As Congress discusses an extension of help for first-time buyers, a watchdog says thousands may have illegally received payments

Even as support grows in Congress for an expansion of the soon-to-expire $8,000 first-time home-buyer tax credit, a Treasury Dept. inspector told lawmakers on Oct. 22 that illegal immigrants, children as young as age 4, and thousands of others might have illegally received payments.

The credit, which is limited to buyers who have not owned a home for the past three years, is due to expire Nov. 30. But several bills to extend the credit have been introduced, including one co-sponsored by Senate Banking Committee Chairman Chris Dodd (D-Conn.) that would extend the credit to June 30, 2010, and expand it to include buyers who previously owned homes.

About 1.4 million borrowers have claimed a total of about $10 billion in credits through the program, which was approved in February. But 19,351 people who filed electronic tax returns for the 2008 tax year claimed credits of more than $139 million for homes that had not yet been purchased, J. Russell George, U.S. Treasury Inspector General for Tax Administration, told the House Ways & Means Committee.

It’s unclear how many paper returns had similarly inappropriate claims, he said. George said another 70,005 taxpayers appear to be previous homeowners based on their returns, which included mortgage interest, real estate taxes, and other home-related items. And more than 580 taxpayers under age 18 claimed nearly $4 million in credits, including some 4-year-olds. George suggested that their parents might have been trying to get around income restrictions (the full credit is available only to single taxpayers earning up to $75,000 and couples earning $150,000).

IRS Freezes 10,000 Refunds

George said that he’s concerned about the IRS’ ability to “effectively administer” the applications for tax credits being claimed before the existing deadline, “let alone those claimed before future deadlines” if the credit is extended.

Linda Stiff, the IRS deputy commissioner for services and enforcement, said the tax credit went into effect in February during the busy tax season and it took time to develop filtering mechanisms that were later put in place to catch questionable claims.

The IRS has frozen 10,000 refunds pending audits, identified 167 criminal schemes, and launched 115 criminal investigations relating to suspicious claims.

The reported fraud in the system comes when the fate of the tax credit is still uncertain. Mark Zandi, chief economist for Moody’s Economy.com (MCO), said allowing the tax credit to expire would be a serious mistake even though it is “one of the least efficient ways” the government has to support the housing market.

According to Zandi, only about 400,000 additional homes will sell because of the credit by the time it expires. And about 1.8 million buyers will have claimed the credit. Expanding the credit to include previous homeowners and extending the credit through June will cost about $30 billion, on top of about $8 billion that would have already been spent.

“The market is literally on life support—it’s fragile,” Zandi said. “If we take it off, we risk taking a big step back.”

Reelection Politics

Jaret Seiberg, policy analyst with Concept Capital’s Washington research group, said the fraud that was uncovered isn’t enough to stop the extension, which has strong bipartisan support, particularly from lawmakers in districts where home prices are plunging.

Senate Majority Leader Harry Reid, who is facing a difficult challenge in his home state of Nevada, co-sponsored a bill to extend the existing credit by six months. Dodd, another strong supporter, is also facing reelection in Connecticut in 2010.

“The Inspector General’s report is going to force Democrats to include more safeguards in the extension,” Seiberg said. “But it doesn’t change the underlying politics. Incumbents in both parties need it enacted to get reelected.”

Senator Johnny Isakson (R-Ga.), who is co-sponsoring the extension with Dodd, said that the problem tax returns represent a small fraction of those who received the credit and his bill will include measures recommended by the Treasury Inspector General and the IRS to minimize fraud in the future. Among the proposed safeguards: a requirement that borrowers attach documents verifying that they purchased the home and proof of age of the claimant. “Any fraud is unacceptable,” Isakson, a former Realtor, said. “Nobody is against stopping fraud.”

A government watchdog today said the Internal Revenue Service’s program to prevent tax fraud led to $65 billion in under-reported income in 2008, but the program is still marred by deficiencies.

Since the new IRS tax whistleblower law was passed in 2006, the IRS has seen “significant growth in claims,” Treasury Inspector General for Tax Administration J. Russell George noted in a report dated Aug. 20 but only released today. “However, without effective control over and timely processing of these claims, the success of the IRS whistleblower program could be diminished.”

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If you run a small business or rent out a property, pay attention to the latest Obama Treasury proposals.

One of the seemingly less controversial aspects of the Obama administration’s tax proposals is related to tax enforcement. Who can object to making everyone pay what they owe? Certainly, it’s better than raising taxes on law abiding folks.

