TREASURY
INSPECTOR GENERAL FOR TAX ADMINISTRATION
Use of the Free File Program Declined After Income Restrictions Were Applied
September 29, 2006
Reference Number: 2006-40-171
This
report has cleared the Treasury Inspector General for Tax Administration
disclosure review process and information determined to be restricted from
public release has been redacted from this document.
Phone Number |
202-927-7037
Email Address | Bonnie.Heald@tigta.treas.gov
Web Site |
http://www.tigta.gov
September 29, 2006
MEMORANDUM FOR COMMISSIONER, WAGE AND INVESTMENT DIVISION
FROM: Michael R. Phillips /s/ Michael R. Phillips
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Use of the Free File Program Declined After Income Restrictions Were Applied (Audit # 200640029)
This report presents the results of our review to determine the impact of the October 2005 Agreement between the Internal Revenue Service (IRS) and the Free File Alliance (referred to as the Alliance) on taxpayer service and electronic filing. This audit was requested by the Chairman of the House Ways and Means Committee, Subcommittee on Oversight.
Impact on the Taxpayer
The IRS established the Free File Program to provide
taxpayers with the ability to prepare and file their returns electronically for
free. The IRS partnered with the
Synopsis
The Free File Program was established in
response to the IRS Restructuring and Reform Act of 1998,[1]
President Bush’s E-Government Initiative, and the Office of Management and
Budget’s EZ Tax Filing Initiative. The
IRS partnered with a group of tax software companies (the
The intent of the E-Government and EZ Tax Filing Initiatives
was to provide all taxpayers a way to prepare and file their tax returns
electronically without having to pay for those services. The IRS’ current Free File Program does not
fully satisfy this intent. The Program
is limited to specific taxpayers, may be difficult for some taxpayers to use,
and allows
The amended
Free File Program Agreement eliminated roughly 39 million taxpayers from eligibility
for the Program, and participation in the Program dropped almost 23 percent.
The addition of a limit on eligibility for the Free File Program as well as the negative publicity generated by that limit reduced participation in the Program. The amended Agreement between the IRS and the Alliance eliminated roughly 39 million taxpayers from eligibility for the Free File Program during 2006 by limiting the Program to 70 percent of taxpayers, or an adjusted gross income[2] of $50,000 or less. The negative publicity resulting from this limit may have further discouraged taxpayers from participating. As of the end of April 2006, participation in the Program had dropped almost 23 percent compared to the same time last year.
There are indications that the income limit also has affected the growth of electronic filing. Electronic filers include taxpayers who pay a tax professional to prepare and file their tax returns, taxpayers who prepare their own returns using tax preparation software and file the returns online using their personal computers, and taxpayers who use the Free File Program. While the online portion of electronic filing had grown 19 percent by the end of April 2006, participation in the Free File Program had declined substantially as mentioned above. Overall, electronic filing grew slightly over 6 percent during the same period.
The income limit is not the only factor affecting the success of the Free File Program. A significant number of taxpayers continue to prepare their returns electronically but file the returns on paper. In 2005, 72.5 percent of the approximately 62 million taxpayers who filed their returns on paper actually prepared their returns on computers. If these taxpayers would file electronically, the IRS could save approximately $106.7 million in processing costs.
The amended Agreement did add additional consumer protections, including limiting offers for Refund Anticipation Loans,[3] improved security over taxpayer data, and improved performance standards for Alliance members. However, the Senate Committee on Finance and the National Taxpayer Advocate noted questionable advertising and fees on the individual Alliance members’ Free File webpages. Such practices can discourage taxpayers from using the Program. Our review of the Free File webpage also showed the webpage could be confusing or difficult for some taxpayers to use.
Many of these issues are the result of the IRS having to work through the tax preparation industry to provide the Free File Program. Some members of Congress, the tax preparation industry, and other tax professionals question whether it is appropriate for the IRS to offer assistance in preparing tax returns and also make necessary adjustments and/or additional assessments as part of processing returns and collecting the proper taxes. Regardless, Congress is still concerned that the current Free File Program Agreement is not adequate and does not serve the best interests of taxpayers or meet the intent of the E-Government and EZ Tax Filing Initiatives. The Senate Committee on Finance has asked the Government Accountability Office to study the feasibility of providing taxpayers a way to prepare their tax returns electronically through the IRS rather than through a third party. In addition, we plan to continue our work on the IRS Free File Program to make additional assessments of the IRS’ efforts to provide free electronic tax return preparation and filing services.
