IRS develops system to combat tax-related fraud

As part of its effort to fight identity theft, the Internal Revenue Service has developed a method to flag accounts that criminals using stolen personal information have targeted for tax fraud.

Comment on this article in The Forum.That effort is one of several steps included in a report that Nina Olsen, the IRS' national taxpayer advocate, submitted to Congress on Tuesday outlining the agency's fiscal 2009 priorities, most of which focus on protecting taxpayers' personal information. Her office, the Taxpayer Advocate Service, is an independent organization in the IRS that assists taxpayers who have been unable to solve problems in other units.

One of the biggest concerns is tax-related identity theft, which can be committed in two ways. One kind of fraud involves a thief using personal information to file a fraudulent tax return to collect a refund before the victim files a return. A criminal also can commit employment fraud, in which an individual's Social Security number is used to gain employment falsely, which puts the victim at risk of being suspected of tax fraud.

A criminal can use a Social Security number repeatedly to file false returns, which can freeze accounts and require taxpayers to spend months resolving the issues. To reduce this burden, the IRS developed the identity-theft indicator, which electronically flags accounts that have been the target of identity theft. Once the IRS marks an account, if another incident occurs, a taxpayer will not have to spend months proving the fraud occurred; the agency will know the account has been compromised before.

Olson points out in the report, however, that the indicator system has limited use. The IRS will use the indicator only in cases in which individuals can prove to the agency that they were the victim of identity theft. So, while the indicator could prevent repeated fraud on the same account, it will not prevent the first incidence of identity theft. In addition, because the indicator goes into effect only after a taxpayer proves fraud, the IRS will substantially underestimate the number of tax-related identity theft cases that occur each year.

Under a second phase, scheduled to take effect in fiscal 2009, the IRS will program the indicator to distinguish valid returns from fraudulent ones, which should stop tax-related identity theft before it occurs. The IRS is working on the algorithm that it will use to identify suspicious returns.

In her report, Olson wrote that the agency needed a standard by which all IRS units can use to determine when to flag accounts. "The National Taxpayer Advocate also is concerned about a lack of consistency in the implementation of the tracking code while the IRS is still developing business rules to determine how and when the identity theft indicator should be placed on a victim's account and what the consequences of such an indicator would be," Olson wrote.

The IRS released the advocate report three months after the Senate Finance Committee held a hearing on tax-related identity theft. Chairman Max Baucus, D-Mont., sharply criticized the agency for not having a mechanism to allow taxpayers to report when their identities have been stolen. Baucus gave the agency 90 days to provide a status report, including goals, timelines and milestones for solutions.

IRS Commissioner Douglas Shulman, who had just been sworn in at the time of the hearing, promised to make improvements by the fall. IRS officials were not available for comment before this article was posted.

The agency also plans to create by Oct. 1 a unit to assist identity theft victims. Taxpayers who suspect their account has been the target of identity theft will be able to call a hot line to report their concerns and take steps to protect their accounts. Olson recommended that the unit operate much like her organization, which has one employee overseeing a case from start to finish so the worker can more easily monitor the progress of the case. Olsen said taxpayers are frustrated by the current system, which requires them to contact multiple people to resolve any incidence of identity theft.

"While we are encouraged by the IRS' plans to set up an identity theft hot line, it is not clear to us that the IRS vision for this centralized unit mirrors ours or otherwise provides the assistance required by identity theft victims," Olsen wrote.