The Earned Income Tax Credit (EITC) is a refundable credit for low- and moderate-income working individuals and families based on their earned income. EITC significantly reduces poverty, with children constituting over half of the individuals it lifts out of poverty. The amount of the credit increases as earnings increase, reaches a plateau, and then falls as earnings increase. As of December 2021, 25 million workers and families got about $60 billion in EITC benefits. The average amount of EITC received nationwide was about $2,411. Congress provided this credit for individuals and families to be able to afford their day-to-day living expenses. Claiming EITC can be complicated and may involve filing an additional tax form, which leads to errors of both over and underpayment. As I’ve noted in recent blogs (here and here), the American Rescue Plan Act of 2021 (ARPA) temporarily increased the amount of EITC available to eligible taxpayers and expanded the pool of eligible taxpayers. The IRS recently published frequently asked questions about the tax year 2021 EITC.
Every year, millions of taxpayers claim EITC on their returns, and in recent years, the IRS has been selecting about one percent of returns claiming the EITC for audit, which translates to hundreds of thousands of these returns overall. Many EITC audits begin shortly after the filing of a tax return and before the issuance of the refund. If an audited taxpayer demonstrates the credit was properly claimed, the IRS will release the refund at the conclusion of the audit. As I reported in my 2021 Taxpayer Rights and Service Assessment, in fiscal year (FY) 2021, it took an average of 340 days for the IRS to complete an audit of a taxpayer whose income was less than $50,000.
As I discussed in my 2021 Annual Report to Congress, in FY 2019, 82 percent of audited individual taxpayers with incomes (total positive incomes) below $50,000 had claimed EITC on the audited return. Most of the audits of these low-income taxpayers (92 percent) were correspondence audits, meaning the IRS conducted the audits by mail rather than in person. Unfortunately, many taxpayers do not respond or participate in correspondence audits. This results in the IRS disallowing the EITC and closing the audit. Figure 1 shows the non-response rate for audits of taxpayers claiming the EITC whose incomes were less than $50,000.
|Non-Response Rate for Audits of Taxpayers With Incomes Less Than $50,000 Who Claimed EITC on the Original Return
There are several possible explanations for why taxpayers do not respond to an audit: they did not understand the process, did not receive the audit notice, or did not realize from the audit notice the IRS was auditing them (which, according to a 2007 TAS study, happens more than 25 percent of the time), and knowingly or unknowingly abandoned a valid EITC claim. Additional difficulties low-income taxpayers encounter in the correspondence audit process may stem from language barriers, lower financial and computer literacy, and higher levels of transiency. And about one-third of the eligible EITC population changes each year, meaning that a portion of audited taxpayers may be facing these complicated rules for the first time each year.
The EITC Audit Process
When the IRS audits an EITC claim, it is often because IRS records show that a child claimed by the taxpayer does not meet the age, relationship, or residency test to be considered a qualifying child under IRC § 32(c)(3), but it could also be because the income shown on the return is inconsistent with IRS records or does not meet the income requirements of IRC § 32(c)(2). One study with the most recent data available from the IRS showed that 21 percent of known EITC errors (meaning an error identified during an audit with full taxpayer participation) were attributable to qualifying child rules; 58 percent of the errors were tied to income misreporting; and nine percent contained both errors.
Qualifying child errors account for the most dollars of erroneous claims by far. Of the qualifying child errors, 20 percent involved the relationship test, ten percent related to the age test, and 75 percent involved residency. Income misreporting – and in particular self-employment income misreporting – accounts for the second highest dollar amount of erroneous claims.
The IRS notifies a taxpayer of an audit by sending a notice, such as Notice CP 75 or 75A, by certified mail. The first lines of the audit notice state that the IRS is auditing the income tax return for the specified year, that the taxpayer needs to send supporting documentation, and that the IRS is holding the EITC portion of any claimed refund (and the refundable portion of the Child Tax Credit, if it was claimed) pending the results of the audit. It is the taxpayer’s obligation to provide the documentation necessary to support the claimed income, deductions, expenses, or credits. The notice directs the taxpayer to consult Form 886-H-EIC, Documents You Need to Send to Claim the Earned Income Credit on the Basis of a Qualifying Child or Children for Tax Year 2021, to assist with an EITC claim that includes a child. Form 886-H includes a list of documents the IRS generally accepts to prove that a child is a qualifying child. The IRS has also developed an EITC Audit Document Checklist, tailored to taxpayers who are being audited, to help them identify documents they can use to substantiate that they meet the requirements for claiming EITC for a child. The IRS posts educational material on IRS.gov, such as What to Do if We Audit Your Claim and What to Do if We Deny Your Claim for a Credit and provides templates taxpayers can use to prove residency for qualifying children. The templates can be filled out by schools, healthcare providers, and childcare providers. In collaboration with TAS, the IRS also developed Form 14086, Qualifying Children Residency Statement Third Party Affidavit, that other third parties, such as clergy, a landlord, or a property owner, can provide in support of the taxpayer’s claim.
When it is verifying income, the IRS may send the taxpayer a Form 886-L, Supporting Documents, requesting paystubs or a detailed letter from the taxpayer’s employer to establish the amount of the taxpayer’s income. If the taxpayer is self-employed, the IRS may send a Form 11652, Questionnaire and Supporting Documentation Form 1040 Schedule C (Profit or Loss from Business), asking for copies of business records that substantiate claimed income and deductions.
