Two Years Later: Form 1042-S Frozen Refunds

We welcome back a former student of Les and mine, Sonya Miller, who is now an Assistant Professor-in-Residence at the William S. Boyd School of Law, University of Nevada, Las Vegas.  She also directs the brand new Russell M. Rosenblum Tax Clinic Program serving low income taxpayers in the Las Vegas area.  Sonya wrote one of the most popular posts we have had at PT about the IRS program directed at nonresidents and their requests for refunds.  In today’s post she updates us on the program.  The program seems to be a situation in which someone saw abuse and the IRS chose a blunt an instrument to combat that abuse.  In doing so it caught a lot of people in its net that did not belong there, spent more of its own resources than necessary and paid out several million dollars in interest.  The program may have had successes that we do not chronicle because we do not know about them.  Perhaps we will learn about them in some future TIGTA audit.  Keith

Around this time in 2015, while I was directing the Federal Tax Clinic at the University of South Dakota School of Law, it came to the clinic’s attention that the Service was freezing refunds from Form 1042-S withholding for nonresident students at the University. The clinic and I wrote about the issue in Procedurally Taxing here. At that time, dealing with the Service to represent these taxpayers was extremely frustrating; it was like talking to a brick wall. Repeated phone calls to the practitioner priority line yielded virtually no information. We contacted the Taxpayer Advocate Service (TAS) for assistance and still it was slow going. This is likely because, as the National Taxpayer Advocate (NTA) noted in her Fiscal Year 2016 Objectives Report to Congress, the Service directed taxpayers to contact the Taxpayer Advocate Service (TAS) for assistance but had not provided TAS with any specific procedures or protocols that could be followed to assist these taxpayers. Indeed, in her Fiscal Year 2017 Objectives Report to Congress, the NTA notes that the Service was no more forthcoming with TAS than it was with other third parties: “The National Taxpayer Advocate and her staff raised concerns about the matching program and the student Form 1042-S issues. These concerns, however, were repeatedly dismissed by the IRS officials charged with operating the program.” On behalf of affected taxpayers, TAS issued mass Operation Assistance Requests and developed Taxpayer Assistant Orders.


The NTA further noted in her report the unfair burden the Service placed on compliant nonresident taxpayers in an attempt to catch a few bad actors, while leaving compliant taxpayers with virtually no recourse for proving that they were entitled to the frozen refunds. Indeed, this was our experience at the South Dakota clinic. Early on in representing our student taxpayers, we contacted the University’s comptroller and received proof that the University had in fact withheld taxes from the students and had turned the money over to the Service. Still, the Service refused to release the refunds. It took so long to get the refunds released that I cannot be sure that it was our representation of the students that caused the Service to finally release the refunds. By the time the students contacted us, the refunds from their 2014 Forms 1040NR had been frozen for five months or more. Some of the students waited over a year to receive their refunds.

To be fair to the Service, it was trying to prevent fraud. Even so, no such burden exists for domestic taxpayers whose withholding agents fail to turn over withholdings. When an employer fails to turn over payroll tax to the Service, domestic taxpayers are still entitled to receive a refund from any over withheld taxes. Moreover, the Service’s means (trying to match the information in each and every Form 1042-S reported by withholding agents to each and every Form 1040NR or 1040NR-EZ filed by taxpayers) to reach the end of preventing fraud, was a blunder, which the Service recognizes in hindsight. However, the Service does attempt to place more of the burden on withholding agents by disincentivizing bad behavior. Withholding agents face hefty penalties if they fail to meet the requirement to file Forms 1042-S. They also face penalties for failing to furnish correct Forms 1042-S to recipients. Failing to ensure that Forms 1042-S reported to the Service exactly match the forms provided to the taxpayer is one common mistake that withholding agents make. Treasury Regulation 1.1461-1(h) lists the code sections for all of the penalties to which withholding agents may be subject.

However, notwithstanding its limited resources, as the NTA highlights, the Service could always do more to use its resources effectively.  In her Fiscal Year 2017 Report to Congress, the NTA states that the Service’s verification process for refunds based on Forms 1042-S “has not only been costly for taxpayers, but for the IRS, which has estimated that an extension of the freezes through early 2016 would generate an interest expense of over $4 million.” She further states that the Service could have maximized its resources had it “simply used technology already developed and pre-tested in the domestic withholding context” rather than using a separate, systemic matching program.

