Tax Administration: Many Taxpayers Rely on Tax Software and IRS Needs to Assess Associated Risks
Published: 2009-02-25T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Individual taxpayers used commercial tax software to prepare over 39 million tax returns in 2007, making it critical to the tax administration system. The majority were then filed electronically, resulting in fewer errors and reduced processing costs compared to paper returns. GAO was asked to assess what is known about how pricing of tax software influences electronic filing, the extent to which the Internal Revenue Service (IRS) provides oversight of the software industry, and the risks to tax administration from using tax software. To do so, GAO analyzed software prices, met with IRS and software company officials, examined IRS policies, and reviewed what is known about the accuracy, security, and reliability of tax software.
section_title: What GAO Found
paragraphs: IRS has little information about how the pricing of tax software affects taxpayers' willingness to file tax returns electronically. In 2009, the two largest tax software companies eliminated separate fees to file federal tax returns electronically when using software purchased from retail locations or downloaded from a Web site. As a result, IRS has an opportunity to study whether this and other changes are effective in increasing electronic filing. Additionally, IRS would benefit from being able to identify which software package the taxpayer used to better target research and efforts to increase software use and electronic filing. IRS provides some oversight of the tax software industry but does not fully monitor compliance with established security and privacy standards. Further, IRS has not developed a plan to monitor compliance with new standards, which are optional in 2009 but may be mandatory in 2010. Without appropriate monitoring, IRS has limited assurance that the standards are being implemented or complied with. IRS has not conducted an assessment to determine whether taxpayers' use of tax software poses any risks to tax administration. Risks include that IRS may be missing opportunities to systemically identify areas to improve software guidance and enhance information security. IRS officials said the likely benefits of an assessment would not warrant the costs but have not determined either the benefits or costs of such an assessment. Moreover, IRS has also said that it is in the agency's best interest to ensure that taxpayers can rely on commercial software to make electronic filing accurate, easy, and efficient. Further, if even small improvements in the accuracy of tax returns could be made by clarifying the guidance in tax software, the effect on revenue could be substantial. Without a risk assessment, IRS does not know whether its existing oversight of the tax software industry is sufficient or needs to be expanded.

section_title: Letter
paragraphs: In 2007, over 39 million income tax returns were prepared by individuals  using commercial tax software such as TurboTax, TaxCut, or TaxAct, and  more than 66 percent of those returns were then filed electronically. This  volume makes commercial tax preparation software a critical part of the  tax administration system.
Both taxpayers and the Internal Revenue Service (IRS) benefit from  commercial tax software. Taxpayers use tax software as an alternative to  hiring a paid preparer or manually preparing tax returns on their own.  Taxpayers rely on tax software to answer tax law questions, prepare tax  returns that are accurate, and, in many cases, file those returns  electronically. Taxpayers also expect tax software to ensure the security  and privacy of their tax information. Tax software that does not help  taxpayers prepare accurate returns or that cannot be trusted to file  electronically in a secure and timely manner could contribute to taxpayer  noncompliance, the need for costly IRS enforcement actions, and  taxpayers reverting to error-prone paper filing. It is in IRS’s best interest to  ensure that taxpayers can rely on commercial software to make electronic  filing easy and efficient.
In recent reports, we have assessed the quality of services provided by  paid tax return preparers because of the important role they play in the tax  administration system and recommended that IRS do more to monitor the  accuracy of returns prepared by paid preparers. However, less is known  about the quality of tax software, why some taxpayers decide to use it, and  its impact on electronic filing. Because of this lack of information, and  your interest in making tax administration more effective, you asked us to  study the use and quality of individual tax software.
As requested, our objectives were to assess (1) what is known about how  pricing strategies affect the use of tax software and electronic filing; (2)  the extent to which IRS provides oversight of the tax software industry to  help ensure tax returns are accurate, taxpayer information is secure, and  electronic filing systems are reliable; and (3) what is known about the  risks of the reliance on commercial tax software used by individuals.
To meet our objectives, we:    analyzed prices for the top three tax software companies for both  online and retail/downloaded products for filing seasons 2008 and 2009  and reviewed studies examining the effects of varying pricing  structures;    obtained and analyzed internal revenue manuals, industry standards,  and government guidance and compared them to IRS’s current  procedures;    determined IRS’s legal authority to regulate the accuracy and security  of commercial tax software;    obtained and analyzed IRS security testing reports, certifications, new  security requirements, and data on unauthorized disclosures of  taxpayer information;  reviewed Office of Management and Budget (OMB), GAO, and industry  best practices for assessing risks;    documented the availability of IRS risk assessments and of IRS and  selected tax software companies’ contingency plans and lessons  learned documentation;  reviewed results from a limited number of others’ tests of how  accurately and consistently tax software applied tax laws; and  reviewed the effects of electronic filing disruptions in the United  States, Canada, and Great Britain.
Additionally, for all objectives, we reviewed pertinent reports and  interviewed officials from IRS, the Treasury Inspector General for Tax  Administration (TIGTA), the Electronic Tax Administration and Advisory  Committee, and the IRS Oversight Board. We also interviewed officials  from industry advisory councils and select tax software companies, and  visited a major tax software company’s data center. Our review focused on  tax software designed for individuals who prepare their own returns, not  software used by paid preparers, certified public accountants, attorneys,  or other tax preparers.
