Tax Refunds: Enhanced Prerefund Compliance Checks Could Yield Significant Benefits
Published: 2011-05-25T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2010, the Internal Revenue Service (IRS) processed about 137 million individual income tax returns and issued 107 million refunds totaling over $312 billion. The compliance checks it performs before refunds are issued thus could affect millions of taxpayers and billions of dollars of refunds by identifying taxpayers who overclaim or underclaim tax benefits to which they are entitled. Math error authority (MEA) is just one example of the prerefund compliance checks that IRS uses. During 2010, IRS sent taxpayers 8.4 million notices for almost 10.6 million math errors identified on their 2009 individual tax returns. GAO's statement today will focus on three key areas: (1) prerefund checks and their benefits, (2) how those checks can be enhanced immediately, and (3) how they may be enhanced in the future. It is mostly based on GAO's previous work issued from 2008 through 2011, including an interim report on IRS's 2011 tax filing season, and our ongoing analysis of the 2011 filing season.
section_title: What GAO Found
paragraphs: Prerefund compliance checks enable IRS to help confirm taxpayers' identity, quickly and efficiently correct some errors with virtual certainty, and identify and audit some returns before refunds are issued. Math error checks are among the most beneficial of these checks for both IRS and taxpayers. For example, they have the potential to deter billions of dollars in erroneous refunds, especially for refundable tax credits that have increasingly been enacted and that have resulted in significant overclaimed refunds and fraudulent claims. Taxpayers benefit from prerefund checks in several ways, including that IRS identifies those underclaiming benefits. Last year GAO reported that IRS corrected about 7.7 million errors associated with the Making Work Pay credit, including about 60 percent in the taxpayers' favor, meaning that taxpayers received larger refunds (or had lower taxes due) than they had anticipated. For almost a century, Congress has been expanding IRS's MEA on a case-by-case basis. In 2010, GAO suggested that authorizing the use of MEA on a broader basis with appropriate controls to protect taxpayer rights could help IRS immediately address compliance problems with newly created tax credits. In the absence of broader MEA, from 2008 through 2011, GAO also suggested that Congress expand MEA for more limited purposes. Longer term, other IRS initiatives, such as matching information returns to tax returns during the filing season and leveraging new paid preparer requirements, could enhance compliance before refunds are issued. One prerequisite would be a major reworking of some fundamental IRS computer systems.

section_title: Letter
paragraphs: Thank you for the opportunity to be here today to discuss the Internal  Revenue Service’s (IRS) prerefund compliance checks and the tools used  as part of these checks.
To provide an idea of the universe that these checks could affect, in 2010,  IRS processed about 137 million individual income tax returns and issued  107 million refunds totaling over $312 billion. Its compliance checks thus  could affect millions of taxpayers and billions of dollars of refunds by  identifying taxpayers who overclaim the amount due to them and  taxpayers who underclaim tax benefits to which they are entitled.
Before processing refunds, IRS checks returns for clerical and  mathematical errors and conducts some additional checks on the  information presented in the return. Math error authority (MEA) is just  one example of the prerefund compliance checks that IRS uses. In 2010,  IRS sent 8.4 million notices to taxpayers for almost 10.6 million math  errors identified on their 2009 tax year returns.
We have long highlighted the importance of improving IRS’s prerefund  compliance checks as a means to improve compliance while minimizing  taxpayer burden. In 1998, we found that inadequate controls over refunds  was a material weakness that could adversely affect IRS’s ability to record,  process, summarize, and report financial data. We continue to believe that  enhanced preventive controls are keys to improving IRS’s ability to correct  taxpayer errors by preventing the disbursement of erroneous refunds,  thereby saving the federal government potentially billions of dollars.
