all work and no play: taxation auditing report

8/7/2019 All Work and No Play: Taxation Auditing Report

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Copyright Appleseed 2010All rights reserved

Please contact Jeremy Cook for permission to reproduce.202.347.7960 or [email protected]


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INTRODUCTION

The New York State Earned Income Credit (the EIC)1 is considered one

of New York States most capable tools for helping low-income working

New Yorkers and their families make ends meet. Federal, state and local

earned income tax credits are refundable credits that return tax dollars to

qualifying families and individuals. The amount varies depending on

income, marital and parental status, but working families earning less than$44,000 per year may be eligible for up to $7,354 from earned income tax

credits alone. To qualify, applicants must be between ages 25 and 64 (if

childless), have a valid Social Security number, report earned income and

le a tax return to the appropriate authority. (Source: http://www.otda.

state.ny.us/main/reform/#eitc).

In New York City, total EIC claims exceeded $1.6 billion in 2007. (Source:

NYC Department of Consumer Affairs Press Release, January 23, 2008).

Many of these low-income individuals and working families, however,

face signicant difculties in claiming the EIC because they hold jobs

that classify them, for tax purposes, as self employed,2 and/or for whichthey receive cash wages. These self-employed low-income cash earners

(hereinafter referred to simply as cash earners) are a large and growing

population.3 As some of the lowest paid workers in our communities

childcare providers, taxi drivers, hairdressers, day laborersthey stand to

benet the most from the EIC. Yet, in addition to the ubiquitous challenges

faced by many low-income workers in navigating the tax system (including

lack of access to good tax preparation services and nancial literacy issues),

cash earners must also confront income documentation requirements that

are ambiguously dened, poorly explained, and sometimes incompatible

with the everyday practices of cash earners and those who pay them. Cash

earners who do not comply with these requirements, however, considerablyincrease the likelihood that their EIC claim will be denied, or that their tax

return will be audited.

New York City estimates that more than 150,000 City residents never claim

their federal, state and city earned income tax credits, totaling more than

$160 million. (Source: NYC Department of Consumer Affairs Press Release,

April 8, 2009). Thus, in spite of the considerable publicity given to the

EIC as an anti-poverty measure, the process for claiming the EIC and the

rules under which EIC claims are adjudicated need to be changed to ensure

that the EIC actually benets cash earners. This policy brief addresses the

most signicant obstacles that cash earners face when claiming the EICand suggests concrete changes that could remedy this problem. These

obstacles, rarely encountered in isolation but rather tending to compound

each other, include the following:


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I. DOCUMENTATION PROBLEMS

Several of the most signicant obstacles for cash earners claiming the

EIC have to do with some aspect of income documentation. The New

York State Department of Taxation and Finance (the NYSDTF) requires

that EIC claimants be able to present income documentation sufcient

to substantiate the earned income required to claim the credit. Because

the credit is available only to those who earn income, some form of

documentation requirement is understandable and desirable. But, as

simple as it is in principle, this requirement, as currently administered

by the tax authorities, trips up cash earners in ways that are unrelated to

whether or not they deserve the EIC.

A. Tax forms and instructions do not state that income

documentation is required.

As currently drafted, the tax forms, instructions, and website do not

conspicuously state that EIC claimants must provide documentation

verifying their income; they merely direct claimants to state their income

on a form. Though the requirement is not clearly stated, EIC claimants

who do not submit such documentation may have their claims denied, or

be asked to submit such documentation later.

It seems that, because most workers, who are not cash earners, have their

income substantiated by other standard documentation, such as a W-2

the generalized tax instructions assume the existence of independently

generated statements of income.4 Cash earners are in a different situation

than most taxpayers in that their income is not independently documented

and submitted to the IRS. These general instructions are therefore

unhelpful to cash earners.

B. Forms and instructions do not state how to document income.

The tax forms, instructions, and web pages pertaining to the EIC offer

no useful guidelines about what sort of documentation is considered

sufcient to verify a persons income. Thus, even if cash earners claiming

the EIC understand that they must document their earned income, they

still learn nothing about how they should do so. Though documenting

ones income may not be particularly onerous for workers receiving a

W-2 or the like, cash earners need more guidance as to what records are

sufcient to claim the EIC.


