More thoughts on Rachel Porcaro

Ms. Porcaro, the Seattle hairdresser and single parent of two boys who spent a lot of money contesting an IRS audit, has been much on my mind.

By coming forward to share her story, Rachel Porcaro has put a face on the faceless millions of low-income taxpayers who have been audited in the past decade. As I noted before, the IRS feels obligated to audit so many low-income taxpayers with refundable credits because there are very high error rates on their returns, some due to deliberate fraud, and some due to honest errors caused by the complexity of the tax code (all those bed buffaloes in the tax code!)

Of course, when the IRS chooses a return for audit, they can't know for sure, in advance of the audit, whether there are errors on that particular tax return, so inevitably some perfectly compliant, innocent, honest taxpayers are going to be caught up in the audit process, which can cost a lot of time, trouble, anxiety, and money to straighten out.

According to National Taxpayer Advocate Nina Olson, many honest compliant taxpayers just give up and don't even try to defend their position.

Rachel Porcaro provides a glimpse into the burdens that low-income taxpayers determined to prove their compliance may face.

She hired a CPA/attorney tax pro, Dante Driver, to help her with the IRS audit. According to the press coverage, the IRS was initially demanding $16,000 in additional taxes, interest, and penalties for her 2006 and 2007 tax returns. After spending $8,000 in legal/accounting expenses, she managed to get the IRS to agree to a lesser figure of $1,600.

That's a lot of legal fees for a low-income single mom to be spending. Her attorney, Dante Driver, has stated that even the final $1,600 was contestable, but the legal cost of fighting any longer was just not worth it.

Did she have any alternatives?

I've been thinking a lot about the alternatives that face low-income taxpayers like Rachel Porcaro, who are audited at rates much higher than the general public. Her story makes a good case study.

What can a low-income taxpayer in her situation do when faced with an IRS audit and a demand to pay back a very large sum of money, almost as much as she makes in an entire year?

Alternative #1: Get help from her original tax preparer
The Seattle Times reported that H&R Block prepared Ms. Porcaro's original tax returns. The H&R Block website states that it will provide a substantial amount of free assistance and support to any of its customers who are audited. They will also pay for any penalties and interest that resulted from errors made by their preparers. Customers who pay the optional $30 "Peace of Mind" fee are entitled to even more support. An IRS-credentialed Enrolled Agent employed by Block will represent Peace of Mind taxpayers at their audits, and Block will also pay up to $5,000 of additional tax liability assessed by the IRS at such audits.

Hindsight is 20-20, as they say, but in retrospect, it seems that Rachel Porcaro might actually have been at least a little bit better off if she'd opted for the $30 Block "Peace of Mind" plan in 2006 and 2007. (Of course, there is a good deal of fine print on those Block guarantees, and in order to collect the penalties and interest and $5,000 per year in additional tax liability reimbursement, she would have needed to establish that it was Block's errors that created the problem, not her own errors. Arguing with a tax pro about whose error was actually responsible for the additional tax liability could be a tough challenge for typical taxpayers. Also, it should be noted that any amounts reimbursed by Block under their Peace of Mind guarantees would constitute taxable income on her next year's tax return! So, the bottom line for the Peace of Mind guarantee isn't so clear after all.)

In any case, it's understandable that Rachel Porcaro didn't pay the $30 for the Block Peace of Mind program. Back at the time she filed her 2006 and 2007 tax returns, she probably did not realize that low-income taxpayers are audited at rates much higher than the general population.

Alternative #2: Get free help from a Low Income Tax Clinic As a low-income taxpayer, Rachel Porcaro was also entitled to contact a Low Income Tax Clinic (LITC). There are 168 LITC programs located around the country, mostly at law schools. These are private non-profit programs that receive funding from the IRS to assist taxpayers in audits and other IRS legal matters. Taxpayers with incomes up to 250% of the poverty level are eligible for assistance, so Rachel Porcaro would certainly have qualified.

Fortunately, because Rachel Porcaro lives in Seattle, she is close to one of the largest LITC programs in the country, the University of Washington Low Income Tax Clinic. The clinic received a $91,000 IRS grant this year, the largest such grant awarded in the country. The University of Washington Low Income Tax Clinic has also benefited from the generosity of the Gates family as it is located in a modern and well-equipped building named after Bill Gates' father, William H. Gates II, someone who clearly cares a great deal about tax equity.

What are the odds that the University of Washington Low Income Tax Clinic will be able to help a taxpayer like Rachel Porcaro?

Not very good.

According to the Brookings Institution EITC database of IRS statistics, Rachel was just one of out of 154,000 low-income taxpayers in the greater Seattle-Tacoma-Bellingham area served by the clinic who filed a tax return claiming EITC in 2006. Using figures from Nina Olson's 2007 Congressional testimony, we can estimate that 2.5% of those EITC tax returns were selected for audit.

