The only way to stop tax refund fraud is to change the way the tax filing and refund system works, and while this may be a painful process for employers and taxpayers alike, it's necessary.
The Problem With Data
Unless you've been hiding out in the Unabomber Suite at the Loon Lake Lodge, you know that data-related crimes are legion, but what you may not know is that data-related tax fraud specifically is increasing geometrically. It is a problem screaming out for a solution.
The mother of these crimes is the by now all-too-familiar data breach -- what I like to call the third certainty in life. We know for sure that way more than a billion records are "out there" as a result of data breaches. That's a ginormous amount of information, and it can be used to commit a panoply of crimes -- one of the more lucrative among them being tax refund fraud.
Tax refund fraud losses are estimated to reach $21 billion by this year, according to the Treasury Inspector General for Tax Administration, which provides independent oversight of the Internal Revenue Service. It is an astounding figure, greater than the gross domestic product of many small nations.
The fact that you have not yet become the victim of taxpayer identity theft may have more to do with dumb luck than your efforts to stay safe. For while there are mountains of records out there, there are only so many criminals available to use them for this or that identity-related crime. It may not be tax fraud, but at some point the bad guys are going to get you. (If you do have reason to believe your personal information was compromised, you should monitor your credit for signs of other identity theft. You can do so by pulling your credit reports for free each year at AnnualCreditReport.com and viewing your credit scores for free each month on Credit.com.)
The Problem With April 15
In 2012, the IRS received more than 148 million tax returns. The agency issued almost $310 billion in refunds to approximately 110.5 million taxpayers. That is a whole lot to keep track of, a fact that is not lost on identity thieves. According to a report from the Government Accountability Office, by March 1 of 2012, the IRS had already paid out around half of that year's tax refunds. That is a month and a half before the April 15 filing deadline.
If you were a criminal, you would see that timeline as an irresistible opportunity.
As December fades into January, and you start preparing your taxes, employers also get to work on filing your W-2 with the government. The feds then compare your tax return to the W-2 your employer files to make sure everything matches up. But here's the catch: Employers don't have to file W-2 wage data until March 2, if they file on paper, and March 31 for e-filers.
And that's the perplexing part: Half of the refunds in 2012 were sent out on blind faith. As things stand now, the IRS only starts the process of matching employer-reported W-2 data to tax returns in July, long after most refunds have been issued. It's called "look-back" compliance.
Does that sound a tad crazy to you? If you answered in the affirmative, you might just be sane (at least with regard to this issue). While justice is blind and we like it that way, that's the only part of government where lack of vision is a virtue, and it's high time the IRS should consider getting new glasses.
To be fair, part of the reason for the slow compliance check is that W-2s have to go through the Social Security Administration before being sent over to the IRS. Why it's done this way is anyone's guess, but it doesn't matter. Until it is changed, tax refund fraud is only going to get worse and worse and worse, which is the fundamental problem with April 15, March 2 and March 31, both reflexively and respectively.
Given that problem set, a simple (and necessary) change applied to the flow of information is not going to solve the problem by itself. The IRS uses look-back compliance for an important reason: to get money back to taxpayers as soon as possible. Many taxpayers rely on refunds to make ends meet, and as a result the IRS is under enormous congressional pressure to issue refunds promptly. In fact, the agency is required by law to pay interest if it takes longer than 45 days after the tax return's due date (typically April 15) to issue a refund.
It is by dint of this system that most taxpayers can expect a refund within 21 days of filing their tax return, and that is an excellent thing. Unfortunately, for those who become victims of tax-related fraud and refund diversion, it may take more than 300 days to actually get their money back.
Why We Must Eliminate Look-Back Compliance
That said, the refund process is a quaint relic of simpler times. It's the epitome of an analog approach devoured in our digital reality, and because of this, look-back compliance should go the way of the mainframe computer.
There is no simple solution that can make this happen overnight. The GAO's suggestion of earlier W-2 filing deadlines might allow the IRS to match employer-reported wage information to taxpayers' returns before issuing refunds. The recommendation in the report was to move up the employers' deadline from March 31 to January 31. This could be facilitated by requiring all employers to e-file W-2s, instead of the current arrangement, in which only companies with more than 250 employees have to e-file. Paper filing costs more, and it takes longer, which exacerbates the problem. It was probably time to institute mandatory W-2 e-filing a decade ago, but better late than never.
Of course, these issues are for those "guardians" in Congress to figure out, but one thing is certain -- something has to change.