When a taxpayer seeks TAS assistance with an EITC audit, TAS employees are encouraged to reevaluate what documents the IRS considered in the audit and then explore what additional documents the taxpayer has to offer. To help identify acceptable documents the IRS can consider in an audit related to qualifying children but that are not listed in other IRS guidance, TAS assembled a list of “alternative” documents that are included in the Internal Revenue Manual (IRM). To illustrate how to use various documents, a separate IRM provision presents case scenarios and suggests specific documents that could be used to support EITC eligibility. Another IRM provision includes an example of how to work with a self-employed taxpayer who needs assistance identifying documentation to substantiate income.
Over the years, TAS has urged the IRS to be flexible in its approach with EITC taxpayers, as this area of law is complex and involves very personal aspects of a taxpayer’s life. The IRS should revise its IRM guidance to allow employees to identify acceptable substantiating documents from among the documents a taxpayer can produce and include a discussion of the impact of a taxpayer’s statement. This would put taxpayers who are undergoing correspondence audits on the same footing as taxpayers who are seeking to substantiate their EITC claims in other forums. If the Independent Office of Appeals, a Chief Counsel attorney, or a trial judge were considering the matter, they would consider a taxpayer’s oral testimony in reaching a determination about eligibility for EITC. IRS examiners should also consider the taxpayer’s representations and statements in reaching a decision to allow or disallow EITC. However, with a correspondence audit, this is more difficult compared to an examination in which a revenue agent is assigned to a particular audit and has direct contact with a taxpayer. The IRS should also augment its existing training to include experiences of the low-income taxpayer. This would give IRS employees a better sense of the obstacles an EITC taxpayer may be facing during or as a result of the audit. As I recommended in my 2021 Annual Report to Congress, the IRS should assign one employee to each correspondence audit, including EITC audits. This would help the IRS employee become familiar with the taxpayer’s situation and, where appropriate, work with the taxpayer to “get to yes” rather than disallow the credit.
Each year as part of our Annual Report to Congress, TAS proposes legislative recommendations to improve taxpayer rights, taxpayer service, and tax administration. TAS has long advocated for dividing EITC into two credits: (i) a refundable worker credit based on each individual worker’s earned income without regard to the presence of qualifying children, and (ii) a refundable child benefit. For wage earners, claims for the worker credit could be verified with nearly 100 percent accuracy by matching claims on tax returns against Forms W-2, significantly reducing improper payments on those claims. The portion of EITC that varies based on family size could be combined with the Child Tax Credit into a larger family credit. In 2019, TAS published a special report: Earned Income Tax Credit: Making the EITC Work for Taxpayers and the Government: Improving Administration and Protecting Taxpayer Rights. The report presents proposals to improve EITC and its administration so the credit better achieves policymakers’ objectives (i.e., increasing labor force participation and reducing poverty), while imposing less burden on both the IRS and taxpayers. Regardless of the specific approach taken in any future EITC legislation, it is imperative that the credit be easily administrable with the goal of reducing the need for increased audits and reducing potential fraud. I cannot stress enough the benefits of simplifying EITC to ensure individuals and families receive the benefits Congress intended without requiring the IRS to audit these credits for improper payments.
An improper payment is defined as “any payment that should not have been made or that was made in an incorrect amount (including overpayments and underpayments) under statutory, contractual, administrative, or other legally applicable requirements” and “any payment to an ineligible recipient.” For FY 2019, the IRS estimates that approximately 25 percent of the total EITC program payments were improper. Restructuring and simplifying the EITC for ease of administration will have the added benefit of reducing improper payments and the need to audit EITC returns.
Each taxpayer claiming EITC brings a unique set of facts that the IRS must consider in determining qualification. Although the IRS has tools to help it determine whether an EITC claim should be subject to audit, it has no way of knowing the particulars of each family until the audit is complete. If taxpayers are eligible for EITC and are being audited, they should not be deterred if the paperwork they can produce supports their EITC claims but does not exactly match what the IRS is requesting. Practitioners and taxpayers should think carefully and creatively about what documentation is available that would address the areas covered by the audit. The taxpayer can be his or her own best advocate and should not be discouraged by the audit process. IRS agents, Appeals Officers, and Counsel attorneys strive to get to the right result and apply the law fairly and consistently. If a taxpayer encounters a problem, it should be elevated within the IRS. The system is not perfect, but it has checks and balances to get to the right answer.
Eligible taxpayers can reach out to Low Income Taxpayer Clinics (LITCs) for assistance with EITC audits. LITCs are independent from the IRS and TAS. LITCs represent individuals whose income is below a certain level and who need to resolve tax problems with the IRS. LITCs are a great resource and can represent taxpayers in audits, appeals, and tax collection disputes before the IRS and in court, including the Tax Court. In addition, LITCs can provide information about taxpayer rights and responsibilities in different languages for individuals who speak English as a second language. For more information or to find an LITC near you, visit www.taxpayeradvocate.irs.gov/litc or see IRS Publication 4134, Low Income Taxpayer Clinic List. This publication is also available online at www.irs.gov/forms-pubs or by calling the IRS toll-free at 800-TAX-FORM (800-829-3676).
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.