How the IRS Monitors Tax Credits

It’s not looking good for the essential enforcement mechanism of ObamaCare. It turns out that not only is the IRS prone to apply a political litmus test to applicants for tax-exempt status, but it isn’t even very good at issuing legally required tax credits.

One of the lesser-known provisions of the Affordable Care Act was an expanded tax credit for families that adopt children. According to a report from the National Taxpayer Advocate, domestic adoptions can cost up to $15,000 for fees and legal expense, so in 1996 Congress adopted a tax credit of up to $5,000 to help families offset some of those costs. The amount of the credit grew over time and was up to $11,650 by 2008. This was a credit against existing taxes, so only families that actually paid taxes would benefit, even though other families also were on the hook for the costs of adoption.

As part of the Affordable Care Act, Congress increased the amount of the credit to $13,170 per child and made it refundable for the tax years 2010 and 2011, so any family that adopted a child would be eligible even if they did not otherwise pay taxes. It put the IRS in charge of issuing these credits.

It seems this was an almost insurmountable challenge for the IRS. It wasn’t sure what documentation would verify the claim and it was terrified of fraud. It ended up flagging 90% of all the returns that claimed a credit, usually for lack of documentation or income information, and it actually audited 69% of the returns. Rather than simply calling the taxpayer to request better documents, it kicked these returns over to its correspondence audit department, which took on average 126 days to complete.

In spite of the massive scrutiny, out of $668.1 million in tax credits claimed in tax year 2011, the Service disallowed only $11 million, and failed to find a single case of fraud. It also had to pay out $2.1 million in interest on claims that were held up for over 45 days.

The Tax Advocate’s report sums it up thusly –

The IRS’s Compliance Strategy for the Expanded Adoption Credit Has Significantly and Unnecessarily Harmed Vulnerable Taxpayers, Has Increased Costs for the IRS, and Does Not Bode Well for Future Credit Administration.

Now to be fair, this isn’t just the IRS’s fault, Congress bears some blame here, too.

The provision was inserted into the ObamaCare law even though it has nothing to do with health care. It was a very generous benefit, but it was written to last only two years, presumably to keep ObamaCare looking less expensive than it actually is and get a better score from CBO. And the tax credit expired completely except for special needs children at the start of 2013, and even that will be phased out for taxpayers with incomes over $186,000, making administration even more complicated. A footnote to the report says –

The refundability of the credit expired on Dec. 31, 2011, and the credit has reverted to a nonrefundable credit of up to $12,650 for tax year 2012. Rev. Proc. 2011-52. For 2013 and beyond, the credit will be available only for special needs adoptions and may only be claimed for qualified expenses incurred up to a maximum of $6,000. Economic Growth and Tax Reconciliation Act of 2001, Pub. L. No. 107-16, raised the limit of the original credit to $10,000 and does not apply to taxable years beginning after Dec. 31, 2012.

This whipsawing of tax law has become characteristic of the Democrats in Congress. Last year before the “fiscal cliff” agreement no one could predict in December of 2012 what their tax rates would be the following month. How can anyone plan for even the near future under these circumstances?

And importantly, how can the IRS develop information systems, explanatory brochures, the necessary forms, and train staff when they don’t know from month to month what is expected of them?

Still, if there was all this chaos for the tiny handful of families who adopted children in 2010 and 2011, the prospects for effective management of the many millions of people who are expected to claim a health insurance tax credit are not bright.

One of the problems for the adoption tax credit was that, being refundable it reached lower-income families who are not accustomed to filing taxes or providing documentary proof of expenses. Many of these people are barely literate and have a hard time understanding bureaucratic paperwork. Imagine how they will respond to the maze of forms and paperwork required under the Affordable Care Act.

The report is very concerned about the prospects. Its conclusion is stark –

By design, the adoption tax credit plays a critical role in helping taxpayers — particularly low and middle income taxpayers — meet the financial burden that may be involved in adopting a child. The IRS, facing a sizeable refundable credit, reacted with an enforcement strategy that was focused on stopping nearly all returns claiming the credit and subjecting a large percentage of them to an audit, instead of reaching out to stakeholders (including states) to understand the impacted taxpayer population. When problems emerged, the IRS simply continued selecting returns for audit. This approach forced taxpayers to withstand lengthy delays and the IRS to expend valuable resources with very little to show for them. As the IRS faces a new refundable credit in the form of the Premium Tax Credit, it should study and learn from its mistakes to avoid repeating them again, when there will be even more at stake.

The response to this report from the Service is not encouraging. It is defensive and arrogant. It explains that it did everything that could be reasonably expected. Too bad some people don’t understand. The tone is very similar to the tone is has been taking with Congress ― we’ve done nothing wrong and only stupid people would think otherwise.

What a ride we are in for.

Comments (23)

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  1. JD says:

    What a ride we are in for, indeed. It will be bad, hopefully just bad enough for people to demand change.

  2. JD says:

    “Imagine how they will respond to the maze of forms and paperwork required under the Affordable Care Act.”

    It will be interesting to see how ACA plays out for low-income people. Like the author hints, I imagine that many eligible people will be denied coverage negating Obamacare’s intended effects.

  3. Studebaker says:

    When the individual mandate and its associated penalty was first floated, the IRS commissioner sounded reluctant to become the health insurance Czar. This led many people to assume the mandate would not be vigorously enforced. What they failed to realize is that this is precisely how bureaucracies are made! Bureaucracies will always leap at an attempt to expand their domain.

