Tax Fraud and Noncompliance: IRS Can Strengthen Pre-refund Verification and Explore More Uses
Fast Facts
Fraudsters used false identities to steal at least $1.68 billion in tax refunds in 2016.
To help address fraud and compliance issues, Congress moved up the deadline for employers to submit W-2s and had IRS hold refunds for those claiming certain tax credits beginning in 2017. These changes gave IRS more time to work on identifying discrepancies before issuing refunds.
We found this process helped IRS identify and prevent fraud, but IRS could do more to maximize its potential.
We made 6 recommendations, including that IRS take steps that would allow it to review more W-2s before issuing refunds and reduce the risk of fraud and noncompliance.
This is a photo of a 2017 W-2 Wage and Tax Statement form.
Highlights
What GAO Found
Beginning in 2017, as required by law, the Internal Revenue Service (IRS) held all refunds for taxpayers claiming the Earned Income Tax Credit (EITC) or Additional Child Tax Credit (ACTC) until February 15. IRS also took actions to verify wage and other information reported on tax returns before issuing refunds, referred to as systemic verification, but several factors limited its success. IRS received over twice as many (over 214 million) Forms W-2, Wage and Tax Statement (W-2) by February 15 compared to the same time in 2016, and reported that W-2 data were responsible for improving fraud detection and reducing taxpayer burden. However, IRS was unable to verify over half of the returns it held until February 15 before issuing the refunds. For example, IRS received W-2s daily but its information technology systems processed them weekly. In response to GAO's review, IRS reported it is planning to assess options for processing W-2s daily. Also, some employers submit W-2s late, but IRS did not track the extent to which late W-2s are associated with fraud or noncompliance. Further, IRS has not assessed options for enforcing late W-2 penalties earlier. Additionally, about 9 percent (about 23 million) of W-2s were filed on paper, which IRS does not begin to receive from the Social Security Administration (SSA) until March. By law, employers who file 250 or more W-2s are required to file W-2s electronically, while those who file fewer than 250 W-2s may opt to file on paper or electronically. In August 2014, GAO suggested that Congress provide the Secretary of the Treasury with the authority to lower the electronic filing requirement from 250 W-2s to 5 to 10. This action could also have the benefit of reducing SSA's W-2 paper processing costs by $9.7 to $11.3 million per year. These issues reduce IRS's access to timely W-2 data, limiting its ability to prevent fraud and reduce noncompliance before issuing refunds.
IRS's preliminary and final analyses of the February 15 refund hold both showed that IRS could have detected significantly more in potential fraud and noncompliance if it held all refunds until late February, when it had more W-2 data available. There are differences between these analyses. For example, the final analysis included more returns and estimated total revenue IRS could protect by extending the refund hold and expanding it to all taxpayers. In that analysis, IRS estimated that it could have protected $100 million in fraud and noncompliance had it held all taxpayer refunds until February 15—$35 million more than it protected by holding refunds with EITC or ACTC. IRS further estimated that moving the refund hold to March 1 for all taxpayers could protect $895 million compared to $533 million if it only held refunds with EITC or ACTC until that date. However, GAO found limitations to IRS's analyses. For example, while IRS has plans to further explore holding refunds longer, it does not have an evaluation plan to assess the effectiveness of the refund hold on systemic verification. Also, IRS did not fully assess the benefits and costs, including taxpayer burden, of the refund hold, nor how its analysis informs its broader fraud risk management or compliance efforts. As a result, IRS does not have sufficient information to inform a decision on potential changes to the refund hold date and those subjected to it. Finally, IRS has not assessed the benefits and costs of expanding systemic verification to use for pre-refund compliance checks in other areas such as income underreporting and employment fraud. Therefore, IRS may be missing opportunities to maximize use of early W-2 data.
Why GAO Did This Study
IRS continues to confront the ongoing problems of identity theft (IDT) refund fraud. The agency estimates that at least $1.68 billion was paid in IDT refund fraud in 2016. To help address this issue, consistent with GAO's prior reporting, the Protecting Americans from Tax Hikes Act of 2015 advanced the deadline for employers to file W-2s to SSA to January 31 (about 1 to 2 months earlier than in prior years). This change allows IRS more time to match wage information to tax returns through systemic verification, and identify any discrepancies before issuing refunds.
