A tax loophole for common folks

Not enough people are as honest about their taxes as Larry Featherly, an unemployed man who badly needs cash so he can get his car fixed, find a job, and move out of his parents' house.

Mr. Featherly volunteers that his two teenage daughters are in foster care. This admission means that Featherly will not get as much back from the government's main antipoverty program for working people, called the Earned Income Tax Credit (EITC). Instead of being eligible for up to $4,000 from the government, he will get $836.

"My goal is to get my kids back," he says while watching two students from nearby Colgate University prepare his return.

The accuracy of returns such as Featherly's - especially on the issue of children living with their families - is now at the heart of a debate over the $36 billion program for 21 million Americans. Despite efforts to fix the problem, the Internal Revenue Service believes there are still errors, either unintentional or fraudulent, in this program.

It is now experimenting with a pilot program to try to cut down on the mistakes. President Bush, in his budget proposal, suggests simplifying the program in yet another effort to improve it.

Yet advocates of the EITC say if there is any mistake, it is the fact that some 25 percent of the people who are eligible for the program don't apply - perhaps because they don't know they are eligible.

"We are basically running a social-services program without the administrative infrastructure," says David Williams, the EITC director at the Internal Revenue Service (IRS) in Washington. "We are administering the largest means-tested, antipoverty program."

Last week, in part because of concerns about the error rate, the Senate Budget Committee voted to lop 10 percent off the program, a vote reversed by the full Senate. The House, in its version of the budget, has yet to tackle the program. "The House has said it would like $8 billion out of program cuts or tax increases," says John Wancheck, outreach coordinator for the earned-income credit at the Center on Budget and Policy Priorities in Washington. "When you look at places for cuts, Medicaid and EITC are at the top of the list."

This is not the first time the EITC has been under scrutiny. The IRS looked at 1999 returns and concluded that the error rate was about 30 percent. In 2001, Congress made changes to the program in an effort to cut down on the problem. No one knows if they've worked. Mr. Williams says, "What I would say is that [the error rate] is lower and hopefully significantly lower than the 1999 study, but one of the reasons it remains high and sticky is that our entire economic base shifts rapidly."

This is particularly true, he points out, among low-wage earners. He says they frequently change jobs and move to find work. They also tend to have a high rate of family issues.

Yet even the IRS admits the rules are confusing. Last week at a Monitor breakfast, IRS Commissioner Mark Everson said, "I was in a conversation with someone yesterday - it is tough for a lot of people to figure out if they qualify or not."

To try to remedy the problems, the IRS runs what Williams terms "a very robust" audit of people who use the program. As soon as it finds out about "income tax preparation mills," which specialize in fraudulently preparing returns, it busts them.

It is now running a pilot program involving 25,000 people who must now "prequalify" their dependents. For example, to qualify as a dependent, the child must have lived with the tax filer for over half the year. A taxpayer in this pilot program must present records, such as school correspondence, utility bills, or even an official letter from a principal, to prove the child's residency. "We are trying to reduce the error rate while not driving away eligible taxpayers," says Williams.

It is also an effort that meets with a fair amount of criticism from those who work with those in need. "Everyone says, 'Why not go after the Enrons and the people who write off things they shouldn't?' " says Mary Dupont, executive director of the Nehemiah Gateway Community Development Corp., a nonprofit in Wilmington, Del. "By enforcing such an onerous process, you might be turning away thousands of people who need it to survive."

Mr. Everson has defended the audits, especially since the General Accounting Office calls the program one of only two dozen high-risk areas that the government needs to manage to prevent fraud. "This has been highlighted for a long time," he said.

The EITC plays no insignificant role in Wampsville, the county seat of Madison County, a mostly rural part of New York. Last year, nearby Colgate University joined some 14,000 others groups that are part of the IRS's Volunteer Income Tax Assistance (VITA) program. The IRS trained Colgate students how to use government software and electronically file returns. As of last Wednesday, the students had filed 121 federal tax returns this year for people with an average income of $11,946. The average federal and state EITC refund is $1,588.

"We are taking a survey on what people plan to do with the money, and the top five responses are to get an apartment, buy a durable, move to another place, purchase a car, or pay bills," says Jill Tiefenthaler, an associate dean who initiated the program0 at Colgate.

Many of the recipients view the EITC almost as a savings account. At the county offices, Tiffany Mahady and Janet Orcutt both work as Medicaid social welfare examiners, helping to determine if people qualify for the program. Both have low enough incomes that qualify them for the tax credit.

Ms. Mahady, a young woman with a 2-1/2 year old daughter, is using the $4,000 she is receiving to pay off her credit card and buy a more reliable used car. This is her second year receiving the check.

Ms. Orcutt, who is filing for the program for the first time, will use her $4,000 to pay off bills and buy her two teenage sons some new clothes. "Their pants are too short," says Orcutt.

For some others, the EITC is a welcome surprise. Gorgene Schmidka of Oneida, a home healthcare provider, hurt her back and hardly worked last year. Her sole income was the Social Security check her mentally impaired daughter received each month. So she was pleasantly surprised when she found out she would receive a check for $3,000.

"It will be very useful," she says as she smiles.

• David T. Cook contributed to this report from Washington.