TREASURY
INSPECTOR GENERAL FOR TAX ADMINISTRATION
Individual Tax Returns Were Timely Processed in 2006, but Opportunities Exist to Improve Verification of Certain Tax Deductions
October 10, 2006
Reference Number: 2006-40-164
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
October 10, 2006
MEMORANDUM FOR COMMISSIONER, WAGE AND INVESTMENT DIVISION
FROM: Michael R. Phillips /s/ Michael R. Phillips
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Individual Tax Returns Were Timely Processed in 2006, but Opportunities Exist to Improve Verification of Certain Tax Deductions (Audit # 200640016)
This report presents the results of our review to evaluate whether the Internal Revenue Service (IRS) timely and accurately processed individual paper and electronic tax returns[1] during the 2006 Filing Season. The filing season is the period from January through mid-April when most individual income tax returns are filed. This audit focused on the implementation of new tax law changes identified in Appendix V that affected Tax Year 2005 tax returns. In addition, we reviewed the corrective actions taken for the conditions identified in our review of the 2005 Filing Season[2] to determine whether they were adequate.
Impact on the Taxpayer
Each year, legislated tax law changes create complex challenges for both the IRS and individual taxpayers. Overall, our review of the 2006 Filing Season found that most of these changes were implemented correctly with no significant delays in the processing of tax returns. The IRS had processed approximately 118.9 million individual income tax returns through May 26, 2006, and had timely issued refunds to applicable taxpayers within the processing time required.
Synopsis
The IRS had a successful 2006 Filing Season even though it was an unusually difficult one because of the many late tax law changes due to the Hurricanes.
The IRS had a successful 2006 Filing Season. It completed processing returns on schedule and timely issued refunds within the required 45 calendar days of the April 17, 2006, due date.[3] The April 15 due date was on a Saturday this year, so the deadline was extended to April 17 for timely filed returns.[4] Through May 26, 2006, the IRS had processed approximately 118.9 million individual income tax returns, including 70.9 million (59.6 percent) processed electronically.
The 2006 Filing Season was unusual due to the significant tax law changes to assist taxpayers adversely affected by the devastation caused by Hurricanes Katrina, Rita, and Wilma that struck the Gulf Coast States in August and October 2005. In addition, significant law changes were included in provisions from the Working Families Tax Relief Act of 2004[5] and other legislation that became effective for Tax Year 2005.
Overall, most key tax law changes for the 2006 Filing Season we reviewed were implemented correctly. Additionally, one condition reported during the 2005 Filing Season review was no longer a concern this year. Last year, we analyzed returns that were processed with an entry exceeding $100,000 for the State sales tax or State income tax deduction and/or the amount of nontaxable combat pay reported.[6] In some instances, these entries were caused by taxpayers or the IRS incorrectly entering the amounts, which created erroneous credits and understatements of tax liabilities. In this year’s review, we reviewed questionable large-dollar amounts of the same deductions and nontaxable combat pay along with other tax law changes and found they were generally accurate and, when inaccuracies occurred, they were corrected during return processing.
However, we also identified opportunities to improve the processing and accuracy of tax returns containing the following tax provisions:
· Taxpayers over the age of 70½ claimed improper Individual Retirement Arrangement (IRA) deductions.
· Eligible taxpayers did not take full advantage of the sales tax deduction.
· Single taxpayers continued to claim a non-permissible “dual benefit” by taking both the tuition and fees deduction and the Education Credit.
Recommendations
The recommendations included in this report can assist the IRS in effectively administering tax law changes. We recommended the Commissioner, Wage and Investment Division:
· Revise the IRA worksheet in all tax instructions where this worksheet is used to clearly state that taxpayers over age 70½ cannot take the IRA deduction.
If the sales tax and tuition and fees deductions are extended to Tax Year 2006 and beyond, we recommended the Commissioner, Wage and Investment Division:
· Ensure the Sales Tax Calculator is available on the IRS Internet web site (IRS.gov) to assist individuals in calculating their deductions.
