Executive Summary

Objective and Scope

Background

Results

Conclusion

Appendix I – Detailed Objective, Scope, and Methodology

Appendix II – Major Contributors to This Report

Appendix III – Report Distribution List

Appendix IV – Evolution of the Earned Income Credit Law

Appendix V – Geographic Participation

Appendix VI – Selected Earned Income Credit Statistics by State

Appendix VII – Earned Income Credit Roles and Responsibilities

Appendix VIII – Treasury Inspector General for Tax Administration and Internal Revenue Service Inspection Audits Related to the Earned Income Credit

Appendix IX – General Accounting Office Audits Related to the Earned Income Credit

Appendix X – Treasury Inspector General for Tax Administration and Internal Revenue Service Inspection Recommendations Related to the Earned Income Credit

Appendix XI – General Accounting Office Recommendations Related to the Earned Income Credit

Appendix XII – Earned Income Credit Initiatives

Appendix XIII – Bibliography

Appendix XIV – Management’s Response to the Draft Report

Executive Summary

Due to continuing concerns about the efficient administration of the Earned Income Credit (EIC), the Treasury Inspector General for Tax Administration (TIGTA) performed a comprehensive assessment of the Internal Revenue Service’s (IRS) administration of the EIC. The objective of this review was to evaluate the history of the EIC, difficulties the IRS has faced involving the EIC in the past, and the problems the IRS faces in the future.

The EIC is a refundable credit created by the Congress in 1975 to offset the impact of Social Security taxes on low-income families and to encourage low-income families to seek employment rather than welfare. This credit provides a major source of assistance to low-income families. The IRS has the responsibility for administering the EIC.

Since the inception of the EIC, laws and the administration of the credit have grown increasingly complex, and the dollars involved have increased significantly. For example, the IRS has gone from the use of a single line on the tax return for the EIC to a publication and schedule devoted to EIC instructions and computations. The amount of the allowable credit has expanded from a maximum amount of $400 in 1975, to $3,816 in 1999. The maximum amount of earned income or Modified Adjusted Gross Income allowed to qualify for the credit has expanded from $8,000 to $30,580 during the same time frame. In addition, the criteria for the credit has been complicated by qualifying EIC child rules, expanded phase-in (credit gradually increases with income) and phase-out (credit gradually decreases with income) levels, and the availability of receipt of advance payments of the credit throughout the tax year (advance EIC).

As the EIC has evolved, many more taxpayers have become eligible for the credit. Along with expansion has come growth in EIC noncompliance, both unintentional and fraudulent. The Congress has also been concerned with the effectiveness of the IRS to both achieve full participation levels in the EIC among taxpayers who qualify for the credit and reduce EIC noncompliance. In 1997, the Congress authorized the IRS to spend a total of $716 million over a 5-year period for the improved administration of the EIC.

Although the EIC program is a highly visible and well-known source of noncompliance, it is not the most significant. In his May 8, 1997, testimony before the House Committee on Ways and Means, the Treasury Deputy Assistant Secretary for Tax Analysis stated that the IRS released a study that the gross individual income tax gap in 1992 was between $93.2 and $95.2 billion. The tax gap was largely attributed to underreporting of business income, underreporting of non-business income, and failure to file tax returns.

The EIC program and its implementation have changed dramatically since it was first enacted. The IRS has faced, and continues to face, problems with a complex processing structure, implementation of legislative changes, and a lack of reliable, current data on compliance and participation levels. As the IRS implements its new organizational structure and works to implement the Government Performance and Results Act of 1993 (GPRA), now is an excellent opportunity to assess the program as a whole and make further improvements.

The IRS uses a complex process to administer the approximately $30 billion in EIC claims received each year. The over 18 functions that process these claims have conflicting goals and different approaches for achieving full participation and compliance, both between and within functions. For example, one function’s goal is to process paper tax returns and issue refunds within 45 days. Another function’s goal is to identify fraudulent returns during processing of the returns and stop payment of the refunds.

Since Calendar Year (CY) 1993, the Government Accounting Office (GAO), IRS Inspection, and TIGTA have issued numerous reports disclosing widespread and serious weaknesses in the IRS’ administration of the EIC. The EIC program has been the subject of extensive review by the GAO, TIGTA, and internal IRS studies. The focus of these studies has centered on two competing problems, EIC full participation and EIC overclaims. Yet, problems with ensuring EIC compliance and full participation still exist. In 1999, the GAO reported EIC fraud as a high-risk area.

Studies that addressed the EIC participation rate showed significant differences in the estimates of the percentage of eligible taxpayers that claim the EIC credit. Two studies conducted outside the IRS on EIC participation, released between CYs 1994 and 1998, estimated 70 to 88 percent of eligible taxpayers received the credit. In contrast, another private study conducted from CYs 1996 to 1997 estimated that only 65 percent of the eligible taxpayers nationwide claimed the credit. The IRS is conducting a new study using 1996 tax return information. While the new study will provide the IRS with a more current participation rate, it still will not provide data about today’s EIC population so that a participation rate can be determined.

The EIC noncompliance has been a concern for a number of years. A root cause of EIC noncompliance is that taxpayers determine if they are entitled to receive the credit and the IRS has limited ability to verify entitlement before the refunds are issued. The EIC noncompliance studies conducted on Tax Years (TY) 1994, 1995, and 1997 returns, showed EIC overclaims remained high. The studies showed EIC overclaim amounts reached as high as $9.3 billion, of the total returns with EIC claims for TY 1997, based on preliminary results. The EIC noncompliance studies have remained the only information the IRS has available to baseline EIC overclaims. However, none of these studies have been used by the IRS to establish baselines. Without studies that establish valid and reliable baselines, IRS management cannot accurately identify the population of all eligible EIC taxpayers, measure the extent of noncompliance, or determine if planned activities will achieve desired outcomes.

The IRS has several EIC initiatives underway that include: (1) developing a new taxpayer compliance measure, (2) providing expanded customer service, (3) strengthening enforcement activities, and (4) enhancing research efforts. These efforts are intended to reduce overclaims and erroneous filings associated with the EIC. The IRS received from the Congress $144 million in Fiscal Year (FY) 2000 and will receive another $145 million in FY 2001 to fund these activities. Furthermore, the IRS is reorganizing, which will provide a great opportunity for the IRS to address the ongoing problems of improving compliance and identifying EIC-eligible taxpayers that do not claim the credit. However, plans for the new IRS structure do not improve the way IRS processes EIC returns.

Management Response: For this management advisory report, the primary purpose of the IRS’ response was to present an overview of the current status of the EIC compliance program. According to management’s response, the IRS will soon release to the public the most recent EIC study: Compliance Estimates for Earned Income Tax Credit Claimed on 1997 Tax Returns. This study will provide a starting point from which the IRS will be able to evaluate future IRS efforts.

The response also states that the IRS has recently launched new enforcement efforts to detect and prevent erroneous EIC claims before tax refunds are paid. The IRS has also implemented a program aimed at educating paid preparers, and is continuing other outreach programs to state and local governments, faith-based organizations, community groups, business leaders, and low-income taxpayer advocates.

The full response is included in the report as Appendix XIV. Also, an attachment with specific comments is included in management’s response and these comments have been considered for inclusion in the report where appropriate.

Our office plans to complete future work that will assess the progress the IRS’ initiatives are making toward improving the administration of the EIC.

Objective and Scope

Our overall objective was to evaluate the history of the Earned Income Credit (EIC), difficulties the Internal Revenue Service (IRS) has faced involving the EIC in the past, and the problems the IRS faces in the future. We analyzed various reports and statistics regarding the growth in the EIC between Tax Years (TY) 1975 and 1998. We also determined what action the IRS has taken and is planning to take to administer the EIC.

All audit work was done using National Office information and contacts during the period April to June 2000. Our analyses were made using data available through normal management reports. We did not conduct tests to verify the accuracy of the data in the reports.

Details of our audit objective, scope, and methodology are presented in Appendix I. Major contributors to this report are listed in Appendix II.

Background

In 1975, the Congress authorized the Secretary of the Treasury to amend the Internal Revenue Code to provide a credit to taxpayers with certain earned income. The Bill, H.R.2166, became Public Law 94-12 on March 29, 1975. The credit, known as the EIC, was a refundable credit established to offset the impact of Social Security taxes on low-income families and encourage low-income families to seek employment rather than welfare.

Since the inception of the EIC, laws and the administration of the credit have grown increasingly complex, and the dollars involved have increased significantly. For example, the IRS has gone from the use of a single line on the tax return for the EIC to a publication and schedule devoted to EIC instructions and computations.

The EIC was originally established as a work bonus designed to offset Social Security taxes and was not designed to vary by family size; the taxpayer merely had to have at least one qualifying child. This credit is a unique program in the IRS. The IRS processes are designed to address the traditional aspects of tax administration, where refunds are generally based on excess withholding of taxpayer’s money. However, the EIC allows taxpayers to receive refunds in addition to their excess withholdings. Also, the EIC requires taxpayers to prove their eligibility in order to get the credit.

