TIGTA: IRS Improperly Enforced Law Penalizing Erroneous Claims

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By Jason Bramwell

A November 12 report released by the Treasury Inspector General for Tax Administration (TIGTA) – The Law Which Penalizes Erroneous Refund and Credit Claims Was Not Properly Implemented – found that by incorrectly interpreting provisions in the Small Business and Work Opportunity Tax Act of 2007, the IRS significantly limited the number of erroneous tax refund and improper tax credit claims on which it could assess penalties.

Because certain tax refund schemes were overwhelming IRS resources to the point that the agency was unable to prevent the issuance of erroneous refunds, Congress in May 2007 enacted the Small Business and Work Opportunity Tax Act, which amended the Internal Revenue Code to enhance the IRS' ability to dole out monetary penalties for erroneous tax refund or tax credit claims. 

Under the law, taxpayers who claim excessive tax credits or refunds may be penalized up to 20 percent of the erroneous tax credit or refund claim. 

What TIGTA discovered was the IRS assessed only eighty-four erroneous refund penalties totaling $1.9 million between May 2007 and May 2012. Penalties were not assessed because the IRS Office of Chief Counsel incorrectly interpreted the law as to when the IRS had the authority to assess the erroneous refund penalty. 

In response to concerns raised from various IRS functions, the Office of Chief Counsel subsequently revised its interpretation of the law as to when the erroneous refund penalty could be assessed, and it issued an updated memorandum in May 2012. However, TIGTA noted the IRS has yet to develop processes and procedures to enable its campus operations functions, which disallow the majority of individual tax credits, to assess the penalty. 

"In the year after the IRS revised its interpretation of the law (June 3, 2012 through May 25, 2013), there were 709,123 individual tax credits totaling more than $7.5 billion disallowed by these functional areas", TIGTA stated in its report. "Applying the 20 percent erroneous refund penalty rate to the total credit amount disallowed computes to more than $1.5 billion in penalties that potentially could have been assessed.

IRS management raised concerns about the cost and benefits of establishing processes and procedures for campus operations to assess erroneous refund penalties, but has not provided any documentation and/or analysis to support the validity of these concerns, according to TIGTA. 

"In view of the significant problems of erroneous claims for credits and refunds and the related costs to the government, we believe that the IRS should reexamine its decision and put appropriate procedures and processes in place to comply with this section of the law", TIGTA stated in the report. 

J. Russell George, Treasury Inspector General for Tax Administration, said in a written statement he is troubled that even though the IRS has revised its interpretation of the law, the agency has still failed to establish processes to assess penalties on the majority of disallowed tax credit claims.

"Taxpayers who seek refunds or credit claims that have no reasonable basis in law must be penalized, for they create unnecessary burden on both the IRS and the American people by straining resources and impeding tax administration", he said.

TIGTA recommended the IRS develop processes and procedures to enable campus operations to assess the erroneous refund penalty for disallowed credit claims that are excessive and do not have a reasonable basis. The IRS agreed with the recommendation and stated that a cross-functional team of affected stakeholders will determine the operational and procedural changes needed to integrate assessment of the erroneous refund penalty into campus operations. 

While the IRS has implemented enforcement of the provisions of Internal Revenue Code Section 6676, Erroneous Claims for Refund or Credit, in its field audit operations, the agency recognizes that additional actions can be taken to identify campus operations where the penalty should be considered, according to Peggy Bogadi, commissioner for the IRS Wage and Investment Division. 

"However, as noted in the report, there are significant concerns regarding the costs associated with implementing enforcement of the penalty provisions within the campus environment", she wrote in a memorandum in response to the report. "The Section 6676 penalty may be appealed administratively but, unlike income tax and certain other penalties, cannot be considered by the Tax Court in a normal deficiency context. This nuance renders the penalty assessment incompatible with existing automated campus-based compliance processes. The corrective action, whether accomplished manually or through automation, will have associated costs (both direct and opportunity) substantially higher than the estimated annual direct labor costs of $3.4 million cited in the report." 

She also added that taxpayers may avoid the penalty for any denied claim in which they have a reasonable basis. 

"The determination of reasonable basis is a judgmental decision based on a review of the position taken on the return and all applicable supporting authorities for the position", Bogadi wrote. "In a declining budget environment, this will require the reassignment of examiners from other critical priority compliance work, such as identity theft and refund fraud." 

Bogadi stated the IRS disagrees with TIGTA that IRS management disregarded its responsibility for establishing processes and procedures for assessing the erroneous claim penalty. 

"At the time the penalty provisions were enacted, and afterward, the IRS faced an unprecedented year-by-year increase in the number of fraudulent claims for refund by unscrupulous individuals", she wrote. "Identifying and stopping those fraudulent claims has been the foremost priority. Moreover, we disagree with the characterization that erroneous chief counsel advice, which was later corrected, caused any failure to implement the Section 6676 penalty." 

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