Why Taxpayers Are Leaving Billions on the Table

Many Fail to Claim Deductions Tied To Local Outlays

Millions of people overlooked an important tax break and made other costly mistakes earlier this year on their 2006 returns, according to a recent report by the U.S. Treasury Inspector General for Tax Administration, a Treasury Department unit.

For example, nearly 2.1 million taxpayers who were eligible to deduct their state and local sales taxes didn't do so, up 50% from the previous year. These people missed taking advantage of potentially $3.6 billion in deductions, Treasury auditors said. (Read the report.)

Many people also neglected to claim a one-time telephone excise-tax refund. Eric Smith, an IRS spokesman, said yesterday that nearly 72% of all individual return filers had requested the refund as of early September. In all, about 93 million filed for refunds totaling about $4 billion. The Treasury report said the IRS had expected to hand out about $8 billion.

Some people, however, made mistakes in their favor. For example, taxpayers improperly took additional exemptions for housing victims of Hurricane Katrina. Some people who are older than 70½ claimed improper deductions for an individual retirement account. And some people made the mistake of claiming a dual benefit of both the tuition and fees deduction and an education credit.

The Treasury unit's report concluded that the 2007 tax-filing season "generally" was successful, and also said "most" returns were "timely and accurately" processed by the IRS. But the report also contained fresh reminders of just how easy it is to make mistakes.

If you discover an error on your return, there's a simple remedy: File what's known as an amended return. Use Form 1040X, which is available on the IRS Web site (www.irs.gov) -- but note that you can't file an amended return electronically. You'll have to do it the old-fashioned paper way.

How could so many people make mistakes, especially in view of the growing numbers who rely on tax professionals or tax-preparation software to prepare their returns?

One simple answer is the tax law's growing complexity. "Taxes are hard, and there are lots and lots of things to keep track of, particularly if you're still doing it by hand," says Mel Schwarz, a partner in the national tax office of Grant Thornton LLP in Washington.

But part of the blame lies with congressional delays in taking action last year. Lawmakers didn't act until very late in the year to extend the life of several tax provisions that had expired at the end of 2005. Congress didn't act until after the IRS deadline for sending 2006 forms and publications to the printer.

One of those provisions gives taxpayers who itemize the option of deducting their state and local sales taxes instead of their state and local income taxes. This is especially important for millions of people who live in Florida, Texas, Nevada, Washington and other states that don't have a state income tax. It is also useful for people in many other states with low taxes.

The IRS agreed with a Treasury recommendation to do more to inform people about the sales-tax deduction rule. Whether this provision will still be around for the 2008 tax year is anyone's guess.

Why so many people didn't bother to claim the phone refund remains unclear. In a separate report, the Treasury unit said: "We believe a significant amount" of the telephone excise tax that had been collected by the IRS "may never be refunded." The report said "many" people apparently were "simply unaware" of the refund or didn't realize they qualified for it. (Read the report.)

Separately, Treasury auditors found a small number of people who mistakenly had claimed IRA deductions even though they were older than 70½. In response, the IRS agreed to add a statement to the top of the IRA work sheet saying taxpayers age 70½ or older can't take the deduction. The IRS also will revise wording on certain lines of the work sheet. (See a list of recent TIGTA reports.)