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IRS Needs Significant Additional Controls in Its Role as Disbursing Agent for Refundable Tax Credits

Expert Witness: Fulcrum Inquiry
In two reports made public in December 2009, the IRS Inspector General concluded (i) the IRS ignored previous recommendations, causing significant refundable tax credits to be paid improperly, and (ii) by improperly issuing taxpayer identification numbers, the IRS allowed billions of dollars of fraudulent refundable credits.

In two reports made public in December 2009, the Treasury Inspector General for Tax Administration (“TIGTA”, but usually referred to in the rest of this article as the IRS Inspector General) found that:

1. The IRS ignored previous recommendations as to how to administer the First-time Home Buyer’s Credit, causing significant refundable tax credits to be paid to those that are not entitled to the payments under the law, and

2. The majority of Individual Taxpayer Identification Numbers (ITIN) issued by the IRS (the identification obtained by those who are not entitled to social security numbers) are missing
important documentation needed to support issuance of the numbers. Consequently, the vast majority of ITINs should not have been issued. Billions of dollars of improper/fraudulent refundable credits are being paid using these numbers.

Surprisingly, the press has given this story little attention. The Obama administration needs to provide significantly greater attention to the Treasury Department’s IRS operation.

Recovery Act credits are being paid to many not entitled to these benefits.

The IRS is apparently unwilling to take compliance of the First Time Homebuyer Credit seriously. The manner in which the IRS is addressing (or in this case not addressing) compliance with this credit has now been addressed by three separate reports of the IRS Inspector General.

The American Recovery and Reinvestment Act of 2009 ("Recovery Act”) included a tax credit for certain first-time home buyers as part of the $787 billion of spending that President Obama signed in mid-February. The Recovery Act provides $252 billion and $74 billion in tax breaks to individuals and businesses, respectively. Tax benefits for individuals include the first-time homebuyer credit, residential energy improvements, and the “Making Work Pay” credit designed to reduce tax bills for working families. For businesses, the tax credits include renewable energy investments, accelerated depreciation and loss carrybacks.

The First-time Homebuyer Tax Credit allows anyone who hasn't owned a primary residence in the past three years and earned less than a specific income threshold ($75,000 for individuals, $150,000 for married couples) to obtain a refundable tax credit of up to $8,000 if they bought a primary residence on or after January 1, 2009. President Obama’s program expanded a similar but less-generous home buyer tax credit that had been established in the Housing and Economic Recovery Act of 2008. In November 2009, the First-time Homebuyer Tax Credit, which would have otherwise expired on November 30, 2009, was (i) extended to April 30, 2010 and (ii) expanded to include those who already own homes.

In November 2008, the IRS Inspector General memorialized its recommendation (in report no. 2009-40-142) that the IRS (i) use information provided by taxpayers claiming the credit to verify eligibility to receive the money, and (ii) require that taxpayers provide documentation to verify that a home had actually been purchased. One standard and easy-to-provide piece of documentation is U.S. Department of Urban Development Settlement Statement (HUD-1), which homebuyers receive as part of their escrow closing.

The IRS disagreed with both recommendations. The IRS claimed that the suggested requirement would be burdensome and would prevent up to 2 million taxpayers from e-filing. The IRS Inspector General memorialized its recommendation at the time (in report no. 2009-40-142) as follows:

“On November 25, 2008, we issued a memorandum to the Commissioner, Wage and Investment Division, outlining our concerns that controls would not be adequate to prevent an individual from erroneously or fraudulently claiming the credit and receiving the maximum $7,500 credit.”

In the next audit on this subject, entitled “The Internal Revenue Service Faces Significant Challenges in Verifying Eligibility for the First-Time Homebuyer Credit” (no. 2009-41-144), the IRS Inspector General looked at the returns that were being filed. The IRS Inspector General concluded:

“Key controls were missing to prevent individuals from erroneously claiming the Credit. Despite recommendations made in our November 25, 2008, memorandum as part of a prior audit, the IRS did not use information provided on the First-Time Homebuyer Credit (Form 5405) to verify eligibility requirements to claim the Credit and did not require taxpayers to provide documentation to substantiate the purchase of a home. As a result, TIGTA identified 19,351 Tax Year 2008 electronically filed tax returns on which taxpayers claimed Credits totaling over $139 million for homes that had not yet been purchased.”

The IRS response to this finding focused on wishful thinking that perhaps the problem was not that bad. The IRS response states:

“The report notes that approximately $140 million in credits were paid to taxpayers who indicated a future purchase date for the home, when they should only be eligible after purchasing a home. … While it is true that the IRS should have rejected the claim as improperly filed, if the taxpayer did indeed purchase a home prior to December 31, 2009 and refilled the claim after the purchase date, the credit would still be due.”

In December 2009, the IRS Inspector General made public a third report on the subject. The third report, entitled “Evaluation of the Internal Revenue Service’s Capability to Ensure Proper Use of Recovery Act Funds” (no. 2010-41-011) addressed additional programs under the Recovery Act. The Inspector General found that the lax or nonexistent processes identified with the new home credit extended to the majority of the Recovery Act benefits.

