Taxpayers who claimed the earned income tax credit for 2019 were audited as a result of the IRS’s destruction of millions of information returns, despite the agency’s claim that no “negative consequences” resulted from its action.
The decision by the IRS to expunge 30 million information return documents — mostly third-party income reporting on Forms 1099 — meant the agency didn’t have records to match income reported by thousands of low- and middle-income taxpayers claiming EITCs. But it continued auditing those taxpayers for “missing” Forms 1099 anyway.
The issue was first identified by Justin Schwegel of Gulfcoast Legal Services Inc.
Lawyers at low-income taxpayer clinics in Florida, Indiana, and Maine confirmed to Tax Notes that taxpayers they represent faced automated correspondence exams for the 2019 tax year because the IRS said the Forms 1099 for their non-employee income were missing or “not submitted.”
In each case, the Form 1099 had been filed by the payer of that income, but it took legal assistance, a trip to the Tax Court, and an affidavit from the payer to resolve the issue.
How is the taxpayer harmed in these cases? Normally, less income means less taxes, and the IRS is concerned about underreporting income, not overreporting it. But here, if the taxpayer wants to claim an EITC, they must have reported earned income. Without the Form 1099 match, in the IRS’s view, this taxpayer didn’t earn income, so wasn’t eligible for an EITC.
Schwegel and several other LITC lawyers agreed that while the cases they’ve seen are troubling, the bigger problem is that many affected EITC claimants aren’t represented, don’t know where to go for help, and often can’t successfully navigate the audit process on their own.
“My biggest worry is the number of taxpayers that got lost in the exam process and gave up, and lost their earned income tax credit for 2019 because the IRS destroyed all those 1099s,” Dee Dee Gowan of Indiana Legal Services Inc. told Tax Notes. “And if they got [the credit refund], they have to pay it back — with penalties and interest.”
The IRS “needs to go back and unravel every single one of those exams . . . as a corrective measure for all those taxpayers that didn’t make it to Tax Court,” Gowan said.
Destroyed Returns
The destruction of approximately 30 million paper-filed information return documents was discovered by the Treasury Inspector General for Tax Administration and reported in September 2021. TIGTA issued a separate report on its investigation in May 2022, drawing significant attention from tax professionals and the public.
The documents were destroyed in March 2021, according to TIGTA’s reports.
In a May 2022 statement, the IRS said it had destroyed 1 percent of the 3.2 billion information returns it received in 2020 — for the 2019 tax year — “due to a software limitation and to make room for new documents relevant to the pending 2021 filing season.”
The agency assured the public then that “there were no negative taxpayer consequences as a result of” the document destruction. It also promised that "taxpayers or payers have not been and will not be subject to penalties resulting from this action."
But in the months after destroying the Forms 1099, the IRS was sending automated audit notices to deny or claw back EITCs on the basis that those forms were missing, sometimes asserting that they hadn’t been filed at all.
The IRS uses the automated correspondence examination (ACE) system to identify some returns for audit. One flag for audits is a mismatch between income reported on a taxpayer’s Schedule C and the income reflected in IRS records for the same year.
The IRS income data is based on information reporting by third parties, usually on one of the Form 1099 series, including Form 1099-MISC, “Miscellaneous Income,” and Form 1099-NEC, “Nonemployee Compensation.”
TIGTA described the purpose of this information reporting in its May 2022 report referencing the document destruction: “The IRS uses these documents to conduct post-processing compliance matches to identify taxpayers who do not accurately report their income.” It appears the IRS continued to conduct compliance matching — and audit low- and middle-income taxpayers claiming EITCs — even after it had destroyed millions of the matching documents in its possession.
Patient Zero?
After one of his clients was audited because of a mismatch between income reported on the taxpayer’s Schedule C for 2019 and the income reflected in IRS records, Schwegel asked the IRS how many self-employed EITC claimants were audited because of a similar mismatch for that year. The IRS’s answer: about 33,000.
Schwegel presented the cautionary tale and his preliminary research results in a June 28 webcast sponsored by the Center for Taxpayer Rights.
According to Schwegel, the taxpayer sought assistance when the IRS examiner didn’t accept the taxpayer copy of Form 1099 — which showed the income the taxpayer had reported on Schedule C — because the agency didn’t have that Form 1099 in its system.
The taxpayer reached out to Gulfcoast Legal Services less than a week after the IRS issued its May 2022 statement about the destroyed information returns, and Schwegel realized his client’s missing paper Form 1099 was likely among them.
Schwegel said he was able to help that taxpayer resolve the situation, but he wondered how many other taxpayers were flagged for audit because of a similar mismatch. So he asked.
The IRS responded that approximately 33,000 taxpayers were audited as a result of this kind of mismatch for the 2019 tax year, according to Schwegel, who supervises Gulfcoast’s LITC.
It’s unclear how many of those audits were the result of the destroyed Forms 1099. But IRS data for surrounding tax years (2012 to 2018 and 2020) showed that on average, only about one-third as many EITC filers were audited for the same mismatch, Schwegel said.