My statement today will focus on three key areas: (1) prerefund checks  and their benefits, (2) how those checks can be enhanced immediately,  and (3) how they may be enhanced in the future. It is based mostly on our  previous work issued from 2008 through 2011, including our interim report  on IRS’s 2011 tax filing season, and our ongoing analysis of the 2011 filing  season. Those performance audits were conducted 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: Current Prerefund Checks Provide Significant Benefits
paragraphs: Prerefund compliance checks enable IRS to help confirm taxpayers’  identities and ensure that returns have required information, quickly and  efficiently correct certain errors with a virtual certainty of being right,  identify and audit some returns even before refunds are completed, and  help detect possible fraud. Figure 1 shows IRS’s prerefund process.
subsections: section_title: Steps to Confirm Taxpayers’ Identities and Ensure That Required Information Is Provided
paragraphs: When tax returns are first received by IRS, the initial process helps correct  taxpayer identification errors and ensure taxpayers have filled in all fields  that are required for IRS to process the return. The process differs slightly  for electronically and paper filed returns. For electronic returns, IRS  checks for possible mismatches among taxpayers’ identity information,  such as their names, Social Security numbers, and addresses. When  mismatches occur, IRS rejects the tax return back to the taxpayer or paid  preparer for possible correction. For paper returns, IRS staff review each  return to ensure that all forms and data needed to process the return are  present and may correspond with the taxpayer for missing information.  IRS staff then transcribe data from the paper return into IRS computer  systems and programming matches taxpayers’ identity information if  possible. Later on in the process, IRS staff may also correspond with  taxpayers or their paid preparers to obtain other missing information, as  well as research and correct certain errors that would affect processing  the return, such as transposed numbers within Social Security numbers.
subsections: section_title: Application of Computerized Filters
paragraphs: After initial errors are corrected, the return information is captured in  IRS’s tax return processing systems. At this point, IRS applies additional  computerized filters. Some filters identify errors that can be corrected  using IRS’s MEA. Other filters identify errors that can be addressed  through audits either before a complete refund is sent to the taxpayer or  afterwards. Finally, still other filters identify possible cases of tax fraud.
section_title: Math Error Authority Checks
paragraphs: When IRS’s computer programs identify errors on returns that can be  corrected with virtual certainty, those returns are forwarded to IRS’s Error  Resolution System (ERS). Despite the name, math errors encompass much  more than simple arithmetic errors. They also include, for instance,  identifying incorrect Social Security or other taxpayer identification  numbers, problems with taxpayers’ filing status or claiming of dependents,  and missing schedules or forms. Some of these errors are detected from  information included on the tax return itself, and some are detected by  comparing information on the return to other internal IRS databases or  databases of information obtained from others, such as the Social Security  Administration.
In ERS, IRS staff manually review the error and enter codes that then  automatically generate a notice to the taxpayer that explains the error,  identifies the revision in the taxpayer’s refund amount—or possibly a new  balance due to IRS, and instructs the taxpayer on how to respond if he or  she disagrees with the change IRS has made.
section_title: Prerefund and Postrefund Audits
paragraphs: When IRS filters identify an error not correctable with MEA, the return is  placed in queue for possible prerefund or postrefund audit. Depending on  available resources, IRS will audit a portion of these returns, generally  through correspondence audits with taxpayers, before complete refunds  are sent to the taxpayers. In some cases, IRS will send the taxpayers the  portion of their refunds that was claimed correctly while withholding the  portion that IRS considers likely to be in error. To the extent returns are  not handled in prerefund audits, IRS will include them for possible  postrefund audits.
section_title: Fraud Investigations
paragraphs: Based on IRS’s computer filters, IRS identifies some refund claims that  may be fraudulent. These are forwarded to IRS’s Criminal Investigation  division. Those investigations may occur simultaneously as math error or  audit corrections are being made to the return. In some cases, the  investigation may be of a taxpayer and in other cases it may focus on a  paid preparer or others who may be engaging in systematic fraud affecting  more than one return.
section_title: Benefits of Prerefund Checks
paragraphs: Collectively and individually, these prerefund checks have benefits for IRS  and taxpayers. The initial checks on taxpayers’ identities and  completeness of returns help ensure that returns can be accepted and  processed quickly for taxpayers. It also allows IRS to detect common  errors or noncompliance such as if a taxpayer uses a false Social Security  number to claim a dependent.
