Adoption Tax Credit: IRS Can Reduce Audits and Refund Delays
Published: 2011-10-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The federal adoption tax credit, established in 1996, was amended in 2010. These amendments included making the credit refundable (meaning taxpayers could receive payments in excess of their tax liability) and increasing the maximum allowable credit to $13,170 of qualified adoption expenses for tax year 2010. As of August 20, 2011, taxpayers filed just under 100,000 returns, claiming about $1.2 billion in adoption credits. Following these changes, the Internal Revenue Service (IRS) developed a strategy for processing adoption credit claims. GAO was asked to (1) describe IRS's strategy for ensuring compliance with the adoption credit for the 2011 filing season, (2) assess IRS's related communication with taxpayers and stakeholders, and (3) assess its processing and audit of claims. To conduct its analysis, GAO analyzed IRS data and documents, interviewed IRS officials, observed IRS examiners, and interviewed other stakeholders.
section_title: What GAO Found
paragraphs: IRS's strategy for ensuring taxpayer compliance with the adoption credit included the following: (1) Communicating and reaching out to taxpayers and other stakeholders, including tax professionals and adoption organizations, about new requirements. (2) Requiring taxpayers seeking the adoption credit to submit proof of a completed or in-progress adoption with their return. Because taxpayers claiming the credit for a special needs child (meaning that a state determined the child cannot or should not be returned to a parent, and using specified criteria, the state can reasonably assume that the child will not be adopted without state assistance) are allowed to claim the full credit without providing documentation of adoption expenses, they also needed to provide documentation certifying the special needs status of the child. (3) Requiring that returns and supporting documentation be filed on paper. (4) Automatically sending returns with missing or invalid documentation for correspondence audits (audits that IRS conducts by mail). To inform taxpayers, paid preparers and other stakeholders about new adoption credit requirements, IRS used various tools including its website, Twitter accounts, and YouTube recordings. However, IRS did not make a specific effort to communicate or convey information about documentation requirements for special needs children to state adoption managers, who administer state adoption programs. Further, IRS did not specify in training materials for its audit examiners what documentation was required to prove special needs status. IRS later revised its training materials to say that a state adoption assistance agreement (an agreement between the state and adoptive parents) was sufficient proof but did not provide samples of such agreements in the materials or place any on its website. As a consequence, taxpayers submitted a majority of returns with either no documentation or insufficient documentation. As of August 2011, 68 percent of the nearly 100,000 returns on which taxpayers claimed the adoption credit were sent to correspondence audit. However, of the approximately 35,000 returns on which audits have been completed as of August, IRS only assessed additional tax about 17 percent of the time. The equivalent rate for all correspondence audits in 2010 was 86 percent. The time it has taken IRS to audit these predominantly legitimate adoption credit claims has resulted in considerable delays in the payment of the related refunds. For the 2012 filing season, IRS has options that might allow it to reduce the number of costly audits and issue refunds faster while still maintaining a robust enforcement strategy. One option is for IRS to immediately send a letter to taxpayers who submit returns without any documentation requesting it before initiating an audit. This could potentially reduce the number of audits and delayed refunds, but IRS has not yet determined the extent of this impact. IRS officials acknowledged that data from the 2011 filing season experience should allow them to determine whether sending an initial letter requesting documentation would be more effective than initiating a correspondence audit.
section_title: What GAO Recommends
paragraphs: GAO recommends that IRS communicate with state and local adoption officials, provide examiners with examples of adoption assistance agreements, place the agreements on its website, and determine whether sending a letter before initiating an audit would reduce the need for audits. IRS generally agreed with three of GAO's recommendations, but had concerns that placing sample agreements on its website may enable fraud. However, since other proof of adoption must accompany a tax credit claim, GAO believes the benefits of making these agreements available to adoptive parents outweigh the risks.

