The Automated Substitute for Return Procedures

Today we welcome guest blogger Michelle Drumbl.  Professor Drumbl teaches tax at Washington and Lee University School of Law and runs the low income taxpayer clinic there.  She thanks clinic student Hollie Floberg for her assistance in writing this post.  One of Professor Drumbl’s suggestions concerns the use of the substitute for return procedures to pursue returns with little collection potential.  I wrote about the IRS policy of taking collection into account in the TFRP context.  That policy may have some play here.  Keith

The automated substitute for return (ASFR) procedure, authorized by section 6020(b) of the Internal Revenue Code, provides the Internal Revenue Service with a mechanism by which to use third-party information reporting to assess a tax liability for nonfilers. This enforcement mechanism is a relatively easy way for the Service to narrow the so-called “tax gap,” defined as “the amount of true tax liability faced by taxpayers that is not paid on time.” In the context of closing the tax gap, income that is subject to information reporting is low-hanging fruit. Unsurprisingly, studies show that taxpayer compliance rates are higher when income is subject to “substantial information reporting” (and highest if subject to both information reporting and withholding).

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It is hard to refute that noncompliance undermines the tax system, or to deny the appropriateness of the Service pursuing assessment of unreported income it can easily verify. However, in her recently released 2015 Annual Report to Congress, National Taxpayer Advocate (NTA) Nina Olson identifies the selection criteria for cases in the ASFR program as Most Serious Problem #17. Olson insightfully identifies a number of ways in which the ASFR process, while easy for the Service, is imperfect for the taxpayer. Olson’s critique of the current ASFR selection criteria includes three points: 1) the IRS has a poor collection rate on these assessments; 2) the IRS has a high abatement rate on amounts assessed through ASFR; and 3) the ASFR program has a low return on investment.

I will address some of these points and the NTA’s recommended solutions from my perspective of a practitioner representing low-income taxpayers, and add some observations of my own. 

When Using its Third-Party Documentation, the IRS Should Take into Account Deductions and Credits, Not Just Income

In describing the abatement rate on ASFR assessments, Olson notes that the program could increase efficiency and return on investment if, as part of its case selection, it more carefully considered third-party documentation consistent with possible deductions and credits. She notes that selection of cases likely to result in abatement causes “rework for the IRS and potential harm for the taxpayer”. She suggests that the IRS refine its selection process by “considering third-party documentation that supports deductions or credits when determining which cases to select for the program”.

Olson’s point is well taken. The ASFR assessment process takes into account all income reported as earned by the taxpayer, but it ignores reported items that would reduce taxable income. For example, mortgage interest is reported to the IRS on Form 1098, state income tax withholding is reported on Form W-2, and student loan interest is reported on Form 1098-E. All of these reported payments potentially reduce a taxpayer’s liability.

I agree with Olson that the failure of the IRS to use or acknowledge this readily accessible information is inefficient, but the burden must remain on the taxpayer to claim these deductions. These deductions cannot be accurately calculated by the IRS during the ASFR process because the IRS has imperfect information. For example, the student loan interest deduction phases out at a certain income level, and it is possible that the taxpayer has additional income not subject to information reporting. Thus, it would be premature to propose the deduction based only on the income information reported by third parties. Accordingly, it is not unreasonable for the IRS to omit these deductions in calculating its proposed ASFR assessment. After all, the taxpayer sat on his or her rights by not filing a return; appropriately, the burden of filing and claiming deductions or credits rests with the taxpayer. But as I describe in my recommendation below, the IRS can and should communicate these possibilities to the taxpayer when known. Another issue the IRS should address more clearly in its communications is filing status.

Filing Status Presents Challenges for Taxpayers beyond What the NTA Report Describes

Olson is absolutely correct that filing status matters. Married taxpayers who file a joint income tax return are entitled to a number of potential benefits that are denied to married taxpayers who file separately. Most notably for low-income individuals, the earned income tax credit is not available to married taxpayers filing separately. But because joint filing is at the taxpayers’ election, an ASFR assessment must be based upon a filing status of single or married filing separately. Olson addresses this issue, but she does not describe the limitations that section 6013(b)(2) impose on married taxpayers who wish to file a joint return after filing separate returns.

Professor Kathryn Sedo has blogged here and here about one possible “procedural trap for unrepresented taxpayers” that arises under section 6013(b)(2)(B), namely that married taxpayers cannot amend from a separate return to a joint return once either spouse has filed a petition in Tax Court with respect to such tax year.

