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”!

State Tax Refunds And Debit Cards

I have noticed that more and more states are increasingly requiring individual income tax refunds to be electronically deposited or received on a debit card.

What got me thinking about this is Virginia’s decision to require electronic refunds, beginning with the 2013 tax season.  One can have his/her refund electronically deposited or loaded onto a debit card. There will be no physical checks.

Virginia is joining Louisiana and Oklahoma with its electronic refund/debit card policy.

I find myself recalling IRS issues with identity theft and debit cards this past filing season. The IRS has estimated that more than $5 billion was refunded to identity thieves in 2011.   A majority of these cases used direct deposits, including debit cards. Thieves prefer debit cards to a paper check, which may require a photo ID matching the taxpayer’s name to cash it. Makes sense.

So what does the identity thief need? He needs a name and social security number, preferably from someone who will not be filing a tax return. An address would also be nice. Find a foreclosed house. Maybe put a new mailbox on it. The thief fills out a tax return, making up the wages, withholdings and so on. As long as he is the first person using the identity for the tax year, it is – as one U.S. Attorney phrased it – a “remarkably simple crime to commit.” Couple this with a hard-to-trace debit card, and the IRS is almost sending cash through the mail.

Do you find yourself wondering how it is cheaper for a state to issue debit cards rather than a physical check? Say that Kentucky issues 1,200,000 refunds using physical checks. Kentucky has the cost of the checks, plus equipment, personnel costs and postage. If Kentucky associates with a debit-card-issuing institution (I am thinking the to-be-formed Hamilton Bank of the Bluegrass, as an example), they instead send one transfer to The Hamilton Bank, as well as a data base of the individual refunds. No mess, no fuss. One can see the savings to Kentucky.

I would – I mean The Hamilton Bank of the Bluegrass would – issue the debit cards. How does The Hamilton Bank make money? First, there would be the float while the debit cards carry balances. Second, there could be merchant fees upon use of the card. Third, The Hamilton Bank would allow one to withdraw cash, but only at conveniently-located-Hamilton-Bank-ATM locations in greater Cincinnati, northern Kentucky and the Bluegrass. Any other ATM’s would trigger a fee. Fourth, The Hamilton Bank would charge fees for inactivity, replacement cards and etc.  I am thinking this could be a sweet deal for me, er… I mean The Hamilton Bank of the Bluegrass.

Kidding aside, I do understand the states’ interest in moving tax administration to an all-electronic format. Practitioners have already seen some of the advantages of electronic processing: verification of receipt and filing, record of filings and payments, transcript deliveries and etc. Electronic refunds fit into this structure. However, the government cannot electronically refund to someone who does not have a bank account, which is how we wind up talking about preloaded debit cards.

Do You File Taxes With South Carolina?

Heads up if you file tax returns with South Carolina.

On October 26 the S.C. Department of Revenue announced that approximately 3.6 million social security numbers and almost 400,000 credit and debit card numbers were compromised.  

Government officials emphasized that no public funds were accessed or put at risk. No word from government officials on your whether your private funds were put at risk, though.

On October 10 the S.C. Division of Information Technology informed the Department of Revenue of a potential cyber attack. On October 16, investigators discovered two attempts to hack the system in early September. They later discovered that a previous attempt was made in late August. Government officials believe they have closed the vulnerability in the system.

If you have filed a South Carolina tax return since 1998, please visit protectmyid.com/scdor or call 1- 866-578-5422 to determine if your information is affected. If so, you can immediately enroll for free in one year of identity protection service with Experian.

The IRS Draws Congressional Attention

The IRS itself has been in the news recently. Whether it is the ham-handed treatment of Section 501(c)(4) political/nonprofit groups or the shadow funding of ObamaCare, the agency has been drawing attention and criticism. Today we are going to talk about two recent studies requested by Charles Boustany (U.S. Rep – LA). He presently serves as the Chairman of the House and Ways Subcommittee on Oversight.

The first report is titled “There Are Billions of Dollars in Undetected Tax Refund Fraud Resulting From Identity Theft.”  It addresses identity theft, which has been the number one consumer complaint with the Federal Trade Commission for 12 consecutive years.

The IRS presently processes returns and issues refunds before receiving the information forms with which to crosscheck. For example, if someone receives his/her Form W-2 and files for a refund in January, the IRS is issuing that refund check before the underlying wage information has been received from the employer, much less integrated into IRS information systems. This weakness has been exploited and has become a virtual cottage industry in certain cities such as Tampa, Florida.

