By Leslie Book and Guest Blogger, Susan Morgenstern, Senior Attorney, Cleveland Legal Aid Society
This post considers the peculiar intersection of the earned income credit (EIC) and the application of civil penalties to those who have erroneously claimed the EIC. There are lots of points to discuss on this topic. For example, there is a legal issue as to whether a disallowed EIC produces an “underpayment” under section 6664(a) to which the 20% accuracy-related penalty may apply. Another issue is the application of the 2 or 10-year ban under Section 32(k)(1) to individuals who recklessly or intentionally disregarded rules in claiming the EIC, or who fraudulently claimed the EIC. That penalty is unprecedented in the tax code because it governs tax behavior prospectively; its analogy can be found in other public benefits programs, like food stamps, which has a separate procedure for determining intentional program violations. Suffice to say for now that there is lots wrong with the way the IRS currently administers that ban, with great potential hardship and little guidance for either the IRS, taxpayers, or practitioners. We will talk about the ban and the definition of underpayment in upcoming posts.
This post addresses issues under Section 6664(c)(1), which provides an exception to accuracy-related penalties for any portion of an underpayment if the taxpayer establishes reasonable cause and the taxpayer acted in good faith. Edge v Commissioner, TC Summary Opinion 2013-68, a nonprecedential opinion from this past August, presents facts that are very common for those who have worked with low income taxpayers.
The petitioner, John Edge, was a marginally employed cook who also had odd jobs, earning about $16,000 in 2011, the tax year at issue. For that year, apart from some time when his fiancée and her kids traveled around Christmas, Edge lived with his fiancée, and her two biological children. From the bare details in the opinion, Edge cared for his fiancee’s kids as his own; he attempted to adopt her kids but the opinion states his efforts were unsuccessful. He claimed one of his fiancee’s kids as a qualifying child for the EIC, on the advice of a commercial return preparer who had prepared his returns for a number of years. The opinion states that Edge told the commercial preparer about his living situation and his relationship with his fiancée and her kids.
So for those of you who do not practice in this area, the claiming of kids unrelated to the taxpayer as qualifying children for the EIC is a problem. Generally, to qualify for the EIC, (except for the small EIC available for childless workers), the kids must be related by blood or by law (e.g., foster children, step-children, adopted children). As an aside, it did not used to be that way. Prior to 2000, adults like Edge could have claimed an unrelated child as a qualifying child if the child lived with the taxpayer for the entire year, and the taxpayer cared for the child as if the child were his own child. In an effort to reduce high EIC error rates, Congress thought that clamping down on the claiming of unrelated children would reduce that error rate. Despite this change, and many others that go beyond the scope of this post, error rates for the EIC are still fairly high. A recent TIGTA report discusses the improper claim rate in FY 2012, though research from the Taxpayer Advocate Service nicely summarized in a report from the Center on Budget and Policy Priorities shows that there are methodological concerns with the error rates that Treasury has reported over the years.
Let’s bring this back to the Edge case. IRS properly disallowed the EIC as a result of the child’s lack of relationship with Edge. The Tax Court upheld that part of IRS’s decision. Significantly, the Court addressed whether Mr. Edge should be subject to a 20 per cent accuracy-related penalty on top of the disallowed EIC. The issue of whether penalties should apply when a taxpayer makes a mistake on his tax return after receiving erroneous advice from a tax advisor is one that comes up with frequency in tax cases, though has not been an issue in many reported EIC cases.
Citing to the regs under Section 6664, and some recent cases addressing how the Tax Court considers whether reliance on a tax professional is reasonable cause for the error, Edge lays out the standard, and concludes that the penalties are not appropriate:
The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account the pertinent facts and circumstances, including the taxpayer’s reliance on professional advice.
It is clear from the record that petitioner, a cook, is not a tax expert or experienced in tax matters. Moreover, we find that petitioner relied reasonably and in good faith on his commercial preparer, with whom he had an established relationship of several years’ standing without incident and with whom he met to fully disclose the information necessary to determine his proper tax liability for 2011.(citations omitted)
One of the cases Edge cites is Neonatology v Commissioner, a Tax Court case from 2000. Neonatology sets out a test for determining whether a taxpayer’s use of a tax adviser will insulate the taxpayer from penalties: (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.
The Neonatology case and its standard place the IRS in a difficult position on exams involving EIC because the EIC examinations are almost solely done by correspondence. It is hard from correspondence alone to make a meaningful case by case determination as to whether the taxpayer’s adviser was competent, for example, or whether the taxpayer told the preparer everything he would need to know to prepare an accurate tax return, though new due diligence rules should make that task easier.
This issue in some ways dovetails back to an issue Les has previously blogged on, the IRS’s stalled efforts to impose a more robust oversight regime for unlicensed tax return preparers. It is difficult to say that the IRS’s stalled return preparer regime would have prevented Edge from erroneously claiming his fiancee’s kid as a qualifying child. One of the assumptions behind the IRS’s desire to have expanded oversight over return preparers in the form of a test and ongoing education is that those requirements will generate preparers who would be less likely to make mistakes based on erroneous understanding of the law. Not everybody agrees with the empirical claim that increased education and a test will produce preparers who will be less likely to submit erroneous returns. Reasonable people can disagree on this, and understanding the reason why a preparer may submit a return that has an error is not straightforward. Consider Edge. It is not clear why Edge’s EIC was wrong. Perhaps the preparer knew the law, but chose to misstate eligibility for the EIC for Edge because he genuinely felt bad for Edge. Perhaps he wanted to ensure higher refunds so Edge would not go another preparer who might have been willing to look the other way. This is not a complete list. Would expanded IRS oversight have contributed to Edge submitting a correct return? Who knows? We believe that the increased education and testing, as well as uniform registration requirements, will increase visibility and accountability in the tax system, and contribute to fewer returns where errors are facilitated by corrupt or unqualified preparers. Others (like our colleague in the blogosphere Joe Kristan at the excellent Tax Update Blog) disagree with us.
Let’s bring this back to the IRS and its unenviable position of administering the EIC. If the DC Circuit does not reverse the District Court in Loving and the IRS’s mandatory certification and continuing education regime for preparers is scrapped (unless there is a legislative fix), perhaps the IRS can institute a voluntary testing and continuing education program. One possibility would be that a taxpayer who goes to a preparer who is tested and meets continuing education requirements would be insulated from penalties (assuming of course that she provided accurate information to the preparer and relied in good faith on the preparer). Another way to incentivize people to go authorized preparers would be to tie speed of refund to type of preparer, with licensed preparers’ returns moving to the head of the line. This type of plan would need a great deal more thought, including whether it would be limited to certain refundable credits and not others. We will not pretend to think through the implications of a plan in this post. Yet, IRS and Congress are rightly concerned about error rates and program integrity. Barring the unrealistic prospect of Congress removing hard to verify refundable credits from the tax system, it is likely that there will be continued efforts to reign in program errors. Perhaps it is time to think outside the existing box.
In any event, IRS does have tools to sanction preparers who may be improperly preparing tax returns, and IRS should remain vigilant in rooting out preparer misconduct, irrespective of the outcome in Loving or the adoption of any plans to incentivize taxpayers to seek out certain preparers.