We conducted this performance audit from April 2008 through February  2009 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives. See appendix I for more  details on our scope and methodology.
subsections: section_title: Background
paragraphs: While a large number of tax software companies offer return preparation  and electronic filing services, three companies provide the tax software  used by the majority of individuals who prepare and file their returns  electronically (see app. II). One company’s product—Intuit’s TurboTax— represented over half of the returns filed electronically by individual  taxpayers. These and other tax software companies generally offer several  versions of retail, online, and downloadable software packages that  taxpayers can use to prepare federal and state tax returns. They generally  charge less for versions that are designed to handle simple tax returns and  charge more for versions that can prepare more complicated returns such  as those dealing with business expenses. In 2008, the three companies also  employed two basic pricing strategies. One strategy was to charge  separate, incremental fees for federal return preparation, state return  preparation, and electronic filing. For example, in 2008, one company  charged about $40 for federal return preparation, with incremental fees of  about $20 for electronic filing. The other pricing strategy used was to  bundle several services together—typically return preparation and  electronic filing—and charge one price for the bundle.
Tax software is one of the three major methods that taxpayers use to  prepare their returns. As figure 1 illustrates, over 39 million (or 28 percent)  of the approximately 138 million individual income tax returns filed in  2007 were prepared by individuals using tax software. Over 77 million  individuals used a paid preparer to prepare returns electronically in 2007,  and 71 percent of those returns were also submitted electronically to IRS.  The remaining 21 million returns were manually prepared by individuals or  their paid preparers. After preparation, taxpayers can either electronically  file their return or mail a paper copy to IRS. Figure 1 shows that millions  of taxpayers who had a return prepared electronically (either by using tax  software or a paid preparer) filed paper copies. Such returns are called “v- coded” because IRS codes such returns with a “v” to process and track  them separately from other paper-filed returns.
Many of the companies that sell tax software also have partnered with IRS  to provide free electronic preparation and filing to eligible taxpayers.  Those taxpayers have the option of filing their returns for free using  products from the Free File Alliance, LLC (FFA)—a consortium of tax  preparation companies that provides online electronic preparation and  filing to eligible taxpayers at no charge. Figure 1 includes the  approximately 4 million FFA returns filed in 2007 by individuals using  commercial software.
To help improve paper processing, about half of the state revenue  agencies use a bar coding technology to convert data on paper returns to  electronic data. Bar coding is less expensive and more accurate than  processing paper returns because it eliminates manual transcription but is  still more expensive and less efficient than electronic filing. IRS does not  use this technology for processing individuals tax returns.
Returns filed electronically have significant advantages for IRS and  taxpayers compared to paper-filed returns as discussed below and further  detailed in appendix III.
IRS estimates that processing an electronically filed return costs the  agency $0.35 per return while processing a paper return costs $2.87 per  return. Using IRS’s current cost estimates based on fiscal year 2005  return data, we estimate IRS would have saved approximately $143  million if the 56.9 million paper returns in 2007 had been filed  electronically.
Electronically filed returns also have higher accuracy rates than paper- filed returns because tax software eliminates transcription and other  errors.  IRS processes electronically filed returns in less than half the time it  takes to process paper returns, facilitating faster refunds.
We have previously reported that electronically filed returns have the  potential to improve IRS’s enforcement programs. IRS does not use all  tax return information in its automated compliance checking programs  because IRS policy is to post the same information from electronic and  paper returns, and the cost of transcription prevents IRS from  transcribing paper returns in full. IRS officials previously estimated in  2007 that having all tax return information available electronically  would result in a $175 million increase in tax revenue annually from at  least one of its compliance programs.
IRS recently issued the results of the first phase of its Advancing E-file  study, which examines tax filing behavior and characteristics and contains  potential options to increase electronic filing.
We have previously reported that IRS’s ability to achieve efficiencies  depends on its continuing ability to increase electronic filing. We recently  suggested that Congress mandate that paid tax return preparers use  electronic filing and that IRS require software companies to include bar  codes on individual paper returns. IRS agreed to study the latter option.
IRS has responsibility for enforcing tax laws in the Internal Revenue Code  (IRC). In addition, IRC section 6011 provides specific authority for IRS to  prescribe forms and regulations for tax returns, including the information  required on those returns and whether they must be filed electronically.  The IRC imposes civil and criminal penalties on paid tax return preparers,  which include tax software companies, for unauthorized disclosure or use  of a taxpayer’s personal and tax-related information. In addition to tax  law penalties, the providers of services for preparing and filing tax returns  are subject to the privacy and safeguarding rules created under the  Gramm-Leach-Bliley Act (see app. IV).
section_title: IRS Has Little Information about How Tax Software Pricing Strategies Affect Taxpayers’ Willingness to Use Software and File Electronically
paragraphs: For the 2009 tax filing season, the two largest tax software companies that  previously charged separate electronic filing fees for federal returns in  some of their retail and downloadable products have eliminated those  electronic filing fees. Moreover, the three largest companies will bundle  federal tax preparation with electronic filing for all of their products (see  app. II). However, for some products, the companies will still charge  separate, incremental fees for other services such as state return  preparation, state electronic filing, and return review by a tax professional.  According to industry representatives, IRS officials suggested they  eliminate separate federal filing fees to encourage electronic filing.  However, the effect of these changes on electronic filing will not begin to  be known until the end of the present tax filing period and will be difficult  to determine. On one hand, taxpayers who buy a tax software package  that includes a bundle of services may be encouraged to use software and  file electronically because there is no longer a separate charge for doing  so. On the other hand, if the cost of such a package is significantly higher,  it may discourage taxpayers’ use of tax software since they may not be  able to purchase a less expensive package that does not include electronic  filing.