Math error checks are among the most beneficial of the prerefund checks  for both taxpayers and IRS. These checks have the potential to protect  billions of dollars in federal revenue from being erroneously refunded to  taxpayers, especially for refundable tax credits that have been increasingly  enacted in recent years, as significant overclaimed refund amounts result,  sometimes through fraudulent claims. For example, Congress enacted  three different versions of the refundable First-Time Homebuyer Credit  (FTHBC) but did not immediately provide IRS with MEA to automatically  verify certain information. In 2009, we proposed that Congress grant MEA  to IRS to conduct prerefund compliance checks to ensure that taxpayers  do not claim the homebuyer credit in multiple years. We calculated that  IRS prevented about $95 million in erroneous refunds in fiscal year 2010  using this new authority. In addition, this and various other MEA  provisions for the FTHBC granted to IRS after the credit was first enacted  allowed IRS to deny approximately 350,000 erroneous claims in 2010,  thereby saving tax revenue and enabling IRS to use scarce enforcement  resources elsewhere. If not denied, this large volume of erroneous claims  would have roughly translated into a billion dollars or more in improper  payments.
IRS can use MEA to correct errors it identifies and send the corrected  refund amount to the taxpayer instead of trying to recover overpayments  after audit. In postrefund enforcement, IRS may not recover all funds that  are owed, which may be especially true for cases of fraud, and may incur  additional costs in attempting to collect the delinquent taxes. We have  previously reported that prompt compliance checks are important because  as unpaid taxes age, the likelihood of collecting all or part of the amounts  owed decreases.
For taxpayers, some MEA helps them receive tax benefits for which they  are eligible by identifying individuals who underclaimed the benefits. For  example, last year we reported that from January 1 through September 30,  2010, IRS corrected about 7.7 million errors associated with the Making  Work Pay credit, including about 60 percent in the taxpayers’ favor. These  corrections meant that taxpayers received larger refunds (or had lower  taxes due) than they had anticipated.
If IRS conducts a prerefund audit, it holds disputed refund amounts until  the taxpayer’s proper tax liability can be determined and the audit is  concluded. As with math error checks, prerefund audits are preferable  because once a refund has been paid, IRS may be unable to collect all  amounts due and can incur significant expenses in the collection of  delinquent tax debts. For taxpayers, prerefund audits also minimize the  possible interest expenses they would incur if the audits did not occur for  months or more after their return was filed. Generally, taxpayers accrue  interest on underpaid taxes from the date the tax becomes due.
Finally, beginning fraud investigations as quickly as possible has several  advantages for IRS. In general, the more quickly such investigations are  begun, the more likely evidence will be available. To the extent that  investigations lead to quick action, perpetrators of fraud may be stopped  before they can continue their efforts through the filing season. An  affirmative IRS investigative presence and successfully resolved cases may  also deter some who would otherwise be tempted to engage in fraudulent  activities.
section_title: Prerefund Checks Can Be Enhanced
paragraphs: For almost a century, Congress has been expanding IRS’s MEA on a case- by-case basis. Its most recent expansions were to help determine the  eligibility for certain credits such as the FTHBC. The increase over time  has resulted in the 13 existing MEA provisions shown in appendix I.
