E-filing year one: looking back and planning for the future.

September 15 marked the one-year anniversary of the Modernized e-File Initiative (MeF) for corporate income tax, when companies with assets over $50 million were required to electronically file their income tax returns. The process of preparing and filing corporate income tax returns has never been a small feat. Large companies typically have numerous subsidiaries, multiple elections and disclosure statements, and attachments that result in thousands of pages of printed return material.

E-filing was intended to modernize the process. Removing the burden of paper filing would improve data quality, automate analysis, identify trends, track commonalities, and streamline compliance efforts. While the initiative was largely successful, many companies that transitioned to e-filing endured numerous hiccups and headaches. Worse, many understaffed corporate tax departments that struggled to grapple with the effects of the Sarbanes-Oxley Act and Schedule M-3 requirements from 2004 saw MeF as yet another unfunded government mandate that diverted both time and budget dollars from other tasks.

Now, as tax year 2005 draws to a close, the industry must evaluate what went well--and what went wrong--before e-filing begins for 2006. By breaking down the challenges and opportunities of e-filing this past year, tax professionals can pinpoint solutions for navigating the same pitfalls next year, and achieving e-filing's full potential.

Jumping the Tax Hurdles

Corporate tax departments and software vendors worked diligently throughout 2006 to comply with the MeF mandate. Under the new requirements, tax departments had to aggregate data electronically. Companies then had to format, validate, attach supporting documents, review, and transmit their return in one consolidated file.

During the paper-filing era, tax departments commonly used multiple applications such as tax compliance software, Microsoft Excel, and Microsoft Word to calculate and store return data. Companies could utilize the functions and formatting within these tools to create supporting documents that could be printed and manually inserted into the paper file return. As a result of e-filing mandate, tax departments had to consolidate the information into one methodology--Extensible Markup Language (XML), a flexible text format designed to meet the challenges of large scale electronic publishing. To ease the transition to e-filing, in 2005 the IRS allowed departments to use PDF file attachments and paper filing options instead of XML for some domestic and international forms. This provided some relief to the aggregation but still required numerous forms and schedules had to be collected into one system. Additionally, even the PDF files had to be added to the XML file in a prescribed manner.

In addition to finding their way around new technology, tax departments had to learn and understand IRS modernized e-filing requirements. Just getting an inventory of all the mandated filing requirements and identifying data sources was difficult. Then tax professionals had to define new terms, which further constricted already tight timeframes. Two new terms that were important to understand were "business rule validations" and "format validations."

Business rule validations defined IRS rules that related to the tax correctness of the return. Business rules consist of 12 different categories including: missing documents, missing data, and math errors. Format validations, as implied, had more to do with whether the data recorded was in the correct format, such as numerical, date, character, etc. Reading and interpreting these business rules and format validations was a challenge. Sometimes, locating the error was the issue. For example, a rule might specify that the data on a specific form is not in the right format. The company, however, could have had a dozen or more instances of the form and would need to find the particular one with the error in order to clear the validation rule.

Other times, the rule itself was not very clear, such as the case for rules that included "invalid child element." Invalid child element validations indicated that data did not comply with IRS prescribed XML format. While this terminology is common to IT professionals, it was a foreign language to many tax preparers. Tax preparers might ask, "Why couldn't you just say in English that I need to enter the paid preparer's phone number? Why did the error have to talk about missing elements?"

Additionally, business rules and format validations changed established industry standards. In the paper filing process, companies would typically enter "various" for certain dates that property entered or exited service or "available upon request" for certain detail that would be provided upon audit. Now, MeF rejects these terms since it is invalid data for XML format.

Software vendors attempted to clear some hurdles by enhancing compliance applications to automate the process of locating and resolving e-filing validations. Tax departments still had to make sure, however, that they were comfortable with the systems production of the XML file before submitting the return.

Adding to the Schedule M-3 hurdle from the previous tax year, these rules specifically targeted the new book/tax reconciliation Schedule M-3 changes by ensuring that certain elements appeared on the correct lines of the form. These specific rules pushed book/ tax and other tax adjustments to the front end of the tax return compliance process.

Tax departments faced another hurdle aggregating data from multiple external sources and service providers, and converting it to one compressed file. It was essential for them to become comfortable reviewing and validating XML files.

To complicate matters further, vendors were hesitant to assume the development cost and potential liability for accepting XML from competing sources, since the validity of the complete return could ultimately come back to the transmitter. Imagine a grocery store allowing customers to carry in products from another competing store (store 2) so that all of the items can be bagged together. If an item purchased at store 2 turns out to be damaged, then how do the two stores reconcile who should have responsibility for the issue? This is an issue that vendors will have to work through in the coming tax seasons in addition to the technical complexities of integrating two XML sources of data.

As a result of these hurdles, the e-filing mandate shifted a significant commitment of time and effort to the front end of the returns process. This forced corporate taxpayers to be more transparent with return data upfront, instead of later during an audit.

Overall, learning new rules, formatting the data to MeF specifications, validating the data, and receiving an acceptance or acknowledgement from the IRS in order to file on time created a steep learning curve that many companies struggled to scale.

Developing An Action Plan

These hurdles from 2005 can be translated into efficient success for 2006, now that companies know what lies ahead and can plan accordingly. Indeed, a well-devised action plan helps companies develop internal processes necessary for tackling upcoming e-filing challenges. These new processes will also be valuable for new laws and changes the tax department will face in the future.

The following steps--assessment, education, preparation, gap analysis, and implementation--will guide companies in developing their action plans for year two of the e-filing mandate, and ensure a successful filing season.

1. Assessment. With tax year 2005 fresh in everyone's mind, tax departments can document bottlenecks, and generate several good ideas to make the second compliance year smoother. They should also assess data and tools needed such as a detailed work plan, inventory of forms and schedules to be filed, and an automated e-file package viewer and editor to streamline the review process.

