‘There Will Come Soft Rains’: Automation Amid Unprecedented Destruction

Pandemic Problems

The COVID-19 pandemic caused many IRS processing facilities to close in 2020. This created a backlog of unprocessed paper correspondence that led to the IRS destroying 30 million information returns, mostly 2019 Forms 1099. That is income that taxpayers usually report on their Schedules C. Many low-income taxpayers need the income reported to the IRS on a Form 1099 to claim the earned income tax credit. The IRS did not update audit filters to account for the destroyed documents. For tax year 2019, the IRS audited 33,194 taxpayers who claimed the EITC based on Schedule C income the IRS was unable to substantiate. Some of those audits were likely triggered by the document destruction, which created a mismatch between income claimed by the taxpayer and IRS income records.

During the onset of the pandemic in early 2020, the IRS closed many of its mail processing facilities to protect workers’ health and safety. That probably helped slow the spread of a global pandemic, but it also led to a backlog in mail processing most comically demonstrated by the piles of paper correspondence in the cafeteria of the IRS’s Austin campus.¹

Less comical was the revelation in a report by the Treasury Inspector General for Tax Administration that the IRS destroyed 30 million information returns because of the backlog.² Following the TIGTA report, the IRS issued a statement indicating that the documents were “destroyed due to a software limitation and to make room for new documents relevant to the pending 2021 filing season.”³

The statement went on to say that the documents destroyed were mostly Forms 1099 “submitted on paper,” that 99 percent of information returns were successfully processed, and that the destroyed information returns constituted less than 1 percent of information returns. However, based on the number of paper information returns the IRS processed in 2018, 2019, and 2020, it is likely the IRS processed less than 23 percent of the paper information returns it received in 2020. Most importantly, the IRS stated, “There were no negative taxpayer consequences as a result of this action.” That seems inaccurate.

Piecing together the TIGTA report and IRS statement, the IRS destroyed 30 million paper information returns, mostly Forms 1099 from tax year 2019, in early 2021, to make room for 2020 tax year documents. The Social Security Administration processes Forms W-2, so paper W-2s were not affected by the IRS document destruction.⁴

It is impossible to know exactly how many information returns of each type were destroyed. Freedom of Information Act response 2022-21018 showed that the IRS processed 41,360,160 paper information returns in calendar year 2018; 39,855,299 in 2019; and just 8,589,291 in 2020. This implies the IRS estimate of around 30 million documents is close. The Form 1099-MISC saw the steepest drop, with 22,797,102 fewer processed in 2020 than 2019.

For 2019 Form 1099-MISC was used to report payments to self-employed individuals and independent contractors who report the income on Schedule C, though as of 2021, Form 1099-NEC is used instead. Information returns received in 2020 will mostly be related to the 2019 tax year, although there would have been a few from earlier years.⁵

The IRS document destruction was met with harsh scrutiny following the TIGTA report. Rep. Bill Pascrell Jr., D-N.J., called on President Biden to dismiss former IRS Commissioner Charles Rettig.⁶ Senate Finance Committee ranking member Mike Crapo, R-Idaho, drafted a letter signed by 13 fellow Republican senators seeking answers from Rettig.⁷ Presciently, the letter asked, “Has the destruction of 30 million information returns negatively affected the ability of qualifying taxpayers to receive the earned income tax credit?”

A Nightmare Audit

Miguel Rodriguez,⁸ my client, did construction and remodeling work as an independent contractor for a landlord who owns several units. The landlord paid Rodriguez in cash and reported the payments for 2019 to the IRS on a paper 1099-MISC. In 2021 Rodriguez’s 2019 tax return was audited by correspondence exam.

Many low-income taxpayer audits are counterintuitive. The taxpayer must prove to the IRS that they earned the income in question to qualify for refundable credits. These credits phase in with earned income.

Rodriguez and his wife filed a joint tax return in 2019. The only income reported on the joint 2019 return was his $18,000 Schedule C income. After the self-employment tax deduction, his earned income was $16,728. This entitled him and his wife to an EITC of $6,557, and an additional child tax credit of $2,134. After self-employment tax, they received a refund of $6,148.