In an effort to “try harder and do better,” it has been reported (full text on file with the author) that the Service will no longer systemically freeze all refunds based on Forms 1042-S and will manually review all frozen refunds. The service describes its matching program in IRM Unfortunately, we the people are not privy to most of the information in this IRM—the Service has heavily redacted it. It seems that the Service redacts information for fear that people will use the information to game the system. So, if I had to hazard a guess, in line with the de minimis exception in IRS Notice 2015-10, the redacted information probably says something about which refunds will be systemically frozen and which will not and that there’s a threshold amount to make this decision. Nevertheless, in IRM, the Service does set out what the matching program looks for in determining a good match. Where refunds are frozen, the freeze will systemically release after a little over five months. Also, IRM, informs IRS employees that nonresident taxpayers have rights under the Taxpayer Bill of Rights, which means that the Service cannot just keep nonresident taxpayers in the dark regarding the status of their refund claims. Change has been somewhat slow but the Service has taken responsibility for its transgressions and appears to be moving in the right direction.







Freezing the Refunds of Our Guests

PT is excited to put up its 500th post today.  We thank you for following us on this journey into the nooks and crannies of tax procedure.

Today we welcome first time guest blogger Sonya Miller.  Sonya was my student and clinic co-worker at Villanova where she obtained her LLM.  Villanova’s LLM program has tuition assistance for students who work 20 hours per week in the clinic while studying for their LLM.  Sonya was one of the amazing recruits to Villanova as a result of this program.  (If you know someone seeking an LLM that also wants tax controversy experience, tell them to check out the program.)  She clerked after her LLM and is now starting a new tax clinic herself.  She writes to talk about a group of cases that her clinic has encountered as it starts up.

Refund freezes are not a new thing.  For those practicing in the earned income tax credit (EITC) area, you know that the IRS routinely freezes the refunds of individuals seeking the refundable EITC.  So, the IRS does not just pick on guests but freezes refunds of other vulnerable citizens.  The IRS usually engages in freezing refunds where it feels vulnerable itself because sending out the refund will be the last it sees of those dollars and the circumstances surrounding the claim suggest that the taxpayer may not qualify for the requested amount.  The decision to freeze may make perfect sense as a tactic to avert inappropriate revenue loss; however, the lack of communication to the affected individuals coupled with the blunt rather than surgical use of the tactic lands the IRS once again in the doghouse. 

Taxpayers have remedies although they may not be easy remedies to pursue.  For those who read the recent post on bypassing normal channels at the IRS, take a look at the excellent comments it has drawn suggesting additional strategies.  In effect Sonya is exercising the strategy suggested by one commentator – publicity of the problem.  The other commentator suggests litigation and that soon will be available to Sonya’s clients.

It can be easy to forget that a tax return is a refund claim.  If the IRS freezes a taxpayer’s refund for more than six months, the door to the district courts swings open.  This is a strategy that Rob Nassau who directs the tax clinic at Syracuse has employed for frozen EITC refunds.  The next post from Sonya may describe the best procedure for bringing suits in these cases and her dealings with the Department of Justice Tax Division.  Keith


The Federal Tax Clinic at the University of South Dakota School of Law began operations this fall. We are aware of a group of nonresident taxpayers (taxpayers that fall under the rules for aliens temporarily present in the United States as students, trainees, scholars, teachers, researchers, exchange visitors, and cultural exchange visitors) who had their 2014 refunds frozen. Their refunds were the result of Form 1042-S (Foreign Person’s US Source Income Subject to Withholding) withholdings. The taxpayers were not aware of why their refunds had been delayed. We believe that they are among the many nonresident taxpayers whose refunds the IRS began systemically freezing this year.


In an IRM Procedural Update issued January 30, 2015, IRM, the Service advises that beginning January 1, 2015, it will systemically freeze a taxpayer’s entire refund where the taxpayer filed Form 1120-F and any portion of the refund is supported by a Form 1042-S. The freeze lasts up to 168 days, during which time Compliance will check the validity of the refund. If Compliance finds that the refund is not valid, the IRS will extend the freeze. If a taxpayer calls the IRS inquiring into the status of the refund, then the Service will advise the taxpayer that “[t]he IRS will need additional time to process your return. Please allow IRS up to six months from the original due date or the actual filing date of the return whichever is later to receive your refund.”  The IRM provides that no notices will be generated regarding the systemic freeze. However, if taxpayers call the IRS and claim hardship as the result of not having received their refund, the IRS will refer them to the Taxpayer Advocate Service. Although IRM presumably applies only to taxpayers filing Form ll20-F, i.e. foreign corporations, it appears that the IRS is also applying the IRM to systemically freeze the refunds of individuals who filed Form 1040NR.

