IRS Improperly Freezes Refunds, Report Says

The government improperly identifies hundreds of thousands of taxpayers every year as potential cheats, forcing them to endure needless delays of up to three years to receive the refunds they deserve, according to the Internal Revenue Service’s taxpayer advocate.

And the IRS does not make a practice of contacting taxpayers under investigation and allowing unwitting suspects the chance to prove that their returns were accurate -- or to show that errors were honest mistakes rather than fraud.

Many of the taxpayers whose refunds have been held back are working poor people who need the money, said Nina E. Olson, head of the Taxpayer Advocate Service, an agency created within the IRS to handle taxpayer complaints.

A report issued Tuesday by Olson’s office flagged the practice of freezing refunds as one of the most serious failings in IRS operations. The IRS “cannot and should not treat every taxpayer as a tax cheat,” the report said.

The review found that in 80% of a sample of such cases brought to the taxpayer advocate last year, the IRS wound up paying full or partial refunds.

The overwhelming number of people affected were poor. One possible contributor is the complexity of the earned income tax credit, a benefit designed for low-income workers.

The earned income tax credit refunds as much as $4,400 of tax payments for couples with two or more children who earn about $37,000 or less. A single person with no children would get up to $399 back if they earn up to $13,750.

The median adjusted gross income of taxpayers whose refunds were frozen and whose cases were reviewed was $13,300 -- and the median refund was $3,519.

The survey found that the median delay was 8 1/2 months.

Olson said in an interview that the refund problem developed as the IRS tried to bolster its enforcement function in response to increasing tax fraud. “The IRS should be doing it,” she said, “but it should be doing it well. It shouldn’t be tormenting people.”

The advocate service’s findings regarding the “questionable refund program” drew swift reactions from leading senators in both parties.

Senate Finance Committee Chairman Charles E. Grassley (R-Iowa) said he was “especially troubled” by the suggestion that innocent taxpayers were having money withheld.

“Refunds have been a source of abuse recently,” Grassley said, “but we need to make sure taxpayers have proper due process when the IRS decides to freeze a refund.” He added that taxpayers “often do not know their refund has been frozen and can’t effectively challenge the IRS’ actions.”

Sen. Max Baucus (D-Mont.), the committee’s ranking Democrat, said the report suggested that the IRS was going after fraud “at the expense of honest taxpayers who need these refunds for food, medicine, home heating and other basic needs.”

The Taxpayer Advocate Service began its review after receiving 28,500 complaints last year from taxpayers whose refunds had been frozen.

The office examined a sample of the complaints after they had been resolved and found that in about two-thirds of them, the taxpayers were “fully entitled” to receive their entire refund or, in some cases, even more. An additional 14% eventually received a partial refund.

“Clearly, the amounts at issue and the lengthy delays cause significant hardship for many of these taxpayers,” Olson said in the report.

“We’ve had cases drag on for two or three years,” said Diana Leyden, who teaches law at the University of Connecticut and directs the university tax clinic that helps low-income taxpayers file returns. “Without our services, our clients wouldn’t be able to navigate their way over the hurdles the IRS erects.”

Julie Kruse, director of advocacy for the Center for Economic Progress in Chicago, said: “This is the biggest check of the year for these families. It creates a significant hardship when 25% of your income is withheld.”

The IRS, given a chance to make its case within the report, responded that the taxpayer advocate had “significantly overstated the problem.”

The office surveyed only cases of delayed refunds in which the taxpayers complained, and the IRS argued that innocent taxpayers were more likely to complain than guilty ones.

IRS investigative officials conceded that they could do a better job of communicating with taxpayers whose refunds had been frozen. But “it would be clearly detrimental to any ongoing investigation to notify them that they are under investigation,” said Richard Speier, acting chief of the criminal investigations division. “Our role is to protect the legitimate tax dollars that come in from honest taxpayers.”

By delaying a small fraction of the 106 million refunds sought on the nation’s 136 million tax returns during 2004, the IRS said it had “stopped literally billions of dollars of false refunds to criminals.”

Since 1999, the IRS said, its criminal investigators had stopped about $5 billion in fraudulent refunds. In 2004, it took credit for blocking $2.1 billion in fraudulent refunds, although $1.8 billion of that came from two returns that were not typical of the returns usually flagged by the IRS.

And that total pales beside the estimate of about $300 billion a year that taxpayers owe but do not pay.

“Even in cases where [the criminal investigation office] has made ‘conclusive’ determinations of fraud and characterized the taxpayers as ‘criminals,’ ” Olson said, 46% of taxpayers ended up receiving full refunds.

The IRS screens all tax returns seeking a refund by using a computer program designed to flag those with the earmarks of fraud.

Refunds are delayed in all flagged returns until tax examiners have a chance to look at them. The IRS releases the refunds in cases that clearly do not involve fraud, and freezes the refunds for the rest.

In addition, the IRS freezes the refunds claimed by taxpayers determined to have submitted a fraudulent return within the last several years. The IRS won’t reveal the exact number.

“Despite the serious consequences of a finding of fraud,” Olson said in the report, “the IRS often freezes refunds without advising the taxpayer that it has made a determination of fraud, of the reasons for the determination, or of the consequences of that determination.

“Unless the taxpayer takes the affirmative step of contacting the IRS to inquire about his or her refund, the taxpayer may never know the IRS’ position,” she said.