section_title: Letter
paragraphs: As an incentive to encourage adoptions, since 1996 taxpayers have been  able to take a tax credit for adoption-related expenses. In 2010, Congress  expanded the adoption tax credit from $10,000 to a maximum of $13,170  and made the credit refundable for tax years 2010 and 2011, meaning  taxpayers could receive payments even if their tax liability was less than  the credit. Because of the changes, the Internal Revenue Service (IRS)  developed a new enforcement strategy that included communication with  taxpayers and stakeholders to ensure that they understood the new law  and related documentation requirements. The strategy also included  special screening of adoption credit claims followed by audit if the  documentation was missing or looked questionable.
In this context, you asked us to    describe IRS’s strategy for ensuring taxpayer compliance with the    assess IRS’s adoption tax credit-related communication with  taxpayers and stakeholders, and    assess IRS’s processing and audit of adoption tax credit claims and  identify improvements, if needed, for the 2012 filing season.
For this report, we analyzed IRS information on adoption credit claims for  tax year 2010 and prior years and audit work conducted during the 2011  filing season. We obtained and reviewed IRS plans for processing and  auditing returns on which taxpayers claimed the credit and for  communicating information about the credit to the public, tax  professionals, and other stakeholders. We used IRS’s adoption credit  communication and compliance strategies as criteria for assessing IRS’s  performance. We interviewed IRS officials, including examiners,  responsible for processing and auditing adoption credit claims and for  communication. We also interviewed key outside stakeholders, including  Treasury Inspector General for Tax Administration (TIGTA) officials and  representatives of adoption advocacy organizations, such as the Child  Welfare League of America and the North American Council for  Adoptable Children. We spoke to adoption officials in five states  recommended to us by the advocacy organizations to examine how  states were dealing with the adoption tax credit. We spoke with IRS  officials and reviewed data collection procedures and determined the data  used in this report were sufficiently reliable for our purposes.
We conducted this performance audit from December 2010 through  October 2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: The federal adoption tax credit was first authorized in the Small Business  and Job Protection Act of 1996, which provided for a nonrefundable credit  for adoption expenses, not to exceed $5,000, or $6,000 for children with  special needs. Special needs children are defined as those children who  a state determined cannot or should not be returned to a parent, and  using specified criteria, the state can reasonably assume that the child  will not be adopted without state assistance. Parents of adoptive children  with special needs are also eligible for direct assistance under Title IV-E  of the Social Security Act.
Although the federal Department of Health and Human Services (HHS)  oversees state administration of the payments for direct adoption  assistance, the state agencies designate which children are considered to  have special needs. State adoption agency managers provide guidance  to adoptive families on how to manage the adoption process and  frequently receive inquiries about documentation and other administrative  requirements. Documentation certifying adoptions varies from state to  state. In its oversight role for state adoption programs, HHS provides  information to states through guidance and technical assistance. It also  provides information to states and families on adoption-related issues  through websites.
When the credit was first enacted in 1996, families that had qualifying  expenses greater than the maximum limit for the credit could carry over  that amount and claim those expenses for up to 5 years. Also, the law  phased out the credit for taxpayers above an upper income limit (which  was $182,520 in adjusted gross income for tax year 2010). Families  adopting non–special needs children can claim only the amount of  documented qualified expenses up to the maximum limit. However, since  2002, families adopting special needs children have been able to claim  the maximum tax credit without having to document adoption expenses.
For tax years 2010 and 2011, the Patient Protection and Affordable Care  Act (PPACA) of 2010 made the adoption credit refundable and set the  maximum credit at $13,170 for 2010, with the maximum amount for 2011  indexed for inflation. The credit is scheduled to revert to a nonrefundable  credit with a $10,000 maximum for tax year 2012. For 2013 and beyond,  the credit will be available only for special needs adoptions and may only  be claimed for qualified expenses incurred up to a maximum of $6,000.  See appendix I for detailed information on adoption tax credit legislation.
Since the original provision was adopted in 1996, taxpayers have claimed  about $4.28 billion in adoption tax credits. For tax year 2010, taxpayers  filed almost 100,000 returns claiming the credit, with over $1.2 billion  claimed as of August 2011. Figure 1 shows the total number of claimants  and amount of claims for each year since 1998.
We have previously reported that refundable tax credits have presented a  challenge to IRS. Because taxpayers can claim refundable credits in  excess of their tax liability, those attempting to commit fraud may file false  claims in efforts to get improper payments from the Treasury. For  example, IRS has had to deal with fraudulent claims and improper  payments involving the Earned Income Tax Credit and First-Time  Homebuyer Credit (FTHBC), both of which are refundable. In such  cases, Congress and IRS have taken steps to reduce the amount of fraud  and improper payments while trying to minimize the number of returns  that need to be audited. Audits are reviews of taxpayers’ records to  determine if they paid the correct amount of taxes.
As we have also previously reported, audits are costly to IRS and can  create delays in delivering refunds to taxpayers because, in some cases,  IRS holds the portion of the refund being audited until the audit is  complete. As an alternative to the standard audit process, Congress can  approve math error authority (MEA) to allow IRS to automatically deny  claims, without doing an audit, in cases where the taxpayer did not  provide required documentation. In 2009, Congress approved MEA for  the FTHBC, which helped significantly reduce improper payments. Having  MEA allows IRS to automatically deny credit claims in instances where  IRS can tell with virtual certainty that the taxpayer did not provide all of  the required information and allows IRS to devote costly audit resources  to other priorities. In cases where taxpayers disagree with the credit  disallowance, they may request an abatement.
section_title: IRS’s Adoption Tax Credit Compliance Strategy Involved Communication, Documentation, and Audit
paragraphs: After the changes to the adoption tax credit took effect in 2010, IRS  adopted a compliance strategy to minimize improper payments and  maximize accurate returns. This strategy included the following major  elements:    Communicating and reaching out to taxpayers, tax professionals,  Congress, the states, and adoption organizations, with the objective of  conveying information about changes in the law and documentation  requirements.    Requiring taxpayers claiming the credit to submit documentation that  the adoption of the child for whom credit was being claimed was  already completed or in progress (an adoption order or decree for a  completed adoption, or a home study, placement agreement, hospital  or court document, or lawyer’s affidavit for an adoption in progress),  along with IRS Form 8839.    Requiring taxpayers claiming special needs status for their child to  submit documentation from their state or local adoption authority  certifying that status.    Requiring taxpayers claiming the credit to file on paper rather than  electronically so that required documentation could be included with  the return.    Screening returns for proper documentation and possible audit, as  shown in figure 2.
IRS’s strategy included monitoring the success of its efforts in processing  tax year 2010 adoption credit claims during the 2011 filing season. IRS  officials met in early October 2011 to discuss lessons learned concerning  the execution of its tax year 2011 adoption credit strategy and consider  changes in the strategy for next year’s filing season.
section_title: Taxpayers and Stakeholders Did Not Have Important Information on the Adoption Tax Credit
paragraphs: To inform taxpayers, paid preparers, state agencies, adoption advocacy  groups, and other stakeholders about the new law and documentation  requirements, IRS planned to use various means of communication, such  as its website, media releases, phone forums, webinars, Twitter accounts,  and YouTube recordings. IRS aimed its communications at interested  parties, such as paid tax preparers and adoption advocates and  agencies, through, for example, specially directed e-mails, articles in  professional publications, and appearances at meetings and conferences.
However, IRS missed some opportunities to communicate on matters that  later became areas of concern. For example, while IRS held a webinar on  the adoption tax credit for tax professionals, IRS officials reported that  because of a lack of resources they canceled the single scheduled  webinar for adoption agencies and organizations that may have clarified  IRS’s documentation requirements for claiming the adoption credit. In  addition, IRS did not make an effort to communicate to state adoption  program managers or convey information about documentation  requirements for claims involving special needs children, which could  have helped state adoption managers better inform adoptive parents who  asked them what documentation to provide to IRS.
Because of this, according to officials from adoption advocacy groups and  state adoption agencies, key information about the credit did not reach  some taxpayers and stakeholders, especially concerning the  requirements for certification of children with special needs. As a result,  according to state adoption officials and adoption organization  representatives who received calls from taxpayers, IRS sent notices to  many adoptive families that their returns would be subject to audit and  their refunds delayed. When adoption organizations contacted IRS, the  agency acknowledged a problem with its communications and the clarity  of its guidance and took some corrective steps, including placing  additional information about the adoption credit and special needs  documentation on its website. IRS plans to take additional steps,  including revising the adoption credit claim form (Form 8839) and related  instructions for the 2012 filing season. However, IRS has not indicated  that it plans to target future communications specifically to state and local  adoption officials.
In addition, IRS did not adequately inform its tax examiners regarding  certain aspects of the adoption tax credit. In particular, IRS did not specify  in its examiner training materials what documentation it required and  would accept to verify that adopted children had special needs status.  While, in March 2011, IRS provided examiners with some examples of  state adoption assistance agreements, which certify special needs status,  it did not include any such examples in its training materials, even after  the materials were revised in June. According to the state adoption  officials with whom we spoke, the inadequate preparation of examiners  led to difficulties getting IRS to accept adoption assistance agreements as  proof of special needs status. For example, in response to audits and in  order to get IRS to accept documentation, adoption assistance  representatives from Wisconsin had to prepare a letter certifying special  needs status and provide it to the families that were waiting on refunds. In  June 2011, IRS revised its training materials and the Internal Revenue  Manual to indicate that a state agreement to provide adoption assistance  under Title IV-E of the Social Security Act was sufficient proof of special  needs status, but did not include examples of adoption assistance  agreements in the revised materials. IRS left the question of whether  certification was sufficient in the absence of such an agreement up to the  examiner’s judgment.
According to adoption advocacy organization officials, problems persist  even after the steps IRS took, with some examiners still not recognizing  assistance agreements from some states as proof of special needs  eligibility. Because adoption assistance agreements vary from state to  state and, in some states, adoption assistance agreements are executed  at the county level, adoption advocacy representatives acknowledged that  IRS examiners faced challenges in identifying what documentation would  be acceptable as proof of special needs status in each state. IRS took  some steps to clarify what constituted sufficient documentation  throughout the filing season. However, more could be done to clarify for  taxpayers or its examiners what would be acceptable documentation,  such as providing copies of acceptable adoption assistance agreements  for each state in the revised training materials. Providing copies of state  adoption assistance agreements would likely be relatively low cost,  particularly since representatives from an adoption organization told us  that they had provided IRS with agreements from about 40 states.  Because of its role in overseeing state adoption agencies, HHS may also  be able to aid IRS in reaching out to state adoption agencies.
Further, if IRS were to provide examiners with examples of adoption  assistance agreements for each state, it could also post such information  on its website to help taxpayers and paid tax preparers understand what  constitutes acceptable documentation. The incremental cost of providing  such information would likely be negligible.
section_title: IRS Can Reduce the Number of Audits in 2012
paragraphs: For the 2011 filing season, IRS screeners automatically directed all  returns on which taxpayers claimed the adoption tax credit and where  documentation was either missing or of uncertain validity to  correspondence audit (audits by mail). A senior IRS official acknowledged  that this process resulted in a large number of adoption credit–related  correspondence audits and diverted IRS resources from other more  productive audits.
As of August 6, 2011, IRS had sent 68 percent of almost 100,000 returns  it had processed on which taxpayers claimed adoption credits to  correspondence audit. Of those returns sent to audit, 83 percent were  sent because of missing documentation or documentation IRS could not  determine to be valid. IRS reported that it ended up disallowing all or a  portion of the credit for only about 6,000 (17 percent) of the approximately  35,000 returns on which audits have been completed and assessed   $17.7 million in additional tax. This means that for 83 percent of adoption  tax credit returns audited thus far, there was no change in the tax owed or  refund due. Reducing the number of adoption tax credit audits would  allow IRS to do more correspondence audits of other returns where the  chance of assessing additional tax would be greater. To this end, all  correspondence audits conducted in 2010 resulted in additional tax being  assessed 86 percent of the time, compared to 17 percent for the adoption  credit in 2011. Further, IRS officials also told us that they had not found  any fraudulent adoption tax credit claims, and there had been no referrals  of adoption tax credit claims to its Criminal Investigation unit.
Through September 10, 2011, IRS used a disproportionate share of its  audit resources on the adoption credit. IRS reported spending 32,000  staff days on adoption tax credit audits during the 2011 filing season. This  represents about 3.5 percent of all staff days expended on initial review  and correspondence audits. By comparison, the almost 100,000 returns  filed on which taxpayers claimed the adoption tax credit as of August 20,  2011, represent less than one-tenth of 1 percent of all individual returns  filed up to that point.
According to IRS officials, data for audits completed through September  2011 show that an adoption credit correspondence audit takes, on  average, 74 calendar days. This delays refunds, which, according to  adoption agency officials, can create difficulties for families expecting to  cover adoption costs with the refund.
According to IRS officials, there are several options, each with  advantages and disadvantages, for how returns on which adoption credits  are claimed could be handled in the 2012 filing season. These include  alternatives that could reduce costs and refund delays for claims  submitted without any documentation—41 percent of claims processed as  of August 2011—by either employing MEA or by sending a notice without  an audit.
If IRS retains its 2011 strategy, it would risk again sending a relatively  large proportion of adoption credit claims to audit that generate  relatively low dollar amounts of assessed taxes. Doing so would likely  ensure that all claims are properly documented, but would divert IRS  resources from other priorities and continue to delay refunds to  taxpayers.    Alternatively, IRS could seek to obtain MEA from Congress permitting  IRS to disallow the adoption tax credit without audit if a taxpayer did  not supply any documentation, similar to authority granted earlier to  IRS for returns on which taxpayers claimed the FTHBC. TIGTA  suggested to IRS in October 2010 that it seek MEA for the adoption  tax credit, and IRS and Treasury Department officials considered  requesting such authority prior to the 2011 filing season. However,  IRS and Treasury officials determined that current compliance tools  would be sufficient. As a result, they did not request the additional  authority.    Finally, IRS could institute a procedure by which, immediately  following initial screening of the return, it would send a letter to  taxpayers who did not provide any documentation, notifying them of  what documentation is needed. In this case, IRS would not disallow  the credit, but would instruct the taxpayer to respond to the letter  within 20 days while IRS holds the return until the taxpayer responds.  If the taxpayer is able to produce adequate documentation in  response to the letter, the IRS examiner initially screening the return  could approve the return for processing without further audit and  taxpayers would receive refunds faster than they would if their returns  were audited. However, current procedure specifies that if the  taxpayer is unable to produce the requested documentation, the  return would be sent for audit so that IRS can resolve the issue. Thus,  if a taxpayer did not send in documentation, his or her return would  also be sent to audit, possibly creating a longer delay than with IRS’s  current strategy, since there would be additional time spent while IRS  waited for the taxpayer to send in documentation.
IRS has not yet determined whether sending a letter upon initial  screening would lead to a significant number of taxpayers submitting  documentation after receiving the letter, thus reducing processing time  and the number of audits. IRS officials told us that data from the 2011  filing season on the number of claimants who submitted documentation  while undergoing a correspondence audit should help determine whether  sending an initial letter after screening the return would be more effective.