· Create a new form to capture the required information for the tuition and fees deduction to ensure compliance with the tax legislation.
Response
IRS management did not agree with our first recommendation. However, the IRS is taking an alternative corrective action and will revise the IRA worksheet for Tax Year 2006 to emphasize the importance of reading the section of the instructions that addresses the issue.
IRS management agreed with both of our other recommendations. The IRS will develop a web‑based version of the Sales Tax Deduction Calculator in time for the filing of Tax Year 2006 tax returns. In addition, in anticipation of legislation to extend the deduction, the IRS began developing a new form for the tuition and fees deduction. The IRS is monitoring the progress of the legislation to ensure the form will be available timely. Management’s complete response to the draft report is included as Appendix VI.
Office of Audit Comment
Although we are concerned
taxpayers may continue to improperly claim this deduction, we
are pleased the IRS plans to revise the IRA worksheet to emphasize
that taxpayers read the instructions prior to completing the
worksheet. We will monitor this issue during next year’s tax
return filing season to determine whether the corrective action taken is
effective and reduces the number of improper IRA deduction claims.
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.
The 2006 Filing Season
Was Completed Timely, and Most Returns Were Accurately Processed
Taxpayers Claimed Improper
Individual Retirement Arrangement Deductions
Eligible Taxpayers
Did Not Take Full Advantage of the Sales Tax Deduction
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 – Overview of Tax Provisions and Other Tax Law Changes Examined During the
Review
Appendix
VI – Management’s Response to the Draft Report
Abbreviations
|
AGI |
Adjusted Gross Income |
|
EGTRRA |
Economic Growth and Tax Relief Reconciliation
Act of 2001 |
|
EITC |
Earned Income Tax Credit |
|
GO Zone |
Gulf Opportunity Zone |
|
IRA |
Individual Retirement Arrangement |
|
I.R.C. |
Internal Revenue Code |
|
IRS |
Internal Revenue Service |
|
KETRA |
Katrina Emergency Tax Relief Act of 2005 |
|
MAGI |
Modified Adjusted Gross Income |
|
TIGTA |
Treasury Inspector General for Tax
Administration |
|
TY |
Tax Year |
|
W&I |
Wage and Investment |
The IRS expected continued growth in electronically filed returns, which surpassed a milestone last year when more than one-half of the returns were filed electronically.
The filing season[7] is a critical program for the Internal Revenue Service (IRS) because it is during this time that most individuals file their income tax returns and contact the IRS if they have questions about specific tax laws or filing procedures. The IRS estimated that 135 million individual income tax returns[8] would be filed during 2006 and most of these would be filed during the 2006 Filing Season. It also expected continued growth in electronically filed returns, which surpassed a milestone last year when more than one-half of the returns filed were filed electronically. Through May 26, 2006, the IRS had processed approximately 118.9 million individual income tax returns, including 70.9 million (59.6 percent) processed electronically. One of the challenges the IRS encounters in processing these returns is the correct implementation of tax law changes.
Changes to the tax law are usually made each year and the changes have a major impact on how the IRS conducts its activities, how many resources are required, and how quickly it can meet its strategic goals. This filing season was an unusually difficult one for the IRS because there were many late tax law changes in response to the Hurricanes that struck the United States. Disaster relief provisions were enacted into law for taxpayers affected by Hurricanes Katrina, Rita, and Wilma. The latest legislation, the Gulf Opportunity Zone (GO Zone) Act of 2005[9] was signed into law on December 21, 2005. Late legislation gave the IRS very little time to revise the necessary tax forms and computer programs before the start of the 2006 Filing Season.
During the 2006 Filing Season, the IRS processed individual
income tax returns in six
Wage and Investment (W&I) Division Submission Processing sites[10]
located throughout the country. All of
the six sites processed paper-filed individual income tax returns, and all but
the Atlanta Submission Processing Site processed electronically filed
individual income tax returns.