The amount of the allowable credit has expanded from a maximum amount of $400 in 1975, to $3,816 (maximum EIC allowed for claims with more than 1 EIC qualifying child) in 1999. The maximum amount of earned income or Modified Adjusted Gross Income (AGI) allowed to qualify for the credit has expanded from $8,000 to $30,580 (maximum modified AGI with more than 1 EIC qualifying child) during the same time frame. The EIC is also available to taxpayers without qualifying children. The maximum amount allowable for this credit for TY 1999 is $347.

Credit amounts depend on the number of qualifying children who meet age, relationship, and residency tests. The credit gradually increases with increasing income (the phase-in range), plateaus at a maximum amount (the plateau range), and then gradually decreases until it reaches zero (the phase-out range). For example, in TY 1999 for taxpayers with 2 children, the credit amount gradually increases until modified AGI reaches between $9,500 and $12,500. Once income reaches $12,500, the credit begins to gradually decrease.

Taxpayers with earned income or modified AGI exceeding the maximum qualifying income level are not eligible for the credit. Taxpayers with AGI falling in the credit’s phase-out range receive the lesser amount resulting from using their earned income or modified AGI in calculating the credit.

Over the past 25 years, the credit has been subject to numerous legislative changes that both expanded taxpayer eligibility and complicated the application of the credit. In addition to complex qualifying child eligibility rules, the criteria for the credit has been complicated by the availability of receipt of advance payments of the credit throughout the tax year (advance EIC). Appendix IV provides detailed information on each legislative change since enactment of the EIC.

As the EIC has evolved, many more taxpayers have become eligible for the credit. Along with expansion has come growth in EIC noncompliance, both unintentional and fraudulent. In 1999, the General Accounting Office (GAO) reported on EIC fraud as a high-risk area. Subsequently, the IRS reported filing fraud in the EIC as a new Federal Managers’ Financial Integrity Act (FMFIA) material weakness. This identified the EIC as a national significant control deficiency that is required to be monitored and assessed. Due to this designation, the IRS is required to report its progress in correcting the EIC material weaknesses in its Annual Assurance Statement to the Congress.

The Congress has also been concerned with the effectiveness of the IRS to both reduce EIC noncompliance and increase participation levels in the EIC among taxpayers who qualify for the credit and may not be claiming it. In 1997, the Congress authorized the IRS to spend a total of $716 million over a 5-year period for the improved application of the EIC. The TIGTA is currently conducting a review of the IRS’ administration of the EIC appropriation.

The EIC has grown steadily since it was created in 1975. The number of taxpayers claiming the EIC increased from approximately 6.2 million in TY 1975 to 19.4 million in TY 1998 ($1.25 billion in EIC claimed in 1975 to over $30 billion in 1998). During the same period, the average credit increased from approximately $202 to $1,577. See Figures 1 - 3 below.

Figure 4 shows the percentage of taxpayers claiming the EIC compared to all individual tax returns filed for TYs 1975 through 1998. Between TYs 1975 and 1985, the percentage of EIC claims remained relatively constant at around seven percent. However, by TY 1990, it had grown to 11 percent, and during the past few years has leveled out at around 16 percent.

The advent of electronic filing (ELF) has also impacted the EIC. The IRS, in partnership with H&R Block, developed ELF, now called e-file, and brought it to the IRS in the 1980s. The IRS implemented e-file nationwide in 1990. Generally, taxpayers claiming the EIC have the option to file their tax returns using traditional paper forms or e-file methods. E-file benefits include more accurate and faster processing, resulting in taxpayers receiving faster refunds. With e-file, taxpayers receive their refunds in half the time of filing using paper. In TY 1992, approximately 5.6 million taxpayers claimed the EIC on e-file returns, compared to approximately 8.9 million in TY 1998.

While EIC claims filed using e-file have increased, the percentage of EIC e-file returns have declined when compared to the significant growth in total e-file returns. EIC e-file returns represented approximately 45 percent of electronically filed returns in TY 1992 and approximately 30 percent in TY 1998. Figure 5 shows a comparison of the total e-file returns filed to EIC e-file returns filed.

A recent IRS study showed that approximately 65 percent of taxpayers claiming the EIC on TY 1997 returns used a paid preparer. However, the net benefit of this credit to these taxpayers is reduced by the costs associated with paying someone to prepare their return. Comparatively, only 53 percent of all individual taxpayers used a paid preparer during TY 1997. It would appear that the increasing complexity of EIC requirements may be a driving factor in the use of paid preparers.

The figure below depicts the numbers of EIC and total returns prepared by a paid preparer.

Appendices V and VI provide detailed information on the EIC demographics for TYs 1997 and 1998.

Results

The Congress legislated the IRS to administer the EIC. The IRS has defined this role as ensuring the efficient administration of the law; increasing the full participation of eligible taxpayers; and reducing overclaims, fraud, waste, and abuse.

Each year, the IRS allocates resources and implements activities designed to administer the EIC. However, IRS management cannot accurately identify the population of all eligible taxpayers, measure the extent of fraud, or determine if planned activities will achieve desired outcomes. The IRS also does not know if these efforts will increase EIC participation, improve compliance, and reduce inherent EIC vulnerabilities.

For the EIC program, the IRS has not established Government Performance and Results Act of 1993 (GPRA) goals. The Congress enacted the GPRA, in part, to establish accountability over programs and activities and to improve the confidence of the American people in the Federal Government, by systematically holding Federal agencies accountable for achieving program results. The IRS’ outcomes should be based, in part, on how its actions and activities effect the wage-earner taxpayer - the vast majority of the IRS’ customers.

The ability of the IRS to establish GPRA goals and measures has been hampered by a lack of current reliable information. With the abolishment of the taxpayer compliance measurement program, the IRS has undertaken a number of studies to measure noncompliance in the EIC program. However, not all of these studies were considered reliable, and they provide data that are several years old. In addition, no current data are available on the number of individuals who are eligible for the credit but do not claim it. Due to the comprehensiveness of this assessment, this report has been formatted into two major sections:

• Earned Income Credit Organizational Structure and Program Administration (Page 10)

• Earned Income Credit Research Studies and Initiatives (Page 26)

Earned Income Credit Organizational Structure and Program Administration

Modernization and reorganization efforts under way create a great opportunity for the IRS to address the ongoing problem of defining full participation and reducing noncompliance. Under the new reorganization, the EIC Project Manager will report directly to the Commissioner, Wage and Investment Division. However, no significant changes have been made to the roles and responsibilities of this project office under the new organization. Also, there are no significant changes planned for the way the IRS processes EIC returns.

Both taxpayers and the IRS face many difficulties in dealing with the complex legal requirements of the EIC. The IRS uses a complex process to administer approximately $30 billion in EIC claims received each year. This process crosses many functional lines, and includes conflicting goals and differing approaches for achieving full participation and reducing overclaims, both between and within functions. For example, one function’s goal is to process paper tax returns and issue refunds within 45 days. Another function’s goal is to identify fraudulent returns during processing of the returns and stop payment of the refunds.

Much of this complexity passes on to the over 19 million taxpayers who claim the credit. For example, the IRS has gone from the use of a single line on individual tax returns for the EIC to a separate publication and schedule devoted entirely to EIC instructions and computations.

Currently, there are over 18 submission processing, customer service, and IRS support functions that play a role in EIC processing. This organizational structure was designed to address the traditional aspects of tax administration where refunds are generally issued because taxpayers have excess withholding. Faced with administering this refundable credit, the IRS forced the EIC to fit by integrating administration of the credit into the existing processing structure.

To manage this process, the EIC Project Office oversees and coordinates the EIC activities. The IRS has established EIC partners, comprised of representatives from the affected functions, who work with the EIC Project Office to coordinate and implement EIC activities. Fifteen of these partners address EIC non-compliance and nine address full participation (with seven addressing both compliance and full participation.)

The EIC Project Office developed a strategy that covers Fiscal Years (FY) 1998 to 2002. The strategy contains planned actions that address outreach and education, assistance, prevention, and identification and research. However, the strategy does not contain measurable goals and objectives, or meaningful outcomes that are quantifiable and measurable. For example, the FY 2000 portion of the strategy contains a planned action to develop and implement an integrated strategy contacting EIC preparers for outreach, education, and compliance enforcement visits. The FY 2000 portion of the strategy did not contain time frames for completing the integrated strategy, and an expected outcome or a measure to define whether the activity achieved its goal.

The following pages are illustrations of the 1998 IRS organizational structure (Figure 7) and the proposed organizational structure after modernization (Figure 8); a table of the EIC partners and their roles and responsibilities as they relate to administering the EIC (Figure 9); and a high-level flow chart summarizing the process for EIC returns (Figure 10).

See Appendix VII for a more detailed description of the roles and responsibilities of the EIC partners.