The two largest tax software companies that eliminated federal electronic  filing fees also made some other pricing changes for preparing and  electronically filing both federal and state tax returns in 2009 including:    online tax packages are generally priced lower than in 2008;    online tax packages are generally priced lower than    most retail/downloadable packages remained essentially the same in  price when compared to 2008.
For the third largest tax software company, its package prices for both  online and retail/downloadable products remained the same in 2009 as in  2008 because the preparation and electronic filing fees remained the same  in both years. See appendix II for more details.
Another change in 2009 is that IRS and FFA have agreed to provide a  fillable version of federal tax forms. These fillable tax forms, which  taxpayers can complete online and file electronically, will provide a basic  calculator function but will not provide the question-and-answer format  similar to commercial tax software. The forms will be accessible for free  to all taxpayers via IRS’s Web site and are in addition to FFA’s current free  products for eligible taxpayers described in the background of this report.
As part of the upcoming second phase of its Advancing E-file study, IRS  plans further surveys to obtain taxpayers’ views on electronic filing.  However, it does not plan to include questions, for example, about the  effect of 2009 pricing changes on taxpayers’ willingness to file  electronically. Currently, IRS has little such information. For example, IRS  and the Oversight Board surveys to date have not addressed how a  separate charge for electronic filing affects taxpayers’ willingness to file  electronically.
With the 2009 changes, however, IRS has an opportunity to directly  measure the effect of eliminating separate fees to file federal tax returns  electronically, making changes to software pricing overall, and making  electronic tax forms available so that all taxpayers can complete and file  for free online. We recognize that such a direct study would not be simple  to conduct because, for example, it may be difficult to isolate the effect of  multiple price changes and factors other than price, such as accuracy and  security, which also affect taxpayers’ willingness to file electronically.  Further, prior year data are limited. However, even limited information  about how taxpayers’ electronic filing behavior changes after price  changes would give IRS an empirical basis for supporting the continued  elimination of separate fees for electronic filing and other pricing changes  as well as complementing surveys of taxpayers’ views.
Ideally, to study the effect of pricing on electronic filing rates, IRS would  need to know the software package and version used by each taxpayer in  order to know the approximate price paid. Currently, IRS requires a  software identification number on electronically filed returns, which does  not identify the specific software package or version used to prepare those  returns. IRS does not require any type of software identification number  on v-coded returns (returns prepared using software but filed on paper).  Having a more complete software identification number would not only  allow IRS to better target its research but also its enforcement activities  and efforts to increase use of tax software and electronic filing. Officials  from one software company told us that such a change could be easily  made by their company at a relatively low cost.
section_title: IRS Oversight of the Tax Software Industry Is Not Comprehensive or Systematic
paragraphs: In its Advancing E-file study, IRS reported that one of the most important  factors influencing taxpayers’ use of tax software is its ability to  accurately apply tax laws. IRS requires tax software to pass its  Participants Acceptance Testing System (PATS), which includes verifying  that computations are correct, tax rate schedules are updated, and returns  transmitted electronically are compatible with IRS systems. However,  PATS does not go further in testing to determine, for example, whether the  guidance tax software provides is sufficient in helping taxpayers prepare  accurate tax returns.
IRS developed a National Account Manager (NAM) position in 2000 to  serve as the main communication channel between the tax software  industry and IRS. NAMs communicate in regularly scheduled conference  calls with tax software companies about issues of mutual interest  including tax law changes, updates to IRS forms and publications, and the  upcoming tax filing season. Software companies also contact the NAMs  when they encounter technical issues such as a disruption to electronic  filing. IRS also works with tax software industry groups and advisory  councils, such as the Council for Electronic Revenue Communication  Advancement, on annual updates to tax laws and procedures (see app. V).
IRS monitors acceptance rates for electronically transmitted returns,  including the reasons for rejected returns, throughout the tax filing season  and provides a “report card” to software companies at the end of each  filing season. Rejected returns are sent back to the taxpayer for  correction and resubmission. IRS’s monitoring efforts allow the agency  and software companies to identify and resolve problems with  electronically filed returns.
For example, in 2008, IRS asked tax software companies to hold returns  with the Alternative Minimum Tax until IRS was able to process them.  Through its monitoring efforts, IRS officials identified companies that  were transmitting those types of returns which IRS then rejected. IRS sent  notices to these companies, which reduced the number of rejected  returns.
IRS has worked with the tax software industry on an ad hoc basis to  clarify the guidance provided by tax software. For example, for 2009:  IRS is working with software companies to ensure their packages make  users enter a “yes” or “no” response to questions about having a foreign  bank account and signature authority. Prior to this change, some  companies’ software defaulted to a “no” response.
Another example involving commercial software used by paid preparers  rather than individual taxpayers shows that IRS can work with the  software companies to influence and improve guidance:  IRS’s Earned Income Tax Credit (EITC) office worked with a group of  tax software developers to ensure software used by paid preparers  eliminated default answers where taxpayers’ answers are critical to  return EITC accuracy, and incorporated a “note” capability in the tax  software enabling the preparer to record additional inquiries and  taxpayer responses.