Recommendations
We recommended the Director, Electronic Tax
Administration, expand the Guide Me To A Service tool to include a summary of the services
available from the
Response
IRS management agreed with both of our recommendations. Management indicated they would consider the
feasibility of expanding the Guide Me To
A Service tool and will initiate discussions with the Electronic Tax
Administration Public Portal Branch and the
Office of
Audit Comment
The IRS provided only the initial steps for its corrective actions. We will follow up to evaluate whether its actions are adequate to achieve the intent of the recommendations. In response to our draft report, the Commissioner, Wage and Investment Division, included some general comments and assertions we believe warrant additional comment. Our response to these issues can be found in Appendix VII.
Copies of this report are also being sent to
the IRS managers affected by the report recommendations. Please contact me at (202) 622-6510 if
you have questions or Michael E. McKenney, Assistant Inspector
General for Audit (Wage and Investment Income Programs), at (202) 622-5916.
Changes to the
Agreement Reduced the Number of Taxpayers Eligible for the Free File Program
The New Agreement Added
Additional Consumer Protections
Appendices
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix
IV – Changes to the Free File Program Agreement
Appendix V
– Refund Anticipation Loan Requirements
Appendix
VI – Eligibility Requirements for Each Alliance Member
Appendix
VII – Office of Audit Comments on Management’s Response
Appendix
VIII – Management’s Response to the Draft Report
Abbreviations
|
AGI |
Adjusted Gross Income |
|
e-filed |
Electronically Filed |
|
IRS |
Internal Revenue Service |
|
RAL |
Refund Anticipation Loan |
|
RRA 98 |
IRS Restructuring and Reform Act of 1998 |
The Internal Revenue Service (IRS) Restructuring and Reform Act of 1998 (RRA 98)[4] established a goal for the IRS to have 80 percent of Federal tax and information returns filed electronically by 2007. It also required the IRS to work with private industry to increase electronic filing.
In 2001, President Bush established an agenda to improve management of the Federal Government. One of the agenda items is the E-Government Initiative, which is an integral part of the President’s Management Agenda to make it easier for citizens and businesses to interact with the Federal Government, save taxpayer dollars, and streamline citizen-to-Government transactions. In response to the President’s E-Government Initiative, the Office of Management and Budget developed the EZ Tax Filing Initiative. EZ Tax Filing was intended to make it easier for citizens to file taxes in a web-enabled environment. Citizens would no longer have to pay for basic, automated tax preparation. The goal of the Initiative was to increase the number of citizens who filed electronic tax returns.
In response to the RRA 98, the President’s Management Agenda, and the EZ Tax Filing Initiative, the Department of the Treasury, the Office of Management and Budget, and the IRS launched the Free File Program featuring private-sector partners that allow qualifying taxpayers to prepare and file their tax returns online for free. This Program was made possible through a public-private partnership with a consortium of tax software companies known as the Free File Alliance, LLC[5] (referred to as the Alliance).
In January 2003, the IRS and the Alliance launched the Free
File Program, which provides taxpayers with access to free online tax preparation
and electronic filing services. Eligible
taxpayers may prepare and file their Federal income tax returns electronically using
commercial online software provided by Alliance members. According to statistics provided by the
Alliance, more than 2.79 million taxpayers used the Program in its first year. In subsequent years, the
Taxpayers access the Free File webpage through the IRS
Internet web site, IRS.gov (see Figure 1).
The Free File page contains a list of free offer descriptions available
from the various companies participating in the Program. The IRS does not endorse any particular Free
File company or product offered. Individual
company offers vary, and some may be limited to specific States and income
levels. Companies are also allowed to
offer additional services to taxpayers for a fee. Taxpayers are not obligated to purchase any
of those services as a condition of electronically preparing and filing their Federal
tax returns free of charge.
Figure 1: Free File Webpage
Figure 1 was
removed due to its size. To see Figure
1, please go to the Adobe PDF version of the report on the TIGTA Public Web
Page.