GAO was asked to assess how well IRS implemented systemic verification. GAO assessed IRS's performance using systemic verification and the extent to which IRS analyzed the effectiveness of the refund hold on this process. GAO analyzed IRS and SSA data and documents, observed SSA's paper W-2 process, and interviewed IRS and SSA officials. GAO compared IRS actions to laws; IRS policies; and standards for internal control, fraud risk management, and program evaluation.
Recommendations
GAO recommends IRS collect data to track late W-2 filing penalties and assess options for earlier enforcement; assess the benefits and costs of using existing authority to hold refunds longer, hold all refunds, or both, and expanding systemic verification to other areas; and take actions based on the assessments. IRS listed steps to respond to 5 of 6 recommendations, but said it could not enforce penalties earlier. GAO recognizes the challenges but clarified that assessing other options would provide benefits, as discussed in the report.
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Internal Revenue Service | The Acting Commissioner of Internal Revenue should collect data to track late W-2 filing penalty notices and the extent to which they are associated with fraud and noncompliant returns. (Recommendation 1) |
In April 2019, IRS provided the results of its assessment to determine the extent to which late W-2 filing penalty notices are associated with fraud and noncompliant returns. The results showed no significant association between fraud and noncompliant returns and late W-2 filing. In 2018, IRS implemented new filters that help IRS monitor the effect of late W-2 filing and fraud and noncompliance. As a result, IRS can better monitor and track fraudulent and noncompliant refunds associated with missing W-2 information.
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| Internal Revenue Service | The Acting Commissioner of Internal Revenue should assess options for improving enforcement of late W-2 filing penalties, for example, by mailing notices before the next filing deadline. (Recommendation 2) |
In August 2022, IRS officials described several options they had considered in response to our recommendation, including sending notices to employers if IRS identified potential missing or late filed W-2 information returns. Based on their discussions with internal stakeholders, IRS officials concluded that the agency did not have reasonable options available to improve enforcement of late W-2 filing penalties in order to increase the availability of W-2 data for systemic verification to detect and prevent fraud and noncompliance. Specifically, IRS officials stated that the agency does not have all the information required for calculating and sending late penalty notifications prior to the beginning of the next filing season, and that they do not want to risk increasing the burden on employers by sending notices before a final determination could be made. Moreover, since we issued our report, IRS and Congress have taken actions that change the circumstances under which we made this recommendation. Specifically, in response to other recommendations in our report, beginning in January 2019, IRS began holding returns at higher risk of fraud until a W-2 was available to verify the income. In addition, in 2019, IRS worked with the Social Security Administration to improve the transmission of W-2s so more of them were available earlier in the filing season for IRS to conduct systemic verification. Finally, Congress changed the electronic filing requirement as part of the Taxpayer First Act. Previously, those that filed 250 or more returns in a year, such as W-2s, were required to do so electronically. Under the new law, beginning in 2022, this requirement applies to those filing 10 or more returns in a year. As a result, more W-2 data are available to IRS earlier in the filing season. Based on IRS's deliberation of potential options for improving enforcement of late W-2 filing penalties, as well as the changing circumstances since we made our recommendation, we are closing this recommendation as implemented.