The problem is that some of the administration’s enforcement proposals will add big paperwork burdens and costs for small business, at a time when many are already struggling. That could put a damper on hiring, although arguably the proposals will be good for one sector–the accounting firms hired to deal with all the additional filings and requirements. (I say arguably, because in the current economy, there’s a limit to how much extra accounting firms can charge their small-business clients, meaning they might have to absorb some of the extra costs themselves.)

In the Obama administration’s defense, many of these proposals were first put forward by the Bush Treasury in response to pressure from Congress to address the “tax gap.” (That gap–$345 billion in 2001–is the difference between what the Internal Revenue Service estimates it’s owed, and what taxpayers hand over voluntarily.) While these proposals didn’t move last year, I expect them to receive serious consideration with a new administration and a Congress that is aggressively seeking new sources of revenue. That’s why consideration of the burdens they would impose is crucial now.

These new tax paperwork burdens come on top of an already grinding load imposed on small business. A recent IRS study estimated that small business spends approximately $100 billion a year on tax compliance. But what’s really significant is that the tax compliance burden is far higher–as a percentage of receipts and on a per-employee basis–for small businesses than for large ones, because of the fixed costs of filing returns and setting up compliance. A study sponsored by the IRS found that while large businesses spend just 0.5% of gross receipts on tax compliance, those with revenues of $100,000-$500,000 spend 5% of their receipts on it. Even smaller businesses spend an even higher percentage.

Here’s a rundown of what the Obama Treasury has proposed:

Businesses would have to report their payments to other corporations to the IRS. Currently, a business that pays an individual $600 a year or more for services must file an information return–a Form 1099–with the IRS. But businesses don’t have to file a 1099 when they pay a corporation for services. The Obama administration proposes businesses be required, beginning with payments made next year, to file 1099s for all payments for services above $600 made to corporations (although not to tax-exempt corporations).

My concern with this, and the other information reporting discussed below is not only the burden it places on business but also what end that new burden will serve. Tax professionals are more and more cynical about the extent to which the IRS is actually looking at and matching the billions of information reports it already gets. If taxpayers (or their accountants) don’t believe the IRS is looking at these reports, than issuing them won’t have much affect on those who might omit income.

When I reviewed the IRS’ use of information reports–while I worked at the Senate Finance Committee and, before that, the IRS Restructuring Commission–it was stunning to find how many information reports sat gathering dust in IRS closets. In addition, while in some areas the IRS does make good use of information reports by matching them with taxpayers’ returns, often, due to staffing constraints and poor management of existing resources, the IRS works only a small portion of the mismatches if finds. Making use of the 1099 issued to corporations could be far more labor intensive for the IRS than is matching 1099s issued to individuals. Congress needs to take a sharp look at what the IRS is doing with the information it already receives before considering new reporting burdens, particularly on small business.

Business would have to verify Taxpayer Information Numbers (TINs) of contractors and withhold taxes when they can’t be verified. This is a stunner. Let’s go through the steps of this new proposal from Treasury, which applies to all businesses. 1) Jane’s Nursery, a small business, has to determine whether or not a contractor–say the mulch supplier–was paid more than $600. (Presumably Jane will not have to determine whether or not the mulch supplier is a corporation because of the other changes in law discussed above.)

2) Jane next demands/receives the TIN of the mulch supplier. If Jane gets a TIN and a name, then 3a) Jane (or more likely her accountant) contacts the IRS to verify the contractor’s TIN. 4a) The IRS discloses to Jane’s accountant whether the TIN and name match. 5a) If the TIN and name match, Jane can make a payment for the mulch. 6a) Jane or her accountant issues a 1099 to the IRS.

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Despite some decreases in 2008, the IRS’s overall level of compliance activities remains higher than in the years immediately after implementation of the IRS Restructuring and Reform Act of 1998.

A new report by the Treasury Inspector General for Tax Administration found, however, that some IRS collection function activities and results declined during 2008 after several years of improved results. The use of liens continued to increase, but the use of levies and seizures decreased during the year. Enforcement revenue collected also decreased, and the total dollar amount of uncollected liabilities increased.

J. Russell George

“Continued effort to improve compliance is important for reducing the estimated $345 billion tax gap and maintaining the integrity of the voluntary compliance system,” said TIGTA Inspector General J. Russell George in a statement.

The overall percentage of tax returns examined decreased by almost 3 percent; however, the overall percentage of tax returns examined was almost 12 percent higher than in 1999.

The number of tax returns of individuals examined increased, with almost 82 percent conducted via correspondence examinations. The number of corporate tax returns examined increased by just over 1 percent, a decline of almost 23 percent since 1999.

