IRS relies on data from SSA to determine the accuracy of SSNs and names recorded on tax documents submitted by individual taxpayers. IRS uses this information to establish the identity of each taxpayer and to ensure that each transaction is posted to the correct account on the IMF. When processing paper tax returns with missing or incorrect SSNs, IRS service centers first try to make corrections by researching IRS files or other documents (for example, Form W-2 wage and tax statements) that accompany a tax return. Returns that can be corrected, along with those that match SSA records, are posted to the “valid” segment of the IMF. Returns that cannot be corrected are posted to the “invalid” segment of the IMF, using either the incorrect SSN on the tax return or a temporary number assigned by IRS. As of January 1, 1995, 4.3 million accounts were posted on the invalid segment of the IMF, and 153.3 million accounts were posted on the valid segment. IRS created the invalid segment of the IMF to store the accounts of taxpayers who had changed their names, because of marriage or divorce for example, and had not yet informed SSA of the name change. However, IRS has posted returns to the invalid segment of the IMF to cover other situations, such as when a taxpayer (1) uses the SSN of another individual, (2) uses an SSN that is not issued by SSA, or (3) is assigned a temporary number. IRS tries to resolve invalid accounts and move them to the valid segment of the IMF by corresponding with taxpayers to verify their identities, periodically matching invalid accounts against updated SSA records, and reviewing tax documents subsequently filed by taxpayers. Our objectives were to (1) measure the growth of accounts on the invalid segment of the IMF, (2) assess IRS’ procedures to verify the identities of tax return filers whose returns were posted to the IMF invalid segment, and (3) identify any effects the procedures may have on IRS’ TSM goals and its income-matching program. To measure the growth of accounts on the IMF invalid segment, we reviewed IRS management and internal audit reports about the growth and composition of accounts on the IMF. We also interviewed officials at IRS’ National Office on the makeup of the IMF invalid segment and the reasons for the growth in these accounts. To assess IRS’ procedures for verifying taxpayer identities, we reviewed (1) IRS procedures (1995 and pre-1995) for processing returns with missing or incorrect SSNs, (2) the notice IRS uses to verify taxpayer identities, and (3) other pertinent documents. We also interviewed officials at IRS’ National Office and at IRS’ Austin, TX; Cincinnati, OH; Fresno, CA; Ogden, UT; and Philadelphia, PA service centers on the process for posting returns to the IMF invalid segment and changes implemented in 1995 to verify taxpayer identities. We chose Cincinnati because of its proximity to the audit team conducting the work. We chose the other 4 centers because, out of IRS’ 10 service centers, they processed and posted more than 60 percent of the accounts on the IMF invalid segment in 1994. To identify the potential effects of IRS’ posting procedures, we did the following: We selected a random sample of 400 tax year 1993 returns from accounts that were posted to the IMF invalid segment before IRS implemented its new procedures. Our sample results are not projectable to the universe of accounts on the IMF invalid segment. Our objective was to determine whether the filers accurately reported their wages and withheld taxes. The sample consisted of returns with refunds of more than $1,000 that were posted to the IMF invalid segment by the Austin, Fresno, Ogden, and Philadelphia service centers between January 1, 1994, and June 30, 1994. The 400 returns included 50 from each center that had been posted with IRS temporary numbers and 50 from each center that had been posted with incorrect SSNs. The Cincinnati service center’s Criminal Investigation Branch contacted employers of the 400 filers to verify employment and wage information. The branch obtained responses on 357 returns. For the 43 returns with no response, we verified the wage information using information return transcripts. We analyzed 100 of the 400 returns to determine why they posted to the IMF invalid segment and to profile some of the filers’ characteristics. The 100 returns included 25 returns (12 that had been posted with temporary numbers and 13 that had been posted with incorrect numbers) randomly selected from each of the 4 service centers. Among the 100 returns were 58 that were posted to accounts containing a computer code that automatically released refunds. We also interviewed cognizant officials from IRS’ National Office and the previously mentioned service centers regarding any effects that returns with missing or incorrect SSNs may have on IRS’ income-matching programs and its TSM plans. We reviewed IRS reports on TSM plans and analyzed documents relating to IRS’ processing costs. We did our audit work from December 1993 through May 1995 in accordance with generally accepted government auditing standards. We requested comments on a draft of this report from you or your designee. On June 21, 1995, the Assistant Commissioner for Taxpayer Services, the Staff Chief for the National