table shows our estimate of the cumulative number of taxpayer hours associated with Forms 2210 that would be avoided at various higher ES tax payment threshold levels:

The following table shows our estimate of the cumulative amount of postage costs that taxpayers would avoid at various higher ES tax payment threshold levels:

The above estimate is based on the assumption that each of the affected taxpayers would have mailed four ES tax payment vouchers to the IRS at a postage cost of $ .32 each.

An ES tax penalty is imposed on those taxpayers who were required to make payments but did not pay enough estimated taxes throughout the year or did not make the payments on time. Taxpayers are exempted from ES tax penalties if their withholding and ES tax payments were at least 90 percent of their current year tax liability or at least 100 percent of their prior year tax liability.

Of the approximately 11 million taxpayers who made one or more ES tax payments for TY 1996, 1,923,000 (17.5 percent) incurred ES tax penalties.

The following table shows our estimate of the cumulative number of these taxpayers who would have avoided ES tax penalties at various higher ES tax payment threshold levels:

The estimated number of ES tax penalties that would be avoided at higher threshold levels includes penalties self-assessed by taxpayers on Forms 2210 and penalties assessed by the IRS.

Raising the Estimated Tax Payment Threshold Level Would Reduce Internal Revenue Service Operating Costs

Raising the ES tax payment threshold to $2,000 would save the IRS more than $5.9 million in annual operating costs. These savings would include:

• An estimated $472,000 in printing and mailing costs for the Form 1040-ES/V packages.
• An estimated $5,468,000 in remittance processing costs.

In addition, there would be additional undetermined cost savings to the Department of the Treasury’s Financial Management Service (FMS).

We were advised that it costs the IRS $ .29 to print and mail each Form 1040-ES/V package. The following table shows the printing and mailing cost savings that could be realized incrementally at various higher ES tax payment threshold levels:

Taxpayers are required to send their quarterly ES tax payments to certain commercial Lockbox Banks, which process the payments and credit the amounts to the Treasury’s deposit account for a per-item fee. The per-item fee, which varies from bank to bank depending upon the contract terms negotiated with the bank, is paid by the FMS.

The Lockbox Banks record the payment and payer information on computer tapes that are shipped to the IRS service centers for updating the taxpayer accounts. On a daily basis, the Lockbox Banks forward processed ES tax vouchers and unprocessable work from the previous day to the IRS service centers.

A total of 39.1 million ES tax payments were received during FY 1997. The most current information available shows that it costs the IRS $838.75 to process 1,000 ES tax payments, or an average of $ .84 per payment. The following table shows the remittance processing cost savings that could be realized incrementally at various higher ES tax payment threshold levels, assuming that each taxpayer made four quarterly payments:

Raising the Estimated Tax Payment Threshold Level Could Have an Undesirable Impact on Accounts Receivable

One potential issue with raising the ES tax payment threshold level is that currently compliant taxpayers may become accounts receivable problems for the IRS once the legal requirements and the discipline for making quarterly ES tax payments are removed. While we cannot conclusively predict taxpayer behavior under a different set of requirements, the approximately $2.6 billion that was collected for TY 1996 through ES tax payments from taxpayers with ES tax liabilities ranging from $1,000 to $1,999 could be put at some risk if the threshold level was raised to $2,000.

Our analysis of TY 1996 accounts showed that those taxpayers who made ES tax payments and had ES tax liabilities (i.e., income tax minus withholding) ranging from $1,000 to $1,999 generally were compliant. In the aggregate, the total ES tax payments made by these taxpayers exceeded their total ES tax liabilities by approximately $189.5 million. Individually, about six percent of these taxpayers were underpaid by the tax return due date.

However, the ratio of total ES tax payments made to total ES tax liability declined as the ES tax liability increased. For example, the following table shows that the ratio of total ES tax payments made to total ES tax liability declined from 113 percent to 104 percent to 97 percent as the ES tax liability increases from the $1,000-$1,499 strata to the $1,500-$1,999 strata and $2,000-$2,499 strata, respectively.

