The Solution to Tax ID Theft Is an Unpopular One: Slower Refunds

— -- The Government Accountability Office estimates that $5.8 billion was lost to identity thieves filing fraudulent tax returns in 2013 and that there may have been as much as $24.2 billion in thwarted attempts. Tax refund fraud losses are estimated to reach $21 billion by 2016, according to the Treasury Inspector General Tax Administration.

While the massive loss chronicled in the GAO report was big news (for a nanosecond anyway) the GAO’s recommendations for stemming the rising tide of tax-related fraud did not get a lot of attention. As we wend our way through a tax-filing season that will doubtless make headlines for record-breaking refund fraud, let's take a moment to revisit those recommendations.

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The only way to stop tax refund fraud is to change the way the tax filing and refund system works, and this may be a painful process for employers and taxpayers alike.

Why Is So Much Fraud Happening?

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. It’s a lot to keep track of, and identity thieves are making serious bank on that fact. According to the GAO report, by March 1, 2012 -- a month and a half before the filing deadline -- the IRS had already paid out around half of that year’s tax refunds. And there’s the problem.

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When the fiscal year ends and you begin the less than pleasant process of 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. So, half the refunds in 2012 were sent out on blind faith. (You read that right -- 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 crazy to you? Well, it is. 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, you ask, is it done this way? Now in your heart you know the answer. It’s because that’s the way they do it! But facts are stubborn things, and tax refund fraud is only going to get worse if the process doesn’t adapt to current circumstances.

That said, a simple change applied to the flow of information is not going to solve the problem. 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 (that is, typically April 15) to issue a refund. It is by dint of this system that most taxpayers can expect a refund within 21 days after filing their tax return.

The refund process as it stands now makes sense only as the quaint relic of simpler times. It’s the epitome of an analog approach getting trounced by our digital reality. Not to put too fine a point on it, I believe look-back compliance should go the way of the horse and buggy.

No Pain, No GainThere 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 Jan. 31. This could be facilitated by requiring all employers to e-file W-2s, instead of the current arrangement, which states that only companies with more than 250 employees have to e-file. Paper filing costs more, takes longer and thus exacerbates the problem. The time for mandatory e-filing of W-2s was probably a decade ago, but better late than never.

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The other solution, unfortunately, may involve changing the rules about refunds—or possibly even pushing tax day to later in the calendar. The GAO also brought up the possibility of delaying refunds, which is probably the most controversial recommendation from the viewpoint of taxpayers. After all, many Americans use their refunds to pay down debt, buy a new car or just help them pay their bills on time. A longer wait for a refund would clearly be unpopular, but throwing billions of dollars to identity thieves every year and doing little to stop it is untenable.

Refunds must be verified in order to keep tax refunds from landing in the wrong hands. The way to make this happen is by ending look-back compliance, or a drastic systems improvement.

I am not discounting the trouble the above suggestions could cause for people. Loans to bridge the time people spend waiting for refund checks wastes money that would be better spent on the necessities of life, but at the end of the day, we might have to make changes in the way wages are reported and refunds are issued to successfully contain the tax fraud epidemic, and that might require some less-than-wonderful adjustment time for all of us.

Any opinions expressed in this column are solely those of the author.

Adam Levin is chairman and co-founder of Credit.com and Identity Theft 911. His experience as former director of the New Jersey Division of Consumer Affairs gives him unique insight into consumer privacy, legislation and financial advocacy. He is a nationally recognized expert on identity theft and credit.