Millions of dollars in refundable tax credits that were determined to be erroneous after taxpayers received them may never be recovered by the Internal Revenue Service, but the IRS plans to clamp down on erroneous and fraudulent claims for tax breaks such as the Earned Income Tax Credit.

A new report released Monday by the Treasury Inspector General for Tax Administration on refundable tax credits found that they are highly vulnerable to fraud. Refundable tax credits such as the EITC, the Additional Child Tax Credit, the First-Time Homebuyer Credit, and the American Opportunity Tax Credit for education also provide valuable tax breaks for low-income taxpayers and the middle class.

TIGTA initiated its audit to determine the effectiveness of efforts by the IRS to recover refundable credits disallowed during post-refund examinations and to consider options the IRS could implement to decrease the issuance of erroneous refundable credits. 

“Because of the susceptibility of these credits to fraud, and the low success rates in recovering erroneous credits once refunds have been issued, the IRS should take every reasonable step possible to identify potentially questionable credits and validate those credits before associated refunds are issued,” said TIGTA Inspector General J. Russell George in a statement.

To collect erroneous refundable credits issued to the taxpayer, the IRS frequently needs to rely on a process of refund offsets, which withhold future tax refunds to repay any amounts owed by the taxpayer. If the taxpayer does not repay the erroneous credit in a timely manner, the IRS must wait for the annual tax season to collect any money. In that case, the IRS would only be able to collect if the taxpayer is eligible for a refund.

TIGTA found that due to post-refund examinations of tax returns, taxpayers were required to repay more than approximately $2.3 billion in erroneous refundable tax credits during tax years 2006 through 2009. By the end of December 2011, the IRS had recovered an estimated $1.3 billion, of which more than 70 percent was collected through refund offsets.

TIGTA recommended that the IRS implement additional controls to identify and stop erroneous claims for refundable credits before refunds are issued, including implementing an account indicator to identify taxpayers who claim erroneous refundable credits to prevent them from erroneously receiving those claims for a specific period in the future. TIGTA also recommended that the IRS freeze and verify claims for the ACTC on all returns for which the EITC is frozen; and coordinate with the Treasury Department’s Office of Tax Policy to seek legislation to expand the EITC due diligence requirements to include the ACTC.

IRS management agreed with TIGTA’s findings and plans to take appropriate corrective actions. However, rather than implementing an account indicator to identify taxpayers who claim erroneous refundable credits, the IRS plans to develop pre-refund examination filters to ensure historical information is available and used as selection criteria. While this planned action is different than what TIGTA recommended, TIGTA said it believes that it is a viable alternative.

“As noted, we are in the process of refining the filter process to address many of the issues raised in the report,” wrote Peggy Bogadi, commissioner of the IRS’s Wage and Investment Division, in response to the report. “Our experience with the EITC indicates that the filtering process applied during initial return processing results in a better selection of claims to be referred for pre-refund examination when compared with relying solely on the presence or absence of the EITC ban indicator.”