Although Congress sometimes quickly extended MEA to address  compliance issues with newly created tax credits, at times a round of  initial errors occurred before IRS was able to obtain the new authority. We  suggested in 2010 that authorizing the use of MEA on a broader basis  rather than on a case-by-case basis, with appropriate controls to protect  taxpayer rights, could minimize the danger of that happening in the  future. In the past we identified benefits to IRS and taxpayers that could  arise from broader MEA. I already mentioned some of these earlier, but, to  summarize, broader MEA could    enable IRS to correct all or nearly all returns where IRS identifies the  noncompliance and the needed correction with virtual certainty, not just  those it can address through other enforcement means;    be low cost and less intrusive and burdensome to taxpayers than audits;    ensure that taxpayers who are noncompliant on a particular issue are  similarly treated, that is, that a greater portion of them are brought into  compliance, not just those that IRS could otherwise address through other  enforcement means;    enhance equity between compliant and noncompliant taxpayers because a  greater portion of the noncompliant taxpayers would be brought into  compliance;    provide a taxpayer service as it would generally allow noncompliant  taxpayers to receive their refunds faster than if IRS had to address the  error through some other compliance mechanism, have their returns  corrected without penalty and before interest is accrued, and avoid time- consuming interaction with IRS under its other programs for resolving  noncompliance;    help ensure that taxpayers receive the tax benefits for which they are  eligible by identifying taxpayers who underclaim a tax benefit;  free up IRS resources to pursue other forms of noncompliance; and    allow IRS to quickly address provisions arising from new and quickly  moving initiatives like the American Recovery and Reinvestment Act of  2009 (Pub. L. No. 111-5) without waiting for new MEA to go through the  legislative process.
While providing broad MEA is ideal, we have also suggested that Congress  expand MEA for more limited purposes. As we recently reported, IRS does  not have MEA to review prior year tax returns to ensure that taxpayers do  not claim credits or deductions in excess of lifetime limits such as for  residential energy credits. We have identified four specific cases where  IRS could benefit from additional MEA, including for the FTHBC for which  Congress granted authority. Expanding MEA should also provide many of  the same benefits described above. Table 1 provides a summary of GAO’s  previous matters for congressional consideration for expanded MEA.
MEA allows IRS to correct a tax return and send a notice to the taxpayer  regarding the correction without going through the statutory deficiency  procedures. Instead, IRS notifies the taxpayer that it has identified the  error and has made a change to the return. Taxpayers have 60 days to  contest the assessment outlined in those notices. Further, if they do not  contest the assessment within that time, they lose their right to file an  appeal with IRS or the U.S. Tax Court but have the option of filing an  amended tax return to be considered by IRS. The National Taxpayer  Advocate and some in Congress are concerned that not following the  statutory deficiency procedures might undermine taxpayer rights because  IRS might use broad authority in situations where it does not know with a  high degree of certainty that the taxpayer made an error. In addition,  taxpayers might not ask, within 60 days after being assessed tax by IRS, to  have their assessment reversed by IRS and thus might be unable to  challenge an IRS notice through normal deficiency procedures or in the  Tax Court.
To mitigate these concerns, Congress could extend broader MEA to IRS  but could specify criteria governing when IRS could use the authority.  Traditionally, math error checks have allowed IRS to detect errors or  determine taxpayer eligibility with virtual certainty, thus letting IRS make  corrections without first corresponding with the taxpayer. To ensure IRS  continues to use MEA only in these limited circumstances if given broader  authority, Congress could, for example, require IRS to submit a report to it  or an entity it designates on a proposed new use of MEA. The report could  include how such use would meet the standards or criteria outlined by  Congress. The report could also describe IRS’s or the National Taxpayer  Advocate’s assessment of any potential effect on taxpayer rights. Or,  Congress could require a more informal procedure whereby IRS simply  notifies a committee, such as the Joint Committee on Taxation, of its  proposed use and subsequently submits a report after such use is  underway. In any case, Congress could provide IRS broader authority to  use MEA than is currently authorized but still provide appropriate  safeguards and require IRS to report in order to alleviate concerns of  improper use of MEA.
