Leo Unzeitig, J.D., CPA - San Antonio
The deadlines for filing 2021 information returns by paper have just passed. Hopefully, everyone made the cutoffs. But if not, taxpayers are likely better off filing electronically anyway.
The U.S. Treasury Inspector General for Tax Administration (TIGTA) released a report recently with new details highlighting the pandemic’s effect on the IRS’ ability to process 2020 business tax returns. Unsurprisingly, the IRS has issues. The number of unprocessed paper returns swelled from just over 200,000 in 2019 to nearly 8 million in 2020. While a staggering 3,230% year-over-year increase in unprocessed returns is shocking, the gross number of returns unprocessed was actually significantly higher. According to TIGTA, there were an additional 30 million paper returns that the IRS simply destroyed rather than process.
Now I understand that these are unprecedented times. And I think we can all appreciate that the IRS is underfunded and working against staffing challenges. But how exactly did this happen? And why did the IRS choose to destroy the returns rather than store them and process them at some later date?
The details in the TIGTA report are limited to just a few paragraphs and sometimes require a bit of reading between the lines. As best I can tell, a group of auditors was performing “on-site walkthroughs” at the Ogden processing center when they happened to learn that the IRS destroyed paper-filed information returns (which TIGTA defines as any “statement, return, form, or schedule that shows a payment of rent, salaries, wages, dividends, interest, or royalties made to another person”). These seem to be solely information returns (i.e., Forms W-2, 1099, etc.) that are generally filed for computer matching purposes and have no corresponding tax due.
But after learning that the IRS was destroying unprocessed returns, TIGTA understandably pressed for additional details after which IRS management “estimated that approximately 30 million documents were destroyed on or around March 19, 2021.” The second-most interesting detail here is the date. Given that the filing deadline for most of those paper-filed information returns is Feb. 28, the IRS must have made the decision early in the year, or at least very quickly after the filing deadline, that those returns would not be processed. The report confirms as much by stating that its computer system for processing those types of returns is only good for a single tax year and needs to be updated for each new filing season.
IRS management made the decision to prioritize Forms 941 over other information returns and determined that saving the paper returns would do no good because retrieving them would be difficult. (Anyone who has been involved in an exam recently will know that the first document request is invariably a copy of the taxpayer’s original return--the one item that should already be in the government’s possession.)
Now, I know what you are thinking. Why does the IRS bother requiring taxpayers to go through the time, effort and expense to file returns if the IRS knows it will not be able to process them? Here, I have to cut them some slack. I suspect the answer is that most of those returns are required to be filed by statute and are not merely an exercise of the IRS’ discretionary authority. See Sections 6041 through 6050Y. Thus, even if the IRS acknowledged to taxpayers that it would not be able to process the returns, the Code mandates they be filed nonetheless.
The more concerning aspect to taxpayers, practitioners and the IRS is what will happen over the next few years as the IRS computer system begins to propose failure-to-file information return penalties. Because the IRS prioritized filing Forms 941 above all else, the computer system should know that wages were paid to employees, thus presenting a mismatch when there are no corresponding Forms W-2 in the file. Presumably, the IRS computer will start issuing notices and proposing penalties.
We have increasingly seen this type of issue come up and the Combined Annual Wage Reporting (CAWR) unit, often charged with considering responses and requests for penalty abatement in this area, is so understaffed that correspondence is unanswered for months, if not years, and very strong requests for abatement are denied without explanation. More often than not, penalties are assessed and revenue officers proceed with aggressive collection actions before the issue can be resolved and the penalties abated.
While this issue portends a huge mess, SBSE management apparently developed a “risk assessment” to evaluate the impact. TIGTA and the IRS shared no further details regarding this investigation, but I suspect that because most large taxpayers are required to file information returns electronically, the impact will be limited to the “small” taxpayers who file by paper and thus have a relatively small potential penalty exposure. Unfortunately, these are the taxpayers who most often spend disproportionate time and resources resolving minor issues with the IRS.
Perhaps the best we can do is remember this issue in several years and raise it in a penalty abatement letter or in response to criminal charges for failing to file returns. Maybe we can also urge clients to file information returns electronically rather than by paper. But it is certainly an open question whether the IRS has sufficiently prepared for this issue in the current filing season. Given the current state of affairs, I am sure there are some who hear the IRS sharpening the shredder blades.