Taxpayers Can Lose Thousands When the IRS Doesn’t Follow Its Own Procedures

Congress establishes certain refundable credits to assist taxpayers with particular expenses. In an attempt to prevent improper claims of these credits, Congress authorizes the IRS to ban taxpayers from claiming certain refundable credits for two years if it determines that the taxpayers claimed the credit(s) due to reckless or intentional disregard of the rules and regulations.

In a Taxpayer Advocate Service (TAS) research study on these bans, we found on average, taxpayers in the study lost approximately $4,100 each year of the ban. This is a significant dollar amount for many taxpayers, particularly low-income taxpayers claiming the Earned Income Tax Credit (EITC). Considering the financial impact this ban has on taxpayers, it is especially concerning that the study showed that the IRS often fails to follow its own policies and procedures when imposing this ban.

TAS reviewed 352 cases where the IRS imposed a two-year ban during Fiscal Year (FY) 2022 or the first eight months of FY 2023, and found:

• In 76 percent of the cases, the IRS failed to secure required managerial approval;
• In 81 percent of the cases, the IRS did not adequately explain to the taxpayer why it imposed the ban, as required;
• In 30 percent of the cases, the IRS did not previously disallow the same credit for the same reason for which it imposed the ban; and
• At least 50 percent of the prior audits took place more than three years from when the IRS imposed the two-year ban.

A number of the taxpayers on whom the IRS imposed the two-year ban had their returns completed by a paid preparer. Specifically, 169 taxpayers out of the 352 cases (48 percent) used a paid preparer. However, only 15 of the 169 preparers had a professional designation, including one who was a state regulated return preparer and another who was a Volunteer Income Tax Assistance volunteer.

Read the full 2023 TAS study on this issue.

This isn’t the first time that TAS has raised concerns about the IRS’s imposition of the two-year ban. A 2019 TAS Research Study determined that IRS’s application of the ban wasn’t always consistent or fair.

Taxpayers Failure to Respond to the IRS’s Audit May Result in the Two-Year Ban Being Asserted Automatically

The IRS imposes the two-year ban one of two ways:

• Manually, where an auditor reviews the case and makes a decision regarding the ban, or
• Systemically, where certain factors are met and the IRS imposes the ban automatically, without including a review from an IRS auditor.

When the IRS imposes the ban systemically, the taxpayer’s failure to respond to the audit will automatically lead to the application of the ban. Out of the 352 cases reviewed, 162 taxpayers – 46 percent – never responded to the audit, but the United States Postal Service returned just 16 percent of the no-responses as “undeliverable mail.” For these taxpayers, failure to respond would be considered as either a factor for the IRS to assert the ban if it was being imposed manually or would have resulted in an automatic assertion if the IRS imposed the ban systemically.

It is concerning that the IRS doesn’t require examiners to attempt to reach the taxpayer if the taxpayer hasn’t responded to the audit, considering the significant consequences such an omission can cause.

Taxpayers Received Inadequate Explanations of the Two-Year Bans

Regardless of whether the IRS imposes the ban manually or systemically, taxpayers will receive a Form 886-A, Explanation of Items, and a statutory notice of deficiency, in which the IRS will impose the ban. The TAS study found that the Form 886-A attached to the statutory notice of deficiency often failed to provide a sufficient explanation as to why the IRS imposed the ban. For example, of the 352 taxpayers in the sample, 349 received Form 886-A. Out of these 349 cases, the TAS review deemed the explanation to the taxpayer to be inadequate 81 percent of the time. When a statutory notice of deficiency is issued, the IRS only requires examiners to include a specific explanation for the ban when the taxpayer has responded to the audit. If the taxpayer hasn’t responded, the auditor provides a standard explanation.

As mentioned above, in 46 percent of the cases reviewed, taxpayers didn’t respond to the audit; therefore, the IRS did not require examiners to provide a specific explanation of the two-year ban in the statutory notice of deficiency. And, out of the remaining 54 percent of cases where the IRS requires an auditor to provide a specific explanation for the ban in the statutory notice of deficiency, only 11 percent included such an explanation.

Managerial Review Was Not Obtained in the Majority of Cases

One important procedural difference between when the IRS imposes the ban manually or systemically is whether the imposition of the ban requires managerial approval. If the IRS imposes the ban systemically, the IRS does not require managerial approval. But if the IRS imposes the ban manually, the IRS requires managerial approval; however, TAS’s review found that examiners rarely obtained such approval.

The IRS imposed the two-year ban systemically in 123 out of 352 cases, or 35 percent of the time. In the remaining 229 cases, IRS policy requires the examiner to obtain managerial approval, but examiners did not obtain managerial approval in 174 of these cases, or 76 percent. Therefore, most two-year bans imposed by the IRS are receiving no managerial review, either because IRS procedures do not require such review, or the IRS is not observing its own guidance.

Prior Audits Were Not Always a Good Indicator of Whether the Two-Year Ban Should be Imposed

Another factor the IRS considers when imposing the two-year ban systemically or manually is if it has previously audited the taxpayer for the same refundable credit in question. One justification for the IRS considering a prior audit that resulted in a disallowance is that the prior audit should have provided the taxpayer with information on the rules surrounding the refundable credit, thus avoiding any future improper claims. One finding in the TAS study showed that prior audits resulting in a disallowance for EITC, Additional Child Tax Credit, and/or American Opportunity Tax Credit took place three years or more prior to the imposition of the ban more than 50 percent of the time. Additionally, the study found the IRS imposed the ban in several cases even though the prior disallowance was for a different reason.

Specifically, in 107 of the 352 cases (30 percent), the IRS did not previously disallow the same credit for the same reason. It seems unfair of the IRS to consider that the prior disallowance gave the taxpayer adequate notice of the rules for claiming the credit when the prior disallowance was more than three years from the time of the current disallowance, or the prior disallowance was for a completely different reason than the current one.

National Taxpayer Advocate Recommendations

I made these recommendations in the 2023 Annual Report to Congress Research Study:

1. Require managerial review and approval of all language in Form 886-A and the statutory notice of deficiency explaining the reason for the two-year ban.
2. Only impose a ban where the prior audit addresses the same rule under consideration in the current audit.
3. Not consider a prior audit of a refundable credit conducted more than three years from the date of the current audit.
4. Where the IRS imposes the two-year ban systemically, make additional attempts to reach the taxpayer when the taxpayer has not responded to the audit notice before considering the taxpayer’s failure to respond as reckless or intentional disregard of the rules and regulations.
5. Require IRS managers to conduct regular reviews of employees’ cases and imposition of the two-year ban to ensure that they are following all IRS procedures.

Unfortunately, the IRS did not agree to implement any of these recommendations. The IRS’s responses to our recommendations and our comments on these responses can be found in the TWO YEAR BAN: Study of the Two-Year Bans on the Earned Income Tax Credit, Additional Child Tax Credit, and American Opportunity Tax Credit.

In a nutshell, the IRS essentially believes that its procedures for imposing the two-year ban are adequate, despite TAS’s study identifying several areas where either:

• The IRS didn’t follow its own procedures, or
• Where the IRS’s procedures do not support its rationale for imposing the two-year ban.

Conclusion

When the IRS addresses improper credits by imposing a two-year ban on taxpayers, it must ensure it is following its own policies and procedures. Failure to do so may result in unjust application of the two-year ban, possibly placing a financial hardship on taxpayers. To ensure the IRS is imposing the ban fairly and even-handedly, it should review its policies and procedures, and develop safeguards to ensure examiners are following those policies and procedures.