What does a recent performance audit by the Treasury Inspector General for Tax Administration (TIGTA) tell us about the IRS’s handling of Form 1042-S returns? And what measures is the IRS taking to its increase its scrutiny of this area?
- While a recent government audit of the IRS’s handling of Form 1042-S enforcement revealed continuing compliance gaps, the audit report indicates that the IRS’s ability and interest in enforcing Form 1042-S tax reporting has only increased over the past decade.
- The audit report also reminds us what a complicated endeavor Form 1042-S reporting has become, even as the IRS becomes more stringent in reviewing these tax information reporting returns.
- In order to reduce potential tax liabilities and maintain good customer relationships, financial institutions need to strive toward accurate Form 1042-S tax reporting.
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The Treasury Inspector General for Tax Administration issued a performance audit earlier this year on the IRS’s handling of Form 1042-S returns.
The June 2020 report confirms that the IRS’s ability and interest in enforcing Form 1042-S tax reporting has only increased over the past decade. It also reminds us what a complicated endeavor Form 1042-S reporting really has become.
Preparing Form 1042-S correctly
For a broker or other financial institution, Forms 1042-S that need to be prepared for U.S. source payments made to non-U.S. account holders are quite different from the Forms 1099 they file for payments to U.S. persons.
The biggest difference is likely to be that for Forms 1099, tax withholding is the exception rather than the rule. However, for Forms 1042-S the default rule is 30 percent tax withholding unless an exception applies.
For a Form 1042-S to be prepared correctly, a number of questions have to be answered.
Is the payment in question eligible for reduced withholding or exemption from tax withholding? If there is reduced withholding, what is the reason for the reduced rate, and is it supported by the documentation? If there is no withholding at all, which of the numerous exemption codes matches with the tax status of the payee and the income type in question? How does the payee’s FATCA status interplay with the payee’s regular (Chapter 3) tax status?
Each question is an opportunity for error, and the dollar impact to the U.S. Treasury of withholding mistakes has risen exponentially.
With the recent issuance of section 1446(F) withholding regulations, reporting will only become more complicated as withholding and reporting on sales of publicly traded partnership interests begin in 2022.
Closing Form 1042-S compliance gaps
The TIGTA report contained an interesting statistic.
In 2011, some 3.6 million Forms 1042-S were filed, with $12 billion of tax withheld. Fast forward to 2017 (the TIGTA report’s audit year) and we have 6.3 million Forms 1042-S filed and $528 billion withheld in taxes.
Understandably, the tax authority’s interest in Form 1042-S tax reporting enforcement has grown.
In 2018, the IRS both announced a new enforcement campaign relating to Form 1042-S compliance and updated its audit procedures manual relating to withholding agent Form 1042/Form 1042-S audits. Additionally, the recent TIGTA report and its recommendations are further indicators of the tax authority’s interest in closing any compliance gaps.
According to the TIGTA report for the 2017 audit year, there were 6,016 withholding agents that had discrepancies in their Form 1042-S filings that totaled $2.3 billion in tax.
The discrepancies were between amounts reported on Forms 1042-S and Forms 1042. The Forms 1042-S are the separate reports filed for different income payments paid to each recipient, and the Form 1042 is the annual return filed by the withholding agent that tallies the payments made on Forms 1042-S and the amount of withheld tax deposited with the Treasury.
The TIGTA report found that then-existing IRS filters identified 4,097 of the 6,016 withholding agents with reporting discrepancies totaling $2.1 billion, but did not identify the remaining 1,919 withholding agents with reporting discrepancies totaling more than $182.7 million.
There were also 366 withholding agents that claimed $506 million more in credits for tax withheld on Form 1042 than reported on Forms 1042-S.
While the report indicated that the IRS in some cases did not want to expend additional resources to take up 2017 tax cases or lower certain tolerance thresholds for review due to resource constraints, there were also revelations that the IRS was, on an ongoing basis, in the process of further tightening Form 1042-S enforcement.
How is IRS improving Form 1042-S tax reporting compliance?
For example, the report noted that the IRS had in place 12 ‘filters’ for identifying Form 1042/Form 1042-S data discrepancies. But it was also working on 12 additional filters to improve its screening/audit process. (We don’t know exactly what these filters are because the details appear to have been redacted from the report.)
There are also indications that the IRS is working to improve data reliability that would in turn improve the efficiency of Form 1042-S tax reporting review.
For example, a new requirement for Form 1042-S beginning in 2017 was that a Form 1042-S had to have a unique form identifier. This was implemented to allow the IRS to track amended and corrected forms issued to the same recipient.
The report indicates that processes at the IRS were being updated to make use of the unique form identifier. Moreover, there is a desire on the part of the IRS to allow for e-filing of Forms 1042. Currently, Forms 1042 have to be filed in paper format, which requires an additional level of data transcription at the tax agency to make the data usable for audit review (with also the possibility of transcription errors). This may change in the future.
IRS tightens tolerance thresholds
Finally, the report indicated in certain areas that the IRS was willing to tighten its tolerance thresholds at which it would review certain issues manually, even though this may require additional resources. This arose, for example, in TIGTA’s review of Form 1040-NR filings by non-U.S. persons claiming credit or refunds for tax that may have been over-withheld.
To support such claims for credit or refund, non-U.S. payees are generally required to submit a copy of the Form 1042-S they received that shows the amount withheld on the payment(s) to them.
TIGTA identified 7,910 Forms 1040-NR that claimed withholding credits without supporting Forms 1042-S and that were not selected by the IRS for review. These apparently fell below the IRS’s dollar threshold for manual review (its tolerance threshold).
Such reviews are labor intensive because there is no automatic matching of a Form 1040-NR tax return to a Form 1042-S since many, if not most, Forms 1042-S are issued without U.S. taxpayer identification numbers.
In this case, the IRS decided to lower its threshold for review at least at the margins to increase the number of the cases subject to manual audit.
Ferreting out reporting discrepancies
If there is something to be learned from the TIGTA report, it is that the IRS and Treasury have become increasingly serious about ferreting out Form 1042-S reporting discrepancies. Thus, there is increasing risk that mistakes in withholding and reporting could result in tax liabilities for withholding agents such as banks and brokers. Withholding agents become themselves liable for under-withheld taxes.
Moreover, mistakes in reporting also affect these firms’ customers, who may need to rely on the Form 1042-S to request an applicable refund or credit. Inaccurate Forms 1042-S become more problematic for customers as the IRS increases its scrutiny over these refund claims.
From reducing potential firm tax liabilities to maintaining good customer relationships, accurate Form 1042-S tax reporting has become increasingly crucial.