IRS officials, however, acknowledged that these efforts were not the result  of a comprehensive and systematic approach to improving the guidance  provided by software. IRS does not have plans to review tax software to  see if the guidance it provides to taxpayers is sufficient in helping them  prepare accurate returns, in part because IRS relies on the extensive  scenario and other testing done by the industry as discussed in the next  section. As a result, IRS does not know if it is missing opportunities to  improve tax software guidance to better ensure compliance. As an  example of such an opportunity, we recently recommended that IRS  expand outreach efforts to external stakeholders, including software  providers, as part of an effort to reduce common types of misreporting  related to rental real estate. IRS agreed with these and most of the  recommendations in that report and outlined the actions it plans to take to  address those recommendations.
subsections: section_title: Security and Privacy of Taxpayer Information
paragraphs: IRS has provided limited oversight of the software industry’s efforts to  ensure that taxpayer information is secure. Taxpayers who file their  returns on their home computers using online, retail, or downloadable tax  software products are sending their returns to authorized electronic filing  providers. IRS does not have the capability to receive electronic returns  directly from individual taxpayers. Only IRS-authorized electronic filing  providers, including Electronic Return Originators (ERO) and software  companies, among others, can transmit tax returns electronically to IRS.  According to TIGTA, EROs were responsible for the majority of  electronically filed tax returns accepted by IRS in 2007. IRS regulates  authorized electronic filing providers by conducting suitability checks of  applicants during the application screening process, including checks of  the applicants’ criminal backgrounds, credit histories, and tax  compliance. Once approved, authorized electronic filing providers are  subject to IRS monitoring visits, which are conducted to ensure that the  providers are meeting requirements such as ensuring security systems are  in place to prevent unauthorized access to taxpayer data. However, in  2007, TIGTA identified deficiencies in IRS’s monitoring program. For  example, IRS did not suspend electronic filing providers who were in  violation of program requirements even though they had been issued  notifications of suspension. In response, IRS added a new control  procedure, effective January 30, 2008, to better track suspension cases.
IRS has also established security and privacy requirements that apply to  FFA members. For example, according to IRS officials, FFA members  must adhere to the Payment Card Industry (PCI) standards and third-party  security and privacy certifications, and use PCI-approved companies to  conduct penetration and vulnerability testing. IRS has a Memorandum of  Understanding (MOU) with FFA requiring members to provide IRS with  documentation demonstrating compliance with security standards.  However, IRS does not fully monitor compliance with existing FFA  security and privacy requirements. Although IRS receives FFA security  reports, it does not actively review or validate those reports unless a  problem, such as a security incident, is reported.
For 2009, IRS is suggesting that all authorized electronic filing providers  that participate in online filing adhere to new security and privacy  standards, the majority of which are similar to existing FFA requirements;  however, IRS is not requiring compliance with those standards (see app.  VI). These standards are optional in 2009 because IRS finalized them late  in 2008. IRS has no plans to determine if tax software companies that are  authorized electronic filing providers participating in online filing are  adhering to advisory security and privacy standards for the 2009 filing  season. Because the new standards would apply to a relatively few  number of companies and include the three largest, the costs to collect  information on adherence to the standards would be low. For the 2010  filing season, IRS may make those standards mandatory. Also, IRS is  considering expanding these standards to include software companies that  offer retail and downloadable products but has not yet established a time  frame for doing so. IRS officials stated they are considering developing a  plan to monitor compliance with these security and privacy standards for  2010. Without appropriate monitoring, IRS has limited assurance that the  standards have been adequately implemented or software companies are  complying with the standards. As a result, IRS does not know whether the  confidentiality and integrity of the taxpayers’ data are at an increased risk  of being inadequately protected against fraud and identity theft.
section_title: Reliability of Electronic Filing
paragraphs: Tax software companies have been reliable providers of electronic filing  services, with one recent exception which did not have a significant effect  on tax administration. In 2007, customers of some of Intuit’s products  experienced a disruption in their ability to file electronically on tax day.  For approximately 13 hours, taxpayers could not reliably file their returns  electronically through Intuit to IRS. According to IRS, about 171,000 tax  returns were affected. IRS accommodated affected taxpayers by extending  the tax filing deadline and not applying late filing penalties. IRS reported  that the disruption did not delay processing of tax returns, payments to the  government, or refunds to taxpayers because IRS already had a processing  backlog of millions of returns at that time. Intuit agreed to pay any other  penalties that customers incurred and also refunded any electronic filing  fees charged during the disruption.
IRS’s MOU with FFA requires the latter’s members to maintain a continual  level of service throughout the filing season. For example, members are  not permitted to schedule any planned blackouts of service during that  time. However, IRS does not monitor compliance with this requirement  and does not have a similar requirement for non-FFA tax software  companies. Additionally, while IRS’s PATS testing reviews tax software to  ensure that returns transmitted electronically are compatible with IRS  systems before the start of the filing season, it does not do so throughout  the filing season. All industry representatives we spoke with believed that  testing throughout the filing season was important because of the potential  effect of late tax law changes.
section_title: IRS Has Not Assessed the Risks to Tax Administration of the Use of Commercial Tax Software by Individuals
paragraphs: Despite devoting some resources to oversight of the tax software industry,  IRS has not conducted an assessment to understand whether reliance on  commercial tax software poses any significant risks to tax administration.  Broadly defined, risk assessment involves (1) identifying future,  potentially negative outcomes and (2) estimating the likelihood they will  occur. In IRS’s case, those outcomes include the possibility of security  breaches, disruptions in electronic filing, and missed opportunities to  identify and correct compliance problems. While the likelihood of these  outcomes occurring may be low, IRS does not know whether this is the  case.
