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Policing Tax Evasion and Tax Fraud: A Consequence of the Regulations Concerning Conflicting

This page is based on an article previously published by the Council on Law in Higher Education: Mark Kantrowitz, Policing Tax Evasion and Tax Fraud: A Consequence of the Regulations Concerning Conflicting Information, Best Practices in Finanancial Aid Administration, Regulatory Advisor, Council on Law in Higher Education, Volume 1, Number 2, April 2005. It has been updated to reflect subsequent statutory and regulatory changes.

Introduction

Financial aid administrators are occasionally placed in the awkward position of policing discrepancies on the income tax returns of students and their families. This can involve requiring the family to file IRS Form 4506, Request for Copy of Tax Return or IRS Form 4506-T, Request for Transcript of Tax Return, in order to verify the information submitted on the Free Application for Federal Student Aid (FAFSA) and the worksheets. Sometimes the school will require the family to file an amended income tax return to resolve the discrepancies. This is a natural consequence of the regulations concerning conflicting information.

The regulations concerning conflicting information appear in the Student Assistance General Provisions as part of the standards of administrative capability. In order to participate in Title IV programs, 34 CFR 668.16(f) requires schools to "identify and resolve discrepancies in the information that the institutions receives from different sources with respect to a student's application for financial aid". In particular, 34 CFR 668.16(f)(2) indicates that schools should review copies of any income tax returns they receive for conflicting information. Also, 34 CFR 668.54(a)(3) states that "If an institution has reason to believe that any information on an application used to calculate an EFC is inaccurate, it shall require the applicant to verify the information that it has reason to believe is inaccurate." The regulations concerning referral of fraud cases to the Office of the Inspector General in 34 CFR 668.16(g) require schools to refer applications that may have engaged in fraud, including false statements of income, when that information is credible and affects eligibility for financial aid or the amount of financial aid. (Fraud involves false information submitted with intent to deceive. Since conflicting information can also include errors, the fraud referral requirements are stricter than the requirements for conflicting information.)

Conflicting Information Includes Income Tax Returns

The goal of verification is to ensure that financial aid awards are based on information that accurately reflects the family's ability to pay. When a school has conflicting information or other reason to believe that the information on a student's financial aid application is incorrect, the school is required to resolve the discrepancy before disbursing aid and to require repayment of any undeserved aid previously disbursed.

Conflicting information is any discrepancy between the student's financial aid application and all other information available to the school that materially affects eligibility for financial aid or the amount of aid. The school must review all information in its possession for such discrepancies, regardless of which office or division of the school collects that information. The regulations in 34 CFR 668.16(b)(3) and 668.16(f) require other offices to share relevant information with the financial aid office.

Information that must be reviewed includes information submitted on a sibling's financial aid application (subject to the limitations of FERPA), information submitted in conjunction with a request for a professional judgment review, and oral or written statements made by the student or parent.

Thus the school must review all income tax returns in its possession for conflicting information, regardless of whether they were collected for verification or for other reasons. This includes both state and federal income tax returns.

Guidelines for Reviewing Income Tax Returns

Financial aid administrators are not required to be tax accountants or auditors. So financial aid administrators often wonder how deeply they should review the information reported on the family's income tax returns. The following principles represent a good set of guidelines:

  • The conflicting information must materially affect eligibility or the amount of financial aid. Minor arithmetic errors or typos that do not significantly affect financial aid are not considered to be conflicting information. For example, 34 CFR 668.59 indicates that schools must require the student to submit a corrected FAFSA or adjust the Pell Grant amount when a discrepancy in take-home pay (AGI plus untaxed income minus US taxes paid) exceeds the verification tolerance of $400 or when there is a discrepancy in any nondollar item, such as household size.

  • The conflicting information must relate to specific data elements reported on the FAFSA and must represent a difference between the items reported on the FAFSA and the items reported on the income tax return. If the corresponding lines of the income tax return and FAFSA match, there is no conflicting information. This means that the financial aid administrator just needs to do a simple comparison of corresponding lines of the two forms, looking for cases where the lines do not match.