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1. Tax appeal decisions have no precedential value.

Even if DTA decisions consistently articulated clear, specic cash

income documentation requirements, they would still be of limited

value to taxpayers contesting adverse assessments of their cash income

documentation. DTA decisions are statutorily barred from being

considered as precedent in other proceedings, including subsequen

appeals before the DTA itself.8 Therefore, even if a particular method

of documenting cash incomea tax drivers handwritten ledger, forexamplehad been deemed sufcient to claim the EIC in one case, other

cash earning taxi drivers could not be assured that using the same method

would be permitted in their cases.

2. Tax appeal judges have unconstrained discretion to determine

thesufciencyofincomedocumentation.

There is no binding law that constrains the discretion of the tax

administrative law judges as to what substantiation is sufcient. Given

the lack of clearly dened standards and the inapplicability of previous

DTA determinations, DTA judges rule on the sufciency of cash incomedocumentation on a case-by-case basis. Wide latitude of judicial discretion

permits administrative law judges the exibility to accept varied forms o

cash income documentation. But discretion and exibility can guarantee

neither uniformity nor predictability, and leave cash earners without

guidancenot even so much as a conservative safe harbor. Though mos

published DTA decisions deny petitioners claimed income under the EIC

the fact that these denials rest on an exercise of judicial discretion alone

aggravates the problem of the non-transparent standard.

3. Theburdenofprooffallsonthepetitioningtaxpayer.

Finally, the procedure for contesting adverse NYSDTF determinations

may itself be an obstacle to cash earners income verication. Under Tax

Law 689(e), a taxpayer whose requested tax refund has been adjusted by

the NYSDTF bears the burden of proof to show by clear and convincing

evidence that the adjustment is erroneous.9 For taxpayers documenting

cash income, this presents a twofold problem: Not only are cash earners

tax lings more likely to be adjusted by the NYSDTF than those of non-

cash earners, but if they are adjusted, documentation of cash income may

be less likely to constitute clear and convincing evidence sufcient to

overturn the adjustment.


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D. Documentingincomeisdifcultforcashearners.

In addition to the documentation requirement difculties noted thus far,

cash earners may face more fundamental difculties in documenting their

income:

1. More initiative is required of cash earners than other workers.

Documenting cash wages, particularly cash wages that vary greatly fromweek to week and season to season, requires that cash earners be more

organized and more precise in their accounting than other workers ever

have to be. Workers who are paid by check and receive a W-2 every year

do not need to keep precise, coherent, standardized records; they are kept

for them, and often automatically supplied to the tax authorities. Cash

earners, by contrast, must develop and adhere to a system of documenting

their income, which, besides satisfying the ambiguously dened

requirements noted above, must be practical enough so that cash earners

can actually use it.

2. Differenttypesofworkhavedifferentrecordkeepingnorms.

Cash earners work in a wide range of professions, each of which may

have different norms for recording earnings. Taxi drivers, for example,

typically record their earnings differently than day laborers. Recording

practices that are normal for some professions, such as a handwritten

ledger documenting taxi fares collected, may be inconsistent with the

income documenting expectations of the tax authorities.

II. CASH EARNERS ALSO CONFRONT THE

CHALLENGES THAT AFFECT OTHER WORKERSCLAIMING THE EIC.

In addition to the difculties specically caused by receiving cash wages,

cash earners who are eligible for the EIC must overcome all the other barriers

and disadvantages that low-income taxpayers face in general. These

impediments include the complexity of the tax code, fear of consequences

unrelated to tax administration, and socioeconomic characteristics

disproportionately represented among low-income persons.

A. The process to claim the EIC is complicated and confusing.

Complex eligibility rules that include sliding scale earnings limits,10

a unique denition of qualifying children,11 and distinctions between


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different types of income, make claiming the EIC a complicated and

confusing process for any claimant, cash earner or otherwise.12 Thoughinstructional publications issued by state tax authorities and taxpayer

assistance organizations certainly help individuals become aware of anddetermine their eligibility for the EIC, these materials are generally less

effective in explaining in adequate detail how one applies for the EIC.13 Interms of explaining how one applies for the EIC, as noted above, the tax

form instructions do not state clearly that submitting documentation o

earned income is required.

