IRS Penalties and First Time Abatement

I drafted a letter this past Monday. Later in the day I saw a report from the Treasury Inspector General of Tax Administration (TIGTA) on the same topic. Serendipity.

We have a newer client who set-up an S corporation in 2011. That’s fine, except that he had not spoken with an accountant and did not meet us until April, when his individual tax return was due. This meant that his S corporation return was already late, as corporate returns are due a month earlier than individual returns.

Sure enough, he received a letter from the IRS asking for $195 – because the S corporation return was a month late.

So I drafted a letter that included the following magic words:

The taxpayer requests first-time abatement under IRM 20.1.1.3.6.1. Tax year 2011 was the taxpayer’s initial year of existence.”

The “IRM” is the Internal Revenue Manual.

The idea behind the first-time abatement (FTA) is “get out of jail free.” You haven’t had problems with the IRS before, and the IRS spots you a mulligan.

IRS penalties normally do not work this way. One usually has to provide “reasonable cause”for why one failed to file, pay or whatever. Penalties can add up. There are two common ones:

(1) The failure-to-file (FTF) penalty is usually 5 percent of the unpaid taxes for each month or part of a month that a tax return is late, not to exceed 25 percent. If you file the tax return more than 60 days late, figure the minimum FTF penalty to be the smaller of $135 or 100 percent of tax due.

(2) If you file but do not pay in full, then the failure-to-pay (FTP) is usually one-half of one percent each month or part of a month that the taxes remain unpaid. This penalty can be as much as 25 percent of the unpaid taxes.     

The IRS can abate both penalties if one shows reasonable cause. A top-of-the-line reasonable cause is to get hit by a bus and be in the hospital. As you can guess, the IRS does elevate the bar a bit for reasonable cause. “I was busy” is almost a guaranteed loser.

Let’s circle back to the FTA. You do not need to show reasonable cause; all you have to do is ask for it. And with that we have the following from the TIGTA report:

“Penalty waivers should not be granted only to taxpayers or preparers with knowledge of IRS processes,” said TIGTA Inspector General J. Russell George.

TIGTA estimated that for 2010, approximately 250,000 taxpayers with FTF penalties and 1.2 million taxpayers with FTP penalties qualified for FTA but not receive abatement. The reason? The taxpayers did not to ask for it. TIGTA estimated the unabated penalties at more than $181 million.

TIGTA is requesting that the IRS review its procedures for penalty assessment, especially with an eye toward first-time abatement. For example, perhaps the IRS could send a notice but immediately apply the FTA. It would inform the taxpayer of the penalty and abatement, thereby saving on IRS manpower and reducing the number of times folks like me have to write an FTA letter. Sounds like a winner.

Until then, remember that first-time abatement is available. Do not be one of the $181 million.

A TIGTA Report on IRS Contractor Payments

The Treasury Inspector General for Tax Administration (TIGTA) has released a new report titled “Deficiencies Continue to Exist in Verifying Contractor Labor Charges Prior to Payment.”

What happened is that the IRS received appropriations from the American Recovery and Reinvestment Act of 2009. You may remember this Act by another name – the “Stimulus.” TIGTA was auditing certain expenditures and also reviewing IRS internal controls over contract review, approval and payment.

TIGTA selected a statistical sample of $1 million in labor charges. What did it find?

(1)   The IRS could not document $394,430 of invoiced labor hours that were paid.

(2)   The labor rates paid were not verified to the contract for the qualification level of the individual paid.

(3)   Although the IRS verified the qualification and experience of key contract personnel, they did not do so for other personnel. The IRS was supposed to do this by the contract.

My Take: I am glad that someone is keeping an eye on these expenditures. An error rate of 39.4% is not too reassuring, however.

The IRS Draws Congressional Attention

The IRS itself has been in the news recently. Whether it is the ham-handed treatment of Section 501(c)(4) political/nonprofit groups or the shadow funding of ObamaCare, the agency has been drawing attention and criticism. Today we are going to talk about two recent studies requested by Charles Boustany (U.S. Rep – LA). He presently serves as the Chairman of the House and Ways Subcommittee on Oversight.