That means that there were 4,000 other low-income working taxpayers like Rachel Porcaro whose returns were audited in the Seattle area last year.

The University of Washington runs the only low-income tax clinic in the greater Seattle area (Seattle-Tacoma-Bellingham metropolitan area). According to their website, "During 2008, the clinic handled 132 cases through the IRS administrative process and 67 cases in the United States Tax Court."

So the University of Washington assisted less than 200 taxpayers in 2008, and surely not all were EITC taxpayers. The clinic director mentions, for example, assisting senior citizens, who also need tax help but who typically would not be included in the EITC statistics since they rarely claim it.

Even if all 200 University of Washington cases had been EITC cases, that means that about 5% of the low-income EITC taxpayers like Rachel Porcaro whose returns were selected for audit last year got free help from the only LITC in greater Seattle.

So where does that leave Rachel Porcaro and the overwhelming majority of the EITC audited taxpayers that the clinic can't serve? Unfortunately, their remaining options are not very good. According to a recent study published National Taxpayer Advocate Nina Olson, the vast majority of low-income taxpayers go to their audits without any legal representation.

Alternative #3: Do-it-yourself approachRachel Porcaro could have tried contesting the audit on her own, but she's a hairdresser, not a tax expert. A hairdresser going into an IRS audit probably feels very much like she's in a David vs. Goliath situation.

Even TaxGirl Kelly Erb, an experienced tax lawyer who used to work for the IRS as an auditor herself, felt "that it was a "completely different feeling"" when she was preparing for her own audit recently.

It is, I must say, a completely different feeling.

For those of you who have never been audited, let me advise that the experience isn’t fun. The requests for information can be somewhat overwhelming – especially for a small business. Our bookkeeper has spent days and days putting together charts and reports. We’ve been printing out ledgers and bank account statements and desperately looking for supporting documentation. It’s all part of the examination process.

If an experienced tax lawyer like Kelly was daunted by her audit, how do you think a hairdresser like Rachel Porcaro would feel? Especially if the IRS is demanding $16,000 in taxes and penalties from someone making $10 per hour cutting hair.

National Taxpayer Advocate Nina Olson recently published a study showing that low-income taxpayers who go to an audit without representation are twice as likely to come out of the audit with negative results (i.e., losing their EITC and/or owing additional tax) as those who have legal assistance.

As noted above, Rachel Porcaro wound up hiring a very expensive CPA/attorney and spending $8,000 in fees to contest the IRS audit.

Such professionals are very expensive--and few of them specialize in the kind of tax law that applies to low-income working taxpayers like Rachel Porcaro.

Billing rates for attorney/CPAs can run hundreds of dollars per hour.

According to the press coverage, Rachel Porcaro made $10 per hour cutting hair at SuperCuts.

At that rate, it would take her 800 hours of cutting hair to pay off the legal bills run up during her audit.

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.

Dave Williams and the Earned Income Tax Credit

Next week, my former student David Williams, who is now Director of Electronic Filing and Refundable Tax Credits at the IRS, will be speaking to my public finance class. Before joining the IRS, Dave worked as an aide to Senator Bill Bradley, who chaired the Senate Finance Committee during the 1990s. One of Dave's big projects with the Senate Finance Committee staff was working on the legislation to the Earned Income Tax Credit (EITC) as part of the welfare reform movement. The Washington Post ran a profile featuring Dave's work, David Williams: IRS Official Greatly Expanded Anti-Poverty Program.

Under the old AFDC welfare system, the odds were stacked heavily against a welfare recipient ever getting off of welfare. For every dollar of income she earned, under the old system, she would lose more than a dollar in benefits, once taxes were taken into account. The expansion of the EITC that went into effect as part of the mid-90s welfare reform was designed to make work pay, and it has led to a significant increase in people working their way out of the poverty trap.

For my public finance students, and anyone else who wants to learn more about the Earned Income Tax Credit, the Tax Policy Center provides an excellent introduction here. The EITC is now the biggest federal cash anti-poverty program in existence. Here is a graph drawn from that introduction, which illustrates the complex web of phase-in and phase-outs of the Earned Income Tax Credit.



As you can see, the EITC has both phase-in and phase-out ranges. When a taxpayer's income and number of qualifying children places him in the phase-in range, he actually faces a negative income tax rate. Effectively, the government is subsidizing earned income, providing matching money of up to 45 cents on the dollar for those taxpayers. Eventually, the subsidy levels off and reaches a plateau, where additional amounts of earned income do not change the amount of the subsidy for a while. After the plateau, the subsidy begins to decline during the phase-out region until it declines to zero. During the phase-out region, the taxpayer may face a very high marginal tax rate when you consider the regular income tax, the payroll tax, the phase-out implicit tax, and possibly state income taxes and phase-outs as well. (The new health care bill has subsidy phase-out provisions that may add to that effective marginal tax rate as well.)

In addition to the federal EITC shown above, many states offer EITCs that piggy-back on the federal EITC. For example, New Yorkers may qualify for a state EITC that is 30% of the federal credit.

