Some taxpayers are receiving automatically generated IRS notices of underpayments and penalties with respect to Form W-2 income tax and FICA withholdings, unemployment taxes, and backup withholding, as well as other year-end individual information returns. This LawFlash addresses some of the areas covered by these IRS notices relating to payroll taxes, equity compensation, and various types of information returns—including Forms 1099—and how taxpayers can resolve them.
Changes to tax forms and return-processing systems to reflect legislative enactments such as the Families First Coronavirus Response Act (FFCRA), Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the Consolidated Appropriations Act 2021, and the American Rescue Plan Act have led to increased taxpayer confusion. This confusion, has, in turn, further disrupted accurate return processing capabilities within the IRS. Our clients, for example, have been receiving system-generated IRS notices with surprising frequency that demand payment of tax underpayments, and oftentimes penalties. Such erroneous notices compound the IRS’s record processing backlogs brought on by the COVID-19 pandemic.
In most instances, taxpayers can resolve the underlying erroneous tax and penalty assessments by providing the IRS with clarifying factual information, supporting records, step-by-step computations illustrating the basis for the error, and detailed explanations of applicable law. The Service Centers’ issuance of these notice and demand tax and penalty letters is expected to increase considerably in 2022 and 2023.
The IRS’s return-processing systems were slow to recognize the elective deferral of any deposits of employer-share Social Security taxes on wages paid from March 27, 2020 through December 31, 2020, as permitted by the CARES Act. Employer quarterly employment tax returns (Forms 941) for the first quarter of 2020 were not designed to reflect this deferral. IRS systems continued to have problems processing subsequent versions of Forms 941 for later quarters. Many employers received troubling IRS notices of underpaid taxes and penalties (the latter often collected automatically from other tax payments by offset). These errors often took months to resolve.
These problems should be compounded as employers begin depositing with the IRS the first half of their employer-share Social Security taxes deferred from 2020, a payment which is due no later than January 3, 2022. (The statutory deadline is December 31, 2021, but since that day is a holiday, the actual deadline is delayed until January 3, 2022.) The second half of these deferred taxes is due a year later, on January 3, 2023. (See our prior LawFlash on the importance of timely and fully depositing deferred employer-share Social Security taxes.)
In brief, starting in late October 2021, the IRS sent thousands of employer special notices— designated as “CP256V Notices”— that detail the amounts of employer-share Social Security taxes deferred from the different quarters in 2020 that the IRS believes are scheduled to be repaid at the end of 2021. Many employers have not yet received these notices while the employers that have received them believe that some of their deferrals, and some of their repayments, have not been correctly processed, and thus the amounts slated for repayment do not match employer records. Employers are also concerned that if they fail to designate their repayments to the correct quarters, any overpayment allocated by IRS systems to one particular quarter in 2020 will not necessarily be carried over to cover amounts of deferred Social Security taxes due for other quarters.
The stakes for proper allocation of employer repayments are very high. According to unofficial, surprisingly harsh (and controversial) IRS guidance - PMTA 2021-07, “Penalty for Failure to Deposit Taxes Deferred Under CARES Act Section 2302(a)(2),” (dated June 21, 2021, but not released until August 2021), the IRS warned that if full repayment of each of the two halves of the employer-share Social Security taxes deferred in 2020 is deposited by the year-end due dates in 2021 and 2022, the IRS will consider the deferral “completely invalid” and can assess the 10% Section 6656 failure-to-deposit penalty on 100% of the amounts deferred.
Credits are applied against the federal unemployment taxes (FUTA) for state unemployment taxes (SUTA) that generally reduce the FUTA tax rate to 0.6% on the first $7,000 of wages (i.e., $42 per employee). Many of our clients have reported problems with IRS processing of their Forms 940, since the allowed credit for SUTA taxes has not been properly applied, causing IRS systems to calculate tax underpayments and penalties that can take many months to resolve.
