TIGTA Wants IRS to Take Steps to Prevent Fraudulent Refunds

By Jason Bramwell
After reviewing the IRS's primary tool for detecting fraudulent tax returns, the Treasury Inspector General for Tax Administration (TIGTA) recommended the IRS take steps to fix ineffective income and withholding verification processes that are resulting in the agency issuing potentially fraudulent tax refunds.
As of April 3, 2013, the IRS reported that through the use of its Electronic Fraud Detection System (EFDS), the agency prevented nearly $1.2 billion in fraudulent tax refunds from being issued. But in a TIGTA report released on October 28, Income and Withholding Verification Processes Are Resulting in the Issuance of Potentially Fraudulent Tax Refunds, many potentially fraudulent refunds are slipping through cracks in IRS verification processes. 
After analyzing tax year 2010 tax returns in July 2012, TIGTA identified almost 1.5 million tax returns that were not detected by the IRS as potentially fraudulent, even though the returns had the same characteristics as tax returns deemed fraudulent by the IRS due to identify theft. Of the 1.5 million undetected tax returns identified by TIGTA, only 120,197, or 8 percent, received a fraud score high enough to be sent to a tax examiner for verification. 
TIGTA examiners reviewed a random sample of 272 of the 120,197 tax returns and found that 104 returns  with refunds totaling $613,929  were not worked timely. Examiners confirmed that ninety-six of those tax returns had false income and withholding, but "actions to prevent the issuance of the fraudulent refunds were not taken timely," and the remaining eight tax returns were not screened within the required time period to prevent the issuance of a refund.
"Once a tax return is identified for screening, there is a two-week window to determine if the tax return should be sent to a tax examiner for verification," TIGTA stated in the report. "If verification is needed, an eleven-week refund hold is placed on the account to allow time to complete the verification. If no action is taken to either extend the refund hold or place a permanent hold on the account, the refund is systemically released. The IRS explained that a limit in the number of refund hold transactions that could be manually processed each day prevented permanent holds from being placed on accounts in time to prevent the automatic release of the refunds. The IRS indicated that changes were made in January 2013 to stop the automatic release of refunds for tax returns with confirmed false income and withholding."
In its report, TIGTA made the following two recommendations to the IRS: 
  1. Ensure that actions are taken to prevent the issuance of potentially fraudulent refunds when tax returns are not timely screened and verified and that case notes are sufficient to support the actions tax examiners took to verify income and release the tax refunds.
  2. Revise procedures to ensure that when tax returns identified as potentially fraudulent are also assigned to another IRS function to address processing issues, the tax refunds are held until the tax return is screened and verified by a tax examiner in the IRS Integrity and Verification Operations.
The IRS agreed with both recommendations. Regarding the TIGTA's first recommendation, the IRS said that in addition to the corrective actions it took last January to prevent the automatic release of refunds for tax returns with confirmed false income and withholding, the IRS has increased its system capacity for pending transactions "fivefold" and now performs daily manual monitoring to ensure that maximum daily limits are not exceeded. The agency said it also will reemphasize the documentation requirements of case actions and ensure through operational reviews that procedures are being followed.
In response to the second recommendation, the IRS will "revise instructions in the Internal Revenue Manual . . . in the Error Resolution System and Integrity and Verification Operations functions to require positive verification that the issue triggering an error code or referral has been addressed by the other function before returns are released for further processing. For pre-refund referrals to other functions, accounts will be updated to prevent the account from refunding prior to resolution."
The IRS is also developing a new system, the Return Review Program, to replace the EFDS, which was implemented in 1994. The Return Review Program is expected to enhance the agency's ability to detect, resolve, and prevent criminal and civil tax noncompliance. The IRS determined that the EFDS is outdated and would be inefficient to maintain, upgrade, or operate beyond calendar year 2015. The IRS expects to phase in the new system beginning in January 2015. 
In a memorandum responding to the TIGTA report, Peggy Bogadi, commissioner of the IRS Wage and Investment Division, said the report accurately describes the challenges the IRS faces in processing returns prior to the availability of third-party data. 
"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 wrote. "When all EFDS data models are considered through May 25, 2013, the Integrity and Verification Operations function screened and stopped over 660,000 fraudulent returns with associated refunds of $4.2 billion. Moreover, looking across all IRS activities in this area, in the first five months of calendar year 2013, we stopped over one million fraudulent refunds valued at more than $6 billion."
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