Building on proven best practices learned from the first year of e-filing eases the transition. For example, companies that reviewed and cleared business rules and format validations at the single-entity level first had fewer issues than those that waited until the final stages of the compliance process, and only cleared issues at the consolidated level. As a result, they will maintain this best practice going forward, since working at the single-entity level leverages staff participation, reduces the risk of re-work, and shortens the overall process.

Finally, organizations should keep close connections with software providers. Software vendors have compiled issues their client base encountered, clarified, and resolved e-file requirements with the IRS, and are now able to communicate best practice techniques to the clients. They can also communicate the client issues back to the regulatory agencies. Furthermore, companies that sent questions to their tax software vendor this past year or attended training, conferences, and webcasts, found nuggets of time-saving information that streamlined the process.

2. Education. Corporations should educate their tax departments about the assessment, and find out about new and changing requirements for tax year 2006. This action plan phase helps departments learn about relevant compliance issues and opens a discussion of key concerns, possible obstacles, and preparation for the changes.

Departments should also learn about new MeF mandates and filing stipulations. All relevant information should be gathered, including IRS publications, instructions, and data provided on the IRS's website (www.irs.gov). Subscribing to the IRS's News for Large and Mid-Size Corporations newsletter on e-filing is an easy way to stay informed. Creating internal teams that can focus on MeF, schedule training, and educate the tax department on relevant compliance requirements and processes is another important education step towards a successful filing season.

In the end, a company must establish an overall understanding of its compliance needs and consider whether the tax department is ready to proceed with the project.

3. Preparation. Along with preparing the tax department with thorough personnel training, companies should establish one or two electronic filing team leads who can be the primary contacts for IRS and vendor updates. These leads can stay up-to-speed and communicate any requirements or process changes for the new tax season.

One suggested area of improvement for most companies is getting an early start on election and disclosure statements required to be attached to their return. The formatting restrictions on elections during this past season were somewhat rigid by limiting tabs, carriage returns, and other characters. By looking at these statements and requirements now, there will be time to get an approved, formatted statement through legal before this coming tax season begins. There will also be time to develop standards that can be applied to any new election statements.

Defining project milestones and due dates is also an important preparation activity. Is the company going to electronically file an extension? If so, then by what date does that work need to start and be complete? When should book/tax adjustments be finalized? Are there any ways to better automate or classify these so that they flow to schedule M-3 easier than last year? These and similar questions will keep a tax department's e-filing process on track for tax year 2006.

4. Gap Analysis. A gap analysis identifies any missing elements and areas that require greater detail. For example if a company wants to proceed with automating adjustments out of its general ledger, then the gap analysis would highlight any barriers to that automation including business issues, technical issues, hardware upgrades, security concerns, etc. By performing a gap analysis, companies can ensure they get the full benefit of initiatives highlighted during the assessment phase.

Vendor relationship is an important part of gap analysis. This is especially true for automation activities, but also for understanding what items--whether related to automation, tax calculation, form presentation, or a host of other vendor provided details--the software will address prior to creating any custom and in-house processes.

Another gap item could be the new FIN 48, the Financial Accounting Standards Board's new guidance on accounting for uncertainty in tax positions. Attending to the already mountainous pile of new functionality, FIN 48 might require liability studies that must be coordinated so as not to interfere with the current filing process. Likewise, compliance with section 404 of the Sarbanes-Oxley Act may be a gap item for all the new processes. As such, companies should make sure that internal auditors make time to review any changes to compliance processes for potential risks.

5. Implementation. Once a company conducts a thorough analysis and ensures all requirements and process documentation are in place, it must put the plan into action. At this stage, the company should explore different methods for helping the tax department prepare for e-filing.

Many companies have already documented their processes this year, and are well positioned to make improvements. Such improvements can include enhanced education on the e-filing process steps, better data collection processes, steps to move from manual to automated procedures, and standardized return attachment formats.

Whatever changes companies pursue, they must organize the tax team, effectively communicate the plan to them, and clearly state their responsibilities. The key to reducing the e-file compliance burden and improving the tax department's ability to devote more time to higher value-add activities such as planning and analysis is automation.

Reaping E-Filing's Rewards

Overall, the modernized e-filing mandate advanced the goal of real-time auditing. This IRS change, coupled with new Schedule M-3, provides an unprecedented level of sophistication and detail to tax reporting. As a result, the IRS now has additional detail in an electronic format, and can easily begin the audit process prior to being on site and requesting companies' books and records.

As data and processes become more standardized, more tools will be available to permit data sharing across service providers. This will enhance process flexibility, giving companies more control over their own business objectives. XML programs will continue to evolve making it much easier to find and interpret data, and build the comfort levels of tax teams regarding the information they ultimately file.

At the end of the day, e-filing will help tax departments far more than it hurts them (despite the transitory burdens it imposes), especially for companies that turn the mandate's challenges into an opportunity to automate all their tax processes. Indeed, automating general ledger downloads and book/tax adjustment creation helps companies decrease the burden on their tax departments. And leading companies are investigating data collection and tax repository solutions that drive their tax information needs. Such tools release organizations from the burden of filing, and help them devote additional time to more strategic, high-value activities, such as tax liability studies and other tax planning.

This is where e-filing's ultimate benefit lies--in making company tax compliance easier, faster, more transparent, and more accurate. Companies that embrace the change take one huge step in lessening their learning curve for 2006, and set up their company for success.

Donna Castellano is a senior product manager and Robert Jameson is a business analyst manager for Vertex, Inc., a provider of tax technology solutions. They may be reached, respectively, at [e-mail] and [e-mail].