Tax Preparers and Identity Theft

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1 Tax Preparers and Identity Theft It is a form of crime unique to the 21st Century, as the massive collection of data from consumers and a lack of sophisticated computer security measures combine to offer thieves a simple and relatively safe way to steal. First used to steal credit card numbers, identity theft focuses today on information such as Social Security Numbers, dates of birth, and home addresses. With 74 percent of tax filers in the United States receiving refunds that average $2,803, it was inevitable that identity theft would eventually strike the Internal Revenue Service and tax preparation professionals. This form of fraud was first noted as a relatively minor nuisance in 2005, but quickly rose to become the number one tax scam in the nation by According to J. Russell George, the Treasury Inspector General for Tax Administration, the number of documented cases grew from 500,000 in 2009 to 1.8 million in calendar year 2012, despite efforts that prevented some $20 billion in fraudulent refunds in that year. A driving force in the rise of fraud cases has been the expansion of the Earned Income Credit, Child Tax Credit, and other refundable credits that are not tied to income withholding reflected on a Form W-2. Prior to the expansion of these refundable credits, refunds were small and easily tracked through the W-2 forms, and fraud was limited because of the amount of specific information a thief would need. Today, the refund has nothing to do with the taxes withheld from wages but rather is calculated based on information that can be fabricated such as the number and names of children.. Any time there is a refundable credit, there is a possibility that it will be used for fraud, notes John Sapp, Vice President of Strategic Development for Drake Software. The rise in identity theft for tax returns correlates closely to the increase in benefits under the Earned Income Tax Credit. And we are facing the threat of even more fraud with the refundable tax credits under the Affordable Care Act, which will begin in Essentially, the problem is that it is impossible to identify fraud before it occurs. And there will always be people who see a refundable credit and try to take advantage of it. Reflect on the Season Just Passed The term identity theft has been around since 1964 but it was not until 2005 that it became a significant factor for American consumers, and not until 2008 that it began to affect the process of filing federal and state income taxes. Page 1

2 There are many forms of identity theft that are tracked as crimes. The three that directly affect the preparation and filing of taxes are financial theft, in which the whole identity of an individual is taken in order to steal money such as an income tax refund; child identity theft, in which the identity of a child is stolen and used; and synthetic identity theft, in which only the Social Security Number is stolen and other information is fabricated around that number for financial gain. The use of Social Security Numbers from deceased or retired individuals is growing because the Social Security Administration records can take up to a year to reflect a change in status. In addition, federal privacy laws prohibit the Social Security Administration from sharing with tax preparers or even the IRS its database of persons who are no longer receiving benefits because they are deceased. And a 2012 study by the Washington, D.C.-based Identity Theft Assistance Center found that child identity theft is on the rise. Children are often issued Social Security Numbers at birth but do not use this number until their teens, enabling identity thieves to use their information for years of fraudulent activities without risk of discovery until the child begins working and paying taxes. With increasing attention to the problem, possible solutions have been offered by both government and the industry. The Treasury Inspector General has offered recommendations that include better matching of tax returns against Social Security benefits payments, tighter controls over where the refunds are delivered, tighter requirements for employers in filing W-2 and 1099 information, and closer cooperation with law enforcement. The American Institute of CPAs has also made recommendations to the Internal Revenue Service to reduce fraud, beginning with the ability to truncate Social Security Numbers on W-2s and other documents, and curbing the late enactment of tax law changes that force tax documents to be filed later. Ultimately, though, it is about knowing who people are, notes John Sapp. It is nearly impossible for tax preparers to positively identify every client, because neither they nor their electronic filing partners have access to real-time information about the customer. Even the Social Security Administration and the IRS have trouble identifying fraud, because their databases can t quickly match changes in the status of taxpayers. Page 2

