Fighting the Rising Tide of Tax Fraud With Analytics: Q&A With Andrew Schaufele of Maryland's Bureau of Revenue Estimates

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

Interview by Kathleen Caggiano

Andrew Schaufele is in his third year as Director of the Bureau of Revenue Estimates after serving for several years as the Assistant Director. Before joining the Comptroller's Office, Andy spent seven years in various private sector management positions, working in both consumer and commercial oriented product lines. He holds a bachelor's degree from Towson University, where he studied management and economics, and a Master of Business Administration from the joint University of Baltimore and Towson University program.

Bloomberg BNA:

Why has tax fraud become such a hot topic recently?

Schaufele:

Several factors have coalesced in recent years. First, the public has become keenly aware of their “digital footprint” and the prevalence of identity theft. It is hard to find a single individual that has not had a personal experience with some sort of identity theft, most notably credit card theft or fraudulent use of identifying information such as a Social Security number.

Second, the criminals have evolved in their use of technology. I believe there are three types of criminals perpetrating tax fraud crimes: (1) the small-time criminal that has a few stolen Social Security numbers and files a relatively small number of fraudulent returns; (2) the tax preparer that increases the level of refund claim by either taking advantage of a legitimate taxpayer or by convincing a taxpayer to bend the rules; and (3) the organized criminal and criminal organizations that dedicate significant resources to fraud. Web-based software and electronic filing has made preparation of tax returns simple and low cost for all three types; however, perhaps most significantly, the organized criminal has advanced up the learning curve. They now have better datasets (stolen information) and the technological capability to automate return filing at federal and state levels of government. The marginal cost per fraudulent return is likely minimal.

Third, the addition of computer chip technology into the credit card and retail industries dealt a major blow to credit card fraudsters. While the new technology will certainly not eradicate credit card fraud—the fraudsters always adapt—it has, at a minimum, raised the cost of business for fraudsters. Such measures incentivize them to dedicate resources towards other markets. We realized that a higher incident of organized attacks was imminent when we saw that the high profile hacks had shifted from retailers to organizations with broad swaths of personal information including Social Security names, addresses, birth dates, etc. It was no longer Target and Home Depot—it was Carefirst, Anthem, the federal Office of Personnel Management (OPM), and myriad other homes of personal information. Then, of course, came the IRS breach where full transcripts of tax returns were stolen. After tallying up the publicly reported breaches from 2014 and 2015 that were thought to have been focused on personal information and adjusting for redundancy (e.g., the same person in the Carefirst breach was in the OPM breach), we estimated that information for 75 million individuals had been stolen over essentially a one-year period. That information is then sold on the “dark web.”

Bloomberg BNA:

What type of taxpayers are most impacted by tax fraud?

Schaufele:

All taxpayers are impacted one way or another. The indirect impact is clear: less resources for government leads to either reduced services or increased taxes. More directly, as in the example above where taxpayers are taken advantage of by preparers, these taxpayers tended to be of lower-income backgrounds, generally those most in need of speedy refunds and the benefits of any earned income tax credits to which they might be entitled. With the results from our fraud model this year and subsequent investigation, we have suspended the processing of returns from 66 different tax preparation locations. The investigations of these locations and individuals are pending. Relatedly, we recently announced the indictment of a Liberty Tax franchisee and eight of her employees. Their scam was simple: pay $50 to homeless individuals and drug addicts for their personal information, then they would file fraudulent returns with that information claiming refunds well in excess of cost. All of these events are unbearable, but this one is truly disgusting.

Of course, those that have their identities stolen are impacted as well. If a taxpayer has had a fraudulent return filed with their information, each of their subsequent legitimate filings takes more time to process and they must submit an Identity Theft Affidavit to the IRS.

There is also an impact to those that are perhaps not directly impacted. For example, increased vigilance impacts processing. This is another area where our modeling has made significant strides. Several years ago, we had a litany of stand-alone metrics for identifying potentially fraudulent refunds. Those metrics led us to review approximately 110,000 tax returns per year. We were identifying fraud in only 5 percent to 10 percent of those, meaning that we had to slow refunds for a substantial number of legitimate filers. The fraud model is capturing more money with the required review of half the original number of returns and we are “hitting” on approximately 60 percent of those we review. Our comptroller is passionate about customer service and we found this to be an effective tool in support of that goal.

Bloomberg BNA:

Is tax fraud a federal issue, state issue or both?

Schaufele:

It is an issue for both. Because tax rates are higher at the federal level, the rewards for criminals are also larger. However, the two are closely related. Most electronic filing tools permit the filing of both the federal and state return simultaneously. Therefore, each fraudulent return is likely to have been filed in both arenas. The Maryland Comptroller is party to a memorandum of understanding (MOU) with the IRS and many other states where we all share identified fraud cases.

Additionally, for the organized criminal, there is very little cost to applying their stolen information to the federal return and a return for every single state. Technology permits the automated manufacturing of tax returns such that a program can take information from the criminal's database and apply it to every tax return. Once the criminal has invested in the set up, there is little incentive not to cast as wide a net as possible.

Bloomberg BNA:

How does Maryland's data-driven analytics system for detecting tax fraud work exactly?

