Would you like the IRS to prepare your tax return for you? Under a proposed system, the Internal Revenue Service would pre-fill taxpayers' returns with the data employers and financial institutions already report to it. What would such a system mean for federal taxpayers, tax preparers and federal revenue?
How IRS-Prepared Returns Could Affect Taxpayers
Under what's known as a "return-free" system, taxpayers would accept or correct their IRS-prepared returns before paying any tax due or requesting a refund. This system could mean significant cost savings for taxpayers, who would no longer have to purchase tax software, hire an accountant or spend hours preparing a return.
"For many filers with simple situations and little tax planning flexibility, a formulaic government tax prep system could - in theory - work well, since the math is very simple," says Jeff Camarda, chairman and CIO of Camarda Wealth Advisory Group in Fleming Island, Fla.
A number of problems, however, could prevent such a system from functioning well.
"The IRS is already quite error prone," Camarda says, and correcting errors is difficult enough with a taxpayer advocate on the job. The IRS might not detect or actively correct its own errors.
Furthermore, the IRS would not be aware of unreported items, such as business expenses, that influence taxpayers' filing decisions, Camarda says. The tax code's complexity "makes such a simplistic system very problematic," he adds.
An IRS-prepared return program would be perfect for someone with a simple W-2 who takes the standard deduction and has no asset transactions, but it would never work for people with complex returns, or even those with transactions as simple as stock sales, says Vincenzo Villamena, managing partner of Online Taxman and a licensed CPA in New York.
Accuracy and Fairness of IRS-Prepared Returns
Critics of return-free programs are concerned about the program’s accuracy and fairness, according to a March 26 ProPublica article by Liz Day.
The IRS already has a system for filing returns on behalf of taxpayers. It employs this system, called a substitute for return (SFR), when a taxpayer hasn't filed a return or responded to IRS requests to do so. The SFR system uses data reported to the IRS plus internal IRS data to compute how much a taxpayer owes and send him or her a bill. This system has a major shortcoming, however.
"When the IRS files an SFR for you, they do not include any allowable exemptions or deductions," says Evan Wolf, a tax attorney in Franklin, Michigan. "If you fall into this category, you will owe significantly more than you would if you filed yourself."
If a system of voluntary IRS-prepared returns were similar to the SFR system, it could overcharge taxpayers who accepted their pre-filled returns instead of adjusting them to account for the exemptions, deductions and credits they qualify for that the IRS has no way to know about.
IRS-Prepared Returns Would Impact Major Tax-Prep Firms
In theory, a return-free system means taxpayers wouldn't need to buy tax software or hire tax professionals to prepare their tax returns. Both H&R Block and Intuit, the company behind TurboTax, have lobbied against such a system, according to Day's article.
"Honestly, they would probably lose a lot of business," says Villamena. "These companies go for lower-hanging fruit - the easy returns by people that either don't want to deal with their taxes or don't know how." These are the same clients that would be the target market for automation, he says.
Taxpayers with an annual income of $57,000 or less in 2012 are already eligible for free tax software through the Free File Alliance, and anyone can use the IRS's free fillable forms, which do the tax math for you. The latter option is only useful, however, if you can make sense of those forms and don’t need software or a professional to walk you through them.
Wolf thinks that under a return-free system, companies like H&R Block and Turbo Tax "would lose a lot of money, but would still have plenty of business from everyone that is married, has kids or claims any other expenses or deductions."
Would IRS-Prepared Returns Cause Taxes to Rise?
A return-free system does not require any change in tax rates or tax brackets. There are a few reasons, however, why taxpayers might find themselves paying more in taxes if the IRS prepared their returns.
The Tax Policy Center states that such a system would be easier to manage if most taxpayers had the same marginal tax rate, if all tax returns were filed individually rather than some being filed by couples, and if there were limited deductions. Such changes would affect everyone's tax rates and cause some taxpayers to pay more and others to pay less than they do now.
The Tax Policy Center emphasizes that taxpayers could continue to file returns as they do now -the return-free system would be optional. Taxpayers wouldn't have to accept IRS calculations or pay more than they truly owe. But Villamena adds that people might just take the standard deduction and not deduct valid expenses related to work, charitable donations and moving.
Furthermore, less-educated taxpayers might not understand that they have the option to calculate their own tax bills. If the IRS calculation doesn't factor in every exemption, deduction or credit a taxpayer is entitled to, those taxpayers could pay more.
In addition, the IRS might need additional resources - that is, tax dollars - to pay its staff to prepare returns. The government might need to raise taxes to cover this expense.
The Bottom Line
If the IRS prepared taxpayers' returns for them using the data it already collects from employers and financial institutions, taxpayers with simple tax situations could save time and money on tax preparation. To make the most of such a system, taxpayers would need to be educated about whether they have a more complex situation in which they would save money by rejecting the IRS' pre-filled return. Those taxpayers would still need to hire a tax professional or purchase software to add the data to their returns that would qualify them for the exemptions, deductions and credits that would lower their tax bills.