Among the most significant taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. law changes that the Congress enacted at the end of the year was to make nineteen temporary tax provisions permanent. The Tax Foundation and other commentators have discussed those provisions. However, in the “Program Integrity” title of the Protecting Americans from Tax Hikes (PATH) Act of 2015, the Congress addressed the handling of incorrect claims on refundable credits. Two changes enacted by section 209 of the PATH Act make incorrect excessive claims of refundable credits from now on more costly to the taxpayer.
First, the PATH Act specifies the definition of the term ‘underpayment’ in the Internal Revenue Code section 6664. Second, it repeals the exemption of the earned income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. from penalties that apply, under tax code section 6676, on “erroneous claim for refund or credit.”
Determining underpayment
The tax code uses the concept of underpayment to determine the base of accuracy-related and fraud penalties (sanctioned in sections 6662-6665 of the code). The definition of underpayment and how to calculate it was scrutinized during the Tax Court rulings in Rand v. Commissioner and in Feller v. Commissioner. Pursuant to section 6664(a) of the tax code, an underpayment is the amount by which the ‘tax imposed’ exceeds ‘the amount shown as the tax by the taxpayer in his return’:
Underpayment = Tax imposed – The amount shown as the tax by taxpayer on his return
The issue in Rand was whether ‘the amount shown as the tax by taxpayer on his return’ should include the refundable credits claimed by the taxpayer.
The Tax Court ruled that the underpayment formula should take into account the refundable credits but should not allow ‘the amount shown as the tax’ to fall below zero. The PATH Act of 2015 reverses the Rand ruling and requires the underpayment formula to include credits claimed, even when ‘the amount shown as the tax’ becomes less than zero.
Interpretations on how to determine ‘the amount shown as the tax’ and the underpayment
| (1) | (2) | (3) | |
|
Refundable credits do not reduce ‘the amount shown as the tax’ *
|
Refundable credits reduce ‘the amount shown as the tax,’ but not below zero ** |
Refundable credits can reduce ‘the amount shown as the tax’ below zero *** |
|
|
Tax imposed |
$144 |
$144 |
$144 |
|
Refundable credits claimed |
$7,471 |
$7,471 |
$7,471 |
|
Amount shown as the tax |
$144 |
$0 |
$-7,327 |
|
Underpayment |
$0 |
$144 |
$7,471 |
|
Accuracy or fraud-related penalty |
$0 |
$29 |
$1,494 |
* Interpretation of taxpayers and 1st dissenting opinion in Rand
** Majority opinion in Rand
*** Interpretation of IRS Commissioner and 2nd dissenting opinion in Rand; new ruling under the PATH Act of 2015
Both parties in Rand agreed that the tax liability of, or the correct tax imposed on, the taxpayers was $144. The taxpayers had incorrectly claimed $7,471 in refundable credits. They argued that the amount shown as the tax on return should have been calculated without taking into account the refundable credits claimed.
In this case, their ‘amount shown as the tax’ would coincide with the ‘tax imposed’ and, based on the formula above, there would be no ‘underpayment’ on which to impose an accuracy-related or fraud penalty. This interpretation of the old law is illustrated in column (1) in the table above.
The majority of the Tax Court’s decision in Rand invoked the contextual and historical relatedness of the term underpayment with the term ‘deficiency’ (defined in section 6211 of the tax code). The majority argued that since only certain credits are stipulated to be left out from the calculation of ‘the amount shown as the tax’ when determining ‘deficiency,’ the credits not expressly listed should be taken into account when calculating ‘the amount shown as the tax’.
However, paragraph (b)(4) of section 6211 of the Internal Revenue Code stipulates explicitly that any excess of a named list of credits over ‘tax imposed,’ as calculated without taking into account those credits, is to be accounted as a negative amount of tax. The Tax Court majority held that, since the legislature has not explicitly stated the same for determining ‘underpayment’ in section 6664, the credits, which should be taken into account when calculating ‘the amount shown as the tax,’ cannot reduce the ‘amount shown as the tax’ below zero.
Hence, in the majority opinion, the correct ‘amount shown as the tax’ in Rand was the taxpayers’ tax liability of $144, as reduced to zero – but not below – by their incorrectly claimed refundable credits. The remaining underpayment would be $144 ($144 – $0). A 20-percent accuracy-related underpayment penalty would result in a penalty of $29. This interpretation of the old law is illustrated in column (2) of the table.
Lastly, the IRS Commissioner presented a third interpretation of the law in Rand. It argued that the credits claimed by the taxpayer should both be taken into account when calculating ‘the amount shown as the tax,’ and they can reduce that amount below zero. In this case, the underpayment in the example used would be $7,471 ($144 – (-$7,327)) resulting in an accuracy-related or fraud penalty of $1,494 – a penalty 51 times as big as ruled in Rand. This interpretation of the old ruling is illustrated in column (3) in the table.
The PATH Act of 2015 enacts the third interpretation as the new law. It does so by stipulating that, similarly with determining ‘deficiency’ in section 6211 of the tax code, the excess of allowed or claimed credits over imposed or shown tax, respectively, shall result in a negative tax, i.e., a bigger underpayment. This means that ‘the amount shown as the tax’ in the underpayment calculation can be negative if there is a refundable credit.
How significant are the changes?
The amendment of the law that lets ‘the amount shown as the tax’ become negative does not really affect IRS’s ability to levy penalties on misrepresented claims for credits. IRS already has the authority to impose a penalty on wrongfully claimed credits under section 6676 of the tax code, entitled “erroneous claim for refund or credit.” Importantly, the definition and rules of the underpayment do not apply when calculating the base of this penalty. To avoid double penalties, the penalties applied for erroneous claims cannot apply to any portion of a claim to which an accuracy-related or fraud penalty is applied.
There is one caveat, though. At the time of the Tax Court’s ruling in Rand, the earned income tax credit (EITC) was explicitly exempt in the tax code from the penalty on erroneous claim for refunds and credits. The PATH Act of 2015 repeals this exception. Hence, the real significance of the changes discussed here concerns the treatment of incorrectly claimed EITC.
The IRS estimates that for the fiscal year 2013, improper payments from EITC amounted to $13.3 to $15.6 billion, or 22 to 26 percent of total EITC payments. The extent of erroneous claims and payments from EITC makes it clear why Congress decided to act on the problem. The Joint Committee on Taxation estimates that the changes of the tax code that were discussed here will increase federal revenues by $564 million over the next ten years. This means that they are expected to help recover a modest 0.4 percent of improper earned income tax credit payments annually. However, it’s a start.
Given that there were three different interpretations how to calculate underpayment under the old law, a clearer code is as an improvement, too. It might reduce tax disputes, provide a stronger incentive to carefully review one’s return, and discourage fraudulently filing for refundable credits. For now, the Chief Counsel of IRS has issued a notice (CC-2016-004) that instructs its attorneys to not concede accuracy-related or fraud penalties in excess to what was provided in Rand.
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