Although resolving these cases is important, a more balanced oversight effort that includes current market activity would provide a better understanding of current compliance problems. IRS has recognized that its tax-exempt bond oversight efforts need to be improved, and initiatives are either under way or planned. As IRS moves forward, several areas merit particular attention.

First, IRS has not used tax-exempt bond return information to monitor issuers' compliance. The Expanded Bond Audit Program's effectiveness could be improved if it were to use information collected from issuers for its oversight efforts. This information could help IRS determine whether current staffing and training practices, which were designed to address specific abuses, are effective for a continuing Expanded Bond Audit Program. Second, IRS' plan for improving its tax-exempt bond oversight, while a positive step, does not provide a clear direction for integrating tax-exempt bond efforts throughout IRS. Developing and executing a plan that includes all these efforts and uses its established planning principles would focus IRS' attention on identifying and resolving key issues that affect tax-exempt bond compliance and set a clear direction for its efforts.

While IRS can take such administrative actions to improve its oversight of tax-exempt bonds, Congress can also take actions to enhance IRS' ability to provide a deterrent to abusive use of tax-exempt bonds. Although IRS does not know the current extent of noncompliance in this area, it is reasonable to assume that some degree of noncompliance exists. For example, the tax-exempt bond market is approaching $800 billion, and IRS' presence has been limited given IRS' allocation of constrained resources across a range of priorities. Nevertheless, IRS has discovered some cases of noncompliance. But the basic sanction available to IRS-collecting taxes on interest earned by bondholders—is inadequate to deter noncompliant behavior by those who are most responsible for abusive transactions. That is, this sanction applies to the innocent purchasers of the bond but not to the bond's issuer and the specialists the issuer relies on to provide legal, financial, and other services. This aspect of the sanction is contrary to a commonly accepted theory that to provide the best deterrence, a penalty should be targeted to those responsible for the noncompliance. Legislation would be needed to develop better-targeted penalties.

As another way to enhance IRS' ability to provide a deterrent to abusive use of tax-exempt bonds, Congress may wish to explore options for bringing market forces to bear against abusers by modifying the present disclosure prohibitions. These provisions are based on, among other things, a respect

for citizens' privacy, a judgment that violating privacy would be detrimental to voluntary compliance, and a fear of possible inappropriate use of taxpayer information for political purposes. If IRS could, in some way, disclose limited information about the results of its tax-exempt bond enforcement activities, market participants would be in a better position to make judgments about the potential consequences of doing business with specific parties. Such disclosure should also enhance the present incentives for voluntary compliance. Thus, Congress may wish to consider the issue of whether governmental participants in the tax-exempt bond market should continue to be afforded the same degree of privacy as individual taxpayers.

Principal Findings

IRS' Principal Program Is
Reactive

Additional Improvements
Needed in Current

Program

IRS' tax-exempt bond oversight relies heavily on voluntary compliance and the checks and balances provided by the reviews of bond counsels at issuance. Overall, IRS considers traditional enforcement activities to be a key element in encouraging compliance and its Expanded Bond Audit Program-IRS' principal tax-exempt bond enforcement program-provides this element for tax-exempt bond oversight. (See pp. 25-26.)

Although the Expanded Bond Audit Program has taken steps to establish a more active enforcement presence, it has, as have earlier IRS tax-exempt bond efforts, primarily pursued cases identified through tips and other outside sources. Also, the program's enforcement efforts have focused on an alleged surge in abusive bonds issued in anticipation of the stricter requirements in the Tax Reform Act of 1986. Resolving these old cases and following up on tips is important. However, a more proactive effort that includes reviews of some more current bond issues would enhance IRS' knowledge of current compliance problems and better position IRS to determine whether it is obtaining an acceptable deterrent effect from its enforcement presence. (See pp. 26-29.)

Although IRS has collected information from tax-exempt bond returns for
about 10 years, it does not use the return information to spot probable
noncompliance and target enforcement efforts. Officials recently have
begun considering how information could be more effectively used in
tax-exempt bond oversight. (See pp. 29-31.)

Better Planning Needed

Penalties to Promote
Compliance

Revenue agents assigned to the Expanded Bond Audit Program have not received final guidance providing current procedures to detect noncompliance and address abuses. In addition, program officials say that the program will be permanent and become more active in identifying and investigating other types of abuses. However, current staffing and training practices, which were established so that the Expanded Bond Audit Program could investigate a specific group of abuses, may not be appropriate for these broader efforts. Agents have limited opportunities in which to apply their training and have not been trained on the many other tax-exempt bond requirements they would need to know to recognize other forms of noncompliance. (See pp. 31-35.)