After inquiring into the status of one refund (the taxpayer filed Form 1040NR), the IRS advised us that there was a 168-day hold on the refund because of the taxpayer’s Form 1042-S. IRM is the only IRS literature we have found that references a 168-day freeze for refunds supported by a Form 1042-S, which causes us to conclude that the IRS is likely applying this IRM, meant for Forms 1120-F, to Forms 1040NR. Additionally, similar to the language found in the IRM, the IRS has posted a statement to its website advising taxpayers who filed a Form 1040NR with Form 1042-S that the Service will need up to six months from the due date of the return or the date the return is received, whichever is later, to process the return and issue any refund.

In a follow up communication, the IRS advised us that it issued 3064C Letters to the nonresident taxpayers in mid-September 2015 (about five months after the taxpayers filed their returns) informing them that the Service needed more time to process the returns. We have not seen these letters. However, it is our understanding that the IRS does not address why the taxpayers’ refunds have been frozen or what the taxpayers can do to expedite the process. Prior to these letters, the IRS had not made any attempt to individually notify the taxpayers of the refund delays. As Yogi Berra is quoted to have said, “It’s déjà vu all over again.” The IRS has a significant history of silently freezing refunds.

The National Taxpayer Advocate (NTA) raised the issue of frozen refunds in her Annual Report to Congress as early as 2003 and as recently as 2013. In her 2005 Report the NTA listed Criminal Investigation Refund Freezes as one of the most serious problems within the IRS. Criminal Investigation Refund Freezes are a part of the Questionable Refund Program, which was “designed to identify fraudulent returns, to stop the payment of fraudulent refunds and to refer identified fraudulent refund schemes to Criminal Investigation (CI) field offices.” Although we believe the systemic freeze of refunds supported by a Form 1042-S is more likely the result of proposed Treasury Regulations detailed in IRS Notice 2015-10 than the result of the Questionable Refund Program, the same concerns regarding taxpayer rights noted in the NTA’s 2003, 2005, and 2013 Annual Reports applies.

Notice 2015-10 proposes regulations that affect the treatment of claims for refund and credits made by taxpayers subject to withholding rules under I.R.C. §§1441 – 1443 and §§1471 – 1472. The proposed regulations will allow the IRS to deny refunds to the extent that withholding agents have not deposited the correct amount of withholdings under I.R.C. §6302 and to the extent that reported withholdings are fictitious. As with cases in the Questionable Refund Program, the IRS is understandably concerned about the potential for fraud. This is especially true for withholdings reported on Form 1042-S because both the claimant and the withholding agent may be outside of the United States, making recovery of erroneously issued refunds nearly, if not actually, impossible.

Nevertheless, the problem with systemically freezing taxpayer refunds to investigate the validity of the refunds is that inevitably the “innocent” get caught in a net meant for “bad” actors. Regarding withholdings reported on Form 1042-S, the IRS acknowledges in Notice 2015-10 that perhaps there should be an exception for withholding agents who have a history of compliance or where the refund claimed is de minimis. However, judging from the frozen refunds, it appears that the IRS currently is not applying any such exceptions. If it were, we would think that the withholding agent in many of these cases—e.g., domestic withholding agents that are subject to IRS jurisdiction and have an excellent record of tax compliance (such as U.S. educational institutions), would be excepted from lengthy queries or that the taxpayers’ refunds (sometimes just a few hundred dollars each) would be viewed as de minimis.

The NTA has repeatedly emphasized the IRS’ need to implement proactive handling and management procedures to notify taxpayers that their refunds have been frozen and to provide a reason for such action and an opportunity to address the issue so that the refund claim may be resolved as expeditiously as possible. In 2006 the New York Times reported that the IRS would begin notifying taxpayers regarding frozen refunds, quoting then Commissioner Mark W. Everson as saying “I believe that appropriate notification should be given when refunds are frozen … Honest taxpayers expecting a refund deserve to be treated fairly.” Since then Mr. Everson’s belief that taxpayers deserve to be treated fairly has been made a priority, if not a reality. The Taxpayer’s Bill of Rights gives taxpayers the right to be informed, the right to quality service, the right to challenge the IRS’ position and be heard, and the right to a fair and just tax system. A systemic freeze of taxpayers’ refunds without prompt notice infringes upon these rights. A vague letter to the taxpayer requesting more time to review the return five months after the IRS has already frozen the taxpayer’s refund does not amount to fair treatment.