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| Internal Revenue Service | The Acting Commissioner of Internal Revenue should develop an evaluation plan to fully assess the benefits and costs, including taxpayer burden, of modifying the February 15 refund hold, and determine how this effort informs IRS's overall compliance strategy for refundable tax credits and fraud risk management. (Recommendation 3) |
IRS has taken actions to assess the benefits and costs of modifying the February 15 refund hold, as GAO recommended in January 2018. In November 2018, IRS provided its assessment of the February 15 refund hold. In it, IRS reiterated its findings regarding the benefits of the refund hold. These benefits included potential savings if IRS modified the hold to include all taxpayers, extended the hold to a later date when more W-2 data are available, or both. While IRS did not fully assess costs or taxpayer burden associated with modifying the February 15 refund hold, it took actions in January 2019 and January 2020 that suggest cost and burden were considerations. Specifically, IRS began holding returns at higher risk for fraud and noncompliance, and for which IRS did not have a W-2, beyond the February 15 refund hold until a W-2 was available to verify against the return. In March 2021, IRS officials stated that the agency had been able to automate these functions so that staff were not required to manually review the returns, allowing staff to work on other tasks. Further, IRS continued to select returns to hold using a risk-based method, in part, to limit taxpayer burden by not affecting larger populations expecting refunds. IRS's assessment using key data allowed it to make more informed decisions to better use W-2 information and prevent issuing invalid refunds.
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| Internal Revenue Service | Based on the benefits and costs assessment in Recommendation 3, the Acting Commissioner of Internal Revenue should use IRS's existing authority to modify the refund hold such that it minimizes the risk of releasing fraudulent or noncompliant refunds. (Recommendation 4) |
IRS took actions consistent with GAO's January 2018 recommendations by modifying its filters to hold more returns claiming the Earned Income Tax Credit (EITC) or Additional Child Tax Credit (ACTC) beyond the February 15 refund hold date based on a risk-based selection method. In addition, beginning in the 2020 filing season, IRS made similar changes to hold more high-risk returns not claiming EITC or ACTC until W-2 data were available. These actions are consistent with GAO's recommendation. By taking these actions, IRS is better able to use W-2 information and prevent issuing invalid refunds.
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| Internal Revenue Service | The Acting Commissioner of Internal Revenue should assess the benefits and costs of additional uses and applications of W-2 data for pre-refund compliance checks, such as addressing underreporting, employment fraud, and other fraud or noncompliance before issuing refunds. (Recommendation 5) |
In September 2019, IRS provided results for a pilot encouraging voluntary compliance through expanded systemic verification using W-2 data. In the pilot, IRS sent soft notices to a targeted group of taxpayers whose returns under-reported income compared to W-2 data. In its analysis, IRS reported that some taxpayers voluntarily amended their returns after receiving the soft notice, resulting in a net increase in tax revenue. IRS continued this pilot in 2020, 2021, and 2022, and provided additional data on results of the pilot. In January 2023, IRS officials told us that they would not continue the pilot in 2023 due to insufficient resources. However, in April 2023, IRS released its Inflation Reduction Act Strategic Operating Plan, which included an initiative to notify taxpayers and tax professionals of potential mismatches for simple types of income (W-2 and 1099 NEC) and processing errors. This initiative included milestones in fiscal years 2024 and 2025. We will follow up with IRS to determine the status of the initiative. If IRS has conducted an assessment of the costs and benefits of this, or related, initiatives, it would satisfy our recommendation.
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| Internal Revenue Service | Based on the assessment in Recommendation 5, the Acting Commissioner of Internal Revenue should implement any identified changes to improve pre-refund compliance checks. (Recommendation 6) |
In September 2019, IRS provided results for a pilot encouraging voluntary compliance through expanded systemic verification using W-2 data. In the pilot, IRS sent soft notices to a targeted group of taxpayers whose returns under-reported income compared to W-2 data. In its analysis, IRS reported that some taxpayers voluntarily amended their returns after receiving the soft notice, resulting in a net increase in tax revenue. IRS continued this pilot in 2020, 2021, and 2022, and provided additional data on results of the pilot. In January 2023, IRS officials told us that they would not continue the pilot in 2023 due to insufficient resources. However, in April 2023, IRS released its Inflation Reduction Act Strategic Operating Plan, which included an initiative to notify taxpayers and tax professionals of potential mismatches for simple types of income (W-2 and 1099 NEC) and processing errors. This initiative included milestones in fiscal years 2024 and 2025. We will follow up with IRS to determine the status of the initiative. If IRS implements this initiative based on its assessment of the costs and benefits from the pilot results, or assesses and implements additional options to address other fraud and noncompliance before issuing refunds, it would satisfy our recommendation.
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