Loophole Leads to IRS Refunds in Disaster Areas

A loophole in federal tax law has resulted in more than 630,000 taxpayers getting an IRS check in the mail because they live in counties that were declared disaster areas--even though few suffered any damage.

The Internal Revenue Service acknowledged Friday that it has been automatically sending out refunds of interest charges for late taxes to any taxpayer who lived in an area declared a disaster area since 1997. Tens of thousands of California residents have received refunds, some for as much as $4,000.

Although Congress had sought to give individuals a break when natural disasters interfere with meeting tax deadlines, it apparently had not intended to give every resident of these disaster areas an interest-free loan on late taxes. The total amount of the refunds is unknown.

The congressional blunder has been compounded by a newly eager-to-please IRS, which has been seeking to repair its tattered image.

“I’m stunned. That is not what Congress intended,” said Rep. Robert Matsui (D-Sacramento), who serves on the House Ways and Means Committee that oversaw the legislation. “My understanding was that [the refund program] was intended only for people who were in fact affected by the disaster itself.”

The loophole appears to be another of the unintended consequences of massive tax bills passed in recent years that ostensibly were designed to simplify tax law. Congress has been forced to pass numerous technical revisions to the 1997 Taxpayer Relief Act, although it has yet to address or even acknowledge the refund snafu.

“It’s nonsense, the idea of presuming that just living in a disaster area entitles you to file late,” said Don Alexander, a former IRS commissioner who is now a tax lawyer in private practice. “These [laws] are done extraordinarily quickly at 2 a.m. by people who are very tired and who can’t think through the questions they should be asking.”

An IRS spokesman said the agency is simply carrying out the law as Congress wrote it.

“The law calls for the abatement of the interest,” said spokesman Ken Hubenak. “You don’t have to have had disaster damage” to qualify.

Other IRS officials said privately that they believed the majority of those who received refunds were not directly affected by disaster losses.

The refunds stem from changes in the Taxpayer Relief Act of 1997 and follow-up legislation last year that sought to give a tax break to people who lived in counties declared by the president to be disaster areas. The laws made those residents eligible for refunds of any interest they had been charged for paying their taxes late.

As a result, hundreds of thousands of people who filed extensions in 1997 and 1998 have received refunds of the interest they paid, and more may be eligible this year. Most of the taxpayers did not even have to apply for the money--the IRS said it sent the refunds automatically after matching its list of people who paid extension-related interest with the Federal Emergency Management Agency’s list of disaster area ZIP Codes.

Starting in December, the IRS sent out about 70,000 interest refunds tax returns filed in 1997 and about 560,000 for tax returns filed in 1998, Hubenak said.

The refunds have startled some taxpayers and their accountants. Patricia Gill, a San Francisco certified public accountant, said one of her clients got a $100 check, while another got nearly $4,000. Neither suffered disaster damage.

“I couldn’t make any sense of it,” Gill said. “I didn’t know if there was a mistake in the IRS’ computer processing or a mistake in the drafting of the law.”

Matsui said he recalled some congressional discussion about how taxpayers should prove they qualify for the interest payment relief, but the issue apparently was never resolved. Matsui said he presumed that the IRS would require taxpayers to apply for the refunds and to prove that they deserved them.

“The IRS should have required a person to state under penalty of perjury, at least, that the late filing was because of disaster,” Matsui said. “But this is what’s going on now with the IRS--they’re bending over backward now to show they’re consumer-friendly.”

The IRS has been chastened by scathing congressional hearings about aggressive and abusive practices. While Congress strengthened taxpayer rights, the IRS has instituted numerous internal reforms, including hosting problem-solving days for taxpayers and issuing public apologies for its mistakes.

“This is the new warm and fuzzy IRS,” said Alexander, who served as commissioner from 1973 to 1977. “Warm, and fuzzy in its thinking.”

Others cautioned that the legal teams that drafted tax legislation, in consultation with IRS and U.S. Treasury officials, may have decided against creating administrative procedures to handle who would and would not get the refunds.

“It might be pure common sense,” said Phil Brand, former chief compliance officer for the IRS and now director of KPMG’s tax controversy services in New York. “It might have been a lot less costly [for the law] to have been written this way.”

Congress had expected the refunds to cost $25 million a year, although the actual cost is now unknown. To stop the refunds it is likely that Congress would have to pass yet another law.

The IRS was also unable to estimate how many refunds went to Californians, although the number is expected to be in the tens of thousands.

Californians are more likely than the average taxpayer to file for extensions and to be charged interest for paying their taxes late. Los Angeles accounted for 3.3% of extension filings last year, while filing 2.6% of the nation’s returns, said Keith Kimball, IRS spokesman in Los Angeles.

What’s more, cold weather crop damage in the northern reaches of Los Angeles County could mean thousands more urban residents could qualify for refunds this year--simply for living in the right place at the right time.

Much of California was declared a disaster area in recent years. El Nino storms and floods prompted President Clinton to designate 48 of California’s 58 counties, including much of Northern California, as disaster areas in 1997. In 1998, 41 California counties, including all of Southern California except Imperial County, became disaster areas.

So far this year, the president has declared 18 California counties to be federal disaster areas because of unusually cold weather that damaged citrus crops. The counties include Los Angeles, San Bernardino, Ventura and Santa Barbara.

The refunds outrage Anna Maria Galdieri, an Oakland CPA who worked on 1991 federal disaster relief legislation. Galdieri said the refunds benefit wealthier taxpayers and business owners who procrastinated but who happened to live in a county that was declared a disaster area.

On top of the interest, taxpayers might still have to pay penalties that typically equal 0.5% of their tax bill for each month or part of a month that they are late.

Taxpayers who believe they should have gotten a refund of the interest they paid but did not can call the IRS at (800) 829-1040 for details and a copy of Form 843, Claim for Refund and Request for Abatement.

A Tax Primer

On Sunday, the Business section looks at the new tax laws and finds that middle-income families and those with capital gains may see plenty of savings. But almost everyone faces a slew of fresh complications. C1