Because of an IRS backlog of paper tax returns and its inability to process them, the agency decided to destroy an estimated 30 million paper-filed information return documents in March 2021, according to a new report.
The report, recently released by the Treasury Inspector General for Tax Administration (TIGTA), noted that the IRS typically uses information return documents for post-processing compliance matches to identify taxpayers who don’t accurately report their income. The report focuses on how the IRS should be doing more to encourage electronic filing of business tax returns and reduce paper filing. TIGTA reported that, while e-filing of business tax returns has continued to increase, the e-filing rate still lags behind that of individual tax returns.
“Repeated efforts to modernize paper tax return processing have been unsuccessful,” said the report.
During the pandemic, millions of paper tax returns and other documents accumulated at IRS facilities and the agency has been working overtime to catch up on the backlog. Another recent TIGTA report noted that more than 16.4 million individual tax returns, transactions, and Accounts Management cases remained in inventory as of the end of 2021. During a Senate oversight hearing last week, IRS Commissioner Chuck Rettig testified that the number of unprocessed tax returns from 2021, as of April 21, had been reduced to 1.8 million.
The IRS continues to receive large volumes of paper-filed tax and information returns, leading to significant costs to process them every year, according to the new TIGTA report. In fiscal year 2020, the IRS spent more than $226 million on processing paper-filed tax returns.
The report acknowledged that the IRS has taken a number of actions and developed initiatives to increase e-filing. On top of that, legislative requirements have resulted and will continue to lead to increases in e-filing. But TIGTA believes the IRS needs an overall strategy.
“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,” said the report. “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.”
The IRS backlog problems led to the wholesale destruction of millions of information returns.
The report does not explain exactly why the IRS destroyed millions of information returns, but it seems to be part of an effort to expedite the processing of the backlogged business tax returns.
“This audit was initiated because the IRS’s 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,” said the report. “The IRS uses these documents to conduct post-processing compliance matches to identify taxpayers who do not accurately report their income.”
However, it is unclear why the IRS decided not to retain the paper information returns to do compliance checks later.
Since 2014, the overall percentage of business tax returns e-filed has increased from 41% to 63%. Employment tax returns continue to provide the most significant opportunity for growth in business e-filing, TIGTA noted. 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.
TIGTA recommended the IRS develop a Service-wide strategy to prioritize and incorporate all forms for e-filing; develop processes and procedures to identify and address potentially non-compliant corporate filers; and develop processes and procedures to ensure that penalties are consistently assessed against business filers that are non-compliant with e-filing requirements.
The IRS agreed with the first recommendation to develop a Service-wide strategy to incorporate all forms for e-filing, but didn’t agree with the report’s other two recommendations. IRS officials said they didn’t need to develop processes and procedures to identify non-compliant corporate filers because all requirements needed to assess penalties are not known at the time of filing.
The IRS also has systemic processes in place for e-filed partnership returns, which were found to be working as intended. Other types of business returns have differing criteria for e-filing requirements and exceptions to the requirements, which prevent the implementation of a standard process for all business filers.
TIGTA, for its part, said it believes that IRS management’s justification for taking no action on two recommendations is insufficient.
“In view of the backlogs of paper tax returns, the IRS should take additional steps in an effort to continue to reduce paper return filings,” said the report.
The IRS pointed out that it’s facing a tight budget but is continuing to pursue more ways to spur e-filing of various types of business tax returns. “Constrained funding is the foremost obstacle we face in implementing our modernization strategies,” said Kenneth Corbin, commissioner of the IRS’s Wage and Investment Division, in response to the report. “In 2015, we developed business tax return strategies for the employment tax family of returns (forms 94x), Form 990, Return of Organization Exempt from Income Tax, and Form 2290, Heavy Highway Vehicle Use Tax Return. Each of the strategies provided a framework of opportunities to increase the business return e-file rates.”
