Tax Refunds and the Disposable Income Test

We welcome back occasional guest blogger Marilyn Ames, who like me is retired from the Office of Chief Counsel, IRS and who did a lot of bankruptcy work when she worked for the government.  She discusses today a recent 5th Circuit case allowing the debtor to keep an earned income tax credit despite some local rules in Texas requiring her to turn a part of it over.  Although the 5th Circuit does not base its decision on the fact that the refund resulted from the earned income tax credit, that fact plays an important role.  Keith

As illustrated by the Covid-19 payments recently dispersed by the Internal Revenue Service and the use of the IRS to carry out portions of Obamacare, Congress frequently uses the IRS and the Internal Revenue Code as a means of administering social programs that have little or nothing to do with taxes. One of the problems of using the IRS to execute these types of programs is that courts assume that all provisions in the Internal Revenue Code are tax-related, which can, at worst, result in decisions at odds with the purposes of these programs, and at best, create precedent that fails to acknowledge Congressional intent.

read more...

The Fifth Circuit’s recent decision in the bankruptcy case of Matter of Diaz (found here or at 2020 WL 5035800) illustrates this issue. While the Fifth Circuit reached what is clearly the right conclusion under the Bankruptcy Code, it did so without recognizing why its decision was correct as a matter of policy. The Diaz case involves the amount of a tax refund that must be turned over as part of a Chapter 13 plan as disposable income, to be paid to general unsecured creditors. The bankruptcy court, the district court and the Fifth Circuit all failed to state why the debtor had a refund, but the Fifth Circuit does provide enough facts for an educated guess to be made that Ms. Diaz’s refund for 2017 resulted from the earned income credit. During 2017, Ms. Diaz worked as a medical assistant, and earned $2,644.16 per month, or a total of $29,791 for the year. During this year, she was a single parent with two children.  She filed bankruptcy on December 1, 2017, but her bankruptcy schedules filed later included her refund for 2017 in the amount of $3,261. Assuming that Ms. Diaz filed a return showing three exemptions and claiming the standard deduction for a head of household of $9,350, her return for 2017 would have showed a taxable income of $8,291 and a tax liability of $828. Making another assumption that she qualified for the earned income credit, the EITC for 2017 would have been $3,208, or about the amount of the refund she claimed on her return. (The tax liability on her return could have been offset by the child tax credit, resulting in a refund of any withholding, and she could also have been entitled to the additional child tax credit, but close enough given the facts available.)

Ms. Diaz filed bankruptcy in the Western District of Texas, which uses a standard form for Chapter 13 plans. Section 4.1 of the standard form provides that the debtor must turn over any tax refunds in excess of $2,000 to be disbursed to creditors pursuant to the plan by the Chapter 13 trustee. The only exception to turning over these funds is if the debtor’s plan provides for payment of 100% of the general unsecured claims, the debtor files a notice requesting that she be permitted to keep the excess refund amount, and the trustee does not object. Ms. Diaz could not make such a request, as her plan provided for only 12% of the general unsecured claims to be paid. Rather than filing a plan providing for the excess amount of $1,261 from her 2017 refund to be turned over to the Chapter 13 trustee, Ms. Diaz filed a plan that divided the total amount of her refund by 12 months, and then included that portion in her monthly income.  Provision 4.1 of the standard form was then stricken through. When the refund was included as part of her monthly income, the plan was adequate to meet the requirements of the Bankruptcy Code.

This gerrymandering did not sit well with the Chapter 13 trustee, who objected to the plan as it did not meet the provisions of Section 4.1 of the standard plan.  Ms. Diaz argued that the plan violated both the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. The bankruptcy court and the district court for the Western District of Texas disagreed, holding that the district court had authority to require that a standard Chapter 13 plan be used pursuant to the provisions of Federal Rule of Bankruptcy Procedure 3015.1, and that tax refunds are disposable income under Bankruptcy Code § 1325(b)(2) that must be included in the plan. The bankruptcy court rejected the debtor’s argument that her tax refund was similar to payments received for dependent adult children that are excludable from a debtor’s disposable income, apparently not recognizing that all or part of the debtor’s refund was probably attributable to the EITC, which is computed based on the number of dependents a taxpayer has. The district court affirmed the ruling of the bankruptcy court with even less consideration of why the debtor was entitled to a refund.  The bankruptcy court opinion can be found here (586 BR 588) and the district court opinion can be found here (2019 WL 4545613).

The Fifth Circuit disagreed that the debtor was required to turn over the refund, relying on Bankruptcy Code § 1325. If a plan does not provide for an allowed unsecured claim pursuant to § 1325(a), the plan cannot be confirmed unless the debtor includes all projected disposable income to be paid out to general unsecured creditors. Ms. Diaz’s plan did not provide for her unsecured creditors pursuant to § 1325(a), so she could only have a plan confirmed that included all projected disposable income. Noting that district courts may not adopt local rules or create standard plans that abridge, enlarge or modify any substantive right, the Fifth Circuit focused on whether the tax refund in excess of $2,000 was part of the debtor’s projected disposable income that had to be turned over to the Chapter 13 trustee.

Although the Bankruptcy Code does not define projected disposable income, § 1325(b)(1)(B) does state how it is to be calculated. Disposable income is the current monthly income received by the debtor, less “amounts reasonably necessary to be expended” for the debtor’s maintenance and support, plus any qualifying charitable contributions and business expenditures. Current monthly income is calculated by averaging the debtor’s monthly income in the six full months preceding the bankruptcy petition. The definition of “amounts reasonably necessary to be expended” is included in §1325(b)(3), and is different depending on whether the debtor has monthly income, when calculated for a year, greater than the median family income of the applicable state.  This amount can vary depending on the number of individuals in the household. If the debtor has current monthly income, when calculated over 12 months, greater than the applicable state median family income, only those expenses included in Bankruptcy Code § 707(b)(2) are included as amounts reasonably necessary.  If the debtor has less than the applicable median amount, all amounts for the maintenance or support of the debtor or the debtor’s dependents are included.

In the Diaz case, Ms. Diaz’s current monthly income, projected over 12 months, was less than $59,570, the median income for a family of her size in Texas in 2017. The expenses she claimed on her bankruptcy schedules totaled far less than the IRS National Standards for a family of the same size.  The Fifth Circuit concluded that “[W]e find it entirely plausible that Debtor will use her ‘excess’ tax refund of $1,261 for expenses that are reasonably necessary for her family’s maintenance and support.” Because the standard form required Ms. Diaz to turn over the tax refund in excess of $2,000 without determining whether the excess was an amount reasonably necessary to be expended, it violated her substantive right as a below-median income debtor to retain any refund reasonably necessary to be expended for her family’s support.

Although reaching the correct decision under the Bankruptcy Code, the Fifth Circuit failed to consider whether the refund was generated by the EITC and, if so, whether that fact should be considered in determining whether a debtor should be required to include these funds. The earned income tax credit was enacted in part to provide relief for low-income families. Hopefully, the provisions of Bankruptcy Code § 1325(b)(1)(B) expanding the amounts that can be considered to be amounts reasonably necessary to be expended for the maintenance and support of families with incomes below the median income of the state will be sufficient to continue to protect the relief Congress granted to low-income families through the EITC provisions. However, the fact that Ms. Diaz was required to appeal her case to the Fifth Circuit in order to protect her rights argues for an opinion that more explicitly recognizes the purposes of the EITC.

Going Forward – Refundable Credits in the 2021 Filing Season and Beyond

In my last post I called on the IRS to reopen its non-filer portal for recipients of federal benefits who have dependents and issue supplemental Economic Impact Payments for those dependents. On August 14th, the IRS announced on that it would do that very thing, responding to congressional and public pressure and facing what promised to be an adverse ruling in pending litigation.  This is truly an important development that will provide much-needed financial assistance to vulnerable families in the midst of a pandemic.  It also provides a foundation for the IRS to build on in future filing seasons.

“read

A second proposal I made in that post received some interesting comments.  I proposed the IRS use its internal Form W-2 and 1099-MISC-NEC data to identify those taxpayers who appeared to qualify for the childless worker Earned Income Tax Credit (EITC) and automatically pay out the amount of EITC based on those earnings.  By now, the IRS has received almost all of the wage and information returns for 2019.  The National Taxpayer Advocate reports that by February 28, 2020, the IRS had received 3.9 percent more W2s and 12.8 percent more 1099-MISC forms than the year before.  (For comparison, the IRS received 219 million W2s by February 4, 2019.)    IRS also can determine whether the taxpayer was claimed as a dependent on another’s return, so the risk of noncompliance is very low.  In fact, in 2018 the Treasury Inspector General for Tax Administration, whose job is to ferret out fraud, waste, and abuse in the tax administration, actually recommended the IRS automatically calculate and pay out the EITC.

One comment questioned how someone could live on, say, $7,000 a year and cited an example of a client who, upon questioning, ceded that he had unreported cash income.  Another noted that one of his clients had low wage income but was receiving a significant amount of income that was reported on an estate’s Schedule K-1, which likely would not be in the IRS’s systems yet.  I will address the issue of living off of $7,000 a year below, but as to the K-1 income, my response is something I have said to the IRS for decades:  you design tax administration around the 95 percent of the taxpayers who are trying to comply, not around the 5 percent who are not.  No aspect of tax administration will have zero errors or noncompliance; you have to accept some people will slip through.  Otherwise, you end up with the byzantine tax administration we have now. 

The proposals outlined in my earlier post don’t solve all the problems with unclaimed EITC or missed EIPs.  They addressed emergency situations and provided a one-time way to get much needed dollars out to the most vulnerable populations in our society, populations that are most impacted by the coronavirus and pandemic-related job loss.  For 2021 and beyond, the IRS can build on its EIP initiatives this year to increase the EITC participation rate while minimizing taxpayer burden.  But before I discuss these proposals, let’s take a high-level look at poverty in America.

Refundable tax credits play an important role in reducing poverty in America

According to the US Census Bureau, the 2018 official poverty rate was 11.8 percent, with 38.1 million people in poverty.  The official definition of poverty is established by the Office of Management and Budget in Statistical Poverty Directive 14 and is used to determine eligibility for various government programs.  Here are some rather stunning statistics from the U.S. Census Bureau report, Income and Poverty in the United States: 2018, (the 2019 poverty statistics will be issued on September 15, 2020).  For purposes of determining family poverty, Census defines a family as “a group of two or more people related by birth, marriage, or adoption and living together.”