3 For today, as we continue to work closely with the IRS and other agencies to identify the problem and how best to address it, the most important thing tax preparers can do is become more aware that identity theft is a growing problem, and learn to identify the warning signs of potential fraud. The Seven Signs That A Return May Be Fraudulent Data derived from the Internal Revenue Service, the Treasury Department, and the Federal Trade Commission indicate there are signs that tax preparers and others may use to recognize a potentially improper return. While not necessarily an indicator of actual fraud, these are the top seven signs that may cause preparers to take additional steps to due diligence: 1. Where the return is filed. Filing a tax return using a child s Social Security Number is growing in prevalence, but the largest target audience for identity theft is still older Americans. It is therefore not surprising that identity theft is especially prevalent in Arizona, which had more victims per capita than any other state in 2010, with about 149 victims for every 100,000 residents. Treasury Inspector General J. Russell George told Congress in 2013 that 76,000 tax returns for tax year (TY) 2010 filed from Arizona using the identities of senior citizens had characteristics of an IRS-confirmed identity theft case. These tax returns resulted in potentially fraudulent tax refunds totaling over $374 million. So, one indicator may be that the returns are filed in southern states with higher populations of seniors. 2. When it is filed. Scammers file a fraudulent return before the real consumer can, so the first of the early filers may be the most suspect. The highest percentage of fraudulent returns is filed before February 28, so that the W-2s cannot be compared to the information filed with the IRS by companies. Unfortunately, this is also a peak period for filing among those who expect a legitimate return; however, it is useful to note that a higher level of fraud occurs earlier, rather than later, in the tax season. 3. Returns from very young filers. IRS analysis of questionable TY 2010 tax returns that appeared to have been filed by an identity thief included 2,274 tax returns filed by children under the age of 14 who received approximately $4 million in refunds based on education credits. The IRS identified 109,618 taxpayers as of May 2, 2012, who received a refundable tax credit totaling more than $159 million for TY 2011, even though the individuals receiving the credit were of an age that was unlikely to be enrolled in a qualifying educational program. Few children under 14 have income to claim on their own, due to child labor laws. Page 3

4 4. Whether the return is filed electronically. Of the 1.5 million returns identified by the Treasury Inspector General as fraudulent, 1.4 million were filed electronically. How useful this may be is questionable, but may result in future additional delays in refunds from electronically filed returns. 5. The refund is posted to a temporary debit card. These debit cards are often used for legitimate payments by low-income families that do not have a bank account; however, they are also used for untraceable payments such as fraud. Be wary of a debit card used for a refund that is not backed by a financial institution, including one issued by an online entity or retail store. 6. The refund is deposited into an account or card held by someone else. The Treasury Inspector General has noted since 2008 that the IRS is not in compliance with directdeposit regulations that require tax refunds to be deposited into an account only in the name of the individual listed on the tax return. Direct deposit provides the ability to receive fraudulent tax refunds quickly, without the difficulty of having to negotiate a tax refund paper check. Of the approximately 1.5 million TY 2010 tax returns identified as fraudulent, 1.2 million (82 percent) involved the use of direct deposit to obtain tax refunds totaling approximately $4.5 billion. One bank account for TY 2010 received 590 direct deposits totaling over $900, Multiple returns to a single address. It is not uncommon to have two or more returns for a single address, particularly when the household supports multiple generations in the same family. But having more than three or four returns listing the same address could be a major red flag for possible fraud. Addressing the Problem In 2013, pilot efforts by the Internal Revenue Service and local law enforcement agencies in selected states resulted in some very public prosecutions of tax preparers who themselves engaged in filing fraudulent returns. Still, the number of those arrested is relatively small compared to the overall size of the professional tax preparation market. Instead, the focus is shifting already to how tax professionals can help stem the tide of identity theft and fraudulent tax returns. When your taxes are prepared by a professional, the client is face to face with the tax preparer, says Drake Software s John Sapp. The preparer is able to assess the client and the returns to match indicators about the client s paperwork. That makes the tax preparation professional the first line of defense that the IRS has against fraud. Still, there are no easy answers, and it will take a unified effort by the government, tax preparers, and their partners to find solutions. Page 4

5 Drake Software is extending additional support to its family of tax preparation professionals to assist in reducing fraud because it ultimately harms the industry. There are some professionals who are unscrupulous, but ultimately, they exit the industry because their efforts harm their own businesses, says Sapp. The emphasis has to be not on the small number of unscrupulous preparers, but on the majority of our customers who are doing the right thing and need assistance in identifying and helping to prevent theft with realistic measures. Education is one way in which we help, he continues. We include information on the responsibilities of tax preparers in our training courses for Circular 230 and our Earned Income Credit due diligence training. And we support the efforts of organizations such as the Internal Revenue Service to combat this crime. Eliminating fraud is not the job of any single organization or company. It is an obligation of our industry and every member of that industry. For the sake of our customers and their clients, this is an issue that we will take an active role in resolving. By Dave McClure Dave McClure is a technology consultant and columnist for some of the nation s leading accounting and business publications. He writes on topics that address workflow, firm management, software analysis, and utilization of technology. DrakeSoftware.com Page 5