The N.C. Department of Revenue is sifting through a backlog of 230,000 unresolved tax returns from as far back as 1994 that include cases in which taxpayers are owed money - but are now unlikely to get it.
E-mail correspondence obtained by The News & Observer outlined the problem, and it revealed a debate within the department over how to deal with longstanding cases where its computer system flagged returns to indicate taxpayers who mistakenly overpaid their taxes.
The e-mail messages also show that the department knew about overpayments but did not refund them.
North Carolina law gives taxpayers up to three years to claim a refund from a filed return, just as it gives the Revenue Department up to three years to collect an unpaid tax.
In the past, department policy allowed for overpayments to be refunded in a timely manner, after they were flagged by Revenue Department computers.
But that policy changed last year. Top revenue officials now say that an overpayment flagged by a computer is not considered to have been discovered until it is later verified by an agency employee.
The new policy makes no provision for conducting this review quickly. As a result, the Revenue Department can hold on to overpayments until it doesn't have to pay them back.
Revenue Secretary Kenneth Lay, when asked about overpayments in a June 22 interview, said that he did not know how many there were and that he could only speak about actions taken after he took office in early 2009.
The department later declined to produce records pertaining to the matter, saying that doing so would expose information about individual taxpayers, and it received an opinion in support from an assistant attorney general.
The N&O won release of the records after appealing to the Attorney General's Office.
On Tuesday, Lay released the e-mail correspondence reflecting the backlog and the internal debate. In a letter accompanying the e-mail records, Lay wrote that it would be the department's "final response."
Chrissy Pearson, a spokeswoman for Gov. Bev Perdue, said the governor and her staff did not know about the backlog or the policy change regarding overpayments.
"She was incensed," Pearson said.
Pearson said Revenue Department officials told the Governor's Office that they can't say how much money the state could capture in overpaid taxes under the new policy or how many taxpayers stand to lose money as a result of what it has already captured.
The backlog involves 230,000 tax returns that have been flagged by computer for a variety of reasons from 1994 to this year, including underpayment of taxes. Some are flagged over questions as simple as conflicting information about a taxpayer's residence.
Pearson said she thinks that some taxpayers who overpaid their taxes are now out of luck because the statute of limitations has expired.
"It is the governor's strong feeling that if we as a state have the opportunity to process these accounts in accordance with the law and pay people back the money that they are owed, that we should be doing it if we can," Pearson said.
"Unfortunately, the 'if we can' is the big question here."
That's because Revenue Department officials told Pearson they would need $1 million for additional staff and resources to close out the backlogged returns. They told Pearson a minority of those returns would likely involve overpayments. They denied that the policy change was an attempt to hold on to money at a time of tight state budgets.
Too much? Too late.
Taxpayers who overpay their taxes are already in a difficult position. If they don't know they've paid more than they owed, how can they request a refund?
In the case of basic errors, the Revenue Department can come to the rescue. Its computer system processes every return shortly after it is received and flags errors.
In the past, the department regarded that flag as a "discovered" overpayment eligible for a refund.
The flagged returns still had to be reviewed by department employees before any refunds would be paid. But since the flagging happened well before the three-year statute of limitations had expired, there was little question the taxpayer should get the refund - even if the actual review took place after the three years was up.
But starting last year, the department took a different approach, the e-mail correspondence shows.
Lay now contends that a computer-flagged overpayment has not actually been "discovered" as such until a Revenue Department employee confirms what the computer system found. The three-year statute of limitations could expire before the review takes place.
Nancy Pomeranz, the department's personal taxes division director, learned of the policy change last year when her staff was told not to take up a backlog of flagged overpayments that had run past the statute of limitations.
In October, she asked John Sadoff, the assistant secretary for tax compliance, for an explanation. Sadoff told her that just because the computer flagged the return did not necessarily mean the overpayment existed.
Pomeranz then cited two cases as clear examples in which a refund should be made. In one, a taxpayer sent a $4,000 payment with a tax return that showed he only owed $1,000. In the other, a taxpayer failed to claim credit on the return for a $150 estimated tax payment and should have been credited with the payment.
"My folks were told not to process any refunds in any situation where the statute has run now because no refund is 'discovered' until someone actually looks at it or handles it," Pomeranz wrote in an Oct. 12 e-mail message to Sadoff. "I do not agree and, as I mentioned in my earlier e-mail, this is contrary to our long-standing position."
In December, Pomeranz again asked if her staff could move forward with thosecases. She still had not received a clarification, and she again expressed concern that in some cases she was convinced the taxpayers were owed refunds.
Alan Woodard, the department's examinations director, replied with a reiteration of the new policy: "The Agency has determined that a refund is discovered when a [Department of Revenue] employee takes a specific action to identify, review, and approve an overpayment of tax."
On Friday, Pomeranz told the governor's staff that it is unlikely those two taxpayers got a refund. She has declined to be interviewed by a News & Observer reporter.
Sadoff and Woodard could not be reached for comment.
This internal debate took place as a struggling economy caused state revenues to drop, and the department was under the gun to help close the gap. In October 2009, three months into the fiscal year, budget forecasters knew revenue was down at least $45 million. While lawmakers were in session this spring fashioning a new budget, the revenue shortfall grew to $800 million.
Pro sees a problem
Jack Cummings, a Raleigh tax attorney who has handled major cases, reviewed the correspondence at The N&O's request. He said it appeared that the department had found a way to run out the clock on people who had overpaid their taxes.
It's particularly troubling, he said, because the state moves quickly when the computer system reports those who underpay their taxes.
"If the department thinks there's an assessment to be made, they will do everything they can to get it within three years," Cummings said.
Cummings represented a Greensboro company that won a lawsuit in 1996 that invalidated the state's intangibles tax, which was levied on stocks, bonds and mutual funds of companies that did not exclusively do business in North Carolina.
Not ASAP anymore
Until 2007, state law required the Revenue Department to return overpayments it discovers to the taxpayer "as soon as possible together with any applicable interest." That language was repealed in favor of a new law that largely dealt with how tax disputes would be settled.
The new language lays out a procedure for the department to take the initiative on refunding money to taxpayers.
The department can only do so, according to the new law, when the statute of limitations has not expired, the amount shown due on the return is not correct, and that correction shows that the taxpayer overpaid.
Under this language, Cummings said, the department may not have an obligation to address situations in which the return is correct, but the taxpayer accidentally paid more than what the return indicated was owed.
Such accidental overpayments can easily happen, Cummings said. There are cases where someone writes the wrong number on a check to the Revenue Department, forgets having made estimated tax payments earlier in the year, or loses track of a prior year's refund that was applied to this year's taxes.
State Sen. Dan Clodfelter, a Charlotte Democrat and a Finance Committee co-chairman, said the 2007 law, which sailed through the legislature, did not intend to give the Revenue Department a means to capture taxes that were overpaid. He said he would be troubled to find Revenue officials applying the law that way.
"If there's a glitch in the statutory language, I know how to fix it, and we will fix it," Clodfelter said. "And we will do it retroactively. We're not going to let this kind of thing catch people."
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