OMB’s and our guidance suggest that agencies conduct risk assessments  to identify risks that could impede the efficient and effective achievement  of their goals and allow managers to identify the most significant areas in  which to place or enhance internal controls. Moreover, by increasing  awareness of risks, these assessments can generate support for the  policies and controls that are adopted in order to help ensure that these  policies and controls operate as intended. Further, federal law requires  agencies to implement an information security program that includes  periodic assessments of risk.
According to IRS officials, the agency has not conducted a risk assessment  because it does not believe the benefits warrant the cost of such an  assessment. IRS and software industry officials we spoke with believe it is  in the industry’s financial interest to ensure that taxpayers can rely on tax  software. In their annual filing reports, both Intuit and H&R Block  identified financial losses and harm to their reputation as potential risks of  system failures or interruptions. For example, Intuit reported one of the  many risks to its company is that the interruption or failure of its  information and communication systems could cause customers to revert  to paper filings, resulting in reduced company revenues. In addition,  according to IRS officials and tax software industry representatives, the  industry has not yet experienced a significant problem with tax software  or electronic filing. IRS and tax software industry officials further stated  that the industry is better suited to conduct extensive scenario and  security testing because of the significant cost of conducting such testing.  Software industry officials reported spending tens of millions of dollars  each year on testing to ensure accuracy. Further, they reported employing  hundreds of tax analysts to review and simplify IRS instructions,  publications, and forms; monitor proposed changes to tax legislation; and  consult with IRS and state revenue agencies to ensure accurate  interpretations of tax laws. Intuit officials reported complying with  recognized international security standards. Intuit officials also reported  undergoing a biennial third-party security assessment, as well as  proactively conducting ongoing security application assessments and  vulnerability and penetration testing. Industry representatives noted the  current public-private partnership between IRS and the software industry  provides reliable coverage for electronic filing through redundancy in the  market, unlike other countries that offer only a government-sponsored  Internet filing option.
While the above may be true and financial and other incentives may exist,  IRS’s position is not based on an actual, systemic assessment that  identifies potential negative outcomes and the likelihood of their  occurrence. Further, there are several reasons to believe that the benefits  of assessing the risks associated with reliance on commercial tax software  are significant.
As already noted, IRS has said that it is in the agency’s best interest to  ensure that taxpayers can rely on commercial tax software to make  electronic filing accurate, easy, and efficient. Continued growth in  electronic filing depends on increasing use by individual taxpayers and  maintaining their confidence in the accuracy as well as the security and  privacy of their tax information, and the reliability of electronic filing.  However, IRS does not know whether there are security and privacy risks  because it has not monitored existing requirements. While tax software  companies have not reported significant security breaches involving  taxpayer data either residing on their databases or during electronic  transmission to IRS in recent years, cases of lost or stolen data at other  taxing authorities illustrate the potential negative outcomes of such a  breach. For example, in 2007, Oregon’s Department of Revenue  experienced a breach in which electronic files containing confidential  taxpayer information may have been compromised by an ex-employee  downloading a contaminated file.
While tax administration has not been significantly affected by disruptions  to electronic filing, as noted previously, on tax day 2007, about 171,000  Intuit customers experienced a 13-hour disruption. During this time, Intuit  customers could not reliably file their returns electronically with Intuit,  and ultimately to IRS, but this disruption did not significantly affect tax  administration. Additionally, Canada and Great Britain recently  experienced disruptions with their electronic filing systems (see text  box).
If enhancements to tax software could produce even small improvements  in voluntary compliance by taxpayers, the additional dollars of tax revenue  could be substantial. Tens of billions of the $290 billion dollar net tax gap  (after IRS’s collection efforts) are associated with sole proprietors and  individual owners of rental real estate. We have made several recent  recommendations intended to improve the compliance of these taxpayers  by enhancing the clarity of tax software which, as we noted, IRS plans to  address in most cases. However, IRS has not conducted research on the  correlation between tax software and compliance—such as whether and  how tax software packages influence compliance. Such research could be  enhanced even more by the use of a single software identification number,  which would allow IRS to identify the specific software package used by a  taxpayer. Although limited testing of hypothetical scenarios by TIGTA and  the National Taxpayer Advocate led them to identify possible software  weaknesses that might affect compliance, this testing was based on a  nonstatistical sample of scenarios and software packages. Because there  are millions of potential scenarios and each one is different, it is not  possible to generalize from the nonstatistical samples and reach  conclusions about the overall effect of tax software on compliance.  Furthermore, hypothetical scenarios do not provide evidence about how  taxpayers actually use the software or whether taxpayers are actually  complying with tax laws.
IRS is already devoting resources to oversight of the tax software industry,  as described in the previous section. IRS does conduct some testing, has  developed the NAM position to communicate with the software industry,  and tracks some performance. Also, according to IRS officials, in 2010 IRS  plans to devote additional resources to implement new security and  privacy requirements and monitor compliance.
