The IRS

Gregory J. Cook, EA, CPA

Accredited Tax Advisor

IRS Program Gone Wrong

In a 1998 report, Compliance with Self-Employment Tax Requirements (Reference Number 083502, dated May 19, 1998), the Treasury Inspector General for Tax Administration (formerly IRS Internal Audit) recommended that the IRS take steps to improve its process of administering self-employment tax requirements. The objective of this audit was to determine whether the IRS had taken effective corrective actions in response to that report to improve the identification and collection of unreported self-employment taxes.

Results

The IRS has taken some actions to address unreported self-employment taxes. Changes were implemented to the computer screening criteria used to identify tax returns with unreported self-employment taxes. The IRS also developed an educational letter which was sent to taxpayers filing these tax returns, requesting the taxpayers to review their tax returns and amend the returns by submitting Self-Employment Tax (Schedule SE) if they deemed it necessary. This letter was sent well after the tax returns had been processed.

Despite these efforts, significant amounts of self-employment taxes remain un-assessed and uncollected each year. The IRS needs to take steps to further improve the identification and collection of these taxes. The ongoing "stand up" of the IRS new Small Business/Self-Employed (SB/SE) Division presents an excellent opportunity to address these issues.

The Internal Revenue Service Could More Timely Identify and Collect Unreported Self-Employment Taxes

In our prior report, we recommended that the IRS identify taxpayers owing self-employment taxes when returns are processed and work those cases immediately in Correspondence Examination. The IRS has not implemented those recommendations. Author Comment: They still haven't, because in the two cases I worked recently, the first was on a 2005 tax return (The IRS sent the letter just before the statute of limitations was about to expire) and the second was on a 2007 tax return.


Identifying unreported self-employment taxes as tax returns are processed and assessing self-employment taxes on those cases with available tax refunds would help the IRS:

  • Comply with the desires of the United States (U.S.) Congress for the IRS to promptly inform taxpayers of their obligations with respect to tax deficiencies.
  • Minimize the burden to some taxpayers of paying self-employment taxes.
  • Minimize the cost of collecting the taxes.

By assessing unreported self-employment taxes before refunds are issued, the IRS could immediately collect self-employment taxes of $21 million each year owed by 78,000 taxpayers with self-employment income of $2,000 or more.

Author Comment: I highly suspect the accuracy of these estimates, but I do believe they could send threatening, scary letters and get people to pay them $269 rather than fight! ($21,000,000 divided by 78,000 people = $269) Actually what they are suggesting, is for the IRS to just go ahead and deduct $269 from these peoples refunds (that's even better).



The Internal Revenue Service Needs to Reduce Certain Processing Errors to Further Improve the Computerized Identification of Unreported Self-Employment Taxes

The IRS made processing errors on tax returns and related documents, which caused its computers to erroneously identify some taxpayers as owing self-employment taxes. An estimated 30,000 taxpayers were erroneously identified in this way and sent self-employment tax education letters. These taxpayers had either: (1) claimed religious exemptions from self-employment tax requirements, (2) reported "Other Income" on the U.S. Individual Income Tax Return (Form 1040) line 21, or (3) indicated they were statutory employees by checking the appropriate box on Profit or Loss From Business (Schedule C).

Criteria for Prioritizing Self-Employment Tax Cases Need to Be Revised to Accurately Reflect Potential Unreported Self-Employment Taxes

The logic of the IRS computer program to identify and prioritize tax returns with unreported self-employment taxes is flawed. (NOTE: Author strongly agrees) As a result, tax returns with significantly varying amounts of unreported self-employment taxes can receive the same priority in the IRS compliance program. This can lead to the ineffective use of scarce Examination function resources.

Educational Letters to Taxpayers Potentially Owing Self-Employment Taxes Could Be Improved

The educational letters sent to taxpayers appearing to owe self-employment taxes should be more specific and assertive, provide an explanation of the importance of the self-employment tax, and explain to taxpayers what will happen if they do not respond. If taxpayers are not convinced of the importance of taking action in response to an IRS letter, many will not respond.

