Thursday, December 10, 2009

Why do low-income taxpayers have IRS targets painted on their backs?

The blogosphere has been reverberating with comments on an article by reporter Danny Westneat in the Seattle Times, $10 an hour with 2 kids, IRS pounces. (Tax Prof Paul Caron post here, TaxGirl Kelly Erb here, The Wandering Tax Pro Robert D Flach post here.)

Here are the relevant facts as the Seattle Times reported them in the article:

1) Taxpayer Rachel Porcaro was a 32-year-old single parent.
2) She made $18,992 cutting hair at Supercuts at $10 per hour in 2007.
3) She and her two children, ages 8 and 10, lived with her parents.
4) She paid her parents $400 per month in rent.
5) She claimed Earned Income Credit based on her children.
6) She also claimed her two children as dependents.
7) She was audited by the IRS.

First of all, it's important to note that all facts reported in the article come from Rachel Porcaro, her family, and her tax advisor. The Seattle Times contacted the IRS to get its side of the story, but confidentiality rules prohibit the IRS from commenting on individual taxpayers that it audits.

However, based on the facts reported in the article, I can say that situations like Rachel Porcaro's are very common, and very similar to many taxpayers whose situations are simple enough to qualify to use the free tax preparation services of a Volunteer Income Tax Assistance (VITA) site like the one we operate at Union College.

In fact, even the first level Basic VITA certification tests that my students will take in the first week of January will require them to demonstrate that they understand how to use the IRS-provided resources (Pub 4012 and Pub 17) to prepare an accurate tax return for taxpayers whose circumstances look very much like the article's description of Rachel Porcaro's situation.

The article reports that Rachel wondered why her return had been selected for audit:

"I asked the IRS lady straight upfront — 'I don't have anything, why are you auditing me?' " Porcaro recalled. "I said, 'Why me, when I don't own a home, a business, a car?' "The answer stunned both Porcaro and the private tax specialist her dad had gotten to help her. "They showed us a spreadsheet of incomes in the Seattle area," says Dante Driver, an accountant at Seattle's G.A. Michael and Co. "The auditor said, 'You made eighteen thousand, and our data show a family of three needs at least thirty-six thousand to get by in Seattle."

"They thought she must have unreported income. That she was hiding something. Basically they were auditing her for not making enough money."

Rachel Porcaro's curiosity is understandable, but the truth is that an individual taxpayer is not entitled to an answer to the question as to why her particular return was selected for audit. In fact, it's entirely possible that even the auditor did not even fully understand exactly why Rachel's particular return had been selected for audit.

Some of the IRS criteria for audit selection are classified, a closely guarded secret limited to a few high-level IRS employees. Rank and file auditors do not know all the details of the audit selection process. The IRS has considerable discretion in how it selects returns for audit. It is under no obligation to reveal why a particular individual's return was selected for audit, just as airport security is not obligated to reveal why it selected a particular airline passenger for a special inspection.

For research purposes, for example, the IRS may have good reason to select some returns entirely at random, in order to get information that will enable it to better target future audits. Alternatively, the IRS may want to select some tax returns entirely at random in order to discourage taxpayers from thinking that they can prevent detection simply by making their returns "look typical." That's the same reason that airport security occasionally chooses an innocent-looking 13-year-old girl or 90-year-old grandmother for a more extensive baggage inspection at the airport.

However, although the IRS won't reveal why it selected any particular individual's return for audit, it does release aggregate statistics showing the percentage of tax returns audited in various categories.

Those statistics show that the IRS audits a lot of taxpayers who look very much like Rachel Porcaro at rates much higher than the general public. The graph shown below demonstrates audit rates for EITC taxpayers at over double the rate of the average taxpayer.

TABLE 4. INDIVIDUAL INCOME AND EITC RETURN COVERAGE RATES (1997-2005)Source: Congressional Testimony National Taxpayer Advocate Nina Olson March 5, 2007

Rachel Porcaro's tax return was one of 25 million tax returns filed in 2007 claiming the Earned Income Tax Credit (EITC). Using the most recent statistics available on audit odds from the graph above suggests that about 625,000 EITC taxpayers like Rachel Porcaro had their 2007 tax returns selected for audit. Millions of EITC tax returns have been audited over the past decade. An IRS official has stated that only taxpayers with incomes above $200,000 have higher audit odds than EITC taxpayers.

