Dude, Free Dragon! and the Earned Income Tax Credit

I am looking at a report from the Treasury Inspector General for Tax Administration (TIGTA) dated March 31, 2014 and carrying the non-hummable title of

The Internal Revenue Service Fiscal Year 2013 Improper Payment Reporting Continues to Not Comply With the Improper Payments Elimination and Recovery Act.”

We have reviewed a number of previous TIGTA’a publications, and this one concerns the earned income credit. The initial idea behind it was laudable enough: it was intended to provide a floor to the most economically disadvantaged, while simultaneously diluting the disincentive as someone weaned off welfare and went back into the workforce.

Sounds good, right?

There is a card game called Magic: The Gathering. I have a number of friends who play, and one in particular who is a Tournament judge. Think of Dungeons and Dragons, translate it into a card game and you have Magic: The Gathering. The reason I bring it up is that there is a Magic card that allows one to put a dragon onto the board at no cost to the player. Dragons are as formidable as you would expect, so this is not insignificant in game context. The friends refer to it colloquially as “Dude, free dragon”!

The earned credit is the tax Code version of “Dude, free dragon”!

This credit was virtually built to be abused, and abused it has always been and will always be. One cannot turn down free dragons.

What does it take to power the earned income tax credit? It takes two things: earned income and a dependent child.

·        Earned income means that you have paid social security or self-employment tax on it. Workers compensation or unemployment, for example, will not power the EITC as one does not pay social security on either.

·       The other thing you need is a kid. Two is better than one. Three is better than two. Four is no better than three, so there is a limit to this escalation.

NOTE: There is a very limited credit for someone with little income and no children, but we will set that category aside for this discussion.

You need to have a job. Makes sense, if you remember what I said earlier about removing disincentives to return to work. A W-2 job is the easiest to understand.

Self-employment income will also do it. I suspect that any tax practitioner who has been around the block a few times has had or heard of an EITC client reporting self-employment income, likely with few if any expenses. The taxpayer is incentivized to lowball his/her expenses, as the credit can outstrip any additional taxes due from overstating his/her actual income. Alternatively, one might simply “make up” income, just to power the EITC.

You also need a kid. This is where it gets problematic, especially nowadays.  It can take the discipline of a sociologist to follow the convoluted trail of who-did-what-and-then-moved-in-with…. The bottom line is that a kid is the key to this ride. Having a kid, especially a kid you can “lend” out, becomes a commodity, and, like any commodity, the kid has value.

Where does a tax pro see this? Easy. How about two unmarried people who have a child together. One brings a child from a prior marriage. The facts make more sense if they maintain two households, but they wouldn’t be the first to live together and have two EITCs sent to the same address.

OBSERVATION: I am giving the IRS this one for free: check for two EITCs sent to the same address. You are welcome.

So you come to see me. You tell me that you are taking care of your on-and-off-girlfriend’s second daughter, because her mother is irresponsible and you have taken a liking to the girl. You are thinking of adopting, immediately after that around-the-world flight on a paraglider you are planning.  Coincidentally the kid also gives you an earned income tax credit. How am I to know whether this is really taking place, whether that the child is living with you and not with her mother, yada yada yada?

I will tell you what the IRS has said I am to do. Then I will tell you what I actually do.

The IRS keeps expanding what a tax preparer is to do when faced with an earned income tax credit.  Let’s go back to the Improper Payments Information Act that TIGTA referenced. This law goes back to 2002. TIGTA goes on to explain:

… the IRS’s estimates of Fiscal Year 2012 improper EITC payments were understated. They were based on an assumption that a provision in the American Recovery and Reinvestment Act of 2009 … that increased the EITC for certain taxpayers would expire at the end of 2010. However, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended the provision through 2012.”

Did you get that? The IRS did not update its 2012 estimates for a law passed in 2010. Amazing. Let a tax CPA do that and he/she will soon have no clients.

Let’s continue:

It was later extended through December 2017 by the American Taxpayer Relief Act of 2012.”

There is my second freebie to the IRS.

The EITC remains the only revenue program fund to be considered at high risk for improper payments.”

How much money are we talking about?

The IRS estimates that 22% to 26% of EITC payments were issued improperly in Fiscal Year 2013. The dollar value … was estimated to be between $13.3 billion and $15.6 billion.”

This is real money, even by Washington standards. So what was the IRS plan to deal with this?

The IRS announced a plan in January 2010 to register, license and create enforcement tools that would impact the paid preparer community more broadly.

Paid preparers assisted in the preparation of approximately 66 percent of all EITC claims paid in Tax Year 2008.”

Let me see if I get this right:

·       The IRS has a “Dude, free dragon” tax credit

·       People abuse “Dude, free dragon”

·       A normal person can hardly prepare his/her own taxes anymore, so he/she uses a preparer, therefore

·       Abuse of the EITC is the preparer’s fault

Right….

Let’s continue.

However, in January 18, 2013, a Federal Court enjoined the IRS from enforcing the regulatory requirements for registered tax return preparers.”

We discussed this in an earlier blog. The IRS was arguing that they could regulate preparers because of a Treasury decision having to do with government payment for horses after the civil war. The Federal Court said no; the IRS did not have legal authority and could not arrogate such authority to itself.

NOTE: Seems quaint reasoning, especially after six years of the current Administration, doesn’t it?

The IRS is miffed, sticks out its lip and pouts:

The Court ruling materially affects the basis on which the IRS planned to establish a baseline for meaningful reduction targets as previously indicated.”

So IRS Commissioner Koskinen is placing blame on the tax preparer community. If only the IRS could regulate preparers!

There is some truth to this. There are many grades of preparers. There are the classically-trained, such as tax attorneys and tax CPAs. There are also Enrolled Agents (EAs), many of which are quite good. Then we drop to people who have taken an H&R Block course. Then you have those that never even took the course. It is that last category or two that the IRS wants to reach, but they have been stymied.

In the meanwhile, you come into my office with an EITC. What does the IRS expect me to do?

Remember that the key is the kid. The IRS wants me to:

·       Review school records

·       Review health care records

·       Review child care provider records

·       Review social services records

And so on. If I don’t do this, I have to indicate to the IRS that I did not do so. On a form included with your tax return. The IRS reserves the right to later come to my office and review my files.

As much as I appreciate the opportunity to soothe my inner social worker, it seems a lot to ask for the few hundred dollars I may charge for that tax return.

So what do I do?

Easy. I do not accept a client with an EITC. Furthermore, I would also consider releasing an existing client who slips into the EITC, unless I know them well and have very strong confidence in their tax numbers. I have to, as the risk to me from that tax return is disproportionate.

I cannot afford to play “Dude, free dragon”!