The Internal Revenue Service is permitting millions of dollars in potentially improper self-employed retirement plan deductions to be claimed, according to a new government report, which estimates that up to $71.4 million over five years could be saved with better controls.
Self-employed taxpayers are able to deduct contributions made to their Simplified Employee Pension, or SEP, plan, or another qualified retirement plan account, on line 28 of their individual tax returns under certain circumstances, according to the report, which was heavily redacted in its public release Thursday. The report also noted that the IRS could make better use of third-party data to detect potentially improper SEP deductions, and if it improved its controls, it could realize up to $29 million in revenue over five years.
A Simplified Employee Pension is a retirement plan that allows self-employed taxpayers to make contributions toward their own and their employees’ retirement without getting involved in a more complex qualified plan, the report noted. Under a SEP, self-employed taxpayers make contributions to a traditional Individual Retirement Arrangement that is established for each eligible employee. Employees own and control their SEP IRA. Employers can also create SEPs by executing a formal written agreement that provides benefits to all their eligible employees.
SEP IRAs are managed by financial institutions or entities that have been approved by the IRS to serve as third-party trustees. They are required to annually notify employers, employees and the IRS of the contributions made to SEP IRAs by filing a Form 5498, IRA Contribution Information. An analysis of the 5498 forms for tax year 2011 revealed that more than 207,000 taxpayers had SEP contributions, for a total of $1.7 billion.
Self-employed taxpayers can claim deductions for contributions to a SEP, a Savings Incentive Match Plan for Employees (SIMPLE) or another qualified retirement plans on line 28 of Form 1040. To be eligible for a deduction for contributions to their own retirement plans, taxpayers must be self-employed. A self-employed taxpayer’s compensation needs to be reported on a Form 1040; Schedule C, Profit or Loss from Business (Sole Proprietorship); Schedule E, Supplemental Income and Loss; or Schedule F, Profit or Loss from Farming.
For contributions to their own retirement plan account, self-employed taxpayers take a deduction on line 28 of Form 1040. For SEPs, the deduction on line 28 is limited to the smaller of a maximum contribution amount, or 25 percent of the self-employed taxpayer’s net earnings.
TIGTA’s review focused on the IRS’s controls for providing reasonable assurance that SEP deductions that are intended for self-employed taxpayers are accurate and that the amounts deducted are consistent with the amounts reported on third-party payer documents submitted by trustees and financial institutions. TIGTA also reviewed how controls over SEP deductions affected other self-employed retirement plan deductions on line 28 of Form 1040. Deductions that were made on behalf of employees on a corresponding Schedule C, E or F were not included in the scope of the audit.
By following up on improper deductions identified by TIGTA, the reports said the IRS could potentially protect more than $14 million in revenue for tax year 2011. In addition, if the IRS improves its controls in this area for future tax return processing, it could protect more than $71 million in additional revenue over five years.
For tax year 2011, approximately 200 taxpayers who did not file a Schedule C, E or F to report their net earnings from self-employment claimed more than $2 million in SEP deductions on line 28 of Form 1040. Since taxpayers are not required to state on line 28 whether the deduction they are claiming is for a SEP or another type of self-employed retirement plan, TIGTA used Form 5498 information returns that are filed with the IRS subsequent to the individual tax returns to determine that these taxpayers were contributing specifically to a SEP.
TIGTA reviewed a random sample of 50 of these accounts and verified that these taxpayers contributed to a SEP and claimed a deduction on line 28, but they did not file a Schedule C, E or F to indicate that they were self-employed. Reporting net earnings from self-employment is a requirement for taking a SEP deduction on line 28, TIGTA noted.
TIGTA also reviewed the tax accounts for five taxpayers who would have had a significant tax increase if their line 28 deduction had been denied in tax year 2011 and determined that four taxpayers had each claimed potentially improper deductions of up to $17,500 on one or both of their previous two tax returns. Of the five taxpayers, three had taxable income that exceeded or would have exceeded $100,000 had the deduction not been allowed.
In response to the report, IRS management disputed several of the report’s findings. “While we believe actions can be taken to improve the execution of existing processes, we generally disagree with the facts and conclusions presented in the report,” wrote Peggy Bogadi, commissioner of the IRS’s Wage and Investment Division.
She also disagreed with TIGTA’s conclusion that controls are not in place to detect potentially improper SEP deductions. “Current procedures are in place to determine whether taxpayers claiming SEP deductions on the Form 1040 reported self-employment income on the tax return,” she wrote. “Employees are instructed to deny the deduction if there were no evidence that the taxpayer reported self-employment income on Schedule C, Profit or Loss from Business (Sole Proprietorship), Schedule E, Supplemental Income and Loss, or Schedule F, Profit or Loss from Farming.”