The Congress amended the Internal Revenue Code of 1986 to prevent fraudulent claims for the EIC. This amendment required the IRS to disallow the EIC to any taxpayer without verification of the SSN. Taxpayers can claim the EIC only if they have valid SSNs that allow them to work. In addition, the taxpayer’s spouse and qualifying child, if applicable, must have a valid SSN. If any of the SSNs are determined to be invalid, the EIC may be disallowed. During EIC processing, the IRS uses math error procedures to disallow credits when SSNs are invalid or do not match SSA records.

The IRS relies exclusively on the SSA to issue SSNs to United States (U.S.) citizens or to persons who have permission from the Immigration and Naturalization Service to work in the U.S. Social Security began in 1935, as a system to keep track of earnings and eventually the benefits of people who worked in jobs covered under the program. SSNs were first issued in November 1936.

Since its inception, the use of the SSN has grown from its initial purpose to include its current use for identification and record keeping purposes. There are about one billion possible SSN combinations, and since inception, the SSA has issued over 400 million. As of October 1999, about 217 million SSNs were active. In addition to this extraordinary number of SSNs in circulation creating unique challenges for the IRS in administering the EIC, there are also several types of SSNs assigned to individuals who cannot claim the EIC.

Individuals having social security cards with an imprinted overstamp, "not valid for employment" cannot get the EIC credit. These numbers are issued to aliens who are not entitled to work in the U.S., but who need an SSN so they can get federally funded benefits such as food stamps or supplemental security income. An alien is an individual who is not a citizen or national of the U.S. As of October 1998, 7.9 million SSNs were issued to aliens not authorized to work.

Also, taxpayers using the Individual Taxpayer Identification Number (ITIN) or Adoption Taxpayer Identification Number (ATIN) cannot qualify for the EIC. The ITIN is a TIN issued to an alien individual by the IRS, upon application, for use in connection with filing requirements. The ATIN is issued for a child to adopting parents who cannot get a SSN for the child until the adoption is final.

Another common problem related to SSNs is duplicate usage. In some cases, this can occur because divorced parents both claim the same child as a dependent. However, the motive may also be fraud. (We are conducting additional audit work in this area.)

The IRS Restructuring and Reform Act of 1998 (RRA 98) required the IRS to conduct an annual analysis of the sources of complexity in the administration of Federal tax laws and report these results annually to the Congress. The Office of Program Evaluation and Risk Analysis conducts the annual reviews, which report on reducing the complexity and modifying any provision believed to add undue and unnecessary burden to the administration of the Federal tax law.

The IRS issued the first IRS Annual Report on Tax Law Complexity in June 2000. In the report, the IRS noted, "Complexity adds to burden by increasing their (taxpayers) investment in these areas trying to figure out if and how specific provisions apply to them. Significant reductions in burden, as well as increases in compliance may be driven by a relatively small simplification change that affects many taxpayers." The report addressed three specific provisions in the IRS tax code that impacted individual taxpayers. One of the provisions, filing definitions, addressed the myriad definitions used to determine a taxpayer’s eligibility to claim dependency exemptions and credits for qualifying individuals. The credits analyzed included the EIC.

Information analyzed from various sources both internally and externally surfaced inconsistent filing definitions for dependency exemptions and credits for qualifying individuals as a major contributor to tax law complexity. To reduce complexity associated with filing definitions, the IRS suggested that the Congress consider adopting one definition of relationship for dependents and qualifying individuals for tax credits including the EIC, and adopt one age criteria for the filing definitions addressed in the report. Currently, the dependency exemption for Head of Household, and the Dependent Care and Education credits generally use the same relationship test. This test is different for both the Child Tax Credit and EIC eligibility. However, in the report, the IRS does not quantify the potential effect of its suggestion on reducing taxpayer burden or improving productivity.

In 1993, the Congress mandated that Government offices measure organizational performance. The GPRA requires Federal agencies to establish a hierarchy of performance measures and goals applicable to various organizational units within their agencies. These performance measures and goals should be expressed in objective, quantifiable, and measurable forms to define the level of performance to be achieved by a program activity. The IRS has adopted a number of performance measures that focus on various aspects of tax administration. However, these measures have not focused on the administration of the EIC.

In addition to GPRA requirements, the EIC appropriation for FY 1998 provided additional monies for funding essential compliance and error reduction initiatives and requested data on EIC compliance. The Conference Report accompanying that appropriation bill stated that the IRS should establish a method to track the expenditure of funds and measure the impact of the additional funding on compliance. The Conference Report also required the IRS to submit quarterly reports that identify the expenditures and the change in the rates of compliance to the Committee on Appropriations. The IRS has reported to the Congress on the amounts of revenue protected or collected by various EIC compliance programs, but it has been unable to provide meaningful outcome data, such as the impact these funds have had on improving compliance.

In May 2000, the Chairman of the Senate Committee on Governmental Affairs requested that the GAO initiate a review of the Department of the Treasury’s FY 1999 GPRA report and the FY 2001 GPRA performance plan. The review was to assess thoroughness, completeness, and reliability of the information in the FY 1999 performance report with respect to certain agency outcomes, one of which is less fraud, waste, and abuse related to the EIC.

The GAO and TIGTA assessments of EIC activities indicate that the IRS is continuing to take steps that address the EIC process rather than meaningful outcomes. Without a meaningful outcome focus, as required by the GPRA, that would define both the levels of overclaims and EIC participation among eligible taxpayers, the IRS cannot ensure that expenditures of these resources effectively address EIC risks and vulnerabilities.

A GAO report on the IRS’ efforts to reduce EIC noncompliance stated, "The 5-year initiative could be into the fourth year before the IRS has TY 1997 and 1998 study data to compare in assessing the initiative’s results. That would be too late for the IRS to identify and implement meaningful adjustments to the initiatives. IRS plans to measure the results of individual programs implemented in 1998, but some of these results will not be available for planning fiscal year 1999 activities."

Since the abolishment of the Taxpayer Compliance Measurement Program, the IRS has been somewhat hampered in its efforts to identify both overall compliance rates and EIC compliance rates. A GAO official told lawmakers on April 10, 2000, that the Congress must come to terms with the fact that a reliable measure of compliance needs to include at least some audits of a scientifically-selected random sampling of taxpayers. Further, the GAO, in a recent assessment of the IRS’ balanced performance measure system, stated that the IRS has no tool for reliably measuring taxpayer compliance. The IRS has also had mixed results in its attempts to measure EIC compliance. (This is discussed in a later section of the report entitled Earned Income Credit Research Studies and Initiatives.)

Over the years, the GAO, IRS Inspection, and TIGTA have issued numerous reports disclosing widespread and serious weaknesses in the IRS’ ability to: (1) increase full EIC participation by eligible taxpayers, (2) ensure compliance through verification of the taxpayer’s eligibility, and (3) reduce inherent EIC vulnerabilities.

The findings and recommendations have ranged from technical to programmatic implementation. The reports issued by the IRS Inspection and TIGTA made 50 recommendations that related to the EIC, of which 47 were implemented. Implementing these recommendations has resulted in improved compliance in certain areas and better fraud detection. However, because the IRS does not have reliable data to measure EIC compliance, the impact of these initiatives cannot be determined.

Problems with ensuring EIC full participation and reducing EIC overclaims continue to exist. For the first 18 years, the EIC received little attention or audit work and IRS Inspection efforts to assess the EIC were fragmented. Since the inception of the TIGTA in January 1999, audit work has become strategic and focused on high-risk EIC areas.

For the period 1993 through 2000, there have been nearly 40 final audit reports issued:

• From 1993 to January 17, 1999, there were 18 final reports issued by IRS Inspection related to the EIC.
• From January 18, 1999, to the present, there have been five final reports issued by TIGTA related to the EIC.
• From 1994 to 2000, the GAO issued over 16 reports related to the EIC.

Examples of the recommendations made by the IRS Inspection and the TIGTA include:

• Refinements to Questionable Refund programming to detect EIC overclaims. For example:

During a review of the 1993 Filing Season, IRS Inspection found that when the EIC was claimed on an e-file return, the absence of a valid dependent SSN was a strong indicator of fraud. In one sample, 67 percent of the dependents claimed on the fraudulent returns had either invalid SSNs or no SSNs listed for the dependents. IRS Inspection recommended that the IRS be provided the information necessary to identify fictitious dependents supporting fraudulent e-file EIC claims.

• Clarification of EIC instructions to ensure eligible, and only eligible, taxpayers claim the credit.
• Ways to verify eligibility of taxpayers and dependents claiming the EIC.
• Methods to ensure taxpayers are notified of errors concerning EIC eligibility.
• Availability of adequate resources to work the EIC specific cases, both in Customer Service and the Criminal Investigations Branch.
• Thorough testing of computer programming intended to identify and resolve incorrect and missing TINs. For example:

The IRS implemented a new computer program intended to identify taxpayers who filed a return in 1998 and in the prior year with the same incorrect TIN. The TIGTA determined this program did not work as intended, as returns that met the criteria were not identified.

