Expatriates Take Note: IRS Slipshod Work and Secrecy Prevent Taxpayers From Obtaining Critical Records

According to a report (TIGTA Report) dated July 13 2017, by the Treasury Inspector General for Tax Administration (TIGTA), the Internal Revenue Service (IRS) systematically loses and destroys important taxpayer records due to carelessness and negligence. The TIGTA Report details the calamities — computer hard drives are erroneously destroyed or damaged; the IRS does not follow its own policies requiring it to document records that have been searched; IRS policies for preserving records from separated employees are woefully inadequate; repeated changes in IRS’ electronic media storage policies combined with reliance on employees to maintain records has led to confusion and loss of records; a recently instituted executive e-mail retention policy, which should have resulted in the archiving of e-mails was not implemented effectively simply because some personnel did not turn on the automatic archiving feature!

It can’t get much worse than this; or can it?  Trust me, it can! IRS employees have been known to flush returns down the toilet and hide them in their homes when the workload became overwhelming. Despite the damning TIGTA Report and the toilet etc. escapades we have had IRS agents with 30 years of experience claim as late as 2016 that they have “never experienced or observed the IRS losing a return.” See In Re Michelle McGrew v. IRS, (US Bankruptcy Court, Northern District Iowa, October 13 2016) at page 7.  Sounds incredulous.

The TIGTA Report noted this 2014 incident:

We found that when an employee separated from the IRS in August 2014, the employee left his laptop with his secretary. That employee was under a litigation hold to ensure that relevant evidence was preserved for use in litigation. However, without a policy in place to ensure that laptops of separating employees under litigation holds were maintained, that laptop was sent to the IT organization for standard sanitization and disposal.

Even Freedom of Information Act Responses Were Found Lacking

Even when taxpayers request files from the IRS under the Freedom of Information Act (FOIA), the IRS work has been somewhat careless and one is left with little confidence that the agency will make a serious attempt to find the requested documents. FOIA enables the public to request access to Federal records and information. The IRS’ ability to adequately respond to FOIA requests is essential in maintaining the public’s trust and ensuring transparency in this government agency.  Yet, the TIGTA Report found numerous problems with the FOIA requests including these: “the search methods used were not properly documented in accordance with IRS policies, did not identify all potential custodians, and erroneously concluded that records associated with separated employees had been destroyed when potentially responsive records were available. Federal laws governing FOIA searches, IRS policies for responding to congressional requests, and court procedures all include specific guidance that requires adequate searches of records in response to external requests. However, in some of the cases reviewed, documentation of IRS search efforts in response to requests for records was not adequate.”

In addition, federal law mandates that FOIA requests have explicit response deadlines – specifically, Federal agencies are required to respond to requests within 20 business days of receipt, and can request an extension of 10 working days. If an agency grants a FOIA request, the law requires that the agency make responsive records “promptly available” to the requester.  TIGTA examined almost 50,000 closed FOIA cases during its audit period.  The IRS records indicated that over 36,000 FOIA cases were closed in 20 business days or less. For the almost 13,000 remaining cases, the average closing time was 51 business days. In reviewing the remaining cases that had much longer processing times, TIGTA found that 100 cases took between one and two years to close, and three cases took between two and 2.5 years to close.

Expatriates Take Note

How can the IRS’ carelessness jeopardize the average American taxpayer? One area involves the disagreement between the IRS and a taxpayer as to whether a tax return was ever filed for a particular year.  Any taxpayer facing this problem is confronted with a Herculean task to prove he filed the “missing” return.  This is a serious problem for any taxpayer but it can be particularly harrowing if the taxpayer is an American living and working overseas.  Often times, a taxpayer living Stateside can prove the IRS lost a federal tax return by showing his State tax return that was filed. Many US States have a tax system that mirrors the federal system and may even require the taxpayer to attach a copy of the federal tax return to their State return.  On the contrary, a US taxpayer living and working abroad typically has no need to file any State tax returns since he will have broken residency with the State.

