By misinterpreting federal law, the Internal Revenue Service has sharply limited the number of erroneous tax refunds and improper tax credit claims on which it can assess penalties, according to a new study.

The report, released publicly Tuesday by the Treasury Inspector General for Tax Administration, focused on the IRS’s incorrect interpretation of provisions in the Small Business and Work Opportunity Tax Act of 2007, which amended the Tax Code to enhance the IRS’s ability to seek monetary penalties for the growing number of erroneous tax credit and refund claims. Under the law, taxpayers who claim excessive tax credits or refunds can be penalized up to 20 percent of the erroneous tax credit or refund claim. TIGTA conducted its audit to determine whether the IRS is properly assessing the erroneous claim for refund or credit penalty on individual tax accounts.

TIGTA found that the IRS incorrectly interpreted the law, significantly restricting the types of erroneous tax refund or credit claims to which the penalty would apply. The IRS assessed only 84 erroneous refund penalties totaling $1.9 million between May 2007 and May 2012.
In response to concerns raised from various IRS functions, the IRS Office of Chief Counsel subsequently revised its interpretation of the law as to when the erroneous refund penalty could be assessed and issued an updated memorandum in May 2012.

But although the IRS has revised its interpretation of the law, it has not developed processes and procedures to enable its Campus Operations unit to disallow the majority of individual tax credits to assess the penalty. For example, 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 disallowed by Campus Operations for which the IRS could have potentially assessed erroneous refund penalties totaling more than $1.5 billion.

“I am troubled that even though the IRS has revised its interpretation of this law, it has still failed to establish processes to assess penalties on the majority of disallowed tax credit claims,” said TIGTA Inspector General J. Russell George in a statement. “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.”

IRS management raised concerns about the costs and benefits of establishing processes and procedures for the Campus Operations to assess erroneous refund penalties, but has not provided any documentation and/or analysis to support the validity of these concerns. In view of the significant problem of erroneous claims for credits and refunds and the related costs to the Government, TIGTA said it believes that the IRS should put appropriate procedures and processes in place to comply with this section of law.

TIGTA recommended that 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 the Campus Operations.

The IRS pointed out that its field audit operations have already begun enforcing the law, but added that there are costs associated with expanding enforcement to Campus Operation that could prove less than cost-effective given the budget constraints faced by the agency.

“While the IRS has implemented enforcement of the provisions of Internal Revenue Code section 6676, Erroneous claims for refund or credit, in our field audit operations, we recognize that additional actions can be taken to identify appropriate campus operations where the penalty should be considered,” wrote Peggy Bogadi, commissioner of the IRS’s Wage and Investment Division, in response to the report. “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. 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 direct annual labor costs of $3.4 million cited in the report.”

Bogadi also pointed out that taxpayers can 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," she added. "In a declining budget environment, this will require the reassignment of examiners from other critical compliance work, such as identity theft and refund fraud.”

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