Tax Newsletter - June 2022

Issue 1: IRS Statement Concerning the Destruction of 30 million Information Returns Due to Software Limitations – Tax Year 2020

May 13, 2022

IRS processed 3.2 billion information returns in 2020. Information returns are not tax returns, and they are documents submitted to the IRS by third-party payors, not taxpayers. 99% of the information returns IRS uses to matched to corresponding tax returns and processed. The remaining 1% of those documents were destroyed due to a software limitation and to make room for new documents relevant to the pending 2021 filing season.

There were no negative taxpayer consequences as a result of this action. Taxpayers or payers have not been and will not be subject to penalties resulting from this action.

Broadly, this situation reflects the significant issues posed by antiquated IRS technology. In 2020, the IRS prioritized the processing of backlogged tax returns to get taxpayers their refunds and support other COVID-related relief over inputting the less than 1% of information documents – mostly Form 1099’s – that were submitted on paper.

System constraints require IRS to process these paper forms by the end of the calendar year in which they were received. This meant that these returns could no longer be processed once filing season 2021 began. Not processing these information returns did not impact original return filing by taxpayers in any way as taxpayers received their own copy to use in filing an accurate return.

The IRS processed all paper information returns received in 2021 and plans to process those received in 2022.

Excerpts From the May 4, 2022, TIGTA Report - E-Filing Could Have Prevent This Issue

The IRS has taken a number of actions and developed initiatives in an effort to increase e-filing. Furthermore, legislative requirements have resulted and will continue to result in increases in e-filing. The backlogs of paper tax and information returns to be processed along with the inability to ship paper tax returns and/or retrieve paper tax returns from Federal Records Centers due to the pandemic demonstrate the need for the IRS to develop a Service-wide strategy to further increase e-filing.

However, the IRS does not have a Service-wide strategy that identifies, prioritizes, and provides a timeline for the addition of tax forms for e-filing nor an accurate and comprehensive list of tax forms not available to e-file. Since 2014, the overall percentage of business tax returns e-filed increased from 41 % to 63 %.

Employment tax returns continue to provide the most significant opportunity for growth in business e-filing. The IRS has yet to establish processes and procedures to identify and address corporate, employer, and Heavy Highway Vehicle Use Tax filers that do not comply with e-file mandates.

TIGTA’S analysis of tax return filings identified 15,108 filers that paper-filed 22,569 Tax Year 2018 returns that were required to be e-filed. TIGTA estimates that the processing of these returns cost the IRS $30,196 in comparison to the $3,405 to process the required e-filed tax returns.

The Internal Revenue Service (IRS) continues to receive large volumes of paper-filed tax and information returns, resulting in significant costs to process each year. For example, in Fiscal Year1 2020, the IRS expended more than $226 million to process the most frequently paper-filed tax returns. The cost per paper-filed return ranges from $3.04 to $15.21, whereas the cost to process the same tax return electronically ranges from less than $0.01 to $0.37. Figure 1 provides a comparison of volumes by filing method as well as the associated per-return cost to process.

Temporary closure of Tax Processing Centers continues to result in significant backlogs of paper tax and information returns to be processed. As TIGTA reported, the IRS closed its Tax Processing Centers in March and April 2020 in response to the Coronavirus Disease 2019 (COVID-19) pandemic.

Since reopening its Tax Processing Centers in June 2020, the IRS continues to have a significant backlog of paper-filed individual and business tax returns that remain unprocessed. The continued inability to process backlogs of paper-filed tax returns contributed to management’s decision to destroy an estimated 30 million paper-filed information return documents in March 2021.

The IRS uses these documents to conduct post-processing compliance matches such as the IRS’s Automated Underreporter Program to identify taxpayers not accurately reporting their income. IRS management advised us that once the tax year concludes, the information returns, e.g., Forms 1099-MISC, Miscellaneous Information, can no longer be processed due to system limitations. This is because the system used to process these information returns is taken offline for programming updates in preparation for the next filing season

Issue 2: Study States Nearly Half of Tax Returns Can Be Prefilled

Senator’s Elizabeth Warren and Jeanne Shaheen have reintroduced the Tax Filing Simplification Act of 2019

Based on a study an American taxpayer will spend an average of 11 hours preparing their tax returns and will pay about $200 for tax preparation services – a cost equal to almost 10% of the average federal tax refund.

