Taxed to the Max

By Larry Barrett  |  Posted 2003-04-09

In 1998, Congress gave the Internal Revenue Service 10 years to overhaul its information systems and reduce the $4.2 billion the government spends each year processing income tax returns.

The IRS is aiming to get 80% of federal tax returns filed electronically by 2007 to comply with the IRS Restructuring and Reform Act. Not only does e-filing offer the promise of savings for the IRS, it stands to reduce errors in the processing of tax returns. Americans have been able to submit their tax returns electronically since 1986, but only 35.6% of the 131.7 million returns were processed that way in 2002.

It's another story for business.

Of 1.2 million Form 1120s—U.S. corporation income tax returns—filed in 2001, none were filed electronically. The IRS plans to offer that feature in the 2004, but cannot do so now because IRS information systems are not set up to accept tax return forms used by large companies.

The IRS has been able to accept Form 1065 returns used by partnerships. But of 2.1 million Form 1065s filed in 2001, only 1% were submitted electronically. The goal is to get 12% by 2004. (The IRS can accept other business records electronically such as employment taxes, estates and trusts.)

To reach its targets, IRS officials and tax preparation professionals say the IRS must overcome significant technical shortcomings-such as its current inability to receive Word, Excel and Adobe PDF attachments accompanying electronic returns-if this goal is ever to be realized.

Other stumbling blocks persist. Some taxpayers and tax preparers distrust e-filing, fearful it will increase the chance of an audit. (The IRS disputes that notion.) While the lure of getting a refund two to three weeks faster than those filing a paper return is an incentive for some, it's not the case for those who owe the government money on April 15.

For its part, the IRS is working to replace the antiquated proprietary software used to receive e-filings. That's so it can handle an estimated 105 million electronic returns in 2007 from both individuals and businesses, says Terry Lutes, director of the IRS Electronic Tax Administration.

The new system, he says, will use eXtensible Markup Language (XML), enabling taxpayers to file attachments and other documentation. The IRS concluded that XML would be the ideal programming language for the system because of its ability to exchange data between different software systems while also separating the data from the presentation of the data. In a best-case scenario, Lutes concedes this system won't be in place until sometime in 2004.

"Getting to that goal is going to be tough," says Thala Rolnick, a member of the Electronic Tax Administration Advisory Committee, an organization of tax professionals who provide Congress with an annual report that tracks the IRS' progress on e-filing systems and services. "The IRS has not wanted to say they won't make it, but it's not looking good."

Why the push for e-filing? The IRS says processing a paper income tax return costs about $2.40 in direct labor compared with $1.40 for an electronic return. All of those gains are realized on the front end where the data is manually entered into IRS computers.

But it's difficult to determine exactly how much the IRS saves from an increase in e-filings. A February 2001 study by the General Accounting Office (GAO) found that between 1997 and 2000, actual IRS expenditures for processing both paper and electronic returns actually climbed from $795 million in 1997 to $924 million in 2000, even though the percentage of e-filings went from 15.8% to 27.6% in this same period. The GAO says savings from e-filing were offset by an increase in tax returns filed both by paper and electronically.

In pointing to places where the IRS stands to trim costs, Lutes highlights a plan to shutter a processing center in Brookhaven, N.Y., by this time next year, saving more than $50 million. For now, that's the only tangible gain the IRS has seen from the proliferation of e-filing, but Lutes says other sites may be closed in the future.

What can corporate technology project managers learn from the IRS? Waiting 16 years to update systems leaves an organization unable to handle the most basic functions such as accepting attached documents. Establishing an ambitious business goal without the technology in place only results in frustration.-filing works">

How e-filing works

Once an electronic return is filed, it's transmitted through a secure network connection to the IRS processing computers in Austin, Texas, or Memphis, Tenn. At that point, the document is transferred into a proprietary format developed by the IRS. (This format eventually will be replaced by the one running on an XML-based system.) The returns are then sent to the IRS' Electronic Management System, which uses equipment from NCR Corp. This equipment is scheduled to be changed over to Sun Microsystems workstations.

E-filings are then processed through Unisys error-detecting software. If errors are found, the return is automatically kicked back to the site for review. Typical errors include incorrect Social Security numbers, erroneous addresses and misspelled names. After the returns are reviewed for errors, they are sent to mainframe computers in the IRS' Masterfile System in Martinsburg, W.Va. From there, the returns eligible for refunds are sent in large batches to Treasury Department computers in Washington, D.C. While it's true that e-filing does "speed up" the processing of tax returns, those gains in efficiency essentially come from reducing the amount of time IRS employees spend entering selected data from paper returns as they arrive at the various processing centers.

It typically takes an IRS processor a couple of minutes per return to enter this data into the IRS system. E-filings eliminate this step because the data is plugged into the system when it's transmitted by a tax preparer.

