Instances of suspected fraud include 700 fraudulent returns filed from an address in Bulgaria.
In total, the agency failed to prevent 1.1 million potentially fraudulent tax returns for 2011 from being processed, according to an audit by the Treasury Inspector General for Tax Administration. That includes 5,500 fraudulent returns filed by a single tax preparer -- for a refund of nearly $27 million -- and a payout of $490,000 to an address in Bulgaria that was listed on more than 700 tax returns.
But the report said the IRS is improving. The $3.6 billion in fraudulent refund claims is down from the $5.2 billion the agency paid out the year before.
The IRS said it has caught 12.6 million suspicious returns, amounting to $40 billion in refunds over the last two years. Earlier this year, it arrested hundreds of identity theft suspects in a series of raids.
Despite the impact of "significant budget cuts," the IRS said it has a "comprehensive and aggressive identity theft strategy that focuses on preventing refund fraud, investigating these crimes and assisting taxpayers victimized by it."
Many fraudulent refund claims are filed using a Social Security number or personal Taxpayer Identification Number tied to a deceased person or dormant account.
Victims of identity theft could wait months for their refunds. The IRS, however, says it has a team of 3,000 employees working on identity theft issues and says all cases are resolved within 120 days.
The IRS screens tax returns for a variety of clues to help spot fraudulent filings. For example, it flags multiple applications that are filed listing the same address or bank account.
But it still has not found ways to block some avenues of fraud, the report found.
The inspector general report recommended the agency deactivate the Taxpayer Identification Numbers of those who are deceased or are no longer required to pay taxes. It also urged the agency to develop additional identity theft filters.
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