While significant problems have not occurred to date, without performing  a risk assessment—the first step in risk management and mitigation—IRS  does not know the potential magnitude or nature of problems or their  likelihood of occurring. As a result, IRS does not have an informed basis  for making resource allocation decisions, taking steps to mitigate any  significant risks, or avoiding costly risk mitigation in areas where the risks  are low.
section_title: Conclusions
paragraphs: Commercial tax software—which is used by tens of millions of  taxpayers—is a critical part of the tax administration system and a  potential tool for increasing electronic filing. However, IRS does not  identify which software packages taxpayers use or have information on  the correlation between particular packages and compliance. Further, IRS  does not know whether changes to software pricing would be an effective  strategy for increasing electronic filing. Nor does IRS have assurance that  tax software companies are adequately protecting and securing taxpayer  data, another possible influence on taxpayers’ willingness to file  electronically.
Despite its role in influencing electronic filing and the accuracy of tax  returns, IRS has not conducted a risk assessment of taxpayers’ reliance on  tax software. Such an assessment could be done alone or as part of a  broader study that would include paid preparers. Without a risk  assessment, IRS does not know whether its existing investment in  oversight of the tax software industry is too great, about right, or needs to  be expanded.
section_title: Recommendations for Executive Action
paragraphs: To help increase electronic filing and allow IRS to better target its efforts,  we recommend that the Commissioner of Internal Revenue direct the  appropriate officials to take the following six actions:  1.  require tax software companies, as soon as practical, to include a  software identification number that specifically identifies the software  package used to prepare tax returns, which can be used in IRS  research efforts;  2.  ensure that, as part of the second phase of IRS’s Advancing E-file  Study, surveys ask taxpayers the effect of tax software pricing changes  and the opportunity to file for free using online tax forms on IRS’s Web  site on their decision to either file or not file tax returns electronically;  3.  to the extent possible, study the effect of the 2009 pricing changes and  the opportunity to file for free using online tax forms on IRS’s Web site  on taxpayers’ use of tax software and electronic filing rates;  4.  determine if tax software companies that are authorized to participate  in online filing are adhering to advisory security and privacy standards  for the 2009 filing season;  5.  develop and implement a plan for effectively monitoring compliance  with recommended security and privacy standards for the 2010 filing  season; and  6.  assess the extent to which the reliance on tax software creates  significant risks to tax administration, particularly in the areas of tax  return accuracy, the security and privacy of taxpayer information, and  the reliability of electronic filing.
section_title: Agency Comments
paragraphs: The Deputy Commissioner of Internal Revenue provided written  comments in a February 19, 2009 letter in which she agreed with all our  recommendations and outlined IRS’s actions to address those  recommendations (see app. VII). With respect to requiring tax software  companies to identify the software package used, IRS plans to require an  identification number on paper tax returns created using software.   Related to ensuring that Advancing E-file surveys ask taxpayers about the  effect of tax software pricing changes, IRS reported those surveys had  already been finalized. In its place, IRS will be analyzing monetary  disincentives associated with taxpayers’ choice of filing method and plans  to study the effect of the pricing changes on taxpayer electronic filing  decisions.  With respect to ensuring authorized electronic filing providers  adhere to the advisory security and privacy standards for the 2009 filing  season, IRS reported it plans to sample and observe online providers’ Web  sites to determine compliance.  If IRS decides to make the standards  mandatory, the agency will develop a monitoring and enforcement plan.   Finally, to assess risks related to the reliance on tax software, IRS plans to  summarize whether and the extent to which the agency is authorized to be  involved in aspects of the software industry, including what additional  authority it would need to impose changes and sanctions.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of the report until 30 days after its  date. At that time, we will send copies of this report to the Secretary of the  Treasury; the Commissioner of Internal Revenue; the Director, Office of  Management and Budget; relevant congressional committees; and other  interested parties. This report is available at no charge on GAO’s Web site  at http://www.gao.gov.
For further information regarding this report, please contact James R.  White, Director, Strategic Issues, at (202) 512-9110 or whitej@gao.gov or  Gregory C. Wilshusen, Director, Information Security Issues, at (202) 512- 6244 or wilshuseng@gao.gov. Contacts for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  Individuals making key contributions to this report can be found in  appendix VIII.
section_title: Appendix I: Scope and Methodology
paragraphs: To determine what is known about how pricing strategies affect the use of  tax software and electronic filing, we obtained and analyzed the prices for  the top three tax software companies for both online and retail or  downloaded products for filing seasons 2008 and 2009. These costs did not  include any rebates or promotional prices. We limited our data analysis to  the top three software companies because they account for 88 percent of  all returns filed electronically by individuals and accepted by the Internal  Revenue Service (IRS). We also reviewed literature concerning the  economics of information goods, including software pricing.
Further, we obtained and analyzed findings from IRS’s Taxpayer  Satisfaction Studies and reviewed the IRS Oversight Board’s November  2006 Taxpayer Customer Service and Channel Preference Survey to  determine why federal taxpayers do not file returns electronically.
