Rich Fraud, Poor Fraud: The GOP's Double Standard On Tax Mistakes

Their new tax bill lavishes breaks on businesses that underpay what they owe.

WASHINGTON ― The Republican tax bill would provide new tax breaks for businesses ― many of which already shirk taxes on a massive scale.

At the same time, in the name of fraud prevention, the bill could create new obstacles for poor people who claim a tax credit designed to boost their pay and nudge them out of poverty.

The IRS already audits poor people quite often. Of the 1.2 million audits the IRS conducted last year, more than 400,000 targeted filers with annual incomes of less than $25,000 who had questionably claimed the earned income tax credit, or EITC, on their return. Government watchdogs have questioned the IRS about this trend, since the sums involved are relatively small and the people involved are less able to pay for their mistakes.

Geri Hepburn of Seminole County, Florida, heard from the IRS earlier this year about her tax return for 2015. Hepburn said she’d earned about $17,000 that year as a freelance chef, mostly cooking for individuals in their homes. For a mother of three like Hepburn, an annual income of $17,000 makes her eligible for the maximum EITC benefit of more than $6,000.

In a letter, the IRS asked her to prove in 30 days that she’d actually earned her money from cooking, since she’d reported it as business income on Schedule C of IRS Form 1040 ― meaning the IRS didn’t have an employer’s W-2 forms on file to corroborate the earnings, as it does for regular employees.

Hepburn says she asked for more time, writing that she’d recently undergone a hysterectomy and moved, and that any paperwork documenting her work from that year would be somewhere in the dozens of boxes she hadn’t unpacked yet. But in August, the auditors said they’d determined she actually earned no money in 2015, since she couldn’t substantiate it ― and that she owed the IRS $6,621, roughly the amount she’d received as a refund in 2016.

“Because we determined that the activity described on your Schedule C does not meet the guidelines of carrying on a trade or business,” the letter said, “we removed your gross income and adjusted your self-employment tax to zero.”

Hepburn says she’s been losing sleep over the audit. Experts say her case could still have a favorable outcome, but the amount she owes will only grow with interest. If she can’t set up an installment plan or pay a compromise amount, the IRS could put a lien on her assets, which can include bank accounts or physical property.

“I’ve been awake wondering what the hell is going to happen, how the hell I’m going to deal with it,” she said.

Cases like Hepburn’s are typical, said Keith Fogg, director of Harvard University’s taxpayer clinic, which frequently assists tax filers with finding documentation of their self-employment earnings.

“Child care, hair care and lawn care would be the three primary businesses that I see in this particular area,” Fogg said, adding that documentation of business income can include things like Craigslist ads and Facebook posts.

Though earned income credit audits are common, Fogg doesn’t think they make a ton of sense from a revenue standpoint.

“I don’t understand why Congress wants to tell the IRS to audit these people in general, because the big money is not here,” Fogg said. “The big money is in small businesses.”

In the tax debate on Capitol Hill, “small business” is code for firms that are not taxed as corporations, with their profits instead passing through the business to its owners’ individual tax returns. These businesses are not necessarily small, and their owners already contribute more to the “tax gap” ― the difference between what Americans collectively owe the IRS and what it collects ― than any other single type of tax filer.

The Republican tax bills would create new tax breaks for “pass-through” firms that experts say would encourage high-income individuals to falsely reclassify their wages as business profit in order to qualify for the preferential tax treatment.

“The various lines drawn by the provisions will result in substantial tax planning and lower taxes for anyone able to characterize their livelihood as an eligible business rather than as a job,” a group of 13 tax scholars wrote in a paper published last week.

In other words, the GOP tax agenda would create new benefits for business owners who already under-report their income, and new restrictions for poor people claiming they deserve the earned income tax credit ― even though the IRS already audits them like crazy.

Congress created the earned income tax credit in the 1970s as a “work bonus” to reward poor people for punching the clock, which was more palatable to lawmakers than expanding welfare programs. Congress made the credit more generous six times since then, including in the vaunted 1984 tax reform.

More than 28 million households benefit from the credit today, making it one of the U.S. government’s biggest safety net programs ― and a target for Republicans, who in recent years have characterized it as “welfare” and claimed it’s full of fraud.

I don't understand why Congress wants to tell the IRS to audit these people in general, because the big money is not here. Keith Fogg, director of the Federal Tax Clinic at Harvard University

The bills the Senate and House of Representatives have passed ― which still need to be reconciled and voted on again before a final bill can become law ― would require claimants to provide Social Security numbers for themselves and their children. This would effectively cut benefits for about 1 million people, mostly immigrants.

The House bill also has a provision directing the IRS to double-check earned income claims that report business income, which amounts to about a quarter of claims ― the smallest “small business” activity that exists. And it asks the IRS to make sure filers claiming business income have taken advantage of available deductions.

Larry Zelenak, a tax professor at Duke University School of Law, said it would be unusual for the IRS to want to make sure a businessperson took as many deductions as possible. He said relevant expenses would include gasoline for a landscaper’s truck, for example. 

“If you’re not deducting gasoline, you’re in trouble,” Zelenak said.

Republicans say it’s a harmless provision that won’t deny benefits to anybody who deserves them.

“I think everything in the business world requires documentation. Whether you’re getting a refund or a rebate, it requires documentation,” Rep. Jim Renacci (R-Ohio), a member of the tax-writing House Ways and Means Committee, told HuffPost.

“If they can’t justify, the IRS asks them for substantiating information, that’s all,” he said. “It doesn’t hurt anybody who qualifies.”

The Joint Committee on Taxation estimated that the provision would have a negligible revenue effect ― possibly because the IRS already asks EITC claimants to substantiate business income in the course of its many audits.

The Government Accountability Office found in a 2012 investigation that EITC audits yield less revenue than most other types of examinations, bringing in about $5.40 for every dollar spent on the audit itself. By contrast, audits of business returns with more than $200,000 of income yielded $13 for each dollar spent. If the IRS shifted $124 million from auditing poor filers to auditing wealthier ones, it could bring in an additional $1 billion of revenue.

About 23 percent of EITC claims are overpayments, mostly due to people incorrectly reporting income or custody of children. It’s a high error rate relative to other programs that help poor people, such as food stamps. Zelenak said it’s reasonable for lawmakers to want to add integrity measures, considering how little overhead goes into distributing the benefit relative to other programs.

But with some of those errors, as in Hepburn’s case, the problem is simply that the claimant failed to substantiate her income; she wasn’t necessarily ineligible.

Though the EITC error rate is high relative to safety net programs, it’s not wildly out of proportion compared with the overall tax gap, which hit an annual average of $458 billion, or 18 percent of taxes owed annually, from 2008 through 2010, according to the most recent data available. Under-reporting of pass-through business income contributed 27 percent of that amount, or $125 billion a year.

The tax gap has received little attention during the rushed debate over the Republican tax bill. Sen. Ron Johnson (R-Wis.), Capitol Hill’s biggest champion of cutting pass-through taxes, seemed oblivious when HuffPost asked if he had any concerns about the tax gap a few weeks ago.

“Show me the proof,” Johnson said. “Let me see the numbers on that.”

UPDATE 12/22/17: The final version of the legislation passed by Congress did not include the House bill provision relating to EITC claims and self-employment income.

Arthur Delaney co-hosts the HuffPost Politics podcast: