Electronic tax filing: how is it working?
Approximately 14 million individual tax returns were filed electronically for the 1993 tax year. This figure represents about 12% of all individual Federal income tax returns. The number of electronically filed tax returns is expected to rise to 80 million for the year 2001, according to IRS projections. This rapid growth has implications for tax practitioners who, on whole, have been reluctant to board the ETF bandwagon. Before deciding whether to adopt ETF, practitioners should be aware of the alternative ways of filing electronically.
This article critiques the current electronic filing system, discusses a new electronic system which is on the horizon and suggests that preparation of condensed PC returns may be a commonsense alternative at the present time. Knowledge of these alternatives will enable the practitioner to decide if, when and how to begin filing tax returns electronically.
The Growth of Electronic Tax Filing
The method of ETF now in existence is commonly referred to as the Electronic Filing System (EFS). To date, only individual income tax returns can be filed using EFS, although it is being expanded to allow the filing of other types of income returns including partnerships, estates, trusts and corporations.
In order to file an EFS return, a completed tax return must be converted into an electronic return using special IRS-approved software. The return is then transmitted to the IRS using a modem.
As a result of the IRS's ongoing campaign of encouraging the use of EFS, the number of electronically filed returns has continually increased. Exhibit 1 shows the growth of EFS since its inception. Both the number of participants and the number of EFS returns have risen, although the rate of growth has slowed over the last several years. Participants include electronic return originators (EROs), who convert the completed return into electronic format; and transmitters, who transmit the return to the IRS via modem. Many EROs are also transmitters, and vice versa.
Given this growth, are practitioners who have not participated in EFS losing clients and foregoing profits? The answer depends on the particular firm, but in general the answer is no. According to the GAO, the average adjusted gross income (AGI) of taxpayers who filed electronically in 1991 was $20,000, whereas the average AGI of taxpayers in general was $30,000 (GAO, 1993). Forty-one percent of electronic filers received the earned income credit. Thus, most electronic filers do not fit the profile of the typical accounting firm client. As shown in Exhibit 2, the highest percentages of electronic filers are taxpayers whose AGI ranges from $5,000 to $20,000.
The main benefit of EFS to date has been faster refunds. Electronic filers typically receive refunds within two to three weeks of filing the return, whereas refunds generated from paper returns are normally received within five to six weeks. The refund from an EFS return typically takes about three weeks if the taxpayer elects to receive a paper check, whereas it is received in about two weeks if the taxpayer elects to have the IRS directly deposit the refund into the taxpayer's bank account.
For the past few years, many commercial tax return preparers have acted in conjunction with banks to offer Refund Anticipation Loans (RALs) to their clients. In the case of a RAL, the taxpayer who elects the direct deposit option will receive a bank loan following acknowledgment by the IRS of a valid return, which normally takes about three days. The bank loan is repaid when the direct deposit refund is received. Thus, a taxpayer who files electronically and receives a RAL will accelerate the receipt of his or her funds by about 4.5 to 5.5 weeks.
Exhibit 1. Growth of Electronic Filing
Growth in No. Number of Number of of Electronic Tax Year Participants Electronic Returns Returns (%)
1985 5 24,820 1986 69 77,612 213 1987 2,407 583,462 652 1988 9,429 1,200,000 106 1989 21,539 4,191,304 249 1990 34,859 7,522,708 79 1991 55,511 10,923,911 45 1992 65,217 12,343,000 13 1993 - 13,421,401 (as of 4/15/94)
Sources: IRS Publication 1345, "Handbook for Electronic Filers of Individual Income Tax Returns (Tax Year 1993)
IRS Publication 1811, "IRS 1994 Nationwide Tax Forum Seminar Handbook"
The average fee charged by banks for a RAL is approximately $35, and banks will typically lend up to some maximum amount (for example, up to $3,000). Although the effective interest rate on these loans borders on being usurious, the loans are very popular. The GAO reported that taxpayers obtained RALs on approximately 74% of the EFS returns for the 1992 tax year (GAO, 1993).
Electronic filing has not been popular to date with moderate- and high-income taxpayers having refunds due. The GAO, citing the results of IRS focus groups, concluded that taxpayers not filing electronically differed from those who file electronically. In general, they appeared to be better money managers and were not attracted to EFS by the appeal of faster refunds. Apparently the cost of filing electronically exceeds the benefit. The GAO reported that the median fee charged for transmitting a Form 1040 electronically was $22 for calendar years 1990 and 1991 (GAO, 1993). Given that the average refund for taxpayers amounts to $930 and that electronic filing accelerates the refund by only three weeks on average, the EFS fee becomes a borrowing charge of 41%. For taxpayers paying both the EFS fee and a RAL fee, the effective borrowing rate is even higher.
Various scenarios and the associated borrowing rates are shown in Exhibit 3. The majority of taxpayers with refunds due would be better off borrowing funds from a lender rather than paying the $22 electronic filing fee. An even better alternative for these taxpayers would be to reduce fourth quarter withholdings and/or estimated tax payments in order to obtain use of the funds with no interest charge whatsoever.
