TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Sunday, April 29, 2012

Johnston: Tax Preparers, Not Working Poor, Defraud EITC Program

Reuters: Abusing a Tax Loophole Meant to Aid the Poor, by David Cay Johnston:

Each year the IRS 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. ...

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% of IRS correspondence audits that now deal with the Earned Income Tax Credit should concentrate on faked Schedule Cs that inflate incomes.

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What a bizarre argument. People who sign returns showing more income than they earn are blameless?

I have no doubt that unscrupulous tax preparers contribute greatly to fraud, but even someone without formal training should know that, if someone asks you to sign a return showing double what you made and tells you that you will get a fat check from the government, something is amiss.

I agree that the original idea to falsify income comes from preparers, but the taxpayers who tell them to go forward with it are hardly free from blame.

Posted by: andy | Apr 29, 2012 2:32:09 PM

Andy, I did not say the taxpayers were blameless, I said all the evidence -- and I have been asking people about this for a couple of years -- is that the preparers do this, not individuals.

Many low-income people are completely baffled by the tax system and terrified of it, which is bizarre. Just like Judge Posner they just sign where told.

There are taxpayers who did not understand, for example, that they have to add up each W-2, not just report the largest one.

No one I have spoken to at the IRS, at state agencies, at poor people's clinics nor taxpayers themselves have told me they ginned up fake Schedule C income.

Posted by: David Cay Johnston | Apr 30, 2012 5:16:50 PM

Hi, David. Yeah, I just ran the numbers on your example for 2011, putting the additional $7,000 on a Schedule C with no deductible expenses. I get an EITC of close to your figure of $5,636, PLUS a big increase in the refundable additional child credit (which you didn't factor in, but is scheduled to sunset at the end of this year, anyway, and I'm willing to bet won't be renewed) of $1,426, versus a CTC of only $450 with $6,000 earned income. Some of this might not be fraud. Lots of low-income taxpayers have some self-employment income they might not have mentioned except for finding out it's in their interest to report it, either because they didn't think it was taxable or they don't have a 1099-MISC or other records. The IRS and Congress didn't include it in all the recent new EITC due diligence requirements, but maybe a good one for the checklist (not that it needs more than the 23 lines it already has) would be substantiating all earnings. If the taxpayer was compensated in cash, at least get a signed statement from the employer.

Posted by: PHB | May 1, 2012 10:16:33 AM


Thanks for the clarification. I was perhaps mistakenly overreacting to Paul's title of this most (not the title to your article). Still, I think the substance of your article points the finger solely at return preparers with no criticism for the taxpayers who actually go along with the charade.

Posted by: andy | May 1, 2012 5:55:14 PM