  • The 2018 poverty rate for primary families (i.e., a family that includes a householder) was 9.0 percent.
    • For female householder families, the rate was 24.9%.
    • For married couples, the rate was 8.1%.
  • The 2018 poverty rate for unrelated individuals not in families was 20.2%.  (This is a cohort of the childless worker EITC population.)
    • For unrelated male individuals not in families, the rate was 17.7%.
    • For unrelated female individuals not in families, the rate was 22.6%.
  • The 2018 poverty rates varied significantly by race:
    • For Blacks, the rate was 20.8%.
    • For Hispanics, the rate was 17.6%.
    • For non-Hispanic Whites, the rate was 8.1%.
  • The 2018 poverty rate varied by sex:
    • For males, the rate was 10.6%.
    • For females, the rate was 12.9%
  • The 2018 poverty rate varied significantly by age:
    • For children under the age of 18, the rate was 16.2%.
    • For persons age 65 or older, the rate was 9.7%.
  • The 2018 poverty rate for workers was 5.1%.
    • For full-time year-round workers, the rate was 2.3%.
    • For less-than-full-time year-round workers, the rate was 12.7%.
    • For workers who did not work at least 1 full week, the rate was 29.7%.

The Department of Health and Human Services publishes the poverty guidelines each year in the Federal Register.  The 2020 poverty guidelines are below:

Since 2011, in collaboration with the Bureau of Labor Statistics, the Census Bureau has also computed and published the Supplemental Poverty Measure (SPM), which takes into account the impact of government benefit programs for low income persons and families – including food stamps, school lunches, housing assistance and refundable tax credits —  as well as deductions for certain necessary expenses, including taxes, child care, commuting, health insurance premiums and co-pays, and child support, that are not included in calculating the official poverty rate.  Here are a few eye-opening factoids from the SPM:

  • For 2018, the Supplemental Poverty Measure was 12.8 %, a full percentage point higher than the official poverty rate.
  • Social Security benefits moved 27.2 million persons out of poverty in 2018.
  • Refundable tax credits moved 8.9 million persons out of poverty in 2018.
  • If the EITC and the refundable portion of the Child Tax Credit were not included in the SMP calculation, the 2018 SPM poverty rate would have been 15.5 % rather than 12.8 % — meaning the tax code accounts for an almost 4 percentage point reduction in the official poverty rate of 11.8 %.

The Supplemental Poverty Measure shows that it is possible for someone to live on earnings of $7,000 a year by receiving federal benefits, including the Earned Income Tax Credit.  In fact, according the U.S. Census Bureau, 10.2 percent of over 128 million householders had money income under $15,000 in 2018.  That is the reality for over 13 million Americans.

Going forward, the IRS needs to take more proactive steps to get the EITC and other refundable credits into the hands of eligible taxpayers

The stunning data presented above should give us all pause to reflect on the significant role the tax code and IRS play in lifting Americans out of poverty.  Although some complain that the IRS should not be in the benefits business (or, more cynically, it should only be administering social benefits to home-owners and businesses), it turns out the EITC is an efficient and effective program.  Yes, there are plenty of things that need fixing about the EITC, and I personally have made scores of recommendations in that regard.  But folks who wish for a past time when the EITC didn’t exist need to just get over it.  And that includes the IRS – it needs to embrace its role as deliverer of social benefits.

The IRS can begin its embrace in the 2021 filing season and beyond, by keeping the non-filer portal and enhance it by adding a screen and checkboxes designed to determine eligibility for the EITC.  The IRS’s own data show that through April 17, 2020, 5.631 million filers used Free File, a 110 percent increase over 2019, largely attributable to taxpayers who used the non-filer portal and thus bumped up the abysmal Free File usage rates.  [See National Taxpayer Advocate Fiscal Year 2021 Objectives Report to Congress, pages 97-98.]  Usage would increase even more if the portal were made available on mobile devices as well as in other languages.  Moreover, the IRS could consider a telefile version of the nonfiler portal – which would really help out those households who don’t have broadband or any internet access in their homes.

In 2018, TIGTA recommended the IRS modify Form 1040 to capture information that would allow it to automatically issue the EITC to taxpayers who filed a return.  Although the IRS ultimately declined to go along with this recommendation, it is a good idea that should be adopted.  Here is TIGTA’s suggested mock-up for the pre-“simplified” Form 1040:

In addition to adding these boxes to the face of the Form 1040, IRS should add to the non-filer portal a few extra checkboxes:  Did you (and your spouse, if filing married-filing-jointly) have your principal residence in the US for more than six months of the year?  Would you like the IRS to compute your eligibility for and amount of the Earned Income Tax Credit?  If a taxpayer enters dependents on the nonfiler portal, another checkbox can pop up:  Did this child live with you in the US for more than six months of the year?  These questions, along with retaining the checkbox question about being claimed as a dependent on another’s return and IRS internal databases and filters, provide all the information the IRS needs to get the EITC out to eligible households.

Second, as TIGTA recommended in 2018, the IRS should study how best to use CP-09 and CP-27 letters, the EITC reminder notices IRS sends to taxpayers with children and without children, respectively.  Today, IRS sends out these letters to only a fraction of taxpayers it believes are eligible for underclaimed EITC, and it completely ignores those who have not filed a return.  According to TIGTA, for Tax Year 2014, IRS estimated 5 million households were potentially eligible for EITC totaling $7.3 billion.  Of those 5 million taxpayers, 1.7 million filed returns but did not claim the EITC.  TIGTA reported the IRS annually spends $2 million issuing notices to potentially eligible taxpayers, but the notices were sent to only 361,000 of the 1.7 million filers (and none to the nonfilers).  The response rate to these letters was 28 percent for taxpayers with children, and 57 percent for taxpayers without children.   The CP-09 and CP-27 letters may not be necessary for filers if the IRS adopted TIGTA’s and this post’s recommendations to modify the Form 1040 and the non-filer portal.  Instead, these letters (or postcards) could be sent at the beginning of the filing season to prompt nonfilers to file and claim the EITC.   

As TIGTA noted, the CP-09 and CP-27 letters historically have had low response rates.  But thousands of businesses and political campaigns have figured out that direct marketing, done correctly, actually has an impact.  The IRS possesses a mother lode of data on nonfilers – it has Forms W-2 and 1099s; all of those forms have taxpayer addresses.  The IRS could use this address data to send the letters, or generic postcards, to EITC nonfilers.  A postcard with a generic message about EITC eligibility, can be written so as to not violate IRC § 6103.  For example: 

The EITC is a tax credit for low income workers with or without children. To learn whether you are eligible for the credit, go to [website] or call [toll-free dedicated number]. If you haven’t filed a return, you may be able to use the non-filer portal to claim the EITC.

It may be people don’t open IRS letters, but they will read a generic postcard about needing to file in order to get the EITC.  This is worth experimenting with. 

The IRS could also send letters to potentially eligible filers and nonfilers immediately before the opening of the next filing season, urging people to check out the EITC; a TAS study found that educational letters, sent to taxpayers who appeared ineligible for the EITC in the previous year but were not audited, with the words “important tax information” on the envelopes and mailed right when W-2s were being issued, resulted in significant taxpayer behavior changes.  Recipients apparently opened the envelopes and read them. 

IRS also could promote the non-filer portal during its EITC Awareness Day events every January.  Moreover, since the non-filer portal is built upon the Free File Alliance’s Free Fillable Forms portal, as discussed here, it won’t run afoul of the IRS-FFA agreement.

In the past, the IRS cited lack of resources to be able to handle the responses to more of the  CP-09 and CP-27 notices.  As I’ve noted in other posts, I understand all too well the problem of diminished resources.  But EITC funds are lifelines to these taxpayers and should be prioritized as much as enforcement hires.  If the IRS were to adopt a dual-role mission statement, as I’ve recommended since 2010, it and the Administration would develop a budget proposal to provide the resources and staffing necessary to issue the notices and process responses.  Moreover, if the IRS maintains and improves the portal, nonfilers would use the portal instead of mailing in a response, so the resource demand would be minimized.  Congress has a role to play here, too.  It can nudge the IRS in the right direction and provide it with dedicated funding to increase the EITC participation rate.  With the pandemic showing the vital role the IRS plays in the delivery of economic benefits, Census data showing the important role of refundable tax credits in lifting millions of Americans out of poverty, and Congress finally aware of what years of underfunding have done to tax administration, now is the time to make the case for robust and proactive taxpayer assistance. 

IRS, we applaud your work and we feel your pain, but we need you to do more to get dollars out to vulnerable taxpayers

As Congress and the Administration debate the shape and scope of the next coronavirus relief package and unemployment benefits end or are delayed, the Internal Revenue Code already provides another way to get dollars into low income workers’ pockets – the childless worker Earned Income Tax Credit (EITC).  The IRS can and should pay out this credit to every taxpayer who appears eligible for it based on 2019 return filings, including through the non-filer portal.

read more...

Before I launch into a discussion of how this could be done, and because the IRS seems particularly sensitive right now about any criticism of its performance in implementing CARES Act and other economic stimulus provisions, I want to stipulate the IRS accomplished a near-miracle in getting over 160 million payments out to needy households, and it should be congratulated on that act.  We all recognize the challenges the IRS faced, and still faces, with its workforce hobbled by the pandemic closures of offices, and the precautions necessary as it tries to get back to some semblance of normal work.  And we applaud the sacrifices IRS employees made to program IRS systems and develop new applications and issue guidance.

However, because these are extraordinary times, more is being asked of the IRS.  Those asking for more are not being mean-spirited or ungrateful or even ungracious.  They are advocating for various populations who have been left out in the cold. 