However, the IRS had no record of a Form 1099-MISC on file for Rodriguez for 2019 to substantiate his claimed income, and without earned income, he was not entitled to the EITC or additional child tax credit. The IRS exam letter proposed changes to the tax return that would have made him repay the $6,148 refund plus an accuracy-related penalty of $1,230 and $397 in interest. The total proposed deficiency was $7,775, 46 percent of his 2019 adjusted gross income.

Rodriguez had faith in the system. He was determined to work with the examiner. In November 2021 the examiner sent correspondence instructing him that the IRS was sticking with its proposed assessment, in part because the Form 1099 was not on file with the IRS. However, the letter also instructed him that the IRS needed a statement from the Form 1099 payer and records showing he deposited his income into his bank account.

The landlord drafted and notarized a statement that attested to both paying Rodriguez and filing the Form 1099 with the IRS. The IRS had destroyed the documents by this point. Rodriguez provided a copy of the paper Form 1099-MISC and bank records showing deposits roughly equal to the income claimed on his Schedule C. The IRS had Forms 1099 on file from the landlord for payments to Rodriguez for 2016, 2017, 2018, and 2020. Surely this was enough for Rodriguez to win his audit. Not quite.

In response to the documents, Rodriguez received a statutory notice of deficiency. Explanatory Form 886-A stated, “We continue to disallow your Schedule C income in the amount of $18,000. The 1099-MISC income has not posted to date.” Spoiler alert: The 1099-MISC would never post.

The examiner determined the landlord’s notarized statement was not detailed enough and could not substantiate Rodriguez’s income. Rodriguez’s bank records were no good either. They were from a joint bank account, and the IRS could not tell who had made the deposits. Never mind that it was a joint tax return. Rodriguez lost faith in the system.

Rodriguez called a few attorneys. Most told him his case would likely cost more to litigate in Tax Court than the amount in controversy. He and his wife considered borrowing money to pay the IRS, but the last attorney he called referred him to the low-income taxpayer clinic at Gulfcoast Legal Services (GLS) for free representation.

GLS received no response to the additional documents submitted to the examiner and filed a petition in Tax Court. The IRS attorney submitted an answer denying the IRS had “erred to the extent alleged.” She had not heard of the document destruction before Rodriguez’s case. However, she proved to be much more reasonable than the examiner. She was ultimately willing to concede the case after several email exchanges about the circumstances that led to the audit and later confirming the payments with the landlord. The IRS also agreed to pay GLS nearly $4,000 in fees under section 7430, implying that the IRS position was not substantially justified. Litigating fees under these facts may have proven difficult for the IRS.

Signs of a Bigger Problem

Rodriguez’s story had a happy ending, but he was not alone. The IRS destroyed roughly 22 million Forms 1099-MISC from 2019;⁹ his was just one of 22 million. Low-income taxpayers often rely on Form 1099 income to qualify for refundable credits.

After taking Rodriguez’s case, GLS became concerned that other low-income taxpayers may have faced similar negative consequences from the IRS’s destruction of information returns. GLS submitted a Systemic Advocacy Management System (SAMS) complaint (No. 61208), “Improper Audits/Deficiencies Due to IRS Destruction,” on this topic in August 2022. It described Rodriguez’s audit and suggested it was likely triggered by the Form 1099 destruction. The complaint advised the IRS that it was submitted “due to the potentially large systemic nature of this problem.”

The IRS’s Systemic Advocacy Unit left GLS a voicemail closing the SAMS issue and advising that Rodriguez should have petitioned the Tax Court. It did not mention the systemic issue of improper audits. Follow-up emails from GLS to Systemic Advocacy pleading to reopen IRS review of the systemic issue went unanswered.

GLS submitted several FOIA requests to learn more.