Consider what TIGTA discovered:

·         2,137 returns resulting in $3.3 million in refunds were sent to one address in Lansing, Michigan

·         518 returns resulting in $1.8 million in refunds were sent to one address in Tampa, Florida

·         23,560 refunds totaling more than $16 million were issued to 10 bank accounts;  2,706 tax refunds totaling $7.3 million were issued to a single account

This is real money. TIGTA estimates that the IRS will issue almost $21 billion in identity-theft refunds over the next five years.

TIGTA made several recommendations, including:

·         Taking advantage of the information reporting available to the IRS. Social security benefit information, for example, is available in December - before filing season begins. Whereas this is a fraction of identity fraud, it is a positive step.

·         The IRS uses little of the data from its identity theft cases to develop patterns and trends which could be used to detect and prevent future tax fraud. Examples include whether the return was electronically or paper-filed, how the refund was issued, and, if issued by direct debit, the account number or debit card number receiving the refund.

·         Allow the IRS greater access to the National Directory of New Hires (NDNH). NDNH is a national database of newly-hired employees. It includes an employee’s name and address as well as wage information. By referencing information from prior year tax filings, the IRS could correlate NDNH data to determine whether reported wage reporting and claimed withholding appear fraudulent.

·         Encourage banks and work with federal agencies to ensure that direct deposit refunds are made only to an account in the taxpayer’s name.

·         Limit the number of tax refunds issued via direct deposit to the same bank account or debit card.

NOTE: That recommendation seems obvious.

“Substantial Changes Are Needed to the Individual Taxpayer Identification Number Program to Detect Fraudulent Applications”

The second report is disturbing. IRS employees had contacted Congress directly about supervisor misconduct and potential fraud in a program that reviews and verifies individual taxpayer identification numbers (ITINs). Congress then called in TIGTA to investigate.

We should explain that an ITIN is an Individual Tax Identification Number. ITINs were started in 1996 as tax identification for individuals who may have U.S. tax filing requirements but are not eligible for social security.

How can this happen?

·         Consider a German businessperson who invests in and receives income from a Miami shopping mall

·         Consider a Nigerian graduate student attending the University of Missouri (many) years ago with yours truly

·         Consider my brother-in-law’s wife, who is English and married to a U.S. citizen 

An ITIN will allow one to open a bank account and file tax returns. For example, if one’s spouse is English and one lives in England, the spouse will need an ITIN to file a U.S. income tax return. The children – who possibly have never been to the U.S. – will need ITINs to be claimed as dependents on the U.S. income tax return.

OBSERVATION: This is one of the absurd consequences of the U.S. worldwide income tax regime. A U.S. citizen has to file tax returns, even if he/she has lived outside the U.S. for many years, has a family outside the U.S. and has no immediate plans of repatriating to the U.S.

When one finally obtains a green card, one can transfer work and wage information from the ITIN to the Social Security Administration.

One applies for an ITIN by filing a form (Form W-7) and attaching supporting documents to verify one’s identity and foreign status. A passport will satisfy both the identity and foreign status requirements. The IRS will otherwise accept a combination of documents, including a foreign driver’s license, a foreign birth certificate, a foreign voter’s registration, a visa or other IRS-listed documents. The process usually takes place through the mail, which means that no US-agency employee actually sees the person applying for the ITIN.

Unfortunately, ITINs have been swept-up in political battles. For example, there is fear that the IRS will share this information with Immigration, although the IRS is not permitted by law to do so. This may discourage people from obtaining ITINs, so the argument goes. On the other hand, there are states that will allow one to obtain a driver’s license solely with an ITIN, which seems a perversion of its intended purpose.

TIGTA goes into the IRS to investigate the complaints. Here are some of its findings:

·         IRS management is not concerned with addressing fraudulent applications in the ITIN Operations Department because of the job security that a large inventory of applications to process provides. Management is interested only in the volume of applications that can be processed, regardless of whether they are fraudulent.

·         IRS management has indicated that no function of the IRS, including Criminal Investigation or the Accounts Management Taxpayer Assurance Program, is interested in dealing with ITIN application fraud.

·         IRS management has:

o    Created an environment which discourages tax examiners responsible for reviewing ITIN applications from identifying questionable applications.

o   Eliminated successful processes used to identify questionable ITIN application fraud patterns and schemes.

o   Established processes and procedures that are inadequate to verify each applicant’s identity and foreign status.