For example, while it is understandable and even commendable the IRS wanted to get automated Economic Impact Payments (EIPs) out to elderly and disabled Social Security beneficiaries very quickly and thus set a 40-hour deadline for these individuals to enter their dependents into the nonfiler portal, it is inexcusable for the IRS not to provide an ongoing option for those individuals who missed the short deadline to be able to obtain the EIP for their dependents now, not in 2021.  We are in the midst of a pandemic and an unprecedented economic turndown, for heaven’s sake, and 2021 is just too far away.  These payments are a lifeline for many of the most vulnerable members of our society and they cannot wait. 

In fact, in a recent communication to its employees, and as the National Taxpayer Advocate (NTA) confirmed in a recent blog, the IRS advised that the programming will be completed by August 13, 2020, that will enable it to issue dependent payments for those who actually entered their information into the nonfiler portal but failed to receive the payments due to a programming bug.  If the IRS is able to “perform automated recovery” procedures for these payments, it can surely allow those who missed the April 22 deadline to now enter their dependent information into the nonfiler portal and apply the “automated recovery” procedures here, too.  Since it has already developed the programming, it cannot claim it does not have the resources.

The IRS has sufficient information to pay out the childless worker EITC automatically

The idea of automating the childless worker EITC has bounced around for years.  As the NTA, I recommended it in my 2016 Annual Report to Congress, here.  The Treasury Inspector General for Tax Administration (TIGTA) recommended it in April, 2018, here.  TIGTA’s report, The Internal Revenue Service Should Consider Modifying the Form 1040 to Increase Earned Income Tax Credit Participation by Eligible Filers, notes that for Tax Year 2014, the IRS estimated 5 million households were potentially eligible for the EITC, leaving $7.3 billion unclaimed.  Of those 5 million taxpayers, 1.7 million actually filed returns and did not claim the EITC.  In recommending that the IRS modify the Form 1040 to capture information that would allow it to automatically issue the EITC to taxpayers who failed to claim it, TIGTA noted the IRS annually spends $2 million issuing notices to potentially eligible taxpayers, but the notices were sent to only 361,000 of the 1.7 million filers (and none to the non-filers), and only 28 percent of the eligible-with-children responded and 57 percent of the eligible-without-children responded.  TIGTA even provided a nifty mock-up of how the 1040 could be modified.

On January 31, 2020, Senators Sherrod Brown and Catherine Cortez Masto wrote Commissioner Rettig asking why the childless worker EITC could not be paid out automatically based on available wage and other income data.  In the letter, here, the Senators cited the TIGTA report discussed above and asked whether the IRS had studied TIGTA’s recommendation and if so, why it had not implemented the recommendation.

In his response to the Senators, the Commissioner stated that

 [i]n 2018, the IRS and Treasury began developing a shorter, streamlined Form 1040 with the goal of simplifying the experience for taxpayers and partners in the tax industry.  Adding additional information to the Form 1040 for EITC purposes would not align with the new simplified Form 1040 strategic approach. 

The Commissioner then cited this very absence of such information, and the consequent risk of improper payments, as the reasons IRS could not automatically issue EITC refunds to childless workers: 

For example, based on the information on the Form 1040, the IRS cannot determine if a taxpayer can be claimed as a dependent on another return or if the taxpayer lived in the United States for more than six months.

Before we explore the IRS’s position a little more closely, a little bit of background is helpful.  The childless worker EITC is available to taxpayers who are at least 25 years of age and under 65 years of age.  For Tax Year 2019, eligible taxpayers filing as single or head of household must have less than $15,570 adjusted gross income (AGI); married-filing jointly taxpayers must have AGI below $21,370.  (Married-filing-separately taxpayers are not eligible for the credit.)  Both the childless and child-based EITC require earned income, which means that income will be reported and on file with the IRS on Forms W-2 or Forms 1099-MISC.  The IRS has announced that for 2021 filing season, a new Form 1099-NEC will be required, which should make it even easier to identify non-employee compensation.  IRC § 6071 requires both of these forms to be filed by January 31 of each year.  By now, pandemic notwithstanding, the IRS should have this earned income information for Tax Year 2019 for almost every single worker in the United States.

Other than earned income, the requirements for the childless worker EITC are that the person claiming the credit (1) not be claimed as a “qualifying child” of another person; (2) not be claimed as a dependent on someone else’s tax return; (3) have the principal residence in the United States for more than half the year; (4) have the appropriate Social Security Number (SSN); and (5) have less than $3,600 in investment income.  The IRS can check all of these requirements against its internal databases, except for the principal residence test.

In fact, taxpayers who file a Form 1040 must check a box on the front of that form declaring that they cannot be claimed as a dependent on someone else’s tax return.   Similarly, one of the questions taxpayers must answer when they complete the IRS’s nonfiler portal is whether you can be claimed as a dependent on someone else’s tax return.  So the IRS has affirmations of this status requirement for hundreds of millions of taxpayers, made under penalties of perjury.  (As I noted in an earlier post here, the nonfiler portal requires the submitter to affirm the jurat.)

What’s more, any return filed claiming a refund passes through innumerable filters and databases designed to identify questionable and fraudulent claims, including duplicate claims of qualifying children (one of the Commissioner’s concerns in his letter to the Senators).  It has Social Security databases matching name, age, and parentage of social security number holders, among other information.  Regardless of what people claim on their returns, the IRS checks those claims against its databases.  It is doing that even as I write this.  Thus, the IRS has internal processes in place to prevent improper automated payments of the childless worker EITC.

Okay.  So, as of today, the IRS has earned income and other income information necessary for computing EITC eligibility for most taxpayers.  It also has a sworn statement from the vast majority of taxpayers as to their status of being claimed as a dependent on another’s return.  And the IRS has internal databases that can check the taxpayer’s SSN, age, and status as dependent/qualifying child on another’s return.  All that is left to verify is the “more than 6 months U.S. residence” status.

I propose a two-prong approach for this last test.  I’ll discuss how to handle this for Tax Year 2020 returns later in this blog, but for 2019 returns, filed in 2020, the IRS could administratively deem this requirement to be met unless the IRS has clear and convincing evidence to the contrary.  The IRS uses “tolerances” all the time in letting errors go unchallenged, and if there were ever a time to use tolerance, today is the time.  Thus, by administratively deeming taxpayers with a US address on their returns to have lived in the US for more than 6 months of the tax year, the IRS can create an “automated recovery” algorithm that computes and pays out the childless worker EITC to taxpayers who filed returns (including the nonfiler portal) without requiring an amended return.  This approach saves the IRS resources dedicated to processing amended (paper) returns as well as the letters it sends out to potentially eligible childless workers.

If IRS is nervous exercising its administrative discretion in this way, let me point out that nowhere on the Form 1040 or any of its schedules does the IRS require the taxpayer to aver its principal residence was in the US for more than six months of the year, and yet it stills pays out the childless worker EIC to people who claim it on the return.  To claim the childless worker EITC, you do not attach any schedule whatsoever, you simply write in the amount, per a look-up chart, on line 18a of the Form 1040.  Buried in the 17 page EITC section of the Form 1040, Step 4, Question 3 asks: “Was your main home, and your spouse’s if filing a joint return, in the United States for more than half of 2019?”  If the answer is “no,” you can’t take the credit.  In fact, the IRS instructs you to write “no” next to line 18a, presumably because it does use data on returns to identify potentially eligible EITC recipients that it can contact, via Letter CP-27!  Since the IRS is already using return data to identify some eligible taxpayers and send them CP-27 letters, it can use the same algorithm to identify, calculate, and pay out the childless worker EITC.

The maximum amount of the 2019 childless worker EITC, for earned income between $6,950 and $8,649, is $529, nothing to sneeze at in the midst of the pandemic.  As anyone who has practiced in the field of poverty law can tell you, to truly understand the impact of money to a low income person, add a zero.  $529 to them is as $5,290 to more affluent persons.

The Nonfiler Portal Created a “Filing Trap” for Households with Income Below the Filing Threshold

The IRS actually inadvertently exacerbated EITC underclaims via its nonfiler portal.  Again, this observation is not meant to be piling on to the IRS (I will say this over and over and over …).  It created the portal in record time, and it has been a useful tool.  But the nonfiler portal created what Gabriel Zucker of New America has called the “filing trap.”  People who used the portal were not given the option to compute the EITC – either the childless EITC or the child-based EITC.  For a family of four – two parents and two qualifying children – with income between $23,950 and $23,999, entering their dependents into the non-filer portal meant they lost out on $4,787 of EITC (they would lose $2,736 for 1 child, and $5,515 for 3 children).  Similarly, childless workers with income of $11,999 and filing through the nonfiler portal did not have the option to request $275 of EITC benefits.  To receive it now, they will have to file a paper amended 2019 Form 1040.   Good luck getting that processed.  And does the IRS really want to receive all those paper Forms 1040X?  (The IRS has announced that electronic filing for those forms is coming, but it’s not here yet, so that’s not much help for folks who need their EITC now.)

There is a better way.  As discussed above, for the childless worker filers, whether on a Form 1040 or through the nonfiler portal, the IRS can automatically calculate the childless worker EITC from information it has available to it in-house.  For the child-based EITC, it can use its internal data and the information about dependents provided on the non-filer portal to compute the appropriate amount of EITC.  For this extraordinary filing season, for once the IRS can use its internal data and filters for the good of these vulnerable taxpayers.  It can identify duplicate claims, etc., but it can also compute the EITC for taxpayers who appear eligible and which the IRS’s own system, which it encouraged taxpayers to use, blocked them from claiming.

Going Forward – Filing Season 2021 and Beyond

The proposals outlined above don’t solve all the problems with unclaimed EITC or missed EIPs.  They address emergency situations and provide a way to get much needed dollars out to the most vulnerable populations in our society, populations that are most impacted by the coronavirus and pandemic-related job loss.  For 2021 and beyond, the IRS can build on what it has created this year to increase the EITC participation rate while minimizing taxpayer burden.  In my next blog post, I’ll explore how the IRS can keep the non-filer portal and expand its utility, as well as how it could improve the use of CP-09 and CP-27 letters.  Oddly enough, the pandemic opens the door for the IRS to embrace its role in delivering social benefits.  It would be more than a shame if it did not seize that opportunity.