Automated Correspondence Exams

The IRS uses an automated system to initiate the vast majority of exams based on several risk factors, or automated correspondence exam (ACE) “filters.” These filters are listed in the Internal Revenue Manual at 4.19.20.2(9), but the publicly available IRM is redacted. Tax returns with “indicators of potential noncompliance are assigned a risk score and made available for audit. Returns with no indicators of potential noncompliance are [not] made available for audit.”¹⁰ GLS requested that the IRS share the ACE filters in place to select 2019 returns for audit, but the IRS asserted an exception to FOIA to protect “techniques and procedures for law enforcement.”

In the absence of direct evidence, one must rely on the circumstantial. The IRS has warned tax return preparers and Volunteer Income Tax Assistance (VITA) program volunteers that a taxpayer who claims the EITC based on a “Schedule C without a Form 1099” should “raise a red flag.”¹¹ Several IRS webpages about the EITC warn against taxpayers inventing Schedule C income to claim tax credits. According to the IRS, “fictitious Schedule C’s especially those with no 1099 Misc support . . . that qualify for or maximize EITC is a growing problem.”¹²

The IRS also advises taxpayers that returns are chosen for examination “by computerized screening . . . or by an income document (for example, Form W-2 or 1099) matching program.”¹³ The IRS can match a taxpayer’s Forms 1099 to income claimed on their returns and may use a discrepancy in that information to select a taxpayer for audit.

Given the various IRS statements about what a “red flag” Schedule C income is, when a taxpayer qualifies for the EITC and has no corresponding Form 1099, it would be surprising if the IRS did not use this combination of factors as a strong indicator of potential noncompliance when assigning a risk score. It is also unclear how Rodriguez’s 2019 tax return was selected for audit if not for the mismatch between the Schedule C income he used to claim the EITC and IRS income records.

The IRS did provide GLS with data on the number of exams the IRS opened for 2019 tax returns that claimed the EITC based on Schedule C income that the IRS was not able to substantiate. For tax year 2019, the IRS opened 33,194 exams under project code (PC) 0288 “questionable Schedule C income.” That is the project code under which Rodriguez’s exam was opened. According to the IRS, the “focus of PC 0288, Questionable Schedule C with EITC, is to determine if the taxpayer had self-employment income.”¹⁴

That 33,194 PC 0288 exams were opened for tax year 2019 is unusual. On average, the IRS opened 10,263 PC 0288 exams each year from 2012 to 2020, excluding 2019. The only year that came close was 2017, but the IRS conducted more PC 0288 audits for tax year 2019 than 2017, despite having conducted 74,356 (36 percent) more EITC audits for tax year 2017 than 2019. The IRS just happened to audit more EITC/Schedule C tax returns for the year that it destroyed 22 million Forms 1099-MISC that could substantiate Schedule C income than for any other year from 2012 to 2020. That raises a red flag.

PC 0288 exams also constituted a disproportionate share of EITC exams for 2019. Excluding 2019, from 2012 to 2020, just over 3 percent of all EITC audits were initiated under PC 0288. For tax year 2019, nearly 16 percent of EITC audits were initiated under PC 0288, more than five times the average.

The IRS likely has an ACE filter that flags for potential audit Schedule C filers who claim the EITC without a corresponding Form 1099, and it appears these audits are conducted under PC 0288.¹⁵

Based on this presumption, GLS submitted a FOIA for a description of the safeguards the IRS put in place to ensure it did not initiate 2019 automated correspondence exams for taxpayers claiming refundable credits when the IRS may have destroyed information returns substantiating the income. The IRS had no responsive records.¹⁶

Without knowing the audit filters used to select 2019 returns, it is unclear what happened. However, the available facts paint a concerning picture. There is a strong likelihood that the IRS audited many low-income taxpayers because it destroyed the documents that would have substantiated income claimed on their Schedules C that they relied on to claim the EITC:

• For tax year 2019, the IRS destroyed about 22 million Forms 1099-MISC. Many would have been for taxpayers filing a Schedule C and claiming the EITC.

• The IRS warns return preparers and VITA volunteers that Schedule C income without a corresponding Form 1099 should raise red flags. It most likely raises a red flag to IRS audit selection algorithms.

