TREASURY
INSPECTOR GENERAL FOR TAX ADMINISTRATION
Untimely Processing of Taxpayer
Carryback Loss Claims Resulted in Significant Interest Costs
August 31, 2006
Reference Number: 2006-40-139
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
Phone Number |
202-927-7037
Email Address | Bonnie.Heald@tigta.treas.gov
Web Site |
http://www.tigta.gov
August 31, 2006
MEMORANDUM FOR COMMISSIONER, WAGE AND INVESTMENT DIVISION
FROM: (for) Michael R. Phillips /s/ Michael E. McKenney
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Untimely Processing of Taxpayer Carryback Loss Claims Resulted in Significant Interest Costs (Audit # 200540034)
This report presents the results of our review to determine whether refunds resulting from carryback claims filed by individuals on an Application for Tentative Refund (Form 1045) or an Amended U.S. Individual Income Tax Return (Form 1040X) were issued timely by the Internal Revenue Service (IRS) to minimize unnecessary taxpayer burden and avoid the payment of interest.
Synopsis
When taxpayers incur a significant loss from business activities or natural disasters to the extent their deductions exceed their income, they can opt to carry back the loss to prior tax years and obtain a refund of taxes paid in those prior years by filing a Form 1045 or Form 1040X. The IRS must process the claim and issue a refund within 45 calendar days of the received date of the Form or the due date of the loss year return (whichever is later) to avoid paying interest on the refund amount. The IRS was able to avoid or minimize the amount of interest it paid on 14 percent of the 499 carryback claims we reviewed. However, improving the processes the IRS uses to work carryback claims could reduce further the amount of interest it pays.
The IRS could pay over $101.7 million in interest during the next 5 years if processing delays are not corrected.
Delays in processing carryback claims increase the burden on taxpayers who are already experiencing financial hardship by extending the amount of time they must wait for their refunds and can result in the IRS paying additional interest. We reviewed a sample of 499 carryback claims (Form 1045 and Form 1040X transactions) that had posted to the IRS Individual Master File[1] between August 1, 2004, and July 30, 2005. While the IRS timely processed most of the 499 claims, it paid approximately $1.8 million in unnecessary interest on 24 percent of the refunds issued. Based on this sample, we estimate about 5,700 claims were not processed timely and interest of approximately $20.3 million was paid unnecessarily. If this condition is not corrected, it could affect approximately 28,400 taxpayers, and the IRS could pay unnecessary interest totaling over $101.7 million during the next 5 years.
We identified several causes for the delays in processing carryback claims and the payment of unnecessary interest.
The IRS could pay significantly more interest if improvements to its procedures for working carryback claims are not made soon. Rising interest rates equate to more interest paid per claim. Since September 2004, the interest rate has increased from 4 percent to 7 percent for tax overpayments to individuals. In addition, the volume of carryback claims the IRS receives is likely to increase as a result of Hurricanes Katrina, Rita, and Wilma. The National Hurricane Center[5] estimates personal damages suffered by victims of the Hurricanes that hit the Gulf Coast Region of the United States in 2005 at almost $100 billion. The impact of inefficiencies in IRS procedures will be compounded as the inventory of claims grows. The IRS also is going to have fewer locations available to receive and process these claims as it continues to close Submission Processing sites. The IRS Net Tax Refund Reports are one tool the IRS can use to monitor the number of carryback claims being paid with interest. However, IRS managers were not using these Reports to monitor the timeliness of carryback claims processing.
Recommendations
We recommended the Director, Submission Processing, require that all carryback claims be identified upon receipt in the Submission Processing sites and routed directly to the IRS function responsible for processing them. The Director, Accounts Management, should reemphasize the importance of following current manual refund procedures for carryback claims. The Director, Accounts Management, also should ensure the annual Program Letter emphasizes the importance of working carryback claims within the interest-free period and use the Net Tax Refund Reports as a tool to evaluate the timeliness of carryback claim processing.
Response
IRS management agreed with our recommendations. The IRS will implement a prescreening process for all Forms 1040X with carryback claims. The IRS indicated instructions are already in place to expedite Forms 1045. Management has issued employee alerts stressing the importance of working carryback claims within the 45-day interest-free period and will consider including evaluations of manual refunds on carryback claims in their business reviews. Under separate cover from the Program Letter, the IRS will issue specific guidance on processing carryback claims. Finally, the IRS will begin using the Net Tax Refund Reports as a tool to evaluate the timeliness of processing carryback claims. Management’s complete response to the draft report is included as Appendix VI.