Good grief! The IRS disbanded an ITIN team that was having too much success, countered by provided virtually no training to new hires and transfers and put negative evaluations in overly-eager reviewers’ files.

TIGTA made nine recommendations in this report. The IRS agreed with seven and has already announced plans to implement interim changes. One has caused quite the consternation in the immigrant community by requiring copies of original documents with ITIN applications.

OBSERVATION: Let’s be fair here: would you be comfortable sending original copies of anything to the IRS? Assuming you can find that birth certificate from the mother country, how are you going to replace it when the IRS loses the thing?

A Tax Crook Story

I have previously argued against draconian laws to protect against the morally unscrupulous. The key concept here is draconian: the little good the law does is far outweighed by its burden on society. Sometimes I believe that recent tax regulation is approaching this line.

And then I read about Todd Halpern, a tax preparer in New Jersey.

In 2008 Halpern purchased a tax preparation business from the widow of the prior owner. He received all the computers and client records in the purchase. Makes sense: the widow didn’t need them. The new practice required a new electronic filing number, but Halpern did not obtain one. He kept the previous owner’s number. Why? Because Halpern’s criminal record would keep him from getting a new number.

Then he prepares a tax return for the mom of a client. The problem is that the mom had no income. She collected social security and was claimed as a dependent on her son’s return.  Halpern falsified her return, using fake income and deductions, to generate a refund. To complete the loop, he had the refund deposited to his account.

He kept doing this. After all, what could go wrong? The IRS estimates that he received approximately $375,000 in diverted refunds between July and August, 2009.

The guy is a crook. There exist enough laws to put him in jail.

Or maybe he can run for Congress.

The IRS and Identity Theft

One of the downsides of increased electronic tax filing is increased identity theft. We had one of our e-filings intercepted this year by the IRS for identity mismatch. The IRS did not accept the e-file and instead required a paper return with Form 14039, Identity Theft Affidavit, attached.

I was looking at (OK, I was skimming) a report from the Treasury Inspector General for Tax Administration issued May 3rd. Imagine my surprise to learn that the IRS has no special procedures for our return with Form 14039 attached.

The IRS considers the paper filing to be a duplicate return and does not immediately process it. An employee enters a transaction code into the taxpayer file to memorialize receipt. The return then goes to a separate queue to be worked on, possibly after April 15 when the filing season has ended. The IRS transfers the file to Duplicate function for initial review. If Duplicate considers it an identity theft case, the file is again transferred, quite likely to the Accounts Management function. It is there assigned an assistor, who requests copies of the original tax returns and begins the process, including correspondence, of determining who the legitimate taxpayer is.

This process is slow and the refund can be delayed until late in the year or even the following year. The average case resolution is 414 days.

The assistor very likely works in Accounts Management. The problem is that these employees also answer the toll-free telephone lines during busy season. According to TIGTA, 87% of assistors working identity fraud also answered the phones, and 60% stated that they worked the toll-free line exclusively. TIGTA considers the optimal assistor inventory (that is, caseload) to be 100 to 125 per assistor, but the average assistor had an inventory exceeding 300 cases.

The identity problem is new enough that IRS guidelines are spread out over almost 40 sections in the Internal Revenue Manual. Sometimes the guidelines are inconsistent. The IRS in addition does not have procedures to spot trends which could be useful in detecting or preventing future fraud. One problem, for example, is sending notices to the last address of record, which could just be the person perpetrating the fraud.

Training has also been an issue. TIGTA’s survey showed that almost half of the assistors believed that their training was not sufficient. In one office, 13% of assistors had received no identity theft training.

To be fair, the IRS has agreed with TIGTA’s findings and has begun implementation of many recommendations. For example, there will be specialized units in Accounts Management to work only identity fraud cases.

Then we have Congress. Three representatives this week introduced the “Fighting Fraud Act,” which would double the current penalties for tax preparers who are involved with identity theft. The intent is to give the IRS greater incentive to prosecute this type of theft, presumably because the potential payoff is greater.

Really? This is the best the mandarin class can dream up? Here is an idea: the IRS assigns a PIN to every preparer. Require every professionally-prepared return to require the preparer’s PIN. If a preparer is involved with this type of nonsense, the IRS revokes the PIN and bans the preparer from working before the IRS.

Will this stop the completely unscrupulous? Here is a question in return: in human history, has it ever been possible to stop the completely unscrupulous?