The overall concept presented in the GAO reports was that the EIC program has historically been vulnerable to high rates of invalid claims. For example:

• In 1996, the GAO reported that EIC claims for years have been the source of many errors identified during processing. According to the GAO report, in 1995, the IRS identified 1.6 million EIC-related errors involving about 8 percent of all returns with EIC claims. Of the 1.6 million errors, about 600,000 involved situations where the taxpayer claimed the EIC but was found not to qualify, and about 1 million cases where the taxpayer erred in computing the EIC.
• A report issued in 1999 discussed that during 1998, the IRS reported that it processed EIC claims totaling over $29 billion, including over $23 billion (79 percent) in refunds. Of the 290,000 EIC tax returns with indications of errors or irregularities that IRS examiners reviewed, $448 million (68 percent of $662 million claimed) were found to be invalid.

Many of these reports cited inadequate internal controls and difficulty in quickly verifying taxpayer’s eligibility for the credit as factors contributing to noncompliance. The reports also presented data relating to the EIC overclaim rate and the profile of EIC recipients.

Recommendations made by the IRS Inspection and the TIGTA have improved the IRS’ process to meet the goal of giving the EIC to qualified taxpayers. For example:

• In response to a recommendation by the IRS Inspection in 1993, the IRS rejected e-file returns that had an invalid SSN for a dependent.
• Another recommendation led to the IRS revising individual tax packages and taxpayer information publications to explain the importance of providing both correct SSNs and names for EIC-qualifying children, to avoid problems in processing.
• As a result of a recommendation in 1994, the IRS disallowed the use of "Applied for" in place of an SSN for dependents.

As part of the reorganization, as of March 2000, the IRS identified 5,290 recommendations from various sources such as task forces, prior year legislation, the GAO, IRS Inspection, and employee suggestions. These recommendations were prioritized into 157 primary short-term initiatives. The EIC was included as part of one of the primary initiatives. The IRS indicates that 80 of the 157 primary initiatives have been completed. However, the EIC-related initiative has not been completed. For more information on the TIGTA, IRS Inspection, and GAO audits and recommendations, see Appendices VIII - XI.

Earned Income Credit Research Studies and Initiatives

The EIC has been the subject of numerous internal and external studies that addressed vulnerabilities and high- risk areas. However, none of these studies have been used by the IRS to establish baselines to assess the EIC program in terms of growth in noncompliance, levels of fraud, the number of individuals who should be claiming the credit but do not, and other aspects of the program that would be useful for effective administration. Not all of the studies have been considered reliable. Nonetheless, all of the studies continue to show unacceptable levels of noncompliance and indicate that additional work needs to be done to improve full participation by eligible individuals.

The number of taxpayers who are entitled to the EIC compared to the number of taxpayers actually receiving the credit is referred to as the EIC participation rate. Two studies conducted outside the IRS on EIC participation, released between Calendar Years 1994 and 1998, estimated 70 to 88 percent of eligible taxpayers received the credit. However, another private study of the EIC indicates the participation rate may be much lower.

This private study performed in Los Angeles estimates only 65 percent of the taxpayers nationwide entitled to receive the EIC actually claimed the credit. In addition, a recent Washington Post news article cited that an estimated 250,000 Illinois families are losing up to $300 million a year by failing to apply for the credit. Not only does the EIC give money back to working people, it also pumps millions into the state’s economy.

There are many media examples of ways taxpayers use the EIC. In a few examples, the EIC enabled taxpayers to purchase a car and another to pursue a doctorate degree. Another example is of a taxpayer that was a welfare mom, left with two babies by a former drug-addict husband. She used the EIC to buy shoes, clothes, and other necessities for her kids. This taxpayer is now an executive assistant and no longer qualifies for the EIC.

The IRS has requested that the Office of Research perform another study of EIC participation using 1996 tax return information. While the new study will provide the IRS with a more current participation rate, it will not provide data about today’s EIC population due to the age of the data being used. The following table represents the results of eligibility studies conducted.

Without a process to identify these taxpayers, the IRS will continue having difficulty managing initiatives targeted at increasing EIC participation.

EIC overclaims have been a concern for a number of years and is a major factor underlying the GAO’s designation of filing fraud as one of the Federal program areas at high risk because of vulnerability to waste, fraud, abuse, and mismanagement. In the past, the IRS measured overall taxpayer noncompliance through its Taxpayer Compliance Measurement Program (TCMP). The last TCMP, involving audits of TY 1988 returns, found that about 42 percent of EIC recipients were not entitled to some or all of the credit claimed (representing about 34 percent of the EIC dollars paid that year). However, these TCMP results may not represent current compliance levels because the EIC has changed substantially since 1988. For example, changes enacted in 1990 included a major redesign and simplification of the EIC eligibility rules that had accounted for many of the errors found in the 1988 TCMP.

In the absence of the TCMP and in an effort to understand the scope of EIC overclaims, the IRS and outside researchers have conducted several EIC studies. Figure 12 summarizes information about the EIC studies conducted since 1993.

The EIC noncompliance studies conducted between 1993 and 1998 used different methodologies but continue to show high levels of noncompliance.

A study was conducted at an IRS service center between January and May 1993 on a sample of EIC claims where no valid child’s SSN was provided on the EIC schedule. Of 1,981 returns examined, 69.8 percent resulted in a change, with an average decrease of $1,197 in EIC claims.

The IRS conducted a broader, more statistically reliable study of EIC returns filed electronically and on paper in 1995. The study showed that of the $17.2 billion in EIC claims on TY 1994 returns filed between January and April 1995, about $4.4 billion, or 25.8 percent, of total EIC claimed was estimated to be overclaims. The most common EIC error was taxpayers claiming qualifying children who did not reside with them for over half the year.

The IRS conducted a study of TY 1995 returns. However, the methodology and related results were not considered to be reliable by the Department of the Treasury and the study was never released. This study suggested the overclaim rate to range between $8.4 and $8.9 billion.

The IRS conducted a study of 2,221 EIC returns filed electronically and on paper between January 20 and May 29, 1998. The preliminary results of the study found that EIC overclaim amounts reached as high as $9.3 billion of the total returns with EIC claims for TY 1997. The study further showed that of the $29 billion in EIC claims paid, approximately $7.3 billion should not have been paid. This number represents overclaims reduced by underclaims and amounts prevented from being paid out or recovered through IRS enforcement activities.

This study also found the one of the most common errors was unqualified children being claimed.

Some overclaims involve mathematical errors and other obvious mistakes made by taxpayers or their representatives in preparing the returns. Staff in the IRS’ 10 service centers review each paper return when it is received to make sure it is accurate and complete (e.g., includes required supporting schedules and basic entitlement information, such as the SSN of qualifying children, etc.) for returns claiming the EIC.

The most serious form of overclaim involves deliberate attempts to defraud the Government (e.g., through phony refund claims). The Questionable Refund Program, established in the 1970s, is the IRS’ primary effort to identify fraudulent refund claims, including those involving the EIC. An IRS computer program analyzes all returns to identify those that are potentially fraudulent. Then, fraud detection teams in the 10 service centers perform more in-depth reviews. If a return is considered fraudulent, the IRS attempts to stop the refund before it is issued.

Responding to a TY 1994 study showing a 25.8 percent ($4.4 billion) noncompliance rate for EIC tax rules, the Congress enacted legislation that permitted budget authority for 5 years, and a new EIC appropriation to address EIC noncompliance.

The funding was to be appropriated as follows, not more than:

• $138,000,000 for FY 1998.
• $143,000,000 for FY 1999.
• $144,000,000 for FY 2000.
• $145,000,000 for FY 2001.
• $146,000,000 for FY 2002.

The following table (Figure 14) highlights EIC initiatives and results from 1993 - 1999. Details can be found in Appendix XII.

The IRS has several EIC initiatives underway. For example, it is working to develop a new taxpayer compliance measure. Other initiatives include the following:

To effectively address overclaims, the IRS plans to establish a compliance council to:

• Ensure a strategic, coordinated approach to compliance issues.
• Conduct high-level performance reviews of strategic compliance initiatives.

For FYs 2000 and 2001, the EIC appropriation provides for expanded customer service, strengthened enforcement activities, and enhanced research efforts to reduce overclaims and erroneous filings associated with the EIC.

Some examples of the IRS’ plans to expand customer service include the following:

• Increased outreach activities.
• Improved promotional materials to better explain eligibility requirements.
• Increased toll-free assistor availability to EIC-eligibles.

Examples of the IRS’ plans to increase enforcement activities include efforts to:

• Enhance computer identification and selection of questionable EIC claims.
• Expand Examination and Criminal Investigation activities.

Some examples of the IRS’ plans to enhance research activities and projects include efforts to:

• Focus on EIC claimant characteristics and patterns of noncompliance that are designed to improve education and outreach products.
• Strengthen the IRS’ abuse detection capabilities and measure the effects of agency-wide programs on compliance levels for the EIC-eligible taxpayer population.