The first report is titled “There Are Billions of Dollars in Undetected Tax Refund Fraud Resulting From Identity Theft.”  It addresses identity theft, which has been the number one consumer complaint with the Federal Trade Commission for 12 consecutive years.

The IRS presently processes returns and issues refunds before receiving the information forms with which to crosscheck. For example, if someone receives his/her Form W-2 and files for a refund in January, the IRS is issuing that refund check before the underlying wage information has been received from the employer, much less integrated into IRS information systems. This weakness has been exploited and has become a virtual cottage industry in certain cities such as Tampa, Florida.

Consider what TIGTA discovered:

·         2,137 returns resulting in $3.3 million in refunds were sent to one address in Lansing, Michigan

·         518 returns resulting in $1.8 million in refunds were sent to one address in Tampa, Florida

·         23,560 refunds totaling more than $16 million were issued to 10 bank accounts;  2,706 tax refunds totaling $7.3 million were issued to a single account

This is real money. TIGTA estimates that the IRS will issue almost $21 billion in identity-theft refunds over the next five years.

TIGTA made several recommendations, including:

·         Taking advantage of the information reporting available to the IRS. Social security benefit information, for example, is available in December - before filing season begins. Whereas this is a fraction of identity fraud, it is a positive step.

·         The IRS uses little of the data from its identity theft cases to develop patterns and trends which could be used to detect and prevent future tax fraud. Examples include whether the return was electronically or paper-filed, how the refund was issued, and, if issued by direct debit, the account number or debit card number receiving the refund.

·         Allow the IRS greater access to the National Directory of New Hires (NDNH). NDNH is a national database of newly-hired employees. It includes an employee’s name and address as well as wage information. By referencing information from prior year tax filings, the IRS could correlate NDNH data to determine whether reported wage reporting and claimed withholding appear fraudulent.

·         Encourage banks and work with federal agencies to ensure that direct deposit refunds are made only to an account in the taxpayer’s name.

·         Limit the number of tax refunds issued via direct deposit to the same bank account or debit card.

NOTE: That recommendation seems obvious.

“Substantial Changes Are Needed to the Individual Taxpayer Identification Number Program to Detect Fraudulent Applications”

The second report is disturbing. IRS employees had contacted Congress directly about supervisor misconduct and potential fraud in a program that reviews and verifies individual taxpayer identification numbers (ITINs). Congress then called in TIGTA to investigate.

We should explain that an ITIN is an Individual Tax Identification Number. ITINs were started in 1996 as tax identification for individuals who may have U.S. tax filing requirements but are not eligible for social security.

How can this happen?

·         Consider a German businessperson who invests in and receives income from a Miami shopping mall

·         Consider a Nigerian graduate student attending the University of Missouri (many) years ago with yours truly

·         Consider my brother-in-law’s wife, who is English and married to a U.S. citizen 

An ITIN will allow one to open a bank account and file tax returns. For example, if one’s spouse is English and one lives in England, the spouse will need an ITIN to file a U.S. income tax return. The children – who possibly have never been to the U.S. – will need ITINs to be claimed as dependents on the U.S. income tax return.

OBSERVATION: This is one of the absurd consequences of the U.S. worldwide income tax regime. A U.S. citizen has to file tax returns, even if he/she has lived outside the U.S. for many years, has a family outside the U.S. and has no immediate plans of repatriating to the U.S.

When one finally obtains a green card, one can transfer work and wage information from the ITIN to the Social Security Administration.

One applies for an ITIN by filing a form (Form W-7) and attaching supporting documents to verify one’s identity and foreign status. A passport will satisfy both the identity and foreign status requirements. The IRS will otherwise accept a combination of documents, including a foreign driver’s license, a foreign birth certificate, a foreign voter’s registration, a visa or other IRS-listed documents. The process usually takes place through the mail, which means that no US-agency employee actually sees the person applying for the ITIN.

Unfortunately, ITINs have been swept-up in political battles. For example, there is fear that the IRS will share this information with Immigration, although the IRS is not permitted by law to do so. This may discourage people from obtaining ITINs, so the argument goes. On the other hand, there are states that will allow one to obtain a driver’s license solely with an ITIN, which seems a perversion of its intended purpose.