Missing Tax Return Can Jeopardize Foreign Earned Income / Housing Exclusions

Most Americans working abroad know they may be eligible to exclude certain foreign earned income (wages, compensation for services) and housing amounts from US taxable income.  This means that, unlike their counterparts working in the USA, they won’t be taxed on some or all of the amounts paid by their employer when they are living and working in a foreign country. These exclusions are permitted under the rules governing the Foreign Earned Income Exclusion (FEIE) and  Foreign Housing Exclusion (FHE) of Section 911 of the Internal Revenue Code.  A tax return must be filed within certain time limits in order to claim these exclusion benefits by filing an election to take them.

What happens if a taxpayer moves abroad and has filed tax returns making the election, but the IRS later asserts that a tax return was never filed for the year(s) in question? Under the relevant tax rules, claiming the exclusions is permitted for any tax year, no matter how far back and no matter when the delinquent returns are filed so long as the IRS has not taken the first step and notified the taxpayer of their failure to make the election and that tax is owed.  On the other hand, if the IRS contacts the taxpayer first, the benefits can be denied – this can happen if the taxpayer owes any amount of federal income tax. If the taxpayer fails to keep a copy of the return and proof of filing it with the IRS, he may be out of luck.  This is particularly troublesome if the “missing” tax return is an earlier tax return claiming the FEIE/FHE election, since once the election is made it carries over to all subsequent tax years if not revoked by the taxpayer. In any event, counting on the IRS to have a copy of the tax return is foolhardy, especially in light of the recent TIGTA Report.

Gifts or Bequest from A Former American?  Can You Prove Five Years of Tax Compliance?

The IRS’ lack of good record-keeping should be of great concern to Americans receiving gifts or inheritances from former US citizens or green card holders since these individuals may be called upon to prove that the former American from whom they received the gift or bequest was, among other things, fully tax compliant for the five year period prior to relinquishing US status (i.e., he must prove the individual was not a so-called “covered expatriate”).  Internal Revenue Code Section 2801 imposes a tax on US recipients of certain gifts and bequests received from “covered expatriates”.  Such “covered” gifts or bequests may be taxable to the US recipient of that gift or bequest at the highest gift or estate tax rate in effect at the time of receipt. Currently, the highest Gift and Estate Tax rate is 40%. Under recently proposed IRS Regulations implementing Section 2801, the compliance burden is firmly placed on the US recipient of a gift or bequest from a foreign person to determine if the Code Section 2801 tax might apply to the recipient.

When the US recipient is tasked with determining whether the person from whom he received the gift or bequest was a “covered expatriate”, he or she really needs proof about the status of that foreign person and such proof may entail the necessity to have the former American’s tax returns to hand.  One can imagine that obtaining this proof may be difficult, if not impossible – especially if the gift or bequest is received many years after the expatriation has taken place.  You cannot count on the IRS to have maintained the former American’s tax records!

My tax blog post discusses this topic in detail.  The rules concerning gifts or bequests from former US persons are extremely complicated, yet they must be understood and planning must be set in motion in order to prevent possible disastrous tax consequences occurring later.

TIGTA Recommendations

TIGTA made five recommendations related to improving the IRS’ policies for record retention and responding to external requests for records, including recommendations that IRS implement an enterprise e-mail solution  enabling it to comply with Federal records management requirements, and agency-wide dissemination of its newly issued policy on the collection and preservation of Federal records associated with separated employees. Not surprisingly, IRS management agreed with all five of TIGTA’s recommendations.

Will things really improve?  Let’s wait and see, but I am not holding my breath.

My Recommendations

Taxpayers have to be proactive and take matters into their own hands whenever possible. This means maintaining their own tax return records and proof of filing; if relevant, it also means encouraging family members who have expatriated to get their records in order!  We can help.

All the US tax information you need, every week — Just follow me on Twitter @VLJeker

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