IRS fraud watch cuts refund loans

March 12, 1995|By Timothy J. Mullaney | Timothy J. Mullaney,Sun Staff Writer

A year ago, John Davis and his son had a nice little tax preparation business. They did 1,600 returns and filed hundreds of them electronically with the Internal Revenue Service. For an extra fee, many customers got loans against their refunds in two or three days and everyone, or so it seemed, was happy.

But things are different this year, and the waves are being felt from Capitol Hill all the way to Davis Bros. Tax Service in Essex.

An IRS crackdown on fraud has made refunds harder to verify and loans riskier to collect, and lenders have responded either by getting out of the business or by doubling or tripling interest rates that already ran as high as 75 percent annually.

"This year bank fees are as high as $108," on an average $1,200 refund loan with a maturity of two to three weeks, Mr. Davis said. Even at those rates, banks are turning down many more applications. He says his business is down 30 percent.

"People had come to expect it," he said. "Now it's so messed up that people choose not to do it."

The refund loan industry paints the story as a tale of Big Government beating up on the entrepreneurs who made the loans a multi-billion industry between 1990 and last year.

The IRS says it is simply doing what Congress wants: clamping down on up to $5 billion in tax fraud annually, though IRS officials concede they don't know how much of the fraud is related to refund loans.

"It's a red herring for the IRS' inability to deal with fraud," charged Gary Perkinson, coordinator of the Electronic Filing Coalition of America, a lobbying group of tax preparers, software companies and refund anticipation lenders that have felt the pain of the IRS actions.

One of the largest lenders, Beneficial Corp. unsuccessfully sought an injunction against the IRS last month and recently warned Wall Street that the $15 million it earned before taxes on refund anticipation loans last year will turn into a loss, possibly as high as $80 million, this year.

H&R Block, the nation's largest tax preparation service, last month blamed the changes for a 131 percent increase in its third-quarter loss in its tax services unit. Block said it had filed 22.2 percent fewer electronic returns during the first six weeks of tax season.

The industry's woes, however, leave the IRS unswayed.

"Congress is hearing estimates of lost revenue of between $1 billion and $5 billion and asking what steps can we take to keep it from happening, because once the money leaves it's difficult to get it back," said Domenic LaPonzina, a spokesman for the IRS in Baltimore. "The lending institutions say it's hurting them. Fine, it is. But we had to come down on the side of the taxpayers."

In between the two are consumers of a product marketed most heavily to the working poor and a Congress that is skeptical of both the IRS and the industry.

""The target audience is working-class people and the interest rates are unconscionable," said Rep. Benjamin L. Cardin, a Baltimore Democrat who sits on the House Ways and Means Committee. "This is an unregulated industry, and it needs to be looked at."

An aide to a Maryland representative was more tart.

The refund loans are "plainly a rip-off," the aide said. "What you have is people being preyed upon and acting imprudently." The lenders are are "not going to Columbia and saying, 'do I have an idea for you.' "

L The refund loan business began as an unintended side effect.

It started in 1990, when the IRS began urging taxpayers to file returns electronically to reduce processing time and cut the error rate.

Electronic filing also cuts the time it takes for taxpayers to get their refunds to two to three weeks rather than the usual six.

Until this year, it also meant very fast payments of the earned income tax credit, a government payment of up to $2,528 paid to qualifying taxpayers who work in lower-income jobs.

Lenders and tax preparers quickly realized that many people would pay to get their money even sooner -- in the form of a very short-term loan. And the IRS' willingness to signal an early clearance on refunds and to deposit payments directly with the lending bank made the loans very low risk.

Four major lenders got into the business, and they accounted for 90 percent of the 9.5 million loans in 1994. By last year Beneficial was charging a $29 service fee, in lieu of a conventional interest rate, for loans of $600 or more. Mellon Bank Corp. of Pittsburgh also charged an average $29 fee, a spokeswoman said.

Because the IRS processes electronic returns so quickly, the annual return on these loans is far higher than virtually any other kind of lending. A $29 fee on a $1,000 loan with a two-week term works out to a 75.4 percent annual rate, and that doesn't include the electronic filing fee charged by the preparer -- $35 in H&R Block's case. The charges drew heavy criticism.

"Every consumer reporter has done this story," said Mr. LaPonzina.

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