Another limitation, set forth in section 6013(b)(2)(A), is that if one of the spouses has filed a separate return, the taxpayers are prohibited from amending to file a joint return after the expiration of three years from the due date of the return for such tax year.

As I write about in a forthcoming article, in my low-income taxpayer clinic I commonly encounter married couples in which one spouse is a wage earner subject to information reporting and withholding and the other spouse receives nonemployee compensation subject to self-employment tax and no withholding. If a low-income couple with dependent children files a joint return, it may result that the personal exemptions, the standard deduction, the earned income credit, and the child tax credit combine to offset (in part or whole) the self-employment tax and the lack of withholding. However, a couple who lacks proper information and tax advice does not realize this; fearing a tax bill because of the self-employment tax and the absence of withholding, the taxpayers make a decision to file separate returns (or, quite commonly, a decision for one to file a separate return and one not to file).

Assuming the self-employed individual receives a Form 1099-MISC, the IRS will eventually discover the nonfiler and may pursue an assessment through the ASFR procedure. But this does not necessarily happen within three years of the due date of the return; as Olson describes, ASFR criteria require, among other things, that the module be “not older than five years prior to the current processing year.” But because of section 6013(b)(2)(A), the spouse who files a separate return has a limited window in which to amend and file jointly. Thus the nonfiler who comes into compliance more than three years late (perhaps in response to a proposed ASFR assessment) will have no choice but to file as married filing separately for those years if his or her spouse filed a separate return.

The IRS should (but currently does not) advise a nonfiler receiving a proposed ASFR of the time limitations imposed by section 6013(b)(2)(A) for amending to file jointly.

My Recommendation: Advise Taxpayers More Clearly of their Rights and Options, and Do So Sooner

The IRS can and should be much clearer in its communications with the taxpayer during the ASFR assessment process. My recommendation would be for the IRS to contact nonfilers within one year of the missed deadline and to include a letter explaining their rights and responsibilities more clearly. Currently, the 30-day proposed assessment letter lists the details of income reported by others. This letter should include all information received from third parties, not just income reported; it should notify (or remind, as the case may be) the taxpayer of any information reporting it received relating to possible deductions or credits. The letter could state clearly that the reported information may or may not be relevant in determining certain deductions or credits, note explicitly that the IRS has not included any deductions or credits in its calculation of the proposed assessment, and remind the taxpayer that it is his or her responsibility to affirmatively claim any deductions or credits on the return.

Moreover, the 30-day letter should be used as a reminder that the taxpayer may be eligible to use a more favorable filing status and is entitled to claim any qualifying dependents, either of which may reduce the proposed assessment. Specifically, it should notify the taxpayer that if he or she is married, there remains the option to file jointly with a spouse; it should further provide the deadline by which the taxpayer would need to file if the taxpayer’s spouse previously filed a separate return and wishes to amend and file a joint return.

Finally, the notice should recommend that the taxpayer visit a low-income taxpayer clinic if income eligible. 

In Conclusion: A Word About Those Low Collection Rates

Olson notes that the ASFR program has poor collection rates, citing statistics that the Service collected less than one-third of the amount assessed through ASFR in fiscal years 2011-2014. She suggests that the poor collection results are evidence of inefficient selection criteria, and notes that the ASFR program has a low return on investment relative to other IRS programs.

I feel strongly that the IRS should not simply choose to ignore nonfilers who represent a poor “return on investment” just because the program has “low collection rates”. Nonfilers degrade the tax system. They undermine the faith of the general public in a fair system, and they should not be given a pass because the relative dollar amounts are small or because they likely cannot afford to pay the liability. Olson speaks of the right to a fair and just tax system, but this concept cuts both ways. Compliant taxpayers expect the IRS to enforce filing requirements in an even-handed manner. Taxpayers who cannot afford to pay their tax liabilities have many avenues of relief available to them, including financial hardship status, a variety of installment agreement options, and the offer in compromise process. Taxpayers whose income exceeds the filing threshold must be expected to file a timely return and report their income, even if it is unlikely that the IRS will ever collect from them.

While the ASFR process can be modified in ways that would make it a more taxpayer-friendly (and perhaps a more efficient) procedure, it should not use collection likelihood (or the lack thereof) as part of its selection criteria.