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The IRS paid $3 billion in interest to taxpayers because it failed to get refunds out on time

GAO criticizes agency for year-over-year increases in refund interest payments

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The IRS penalizes taxpayers who don’t pay their tax bills on time, but the agency’s own delays are costing taxpayers billions of dollars as well.

The IRS paid $3.03 billion — yes that’s with a “b” — in interest on delayed refunds to taxpayers for fiscal 2020 because it didn’t get the payments to them in time, according to a report released by the Government Accountability Office this week. That’s almost a 50 percent increase compared with the $2.06 billion paid in interest on refunds in fiscal 2019.

Generally, if a return is filed on time, the IRS has a 45-day interest-free processing window. If the agency misses this deadline, interest is added to the refund. By the end of the summer, the IRS said, it had to send interest payments to nearly 14 million individual taxpayers who filed their 2019 returns on time.

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The average refund interest amount last year was just $18, the IRS said. Of course, the amount for each individual taxpayer varied.

Under the tax code, the interest rate is set on a quarterly basis. For individuals, the overpayment and underpayment rate is the federal short-term rate plus three percentage points. Currently, the interest rate is 3 percent.

On average, interest payments for late refunds don’t result in huge windfalls for taxpayers, although the IRS is paying a higher interest on delayed refunds than you could earn in a savings account right now.

But the total cost to the government — or rather taxpayers — is growing, and a cause for concern.

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In response to the GAO report, the IRS pointed out that returns that are amended can reduce the amount of taxes owed, thereby triggering a refund interest payment. The agency also attributed the increase in interest payments last year to the extension of the tax season from April 15 to July 15, which was necessary because of office closures and social distancing requirements to prevent the spread of the coronavirus.

By law, the IRS still had to calculate and pay interest going back to April 15, even though people had until July 15 to get their return in on time.

Despite the unusual circumstances from coronavirus-related delays, the GAO found in its review of IRS data that refund interest payments have been increasing over the past several years and will continue to cost the government money if the agency doesn’t address its backlog of unprocessed and suspended returns.

In fiscal 2017, the IRS paid just over $1.1 billion in refund interest. The following year, the amount was nearly $1.6 billion, according to the GAO findings.

“Faced with an unprecedented crisis, IRS took steps to manage disruptions to the filing season while protecting the integrity of its mission and health of its employees,” the GAO said in its report. “Nonetheless, IRS’s reliance on manual processing led to a significant backlog of paper-based and manual work.”

Delays in processing returns and sending refunds aren’t just a pandemic problem, agreed Erin M. Collins of the independent Taxpayer Advocate Service, an organization within the IRS that helps taxpayers resolve issues with the agency.

The GAO report correctly identifies the elephant in the room — excessive reliance on paper for exchanging information between taxpayers and the IRS, Collins said.

“Although the IRS plans to modernize its systems to reduce the dependency on paper, it is moving toward that goal slowly due to a lack of adequate, multiyear funding,” Collins said. “IRS modernization is not a luxury or an option anymore. The 2020 filing season highlighted the result of the IRS’s continued reliance on antiquated technology.”

As of Jan. 29, the IRS said it still had 6.7 million individual 2019 tax returns in its “processing pipeline.” And now the agency is dealing with an influx of returns for the current filing season. As of Feb. 19, the IRS reported receiving close to 35 million returns. Of those returns received, more than 16 million indicated taxpayers were owed refunds, averaging $2,880.

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During 2020 and continuing into 2021, the IRS has been in the difficult position of having to balance the health and safety of its employees with meeting taxpayer needs. But millions of taxpayers are still waiting for the processing of returns and the resolution of correspondence that is languishing in the IRS system, Collins said.

“The enormous amount of refund interest paid to taxpayers may be seen as a benefit by some, but I believe most taxpayers would prefer to receive their refunds and not wait,” she said.

And, before you ask: Yes, the refund interest received by taxpayers is considered taxable income, which just adds to the madness. It makes more financial sense to fix this problem than continue to allow the government to waste billions on what amounts to late fees.