Welcome to the IRS ‘two-class tax system’ that punishes low-income workers

National Taxpayer Advocate Nina Olson attracted attention -- well under the radar -- this past week as she warned of an emerging “two-class tax system” in which the lower middle class will face harsh IRS tax penalties while wealthy individuals and corporations will be treated much differently.

An IRS modernization process with a greater emphasis on Internet services, Olson suggested, could leave older Americans with limited computer skills at a particular disadvantage. They could be charged user fees to talk with the IRS the old-fashioned way.

At the same time, Congress has voted to punish not just once, but for years to come, low-income families who file erroneous tax returns. The massive budget bill passed by Congress and signed into law by President Obama in December imposes new IRS penalties that apply to low-income workers but not necessarily to those who can afford to hire high-priced tax lawyers to battle the feds.

IRS decides what is intentional

The budget bill expands a ban on the working poor from declaring the Earned Income Tax Credit (EITC) for two years if they have improperly claimed benefits in the past labeled as “reckless or intentional disregard” of the rules. Now this prohibition also applies to the Child Tax Credit and the American Opportunity Tax Credit for college tuition costs.

According to the Tax Policy Center, an individual who improperly files for any of these credits is banned from receiving that subsidy for 10 years. The cost to the federal budget is infinitesimal but the cost for a family of limited means can be significant: Losing the child credit would cost up to $1,000 per child annually.

More importantly, the definition of tax fraud punishment is all over the map.

Olson reported in 2011 that of the 5,500 families banned from taking the EITC, more than 2,100 were barred because they did not respond to written IRS requests that they substantiate their claims.

“Apparently, if you are poor, not opening your mail or not leaving a forwarding address when you move is sufficient evidence of intentional disregard of the law,” wrote Howard Gleckman of the Tax Policy Center.

Army of tax advisers makes the difference

In contrast, large charitable organizations that do not report to the IRS at all are subject to a maximum penalty of $50,000. The IRS can revoke an organization’s tax-exempt status, but only if it fails to file a return for three consecutive years.

Similarly, hedge fund managers on Wall Street who mischaracterize income as capital gains to benefit from lower tax rates may end up paying back taxes and perhaps interest—after years of expensive litigation. But they are at no risk of losing future tax benefits.

“Of course, there is no real symmetry here. Trade associations, multinational (corporations) and hedge funds pay armies of tax advisers to push the limits of the law as far as possible without stepping over the line. Low-income households can’t. They rely on often-incompetent or corrupt preparers to guide them through complex rules they do not understand,” Gleckman wrote.

In her annual report to Congress, Olson, an ombudsman for the public, warned that the 5-year modernization plan by the IRS will move taxpayers, particularly those of modest economic means, away from IRS help desks and one-on-one phone calls and into the arms of paid tax preparers -- if they can afford a tax preparer at all.

Pay-to-play system

According to Politico, Olson said the IRS threatens to create a two-tiered process and a "pay-to-play system:"

"Those who are sophisticated enough to understand their tax problem or their tax needs and can navigate the self-help options well enough to protect their rights will be able to do so. Those who have the ability to pay a third party to navigate the IRS and protect their rights will do so," Olson wrote.

Olson

"But for those who have neither the expertise, the time, nor the resources to navigate these options -- they will be up a creek. They will make mistakes with self-help; they will agree to ‘assessments’ and ‘adjustments’ they never should; and they will forfeit significant due process protections like the right to go to the United States Tax Court or have a collection due process hearing -- all because they can't talk with an IRS employee about their situation or because they can't afford to pay someone to help them."

And it's not just an over-reliance on computers and automation that Olson is worried about. The second-biggest problem for taxpayers, according to the advocate, is that the agency might rely on user fees to make up some of its budget shortfall. If some taxpayers can afford those fees and others can't, that could undercut the IRS's ability to run a fair and just tax system, Olson’s report said.

NRA cheating well-documented

The New York Post, hardly a liberal publication, reported last month that the National Rifle Association has repeatedly filed misleading tax returns. For six years it failed to report that its political action committee (PAC) was an associated organization. For seven years, it simply ignored a tax form question about whether it engaged in lobbying. From 2008-2013 it failed to report the amount it spent on lobbying. The trade group blamed these years of incorrect filings on a “clerical error.”

Here’s Gleckman’s reaction:

“Does this constitute ‘reckless or intentional disregard’ of the tax rules (by the NRA)? Who is to say what is in the mind of someone who files an improper tax return? But it seems more clear-cut for a huge organization that relies on teams of accountants and lawyers than a single mom who fails to comply with complicated rules governing whether she, or her children’s father, should claim the EITC or the Child Tax Credit.”