New tools for combating income tax refund fraud

Billions of dollars in fraudulent refunds are being paid out by government every tax year. This not only puts a strain on government’s ability to provide services, but it also erodes public trust in the country’s tax system. The increasing reliance on e-filing for tax returns increases the efficiency of tax operations and taxpayer convenience. But it also strips away crucial layers of protection between identity thieves and unwarranted tax refunds. Stealing identities and filing for tax refunds has become one of the fastest growing non-violent criminal activities in the country.

One of the weaknesses in the tax filing system comes from the need to quickly process returns and provide refunds. Most tax returns are processed and refunds released within a few days or weeks. This quick turnaround doesn’t allow the government time to fully authenticate all the elements submitted on returns, and fraudsters know how to exploit this vulnerability. Once released, these monies are untraceable.

According to the Treasury Inspector General for Tax Administration, the number of identified fraudulent tax returns has increased by 40 percent from 2011 to 2012, an increase of over $4 billion dollars. TIGTA also found that the ongoing challenge of authenticating taxpayers is contributing to the growth in tax fraud.

Even though some revenue agencies have adopted verification techniques, such as requiring the use of a personal identification number or information from a previous year’s return, these controls can be circumvented and are inadequate to prevent identity-based income tax fraud. Income tax refund fraud is not only committed by individual perpetrators but also by large organizations, with multiple players spanning several years and thousands of filings. Losses can range into the millions.    

Risk-based versus traditional rules-based tax return analysis

The most reliable systems for authentication and fraud detection are those that incorporate multiple data assets spanning information categories – such as public records and demographic data – as well as credit history attributes and historical credit application and inquiry records. Scores that incorporate a breadth of varied data categories outperform models built on singular categories.

In addition to verifying a tax filer’s identity, tax agencies must also authenticate suspect returns. In conjunction with a risk-based identity proofing process, tax refund fraud detection can be further strengthened with a knowledge-based authentication process usually referred to as “out of wallet” questions. Those are questions whose answers could not be gleaned from a stolen wallet or a quick Internet search and might include questions like “What was the color of your first car?” 

As part of the knowledge-based authentication process, the tax filer associated with the suspect return is directed to a government website to answer a list of questions correctly in order to receive the refund. New identity authentication tools use challenge-response question technology to dynamically formulate questions only the true taxpayer would know.

With an adjustable question configuration and the ability to change strategies for each inquiry, tax agencies can verify ID, prevent fraud and meet detection objectives. This process also helps eliminate “false positives” from the suspect pool of returns. Unlike systems that rely solely on public records data sets, using both publically available information and credit-related data increases the difficulty of the questions, thus assuring only legitimate tax payers will pass.

Beyond individual authentication  

The majority of fraudsters who steal identities to perpetrate tax fraud often use the same credentials to commit other financial fraud. As such, risk-based authentication systems not only verify the identity information reported on the tax return, but they can also determine if those same credentials are being used to commit other credit or financial fraud. This further strengthens the government’s ability to identify and prevent even greater numbers of fraudulent refunds from being paid.

Furthermore, individuals committing fraud will often use the same computer to submit tax returns, submit credit applications, open accounts, etc. Agencies can use new device-proofing capabilities to authenticate the computer being used, which will provide additional assurance that it has not been involved in any fraudulent activity.

The future of combating income tax refund fraud

The use of a risk-based identity authentication process coupled with business rules-based analysis and knowledge-based authentication tools is critical to identifying fraudulent tax returns.

In addition, the ability to perform non-traditional checks that go beyond the authentication of the individual to consider the methods and devices used to perpetrate tax refund fraud further strengthens the tax refund fraud detection process. Including multiple non-traditional checks within a risk-based authentication process also closes additional loopholes exploited by the tax fraudster, while decreasing the number of false positives.

Agencies can combat income tax refund fraud with authentication tools that fit seamlessly into any existing tax return evaluation process, adding little to no additional time to the current process. As a result, government can assure a continued quick turnaround for refunds while providing increased assurance that the refunds are being provided only to the legitimate taxpayer.