Is IRS Too Soft on People Claiming EITC? Treasury Says Yes and Also Suggests No

The pressure on the IRS to deliver the economic impact payment (EIP) highlights some of the general challenges the IRS faces when Congress tasks the IRS to deliver benefits.  With respect to the EIP, faced with a public that needs the money that Congress has earmarked, IRS has had to move quickly. In times like these, when balancing speed with accuracy, IRS should and admirably has erred on the side of speed.  With lives upended and millions of Americans struggling, this is the right call. 

As an administrator that regularly gets taken to task when it comes to its administration of refundable credits like the EITC, IRS faces a similar trade off in its more routine day to day work.  IRS knows that millions of Americans rely on those Code-based benefits. At the same time, about 25% of the EITC is classified as an improper payment, as Congress has been sure to remind Commissioner Rettig when he has been up on the Hill.

Two recent publications highlight the competing pressures the IRS faces as a result of it having responsibility for administering the EITC.  One is a TIGTA report taking the IRS to task for failing to impose civil penalties and bans on individuals who appear to be improperly claiming the EITC. The other is a Treasury Office of Tax Analysis (OTA) working paper that emphasizes that the vast majority of people claiming the EITC have an eligible familial relationship with a claimed qualifying child.

For folks who are looking for differing perspectives on an issue I suggest that you read both, back to back.  If reading TIGTA reports and OTA working papers is not your ideal way of spending an afternoon, in this post I will discuss the highlights of both.

read more...

TIGTA: IRS Not Doing Enough to Deter and Punish Improper Claimants

First, the TIGTA Report. TIGTA’s steady drumbeat on EITC and refundable credits is that IRS is not using the enforcement tools that Congress has given to it. 

Congress provided the IRS with tools to address taxpayers identified as submitting fraudulent or reckless refundable credit claims. These tools include the authority to assess the erroneous refund penalty and require taxpayers to recertify that they meet refundable credit eligibility requirements for credits claimed on a return filed subsequent to disallowance of a credit, and the ability to apply two-year or 10-year bans on taxpayers who disregard credit eligibility rules. However, the IRS does not use these tools to the extent possible to address erroneous credit payments. 

What are the consequences of IRS not using its robust power to sanction taxpayers? In TIGTA’s view,

[t]he ineffective use of the various authorities provided in the I.R.C. is a contributing factor in the high rate of improper payments. The IRS estimates that 25 percent ($18.4 billion) of EITC payments made in Fiscal Year 2018 were improper payments. The IRS also estimates that nearly 33 percent ($8.7 billion) of ACTC payments made during Tax Years 2009 through 2011, and more than 31 percent ($5.3 billion) of AOTC payments made during Tax Year 2012, were potentially improper. 

The main gripe TIGTA emphasizes is that the IRS has failed to use its power to impose a 20% erroneous refund penalty under Section 6676, a power that Congress amended a few years ago to specifically apply to individuals erroneously claiming refundable credits like the EITC:

In Years 2015, 2016, and 2017, the IRS assessed the erroneous refund penalty on 3,190 erroneous claims totaling $2.7 million. However, our analysis identified 494,555 withholding and refundable credits disallowed for Tax Years 2015, 2016, and 2017 (as of December 27, 2018). These taxpayers filed 798,504 tax returns that claimed more than $2.6 billion in improper withholding or refundable credits. Applying the 20 percent erroneous penalty rate to the disallowed credits computes to almost $534.7 million in penalties that the IRS potentially could have assessed. 

TIGTA goes on state that IRS has studied the impact of the few cases when IRS has in fact imposed the 6676 penalty, and it appears that IRS is teeing up some recommendations based upon its study (FYI – I have not seen the study nor do I know if IRS is planning on releasing it; it would be interesting as well to see how much tax is collected out of previously assessed penalties—I suspect not much). 

The report also criticizes IRS for failing to systematically impose a two-year ban on taxpayers who in TIGTA’s view are recklessly or intentionally disregarding rules and faulty IRS processes for allowing individuals to recertify eligibility for the EITC (and other disallowed credits). As to the ban, TIGTA notes that in successive years people appear to be incorrectly claiming the EITC. ( Note: as advocates know appearances may be misleading as claimants may be unaware of the rules or simply not able to document meeting eligibility criteria. For more on the ban, see Bob Probasco’s excellent three part series, The EITC Ban-Further Thoughts Part 1Part 2 and Part 3.) In a heavily redacted section, TIGTA suggests that the IRS should impose the ban earlier and more frequently. This would free scarce audit resources to investigate other individuals and prevent erroneous claims.

The TIGTA report also discusses recertification. For individuals who have had credits denied through deficiency procedures, Section 32(k) provides that “no credit shall be allowed under this section for any subsequent taxable year unless the taxpayer provides such information as the Secretary may require to demonstrate eligibility for such credit.” TIGTA highlights IRS problems with its processes to ensure that taxpayers who recertify are in fact eligible for the claimed credits.

OTA: The “Improper” EITC Claimants Look Like the Proper Claimants

The OTA paper looks at the EITC very a different perspective. While noting the stubborn 25% or so improper payment rate, OTA attempts to study the characteristics of the people who are not eligible or who appear to be overclaiming the credit. The reason for the inquiry is to help frame the debate around improper payment rates. As OTA notes, 

from the social welfare perspective, policymakers might view a case where a child lived with her low-income grandmother for 6 months of the year differently from a case where an unrelated person claimed a child she did not live with at all; but, both cases would be counted equally in computing the EITC error rate.

What the improper payment rates alone fail to tell us is context. 

When a taxpayer fails to meet the qualifying child tests for an EITC claim, it is generally unknown how closely this taxpayer is related to the child and whether another taxpayer could have correctly claimed the child. 

It is possible for more than one taxpayer to have provided some care for the child during the year, but no single taxpayer to be eligible to claim the EITC for that child under the law (e.g., the child does not live with any taxpayer for more than half the year). In other cases, the erroneous claim may have precluded the actual caregiver from claiming the child. 

What OTA does in the paper is to provide more detail to allow for a “more nuanced consideration of EITC qualifying child errors and the associated social welfare implications.”

What kind of nuance did OTA look to identify? Essentially OTA looked to see if there was a family relationship between the adult and the child claimed as a qualifying child:

Specifically, we analyzed the intensity of the familial relationship between the child and the actual claimant as well as the length of the shared residency, providing information about whether the claim, despite being erroneous, might nonetheless have supported a low-income worker caring for a child. In addition, we studied possible reasons why the “wrong” taxpayer may have claimed the child—whether this occurred due to complicated family circumstances, intentional credit-maximizing behavior, or other reasons—to better understand the causes of EITC noncompliance. Finally, we estimated the credit that could have been received by the parent who did not already claim the child and was potentially the actual caregiver. This result offers an insight into the extent to which the EITC improper payment estimates may overstate not only the social welfare loss but also the monetary loss to the government. 

OTA’s study showed that in the overwhelming number of cases, when there was an error, there still was a close familial relationship between the adult and the child or children, though typically the adult was not the child’s biological parent:

Our analysis suggests an intense relationship between the child and the claiming taxpayer in most cases. About 87 percent of the children, despite being claimed with qualifying child errors, had a valid familial relationship (84 percent) or lived with the taxpayer for more than half of the year (7 percent) or both. However, compared to children who met all of the qualifying child tests, the children in our sample were much less likely to be the son or daughter of the taxpayer, and more likely to have other valid familial relationships (e.g., grandchild or nephew/niece) with the taxpayer. 

The whole paper deserves a careful read, but the bottom line conclusion is that the majority of children claimed with qualifying child errors had an eligible familial relationship with their claimants and in a majority of the cases there was no parent who under current eligibility criteria could in fact be eligible to claim a child.

Furthermore, about 60 percent of the children did not appear to have a parent who could be the “right” taxpayer, as stipulated by law, who could file a claim. We conclude that a substantial portion of erroneous EITC claims likely helped support children in low-income families despite those children being claimed in error. Parents of another 4 percent of children were found to have filed a duplicate claim with the taxpayer under audit. For the remaining 36 percent of children, who had a tax-filing parent not already claiming the child, the family members’ filing patterns were consistent with the credit-maximizing motive in 85 percent of cases. We offer a few explanations, including taxpayer confusion about EITC rules or law changes, to account for the claiming pattern of the remaining 15 percent of cases. Finally, we estimate that the forgone credit that could have been received by non-claiming parents amounted to about 10 percent of the total overclaims attributable to qualifying child errors, or 4 percent of all EITC overclaims. Taken together, these results suggest that the official improper payment rate overstates the social welfare loss and monetary loss to the government.  (emphasis added)

Conclusion

At the end of the day, the OTA study and TIGTA report are likely to appeal to differing parts of the trade off I discussed in the introduction. It could very well be that administrators (and readers and Congress for that matter) do not necessarily value social welfare concerns in the same way that I or others do.  People could place a higher value on rule following. After all, Congress is responsible for determining the eligibility criteria, and it could change the criteria to reach some of the adults who are improperly claiming the credit (I and others have suggested this in past papers, most recently from me in the special report to Congress on the EITC that was part of the TAS FY 2020 Objectives Report). 

How does the current pandemic and economic crisis influence this issue? If I were in the IRS now, I would be strongly advocating for the IRS to slow down on the TIGTA recommendation to impose more civil penalties and sanctions on EITC claimants. Context matters. People are struggling. While it should not mean a green light for allowing erroneous claims to go out of the door, OTA helps us understand that the overwhelming majority of Americans who appear to be improperly claiming the credit have a close family relationship with the children identified on their tax return. 

When the current crisis clears, Congress should take a hard look at the EITC and other credits. It could help the IRS by boosting the childless EITC, which in addition to helping millions of working Americans will also likely decrease incentives for people to share children to ensure eligibility. Congress should also reconsider the eligibility requirements that are difficult and expensive for the IRS to verify and which make less sense in today’s world, like pegging eligibility on arbitrary residency rules that 1) may understate the importance of family members who are connected financially and emotionally but who do not live with a child for more than 6 months and 2) do not work well when there are multigenerational families living together.

Review of 2019 (Part 2)

In the last two weeks of 2019 we are running material which we have primarily covered during the year but which discusses the important developments during this year.  As we reflect on what has transpired during the year, let’s also think about how we can improve the tax procedure process going forward.

read more...