Management’s Response: For this management advisory report, the primary purpose of the IRS’ response was to present an overview of the current status of the EIC compliance program. According to management’s response, the IRS will soon release to the public the most recent EIC study: Compliance Estimates for Earned Income Tax Credit Claimed on 1997 Tax Returns. This study will provide a starting point from which the IRS will be able to evaluate future IRS efforts.

The response also states that the IRS has recently launched new enforcement efforts to detect and prevent erroneous EIC claims before tax refunds are paid. For example, the IRS will:

• Partner with the Department of Health and Human Services and the Social Security Administration to permit the IRS to cross-check information reported on tax returns regarding the qualifying EIC child.
• Deny the EIC claim if the claim was denied the previous year and the taxpayer did not follow recertification requirements that were enacted in 1997.

The IRS has also implemented a program aimed at educating paid preparers, and is continuing other outreach programs to state and local governments, faith-based organizations, community groups, business leaders, and low-income taxpayer advocates.

The full response is included in the report as Appendix XIV. Also, an attachment with specific comments is included in management’s response and these comments have been considered for inclusion in the report where appropriate.

Our office plans to complete future work that will assess the progress the IRS’ initiatives are making toward improving the administration of the EIC.

Conclusion

Each year, the IRS allocates resources and implements activities designed to administer the EIC. The IRS uses a complex process to administer the approximately $30 billion in EIC claims received from over 19 million taxpayers. Since its inception, the administration of the EIC has been forced to fit into the IRS’ existing organizational structure. This has resulted in conflicting goals and approaches among functions that process EIC claims.

Despite the wide range of audit work and studies disclosing deficiencies in the administration of the EIC, problems with ensuring compliance and full participation continue to exist. The IRS has initiated or been subject to numerous internal and external studies that addressed EIC vulnerabilities and high-risk areas. However, some of these studies have not been reliable and the results are several years old. Also, despite problems with the inappropriate use of SSNs, the IRS has not yet implemented planned computer matches that will partially address this problem. As the IRS reorganizes and implements the GPRA, it should assess the EIC program as a whole to identify ways to further improve it.

Detailed Objective, Scope, and Methodology

The overall objective was to evaluate the history of the Earned Income Credit (EIC), difficulties the Internal Revenue Service (IRS) has faced involving the EIC in the past, and the problems the IRS faces in the future.

To accomplish our objective, we completed the following sub-objectives and tests.

1. Reviewed various sources of EIC legislation, including Commerce Clearinghouse, Research Institute of America, and the Library of Congress to identify the law that created the EIC and the key legislative changes since 1975.
2. Researched Statistics of Income quarterly and annual publications to determine the number of taxpayers claiming the EIC, the dollar amounts claimed, and the growth of electronic filing as it relates to the EIC.
3. Researched the Congress’ Joint Economic Committee web site.
4. Obtained copies of research studies on EIC participation from 1994 and 1998.

1. Determined the audit work involving the EIC performed by the General Accounting Office (GAO), IRS Inspection, and the Treasury Inspector General for Tax Administration (TIGTA).
1. Researched the directory of audits performed by IRS Inspection from 1992 through 1998 and by TIGTA in 1999 and 2000, including audits in process, to identify EIC reviews and audit reports issued and recommendations made.
2. Researched the GAO web site to identify GAO reports and testimony related to the EIC from 1994 to 2000.
2. Obtained the results of past and current IRS studies of EIC compliance.

1. Researched GAO reports issued on EIC compliance to identify results of the last Taxpayer Compliance Measurement Program audit conducted in 1988 and on the IRS compliance study of 1994 returns.
2. Reviewed report issued in September 1993 by Dr. Malcolm K. Sparrow, "Fraud in the Electronic Filing Program - A Vulnerability Assessment prepared for the Internal Revenue Service."
3. Reviewed IRS Inspection notes from an August 1998 briefing by Dr. Sparrow to the IRS on EIC-Based Refund Fraud.
4. Reviewed an IRS draft report on EIC compliance for Tax Year (TY) 1997 returns (1998 EIC Baseline Study) to identify the latest research results on EIC compliance to date.
5. Researched IRS memorandums to identify plans for an EIC compliance study in Fiscal Year (FY) 2000.

1. Determined the roles and responsibilities of the various IRS functions in administering the EIC.
1. Researched IRS internal web sites and EIC appropriation reports to identify the EIC internal partners and their roles in administering the EIC.
2. Obtained from the IRS Criminal Investigation Division the results of its work in identifying fraudulent refund schemes, including the amounts of refunds deleted by type of return filed (paper or electronic).
3. Researched IRS processing documentation to determine how EIC returns are processed (electronic and paper), including post processing activities.
2. Identified the IRS EIC initiatives, including those prior to the EIC annual appropriation (FY 1997 and earlier).
1. Reviewed IRS Revenue Protection Strategy results for TYs 1993 through 1996 to identify the results of IRS programs to identify invalid EIC claims.
2. Reviewed IRS EIC appropriation reports for FY 1998 and FY 1999 to identify IRS EIC initiatives and the results of those initiatives (e.g., revenue protected, number of taxpayers assisted, actual IRS resources expended, etc.).
3. Determined what steps the IRS plans to take in the future to improve EIC compliance and expand EIC customer service.
1. Reviewed the IRS Criminal Investigation Modernization Blueprint to identify future plans for a Compliance Council and its roles and responsibilities.
2. Reviewed the IRS EIC FY 2001 Budget Justification and Budget in Brief to determine what plans the IRS had to improve EIC compliance and assistance efforts in FY 2000 and the plans for FY 2001.
3. Researched the Internet tax site "Tax Notes Today" to identify current IRS work on a National Compliance Survey.
4. Reviewed the June 2000 Annual Report from the Commissioner on Tax Law Complexity to determine the IRS’ plans to address EIC administration complexity issues.
4. Assessed the importance of the social security number (SSN) in EIC compliance.

1. Researched the Internet to obtain the history of the Social Security system.
2. Researched IRS publications on valid and invalid numbers for EIC eligibility (SSN, Individual Taxpayer Identification Number, and Adoption Identification Number).

Major Contributors to This Report

Walter E. Arrison, Associate Inspector General for Audit (Wage & Investment Income Programs)

Susan Boehmer, Director

Michael Phillips, Director

Stanley Rinehart, Director

Deann Baiza, Audit Manager

Donald Butler, Audit Manager

Bryce Kisler, Audit Manager

Patricia Lee, Audit Manager

Dan Adams, Senior Auditor

John Hawkins, Senior Auditor

S. Kent Johnson, Senior Auditor

Frank Jones, Senior Auditor

Edie Lemire, Senior Auditor

Bobbie Draudt, Auditor

Kathy Henderson, Auditor

Elizabeth Stout, Auditor

Tom Joyner, Computer Specialist

Report Distribution List

Deputy Commissioner Operations C:DO

Office of the Commissioner, Wage and Investment Division W

Earned Income Tax Credit Project Manager OP

Office of Management Controls M:CFO:A:M

Office of the Chief Counsel CC

Director, Legislative Affairs CL:LA

Director, Strategy and Finance, W:SF

Director, Office of Program Evaluation and Risk Analysis M:O

Audit Liaison, Earned Income Tax Credit Program Office OP

National Taxpayer Advocate TA

Evolution of the Earned Income Credit Law

The Congress established the Earned Income Credit (EIC) in 1975 to offset the impact of Social Security taxes on low-income families and encourage low-income families to seek employment rather than welfare. The EIC was originally established as a work bonus designed to offset Social Security taxes and was not designed to vary by family size; the taxpayer merely had to have at least one qualifying child. The EIC was a temporary 10 percent credit with a maximum value of $400. Over the past 25 years, the credit has been subject to legislative change. The revisions both expanded eligibility and complicated the application of the credit.

Today, the EIC is available to taxpayers who have earned income and meet Modified Adjusted Gross Income (AGI) thresholds. Credit amounts depend on the number of qualifying children who meet age, relationship, and residency tests. The credit gradually increases with increasing income (the phase-in range), plateaus at a maximum amount (the plateau range), and then gradually decreases until it reaches zero (the phase-out range). Taxpayers with earned income or AGI exceeding the maximum qualifying income level are not eligible for the credit. Taxpayers with AGI falling in the credit’s phase-out range receive the lesser amount resulting from using either their earned income or AGI in calculating the credit.

The following are key legislative changes since enactment of the EIC.