Another potential benefit: The typical error rate for electronic returns is believed to be 1%, compared with 18% for paper filings, according to an IRS study. However, the IRS could not provide historical data on errant filings to support that claim.

v"Electronic filing improves the efficiency of the current system because it gets the data into the IRS computers directly rather than having the data from mailed returns inputted into the computers at the processing centers by IRS employees," Lutes says. "It cuts down on errors and helps filers who are eligible for refunds get their refunds faster."

To realize the benefits of e-filing, the IRS has to find ways to improve participation. IRS officials briefly considered offering their own e-filing system but realized, according to Lutes, that it did not have the architecture or funding to offer electronic filing directly. In a highly visible initiative, the IRS has turned to commercial companies to help reach its goal and has targeted taxpayers who use the simplest forms. Enter the Free File Alliance (FFA), a consortium made up of Intuit, H&R Block, Jackson Hewitt and 14 other firms. Starting this year, these companies are offering free e-filing services to taxpayers who fit certain criteria. Most offer the services to individuals who reported less than $27,000 a year in adjusted gross income.

Taxpayers eligible for free e-filing services simply log on to the Web site where they're directed to one of the tax preparation providers participating in the FFA. Once a participant is selected, the taxpayer is redirected to the company's site to begin filling out the return.

It's a tenuous quid pro quo arrangement best summed up by Intuit spokesman Scott Gulbransen, who says the FFA "is a corporate philanthropic effort but also, in all honesty, a way for us to keep the government out of our business."

The bottom line: Tax preparation services and software providers protect their role as middlemen to the IRS, and these companies get to offer taxpayers—for a fee—other services such as refund anticipation loans or consulting services with a tax preparer.

Wooing the taxpayer

According to the IRS, there are 32.1 million taxpayers who use "simple" returns-1040A, 1040EZ and 1040 forms without attachments. By definition, they are the most basic of income tax returns and require the least explanations and accompanying attachments. In 2001, 27% of taxpayers fitting this profile filed electronically, and the IRS now hopes to woo the others into filing through the FFA, though only a portion are eligible for the free service.

Intuit, which began offering free e-filing services in 1998, filed 10.2 million returns electronically last year. Of these, just over 1 million were free e-filings.

Gulbransen says Intuit hasn't figured out how much it actually costs the company to offer the free e-filings and would not disclose how many additional services it sold to customers using its e-filing services.

One drawback to the FFA cited by consumer advocates has nothing to do with technology—they worry that low-income taxpayers due an income tax refund will opt for a high-cost loan secured by their refund. These so-called refund anticipation loans carry annual percentage rates of 67% to 774%, and, critics say, are tempting to those who can least afford them.

Eventually, the IRS will have to reach out to the 20.3 million taxpayers who use more complex returns. (In 2001, 24.1% in this segment filed electronically.) But the IRS is holding off on courting these people because its systems cannot accept Word or PDF documents and other attachments.

Then, there are other factors making these taxpayers less likely to file their forms electronically. "Folks with complex returns are generally higher income and either owe money or are in a financial position that does not make our key marketing message—a faster return—as attractive to them," Lutes says. Tax preparers are not rushing out to promote e-filing to those with complex returns either—at least until the IRS can accommodate attachments. That's because the preparers can end up spending as many as two hours entering data into electronic filing fields—required by IRS' proprietary software—to document, for example, hundreds of stock transactions.

"If I want to input 5,000 long-term transactions, I can and the IRS will accept them." says Rolnick, a tax advisory committee member and a certified public accountant at McConachie & Moore in Sun City, Ariz. She'd rather not, preferring to send paper documents to support the tax return.

If the IRS is ever going to get 80% of all Americans to file electronically, it also needs to address the daunting challenge of mollifying fears—real or imagined—that many taxpayers have about e-filing. Whether right or wrong, some taxpayers believe they are more likely to be audited by the IRS if they file electronically.

Others—especially those expecting to pay taxes—prefer to file a paper return because getting a faster refund, the only real incentive to electronic filers, doesn't apply to them.

"People are frightened by the IRS and the IRS knows this," says Marc Aulbaum, a lawyer based in New York City. "It's unrealistic for the IRS to think it's going to hit this (80%) goal. Especially when filing electronically really isn't in the taxpayer's best interest."

With that kind of thinking, the IRS might be filing for an extension of its own.

Headquarters: 1111 Constitution Avenue NW,
Washington, DC 20224
Phone: (202) 622-7990
Business: Processes more than 130 million tax returns each year
Director of Electronic Tax Administration: Terry Lutes
Financials in 2002: Collected more than $2 trillion in income taxes in fiscal 2001
Challenge: Maintain current e-filing system for individual income tax returns and improve e-filing participation

  • Achieve 80% electronic filing of income tax returns by 2007
  • Reduce total cost of processing income tax returns by $243 million a year by 2007
  • Reduce the cost of collecting $100 in taxes from 39 cents in 2000 to 4 cents by 2007