The regulations do not explicitly provide for a material discrepancy standard for the review of conflicting information. Technically a college must review all conflicting information even if it doesn't affect eligibility or the amount of aid. (There is, however, a verification tolerance for minor errors of $400 or less in dollar amounts, per 34 CFR 668.59(a)(2)(ii) and (c)(2)(ii). The regulations at 34 CFR 668.54(b) provide for a few exclusions from the verification requirement, such as an applicant who does not receive student aid for reasons other than the failure to verify the FAFSA information. But these regulations do not constitute a material discrepancy standard and the US Department of Education has not issued a Dear Colleague Letter or other subregulatory guidance outlining a material discrepancy standard for conflicting information. Dear Colleague Letter DCL GEN-09-05 did, however, adopt a material difference standard with regard to allowing schools to zero out earned income for a recently unemployed independent student.)

The US Department of Education has provided some guidance in the Application and Verification Guide regarding conflicting information:

  • Tax Filer Status. "If someone whose data were required on the FAFSA submits a signed statement claiming non-filer status and you have reason to believe that person would have been required to file a U.S. tax return, this constitutes conflicting information and must be resolved. ... For example, in such a case, you might require a letter from the IRS, a copy of the applicable tax provision, or other documentation supporting the claim to nonfiler status. Conflicting information must be resolved before you can disburse federal student aid." (Page AVG-88 of the 2009-10 Application and Verification Guide)

  • Professional Judgment. "You must resolve any inconsistent or conflicting information shown on the output document before making any adjustments." (Page AVG-105)

  • Conflicting Information Must Be Resolved Before Aid Can Be Disbursed. "If your school has conflicting information concerning a student.s eligibility or you have any reason to believe a student.s application information is incorrect, you must resolve the discrepancies before disbursing FSA funds. If you discover discrepancies after disbursing FSA funds, you must still reconcile the conflicting information and take appropriate action under the specific program requirements." (Page AVG-107)

    "You may not disburse aid until you have resolved conflicting information, which you must do for any student as long as he is at your school. Even if the conflict concerns a previous award year, you must still investigate it. You have resolved the matter when you have determined which data are correct; this might simply be confirming that an earlier determination was the right one. Of course, you must document your findings in the student.s file and explain why, not simply assert that, your decision is justified." (Page AVG-108)

  • Filing Status and Exemptions. "We have already stated that financial aid administrators do not need to be tax experts, yet there are some issues that even a layperson with basic tax law information can evaluate. Because conflicting data often involve such information, FAAs must have a fundamental understanding of relevant tax issues that can considerably affect the need analysis. You are obligated to know: (1) whether a person was required to file a tax return, (2) what the correct filing status for a person should be, and (3) that an individual cannot be claimed as an exemption by more than one person." (Page AVG-107)

  • Head of Household Status. "An FAA noticing that a dependent student.s married parents have each filed as 'head of household' (which offers a greater tax deduction than filing as single or married) must question whether that is the correct filing status. ... Resolution of the conflict may be a reasonable explanation of why there appears to be a conflict but is none, or the parents may refile and submit a copy of the amended return." (Page AVG-107)

It is not uncommon for tax protesters to claim that they are not required to file an income tax return or to report certain income on the tax returns. They might file an IRS Form 1120S for an S Corporation without filing a corresponding IRS Form 1040, or they may include personal expenses on the corporate income tax return. They often will cite particular sections of the Internal Revenue Code with narrow or absurd interpretations or claim that certain tax practices are unconstitutional or illegal. Often they want to have it both ways, to get the benefits of being a taxpayer without paying taxes. The bottom line is that failure to file a federal income tax return when required, misreporting the amount of income on a federal income tax return or filing a frivolous income tax return represents conflicting information. Federal student aid cannot be disbursed until the conflict is resolved by filing a complete and accurate federal income tax return.

The use of head of household filing status is prone to error even on income tax returns completed by professional tax preparers. Often the error will involve a married taxpayer that does not qualify as "considered unmarried".

Superficial Review with Minimal Interpretation

The comparison of income tax returns with financial aid applications is a review, not an analysis. Imputing the amount of assets from reported interest and dividends goes beyond the scope of such a review. However, it is considered conflicting information when interest or dividend income is reported on the income tax return but no assets are reported on the FAFSA.

Similarly, if the financial aid administrator believes that the family has engaged in tax evasion, but that evasion does not relate to specific lines of the FAFSA or otherwise affect eligibility for financial aid, it does not represent sufficient grounds to require the family to submit an amended income tax return. Even though tax evasion does affect the family's tax liability, so long as the same tax liability was reported on the FAFSA there is no conflicting information.

