How the IRS Monitors Tax Credits

by Greg Scandlen, NCPA June 5, 2013

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.