Electronic filing is not popular with "balance due" taxpayers. IRS figures show that in 1992, which was the first year for nationwide electronic filing of balance due returns, only 0.2% of these returns were filed electronically (GAO, 1993). Approximately 68% of the 110 million Federal individual income tax returns for 1992 involved a refund due; the remaining 32% involved either a balance due or a zero balance. This group is a source of growth for tax return preparers offering EFS, although as discussed later, [TABULAR DATA FOR EXHIBIT 2 OMITTED] balance due taxpayers have very little incentive for filing electronically.
In addition to the lack of demand for EFS by many clients, another drawback of the system is that the EFS return is not totally paperless. The signature of the taxpayer is recorded on Form 8453 at the time the electronic return is originated. The IRS requires the ERO to submit this signature portion of the electronic return within one business day after the ERO receives acknowledgment of IRS acceptance of the electronically filed return. The taxpayer's wage documents (W-2s) are attached to the Form 8453. The need for assigning one or more employees to this process of receiving acknowledgments and submitting signature documents adds a layer of overhead to the firms cost structure.
Exhibit 3. Annualized Borrowing Costs Associated With Electronic Filing.
Facts: Amount of taxpayer refund $930 Fee charged for electronic filing (22) Refund net of electronic filing fee $908 Fee charged for Refund Anticipation Loan (35) Refund net of all fees $873
Scenario 1: Taxpayer elects to receive paper refund. The refund has been accelerated from 6 weeks (if a paper return was filed) to 3 weeks.
Scenario 2: Taxpayer elects to receive direct deposit of refund. The receipt of funds has been accelerated from 6 weeks to 2 weeks.
Scenario 3: Taxpayer borrows on a refund anticipation loan. The refund has been accelerated from 6 weeks to 0.5 weeks.
Scenario 1 Scenario 2 Scenario 3
Total borrowing charges (sum of EFS fee and RAL fee) $ 22 $ 22 $ 57 + Amount of refund $930 $930 $930 x Annualization factor 52/3 52/4 52/5.5 = Annualized borrowing rate 0.41 0.31 0.58
A final drawback of EFS is the cost of getting started. Time to attend seminars and read IRS handbooks is important to understand the process. Additionally, the IRS-approved software must be purchased, as well as a modem. For all prior filing seasons, the IRS required the use of a bi-synchronous modem, which costs approximately $2,000; however, the IRS plans to allow use of asynchronous modems for the upcoming filing season. Asynchronous modems are the industry standard, and since many PCs are purchased with a built-in modem, this change to asynchronous protocol will lower the start-up cost relative to previous years. After obtaining the required software and hardware, the practitioner must file certain forms with the IRS and complete a suitability testing procedure required of all new participants.
Benefits of EFS to the Practitioner
Currently, there are few reasons for most accounting firms to participate in EFS. The primary obstacles hampering the growth in electronic filing are the high cost to accounting firms of implementing EFS and the low demand for EFS by their clients. Given that most electronic filers do not fit the profile of the typical CPA firm client and electronic filing in its present form is not attractive to the majority of taxpayers, why should firms consider participating in the EFS program?
In response to a GAO questionnaire, tax return preparers identified several IRS incentives that could encourage participation in the EFS program. One of these was a tax credit to taxpayers who file electronically. Allowing such a credit in (at least) the amount of the electronic filing charge would help overcome the greatest obstacle currently present - the lack of taxpayer demand for EFS.
Another possible IRS incentive would be providing free electronic-filing software to preparers who file electronically. This would provide the impetus for more firms to offer EFS. This combination of higher demand and greater supply would spur a new round of growth in EFS. However, the IRS currently has no plans to offer any of these incentives.
Benefits of EFS to Taxpayers
Currently, EFS provides several important benefits to taxpayers besides speedy refunds. First, errors related to missing information and inaccuracy are caught through the use of computer checks when the IRS receives the tax returns. The IRS informs the transmitter of these errors, and they can be corrected almost immediately. This resulted in an error rate for electronic returns of only 2.8% in 1992, versus 18% for paper returns, according to the IRS (GAO, 1992). Secondly, the IRS and 30 states are working together in a joint Federal/state tax return program that simplifies the filing process for the taxpayer. State governments obtain data directly from the IRS, thereby enhancing data integrity. This may also speed up the refund process at the state level. The taxpayer will save the cost of an additional tax return filing, and states should see some cost savings due to the reduced amount of paper return handling and processing.
Another benefit is that the IRS acknowledges receipt of the taxpayers return with EFS, thereby providing documentation of receipt. This factor is important in cases where time is of the essence, such as when a balance-due taxpayers return includes a Form 2210 underpayment penalty.
Finally, electronic filing saves a lot of paper. Trees are becoming a scarce resource, and it is in the taxpayers' best interest to help the IRS reduce the amount of paper forms and instructions. The resolve of U.S. taxpayers' to protect the environment is probably underestimated; one needs only to examine the overwhelming success of household recycling to find evidence that taxpayers would consider saving trees an important reason to file their returns electronically.
