Tax Administration: Many Taxpayers Rely on Tax Software and IRS Needs to Assess Associated Risks
Released: 2009-04-02T00:00:00

Letter

Background

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).

IRS Has Little Information about How Tax Software Pricing Strategies Affect Taxpayers’ Willingness to Use Software and File Electronically

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.

IRS Oversight of the Tax Software Industry Is Not Comprehensive or Systematic

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.

Security and Privacy of Taxpayer Information

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.

Reliability of Electronic Filing

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.

IRS Has Not Assessed the Risks to Tax Administration of the Use of Commercial Tax Software by Individuals

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.

Conclusions

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.

Recommendations for Executive Action

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.

Agency Comments

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.

Appendix I: Scope and Methodology

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.

Appendix II: Tax Software Markets and 2008 and 2009 Pricing of Tax Software for Return Preparation and Electronic Filing

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.

Appendix III: Advantages and Disadvantages of Alternative Tax Preparation and Filing Methods

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.

Appendix IV: Laws Applicable to Tax Service Companies

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.

Appendix V: Tax Software Industry Groups and Advisory Councils

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.

Appendix VI: Proposed Security and Privacy Requirements

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.

Appendix VII: Comments from the Department of Treasury

Appendix VIII: GAO Contacts and Staff Acknowledgments

Acknowledgments

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.