How the EITC’s complicated rules make low-income taxpayers targets for return audits
More taxpayers than ever can claim the earned income tax credit (EITC) this filing season. Before legislation enacted last year expanded EITC eligibility for 2021, an average 25 million workers claimed the EITC for total payouts surpassing $60 billion. Preparers should ensure returns are error-free to avoid a grueling audit process that could lead to a reduced credit amount, outright denial, or even a ban from future claims.
Background.
The EITC has been one of the country’s most popular anti-poverty programs since its inception. Originally enacted in the Tax Reduction Act of 1975, the EITC has undergone considerable design overhauls, with notable mechanical changes made by the Regan and Clinton administrations.
Today, an eligible taxpayer claims the EITC during tax season while completing their income tax return. This is notably distinct from other refundable tax benefits, such as the child tax credit, where the taxpayer submits a separate application. At the same time, the EITC is designed to synergize with similar benefits. The credit is included in a tax return as a lump sum amount, which varies depending on the taxpayer’s income, filing status, and number of dependents.
To generally qualify for the EITC, a taxpayer must:
- have worked and earned income under a specified yearly threshold,
- have limited investment income (up to $10,000 for 2021, which will be adjusted for inflation for later years),
- have a valid Social Security number,
- have been a U.S. citizen or a resident alien all year, and
- not file Form 2555, Foreign Earned Income Exclusion.
Taxpayers without a qualifying child can claim the EITC but will receive a smaller amount compared to families with one or more qualifying children. The credit amount and income limits incrementally increase per qualifying child.
The average amount of EITC received is about $2,500. The number of taxpayers who claim the EITC varies from year to year, depending on ‘turnover’—that is, taxpayers that are no longer eligible—and newly eligible taxpayers. An estimated 15-20% of eligible taxpayers do not claim the EITC. Participation rates differ by year, but also by state.
An estimated 17 million new taxpayers qualify for the 2021 EITC following the latest expansion to the program by the American Rescue Plan Act (ARPA; PL 117-2), a $1.9 trillion COVID-19 relief package enacted March 2021. Many of the EITC provisions were temporary and only apply for 2021. President Biden’s Build Back Better proposal would have made these changes permanent. Because the BBB fizzled out in the Senate, this will be a uniquely different tax season for the EITC.
ARPA allows more taxpayers as young as age 19 who do not have children to claim the credit. Special exceptions apply to those age 18 and were either formerly in foster care or are experiencing homelessness. The age cap was also lifted, meaning those age 65 or older with earned income qualify. A taxpayer can use their 2019 income if it would result in a higher credit.
For claimants without children in 2021 filing single or as a head of household, the adjusted gross income (AGI) limit is $21,430. Married joint filers without children can make up to $27,380. The maximum EITC for childless claimants is $1,502.
The highest possible EITC for 2021 is $6,728, which is available to taxpayers with three or more qualifying children (making up to $51,464, or $57,414 if married and filing jointly). For 2021 and beyond, a taxpayer that does not provide a qualifying child’s name, age, and taxpayer ID number can still claim the EITC. Prior to ARPA, such a taxpayer was barred from claiming the credit.
‘Cheaper and easier.’
The IRS cannot begin processing returns with EITC claims until mid-February, by law. Congress, the IRS, and the Treasury Department as a whole, seek to minimize what it describes as “erroneous” or “improper” payments associated with the EITC, so returns with EITC claims are more closely scrutinized through examination.
A study conducted in a National Bureau of Economic Research (NBER) working paper found that EITC audits make up “roughly 35% to 45% of all correspondence audits,” or audits conducted by mail. According to a special report to Congress by former National Taxpayer Advocate Nina Olson, “virtually all” EITC audits are correspondence audits (99.9% in fiscal year 2018) compared to a small handful of field (in-person) audits. On average, an about 330,000 EITC returns are audited each year.
In April 2019, Sen. Ron Wyden, D-OR, ranking member of the Senate Finance Committee, asked IRS Commissioner Chuck Rettig at a hearing why EITC recipients are more likely to be audited. In September later that year, Rettig responded with a report, estimating that “approximately 50% of EITC claims have errors and the $18.1 billion improper payments account for almost half of the $40 billion portion of the tax gap attributable to credits.”
Rettig proceeded to explain that due to diminished resources at the IRS after years of budget cuts, auditing EITC returns are more cost-effective than dedicating higher-paid examiners to audit wealthy taxpayers that can take between 61 hours to 251 hours to complete, compared to the 5-hour turnaround time of an EITC audit, which are done by lower-level employees.
“Your September 6, 2019 response—received some five months after I made the request— essentially states that the [IRS] audits EITC recipients simply because it is cheaper and easier to do so,” a frustrated Wyden retorted in a October 15, 2019, letter to Rettig. “The decision by the IRS to continue auditing working families at high rates while doing nothing to audit those at higher incomes is particularly incongruous given who is failing to pay their taxes.”
