The Internal Revenue Service hasn’t been properly vetting millions of dollars in deductions claimed for the qualified business income tax break that could be erroneous, according to a recent report.
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The deduction can be taken by owners of domestic businesses operated as a sole proprietorship or through a partnership, S corporation, trust or estate. Along with individual taxpayers, some estates and trusts can also claim the Section 199A deduction. However, businesses like accounting firms, law firms, consultancies, financial services providers, performing arts organizations, athletic teams and brokerages aren’t allowed to claim the deduction if the principal asset of the business is the reputation of its employees or owners.
Starting in tax year 2019, the IRS developed two forms for taxpayers to use when figuring their QBI deduction: Form 8995, "Qualified Business Income Deduction Simplified Computation," and Form 8995-A, "Qualified Business Income Deduction."
The IRS developed 17 new business rules last year to identify potentially erroneous QBI deductions, in addition to two rules previously used in 2019. TIGTA found that 16 of those 17 rules were working correctly by identifying and rejecting tax returns that had a specific error condition as defined under those rules.
For the remaining rule, the IRS disabled it from Feb. 23 through March 22, 2020, because it was erroneously rejecting tax returns that didn’t generate the specified error. The IRS corrected the programming for that business rule on March 22, and TIGTA confirmed that the revised programming was working as intended.
Despite those business rules and filters, the IRS still isn’t catching millions of dollars in potentially erroneous QBI deductions, according to TIGTA. The report is partially redacted so it isn’t clear what criteria were being used, but TIGTA’s analysis of tax returns filed last year as of April 16 identified 12,980 tax returns for 2019 claiming about $57 million in QBI deductions for which the filer’s qualified business income is in some way in doubt. In response to a recommendation from TIGTA in an earlier report, the IRS established a process to identify tax returns with QBI deductions for which the claimant didn’t meet these criteria.
However, although the IRS is now able to identify these types of claims, it’s taking no action at the time the tax returns are processed to make sure the filers are entitled to the deduction. Tax examiners in the IRS’s Error Resolution Unit are reviewing the returns, but it isn’t clear from the redactions what they are doing with them, However, the report points out that the problems could stem from simple input errors by taxpayers, such as inadvertently entering their standard deduction amount on the line that’s supposed to be for the QBI deduction. The IRS does flag those returns to be potentially selected for a post-processing examination to make sure they qualify for the QBI deduction.
Of the 12,980 tax returns identified by TIGTA, 12,480 with QBI deductions totaling nearly $37 million met the IRS’s dollar thresholds and were flagged. However, TIGTA found that the dollar “tolerances” set by the IRS to select a return for an examination results in the majority of those returns not being examined. TIGTA analyzed them and determined that 11,897 of the 12,480 tax returns (that is, 95.3 percent) didn’t meet the IRS’s dollar tolerance to be selected for post-processing compliance treatment. That means the QBI claim is allowed and not reviewed to ensure it’s valid. Those 11,897 tax returns claimed $28.2 million in QBI deductions.
In contrast, the IRS denied QBI deductions for 58 of the 68 tax returns for 2018 that were examined, as of May 2020, totaling more than $4.3 million. According to the IRS’s examination results, the taxpayers agreed with the change to the QBI deduction, acknowledging they did not qualify, in 57 out of the 58 cases.
TIGTA also found that employees in the IRS’s Submission Processing Code and Edit function didn’t correctly process paper-filed tax returns claiming millions of dollars in QBI deductions. Its review of more than 2.8 million paper-filed tax returns identified 31,196 that included a QBI deduction. Further analysis by TIGTA of the 31,196 returns identified 5,193 paper-filed tax returns with QBI deductions totaling $45.3 million that were incorrectly processed.
TIGTA made five recommendations to the IRS to improve its ability to verify QBI deductions, and the IRS agreed or partially agreed with two of the recommendations, but disagreed with the other three. Several of the recommendations were redacted from the report, but in response to one of them, the IRS plans to update Forms 8995 and 8995-A and to evaluate tax returns for 2020 that claimed a QBI deduction to determine if there’s an increasing compliance risk that warrants additional compliance actions.
Eric Hylton, commissioner of the IRS’s Small Business/Self-Employed Division, disagreed with the report’s finding that $48.7 million in potential tax revenue could be derived from the erroneous QBI deductions.
“This measure assumes the results of a small sample of 68 examined returns can be extrapolated to the population of returns identified by TIGTA as being similar, an assumption that is not statistically supported,” he wrote in response to the report. “Additionally, the IRS has determined that taking the actions suggested during processing activities could harm taxpayers and increase risks. Conversely, to pursue post-processing compliance activities would create an opportunity cost that would reduce overall revenue potential by diverting resources from other productive workstreams.”