2017 Tax Legislation

The Tax Cuts and Jobs Act (TCJA) has already had significant effects on taxpayers in the first two years since its enactment. The law almost doubles the standard deduction for taxpayers, while mostly eliminating personal exemptions and limiting or eliminating certain personal deductions. Of particular relevance in the LITC context, the Child Tax Credit (CTC) was doubled from $1,000 to $2,000 per qualifying child (though only $1,400 is refundable). While the elimination of the personal exemption for dependents largely makes this a wash for many taxpayers, low income taxpayers may actually be advantaged by the change, since the CTC is partially refundable, and exemptions are of less benefit to those with low marginal rates. Finally, beginning in 2019, the TCJA eliminates the shared responsibility penalty assessed on taxpayers who fail to enroll in qualified health insurance plans under the Affordable Care Act.

The TCJA has also led to another potentially unintended consequence for some taxpayers seeking ITINs for their dependents. Since the dependency exemption is now worth $0 and because (almost) all tax benefits attributed to an ITIN dependent requires that they physically live in the United States (see e.g. IRC 24(h)(4)(B)), the IRS is now reluctant to issue ITINs to dependents outside of the US unless a specific tax benefit is demonstrated. (See W7 Instructions, “What’s New”). This causes serious problems for taxpayers that live in “non-conforming” states (like Minnesota) where a dependency exemption is still worth something on the state return, but their dependent lived in Mexico the whole year. These taxpayers can’t get an ITIN for the dependent because there is arguably no federal tax reason, and they can’t put their dependent on the state return because they don’t have a federally issued ITIN. The University of Minnesota LITC has dealt with this issue and had some success by working with a VITA site that issues ITINs. In at least one instance, the clinic was able to get an ITIN issued based on an issued position letter that argued that there was a federal benefit to an ITIN.

Leslie Book, Suggestions to Get Up to Speed on (Some) Issues With the New Tax Law, Procedurally Taxing (Dec. 17, 2017), https://procedurallytaxing.com/suggestions-to-get-up-to-speed-on-some-issues-with-the-new-tax-law/

Third party contacts

Until the TFA was enacted, a 9th Circuit case, J.B. v. United States, represented anew obstacle for IRS making contact with third-parties during an audit. During the course of the audit of the petitioner and his wife, the IRS issued a summons to a third-party (incidentally, the California Supreme Court), seeking information on compensation issued to the petitioner. The petitioner then moved to quash the summons, on the basis that the IRS failed to give reasonable advance notice of the third-party contact (in accordance with IRC § 7602(c)(1)) when it sent Publication 1, a pamphlet included with the initial notice of audit. Publication 1 is a generic publication that broadly gives advance notice of the possibility that the IRS will make contact with a third party.

The 9th Circuit held that the publication was insufficient as not reasonably calculated to inform the taxpayer of the contact. The court based its decision on a number of factors, including the two-year length between the issuing of Publication 1 and the contact, the possibility of privileged information being included in the summons, and the extensive contact between the taxpayers and IRS. Perhaps most relevantly, the court suggested in a footnote that Publication 1 alone may never be sufficient to provide reasonable notice due to its broad language and lack of certainty regarding the chance of contact.  But see, High Desert Relief, Inc. v. United States, 917 F.3d 1170, 1193 (10th Cir. 2019) (assuming, without deciding after J.B., that Publication 1, in substance, did provide sufficient notice under section 7602(c)(1)). 

Following a 2017 National Taxpayer Advocate report discussion of TPCs, Section 1206 of the Taxpayer First Act (TFA) amended IRC § 7602(c) by repealing the requirement for the IRS to provide “reasonable notice,” making J.B. less relevant.  It clarified that the IRS may provide this third-party contact (TPC) notice only if it intends to make a TPC during the period specified in the notice, which may not exceed one year.  Generally, the IRS must send the notice at least 45 days before making the TPC.  TAS has been advocating that an IDR be included with the TPC notice so that the taxpayer has a realistic opportunity to avoid a TPC that seeks new information by providing the information requested.

See Leslie Book, Ninth Circuit Rejects IRS’s Approach to Notifying Taxpayers of Third Party Contacts, Procedurally Taxing (Mar. 4, 2019), https://procedurallytaxing.com/ninth-circuit-rejects-irss-approach-to-notifying-taxpayers-of-third-party-contacts/

EITC

Special Report to Congress

Before leaving her post as National Taxpayer Advocate, Nina Olson issued a Special Report on the Earned Income Tax Credit as part of her annual report to Congress. The report makes a number of recommendations to improve administration of the EITC, notably including that the IRS develop an examination process for EITC bans and that Congress legislate whether the Tax Court has jurisdiction over EITC ban cases. Under the current situation, taxpayers are left with little recourse or due process opportunity when the IRS imposes such a ban.

See Bob Probasco, The EITC Ban – Further Thoughts, Part One, Procedurally Taxing (Sep. 27, 2019), https://procedurallytaxing.com/the-eitc-ban-further-thoughts-part-one/

Leslie Book, EITC Ban: NTA Report Recommends Changes and IRS Advises on its Application to Partial Disallowances, Procedurally Taxing (Aug. 8, 2019), https://procedurallytaxing.com/eitc-ban-nta-report-recommends-changes-and-irs-advises-on-its-application-to-partial-disallowances/

Earned Income for EITC but not for Income Taxes

Feigh v. Commissioner involved a novel issue of law: the interplay between the exclusion of Medicaid Waiver Payments from income (a change made via notice in 2014) and the EITC. The petitioners in Feigh would have been able to exclude these received payments from their income, but it actually would have made them worse off by removing the “earned income” necessary for them to qualify for the EITC and Child Tax Credit (“CTC”). The IRS rationale was that it was preventing the provision of a double tax benefit not intended by Congress. The Tax Court applied Skidmore deference to the IRS notice changing the waiver treatment and found that the notice was not persuasive that payments were excludible under IRC 131. The court then held that the IRS could not reclassify the status of the payments via notice as a means to eliminate the benefits of the EITC and CTC.

See Caleb Smith, Invalidating an IRS Notice: Lessons and What’s to Come from Feigh v. C.I.R., Procedurally Taxing (June 17, 2019), https://procedurallytaxing.com/invalidating-an-irs-notice-lessons-and-whats-to-come-from-feigh-v-c-i-r/

Innocent Spouse

Jurisdiction of District Court to hear refund

The question of whether taxpayers can bring an innocent spouse claim as part of a refund suit is an increasingly litigated issue. Under the long-time rule of Flora v. United States, taxpayers must pay their assessment first in order to bring a refund claim in federal district court. But whether such taxpayers could litigate the merits of their innocent spouse claims in such an action has been unclear. In 2018, a Texas district rejected the argument that an innocent spouse claim could proceed in a refund suit in Chandler v. United States. But in the more recent case of Hockin v. United States, an Oregon district court allowed a refund suit involving such a claim to proceed. Hockin is set for trial in early 2020 and may prove an interesting test case for this issue.  Ms. Hockin was represented by the tax clinic at Lewis & Clark and the tax clinic at the Legal Services Center of Harvard Law School filed an amicus brief in this case on behalf of Ms. Hockin.

See Sarah Lora & Kevin Fann, Innocent Spouse Survives Motion to Dismiss in Jurisdictional Fight with the IRS, Procedurally Taxing (Sep. 18, 2019), https://procedurallytaxing.com/innocent-spouse-survives-motion-to-dismiss-in-jurisdictional-fight-with-the-irs/

Carlton Smith, Another District Court Holds It Lacks Jurisdiction to Consider Innocent Spouse Refund Suits – at Least for Section 6015(f) Underpayment Cases, Procedurally Taxing (May 3, 2019), https://procedurallytaxing.com/another-district-court-holds-it-lacks-jurisdiction-to-consider-innocent-spouse-refund-suits-at-least-for-section-6015f-underpayment-cases/

Carlton Smith, Update: Can District Courts Hear Innocent Spouse Refund Suits?, Procedurally Taxing (Dec. 24, 2018), https://procedurallytaxing.com/update-can-district-courts-hear-innocent-spouse-refund-suits/

Innocent Spouse and Rev Proc.

Under Rev. Proc. 2013-34, actual knowledge of a spouse’s omission of income does not preclude equitable innocent spouse relief under IRC 6015(f). A recent case litigated by the tax clinic at the Legal Services Center of Harvard Law School has sought to reinforce the availability of equitable relief to such taxpayers. In Jacobsen v. Commissioner in the 7th Circuit, the petitioner has challenged the Tax Court’s denial of his appeal of an innocent spouse determination. The petitioner had four positive factors for relief under the statute, but the Tax Court found that his actual knowledge of embezzled income outweighed those factors thus not entitling him to relief. Oral argument was held in September 2019, and the case is currently pending.  Since the oral argument in Jacobsen two additional Tax Court cases have ruled against individuals claiming innocent spouse status where there was three positive factors and knowledge was the sole negative factor.  The Tax Court seems to be placing a heavy thumb on the scale when knowledge exists.

See Carlton Smith, Seventh Circuit to Hear First Case about Applying Latest Innocent Spouse Equitable Rev. Proc., Procedurally Taxing (July 30, 2019), https://procedurallytaxing.com/seventh-circuit-to-hear-first-case-about-applying-latest-innocent-spouse-equitable-rev-proc/

Cracks in the Flora Rule? Definition of a “Tax” and the New World of Refundable Credits

This year, the Notre Dame Tax Clinic litigated a case in the U.S. District Court for the Northern District of Indiana, which sought a refund of taxes claimed on our clients’ amended tax return. Alexander Ingoglia, a 3L at the Notre Dame Law School and a student in the Clinic, worked on this case last spring, and composed our response to the government’s motion to dismiss for lack of jurisdiction. Alex describes the case and the cracks it might show in the Flora rule.  – Patrick  

In 1960, the United States Supreme Court decided United States v. Flora and established the full-payment rule.  The rule requires plaintiffs to pay their entire tax deficiency before obtaining jurisdiction to sue the government for a tax refund in federal district court or the Court of Federal Claims.  However, we encountered a case in the Notre Dame Tax Clinic this year that presented facts that challenged the Flora rule.  While the case came to an end before the court considered its jurisdiction with respect to the facts, several unique facts established a credible distinction from Flora’s full-payment rule.  As a student attorney in the clinic, I had the opportunity to research Flora’s progeny and the statutory meaning behind the underlying jurisdictional hurdle while representing our client.

read more...