Benefits of EFS to the IRS
Related to the saving of paper is the saving of storage space at the IRS. The Federal government currently uses more than 1 million cubic feet of space to store over 1.2 billion tax returns. According to the GAO, the returns stored in this space could be stored on about 200 12-inch optical disk platters if they had been filed electronically (GAO, 1992).
Another benefit is that the IRS spends less money to process electronic [TABULAR DATA FOR EXHIBIT 4 OMITTED] returns. Electronic filing eliminates much of the manual sorting, coding and editing necessary in processing paper returns. A result of these processing efficiencies is that the taxpayer data stored at the IRS is more accurate for electronically filed returns than for paper returns. Also, taxpayer data from electronically filed returns can be retrieved faster and at less cost than data from paper returns.
Form 1040PC - The Current Alternative to EFS
For many firms, the 1040PC format is a practical alternative to EFS. It offers most of the advantages of EFS without the disadvantages. The 1040PC format is a print option offered by more than 30 tax preparation software packages. By condensing the tax return information into a three-column format, the print option reduces most paper returns to two pages. The taxpayer signs the condensed return, attaches the wage documents (W-2s) and any other necessary signature documents (such as a doctor's statement) and sends the return to the IRS.
The IRS will begin scanning the PC returns using data imaging equipment during the upcoming tax season; as a result, the PC returns will result in fewer IRS input errors, faster input and faster refunds compared to conventional paper returns.
Even though the PC return is technically classified as a paper return, it generally involves about the same amount of paper as an EFS return, since the EFS return requires submission of the Form 8453 paper signature document. An advantage of PC returns is that they do not require the additional IRS-approved software required by EFS to convert the return to electronic format. Also, no modem is necessary.
Unlike EFS, preparers of PC returns are not required to register with the IRS and undergo suitability testing; all that is required is a personal computer, any type of printer and any one of the tax preparation software packages that feature the PC print option. For the tax year 1993, 33 software packages included the PC print option, up from 24 in 1992 and only 3 in 1991.
As with EFS, PC returns allow the taxpayer to select a direct deposit option for refunds. Additionally, the PC return affords the taxpayer a "file now, pay later" option whereby the taxpayer files the tax return any time prior to its due date while deferring payment of the balance due to April 15.
The IRS benefits from the filing of PC returns in several ways. As a result of the IRS initiating electronic scanning, labor costs will be reduced and input accuracy will be increased. Also, fewer pages results in lower storage and handling costs. The IRS is currently investigating the feasibility of a Federal/state PC return. Additionally, the IRS is expanding its PC return experiment into the corporate return area. An 1120-A/PC short form corporate return will be tested by the IRS in the 1994 tax year. A summary of the features of the PC alternative is shown in Exhibit 4.
Electronic Data Interchange - The Future Alternative to EFS
Electronic Data Interchange (EDI) is the electronic exchange of business information in a standard format. Businesses have used EDI in recent years for purchasing and inventory management. The IRS is phasing in EDI as an alternative to its current electronic filing system. The IRS plans to support both the EFS and EDI formats until it determines that such dual support is not cost beneficial.
The IRS plans to begin receiving the 1040A and 1040EZ by January, 1995, and the complete 1040 family of tax returns by January, 1996. The IRS plans to accept EDI corporate returns in 1997 and partnershipreturns in 1998. After the system is fully implemented, businesses will have the advantage of filing various types of Federal and state tax returns using a single standardized format. In order for tax return preparers to become involved with EDI, the preparer must purchase commercially available translation software and a modem. More information will be available in the near future as software companies work with the IRS to develop the software needed to file under the EDI system.
The primary selling point of the current electronic filing system has been fast refunds. This selling point has not appealed to the typical individual tax client of accounting firms. Each firm should assess the costs and benefits associated with the adoption of electronic filing. In order to gather information about EFS and the procedures involved in participating in the program, tax practitioners should obtain Publication 1345 from the IRS. Additionally, the IRS provides free EFS informational seminars through its district offices.
The IRS is in the process of implementing an alternate electronic filing method in conjunction with the Electronic Data Interchange system. The IRS plans to support both EFS and EDI as alternative ways of filing electronically. Accountants should compare the advantages and disadvantages of the two systems before committing to either. In the meantime, each accounting firm should strongly consider the PC alternative, which offers most of the advantages of the current electronic filing system.
S. Srinivasan is associate professor of CIS, and Richard M. Walter, CPA, is assistant professor of accountancy at the University of Louisville, Louisville, Kentucky.
GAO/GGD-93-40, Tax Administration: Opportunities to Increase the Use of Electronic Filing, January, 1993.
GAO/GGD-93-27, Tax Administration: IRS Can Improve Controls Over Electronic Filing Fraud, December, 1992.
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|Author:||Srinivasan, S.; Walter, Richard M.|
|Publication:||The National Public Accountant|
|Date:||Apr 1, 1995|
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