Both paper and electronic tax returns and related schedules are processed through the IRS computer systems and recorded on each individual’s tax account at these sites. The IRS computer systems are made up of a complex series of processing subsystems that are linked and programmed nationally to check the validity and math accuracy of the return data provided. If an error is found, the taxpayer is sent a notice that asks for additional information or explains any change that is made to the amount of tax due or to the refund.
This review was performed at the W&I Division Headquarters in Atlanta, Georgia; the Submission Processing offices in Lanham, Maryland, and Cincinnati, Ohio; and the Austin, Texas, Submission Processing Site during the period January through June 2006. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
The 2006 Filing Season Was Completed Timely, and Most Returns Were Accurately Processed
The IRS had a successful 2006 Filing Season. It completed processing returns on schedule and timely issued refunds within the required 45 calendar days of the April 17, 2006, due date.[11] The April 15 due date was on a Saturday this year, so the deadline was extended to April 17 for timely filed returns.[12]
Electronic returns increased over 6.4 percent over the same time last year. The largest increase was seen in taxpayers filing online from home computers (19 percent),[13] but a decrease of almost 23 percent was seen in the IRS Free File Program.[14] This decrease could be attributed to limiting participation in the Program by at least 30 percent of taxpayers in October 2005. Figure 1 compares electronic returns to paper returns filed during the 2006 Filing Season.
Figure 1: Volumes
of Electronic and Paper Tax Returns Filed
During the 2006 Filing Season
Figure 1 was removed due to its
size. To see Figure 1, please go to the
Adobe PDF version of the report on the TIGTA Public Web Page.
One condition reported during the 2005 Filing Season[15] was no longer a concern this year. Last year, we analyzed returns that were processed with an entry exceeding $100,000 for the State sales tax or State income tax deduction and/or the amount of nontaxable combat pay reported.[16] In some instances, these entries were caused by taxpayers or the IRS incorrectly entering the amounts, which created erroneous credits and understatements of tax liabilities. In this year’s review, we reviewed questionable large-dollar amounts of the same deductions and nontaxable combat pay along with other tax law changes. We found they were generally accurate, and when inaccuracies occurred they were corrected during return processing.
Implementation
of key tax law changes
The 2006 Filing Season was unusual due to the significant tax law changes to assist taxpayers adversely affected by the devastation caused by Hurricanes Katrina, Rita, and Wilma that struck the Gulf Coast States in August and October 2005. The Katrina Emergency Tax Relief Act of 2005 (KETRA)[17] was signed into law on September 23, 2005, and contained $3.3 billion in estimated tax relief for Fiscal Year 2006. The GO Zone legislation followed in December 2005, with an additional $3.9 billion in estimated tax relief for 2006. Taxpayers who were adversely affected by the Hurricanes were able to elect to use their 2004 earned income to calculate their Earned Income Tax Credit (EITC) and refundable Child Tax Credit, double their Hope and Lifetime Learning Credits for students who attend an educational institution in the GO Zone, and deduct personal casualty or theft losses caused by the Hurricanes as a separate deduction from all other casualty losses along with many other tax benefits. Also, taxpayers who provided housing for Hurricane Katrina displaced individuals could claim an additional exemption, and cash contributions paid to qualified charitable organizations after August 27, 2005, were not subject to any limitations.
Hurricanes Katrina, Rita, and Wilma legislation provided an estimated $7.2 billion in tax relief to affected taxpayers in 2006.
In addition, significant law changes were included in provisions from the Working Families Tax Relief Act of 2004[18] and other legislation that became effective for Tax Year (TY) 2005. One of these changes provides a uniform definition of a qualifying child to be used in determining various tax benefits. See Appendix V for an overview of the tax law provisions examined during this review.
Overall, most key tax law changes for the 2006 Filing Season were implemented correctly. These tax law changes involved:
· Additional exemption for housing Hurricane Katrina displaced individuals.