Twenty-four years ago, President Clinton signed – an IRS reform bill mandating that the IRS develop procedures to implement a “return-free” tax system to dramatically simplify the filing process for individuals with simple tax situations. The law was to take effect in 2008. Instead, IRS developed the “free-file” program which many have found is not always Free and is currently used by about 3% of those who file a tax return. The program has serious issues, the complex offering of services as well as privacy issues.

The National Taxpayer Advocate has consistently called for dismantling Free File. Instead, the IRS has repeatedly signed binding Free File agreements with the tax preparation industry, pledging that the federal government will “not enter the tax preparation software and e-filing services marketplace.” These agreements block the IRS from offering a free portal that would allow taxpayers to choose to file directly with the federal government.

What Would the Tax Filing Simplification Act of 2019 Try to Accomplish?

• The Tax Filing Simplification Act of 2019 makes several commonsense changes to simplify the tax filing process for millions of American taxpayers and lower their costs. The Act:
• Prohibits the IRS from entering into agreements that restrict its ability to provide free online tax preparation or filing services.
• Directs the IRS to develop a free, online tax preparation and filing service that would allow all taxpayers to prepare and file their taxes directly with the federal government instead of being forced to share private information with third parties.
• Enhances taxpayer data access by allowing all taxpayers to download third party-provided tax information that the IRS already has into a software program of their choice.
• Allows eligible taxpayers with simple tax situations to choose a new return-free option, which provides a pre-prepared tax return with income tax liability or refund amount already calculated.
• Mandates that these data and filing options be made available through a secure online function and requires any participating individual to verify his or her identity before accessing tax data.
• Reduces tax fraud by getting third-party income information to the IRS earlier in the tax season, allowing the agency to cross-check this information before issuing refunds.
• This approach to tax filing has been praised in the media and endorsed by tax scholars and a bipartisan set of policymakers.

The IRS could automatically complete just under half of all tax returns, according to research by Treasury Department officials and economists.

Using a random sample of 344,400 returns for 2019 cross-referenced with various information returns, the study employed two methods for gauging how accurate pre-populated returns could be.

The first, referred to as the "upper bound" approach, checked for situations that would lead to a blatantly erroneous return, such as discrepancies with income, credits, or deductions.

Second, the NBER TAXSIM tax calculator tool was used to directly determine tax liability in a "lower bound" approach.

The study found that automated returns are "particularly successful for taxpayers who are single, young, and lack dependents." However, accuracy decreased among those with higher incomes, especially those who itemize their deductions.

Nonfilers with a filing obligation may be encouraged to comply. An estimated 8.8 million nonfilers (55%) appeared to have a balance due without factoring in deductions.

Issue 3: New Partnership Audits on the Horizon

The IRS is working to increase and strengthen its partnership examinations, senior officials in two agency units that oversee corporations told attendees at an American Bar Association tax conference.

The IRS LB&I hired about 40 people with partnership expertise a year ago and is trying to bring in, from law and accounting firms, additional staff with similar experience. Current LB&I employees will undergo training this summer in dealing with partnerships.

The program is part of a centralized partnership audit regime implemented with passage of the Bipartisan Budget Act of 2015 (PL 114-74, BBA), which took effect in January 2018 as a way to ease administrative burdens on the IRS. Under the BBA, eligible partnerships can choose to opt out of the centralized audit regime on a timely filed tax return, and it was expected when the regime was launched that many would do so. While only 22% of partnerships elected to opt out in 2020, the number is growing, she said.

Some partnerships seem to believe that opting out of the BBA regime will reduce their chances of being audited, Paz said. But she said such an assumption " is not grounded in reality" and that the IRS considers a partnership's compliance risk regardless of whether it participates in the audit regime.