  4. David Lenihan says:

    I am always concerned about refundable tax credits. They end up being just another source of income to claimants with virtually no audit or fraud detection. I am thinking specifically of the earned income tax credit, which ended up being a boon to illegal immigrant tax payers claiming massive EITC for up to 20 children….without any effective fraud detection by the IRS.

  5. Slaw says:

    The IRS is a mess. It is inept at even the easiest tasks.

  6. Joe Barnett says:

    Hundreds of thousands of children are in foster care today because there are not enough adoptive families. (This ground-breaking NCPA study provided the most comprehensive count of children stuck in foster care http://www.ncpa.org/pdfs/st210.pdf) Eliminating or limiting the adoption tax credit makes adoption even more expensive for moderate and low-income families. The fiscal cliff bill signed into law Jan, 2, 2013, made a $10,000 tax credit permanently available for all adoptive families who meet the income qualification(the credit phases out for families with more than $150,000 in income). However, the credit is nonrefundable – meaning families do not receive the credit unless they have an income tax liability.

    • Greg Scandlen says:

      Thanks for the cite, Joe. According to the Advocate’s report the continuing credit also is confined to “special needs” children, not “all” adoptive families. Is that not correct?

      • Roget says:

        Benevolent government we have, offering to pay two/thirds the cost of adoption through tax credits to remove a child from the system. Sounds like their reimbursement rates for just about everything. I’m sure they considered the aggregate cost of a child in the system when thinking this up.

        I can has an idea. Stop subsidizing low-income families with eleventeen children and offer an incentive (not a deduction) for adoption.

      • Joe Barnett says:

        My understanding is that (under the fiscal cliff legislation) the credit available for adoptions in 2013 and subsequent years is not limited to special needs children. However, there is a flat credit for special needs adoptions that does not require documentation of actual expenses.

  7. Rock says:

    “Rather than simply calling the taxpayer to request better documents, it kicked these returns over to its correspondence audit department, which took on average 126 days to complete.”

    - Just ask! Why make it more difficult than it needs to be?

  8. Sam says:

    We can’t eliminate the IRS but we can change the way it does business and this should be essential.

  9. Big Al says:

    “It ended up flagging 90% of all the returns that claimed a credit, usually for lack of documentation or income information … the Service disallowed only $11 million, and failed to find a single case of fraud.”

    The IRS is charged with making sure proper paperwork is filed and claims are substantiated in order to protect tax payer’s dollars from being handed out haphazardly. This applies to adoptions, the ACA, Tea Party exemptions, and a myriad of other Congressional gifts. As far as ‘fraud’, determining intent and pursuing charges normally costs more than simply disallowing incorrect returns.

    The IRS’s job is daunting and they have continued to change and improve their auditing standards over the many administrations. The IRS acts on the directive of Congresses, and when changes are made or unless Congress wishes to eliminate the IRS and go on the honor system, the ACA and American people’s tax dollars are still in very effective hands.

  10. Cory says:

    Technology could go far in reducing these problems:

    “The inability of taxpayers to e-file returns claiming the credit resulted in delays and additional burden on taxpayers and the IRS”

  11. dnaxy says:

    Anthony Downs in his book “Inside Bureacracy” says “Organizations that cannot charge money for their services must develop nonmonetary costs to impose on their clients as a means of rationing their outputs.”

  12. David Alexander says:

    I’m confused, practically everyone agrees the IRS has a terrible track record. They also have a nearly impossible task in responding to the never ending playground of congressional tinkering. Beyond all the shouting and screaming lies one gigantic problem and one too simple solution. The problem is taxing incomes and capital is exactly the wrong thing to do. That is the single most anti growth policy imaginable. The solution is to only tax consumption at the federal level and eliminate the IRS entirely. The FAIR TAX proposed legislation has been around for years. IT’S TIME TO BRING IT OUT FOR DISCUSSION DEBATE AND ENACTMENT.

  13. Big Al says:

    @David
    If we were to implement a Fair Tax or VAT/National Tax on consumption, and have a balanced budget, and pay off our debt over 10 years … the flat/fair/VAT tax would need to be near 30%. And even then, unless you have a great deal of faith in the honor system, you still need a watch dog agency.

    • David Alexander says:

      @Big Al,
      The real issue is that a tax on income and capital can never provide a fair, open and honest result. Congress will never stop granting special favors to special groups and therefore no result will be satisfactory. Only the Fair Tax begins from an even playing field, eliminates the IRS, creates real incentives to prosper and save, eliminates filing tax returns and requires minimal surveillance, same as state sales taxes. 23% is a bargain considering all the taxes eliminated. Isn’t it at least worth a national discussion and debate??

      • Big Al says:

        I personally would love to have a Fair tax. It would mean a reductin in taxes for me and pull the favoritism/regulate commerce teeth from Congress; however, that would also mean the even the poor would need to pay 23%. Also, i am assuming you base your 23% on having a balanced budget (which we don’t have yet) and forget that we still have $17 trillion in loans to still pay off. The numbers have to balance, so i think it would be at or over 30% for quite some time … which in turn could damage the economy. I think simplification is in the process though.

  14. Linda Gorman says:

    Wait until a state exchange tries to claw-back insurance subsidies because an individual’s income was determined (retroactively) to be above the subsidy line and it really wasn’t because someone else was also using that identity to work and pay taxes. Identity theft makes it impossible to determine whether or not the income attributed to an individual was actually earned by him and the IRS doesn’t have a clue.

    For more, see http://healthblog.ncpa.org/identity-problems/.