To determine the extent to which IRS provides oversight of the tax  software industry to help ensure tax returns are accurate, we reviewed  and summarized IRS’s legal authority to regulate the accuracy and security  of commercial tax software. We also obtained and analyzed internal  revenue manuals, industry standards, and government guidance and  compared them to IRS’s current procedures. We reviewed the Free File  Alliance, LLC (FFA) Memorandum of Agreement (MOU) outlining IRS and  FFA’s agreements to provide free income tax software to individuals.
To determine the extent to which IRS provides oversight of the tax  software industry to help ensure that taxpayer information is secure, we  interviewed IRS and FFA officials. In addition, we obtained and analyzed  IRS’s new electronic filing security and privacy standards, comparing them  to industry standards. We also reviewed the FFA MOU to assess the extent  to which security and privacy requirements were already in place for FFA  members.
To determine the extent to which IRS helps ensure electronic filing  systems are reliable, we reviewed IRS requirements for electronic return  originators, the FFA MOU, and documents and literature describing a  significant disruption in electronic filing at Intuit. We also reviewed  documents and interviewed Intuit officials to determine the extent of the  disruption and corroborated the information they provided during  interviews with IRS officials to determine the effect the disruption had on  taxpayers and the agency.
To determine what is known about the risks of the reliance on commercial  tax software used by individuals, we reviewed Office of Management and  Budget (OMB) and GAO guidance, including the criteria for assessing risk  at an agency as well as industry best practices for risk assessments and  internal controls; and interviewed IRS officials to determine what risk  assessments IRS had in place. We also reviewed selected tax software  companies’ filing statements with the Securities and Exchange  Commission to determine if they identified any risks. We also interviewed  IRS and software industry officials to determine what steps they took to  identify and address risks.
We reviewed the Treasury Inspector General for Tax Administration’s  (TIGTA) and National Taxpayer Advocate’s (NTA) reports detailing their  respective tests of how accurately and consistently tax software applied  tax laws. Because the various tax software tests we reviewed were limited  to a subset of tax software packages and used a nonstatistical sample of  tax scenarios, their results were not generalizable to all types of taxpayers,  tax filing situations, tax laws, or the entire tax software industry. We also  reviewed literature on the effect of significant electronic filing disruptions  in tax software systems in selected other countries. We selected Canada  and Great Britain because these were the examples that IRS provided on  electronic filing disruptions in other countries.
For background purposes, we also used IRS data to compare the cost of  processing returns, and obtained and analyzed math error authority data,  reject errors, and processing times across the different tax return filing  methods.
Additionally, for all objectives, we reviewed reports and interviewed  officials including those from IRS, NTA, TIGTA, FFA, the Electronic Tax  Administration and Advisory Committee, the Federation of Tax  Administrators and the IRS Oversight Board. We also interviewed officials  from select industry groups such as the Council for Electronic Revenue  Communication Advancement, the National Association of Computerized  Tax Processors, and selected tax software companies. We visited a major  tax software provider’s data center. Our work was done primarily at IRS  Headquarters in Washington, D.C. and its division offices in New  Carrollton, Maryland, and Atlanta, Georgia.
We conducted this performance audit from April 2008 through February  2009 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Tax Software Markets and 2008 and 2009 Pricing of Tax Software for Return Preparation and Electronic Filing
paragraphs: While a large number of companies offered tax preparation services in  2008, the top three tax software companies electronically filed 88 percent  of returns prepared by individual taxpayers (as opposed to the returns  prepared and electronically filed by paid preparers). Each of the  companies outside the top three held less than 3 percent of the tax  software market as measured by the number of electronically filed  returns. However, tax software companies also compete with the paid  preparer industry as well as manual preparation.
Based on a review of pricing literature for software companies, tax  software companies, like other software and information technology  companies, have low marginal costs and high fixed costs for product  development. In such markets, if the price charged to taxpayers is equal  to the marginal cost, companies will not be able to cover their average cost  of production and cannot stay in business. Therefore, companies in these  markets will attempt to recover more of their fixed costs through various  forms of price discrimination. Price discrimination can take the form of  developing different versions of the product to match the needs of  different types of consumers, who are then charged different prices  according to their willingness to pay.
The literature also suggests that companies in these markets may offer  products that consist of several services bundled together— sometimes  charging separate prices for each service or charging a single price for  different combinations (bundles) of services. The bundling strategy is  thought to potentially increase a company’s revenue by attracting  consumers who may value particular elements of the bundled product.  Tax software companies bundle some or all of the following services or  features: federal tax preparation, state tax preparation, electronic filing for  federal and state returns, help services and technical support, return  printing services, storage of information from prior returns, links to  outside providers of relevant information (W-2s), and built-in accuracy  checks.
Some tax software companies offer only online services to taxpayers,  while others offer the option of downloading the program to a home  computer or purchasing software from a retail location. The pricing  structure may vary depending on whether a taxpayer prepares a return  online or purchases a retail or downloadable program (see tables 1 and 2).  In 2008, the largest companies offering online preparation products for  federal returns usually bundled electronic filing with federal return  preparation. However, if the program was downloaded or purchased at a  retail location, electronic filing often involved a separate charge.
For the 2009 tax filing season, the two largest tax software companies that  previously charged separate electronic filing fees for federal returns for  some of their products have eliminated those electronic filing fees. The  three largest companies will bundle federal tax preparation with electronic  filing for all of their products. For some products, the companies will still  charge separate, incremental fees for other services such as preparation  and electronic filing for state returns, as well as return review. The two  largest tax software companies that eliminated federal electronic filing  fees also made some other pricing changes for preparing and  electronically filing both a federal and state tax return in 2009 including:    online tax packages are generally priced lower than 2008;    online tax packages are generally priced lower than    most retail/downloadable packages remained essentially the same in  price when compared to 2008.
