One of the most frequent excuses for NQIs not complying with reporting obligations, over and above lack of awareness, has always been the failure of the IRS to penalise firms for problems in filing.

I thought the community should be aware that we are now starting to see the needle move. There have been a number of NQIs penalised for late reporting, sometimes going back as far as 2014 reporting season. In the latest case we’ve heard about, the issue was caused by a non-disclosing NQI adding new recipients.

It is important to remember that when we talk about ‘amended reporting’, that’s amending a return that was already filed. So, presuming that you gained the usual extensions and filed Forms 1042-S by April 14th, you can amend any or all of those forms up to the date that you file your tax return, Form 1042. This is normally done because of a combination of errors identified by upstream payors or by reclassifications of income, both of which lead to NQIs receiving amended reports after the main filing date. However, if an NQI realises that their report is missing some recipient copies, these would generate a penalty relating only to these new 1042-Ss, which are not technically ‘amendments’ but are actually late filings. This is an important concept to understand because the US Treasury almost doubled the late filing penalties in 2015.

This also highlights a likely underlying problem that often goes unnoticed. Typically a non disclosing NQI has an omnibus account at a QI or USWA. So, what they get from above is just a small number of 1042-S forms showing ‘undisclosed recipients’. The NQI now has to report each underlying recipient both to the IRS and to the recipient. From a regulatory standpoint, the 1042-S reports generated by the NQI should reconcile BOTH to the sum of the 1042-Ss received from above AND to the actual payments made to the recipients themselves. However, the IRS has no practical way of knowing (i) whether a recipient ever actually received a 1042-S or (ii) whether the reports delivered to the IRS represent anything other than a re-hash of the upper level 1042-Ss.

The same applies to QIs and it is not unknown for a QI to limit their reporting to a simple re-hash of the upper level reports into their own pooled reporting. For medium and small QIs this is likely simply because most just do not have the resources or understanding available to do what is actually mandated in the QI Agreement. It is easier to make sure there’s a match between a small number of upper level 1042-S forms and your own small number of pooled 1042-Ss, since that’s the only match the IRS is going to do directly. Provided there’s a match between the levels, the IRS has no immediate way of knowing what might (or might not) be going on. The actual mandate of course is to match not just the pooled reports a QI generates with the upper level reports, but also to match the polled reporting to the actual payments credited to recipient accounts. Since QIs don’t have to produce direct recipient 1042-Ss, again, the IRS is out of the loop.

The only way this is going to get picked up is at the time of the first Periodic Review and then it will depend on the knowledge and skillset of those performing the Review.

It looks to us as though the ramping up of the penalties that took place in 2015 and the imposition of penalties which seems, at worst, to be being backdated to 2014, signals a new phase in the IRS’ approach to enforcement. NQIs who have historically been complacent and QIs who have historically been under-resourced need to pay attention to these small but important ‘read between the lines’ signals that become visible to the market. That’s one of the reasons we always suggest (i) quarterly reconciliations with upstream payors to avoid a massive recon problem in Q1 each year and (ii) an Interim Periodic Review (IPR) to identify and correct the broader implications of this kind of mistake (see here).

As the enforcement ramps up in the background, ignorance (which has never been bliss) could easily be viewed as deliberate avoidance of the compliance obligations whether to the regulations themselves in the case of NQIs or the regulations plus the QI Agreement in the case of QIs.

Image Credit: Victor