Abusing a tax loophole meant to aid the poor

By David Cay Johnston
April 26, 2012

Each year the Internal Revenue Service receives tax returns that show more income than was actually earned, in some cases twice the actual earnings.

That seems bizarre at first blush. After all, why would anyone tell the tax man they made more than they did?

The answer is that Congress has created an incentive for the poorest of the working poor to report more than their actual incomes. Doing so can be worth more than $3,000 to impoverished working parents under a form of negative income tax known as the Earned Income Tax Credit that sends government money to the working poor.

But it is not the working poor themselves who make up phony numbers. The problem is with unscrupulous income tax preparers, the IRS Taxpayer Advocate, Nina E. Olson, and others who work with the poor tell me.

Ginning up nonexistent income lets dishonest tax preparers charge larger fees and helps attract new clients as word spreads of their success at getting big refunds.

Just last month the Justice Department sued to shut down what it characterized in court papers as a nationwide chain of tax fraud mills that reported inflated incomes and often did not tell people it was filing tax returns for them.

Asked about the allegations, Instant Tax Service general counsel Todd Bryant said they were baseless, with a handful of problem cases mischaracterized as the norm.

The IRS and the Justice Department identified a problem with tax preparers inflating incomes years ago.

Abusive tax preparers have been found at big firms as well as underground operations. Failing to get tough on the abusers makes it hard for the vast majority of honest preparers to prosper, as clients who know nothing about the complexities of tax naturally gravitate toward whoever has a reputation for getting the biggest refunds.

A PROBLEM THAT’S FIXABLE

Congress could fix the problem of exaggerated incomes and at the same time help end America’s shameful No. 1 ranking among modern nations in child poverty. Sadly, I don’t expect that, given the focus in both parties on tax cuts for corporations and, among Republicans, on more tax cuts for the rich. Indeed, across the country anti-tax Republicans have called for ending the Earned Income Tax Credit.

Milton Friedman, the Chicago School economist and Nobel Prize winner, devised the negative income tax concept decades ago. Friedman demonstrated that people on welfare who go to work could be worse off because of taxes on their earnings. Properly applied, Friedman’s negative income tax idea can ensure that working makes people better off.

President Ronald Reagan hailed the Earned Income Tax Credit as “the best anti-poverty, the best pro-family, the best job creation measure to come out of Congress.” He was right. Last year it lifted 3.3 million children, and an equal number of adults, out of poverty.

Now consider a family with three children that earned $6,000 last year. That may seem extreme, but that was the average wage for a third of American workers in 2010, as I reported in October.

This family will get $2,711.

However, the family’s check more than doubles, to $5,751, when a tax preparer falsely inflates their income to $12,800.

Why does the family making $12,800 get more than twice as much as the $6,000 family? Because Congress set the maximum tax credit for a family with three children at wages of $12,800 to $20,800.

DEVIOUS TAX PREPARERS

The problem of inflated incomes is not with conniving poor people, but with devious tax preparers, everyone I asked about this said.

Nancy Abramowitz, who runs the American University Washington College of Law’s tax clinic for poor people, said she could not recall any individuals who had inflated their own income to increase the tax credit. “It’s always unscrupulous preparers,” she said.

Since employers verify wages, tax preparers usually inflate incomes by creating a phony Schedule C, the tax form used by many small businesses, because it is not verified except in an audit.

Here are four ways Congress and the IRS can fix this:

  • Congress should lower the threshold for securing the maximum credit for families with children from $12,800 to the average wage of the bottom third of workers, currently about $6,000.
  • Congress should pay for the prosecution of as many corrupt tax return preparers as it takes to stop this fraud, including $3,000 rewards to taxpayers who turn in corrupt preparers. Any action by the IRS, not just convictions, should generate a reward check. The reward I propose equals the maximum fraud loss from a single case, making it cost-efficient provided Congress requires the IRS to be generous, not stingy, in rewarding whistleblowers.
  • Congress should delay tax credit refunds for 45 days after a tax return is filed. Olson, the IRS taxpayer advocate, told me that speeding refunds encourages fraud. The United States is unusual in trying to refund money instantly, instead of taking time to make sure payments are proper before cutting checks.
  • For the next few years the 40 percent of IRS correspondence audits that now deal with the Earned Income Tax Credit should concentrate on faked Schedule Cs that inflate incomes.

The focus should be on making work rewarding, not on hurting the working poor.

9 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Agree with all of the above… Doesn’t the IRS do statistical analysis on tax returns, grouped by the identity of the preparer? That could give them some interesting pointers too!

Posted by matthewslyman | Report as abusive

Dodging taxes is a game, just as cheating on tests is a game. A system in which it is stupid not to lie, or a system where lying is an ease of desperation are all corrupting. But is it any wonder when CEO’s get bonuses for cutting jobs. As above, So below , as Hermes said long ago. When bankers and hedge fund managers can purchase laws so that whatever they choose to do is not illegal…. is there any wonder that kids cheat on tests and some folks cheat on taxes. Our system is not only corrupt. It is corrupting.