Factual and Legal Background

Our clients, Mr. and Mrs. Burns, originally filed a timely 2014 tax return, which properly claimed their two grandchildren as dependents.  The Burns’ tax return preparer, however, failed to claim the Burns’ deserved Child Tax Credit (“CTC”) and Earned Income Tax Credit (“EITC”) with respect to the grandchildren.  Pursuant to the Burns’ 2014 tax return, the couple received a $617 tax refund.

When the Burns switched tax preparers, their new preparer realized the mistake and filed an amended return on their behalf in April 2016.  At the time the Burns filed their amended return, they owed no taxes to the IRS.  The Burns reported a $1,889 decrease in adjusted gross income and claimed the EITC and CTC in the amounts of $5,430 and $1,588, respectively.  The Burns’ new tax preparer also noticed a $70 understatement in the Burns’ self-employment tax and reported the increase on the amended return.  In total, the Burns sought to receive a $6,948 refund after combining the additional credits with the increased self-employment tax assessment.

The IRS received the return, but rather than sending the Burns their nearly $7,000 refund, the IRS only assessed the additional $70 self-employment tax.  The IRS sent nothing denying the credits or even a request for additional information to substantiate the claimed credits. The Burns never received a right to challenge the denial of credits administratively or otherwise.

The Notre Dame Tax Clinic filed a complaint in district court on the Burns’ behalf.  The complaint stated that the Burns timely claimed a refund in their 2014 tax return, but that they never received any indication that their claims were insufficient or denied.  Instead, the claimed credits were selectively ignored while the IRS recognized the increased self-employment tax in the same 1040X.  The complaint sought relief in the form of the Burns’ $6,948 refund.

In response, the Department of Justice (“DOJ”) filed a Motion to Dismiss for lack of jurisdiction.  The DOJ asserted that the district court lacked jurisdiction to hear the case, pursuant to 28 U.S.C. § 1346(a)(1), which states that the district courts have original jurisdiction over civil actions “for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected . . . .”  This section serves as a limited waiver of sovereign immunity, allowing plaintiffs to sue the government in federal court. 

Although the section allows plaintiffs to sue the government to obtain their allegedly deserved refunds, the Supreme Court interpreted the limited waiver to include a “pay first and litigate later” requirement.  Flora v. United States, 362 U.S. 145 (1960).  Without a plaintiff fulfilling the “pay first and litigate later” requirement, the district court lacks jurisdiction to hear the case.  The Seventh Circuit reiterated the full payment rule, holding that “[f]ull payment is a jurisdictional prerequisite imposed by Congress.”  Univ. of Chicago v. United States, 547 F.3d 773, 785 (7th Cir. 2008) (citing Flora, 362 U.S. 64–65, 75, 78).  This interpretation of 28 U.S.C. § 1346(a)(1) prevents taxpayers from paying only a small portion of their tax bill to obtain district court jurisdiction. 

Of course, § 1346(a)(1) only dictates jurisdiction in the District Courts and the Court of Federal Claims.  Taxpayers retain the ability to bring cases in tax court without full payment (or any payment) of an alleged tax liability.  However, to sue for a refund in district court, Supreme Court and lower courts’ precedent has long held that a plaintiff must fully pay their tax bill before utilizing the limited waiver of sovereign immunity in § 1346(a)(1). What “fully pay” means, though, is not always clear.

In Flora, the case that established the full payment rule, the facts were simple.  The petitioner claimed ordinary losses.  The Commissioner treated the reported losses as capital, resulting in a $28,908.60 deficiency.  The petitioner paid $5,058.54 of the alleged deficiency and filed a refund claim for that amount with the IRS.  Once denied, the petitioner sued in district court for a refund of the $5,058.54 and a judgment abating the remainder of the assessment.  Recognizing a circuit split and a need for uniform treatment of similar district court suits, the Supreme Court agreed to hear the case.  In the interest of saving “the harmony of our carefully structured . . . system of tax litigation,” the Court ruled that in order to obtain jurisdiction, a tax liability must be fully paid before commencing a refund suit in district court.  The petitioner lost because he had paid only the $5,058.54 portion of the $28,908.60 deficiency.

Flora, at its core, is a decision about statutory interpretation.  Faced with ambiguous language, the Court resorted to legislative history to determine the meaning of “any internal-revenue tax.” 28 U.S.C. § 1346(a)(1).  That history, the Court determined, made it more likely that Congress intended the language to mean that the entirety of a tax must be paid for jurisdiction to arise.  In Flora’s case, this meant paying the entire deficiency assessment relevant to the dispute at hand.

The Burns’ case presented complicated facts.  At the time the Burns filed their 1040X, they owed nothing to the IRS.  In fact, they already collected a refund when originally filing the return.  While the Burns reported a $70 self-employment tax on their amended return, the nearly $7,000 in credits drowned the small self-assessment.  The IRS failed to deny the claimed credits or request additional documentation.  Instead, the IRS ignored the credits, assessed the $70 self-employment tax, and hid behind Flora to attempt to dismiss the refund suit, despite failing to deny or request additional information pertaining to the credits that swallowed the assessment.

The Clinic filed a response to the DOJ’s Motion to Dismiss.  The response differentiated the Burns’ case from Flora and its subsequent progeny on two bases: first, the Burns solely disputed the denial of rightfully claimed credits of the “tax” imposed under IRC § 1.  They did not dispute the unpaid self-employment tax assessment under § 1401.  Second, the Burns had already fully paid the $70 self-employment tax with their $7,000 of deemed refundable credits.

The First Distinction: The Owed Tax and the Refundable Tax are Different “Taxes” under § 1346(a)(1)

Our response argued that the statute’s use of the words “any internal-revenue tax” allows a petitioner to file a refund suit for one type of “internal-revenue tax,” while owing another type of “internal-revenue tax.”  Our argument pointed to several different types of internal-revenue taxes throughout Title 26 of the United States Code, such as §§ 1 (individual income tax), 11 (corporate income tax), 59A (base erosion and anti-abuse tax), etc. Similarly, Flora and the language of § 1346(a)(1) does not bar tax refund suits for a given year where a taxpayer has fully paid one tax period, but owes the government on another tax period.  By the same logic, the statutory language should not bar a petitioner from refund suits where the taxpayer has fully paid one “internal-revenue tax,” but not a separate, undisputed tax. 

Looking first to the text of 28 U.S.C. § 1346(a)(1), we argued that “[t]he term ‘any’ should be given [a] broad construction under the settled rule that a statute must, if possible, be construed in such fashion that every word has some operative effect.” Jove Eng’g, Inc. v. I.R.S., 92 F.3d 1539, 1554 (11th Cir. 1996) (citing United States v. Nordic Village, 503 U.S. 30, 36 (1992) (internal citations omitted)).  Assuming a broad construction of the term “any,” we contended that the contested credits were analytically distinct from the uncontested self-employment taxes.  The two taxes come from different chapters in Title 26 of the United States Code (“IRC”), with separate analyses and calculations.  The CTC and EITC fall under Chapter 1, whereas the self-employment tax falls under Chapter 2.

Flora, on the other hand, completely concerned an IRC § 1 tax.  Flora and its progeny do not contemplate jurisdiction when the petitioner challenges an entirely separate tax than the one creating the alleged deficiency.  Further, the tax creating the alleged deficiency would be eliminated if the Burns succeeded in their case and received their refundable CTC and EITC.  In Flora, the petitioner only paid a portion of his § 1 taxes, then sought a refund for those § 1 taxes paid, with a large § 1 tax deficiency outstanding.  The Burns paid the entirety of the § 1 tax disputed in the lawsuit, which was statutorily distinct from the unpaid, undisputed § 1401 (self-employment) taxes.

We focused primarily on two cases to deliver this point.  The first, Moe v. United States, No. CS-96-0672-WFN, 1997 WL 669955 (E.D. Wash. June 30, 1997), directly took on this distinction, stating that requiring payment of both § 1 and § 1401 taxes “places form over substance,” when the taxes pertinent to the disputed issue were paid.  In Moe, the taxpayer sought a refund with respect to his § 1401 (self-employment) taxes, while he owed taxes under § 1.  While the court granted the defendant’s motion to dismiss on other grounds, it clearly found the plaintiff’s argument persuasive, stating “[p]laintiff[s] should arguably not be required to prepay the uncontested income tax portion of her 1991 tax deficiency in order to litigate the contested 1991 self-employment tax.”  We also relied on Shore v. United States, 9 F.3d 1524 (Fed. Cir. 1993), which allowed the Court of Federal Claims to hear a refund suit even though interest on the underlying tax had not been paid.  The Shore court reasoned that because the interest was not itself disputed in the refund claim or in court, it need not be fully paid prior to filing suit.

The Burns never owed tax under § 1 for 2014.  They claimed refundable credits, causing an overpayment, which they claimed as a refund.  They were never audited or received a deficiency assessment.  Indeed, they never became subject to a tax assessment until the Government ignored their claimed refundable credits in the amended return.  While the Burns owed a tax under § 1401, this was a separate “internal-revenue tax,” which the Burns did not dispute in court.  We argued that, following the statutory interpretation in cases such as Moe and Shore, the Burns passed the statutory hurdles to jurisdiction.

Second Distinction: The Refundable Credits Claimed on the Amended Return Exceed the Tax Reported on the Return

The gist of this distinction is simple: there is no deficiency that needs to be fully paid because the credits claimed outweigh the increased self-employment assessment.  Flora preceded refundable credits in general, let alone the specific CTC and EITC at issue in the Burns’ case.  Thus, Flora could not contemplate the facts in the Burns case.  However, such refundable credits should, reasonably construed, constitute payments of tax that can, in circumstances such as in this case, provide jurisdiction for a District Court to adjudicate a substantive dispute as to the taxpayer’s entitlement to those credits.