Essentially, identifying conflicting information involves a superficial comparison of corresponding items with only minimal interpretation. The only skills required are simple arithmetic and simple tests for equality and the presence or absence of information. Per 34 CFR 668.56(a)(5)(vii), only the first two pages of the income tax return are required for verification. The school is not required to review the schedules, but may do so if they wish.

The number of exemptions claimed is a good example. The number of exemptions does not need to match the household size, since claiming an exemption is often optional and the criteria for an exemption does not correspond with the requirements for including someone in household size. The IRS and the US Department of Education use different definitions of 'dependent'. However, claiming someone as an exemption is an affirmative statement that the taxpayer provides more than half the dependent's support. Since there are only minimal differences in what the IRS and the US Department of Education consider to be support (i.e., primarily in regard to government benefit programs such as welfare), whether someone is claimed as an exemption should be considered when reviewing independent student status that depends on the 50% support rule, such as having a dependent other than a spouse. Also, if both the student and the parent claimed the student as an exemption, this represents conflicting information that needs to be resolved.

Another good example involves filing status. If a parent or applicant files as head of household on their income tax returns, but as married on the FAFSA, it should be considered conflicting information. Technically, one can file as head of household in rare circumstances and still be married, or the marital status could have changed between the end of the tax year and the FAFSA application date. But this filing status is so prone to abuse that it should be considered conflicting information that needs to be resolved.

The US Department of Education has published guidance indicating that even though financial aid administrators are not required to be experts on the US tax code, they are required to know basic tax rules such as "whether a person was required to file a tax return, what the correct filing status for a person should be, and that an individual cannot be claimed as an exemption by more than one person" (see page AVG-107 of the 2009-10 Application and Verification Guide). Basic tax rules can be found in IRS Publication 17, Your Federal Income Tax.

For example, if a student or parent refuses to file an income tax return and the financial aid administrator has reason to believe that they should have filed an income tax return (i.e., income sufficient to require an income tax return) it represents conflicting information that must be resolved. This is the case even if the student or parent signs a statement asserting that they were not required to file. The US Department of Education has published guidance indicating that if an applicant is required to file an income tax return but refuses to file, they are not eligible for financial aid. As a result, most schools will require the family to file an income tax return or to submit a letter from the IRS as documentation supporting the claim of non-filer status.

Resolution of Conflicting Information

Conflicting information is considered to have been resolved when the financial aid administrator has determined which set of information is correct and made appropriate adjustments to the FAFSA, resulting in a corrected EFC and aid package. There is no specific requirement that the school require the family to file an amended income tax return to correct errors on the income tax return. However, most schools will require an amended income tax return in addition to a properly completed verification worksheet so that all records are consistent.

Best Practices: Going Beyond the Requirements

Many financial aid administrators go beyond the basic requirements. Some of the more common best practices include:

  • reviewing the schedules, including schedules C and SE

  • reviewing all untaxed income items

  • selecting low income applicants for extra scrutiny (often to identify errors that prevent the student from receiving all the aid for which he or she qualifies)

  • requiring applicants to submit IRS Form 4506

  • requiring applicants to file an amended income tax return when there is an error on the income tax return

  • requiring all applications to undergo verification, instead of just the 30% required by the US Department of Education
These practices not only ensure that applicants receive the aid that they deserve, but also reduces the school's liability by eliminating discrepancies instead of just resolving them.

Financial aid administrators have the authority to request any documentation they need in order to resolve discrepancies, per section 479A of the Higher Education Act of 1965 and the regulations at 34 CFR 668.51(b), 34 CFR 668.54(a)(3), 34 CFR 668.54(a)(5), 34 CFR 668.60(a), 34 CFR 668.60(b)(1), 34 CFR 668.60(c)(2) and 34 CFR 668.60(d).

A Simple Comparison of Tax Returns and Financial Aid Applications

In summary, financial aid administrators are required to compare the first two pages of a family's income tax returns and any W2 and 1099 statements with the corresponding lines of the FAFSA. When the lines do not match or information is missing, it is considered conflicting information that needs to be resolved. The discrepancies must be resolved before aid can be disbursed. Many financial aid administrators go beyond the letter of the law by reviewing tax return schedules and untaxed income items and by requiring applicants to file an amended income tax return to correct errors on their income tax returns. Such practices are permitted but not required by the regulations. This extra effort helps ensure that qualified applicants receive all of the aid to which they are entitled.

 

 
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