Add another item to the list of red flags that may get you audited: Adopting a child.
The Internal Revenue Service mishandled tax returns of adoptive families, flagging for further review 90 percent of those who claimed the adoption tax credit for the 2012 filing season. And a report by the federal agency’s Taxpayer Advocate Service also found that nearly 70 percent of adoptive families — more than 35,000 — had at least a partial audit of their tax return. By contrast, just one percent of all returns are audited.
"The IRS's misguided procedures, and its failure to adequately adjust these processes when it learned its approach was seriously flawed, have caused significant economic harm to thousands of families who are selflessly trying to improve the lives of vulnerable children," according to the report.
Unless the IRS alters its approach to refundable credits and incorporates more taxpayer-focused procedures, the federal agency will continue to cause problems for taxpayers, the report continues, including those eligible for the new refundable credit contained in the Patient Protection and Affordable Care Act — also known as “ObamaCare.”
The Adoption Tax Credit was created by Congress in 1996 to encourage adoption and to help offset costs to low- and middle-income families, which are estimated to run as high as $40,000. At the time, lawmakers touted the promotion of adoption as “one of the most important things” to strengthen American families.
But IRS officials selected 69 percent of returns claiming the credit in the 2012 filing season for audit, compared to just 1 percent of all tax returns. The payoff, however, was relatively small, the report found.
“Of the $668.1 million in adoption credit claims in tax year 2011 as a result of adoption credit audits, the IRS only disallowed $11 million — or one and one-half percent — in adoption credit claims,” the report continued. “However, the IRS has also had to pay out $2.1 million in interest in TY 2011 to taxpayers whose refunds were held past the 45-day period allowed by law.”
An IRS official said the agency must make sure claims are accurate.
"The IRS implemented the adoption credit program with an approach that balanced the objective of paying legitimate credits in a timely manner with that of ensuring that claims were accurate," IRS spokeswoman Michelle Eldridge said in a statement to FoxNews.com. "Our experiences and lessons learned from other refundable credits taught us that high dollar credits have high risk and the potential for fraud. We must ensure delivery of the credit to those entitled while protecting the government’s interest in minimizing exposure to fraud."
The crux of the problem, according to the report, began in 2010 as part of the Patient Protection and Affordable Care Act. Congress at that time increased the maximum credit per child to $13,170 and made it fully refundable for the 2010 and 2011 tax years, meaning that even taxpayers who had no tax liability in those years could receive the credit as a refund. That led to a drastic increase in refunds, making more families eligible for larger returns.
In the 2008 tax year, 89,134 taxpayers claimed the adoption tax credit for a total of $354.5 million. By 2010, those figures reached 110,591 and $1.2 billion, respectively. In 2011, 51,539 taxpayers claimed $668.1 million in credits.
The National Taxpayer Advocate recommends, among other things, that the IRS provide examples of acceptable adoption credit documentation for taxpayers, develop a third-party affidavit form for verifying a child’s special needs status and to allow electronic filing of adoption tax credit returns that included substantiation in a digital format.
“The IRS, facing a sizeable refundable credit, reacted with an enforcement strategy that was focused on stopping nearly all returns claiming the credit and subjecting a large percentage of them to an audit, instead of reaching out to stakeholders (including states) to understand the impacted taxpayer population,” the report concludes. “When problems emerged, the IRS simply continued selecting returns for audit. This approach forced taxpayers to withstand lengthy delays and the IRS to expend valuable resources with very little to show for them.”
While the adoption tax credit was made permanent with the passage of the American Taxpayer Relief Act in January, it is no longer refundable. A group of lawmakers, however, introduced the Adoption Tax Credit Refundability Act of 2013 on Thursday to restore the refundable portion of the credit.
“Making the Adoption Tax Credit refundable will support and encourage adoption by assisting families with some of the costs,” U.S. Sen. Bob Casey (D-Pa.) said in a statement. “The Adoption Tax Credit has been a proven success in increasing families’ ability to offer permanent homes to adoptive children. Making the credit refundable will allow more families to experience its benefits.”
One-third of all adopted children live with families whose annual household income is at or below 200 percent of the poverty level, according to Department of Health and Human Services data cited by Casey. And despite the misconception that solely wealthy families adopt, nearly 46 percent of families adopting from foster case are at or below 200 percent of the federal poverty level. The tax burden of many of those families are so low that they cannot benefit from the adoption tax credit unless it’s refundable, Casey said.
Mary and Todd Hankel, of St. Croix Falls, Wisc., who in 2005 adopted seven siblings from a troubled Twin Cities family in order to keep the brothers and sisters together, incurred untold expenses. Mary Hankel said the family of five added bedrooms and a bathroom and finished their basement to accommodate the influx.
“No one gets rich off of adoption,” said Hankel, who added that she and her husband have not been audited. “And when you adopt children with special needs, they often have medical or therapeutic needs, and tending to them definitely is not cheap.”
Joe Kroll, executive director of the North American Council on Adoptable Children, told FoxNews.com he thought IRS officials used auditors to perform “document checks” pertaining to the adoptions.
“It was also a situation I believe that it was an unbelievably good deal for a number of people and someone people in the IRS thought it was too good of a deal,” Kroll said. “And if it’s that good of a deal, there’s got to be fraud somewhere.”
Kroll continued: “Someone at the IRS made a decision to run these through scrutiny.”