The Ban on Claiming the EITC: A Problematic Penalty

We have written extensively on the intersection of civil penalties and refundable credits like the EITC. In the early days of the blog, guest blogger Susan Morgenstern and I wrote a piece on the Edge case, which considers the reasonable cause defense for EITC-claiming taxpayers using paid preparers. We have also covered the Rand decision, which guest blogger Carl Smith wrote about here last year, which held that IRS may impose accuracy-related penalties only to the extent that a refundable credit was credited against a positive tax liability. Keith also wrote two posts here and here discussing related issues including strategy for litigating cases following Rand.

We have not addressed the special EITC ban that arises when a taxpayer inappropriately claims the EITC.   The following gives some context, with a focus on the two-year ban for reckless or intentional (but not fraudulent) errors.

Statutory Context and Some Background

The ban is an unusual sanction for the internal revenue code. It is unique because its effect is in future years.  Understanding the statutory mechanism of the penalty is important. Section 32(k)(1)(A) provides for a “disallowance period” preventing taxpayers from claiming the EITC for a period of years after a taxpayer improperly claims the EITC.  Section 32(k)(1)(B) tethers the disallowance period to errors that stem from reckless, intentional or fraudulent conduct. In particular, under Section 32(k)(1)(B) the disallowance period is two taxable years “after the most recent taxable year for which there was a final determination that the taxpayer’s [EITC] claim…was due to reckless or intentional disregard of rules and regulations (but not due to fraud).” The disallowance period increases to 10 taxable years “after the most recent taxable year for which there was a final determination that the taxpayer’s claim of credit under this section was due to fraud.”

There is not much in the statute or in other  authorities that fill in the details in the statutory scheme. For example, neither the statute nor the regulations defines what is reckless or intentional disregard. There is no guidance on how or for that matter when taxpayers are entitled to challenge the Service’s determination imposing the ban.

Many factors contribute to challenges the IRS faces in administering the ban. For example, the lack of legal guidance combined with the characteristics of much of the EITC-claiming population, the extent of taxpayer use of commercial preparers on EITC-claiming returns, and the automatic nature of correspondence examinations leads to a bad mix when it comes to the IRS’s ability to determine if the taxpayer’s actions justify imposing the ban.  Difficulties exist even when a correspondence examination has meaningful communication between the taxpayer and the IRS-and that is no sure thing given characteristics of many of the claimants, including language and literacy barriers and the transience of the population. A further complication is the presence in many cases of a paid preparer whose role in the decision to comply (or not comply) with the rules is not clear from the return, the required to be submitted due diligence documents, or correspondence. In considering whether to impose the ban, IRS examiners who do not meet with or let alone talk to the EITC claimants have to determine whether errors are good faith mistakes stemming from say a misunderstanding of the rules or bad advice from a return preparer, or in fact are more intentional efforts to improperly claim the credit.

Chief Counsel guidance from 2002 (SCA 200245051) sensibly provides that the IRS is not supposed to impose the ban solely on the basis of a taxpayer not responding (or failing to adequately respond) to correspondence. In other words, Counsel opined that there must be some other evidence of a taxpayer’s reckless or intentional disregard, which, as TAS points out in its 2013 report (page 103), requires more than mere negligence to justify the 2 year disallowance. Attempting to ensure that the IRS justifies its actions, IRS policies in the internal revenue manual require examiners to document their reasons for imposing the ban. By requiring managerial approval for imposing the ban, the manual also provides an additional procedural protection.

TAS Findings

The TAS Report found major problems with the IRS’s administration of the two-year ban. I recommend a full reading of the discussion, but below I summarize some of the findings:

1. In 2011, IRS inappropriately imposed the ban about 40% of the time
2. In a two-year sample, in 19% of the cases IRS imposed the ban solely because of a prior year EITC’s disallowance
3. In a two-year sample, in only 10% of the cases did the taxpayers’ responses suggest that the possibility of imposing the ban was present
4. In 69% of the ban cases there was no managerial approval, despite manual provisions requiring approval; and
5. In almost 90% of the ban cases, there was no IRS documentation or correspondence explaining why IRS imposed the ban