This review was performed at the IRS National Headquarters
in
Changes to the Agreement Reduced the Number of Taxpayers Eligible for the Free File Program
After the 2005 Filing Season,[7] the IRS and the Alliance amended the 2002 Agreement to continue the Free File Program through October 2009. The 2005 amended Agreement significantly changed the overall focus of the Program. While the amended Agreement still contributes to the original goal of increasing the number of citizens who file electronic tax returns, new limits effectively changed the intent of the Free File Program. The original intent was to provide free electronic tax preparation and filing services to all taxpayers. The revised intent is to assist low-income and underserved taxpayers. As part of the amended Agreement, new limits were set for participating in the Free File Program. The new limits stem, in part, from the differing objectives of the IRS and the Alliance members. One of the IRS’ principal purposes for establishing the Program was to add another avenue of electronic filing, with the intent of increasing electronic filing overall. However, the Alliance members are businesses that incur a cost to provide free services. According to representatives of Alliance member companies we interviewed,[8] their primary goal is to keep the Federal Government from entering the tax preparation business. A secondary benefit of their participation in the Program is the opportunity to advertise and promote other products. Taxpayers opting to use and pay for these services provide additional revenues to Alliance members.
Per the initial Agreement, a minimum of 60 percent of all taxpayers (approximately 78 million) were eligible for the Free File Program. In 2005, the Alliance made the Program available to nearly all 132 million individual taxpayers and reported that 5.12 million taxpayers used the Program to file their tax returns. The amended Agreement now limits the Program’s availability to 70 percent of taxpayers (approximately 93 million). For Tax Year 2005, this limitation equates to an adjusted gross income (AGI)[9] of $50,000 or less. The net impact of this new limit is that approximately 39 million taxpayers[10] were no longer eligible for free filing services through the Program during the 2006 Filing Season. See Appendix IV for details of the changes made in the amended Agreement.
We validated the methods the IRS used to calculate the aggregate percentage of taxpayers being offered free services and the number of taxpayers eligible for free services from any one Alliance member and found no problems with either method.
The income limit negatively affected participation and electronic filing
It appears the addition of the 70 percent limit
contributed to a decline in participation in the Free File Program. As of the end of April 2006, approximately 3.9
million taxpayers had used the Free File Program compared to approximately 5
million during the same time last year. Figure 2 shows
a comparison of the numbers of taxpayers using the Free File Program in 2005
and 2006. We were unable to determine how many prior users no longer qualify for the
Program because the IRS did not have a way to capture Program usage data prior
to the October 2005 Agreement.
Figure 2: Free
File Program - Comparison of Returns Filed
Figure 2 was removed due to its size. To see Figure 2, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
The lack of positive publicity for
the Program in 2006 also may have played a factor in its declining use. When the Free File Program was open to all
taxpayers last year, the Program received positive publicity that may have
increased taxpayer use. However, most of
the publicity this year has been focused on the reductions in eligibility for
the Program. This negative publicity may
have discouraged some eligible taxpayers from using the free services. Another contributing factor could be that the
IRS is trying to promote the Program to taxpayers who do not have the
technological means to take advantage of it.
It is estimated that only 38 percent of taxpayers with income below
$25,000 have access to the Internet.[11] Taxpayers cannot
use the Free File Program unless they can access the IRS Internet web site.
The reduced participation in the Free File
Program may also be affecting the growth rate of electronic filing. Although electronic filing continues to grow,
the percentage growth from year to year has begun to slow. Electronic filing grew by 16.2 percent in
2002 and 15.6 percent in 2004, but the IRS estimates continued growth will be
no more than 4 percent over the next 4 years.
The actual growth in electronic filing also is not enough to reach the
IRS’ mandated 80 percent goal.
Figure 3 shows the actual percentage growth in electronic filing
compared to the growth the IRS needs to reach its 80 percent goal.
Figure 3: Growth in Electronic Filing - Actual Compared to Estimated
Figure 3 was removed due to its size. To see Figure 3, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Taxpayers who use a return preparation
software package on their home computers to prepare and file their returns
electronically are considered online filers.
