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This past weekend’s New York Time’s cover story describing the dramatic rise in identity thieves targeting the United States Treasury is old news to tax practitioners.

In my January 25, 2012 post, I discussed the National Taxpayer Advocate’s lament regarding the IRS’s need for additional funding.  While that post focused on the impact underfunding has on the so-called “tax gap,” I noted the Taxpayer Advocate’s concern with the explosion of tax-related identity theft.

In her 2011 Annual Report to Congress, Taxpayer Advocate Nina Olson identified tax-related identity theft as one of the Most Serious Problem Facing Taxpayers, noting that it was the leading reason taxpayers sought her office’s assistance.  As described by Ms. Olson, “organized and not-so-organized criminals have sought to profit off the tax system by submitting bogus refund claims and often by stealing and utilizing the identity of another taxpayer.  Each year, the IRS’s task in identifying these claims has become more challenging, with the inevitable result that some fraudulent claims are never identified and many legitimate claims are mistakenly held up, imposing significant burden on honest taxpayers.”  Ms. Olson added that identity thieves often file multiple returns claiming refunds using Social numbers (SSNs) belonging to others and, “by the time the legitimate taxpayers get around to filing, their returns may be blocked because their SSNs have previously been used for the same year.”

The IRS processes approximately 100 million tax returns each year, the majority of which are filed in a short window, with many taxpayers relying on a quick turnaround of their refund claims.  According to the Times article, the Treasury Department’s Inspector General for Tax Administration recently testified that while the IRS detected 940,000 bogus returns in 2010, thereby avoiding paying out $6.5 billion to identity thieves, it missed an additional 1.5 million fraudulent returns, which resulted in more than $5.2 billion in fraudulent refunds.

Not surprisingly, Congress appears poised to respond to the identity theft epidemic by increasing the criminal penalties for those caught filing fraudulent returns.  At best, however, the incremental deterrent effect of such enhanced penalties will not eradicate the problem any time soon.  In the meantime, the IRS must continue to throw scarce resources at protecting the fisc from the growing number of fraudulent claims while limiting the financial and emotional costs and lost time suffered by affected taxpayers.

On the positive side, the Times reports that the IRS has already identified 2.6 million fraudulent refund claims this year, many of which are attributable to identity theft.  The improved detection has been attributed to an increase in personnel focusing on identity theft, distributing PINs to prior victims, and technological advances.  Unfortunately, the IRS’s filters designed to uncover identity theft are both under-inclusive (resulting in fraudulent claims being paid) and over-inclusive (resulting in delays in paying legitimate refund claims, often to taxpayers who depend on their refunds for necessities).  Given that the IRS’s budget was cut by approximately $300 million versus last year, devoting resources to combating identity theft necessarily detracts from other enforcement areas.  Perhaps rather than relying on the questionable deterrent effect of greater criminal sanctions, Congress should consider increasing the IRS’s budget, thereby giving it the resources needed to combat identity thieves without detracting from other enforcement priorities.