By our estimate, 1,002,000 taxpayers with ES tax liabilities ranging from $500 to $999 (i.e., the strata affected by the 1998 tax law change which increased the threshold to $1,000) and making ES tax payments for TY 1996 were overpaid by an aggregate of more than $290 million. The total ES tax payments made by these taxpayers represented 139 percent of their total ES tax liabilities.

Similarly, the following table shows that the rate of underpayment on April 15, 1997 -- the due date of the 1996 tax return -- also increased as the ES tax liability increased. For example, taxpayers with ES tax liabilities ranging from $1,000 to $2,999 were about three times more likely to be underpaid than those taxpayers with ES tax liabilities below $1,000.

In summary, this data indicates that raising the ES tax payment threshold level to $2,000 or higher could expose the IRS to more risk for collection problems than is being presently incurred by increasing the threshold from $500 to $1,000.

Raising the Estimated Tax Payment Threshold Level Would Create Additional Government Borrowing Costs

When taxpayers make four quarterly payments, the government has the use of the money for an average of eight months. The following table shows the calculation of the average deposit period for ES tax payments made timely for TY 1996.

The most significant drawback to raising the ES tax payment threshold is the resultant impact it would have on cash flow into the Treasury. At the $2,000 threshold level, for example, the estimated 1,627,000 taxpayers who currently make quarterly ES tax payments would instead pay the taxes they owe when they file their return on April 15 of each calendar year.

For one tax year, we estimate that raising the threshold from $1,000 to $2,000 would delay the receipt of more than $2.6 billion in taxes and would cost the government more than $66 million in additional borrowing costs.

The following table shows the estimated additional government borrowing costs that would be incurred at various higher ES tax payment threshold levels. For the purposes of this estimate, we applied the 26-Week Treasury bill yield (3.865 percent) that was being earned on October 22, 1998, to the total ES tax payments that were received and factored in the average 8-month deposit period.

Recommendation

We make no specific recommendation as to whether the ES tax payment threshold level for individual taxpayers should be further increased. The Assistant Commissioner (Forms and Submission Processing) needs to carefully balance the benefits (e.g., taxpayer burden reduction and processing cost savings) that could be realized with a higher threshold against the potential downsides (e.g., impact on taxpayer compliance and additional government borrowing costs) before recommending to the Congress that the Internal Revenue Code be amended to raise the threshold.

One method which the Assistant Commissioner (Forms and Submission Processing) could effectively use to evaluate the inherent compliance risk associated with any future increases to the ES tax payment threshold level would be to study the impact that the increase from $500 to $1,000 had on taxpayer behavior in TY 1998. This information would be available at the conclusion of the 1999 filing season.

Management’s Response: The Chief Operations Officer expressed his appreciation for the analysis that we provided at the request of the Assistant Commissioner (Forms and Submission Processing). He stated that the report contains valuable information that will be taken into consideration when making any future policy decisions regarding ES tax payments.

Conclusion

Raising the ES tax payment threshold requirements from $1,000 to a higher level would reduce burden for a significant number of taxpayers and cut the IRS’ operating costs. Most of the taxpayers who would be affected by moderate increases to the threshold level are in the "age 65 or over" group.

However, raising the threshold level could have a detrimental impact on taxpayer compliance by removing the legal requirements and discipline for making quarterly payments. Raising the threshold level would also delay the collection of taxes and result in significant additional government borrowing costs. These two issues need to be carefully considered against the intangible value of taxpayer burden reduction before any proposed legislation is forwarded to the Congress.

Appendix I

Detailed Objective, Scope, and Methodology

The overall objective of this review was to assist Internal Revenue Service (IRS) management in determining whether the threshold requirements for individual taxpayers to make estimated (ES) tax payments should be further increased to reduce taxpayer burden and lower the IRS’ processing costs. To accomplish our objective, we:

1. Obtained a Masterfile extract of all individual income tax modules with ES tax payments for Tax Years (TY) 1996 and 1997 and analyzed a sample of almost 1.1 million of the TY 1996 accounts identified to develop information on the characteristics of the taxpayer population which makes ES tax payments.
2. Stratified the accounts identified according to the amount of the taxpayer's ES tax (i.e., tax liability less withholding credits). The strata included the following: $500-$999; $1,000-$1,499; $1,500-$1,999; $2,000-$2,499; $2,500-$2,999; $3,000-$3,499; $3,500-$3,999; and $4,000-$4,499. For each of these dollar levels, we also developed sub-strata for taxpayers who are under age 65 and taxpayers who are age 65 or older.
1. Determined the number of taxpayers involved at each dollar level.

