IRS Faulted for Adoption Tax Credit Refund Delays

The Internal Revenue Service sent the majority of claims for the adoption tax credit to auditors this year because they lacked the necessary documentation. However, the agency had options that could have enabled it to reduce the number of costly correspondence audits and issue refunds to parents faster while still maintaining a robust enforcement strategy, according to a new report.

The report, released Monday by the Government Accountability Office, found that as of August 2011, 68 percent of the nearly 100,000 returns on which taxpayers claimed the adoption credit in the 2011 filing season were sent to a correspondence audit at the IRS. However, of the approximately 35,000 returns on which audits have been completed as of August, the IRS only assessed additional taxes approximately 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,” said the GAO.

According to IRS officials, data for audits completed through September 2011 showed that an adoption credit correspondence audit takes an average of 74 calendar days. The delayed refunds, according to adoption agency officials, can create difficulties for families expecting to cover the costs of an adoption with the refund.

The federal adoption tax credit was originally established in 1996 and later amended in 2010 to make the credit refundable so taxpayers could receive payments in excess of their tax liability. The maximum allowable credit was also increased to $13,170 of qualified adoption expenses for tax year 2010.

As of Aug. 20, 2011, taxpayers had filed just under 100,000 returns, claiming about $1.2 billion in adoption credits. Following these changes, the IRS developed a strategy for processing adoption credit claims.

The IRS's strategy for ensuring taxpayer compliance with the adoption credit included requiring taxpayers 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 could not or should not be returned to a parent, and using specified criteria, the state could reasonably assume that the child would 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. The IRS also required that tax returns and supporting documentation be filed on paper. Any returns with missing or invalid documentation were automatically sent for correspondence audits that the IRS conducts by mail.

By way of communicating about the new requirements, the IRS reached out to taxpayers, tax professionals and adoption organizations through various tools, including its Web site, Twitter accounts, and YouTube videos.

“A large number of the adoption credit claims did not include the required documentation,” wrote IRS deputy commissioner for services and enforcement Steven T. Miller in response to the report. “In response we issued targeted communications to remind tax preparers and taxpayers of the requirement. We also worked with tax preparation software developers to improve the guidance provided by their products, and we leveraged our relationships with large tax preparation firms to communicate the documentation issue to their preparers.”

However, the IRS did not make a specific effort to communicate or convey information about the documentation requirements for special needs children to state adoption managers, who administer state adoption programs, the GAO found. In addition, the IRS did not specify in training materials for its audit examiners what documentation was required to prove special needs status. The IRS later revised its training materials to say that a state adoption assistance 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 Web site. As a result, taxpayers submitted a majority of returns with either no documentation or insufficient documentation, leading to the audits.

The GAO recommended several ways the IRS could avoid the problems. One option would be for the IRS to immediately send a letter to taxpayers who submit returns without any documentation requesting the paperwork before initiating an audit. This could potentially reduce the number of audits and delayed refunds, but the IRS has not yet determined the extent of this impact, the GAO noted. 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.

The GAO also recommended that the IRS communicate with state and local adoption officials, provide examiners with examples of adoption assistance agreements, place the agreements on its Web site, and determine whether sending a letter before initiating an audit would reduce the need for audits.

The IRS generally agreed with three of the GAO's recommendations, but had concerns that placing sample agreements on its Web site might enable fraud. However, since other proof of adoption must accompany a tax credit claim, the GAO said it believes the benefits of making these agreements available to adoptive parents outweigh the risks.

The IRS plans to keep the advice in mind. “We took steps to minimize burden on taxpayers and to avoid undue delays in issuing refunds; however we also balanced those goals with our responsibility to protect public funds,” wrote Miller. “In the coming weeks, we will examine our implementation strategy for the 2010 tax year to determine what improvements we can make for future years, and to cultivate service-wide best practices.”

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