The percentage of corporate tax returns audited by U.S. collectors fell about 9 percent in 2008 and was down nearly 20 percent from about a decade earlier, an inspector general report released on Monday said.

About 15.3 percent of returns filed by corporations with $10 million or more in assets were examined by the Internal Revenue Service last fiscal year, down from about 16.8 percent in 2007, the Inspector General for Tax Administration for the U.S. Treasury Department said in its annual report.

In 1999, about 19 percent of tax returns for the group were examined by tax collectors. The rate of examination ranged between 15 and 19 percent in the intervening years, with the exception of a 20 percent rate in 2005.

The IRS’s enforcement staff has been whittled down in recent years, a response to fervent complaints by some U.S. lawmakers critical of what was characterized as aggressive tax collection.

“After several years of improved results, many collection function activities and results declined during FY 2008,” the report said.

The enforcement staff shrank 20 percent to 14,900 at the end of 2008, down from 18,700 in 1999, the report said.

President Barack Obama has proposed doubling the agency’s enforcement budget for 2010, including hiring about 800 new staffers just to enforce international tax law. That is part of a wider effort by the administration to crack down on what it calls the abusive use of tax loopholes and outright tax evasion.

Enforcement revenue fell in 2008, though that interrupted a steady rise in the past decade or so, the report said.

The IRS collected $2.75 trillion in fiscal year 2008, a record.

The report did not make any specific recommendations, but noted the enforcement of tax laws is among the key “high-risk” areas consistently cited by the Government Accountability Office.

The tax gap — the difference between what is owed and what is collected — was about $345 billion in 2001, the last year it was examined, according to the government.

The IRS wants to start regulating paid tax preparers used by more than half the nation’s taxpayers in an effort to reduce fraud and errors.

New rules could require education and training as well as licensing for people who get paid to prepare returns, IRS Commissioner Doug Shulman said Thursday.

“In most states, anyone can charge to prepare tax returns regardless of training, education, experience, skill, licensing or registration,” Shulman told reporters. “Virtually anyone can set up a tax return business.”

Shulman said most tax preparers provide quality work, but some are poorly trained or unscrupulous. The IRS, however, can’t say how many fall into either group because the agency doesn’t track the number of complaints filed against tax preparers or their outcomes, according to a report issued in February by the Treasury Inspector General for Tax Administration.

The IRS doesn’t even know how many individuals or companies prepare returns for taxpayers, Shulman acknowledged.

From 2006 through 2008, the IRS initiated more than 600 investigations of fraud among tax preparers. During that time, 356 tax preparers were convicted, with more than 80 percent of them sentenced to prison, home confinement or electronic monitoring.

But when the IRS detects a fraudulent return, it’s the taxpayer — not the tax preparer — who must pay the additional taxes, interest and any penalties, according to the IRS.

Shulman said he will seek suggestions for new rules from the industry and consumer groups before making his proposals to President Barack Obama and Treasury Secretary Timothy Geithner by the end of the year. The proposals could include new regulations or laws.

“I want to enter this with an open mind,” Shulman said. “For me, everything’s on the table.”

Shulman said new rules would give him better leverage to make sure tax preparers act ethically, not only to improve enforcement, but to ensure taxpayers get quality help in preparing their returns.

“When people pay good money, they should not get bad advice,” he said.

About 60 percent of taxpayers pay someone to prepare their returns, Shulman said. An additional 20 percent or so buy computer software. However, tax preparers don’t have to be licensed, unless they represent clients in proceedings before the Internal Revenue Service.

Industry giant H&R Block welcomed Shulman’s initiative, as did several members of Congress.

“We believe that all tax assistance providers should be trained and licensed as necessary,” said Richard C. Breeden, Chairman of H&R Block. “We also strongly support requirements that anyone providing tax preparation services should have the systems in place to ensure full legal compliance and consistently high ethical practices.”

Rep. John Lewis, D-Ga., said low-income taxpayers are often taken advantage of by “fly-by-night” tax preparers who set up shop in storefronts, only to go out of business after tax season.

“If they have problems, they cannot be located,” said Lewis, chairman of a House subcommittee that oversees the IRS. “We’re going to find a way to deal with it.”

Registering tax preparers would enable the IRS to track the ones with problems, said Paul Cinquemani, director of government relations for the National Association of Tax Professionals.

“As complex as the tax law is, believe me it doesn’t hurt to raise the bar,” Cinquemani said. “I don’t understand how anyone operates without getting education to stay on top of tax law. It’s very complex.”

Cinquemani said two kinds of preparers cause problems for taxpayers and the IRS.

“There are the incompetent and there are the unscrupulous,” he said. “Some are both.”