Schaufele:

In order to protect our efforts, we are not willing to release particulars, but can speak in generalities. We use available information to create several statistical applications which work together to provide a probability of fraud for every return processed. The output is similar to the call that most of us have received from our credit card companies; they use historical records and identify anomalies in order to determine whether certain transactions fit a customer's profile. Additionally, we use output from the model in a more holistic fashion (looking at tax returns together, not just one by one), seeking to identify broader conspiracies and organized efforts.

Returns scored above a certain threshold are suspended for review. The review process is performed by our Questionable Returns Detection Team (QRDT). This group is a highly effective unit that is passionate about not allowing fraud dollars out the door. They use available information to determine whether the return is indeed fraudulent.

Bloomberg BNA:

What results have been produced using this system?

Schaufele:

Prior to last year, where we made substantial improvements to our analytical model, we were typically identifying between 5,000 and 10,000 fraudulent claims for approximately $10 million to $20 million. For tax year 2014 (processed during calendar year 2015), we identified 19,150 returns for $38.6 million. The return on our investment is staggering. This year, while the season is far from over, we are well on our way to eclipsing those amounts, perhaps significantly. It is difficult to determine the exact value at this point as we maintain an inventory to review and many for which we've requested additional information. Again, equally importantly, is that we are identifying these higher amounts while reviewing half of the volume. This has freed up resources to do more in-depth research of fraud and to provide customer service in other areas.

Bloomberg BNA:

What is the most surprising information gleaned from the system?

Schaufele:

For me, the most surprising information has been the number of professional preparers that are allegedly engaged in defrauding the state and individuals. It is always difficult to comprehend the limits that some people will go to in order to better themselves at the expense of others. There are truly some morally defunct individuals out there. The majority of our taxpayers and preparers are honest—these few create problems for all. In response to this, the comptroller has introduced legislation in this year's legislative session that seeks to broaden the investigative powers of the office to go after these types of individuals and to shut them down while we investigate.

Bloomberg BNA:

How does this system affect taxpayers on the state level?

Schaufele:

The system affects taxpayers by protecting their identities from being used for tax fraud in Maryland. In many cases, we can get that information to other taxing agencies, through the MOU, and preserve their identities there as well. The collaboration among agencies is key to that effort. Additionally, as mentioned above, we provide far better customer service by more accurately identifying fraud.

There are also the indirect impacts of better use of government funds mentioned above as well.

Bloomberg BNA:

Who benefits the most from this data-driven analytics system?

Schaufele:

It seems almost a false choice to identify a principal beneficiary; all of the identified benefits have relative amounts of importance to those that are impacted. Individuals are likely to be thrilled that we've disallowed and identified a fraudulent attempt with their information, while government budgeters must be thrilled that we're preserving significant amounts of revenue. The benefits are very broad-based.

Bloomberg BNA:

Are there any downsides to the system?

Schaufele:

I don't think there are downsides, but there are challenges. This is an ongoing battle with criminals that requires agility and continued resource commitments. The criminals have advanced their tactics each year. They are improving their data to better mimic actual tax returns. We must continue to evolve and stay a step ahead.

Additionally, maintaining our capabilities as they are now is important. The state's personnel system was designed 30 years ago, long before information technology became what it is today. The system as it stands now is generally incompatible with today's technological requirements, meaning the job classifications and pay scale make employing and then retaining employees difficult. The employees that are concentrated in analytics are home-grown, meaning we have developed and cultivated the skill set internally. Moreover, in Maryland, we compete for employees with some of the most advanced analytical institutions in the world, including the federal government, NSA, defense departments, and all of the private sector employers providing those services.

Bloomberg BNA:

Have other states been using similar measures to prevent tax fraud? If so, have they been successful?

Schaufele:

Many states have taken similar measures. I am not sure whether they would want me to single them out, so I won't. I have heard some success stories, but I believe that we are in a leadership position on this front.

Bloomberg BNA:

Is there anything in particular that taxpayers should do to prevent tax fraud?

Schaufele:

Protecting your personal information is critical but almost impossible unless you want to live off the grid. That said, being vigilant about which websites have your information and only providing Social Security numbers when it is absolutely necessary (it is not necessary under many applications where it is requested). The Maryland Comptroller has provided guidance for taxpayers that can be found here and here.

Taxpayers should carefully review their returns that are prepared by others for suspicious activity, such as whether a tax preparer deducts fees from their refund, does not sign their tax return, or fails to include their preparer taxpayer identification number “P-TIN” on the return. In the event that a taxpayer suspects fraud, they are asked to immediately report the issue to the comptroller's Office by calling 1-800-MD-TAXES (1-800-638-2937) or 410-260-7980 in Central Maryland or by e-mailing TAXHELP@comp.state.md.us.

Additionally, it helps if a taxpayer files their returns return as early as possible. If a taxpayer's return has been filed and accepted, we automatically disallow any subsequent attempts with those Social Security numbers.

Bloomberg BNA:

What do you see happening in the future with regards to tax fraud on the state level?

Schaufele:

The future battle is going to be dealing with tax information that looks almost identical to what the taxpayer would normally file. The criminals are building databases of accurate information, including W-2s. Employer breaches, specifically for W-2 records, are becoming more widespread. This creates complexities from a modeling standpoint as well as an investigative standpoint. That said, we're anticipating this advancement and working towards solutions. We might even already have a few tricks up our sleeves.