IRS Froze Refunds, Study Says
Taxpayers Had No Chance to Respond to Fraud Suspicions

By Albert B. Crenshaw
Washington Post Staff Writer
Wednesday, January 11, 2006

Criminal investigators at the Internal Revenue Service froze more than 120,000 taxpayers' refunds last year on suspicion of fraud without notifying the taxpayers or giving them a chance to respond, the national taxpayer advocate said in a report released yesterday.

The advocate's office, which is part of the IRS, looked at a sample of taxpayers who complained that they never received their refunds. In two-thirds of those cases, there was no evidence of fraud. Many of the returns were filed by low-income workers, including some who claimed the earned-income tax credit, which sometimes entitles filers to a cash payment on top of their refunds.

The median adjusted gross income of taxpayers who were found to have committed "no fraud" was $13,330, and the median income of those who claimed the earned-income tax credit was $11,956. The median refund received was $3,685, which represented significant income for the taxpayers involved, said Taxpayer Advocate Nina E. Olson in her annual report to lawmakers on problem areas in tax administration.

Based on data from fiscal 2004, the Taxpayer Advocate Service estimated that as many as 1.6 million refunds have been frozen by the IRS's Criminal Investigation (CI) division over five years.

"At a minimum, this procedure constitutes an extraordinary violation of fundamental taxpayer rights and fairness. In our view, it may also constitute a violation of due process of law," said Olson of the IRS's freezing of refunds without giving taxpayers notice or the opportunity to defend themselves.

"Even in cases where CI has made 'conclusive' determinations of fraud and characterized the taxpayers as 'criminals,' it has not provided the affected taxpayers with any notice or opportunity to present documentation to rebut CI's suspicion before a final 'determination' is made."

Some refunds are eventually released or the taxpayers subjected to audit. But in many cases, the report said, refunds remain frozen for years.

Taxpayers mystified at the disappearance of their refunds have flooded the Taxpayer Advocate Service with requests for assistance. Last year, the TAS handled more than 28,000 such requests, up from about 16,400 a year earlier, and such complaints now represent the largest number that the advocate service receives about any IRS program.

However, IRS employees, including those of the TAS, generally are forbidden to give a taxpayer any information about a missing refund until six months after the taxpayer contacts the agency, Olson's report said.

The IRS has increased efforts to prevent tax-refund fraud after seeing a growing number of cases, some of them quite large, in recent years. It adopted software to help it identify potential fraud, but Olson said it appears that the software is kicking out more returns than the agency is able to process in a timely fashion.

Yesterday, Richard Speier, acting chief of the Criminal Investigation division, said the agency is facing a sharp increase in refund fraud -- 322 percent over the past six years -- and "we are trying to . . . ensure that honest taxpayers and the tax system itself are not victimized." The 120,000 frozen refunds represent a tiny fraction of about 130 million annual tax returns, he said.

The report stirred concern on Capitol Hill. Senate Finance Committee Chairman Charles E. Grassley (R-Iowa) said that although the number of falsely claimed refunds has increased in recent years, Olson's report "raises serious questions."

"Taxpayers deserve notification of their refund status and a chance to tell their side of the story. It concerns me that the IRS appears to be freezing refunds and leaving taxpayers in the dark about it," Grassley said.

Olson acknowledged that dealing with fraud is an important task and that balancing that goal with protecting taxpayers' rights is not easy.

But the TAS study of taxpayers' complaints found that in 66 percent of the cases, there was no evidence of current-year fraud and that fully 80 percent of these taxpayers ultimately received either full refund or partial refund of the amount they had originally claimed.

The study also found that the median delay in receiving refunds was more than 861/27 months. "Clearly, the amounts at issue and the lengthy delays cause significant hardship for many of these taxpayers," Olson said.

The Criminal Investigation division in a formal reply to Olson -- included in her report -- said it is "keenly aware of the impact our fraud detection activities can have on legitimate taxpayers," but said Olson's conclusions about the program "are drawn from a significantly biased sample and therefore do not accurately represent the effects of the program." The report "significantly overstated the problem," the division added.

However, Speier said, "we are going to be doing much more" to notify taxpayers whose refunds are frozen.

According to the TAS, the Questionable Refund Program, begun in 1977 but recently expanded, uses "data-mining" computer software to pick out refund requests that show indications of possible fraud. Such refund requests are held for a week and then either released or frozen "until the IRS assures itself that no fraud is present."

Refunds frozen for more than a week are supposed to be reviewed by Criminal Investigation division employees and then released or frozen. Frozen returns may be referred to IRS auditors for examination. Such cases are shipped electronically in bulk to auditors twice a year.

But the TAS found that "many, perhaps most" such returns either are not shipped to auditors or are rejected by them. Such refunds remain frozen, and unless the taxpayer contacts the IRS, he or she will never be told what happened.

Indeed, the TAS said, "they may be left in permanent freeze status," adding that it "identified numerous cases that remained [frozen] for over three years."

Olson recommends that taxpayers be notified promptly if refunds are held up, and in cases where fraud is identified, that returns be referred immediately to auditors. She also suggests taxpayers be notified of their right to sue in U.S. district courts or the U.S. Court of Federal Claims to get their refunds.

And her report, which lists the most significant problems with the tax system, finds that the refund freezes are only the second-most serious. No. 1 on Olson's list is the IRS plan to allocate more resources to enforcement and less to taxpayer service while moving "to 'migrate' taxpayers toward electronic services and away from face-to-face contact," which affects the greatest number of taxpayers.

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