In our response, we analogized the refundable EITC and CTC to withholding credits.  By example, we described a situation where a taxpayer neglects to include a W-2 in their tax return, notices it, then attempts to file an amended return to correct the error. If the W-2 produced additional tax of $150, but reported withholdings of $200, the Government surely could not assess the $150 tax, ignore the $200 withholding, and seek dismissal of a refund suit because the taxpayer failed to fully pay the associated tax assessment.  In that example, the government already has $50 owed to the folks amending their return.  Similarly, the government already owed nearly $7,000 to the Burns.  How could the government seek dismissal based on a $70 self-employment assessment when the government owes that same taxpayer nearly $7,000 for the same tax period?  We argued that the withholding credits and the credits in our case were analogous, and thus considering these claimed refundable credits, the tax was fully paid.

Conclusion

After the court received our response, the DOJ contacted us to offer a compromise.  The DOJ proposed a stay in the case while the IRS investigated the authenticity of the claimed credits.  The Burns agreed, and the IRS ultimately agreed that the Burns qualified for the claimed CTC and EITC.  The IRS’s issuance of the refund marked the end of the Burns’ district court case, leaving the unique distinctions in the case unaddressed.  The Burns case demonstrates the ambiguity that remains nearly 60 years after the Supreme Court interpreted 28 U.S.C. § 1346(a)(1) to require full payment in order to establish district court jurisdiction with respect to tax refund claims.

The EITC Ban – Further Thoughts, Part Three

Guest blogger Bob Probasco returns with the third and final post on the ban for recklessly or fraudulently claiming refundable credits. Part Three tackles the ban process.

The first two parts of this series (here and here) addressed judicial review of the EITC ban. The National Taxpayer Advocate’s Special Report on the EITC also made several recommendations about improvements during the Exam stage. The report is very persuasive (go read it if you haven’t already). In Part One, I quoted Nina’s preface to the report, which says that she is “hopeful that it will lead to a serious conversation about how to advance the twin goals of increasing the participation rate of eligible taxpayers and reducing overclaims by ineligible taxpayers.” Part Three is my small contribution to the conversation, concerning the ban determination process.

About that “disregard of rules and regulations” standard

The ban provision refers to a final determination that the taxpayer’s claim of credit was due to “reckless or intentional disregard of rules and regulations.” This standard seems to have been imported from section 6662, although there it covers not only reckless or intentional disregard but also negligent disregard. It seems a strange standard in this context, though.

read more...

The accuracy-related penalty regulations, § 1.6662-3(b)(1), state that disregard of rules and regulations is not negligent, let alone reckless or intentional, if there is a reasonable basis for the return position. But the definition of reasonable basis, § 1.6662-3(b)(3), cross-references the types of authority, § 1.6662-4(d)(3)(iii), applicable to determining whether there was substantial authority for a return position. And those are legal authorities. Arguably, the “disregard of rules and regulations” standard – for the EITC ban as well as the accuracy-related penalty – carries with it an unexamined implication that the facts are known and indisputable; only the application of the law to those facts is at issue.

Such a standard may make a lot of sense with respect to the accuracy-related penalty, at least for sophisticated taxpayers with good records. Those of us who deal a lot with low-income taxpayers and the EITC, however, know that often the credit is disallowed because the taxpayer’s proof is not considered sufficient. It’s a factual dispute, rather than a dispute as to what the law means.

Osteen v. Commissioner, 62 F.3d 356 (11th Cir. 1995) has some interesting discussion of this distinction in the context of the substantial understatement penalty. The very first sentence of the case mentions “certain tax deductions attributable to their farming and horse breeding operations,” so we know that section 183 is going to be the focus. The taxpayers, both of whom were employed full-time, were breeding and raising Percheron horses with the expressed intent to train them, show them, use them to operate a horse-powered farm, and then sell them. The Tax Court opinion, 66 T.C.M. 1237 (1993), determined that the taxpayers did not have “an actual and honest objective of making a profit,” and the Eleventh Circuit concluded that the court’s determination was not clearly erroneous.

The penalty discussion took much longer than the analysis of the profit objective issue. The Tax Court had rejected the petitioners’ penalty defense, which was based on substantial authority, and that puzzled the Eleventh Circuit:

The application of a substantial authority test is confusing in a case of this kind. If the horse breeding enterprise was carried on for profit, all of the deductions claimed by the Osteens would be allowed. There is no authority to the contrary. If the enterprise was not for profit, none of the deductions would be allowed. There is no authority to the contrary. Nobody argues, however, not even the Government, that because the taxpayers lose on the factual issue, they also must lose on what would seem to be a legal issue.

The court reversed on the penalty issue and said that “substantial authority” for a factual issue is met if a decision in the taxpayers’ favor would not have been clearly erroneous:

If the Tax Court was deciding that there was no substantial authority because of the weakness of the taxpayers’ evidence to establish a profit motive, we reverse because a review of the record reveals there was evidence both ways. In our judgment, under the clearly erroneous standard of review, the Tax Court would be due to be affirmed even if it had decided this case for the taxpayers. With that state of the record, there is substantial authority from a factual standpoint for the taxpayer’s position. Only if there was a record upon which the Government could obtain a reversal under the clearly erroneous standard could it be argued that from an evidentiary standpoint, there was not substantial authority for the taxpayer’s position.
 
If the Tax Court was deciding there was not substantial legal authority for the deductions, we reverse because of the plethora of cases in which the Tax Court has found a profit motive in the horse breeding activities of taxpayers that were similar to those at hand.

For those interested in the “factual issue versus legal authority” question, there was also an interesting article by Bryan Skarlatos in the June-July 2012 issue of the Journal of Tax Practice & Procedure: “The Problem With the Substantial Authority Standard as Applied to Factual Issues.”

This is not directly applicable to the EITC ban but a similar approach seems reasonable. A determination in Exam to disallow the EITC often merely means “the taxpayer didn’t prove that she met the requirements,” rather than “the taxpayer didn’t meet the requirements.” But I suspect that some or many of those who make the ban determination proceed with an assumption, implicit if not explicit, that the former is the equivalent of the latter. If the taxpayer doesn’t meet her burden of proof, that may suffice for denying the credit in the conduct year but may not be enough to impose the ban for future years.

For example, one of the three scenarios in IRM 4.19.14.7.1 (7), used as a starting point to help determine whether the ban is appropriate, addresses situations in which the taxpayer provided insufficient documentation but “indicates they clearly feel they are eligible, and is attempting to prove eligibility and it is clear they do not understand.” In those circumstances, the technician is supposed to “[c]onsider the taxpayer’s lack of understanding” before asserting the ban. There is no reference to the relative strength or weakness of the support offered. That formulation strongly supports an assumption by the technician that (understanding the rules + insufficient documentation), rather than (understanding the rules + not meeting the requirements), is sufficient to assert the ban. If so, that’s a problem.

Recommendations for a revised ban recommendation process

The Office of Chief Counsel issued Significant Service Center Advice in 2002 (SCA 200245051), concluding that neither the taxpayer’s failure to respond to the audit nor a response that fails to provide adequate substantiation is enough by itself to be considered reckless or intentional disregard of rules and regulations. That conclusion is also set forth in IRM 4.19.14.7.1 (1): “A variety of facts must be considered by the CET [correspondence examination technician] in determining whether the 2-Year Ban should be imposed. A taxpayer’s failure to respond adequately or not respond at all does not in itself indicate that the taxpayer recklessly or intentionally disregarded the rules and regulations.”

But, as the Special Report points out, the guidance in IRM 4.19.14.7.1 (7) is erroneous and/or woefully inadequate for the CET’s. And research described in the National Taxpayer Advocate’s 2013 Annual Report to Congress showed an incredibly high error rate in the ban determination. The Special Report recommends that the IRS develop a ban examination process independent from the audit process, modeled on other means-tested programs, to improve accuracy and provide adequate due process protections. The report also mentions several recommendations from earlier annual reports. For example, in the 2014 Annual Report to Congress, the NTA recommended (again) that a single IRS employee be assigned to work any EITC audit in which the taxpayer calls or writes to respond.

The Special Report didn’t, and couldn’t, define the appropriate process in depth. That is something that the IRS, in consultation with TAS, will have to develop, and it may take a significant amount of time. But while we’re waiting for that, here are suggestions for some specific parts of a revised process that would be on my wish list.

First, the ban determination process should incorporate the concept of the strength of evidence for and against eligibility. The ban should be asserted only when the evidence against eligibility is significantly stronger than evidence for eligibility. The inability to provide evidence for eligibility is not equivalent to deemed evidence against eligibility. And some types of evidence against eligibility will be stronger or weaker than other types.

Second, the process for determining eligibility for the credit should expand the types of evidence that can be submitted and considered, which in turn will affect the relative strength of evidence to be considered during the ban determination phase. The standard audit request and the IRM 4.19.14-1 list focus on third-party documents. Third-party documents are strong evidence but they’re not the only evidence; they’re just the only evidence Exam seems to accept. The IRS experimented with allowing third-party affidavits in test cases from 2010-2013. Starting with tax year 2018, taxpayers can submit third-party affidavits (signed by both the taxpayer and the third party) to verify the residency of qualifying children (IRM 4.19.14.8.3). Why not for other aspects of the eligibility determination? Why not talk directly with the taxpayer and assess credibility?

This is a pet peeve of mine. It’s frustrating to receive a notice of deficiency (because the technician did not accept other types of evidence) and then get a full concession by the government in Tax Court (because the IRS attorney understands the validity of testimony as evidence). I like getting the right result but would prefer to avoid the need to go to Tax Court, delaying the resolution. As the Special Report points out, the IRS cannot properly determine whether to assert the ban without talking to the taxpayer. If a technician/examiner is talking to the taxpayer for that, and assessing their understanding of the rules and regulations, why not also accept verbal testimony (or statements by neighbors and relatives) and evaluate credibility, to accurately evaluate the strength of the evidence for eligibility and therefore the propriety of imposing the ban?

Conclusion

The Special Report would, if its recommendations were implemented, transform a critically important benefit to low-income taxpayers. Nina, Les, and the rest of the team did a fantastic job. It will be a long, hard fight to achieve that transformation but it will be worth it.