· Temporary suspension of limitations on charitable contributions and personal casualty losses.
· Tax-favored withdrawals from retirement plans for qualified Hurricane distributions.
· Special rule for determining earned income for taxpayers whose main home was in a disaster area.
· Expansion of the Hope Scholarship and Lifetime Learning Credit for students in the GO Zone.
· A qualifying child for the Child Tax Credit.
· The expansion of the Individual Retirement Arrangement (IRA) deduction.
· Increases in the EITC, the standard deduction, and the exemption amounts.
· Increases in income limits for the student loan interest deduction.
However, we also identified opportunities to improve the processing and accuracy of tax returns containing the following tax provisions:
· Taxpayers over the age of 70½ claimed improper IRA deductions.
· Eligible taxpayers did not take full advantage of the sales tax deduction.
· Single taxpayers continued to claim a non-permissible “dual benefit” by taking both the tuition and fees deduction and the Education Credit.
Taxpayers Claimed Improper Individual Retirement Arrangement Deductions
The IRA deduction was increased for TY 2005 to $4,000 and to $4,500 if a taxpayer is age 50 or older. However, the Internal Revenue Code (I.R.C.)[19] states that no deduction will be allowed as a benefit to any individual who has attained the age of 70½ before the end of the taxable year for which the contribution is made.
Our analysis showed the IRS correctly implemented the increases in the IRA deduction; however, we identified 1,826 taxpayers over age 70½ that improperly claimed over $4 million in IRA deductions.[20] Assuming all 1,826 taxpayers received an improper tax benefit from only the IRA deduction, the estimated loss of revenue is $601,423.[21] We realize this is a relatively small volume of taxpayers; however, with the increasing aging of the population, this could become a larger issue in the future.
The instructions for Forms 1040 and 1040A inform taxpayers to use the worksheet in the instructions to calculate the amount of their IRA deductions but to read a list that followed before preparing the worksheet. The first item on the list states, if they were age 70½ or older at the end of 2005, they cannot deduct any contributions made to a traditional IRA for 2005. However, the IRA worksheet instructs taxpayers to enter $4,000 or $4,500 if 50 or older at the end of 2005. This wording is used three different times in the worksheet and implies there is no age limit for this deduction. A taxpayer who has not read the instructions prior to preparing the worksheet would be uninformed and could claim the deduction improperly.
Recommendation
Recommendation 1: The Commissioner, W&I Division, should revise the IRA worksheet in all tax instructions where this worksheet is used to clearly state that taxpayers over age 70½ cannot take the IRA deduction.
Management’s Response: IRS management did not agree with this recommendation. The instructions for Form 1040, Line 32, IRA Deduction, already instruct the taxpayer to read the list on page 31 before filling in the worksheet. The first item on the list explains the age 70½ or older restrictions. However, the IRS will revise the worksheet for TY 2006 to emphasize the importance of reading the list on page 31 of the instructions.
Office of Audit Comment: Although we are concerned taxpayers may continue to improperly claim this deduction, we are pleased the IRS plans to revise the worksheet to emphasize that taxpayers read the instructions prior to completing the worksheet. We will monitor this issue during next year’s tax return filing season to determine whether the corrective action taken is effective and reduces the number of improper IRA deduction claims.
Eligible Taxpayers Did Not Take Full Advantage of the Sales Tax Deduction
This year, 14 percent of taxpayers living in a State with no income tax did not claim the sales tax deduction. This was up from 9 percent last year.
The American Jobs Creation Act of 2004[22] was enacted in October 2004 and allows taxpayers who itemize deductions the option of deducting either State and local sales taxes or State and local income taxes from their Federal income taxes. This legislation allows this deduction in TYs 2004 and 2005 and is most advantageous for taxpayers living in the seven States that do not have a State income tax.[23] During the 2005 Filing Season, taxpayers could determine their deductions by using the tables provided in Optional State Sales Tax Tables (Publication 600) or by saving actual receipts for taxes paid throughout the year. Also, any sales tax paid on certain items such as motor vehicles could be added to the table amount. The Optional State Sales Tax Tables and instructions were not included in the TY 2004 Form 1040 instructions because of the late passage of the legislation.
