photo by Ken Teegardin
The Internal Revenue Service is nearly synonymous with headache-inducing bureaucracy and institutional inflexibility.
In some cases, this reputation springs from misinformation, or simply the fact that no one looks forward to filing - or paying - their taxes. It’s the same reason dentists get a bad rap. The IRS fulfills a necessary but unpleasant function.
Sometimes, though, it seems the IRS goes out of its way not only to meet the public’s dubious expectations, but to top them.
One of the many services Palisades Hudson provides is helping clients who are not U.S. citizens to navigate and comply with U.S. tax law. There are many reasons that international clients might need such assistance. A recent one brought our firm up against IRS immovability in a new way.
A client of ours who is based in Brazil breeds quarter horses and enters them to compete in reining competitions. These competitions happen all over the world, including in the U.S. The client won a National Reining Horse Association competition in 2011, which brought him about $96,000 in prize money.
Since our client is neither a citizen nor resident of the U.S., the IRS required 30 percent of the gross amount be withheld for income taxes. To ensure that foreigners don’t earn money in the U.S. and take it back to their home countries without paying their required U.S. income tax, the IRS requires the withholding on what the Service defines as Fixed or Determinable Annual or Periodical income. Racing purses are considered FDAP income, and so are generally subject to the withholding unless the horse’s owner is exempt and submits Form W-8ECI to the racetrack operator or, in this case, the competition organizer. The form certifies that the income is effectively connected with the conduct of a U.S. trade or business and that the receiver will report the income on his U.S. nonresident alien income tax return.
While the NRHA had to withhold 30 percent of the gross award because our client did not submit a Form W-8ECI, the withholding did not take into account any deductions for such expenses as the costs of transporting the horse from Brazil to the U.S., training fees, competition entry fees, veterinary bills, etc. We determined that this income was effectively connected with our client conducting his horse competition business in the United States, and that our client was due a $17,000 refund of the $29,000 in tax withheld from the gross winnings. We decided to pursue the issue, as $17,000 is a hefty amount to lose to Uncle Sam for not submitting a form.
Since we believed the client was due a refund, he would need to file a nonresident U.S. tax return. While Americans simply report their income to the IRS under their Social Security numbers, noncitizens must apply for an Individual Taxpayer Identification Number, or ITIN, in order to report their U.S. income. The ITIN application, the tax return, and the supporting documents all need to be submitted to the IRS together.
By chance, right around the time last year that we submitted the initial return and application, the IRS implemented interim changes to the ITIN application process. The changes, which became permanent in January, were designed to “ensure ITINs are used for their intended tax administration purposes” - rather than, presumably, for purposes such as fraud.
The biggest change to the application process under the new regulations was that applications are no longer accepted if they simply include notarized copies of the documents proving the taxpayer’s identity and foreign status. Instead, the application now requires either original supporting documents or “certified” documents (exact copies issued by the document’s original issuing agency). Due to the new requirements, our client’s initial request for an ITIN was rejected. In consequence, so was the return.
This began a cycle in which we tried to secure an ITIN for our client repeatedly, and the IRS denied each of his applications. Part of the problem was that, in Brazil, passports are issued through the Brazilian Federal Police. They don’t issue certified copies. Our client, whose business requires frequent international travel, had no desire to part with his passport for as long as IRS approval would take, not to mention the risk of the Service losing his passport altogether. We had to look for alternate solutions.
When my colleagues Larry Elkin, ReKeithen Miller and I recently visited Brazil, we had the opportunity to meet with our client in person. He entrusted us with the original copies of his national identification card and birth certificate, which the IRS accepts as alternate supporting documents to prove foreign identity. When we returned to the U.S., we once again submitted the application, including an explanatory letter.
Once again, the IRS rejected the application.
Apparently stymied, we decided to contact the Taxpayer Advocate Service. The service (commonly referred to by its initials, TAS) is a department within the IRS, but functions as an independent organization. Its goal is to make sure that taxpayers know and understand their rights, and to help overcome hurdles in communication with the IRS. The office was created in the mid-1990s to replace the earlier Office of the Taxpayer Ombudsman. In fiscal 2012, the TAS said it received nearly 220,000 new cases.
We submitted the aptly named Form 911 - a request for taxpayer advocate assistance - in late June. Given that we had been trying to secure our client an ITIN for almost a year by that point, I wasn’t overly optimistic about the speed and effectiveness of a response.
However, about one week later, an advocate called us to say she had been assigned to the case. After I explained the situation, she had me send her the original identification documents, which the IRS had sent back to our office a week prior to its latest rejection notice. The advocate also had me send a copy of the power of attorney form authorizing me to represent my client before the IRS.
She mentioned that I did not need to resubmit the ITIN application and tax return, even though prior rejection notices stated that the applicant must complete a new application and submit a copy of the return each time. Doing so, the advocate explained, restarts the clock for the application process, but the previous application and return remain valid for one year from the date received by the IRS as long as the valid supporting documents are received within that time frame. The IRS’ rejection letter failed to mention this important detail.
Our advocate called me in late July to inform me that she had received the documents and had hand-delivered them to the ITIN Operation Department, since her office happened to be located in the same building. She also informed me that we should expect to receive a reply within a few weeks. Although I was pleased with the responsiveness, service and communication the advocate provided, I was still skeptical that this process would result in my client receiving his ITIN.
Yet in early August, a letter with the client’s newly issued ITIN arrived without fanfare in our office.
While the IRS ought to try to prevent tax fraud in any legal way it thinks best, the new restrictions on ITIN applications have the side effect of making it so aggravating for some noncitizens to submit a tax return that many will likely give up and let the government keep more of their U.S. earnings than it should. Although this may not be the Service’s express intention, it is certainly the perception the new regulations create. It’s hard to imagine this outcome actively worries too many IRS administrators.
The Taxpayer Advocate Service, however, proves that the Service need not embrace its image as a labyrinth of aggravating red tape. Even if the right hand doesn’t know what the left hand is doing, at least the left hand is still there to straighten the right hand’s mess.