Wyden pulled from the same aforementioned NBER study. Done by several IRS and Treasury statistical researchers, as well as a University of Texas economist, the study found that only 15% of audits that disallow the credit are because the taxpayer was found to be ineligible. Still, the IRS claims that about a quarter of all EITC are improper, ranging between $16-19 billion per year, and that the EITC accounts for 11% of the underreporting tax gap.
Wyden also cited research compiled by Kim M. Bloomquist, who previously served as a senior economist in the IRS Office of Research. Bloomquist found that EITC audits are more concentrated in poorer, rural Southern counties predominantly populated by African Americans. Further, Bloomquist also noted that while IRS audit activity has declined overall in recent years, EITC audits dropped at a lesser rate compared to top earners.
Chye-Ching Huang, executive director of the Tax Law Center at the New York University School of Law, corroborates this, telling Checkpoint that “EITC audits have made up an increasing share of all audits conducted since 2010, because the audit rate on EITC recipients has decreased much more slowly over the past decade than audit rates on higher-income taxpayers (including the top 1%).”
A September 2, 2021, Treasury Inspector General of Tax Administration (TIGTA) report on the IRS’s EITC examination compliance strategy concluded that the “IRS’s examination rates for EITC claims appear disproportionate with respect to certain Southern States,” but notes that IRS management said that selection criteria is not influenced by geographic data.
TIGTA nonetheless recommended that the IRS implement more educational outreach efforts in areas with higher error rates. The IRS disagreed, claiming it already has an “extensive outreach and education strategy in place tailored to reach EITC taxpayers in all communities.” The top three most frequently audited states in fiscal year 2019, according to the report, were Mississippi (2.5%), Louisiana (2.25%), and Alabama (2.13%).
Unintentional errors vs. fraud.
Much of the time, errors on EITC claims are unintentional and stem from confusion over eligibility rules, particularly those surrounding qualifying children. One of the most common reasons for reassessments of EITC returns is when there is a “duplicate claim of the same child,” John Wancheck, senior EITC policy advisor to the Center on Budget and Policy Priorities, told Checkpoint in an interview.
“Congress raises hell” over the notion that errors are the result of “fraud,” but the complexity of the credit’s rules is to blame, according to Wancheck. “Fraud is not the principal source” of erroneous claims, he said.
A second TIGTA report released in September 2021 also pointed to problems with the rules. After $1.9 billion in EITC and additional CTC claims were adjusted across 617,297 tax returns in calendar year 2019, TIGTA invested why the credits were denied. Finding that “the complexity of the rules causes taxpayers to erroneously claim the credits,” specifically because of “the intricacy of the rules regarding who can claim a child in instances of divorce, separation, and three-generational families,” TIGTA recommended that simplifying qualifications would ease the burden on taxpayers and reduce administrative costs of the IRS.
Huang said that “it’s important context that the EITC and other refundable credits are subjected to much more extensive reporting requirements on error and fraud than other sources of non-compliance that are responsible for larger shares of the tax gap—including, for example, under-reporting of business income and tax avoidance by the top 1%.”
Treasury said in its fiscal 2021 agency financial report that “overclaims are not rooted in internal control deficiencies, but instead are due to the complexities of verifying eligibility,” and stated its position that such overclaims “should not be reported under the improper payments framework,” but instead “are more appropriately included in analysis of tax compliance.”
Sara Greene, a law professor at Duke University participated in a team study in which she spoke with 200 EITC families for two hours each on how they experience the credit. In an interview, Greene told Checkpoint that confusion about the EITC is not limited to those who claim it. “No one entirely understands how it works,” Greene said.
The Taxpayer Advocate Service previously criticized the IRS for not providing a dedicated phone line to helping taxpayers with EITC questions as a method for reducing errors. Current National Taxpayer Advocate Erin Collins recently testified before the House Oversight Subcommittee that the IRS fails to answer all but a small percentage of taxpayer calls in general due to limited staff. For more, see National Taxpayer Advocate testifies on IRS backlog at Congressional hearing.
Huang believes that it is “unlikely” that the number of EITC audits will increase this year because of these internal challenges at the IRS. At the same time, Huang said that it is “possible that there will be an uptick in unintentional EITC errors this filing season among workers without qualifying children, if more filers in this group who claim the credit for the first time are unfamiliar with the credit’s eligibility rules,” Huang said.
How EITC audits work.
All returns claiming the EITC are run through IRS compliance filters in its automated systems that check for anything that would indicate an error on the return. This includes cross-referencing third-party databases affiliated with various eligibility requirements, such as those concerning residency or dependents. Flagged returns are assigned one or more risk scores that would indicate probable noncompliance. Higher-scored returns are selected for audited, while returns with low or intermediate risk scores are then randomly assigned for audit, making the process “conditional on observables,” and not “completely random or arbitrary,” according to the NBER study (emphasis added).
Wanchek predicts that because of the special rule for former foster children for the 2021 EITC, the IRS may add foster care registries to its list of automatic checks.
Olson took issue with the usage of third-party data sources, arguing in her 2019 special report that “applying data collected for nontax purposes to tax claims is akin to relying on the addresses shown in a telephone directory to deny the home mortgage interest deduction.”
“Even if virtually all the entries in a directory were accurate, they were compiled for a different purpose” and “do not disprove eligibility under the tax law,” Olson continued.
Once a return has been selected for audit, the filer receives a notice from the IRS, usually a notice CP-75 that is sent somewhere between four and eight weeks after the return is initially submitted. The notice informs the taxpayer that their return is being audited and that the taxpayer has 30 days to mail or fax documentation that supports their EITC. In the meantime, the refund is held until the audit is resolved.
If the notice cannot be delivered to the address on file, or if the taxpayer fails to respond, the EITC is fully denied, as the taxpayer is presumed to have passively agreed to not qualified for the credit. A taxpayer could submit supporting documents that still results in a denied or reduced EITC. Any of these scenarios may potentially result in the taxpayer owing tax.
Around 85-90% of EITC audits result in a change, according to the NBER study’s analysis of annual statistics from the IRS Data Book. Claims are more likely to be denied because of undelivered mail or a lack of response, as opposed to the small fraction of discovered “Type 2 errors” that truly confirm ineligibility. In fiscal year 2018, 43% of audited EITC claimants did not respond to their audit notice and waited an average of 207 days to resolve their return.
IRS audit notices have been criticized as being unclear. The notices do not explicitly detail what the discrepancy is or what specific eligibility requirement is in question. The IRS attaches forms and instructions for what the taxpayer should do next, and states that it needs at least another 30 days to review materials. If the information sent does not fully support the return, the IRS then sends an audit report with a proposed assessment, which may include additional tax, penalties, or interest.
An EITC audit can also conclude with the IRS reaching the determination that a taxpayer exhibited a “reckless disregard” for the rules and is banned from claiming the EITC again for two years. In more serious cases, the IRS may impose a 10-year ban. Any taxpayer who had their EITC denied must complete a Form 8862, Information to Claim Certain Credits After Disallowance, with their tax return in the first year in which they claim the EITC again.
Toll on families and what can be done.
Families anticipate the EITC year-round. For many, it’s a way to combat medical or credit card debt and is seen as a social safety net. Many low-income taxpayers work multiple jobs but still accrue debt to cover basic living expenses. The COVID-19 pandemic has only exacerbated this. It can take months—sometimes over a year— for an EITC audit to be resolved, even if the taxpayer fully complies with IRS correspondence.
“Really, this is a huge problem,” Greene said. To claim the EITC again can become a question of opportunity cost for those previously denied it. Many opt to not try again, even if they believe to be eligible, to avoid the risk of audit The NBER study found that “for every $1 that is audited, roughly $0.63 to $0.73 is unclaimed in years after the audits.”
Greene explained that it is a “tremendous burden” on families to come up with necessary proof that they are in fact eligible for the EITC. Taxpayers may need to make phone calls to various offices to get an official document during business hours, but many low-wage jobs are not “flexible,” Greene said. A taxpayer could be waiting to receive a document and not get it in time before the 30-day window closes. Conversely, a higher-income individual under a non-EITC audit could simply “call their accountant,” who would take over the administrative legwork.
“This is confusing for everyone,” Greene added.
Each year, the IRS and its partners hold an event known as EITC Awareness Day to promote the credit at the start of the tax filing season. Wancheck said that this can help “energize” outreach, but also that much of groundwork is done by local groups.
The IRS, however, seems content with its outreach and bemoans EITC errors because the agency believes it has released enough guidance on its rules. The IRS also keeps a list of low-income taxpayer clinics that is updated annually, but not everyone has access to a clinic in their area. Last year, the American Bar Association, Tax Section, advocated for more organizations to open clinics to address coverage gaps. For more, see IRS Low Income Taxpayer Clinic program issues annual report.
Commercial filing products have been under fire for contributing to the error rate because of their profit motive. Some, like Wancheck, have called for stricter regulations on commercial preparers to help ensure accurate returns, which in turn would reduce the chance that an EITC claim gets flagged by IRS filters.
Ultimately, the onus is on preparers to do their due diligence in walking taxpayers through their return and accurately reflect their income and living situation to receive the proper EITC amount, as nearly all EITC use some form of tax filing service.
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