The new unit hopes to better target its partnership audits through more efficient use of the huge trove of data it has available.

Issue 4: No Step-up in Basis for Private Foundation’s Assets

A new Program Manager Technical Advice (PMTA) disagrees with a prior letter ruling.

Heirs can generally benefit from a step-up in basis of inherited assets to their fair market value (FMV) as of the date of the decedent's death. A recent program manager technical advice (PMTA) makes clear that, for purposes of an excise tax, a private foundation resulting from a charitable organization's ceasing to qualify as a public charity cannot claim a step-up upon the conversion - at least not one that happened in the last 52 years - despite a prior IRS letter ruling approving a step-up in similar circumstances.

PMTA 2022-01 was issued November 18, 2021 and released Feb. 1, 2022. In it, the IRS Office of Chief Counsel was asked whether, for purposes of determining capital gain net income under § 4940, the basis of property held by a tax-exempt organization under § 501(c)(3) that is also a public charity under § 509(c)(1), (2), or (3) is equal to its FMV on the date it no longer qualifies as a public charity and becomes a private foundation.

The resulting foundation would be liable for the excise tax on investment income under § 4940(a), which is imposed currently at a rate of 1.39% on a foundation's net investment income for the tax year. One component of net investment income is capital gain net income. § 4940(c)(1) provides that to the extent consistent with § 4940, net investment income is determined under the principles of Subtitle A of the Code.

Generally, the PMTA notes, when determining gain or loss under § 4940 from the sale or other disposition of property, basis is determined under the usual rules of §§ 1011 through 1023 (Chapter 1, Subchapter O, Part II), subject to the special rules of § 4940(c)(3)(B) and disregarding § 362(c) (§. 4940(c); Regs. §. 53.4940-1(f)(2)(B)). (§ 4940(c)(3)(B) modifies deductions allowed in determining net investment income, and §. 362(c) is a special rule for the contribution of property other than money to a corporation's capital.)

The only provision appearing to support a step-up in basis to FMV of an organization's assets upon becoming a private foundation is § 4940(c)(4)(B), which is a transition rule that applies only to property that was held by a foundation on Dec. 31, 1969 (the date of § 4940's enactment), and continuously thereafter until its disposition, the PMTA notes. The basis of such property is its FMV on Dec. 31, 1969.

The PMTA notes that, under similar facts, IRS Letter Ruling 9852023, issued in 1998, held that the basis of property for the purpose of determining capital gain for the § 4940 excise tax was the property's FMV on the date an organization ceased to be a public charity and became a private foundation.

In a footnote to PMTA 2022-01, the Office of Chief Counsel stated that it was aware of this letter ruling and summarily dismissed it, stating, "We believe PLR [private letter ruling] 9852023 is incorrect."

Issue 5: Form 941 – A Bit of History

On January 1, 1950, a new plan took effect to collect taxes due under the Federal Insurance Contributions Act (FICA) and under the federal income tax withholding provisions of the Internal Revenue Code (IRC).

The plan consolidated the two tax collections and used a new form to do so. Up until that point, Form SS-LA was used for Social Security Administration (SSA) tax reporting, and Form W-1 was used for IRS federal income tax reporting. 

IRS Form 941, Employer’s Quarterly Tax Return, replaced these forms more than 70 years ago and has been used by businesses to report federal income tax withholding, Social Security tax, Medicare tax, and Additional Medicare tax. The form has been used to report other items as well – most recently, the coronavirus (COVID-19) pandemic tax credits.

The 2021 final regulations provide guidance on the following issues:

• The disallowance of a credit or deduction for foreign income taxes with respect to dividends eligible for a dividends-received deduction under § 245A. 
• The allocation and apportionment of foreign income taxes, interest expense, and certain deductions of life insurance companies. 
• The definition of a foreign income tax and a tax in lieu of an income tax, including a new attribution requirement (previously the ‘jurisdictional nexus’ requirement). 
• The definition of foreign branch category income and 
• The time at which foreign taxes accrue and can be claimed as a credit. 