These problems will likely be compounded starting in 2023, since the available SUTA tax credit will be reduced for states that have had federal loans outstanding on January 1, 2021, and that have not been repaid within two years. There were extraordinarily large state loans for unemployment benefits triggered by pandemic unemployment benefits, which many states may take longer than two years to repay. This so-called “FUTA credit reduction” automatically reduces the current 5.4% credit for SUTA taxes at a rate of 0.3% per year while the loan remains unpaid, starting in the third year that the loan is outstanding. Thus, the per-employee FUTA tax will increase by $21 per year in states with outstanding loans from the federal government until the state has fully repaid its loan.
It is expected that IRS return processing systems will struggle to process Forms 940 once SUTA tax credit rates begin to vary on a state-by-state basis. This issue will likely be compounded for employers operating in multiple states with different SUTA tax credit rates.
The IRS, for many years, has been following up its annual “B-Notices” to employers (which notify the employer of name-TIN mismatches on information returns) with additional notices that either propose penalties for incorrect Forms 1099, or that assess taxes (applicable in cases where B-Notices have been sent for individual employees in two out of three payment years). Penalties and related tax assessments can often be reduced (or even eliminated) by proof that the incorrect information was provided by the payee-employee, and not due to a payor-employer mistake.
However, given the upcoming scheduled decrease in the reporting trigger for information returns sent by “payment settlement entities” under Section 6050W, which, beginning in 2022 reduces the threshold for sending information returns to $600 in annual payments (reduced from the pre-2022 trigger of $20,000 or 200 payments), it is likely that hundreds of thousands, and possibly millions, of payees will start receiving Forms 1099-K. Thus, it is expected that starting in spring and summer 2023 (as IRS systems process Forms 1099-K that are due to be filed with the IRS by the end of January 2023), IRS processing systems will identify substantially more name-TIN mismatches.
Accordingly, payors sending Forms 1099-K should not only take particular care in accurately collecting names and TINs from payees to prepare for these January 2023 filings, but also be prepared to respond to expected penalty and possible tax-assessment notices that could follow.
Automated IRS systems do not limit their processing for penalty purposes only to mistakes in the 1099-series of information return filings. Recently, several clients have received penalty notices alleging that they have not complied with Section 6039, which requires special information return reporting on incentive stock options (ISOs) and on stock transfers under employee stock purchase plans (ESPPs). Specifically, for ISOs a Form 3921 is required to be sent to the IRS and the employee when an ISO is exercised, and for ESPP options a Form 3922 is required to be sent to the IRS and the employee when the broker transfers stock to the employee’s brokerage account.
Congress enacted Section 6039 to ensure that ISO stock transfers are reported (since that transfer potentially triggers Alternative Minimum Tax if the ISO stock is not sold in the year of transfer), and that ESPP stock sales are reported (since “qualifying dispositions” of stock trigger compensation income that is hard to trace, is not deductible by the employer, and often is never reported on Form W-2). Surprisingly, however, Treas. Reg. § 1.6039-1(b)(3) was amended by the IRS in 2009 to provide that the deposit of ESPP shares by a broker into an employee’s brokerage account would trigger Form 3922 reporting, even if the exercising employee did not sell stock in the year of exercise.
IRS processing systems track Form 3921 and 3922 filings and send penalty notices (Notice 972CG) to employers who fail to file. In response to such penalty notices—in the case of employee reporting—it can often be shown that the employer has provided the required information to employees on forms other than Forms 3921 or 3922. And—at least in the case of ESPP filing penalties—it can be argued that any failure to file Form 3922 with the IRS is an “inconsequential failure” per Treas. Reg. § 301.6721-1(c)(1), because any filing of Form 3922 with the IRS indicating merely that stock was transferred to the employee’s brokerage account is itself not an ESPP “income event.”
Employers and payers should continue to monitor required filing guidance, and to make sure tax returns and information returns are correct and timely filed. Should an IRS notice and demand letter be received, care should be taken to review the information, and to request correction and abatement when errors are discovered, or when reasonable cause supporting penalty abatement exists.
We stand ready to assist companies with respect to any and all information return filing and payroll tax questions, and, in particular, to help respond to any IRS notice and demand tax and penalty letters.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
New York
Mary B. “Handy” Hevener
Anna M. Pomykala
Washington, DC
Steven P. Johnson
Jonathan Zimmerman