The Treasury Inspector General for Tax Administration (TIGTA) has been documenting some careless work being carried out by the Internal Revenue Service (IRS). We have the most recent TIGTA report (Number 2022-40-036) of May 4, 2022 reporting that the IRS destroyed 30 million “paper-filed information return documents” without bothering to process them beforehand. This destruction will make it more difficult for the IRS to determine if future tax returns are accurate and to conduct audits. The IRS’ antiquated computer technology and its inability to process backlogs of paper-filed tax returns that had built up during COVID-19 directly impacted the agency’s decision to destroy the documents. This brazen IRS action has rightly sparked indignation and many questions. Nina Olson, former National Taxpayer Advocate asked: “How can the agency ask taxpayers to meet their filing obligations for information returns when it cavalierly destroys duly filed documents?” Good question.
According to an earlier TIGTA report (TIGTA Report) dated July 13 2017, the IRS systematically loses and destroys important taxpayer records due to carelessness and negligence. The TIGTA Report details the calamities — computer hard drives are erroneously destroyed or damaged; the IRS does not follow its own policies requiring it to document records that have been searched; IRS policies for preserving records from separated employees are woefully inadequate; repeated changes in IRS’ electronic media storage policies combined with reliance on employees to maintain records has led to confusion and loss of records; an executive e-mail retention policy, which should have resulted in the archiving of e-mails was not implemented effectively simply because some personnel did not turn on the automatic archiving feature!
It can’t get much worse than this; or can it? Trust me, it can! IRS employees have been known to flush returns down the toilet and hide them in their homes when the workload became overwhelming. Despite the damning TIGTA Report and the toilet etc. escapades we have had IRS agents with 30 years of experience claim that they have “never experienced or observed the IRS losing a return.” See In Re Michelle McGrew v. IRS, (US Bankruptcy Court, Northern District Iowa, October 13 2016) at page 7. Sounds incredulous.
Expatriates Take Note
How can the IRS’ carelessness jeopardize the average American taxpayer? One area involves the disagreement between the IRS and a taxpayer as to whether a tax return was ever filed for a particular year. Any taxpayer facing this problem is confronted with a Herculean task to prove he filed the “missing” return. This is a serious problem for any taxpayer but it can be particularly harrowing if the taxpayer is an American living and working overseas. Often times, a taxpayer living Stateside can prove the IRS lost a federal tax return by showing his State tax return that was filed. Many US States have a tax system that mirrors the federal system and may even require the taxpayer to attach a copy of the federal tax return to their State return. On the contrary, a US taxpayer living and working abroad typically has no need to file any State tax returns since he will have broken residency with the State.
Missing Tax Return Can Jeopardize Foreign Earned Income / Housing Exclusions
Most Americans working abroad know they may be eligible to exclude certain foreign earned income, explained here and housing amounts from US taxable income. This means that, unlike their counterparts working in the USA, they won’t be taxed on some or all of the amounts paid by their employer when they are living and working in a foreign country. These exclusions are permitted under the rules governing the Foreign Earned Income Exclusion (FEIE) and Foreign Housing Exclusion (FHE) of Section 911 of the Internal Revenue Code. A tax return must be filed within certain time limits in order to claim these exclusion benefits by filing an election to take them.
What happens if a taxpayer moves abroad and has filed tax returns making the election, but the IRS later asserts that a tax return was never filed for the year(s) in question? Under the relevant tax rules, claiming the exclusions is permitted for any tax year, no matter how far back and no matter when the delinquent returns are filed so long as the IRS has not taken the first step and notified the taxpayer of their failure to make the election and that tax is owed. On the other hand, if the IRS contacts the taxpayer first, the benefits can be denied – this can happen if the taxpayer owes any amount of federal income tax. If the taxpayer fails to keep a copy of the return and proof of filing it with the IRS, he may be out of luck. This is particularly troublesome if the “missing” tax return is an earlier tax return claiming the FEIE/FHE election, since once the election is made it carries over to all subsequent tax years if not revoked by the taxpayer. In any event, counting on the IRS to have a copy of the tax return is foolhardy, especially in light of the information revealed by TIGTA.
Gifts or Bequest from A Former American? Can You Prove Five Years of Tax Compliance?
The IRS’ lack of good record-keeping should be of great concern to Americans receiving gifts or inheritances from former US citizens or green card holders since these individuals may be called upon to prove that the former American from whom they received the gift or bequest was, among other things, fully tax compliant for the five year period prior to relinquishing US status. In tax terms, the US recipient must prove the individual was not a so-called “covered expatriate”. Internal Revenue Code Section 2801 imposes a tax on US recipients of certain gifts and bequests received from “covered expatriates”. Such “covered” gifts or bequests are taxable to the US recipient of that gift or bequest at the highest gift or estate tax rate in effect at the time of receipt. Currently, the highest Gift and Estate Tax rate is 40%. Under proposed IRS Regulations implementing Section 2801, the compliance burden is firmly placed on the US recipient of a gift or bequest from an expatriate to determine if the Code Section 2801 tax might apply to the recipient.
When the US recipient is tasked with determining whether the person from whom he received the gift or bequest was a “covered expatriate”, he or she really needs proof about the status of that foreign person and such proof may entail the necessity to have the former American’s tax returns to hand. One can imagine that obtaining this proof may be difficult, if not impossible – especially if the gift or bequest is received many years after the expatriation has taken place. You cannot count on the IRS to have maintained the former American’s tax records!
My earlier tax blog post discusses this topic in detail. The rules concerning gifts or bequests from former US persons are extremely complicated, yet they must be understood and planning must be set in motion in order to prevent possible disastrous tax consequences occurring later.
TIGTA Recommendations
TIGTA has made various recommendations related to improving the IRS’ policies for record retention and responding to external requests for records. However, the latest TIGTA audit indicates things have not really improved at the IRS.
My Recommendations
Taxpayers have to be proactive and take matters into their own hands whenever possible. This means maintaining their own tax return records and proof of filing; if relevant, it also means encouraging family members who have expatriated to get their records in order and to set up an archive with important tax documents to prove an expatriated individual was not a “covered expatriate”! We can help you get these important tax documents ready for a later IRS challenge.
Posted July 14, 2022
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