Gearing up for 'e-file': for 2006 tax returns, the IRS has broadened the scope of corporations required to electronically file their returns. Financial Executives Research Foundation (FERF) asked several financial executives how they expect to respond.

U.S. corporate taxpayers may be filing their tax returns more efficiently--thanks to technological advances--but it's not without additional costs to their tax departments. Conversely, the recipient Internal Revenue Service (IRS) is pleased, since "e-file" is speeding the process and easing tax audits.

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Indeed, after receiving electronic tax filings from more than 12,500 of the largest U.S. corporations last fall, Deborah Nolan, commissioner of the Large and Mid-Size Business Division (LMSB), heralded the transition from paper returns as a "significant milestone in the Service's modernization efforts that will pay dividends for years to come." Nolan credited the success to the collaboration with taxpayers, practitioners and software developers who developed the system to process volumes of complex returns, as well as rules to facilitate taxpayer compliance.

Of those who e-filed, nearly all used commercial software to prepare returns, with about 400 companies self-transmitting. Currently, 18 vendors have passed IRS requirements for e-filing corporate returns forms 1120 and 1120S. Meeting the requirements means that software can provide correct data in the proper format for processing.

Almost 40 percent of 101 corporate tax executives surveyed last October by KPMG and the Tax Executives Institute (TEI) said the biggest e-file challenge they faced was getting comfortable that the e-file included what the corporation intended to be filed. Compliance software issues were cited by 35 percent of the respondents.

Most companies surveyed, 88 percent, incurred additional e-file costs in terms of both money and staffing, with 40 percent categorizing increases as "substantial" and 48 percent, "modest." Of those reporting added costs, 40 percent said the expenses resulted from both tax department and technology support resources, with an additional 33 percent pinpointing tax department staff resources only. Of those that were required to electronically file their 2005 taxes by Sept. 15, 2006, 52 percent reported that their tax return was accepted on the first try; only 3 percent experienced a rejected return more than five times.

Changes for 2006 Tax Returns

Though the 2005 e-file was considered a success, a Thomson Tax & Accounting survey revealed that 712 tax professionals said e-file is still their greatest challenge--particularly with regard to international, federal and state returns, as well as handling of consolidated returns, partnerships and paperless processing.

Part of their concern likely stems from the next tier of companies required to e-file in 2007. Starting with tax periods ending on or after Dec. 31, 2006, corporations with assets of $10 million or more that file U.S. Corporation Income Tax Return Forms 1120 or 1120S and that file over 250 returns per year, must electronically submit their 2006 tax returns through the IRS e-file program.

"This next tier of companies may not have access to the same staffing and technology resources as the larger companies that filed this year, so it's even more prudent that smaller companies begin preparing early and budget accordingly," says Michael Dolan, director in the Washington National Tax practice of KPMG. "Although many will be using outside tax preparers to file their taxes, there will still be added work and costs for management to consider."

This incremental burden on smaller companies is evidenced when comparing the past e-filing experiences of smaller and larger companies. "Many larger companies began the process a year prior to the e-filing deadline," says Molly Delafield, director at Thomson Tax & Accounting. "Many smaller companies were not in a position to do that, and with the IRS's numerous changes throughout the year, there were many adjustments to make in a shorter time period."

Besides expanding the number of companies that must e-file, the major changes for 2006 include: fewer documents allowed in PDF; all parts of the Form 851 are required to be in extensible Mark-Up Language (XML) format (a standardized, universal language required for e-file); more detail on officer compensation; and all international forms will be required in XML with no PDF or paper options. If a new form is created late in the year as a result of legislative changes, and the software industry does not have time to enable the form in XML, then a PDF format of that particular form can be attached to an 1120 or 1120S electronically filed return.

Companies can use a summary form in XML when underlying transactional data contains more than 100 lines or transactions--reducing effort in preparing itemized lists for selected forms, including Form 4562--Depreciation and Amortization; Form 4797--Sale of Business Property; Form 8824--Like Kind Exchange; Form 8873--Extraterritorial Income Exclusion; and Schedule D (1120 and 1120S)--Capital Gains and Losses.

Perhaps the most notable change for multinational companies is the elimination of PDF or paper options for several international forms, including Form 5471--Information Return of U.S. Persons With Respect to Certain Foreign Corporations. These forms and their associated schedules are now required to be submitted in XML and attached at the top consolidated return level.

Tax Departments Take Charge

Generally, e-file is an add-on to the companies' existing year-end tax return filing process. It should be owned and led by tax departments that will have a more comprehensive understanding of the business than information technology (IT) departments or outside vendors. In many cases, the extent of software system changes will drive whether or not existing tax data collection processes will be impacted.

For many companies, the most notable change will be the acceleration of internal deadlines. Timetables to collect tax information will correspond with the e-file date set by a company, which could range anywhere from two weeks to a month before September 15 (the deadline for calendar year-end corporations after filing the typical a six-month extension).

The Washington Post Co. worked with its vendor, RIA, early in the year to analyze its prior-year return and prepare a roadmap document on how each component of the return would get filed. When setting an earlier filing date of August 1, Dean Rohrbaugh, director, Tax Information Systems at The Washington Post, says that the company considered the time needed to go back to the businesses to collect international or affiliate information (for Forms 5471 and 851). In conjunction with legal counsel, tax had to make sure all identifying information for each company (name, location, address, etc.) was correctly documented in the software. The larger the company, he notes, the more extensive the verification process.