• The IRS conducts audits based on an information return matching program.

• The IRS conducts audits under PC 0288 for taxpayers with “questionable Schedule C income” who claim the EITC.

• The IRS conducted more PC 0288 audits for 2019 than for any other year from 2012 to 2020.

• The percentage of EITC audits conducted under PC 0288 for 2019 was also substantially higher than in past years.

• The IRS has no record of safeguards put in place to ensure taxpayers who relied on Schedule C income to claim refundable credits were not audited because of the destroyed Forms 1099.

• The IRS continued opening exams under exam code 0288 and issuing notices of deficiency after being warned of the potential systemic risk.

• IRS auditors did not receive instructions regarding an apparent mismatch between Schedule C income and IRS wage and income records that may have been caused by the IRS destruction of documents.¹⁷

• 29,757 of the taxpayers who were audited under PC 0288 for 2019 received statutory notices of deficiency. This was the most of any year between 2012 and 2020.¹⁸

Those facts are more concerning in the context of low correspondence exam response rates. Generally, more than 40 percent of taxpayers fail to respond to correspondence exams. These taxpayers lose their audits by default. At least one IRS study indicates that the non-response rate may be higher for self-employed taxpayers claiming the EITC.¹⁹ That same study indicated that about 10 percent of correspondence exam letters are undelivered mail.

When a taxpayer does not respond, no examiner is assigned to an ACE.²⁰ For some taxpayers, the IRS audit selection algorithm may have selected their tax return for examination based, at least in part, on the IRS’s destruction of Forms 1099. This could have raised a red flag for Schedule C income with an EITC claim and no Form 1099. Then a computer would have sent a series of automated notices, which the taxpayer may not have received, culminating in a statutory notice of deficiency telling the taxpayer how much money they owe the IRS. It’s dystopian.²¹

Even when a taxpayer does respond, an audit can seem almost impossible to overcome. After review of Rodriguez’s audit, it is no wonder that more than four out of five taxpayers who are audited lose their audits.

There are some knock-on effects to the document destruction that go beyond just the audits. The IRS and Social Security Administration share information. For those who were audited and had their Schedule C income disallowed, their self-employment tax payments, which are netted out of refundable credits, are also disallowed. This will mean a smaller Social Security benefit upon reaching retirement age or if disabled.

The IRS’s SS-8 Unit determines worker classification status in which, for example, a worker wishes to challenge their classification by an unscrupulous employer trying to avoid payroll taxes and unemployment insurance. One GLS client had an SS-8 form returned, in part because he was unable to produce a 2019 Form 1099 from an employer and the IRS had no record of it, although they did have records from 2013 to 2018 and from 2020. The SS-8 analyst assigned to the case said that neither they nor their manager had heard of the document destruction.

Some taxpayers who were audited for 2019 and who had self-employment income disallowed may have problems in future tax years. Some may have received a two-year or 10-year ban from claiming the EITC.²² Many more would have received a recertification requirement to claim the credit in future years, which many taxpayers do not know how to comply with. If they claim the EITC without complying with the recertification requirement, the credit will be reversed using math error authority.²³

The disallowance of 2019 self-employment income also may have led to a reduced EITC for 2020 and 2021. Under the provisions of the Consolidated Appropriations Act of 2020 and the American Rescue Plan Act, taxpayers were allowed to use 2019 earned income to claim a larger EITC for 2020 and 2021 if their 2019 earned income was higher.

The IRS was asked to do a lot during the COVID-19 public emergency. It was asked to do it with a resource base that had been steadily shrinking for a decade. The IRS is not a villain but a resource-strapped federal agency asked to do more with less during a time of global emergency and great uncertainty. Some things may have fallen through the cracks. One of those things was probably updating ACE filters to ensure low-income taxpayers would not be unfairly audited. That hints at a larger problem with how the IRS views itself as an enforcement-first agency: a mentality that is incompatible with its modern role as the largest public benefits administrator in the country.²⁴