Given the complexity of the claim process, it is perhaps not surprising tha

74% of New Yorkers claiming the federal earned income credit use a paid

preparer to navigate the ling rules.14 Using a paid preparer, howevercomes with its own set of risks for low-income workers unfamiliar withthe tax system, including deception by companies offering high interest

refund anticipation loans. Because refund anticipation loans are securedby the eventual tax refund, the consumer ultimately bears the risk thatthe refund will be smaller than expected or nonexistent. Since the risk o

adjustment is not theirs, the companies selling such loans have an incentiveto overstate EIC claims and understate documentation requirements

EIC claimants nances are squeezed further when refunds are adjusteddownward.

B. Many low-income taxpayers fear collateral consequences.

Cash earners, like other low-income workers, may be reluctant to claim

the EIC because they are afraid it will interfere with other social service

benets upon which they depend. This fear is largely a misperception

and efforts are being made to remedy it.15 Still, such fears may make

individuals less likely to claim the EIC.

Likewise, cash earners, like other low-income workers, may be reluctant toclaim the EIC because they are afraid that it will somehow alert immigration

authorities to the presence of undocumented workers in their households

Given the aggressiveness with which alleged immigration violations are

currently pursued, this fear should be taken seriously.

C. Low-incometaxpayersingeneralfacesignicanthurdlesthat

result from socioeconomic and related conditions.

Though this brief is primarily intended to address the obstacles faced by

cash earners claiming the EIC, it is worth reiterating that cash earners,

being a subset of low-income workers in general, must deal with theinstitutional problems that disproportionately affect low-income taxpayers

as a whole, including:


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Limited access to quality low- or no-cost tax preparation

services;

Inability to afford legal counsel for tax law assistance;

Lack of access to computers and online resources for information

and correspondence with tax authorities;16

Limited understanding of how the tax system works

(withholding, credits, refund, etc.);

Difculty with the English language; and

Susceptibility to predatory lenders offering refund anticipationloans.

Were these hindrances not enough, there is evidence that low-income

taxpayers may be more likely to be audited than higher income

taxpayers.

III. DELIVERING THE EIC MORE EFFICIENTLYCOULD SAVE MONEY NOW ALLOCATED TOOTHER SERVICES.

A robust and efciently administered EIC has the potential to reduce state

spending on certain social services by transferring money directly to the

neediest workers in our communities. Given New York States perennial

budgetary challenges, there will be some opposition to any reform that

improves the efciency of the EIC based on a concern for the states

bottom line. This concern is misguided and counterproductive. Reforms

that facilitate the delivery of the EIC do not necessarily correspond to an

equivalent tightening of the budget. Although less tax revenue is possible,

a portion of the states budget is currently allocated to services that low-

income cash earners would avoid if they had the nancial stability that the

EIC affords. For example, households with more nancial resources will

have fewer needs for emergency social services.

RECOMMENDATIONS

In response to the concerns discussed above, we propose the following

measures to improve the effectiveness of the EIC in reducing poverty

among cash earners. The following is not intended to be an exhaustive

list, but rather, a summary of those measures we believe to be bothrelatively easy to implement and likely to yield immediate and noticeable

improvement.


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I. CLEAR AND SPECIFIC LEGAL STANDARD FORMINIMUM DOCUMENTATION

NYSDTF should formulate, articulate and adhere to a legal standard that

states clearly and specically the minimum documentation that is required

to support an EIC claim led by a cash earner. If audited, the claimants

compliance with this standard by providing appropriate documentation

should place the burden of proof of noncompliance with the tax authorities

The standard should have the following characteristics:

A. The standard should accommodate normal practices for

income documentation among cash wage earners.

To effectively improve cash earning workers success in claiming the EIC

the legal standard for minimum documentation should reect an awareness

that cash earners typically do not receive W-2 forms from their employers

may not deposit their wages in a bank account, and may document their

income in ways that are different from self-employed individuals who are

not cash earners. It should be formulated so as to provide as much clarity

as possible about what documents are sufcient, yet be exible enough toaccommodate diverse practices for income documentation.

B. Thestandardshoulddenethetimeframeinwhichrecords

must be kept.