Notice 2022-28 provides guidance under the Internal Revenue Code (Code) to employees and employers using employer leave-based donation programs on the federal income and employment tax treatment of cash payments made by employers under such programs to aid victims of the further invasion of Ukraine by the Russian Federation beginning on February 24, 2022 (further Russian invasion of Ukraine). 

Under employer leave-based donation programs, employees may elect to forego their accumulated leave and employers make cash donations up to the dollar amount of the foregone leave to tax-exempt entities described in § 170(c) of the Code (§ 170(c) organizations) that provide aid to victims of the further Russian invasion of Ukraine.

This bill modifies the requirements for health savings accounts (HSAs) to:

• Rename high deductible health plans as HSA-qualified health plans.
• Allow spouses who have both attained age 55 to make catch-up contributions to the same HAS.
• Make Medicare Part A (hospital insurance benefits) beneficiaries eligible to participate in an HSA’s.
• Allow individuals eligible for hospital care or medical services under a program of the Indian Health Service or a tribal organization to participate in an HSA.
• Allow members of a health care sharing ministry to participate in an HAS.
• Allow individuals who receive primary care services in exchange for a fixed periodic fee or payment, or who receive health care benefits from an on-site medical clinic of an employer, to participate in an HSA.
• Include amounts paid for prescription and over-the-counter medicines or drugs as qualified medical expenses for which distributions from an HSA or other tax-preferred savings accounts may be used.
• Increase the limits on HSA contributions to match the sum of the annual deductible and out-of-pocket expenses permitted under a high deductible health plan and
• Allow HSA distributions to be used to purchase health insurance coverage.

The bill also (1) exempts HSAs from creditor claims in bankruptcy, and (2) reauthorizes Medicaid health opportunity accounts.

The bill allows a medical care tax deduction for (1) exercise equipment, physical fitness programs, and membership at a fitness facility; (2) nutritional and dietary supplements; and (3) periodic fees paid to a primary care physician and amounts paid for pre-paid primary care services.

As the National Taxpayer Advocate, I am the voice of *all* taxpayers within the IRS. As such, my office assists many different types of taxpayers in resolving tax problems with the IRS. While we typically focus on individual tax issues, our purview also includes business taxpayers. One such class of taxpayers involves marijuana-related businesses. I want to shed some light on the frustrations encountered by a growing segment of the business taxpayer population – the growers, distributors, and retailers of marijuana-related products – and educate them on federal tax law.

All but four states have legalized marijuana use in some form (i.e., for recreational or medicinal use). Per the Chief Economist for the National Cannabis Industry Association, there were 35,329 adult-use or medical licenses issued in the U.S. as of October 2021, up from 29,604 such licenses at the start of 2021. Revenue from the licensed marijuana industry is projected to grow to nearly $30 billion annually by 2025.

Despite being able to operate legally under state law, in the U.S., trafficking of marijuana remains a federal offense. Specifically, the Controlled Substances Act (CSA) makes it illegal under federal law to manufacture, distribute, or dispense marijuana, which is classified as a “Schedule I” controlled substance. Schedule I controlled substances are those drugs with a high potential for abuse, no currently accepted medical use in treatment in the United States, and for which there is a lack of accepted safety for use of the drug or other substance under medical supervision. Schedule I controlled substances include drugs such as heroin and LSD. Because marijuana is classified under this category of controlled substances under the CSA, the sale of marijuana remains a violation of federal law, even if permitted in a growing number of states.

Several bills (including the Marijuana Opportunity, Reinvestment, and Expungement Act of 2020, which passed the House in December 2020 by a vote of 228 to 164, and the Cannabis Administration & Opportunity Act, a bill introduced by Senators Booker, Schumer, and Wyden in July 2021) have been introduced seeking to remove marijuana from the definition of a Schedule I controlled substance under the CSA. On April 1, 2022, the House passed legislation to decriminalize marijuana at the federal level. While the Department of Justice has not made it a priority to prosecute businesses that comply with state law, the mere possibility of federal prosecution, no matter how slim, may deter businesses from entering into and/or engaging with the marijuana industry.