For the third largest tax software company, its package prices for both  online and retail/downloadable products remained the same in 2009 as in  2008 because the preparation and electronic filing fees remained the same  in both years.
The effect of these pricing changes on electronic filing will not begin to be  known until the end of the present tax filing period and will be difficult to  determine. On one hand, taxpayers who buy a tax software package that  includes a bundle of services may be encouraged to use software and file  electronically because there is no longer a separate charge for doing so.  On the other hand, if the cost of such a package is significantly higher, it  may discourage taxpayers’ use of tax software since they may not be able  to purchase a less expensive package that does not include electronic  filing.
section_title: Appendix III: Advantages and Disadvantages of Alternative Tax Preparation and Filing Methods
paragraphs: Taxpayers can experience many advantages and disadvantages based on  the various methods for preparing and filing federal tax returns. Taxpayers  preparing and filing their returns electronically may receive advantages  such as reduced time spent on preparing the return and receiving faster  refunds. On the other hand, taxpayers who prepare their returns manually  may experience disadvantages such as increased transcription errors and  slower refunds. Table 3 shows details of the advantages and disadvantages  of the different preparation and filing methods.
section_title: Appendix IV: Laws Applicable to Tax Service Companies
paragraphs: In the Internal Revenue Service Restructuring and Reform Act of 1998,  Congress instructed the agency to establish a goal of having 80 percent of  all individual income tax returns filed electronically by 2007. While the  Internal Revenue Service (IRS) has no legal authority to generally oversee  the operations of tax software companies, IRS does have the authority to  prescribe the forms and regulations for the making of returns, including  the information contained therein and whether forms must be filed  electronically. Accordingly, IRS has an interest in ensuring that tax  software providers comply with tax laws and security and privacy laws so  that taxpayers have confidence in these services and file their tax returns  electronically.
Under section 6103 of the Internal Revenue Code (IRC), IRS is responsible  for safeguarding taxpayer data while in IRS’s control. Section 6103  nondisclosure requirements only apply to IRS and not to private entities  that prepare and send tax data to IRS. However, private entities are  subject to safeguarding and privacy rules with regard to taxpayer  information and can be penalized for improper use and disclosure.
The Gramm-Leach-Bliley (GLB) Act requires financial institutions to  protect consumers’ personal financial information held by these  institutions—including return preparers, data processors, transmitters,  affiliates, service providers, and others who are paid to provide services  involving preparation and filing of tax returns. For companies in the tax  business, the GLB Act delegated rulemaking and enforcement authority to  the Federal Trade Commission (FTC). Complying with the GLB Act  generally means complying with FTC’s Financial Privacy and Safeguards  Rules. The Financial Privacy Rule requires financial institutions to give  their customers privacy notices that explain the financial institution’s  information collection and sharing practices; the Safeguards Rule requires  financial institutions to have a security plan to protect the confidentiality  and integrity of personal consumer information.
Additionally, paid tax return preparers are subject to both civil and  criminal penalties for unauthorized disclosure or use of a taxpayer’s  confidential information. Tax return preparers include persons who  develop tax software that is used to prepare or file a tax return, as well as  any authorized IRS electronic filing provider. Tax return preparers who  knowingly or recklessly disclose or use tax return information for a  purpose other than preparing a tax return are guilty of a misdemeanor  with a maximum penalty of up to 1 year’s imprisonment or a fine of not  more than $1,000, or both. Any unauthorized disclosure or use by a tax  return preparer not acting in bad faith still subjects that preparer to a civil  penalty of $250 for each disclosure, not to exceed $10,000 for the year. A  summary of the federal laws protecting taxpayer information are listed in  table 4.
section_title: Appendix V: Tax Software Industry Groups and Advisory Councils
paragraphs: In an effort to provide more effective tax administration, Internal Revenue  Service (IRS) disseminates information and obtains technical perspectives  and advice through industry and advisory councils. As shown in table 5,  membership in many of these groups, with whom we consulted, is  balanced to include representatives from tax practitioners and  preparers, transmitters of electronic returns, tax software developers,  large and small businesses, employers and payroll service providers,  individual taxpayers, financial industry, academic, trusts and estates, tax  exempt organizations, and state and local governments.
section_title: Appendix VI: Proposed Security and Privacy Requirements
paragraphs: For 2009, the Internal Revenue Service (IRS) has developed six new  optional security and privacy standards which are intended to better  protect taxpayer information collected, processed, and stored by online  authorized electronic filing transmitters, as shown in table 6. These new  standards are based on industry best practices and are intended to  supplement the Gramm-Leach-Bliley Act and the implementing rules and  regulations promulgated by the Federal Trade Commission.
section_title: Appendix VII: Comments from the Department of Treasury
section_title: Appendix VIII: GAO Contacts and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contacts named above, Joanna Stamatiades, Assistant  Director; Amy Bowser; Debra Conner; Vanessa Dillard; Michele Fejfar;  Jyoti Gupta; Jeffrey Knott; Ed Nannenhorn; Madhav Panwar; Joseph Price;  and Robyn Trotter made key contributions to this report.