Director of Submission Processing, and other IRS staff, including representatives from the Office of Chief Counsel, provided us with oral comments. Their comments are summarized and evaluated on pages 13 and 14 incorporated in this report where appropriate. From 1986 through 1994, according to IRS data, the average annual growth rate of accounts on the invalid segment of the IMF was more than twice the growth rate of accounts on the valid segment—5 percent versus 2 percent, respectively. Figure 1 shows year-to-year growth rates since 1986. During this period, the number of accounts on the invalid segment of the IMF grew from 2.8 million on January 1, 1986, to 4.3 million on January 1, 1995, while the number of valid accounts grew from 130.2 million to 153.3 million. From 1990 through 1994, the size of the IMF invalid segment grew by about 821,000 accounts. Most of that growth (52 percent) resulted from IRS’ increased use of temporary numbers to process and post returns. Accounts with incorrect numbers made up the other 48 percent. The IRS National Office official responsible for monitoring accounts on the master file explained that the increase in accounts with temporary numbers stemmed from IRS’ decision in 1990 to not send verification notices to taxpayers whose returns were processed with temporary numbers. Many of these filers, he said, cannot obtain SSNs because they are not legal residents of the United States but are entitled to refunds of withheld taxes or earned income credits. He said that most of these taxpayers were using temporary numbers verified in previous years and that requiring reverification each year would have unduly increased taxpayer burden. He speculated that when IRS’ decision not to require verification became more widely known, more taxpayers who could not obtain SSNs began filing tax returns. Another factor affecting the number of accounts on the invalid segment of the master file was IRS’ willingness to release refunds and allow the accounts to remain on the invalid segment, even though taxpayers’ responses to the verification notice did not resolve the invalid condition. Before 1995, IRS accepted a taxpayer’s response that a return was “correct as filed,” and taxpayers were not required to provide documentation (marriage certificate, birth certificate, etc.) to verify their identities. In 1994, IRS paid out $1.4 billion in refunds on returns posted to the IMF invalid segment. As part of its efforts to combat refund fraud, IRS revised its procedures in January 1995 to require that taxpayers provide documentation to verify their identities. In announcing that IRS would delay refund claims for individuals lacking proper identification numbers, you stated that, consistent with the way financial institutions manage withdrawals of funds, IRS should not permit refunds from the federal treasury without a valid taxpayer identification number. Under the revised procedures, when a taxpayer’s return with a refund request is posted to the IMF invalid segment for the first time, IRS is to freeze the refund and correspond with the taxpayer in an attempt to verify the taxpayer’s identity. Filers with missing or incorrect SSNs who request a refund are to be required to provide a reasonable explanation for the discrepancy and proof of their identity (such as a marriage certificate, birth certificate, earnings statement, or passport) before the refund will be released. The requirement applies to filers whose returns are posted with temporary numbers as well as filers whose returns are posted with incorrect numbers. Once a taxpayer responds satisfactorily to IRS’ verification notice, IRS is to release the refund. Previously, IRS automatically issued refunds to filers with temporary numbers and did not require proof of identity from filers with incorrect numbers before releasing their refunds. IRS uses the CP54B notice to verify taxpayers’ identities before issuing a refund. The current version of the CP54B notice does not reflect IRS’ revised procedures. It does not clearly convey that persons who file with missing or incorrect numbers, including filers who were issued temporary numbers, are required to provide documentation verifying their identities. (Appendix I contains a copy of the CP54B notice annotated to show misleading or potentially confusing sections.) A revised version of the CP54B notice has been developed that reflects IRS’ revised procedures but, as of July 1995, had not been finalized. Until the revised notice is available, IRS National Office officials told us that they plan to use the current version of the notice, followed by additional correspondence if the taxpayer does not respond in accordance with the revised procedures. This practice will increase IRS’ processing costs, create additional taxpayer burden, and delay the issuance of some refunds. IRS expects to send out about 616,000 CP54B notices in 1995. IRS officials said that review and approval of the revised notice was taking longer than expected. As of June 21, 1995, the revision had been approved by the National Office Notice Clarity Unit and was being reviewed by the National Automation Advisory Group. That group is to assign a priority for making the computer programming changes necessary to finalize the notice.