1978 – The EIC became a permanent credit. Required employers to make advance payments of the EIC to employees certified as qualifying for the credit during the current year. [Revenue Act of 1978, P.L. 95-600]

1984 – The credit increased to 11 percent with a maximum of $550. [Deficit Reduction Act of 1984; P.L. 98-369]

1986 – The credit increased to 14 percent and the earned income base was raised, resulting in an increase of the maximum credit from $550 to $800. The legislation increased the amount of income that could be earned (phase-out level) and still be eligible for the credit from $11,000 to $17,000. It provided for annual inflationary adjustments to the credit amount and the phase-out level. [Tax Reform Act of 1986; P.L. 99-514]

1990 – The credit rate and phase-out levels were increased, a higher credit was provided if a taxpayer had two or more qualifying children, and the EIC was revised into three parts - basic credit, supplemental young child credit (for children under the age of one), and supplemental health insurance credit (for amounts paid for the children’s health insurance). Also, this legislation required taxpayers to provide the IRS with the name and age of each qualifying child and a social security number (SSN) for those children age one or older. [Omnibus Budget Reconciliation Act (OBRA) of 1990; P.L. 101-508]

1993 – The EIC was increased by increasing credit rates, earned income base amounts, and phase-out levels. For Tax Year (TY) 1994, the credit maximum was $2,528 for 2 or more children. Provisions were made to continue increasing the credit rate annually until reaching a maximum of 40 percent (for 2 or more children) or 34 percent (for 1 child) for TY 1996 and later. This legislation eliminated the supplemental young child and health insurance components of the EIC.

This legislation also expanded the EIC to include a smaller credit for taxpayers without qualifying children. Single or married taxpayers could claim this credit provided at least 1 of them was between the ages of 25 and 64 at the end of the TY. The credit rate was 7.65 percent and the maximum credit for TY 1994 was $306. It limited the advance EIC to 60 percent of the maximum credit available for taxpayers with 1 qualifying child. Advance EIC allowed taxpayers to receive the credit during the year through their employer; however, it was not available for taxpayers without qualifying children. [OBRA 1993; P.L. 103-66]

Note: The credit rate percentages created by the OBRA 1993 are the current rates applicable for TY 1999.

1994 – This legislation required taxpayers to provide SSNs for each dependent qualifying child regardless of his/her age. This also applied to qualifying children claimed for the EIC if not their dependent. The EIC was extended to military personnel stationed outside the United States. It prohibited prisoner income from being used to compute the EIC and generally prohibited nonresident aliens from claiming the EIC. [Uruguay Round Agreements Act of 1994; P.L. 103-465]

1995 – This legislation denied the EIC for individuals having excessive "investment income." It provided that if the level of "disqualified income" was above $2,350, the taxpayer would not be eligible for the EIC. Disqualified or investment income includes interest (including tax-exempt), dividends, and net income from rents and royalties not derived in the ordinary course of business. [Self-Employed Health Insurance Act of 1995; P.L. 104-7]

1996 – This legislation expanded the definition of "math errors" to include the failure to provide a correct SSN for the taxpayer, his/her spouse, and any qualifying children when claiming the EIC. It revised the definition of AGI to include certain modifications when computing the phase-out level that affects the amount of the EIC. "Modified AGI" is the taxpayer’s AGI without regard to certain losses, including 50 percent of net losses from trades or businesses.

This legislation also revised the definition of "investment or disqualified income" and lowered the threshold to $2,200. Taxpayers with investment income above $2,200 were ineligible for the EIC. Investment income includes items such as interest, dividends, and net capital gains. With the exception of individuals who had an EIC eligibility certificate for the TY beginning in 1996, the provisions were effective for TY 1996 and later. [Personal Responsibility and Work Opportunity Reconciliation Act of 1996, also known as Welfare Reform Act; P.L. 104-193]

1997 – This legislation provided stiff penalties for EIC noncompliance. No EIC would be allowed for 10 years to taxpayers who fraudulently claimed the credit (2 years if not fraudulent but the claim was due to reckless or intentional disregard of the rules). In other instances, if a taxpayer was denied the EIC as a result of deficiency procedures (examination), the taxpayer is required to recertify eligibility by providing qualifying information to the IRS before the credit could be claimed in the following year. It provided for a $100 penalty for each failure by a return preparer to follow due diligence regulations to be established by the IRS on determining the taxpayer’s eligibility and computation of the credit. This legislation also redefined "modified AGI" by increasing the percentage of business losses to be disregarded from 50 percent to 75 percent. [Taxpayer Relief Act of 1997; P.L. 105-34]

1997 – The Congress provided a separate 5-year appropriation for IRS enforcement initiatives related to the EIC, beginning with Fiscal Year (FY) 1998, of not more than $138 million per FY. The total appropriation is not to exceed $716 million. [Balanced Budget Act of 1997; P.L. 105-33]

1998 – This legislation clarified and expanded the IRS’ treatment as a "math error" those returns where the IRS determined from the Social Security Administration that the taxpayer or his/her qualifying children makes him/her ineligible for the EIC. This change was also applicable to the dependent care and child tax credits. This provision was effective for TY 1998 and later. [Tax and Trade Relief Extension Act of 1998; P.L. 105-277]

Geographic Participation

The following maps and tables (Figures 1 - 4) show that for TY 1998, 10 states accounted for 56 percent of the number of Earned Income Credit (EIC) claims filed. Ten states also accounted for about 56 percent of the EIC dollars claimed for the same period. The states with both the highest volume of EIC claims filed and EIC dollars claimed were California, Texas, New York, and Florida.

Selected Earned Income Credit Statistics by State

Earned Income Credit Roles and Responsibilities

Managing the Earned Income Credit (EIC) process is a complex operation that crosses over 18 functional boundaries within the Internal Revenue Service (IRS). To improve management of this process, the IRS established partners comprised of representatives from submission processing, customer service, and support functions. The following is a detailed description of those partners, including their roles and responsibilities. The high-level flowchart (shown in Figure 10 of the report) shows the steps involved in processing tax returns where taxpayers claim the EIC.

Submission Processing processes tax returns, payments, and refunds; sends notices; and reconciles taxpayer accounts. It is responsible for identifying certain errors during tax return processing. The IRS currently has 10 service centers to process tax returns.

Code and Edit manually identifies returns that require further review by the Criminal Investigations Branch (CIB) or Service Center Examination (SC Exam). For example, all returns filed with an Information to Claim Earned Income After Disallowance (Form 8862) are sent directly to SC Exam to be worked. Also, any returns that appear to meet predefined scheme criteria (established by the CIB) are removed from processing and referred to the CIB for further review.

To combat filing fraud, the Congress passed the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 to help the IRS deal with questionable credits and deductions more effectively by using math error procedures. As a result, the IRS can disallow questionable credits, such as the EIC, during the processing of returns when required social security numbers (SSNs) are missing or are invalid (i.e., do not match Social Security Administration records).

Customer Service answers tax law questions and provides taxpayer assistance in determining eligibility for the EIC. Customer Service assists taxpayers primarily through Toll-Free and Walk-In assistance.

Each service center has an Adjustments Section that works math error responses from taxpayers, either by written correspondence or by calls received on the toll-free telephone number. Math error notices are issued for errors identified during tax return processing. Currently, math error notices are issued for the following discrepancies: 1) a missing or invalid primary Taxpayer Identification Number (TIN), 2) a missing or invalid secondary TIN, 3) a missing or invalid TIN for qualifying child(ren), 4) a missing or invalid date of birth for qualifying child(ren), 5) a primary or secondary TIN as an Individual Taxpayer Identification Number (ITIN), and 6)qualifying child(ren) TIN(s)as an ITIN(s).

National Office analysts are responsible for providing workplan projections, writing/updating instructions for processing math error responses, and monitoring resource utilization and workload volume.

Each service center has an Examination section that conducts correspondence audits related to EIC claims that appear to be invalid. Each year, numerous projects are established to cover categories with an excessive EIC overclaim rate. These projects vary from year to year depending on where the major abuse occurs. Some problems encountered include: incorrect filing status, erroneous qualifying child claims, and more than one taxpayer claiming the same qualifying child. The majority of EIC revenue protected by the IRS is due to the efforts of SC Exam.

National Office analysts work closely with the staffs of the Office of Refund Fraud, Assistant Commissioner (Examination), and District Office Research and Analysis to identify types of invalid EIC claims. In addition, analysts also develop workplans/schedules, write/update program instructions in the Internal Revenue Manual (IRM) 21, allocate resources, and monitor resource utilization and workload volumes.

Most cases are the result of soft notices to taxpayers who claimed the EIC using duplicate TINs, referrals by the CIB, recertifications, unsubstantiated math errors, amended returns, audit reconsiderations, and problem resolution cases.

Examination reviews EIC returns referred to district offices by SC Exam. The EIC work performed in district office examination includes examination of return preparers who are non-compliant with EIC procedures and development of fraud referrals on the EIC.

Function: National Office Examination

National Office Examination is involved in two major EIC programs: the EIC Compliance Study and the EIC Return Preparer Strategy. Both of these programs are joint efforts with the Office of Research. National Office Examination develops instructions, procedures, and training for field personnel conducting these programs and monitors progress for quality and timeliness.

In the field, revenue agents and tax auditors in district offices conduct examinations of EIC returns and monitor compliance by return preparers with EIC laws and regulations. Increasingly, agents and auditors will be devoting more of their time to activities related to the Return Preparer Strategy. Increased emphasis on return preparer education and outreach, coupled with increased penalty applications (especially the EIC due diligence penalties), may increase overall compliance with EIC requirements.