Table 1 summarizes the options and the potential advantages and  disadvantages of each.
section_title: Conclusions
paragraphs: The adoption tax credit provides a significant source of financial  assistance to adoptive families. In part because of the amount of money  at stake and potential for improper payments, IRS developed a strategy  for reviewing claims and administering the credit and devoted significant  resources to ensuring compliance. However, in implementing this strategy  IRS missed opportunities to clarify important information about what  documentation it deemed acceptable, increasing the burden on taxpayers  legitimately seeking the credit. Confusion about the documentation  combined with the process used to send returns for correspondence  audits has resulted in delaying refunds to taxpayers and the use of IRS  resources that could likely be better spent elsewhere. In reviewing its  strategy for the 2012 filing season, IRS has an opportunity to reduce the  time and resources spent on correspondence audits of adoption tax credit  claims as well as the number and length of refund delays while still  maintaining a robust enforcement strategy.
section_title: Recommendations for Executive Action
paragraphs: For the 2012 filing season, we recommend that the Commissioner of  Internal Revenue instruct appropriate officials to    ensure that the communications effort specifically includes state and  local adoption officials, and clarifies acceptable documentation for the  certification of special needs adoptees;    provide examples of adoption assistance agreements that meet the  requirements for documenting special needs status, from each state  and the District of Columbia, in training materials given to reviewers  and examiners;    place the agreements on its website to help taxpayers better  understand what constitutes acceptable documentation; and    determine whether requesting documentation in cases where no  documentation is provided before initiating an audit would reduce the  number of audits without significantly delaying refunds and, if so,  implement such a strategy for the 2012 filing season.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Commissioner of Internal  Revenue. In written comments on a draft of this report (which are  reprinted in app. II) the IRS Deputy Commissioner for Services &  Enforcement agreed with our recommendations to extend outreach to  state adoption managers and to determine whether requesting  documentation before initiating audits would reduce the number of audits  without significantly delaying refunds.
However, although he agreed that reviewers and examiners should be  provided examples of adoption assistance agreements, he indicated that  IRS believes current examples of state adoption assistance agreements  available to examiners on an internal website are sufficient to permit them  to accurately evaluate adoption records. As we stated in our report, we  believe making additional examples of state adoption assistance  agreements available to examiners would impose minimal incremental  costs. Providing additional examples would give examiners greater  certainty that taxpayers submitted the correct documentation on a state- by-state basis. Doing so would also give IRS’s examiners a more  comprehensive list of acceptable documentation. In developing a more  comprehensive set of examples for examiners, IRS could also list the  states where documentation originates from the county or local level  without collecting documentation from each jurisdiction.
IRS also expressed concern that posting the agreements on IRS’s  external website might enable unscrupulous individuals to submit  fraudulent documentation in support of a false claim. We understand this  possibility; however, any claim for a tax credit must also be accompanied  by proof that an adoption has taken place or is in progress, which would  not be available on the website. Given these additional documentation  requirements already in place, we believe that the benefits of making  state assistance agreements available to adoptive parents on the IRS  website outweigh the risks.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Chairmen and  Ranking Members of other Senate and House committees and  subcommittees that have appropriation, authorization, and oversight  responsibilities for IRS. We will also send copies to the Commissioner of  Internal Revenue, the Secretary of the Treasury, the Chairman of the IRS  Oversight Board, and the Director of the Office of Management and  Budget. In addition, the report will be available at no charge on the GAO  website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made key contributions to this report  are listed in appendix III.
section_title: Appendix I: Adoption Tax Credit Provisions, 1996 to the Present
paragraphs: As shown in table 2, since 1996, an adoption credit has existed. The  credit has been expanded several times since 1996 and was made  refundable for tax years 2010 and 2011. However, for tax year 2012 the  credit is nonrefundable with a reduced maximum and reverts to the 1996  law (nonrefundable maximum of $6,000 for special needs only) for tax  year 2013 and thereafter.
section_title: Appendix II: Comments from the Internal Revenue Service
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Joanna Stamatiades, Assistant  Director; Steven J. Berke; Abbie David; David Fox; Tom Gilbert; Inna  Livits; Kirsten Lauber; and Sabrina Streagle made key contributions to  this report.