Copies of this report are also being sent to the IRS
managers affected by the report recommendations. Please contact me at (202) 622-6510 if you
have questions or Michael E. McKenney, Assistant Inspector General for Audit (Wage
and Investment Income Programs), at (202) 622-5916.
Manually Issuing
Refunds Resulted in Interest Savings
Processing Claims
More Timely Can Reduce Taxpayer Burden and Save Interest
Appendices
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix
IV – Outcome Measures
Appendix V
– Details on the Selection of Carryback Transactions for Review
Appendix
VI – Management’s Response to the Draft Report
Abbreviations
|
CIS IMF |
Correspondence Imaging System Individual Master File |
|
IRS TC |
Internal Revenue Service Transaction Code |
|
TIGTA |
Treasury Inspector General for Tax
Administration |
|
W&I |
Wage and Investment |
Taxpayers incurring a significant loss from business activities or natural disasters could find their deductions exceeding their income for the year the loss occurred. When this happens, the taxpayers incur a net operating loss (loss). Taxpayers can opt to carry back a loss to earlier tax years and obtain a refund of taxes paid in those prior years. Losses generally can be carried back to the 2 prior tax years.[6]
Hurricanes Katrina, Rita, and Wilma hit the Gulf Coast Region of the United States in August, September, and October 2005, respectively. In fall 2005, Congress passed the Katrina Emergency Tax Relief Act of 2005[7] and the Gulf Opportunity Zone Act of 2005[8] to aid the victims of these Hurricanes. These Acts include provisions that eliminate the limitations on personal casualty or theft losses caused by these Hurricanes. The Gulf Opportunity Zone Act of 2005 also allows taxpayers affected by Hurricane Katrina that live in the Gulf Opportunity Zone[9] to carry back certain qualified losses 5 years.
Individual taxpayers can get their carryback refunds by filing an Application for Tentative Refund (Form 1045) or an Amended U.S. Individual Income Tax Return (Form 1040X), depending on their situations. Figure 1 outlines the differences between a Form 1045 and a Form 1040X. Although there are different criteria for filing each Form, the Internal Revenue Service (IRS) must pay interest on a refund claimed on either Form if the refund is not issued within 45 calendar days of the received date of the Form or the due date of the loss year return,[10] whichever is later.
Figure 1: Differences Between a Form 1045 and Form 1040X
|
|
|
Years to Which a Loss |
IRS Processing Requirements |
|
|
Form 1045 |
Within 1 year of the end of
the loss year. |
Can be used to apply loss to
multiple years. |
Within 90 days of the date
the claim was filed or the last day of the month that includes the due date
of the loss year return,[11]
whichever is later. |
Refunds are considered
“tentative.” The IRS can assess and
collect tax immediately if the refund is later found to be in error. |
|
Form 1040X |
Up to 3 years after the due
date of the loss year return.[12] |
Must file a separate Form 1040X
for each year to which the loss is to be applied. |
Taxpayer can file suit |
The claim is considered
correct when the refund is issued. |
Source: IRS Forms 1045 and 1040X instructions and Net Operating Losses (NOLs) for Individuals, Estates, and Trusts (Publication 536).
The IRS is in the process of changing the way it processes
taxpayer correspondence, including Forms 1045 and 1040X. In November 2003, the IRS Austin Campus[13]
in
This review was performed in the Wage and Investment
(W&I) Division Headquarters in
It is
important that carryback claims are processed timely to reduce the financial
strain on taxpayers suffering losses such as those caused by the
2005 Hurricanes.
The
Timely processing carryback claims and issuing refunds also saves considerable Federal Government resources by eliminating the need to pay interest on those refunds. Claims for refunds resulting from applying a net operating loss to a prior tax year vary significantly from other types of taxpayer claims. The IRS generally must pay interest on claims other than carrybacks, such as those to correct an error on a previously filed return, from the due date of the original return to the date the IRS received the claim. The IRS is required to pay additional interest if these claims are not processed within 45 calendar days. Regardless of how timely a noncarryback claim is processed, the IRS will pay some interest to the taxpayer.
Untimely processing of carryback claims causes the IRS to pay interest it normally would not have to pay.