Tax refunds (such as those provided in the Recovery Act) should be verified before monies are disbursed. The ability to retrieve moneys later is substantially more difficult. The report describes this as follows:

“The ability of the IRS to verify the accuracy and eligibility of tax benefits and credits before a tax return has completed processing and prior to release of funds is the most efficient and effective approach for the IRS. In recent testimony before Congress, the General Accountability Office stated:

Our work has shown that building internal controls in up front is of the utmost importance and that fraud prevention is the most efficient and effective means to minimize fraud, waste, and abuse. Once federal dollars are disbursed fraudulently or improperly, the government is only likely to recover a few pennies on the dollar. Thus, preventive controls are the most important component of a fraud prevention system. These controls prevent ineligible individuals and questionable firms from gaining access to government funds in the first place.”

The Inspector General’s report concludes:

“The IRS is unable to verify eligibility for the majority of Recovery Act benefits at the time a tax return is processed. … The IRS cannot verify the accuracy of all of the legislated requirements before the tax return has completed processing for 39 Recovery Act provisions (13 individual provisions and 26 business provisions). … Verifying specific eligibility requirements for these 39 provisions would require the IRS to request specific documentation from the taxpayer.”

The Inspector General has not yet estimated the full scope of the incorrectly paid tax claims, but is conducting further analysis to obtain such estimates. So far, the Inspector General’s identification of incorrect claims has concentrated on the First-time Homebuyer Credit. Unfortunately, this credit makes up less than three percent of the Recovery Act’s cost associated with the individual taxpayers. In the few months since the second report on the issue, the Inspector General’s estimate of incorrectly claimed tax credits grew substantially. In the report made available in December 2009, the IRS Inspector General reports:

“As of July 25, 2009, we have identified 73,799 taxpayers who may have incorrectly claimed $504 million in the First-Time Homebuyer Credit.”

The IRS declined to comment on the report, although it was given the opportunity to do so. Consequently, citizens and Congress are left to speculate as to the possible justification that the Obama administration might have for this lack of oversight and management.

IRS paying billions in fraudulent refundable credits

At approximately the same time in December 2009, the Inspector General issued a separate report entitled “Individual Taxpayer Identification Numbers Are Being Issued without Sufficient Supporting Documentation” (no. 2010-40-005). This report checked:

“Whether applications for IRS Individual Taxpayer Identification Number (Form W 7) were efficiently and effectively processed and ITINs were appropriately issued. … When Forms W-7 are not effectively processed and ITINs are inappropriately issued, the risk increases that ITINs are being used to file fraudulent tax returns.”

The report was based on a random sample of 658 returns. This is a more than large enough sample to determine reliable conclusions. Shockingly, the Inspector General found that 78 percent of all such applications contained errors. Most of the errors were easy to identify, and consisted of the following:

1. ”443 (97 percent) supporting identification documents (e.g., passports, driver licenses, birth certificates, certificates of accuracy, and partnership agreements) were missing or were illegible.

2. 106 (23 percent) signatures were missing from the Forms W-7.

3. 22 (5 percent) birth dates on identification documents were inconsistent with the birth dates on the Forms W-7.”

The report also found that:

“There are also no controls to prevent an ITIN from being used by more than one taxpayer on multiple tax returns. More than 60,000 ITINs were assigned and used on multiple tax returns processed in Calendar Year 2008. As with Social Security Numbers, ITINs are specific to individuals and should be issued to and used only by that individual. In addition, more than 55,000 ITINs were used multiple times on approximately 102,000 tax returns with refunds totaling more than $202 million.”

Because of multiple filings using the same ITIN, the number of tax returns filed by those with taxpayer identifications numbers that never should have been issued increased. The Inspector General then looked at the results of the tax returns filed using the taxpayer identification numbers that never should have been issued. The Inspector General found that 89% of such tax returns obtained tax refunds, 3% paid additional taxes, and 8 percent had no additional taxes owed. Because of refundable tax credits received by those receiving refunds, the amounts of the refunds significantly exceeded the taxes that allegedly were previously withheld from wages. Mathematically, the refundable credits were around 240% of the withheld taxes.

The IRS had the chance to review the entire report before it was issued. The IRS quibbled with the statistical extrapolations used by the Inspector General, but the overall conclusion remains the same regardless of whose math one wants to adopt.

The above indicates likely massive fraud. Based on the report’s findings, if one completes an inappropriate request for an ITIN, the IRS will most likely issue the fraudulently-requested number. If you do not want to bother making a fraudulent request, you can instead just use someone else’s number, since the IRS will not check for the use a single ITIN on multiple tax returns. Once you have either your own number or someone else’s number, a thief can file a fraudulent tax return that claims a refundable tax credit. The IRS mails you a check without further work or investigation on the IRS’s part.

Over 14 million ITINs have already been issued by the IRS to immigrants who are not American citizens, or to permanent residents who have entered the United States legally. Based on the IRS Inspector General‘s testing, there are billions of fraudulent refunds naively being paid by the IRS.

Unlike the issue with the First-time Homebuyer Tax Credit, the IRS agreed with the most of the Inspector General’s recommendations about ITIN issuances and duplicate tax refund requests. However, given the obvious possibility for fraudulent activity, one must wonder why the problem was allowed to occur at all before the IRS Inspector General’s report.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

Copyright Fulcrum Inquiry

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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