Since the inception of the IRS’ EIC Initiative, Taxpayer Education has played a vital role in seeking to curb erroneous EIC claims through extensive community education and outreach activities. Each district office has established an EIC coordinator position. All around the country, these coordinators conduct local campaigns targeting individuals for whom English is a second language, low-income taxpayers, and organizations/advocacy groups of EIC-eligible taxpayers. Additional volunteer sites are being established throughout communities to assist EIC-eligible taxpayers with return preparation.

National Office analysts develop workplans/schedules and resource allocations and monitor resources utilization and workload volumes. Program guidelines are provided in IRM 21, Customer Service Handbook.

When a taxpayer receives a math error notice, he/she can call Customer Service to provide "corrected" SSN(s) or write a letter that includes this information. A limited validity check is performed before the Customer Service Representative adjusts the taxpayer’s account.

Toll-Free provides 24 hours-a-day, 7 days-a-week coverage for the tax law, informant, and math error notice toll-free telephone numbers. Tax law inquiries are processed on (800) 829-1040, informant calls on (800) 829-0433, and math error notice calls on (800) 808-4262. Calls are distributed based on historical weekly demand patterns and are routed to assistors. There are 25 call site locations throughout the country for the (800) 829-1040 line. The (800) 829-0433 hotline is located in 4 of the service centers, and the (800) 808-4262 line call sites are located in each service center. However, calls for all lines can be routed to any location based on the demand/need.

National Office analysts are responsible for developing workplans/schedules, allocating resources, monitoring workload volume and resource utilization, and providing instructions/guidelines in the IRM 21, Customer Service Handbook.

Each district has at least one Walk-In Assistance site. Walk-In locations provide taxpayers the following types of EIC assistance: preparing tax returns claiming the EIC, resolving issues related to EIC math error notices, assisting taxpayers with the EIC recertification process, and answering EIC tax law questions. The Walk-In staff also conducts EIC awareness campaigns. These campaigns target low-income families and individuals most likely to be eligible for the EIC, educating them on eligibility requirements and the availability of the advance EIC.

National Office analysts develop workplans/schedules, allocate resources, and monitor resource utilization and workload volumes.

The ETA’s Office of Channel Management and Marketing prepares messages each year for placement on the IRS’ website, "The Digital Daily," and on the e-file bulletin board. These messages inform e-file participants (return preparers) about the EIC, due diligence requirements, and the overall Revenue Protection Strategy.

The Office of Public Liaison and Small Business Affairs maintains ongoing liaison relationships with national practitioner organizations, small business trade associations, IRS advisory committees, and other Federal agencies. This office communicates key EIC corporate messages, identifies partnering opportunities, and provides a forum for the introduction and discussion of new ideas. Their programs also serve as a "one-stop" communication vehicle to transmit EIC information between external stakeholders and IRS functions. The Office of Public Liaison and Small Business Affairs often identifies emerging EIC problems and operational issues and coordinates with IRS program owners to share information and resolve the problems.
Support Function Internal Partners

The Office of Appeals reviews taxpayer disputes, including EIC Examination actions taken by the IRS. If an EIC dispute cannot be resolved, the Appeals’ role is to ensure a resolution that is fair and impartial for both the Government and the taxpayer. An appeal provides an independent, impartial review of the case after a proposed audit action and is the last opportunity for the IRS and the taxpayer to reach an agreement before the case may enter the tax court system. The goal is to resolve EIC controversies without litigation, in a way that enhances voluntary compliance regarding the rules of eligibility for the EIC and enhances public confidence in the IRS.

Chief Counsel provides advice to clients (SC Exam, Submission Processing, Taxpayer Service, and Criminal Investigation [CI]) on proposals and new legislation. It provides guidance to taxpayers in the form of publications, written regulations, and review of forms. It also handles tax litigation cases that arise and provides required litigation support. Field offices handle all EIC Tax Court matters while the National Office engages in the following EIC-related activities:

• Analyzes proposed legislation dealing with the EIC.
• Drafts regulations (e.g., due diligence regulations and "recertification" regulations).
• Drafts other formal guidance, such as revenue rulings (although no EIC revenue rulings have been issued for many years).
• Issues written determinations, such as private letter rulings, technical advice memoranda, and all forms of Chief Counsel advice. Chief Counsel has issued a number of Chief Counsel advice memoranda, primarily significant service center advice, on EIC issues.
• Reviews for technical accuracy: Earned Income Credit (Publication 596), Earned Income Credit (Schedule EIC), Information to Claim Earned Income After Disallowance (Form 8862), Paid Preparer’s Earned Income Credit Checklist (Form 8867), Earned Income Credit Advance Payment Certificate (Form W-5), related instructions, and the U.S. Individual Income Tax Return (Form1040) instructions relating to the EIC. Chief Counsel has been actively involved in the redesign of the EIC documents.
• Reviews EIC documents prepared by other functions for distribution to the public.
• Reviews briefs prepared by field counsel offices in EIC Tax Court cases.
• Works with the Justice Department on EIC cases before courts other than the Tax Court.
• Assists the EIC Program Office as requested.

Along with the funding the IRS received to address EIC, the IRS is "required" (by Committee language, not statutorily) to submit a quarterly report to the Congress on how funds have been expended and the results generated by EIC efforts. The CFO’s Office of Revenue Analysis is the office responsible for putting together the report and distributing it to certain interested stakeholders, including the Department of the Treasury, the Office of Management and Budget, the General Accounting Office, and the Senate and House oversight majority/minority chairs. The quarterly report summarizes the major initiatives the IRS has undertaken as part of the EIC Appropriation; the resources dedicated to and expended on each initiative; and the results, in terms of cases closed, enforcement revenue collected or protected, and compliance improvement generated.

The Communications Division is the IRS’ focal point for planning, coordinating, and creating the IRS’ communications activities and products. The Marketing and Taxpayer Information Branch is responsible for providing communications advice and counsel to the EIC Program Office. The Branch:

• Produces both print and electronic products on the EIC and advance EIC.
• Attends conferences and seminars to market the EIC to external stakeholders.
• Uses research to design the Fiscal Year (FY) 2000 campaign concept and FY 2001 communication strategy.

Products for the 2000 Filing Season will include brochures, payroll stuffers, posters, and other print materials, as well as a training video for taxpayer education. The Communications Division also produces a tax professional kit that contains due diligence regulations, Information to Claim Earned Income After Disallowance (Form 8862), Paid Preparer’s Earned Income Credit Checklist (Form 8867), and a CD-ROM.

• Conducts basic research to identify and study areas of EIC noncompliance.
• Develops and tests potential means of addressing EIC noncompliance and provides assistance, where necessary, for nationwide implementation.
• Measures the EIC overclaim rate annually.
• Measures the impact of EIC activities initiated to address noncompliance.

In support of the overall IRS Mission, CI serves the American public by investigating potential criminal violations of the Internal Revenue Code and related financial crimes in a manner that fosters confidence in the tax system and compliance with the law. The CI’s Office of Refund Fraud is the owner of the Revenue Protection Strategy, which includes the EIC.

The Questionable Refund Program (QRP), administered by the CI, is a nationwide multifunctional program established in January 1977. The QRP was designed to identify fraudulent returns, stop the payment of fraudulent refunds, and refer identified fraudulent refund schemes to CI field offices. The QRDT staff scans questionable returns to identify questionable EIC claims, refund schemes, and questionable EIC preparers.

Generally, the National Taxpayer Advocate intervenes in taxpayers’ cases, including EIC cases, when the IRS’ normal processes and systems for resolution fail. The National Taxpayer Advocate also coordinates with the Citizen Advocacy Panels (CAPs); some CAPs have EIC subcommittees.

Treasury Inspector General for Tax Administration and Internal Revenue Service Inspection Audits Related to the Earned Income Credit

General Accounting Office Audits Related to the Earned Income Credit

Treasury Inspector General for Tax Administration and Internal Revenue Service Inspection Recommendations Related to the Earned Income Credit

General Accounting Office Recommendations Related to the Earned Income Credit

Earned Income Credit Initiatives

Tax Year 1994/Processing Year 1995 (Paper Returns Only)

The EIC initiative was broadened to include other issues and for a short while was known as "Refund Fraud." Soon after, the name was changed to the IRS Revenue Protection Strategy (RPS), additional unallowable codes were developed, including codes for missing/invalid dependent, EIC dependent Taxpayer Identification Numbers (TIN) and the fuel tax credit.

Approximately 1.05 million notices were issued; the majority of cases were closed by June 30, 1996. The following table presents the results of this initiative:

For this initiative several unallowable codes were discontinued or their criteria modified. For example, the criteria were changed to require that the return had to reflect three or more invalid TINs before the Examination function would include the case in its inventory. (This decision was based on Tax Year (TY) 1994 results that indicated a high rate of audits resulting in no changes to the tax returns.)