As a result of the TIGTA report, the IRS has come under criticism from Congress and the American Institute of CPAs for destroying an estimated 30 million paper-filed information returns to cope with its backlog last year, with one lawmaker even calling for the IRS commissioner to be replaced immediately.
The IRS typically uses information returns such as Form 1099-MISC to verify the accuracy of the income tax returns filed by taxpayers. IRS officials noted that once the tax year ends, the information returns can no longer be processed anyway due to system limitations. The system used to process the information returns is taken offline for programming updates in preparation for the following filing season.
The IRS has taken steps to hire thousands more employees to help with processing returns after it was recently granted direct authority by Congress.
The recent reduction in the IRS backlog perhaps had begun to mollify lawmakers who had been hearing complaints from constituents about long waits for refunds and stimulus payments, alarming notices in the mail, and the difficulty of reaching anyone at the IRS by phone. But the new reports of wholesale destruction of paper documents, whether or not they were needed anymore by the IRS, provoked fresh consternation this week.
Rep. Bill Pascrell, D-New Jersey, chairman of the House Ways and Means Oversight Subcommittee, called for Rettig to be replaced immediately by the Biden administration, even though Rettig’s term is nearing an end in November.
“The manner by which we are learning about the destruction of unprocessed paperwork is just the latest example of the lackadaisical attitude from Mr. Rettig,” Pascrell said in a statement. “This latest revelation adds to the public’s plummeting confidence in our unfair two-tier tax system. That confidence cannot recover if all the American people see at the IRS is incompetence and catastrophe. Mr. Rettig has had plenty of time and plenty of cooperation to begin the crucial work of fixing the IRS. There needs to be real accountability. President Biden must replace Mr. Rettig immediately and also nominate a chief counsel for IRS.”
Many tax and accounting professionals were also upset to learn that millions of the information returns they had laboriously prepared and filed for clients were being destroyed by the agency due to the massive IRS backlog, although the IRS is apparently preserving electronically filed forms and documents.
“Considering the struggles the IRS has faced in keeping up with returns’ processing the last two years, the recent TIGTA report highlighting the revelation of the IRS’s destruction of 30 million documents last year has been concerning,” said AICPA vice president of taxation Edward Karl in a statement Friday.
Karl continues, “IRS management’s decision to destroy information return documents due to the processing backlog raised numerous questions regarding IRS’s decision-making and risk assessment process. The IRS’s recent statement provided some of the answers, but American taxpayers deserve to know why this decision was made and how it might impact them. The IRS should continue to operate with transparency on this issue. For months, the AICPA has urged the IRS to implement specific recommendations that would help them reduce their backlog more quickly and provide relief to taxpayers, several of which are related to pandemic penalty relief. We are encouraged that the IRS statement indicated that taxpayers and payors have not and will not be subject to penalties. However, the AICPA believes that the IRS should be transparent with their remediation strategy to ensure that taxpayers who attempt to be in compliance, and payors who have been compliant with the information reporting requirements, do not have penalties imposed on them in the future.”
The IRS tried to alleviate the controversy with a recent statement. “We processed 3.2 billion information returns in 2020,” it announced. “Information returns are not tax returns, and they are documents submitted to the IRS by third-party payors, not taxpayers. Ninety-nine percent of the information returns we used were 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.”
The agency blamed the problem on its antiquated technology.
“Broadly, this situation reflects the significant issues posed by antiquated IRS technology,” it said. “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 1099s — that were submitted on paper.”
System constraints require the IRS to process the paper information return 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,” said the IRS. “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.”
I guess the degree of outrage about the IRS backlog and subsequent destruction of the paper information returns depends on the "angle" of how you look at the matter. The initial report and ensuing backlash sound pretty bad, but then later IRS explanations tend to frame this as less of an issue overall. Either way, I wanted to share how the IRS can (and should) be on the receiving end, and having to scramble to remedy their missteps and errors. Reminds me of the hoops they put the average taxpayer through.
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