The legal standard for minimum documentation should not contain an

articial requirement that records of earned income by cash earners be

kept contemporaneously. Many of the tax appeal decisions surveyed for

this policy brief base their decision against the claimant on the fact that

records were not kept contemporaneously with income. Records are

certainly more credible if they are recorded at or near the time of income,

but there must be some indication of how quickly earnings must be

recorded. Ideally, the standard would permit records of cash earnings tha

are otherwise credible to be compiled explicitly for tax ling purposes

including records compiled with the assistance of a tax preparer.

C. A good faith effort to meet the documentation standard should

besufcient.

Cash earners who demonstrate a good faith effort to comply with the

legal standard for minimum documentation should be presumed to have

complied with the standard. A good faith compliance rule must take into

account that many low income cash earners do not have the resources or

the education to account for their income in the same manner as other self

employed taxpayers.


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II. CLEARER INSTRUCTIONS AND GUIDANCEFOR THE AFFECTED POPULATION

As discussed above, one of the greatest challenges cash earners face is the

lack of clear and available instructions for how to document ones income

for the purposes of making an EIC claim, as well as guidance regarding

ones rights and responsibilities in an audit or disallowance of an EIC claim.

NYSTDF should prepare documents addressing these issues (perhaps

with the assistance of advocates for cash earners and/or tax preparers whoassist cash earners) and should make those documents easily availableto cash earners. Not only should the instructions reect rules that bindthe tax authorities, but, when cash earners rely on this specic directionfrom NYSDTF, their claims should be presumed compliant. Translationsof such documents would also be very helpful in reaching non-English-speaking cash earners.

III. ELIMINATION OF ALL AUDITING TARGETSRELATED TO EIC

To the extent that NYSDTF presently adheres to policies that set auditing targets

relating to any aspect of the EIC or employs audit selection practices that cause

EIC claimants to be disproportionately more likely to be targeted for an audit

than other individuals ling tax returns, such policies and practices should be

eliminated. Inequitable policies such as setting benchmarks for the number of

EIC claimants to target for an audit or using data-mining computer software

should not be employed. The NYSDTF should implement and adhere to

policies that ensure that individuals, cash earning and otherwise, who claim

the EIC are not placed at greater risk of audit than other taxpayers.

IV. ONE-TIME PASS FOR FIRST TIME EICCLAIMANTS

The NYSTDF should adopt a policy of granting a one-time pass to

EIC claimants whose rst-ever EIC claim would otherwise be denied for

inadequate documentation. Under this one-time pass policy, the NYSDTF

would grant the claimants EIC claim but notify the claimant that, though

the claim has been granted, certain documentation requirements have not

been met and in subsequent years, any EIC claim will not be allowed absent

such documentation. The NYSDTF would make clear specically what

documentation is necessary but missing, and instruct the claimant about what

documentation will be acceptable for the purposes of making an EIC claim in

subsequent years.


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1 This policy brief focuses on the New York State EIC, also referred to as the Earned Income Tax Credit, or EITC.Because the New York State EIC is determined as a percentage of the federal EIC, this brief addresses the federal Creditindirectly, but does not address the New York City Earned Income Tax Credit. To avoid doubt, the term EIC as usedherein refers to the New York State EIC unless otherwise specied.

2 In tax contexts, self-employed workers are occasionally also referred to as independent contractors.

3 Need statistic Appleseed to supply?

4 The federal earned income credit documentation is similarly silent on the requirement. IRS Publication 596 (2007),Earned Income Credit (EIC), is quite thorough in explaining who qualies for the EIC. It is less clear in explaininghow one who qualies should claim the credit, at least as far as documentation is concerned.

5 See IRS Publication 583 (1/2007), Starting a Business and Keeping Records, which offers the following guidelines:

Kinds of Records To Keep

Except in a few cases, the law does not require any specic kind of records. You can choose any recordkeepingsystem suited to your business that clearly shows your income and expenses.

The business you are in affects the type of records you need to keep for federal tax purposes. You should set up yourrecordkeeping system using an accounting method that clearly shows your income for your tax year. See AccountingMethod, earlier. If you are in more than one business, you should keep a complete and separate set of records foreach business. A corporation should keep minutes of board of directors meetings.