At Johnson & Johnson, the process at the operating companies remained fairly consistent. Tax information deadlines for the operating affiliates were also moved up, which Michael P. Reilly, vice president, Taxation, expects to continue. Most of the e-file work at the company was done by tax, with some cooperation from IT, particularly when installing the software. The company's internal system feeds tax data into its vendor software, CORPTAX, which it has used for the past 15 years as a filing system for the domestic part of its return.

Reilly notes two major challenges for the first year: getting additional vendor support and implementing the CORPINT international software. Because of the scope and complexity of the company's international operations, the implementation of a later version of the CORPTAX international software was required. Without sufficient time to update the CORPTAX domestic software to the later version, J & J was forced to integrate two different CORPTAX versions. He warns tax departments to make sure vendors address these problems effectively early in the process.

Tom Holland, Corning Inc.'s manager, Tax Planning, got involved with a steering committee of clients of its software vendor, Vertex, to ensure the system had the necessary tools to address any errors. "[Being involved with the committee] enabled me to manage the project internally," Holland says. Throughout the process, a tax person was responsible for performing all the edit checks and going through any name fixes.

Additionally, Holland says that the process to save attachments as PDF files, and under IRS naming conventions and making elections within the prescribed IRS methods, required additional time. This could add one to two weeks to an e-file process, all of which should be factored in when establishing an internal timetable.

Software Identifies System Errors

Holland says companies should understand the software's approach to transmitting data and make sure vendors are prepared to handle it. Vertex's e-file solution, for example, has been integrated into the core tax system and is managed from a Web platform. Rohrbaugh says learning how the software works is crucial, particularly when first using it.

By working with their vendor, Holland says his group knew upfront that the IRS system was particular about accepting specific nomenclature or characters. "We started early on and assigned one person to review all the companies in our consolidated group to make sure all the formatting was correct. We ended up with 60 pages of error messages," he says. "At least in the second year, we don't have to do it again."

The process in 2005 was a learning experience, says Holland, particularly because earlier versions of software did not have bells and whistles, giving cryptic error messages. Tax departments had to comb through pages of errors to find the source. Current software releases should have some type of validation feature that will direct a reviewer to the source of an error, especially for more routine ones such as incorrect zip code formats.

The increased functionality of software should help with those 2005 transition items that must now be e-filed for 2006. KPMG's Dolan notes that only 26 percent of those surveyed filed international forms in XML. Since these forms cross-reference to various places in the main return, this represents a huge administrative undertaking for global companies to e-file.

At Johnson & Johnson, for example, the number of legal entities that require a Form 5471 historically represented approximately 75 percent of the paper in the company's total return. This may be added work for those that submitted via PDF last year and less work for companies such as The Washington Post and Corning that decided early on to e-file as many forms as possible via XML.

Based on the many companies that successfully e-filed their 2005 international returns, Thomson's Delafield advises those that have not yet e-filed their Form 5471 to allow ample time for diagnostics. Additionally, since the IRS will only accept one electronic file per return from a company, a single vendor for both domestic and international may provide the best solution.

The bottom line, advises The Washington Post's Rohrbaugh, is that the software has to be adaptable, given the ongoing changes to tax forms and processes. Internet access and quick software download times are also considerations, some of which may be facilitated by data being stored on vendor systems.

The Impact on Company Processes and IRS Audits

In the KPMG/TEI survey, 12 percent said e-filing forced them to examine work processes and that future filings should be more efficient. Rohrbaugh says he thinks e-file is the way to go. "It reduces administrative work. The data in our system is better and much more accurate, and [this] should make it easier going forward."

The KPMG/TEI survey results, however, portray some skepticism within the corporate taxpayer community, as a majority (77 percent) said they felt the IRS was the only beneficiary. However, TEI Executive Director Timothy McCormally believes benefits will materialize soon and that "as companies go through the e-file process again this year, they will realize that all of their hard work in year one will produce greater tax filing efficiencies down the road."

From an IRS perspective, Commissioner Mark W. Everson said in a press release that e-file will cut many months off the audit process and will allow development of sophisticated analytical tools to better select areas of audit inquiry.

J & J's Reilly believes that if the electronically submitted information is effectively used for IRS audits, it should make the ensuing audits more efficient. "IRS examiners can now focus on certain areas of risk and spend less time on other areas. E-file will be considered a success if it results in both taxpayers and the IRS spending less time on audits and results in audits being more current," he says.

Once a company is past initial implementation, financial executives can expect the e-file process to be challenging in some aspects, but not especially burdensome. That said, companies can expect the accelerated tax deadlines going forward. "We are planning for the same kind of timetable for 2006, comments Rohrbaugh. "It is hard to reinforce a pattern of success until you have done [something] a few years."

CHERYL GRAZIANO, CPA ([e-mail]), is Vice President-Research and Operations at Financial Executives Research Foundation (FERF).

RELATED ARTICLE: IRS E-File Advice

1. Using a tax professional? Make sure he or she is an IRS Authorized e-file Provider.

2. If you or your staff will prepare your corporate tax return, work with your software vendor to adjust your tax preparation systems to generate the e-filing.

3. Remember to provide your "name control" to your vendor before filing.

IRS e-file advice and additional resources are available at www.irs.gov.

RELATED ARTICLE: TAKE AWAYS

* After receiving more than 12,500 tax filings from the largest U.S. corporations, the IRS heralded the transition as a significant milestone in modernization.

* Of those that e-filed, 88 percent incurred additional costs in terms of both money and staffing, within tax departments and technology support resources.

* While year-one was dubbed a "success," the next tier of companies to e-file in 2007 could be more challenging, since they are the smaller companies. Challenges are expected with regard to international, federal and state returns, as well as handling consolidated returns, partnerships and paperless processing.