Millions mistakenly take education tax credits

A watchdog has found millions of bad tax credits.

NEW YORK (CNNMoney) -- More than 2 million Americans received education tax credits in error last year, according to a watchdog report issued Thursday, at a total cost to taxpayers: $3.2 billion.

The report, from the Treasury Inspector General for Tax Administration, finds that Recovery Act education tax credits have been awarded to individuals who don't have Social Security numbers, are in prison or are unable to prove they attend an institution of higher learning.

The Internal Revenue Service disputes the report's findings.

Dubbed the American Opportunity Tax Credit, the benefits were authorized in 2009 as part of the economic stimulus package, and max out at $2,500 for eligible individuals.

Almost 9 million taxpayers received $15.5 billion in American Opportunity Tax Credits in 2009, according to the IRS.

But the Treasury Inspector General for Tax Administration said a substantial number of those claims are invalid.

The biggest problem: 1.7 million taxpayers received $2.6 billion in credits, despite the IRS having "no supporting documentation that these taxpayers had attended an eligible institution."

They tried to deduct what?!

Students without Social Security numbers received $103 million in education credits. And 370,924 taxpayers who were not in school for a long-enough time period, or were enrolled in graduate programs, received $550 million.

Meanwhile, 250 prisoners erroneously received $255,879 in tax credits.

"The IRS does not have effective processes to identify taxpayers who claim erroneous education credits," J. Russell George, the Treasury Inspector General for Tax Administration, said in a statement.

"If not addressed, this could result in up to $12.8 billion in potentially erroneous refunds over four years," George said.

The IRS said in a statement it "strongly disputes" the findings, which are "based on a flawed and superficial analysis."

Specifically, the IRS said a majority of cases identified as erroneous stem from an inability to match taxpayer filings with data provided by colleges and universities.

But the Treasury Inspector General for Tax Administration stood by its report. It said that IRS audits had revealed a full 72% of the cases it identified to be erroneous.

And the IRS said it's reforming its procedures.

"Despite our objections to the findings of the report, no amount of fraud is acceptable," the IRS said. "The IRS has already begun to take steps to increase monitoring and improve compliance."