As this year's tax filing> season approaches, so does tax fraud season. Tax fraud can take several forms, including understating income, overstating deductions, and claiming bogus credits. Since some people feel taxes are unfair or too high and some people are just ethically challenged (especially when it comes to money), tax fraud will always exist. Unfortunately, there's plenty of evidence that Congress actually encourages these fraudulent impulses by handing out thousands of dollars in free cash in the form of refundable tax credits to anyone willing to go to the trouble of filling out a few tax forms. Here's the story.
How Refundable Credits Work
When you claim a refundable credit on your federal income tax return, you get the money even if you owe no tax. To understand why this is a horrible idea, consider the following example.
Say you owe zero federal income tax in 2010, but you claim a $13,170 refundable credit for adoption expenses by filing a Form 1040. To claim the credit, you must include Form 8839 (Qualified Adoption Expenses) with your return, along with a court-approved adoption order or decree and a Social Security Number (or Individual Tax ID Number) for the allegedly-adopted child. While the adoption order requirement is intended to discourage fraudsters, I quickly found sample documents on the Internet. So fraudsters are slowed down a bit but not shut down by any means. File your return with the completed Form 8839, a phony adoption order, and a phony Social Security Number for the phony adoptee, and you're in business. In a few weeks, you'll get a check from the U.S. Treasury for $13,170. Not bad for a few hour's work! And you probably won't get caught.
Fearless Prediction: This year's big tax fraud development will be thousands of returns claiming bogus adoption credits. If I can figure out this scam, so can others. In fact, there are some unscrupulous professional tax preparers out there who specialize in filing returns with fraudulent credit claims. This will surely be a profitable year for them.
Fraudulent adoption credit claims were not a major problem until now because the adoption credit was not refundable before 2010. So claiming the credit in earlier years would lower your federal income tax bill, but there was no check sent to you if the credit exceeded your bill. It's the free cash that encourages rampant fraud.
Refundable Tax Credits (and Related Fraud) Are Nothing New
There's no partisan spin to the refundable tax credit fraud saga. Refundable credits have spanned the last several decades from Nixon through Obama. For example:
* The refundable Earned Income Credit (EIC) has been around since 1975, and so have the related fraud problems. The IRS estimates that phony EIC claims run between $11 billion and $14 billion annually. With the federal deficit at $13 trillion and counting, this is ridiculous!
* The now-expired refundable First-Time Homebuyer Credit was worth up to $8,000 in free money. Initially all you had to do to cash-in was include a Form 5405 with your 1040. No need to supply any paperwork to prove you actually bought a home. Was this a giant fraud opportunity waiting to happen? You betcha! One example: after a review, it was discovered that $9.1 million in fraudulent credits were collected by federal prisoners.
When that rampant fraud became obvious, Congress changed the rules to require a real estate closing statement be included with your return. Out of curiosity, I went online to see how long it would take to manufacture a phony closing statement on the official HUD-1 form. It took about 30 minutes: time well-spent for fraudsters seeking $8,000 in free cash.
The Last Word
To sum up, the term "refundable tax credit" is a deception. In reality, refundable credits are more akin to welfare payments. Government welfare programs are fine as long as voters understand them and approve of them. I don't think refundable credits pass that test. Plus, well-conceived government welfare programs are closely monitored. You typically have to show up in person, with documents in hand, and be interviewed by a skeptical case worker in order to collect anything. To collect refundable credits, all you have to do is mail in some forms and wait a few weeks for the check to arrive. And since only around 1% of returns are audited, fraudsters are right in thinking they will probably never be caught. For all these reasons, if Congress wants to get serious about fiscally responsible tax policies, it should repeal refundable credits ASAP.
Corrections & Amplifications
This story originally stated that no documentation is required to claim the refundable adoption credit. However, the revised Form 8839 instructions will include a requirement to attach an adoption order.