Sorry for being so downbeat, but I just bounced here from cheatingculture dot com where one article mentioned three trillion lost to tax cheats, and you can bet that the big money did not go to those who bilk or mislead the poor. I believe DCJ commented on this 3 trillion in January.

Posted by TheOldSodbuster | Report as abusive

As well, the IRS examines a substantial percentage of those claiming the earned income tax credit and disallows the credit to those with false or exaggerated Schedules C, “borrowed” children or the like, and then makes an assessment again the low income individual. That individual, not the unscrupulous preparer, then owes the money to the IRS. Sometimes, the IRS files a federal tax lien against the individual, and that individual’s credit rating is ruined for years. Also, some unscrupulous preparers arrange for the refund to be wired to the preparer’s bank account, provides the individual taxpayer with a cash refund, and has the individual sign a receipt for a refund corresponding to that claimed, but provides a smaller cash refund. In all, often this well-intentioned program turns out to be most damaging to many low-income taxpayers, and richly rewarding to the fleecing preparer.

Posted by OldHand | Report as abusive

David

You forgot about the self employment taxes associated with self employment income. It does not completely offset the added EIC but it takes away at least half. I think you are a bit naive by assuming this is just a tax preparer issue. Most of the people getting the EIC are well aware of how much they need to earn. And you forgot to mention that family would also get the refundable child tax credits. So that family that earns about $12-$20k will get a refund of about $7500 or so. If you want to hand out welfare, don’t do it through the tax code.

Posted by curleybrothers | Report as abusive

The more fundamental question is; Why is welfare imbedded within the tax code?

According to the US Dept. of Labor, the minimum wage is $7.25 per hour. For someone to earn $6000 per year, they would be working only 828 hours, or roughly 16 hours per week. A full-time job at minimum wage would bring in about $15,000. Still not very much money…

Posted by isdjww | Report as abusive

David,

Having utilized the EIC for 20 years, I know for a fact you are correct. In that time I have manipulated the system 3 times – twice minimizing, and one enhancing income. At certain levels the credits are $2,000 for $500 in income. If you manage this in December it is easily legitimately gamed. In all my years, I have only run into a hand full of people that have done this ever – and none on a regular basis.

I am far outside the norm as far as understanding how the credit works – I have assisted thousands of other poor and disabled folks preparing their returns. To a person they were always upset that they would not get the credit they had the previous year utilizing a service.

There are other tax and/or obscure tax-based programs which have created the same disincentives for work with both the poor and disabled. Many of them larger and more insidious. If you want to hear more sometime, let’s talk.

The $6,000 is not surprising on any level – been there, done that, almost out. The disincentives and flat-out punishment for working trap people in ways those who have never been here can not understand. Not any will, commitment, work ethic, or laziness way – simply a structural impediment.

In order to return to work there is usually a ~$20K hole to overcome. That means, best case, from working a minimum wage job a person has to jump to a minimum ~$32K position. I don’t know how many people get an ~$12/hr raise in a year, but not many. Critically, at the new income level you are still in poverty.

Posted by henryedward | Report as abusive

Why are we all so darn stupid and helpless?
This complexity in our tax system has proven to be a disaster, and yet we stand by as if we were all mentally handicapped.

There should only be one flat income tax for everyone and a social security payment for individuals. THAT’S ALL.
No State, City & Town taxes, no sales tax, no tax incentives, no tax breaks, no business/mortgage deductions, no etc., etc., etc. BS taxes & tax breaks.

NO OTHER TAXES, ONLY ONE FLAT INCOME TAX.

We had a very healthy Social Security fund until congress reclassified it as a tax and put into the general fund so that it could be, and has been, raided by our corrupt crony government & their partners from Wall Street.

If the Social Security Fund was left in its original form there would have been a huge surplus in it that we retired senior citizens could use today, WE PAID FOR IT.
But then again we Americans have the reputation of selling our mothers for the dollar.

Posted by GMavros | Report as abusive

The earned income tax credit is unfair, because it subsidizes families with children at the expense of singles

Posted by Kberg | Report as abusive

I prefer a simpler solution.

The EITC (or EIC as it as also called) was meant to refund Social Security taxes. Why not just make the first 10k or so not taxable for Social Security and Medicare tax purposes?

You would have to add a Social Security and Medicare tax calculation section to the 1040, because people might be over withheld or under withheld if they change jobs during the year, but you would eliminate the fraud by eliminating the temptation.

Whenever the government creates a program to hand out free money, people will line up to lie and cheat to get the cash, every single time.

Posted by QuakerOrts | Report as abusive