B. Calculated the total amount of ES tax payments made at each dollar level.

C. Calculated the total underpayment amount at each dollar level (tax liability less withholding credits less ES tax payments.)

D. Calculated the total amount of ES tax penalties assessed at each dollar level.

E. Determined the number of taxpayers assessed ES tax penalties at each dollar level.

3. Evaluated the feasibility of allowing certain taxpayers who currently make quarterly ES tax payments to, instead, fully pay the amount owed with their return by assessing its potential impact on taxpayer burden, third party stakeholders, compliance, revenue, and processing costs.
1. Impact on taxpayer burden
1. Determined the number of taxpayer accounts from each strata (i.e., $500-$999; $1,000-$1,499; $1,500-$1,999; $2,000-$2,499; $2,500-$2,999; $3,000-$3,499; and $3,500-$3,999). Determined the number with self-assessed and/or IRS-assessed ES tax penalties.
2. Obtained an IRS estimate of the time those taxpayers who self-assessed ES tax penalties took to complete and file the complex Form 2210 and developed an estimate of the time those taxpayers would save if the ES tax penalty was eliminated at certain dollar levels.
3. Developed estimates of the time spent by taxpayers in preparing and filing the ES tax payment vouchers and the mailing costs which they incurred.
4. Developed sub-strata for taxpayers under age 65 and taxpayers age 65 or older.
2. Effect on third party stakeholders
1. Interviewed the Assistant Commissioner (Forms and Submission Processing) to solicit his views on the potential benefits and/or barriers to changing the current ES tax deposit requirements.
2. Contacted the Director, Office of Penalty and Administration, to determine if there were any developing plans for implementing modifications to the administration of the ES tax penalty.
3. Effect on taxpayer compliance

1. Selected a statistically valid random sample of taxpayer accounts from each of the following estimated tax strata: under $1,000; $1,000-$1,499; $1,500-$1,999; $2,000-$2,999; $3,000-$3,999; and $4,000- $4,999. The sample size in each strata was sufficient to provide a 95 percent confidence level that the results were accurate within a precision of 3 percent.
2. Requested and analyzed Masterfile Transcripts for the sampled taxpayers in each dollar level to determine:
1. The number and percentage of taxpayers that timely fully paid all taxes owed on their TY 1996 Form 1040 by the April 15, 1997, return due date.
2. The number and percentage of taxpayers who were underpaid on the regular April 15, 1997, return due date.
3. The number and percentage of taxpayers who had not fully paid their tax liability 6 months after the regular return due date.
4. The number and percentage of taxpayers who had not fully paid their tax liability 12 months after the original due date of the return.

4. Effect on revenue/costs
0. Performed analyses at various dollar levels to determine an optimal threshold amount:
1. Calculated the IRS cost savings that could be realized at higher threshold levels by printing and mailing fewer payment voucher packages and processing fewer ES tax vouchers.
2. Estimated the reduction in the number of penalty abatements and adjustment costs that would exist at higher threshold levels.
3. Developed estimates of the cash flow lags that would result from the higher threshold levels.

Major Contributors to This Report

Walter Arrison, Associate Inspector General for Audit (Wage and Investment Income Programs)

Kerry Kilpatrick, Director

Philip Shropshire, Deputy Director

William E. Stewart, Audit Manager

Una K. Smith, Auditor

Marjorie Stephenson, Auditor

Report Distribution List

Chief Operations Officer OP

Assistant Commissioner (Forms and Submission Processing) OP:FS

Assistant Commissioner (Program Evaluation and Risk Analysis) M:OP

National Director of Legislative Affairs CL:LA

Office of Management and Controls M:CFO:A:M

Management's Response to the Draft Report