Although online filing was up about 19 percent at the end of April 2006
compared to last year at that time, the increase appears to be the result of
additional taxpayers who are paying for those services. As of the end of April 2006, paid online
filing was up roughly 36 percent over the same period last year while free
online filing was down almost 23 percent.
Although more taxpayers may be using online services to file their returns, growth in electronic filing as a whole had reached only 6.3 percent at the end of April 2006.[12]
Figure 4: Electronic Filing Statistics[13]
|
Type of Electronic Filing |
Returns Filed |
Returns Filed |
Percentage Growth |
|
Total Electronic Filing |
66.1 |
70.3 |
6.3% |
|
Paid Preparer |
46.1 |
50.5 |
9.4% |
|
Total Online |
16.7 |
19.8 |
18.6% |
|
Paid Online |
11.7 |
15.9 |
36.3% |
|
Free Online |
5.0 |
3.9 |
(22.6%) |
|
Telefile Program[14] |
3.3 |
0 |
N/A |
Source: IRS Filing Season Statistics for the periods ending April 29, 2005, and April 29, 2006.
Another factor that appears to have
negatively affected electronic filing is the elimination of the Telefile
Program. The IRS and the Alliance had
hoped many of the 3.3 million taxpayers who filed their Income Tax Return for
Single and Joint Filers With No Dependents (Form 1040EZ) using the Telefile
Program in 2005 would migrate to the Free File Program. However, many of these taxpayers did not file
electronically and instead filed their returns on paper this year. As of April 28, 2006, the number of electronic
Form 1040EZ returns filed had decreased 17.4 percent from the previous year,
while the number of paper Form 1040EZ returns filed had increased 17.6
percent. The IRS has performed reviews
that show a large percentage of previous users of the Telefile Program filed a
paper Form 1040EZ in 2006. In a separate
audit, we are evaluating the impact of the elimination of the Telefile Program
on electronic filing.
Prior to January 2006, the IRS had no mechanism to collect data about the Free File Program. The IRS had to rely on the Alliance to provide basic information, such as the number of taxpayers who used the Program, and it lacked a method to verify the accuracy of the data being provided. In August 2003, we reported that the IRS should have a method through which to evaluate the effectiveness of the Free File Program.[15] The IRS agreed it needed a way to evaluate the success of the Free File Program, but the Alliance was concerned about providing data to the IRS about the taxpayers who used the Program because the information could be used by the IRS to target compliance efforts to those taxpayers or to develop its own tax preparation and filing software.
During
the 2005 Agreement negotiations, the Alliance agreed to add an indicator to
each return submitted through the Free File Program. This Free File Indicator will allow the IRS
to independently collect data about the Program. For example, it will give the IRS the ability
to answer basic questions about the Free File Program such as why only a small
percentage of eligible taxpayers are participating in the Program.
A significant number of taxpayers continue to prepare their returns electronically but file the returns on paper
Another issue affecting the growth of
electronic filing is the significant number of taxpayers who use computers to
prepare their tax returns (either directly or through a tax preparer) but
choose to print and mail the tax returns.
During 2005, approximately 62 million
taxpayers filed paper tax returns. Of those,
45 million (72.5 percent) prepared their returns using computer software,
printed the returns, and mailed the paper returns to the IRS. Many of these may be taxpayers who purchased
software to prepare their returns but chose not to pay the required additional
fee to file their returns electronically.
These taxpayers may also have concerns about the security and privacy of
electronic transactions with the IRS or have the perception that there is a
greater chance they will be contacted or audited by the IRS if they file
electronically.
When taxpayers choose to file paper instead of electronic returns, they have to wait longer (about 5 weeks) for their refunds and the IRS has to devote additional resources to manually enter the return data into its computer system. When a taxpayer files an electronic instead of a paper return, the IRS estimates it saves $2.37 in processing costs for that return. If the 45 million taxpayers who prepared their returns using software but filed the returns on paper in 2005 changed to electronic filing, the IRS would save approximately $106.7 million. Even if only a small portion of these taxpayers would use the Free File Program or otherwise file their tax returns electronically, the IRS could save a substantial amount of resources. Figure 5 shows that two‑thirds of the taxpayers who prepare their returns electronically file those returns via paper.
Figure
5: Tax Year 2004 Filing Trends
Figure 5 was removed due to its size.