Schwegel’s data requests to the IRS were specific to Project Code 0288, “Questionable Schedule C With EITC.” The Internal Revenue Manual describes these as “single issue cases where only Schedule C net profit is questioned.”
Maine Couple
Helen Hall of Pine Tree Legal Assistance Inc. in Maine handled the case of a young couple who also filed a timely return for 2019 claiming an EITC, which the government paid. Then they received an audit letter in the summer of 2021 — months after the IRS had expunged millions of paper information returns in March 2021 — because of a missing Form 1099.
The taxpayers responded to the audit letter on September 1, 2021, but received a statutory notice of deficiency the next month from the IRS, which refused to change its position because it said a Form 1099-MISC hadn’t been submitted by the payer. The couple was expected to repay the refunded credit — nearly $3,800 — plus interest and penalties.
When Hall got the case in January 2022, the payer had submitted a duplicate Form 1099-MISC, but it still didn’t appear on the IRS’s official transcript for the taxpayers.
Hall, a qualified tax expert, filed a Tax Court petition on their behalf and provided a signed affidavit from the payer verifying the income reported by the taxpayers and confirming that he had previously submitted both a timely original Form 1099 and a replacement one.
Once that documentation was sent to the assigned IRS Appeals officer, the matter was settled in the taxpayers’ favor with no deficiency, Hall said. The Appeals officer didn’t even need to talk to Hall before sending over the decision documents, she added.
Hall said it was lucky that she included the payer’s affidavit in her submission for the taxpayers. “I didn’t know that the IRS had destroyed these documents,” she said, adding, “Who would in their wildest dreams think that the IRS would destroy documents that” payers are required by law to file?
“It makes me wonder how many more cases are out there in the state of Maine that I know nothing about, because those people didn’t know to call” the clinic, Hall said.
Indiana Single Dad
Gowan’s LITC has handled three missing Form 1099 mismatch cases to date and has settled two of them at the Tax Court. Once they reached the Tax Court, the cases “settled pretty quickly, which is great,” she said, but she had to explain the issue to the local IRS counsel because they weren’t aware of it. She said most of the affected taxpayers don’t know where to go for help, so they never make it that far.
Gowan described a now-settled case in which her client, the single parent of three children, filed his 2019 return claiming the EITC by the July 15, 2020, deadline and received the refundable credit in August 2020.
A year later, he got an audit notice and tried to navigate the exam process on his own, without success, Gowan said. A statutory notice of deficiency arrived in February 2022; he filed a Tax Court petition in May 2022; and he went through the IRS Appeals process there, unable at each stage to prove the income reported on his missing Form 1099.
Worse, while that process was ongoing for the 2019 tax year, the IRS notified the taxpayer that it would offset the amount of the disputed deficiency against his 2021 refund — effectively taking that year’s EITC as well.
That’s when he contacted the Indiana Legal Services LITC. Gowan gave him guidance on the documentation he needed to gather and, with the help of a student volunteer, prepared an affidavit for the payer to sign, verifying the income reported on the missing Form 1099 and confirming that the form had been filed.
Gowan said she faxed the documents and affidavit to the IRS office “yesterday at noon, and at 2 o’clock IRS [area] counsel called and settled the case completely in our favor.” Decision documents arrived the next day, including a release of the “offset” on later years’ EITCs, “so they settled very fast once we sent them everything,” Gowan said.
Automated Audits
Virtually all EITC audits are conducted by automated correspondence exam, which is an especially bad fit for low-income taxpayers, according to Caleb Smith of the University of Minnesota Law School.
“To me, the worst customer service is automation, and I think most people would actually agree with that,” Smith said. “What we’re doing with low-income taxpayers is giving them full automation” even though they’re the ones who would benefit most from being able to talk to a human and get an explanation of what’s going on.
The ACE system applies automated filters to flag returns for audit. The IRM section containing them (section 4.19.20.2(9)) says that analysts in both the Small Business/Self-Employed and Wage and Investment divisions “have access to make needed changes” and that “application of filters can be changed at any time.”
According to TIGTA’s September 2021 report, “IRS management stated that the decision to destroy these information returns involved discussions with both” SB/SE and the Wage and Investment Division.
The filters themselves aren’t publicly available, and the IRS has denied a Freedom of Information Act request submitted by Schwegel and Gulfcoast Legal Services seeking the filters used for 2019 returns. But reported cases of ACE audit letters going out to EITC taxpayers whose Forms 1099s were “missing” after the document destruction suggests the filters weren’t changed to account for that destruction.
Had the IRS changed the filters to suppress automated audits of taxpayers affected by the destroyed Forms 1099 or directed its exam personnel to concede the issue for 2019, LITCs wouldn’t be seeing the audits discovered so far, according to Mandi Matlock of Texas RioGrande Legal Aid.
The IRS had no immediate comment on questions about the ACE system filters.