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

Letter

Current Prerefund Checks Provide Significant Benefits

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.

Steps to Confirm Taxpayers’ Identities and Ensure That Required Information Is Provided

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.

Application of Computerized Filters

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.

Math Error Authority Checks

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.

Prerefund and Postrefund Audits

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.

Fraud Investigations

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.

Benefits of Prerefund Checks

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.

Prerefund Checks Can Be Enhanced

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.

The Future Holds Significant Possibilities for Enhancing Prerefund Checks

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.

Concluding Remarks

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.

Contacts and Acknowledgments

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.

Appendix I: IRS Math Error Authorities

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.