Imprecise and Blunt Effects of the Ban

The TAS findings are troublesome and suggest that the IRS may be imposing the ban on people whose conduct does not justify the sanction. Furthermore, the ban may have consequences that reach family members apart from a taxpayer in a way that differs from the ban’s imposition in other non tax settings. In the food stamp program, which has a similar ban for intentional program violations, when a married individual is subject to a ban, that person’s disqualification does not disqualify other members of the household from claiming food stamp benefits(though the disqualified person’s income gets attributed to the rest of the household). See 7 CFR 273.11(c)(1)(i). In the tax context, if a married person is subject to the ban, then her spouse will likely be prevented from claiming the EITC, because generally only married people who file joint returns can claim the EITC.  When IRS imposes the ban the consequences could reach other family members who otherwise might have been entitled to benefit from meaningful credits, and whose conduct may in no way have triggered the disallowance.

In addition to possibly ensnaring innocent individuals, the EITC ban’s impact can be quite severe in some circumstances, and negligible in others.  For example, the ban has a big bite if the taxpayer would otherwise be eligible to claim the EITC, because during the disallowance period the taxpayer’s claim will be disallowed even if she would apart from the ban be eligible to claim the credit. With the maximum EITC for three qualifying children in 2014 at $6143 (and increasing every year with inflation adjustments), the disallowance can result in many thousands of dollars of denied benefits, irrespective of the amount of claimed (and disallowed) EITC in the year giving rise to the disallowance.  On the other hand, the disallowance may have no effect in future years if the taxpayer in a ban year would not have otherwise been eligible to claim the EITC. The amount of the penalty is not sufficiently related to the misconduct, and depends on facts separate from the conduct giving rise to the penalty. Similar conduct may thus produce wildly different results.

The above suggests that the ban is quite a blunt and imprecise weapon in the IRS’s arsenal.  The 32(k) ban is outside the tax administration box, and has its roots in sanction provisions in other means tested transfer programs. While I generally am in favor of considering solutions from other related problems to help address different problems, I question whether 32(k) is an appropriate sanction in the tax administration setting.  Other means-tested programs where preventive sanctions exist (such as food stamps) rely to a much greater extent on traditional on the ground application procedures and in-person enforcement of suspected violations. Our tax system relies extensively on third-party or software-based assistance with delivery of tax benefits and automated enforcement through correspondence exams. Those characteristics contribute to little in the way of direct administrative costs but lead to challenges in (1) detecting errors, (2) distinguishing honest mistakes from more intentional abuses and (3) punishing taxpayers who may be gaming the system.

Procedural Complexity

One other aspect of the TAS findings bears highlighting. The TAS Report at page 112 discusses the difficulties for taxpayers who wish to challenge the IRS decision to impose the ban. Some of those challenges I describe above, like literacy and language barriers.  I agree that the provisions are complex. In addition to the TAS concerns, I believe that it is not even clear what year a taxpayer can get court review of the IRS’s determination that the ban applies.

For ease of reference, I will refer to the year when a taxpayer improperly claimed the EITC as the “conduct year” and the year when the taxpayer cannot claim the EITC as a “ban year.”

When IRS believes a taxpayer has acted with reckless or intentional disregard in a conduct year, it typically will disallow all or part of the claimed EITC in a notice of deficiency. That notice should explain the reasons for the disallowance, and the grounds for why it believes the taxpayer should be prohibited from claiming the EITC in a ban year. If a taxpayer claims the credit during the ban year, IRS cannot make a summary or math error assessment against the taxpayer in the ban year, but must issue a statutory notice of deficiency. See SCA 200228021 (June 7, 2002).

So if a taxpayer wants to get court review of the IRS’s determination leading to the ban, should it petition the Tax Court in the conduct year, or in the ban year? The statute is silent. The legislative history states that the “determination of fraud or reckless intentional disregard of rules or regulations are (sic) made in a deficiency proceeding (which provides for judicial review)” but neither the statute nor any other precedential authority states which deficiency proceeding is appropriate.