Although we are not entitled to know specifically why Rachel Porcaro's return was selected for audit, American taxpayers are certainly entitled to inquire why EITC returns broadly similar to hers are selected for audit at such relatively high rates.

Rachel Porcaro's circumstances may sound straightforward, but the rules for figuring out whether she can claim her children on her tax return for a variety of benefits (dependent exemptions, child tax credits, additional child tax credits, child care tax credits, earned income tax credits, and Head of Household filing status) are surprisingly complex. I'll be talking about those rules in my posts over the next few days as I help my students prepare for the IRS VITA certification exam.

There is a good deal of evidence to show a very high error rate on simple tax returns that look very much like Rachel Porcaro's tax return. Some of that evidence comes from "Secret Shopper" visits to paid and volunteer tax preparers. Some of that evidence comes from studies of audited tax returns. Even highly credentialled tax preparers such as CPAs, attorneys, and enrolled agents have very high error rates on Earned Income Tax Credit returns. No matter who prepared the tax return, whether it was self-prepared, or prepared by a commercial preparer at a big chain like H&R Block, a volunteer at a VITA site, a small independent tax pro, credentialled or not, the error rates in studies are unacceptably high. I have previously posted about a recently released study that found the following EITC error rates on a random selection of EITC returns:

The error rates shown in the chart above range from 45% to 71%, depending on the type of preparer. The chart shown above is based on a random cross-section sample of 1999 tax returns, there are some methodological concerns, and the error rate has come down since then, but it is still too high. An IRS official recently quoted an estimate of 25% for the error rate on EITC returns.

Some of the errors on EITC are deliberate and intentional fraud, but many are honest mistakes due to the complexity in the tax law, especially the rules for what the IRS calls "Qualifying Children." Those rules are surprisingly complex for children who may live and/or be supported by multiple adults, and, to make matters even more confusing, the rules for claiming Qualifying Children changed significantly as a result of the Working Families Tax Relief Act of 2004. Ironically, that act was designed to simplify the tax rules by creating the so-called "Uniform Definition of a Qualifying Child (UDOC)." It turns out those rules aren't as "uniform" as the U in UDOC suggests, creating the potential for continuing confusion.

IRS audit statistics also show a good deal of underreporting of Adjusted Gross Income on EITC tax returns. Again, some of that underreporting may be deliberate fraud and some may be honest misunderstanding about the types of income that need to be reported on a tax return (e.g., Social Security benefits) and the types of income that do NOT need to be reported on a tax return (e.g., Supplemental Security benefits).

Whether it's fraud or honest error, the IRS is obligated to audit tax returns to enforce the tax laws. As Rachel Porcaro's situation demonstrates, enforcement actions can create a lot of confusion, stress, and expense for vulnerable taxpayers.

Congress could do a lot to simplify the tax code to reduce the burden of enforcement on taxpayers like Rachel Porcaro. Part of the reason that low-income taxpayers have targets painted on their backs is that Congress has made the tax law so complicated by putting so many bed buffaloes in the tax code.

I'll have more posts on this topic in the coming days.

Thanks to Ms. Porcaro for coming forward and putting a face on millions of taxpayers who have been audited for EITC returns in the past decade. She paid hundreds of dollars to H&R Block to prepare her tax return, but statistics show that there is still a significant likelihood of error on her tax return. She spent thousands of dollars and a lot of hours and anguish trying to establish her rights to claim her own children on her tax return.

The difficulties Rachel Porcaro faced are part of the reason why I so strongly stress the need for scrupulously careful tax return preparation at our VITA site. Every tax return prepared at our VITA site is prepared by an IRS certified volunteer, double-checked by a second IRS certified volunteer, reviewed again by the original volunteer who walks the taxpayer line by line through her tax return, and then triple-checked by me prior to submitting the e-file tax return for processing. All of this takes a good deal of time, but we feel strongly about preparing accurate tax returns for our taxpayers. We want to secure all tax benefits to which they are legally entitled, but we do not want to create any problems down the road if and when their returns are selected for audit.

1 comment:

  1. In many ways the tax code has been designed so that at any time and under nearly any circumstance any given taxpayer can be found to have errors in their tax return that profit the IRS. I think the only way to prevent this is to intentionally incorporate reverse errors into your taxes. Perhaps after three or four audits per form where the IRS needs to pay back money instead of getting more from the audit will discourage future audits. Its worth a try for those who have the time and money to afford it.