GAO found that IRS' tax-exempt bond efforts do not have objectives or
strategies to identify and resolve key tax-exempt bond oversight issues. IRS
has adopted an overall planning process that focuses on setting objectives
and strategies so that its resources are used effectively. IRS could apply
elements similar to those used in its overall planning process in developing
its tax-exempt bond plan. Doing so would provide better direction by
identifying ways for IRS to achieve its objectives for encouraging voluntary
compliance; defining the roles of all IRS organizations involved with
tax-exempt bonds; determining methods to test for, identify, and pursue
tax-exempt bond abuses; determining staffing and information resource
requirements; and establishing goals to adequately measure IRS' progress.
IRS' Tax-Exempt Bond Committee has prepared a draft action plan for
tax-exempt bonds, but this draft plan does not provide a clear direction for
tax-exempt bond efforts. However, IRS officials recognize the need to
develop in-depth action items, strategies, resources, and other details for a
final plan. (See pp. 36-38.)

Penalties are intended to deter noncompliant behavior. To be effective, such penalties need to be known to, and applied to, the individual(s) responsible for the noncompliant behavior. They also need to be consequential enough to deter noncompliance yet proportionate to the severity of an infraction. Such is not the case for the tax-exempt bond

area.

The basic sanction available to IRS is to tax interest earned by bondholders on abusive bonds. IRS has been reluctant to use this sanction because it punishes investors rather than responsible parties directly, is complex to administer, and is often disproportionately severe. In about 70 cases since

Disclosure Options Could
Promote Compliance

1981, IRS has used a closing agreement—a mechanism to settle various tax disputes to negotiate a settlement with an issuer of a bond IRS Considers noncompliant. However, according to an IRS official, such agreements are not designed to promote voluntary compliance. For example, according to IRS officials, closing agreements are typically much smaller than profits from the noncompliance. Thus, they provide little incentive to comply. Despite IRS' reluctance to tax interest in cases in which bonds do not comply with tax-exemption requirements, it has recently begun considering this sanction.

Another potential penalty, clarified to be applicable to tax-exempt bonds
in 1989, is the penalty in Internal Revenue Code section 6700 for
promoting abusive tax shelters, which would target those responsible for
noncompliance if they were involved in promoting a bond as an abusive
shelter of income for tax purposes. This penalty requires that IRS prove
that someone intentionally promoted a bond through which investors
could illegally shelter income and avoid paying taxes. Because IRS has not
actually tried to apply this penalty in the area of tax-exempt bonds, it is
not known how difficult it will be to prove such intent for complex
tax-exempt bond transactions. (See pp. 44-48.)

In the tax-exempt bond market, market forces can create incentives to
cause compliance. But an important requirement for a properly
functioning market is access by market participants to information about
the risks of investments-information that is not directly available to
tax-exempt bond investors and other participants. Prohibitions in the tax
law preclude IRS from revealing any information that could directly or
indirectly identify any parties to a noncomplying tax-exempt bond
transaction.

If information about tax-exempt bond enforcement actions could be released, such as information on the types of bonds IRS has found to be abusive or the identities of participants in abusive bonds, the market participants that IRS relies on to ensure compliance with bond requirements could make more reasoned judgments about tax-related compliance risks. Thus, these market participants could penalize those presenting such risks, for example, by not doing business with them. Some of the rationales for prohibiting disclosure may not apply as strongly for tax-exempt bonds as for other protected information. For example, an expectation of privacy might be viewed as applying less to governmental bodies who are accountable to the citizens they represent than to the lives

of individuals. In addition, it may be possible to alleviate some concerns
about disclosure for tax-exempt bonds by designing a disclosure provision
that would limit the types and amount of information disclosed and the
timing of disclosures. Nevertheless, removing the disclosure prohibition,
even in a limited sense, must be carefully considered because of the
seriousness of the concerns relating to disclosing information. (See
pp. 48-55.)

GAO recommends that the Commissioner of Internal Revenue:

Partially redirect existing Expanded Bond Audit Program efforts to include active testing of current market compliance, identify and make better use of information to detect noncompliance and direct enforcement efforts, provide final guidance for tax-exempt bond enforcement, and reassess program staffing levels and locations and training needs in light of the program's future.

Develop and implement a plan to guide efforts throughout IRS to make more effective use of resources to promote voluntary compliance in the tax-exempt bond industry. This plan should establish clear objectives and coordinated, proactive strategies to achieve the objectives; assess staff and information needs to carry out the strategies; and set measurable goals.

GAO also recommends that the Commissioner test the use of the penalty for promoting abusive tax shelters in tax-exempt bond enforcement.

Congress may want to consider several options to enhance tax-exempt
bond voluntary compliance. First, Congress may want to consider the
adoption of other penalties for specific kinds of noncompliance. Second, it
also may want to consider whether permitting the disclosure of some
tax-exempt bond-related tax information, with appropriate safeguards,
would improve overall compliance incentives in the industry.

In oral comments on a draft of this report, IRS officials generally agreed with GAO's recommendations to IRS. Their comments are discussed at the ends of chapters 2 and 3. (See pp. 41-42 and p. 61.) Several technical changes were also suggested, which were included as appropriate.