Author comment: The IRS really took this part of the recommendation to heart. Their new approach is to send an IRS letter that reads, "you owe xxxx dollars, if you do not pay within xx days we may take collection action, which might include contacting third parties about you, freezing your bank account, contacting your employer to garnish your wages, ...".

woman presenter

Future plans are to send letters to all taxpayers with self-employment income of $2,000 or more that did not report self-employment taxes. During the implementation of the Self-Employment Tax National Strategy, letters were sent to all taxpayers with self-employment income of $1,000 or more. Letters to taxpayers with less than $2,000 resulted in gross self-employment tax revenue of approximately $3.3 million (Why do they only report the results of the very small cases? See author comments later about this project titled Self-Employment Tax National Strategy).

Although these cases individually may not warrant follow-up by the IRS, they do warrant letters informing taxpayers of their self-employment tax obligation. Author: What they mean by this statement is, we know we're picking on the little guy and it's not a lot of money individually. Don't actually assign case workers to this in order to really determine if they owe it or not (that costs too much), try to limit your spending to one or two of the scary letters that cost about $1 each to generate and send.


Summary of Recommendations

The IRS should identify unreported self-employment taxes during returns processing and assess these taxes before refunds are issued to taxpayers. To make this process more effective, the IRS should improve the accuracy of the information used to determine if taxpayers are liable for self-employment taxes. This information relates to applications for exemptions from self-employment taxes, income reported on line 21 of Form 1040, and the statutory employee indicator on Schedule C.

In addition, the IRS should revise the formula for prioritizing self-employment tax cases and should improve the educational letters sent to taxpayers potentially owing self-employment taxes. Author Comment: What they mean by "improve the letter" is make it more threatening and scary, and what they mean by "respond" is send a check. When you send someone a payment stub with a dollar amount on it and a return envelope for the payment, it is clear what response you are seeking. Remember what they said above about "be more assertive...", "tell them what will happen if they don't respond (send a check)"..."taxpayers may not respond (send a check) if they aren't convinced of the importance of taking action".

Management's Response: In January 2001, the IRS will begin identifying, via computer, taxpayers with potential unreported self-employment taxes as the returns are processed. A project to hold refunds of a limited number of taxpayers who owe self-employment taxes will be tested. If the project is successful and if resources are available, the project will be expanded to all SB/SE Correspondence Examination sites by 2003. The IRS will forward copies of forms indicating taxpayers are exempt from self-employment taxes to the area responsible for processing that information to ensure that the applicable records are updated.

The IRS will revise instructions for Form 1040, line 21 and will revise returns processing instructions to improve the accuracy of data indicating that taxpayers are statutory employees and not liable for self-employment taxes. The IRS will also revise the scoring formula used to identify and prioritize tax returns with potential unpaid self-employment taxes and will make changes to letters sent to taxpayers potentially owing self-employment taxes.

Author: We will test the waters with computer generated IRS letters not people, because those scary letters only cost a $1. And oh yes, we will make the letters more threatening than they were in the past. Although these actions will not improve the over-all correctness, fairness or service we provide, if it brings in dollars, we will expand the project in the future.

Office of Audit Comment: While we agree that sending different letters to taxpayers based on the amount of self-employment tax they owed would result in different treatment of taxpayers, in our opinion, the differing treatment is consistent with the way the IRS currently administers taxes. The IRS takes different actions when processing tax returns or when taking enforced collection actions based on the amount of tax involved. END OF TIGTA REPORT

Author: We admit that we treat the guy who owes us $200 different from the guy that owes $20,000. We can't go to the expense of having an IRS employee actually look at a $200 case and take the time to determine if it's right or wrong (that would cost more than we collect). We don't think there's anything wrong with this approach and we will continue to operate in this fashion. The more money the taxpayer owes us, the more likely he can afford a representative to fight us or simply, the more willing he may be to defend himself.




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