There are significant federal tax-related consequences for businesses engaged in the “trafficking” of marijuana, even in states that have legalized (or de-criminalized) the use of it. Section 61(a)(2) of the Internal Revenue Code provides that, for the purpose of computing taxable income, an individual’s or a business’s “gross income” includes “all income from whatever source derived,” including “income derived from business.” This includes income from illegal sources. Federal courts have consistently upheld Internal Revenue Service determinations that marijuana-related business, including state compliant marijuana dispensaries, have taxable income. These businesses must also pay employment taxes.

While businesses can generally deduct from their gross income “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on [the] trade or business” pursuant to section 162(a), there are exceptions. Section 280E, enacted in 1982, forbids businesses from deducting expenses from their gross income if the business consists of illegally “trafficking” in Schedule I or II controlled substances. Because marijuana is still classified as a Schedule I controlled substance under federal law, all cannabis businesses fall into the category of drug trafficking and remain prohibited from writing off otherwise legitimate business expenses. (Similarly, because marijuana is not a federally recognized course of medical treatment, individual taxpayers are prohibited from claiming associated expenses as itemized deductions on Schedule A of their Form 1040 tax return.)

There is an exception for the cost of goods sold (COGS); marijuana businesses can offset their gross receipts by their COGS, even for products considered controlled substances under federal law. Even so, marijuana-related businesses end up paying federal taxes on gross profit rather than net income.

Example. A marijuana retailer has gross revenue of $1,000,000. It spent $750,000 on COGS and incurred another $200,000 in business expenses (which are nondeductible per Section 280E). Assuming a 30 percent effective tax rate, the marijuana retailer has a federal tax burden of $75,000 ($250,000 taxable income x 0.30). Had the business been allowed to deduct the other $200,000 in business expenses, its tax burden would have been reduced to $15,000 ($50,000 taxable income x 0.30).

In the example above, the marijuana retailer incurred a tax burden five times as large as its non-marijuana-related business counterpart due to Section 280E. Not only is the marijuana retailer effectively taxed at a higher rate, but it may also take longer for a marijuana-related business to recoup its start-up expenses and turn a profit than other businesses.

Furthermore, in part because federal laws significantly limit access to financial institutions for marijuana-related businesses, many such businesses operate on a cash-only basis. If the business receives a cash payment over $10,000, it must file a Form 8300 with the IRS. Such businesses have a need to pay federal taxes in cash, and this can only be accomplished at designated offices where the IRS can accept it. Legislation designed to give marijuana-related businesses more direct access to banking services would make it easier for the IRS to collect the taxes those businesses owe, Treasury Secretary Janet Yellen acknowledged during a December 1, 2021, congressional hearing.

Conclusion

Regardless of your personal or political views, or whether this disparate treatment is fair or not, taxpayers involved in the production, distribution, or sale of marijuana should be aware that there are significant federal income tax challenges that apply to this industry and understand the federal tax consequences. To its credit, the IRS recently posted guidance here and on IRS.gov/marijuana, educating and informing marijuana-related business owners of the specific challenges they may face. Until Congress changes the law removing marijuana from the definition of a Schedule I controlled substance under the CSA, these businesses are not entitled to claim deductions and expenses like other businesses and need to understand the federal tax consequences in conducting its business.

IRS audits individuals to verify if they accurately reported their taxes and, if they did not, to determine if more taxes are owed.

We testified that audit trends vary by taxpayer income. In recent years, IRS audited taxpayers with incomes below $25,000 and those with incomes of $500,000 or more at higher-than-average rates. But audit rates have dropped for all income levels - decreasing the most for taxpayers with incomes of $200,000 or more.

IRS officials said audit rates declined due to staffing decreases and because it takes more staff time and expertise to handle complex higher-income audits.

