Suspecting fraud, the Internal Revenue Services blocked tax refunds sought by 120,000 poor Americans, the IRS' taxpayer advocate told Congress Tuesday.

The taxpayers, however, were not told that their returns were labeled fraudulent, advocate Nina E. Olson said. Her staff examined a sample of the questionable returns, finding suspicions on one in five–at the most. Under the Questionable Refund Program, run by the IRS Criminal Investigation office, a computer screens for potentially fraudulent returns, and the refunds are frozen, possibly for years. Taxpayers are not told anything until six months after trying to find out what happened to the refund.

"At a minimum, this procedure constitutes an extraordinary violation of fundamental taxpayer rights and fairness," Olson said.

Most of the questions surrounded the earned income tax credit, and the average refund sought was $3,500.

Richard Speier, acting chief of the Criminal Investigation division, told the Washington Post that the agency is facing a 322 percent increase in refund fraud over the past six years, and "we are trying to . . . ensure that honest taxpayers and the tax system itself are not victimized." The frozen refunds represent a tiny fraction of about 130 million annual tax returns, he said.

Olson told Congress that 66 percent of the taxpayers who demanded their refunds were found to be due all the money they sought, or even more, the New York Times reported.

The newspaper quoted Leslie M. Book of Villanova University, who runs a tax clinic for the poor: "Surely there are taxpayers who are ineligible claiming the credit," he said. "But freezing refunds without giving taxpayers process is an extremely dangerous way to administer the earned income tax credit. These taxpayers often need more rather than less protection because they are not sophisticated, are afraid of government involvement."

Although the refund freezes gained the most attention, it was No. 2 on Olson's list of worst taxpayer problems, which was contained in her annual report to Congress. Olson listed 21 issues in her report, with No. 1 being that the IRS plans to shift resources away from taxpayer service, encouraging taxpayers to use electronic services rather than face-to-face contact with employees. Olson said the IRS should first study what types of services taxpayers need and how any changes would affect compliance before making changes.

No. 3 on her list was underreported income, and associated self-employment tax, from the “cash economy.” She said income from the cash economy may be the largest component of the tax gap, and may amount to more than $100 billion per year. The questionable refunds by the poor, by contrast, involves no more than $9 billion, but Olson said the IRS devoted far more resources to that problem than the one of businesses dealing only in cash.

Another top concern is the training of private debt collection employees. Starting this summer, private collection firms will be seeking payment from delinquent taxpayers. “The National Advocate is concerned about taxpayers interacting with private collection agents who have no understanding of important tax laws and will be trained by the contractors instead of the IRS,” Olson said in her report.

To read the executive summary, or the entire report, go to http://www.irs.gov/advocate/article/0,,id=152735,00.html