Your recordkeeping system should include a summary of your business transactions. This summary is ordinarilymade in your books (for example, accounting journals and ledgers). Your books must show your gross income, aswell as your deductions and credits. For most small businesses, the business checkbook (discussed later) is the mainsource for entries in the business books. In addition, you must keep supporting documents, explained [in subsequentsections].

The NYSDTF webpage provides a link to the IRS webpages about self-employed workers.6 See Matter of Gallego, N.Y. Div. of Tax Appeals, Small Claims, DTA No. 819528 (Nov. 24, 2004). In that case, the

petitioning taxpayer, a Queens jewelry vendor whose EIC claim was disallowed, was issued a Statement of RefundAdjustment that noted the following documentation requirements:

In order to qualify for the Earned Income Tax Credit and/or Dependent Care Credit, a taxpayer must be able todocument that he received earned income during the tax year. In the case of business income, the taxpayer mustbe able to provide records which support when the income was earned, to whom services were provided, and theexact amount of compensation received from each transaction. Some examples of acceptable proof include: copiesof your receipt booklet, pages from any ledgers you maintain, bank statements, paid receipts, canceled checks and/or invoices.

7 See list of cases and outcomes in the Appendix.

8 New York Chap. 60 Tax Law Art. 40, Sec. 2010.5

9 See Matter of Suburban Restoration Co., Inc. v. Tax Appeals Tribunal, 299 A.D.2d 751, 752 (Appellate Division, Third Dept.2002).

10The amount of the EIC is determined as a function of both income and the number of qualifying children in thehousehold.

11 For example, the denition of a qualifying child for purposes of the EIC is different than the Food Stamp program andTemporary Assistance for Needy Families (TANF).

12 Although this policy brief focuses on the documentation requirement that prevents cash earners from successfully

claiming the EIC, several other documentary hurdles are evident. For a brief overview of the complexity of the EIC,see National Taxpayer Advocates 2008 Annual Report to Congress, 8 (December 3 1, 2008) (available at http://www.irs.gov/pub/irs-utl/08_tas_arc_intro_toc_msp.pdf). A more thorough examination appears in FY 2002 National TaxpayerAdvocates Annual Report to Congress, 47-51 (December 31, 2002) (available at http://www.irs.gov/pub/irs-utl/arc2002_section_one.pdf).

13 See, e.g., Publication 310-NY (12/07) (Information on New Yorks Earned Income Credits) and Form IT-215-I (2007)(Instructions for Form IT-215, Claim for Earned Income Credit), neither of which mentions income documentationrequirements.

14 By comparison, 66% of all lers in New York use a paid tax preparer. These proportions are calculated from tax datafor 2006 available from The Brookings Institution on their website at http://www.brookings.edu/projects/EITC.aspx(last visited July 22, 2009).

15 See, e.g., the New York City Department of Consumer Affairs yer addressing this misconception, available at http://www.nyc.gov/html/dca/downloads/pdf/wceca_eitc_yer_2008.pdf.

16 Recent efforts to streamline the IRS and state tax agencies have aggravated this problem. See generally Janet R.Spragens & Nancy Abramowitz, Lo w-Income Taxpayers and the Modernized IRS: A View from the Trenches, TaxNotes, Vol. 17, No. 11 (June 13, 2005).

17

See Matter of Moreno, N.Y. Div. of Tax Appeals, Small Claims, DTA No. 820959 (Jun. 14, 2007), Matter of Moreno, N.Y. Div.of Tax Appeals, Small Claims, DTA No. 820316 (Jun. 14, 2007), Matter of Defreitas, N.Y. Div. of Tax Appeals, Small Claims,DTA No. 820364 (Apr. 6, 2006) and MatterofValoy, N.Y. Div. of Tax Appeals, Small Claims, DTA No. 819191 (Feb. 19,2004).

18 The decision did not specify what documentation was provided by petitioner.


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APPENDIX

NEW YORK STATE DIVISION OF TAX APPEALSDECISIONS

The following cases adjudicate proof of earned income for the purposes of

claiming the EIC. These decisions are not binding precedent for any New

York judicial proceeding, but may be a useful resource in determining which

factors are relevant in documenting EIC income.

Also, note that these cases were only considered for their analysis of

income documentation, not other EIC-related issues such as verication of

dependents.

(Covers cases through 10/25/07. Current as of 5/27/08.)


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all work and no play: taxation auditing report

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