TIGTA goes into the IRS to investigate the complaints. Here are some of its findings:

·         IRS management is not concerned with addressing fraudulent applications in the ITIN Operations Department because of the job security that a large inventory of applications to process provides. Management is interested only in the volume of applications that can be processed, regardless of whether they are fraudulent.

·         IRS management has indicated that no function of the IRS, including Criminal Investigation or the Accounts Management Taxpayer Assurance Program, is interested in dealing with ITIN application fraud.

·         IRS management has:

o    Created an environment which discourages tax examiners responsible for reviewing ITIN applications from identifying questionable applications.

o   Eliminated successful processes used to identify questionable ITIN application fraud patterns and schemes.

o   Established processes and procedures that are inadequate to verify each applicant’s identity and foreign status.

Good grief! The IRS disbanded an ITIN team that was having too much success, countered by provided virtually no training to new hires and transfers and put negative evaluations in overly-eager reviewers’ files.

TIGTA made nine recommendations in this report. The IRS agreed with seven and has already announced plans to implement interim changes. One has caused quite the consternation in the immigrant community by requiring copies of original documents with ITIN applications.

OBSERVATION: Let’s be fair here: would you be comfortable sending original copies of anything to the IRS? Assuming you can find that birth certificate from the mother country, how are you going to replace it when the IRS loses the thing?

The IRS and Identity Theft

One of the downsides of increased electronic tax filing is increased identity theft. We had one of our e-filings intercepted this year by the IRS for identity mismatch. The IRS did not accept the e-file and instead required a paper return with Form 14039, Identity Theft Affidavit, attached.

I was looking at (OK, I was skimming) a report from the Treasury Inspector General for Tax Administration issued May 3rd. Imagine my surprise to learn that the IRS has no special procedures for our return with Form 14039 attached.

The IRS considers the paper filing to be a duplicate return and does not immediately process it. An employee enters a transaction code into the taxpayer file to memorialize receipt. The return then goes to a separate queue to be worked on, possibly after April 15 when the filing season has ended. The IRS transfers the file to Duplicate function for initial review. If Duplicate considers it an identity theft case, the file is again transferred, quite likely to the Accounts Management function. It is there assigned an assistor, who requests copies of the original tax returns and begins the process, including correspondence, of determining who the legitimate taxpayer is.

This process is slow and the refund can be delayed until late in the year or even the following year. The average case resolution is 414 days.

The assistor very likely works in Accounts Management. The problem is that these employees also answer the toll-free telephone lines during busy season. According to TIGTA, 87% of assistors working identity fraud also answered the phones, and 60% stated that they worked the toll-free line exclusively. TIGTA considers the optimal assistor inventory (that is, caseload) to be 100 to 125 per assistor, but the average assistor had an inventory exceeding 300 cases.

The identity problem is new enough that IRS guidelines are spread out over almost 40 sections in the Internal Revenue Manual. Sometimes the guidelines are inconsistent. The IRS in addition does not have procedures to spot trends which could be useful in detecting or preventing future fraud. One problem, for example, is sending notices to the last address of record, which could just be the person perpetrating the fraud.

Training has also been an issue. TIGTA’s survey showed that almost half of the assistors believed that their training was not sufficient. In one office, 13% of assistors had received no identity theft training.

To be fair, the IRS has agreed with TIGTA’s findings and has begun implementation of many recommendations. For example, there will be specialized units in Accounts Management to work only identity fraud cases.

Then we have Congress. Three representatives this week introduced the “Fighting Fraud Act,” which would double the current penalties for tax preparers who are involved with identity theft. The intent is to give the IRS greater incentive to prosecute this type of theft, presumably because the potential payoff is greater.

Really? This is the best the mandarin class can dream up? Here is an idea: the IRS assigns a PIN to every preparer. Require every professionally-prepared return to require the preparer’s PIN. If a preparer is involved with this type of nonsense, the IRS revokes the PIN and bans the preparer from working before the IRS.

Will this stop the completely unscrupulous? Here is a question in return: in human history, has it ever been possible to stop the completely unscrupulous?