The processes used by the Internal Revenue Service to verify taxpayers’ income and withholding status are inadvertently resulting in the issuance of potentially fraudulent tax refunds, according to a new report.

The report, from the Treasury Inspector General for Tax Administration, noted that a common characteristic of fraudulent tax returns is that the income and withholding reported on the tax return are false. The Electronic Fraud Detection System, or EFDS, is the IRS’s main tool for identifying potentially fraudulent tax returns at the time they are processed. As of April 3, 2013, the IRS reported that it prevented the issuance this year of nearly $1.2 billion in fraudulent tax refunds through its income and withholding verification processes. Yet those same processes are nevertheless leading to the issuance of many potentially fraudulent tax refunds.

TIGTA had earlier reported and testified before Congress that access to current-year third-party income and withholding information at the same time that tax returns are processed is the single most important tool needed by the IRS to identify and prevent tax refund fraud. However, most current-year third party information is not available until well after tax-filing season begins and tax returns are processed, TIGTA pointed out.

In July 2012, TIGTA reported on an analysis of tax year 2010 tax returns in which it identified nearly 1.5 million tax returns that were not detected by the IRS as potentially fraudulent, even though they had the same characteristics as the fraudulent tax returns that the IRS had confirmed as instances of identity theft. Analysis of the 1.5 million undetected tax returns found that only 120,197 (or about 8 percent) received a fraud score high enough to be sent for verification under the IRS’s then-existing processes.

For its latest report, TIGTA reviewed a random sample of 272 of the 120,197 tax returns and found that the IRS’s income and withholding verification process is not always effective in stopping the issuance of fraudulent tax refunds. In the report, TIGTA recommended that the IRS ensure that it take action to prevent the issuance of potentially fraudulent refunds when tax returns are not screened and verified on a timely basis and ensure that the actions it takes in such cases are sufficiently documented. In addition, TIGTA suggested that the IRS should change its procedures to ensure that when tax returns are identified as potentially fraudulent and are assigned to another IRS function for further scrutiny, the tax refunds should be held until the tax returns are screened and verified.

In response to the report, IRS officials agreed with TIGTA’s recommendations and said they have taken action to extend tax account freezes to prevent the release of potentially fraudulent tax refunds. The IRS also plans to re-emphasize the documentation requirements of case actions and revise its instructions for IRS tax examiners to require positive verification that an issue triggering an error code or referral has been addressed.

“The report accurately describes the challenges the IRS faces in processing returns prior to the availability of third-party data,” wrote Peggy Bogadi, commissioner of the IRS’s Wage and Investment Division, in response to the report. “The report is based on tax year 2010 returns that were received and processed during calendar year 2011.  In the two years since those returns were received and processed, the IRS has identified and changed processes where controls needed to be improved and new approaches taken to more effectively address the threats posed by unscrupulous individuals filing fraudulent claims for refund.”

She pointed out that in the first five months of 2013, the IRS has stopped over 1 million fraudulent tax refunds valued at more than $6 billion.

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