The bottom line is that a low-income parent with two or three children working full-time at minimum wage may get a combined federal and state tax EITC refund which is equal to over 50% of her earned income for the year. The EITC could easily make the difference between the family living below the poverty level and above the poverty level.

There are lots of tradeoffs involved in designing the EITC--there is no perfect system, and it's a matter of trying to do the best one can with limited revenues. However, there's a lot of evidence that EITC has been successful in helping many previous welfare recipients start to work and develop human capital and ultimately become self-sufficient, moving into higher paid jobs where they may no longer need subsidies. A recent study, Stepping Stone or Dead End? The Effect of EITC on Earnings Growth, found that many EITC recipients have increased their earnings substantially over time. On the other hand, there are a number of concerns about the EITC, including the very severe marriage penalty for many EITC recipients.

Refundable credits are a "growth industry" these days as the government seems to be loading more and more policy programs onto the shoulders of the IRS. There is a strong and legitimate concern about the potential for fraud with refundable credits. There are particular concerns about systematic large-scale fraud by tax preparers who may fabricate returns with refundable credits, sometimes without the knowledge or consent of the taxpayer whose name is on the return. In some cases, this may involve identity theft, so the IRS has a lot to be worried about. On the one hand, it wants to make sure that all those who are legitimately entitled to refundable credits receive the proper amounts they are due under the law. On the other hand, the potential for abuse means that the IRS needs to take steps to ensure that fraudulent tax returns are detected and those who perpetrated them receive their due civil and criminal penalties. The IRS has a tough balancing act, as always.

It's not perfect, but overall, economists and political leaders on both the right and the left have embraced the EITC as a general success. The idea originally came from conservative economist Milton Friedman's proposal for a "negative income tax," but liberals have also hailed the concept as a successful one. There is strong empirical evidence that it has increased labor force participation rates among the poor and broken the cycle of welfare dependency for many families who had not worked in generations. We'll be talking more about this in class with David.

Stepping Stone or Dead End? The Effect of the EITC on Earnings Growth

The Earned Income Tax Credit (EITC) has many complex provisions which could affect economic behavior.

Past research has analyzed data indicating that

EITC raises labor force participation rates among single mothers, especially those with little education

EITC does not reduce marriage rates (despite the large marriage penalty built into the EITC!)

EITC does not promote higher birth rates (despite the large tax benefits associated with claiming one or two "qualifying children" on a tax return.)

A new study published in the June 2009 issue of the National Tax Journal tackles a new question about the effects of the EITC:

[D]o single mothers who are pulled into employment by the EITC improve their labor market outcomes through increased earnings over time or do they remain stuck in low-earning jobs? On the one hand, we might expect increases in earnings over time. Evidence suggests that even among less-skilled groups, the returns to labor market experience are large (Gladden and Taber, 2000, 2006). On the other hand, we might not expect increases in earnings over time if the employment opportunities available to such single mothers are limited to ‘dead-end’ jobs that have with little potential for future earnings growth.

The authors' conclusion:

Using a panel of administrative earnings data linked to nationally representative survey data, we find no evidence that the EITC expansions between 1994 and 1996 induced single mothers to take “dead–end” jobs. If anything, the increase in earnings growth during the mid–to–late 1990s for single mothers who were particularly affected by the EITC expansion was higher than it was for other similar women. The EITC encourages work among single mothers, and that work continues to pay off through future increases in earnings.

Molly Dahl (Congressional Budget Office), Thomas DeLeire (University of Wisconsin, Robert M. LaFollette School of Public Affairs) & Jonathan Schwabish (Congressional Budget Office) Stepping Stone or Dead End? The Effect of the EITC on Earnings Growth.

hat tip: Taxprof Paul Caron

Did welfare reform work for young single mothers?

Via Mark Thoma, a Federal Reserve Bank of San Francisco article says the answer is yes. Their graph above shows how welfare dependency rates and caseloads have declined since the mid-90s "welfare reform" movement that replaced AFDC (Aid to Families with Dependent Children) with TANF (Temporary Aid to Needy Families.)

In addition, states were given mandates to place strict time limits on the welfare rolls, along with incentives and funds to provide welfare recipients with job training and job search assistance to enable them to leave the rolls quickly. In addition, the Earned Income Tax Credit (EITC) provided cash incentives to "make work pay." Under the old AFDC system, many welfare recipients faced an implicit marginal tax rate in excess of 100% if they took a job. Welfare reform and the EITC have changed that system.

Since Congress overhauled the U.S. welfare system in 1996, single mothers between 18 and 24 have reduced welfare dependency, increased workforce participation, and registered gains in household income. The group's growing attachment to the labor force means they may be better positioned to take advantage of unemployment insurance during the current recession.

The entire article is very much worth reading: Did Welfare Reform Work for Everyone? A Look at Young Single Mothers.