A summary Tax Court opinion from last year, Garcia v Commissioner, considered the ban in the conduct year. Garcia held that the taxpayer’s incorrect claiming of the EITC in the conduct year did not justify imposing the ban in the two successive taxable years.  Yet, the statutory scheme conferring Tax Court jurisdiction suggests to me that the proper year to get court review of the determination is in a ban year, and not the conduct year.

The Tax Court is a court of limited jurisdiction. Section 6214(a) generally provides that the Tax Court has jurisdiction to redetermine the correct amount of the deficiency. Section 6214(b) provides in relevant part that the Tax Court in redetermining the correct amount of a deficiency for any taxable year “shall consider such facts with relation to taxes for other years…as may be necessary correctly to redetermine the amount of such deficiency, but in so doing shall have no jurisdiction to determine whether or not the tax for any other year…has been overpaid or underpaid.”

I discussed this matter with other people whose views on tax procedure I respect. For example, in an exchange with Carl Smith, he noted the statutory problems with the court considering the ban in the conduct year:

Section 32(k) is not described as a penalty or addition to tax.  But, even if section 32(k) is a penalty, it is not contained within Chapter 68 dealing with additional amounts and penalties (Code secs. 6651-6751).  Section 6665 authorizes the deficiency procedures to apply to certain penalties imposed by Chapter 68, but that does not give the Tax Court jurisdiction to treat a section 32(k) determination as a if it were a penalty imposed by Chapter 68.  Finally, there is no provision in the Code giving the Tax Court independent declaratory jurisdiction to review the IRS determination that 32(k) will apply to any EITC claim made in a later year.

While a disallowance and proposed ban should not generate court review of the ban in the conduct year, claiming of the EITC in the later ban year will trigger deficiency procedures. Thus, a taxpayer claiming the EITC in a ban year could challenge the IRS determination that the taxpayer engaged in reckless or intentional disregard. The court as per Section 6214(b) would be able to consider the facts from the conduct year. If the taxpayer claimed the EITC in the ban year, and the IRS believed that on the merits that but for the ban the taxpayer properly claimed the EITC, the proceeding would solely focus on whether the taxpayer’s earlier disregard was intentional or reckless. The taxpayer would not be entitled to litigate the correctness of the EITC claimed in the conduct year. A determination that the facts in the conduct year did not justify the determination would then be a necessary but not sufficient finding that the taxpayer was entitled to claim the EITC in the particular ban year in question if in the ban year the IRS also disallowed all or part of the EITC on other grounds.

Does this make sense from a policy matter? I do not think so. Delaying the possibility of court review to a ban year places additional potential burdens on the court and taxpayers. Memories fade as time passes; it is harder to get documents that may be relevant, and witnesses may be less available. In addition, the uncertainty in outcome might chill lower-income taxpayers from claiming the EITC in a ban year, as the return will carry not only possible preparation costs but also the certainty that the EITC will be disallowed, triggering eligibility costs such as time and even legal fees (though most taxpayers will likely be pro se or represented by clinics, give the costs of representation relative to the amount in controversy). Moreover, the language that I have seen the IRS use in its correspondence in the conduct year suggests to taxpayers that they are prevented from even claiming the EITC in a ban year, which in and of itself may chill taxpayers from filing a return and getting the court review the IRS’s determination.

Parting Thoughts

This post offers few answers but raises many questions and highlights some problems. The TAS Report offers a moderate legislative recommendation when it comes to 32(k) and proposes that the IRS should have the burden of proof in a court proceeding if there is a judicial challenge to the IRS determination. That makes sense to me, but as the above shows I think there are even more fundamental questions with the sanction that warrant renewed legislative attention.

Later this week, at the ABA Tax Section meeting I will be on a panel that will consider among other things Section 32(k) and the special EITC due diligence provisions I wrote about last week. It will be moderated by Andrew Roberson of McDermott Will and Emery. Andrew is the lead counsel in the Rand case. Joining me will be Professor Michelle Drumbl of Washington and Lee and Drita Tonuzi, who heads the Procedure and Administration Division of Chief Counsel’s Office. We will be discussing some of the issues raised in this post as well as other challenges facing taxpayers, preparers and the IRS when it comes to the EITC and other refundable credits. I will share what I learn from my panelists in a future post.