During the 2005 Filing Season, we reported that taxpayers residing in the seven States without a State income tax were four times more likely to omit the sales tax deduction than taxpayers living elsewhere. Of the 33.3 million tax returns processed through May 2005 with itemized deductions, 5.1 million (15 percent) were filed by taxpayers residing in the 7 States without a State income tax. Of these 5.1 million returns, 465,095 (9 percent) did not claim a sales tax deduction.
This year, the IRS included the Optional State Sales Tax Tables and instructions within the overall instructions for Itemized Deductions and Interest and Ordinary Dividends (Form 1040 Schedules A and B) and also provided the general State sales tax rate used to construct the tax tables for each State. However, taxpayers residing in the seven States without a State income tax were six times more likely to omit the sales tax deduction than taxpayers living elsewhere. Through May 2006, 34.5 million returns had been processed with itemized deductions, 5.3 million (15 percent) of which were filed by taxpayers residing in the 7 States without a State income tax. Of these 5.3 million returns, 735,415 (14 percent) did not claim a sales tax deduction. Also, taxpayers in these seven States were more likely to claim the sales tax deduction if they used a paid preparer. Conversely, taxpayers in these seven States that did not use a paid preparer were more likely to omit the sales tax deduction. Figure 2 shows the differences in the percentages between TYs 2004 and 2005.
Figure 2: Percentages
of Eligible Returns That
Missed the Opportunity to Deduct State Income/Sales Taxes
Figure 2 was removed
due to its size. To see Figure 2, please
go to the Adobe PDF version of the report on the TIGTA Public Web Page.
One problem we identified was that the 2005 Sales Tax Calculator was not available on the IRS Internet web site (IRS.gov). The TY 2005 instructions for Form 1040, Schedules A and B, informed taxpayers they could use the Calculator instead of completing the worksheet included in the instructions. However, the 2005 Sales Tax Calculator was not available during the 2006 Filing Season. As such, some taxpayers who prepared their own paper returns may have not claimed the deduction because the 2005 Sales Tax Calculator was unavailable and the worksheet in the instructions was very complex. Although the sales tax deduction was initially available for TYs 2004 and 2005 only, Congress may extend this deduction to TY 2006 and beyond. If so, we believe more taxpayers will benefit from this deduction with the use of the Sales Tax Calculator.
Recommendation
Recommendation 2: If the sales tax deduction is extended to TY 2006 and beyond, the Commissioner, W&I Division, should ensure the Sales Tax Calculator is available on IRS.gov to assist individuals in calculating their deductions.
Management’s Response: IRS management agreed with this recommendation and will develop a web-based version of the Sales Tax Deduction Calculator in time for the filing of TY 2006 tax returns.
Single Taxpayers Continued to Claim a Non-permissible “Dual Benefit” by Taking Both the Tuition and Fees Deduction and the Education Credit
The Economic Growth and Tax Relief Reconciliation Act of 2001[24] created a new “above-the line” deduction for tuition and fees.[25] For TY 2005, taxpayers were allowed to take a deduction of up to $4,000 for qualified tuition and fees paid for the taxpayer, his or her spouse, or his or her dependents. Taxpayers who claim an Education Credit are required to complete Education Credits (Hope and Lifetime Learning Credits) (Form 8863) and identify the student, by name and Social Security Number, for whom the Education Credit is being claimed. Taxpayers who claim the tuition and fees deduction are not required to provide additional information other than what is already on the return to identify the student for whom the deduction is being claimed. However, taxpayers may not receive a dual benefit by taking both the tuition and fees deduction and the Education Cred