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EITC Fraud: A Good Tax Credit Meets Bad Accountants

Ilana Novick

While the IRS aims to increase EITC participation through last week's EITC Awareness Day, the agency has another, equally challenging goal: increase EITC participation without increasing fraud, which, according to a report from the Treasury Inspector General for Tax Administration, costs the IRS billions of dollars in post-refund examinations and recovering lost funds. 

The TIGTA report also found that from 2006 through 2009, taxpayers claimed almost $470 billion in refundable credits. After post-refund examinations revealed discrepancies between actual and reported incomes, taxpayers were required to repay over $2.3 billion in false credits. By the end of December 2011, the IRS had recovered an estimated $1.3 billion, of which more than 70 percent was collected through refund offsets. 

Sometimes these overpayments were due to unintended errors in taxpayer-provided information such as in income reporting on the W-2 form and especially confusion over qualifying children. Much of the fraud however, is caused not by the recipients but by unscrupulous tax preparers, IRS Taxpayer Advocate Nina E. Olson told Reuters. This is not a case of undeserving clients getting more money than they deserve, but of the tax professionals, especially those whose fees depend on the size of their clients' refunds. 

The actual fraud methods vary, but many of the worst offenders avoid the required employer-verification required for salaries by using fake or misreported Schedule C tax forms, common among small business and not subject to verification except during audits. The clients, short on time and information, don't often question the preparer's work, especially when the size of the refund (unlike for the preparers) determines the difference between being able to pay bills or not. 

The fake forms and misreported incomes are too often discovered after the fact, and are responsible for the escalating costs and hassle of recovering erroneous credits or legal fees, such as in March of 2012, when the Justice Department shut down Instant Tax Services, which according to Reuters, the Justice Department called, "tax fraud mills that reported inflated incomes and often did not tell people it was filing tax returns for them." 

While that case resulted in a lawsuit, the TIGTA report instead recommends broader structural changes to administering the EITC to prevent future abuse. As of December 2011, there is a $500 fine for each failure to comply with IRS's due diligence rules for the EITC, as well as a minimum penalty for tax professionals who prepare a return within which the IRS finds any errors due to intentional disregard of the rules.

TIGTA's recommendations supplement these fines with 1) an account indicator for EITC applicants who submit false claims. The indicator would be applied to the account for a specific time period, during which the taxpayer would have to provide documentation before the refund is processed; 2) freezing and verifying claims for the ACTC on all returns for which the EITC is frozen; and 3) additional collaboration with the Treasury Department to produce legislation that would expand due diligence requirements for preparers even further. 

The IRS agreed with most of the recommendations, but decided instead of using the recommended account indicator to develop and apply pre-refund examination filters to each application for the EITC and other refundable credits, to ensure historical information is available and used as selection criteria. 

These changes, if and when they are implemented, will help strike a balance between preventing fraud and making sure the credit is used correctly, and that the millions of Americans who are elligible for it are getting the financial help they need.

Working poor families shouldn't have their EITC refunds padding the bank accounts of unscrupulous tax preparers.