During 1998, the Internal Revenue Service (IRS) received 448,960 individual income tax returns that claimed nearly $106 million in tax credits for the Federal excise taxes paid on certain fuels. The overall objective of this audit was to determine whether the actions taken by the IRS in response to a prior audit report titled, Review of Processing Fuel Tax Claims (Reference Number 070804, dated December 30, 1996) were functioning effectively to reduce the number of erroneous credits.

The actions taken in response to the prior audit report have had mixed success for reducing the number of erroneous fuel tax credits that avoid detection by the IRS. For example, this follow-up audit showed that changes to the processing procedures have helped to ensure that almost all returns claiming fuel tax credits are identified for manual screening when appropriate. However, the actions taken have been ineffective for ensuring that prior year returns are checked when fuel tax credits are disallowed on the current year returns. In addition, the revisions to the tax form and publication were only partially effective for reducing the number of erroneous claims for tax credits for undyed diesel fuel.

The prior audit found that, in 73 percent of the returns for which the fuel tax credit claimed was adjusted, the taxpayer’s prior year return was not checked for the same issue. The IRS subsequently issued instructions requiring the service center Examination function to check the prior year returns. However, we were advised that management took no follow-up actions to ensure the instructions were being followed.

The follow-up audit found that, nationwide, the Examination function had not checked the prior year return in 851 (79 percent) of 1,079 applicable cases where adjustments were made to the fuel tax credits on Tax Year (TY) 1997 returns. The potentially unallowable fuel tax credits claimed on these returns totaled nearly $794,000.

Only the "registered ultimate vendor" (i.e., the person who sells the fuel to the person who actually uses it) can claim a credit or refund for undyed diesel fuel used on a farm for farming purposes. The prior audit identified more than 23,000 taxpayers who incorrectly claimed $4.5 million in tax credits on their 1995 individual income tax returns for undyed diesel fuel used on farms. At least 19,000 of these taxpayers incorrectly received over $2 million in credits for undyed diesel fuel because the amount claimed was less than the dollar amount that was subject to IRS review. Paid return preparers had prepared 83 percent of the returns that incorrectly claimed credits for undyed diesel fuel. Beginning with TY 1996, the IRS changed the tax form, the taxpayer instructions, and the tax publication to include specific statements that tax credits are not allowed for undyed diesel fuel used on a farm for farming purposes.

Nevertheless, this follow-up audit showed that there were still 15,926 individual taxpayers, nationwide, who incorrectly claimed tax credits for undyed diesel fuel totaling $2.45 million on their 1997 returns. Of these returns, 80 percent were professionally prepared.

The IRS questioned the fuel tax credits claimed on only 921 of these 15,926 returns. The remaining 15,005 taxpayers received nearly $1.78 million in fuel tax credits to which they were likely not entitled. These included 14,039 taxpayers who claimed credit amounts that were below the dollar level requiring Examination function screening and 966 taxpayers who claimed credits that were above the dollar level for screening. The credits claimed by the latter 966 taxpayers were not disallowed even though the Examination function’s procedures contained explicit instructions to disallow credits for undyed diesel fuel used in farming.

The IRS has the opportunity to further reduce the number of erroneous fuel tax credits claimed by taxpayers and reduce the number of erroneous credits that avoid detection. This follow-up audit report recommends providing educational notices to taxpayers and professional return preparers and re-emphasizing certain procedures for screening returns claiming fuel tax credits.

Management's Response: Customer Service management is incorporating procedures in the Internal Revenue Manual (IRM) to provide both technical and procedural guidance for employees who work fuel tax credit cases. The 1998 and 1999 versions of the tax forms used for claiming fuel tax credits were revised to provide an explicit caution to preparers not to claim the credit for diesel fuel used on a farm for farming purposes. Educational efforts will be directed to taxpayers who continue to claim unallowable fuel tax credits despite changes made in both forms and publications designed to improve taxpayer compliance.

Customer Service management did not agree with our recommendation to send educational notices to taxpayers who file returns claiming unallowable fuel tax credits. Instead, they are changing the Examination screening criteria to identify a greater number of returns for manual screening.

Office of Audit Comment: We concur with management's alternative corrective action to change the criteria for screening returns claiming fuel tax credits.