Approximately 700,000 notices were issued. Also, during the 1996 Filing Season, more than 300 compliance visits were made in the Southwest District to businesses and tax preparers involved in electronic filing and paper returns to ensure compliance.

Approximately 2.9 million occurrences of missing or invalid uses of social security numbers (SSN) caused electronically filed tax returns to be rejected. Approximately 2.3 million returns were subjected to math error procedures that caused a refund reduction unless the taxpayer could provide correct information. As a result, the issuance of $1.4 billion of erroneous refunds was prevented.

Compliance reviews of 1,800 electronic return originators were performed. The IRS issued 322 warnings and suspended 65 participants for serious breaches of requirements. The Questionable Refund Detection Team (QRDT) identified 2,500 fraudulent schemes involving multiple returns for paper and/or electronically filed returns. It detected approximately 25,000 fraudulent returns and prevented the issuance of over $79 million in refunds.

• The Criminal Investigations Division initiated 172 criminal investigations involving return preparers. Recommendations for prosecution were forwarded on 107 cases. Indictments were obtained on 112 individuals and convictions made in 84 cases.
• For the Fiscal Year (FY) ending September 1997, the Examination Division closed approximately 375,000 cases with assessments exceeding $612.9 million.

Responding to a study showing a 25.8 percent ($4.4 billion) noncompliance rate for EIC tax rules, the Congress enacted legislation that permitted budget authority for 5 years and a new EIC appropriation to address EIC noncompliance. The appropriation provided additional funding for the improved applications of the EIC. The funding was to be appropriated as follows. Not more than:

• $138,000,000 for FY 1998.
• $143,000,000 for FY 1999.
• $144,000,000 for FY 2000.
• $145,000,000 for FY 2001.
• $146,000,000 for FY 2002.

In addition to the funding, the Congress enacted the following six Department of the Treasury proposals in the Taxpayer Relief Act of 1997 to provide the IRS with new tools to combat EIC noncompliance.

1. Required paid preparers to fulfill certain due diligence standards when preparing EIC returns.
2. Provided that taxpayers who fraudulently claim the EIC can be denied the credit for 10 years and those who recklessly or fraudulently disregard the rules and regulations can be denied the credit for 2 years.
3. Provided that taxpayers who are denied the EIC through the IRS’ deficiency procedures are ineligible to claim the EIC in subsequent years unless they provide evidence of eligibility through the recertification process.

Note: In response to this legislation, the IRS established the EIC Recertification Program. When the EIC is denied during an audit, a recertification indicator is placed on the taxpayer’s account. Taxpayers are then required to submit an Information to Claim Earned Income After Disallowance (Form 8862) to claim the EIC after disallowance with their next return on which the EIC is claimed. After receiving this form, the IRS reviews the taxpayer’s return information and either allows the EIC or begins an audit to determine if the taxpayer qualifies for the credit.

4. Allowed the IRS to levy up to15 percent of unemployment and means-tested public assistance and certain other specified payments.
5. Gave the IRS access to a Federal Case Registry of Child Support Orders, which could help identify erroneous EIC claims by non-custodial parents.
6. Required the Social Security Administration (SSA) to collect SSNs of birth parents and provide the IRS with information linking parents’ with their child’s SSN.

Report on the EIC Appropriation Expenditures for FY 1998 ($138 million)

The IRS developed the following action plan to implement EIC initiatives for FY 1998:

Action Plan:

Communication and Assistance:

• Strengthen alliances with Volunteer Income Tax Assistance (VITA), Tax Counseling for the Ederly, and taxpayer advocacy groups for low-income taxpayers.
• Local offices to work with low-income workers to determine eligibility and assist with forms.
• The VITA volunteers to visit homeless shelters to explain credit and eligibility and help file tax returns.
• Work with employers of migrant workers, and volunteers visit work camps.
• Taxpayer Education Coordinators to identify low-wage industries in their areas and provide assistance and/or education.
• Expand low-cost and no-cost education and tax return preparation options for taxpayers so they get the best information regarding their EIC eligibility and the proper way to file a claim for the credit.
• Expand EIC toll-free assistance hours to 24 hours-a-day, 7 days-a-week.
• Contract with a market research firm to determine the effectiveness of current products.
• Use Math Error authority to stop over 600,000 potential erroneous EIC claims.
• Include instructions in materials sent to taxpayers of the importance of providing an accurate SSN.
• Increase staffing for the QRDT, and District Criminal Investigation and Examination Divisions to address potential fraud.

Research Efforts:

• Tax Year 1997 Study to baseline EIC noncompliance.
• A file of EIC taxpayers is being designed that will allow examination of changes in the filing characteristics of taxpayers over time.
• The Duplicate TIN Notices project measures the impact of non-enforcement approaches to changing taxpayer behavior, while the Duplicate TIN Repeater and Schedule C Audit projects will measure the impact of enforcement approaches.
• Develop a systemic way to distinguish between compliant and non-compliant taxpayers through use of the Department of Health and Human Services (HHS) and the SSA data made available to us in recent legislation. (Although this is listed in the 1998 action plan, the database with HHS and SSA information has not been established. Limited testing will begin during FY 2000.)

1998 Summary of Results:

• Resources: Overall, 2,358 Full Time Equivalent (FTEs) (121 percent of planned 1,954 FTEs).
• Obligations: $135.9 million (98 percent of the $138 million).
• Revenue Protected: $977 million (81 percent of the projected FY 1998 total of $1.2 billion).

Action Plan:

Communication and Assistance:

• Outreach and Education Programs were the same as FY 1998.
• Use Math Error authority to stop 450,000 potential erroneous EIC claims.

Research Efforts:

• The TY 1997 EIC Baseline Study.
• Issued reports in 1999 include the Duplicate SSN Research Report and the Advance EIC Report. Reports on EIC Math Errors and EIC and Schedule C Filers are scheduled to be issued in early FY 2000.
• Database with HHS and SSA will be tested during FY 2000.
• Initiate studies on revised EIC forms, worksheets, and publications and a study of the population that appears to be eligible for the EIC, but do not claim the credit.

1999 Summary of Results:

Customer Service

• 72,000 taxpayers assisted with EIC questions and 174,000 returns filed for EIC taxpayers.
• Toll-free assistance was made available 24 hours-a-day, 7 days-a-week resulting in nearly 445,000 callers being assisted with general EIC questions and 512,000 callers helped with specific notice questions.
• The VITA Volunteers provided assistance to help taxpayers file 174,000 EIC returns.
• The IRS sent out over 700,000 soft notices to filers whose prior year return indicated a possible error with advice to correct the error before filing.
• Resources Overall: 2,358 FTEs (103 percent of planned 2,287 FTEs).
• Obligations: $140.5 million (98 percent of the $143 million).
• Revenue Protected: $1.123 billion (89 percent of the projected FY 1999 total of $1.26 billion).

1. Earned Income Credit Tax Credit Campaign Partnership, "$7 Million Extra to L.A. Workers". (1999)
2. General Accounting Office. June 1996. "Earned Income Credit - Profile of Tax Year 1994 Credit Recipients." (GAO/GGD-96-122BR).
3. General Accounting Office. May 1997. "Tax Administration: Earned Income Credit Noncompliance." (GAO/T-GGD-97-105).
4. General Accounting Office. September 1996. "Earned Income Credit: IRS’ 1995 Controls Stopped Some Noncompliance, But Not Without Problems." (GAO/GGD-96-172).
5. General Accounting Office July 1998. "IRS’ Tax Year 1994 Compliance Study and Recent Efforts to Reduce Noncompliance." (GAO/GGD-98-150).
6. Hamilton, Amy. 2000. "IRS Designs New Taxpayer Compliance Measure." Tax Analysts, April 10.
7. Liebman , Jeffrey B. "The Impact of the Earned Income Tax Credit on Labor Supply and Taxpayer Compliance."
8. Lydersen, Kari. 2000."Chicago Urges Poor to Seek Earned Income Tax Credit." Washington Post, March 24.
9. Scholz, John Karl. 1994. "The Earned Income Tax Credit: Participation, Compliance, and Antipoverty Effectiveness," National Tax Journal. (1994)
10. Sparrow, Dr. Malcolm K. 1993. "Fraud in the Electronic Filing Program - A Vulnerability Assessment Prepared for the Internal Revenue Service."
11. Sparrow, Dr. Malcolm K. 1998. "EITC-based Refund Fraud: Briefing Notes" August 7.
12. Internal Revenue Service. Chief Financial Officer. 1999. "IRS Tracking - Earned Income Tax Credit Appropriation Annual Report - FY 1998." Document 9383.
13. Internal Revenue Service. Chief Financial Officer. 1999. "IRS Tracking - Earned Income Tax Credit Appropriation Annual Report - FY 1999." Document 9383.
14. House of Representatives, 1997. Conference Report No. 105-284 (to accompany H.R. 2378). 105^th Cong. 1^st session.

Management’s Response to the Draft Report

The response has been removed due to its size. To see the complete response, please see the Adobe PDF version of the report on the TIGTA Public Web Page.