Audit finds IRS sent $1.6B in bogus tax refunds

— -- The IRS issued an estimated $1.6 billion in potentially fraudulent tax refunds during the 2006 and 2007 filing seasons, far more than the agency initially acknowledged, a government audit reported Thursday.

The questionable payments resulted from breakdowns that left the IRS without its chief computer defense against fraud in 2006, plus limited investigative resources, the audit by the Treasury Inspector General for Tax Administration reported.

"This problem is becoming unmanageable," the audit said.

Unless the IRS cracks down, it could issue more fraudulent refunds, burdening "honest taxpayers whose tax dollars are being used to support this criminal activity," the audit warned.

Auditors recommended a long-term effort that balances growth in tax refund fraud and other investigative priorities with IRS staffing resources.

Calling the report's tone "misleading," Eileen Mayer, head of the IRS Criminal Investigation Division, wrote that the agency examined and stopped more than $2 billion in fraudulent refunds during the two years. Investigating even more tax returns "would come at the expense of other revenue generating activities," Mayer wrote.

Many suspicious returns involve small sums and would produce a "relatively low dollar return" if the agency pursued deep investigations of each one, said IRS spokesman Terry Lemons, adding that the result would be a "loss for the nation's taxpayers."

In all, auditors estimated the IRS issued $894 million in potentially fraudulent tax refunds during processing year 2006, the year its Electronic Fraud Detection System, a vital safeguard, was shut down pending the start of an upgraded computer.

That's roughly four times more than the IRS' estimate in late 2006, when USA TODAY reported the agency had been warned about potentially "catastrophic" problems with the new system, which, due to problems, was unavailable for the entire year.

The IRS re-started the old computer system in 2007, and initially flagged tax returns totaling more than $1.2 billion, the audit found. But, faced with staffing and other limitations, the IRS used a dollar threshold and other screening to exclude more than 500,000 such returns from additional checks, the audit found.

Further investigation would have identified $742 million in potentially fraudulent refunds, auditors said.

"The IRS' attitude that fraudulent refunds below a certain dollar amount are not worth pursuing is troubling," said Sen. Charles Grassley, R-Iowa, the ranking minority member of the Senate Finance Committee.

Sen. Max Baucus, D-Mont., the panel chairman, "expects the IRS to do everything it can," to stop refund fraud, said spokesman Daniel Virkstis.