From tax years 2010 to 2019, audit rates of individual income tax returns decreased for all income levels. On average, the audit rate for these returns decreased from 0.9% to 0.25%. Internal Revenue Service (IRS) officials attributed this trend primarily to reduced staffing as a result of decreased funding. Audit rates decreased the most for taxpayers with incomes of $200,000 and above. According to IRS officials, these audits are generally more complex and require staff's review. Lower-income audits are generally more automated, allowing IRS to continue these audits even with fewer staff.

Although audit rates decreased more for higher-income taxpayers, IRS generally audited them at higher rates compared to lower-income taxpayers, as shown in the figure. However, the audit rate for lower-income taxpayers claiming the Earned Income Tax Credit (EITC) was higher than average. IRS officials explained that EITC audits require relatively few resources and prevent ineligible taxpayers from receiving the EITC.

A group of Democrats in the House of Representatives asked IRS Commissioner Chuck Rettig to increase the 2022 optional standard mileage rate used to deduct the cost of operating an automobile for business purposes.

In reality the standard mileage rates are based on an annual study conducted by the General Services Administration (GSA). IRS then generally complies with the GSA study.

Since gas prices have soared the last few months, it is possible GSA may see the need to provide a 6 month change for the tax year 2022. If this were to happen, it would be announced sometime in June and it would generally be effective in July. The tax year 2022 may be a year when we have two different standard mileage rates. We will provide guidance in the newsletter if an announcement is made.

The Internal Revenue Service announced that interest rates will increase for the calendar quarter beginning July 1, 2022. The rates will be: 

• 5% for overpayments [4% in the case of a corporation].
• 2.5% for the portion of a corporate overpayment exceeding $10,000.
• 5% for underpayments.
• 7% for large corporate underpayments. 

Under the Internal Revenue Code, the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points.

Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points, and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.

The interest rates announced are computed from the federal short-term rate determined during April 2022 to take effect May 1, 2022, based on daily compounding.

Revenue Ruling 2022-11

As of May 27, 2021, the IRS had processed 26.3 million tax returns with RRC claims totaling $39.2 billion. Of these, the IRS issued potentially improper RRC payments totaling $898 million. These include $79.8 million in the RRC that should have been paid to eligible individuals and $818.5 million in the RRC that was paid to ineligible individuals.

The IRS declined to review nearly $598 million of the improper payments and take the actions needed to recover them. Additionally, the IRS stated it has no plans to further assist approximately 10 million potentially eligible individuals in receiving their payment.

Finally, debit card policies and the decision to manually verify RRC claims unnecessarily burdened taxpayers and delayed access to stimulus payments for some taxpayers. TIGTA issued 12 alerts during this review to alert the IRS of their concerns. The IRS implemented programming changes to address one alert and agreed to take action on four additional alerts. These actions include reviewing the tax returns TIGTA identified, taking the actions necessary to correct the taxpayers’ tax accounts, and implementing processes to automate the error resolution process for RRC claims filed during the 2022 Filing Season.

TIGTA Report - 2022-46-032

Recovery Rebate Paid to Ineligible Individuals

The review of tax returns processed as of May 27, 2021, with an RRC claim identified 355,015 individuals who filed tax returns with potentially erroneous claims. These individuals received the RRC totaling more than $603 million.

TIGTA issued three alerts to IRS management regarding concerns. IRS management agreed that 7,022 of the 355,015 individuals TIGTA identified received an RRC for a dependent who was claimed on more than one tax return.

IRS management also agreed that the 14,508 individuals TIGTA identified who were claimed as a dependent on someone else’s tax return overclaimed their RRCs. These erroneous RRC payments totaled more than $32.9 million.

IRS management stated that the overclaimed RRC will be addressed for those returns selected for post-processing treatment. However, IRS management stated that the IRS does not have the resources to address every return involving a duplicated dependent. For the remaining individuals, IRS management did not agree with TGTA’s conclusion that these individuals were not eligible to receive an RRC.

Issue 14: Applicable Federal Rates for June 2022, Rev. Rul. 2022-10

REV. RUL. 2022-10 TABLE 5