The EITC Ban – Further Thoughts, Part Two

Guest blogger Bob Probasco returns with the second of a three-part post on the ban for recklessly or fraudulently claiming refundable credits. In today’s post Bob looks at legislative solutions to the issue of Tax Court jurisdiction.

My last post summarized previous arguments by Les and Carl Smith that the Tax Court lacks jurisdiction to review the proposed imposition of the EITC ban and then examined what the Tax Court is actually doing.  Some cases have ruled on the ban, but some cases have expressed uneasiness about this area and have declined to rule at all.  Congress has clearly stated its intent that judicial review would be available, but it’s appropriate to clarify that by an explicit grant of jurisdiction – preferably in a deficiency proceeding for the year in which the alleged conduct – the taxpayer intentionally or recklessly disregarded rules and regulations – occurred.  The National Taxpayer Advocate’s Special Report on the EITC recommended that Congress provide an explicit grant of jurisdiction to the Tax Court to review the ban determination.  This post offers suggestions – some sparked by Tax Court decisions and/or previous posts here on PT – about exactly how that should be implemented.  The point at which recommendations turn into legislation is a danger zone where flawed solutions can create problems that take years to fix.

Grant Tax Court jurisdiction in a deficiency proceeding for the “conduct year,” not the “ban years”

Les explained the benefits of this approach in his “Problematic Penalty” blog post.  Ballard saw the “attractiveness,” as do I.  It’s even more attractive today.  Although challenging the ban in a proceeding with respect to the conduct year is a better solution, back in 2014 taxpayers at least would have the opportunity to challenge the ban in a proceeding with respect to the ban year. (The “conduct year” is the year for which the taxpayer recklessly or intentionally disregarded rules or regulations to improperly claim the EITC and the “ban year” is a subsequent year for which the taxpayer cannot claim the EITC.)  As Les pointed out, and the Office of Chief Counsel explained in 2002 guidance (SCA 200228021), summary assessment procedures were available for post-ban years (for failure to re-certify) but the IRS would have to issue a notice of deficiency to disallow EITC in a ban year.  But since then, summary assessment authority for the ban years was added by the PATH Act of 2015, in section 6213(g)(2)(K), and the IRS is using it.  There is still an opportunity for judicial review after a summary assessment, but that opportunity has a lot of problems, as described in the Special Report.

read more...

The Special Report, Part IV, also recommends changes in summary assessment authority, under which some adjustments are not subject to the deficiency procedures, for an initial determination in the conduct year that the taxpayer is not entitled to the EITC.  Although I’m not entirely sure, I think the report is not recommending any change to the summary assessment authority under section 6213(g)(2)(K) for automatic disallowances in the ban year.  That’s understandable, as normally the correct application of the ban will be straight-forward and not require a separate examination in the ban year.  But there may some instances where the ban shouldn’t be applied automatically.  I’ll return to that below in the discussion of the application of the determination in the ban year.

Require that the proposed ban be set forth in a notice of deficiency for the conduct year

Of course, judicial review will be difficult if not impossible unless imposition of the ban is explicitly asserted and at issue in a case for the conduct year.  In all seven of the Tax Court cases discussed in my last post, the ban was explicitly asserted in an amended answer (Taylor) or the NOD itself (the other cases).  But that doesn’t always happen.

Carl Smith mentioned, in comments to the “Ballard” blog post, seeing a lot of cases where the ban was imposed by letter (presumably Notice CP79) rather than NOD.  I’ll quote his final sentence:

I wonder why some 32(k) sanctions are imposed by a simple letter and others (though apparently very few) are imposed in notices of deficiency.

My answer might be along the lines of: “Because the IRS thinks it can do that, unless Congress explicitly says otherwise, and it’s easier.”  My experiences with the EITC ban have made me more cynical.

My experience is consistent with Carl’s.  In just the past couple of years, my clinic has had four cases in which the IRS imposed the ban and issued Notice CP79.  Only one of the NOD’s explicitly stated the intent to impose the EITC ban.  In the other three cases, there was no indication whatsoever. 

In fact, in one case, there was an indication that an examiner had decided not to impose the ban.  After the NOD was issued, the taxpayer provided additional information and received a response from the IRS declining to change the proposed tax increase.  The letter included Form 886-A Explanation of Items that, again, did not propose the ban.  It also included a separate attachment, explaining why the additional information provided was insufficient.  That attachment stated at one point (emphasis added):

For future reference on the EITC BAN (Earned Income Tax Credit Ban) – The ban was considered.  If you continue to claim XXXXXXX for the credit and disallowed for no relationship, you could be subject to a 2-year earned income tax ban if you are found reckless and intentionally disregard the tax laws, rules and regulations.  You must meet the relationship test, residency test, age test and support test to be eligible for the credits.

That certainly sounds as though the determination required for the ban had not been made when the NOD was issued.  Nevertheless, when the taxpayer failed to file a petition timely, the IRS imposed the ban.

Given all the evidence that the IRS is asserting the ban without ever mentioning it in a notice of deficiency, the grant of jurisdiction to the Tax Court should be carefully crafted.  It should include not just jurisdiction to review the determination but also incorporate safeguards like those found in Section 6213(a) for tax assessments:

  • The determination required by section 32(k) is not a final determination until: (a) a notice of deficiency setting forth the determination has been properly mailed to the taxpayer; and (b) the expiration of the 90-day or 150-day period or, if a petition is filed in Tax Court, the decision of the Tax Court has become final.
  • Any disallowance of the credit in subsequent years based on the ban, before the determination is final, can be enjoined by a court proceeding, including in the Tax Court, despite the Anti-Injunction Act.

Applying the ban in the ban year

The cases I discussed in the last post suggested some specific issues that may need to be addressed when legislation is drafted to grant Tax Court jurisdiction to review the ban.  The first is obvious and fairly straight-forward.  Congress may need to modify section 7463(b) to specify that the determination in a small case with respect to the ban will be treated as binding for a proceeding in a future ban year.

How do we address the problem (discussed in Ballard and Griffin) that the court may not know yet whether the ban even had an effect in the ban years, because (for example) the taxpayer may not yet have filed returns claiming the credit for those years?  I don’t consider this concern an insurmountable obstacle.  Consider an analogy to the TEFRA partnership rules.  Under those rules, the court makes a redetermination of proposed adjustments on one return (the partnership’s).  The effect of that adjustment on other returns (the partners’) is authorized by provisions for computational adjustments.  The redetermination might turn out to have no effect on the partners’ returns, but the court doesn’t have to consider that in making its ruling in the partnership proceeding.

Currently, any credit claimed in the ban years can be disallowed automatically through the summary assessment authority in section 6213(g)(2)(K).  I don’t like that solution and think that instead Congress and/or the IRS should consider an approach similar to that in TEFRA: providing for some assessments without requiring a notice of deficiency in the ban year, but in other circumstances requiring a notice of deficiency because new fact determinations are needed.

Why might new fact determinations be needed?  Primarily because some exceptions or limitations should be carved out.  An all-or-nothing approach simply doesn’t make sense all the time.  What if:

A. The credit was reduced, but not disallowed, because some of the taxpayer’s earned income was disallowed.

B. The credit was claimed for 3 children and was only disallowed with respect to one.

C. The credit was disallowed because Husband’s earned income could not be verified.  Husband later married Wife, who has earned income and children from a previous marriage, and filed a joint return.  (See page 48 of the Special Report.)

Should we consider for future years, in situations like those: (A) allowing the credit but solely with respect to the taxpayer’s earned income from a Form W-2; (B) allowing the credit solely with respect to the children who qualified in the conduct year; or (C) allowing the credit but solely with respect to Wife’s earned income and qualifying children?

Lopez (situation A) suggested that there might be an exception for a partial disallowance:

It would appear that our findings will result in the reduction of petitioner’s claimed earned income tax credit for each year, but we expect that the credit will not be entirely disallowed for either year.  Consequently, we make no comment in this proceeding regarding the application of section 32(k).

A recent CCA (situation B) mentioned in Les’s blog post, however, concluded that partial disallowance was enough to trigger the ban.  The CCA’s reasoning was that section 32(k) doesn’t prohibit imposition of the ban for partial disallowances; thus, any disallowance is enough to trigger the ban.  “Disallowance” is not explicitly restricted to “total disallowance.”

Fair enough, but that doesn’t seem to be how Lopez interpreted the statute.  I don’t think it is entirely clear under current law.  Section 32(k) doesn’t refer to a disallowance (without explicitly specifying “total”) in the conduct year; it refers to the taxpayer’s “claim of credit” due to disregard of rules and regulations.  If the taxpayer could not legitimately claim any credit at all, that could meet the requirement (if done intentionally or recklessly).  In Lopez, was the “claim of credit” contrary to rules and regulations?  Or was the “claim of [at least some amount of] credit” consistent with rules and regulations but the amount excessive?  Lopez suggests the latter.  Does the answer depend on the reason for the excessive amount?  These questions deserve more thought.  The conclusion in the CCA may not be the best answer.

Another wrinkle came up in Griffin.  The court found the taxpayer was not entitled to EITC at all for 2013 because the taxpayer did not establish that any of the claimed dependents met the necessary tests.  However, the court found the taxpayer might be entitled to EITC for 2014, subject to applicable AGI limitations and thresholds after adjustments, because one of the two dependents claimed as qualifying children did meet all of the tests.  Should the ban be imposed if the taxpayer is not entitled to the EITC at all for one year but is entitled to at least some EITC in another year included in the same NOD, particularly if it’s the latest year included in the NOD?

Even if the CCA above is correct, current law is not immutable.  Congress should consider carving out exceptions or limitations to the ban.  If it doesn’t, we can try to change the law by persuading a court concerning the proper interpretation of the statute.  If the law changes, either through Congress or a court decision, we may want to use a more nuanced approach, like that in TEFRA, rather than blanket summary assessment authority.

Conclusion

This finishes my discussion of judicial review.  Establishing robust judicial review with all the flourishes will provide significant protection to low-income taxpayers who claim the EITC.

Some protection but, given current IRS practices, not enough.  Not all cases even go to Tax Court, so our primary goal should be to reduce the need for judicial review by improving the ban determination process in Exam.  The Special Report offered several suggestions along those lines.  I have some additional thoughts, coming up in Part Three of this series.