section_title: The Future Holds Significant Possibilities for Enhancing Prerefund Checks
paragraphs: The benefits I listed earlier of broadening MEA or using other prerefund  compliance checks could also result from other initiatives that IRS has  already begun or is contemplating. For example, in April, 2011, the  Commissioner of Internal Revenue talked about a long-term vision to  increase upfront compliance activities during returns processing. In one  example, IRS is exploring requiring that information returns be sent to IRS  and taxpayers at the same time as opposed to the current requirement that  some returns go to taxpayers before going to IRS. The intent is to move to  matching those information returns to tax returns during tax return  processing. IRS currently matches data provided on over 2 billion  information returns to tax returns only after the normal filing season.  Matching during the filing season would allow IRS to detect and correct  errors before it sends taxpayers their refunds, thereby avoiding the costs  of trying to recover funds from taxpayers later. This approach could also  allow IRS to use its enforcement resources on other significant  compliance problems. However, the Commissioner made clear that his  vision for more prerefund compliance checks will take considerable time  to implement. One prerequisite would be a major reworking of some  fundamental IRS computer systems.
Other IRS initiatives should also enhance compliance before refunds are  issued. For instance, IRS could leverage new paid tax return preparer  requirements to improve taxpayer compliance before tax returns are filed.  Our work has shown that paid tax preparers play a vital role in  administering our country’s tax system and ensuring compliance with tax  laws. Paid preparers prepare about 60 percent of the federal tax returns  filed annually. However, we and others have found that some paid  preparers make significant errors. We also found that emulating Oregon’s  paid preparer regulatory regime had the potential to lead to more accurate  federal returns. In response, IRS is currently implementing new  regulatory requirements in order to oversee the conduct and competency  of paid preparers.
These new requirements may improve the accuracy of tax returns initially  prepared by paid preparers. The new requirements may also help IRS  address compliance problems that arise during filing seasons. For  instance, IRS may be able to identify specific paid preparers that are  making errors and send them information on their errors, thus reducing  errors on additional returns they may prepare during the filing season. To  achieve the full benefits of the paid preparer regulatory regime, IRS must  continue to make progress with its plans to develop a comprehensive  database containing information on the preparers and tax returns they  prepare. IRS must use information from this database to test which  strategies are most effective for improving the quality of tax returns  prepared by different types of paid preparers. To help with this effort, we  recently recommended that IRS provide a documented framework for  using the paid preparer requirements to improve taxpayer compliance.  IRS agreed with this recommendation.
section_title: Concluding Remarks
paragraphs: In closing, IRS has a massive challenge in ensuring compliance with the  tax laws. Looking forward, with budget constraints a reality and burden on  taxpayers a concern, doing more compliance checks before refunds are  issued has great appeal for both taxpayers and IRS. Through oversight  efforts like today’s hearing, Congress can encourage and authorize the use  of appropriately designed prerefund compliance checks that are critical to  stopping erroneous refunds and ensuring that federal dollars are  protected.
Chairman Boustany, Ranking Member Lewis, this completes my prepared  statement. I would be happy to respond to any questions you or other  Members of the Subcommittee may have at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information regarding this testimony, please contact Michael  Brostek, Director, Strategic Issues, on (202) 512-9110 or  brostekm@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this  statement. Individuals making key contributions to this testimony include  Joanna Stamatiades, Assistant Director; Steven J. Berke; Amy R. Bowser;  David Fox; Tom Gilbert; Lawrence M. Korb; Inna Livits; and Sabrina  Streagle.
section_title: Appendix I: IRS Math Error Authorities
paragraphs: Table 2 summarizes the Internal Revenue Service’s (IRS) 13 areas of  existing math error authority (MEA). As early as the first codification of  the Internal Revenue law in 1926, Congress granted IRS MEA so that IRS  does not have to provide taxpayers with a statutory notice of deficiency  for math errors. A 1976 statutory revision defined the authority to include  not only mathematical errors, but other obvious errors, such as omissions  of data needed to substantiate an item on a return, and provided a  statutory right to file a request for abatement of the assessment within 60  days after the notice is sent. In the 1990s, Congress extended the authority  multiple times, and more recently it has added other provisions to help  determine eligibility for certain tax exemptions and credits, such as the  First-Time Homebuyer Credit.