However, it is possible for the IRS to avoid paying any interest on a carryback claim if the claim is processed within 45 calendar days. One day could mean the difference between not paying any interest and paying thousands of dollars in interest. For example, if a taxpayer files a claim that creates a potential refund of $1 million and the IRS timely processes the claim and issues the refund, the taxpayer receives no interest. However, issuing the refund on the 46th day causes the IRS to pay $179,000 in interest.[18]
In Calendar Year 2004,[19] individual taxpayers filed approximately 88,000 carryback claims[20] that resulted in refunds and the IRS paid interest totaling $25.1 million.[21] The number of carryback claims fell to 61,700 in Calendar Year 2005, and interest paid totaled about $23.3 million.
In September 2004, we reported the IRS could have avoided an estimated $12.6 million in interest paid to corporations on refunds resulting from carryback claims that were not processed within the 45-day interest-free period.[22] For this review, we evaluated the processing of Forms 1045 and 1040X filed by individual taxpayers between August 1, 2004, and July 30, 2005. The IRS was able to avoid or reduce the amount of interest it paid on some of the carryback claims we reviewed. However, improving the processes the IRS uses to work carryback claims can reduce further the amount of interest the IRS pays.
Manually Issuing Refunds Resulted in Interest Savings
The IRS has two methods for issuing refunds to taxpayers. Normally, a refund is generated by the IRS computer system. It generally takes 14 days to issue a generated refund because the information must post to the IRS Master File[23] before the refund can be issued. The IRS also can issue a refund manually. A manual refund takes approximately 2 days to issue and is faster because the refund is issued before the refund information posts to the Master File. Therefore, issuing a manual refund allows the IRS another 2 weeks to 3 weeks to process a carryback claim.
The 45-day interest-free period is computed using the date the refund is issued. Because manual refunds take less time to issue, the IRS may be able to issue them before the 45-day interest-free period on carryback claims expires. Issuing a manual refund could eliminate the need for the IRS to pay interest. Because the 45-day interest-free period is so critical, the IRS requires that the refund be issued manually if a claim is over $1 million. A manual refund also should be issued if the claim is over a certain dollar amount and the 45-day interest-free period is in jeopardy or has expired.
We estimate the IRS avoided paying about $9.4 million in interest by issuing manual refunds.
We reviewed all carryback claims over $1 million and a statistical sample of carryback claims from $10,000 to $1 million that had posted to the Individual Master File[24] between August 1, 2004, and July 30, 2005. The IRS avoided paying approximately $1.6 million in interest on 69 (14 percent) of the 499 claims reviewed by issuing manual refunds as required. Based on these results, we estimate the IRS saved about $9.4 million by issuing manual refunds on 2,882 claims for which the interest-free period would not have been met otherwise. Details on our sample selection can be found in Appendices I and V.
Processing Claims More Timely Can Reduce Taxpayer Burden and Save Interest
While the IRS was
able to avoid some interest costs by issuing manual refunds, it can further
reduce the burden on taxpayers filing carryback claims and the amount of
interest it pays on those claims. Taxpayers
who file carryback claims generally have suffered catastrophic losses, which can
create a financial hardship on individuals.
Any delay these taxpayers experience in receiving a valid refund as a
result of that loss can increase that financial hardship. Delays in processing carryback claims also
cause the IRS to pay interest it does not necessarily have to pay.
The IRS
could pay approximately $101.7 million in interest over the next
5 years if processing delays are not corrected.
The IRS can refine its processes for working carryback claims to better ensure claims are processed timely and refunds are issued within the 45-day interest-free period. An analysis of our statistical sample of carryback claims showed 120 (24 percent) of the 499 claims were not processed within the 45-day interest-free period and the IRS paid interest totaling approximately $1.8 million as a result. Figure 2 provides the details on our samples and the related test results. We estimate about 5,700 claims were not processed timely and interest of approximately $20.3 million was paid unnecessarily. If this condition is not corrected, it could affect approximately 28,400 taxpayers, and the IRS could pay unnecessary interest totaling about $101.7 million over the next 5 years.[25] We anticipate the actual amount of interest the IRS will pay unnecessarily over the next 5 years may be significantly higher than estimated because of continually increasing interest rates and a likely increase in the volume of claims resulting from Hurricanes Katrina, Rita, and Wilma.
Figure 2: Carryback Claim Samples and Test Results
|
Claim |
Claims Reviewed |
Claims Not Processed Timely |
Percentage Not Processed Timely |
|
|
Form 1045 |
|
|
|
|
|
$10,000 to
$1 million |
150 |
24 |
16.0% |
$25,572 |
|
Over $1
million |
72 |
10 |
13.9% |
$429,030 |
|
Form 1040X |
|
|
|
|