Failure of tax fraud detection system worse than estimated

The Internal Revenue Service paid out more than $318 million in improper tax refunds this year, millions more than the tax agency had previously estimated, according to an audit report.

The IRS tried to field a new Web-based version of its decade-old digital tool for detecting fraudulent tax refund claims by January 2006, without keeping the original version in place. But when contractor Computer Sciences Corp. failed for the second time in two years to deliver the updated system, the IRS was left without an automatic electronic tool for catching people who claim improper refunds.

The failure came to public light during a Senate Finance Committee hearing on July 13. At the time, the IRS said that other detection measures captured only 34 percent of fraudulent claims for refunds compared to same period in 2005, resulting in a $200 million to $300 million government loss.

A report released Friday by the Treasury Department's inspector general for tax administration pegs the amount of improper refunds at $318.3 million. In 2005, the system detected $412 million worth of false refunds.

The report faults IRS management for treating the update as a steady state project rather than a development effort requiring closer scrutiny. The tax agency paid $20.5 million in development costs from 2002 until April 19 for the system, primarily to Computer Sciences Corp. The company did not meet its first deadline in 2005, but the IRS believed the contractor's assurances that the system would be ready in January 2006. As a result, the agency did not develop a contingency plan in case the new system did not function.

CSC continues to be the project's lead contractor. A company spokesman referred calls to the IRS.

Currently the IRS is working with CSC to restore its old system, officially called the Electronic Fraud Detection System, by January 2007. No determination has been made on whether to proceed with the Web update, according to the IRS.

The tax agency also is renegotiating its cost-reimbursement contract with the company. The IRS says it is legally obligated to pay all CSC invoices, including $459,718 that CSC billed in 2005 for additional work in restoring the old system when it failed to deliver the Web-based version for the first time. The tax agency says it hopes to introduce some performance measures into the contract, and says that any possible future contracts for a Web-based version would be performance-based.

The IRS has become a champion of performance-based contracting, especially in its historically troubled tax systems modernization effort. Although CSC is also the prime contractor for that ongoing $10 billion project, the two projects have been managed separately. The original EFDS contract, in fact, was awarded to DynCorp, which CSC acquired in 2003. The turnover rate among contractor employees was high as a result, the audit report noted. Numerous changes within the executive ranks at the IRS also contributed to the project's instability, the auditors said.

The audit report is the first of three that will examine potential tax fraud committed as a result of the failed system and cybersecurity issues. Auditors initiated the report following an Aug. 3 letter sent by House Ways and Means Committee Chairman Rep. Bill Thomas, R-Calif., to Treasury Secretary Henry Paulson. In the letter, Thomas chastised IRS officials for neglecting "to dedicate sufficient resources, expertise and oversight" to the project.